H&R BLOCK INC - Quarter Report: 2010 October (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

 

Commission file number 1-6089

 

 

H&R Block, Inc.

(Exact name of registrant as specified in its charter)

 

 

One H&R Block Way
Kansas City, Missouri 64105

(Address of principal executive offices, including zip code)

 

(816) 854-3000

(Registrant’s telephone number, including area code)

 

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   Ö    No        

 

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   Ö    No        

 

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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

 

The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on November 30, 2010 was 305,110,195 shares.

 

 

Form 10-Q for the Period Ended October 31, 2010

 

 

Table of Contents

 

 

 

 

CONDENSED CONSOLIDATED BALANCE SHEETS (amounts in 000s, except share and per share amounts)

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

See Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

Basis of Presentation

The condensed consolidated balance sheet as of October 31, 2010, the condensed consolidated statements of operations and comprehensive income (loss) for the three and six months ended October 31, 2010 and 2009, and the condensed consolidated statements of cash flows for the six months ended October 31, 2010 and 2009 have been prepared by the Company, without audit. In the opinion of management, all adjustments, which include only normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows at October 31, 2010 and for all periods presented have been made.

“H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in our April 30, 2010 Annual Report to Shareholders on Form 10-K. All amounts presented herein as of April 30, 2010 or for the year then ended, are derived from our April 30, 2010 Annual Report to Shareholders on Form 10-K.

 

Management Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Significant estimates, assumptions and judgments are applied in the determination of our allowance for loan losses, potential losses from loan repurchase and indemnity obligations associated with our discontinued mortgage business, contingent losses associated with pending litigation, fair value of reporting units, reserves for uncertain tax positions and related matters. We revise our estimates when facts and circumstances dictate. However, future events and their effects cannot be determined with absolute certainty. As such, actual results could differ materially from those estimates.

 

Seasonality of Business

Our operating revenues are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.

 

Concentrations of Risk

Our mortgage loans held for investment include concentrations of loans to borrowers in certain states, which may result in increased exposure to loss as a result of changes in real estate values and underlying economic or market conditions related to a particular geographical location. Approximately 51% of our mortgage loan portfolio consists of loans to borrowers located in the states of Florida, California and New York.

 

Effective July 20, 2010, our Business Services segment acquired certain non-attest assets and liabilities of Caturano & Company, Inc. (Caturano), a Boston-based accounting firm, for an aggregate purchase price of $40.2 million. We expect this acquisition to expand our presence in the Boston market. We made cash payments of $32.6 million, including $29.8 million at closing. Payment of the remaining purchase price is

 

deferred and will be paid over 14 years. The following table summarizes the fair value of identifiable assets acquired and liabilities assumed and the resulting goodwill as of October 31, 2010:

 

(in 000s)
Customer relationships(1)		$	6,733
Non-compete agreements(2)			2,766
Attest firm affiliation(3)			7,629
Goodwill			27,289
Fixed assets			2,500
Other assets			831
Other liabilities			(1,640)
Unfavorable leasehold(2)			(5,890)
Total purchase price		$	40,218

In connection with the acquisition a deferred compensation plan, an employee retention program and a performance bonus plan were put in place for eligible employees. Expenses related to these plans will be treated as compensation and will be expensed as incurred. We incurred expenses totaling $1.3 million under these plans during the six months ended October 31, 2010.

In October 2010, we signed a definitive merger agreement to acquire all of the outstanding shares of 2SS Holdings, Inc., developer of TaxACT digital tax preparation solutions, for $287.5 million in cash. Completion of the transaction is subject to the satisfaction of customary closing conditions, including regulatory approval.

 

Basic and diluted earnings (loss) per share is computed using the two-class method. The two-class method is an earnings allocation formula that determines net income per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Per share amounts are computed by dividing net income from continuing operations attributable to common shareholders by the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings per share except in those periods with a loss from continuing operations. Diluted earnings per share excludes the impact of shares of common stock issuable upon the lapse of certain restrictions or the exercise of options to purchase 15.6 million shares and 19.3 million shares for the three and six months ended October 31, 2010, respectively and 19.3 million shares for the three and six months ended October 31, 2009, as the effect would be antidilutive due to the net loss from continuing operations during each period.

The computations of basic and diluted loss per share from continuing operations are as follows:

 

		(in 000s, except per share amounts)
		Three Months Ended October 31,								Six Months Ended October 31,
		2010				2009				2010				2009
Net loss from continuing operations attributable to shareholders		$	(106,812	)		$	(126,472	)		$	(234,450	)		$	(257,089	)
Amounts allocated to participating securities (nonvested shares)			(26	)			(27	)			(7	)			340
Net loss from continuing operations attributable to common shareholders		$	(106,786	)		$	(126,445	)		$	(234,443	)		$	(257,429	)
Basic weighted average common shares			306,804				335,346				313,247				334,939
Potential dilutive shares			-				-				-				-
Dilutive weighted average common shares			306,804				335,346				313,247				334,939
Earnings (loss) per share from continuing operations attributable to common shareholders:
Basic		$	(0.35	)		$	(0.38	)		$	(0.75	)		$	(0.77	)
Diluted			(0.35	)			(0.38	)			(0.75	)			(0.77	)

 

The weighted average shares outstanding for the three and six months ended October 31, 2010 decreased to 306.8 million and 313.2 million, respectively, from 335.3 million and 334.9 million for the three and six months ended October 31, 2009, respectively. During the six months ended October 31, 2010, we purchased and immediately retired 19.0 million shares of our common stock at a cost of $279.9 million. We may continue to repurchase and retire common stock or retire shares held in treasury from time to time in the future. The cost of shares retired during the period was allocated to the components of stockholders’ equity as follows:

 

(in 000s)
Common stock		$	190
Additional paid-in capital			11,370
Retained earnings			268,387
		$	279,947

During the six months ended October 31, 2010 and 2009, we issued 1.0 million and 1.6 million shares of common stock, respectively, due to the exercise of stock options, employee stock purchases and vesting of nonvested shares.

