UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

NOVATION COMPANIES, INC.

NOVATION COMPANIES, INC.

FORM 10-Q

TABLE OF CONTENTS

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

Prior to 2016, Novation owned 100% of Corvisa LLC ("Corvisa"). On December 21, 2015, the Company entered into a Membership Interest Purchase Agreement (the "Corvisa Purchase Agreement") with Corvisa Services LLC ("Corvisa Services"), a wholly owned subsidiaryManagement of the Company and ShoreTel, Inc. ("ShoreTel"). Subject tomeasures financial performance based on the terms and conditions under the Corvisa Purchase Agreement, ShoreTel agreed to purchase allresults of the membership interests of Corvisa (the "Corvisa Sale"). The Corvisa Sale closed on January 6, 2016. The operations of Corvisa have been classified as discontinued operations for all periods presented.

During 2018, the Company held approximately $8.8executed trades to sell a portion of its overcollateralization mortgage securities. These sales generated $2.9 million in mortgage securities that continue to be a source of cash proceeds for the Company. The Company's marketableThese sales generated $975,000 in gains during the quarter ended March 31, 2018 and $2.0 million in gains during the second quarter of 2018. Management believes that other mortgage securities are classified as available-for-sale and are includedmay be sold on similar terms in the current marketable securities line items onevent additional cash proceeds are needed. In addition, through the condensed consolidated balance sheet asdate of June 30, 2017. For additional information regarding the Company's marketable securities, see the condensed consolidated statements ofthis filing, HCS has demonstrated that it can provide positive cash flow sufficient to support HCS operations. Management continues to work toward expanding HCS’s customer base by increasing revenue from existing customers and Note 4. The Company's ongoing contractual obligations consist primarily of its senior notes, which are discussed in Note 5targeting new customers that have not previously been served by HCS. In addition, management is exploring cost cutting initiatives that will reduce overall corporate overhead and commitments under operating lease agreements for the Company's office space.

The accompanying condensed consolidated financial statements have been prepared on a basis that assumes the Company will continue as a going concern and contemplates the continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. However, we cannot provide assurance that revenue generated from our businesses will be sufficient to sustain our operations in the long term. Additionally, we cannot be certain that we will be successful at raising cash, whether from divesting of mortgage securities or other assets, or from equity or debt financing, on commercially reasonable terms, if at all. Such failures would have a material adverse effect on our business, including the possible cessation of operations.

The Company's condensed consolidated financial statements are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the condensed consolidated financial statements. The Company's condensed consolidated financial statements should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 20162017 (the "2016"2017 Form 10-K").

On July 20, 2016, (the "Bankruptcy Petition Date"), Novation and three of its subsidiaries, NovaStar Mortgage LLC,NMLLC, NovaStar Mortgage Funding Corporation and 2114 Central LLC (collectively, the “Debtors”), filed the Bankruptcy Petitionsvoluntary petitions (the "Bankruptcy Petitions") for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court. The Debtors’ Chapter 11 casesCourt for the District of Maryland (the “Chapter 11 Cases”"Bankruptcy Court") were being jointly administered under the case Novation Companies, Inc., et al, No. 16-19745-DER.. The Company and one of its subsidiaries subsequently filed with the Bankruptcy Court, and amended, a plan of reorganization for the resolution of the outstanding claims against and interests pursuant to Section 1121(a) of the Bankruptcy Code (as amended andas supplemented, the “Plan”) and a related disclosure statement. The Bankruptcy Court entered an order on June 12, 2017, confirming the Plan (the “Confirmation Order”) solely with respect to the Company, which provided that the effective date of the Plan will occur when all conditions precedent to effectiveness, as set forth in the Plan, have been satisfied or waived.

