GOLDEN ENTERTAINMENT, INC. - Annual Report: 2011 (Form 10-K)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission File No. 0-24993

LAKES ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

 

 

130 Cheshire Lane, Suite 101, Minnetonka, Minnesota 55305
(Address of principal executive offices)

 

(952) 449-9092

 

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None.

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

As of March 24, 2011, 26,405,679 shares of the Registrant’s Common Stock were outstanding. Based upon the last sale price of the Common Stock as reported on the NASDAQ Global Market on July 4, 2010 (the last business day of the Registrant’s most recently completed second quarter), the aggregate market value of the Common Stock held by non-affiliates of the Registrant as of such date was $26.8 million. For purposes of these computations, affiliates of the Registrant are deemed only to be the Registrant’s executive officers and directors.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive Proxy Statement for its 2011 Annual Meeting of Shareholders to be filed with the Commission within 120 days after the close of the Registrant’s fiscal year are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

Private Securities Litigation Reform Act

 

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. Certain information included in this Annual Report on Form 10-K and other materials filed or to be filed by Lakes with the United States Securities and Exchange Commission (“SEC”) as well as information included in oral statements or other written statements made or to be made by Lakes contain statements that are forward-looking, such as plans for future expansion and other business development activities as well as other statements regarding capital spending, financing sources and the effects of regulation (including gaming and tax regulation) and competition.

 

Such forward looking information involves important risks and uncertainties that could significantly affect the anticipated results in the future and, accordingly, actual results may differ materially from those expressed in any forward-looking statements made by or on behalf of Lakes.

 

These risks and uncertainties include, but are not limited to, need for potential future financing to meet Lakes’ development needs; those relating to the inability to complete or possible delays in completion of Lakes’ casino projects, including various regulatory approvals and numerous other conditions which must be satisfied before completion of these projects; possible termination or adverse modification of management or development contracts; Lakes operates in a highly competitive industry; possible changes in regulations; reliance on continued positive relationships with Indian tribes and repayment of amounts owed to Lakes by Indian tribes; possible need for future financing to meet Lakes’ expansion goals; risks of entry into new businesses, and reliance on Lakes’ management. For more information, review Lakes’ filings with the Securities and Exchange Commission. For further information regarding the risks and uncertainties, see the “Risk Factors” section in Item 1A of this Annual Report on Form 10-K.

 

PART I

 

 

Business Overview

 

Lakes Entertainment, Inc., a Minnesota corporation (“Lakes”, “we”, or “our”), develops, finances and manages casino properties, with a historical emphasis on those that are Indian-owned. We currently have development and management or financing agreements with three separate tribes for casino operations in Michigan and California for a total of three separate casino projects. We are currently managing the Four Winds Casino Resort in Michigan for the Pokagon Band of Potawatomi Indians (the “Pokagon Band”) and the Red Hawk Casino in California for the Shingle Springs Band of Miwok Indians (the “Shingle Springs Tribe”). The remaining California project is in the development stage, as discussed in more detail below. We are also involved in other business activities, including the potential development of non-Indian casinos and the development of new table games for licensing to both Tribal and non-Tribal casinos. See Note 18 to our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K for information on our segments.

 

Indian Casino Business.  Lakes’ primary business historically has been to develop and manage Indian-owned casino properties that offer the opportunity for long-term development of related entertainment facilities, including hotels, golf courses, theaters, recreational vehicle parks and other complementary amenities.

 

Lakes developed, and has a five-year contract to manage, the Four Winds Casino Resort for the Pokagon Band in New Buffalo Township, Michigan near Interstate 94. Lakes began managing the Four Winds Casino Resort when it opened to the public on August 2, 2007. The Four Winds Casino Resort is located near the first Interstate 94 exit in southwestern Michigan and approximately 75 miles east of Chicago. The facility features approximately 3,000 slot machines, 64 table games, a 12-table poker room, a 165-room hotel, five restaurants, three bars, a child care facility and arcade, retail space and a parking garage.

 

Lakes also developed, and has a seven-year contract to manage, the Red Hawk Casino that was built on the Rancheria of the Shingle Springs Tribe in El Dorado County, California, adjacent to U.S. Highway 50, approximately 30 miles east of Sacramento, California. Lakes began managing the Red Hawk Casino when it opened to the

public on December 17, 2008. The Red Hawk Casino features approximately 2,150 slot machines and gaming devices, 68 table games, seven poker tables, five restaurants, four bars, retail space, a parking garage, a child care facility and arcade. There is a dedicated interchange on US Highway 50 to provide direct freeway access to the Red Hawk Casino.

 

Lakes has also entered into contracts to develop and finance a casino to be built on the reservation of the Jamul Indian Village (the “Jamul Tribe”) located on State Highway 94, approximately 20 miles east of San Diego, California (the “Jamul Casino”). The Jamul Casino project has been delayed due to various political and regulatory issues related to access from State Highway 94 to the proposed casino site.

 

Non-Indian Casino Business.  Lakes also explores opportunities to develop and operate casinos that are not owned by Indian tribes.

 

In October 2009, Lakes entered into an agreement with Penn Ventures, LLC (“Penn”) for the purpose of funding a percentage of costs associated with the referendum to amend the Ohio constitution to authorize casino gaming in Ohio. On July 13, 2010, Lakes entered into a Termination Agreement with Penn whereby, in consideration of the parties terminating the agreement entered into during October 2009, Penn agreed to pay Lakes $25 million. Accordingly, Lakes no longer has any rights, obligations or interest in the entity that was to be formed in collaboration with Penn Ventures for the development of casinos in Toledo and Columbus, Ohio.

 

In October 2009, Lakes entered into a separate agreement with Rock Ohio Ventures, LLC (“Rock Ohio Ventures”) also for the purpose of funding a percentage of costs associated with the referendum to amend the Ohio constitution to authorize casino gaming in Ohio. As of January 2, 2011, Lakes has contributed approximately $2.4 million to Rock Ohio Ventures related to this referendum effort. During 2011, Lakes has contributed additional capital of approximately $6.0 million. Lakes expects to contribute additional capital to Rock Ohio Ventures for the development of casinos in Cleveland and Cincinnati.

 

We have received various regulatory approvals to develop a casino on approximately 400 acres near Vicksburg, Mississippi. However, uncertainty exists surrounding the development of this project due primarily to changes in the economic environment and credit markets. As a result, the assets associated with the Vicksburg project are recorded at their estimated fair value of $3.3 million.

 

Table Games.  A division of Lakes develops, buys, patents and licenses rights for new table game concepts to market/distribute and license to casinos. We continue to test and market a number of games including “World Poker Tour All In Hold’Em^tm,” “Four The Money,” and “Bonus Craps.” The “World Poker Tour All In Hold’Em^tm” and “Bonus Craps” games are currently operating in several casinos across the United States. The revenues from this division are currently not significant and we are evaluating whether to continue with the business.

 

Real Estate Holdings.  Lakes owns parcels of undeveloped land in California related to its Indian casino project with the Jamul Tribe, in Mississippi related to a potential casino project, and undeveloped land in Oklahoma related to its previous involvement in a potential casino project with the Iowa Tribe of Oklahoma. Lakes also owns an office building and related land in Minnesota related to its corporate offices.

 

History

 

Lakes is a Minnesota corporation formed in 1998 under the name of GCI Lakes, Inc, which was changed to Lakes Gaming, Inc. in August 1998 and to Lakes Entertainment, Inc. in 2002. Lakes is the successor to the Indian gaming business of Grand Casinos, Inc. (“Grand Casinos”) and became a public company through a spin-off transaction in which shares of Lakes common stock were distributed to the shareholders of Grand Casinos. Before the spin-off, Grand Casinos had management contracts for Grand Casino Hinckley and Grand Casino Mille Lacs, both Indian-owned casinos in Minnesota. Those contracts ended before the spin-off. After the spin-off, Lakes managed two Indian-owned casinos in Louisiana previously managed by Grand Casinos. Lakes managed the largest casino resort in Louisiana, Grand Casino Coushatta, until the management contract expired in 2002. Lakes also had a management contract for Grand Casino Avoyelles, which was terminated through an early buy out of the contract effective in 2000. Lakes had a management contract for the Cimarron Casino in Oklahoma from 2006 through May 2010. Lakes began managing the Four Winds Casino Resort in 2007 and the Red Hawk Casino in 2008.

Indian Casino Business

 

Development and Management of Four Winds Casino Resort.  On August 2, 2007, the Four Winds Casino Resort opened to the public. The Four Winds Casino Resort was developed on approximately 675 acres of land, which is held in trust by the United States for the benefit of the Pokagon Band in New Buffalo Township, Michigan, near the first Interstate 94 exit in southwestern Michigan and approximately 75 miles east of Chicago. The facility features approximately 3,000 slot machines, 64 table games, a 12-table poker room, a 165-room hotel, five restaurants, three bars, a child care facility and arcade, retail space and a parking garage.

 

In 1999, Lakes and the Pokagon Band executed a development agreement and management contract governing their relationship during the development, construction and management of the casino. The terms set forth in the development agreement required Lakes to advance approximately $71.2 million for the purchase of land and for the initial development phase of the project. In March 2006, Lakes received notification from the National Indian Gaming Commission (“NIGC”) that it had approved Lakes’ management agreement with the Pokagon Band to develop and manage the Four Winds Casino Resort. On June 22, 2006 the Pokagon Band closed on a $305 million senior note financing agreement and a $75 million commitment for furniture, furnishings and equipment to fund the Four Winds Casino Resort project.

 

On March 2, 2007 (the “Settlement Date”), Lakes contracted with a group of investors for their participation in the loans made by Lakes to the Pokagon Band for the development of the Four Winds Casino Resort, which loans have been assumed by the Pokagon Gaming Authority. As of the Settlement Date, the face value of Lakes’ notes receivable was approximately $104.2 million, including accrued interest of approximately $33.0 million. On the Settlement Date, Lakes transferred 100% of the participation in the Pokagon Gaming Authority loans to the aforementioned group of investors for cash proceeds of approximately $102.1 million, which was based upon the accreted value of the Pokagon Gaming Authority loans less a two percent discount. Lakes incurred transaction fees of approximately $1.1 million, which were recorded as a reduction of net realized and unrealized gains on notes receivable in the consolidated statements of earnings (loss) and comprehensive earnings (loss). Accordingly, based upon the previously recorded estimated fair value of the notes at December 31, 2006, Lakes realized a gain of $0.5 million as a result of the consummation of the participation agreement. This participation was accounted for as a sale and does not have any effect on Lakes’ related management agreement with the Pokagon Band. Lakes has no continuing rights or obligations related to the loans and is isolated, even in default, from liability.

 

The management contract is for five years from the date the casino opened and calls for Lakes to receive a management fee equal to 24% of net income up to a certain threshold and 19% on net income over that threshold. Lakes’ management fee is subordinated to the $305 million senior note financing agreement and the $75 million furniture, furnishing, and equipment financing agreement relating to the Four Winds Casino Resort and is also subject to a minimum guaranteed monthly payment to the Pokagon Band. Generally, the order of priority of payments from the Four Winds Casino Resort’s cash flows is as follows: a certain minimum monthly guaranteed payment to the Pokagon Band, repayment of various debt with interest accrued thereon, management fee to Lakes, and other obligations, with the remaining funds distributed to the Pokagon Band. The Pokagon Band may buy out the Lakes management contract for a fee calculated by multiplying the previous twelve months of management fees earned by the remaining number of years under the management contract, discounted back to the present value at the time the buy-out occurs. If the Pokagon Band elects to buy out the contract, any outstanding amounts owed to Lakes would become immediately due and payable.

 

Development and Management of the Red Hawk Casino.  On December 17, 2008 the Red Hawk Casino opened to the public. The Red Hawk Casino is approximately 30 miles east of Sacramento, adjacent to U.S. Highway 50 and has direct freeway access from a dedicated inter-change. The Red Hawk Casino includes approximately 88,000 square feet of casino space and features approximately 2,150 slot machines and gaming devices, 68 table games, seven poker tables, five restaurants, four bars, retail space, a parking garage, a child care facility and arcade.

 

On September 30, 2008, the California State legislature ratified an amended compact between the Shingle Springs Tribe and the State of California, and on November 28, 2008, the amended compact was approved by the Bureau of Indian Affairs (“BIA”). The amended compact runs through 2029 and allows for a maximum of 5,000 class III slot machines at one gaming facility. The amended compact requires the Shingle Springs Tribe to share

revenues with California based on a sliding scale percentage of net win ranging from 20% to 25% from the operation of the slot machines. The Shingle Springs Tribe also contributes $4.6 million per year to the Revenue Sharing Trust Fund, which pays up to $1.1 million each year to each of the non-gaming tribes in California. The amended compact also allows for the Shingle Springs Tribe to deduct up to $5.2 million annually for 20 years from the payments made to the State of California from the operation of slot machines.

 

During July 2004, the NIGC approved the development and management contracts between the Shingle Springs Tribe and Lakes, permitting Lakes to manage a Class II and Class III casino on the Shingle Springs rancheria. On June 28, 2007, an affiliate of the Shingle Springs Tribe closed on a $450 million senior note financing to fund the construction of the Red Hawk Casino and a dedicated interchange off U.S. Highway 50 to provide direct access to the Shingle Springs Rancheria and the Red Hawk Casino. On September 30, 2008, an affiliate of the Shingle Springs Tribe closed on a $77 million furniture, furnishings and equipment financing for the Red Hawk Casino. The proceeds from the financing arrangement were primarily used to purchase the various components of furniture, furnishings and equipment necessary to furnish the Red Hawk Casino project. Under the development agreement, as amended, Lakes made pre-construction advances to the Shingle Springs Tribe in the form of a transition loan of $49.5 million. In addition, Lakes made advances of $8.8 million associated with land purchases. The land loan was repaid to Lakes, including accrued interest, on June 28, 2007 in connection with the close of the $450 million senior note financing. Advances on the transition loan of $66.7 million remained outstanding as of January 2, 2011.

 

The amended development agreement provided for Lakes to assist in the design, development and construction of the facility as well as manage the pre-opening, opening and continued operations of the Red Hawk Casino and related amenities for a period of seven years from the opening date. As compensation for our management services, we earn a management fee equal to 30% of net income (as defined by the management contract) of the operations annually for the first five years, with a declining percentage in years six and seven. Payment of our management fee is subordinated to the repayment of $450 million senior note financing of an affiliate of the Shingle Springs Tribe, the repayment of $46.1 million furniture, furnishings and equipment financing outstanding as of January 2, 2011 and a minimum priority payment to the Shingle Springs Tribe.

 

The opening of the Red Hawk Casino triggered the repayment terms of the notes receivable which are scheduled to be repaid over the original seven-year term at the stated interest rate of Prime plus 2% (5.25% as of January 2, 2011). If, however, net revenues (as defined in the management and development agreement) from the project are insufficient, payments are deferred. The order of priority of payments from the Red Hawk Casino’s cash flows has been as follows: a certain minimum monthly guaranteed payment to the Shingle Springs Tribe, various debt with interest accrued thereon (including Lakes’ pre-construction advances), management fee due to Lakes, and other obligations, if any, and the remaining funds, if any, distributed to the Shingle Springs Tribe. In order to assist the Red Hawk Casino in increasing cash levels, Lakes will defer allowed payments of principal on the preconstruction advances, if any, beginning in March 2011 until December 2013. These deferrals, if any, do not constitute forgiveness of contractual principal amounts due to Lakes.