During the six months ended October 31, 2010, we acquired 0.2 million shares of our common stock at an aggregate cost of $3.5 million, and during the six months ended October 31, 2009, we acquired 0.2 million shares at an aggregate cost of $3.8 million. Shares acquired during these periods represented shares swapped or surrendered to us in connection with the vesting of nonvested shares and the exercise of stock options.

During the six months ended October 31, 2010, we granted 2.1 million stock options and 0.6 nonvested shares and units in accordance with our stock-based compensation plans. The weighted average fair value of options granted was $2.25 for management options. These awards vest over a four year period with one-fourth vesting each year. Stock-based compensation expense of our continuing operations totaled $2.7 million and $6.2 million for the three and six months ended October 31, 2010, respectively, and $4.8 million and $12.1 million for the three and six months ended October 31, 2009, respectively. At October 31, 2010, unrecognized compensation cost for options totaled $6.4 million, and for nonvested shares and units totaled $16.4 million.

 

The composition of our mortgage loan portfolio as of October 31, 2010 and April 30, 2010 is as follows:

 

														(dollars in 000s)
As of		October 31, 2010								April 30, 2010
		Amount				% of Total				Amount				% of Total
Adjustable-rate loans		$	365,262				59	%		$	411,122				60	%
Fixed-rate loans			254,995				41	%			272,562				40	%
			620,257				100	%			683,684				100	%
Unamortized deferred fees and costs			4,536								5,256
Less: Allowance for loan losses			(87,567	)							(93,535	)
		$	537,226							$	595,405

Activity in the allowance for loan losses for the six months ended October 31, 2010 and 2009 is as follows:

(in 000s)

Six Months Ended October 31,		2010				2009
Balance, beginning of the period		$	93,535			$	84,073
Provision			16,300				27,000
Recoveries			86				29
Charge-offs			(22,354	)			(15,109	)
Balance, end of the period		$	87,567			$	95,993

 

Our loan loss reserve as a percent of mortgage loans was 14.1% at October 31, 2010 compared to 13.7% at April 30, 2010.

In cases where we modify a loan and in so doing grant a concession to a borrower experiencing financial difficulty, the modification is considered a troubled debt restructuring (TDR). TDR loans totaled $121.7 million and $145.0 million at October 31, 2010 and April 30, 2010, respectively. The principal balance of non-performing assets as of October 31, 2010 and April 30, 2010 is as follows:

(in 000s)

As of		October 31, 2010				April 30, 2010
Impaired loans:
30 – 59 days		$	1,366			$	330
60 – 89 days			12,398				11,851
90+ days, non-accrual			149,040				153,703
TDR loans, accrual			111,249				113,471
TDR loans, non-accrual			10,440				31,506
			284,493				310,861
Real estate owned(1)			25,577				29,252
Total non-performing assets		$	310,070			$	340,113

Activity related to our real estate owned is as follows:

(in 000s)

Six Months Ended October 31,		2010				2009
Balance, beginning of the period		$	29,252			$	44,533
Additions			11,185				9,212
Sales			(12,784	)			(10,055	)
Writedowns			(2,076	)			(4,795	)
Balance, end of the period		$	25,577			$	38,895

 

Changes in the carrying amount of goodwill for the six months ended October 31, 2010 consist of the following:

(in 000s)
		Tax Services				Business Services				Total
Balance at April 30, 2010:
Goodwill		$	453,884			$	403,751			$	857,635
Accumulated impairment losses			(2,188	)			(15,000	)			(17,188	)
			451,696				388,751				840,447
Changes:
Acquisitions			6,778				27,655				34,433
Disposals and other			(5,175	)			(2,288	)			(7,463	)
Impairments			-				-				-
Balance at October 31, 2010:
Goodwill			455,487				429,118				884,605
Accumulated impairment losses			(2,188	)			(15,000	)			(17,188	)
		$	453,299			$	414,118			$	867,417

We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur which could, more likely than not, reduce the fair value of a reporting unit’s net assets below its carrying value. No events indicating possible impairment of goodwill were identified during the six months ended October 31, 2010.

 

Intangible assets consist of the following:

																						(in 000s)
As of		October 31, 2010												April 30, 2010
		Gross												Gross
		Carrying				Accumulated								Carrying				Accumulated
		Amount				Amortization				Net				Amount				Amortization				Net
Tax Services:
Customer relationships		$	75,270			$	(37,009	)		$	38,261			$	67,705			$	(33,096	)		$	34,609
Noncompete agreements			22,508				(21,685	)			823				23,062				(21,278	)			1,784
Reacquired franchise rights			219,665				(8,167	)			211,498				223,773				(6,096	)			217,677
Franchise agreements			19,201				(2,453	)			16,748				19,201				(1,813	)			17,388
Purchased technology			14,500				(7,381	)			7,119				14,500				(6,266	)			8,234
Trade name			1,325				(500	)			825				1,325				(400	)			925
Business Services:
Customer relationships			151,882				(124,601	)			27,281				145,149				(120,037	)			25,112
Noncompete agreements			35,818				(23,341	)			12,477				33,052				(22,118	)			10,934
Attest firm affiliation			7,629				(106	)			7,523				-				-				-
Trade name – amortizing			2,600				(2,600	)			-				2,600				(2,600	)			-
Trade name – non-amortizing			55,637				(4,868	)			50,769				55,637				(4,868	)			50,769
		$	606,035			$	(232,711	)		$	373,324			$	586,004			$	(218,572	)		$	367,432