We have incurred significant costs associated with our reorganization and the Chapter 11 proceedings. These costs, which are being expensed as incurred, will significantly affect our results of operations through the effective date of the Plan. Reorganization items include (in(unaudited and in thousands):

During 2018, the Company sold a portion of two of its overcollateralization bonds. These sales generated gains of $975,000 during the three months ended March 31, 2018 and overcollateralization bonds.separately $2.0 million subsequent to March 31, 2018. There were no other-than-temporary impairments relating to available-for-sale securities for the three and six months ended June 30, 2017. Maturities of retained mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. See Note 7 for details on the Company's fair value methodology.March 31, 2018.

Historically, repurchases of loans or indemnification of losses where a loan defect has been alleged have been insignificant and any future losses for alleged loan defects have not been deemed to be probable or reasonably estimable; therefore, the Company has recorded no reserves related to these claims. The Company does not use internal groupings for purposes of determining the status of these loans. The Company is unable to develop an estimate of the maximum potential amount of future payments related to repurchase demands because the Company does not have access to information relating to loans sold and securitized and the number or amount of claims deemed probable of assertion is not known nor is it reasonably estimated. Further, the validity of claims received remains questionable. Also, considering that the Company completed its last sale or

Although it is not possible to predict the outcome of any legal proceeding, in the opinion of management, other than the active proceedings described in detail below, proceedings and actions against the Company should not, individually, or in the aggregate, have a material effect on the Company'sCompany’s financial condition, operations and liquidity. Furthermore, due to the uncertainty of any potential loss as a result of pending litigation and due to the Company's belief that an adverse ruling is not probable, the Company has not accrued a loss contingency related to the following matters in its condensed consolidated financial statements. However, a material outcome in one or more of the active proceedings described below could have a material impact on the results of operations in a particular quarter or fiscal year. See Note 2 for a description of the impact of the Company's Chapter 11 Casescase on these proceedings.

On May 21, 2008, a purported class action case was filed in the Supreme Court of the State of New York, New York County, by the New Jersey Carpenters' Health Fund, on behalf of itself and all others similarly situated. Defendants in the case included NovaStar Mortgage Funding Corporation (“NMFC”) and NovaStar Mortgage, Inc. ("NMI"), wholly-owned subsidiaries of the Company, and NMFC's individual directors, several securitization trusts sponsored by the Company (“affiliated defendants”) and several unaffiliated investment banks and credit rating agencies. The case was removed to the United States District Court for the Southern District of New York. On June 16, 2009, the plaintiff filed an amended complaint. The plaintiffPlaintiff seeks monetary damages, alleging that the defendants violated sectionsSections 11, 12 and 15 of the Securities Act of 1933, as amended, by making allegedly false statements regarding mortgage loans that served as collateral for securities purchased by the plaintiff and the purported class members. On August 31, 2009, the Company filed a motion to dismiss the plaintiff's claims, which the court granted on March 31, 2011, with leave to amend. The plaintiffPlaintiff filed a second amended complaint on May 16, 2011, and the Company again filed a motion to dismiss. On March 29, 2012, the court dismissed the plaintiff's second amended complaint with prejudice and without leave to replead. The plaintiffPlaintiff filed an appeal.appeal in the United States Court of Appeals for the Second Circuit (the "Appellate Court"). On March 1, 2013, the appellate courtAppellate Court reversed the judgment of the lower court, which had dismissed the case. Also, the appellate courtAppellate Court vacated the judgment of the lower court which had held that the plaintiff lacked standing, even as a class representative, to sue on behalf of investors in securities in which plaintiff had not invested, and the appellate court remanded the case back to the lower court for further proceedings. On April 23, 2013 the plaintiff filed its memorandum with the lower court seeking a reconsideration of the earlier dismissal of plaintiff's claims as to five offerings in which plaintiff was not invested, and on February 5, 2015, the lower court granted plaintiff's motion for reconsideration and vacated its earlier dismissal. On March 8, 2017, the affiliated defendants and all other parties executed an agreement to settle the action, with the contribution of the affiliated defendants to the settlement fund being paid by their insurance carriers. The court certified a settlement class and granted preliminary approval to the settlement on May 10, 2017.  One member of the settlement class objected to the settlement and sought a stay of the final settlement approval hearing on the ground that it did not receive notice of the settlement and had no opportunity to timely opt out of the class.  After the court rejected the motion for a stay, the objector filed an appeal and requested a stay of the district court proceedings pending disposition of the appeal. The court of appealsAppellate Court denied the temporary stay of the district court proceedings pending a decision