 

At January 2, 2011, Lakes evaluated the notes receivable from the Shingle Springs Tribe for impairment and concluded that it was probable that substantial amounts due would not be repaid within the contract term and therefore determined that the notes receivable were impaired. This determination was based on the lack of previously expected improvements in operating results due to the continued significant economic pressures in the northern California market and increased competition from a neighboring casino expansion in the market the property serves, all of which have negatively impacted cash flows for the property, as well as the deferral of all principal payments during the fourth quarter of fiscal 2010 due to insufficient net revenues from which to make these payments. Prior to the fourth quarter of fiscal 2010, Lakes had not experienced a three-month period in which all principal payments were deferred. As of January 2, 2011, an allowance of $21.0 million was established through an impairment charge on the notes receivable and is included in the consolidated statement of earnings for fiscal 2010. In addition, due to the carrying amount of the intangibles associated with the Shingle Springs Tribe exceeding the expected future cash flows to Lakes from the Red Hawk Casino during the term of the management agreement, impairment losses of $16.7 million were recognized during fiscal 2010.

 

Although Lakes has concluded that it is probable that substantial amounts due from the Shingle Springs Tribe will not be repaid within the contract term, the Shingle Springs Tribe will remain legally obligated to repay any remaining amounts due to Lakes subsequent to the conclusion of the contract.

Development and Financing of the Jamul Casino.  Lakes acquired its initial interest in the development agreement and management contract for the Jamul Casino from Kean Argovitz Resorts in 1999 and formed a joint venture in which the contract was held between Lakes and Kean Argovitz Resorts — Jamul, LLC (“KAR — Jamul”). This development agreement and management contract have been submitted to the NIGC for approval. On January 30, 2003, Lakes purchased the remaining KAR — Jamul’s partnership interest in the joint venture. In connection with the purchase transaction, Lakes entered into separate agreements with the two individual owners of KAR — Jamul. See Note 17 to our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. Effective March 30, 2006, we entered into a development financing and services agreement with the Jamul Tribe to assist the Jamul Tribe in developing the Jamul Casino which the Jamul Tribe will manage.

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues, including those related to access from State Highway 94 to the proposed casino site. In addition, the California Department of Transportation (“CalTrans”) issued a letter in 2008 to the Jamul Tribe indicating that it would not allow access to a casino operation from State Highway 94. In January 2011, the Jamul Tribe and CalTrans entered into an agreement which will permit CalTrans to review and process the Jamul Tribe’s encroachment permit application relating to the access, and provided that if the Jamul Tribe’s application meets certain legal requirements, CalTrans will issue the encroachment permit. The Jamul Tribe is currently performing various environmental and traffic studies necessary for the permit application.

 

Lakes believes that the Jamul Tribe will ultimately resolve the access issues, but based on the difficulty of obtaining approvals of this nature, Lakes believes that a near-term resolution of the access issue is not probable. In addition, the local opposition to this project has not been resolved and Lakes’ current expectation is that issues associated with this opposition could cause further delays, even if resolution of access issues is achieved. These factors, in combination with the current general economic environment and probable difficulty of financing projects of this nature at desirable rates, have caused Lakes to adjust the projected opening date of this project to January 2016, without adjusting its estimated 50% probability of opening.

 

Significant risk exists related to the Jamul Casino moving forward to completion, and we have recorded significant impairment charges against our investment in this project. However, the Jamul Tribe has the two basic requirements to eventually build a successful project — federal recognition as an Indian Tribe and Indian land eligible for gaming, and Lakes currently expects to continue its involvement with this project.

 

The casino resort is to be located on State Highway 94, approximately 20 miles east of downtown San Diego. Current plans for the casino include approximately 1,000 electronic gaming devices and approximately 20 table games along with various restaurants and related amenities. Under our current development financing and services agreement, we are entitled to receive a flat fee for our development design services, and a flat fee for our construction oversight services, payable evenly over the first five years after the opening date of the Jamul Casino. As part of the current agreement, we will use our best efforts to obtain financing from which advances will be made to the Jamul Tribe to pay for the design and construction of the Jamul Casino. In connection with our financing of the Jamul Casino, the Jamul Tribe will pay interest over a ten-year period on sums advanced by us equal to the rate charged to us for obtaining the necessary funds plus five percent. Amounts previously advanced by Lakes to the Jamul Tribe in connection with the Jamul Tribe’s proposed casino resort are included in the development financing and services agreement financing amount. This agreement is planned to be modified as the political, regulatory and access issues move closer to resolution. Third party financing may not be available with acceptable terms, and if we are unable to obtain the appropriate amount of financing for this project, the project may not be completed as planned.

 

Under the current compact that the Jamul Tribe has with the State and based upon requirements in other compacts approved by the State in 2004, the Jamul Tribe completed a Tribal Environmental Impact Statement/Report that was approved by the Jamul Tribe’s General Council with a record of decision issued by the Jamul Tribe on December 16, 2006. Since that time, the Jamul Tribe has received comments from various state agencies including the representative from the California Governor’s office. The Jamul Tribe and the State have met on several occasions in an attempt to address the State’s comments related to compact requirements. Lakes and the Jamul Tribe have continued to evaluate the Jamul Tribe’s alternatives of pursuing a new compact, complying with certain requirements in their existing compact or building and operating a casino based solely on class II electronic

gaming devices. The current plan is for a smaller scale gaming facility that will become a solely class II electronic gaming device facility which will not require a compact.

 

Consulting Agreements and Management Contracts with the Iowa Tribe of Oklahoma.  On March 15, 2005, Lakes entered into consulting agreements and management contracts with the Iowa Tribe of Oklahoma in connection with two casino projects, the Cimarron Casino and the proposed Ioway Casino Resort.

 

During May 2010, Lakes entered into a termination agreement with the Iowa Tribe of Oklahoma, its governmental components and instrumentalities (collectively, the “Iowa Tribe”) (“Termination Agreement with the Iowa Tribe”), whereby, in consideration of the parties terminating all contracts and agreements between them (including the Management Agreement under which Lakes was managing the Cimarron Casino, the Consulting Agreement for the Ioway Casino Resort, and the Amended and Restated Ioway Note under which approximately $5.0 million was advanced), the Iowa Tribe agreed to pay to Lakes a total of $4.5 million.

 

Non-Indian Casino Business

 

As part of our business strategy, we also seek opportunities to develop and operate new business opportunities including developing our own casinos where applicable laws permit.

 

Agreements with Entities to develop casinos in Ohio.  In October 2009, Lakes entered into an agreement with Penn for the purpose of funding a percentage of costs associated with the referendum to amend the Ohio constitution to authorize casino gaming in Ohio, which passed on November 3, 2009. On July 13, 2010, Lakes entered into a Termination Agreement with Penn whereby, in consideration of the parties terminating the agreement entered into during October 2009, Penn agreed to pay Lakes $25 million. Accordingly, Lakes no longer has any rights, obligations or interest in the entity that was to be formed in collaboration with Penn for the development of casinos in Toledo and Columbus, Ohio.

 

In October 2009, Lakes entered into a separate agreement with Rock Ohio Ventures also for the purpose of funding a percentage of costs associated with the referendum to amend the Ohio constitution to authorize casino gaming in Ohio. As of January 2, 2011, Lakes has contributed approximately $2.4 million to Rock Ohio Ventures related to this referendum effort. During 2011, Lakes has contributed additional capital of approximately $6.0 million. Lakes expects to contribute additional capital to Rock Ohio Ventures for the development of casinos in Cleveland and Cincinnati.

 

During March and April 2010, Lakes entered into an agreement and amendment, respectively, with Quest Media Group, LLC (“Quest”), wherein Lakes agreed to pay a fee to Quest for assisting Lakes in partnering with Rock Ohio Ventures, and Penn during 2009 (collectively the “Project Companies”). Pursuant to the agreement, Lakes shall pay Quest a fee equal to 18.5% of gross distributions from the Project Companies (less certain amounts set forth in the agreement), capped at $0.5 million for each of the first five years or until Lakes recovers prior expenditures, as set forth in the agreement. The April 2010 amendment increased the fee from 18.0% to 18.5% in exchange for a payment from Quest to Lakes of $0.5 million. During fiscal 2010, Lakes made a payment of $0.5 million to Quest as a result of the payment received from the Termination Agreement with Penn.

 

Gaming Site, Vicksburg, Mississippi.  In February 2005, Lakes received gaming site approval with respect to its proposed casino location in Vicksburg, Mississippi from the Mississippi Gaming Commission. The site, adjacent to the Mississippi River, contains approximately 400 acres located three miles south of downtown in Vicksburg, Warren County, Mississippi. Lakes has either purchased, or holds options for the purchase of, the land for this site. During July 2005, Lakes received approval from the Mississippi Gaming Commission of its development plan for a gaming project to be built on this site. Lakes’ approved plan allows for an operation consisting of a 60,000 square foot casino floor which would include multiple bars, live entertainment, various restaurants, 1,200 to 1,500 slot machines, 40 to 50 table games, poker room, valet parking and hotel rooms. This plan allows for expanded gaming, additional hotel rooms, a child care facility, a nightclub, cigar lounge, banquet rooms, and an event center. A total of $9.4 million has been invested as of January 2, 2011. Lakes is continuing to evaluate all alternatives associated with its Vicksburg project, including whether to proceed with development of this project or potentially sell it. As a result of the uncertainty surrounding the development of this project and due to changes in the economic environment and credit markets, the assets associated with the Vicksburg project are carried on the consolidated balance sheets at

their estimated fair value of $3.3 million as of January 2, 2011. Lakes recognized an impairment of approximately $1.6 million during fiscal 2010 and $0.5 million during fiscal 2009.

 

Chisholm Creek Casino and Resort.  In August 2009, Lakes announced that it entered into a joint venture with the Chisholm Creek Casino Resort, LLC (“Chisholm Creek”) relating to an application to the Kansas Lottery to develop and operate a casino project in south central Kansas. On April 9, 2010, Chisholm Creek withdrew its application for the potential casino due to unresolved issues related to the project’s location and uncertainties in the competitive market. Chisholm Creek is a wholly-owned subsidiary of Kansas Gaming Partners, LLC. As of January 3, 2010, Lakes Kansas Casino Management, LLC, an indirect wholly-owned consolidated subsidiary of Lakes, had a 16.67% ownership in Kansas Gaming Partners, LLC. As a result of the withdrawal of the application Lakes also terminated its involvement with this project and as of January 2, 2011, has no amounts recorded in the consolidated balance sheet related to an ownership interest in Kansas Gaming Partners, LLC.

 

Table Games

 

Lakes has a division that develops, buys, patents and licenses rights for new table game concepts to market/distribute and license to casinos. Lakes is continuing to test and market a number of new games, including “World Poker Tour All In Hold’Em^tm,” “Four The Money,” and “Bonus Craps”. The “World Poker Tour All In Hold’Em^tm” and “Bonus Craps” games are currently operating in several casinos across the United States. The revenues from this division are currently not significant and Lakes is currently evaluating whether to continue with this business.

 

Competition

 

The gaming industry is highly competitive and continues to proliferate throughout the country as more jurisdictions are choosing to allow gaming or the expansion thereof. Gaming activities include traditional land-based casinos, river boat and dockside gaming, casino gaming on Indian land, state-sponsored video lottery and video poker in restaurants, bars and hotels, pari-mutuel betting on horse racing and dog racing, sports bookmaking, card rooms, and online gaming outside the United States. The casinos managed by Lakes compete with all of these forms of gaming, and will compete with any new forms of gaming that may be legalized in additional jurisdictions, as well as with other types of entertainment. Lakes also competes with other gaming companies for opportunities to acquire legal gaming sites in emerging gaming jurisdictions and for the opportunity to manage casinos on Indian land. Some of Lakes’ competitors have more personnel and greater financial and other resources than Lakes. Further expansion of gaming could also significantly affect Lakes’ business.

 

According to NIGC tribal data reports, from the end of 2008 through 2009, there were 419 Indian gaming operations nationwide from which, during this same period, tribal gaming revenues decreased $0.3 billion, or 1.0%, to $26.5 billion. NIGC tribal data reports indicate that in California and Michigan, the key areas targeted in the near-term by Lakes, Indian gaming is well-developed.

 

Indian gaming facilities in Michigan can offer all forms of Class III gaming with the exception of sports wagering. The Four Winds Casino Resort competes primarily with the riverboats that operate in northern Indiana. According to the Indiana Gaming Commission tribal data reports, there were five riverboats in northern Indiana in 2010 generating approximately $1.2 billion in gaming revenue with a total of 9,056 slot machines and 346 table games. In addition, a new Indian-owned casino in Michigan opened in 2009 approximately 110 miles away from the Four Winds Casino Resort and another new Indian-owned casino in Michigan opened in February 2011 approximately 100 miles from the Four Winds Casino Resort.

 

There were 62 compacted Indian gaming facilities in the California and Northern Nevada region in 2009. There are two Indian-owned Las Vegas-style casinos located in the vicinity of the Red Hawk Casino. Based on NIGC tribal data reports, California and Northern Nevada (which includes the Red Hawk Casino), tribal gaming revenues decreased 5.3% to $7.0 billion in 2009. This region has the highest tribal gaming revenues in the United States with approximately 26% of all reported Indian Gaming revenue.

 

As previously discussed, the Ohio constitution was amended during 2009 to authorize casino gaming. Competition for Ohio casinos is currently expected to come from the other Ohio casinos to be developed, casinos located in the surrounding states and the possible installation of video lottery terminals at Ohio horse tracks.

Regulation

 

Gaming regulation

 

The ownership, management, and operation of gaming facilities are subject to extensive federal, state, provincial, tribal and/or local laws, regulations and ordinances, which are administered by the relevant regulatory agency or agencies in each jurisdiction (the “Regulatory Authorities”). These laws, regulations and ordinances vary from jurisdiction to jurisdiction, but generally pertain to the responsibility, financial stability and character of the owners and managers of gaming operations as well as persons financially interested or involved in gaming operations. Certain basic provisions that are currently applicable to Lakes in its management, development and financing activities are described below.

 

Neither Lakes nor any subsidiary may own, manage or operate a gaming facility unless it obtains proper licenses, permits and approvals. An application for a license, permit or approval may be denied for any cause that the Regulatory Authorities deem reasonable. Most Regulatory Authorities also have the right to license, investigate, and determine the suitability of any person who has a material relationship with Lakes or any of its subsidiaries, including officers, directors, employees, and security holders of Lakes or its subsidiaries. In the event a Regulatory Authority finds a security holder to be unsuitable, Lakes may be sanctioned, and may lose its licenses and approvals if Lakes recognizes any rights in any entity with such unsuitable person in connection with such securities. Lakes may be required to repurchase its securities at fair market value from security holders that the Regulatory Authorities deem unsuitable. Lakes’ Articles of Incorporation authorize Lakes to redeem securities held by persons whose status as a security holder, in the opinion of the Lakes’ Board of Directors, jeopardizes gaming licenses or approvals of Lakes or its subsidiaries. Once obtained, licenses, permits, and approvals must be periodically renewed and generally are not transferable. The Regulatory Authorities may at any time revoke, suspend, condition, limit, or restrict a license for any cause they deem reasonable.

 

Fines for violations may be levied against the holder of a license and, in certain jurisdictions, gaming operation revenues can be forfeited to the state under certain circumstances. No assurance can be given that any licenses, permits, or approvals will be obtained by Lakes or its subsidiaries, or if obtained, will be renewed or not revoked in the future. In addition, the rejection or termination of a license, permit, or approval of Lakes or any of its employees or security holders in any jurisdiction may have adverse consequences in other jurisdictions. Certain jurisdictions require gaming operators licensed therein to seek approval from the state before conducting gaming in other jurisdictions. Lakes and its subsidiaries may be required to submit detailed financial and operating reports to Regulatory Authorities.

 

The political and regulatory environment for gaming is dynamic and rapidly changing. The laws, regulations, and procedures pertaining to gaming are subject to the interpretation of the Regulatory Authorities and may be amended. Any changes in such laws, regulations, or their interpretations could have a material adverse effect on Lakes.

 

Certain specific provisions to which Lakes is currently subject are described below.