Amortization of intangible assets for the three and six months ended October 31, 2010 was $7.3 and $14.2 million respectively, and $7.5 million and $14.4 million for the three and six months ended October 31, 2009, respectively. Estimated amortization of intangible assets for fiscal years 2011 through 2015 is $30.1 million, $27.7 million, $23.2 million, $19.8 million and $14.5 million, respectively.

In connection with the acquisition of Caturano, as discussed in note 2, we recorded a liability related to unfavorable operating lease terms in the amount of $5.9 million, which will be amortized over the remaining contractual life of the operating lease.

 

We file a consolidated federal income tax return in the United States and file tax returns in various state and foreign jurisdictions. The U.S. Federal consolidated tax returns for the years 1999 through 2007 are currently under examination by the Internal Revenue Service, with the 1999-2005 years currently at the appellate level. Federal returns for tax years prior to 1999 are closed by statute. Historically, tax returns in various foreign and state jurisdictions are examined and settled upon completion of the exam.

During the six months ended October 31, 2010, we accrued additional gross interest and penalties of $2.7 million related to our uncertain tax positions. We had gross unrecognized tax benefits of $130.5 million and $129.8 million at October 31, 2010 and April 30, 2010, respectively. The gross unrecognized tax benefits increased $0.7 million in the current year, due to accruals of tax and interest on positions related to prior years. Except as noted below, we have classified the liability for unrecognized tax benefits, including corresponding accrued interest, as long-term at October 31, 2010, and included this amount in other noncurrent liabilities on the condensed consolidated balance sheet.

Based upon the expiration of statutes of limitations, payments of tax and other factors in several jurisdictions, we believe it is reasonably possible that the gross amount of reserves for previously unrecognized tax benefits may decrease by approximately $21.1 million within twelve months of October 31, 2010. This portion of our liability for unrecognized tax benefits has been classified as current and is included in accounts payable, accrued expenses and other current liabilities on the condensed consolidated balance sheets.

 

The following table shows the components of interest income and expense of our continuing operations:

 

(in 000s)
		Three Months Ended October 31,								Six Months Ended October 31,
		2010				2009				2010				2009
Interest income:
Mortgage loans held for investment		$	6,525			$	8,072			$	12,848			$	15,968
Other			4,110				4,041				8,089				8,432
		$	10,635			$	12,113			$	20,937			$	24,400
Interest expense:
Borrowings		$	20,891			$	18,514			$	41,534			$	37,471
Deposits			1,947				2,284				3,870				4,333
FHLB advances			396				508				792				1,017
		$	23,234			$	21,306			$	46,196			$	42,821

 

We use the following valuation methodologies for assets and liabilities measured at fair value and the general classification of these instruments pursuant to the fair value hierarchy.

The following methods were used to determine the fair values of our other financial instruments:

 

The following table presents for each hierarchy level the financial assets that are measured at fair value on both a recurring and non-recurring basis at October 31, 2010 and April 30, 2010:

 

		(dollars in 000s)
		Total				Level 1				Level 2				Level 3
As of October 31, 2010:
Recurring:
Available-for-sale securities		$	28,834			$	-			$	28,834			$	-
Non-recurring:
Impaired mortgage loans held for investment			226,837				-				-				226,837
		$	255,671			$	-			$	28,834			$	226,837
As a percentage of total assets			5.9%				-%				0.7%				5.3%
As of April 30, 2010:
Recurring:
Available-for-sale securities		$	31,948			$	-			$	31,948			$	-
Non-recurring:
Impaired mortgage loans held for investment			249,549				-				-				249,549
		$	281,497			$	-			$	31,948			$	249,549
As a percentage of total assets			5.4%				-%				0.6%				4.8%

There were no significant changes to the unobservable inputs used in determining the fair values of our level 2 and level 3 financial assets.

The carrying amounts and estimated fair values of our financial instruments at October 31, 2010 are as follows:

 

(in 000s)

		Carrying				Estimated
		Amount				Fair Value
Mortgage loans held for investment		$	537,226			$	317,183
IRAs and other time deposits			490,993				488,890
Long-term debt			1,044,510				1,055,225
FHLB advances			75,000				75,132

 

H&R Block Bank (HRB Bank) files its regulatory Thrift Financial Report (TFR) on a calendar quarter basis with the Office of Thrift Supervision (OTS). The following table sets forth HRB Bank’s regulatory capital requirements at September 30, 2010, as calculated in the most recently filed TFR:

 

(dollars in 000s)
																		To Be Well Capitalized
										For Capital Adequacy								Under Prompt Corrective
		Actual								Purposes								Action Provisions
		Amount				Ratio				Amount				Ratio				Amount				Ratio
Total risk-based capital ratio(1)		$	386,088				81.0%			$	38,141				8.0%			$	47,677				10.0%
Tier 1 risk-based capital ratio(2)		$	379,758				79.7%				N/A				N/A			$	28,606				6.0%
Tier 1 capital ratio (leverage)(3)		$	379,758				30.7%			$	148,485				12.0%			$	61,869				5.0%
Tangible equity ratio(4)		$	379,758				30.7%			$	18,561				1.5%				N/A				N/A

As of October 31, 2010, HRB Bank’s leverage ratio was 26.2%.