On June 20, 2011, the National Credit Union Administration Board, as liquidating agent of U.S. Central Federal Credit Union, filed an action against NMFC and numerous other defendants in the United States District Court for the District of Kansas, claiming that the defendants issued or underwrote residential mortgage-backed securities pursuant to allegedly false or misleading registration statements, prospectuses, and/or prospectus supplements. On August 24, 2012, the plaintiff filed an amended complaint making essentially the same claims against NMFC. NMFC filed a motion to dismiss the amended complaint which was denied on September 12, 2013. The defendants had claimed that the case should be dismissed based upon a statute of limitations and sought an appeal of the court's denial of this defense. An interlocutory appeal of this issue was allowed, and on August 27, 2013, the United States Court of Appeals for the Tenth Circuit (the "Tenth Circuit") affirmed the lower court’s denial of defendants’ motion to dismiss the plaintiff’s claims as being time barred; the appellate courtTenth Circuit held that the Extender Statute, 12 U.S.C. §1787(b)(14) applied to plaintiff’s claims. On June 16, 2014, the United States Supreme Court (the "Supreme Court") granted a petition of NMFC and its co-defendants for certiorari, vacated the ruling of the Tenth Circuit, and remanded the case back to that court for further consideration in light of the Supreme Court’s decision in CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). On August 19, 2014, the Tenth Circuit reaffirmed its prior decision, and on October 2, 2014, the defendants filed a petition for writ of certiorari with the Supreme Court, which was denied. On March 22, 2016, NMFC filed motions for summary judgment, and plaintiff filed a motion for partial summary judgment. Those motions remain pending. Given that plaintiff did not file a timely proof of claim in NMFC’s bankruptcy case, the Company believes it is likely that the case will be dismissed. The Company believes that NMFC has meritorious defenses to the case and expects it to defend the case vigorously in the event it proceeds.

On February 28, 2013, the Federal Housing Finance Agency, as conservator for the Federal Home Loan Mortgage Corporation (Freddie Mac) and purportedly on behalf of the Trustee of the NovaStar Mortgage Funding Trust, Series 2007-1 (the “Trust”), a securitization trust in which the Company retains a residual interest, filed a summons with notice in the Supreme Court of the State of New

This motion to dismiss was withdrawn after plaintiff filed an amended complaint on January 28, 2014, and on March 4, 2014, the Company and NMI filed a motion to dismiss the amended complaint. By a Decision/Order dated November 30, 2017, the court granted in part and denied in part the motion to dismiss the amended complaint. The court dismissed all claims except for plaintiff’s claim for damages for breach of contract, to the extent that claim is based on the Company’s and NMI’s alleged failure to notify plaintiff of allegedly defective loans, and plaintiff’s claim for indemnification. The court denied the motion to dismiss these claims without prejudice to the Company’s and NMI’s right to file a new motion to dismiss in conformity with procedures to be established in coordinated proceedings before the court addressing similar claims against numerous defendants. Briefing of the indemnification issue is complete, and the oral argument is yet to be scheduled. Given the stage of the litigation, the Company cannot provide an estimate of the range of any loss. The Company believes that it has meritorious defenses to the case and expects to defend the case vigorously.

To the extent observable inputs are not available, as is the case with the Company's retained mortgage securities, the Company

estimates fair value using present value techniques and generally does not have the option to choose other valuation methods

for these securities. The methods and processes used to estimate the fair value of the Company's retained mortgage securities

are discussed further below. There have been no significant changes to the Company's valuation techniques. Accordingly, there

have been no material changes to the condensed consolidated financial statements resulting from changes to our valuation techniques.