 

Indian gaming regulation

 

The terms and conditions of management contracts for the operation of Indian-owned casinos, and of all gaming on Indian land in the United States, are subject to the Indian Gaming Regulatory Act (“IGRA”), which is administered by the NIGC, and also are subject to the provisions of statutes relating to contracts with Indian tribes, which are administered by the Secretary of the Interior (the “Secretary”) and the BIA. The regulations and guidelines under which NIGC will administer the IGRA are evolving. The IGRA and those regulations and guidelines are subject to interpretation by the Secretary and NIGC and may be subject to judicial and legislative clarification or amendment.

 

Lakes may need to provide the BIA or NIGC with background information on each of its directors and each shareholder who holds five percent or more of Lakes’ stock (“5% Shareholders”), including a complete financial statement, a description of such person’s gaming experience, and a list of jurisdictions in which such person holds gaming licenses. Background investigations of key employees also may be required. Lakes’ Articles of Incorporation contain provisions requiring directors and 5% Shareholders to provide such information.

The IGRA currently requires the NIGC to approve management contracts and certain collateral agreements for Indian-owned casinos. The NIGC may review any of Lakes’ management contracts and collateral agreements for compliance with the IGRA at any time. The NIGC will not approve a management contract if a director or a 5% Shareholder of the management company (i) is an elected member of the Indian tribal government that owns the facility purchasing or leasing the games; (ii) has been or is convicted of a felony gaming offense; (iii) has knowingly and willfully provided materially false information to the NIGC or an Indian tribe; (iv) has refused to respond to questions from the NIGC; or (v) is a person whose prior history, reputation and associations pose a threat to the public interest or to effective gaming regulation and control, or create or enhance the chance of unsuitable activities in gaming or the business and financial arrangements incidental thereto.

 

In addition, the NIGC will not approve a management contract if the management company or any of its agents have attempted to unduly influence any decision or process of tribal government relating to gaming, or if the management company has materially breached the terms of the management contract or the tribe’s gaming ordinance, or a trustee exercising due diligence would not approve such management contract.

 

A management contract can be approved only after the NIGC determines that the contract provides, among other things, for (i) adequate accounting procedures and verifiable financial reports, which must be furnished to the tribe; (ii) tribal access to the daily operations of the gaming enterprise, including the right to verify daily gross revenues and income; (iii) minimum guaranteed payments to the tribe, which must have priority over the retirement of development and construction costs; (iv) a ceiling on the repayment of such development and construction costs; and (v) a contract term not exceeding five years and a management fee not exceeding 30% of profits; provided that the NIGC may approve up to a seven-year term if NIGC is satisfied that the capital investment required, the risk exposure, and the income projections for the particular gaming activity justify the longer term.

 

The IGRA established three separate classes of tribal gaming — Class I, Class II, and Class III. Class I includes all traditional or social games played by a tribe in connection with celebrations or ceremonies. Class II gaming includes games such as bingo, pull-tabs, punch boards, instant bingo and card games that are not played against the house. Class III gaming includes casino-style gaming including table games such as blackjack, craps and roulette, as well as gaming machines such as slots, video poker, lotteries, and pari-mutuel wagering.

 

The IGRA prohibits substantially all forms of Class III gaming unless a tribe has entered into a written agreement with the state in which the casino is located that specifically authorizes the types of commercial gaming the tribe may offer (a “Tribal-state compact”). The IGRA requires states to negotiate in good faith with tribes that seek Tribal-state compacts, and grants Indian tribes the right to seek a federal court order to compel such negotiations. Many states have refused to enter into such negotiations. Tribes in several states have sought federal court orders to compel such negotiations under the IGRA; however, the Supreme Court of the United States held in 1996 that the Eleventh Amendment to the United States Constitution immunizes states from suit by Indian tribes in federal court without the states’ consent.

 

Because Indian tribes are currently unable to compel states to negotiate tribal-state compacts, Lakes may not be able to develop and manage casinos in states that refuse to enter into or renew tribal-state compacts.

 

In addition to the IGRA, tribal-owned gaming facilities on Indian land are subject to a number of other federal statutes. The operation of gaming on Indian land is dependent upon whether the law of the state in which the casino is located permits gaming by non-Indian entities, which may change over time. Any such changes in state law may have a material adverse effect on the casinos managed by Lakes.

 

Title 25, Section 81 of the United States Code states that “no agreement or contract with an Indian tribe that encumbers Indian lands for a period of 7 or more years shall be valid unless that agreement or contract bears the approval of the Secretary of the Interior or a designee of the Secretary.” The Secretary of the Interior has issued regulations, 25 CFR Part 84, identifying the types of contracts and agreements with Indian tribes which are not subject to Section 81. If, however, an agreement or contract for services is determined to be subject to the requirements of Section 81, it will be void and unenforceable if not approved.

 

Indian tribes are sovereign nations with their own governmental systems which have primary regulatory authority over gaming on land within the tribe’s jurisdiction. Because of their sovereign status, Indian tribes possess immunity from lawsuits to which the tribes have not otherwise consented or otherwise waived their sovereign

immunity defense. Therefore, no contractual obligations undertaken by tribes to Lakes would be enforceable by Lakes unless the tribe has expressly waived its sovereign immunity as to such obligations and, if involving service for Indians relative to their lands, approved by the Secretary. Lakes has obtained immunity waivers from each of the tribes to enforce the terms of its management agreements; however, the scope of those waivers has never been tested in court, and may be subject to dispute. Additionally, unless we believe such approval is not necessary given the nature of a contract, all contracts involving services to Indians relative to their lands have been approved by the Secretary. However, there can be no assurance that the Secretary will agree that it is unnecessary to obtain such approval, and may render such contracts unenforceable. Additionally, persons engaged in gaming activities, including Lakes, are subject to the provisions of tribal ordinances and regulations on gaming. These ordinances are subject to review by the NIGC under certain standards established by the IGRA.

 

Non-gaming regulation

 

Lakes and its subsidiaries are subject to certain federal, state, and local safety and health laws, regulations and ordinances that apply to non-gaming businesses generally, such as the Clean Air Act, Clean Water Act, Occupational Safety and Health Act, Resource Conservation Recovery Act and the Comprehensive Environmental Response, Compensation and Liability Act. We believe that we are currently in material compliance with such regulations. The coverage and attendant compliance costs associated with such laws, regulations and ordinances may result in future additional cost to our operations.

 

Intellectual Property

 

The following is a discussion of Lakes’ intellectual property, which did not provide a significant financial contribution to Lakes’ operations in fiscal 2010.

 

Trademarks

 

Lakes owns two United States registrations for the mark FOUR THE MONEY^® used in connection with casino table games. Lakes has also received approval for registration of the service mark CARLOS SOPRANO’S^tm, to be used in connection with restaurant and related entertainment services.

 

Patents

 

Lakes owns or has exclusive rights to several United States patents and patent applications for various casino games sold or licensed by Lakes. The issued patents expire at various times over the next 20 years.

 

Licenses

 

Lakes has an exclusive worldwide, royalty-bearing license to all patent, copyright and other intellectual property rights related to a casino table game developed by Sklansky Games, LLC, subject to certain marketing restrictions. This license also includes the right to use the trademark World Poker Tour ALL-IN HOLD’EM POKER^tm.

 

Lakes also has an exclusive worldwide, royalty-bearing license to use the name “World Poker Tour”, a tutorial video and the trademark WORLD POKER TOUR and Design in connection with any casino table game or video-enhanced table game used in any legal commercial gaming establishment.

 

Both licenses will remain in effect as long as Lakes pays the royalty amounts set forth in the license agreements.

 

Real Estate Holdings

 

Lakes owns parcels of undeveloped land in California related to its Indian casino project with the Jamul Tribe, in Mississippi related to a potenial casino project, and undeveloped land in Oklahoma related to its previous involvement in a potential casino project with the Iowa Tribe of Oklahoma. Lakes also owns an office building and related land in Minnesota related to its corporate offices.

Employees

 

At January 2, 2011, Lakes had approximately 22 full-time employees. Lakes believes its relations with employees are satisfactory.

 

Lakes has assembled a strong team of gaming industry experts, well-versed in all aspects of casino development, construction and management, many of whom were involved with the success of Grand Casinos. The Lakes team has individual specialists on staff mirroring each of the functional areas found in a casino project. The functional areas include gaming operations, construction and development, finance/accounting, legal/regulatory, systems/information technology, food and beverage, marketing and human resources.

 

Lakes’ management believes this team represents a valuable asset that provides a competitive advantage in creating and enhancing relationships with Indian tribes in the Indian casino business and in the pursuit of non-Indian casino opportunities.

 

Website and Available Information

 

Our website is located at www.lakesentertainment.com. Information on the website does not constitute part of this Annual Report on Form 10-K.

 

We make available, free of charge, our Annual Reports on Form 10-K, our Proxy Statement on Form DEF 14A, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 as soon as reasonably practicable after such forms are filed with or furnished to the SEC. Copies of these documents are available to our shareholders at our website or upon written request to our President and Chief Financial Officer at 130 Cheshire Lane, Suite 101, Minnetonka, MN 55305.

 

 

In addition to factors discussed elsewhere in this Annual Report on Form 10-K, the following are important factors that could cause actual results or events to differ materially from those contained in any forward-looking statement made by or on behalf of us.

 

Current economic conditions may cause further declines in casino gaming activity and other consumer spending which could adversely affect the financial performance of the casinos we manage and result in lower management fee revenue to us.

 

Our operating results and performance depend significantly on the current economic conditions and their impact on consumer spending in the casinos we manage. The decline in consumer spending resulting from the recession and the deterioration of capital and credit markets may cause our revenue generated from the management of Indian casinos to be adversely impacted.

 

Because our primary source of revenue is generated from our management agreements with Indian Tribes which have finite terms, our failure to develop new business opportunities would impact our future growth, cash flow and profitability.

 

The primary source of our revenues in 2010 was generated from our management agreements relating to the Four Winds Casino Resort (which expires in August 2012) and the Red Hawk Casino (which expires in December 2015). With the profits we anticipate from the remaining life of these agreements, we will need to develop and realize new business opportunities to sustain our growth, cash flow and profitability.

 

The commencement or completion of casino development projects may be significantly delayed or prevented due to a variety of factors, many of which are beyond our control, which could have a material adverse effect on our profitability, cash flow and financial condition.

 

The opening of a future facility will be contingent upon, among other things, receipt of all regulatory licenses, permits, allocations and authorizations, and the completion of construction, hiring and training of sufficient

personnel. The scope of the approvals required to construct and open a facility will be extensive, and the failure to obtain such approvals could prevent or delay the completion of construction or opening of all or part of a facility or otherwise affect the design and features of a proposed casino.

 

Even once a schedule for such construction and development activities is established, such development activities may not begin or be completed on time, or at any other time. The budget for a project may also be exceeded.

 

In addition, the regulatory approvals necessary for the construction and operation of casinos are often challenged in litigation brought by government entities, citizens groups and other organizations and individuals. Such litigation can significantly delay the construction and opening of casinos. The Jamul casino project has been significantly delayed as a result of such litigation, and remaining or future litigation may never be successfully resolved or, at a minimum, the Jamul casino project may experience further significant delays before resolution.

 

Major construction projects entail significant risks, including shortages of materials or skilled labor, unforeseen engineering, environmental and/or geological problems, work stoppages, weather interference, unanticipated cost increases and non-availability of construction equipment. These factors or delays or difficulties in obtaining any of the requisite licenses, permits and authorizations from regulatory authorities could increase the total cost, delay or prevent the construction or opening of any of the planned casino development or otherwise affect its design.

 

Because our operating results are highly dependent on the timing of our project under development, delays could cause our results to fluctuate significantly and may adversely affect our profitability, cash flow and financial condition.

 

Failure of our existing, proposed, and other prospective casino projects to successfully compete may have a material adverse effect on our results of operations, cash flow and financial condition.

 

The gaming industry is highly competitive. Gaming activities include traditional land-based casinos, river boat and dockside gaming, casino gaming on Indian land, state-sponsored lotteries and video poker in restaurants, bars and hotels, pari-mutuel betting on horse racing and dog racing, sports bookmaking, online gaming, and card rooms. The casinos to be managed or owned by us compete, and will in the future compete, with all these forms of gaming, and will compete with any new forms of gaming that may be legalized in additional jurisdictions, as well as with other types of entertainment.

 

We also compete with other gaming companies for opportunities to acquire legal gaming sites in emerging and established gaming jurisdictions and for the opportunity to manage casinos on Indian land. Many of our competitors have more personnel and may have greater financial and other resources than us. Such competition in the gaming industry could adversely affect our ability to attract customers which would adversely affect our operating results. In addition, further expansion of gaming into new jurisdictions could also adversely affect our business by diverting customers from our planned managed casinos to competitors in such jurisdictions.

 

The early termination or modification of our management, development, consulting or financing agreements with Indian tribes may reduce or eliminate our revenues under such agreements.

 

Our current management, development, consulting or financing agreements have finite lives and provide that such contracts may be terminated under certain circumstances including, without limitation, upon the failure to maintain the National Indian Gaming Commission’s approval for such agreements, the loss of requisite gaming licenses or an exercise by an Indian tribe of its buy out option. In addition, the National Indian Gaming Commission has the authority to require a modification of such agreements in a manner which may have an adverse effect on us. Such termination or modification may have a material adverse effect on our results of operations, cash flow, and financial condition.

 

If we fail to comply with the laws, regulations and ordinances (including tribal or local laws) applicable to gaming facilities, we may be unable to operate or develop casino projects.

 

The ownership, management and operation of gaming facilities are subject to extensive federal, state, tribal and local laws, regulations and ordinances, which are administered by the relevant regulatory agency or agencies in

each jurisdiction. These laws, regulations and ordinances vary from jurisdiction to jurisdiction, but generally concern the responsibility, financial stability and character of the owners and managers of gaming operations as well as persons financially interested or involved in gaming operations, and often require such parties to obtain certain licenses, permits and approvals.

 

The rapidly-changing political and regulatory environment governing the gaming industry (including gaming operations which are conducted on Indian land) makes it impossible for us to accurately predict the effects that an adoption of or changes in the gaming laws, regulations and ordinances will have on us. However, our failure, or the failure of any of our key personnel, significant shareholders or joint venture partners, to obtain or retain required gaming regulatory licenses could prevent us from expanding into new markets, prohibit us from generating revenues in certain jurisdictions, and subject us to sanctions and fines.

 

If Indian tribes default on their repayment obligations or wrongfully terminate their management, development, consulting or financing agreements with us, we may be unable to collect the amounts due.

 

We have made, and may make, substantial loans to Indian tribes for the construction, development, equipment and operations of casinos to be managed by us. Our only recourse for collection of indebtedness from an Indian tribe or money damages for breach or wrongful termination of a management, development, consulting or financing agreement is from revenues, if any, from casino operations.

 

In addition, we have subordinated, and may in the future subordinate, the repayment of loans made to an Indian tribe and other distributions due from an Indian tribe (including management fees) in favor of other obligations of the Indian tribe to other parties related to the development and operation of the casinos. Accordingly, in the event of a default by an Indian tribe under such obligations, our loans and other claims against the Indian tribe will not be repaid until such default has been cured or the Indian tribe’s senior casino-related creditors have been repaid in full.

 

A deterioration of our relationship with an Indian tribe could cause delay or termination of a casino project and prevent or significantly impede recovery of our investment therein.

 

Good personal and professional relationships with Indian tribes and their officials are critical to our existing and future Indian-related gaming operations and activities, including our ability to obtain, develop and execute management and other agreements. As sovereign nations, Indian tribes establish their own governmental systems under which tribal officials or bodies representing an Indian tribe may be replaced by appointment or election or become subject to policy changes. Replacements of Indian tribal officials or administrations, changes in policies to which an Indian tribe is subject or other factors that may lead to the deterioration of our relationship with an Indian tribe may lead to termination of or delays in the completion of a development project or prevent a project’s completion, which may have an adverse effect on our future results of our operations.

 

If we are unable to obtain additional financing in order to satisfy our cash requirements, we may be forced to delay, scale back or eliminate some of our expansion and development goals.