 

In June 2009, the Financial Accounting Standards Board (FASB) issued revised authoritative guidance associated with the consolidation of variable interest entities (VIEs). The revised guidance replaced the previous quantitative-based assessment for determining whether an enterprise is the primary beneficiary of a VIE and focuses primarily on a qualitative assessment. This assessment requires identifying the enterprise that has (1) the power to direct the activities of the VIE that can most significantly impact the entity’s performance; and (2) the obligation to absorb losses and the right to receive benefits from the VIE that could potentially be significant to such entity. The revised guidance also requires that the enterprise continually reassess whether it is the primary beneficiary of a VIE rather than conducting a reassessment only upon the occurrence of specific events.

We implemented this guidance on May 1, 2010 and evaluated our financial interests to determine if we had interests in VIEs and if we are the primary beneficiary of the VIE.

The following is a description of our financial interests in VIEs which we consider significant or where we are the sponsor. For these VIEs we have determined that we are not the primary beneficiary and, therefore have not consolidated the VIEs. Prior to implementation of this new guidance we did not consolidate these entities.

We have concluded that RSM is not the primary beneficiary of M&P and, therefore, we have not consolidated M&P. RSM does not have an equity interest in M&P, nor does it have the power to direct any activities of M&P and does not receive any of its income. We have no assets or liabilities included in our condensed consolidated balance sheets related to our variable interests. We believe RSM’s maximum exposure to economic loss, resulting from various agreements with M&P, relates primarily to shared office space from operating leases under the administrative services agreement equal to approximately $106.3 million, and variability in our operating results due to the compensation agreements with RSM managing directors. We do not provide any support that is not contractually required.

Our identification of the primary beneficiary of the Trusts was based on a determination that the servicer of the underlying mortgage loans has the power to direct the most significant activities of the Trusts because the servicer handles all of the loss mitigation activities for the mortgage loans.

SCC is not the servicer of the mortgage loans underlying the REMIC Trusts. Therefore, SCC is not the primary beneficiary of the REMIC Trusts because it does not have the power to direct the most significant activities of the REMIC Trusts, which is the servicing of the underlying mortgage loans.

SCC does have the exclusive right to appoint a servicer when certain conditions have been met for specific loans related to two of the NIM Trusts. As of October 31, 2010, those conditions have been met for a minority portion of the loans underlying those Trusts. As this right pertains only to a minority of the loans, we have concluded that SCC does not have the power to direct the most significant activities of these two NIM Trusts, as the servicer has the power to direct significant activities over the majority of the mortgage loans. In the remaining NIM Trusts, SCC has a shared right to appoint a servicer under certain conditions. For these NIM Trusts, we have concluded that SCC is not the primary beneficiary because the power to direct the most significant activities, which is the servicing of the underlying mortgage loans, is shared with other unrelated parties.

 

At October 31, 2010, we had no significant assets or liabilities included in our condensed consolidated balance sheets related to SCC’s variable interests in the Trusts. We have a liability, as discussed in note 11, and a deferred tax asset recorded in our condensed consolidated balance sheets related to obligations for representations and warranties SCC made in connection with the transfer of mortgage loans, including mortgage loans held by the securitization trusts. We have no remaining exposure to economic loss arising from impairment of SCC’s beneficial interest in the Trusts. If SCC receives cash flows in the future as a holder of beneficial interests we would record gains as other income in our income statement. Neither we nor SCC has liquidity arrangements, guarantees or other commitments for the Trusts, nor has any support been provided that was not contractually required.

 

Changes in deferred revenue balances related to our Peace of Mind (POM) program, the current portion of which is included in accounts payable, accrued expenses and other current liabilities and the long-term portion of which is included in other noncurrent liabilities in the condensed consolidated balance sheets, are as follows:

 

		(in 000s)
Six Months Ended October 31,		2010				2009
Balance, beginning of period		$	141,542			$	146,807
Amounts deferred for new guarantees issued			1,422				1,351
Revenue recognized on previous deferrals			(48,358)				(47,044)
Balance, end of period		$	94,066			$	101,114

In addition to amounts accrued for our POM guarantee, we had accrued $11.5 million and $14.5 million at October 31, 2010 and April 30, 2010, respectively, related to our standard guarantee which is included with our standard tax preparation services.

The following table summarizes certain of our other contractual obligations and commitments:

 

		(in 000s)
As of		October 31, 2010				April 30, 2010
Franchise Equity Lines of Credit – undrawn commitment		$	30,683			$	36,806
Contingent business acquisition obligations			22,154				20,697
Media advertising purchase obligation			26,548				26,548

We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. Guarantees and indemnifications of the Company and its subsidiaries include obligations to protect counterparties from losses arising from the following: (1) tax, legal and other risks related to the purchase or disposition of businesses; (2) penalties and interest assessed by federal and state taxing authorities in connection with tax returns prepared for clients; (3) indemnification of our directors and officers; and (4) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the terms of the indemnities may vary and in many cases are limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance we will ultimately prevail in the event any such claims are asserted, we believe the fair value of guarantees and indemnifications relating to our continuing operations is not material as of October 31, 2010.

 

Discontinued Operations

Sand Canyon Corporation (“SCC”, previously known as Option One Mortgage Corporation) ceased originating mortgage loans in December 2007 and, in April 2008, sold its servicing assets and discontinued its remaining operations. The sale of servicing assets did not include the sale of any mortgage loans.

In connection with the securitization and sale of loans, SCC made certain representations and warranties, including, but not limited to, representations relating to matters such as ownership of the loan, validity of lien securing the loan, and the loan’s compliance with SCC’s underwriting criteria. Representations and warranties in whole loan sale transactions to institutional investors included a “knowledge

 

qualifier” which limits SCC liability for borrower fraud to those instances where SCC had knowledge of the fraud at the time the loans were sold. In the event that there is a breach of a representation and warranty and such breach materially and adversely affects the value of a mortgage loan, SCC may be obligated to repurchase a loan or otherwise indemnify certain parties for losses incurred as a result of loan liquidation. Generally, these representations and warranties are not subject to a stated term, but would be subject to statutes of limitation applicable to the contractual provisions.

Claims received by SCC have primarily related to alleged breaches of representations and warranties related to a loan’s compliance with the underwriting standards established by SCC at origination, borrower fraud and credit exceptions without sufficient compensating factors. Claims received since May 1, 2008 follows:

 

(in millions)
		Fiscal Year 2009												Fiscal Year 2010												Fiscal Year 2011
		Q1			Q2			Q3			Q4			Q1			Q2			Q3			Q4			Q1			Q2			Total
Loan Origination Year:
2005		$	40		$	21		$	1		$	-		$	-		$	15		$	-		$	-		$	6		$	1		$	84
2006			89			10			111			7			2			57			4			45			100			15			440
2007			43			10			85			15			4			11			7			-			3			5			183
Total		$	172		$	41		$	197		$	22		$	6		$	83		$	11		$	45		$	109		$	21			707

For those claims determined to be valid, SCC has complied with its obligations by either repurchasing the mortgage loans or REO properties, providing for the reimbursement of losses in connection with liquidated REO properties, or reaching other settlements. SCC has denied approximately 84% of all claims received, excluding resolution reached under other settlements. Counterparties could reassert claims that SCC has denied. Of claims determined to be valid, approximately 24% resulted in loan repurchases, and 76% resulted in indemnification or settlement payments. Losses on loan repurchase, indemnification and settlement payments totaled approximately $58 million for the period May 1, 2008 through October 31, 2010. Loss severity rates on repurchases and indemnification have approximated 60% and SCC has not observed any material trends related to average losses by counterparty. Repurchased loans are considered held for sale and are included in prepaid expenses and other current assets on the condensed consolidated balance sheets. The net balance of all mortgage loans held for sale by SCC was $14.6 million at October 31, 2010.

SCC generally has 60 to 120 days to respond to representation and warranty claims and performs a loan-by-loan review of all repurchase claims during this time. SCC has completed its review of all claims, with the exception of claims totaling approximately $121 million, which remained subject to review as of October 31, 2010. Of the claims still subject to review, approximately $97 million are from private-label securitizations, related to rescissions of mortgage insurance, and $24 million are from monoline insurers.

All claims asserted against SCC since May 1, 2008 relate to loans originated during calendar years 2005 through 2007, of which, approximately 88% relate to loans originated in calendar years 2006 and 2007. During calendar year 2005 through 2007, SCC originated approximately $84 billion in loans, of which less than 1% were sold to government sponsored entities. SCC is not subject to loss on loans that have been paid in full, repurchased, or were sold without recourse.

The majority of claims asserted since May 1, 2008, which have been determined by SCC to represent a valid breach of its representations and warranties, relate to loans that became delinquent within the first two years following the origination of the mortgage loan. SCC believes the longer a loan performs prior to an event of default, the less likely the default will be related to a breach of a representation and warranty. The balance of loans originated in 2005, 2006 and 2007 which defaulted in the first two years is $4.0 billion, $6.3 billion and $2.9 billion, respectively, at October 31, 2010.

SCC estimates losses relating to representation and warranty claims by estimating loan repurchase and indemnification obligations on both known claims and projections of future claims. Projections of future claims are based on an analysis that includes a combination of reviewing repurchase demands and actual defaults and loss severities by counterparty, inquiries from various third-parties, the terms and provisions of related agreements and the historical rate of repurchase and indemnification obligations related to breaches of representations and warranties. SCC’s methodology for calculating this liability considers the

 

probability that individual counterparties (whole-loan purchasers, private label securitization trustees and monoline insurers) will assert future claims.

SCC has recorded a liability for estimated contingent losses related to representation and warranty claims as of October 31, 2010, of $184.7 million, which represents SCC’s best estimate of the probable loss that may occur. This overall liability amount includes $49.7 million, which was established under an indemnity agreement dated April 2008 with a specific counterparty in exchange for a full and complete release of such party’s ability to assert representation and warranty claims. This indemnity agreement was given as part of obtaining the counterparty’s consent to SCC’s sale of its mortgage servicing business in 2008. Though disbursements related to this agreement have not been significant, SCC believes that the full amount under this indemnity agreement will ultimately be paid.

While SCC uses the best information available to it in estimating its liability, probable losses are inherently difficult to estimate and require considerable management judgment. There may be a wide range of reasonably possible losses in excess of the recorded liability that cannot be estimated, primarily due to difficulties inherent in estimating the level of future claims that will be asserted and the percentage of those claims that are ultimately determined to be valid. Although net losses on settled claims since May 1, 2008 have been within initial loss estimates, to the extent that valid claim volumes or the value of residential home prices differ in the future from current estimates, future losses may be greater than the current estimates and those differences may be significant.