 

Lakes’ cash forecast requirements do not include construction-related costs that will be incurred if a project begins construction. The construction of future casino projects will depend on the ability of our and/or our tribal partners’ ability to obtain additional financing for our projects. Given the current state of the debt markets, obtaining such capital on terms that make the projects financially viable may be difficult. If such financing cannot be obtained on acceptable terms, it may not be possible to complete future projects, which could have a material adverse effect on our results of operations and financial condition. In order to assist the tribes, we may be asked to provide guarantees or other support for the tribal obligations. Guarantees by us, if any, will increase our potential exposure in the event of a default by any of these tribes.

 

If additional financing is in the form of equity financing it will be dilutive to our shareholders, and any debt financing may involve additional restrictive covenants and further leveraging of our finite assets. An inability to raise such funds when needed might require us to delay, scale back or eliminate some of our expansion and development goals.

We may be unable to generate sufficient cash flow to satisfy our debt obligations, which would adversely affect our financial condition and results of operations.

 

Our ability to make principal and interest payments on our indebtedness will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. If our business does not generate sufficient cash flow from operations or if future borrowings are not available to us in amounts sufficient to fund our other liquidity needs, our financial condition and results of operations may be adversely affected. If we cannot generate sufficient cash flow from operations to make scheduled principal and interest payments on our debt obligations in the future, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets, or seek additional equity. If we are unable to refinance any of our indebtedness on commercially reasonable terms or at all or to effect any other action relating to our indebtedness on satisfactory terms or at all, our business may be adversely impacted.

 

If one or more of our Indian casino projects fail, or does not achieve sufficient results of operations, our recorded assets related to those projects will be impaired and there may be a material adverse impact on our financial condition, results of operations, and cash flow.

 

The majority of our assets related to Indian casino projects are classified as long-term on our consolidated balance sheet and are in the form of loans to the Indian tribes. These loans, except for the current portion on open projects, are included as notes receivable on the consolidated balance sheet, under the category “long-term assets related to Indian casino projects”. At January 2, 2011, we had $68.5 million in assets related to Indian casino projects, of which $44.4 million was in the form of notes receivable. The notes receivable represented approximately 35% of our total assets. All of the loans are subject to varying degrees of collection risk and there is no established market. For the loans representing indebtedness of Indian tribes, the repayment terms are specific to each Indian tribe and are largely dependent upon the operating performance of each gaming property. Repayments of such loans are required to be made only if distributable profits are available from the operation of the related casinos. Repayments are also the subject of certain distribution priorities specified in agreements with each Indian tribe. In addition, repayment to us of the loans and the manager’s fees under our management contracts are subordinated to certain other financial obligations of the respective Indian tribes. During fiscal 2010, we recorded an impairment charge on notes receivable of $21.0 million related to the Shingle Springs casino project due to the continued significant economic pressures in the northern California market and increased competition from a neighboring casino expansion in the market the property serves, all of which have negatively impacted cash flows for the property, as well as the deferral of all principal payments during the fourth quarter of fiscal 2010 due to insufficient net revenues from which to make these payments.

 

Included in long-term assets related to Indian casino projects are intangible assets related to the acquisition of management contracts of $15.9 million, land held for development of $1.0 million, and deferred management fees and other amounts due from related parties of $5.5 million at January 2, 2011. If one or more of our Indian casino projects does not open, or does not achieve sufficient net revenues after opening, our assets related to that project will be impaired. During fiscal 2010, we recorded an impairment on intangible assets of $16.7 million related to the Shingle Springs casino project due to the issues discussed in the preceding paragraph, all of which have negatively impacted projected cash flows for the property.

 

Various regulatory bodies have made proposals which, if implemented, could negatively impact the economic viability of the Jamul Casino project.

 

The Department of Justice and the National Indian Gaming Commission have made previous proposals to regulate the type of electronic gaming devices currently planned for use at the Jamul Casino. If these proposals are implemented prior to completion of development of the Jamul Casino project, it would affect whether we want to proceed with the development. If these proposals are implemented after completion of the development of the Jamul Casino project, it could negatively impact the revenue generated by the gaming devices and, therefore, have a material adverse effect on our results of operations and financial conditions.

 

Our entry into new businesses may result in future losses.

 

We have announced that part of our strategy involves diversifying into other businesses which could include developing and operating our own casino. Such businesses involve business risks separate from the risks involved in

casino development and these investments may result in future losses to us. These risks include but are not limited to negative cash flow, initial high development costs of new products and/or services without corresponding sales pending receipt of corporate and regulatory approvals, market introduction and acceptance of new products and/or services, and obtaining regulatory approvals required to conduct the new businesses. Diversification activities may never successfully add to our future revenues and income.

 

We are dependent on the ongoing services of our senior corporate management, and the loss of their services could have a detrimental effect on the pursuit of our business objectives, profitability and the price of our common stock.

 

Our success depends largely on the efforts and abilities of our senior corporate management, particularly Lyle Berman, our Chairman and Chief Executive Officer. The loss of the services of Mr. Berman or other members of senior corporate management could have a material adverse effect on us. Although we have obtained a $8.0 million key man life insurance policy on Mr. Berman, we do not maintain key man life insurance on other members of senior corporate management.

 

Our Articles of Incorporation and Bylaws may discourage lawsuits and other claims against our directors.

 

Our Articles of Incorporation and Bylaws provide, to the fullest extent permitted by Minnesota law, that our directors shall have no personal liability for breaches of their fiduciary duties to us. In addition, our Bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Minnesota law. These provisions reduce the likelihood of derivative litigation against our directors and may discourage shareholders from bringing a lawsuit against directors for a breach of their duty.

 

Our Articles of Incorporation contain provisions that could discourage or prevent a potential takeover, even if the transaction would be beneficial to our shareholders.

 

Our Articles of Incorporation authorize our Board of Directors to issue up to 200 million shares of capital stock, the terms of which may be determined at the time of issuance by the Board of Directors, without further action by our shareholders. The Board of Directors may authorize additional classes or series of shares that may include voting rights, preferences as to dividends and liquidation, conversion and redemptive rights and sinking fund provisions that could adversely affect the rights of holders of our common stock and reduce the value of our common stock. Additional classes of stock that may be authorized by our Board of Directors for issuance in the future could make it more difficult for a third party to acquire us, even if a majority of our holders of common stock approved of such acquisition.

 

The price of our common stock may be adversely affected by significant price fluctuations due to a number of factors, many of which are beyond our control.

 

The market price of our common stock has experienced significant fluctuations and may continue to fluctuate in the future. The market price of our common stock may be significantly affected by many factors, including:

 

 

 

We have issued numerous options to acquire our common stock and have the ability to issue additional options, each of which could have a dilutive effect on our common stock.

 

As of January 2, 2011, we had options outstanding to acquire 2.0 million shares of our common stock, exercisable at prices ranging from $1.89 to $6.43 per share, with a weighted average exercise price of approximately $2.99 per share. As of January 2, 2011, we had restricted stock units outstanding to acquire 79,996 shares of our common stock with a weighted average grant date fair value of $3.25 and under the existing stock option plans, there were 699,215 remaining shares available to grant.

 

The market price of our common stock may be reduced by future sales of our common stock in the public market.

 

Sales of substantial amounts of our common stock in the public market that are not currently freely tradable, or even the potential for such sales, could have an adverse effect on the market price for shares of our common stock and could impair the ability of purchasers of our common stock to recoup their investment or make a profit. As of January 2, 2011, these shares consist of approximately 6.2 million shares beneficially owned by our executive officers and directors.

 

 

Not Applicable.

 

 

Corporate Office Facility

 

Lakes owns its corporate office building located in Minnetonka, Minnesota and, occupies approximately 22,000 square feet of the 65,000 square foot building and has leased a portion of remaining space to outside tenants. A lease for a tenant occupying a substantial portion of the building expired on June 30, 2010 and was not renewed. We are currently searching for a tenant or tenants to lease that space.

 

 

Louisiana Department of Revenue Tax Litigation Matter

 

At January 2, 2011, the Louisiana Department of Revenue maintained a position that Lakes owed additional Louisiana corporation income tax for the period ended January 3, 1999 and the tax years ended 1999 through 2001 and additional Louisiana corporation franchise tax for the tax years ended 2000 through 2002. This determination was the result of an audit of Louisiana tax returns filed by Lakes for the tax periods at issue and related to the reporting of income earned by Lakes in connection with the managing of two Louisiana-based casinos. On March 17, 2011, Lakes and the Louisiana Department of Revenue entered into a Settlement Agreement whereby Lakes agreed to pay the Louisiana Department of Revenue $9.0 million in full and final payment for all taxes, interest and fees relating to this matter. In return, the Louisiana Department of Revenue agreed to dismiss the suit and forever discharge Lakes from all proceedings and liabilities relating to this matter. Lakes issued such payment during March 2011, so this matter is now resolved. We have recorded a liability for the settlement amount, which is included as part of income taxes payable on the accompanying consolidated balance sheets.

 

Other Litigation

 

Lakes and its subsidiaries are involved in various other inquiries, administrative proceedings, and litigation relating to contracts and other matters arising in the normal course of business. While any proceeding or litigation has an element of uncertainty, management currently believes that the likelihood of an unfavorable outcome is remote. No provision for loss has been recorded in connection therewith.

 

 

PART II

 

 

Lakes’ common stock currently trades on the NASDAQ Global Market. The high and low sales prices per share of Lakes’ common stock for each full quarterly period within the two most recent fiscal years are indicated below, as reported on the NASDAQ Global Market:

 

 

On March 24, 2011, the last reported sale price for the common stock was $2.98 per share. As of March 24, 2011, Lakes had approximately 848 shareholders of record.

 

Lakes has never paid any cash dividends with respect to its common stock and the current policy of the Board of Directors is to retain any earnings to provide for the growth of Lakes. The payment of cash dividends in the future, if any, will be at the discretion of the Board of Directors and will depend upon such factors as earnings levels, capital requirements, Lakes’ overall financial condition, and any other factors deemed relevant by the Board of Directors.

 

No repurchases of Lakes’ common stock were made during the fourth quarter of Lakes’ fiscal year ended January 2, 2011.

 

 

Not Applicable.

 

 

Overview

 

Lakes Entertainment, Inc. and subsidiaries (“Lakes”, “we, or “our”) primarily develops, finances and manages casino properties with a historical emphasis on those that are Indian-owned. We currently have development and management or financing agreements with three separate tribes for casino operations in Michigan and California, for a total of three separate casino projects as follows:

 

 

 

During May 2010, a subsidiary of Lakes entered into a termination agreement with the Iowa Tribe of Oklahoma, its governmental components and instrumentalities (collectively, the “Iowa Tribe”) (“Termination Agreement with the Iowa Tribe”), whereby, in consideration of the parties terminating all contracts and agreements between them (including the Management Agreement under which Lakes was managing the Cimarron Casino, the Consulting Agreement for the Ioway Casino Resort, and the Amended and Restated Ioway Note under which approximately $5.0 million was advanced), the Iowa Tribe agreed to pay to Lakes a total of $4.5 million in the following manner: $1 million to be paid within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million to be paid in 15 equal monthly installments commencing on June 15, 2010.

 

We have also explored, and continue to explore, other casino development projects. An overview of our non-Indian projects are as follows:

 

 

On October 15, 2010, we implemented a reduction in force resulting in the termination of 13 employees. These actions were designed to streamline and reduce our cost structure, increase our financial strength and align our workforce with anticipated staffing needs. The Company incurred charges of approximately $500,000, which related to cash outlays for employee severance benefits. All amounts were paid as of January 2, 2011.

 

Results of continuing operations

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K for the year ended January 2, 2011.

 

Fiscal year ended January 2, 2011 (“fiscal 2010”) compared to fiscal year ended January 3, 2010 (“fiscal 2009”)

 

Revenues.  Total revenues were $24.6 million for fiscal 2010 compared to $26.2 million for fiscal 2009. The decrease of $1.6 million was primarily due to a reduction in management fees earned from the Cimarron Casino project, as a result of the termination of that agreement in May 2010, as well as a decrease in management fees earned from the Red Hawk Casino. Partially offsetting the decline was an increase in management fees earned in fiscal 2010 from the Four Winds Casino Resort. Revenues in fiscal 2011 will be impacted by the anticipated lower management fees from the Red Hawk Casino due to the continued significant economic pressures in the northern California market the property serves.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses were $11.8 million for fiscal 2010 compared to $14.2 million for fiscal 2009. The decrease of $2.4 million from fiscal 2009 was primarily due to a reduction in professional expenses totaling approximately $1.2 million and a reduction in travel expenses of approximately $0.8 million. For fiscal 2010, Lakes’ selling, general and administrative expenses included payroll and related expenses of $6.7 million (including share-based compensation), travel expenses of $2.0 million and professional fees of $1.6 million. For fiscal 2009, Lakes’ selling, general and administrative expenses included payroll and related expenses of $7.3 million (including share-based compensation), travel expenses of $2.8 million and professional fees of $2.8 million.

 

Impairment charge on notes receivable.  The impairment charge on notes receivable of $21.0 million for fiscal 2010 relates to Lakes impairment analysis of the notes receivable with the Shingle Springs Tribe. At January 2, 2011, Lakes evaluated the notes receivable from the Shingle Springs Tribe for impairment and concluded that it was probable that substantial amounts due would not be repaid within the contract term and therefore determined that the notes receivable were impaired. This determination was based on the lack of previously expected improvements in operating results due to the continued significant economic pressures in the northern California market and increased competition from a neighboring casino expansion in the market the property serves, all of which have negatively impacted cash flows for the property, as well as the deferral of all principal payments during the fourth quarter of fiscal 2010 due to insufficient net revenues from which to make these payments. Prior to the fourth quarter of fiscal 2010, Lakes had not experienced a three-month period in which all principal payments were deferred. There were no impairment charges on notes receivable during 2009.

 

Although Lakes has concluded that it is probable that substantial amounts due from the Shingle Springs Tribe will not be repaid within the contract term, the Shingle Springs Tribe will remain legally obligated to repay any remaining amounts due to Lakes subsequent to the conclusion of the contract.

 

Impairment losses- other.  Impairment losses-other were $22.8 million in fiscal 2010 and $4.2 million in fiscal 2009. Due to the carrying amount of the intangibles associated with the Shingle Springs Tribe exceeding the expected future cash flows from the management agreement for the Red Hawk Casino, impairment losses of $16.7 million were recognized during fiscal 2010. This determination was based on the issues discussed above, all

of which have negatively impacted expected future cash flows for the property. Due to the continued uncertainty surrounding the completion of the Jamul Casino project associated with delays in progress and general economic uncertainties, we recognized impairment losses of $2.5 million during fiscal 2010. Due to the Iowa Tribe’s decision not to move forward with Lakes for the development and management of the Ioway Casino Resort, impairment losses of $2.0 million were recognized in connection with the land and intangible assets related to the Ioway Casino project during 2010. Impairment losses of $1.6 million were recognized during fiscal 2010 related to the land held for development associated with the Vicksburg project due to continued declines in the estimated fair value. Impairment losses in fiscal 2009 were primarily associated with the Jamul Casino project and the Vicksburg project and were due to uncertainty surrounding the completion of these projects.

 

Amortization of intangible assets related to Indian casino projects.  Amortization of intangible assets related to Indian casino projects was $11.1 million for fiscal 2010 compared to $10.4 million for fiscal 2009.

 

Net unrealized gains on notes receivable.  For the year ended January 2, 2011, net unrealized gains on notes receivable were $1.6 million, compared to net unrealized gains of $1.9 million in fiscal 2009. The net unrealized gains in the current year consisted of gains related to the Iowa Tribe of $0.9 million which resulted from the termination agreement with the Iowa Tribe in May 2010 and net gains of $0.7 million related to the Jamul Tribe due primarily to improvements in the credit markets. However, the local opposition to the Jamul project has not been resolved and Lakes’ current expectation is that issues associated with this opposition could cause further delays, even if resolution of access issues is achieved. Net unrealized gains of $1.9 million in fiscal 2009 primarily related to the notes receivable from the Jamul Tribe predominantly due to improvements in the credit markets, partially offset by losses related to further delays in the expected opening date of this project.