A rollforward of our liability for losses on repurchases for the six months ended October 31, 2010 and 2009 is as follows:

 

		(in 000s)
Six Months Ended October 31,		2010				2009
Balance, beginning of period		$	188,200			$	206,595
Provisions			-				-
Losses on repurchase and indemnifications			(3,478)				(5,382)
Balance, end of period		$	184,722			$	201,213

The repurchase liability is included in accounts payable, accrued expenses and other current liabilities on our condensed consolidated balance sheets. There have been no provisions for additional losses included in the income statement since April 30, 2008; however, loss provisions would be recorded net of tax in discontinued operations.

 

We are party to investigations, legal claims and lawsuits arising out of our business operations. As required, we accrue our best estimate of loss contingencies when we believe a loss is probable and we can reasonably estimate the amount of any such loss. Amounts accrued, including obligations under indemnifications, totaled $24.6 million and $35.5 million at October 31, 2010 and April 30, 2010, respectively. Litigation is inherently unpredictable and it is difficult to predict the outcome of particular matters with reasonable certainty and, therefore, the actual amount of any loss may prove to be larger or smaller than the amounts reflected in our consolidated financial statements.

 

RAL Litigation

We have been named in multiple lawsuits as defendants in litigation regarding our refund anticipation loan program in past years. All of those lawsuits have been settled or otherwise resolved, except for one.

The sole remaining case is a putative class action styled Sandra J. Basile, et al. v. H&R Block, Inc., et al., April Term 1992 Civil Action No. 3246 in the Court of Common Pleas, First Judicial District Court of Pennsylvania, Philadelphia County, instituted on April 23, 1993. The plaintiffs allege inadequate disclosures with respect to the RAL product and assert claims for violation of consumer protection statutes, negligent misrepresentation, breach of fiduciary duty, common law fraud, usury, and violation of the Truth In Lending Act. Plaintiffs seek unspecified actual and punitive damages, injunctive relief, attorneys’ fees and costs. A Pennsylvania class was certified, but later decertified by the trial court in December 2003. An appellate court subsequently reversed the decertification decision. We are appealing the reversal. We have not concluded that a loss related to this matter is probable nor have we accrued a loss contingency related to this matter.

 

Plaintiffs have not provided a dollar amount of their claim and we are not able to estimate a possible range of loss. We believe we have meritorious defenses to this case and intend to defend it vigorously. There can be no assurances, however, as to the outcome of this case or its impact on our consolidated results of operations.

 

Peace of Mind Litigation

We have been named defendants in lawsuits regarding our Peace of Mind program (collectively, the “POM Cases”), under which our applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The POM Cases are described below.

Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Case No. 08-CV-591 in the U.S. District Court for the Southern District of Illinois, is a putative class action case originally filed in the Circuit Court of Madison County, Illinois on January 18, 2002. The plaintiffs allege that the sale of POM guarantees constitutes statutory fraud, an unfair trade practice and breach of a fiduciary duty. The plaintiffs seek unspecified damages, injunctive relief, attorneys’ fees and costs. On September 17, 2010, the federal court denied plaintiffs’ motion for class certification. The parties subsequently reached an agreement to settle the case, along with the Soliz case referenced below.

There is one other putative class action pending against us in Texas that involves the POM guarantee. This case, styled Desiri L. Soliz v. H&R Block, et al. (Cause No. 03-032-D), was filed on January 23, 2003 in the District Court of Kleberg County, Texas. This case involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois and contains allegations similar to those in the Marshall litigation. The plaintiff seeks actual and treble damages, equitable relief, attorneys’ fees and costs. No class has been certified. Following the denial of class certification in the Marshall litigation, the parties reached an agreement to settle this case, along with the Marshall litigation. Settlement amounts related to the POM Cases are immaterial to the financial statements and are accrued at October 31, 2010.

 

Express IRA Litigation

We have been named defendants in lawsuits regarding our former Express IRA product. All of those lawsuits have been settled or otherwise resolved, except for one.

The one remaining case was filed on January 2, 2008 by the Mississippi Attorney General in the Chancery Court of Hinds County, Mississippi First Judicial District (Case No. G 2008 6 S 2) and is styled Jim Hood, Attorney for the State of Mississippi v. H&R Block, Inc., H&R Block Financial Advisors, Inc., et al. The complaint alleges fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the sale of the product in Mississippi and seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. We are not able to estimate a possible range of loss. We believe we have meritorious defenses to the claims in this case, and we intend to defend this case vigorously, but there can be no assurances as to its outcome or its impact on our consolidated results of operations.

Although we sold H&R Block Financial Advisors, Inc. (HRBFA) effective November 1, 2008, we remain responsible for any liabilities relating to the Express IRA litigation, among other things, through an indemnification agreement. A portion of our accrual is related to these indemnity obligations.

 

RSM McGladrey Litigation

RSM EquiCo, its parent and certain of its subsidiaries and affiliates, are parties to a class action filed on July 11, 2006 and styled Do Right’s Plant Growers, et al. v. RSM EquiCo, Inc., et al., Case No. 06 CC00137, in the California Superior Court, Orange County. The complaint contains allegations relating to business valuation services provided by RSM EquiCo, including allegations of fraud, negligent misrepresentation, breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty and unfair competition. Plaintiffs seek unspecified actual and punitive damages, in addition to pre-judgment interest and attorneys’ fees. On March 17, 2009, the court granted plaintiffs’ motion for class certification on all claims. The defendants filed two requests for interlocutory review of the decision, the last of which was denied by the Supreme Court of California on September 30, 2009. A trial date has been set for May 2011.