 

Other income (expense).  Other income (expense), net was $28.1 million (which consisted of interest income of $7.0 million partially offset by interest expense of $2.0 million and gain on divestiture of $23.1 million) for fiscal 2010 compared to $6.1 million (which consisted of interest income of $8.0 million partially offset by interest expense of $2.0 million) for fiscal 2009. For fiscal 2010, the gain on divestiture of $23.1 million related to the Termination Agreement with Penn in which Lakes divested its interest in the entity to be formed in collaboration with Penn in exchange for a $25 million payment from Penn.

 

Income taxes.  The income tax provision was $1.2 million in fiscal 2010 compared to $1.4 million in fiscal 2009. Our effective tax rates for fiscal 2010 and fiscal 2009 were 9.1% and 27.7%, respectively. The effective tax rate differs from the federal tax rate of 35% due primarily to a change in the valuation allowance and a tax benefit related to an adjustment to the liability for uncertain tax positions in addition to state income taxes and share based compensation deductions. The liability for uncertain tax position was decreased from $17.0 million as of January 3, 2010 to $9.0 million as of January 2, 2011 which represents the amount Lakes agreed to pay in accordance with the Settlement Agreement with the Louisiana Department of Revenue. In fiscal 2010, the provision primarily consists of changes in valuation allowance of $10.8 million and $1.1 million related to state taxes, offset by $8.5 million of tax benefit for a reduction in the uncertain tax position and current tax benefit of $2.2 million. In fiscal 2009, the provision consisted primarily of changes in the valuation allowance for deferred tax assets of $1.9 million, interest on the Louisiana tax audit matter of $1.0 million and $1.7 million of tax benefits related to stock option exercises.

 

As of January 2, 2011, the Company evaluated its ability to utilize deferred tax assets arising from net operating loss carryforwards, and other ordinary items and determined that a 100% valuation allowance against those items was appropriate at January 2, 2011. Additionally, we evaluated the ability to utilize other existing deferred tax assets arising from other ordinary items and determined that due to a lack of sufficient positive evidence that future income will support the recognition of those other deferred tax assets, a valuation allowance against the deferred tax asset continues to be appropriate for those items at January 2, 2011.

 

Liquidity and Capital Resources

 

As of January 2, 2011, we had $45.2 million in cash and cash equivalents. We currently believe that our cash and cash equivalents balance and our cash flows from operations will be sufficient to meet our working capital requirements during the next 12 months. We currently expect to be able to obtain funds in order to fulfill our

potential future capital needs. However, such financing may not be available at all, or at acceptable terms, or it may be dilutive to our stockholders.

 

Our operating results and performance depend significantly on economic conditions and their effects on consumer spending in the casinos we manage. Declines in consumer spending cause our revenue generated from the management of these casinos to be adversely affected.

 

During the fiscal year ended January 2, 2011, UBS purchased our remaining ARS at their par value of $21.9 million. A portion of the proceeds were used to repay the remaining balance of $14.7 million on our related line of credit with UBS, which was subsequently closed upon repayment. These transactions resulted in a net additional liquidity of $7.2 million to Lakes, and Lakes has no remaining ARS investments and no remaining outstanding balance on the related line of credit.

 

During 2010, when Chisholm Creek withdrew its application to be the Lottery Facility Gaming Manager in the South Central Gaming Zone in Kansas, we received approximately $8.3 million from Kansas Gaming Partners, LLC representing our previous capital contribution for the deposit of a privilege fee with the State of Kansas.

 

As a result of our Termination Agreement with the Iowa Tribe, the Iowa Tribe agreed to pay to us a total of $4.5 million of which $1 million was received within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million is required to be paid in 15 monthly installments commencing on June 15, 2010.

 

As a result of our Termination Agreement with Penn, Penn paid us $25 million. Accordingly, we no longer have any rights, obligations or interest in the entity that was to be formed in collaboration with Penn for the development of casinos in Toledo and Columbus, Ohio. As a result of the payment received from the Termination Agreement with Penn, we paid Quest Media Group, LLC (“Quest”) $0.5 million during the third quarter of 2010, in accordance with a separate agreement between Lakes and Quest.

 

As of January 2, 2011, Lakes had contributed approximately $2.4 million to Rock Ohio Ventures related to this referendum effort. During 2011, Lakes has contributed additional capital of approximately $6.0 million. Per our agreement with Rock Ohio Ventures related to two potential Ohio casinos, Lakes expects to invest additional funds in those projects. As a result we may need to obtain additional financing.

 

During 2008, we closed on a two-year interest-only $8.0 million non-revolving line of credit loan agreement (the “Loan Agreement”) with Centennial Bank (formerly First State Bank). Effective October 28, 2010, the Loan Agreement’s maturity date was extended from October 2010 to October 2012. Amounts borrowed under the Loan Agreement bear interest at 8.95%. As of January 3, 2010, Lakes had drawn $2.0 million under the Loan Agreement. These advances were repaid during the fiscal year ended January 2, 2011, and no amounts were outstanding at January 2, 2011.

 

During the fiscal year ended January 2, 2011, we made a prepayment on a portion of our contract acquisition costs payable related to obtaining the management contract with the Pokagon Band of $3.4 million at an 18% discount. Amounts remaining of approximately $10.7 million for all projects under our contract acquisition cost obligations are payable through December 2015.

 

On October 15, 2010, we implemented a reduction in force resulting in the termination of 13 employees. These actions are designed to streamline and reduce our cost structure, increase our financial strength and align our workforce with anticipated staffing needs. We incurred one-time costs totaling approximately $500,000, which relate to cash outlays for employee severance benefits which are reflected in the financial results in the fourth fiscal quarter 2010. All amounts were paid as of January 2, 2011.

 

Lakes has derived its revenues from the management of the Cimarron Casino, the Four Winds Casino Resort and the Red Hawk Casino. Due to the May 2010 Termination Agreement with the Iowa Tribe, Lakes no longer receives management fees for the Cimarron Casino. Our management contracts with the Four Winds Casino Resort and the Red Hawk Casino extend through fiscal July 2012 and December 2015, respectively. Because of the relatively short operating history of the casinos we manage, and the economic pressures in the northern California market, the amount of our ongoing management fees is uncertain.

The management contract with the Red Hawk Casino includes a minimum guaranteed payment to the Shingle Springs Tribe of $0.5 million a month. Lakes is obligated to advance funds for these minimum guaranteed monthly payments when the casino operating results are not sufficient, and is repaid the advances in subsequent periods when operating results are sufficient. Lakes advanced funds during fiscal 2010 under the obligation, of which $1.0 million is outstanding as of January 2, 2011. We expect to continue to be required to advance funds for the minimum guaranteed payment throughout the next twelve months based on the current projected operating results of the property.

 

At January 2, 2011, we evaluated the notes receivable with the Shingle Springs Tribe for impairment and concluded that the notes receivable were impaired because we determined it was probable that substantial amounts due would not be repaid within the contract term. Lakes continues to manage the Red Hawk Casino and will collect monthly interest as scheduled as well as repayments of any minimum guaranteed monthly payments as discussed above and management fees when allowed as determined by net revenue levels of the Red Hawk Casino. However, the collection of principal on development notes receivable will be deferred until December 2013.

 

Although Lakes has concluded that it is probable that substantial amounts due from the Shingle Springs Tribe will not be repaid within the contract term, the Shingle Springs Tribe will remain legally obligated to repay any remaining amounts due to Lakes subsequent to the conclusion of the contract.

 

On March 17, 2011, Lakes and the Louisiana Department of Revenue entered into a Settlement Agreement whereby Lakes agreed to pay the Louisiana Department of Revenue $9.0 million in full and final payment for all taxes, interest and fees relating to a revenue tax litigation matter. In return, the Louisiana Department of Revenue agreed to dismiss the suit and forever discharge Lakes from all proceedings and liabilities relating to this matter. Lakes issued such payment during March 2011.

 

Lakes’ forecasted operating cash requirements do not include construction-related costs that will be incurred when pending and future development projects begin construction because the construction of our pending casino projects will depend on the ability of the tribes and/or Lakes or its partners to obtain additional financing for the projects, which based on the general economic environment, is subject to considerable uncertainty. If such financing cannot be obtained on acceptable terms, it may not be possible to complete these projects, which could have a material adverse effect on our future results of operations, cash flows and financial condition.

 

If our casino development project with the Jamul Tribe is not constructed or if constructed, does not achieve profitable operations in the highly competitive market for gaming activities, our only recourse is to attempt to liquidate assets of the development, if any, excluding any land in trust and it is likely that we would incur complete losses on our notes receivable and any related intangible assets.

 

In order to assist the tribes, we may elect to guarantee the tribes’ debt financing or otherwise provide support for the tribes’ obligations. Guarantees by us, if any, will increase our potential exposure to losses and other adverse consequences in the event of a default by any of these tribes. In addition, we may lack the funds to compete for and develop future gaming or other business opportunities and our business could be adversely affected to the extent that we may be forced to cease our operations entirely.

 

Critical accounting policies and estimates

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the balance sheet date and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, long-term assets related to Indian casino projects, investment securities, litigation costs, income taxes, and share-based compensation. We base our estimates and judgments on historical experience and on various other factors that are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue recognition:  Revenue from the management, development, and financing of, and consulting with, casino gaming facilities is recognized as it is earned pursuant to each respective agreement. See further discussion below under the caption “Long-term assets related to Indian casino projects.”

 

Share-based compensation expense:  Restricted stock units are valued at the Company’s stock price on the date of grant and amortized through expense over the requisite service period on a straight-line method. We use the Black-Scholes option pricing method to establish fair value of share-based awards. Our determination of fair value of share-based awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility and actual and projected employee stock option exercise behaviors. Any changes in these assumptions may materially affect the estimated fair value of the share-based award. We determine the estimated fair value per share of restricted stock units as the closing stock price on the date of grant, as reported by the NASDAQ Global Market.

 

Income taxes:  We account for income taxes under the provisions of Accounting Standards Codification (“ASC”) 740, Income Taxes.  The determination of our income tax-related account balances requires the exercise of significant judgment by management. Accordingly, we determine deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. We assess the likelihood that deferred tax assets will be recovered from future taxable income and establish a valuation allowance when management believes recovery is not likely.

 

We record estimated penalties and interest related to income tax matters, including uncertain tax positions as a component of income tax expense.

 

Long-term assets related to Indian casino projects:

 

Notes receivable.  We have formal procedures governing our evaluation of opportunities for potential Indian-owned casino development projects that we follow before entering into agreements to provide financial support for the development of these projects. We determine whether there is probable future economic benefit prior to recording any asset related to the Indian casino project. We initially evaluate the following factors involving critical milestones that affect the probability of developing and operating a casino:

 

 

 

We account for our notes receivable from the tribes as in-substance structured notes in accordance with the guidance contained in ASC 320, Investments — Debt and Equity Securities. Under their terms, the notes do not become due and payable unless the projects are completed and operational, and distributable profits are available from the operations. However, in the event our development activity is terminated prior to completion, we generally retain the right to collect in the event of completion by another developer. Because the stated rate of the notes receivable alone is not commensurate with the risk inherent in these projects (at least prior to commencement of operations), the estimated fair value of the notes receivable is generally less than the amount advanced. At the date of each advance, the difference between the estimated fair value of the note receivable and the actual amount advanced is recorded as an intangible asset, and the two assets are accounted for separately.

 

Subsequent to its initial recording at estimated fair value, the note receivable portion of the advance is adjusted to its current estimated fair value at each balance sheet date using then current assumptions including typical market discount rates, and expected repayment terms as may be affected by estimated future interest rates and opening dates, with the latter affected by changes in project-specific circumstances such as ongoing litigation, the status of regulatory approval and other factors previously noted. The notes receivable are not adjusted to a fair value estimate that exceeds the face value of the note plus accrued interest, if any. Due to uncertainties surrounding the projects, no interest income is recognized during the development period, but changes in estimated fair value of the notes receivable still held as of the balance sheet date are recorded as unrealized gains or losses in our consolidated statement of earnings.

 

Upon opening of the casino, any difference between the then estimated fair value of the notes receivables and the amount contractually due under the notes is amortized into income using the effective interest method over the remaining term of the note. Notes receivable are stated at the amount of unpaid principal and are net of unearned discount and, if applicable, an allowance for impaired notes receivable.

 

Notes receivable for open casinos are periodically evaluated for impairment pursuant to ASC 310, Receivables (“ASC 310”). Lakes considers a note receivable to be impaired when, based on current information and events, it is determined that Lakes will not be able to collect all amounts due according to the terms of the note receivable agreement.

 

Additionally, upon significant changes in the development activity prior to the opening of a casino, including termination of the project, notes receivable would be evaluated for impairment pursuant to ASC 310 and any necessary decline in the carrying amount will be recorded as unrealized losses in our consolidated statement of earnings. Subsequent to the initial impairment evaluation, we continue to monitor the note receivable for any changes in expected cash flows and recognize those changes in accordance with ASC 310.

 

Intangible assets related to Indian casino projects.  Intangible assets related to the acquisition of the management, development, consulting or financing contracts are accounted for using the guidance in ASC 350, Intangibles — Goodwill and Other (“ASC 350”). In accordance with ASC 350, we amortize the intangible assets related to the acquisition of the management, development, consulting or financing contracts under the straight-line method over the term of the respective contracts which commence when the related casinos open. In addition to the intangible asset associated with the cash advances to tribes described above, these assets include actual costs incurred to acquire our interest in the projects from third parties.

 

Pursuant to ASC 350, the intangible assets are periodically evaluated for impairment based on the estimated cash flows from the respective contract on an undiscounted basis. In the event the carrying value of the intangible assets, in combination with the carrying value of land held for development and other assets associated with the Indian casino projects described below, were to exceed the undiscounted cash flow, an impairment would be recorded. Such an impairment would be measured based on the difference between the fair value and carrying value of the intangible assets. We principally use internal forecasts to estimate the undiscounted future cash flows used in our impairment analyses. These forecasts and fair value assumptions are highly subjective and judgmental and are primarily based on management’s judgment which takes into account the casino industry, known operating results and trends, and the current economic environment that the casino serves to develop an applied discount rate. During

periods of economic instability, we may not be able to accurately forecast future cash flows from our Indian casino projects. Therefore, our estimates and assumptions may change, and are reasonably likely to change in future periods. These changes could adversely affect our consolidated statements of earnings.

 

Land held for development.  Included in land held for development is land held for possible transfer to Indian tribes for use in certain of the future casino resort projects. In the event that this land is not transferred to the tribes, we have the right to sell it. We evaluate these assets for impairment in combination with intangible assets related to acquisition of management, development, consulting or financing contracts and other assets related to the Indian casino projects as discussed above.

 

Other.  Other assets primarily consist of amounts due from related parties that are directly related to the development and opening of Lakes’ Indian casino project in addition to deferred management fees and interest due from the Shingle Springs Tribe. See Note 17 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. Also included in this category are costs incurred related to the Indian casino projects, which have not yet been included as part of the notes receivable because of timing of the payment of these costs.

 

In addition, we incur certain non-reimbursable costs related to the projects that are not included in notes receivable, which are expensed as incurred. These costs include salaries, travel and certain legal costs.

 

Long-term assets related to Indian Casino projects

 

The consolidated balance sheets as of January 2, 2011 and January 3, 2010 include long-term assets related to Indian casino projects of $64.3 million and $110.6 million, respectively, which primarily related to four separate projects. The amounts are as follows by project (in thousands):

 

 

 

 

 

Notes receivable at fair value.  The key assumptions, estimates and criteria used in the determination of the estimated fair value of the notes receivable are primarily unobservable level three inputs, which are casino opening dates, pre- and post-opening date interest rates, discount rates and probabilities of projects opening. The estimated casino opening dates used in the valuations of the notes receivable related to Indian casino projects that are not yet under construction reflect the weighted-average of three scenarios: a base case (which is based on our forecasted casino opening date) and one and two years out from the base case. Once a casino project is under construction, the weighted-average scenarios are no longer used and only the planned opening date is used in the valuation. The interest rates are based upon the one year U.S. Treasury Bill spot yield curve per Bloomberg and the specific assumptions on contract term, stated interest rate and casino opening date. The discount rate for the projects is based on the yields available on certain financial instruments at the valuation date, the risk level of equity investments in general, and the specific operating risks associated with open and operating gaming enterprises similar to each of the projects. In estimating this discount rate, market data of other public gaming related companies is considered. The probability applied to each project is based upon a weighting of various possible scenarios with one scenario assuming the casino never opens. The other scenarios assume the casino opens but apply different opening dates. The probability-weighting applied to each scenario is intended to effectively capture the element of risk in these projects and is based upon the status of each project, review of the critical milestones and likelihood of achieving the milestones.

 

Jamul Tribe

 

The following table provides the key assumptions used to value the notes receivable from the Jamul Tribe at estimated fair value (dollars in thousands):

 

The following table represents a sensitivity analysis prepared by Lakes as of January 2, 2011 on the notes receivable from the Jamul Tribe, based upon changes in the probability rate of the casino opening by five percentage points and the estimated casino opening date by one year:

 

 

The assumption changes used in the sensitivity analysis above are hypothetical. The effect of the variation in the probability assumption and estimated opening date on the estimated fair value of the notes receivable from Indian tribes was calculated without changing any other assumptions; however, in reality, changes in these factors may result in changes in another. For example, the change in probability could be associated with a change in discount rate, which might magnify or counteract the sensitivities.

 

The following represents the nature of the advances to the Jamul Tribe for the project under development, which represent the principal amount of the notes receivable, as of January 2, 2011 and January 3, 2010 (in thousands).

 

 

 

 

The notes receivable pre-construction advances consist of the following principal amounts advanced to the Jamul Tribe as of January 2, 2011 and January 3, 2010 (in thousands):

 

 

Iowa Tribe

 

As a result of the Termination Agreement with the Iowa Tribe, the carrying value of the notes receivable was adjusted to its estimated fair value of as of April 4, 2010 and the difference between the then estimated fair value and

the amount contractually due under the Termination Agreement with the Iowa Tribe is being amortized into income using the effective interest method over the remaining term. The note receivable is no longer adjusted to estimated fair value, but rather it is evaluated periodically for impairment pursuant to ASC 310. The payment terms of the Termination Agreement with the Iowa Tribe and a discount rate of 6.0% were used as the assumptions for the determination of estimated fair value as of April 4, 2010.

 

Lakes recorded an unrealized gain (loss) of $0.9 million and ($0.2) million for the fiscal 2010 and 2009, respectively, which is included in net unrealized gains from notes receivable in the consolidated statements of earnings. At January 2, 2011, the carrying value of the note receivable is $1.4 million which is expected to be collected within the next fiscal year.

 

The following table provides the key assumptions used to value the notes receivable from the Iowa Tribe at estimated fair value as of January 3, 2010 (dollars in thousands):

 

 

Evaluation of impairment related to long-term assets related to Indian casino projects, excluding the notes receivable.  Management periodically evaluates the intangible assets, land held for development and other costs associated with each of the projects for impairment based on the estimated undiscounted cash flows from the applicable management contract on an undiscounted basis. In the event the carrying value of the intangible assets, in combination with the carrying value of land held for development and other assets associated with the Indian casino projects, were to exceed the undiscounted cash flow, an impairment loss would be recorded, based on the difference between the estimated fair value and carrying value of the assets.

 

The financial models prepared by management for each project are based upon the scope of each of the projects, which are supported by a feasibility study as well as a market analysis where the casino will be built. We (as predecessor to Grand Casinos Inc.) began developing Indian casino projects in 1990 and demonstrated success from the day the first Indian casino opened in 1991 through the expiration of the Coushatta management contract in 2002. Additionally, we have been managing the Four Winds Casino Resort since August of 2007 and the Red Hawk Casino since December of 2008. Lakes had a management contract for the Cimarron Casino in Oklahoma from 2006 through May 2010. Our successful history legitimizes many of the key assumptions supporting the financial models. Forecasts for each applicable casino development were developed based on analysis of published information pertaining to the particular markets in which our Indian casinos will be located and are updated quarterly based on evolving events and market conditions. In addition, we have many years of casino operations experience, which provides an additional resource on which to base our revenue expectations. The forecasts were prepared by us not for purposes of the valuation at hand but rather for purposes of our and the tribes’ business planning.

 

Shingle Springs

 

Due to the carrying amount of the intangibles associated with the Shingle Springs Tribe exceeding the expected future cash flows from the management agreement for the Red Hawk Casino, impairment losses of $16.7 million were recognized during fiscal 2010. This determination was based on the continued significant economic pressures in the northern California market and increased competition from a neighboring casino expansion in the market the property serves, all of which have negatively impacted expected future cash flows for the property.

Jamul Tribe

 

The primary assumptions included within management’s financial model for the Jamul Casino project are as follows:

 

 

Lakes and the Jamul Tribe have consulted with third party advisors as to the architectural feasibility of a plan to build a casino with related amenities such as parking on the six acres of reservation land held by the Jamul Tribe and have concluded that such a project could be successfully built assuming adequate financing can be obtained. The gaming facility is currently planned to be a class II electronic gaming device facility which will not require a compact. The agreement between Lakes and the Jamul Tribe will also be modified as the political, regulatory and access issues move closer to resolution.

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues. Significant risk exists related to this project moving forward to completion, and we have recorded significant impairment charges against our investment in this project. However, the Jamul Tribe has the two basic requirements to eventually build a successful project — federal recognition as an Indian Tribe and Indian land eligible for gaming and Lakes currently expects to continue its involvement with this project.

 

Due to the continued uncertainty surrounding the Jamul Casino project, Lakes recognized an impairment of $2.5 million and $2.4 million related to the intangible assets associated with this project during the years ended January 2, 2011 and January 3, 2010, respectively.

 

Iowa Tribe

 

On April 2, 2010, the Iowa Tribe decided not to pursue the proposed Ioway Casino Resort with Lakes. At January 3, 2010, long-term assets included intangibles assets of $1.4 million and land held for development of $0.9 million. As a result of the Iowa Tribe’s decision on April 2, 2010 not to move forward with Lakes on the Ioway Casino Resort, management performed an assessment of the land fair value and has deemed the land impaired as of the quarter ended April 4, 2010. As a result, Lakes adjusted the carrying value of this land to its estimated fair value of $0.2 million as of that date, recorded an impairment of $0.7 million, and has reclassified the land to Land held for development (not related to Indian casino projects) during fiscal 2010.

 

Description of each Indian casino project and evaluation of critical milestones

 

Pokagon Band

 

Business arrangement.  On August 2, 2007, the Four Winds Casino Resort in New Buffalo, Michigan opened to the public. We receive approximately 24% of net income up to a certain level and 19% of net income over that level, as a management fee. The term of the management contract is five years, which began on August 2, 2007. Payment of our management fee is subordinated to the Pokagon Gaming Authority’s senior indebtedness relating to the Four Winds Casino Resort. The Pokagon Band may also buy out the management contract after two years from the opening date. The buy-out amount is calculated by multiplying the previous 12 months of management fees

earned by the remaining number of years under the management contract, discounted back to the present value at the time the buy-out occurs. The NIGC approved the management contract in March 2006.

 

Shingle Springs

 

Business arrangement.  On December 17, 2008, the Red Hawk Casino opened to the public. We earn a management fee equal to 30% of net income (as defined by the management contract) of the operations annually for the first five years, with a declining percentage in years six and seven. Payment of our management fee is subordinated to the repayment of $450 million senior note financing of an affiliate of the Shingle Springs Tribe, the repayment of $46.1 million furniture, furnishings and equipment financing as of January 2, 2011 and a minimum monthly priority payment to the Shingle Springs Tribe. Generally, the order of priority of payments from the Red Hawk Casino’s cash flows is as follows: a certain minimum monthly guaranteed payment to the Shingle Springs Tribe, repayment of various debt with interest accrued thereon, management fee to Lakes, and other obligations, with the remaining funds distributed to the Shingle Springs Tribe. The management contract includes provisions that allow the Shingle Springs Tribe to buy-out the management contract after four years from the opening date. The buy-out amount is calculated by multiplying the previous 12 months of management fees earned by the remaining number of years under the contract, discounted back to the present value at the time the buy-out occurs. If the Shingle Springs Tribe elects to buy out the contract, all outstanding amounts owed to Lakes immediately become due and payable. The NIGC approved the management contract in July 2004, which was subsequently amended in April 2007.

 

We acquired our initial interest in the development and management contracts for the Shingle Springs Casino from KAR — Shingle Springs in 1999 and formed a joint venture, in which the contracts were held, between us and KAR — Shingle Springs. On January 30, 2003, we purchased the remaining KAR — Shingle Springs’ partnership interest in the joint venture. In connection with the purchase transaction, we entered into separate agreements with the two individual owners of KAR — Shingle Springs (Kevin M. Kean and Jerry A. Argovitz).

 

During 2009, Lakes became obligated to pay Mr. Argovitz $1 million per year (prorated based on a 365 day year) during the remainder of the seven-year initial term of the management contract which commenced in December 2008 between Lakes and the Shingle Springs Tribe, as a result of Mr. Argovitz’s election under an existing agreement related to this project. Also as a result of this election, Mr. Argovitz will not be entitled to obtain a 15% equity interest in the Lakes’ entity that holds the rights to the management fees earned by Lakes from the Red Hawk Casino operations.

 

During 2009, Lakes became obligated to pay to Mr. Kean $1 million per year (prorated based on a 365 day year) during the remainder of the seven-year initial term of the management contract which commenced in December 2008 between Lakes and the Shingle Springs Tribe, as a result of Mr. Kean’s election under an existing agreement related to this project. Also as a result of this election, Mr. Kean will not be entitled to receive consulting fees equal to 15% of the management fees earned by Lakes from the Red Hawk Casino operations.

 

See Note 17 to the consolidated financial statements for further discussion.

 

Jamul Tribe

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues, including those related to access from State Highway 94 to the proposed casino site. In addition, the California Department of Transportation (“CalTrans”) issued a letter in 2008 to the Jamul Tribe indicating that it would not allow access to a casino operation from State Highway 94. In January 2011, the Jamul Tribe and CalTrans entered into an agreement which will permit CalTrans to review and process the Jamul Tribe’s encroachment permit application relating to the access, and provided that if the Jamul Tribe’s application meets certain legal requirements, issue the encroachment permit. The Jamul Tribe is currently performing various environmental and traffic studies necessary for the permit application.

 

Business arrangement.  The Jamul Tribe has an approximate six-acre reservation on which the casino project is currently planned to be built. The reservation is located near San Diego, California. Under the current compact that the Jamul Tribe has with the State of California (the “State”) and based upon requirements in other compacts

approved by the State in 2004, the Jamul Tribe completed a Tribal Environmental Impact Statement/Report that was approved by the Jamul Tribe’s General Council with a record of decision issued by the Jamul Tribe on December 16, 2006. Since that time, the Jamul Tribe has received comments from various state agencies including the representative from the California Governor’s office. The Jamul Tribe and the State have met on several occasions in an attempt to address the State’s comments related to compact requirements. Lakes and the Jamul Tribe have continued to evaluate the Jamul Tribe’s alternatives of pursuing a new compact, complying with certain requirements in their existing compact or building and operating a casino based solely on class II electronic gaming devices. The current plan is for a smaller scale gaming facility that will become a solely class II electronic gaming device facility which will not require a compact. The agreement between Lakes and the Jamul Tribe (discussed below) will also be modified as the political, regulatory and access issues move closer to resolution.

 

Effective March 30, 2006, Lakes entered into a development financing and services agreement with the Jamul Tribe to assist the Jamul Tribe in developing the Jamul Casino which the Jamul Tribe will manage. As part of the current agreement, Lakes will use its best efforts to obtain financing, from which advances will be made to the Jamul Tribe to pay for the design and construction of the Jamul Casino. Under the current development financing and services agreement, Lakes is entitled to receive a flat fee for its development design services, and a flat fee for its construction oversight services, payable evenly over the first five years after the opening date of the Jamul Casino. In connection with Lakes’ financing of the Jamul Casino, the Jamul Tribe is required to pay interest over a ten-year period on sums advanced by Lakes equal to the rate charged to Lakes for obtaining the necessary funds plus five percent. Amounts previously advanced by Lakes to the Jamul Tribe in connection with the Jamul Tribe’s proposed casino resort are included in the development financing and services agreement financing amount. However, as discussed above, this agreement is planned to be modified as the political, regulatory and access issues move closer to resolution. Third party financing may not be available with acceptable terms and if Lakes or the Jamul Tribe is unable to obtain the appropriate amount of financing for this project, the project may not be completed as planned.

 

Lakes acquired its initial interest in the development agreement and management contract for the Jamul casino from Kean Argovitz Resorts — Jamul, LLC (“KAR — Jamul”) in 1999 and formed a joint venture in which the contract was held between Lakes and KAR — Jamul. This development agreement and a management contract has been submitted to the NIGC for approval. On January 30, 2003, Lakes purchased the remaining KAR — Jamul’s partnership interest in the joint venture. In connection with the purchase transaction, Lakes entered into separate agreements with the two individual owners of KAR — Jamul (Mr. Kean and Mr. Argovitz).

 

Under the current agreement with Mr. Kean, he may elect to serve as a consultant to Lakes during the term of the casino management agreement if he is found suitable by relevant gaming regulatory authorities. In such event, Mr. Kean will be entitled to receive annual consulting fees equal to 20% of the management fees received by Lakes from the Jamul Casino operations, less certain costs of these operations. If Mr. Kean is not found suitable by relevant gaming regulatory authorities or otherwise elects not to serve as a consultant, he will be entitled to receive annual payments of $1 million from the Jamul Casino project during the term of the respective casino management agreement (but not during any renewal term of such agreement).

 

Under the current agreement with Mr. Argovitz, if he is found suitable by relevant gaming regulatory authorities he may elect to re- purchase his respective original equity interest in the Lakes’ subsidiary and then be entitled to obtain a 20% equity interest in the Lakes’ entity that holds the rights to the management agreement with the Jamul Tribe. If he is not found suitable or does not elect to purchase equity interests in the Lakes subsidiary, Mr. Argovitz may elect to receive annual payments of $1 million from the Jamul Casino project from the date of election through the term of the respective casino management agreement (but not during any renewal term of such agreement).

Our evaluation of the critical milestones.  The following table outlines the status of each of the following primary milestones necessary to complete the Jamul project as of the end of fiscal 2010 and fiscal 2009. Both the positive and negative evidence was reviewed during our evaluation of the critical milestones.

 

 

Our evaluation and conclusion regarding the above critical milestones and progress.  We entered into a development financing and services agreement with the Jamul Tribe in March 2006, as discussed above which eliminated the need for land contiguous to the reservation land to be taken into trust. We believe that there is no requirement that the NIGC approve the development financing and services agreement. The Jamul Casino is planned to be built on the Jamul Tribe’s existing six acres of reservation land. Reservation land qualifies for gaming without going through a land-in-trust process. We have consulted with third-party advisors as to the architectural feasibility of the alternative plan and have been assured that the project can be successfully built on the reservation land.

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues. Significant risk exists related to this project moving forward to completion, and we have recorded significant impairment charges against our investment in this project. However, the Jamul Tribe has the two basic requirements to eventually build a successful project — federal recognition as an Indian Tribe and Indian land eligible for gaming and Lakes currently expects to continue its involvement with this project. The Jamul Casino could open as early as January 2016.