The certified class consists of RSM EquiCo’s U.S. clients who signed platform agreements and for whom RSM EquiCo did not ultimately market their business for sale. A portion of our loss contingency accrual is related to this matter for the amount of loss that we consider probable and estimable, although it is

 

possible that our losses could exceed the amount we have accrued. The fees paid to RSM EquiCo in connection with these agreements total approximately $185 million, a number which substantially exceeds the equity of RSM EquiCo. Plaintiffs seek to recover restitution in an amount equal to the fees paid, in addition to punitive damages and attorney fees. We believe we have meritorious defenses to the case and intend to defend the case vigorously. The amount claimed in this action is substantial and could have a material adverse impact on our consolidated results of operations. There can be no assurance regarding the outcome of this matter.

On December 7, 2009, a lawsuit was filed in the Circuit Court of Cook County, Illinois (2009-L-014920) against M&P, RSM and H&R Block styled Ronald R. Peterson ex rel. Lancelot Investors Fund, L.P., et al. v. McGladrey & Pullen LLP, et al. The case was removed to the United States District Court for the Northern District of Illinois on December 28, 2009 (Case No. 1:10-CV-00274). The complaint, which was filed by the trustee for certain bankrupt investment funds, seeks unspecified damages and asserts claims against RSM for vicarious liability and alter ego liability and against H&R Block for equitable restitution relating to audit work performed by M&P. The amount claimed in this case is substantial. On November 3, 2010, the court dismissed the case against all defendants in its entirety with prejudice.

RSM and M&P operate in an alternative practice structure (“APS”). Accordingly, certain claims and lawsuits against M&P could have an impact on RSM. More specifically, any judgments or settlements arising from claims and lawsuits against M&P that exceed its insurance coverage could have a direct adverse effect on M&P’s operations. Although RSM is not responsible for the liabilities of M&P, significant M&P litigation and claims could impair the profitability of the APS and impair the ability to attract and retain clients and quality professionals. This could, in turn, have a material adverse effect on RSM’s operations and impair the value of our investment in RSM. There is no assurance regarding the outcome of any claims or litigation involving M&P.

 

Litigation and Claims Pertaining to Discontinued Mortgage Operations

Although mortgage loan origination activities were terminated and the loan servicing business was sold during fiscal year 2008, SCC remains subject to investigations, claims and lawsuits pertaining to its loan origination and servicing activities that occurred prior to such termination and sale. These investigations, claims and lawsuits include actions by state attorneys general, other state and federal regulators, municipalities, individual plaintiffs, and cases in which plaintiffs seek to represent a class of others alleged to be similarly situated. Among other things, these investigations, claims and lawsuits allege discriminatory or unfair and deceptive loan origination and servicing practices, public nuisance, fraud, and violations of securities laws, the Truth in Lending Act, Equal Credit Opportunity Act and the Fair Housing Act. In the current non-prime mortgage environment, the number of these investigations, claims and lawsuits has increased over historical experience and is likely to continue at increased levels. The amounts claimed in these investigations, claims and lawsuits are substantial in some instances, and the ultimate resulting liability is difficult to predict and thus cannot be reasonably estimated. In the event of unfavorable outcomes, the amounts SCC may be required to pay in the discharge of liabilities or settlements could be substantial and, because SCC’s operating results are included in our consolidated financial statements, could have a material adverse impact on our consolidated results of operations.

On June 3, 2008, the Massachusetts Attorney General filed a lawsuit in the Superior Court of Suffolk County, Massachusetts (Case No. 08-2474-BLS) styled Commonwealth of Massachusetts v. H&R Block, Inc., et al., alleging unfair, deceptive and discriminatory origination and servicing of mortgage loans and seeking equitable relief, disgorgement of profits, restitution and statutory penalties. In November 2008, the court granted a preliminary injunction limiting the ability of the owner of SCC’s former loan servicing business to initiate or advance foreclosure actions against certain loans originated by SCC or its subsidiaries without (1) advance notice to the Massachusetts Attorney General and (2) if the Attorney General objects to foreclosure, approval by the court. An appeal of the preliminary injunction was denied. A trial date has been set for June 2011. A portion of our loss contingency accrual is related to this matter for the amount of loss that we consider probable and estimable, although it is possible that our losses could exceed the amount we have accrued. We are not able to estimate a possible range of loss. We believe we have meritorious defenses to the claims presented and we intend to defend them vigorously. There can be no assurances, however, as to its outcome or its impact on our consolidated results of operations.

 

On October 15, 2010, the Federal Home Loan Bank of Chicago filed a lawsuit in the Circuit Court of Cook County, Illinois (Case No. 10CH45033) styled Federal Home Loan Bank of Chicago v. Bank of America Funding Corporation, et al. against multiple defendants, including various SCC related entities and H&R Block, Inc. related entities, arising out of FHLB’s purchase of mortgage-backed securities. Plaintiff asserts claims for rescission and damages under Illinois securities law and for common law negligent misrepresentation in connection with its purchase of two securities originated and securitized by SCC. These two securities had a total initial principal amount of approximately $50 million, of which approximately $42 million remains outstanding. We have not concluded that a loss related to this matter is probable nor have we established a loss contingency related to this matter. We believe the claims in this case are without merit and we intend to defend them vigorously. There can be no assurances, however, as to its outcome or its impact on our consolidated results of operations.