Iowa Tribe

 

During May 2010, a subsidiary of Lakes entered into a Termination Agreement with the Iowa Tribe whereby, in consideration of the parties terminating all contracts and agreements between them (including the Management Agreement under which Lakes was managing the Cimarron Casino, the Consulting Agreement for the Ioway Casino Resort, and the Amended and Restated Ioway Note under which approximately $5.0 million was advanced), the Iowa Tribe agreed to pay to Lakes a total of $4.5 million of which $1 million was received within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million is required to be paid in 15 monthly installments commencing on June 15, 2010.

 

Recently issued accounting pronouncements

 

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-6, Improving Disclosures About Fair Value Measurements, which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. ASU 2010-6 was effective for Lakes’ fiscal year beginning January 4, 2010, except for Level 3 reconciliation disclosures which will be effective for the fiscal year beginning January 3, 2011. The adoption of ASU 2010-6 did not have a material impact on Lakes’ financial statements for the fiscal year ended January 2, 2011, and the adoption of Level 3 reconciliation disclosures is not expected to have a material impact on Lakes’ financial statements for the fiscal year beginning January 3, 2011.

 

In July 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU No. 2010-20 requires a greater level of disaggregation in disclosures relating to the credit quality of the Company’s financing receivables and allowance for loan losses. ASU 2010-20 also requires enhanced disclosures around nonaccrual and past due financing receivables, impaired loans and loan modifications. The standard is effective for the first interim or annual reporting periods ending on or after December 15, 2010, and did not have a material impact on Lakes’ financial statements for the year ended January 2, 2011. In January 2011, the FASB announced that it was deferring the effective date of new disclosure requirements for troubled debt restructurings prescribed by ASU 2010-20. The effective date for those disclosures will be concurrent with the effective date for proposed ASU, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011.

 

Seasonality

 

We believe that the operations of all casinos managed by us are affected by seasonal factors, including holidays, weather and travel conditions.

 

Regulation and taxes

 

We and the owners of the existing and planned casinos that we are and will be working with are subject to extensive regulation by state gaming authorities. We will also be subject to regulation, which may or may not be similar to current state regulations, by the appropriate authorities in any jurisdiction where we may conduct gaming activities in the future. Changes in applicable laws or regulations could have an adverse effect on us.

 

The gaming industry represents a significant source of tax revenues to regulators. From time to time, various federal legislators and officials have proposed changes in tax law, or in the administration of such law, affecting the gaming industry. It is not possible to determine the likelihood of possible changes in tax law or in the administration of such law. Such changes, if adopted, could have a material adverse effect on our future financial position, results of operations and cash flows.

Off-balance sheet arrangements

 

We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors, except for the financing commitments previously discussed.

 

 

Not Applicable.

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Board of Directors

Lakes Entertainment, Inc. and Subsidiaries

Minnetonka, Minnesota

 

We have audited the accompanying consolidated balance sheets of Lakes Entertainment, Inc. and Subsidiaries (the Company) as of January 2, 2011 and January 3, 2010, and the related consolidated statements of earnings (loss), shareholders’ equity, and cash flows for the years then ended. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of January 2, 2011 and January 3, 2010, and the consolidated results of its operations and cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States.

 

 

Piercy Bowler Taylor & Kern

Certified Public Accountants

 

Las Vegas, Nevada

March 31, 2011

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Balance Sheets

 

 

 

See notes to consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Statements of Earnings (Loss)

For the Fiscal Years ended January 2, 2011 and January 3, 2010

 

 

 

See notes to consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Statements of Shareholders’ Equity

For the Fiscal Years ended January 2, 2011 and January 3, 2010

 

 

See notes to consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

For the Fiscal Years ended January 2, 2011 and January 3, 2010

 

 

 

See notes to consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Overview.  Lakes Entertainment Inc. and subsidiaries (collectively “the Company” or “Lakes”) develops, finances and manages casino properties with a historical emphasis on those that are Indian-owned. Lakes currently has development and management or financing agreements with three separate tribes for casino operations in Michigan and California, for a total of three separate casino projects as follows:

 

 

During May 2010, Lakes entered into a termination agreement with the Iowa Tribe of Oklahoma, its governmental components and instrumentalities (collectively, the “Iowa Tribe”) (“Termination Agreement with the Iowa Tribe”), whereby, in consideration of the parties terminating all contracts and agreements between them (including the Management Agreement under which Lakes was managing the Cimarron Casino, the Consulting Agreement for the Ioway Casino Resort, and the Amended and Restated Ioway Note under which approximately $5.0 million was advanced), the Iowa Tribe agreed to pay to Lakes a total of $4.5 million of which $1 million was received within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million is required to be paid in 15 monthly installments commencing on June 15, 2010.

 

Lakes has also explored, and continues to explore, other casino development projects. An overview of the non-Indian projects are as follows:

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

Significant customers and concentrations of credit risk.  Fees earned for services related to the Red Hawk Casino and the Four Winds Casino Resort in 2010 and 2009 and fees earned related to the Cimarron Casino in 2009 were each in excess of ten percent of consolidated revenues in the accompanying consolidated statements of earnings (loss). The decline in general economic conditions in the United States has negatively impacted the local economic conditions near the casinos we manage and has negatively impacted Lakes’ management fees and the availability of credit to finance Lakes’ development projects.

 

The financial instruments that subject the Company to concentrations of credit risk consist principally of its notes receivable due from Indian tribes (Note 6), and accounts receivable in connection with Indian casino management contracts. The notes receivable consist of both open (Shingle Springs Tribe) and development (Jamul) projects. Lakes manages the risk related to open projects and related accounts and notes receivable by overseeing the day-to-day management of operations and evaluating collectability (need for allowance for doubtful collection and possible charge-off) of the accounts and notes receivable based upon operational performance on a case by case basis. For development projects, Lakes monitors the feasibility of the projects, including the likelihood the project will open and be financially successful, before making advances to the Indian tribes. In the event any of the receivables become uncollectible, the maximum losses to be sustained would be the carrying value of the receivables, plus the net carrying value of the related unamortized intangible assets.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Restructuring Activities.  On October 15, 2010, the Company implemented a reduction in force resulting in the termination of 13 employees. These actions were designed to streamline and reduce the Company’s cost structure, increase its financial strength and align its workforce with anticipated staffing needs. The Company incurred charges of approximately $0.5 million, which related to cash outlays for employee severance benefits. The charges incurred are included in Selling, general and administrative expenses on the consolidated statement of earnings and relate to the Corporate segment. All amounts were paid as of January 2, 2011.

 

 

Use of estimates.  Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates that affect the reported amounts of assets and liabilities and disclosures at the date of the financial statements and the reported amounts of net earnings (loss) during the reporting periods. Actual results could differ from those estimates. Significant estimates that are particularly susceptible to change materially within the next year relate to: valuation and the realizability of notes receivable and other long-term assets related to Indian casino projects, fair value measurements, income tax liabilities, and deferred income tax asset valuation allowances.

 

Year end.  The Company has a 52- or 53-week accounting period ending on the Sunday closest to December 31 of each year. The Company’s fiscal years for the periods shown on the accompanying consolidated statements of earnings (loss) ended on January 2, 2011 (“fiscal 2010”) and January 3, 2010 (“fiscal 2009”)

 

Basis of presentation.  The accompanying consolidated financial statements include the accounts of Lakes and its wholly-owned subsidiaries. Investments in entities that the Company does not control, but has significant influence over operating and financial policies, are accounted for under the equity method. Investments in entities in which the Company does not have the ability to exercise significant influence are accounted for under the cost method. All significant inter-company balances and transactions have been eliminated in consolidation.

 

Subsequent events.  Management has evaluated the accompanying consolidated financial statements for subsequent events through the date this Annual Report on Form 10-K was filed with the SEC, and have included the necessary subsequent events in the consolidated financial statements and accompanying footnotes.

 

Revenue recognition.  Revenue from the management, development, financing of, and consulting with Indian-owned casino gaming facilities is recognized as it is earned pursuant to each respective agreement. See further discussion below under the caption “Long-term assets related to Indian casino projects.” Accounts receivable deemed uncollectible are charged off through a provision for uncollectible accounts. No amounts were deemed uncollectible during fiscal 2010 and fiscal 2009.

 

Cash equivalents.  Cash equivalents consist of highly-liquid investments with original maturity of three months or less.

 

Investment securities.  At January 3, 2010, investment securities were comprised of investments in Auction Rate Securities (“ARS”), all of which were held by UBS Financial Services, Inc. (“UBS”) and were accounted for as trading securities under the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320, Investments — Debt and Equity Securities. Lakes also had the nontransferable right (the “Rights”) to sell the ARS at par value to UBS at any time during the period of June 30, 2010, through July 2, 2012 (Note 3). The Rights represented a free standing asset separate from the ARS. The Rights did not meet the definition of a derivative instrument under ASC 815, Derivatives and Hedging. Therefore, Lakes measured the Rights at estimated fair value based on Level 3 inputs under ASC 825, Financial Instruments (“ASC 825”), which permitted Lakes to elect the fair value option for recognized financial assets, to match the changes in the estimated fair value of the ARS. Gains and losses are reported as interest income in the consolidated statements of operations.

 

Investment in unconsolidated investees.  Investments in an entity where the Company owns less than twenty percent of the voting stock of the entity and does not exercise significant influence over operating and financial

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

policies of the entity are accounted for using the cost method. Investments in the entity where the Company owns twenty percent or more but not in excess of fifty percent of the voting stock of the entity or less than twenty percent and exercises significant influence over operating and financial policies of the entity are accounted for using the equity method. The Company has a policy in place to review its investments at least annually, to evaluate the accounting method and carrying value of the investments in these companies. The cost method investments are subject to impairment assessment if there are identified events or changes in circumstance that may have a significant adverse affect on the fair value of the respective investment. If the Company believes that the carrying value of an investment is in excess of estimated fair value, it is the Company’s policy to record an impairment charge to adjust the carrying value to the estimated fair value, if the impairment is considered other-than-temporary.

 

Property and equipment.  Property and equipment (Note 8) is stated at cost less accumulated depreciation. Depreciation of property and equipment is computed using the straight-line method over the following estimated useful lives:

 

 

Long-term assets related to Indian casino projects

 

Notes receivable (Note 6).  Lakes has formal procedures governing its evaluation of opportunities for potential Indian-owned casino development projects that it follows before entering into agreements to provide financial support for the development of these projects. Lakes determines whether there is probable future economic benefit prior to recording any asset related to the Indian casino project. Lakes’ management initially evaluates the following factors involving critical milestones that affect the probability of developing and operating a casino:

 

 

Lakes accounts for its notes receivable from the tribes as in-substance structured notes. Under their terms, the notes do not become due and payable unless the projects are completed and operational, and distributable profits are available from their operations. However, in the event its development activity is terminated prior to completion,

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Lakes generally retains the right to collect in the event of completion by another developer. Because the stated rate of the notes receivable alone is not commensurate with the risk inherent in these projects (at least prior to commencement of operations), the estimated fair value of the notes receivable is generally less than the amount advanced. At the date of each advance, the difference between the estimated fair value of the note receivable and the actual amount advanced is recorded as an intangible asset, and the two assets are accounted for separately.

 

Subsequent to its initial recording at estimated fair value, the note receivable portion of the advance is adjusted to its current estimated fair value (Note 6) at each balance sheet date until the casino opens using then current assumptions including typical market discount rates, and expected repayment terms as may be affected by estimated future interest rates and opening dates, with the latter affected by changes in project-specific circumstances such as ongoing litigation, the status of regulatory approval and other factors previously noted. The notes receivable are not adjusted to a fair value estimate that exceeds the face value of the note plus accrued interest, if any. Due to uncertainties surrounding the projects, no interest income is recognized during the development period, but changes in estimated fair value of the notes receivable still held as of the balance sheet date are recorded as unrealized gains or losses in Lakes’ consolidated statement of earnings (loss).

 

Upon opening of the casino, any difference between the then estimated fair value of the notes receivables and the amount contractually due under the notes is amortized into income using the effective interest method over the remaining term of the note. Notes receivable are stated at the amount of unpaid principal and are net of unearned discount and, if applicable, an allowance for impaired notes receivable.

 

Lakes monitors the credit quality of notes receivable through ongoing review of the casino’s financial position, operating results and projected operating results that are available to Lakes in its capacity as manager of the casino. In addition, Lakes continuously monitors the economic, political, regulatory and competitive conditions that may adversely impact casinos’ projected operating results.

 

Notes receivable related to open casinos are periodically evaluated for impairment. Lakes considers a note receivable to be impaired when, based on current information and events, it is determined that Lakes will not be able to collect all amounts due according to the note receivable contract. Impairment is measured based on the present value of expected future cash flows discounted at the note receivable’s effective interest rate. Interest income for impaired notes receivable will be accrued on the net carrying amount of the impaired note receivable under the effective interest method with significant changes to expected cash flows reflected in the impairment charge on notes receivable.

 

The allowance for impaired notes receivable is established through a charge to expense. Any note receivable principal considered to be uncollectible by management is charged against the allowance for impaired notes receivable.

 

Intangible assets related to Indian casino projects (Note 7).  Intangible assets related to the acquisition of the management, development, consulting or financing contracts are periodically evaluated for impairment based on the estimated cash flows from the contract on an undiscounted basis. In the event the carrying value of the intangible assets, in combination with the carrying value of land held for development and other assets associated with the Indian casino projects described below, exceeds the undiscounted cash flow, an impairment is recorded. Such an impairment is measured based on the difference between the fair value and carrying value of the assets. Lakes amortizes the intangible assets related to the acquisition of the management, development, consulting or financing contracts under the straight-line method over the lives of the contracts commencing when the related casino opens. In addition to the intangible asset associated with the cash advances to tribes described above, these assets include actual costs incurred to acquire Lakes interest in the projects from third parties.

 

Land held for development (Note 7).  Included in land held for development is land held for possible transfer to Indian tribes for use in certain of the future casino resort projects. In the event that this land is not transferred to the tribes, the Company has the right to sell it. Lakes evaluates these assets for impairment in combination with

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

intangible assets related to the acquisition of the management, development, consulting or financing contracts and other assets related to the Indian casino projects as discussed above.

 

Other (Note 7).  Other assets include amounts due from related parties that are directly related to the development and opening of Lakes’ Indian casino project in addition to deferred management fees and interest due from the Shingle Springs Tribe. Also included in this category are costs incurred related to the Indian casino projects, which have not yet been included as part of the notes receivable because of timing of the payment of these costs.

 

In addition, Lakes incurs certain non-reimbursable costs related to the projects that are not included in notes receivable, which are expensed as incurred. These costs include salaries, travel and certain legal costs.

 

Share-based compensation expense (Note 14).  Restricted stock units are valued at the Company’s stock price on the date of grant and amortized through expense over the requisite service period on a straight-line method. Lakes uses the Black-Scholes option pricing method to establish the fair value of share-based option awards. Lakes determination of fair value of share-based option awards on the date of grant using an option-pricing model is affected by the following assumptions regarding complex and subjective variables. Any changes in these assumptions may materially affect the estimated fair value of the share-based award.

 

 

The following assumptions were used to estimate the fair value of stock options:

 

 

Income taxes (Note 13).  The determination of the Company’s income tax-related account balances requires the exercise of significant judgment by management. Accordingly, the Company determines deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Management

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

assesses the likelihood that deferred tax assets will be recovered from future taxable income and establishes a valuation allowance when management believes recovery is not likely.

 

The Company records estimated penalties and interest related to income tax matters, including uncertain tax positions as a component of income tax expense.

 

Litigation costs.  The Company does not accrue for future litigation costs, if any, to be incurred in connection with outstanding litigation and other dispute matters but rather records such costs when the legal and other services are rendered.

 

Earnings (loss) per share.  For all periods, basic earnings (loss) per share (“EPS”) is calculated by dividing net earnings (loss) by the weighted average common shares outstanding. Diluted EPS in profitable years reflects the effect of all potentially dilutive common shares outstanding by dividing net earnings (loss) by the weighted average of all common and potentially dilutive shares outstanding. Potentially dilutive stock options of 2,031,084 and 739,143 shares in fiscal 2010 and fiscal 2009, respectively, were not included in a computation of diluted earnings per share because the effects would have been anti-dilutive for the periods presented.

 

Reclassifications.  Certain immaterial reclassifications have been made to the fiscal 2009 consolidated financial statements to conform to the fiscal 2010 presentation.

 

New accounting standards.  In January 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-6, Improving Disclosures About Fair Value Measurements, which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. ASU 2010-6 was effective for Lakes’ fiscal year beginning January 4, 2010, except for Level 3 reconciliation disclosures which will be effective for the fiscal year beginning January 3, 2011. The adoption of ASU 2010-6 did not have a material impact on Lakes’ financial statements for the fiscal year ended January 2, 2011, and the adoption of Level 3 reconciliation disclosures is not expected to have a material impact on Lakes’ financial statements for the fiscal year beginning January 3, 2011.

 

In July 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU No. 2010-20 requires a greater level of disaggregation in disclosures relating to the credit quality of the Company’s financing receivables and allowance for loan losses. ASU 2010-20 also requires enhanced disclosures around nonaccrual and past due financing receivables, impaired loans and loan modifications. The standard is effective for the first interim or annual reporting periods ending on or after December 15, 2010, and did not have a material impact on Lakes’ financial statements for the year ended January 2, 2011. In January 2011, the FASB announced that it was deferring the effective date of new disclosure requirements for troubled debt restructurings prescribed by ASU 2010-20. The effective date for those disclosures will be concurrent with the effective date for proposed ASU, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011.

 

 

At January 3, 2010, the Company’s investment portfolio was comprised of investments in ARS, all held by UBS. See also Note 11 for a discussion of Lakes’ credit line agreement with UBS which was fully repaid during fiscal 2010. At January 3, 2010, the Company also had the nontransferable right to sell the ARS, at par value to UBS at any time during the period of June 30, 2010, through July 2, 2012. The par value of the Company’s ARS was $24.3 million as of January 3, 2010.

 

During the year ended January 2, 2011, the Company exercised the Rights and the remaining ARS were purchased by UBS (Note 4). There were no remaining ARS as of January 2, 2011.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As of January 3, 2010, investments in securities with original maturity dates beyond three months consist of the following (in thousands):

 

 

 

The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, investments in securities, notes receivable and other long-term assets related to Indian casino projects, equity and cost method investments, accounts payable, contract acquisition costs payable and lines of credit.

 

For the Company’s cash and cash equivalents, accounts receivable, accounts payable and current portion of contract acquisition costs payable, the carrying amounts approximate fair value because of the short duration of these financial instruments. The methods used in estimating the fair value of the Company’s notes receivable from the Shingle Springs Tribe and the Iowa Tribe of Oklahoma (Note 6), investment in unconsolidated investees (Note 10), other long-term assets related to Indian casino projects (Note 7) and long-term contract acquisition costs payable (Note 12) are discussed in the referenced notes to the consolidated financial statements.

 

Investments in ARS, Rights, and in notes receivable from Indian Tribes for projects under development are measured at estimated fair value on a recurring basis using unobservable (Level 3) inputs that reflect management’s estimates about the assumptions that market participants would use in pricing the asset or liability, including estimated cash flows and valuation metrics. The determination of fair value for these items is described in Note 5.

 

 

The following is a list of the most significant factors affecting the estimated cash flows and discount rates used in the Company’s valuation models by asset type:

 

 

The Company’s financial assets that are carried at estimated fair value based on level 3 inputs are summarized below (in thousands):

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Changes in the carrying value of these asset types follows (in thousands):

 

 

To value the Company’s ARS portfolio, the Company utilized valuation models based on management’s estimates of expected cash flow streams and collateral values, default risk underlying the security, discount rates and overall capital market liquidity. The valuation of the Company’s ARS portfolio was subject to uncertainties and evolving market conditions that were difficult to predict. Factors that may have impacted the estimated fair value included changes to credit ratings of the ARS as well as to the assets collateralizing the securities, rates of default of the underlying assets, underlying collateral value, discount rates, and evolving market conditions affecting the liquidity of the ARS.

 

The Rights were a free standing asset separate from the ARS, and represented the Company’s contractual right to require UBS to purchase the Company’s ARS at par value during the period of June 30, 2010 through July 2, 2012. In order to determine the estimated fair value of the Rights, the Company utilized valuation models based on management’s estimates of expected cash flow streams, intrinsic value, and the credit worthiness of UBS.

 

To value the Company’s notes receivable from Indian tribes under development, the Company utilizes valuation models based on management’s estimates of expected cash flow streams, probabilities of casinos opening and the expected opening dates, projected pre- and post-opening date interest rates, and discount rates. The estimated casino opening date used in the valuations of the notes receivable related to Indian casino projects that are not yet under construction reflects the weighted-average of three scenarios: a base case (which is based on the Company’s forecasted casino opening date) and one and two years out from the base case. Once a casino project is under construction, the weighted-average scenarios are no longer used and only the planned opening date is used in the valuation. The projected pre- and post-opening interest rates are based upon the one year U.S. Treasury Bill spot-yield curve per Bloomberg and the specific assumptions on contract term, stated interest rate and casino opening date. The discount rate for the projects is based on the yields available on certain financial instruments at the valuation date, the risk level of equity investments in general, and the specific operating risks associated with open

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

and operating gaming enterprises similar to each of the projects. In estimating this discount rate, market data of other public gaming related companies is also considered. The probability estimate applied to each project is based upon a weighting of various possible scenarios with one scenario assuming the casino never opens. The other scenarios assume the casino opens but at different opening dates. The probability-weighting applied to each scenario is intended to effectively capture the element of risk in these projects and is based upon the status of each project, review of the critical milestones achieved and likelihood of achieving the remaining milestones.

 

As a result of the Termination Agreement with the Iowa Tribe, the note receivable from the Iowa Tribe of Oklahoma is no longer adjusted to its estimated fair value on a quarterly basis, but rather it is evaluated periodically for impairment pursuant to ASC 310.

 

Land held for development.  Land held for development (Notes 7 and 9) is measured at estimated fair value on a nonrecurring basis using unobservable (Level 3) inputs that utilize the market approach technique and reflect management’s estimates about the assumptions that market participants would use in pricing the asset. Significant inputs include recent transactions of comparable properties as well as consideration of its highest and best use.

 

 

The majority of the assets related to Indian casino projects are in the form of notes receivable due from the Indian tribes pursuant to the Company’s development, financing, consulting and management agreements. The repayment terms of the loans are specific to each Indian tribe and are dependent upon the successful development and operating performance of each gaming facility. Repayment of the loans is required only if distributable profits are available from the operation of the related casinos. In addition, repayment of the loans and the development, financing, consulting and management fees under contracts are subordinated to certain other financial obligations of the respective operations. Generally, the order of priority of payments from the casinos’ cash flows is as follows: a certain minimum monthly priority payment to the Indian tribe; repayment of senior debt associated with construction and equipping of the casino with interest accrued thereon; repayment of various debt with interest accrued thereon due to Lakes; development, financing, consulting and management fees to Lakes, with the remaining funds distributed to the Indian tribe.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Information with respect to the long-term notes receivable, net of current portion, activity is summarized in the following table (in thousands):

 

 

 

 

A summary of the activity in the allowance for impaired notes receivable follows:

 

 

Shingle Springs Tribe.  At January 2, 2011, Lakes evaluated the notes receivable from the Shingle Springs Tribe for impairment and concluded that it was probable that substantial amounts due would not be repaid within the contract term and therefore determined that the notes receivable were impaired. This determination was based on the lack of previously expected improvements in operating results due to the continued significant economic

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

pressures in the northern California market and increased competition from a neighboring casino expansion in the market the property serves, all of which have negatively impacted cash flows for the property, as well as the deferral of all principal payments during the fourth quarter of fiscal 2010 due to insufficient net revenues from which to make these payments. Prior to the fourth quarter of fiscal 2010, Lakes had not experienced a three-month period in which all principal payments were deferred. As a result of these factors, Lakes determined it was probable that substantial amounts due would not be repaid within the contract term. As of January 2, 2011, an allowance of $21.0 million was established through an impairment charge on the notes receivable and is included in the consolidated statement of earnings for fiscal 2010. The outstanding principal on the notes receivable from the Shingle Springs Tribe was $67.7 million as of January 2, 2011, which is comprised of $66.7 million related to pre-construction advances and $1.0 million of advances related to the minimum guaranteed monthly payment. The carrying amount of the notes receivable, which is net of unearned discount of $14.9 million and allowance for impairment of $21.0 million, was $31.8 million as of January 2, 2011. The carrying amount as of January 2, 2011 represents the present value of expected future cash flows.

 

Although Lakes has concluded that it is probable that substantial amounts due from the Shingle Springs Tribe will not be repaid within the contract term, the Shingle Springs Tribe will remain legally obligated to repay any remaining amounts due to Lakes subsequent to the conclusion of the contract.

 

Lakes entered into a development and management agreement with the Shingle Springs Tribe in 1999 to develop and manage the Red Hawk Casino which is located adjacent to US Highway 50, approximately 30 miles east of Sacramento, California. The Shingle Springs Tribe obtained $450 million of senior note financing and $77 million for furniture, furnishings and equipment financing, and under the terms of the development agreement, Lakes made pre-construction advances to the Shingle Springs Tribe of $74.4 million, including interest accrued during the pre-construction period. The Red Hawk casino opened on December 17, 2008.

 

The opening of the Red Hawk Casino triggered the repayment terms of the notes receivable which are scheduled to be repaid over the original seven-year term at the stated interest rate of Prime plus 2% (5.25% as of January 2, 2011). If, however, net revenues (as defined in the management and development agreement) from the project are insufficient, payments are deferred. Lakes classifies principal amounts expected to be received within the next fiscal year, if any, as current portion of notes receivable from casino projects on the Consolidated Balance Sheets. The order of priority of payments from the Red Hawk Casino’s cash flows has been as follows: a certain minimum monthly guaranteed payment to the Shingle Springs Tribe, various debt with interest accrued thereon (including Lakes’ pre-construction advances), management fee due to Lakes, and other obligations, if any, and the remaining funds, if any, distributed to the Shingle Springs Tribe. In order to assist the Red Hawk Casino in increasing cash levels, Lakes will defer allowed payments of principal on the preconstruction advances, if any, beginning March 2011 until December 2013. These deferrals, if any, do not constitute forgiveness of contractual principal amounts due to Lakes. Due to the temporary nature of the principal payment suspension and no forgiveness of principal is being granted, any such deferrals would not meet the criteria for a troubled debt restructuring under ASC 310-40 Troubled Debt Restructurings by Creditors.

 

Management estimates the fair value of this financial instrument as of January 2, 2011, to be approximately $26.6 million using a discount rate of 22.5% and a remaining estimated term of 121 months. Management estimated the fair value of the notes receivable with the Shingle Springs Tribe as of January 3, 2010, to be approximately $50.8 million using a discount rate of 19.0% and a remaining term of 72 months.

 

The management contract includes provisions that allow the Shingle Springs Tribe to buy-out the management contract after four years from the opening date. The buy-out amount is based upon the previous year of management fees earned multiplied by the remaining number of years under the contract, discounted back to the present value at the time the buy-out occurs. If the Shingle Springs Tribe elects to buy out the contract, all outstanding amounts owed to Lakes would immediately become due and payable.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Jamul Tribe.  The Jamul Casino is planned to be built on the Jamul Tribe’s existing six acres of reservation land. Reservation land qualifies for gaming without going through a land-in-trust process. Under the form of tribal-state compact first signed by the State of California (the “State”) with the Jamul Tribe in 1999, the Jamul Tribe is allowed to operate up to 350 Class III slot machines without licenses from the State. This form of compact also allows California tribes to operate additional Class II electronic gaming devices. Under these tribal-state compacts, there is a State-wide limitation on the aggregate number of Class III slot machine licenses that are available to tribes. Certain tribes have entered into new tribal-state compacts or amendments to the 1999 form of tribal-state compact that allow them to operate an unlimited number of Class II electronic gaming devices without the need for obtaining additional licenses, subject to the payment of additional fees to the state, including in recent cases, fees based on a percentage of slot “net win.” Currently, the Jamul Tribe has not amended its tribal-state compact. If the compact is not renegotiated and amended, the Jamul Tribe believes it could either operate under their existing compacts which allow for up to 350 Class III gaming devices and an unlimited number of Class II electronic gaming devices or it could choose to operate only class II electronic gaming devices without a compact. At this time, the Jamul Tribe is proceeding with only class II electronic gaming devices. This number of gaming devices is adequate under either approach to equip the planned development; and therefore, Lakes believes the availability of additional slot licenses should not prevent the project from progressing.

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues, including those related to access from State Highway 94 to the proposed casino site. In addition, the California Department of Transportation (“CalTrans”) issued a letter in 2008 to the Jamul Tribe indicating that it would not allow access to a casino operation from State Highway 94. In January 2011, the Jamul Tribe and CalTrans entered into an agreement which will permit CalTrans to review and process the Jamul Tribe’s encroachment permit application relating to the access, and provided that if the Jamul Tribe’s application meets certain legal requirements, CalTrans will issue the encroachment permit. The Jamul Tribe is currently performing various environmental and traffic studies necessary for the permit application.

 

The local opposition to this project has not been resolved and Lakes’ current expectation is that issues associated with this opposition could cause further delays, even if resolution of site access issues is achieved. These factors, in combination with the current general economic environment and probable difficulty of financing projects of this nature at desirable rates, have caused Lakes to estimate the probability of eventual opening of this project at 50%, and adjust the estimated opening date of this project to January 2016. Lakes’ management has also decreased the discount rate to 20.0% for this project, due to the leveling financial markets during 2010, which decreased the estimate of the required yield on the notes. As a result, Lakes recorded an unrealized gain on its notes receivable of $0.9 million during fiscal 2010.

 

Under the terms of its contracts, Lakes continues to make advances to the Jamul Tribe because Lakes believes the project will eventually succeed. Lakes made advances to the Jamul Tribe of $3.1 million and $2.9 million during fiscal 2010 and fiscal 2009, respectively. However, significant risk exists related to this project moving forward to completion, and Lakes continues to record significant impairment charges against its investment in this project. The Jamul Tribe has the two basic requirements to eventually build a successful project — federal recognition as an Indian Tribe and Indian land eligible for gaming and Lakes currently expects to continue its involvement with this project.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The terms and assumptions used to value the notes receivable at estimated fair value related to the Jamul Tribe are as follows (dollars in thousands):

 

 

Iowa Tribe  As a result of the Termination Agreement with the Iowa Tribe whereby the Iowa Tribe agreed to pay Lakes a total of $4.5 million of which $1.0 million was paid in May 2010 and the remaining $3.5 million is required to be paid in 15 monthly installments commencing on June 15, 2010.

 

As a result of the Termination Agreement with the Iowa Tribe, the carrying value of the notes receivable was adjusted to its estimated fair value of as of April 4, 2010 and the difference between the then estimated fair value and the amount contractually due under the Termination Agreement with the Iowa Tribe is being amortized into interest income using the effective interest method over the remaining term. The note receivable is no longer adjusted to estimated fair value, but rather it is evaluated periodically for impairment pursuant to ASC 310. The payment terms of the Termination Agreement with the Iowa Tribe and a discount rate of 6.0% were used as the assumptions for the determination of estimated fair value as of April 4, 2010.

 

Lakes recorded an unrealized gain (loss) of $0.9 million and ($0.2) million for the fiscal years ended January 2, 2011 and January 3, 2010, respectively, which is included in net unrealized gains from notes receivable in the consolidated statements of earnings. At January 2, 2011, the carrying value of the note receivable is $1.4 million, which approximates fair value.

 

The terms and assumptions used to value Lakes’ notes receivable from the Iowa Tribe at estimated fair value as of January 3, 2010 are as follows (dollars in thousands):

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)