 

Other Claims and Litigation

We have been named in several wage and hour class action lawsuits throughout the country, respectively styled Alice Williams v. H&R Block Enterprises LLC, Case No.RG08366506 (Superior Court of California, County of Alameda, filed January 17, 2008); Arabella Lemus v. H&R Block Enterprises LLC, et al., Case No. CGC-09-489251 (United States District Court, Northern District of California, filed June 9, 2009); Delana Ugas v. H&R Block Enterprises LLC, et al., Case No. BC417700 (United States District Court, Central District of California, filed July 13, 2009); Barbara Petroski v. H&R Block Eastern Enterprises, Inc., et al., Case No. 10-CV-00075 (United States District Court, Western District of Missouri, filed January 25, 2010); Lance Hom v. H&R Block Enterprises LLC, et al., Case No. 10CV0476 H (United States District Court, Southern District of California, filed March 4, 2010); and Stacy Oyer v. H&R Block Eastern Enterprises, Inc., et al., Case No. 10-CV-00387-WMS (United States District Court, Western District of New York, filed May 10, 2010). These cases involve a variety of legal theories and allegations including, among other things, failure to compensate employees for all hours worked; failure to provide employees with meal periods; failure to provide itemized wage statements; failure to pay wages due upon termination; failure to compensate for mandatory off-season training; and/or misclassification of non-exempt employees. The parties have agreed to consolidate certain of these cases into a single action because they allege substantially identical claims. The plaintiffs seek actual damages, in addition to statutory penalties, pre-judgment interest and attorneys’ fees. We have not concluded that a loss related to these matters is probable nor have we accrued a loss contingency related to these matters. Moreover, we are not able to estimate a possible range of loss. We believe we have meritorious defenses to the claims in these cases and intend to defend them vigorously. The amounts claimed in these matters are substantial in some instances, however, and the ultimate liability with respect to these matters is difficult to predict. There can be no assurances as to the outcome of these cases or their impact on our consolidated results of operations, individually or in the aggregate.

In addition, we are from time to time party to investigations, claims and lawsuits not discussed herein arising out of our business operations. These investigations, claims and lawsuits include actions by state attorneys general, other state regulators, individual plaintiffs, and cases in which plaintiffs seek to represent a class of others similarly situated. We believe we have meritorious defenses to each of these investigations, claims and lawsuits, and we are defending or intend to defend them vigorously. The amounts claimed in these matters are substantial in some instances, however, the ultimate liability with respect to such matters is difficult to predict. In the event of an unfavorable outcome, the amounts we may be required to pay in the discharge of liabilities or settlements could have a material adverse impact on our consolidated results of operations.

We are also party to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (collectively, “Other Claims”) concerning the preparation of customers’ income tax returns, the fees charged customers for various products and services, relationships with franchisees, intellectual property disputes, employment matters and contract disputes. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse impact on our consolidated results of operations.

 

 

Results of our continuing operations by reportable operating segment are as follows:

 

														(in 000s)
		Three Months Ended October 31,								Six Months Ended October 31,
		2010				2009				2010				2009
Revenues:
Tax Services		$	110,921			$	109,305			$	202,566			$	197,268
Business Services			203,426				206,602				378,136				384,220
Corporate			8,542				10,174				16,661				20,098
		$	322,889			$	326,081			$	597,363			$	601,586
Pretax income (loss):
Tax Services		$	(154,355	)		$	(172,188	)		$	(328,979	)		$	(344,162	)
Business Services			8,397				174				7,964				1,495
Corporate			(29,161	)			(40,839	)			(61,421	)			(81,059	)
Loss from continuing operations before tax benefit		$	(175,119	)		$	(212,853	)		$	(382,436	)		$	(423,726	)

 

In July 2010 the Financial Accounting Standard Board (FASB) issued Accounting Standards Update 2010-20, “Disclosures About Credit Quality of Financing Receivables and Allowance for Credit Losses.” This guidance would require enhanced disclosures about the allowance for credit losses and the credit quality of financing receivables and would apply to financing receivables held by all creditors. This guidance is effective beginning with the first interim or annual reporting period ending after December 15, 2010. Early application is encouraged. We are currently evaluating the effect of this guidance on our financial statement disclosures.

In October 2009, the FASB issued Accounting Standards Update 2009-13, “Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements.” This guidance amends the criteria for separating consideration in multiple-deliverable arrangements to enable vendors to account for products or services (deliverables) separately rather than as a combined unit. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (1) vendor-specific objective evidence; (2) third-party evidence; or (3) estimates. This guidance also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. This guidance is effective prospectively for revenue arrangements entered into or materially modified beginning with our fiscal year 2012. We believe this guidance will not have a material effect on our consolidated financial statements.

In June 2009, the FASB issued guidance, under Topic 860 – Transfers and Servicing. This guidance will require more disclosure about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a qualifying special purpose entity and changes the requirements for derecognizing financial assets. We adopted this guidance as of May 1, 2010 and it did not have a material effect on our consolidated financial statements.

 

Block Financial LLC (BFC) is an indirect, wholly-owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on January 11, 2008 and October 26, 2004, our unsecured committed lines of credit (CLOCs) and other indebtedness issued from time to time. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in

 

subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholders’ equity and other intercompany balances and transactions.