The Company's marketable securities are classified as available-for-sale and are reported at their estimated fair value with

unrealized gains and losses reported in accumulated other comprehensive income. To the extent that the cost basis of the

Company's marketable securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an

impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to

earnings as a realized loss. The specific identification method is used in computing realized gains or losses.

serves as a cushion for losses that have and may occur in the underlying mortgage pool. The OC bonds may receive cash if and when it is determined that actual losses are less than expectations. As of June 30, 2017,March 31, 2018, the aggregate overcollateralization was approximately $27.0$23.1 million. The timing and amount of cash to be generated by the OC bonds is contingent upon the performance of the underlying mortgage loan collateral.

Prior to 2016,2017, the Company determined that it was no longer more likely than not that it will recognize a portion of its deferred tax assets. Therefore, as of June 30, 2017March 31, 2018 and December 31, 2016,2017, the Company maintained a full valuation allowance against its net deferred tax assets of $293.7$162.9 million and $292.2$162.7 million, respectively. The Company's determination of the extent to which its deferred tax assets will be realized requires the exercise of significant judgment, based in part on business plans and

from as early as 2004. The state NOL carryforwards may expire as early as 2017 and as late as 2037.

There have been no options granted during 20162017 or 2017.2018. As of June 30,March 31, 2018 and December 31, 2017, and 2016, the Company had 0.12.8 million and 1.54.3 million nonvested shares outstanding, respectively. These shares, on weighted-average basis, are not included in the calculation of earnings (loss) per share for any period presented as they are anti-dilutive. While the nonvested shares granted during 2017and 2016 vest one year from the date of grant, the nonvested shares granted in prior years vest ratably over their original term of six years.

Statements in this report regarding Novation Companies, Inc. and its business that are not historical facts are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are those that predict or describe future events, do not relate solely to historical matters and include statements regarding management's beliefs, estimates, projections, and assumptions with respect to, among other things, our future operations, business plans and strategies, as well as industry and market conditions, all of which are subject to change at any time without notice. Words such as “believe,” “expect,” “anticipate,” “promise,” “plan,” and other expressions or words of similar meanings, as well as future or conditional auxiliary verbs such as “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. Actual resultsRisks, uncertainties, contingencies, and operations for any future period may vary materially fromdevelopments, including those discussed herein. Some important factors that could cause actual results to differ materially fromin “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report and those anticipated include: decreasesidentified in cash flows from our mortgage securities; our ability to remain“Risk Factors” in compliance with the agreements governing our indebtedness; the outcome of litigation actions pending against us or other legal contingencies; our compliance with applicable local, state and federal laws and regulations; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are from time to time included in our filings with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2016, as amended2017, (the "2016"2017 Form 10-K"). Other factors not presently identified may also, could cause actualour future operating results to differ. This report speaks only as of its date and we expresslydiffer materially from those set forth in any forward-looking statement. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We disclaim any dutyobligation to update any such factors or to publicly announce the informationresults of any revisions to any of the forward-looking statements contained herein except as required by federal securities laws.to reflect future results, events or developments.

amounts) are derived from our condensed consolidated financial statements for the periods presented and should be read in conjunction

The Company has incurred significant costs associated with our reorganization and the Chapter 11 proceedings, which primarily consis of legal fees, and are being expensed as incurred. The Company expects theseThese costs to decreasehave decreased significantly during the third quarter of 2017 as a result of the completion of the Company's reorganization efforts. Reorganization items were $3.1 million and $1.8 million for the

The 2011 Notes accrued interest at a rate of 1.0% per annum until January 1, 2016 and then accrued interest at a rate of three-month LIBOR plus 3.5% per annum. Interest on the 2011 Notes was payableCompany's condensed consolidated financial statements have been prepared on a quarterly basis and no principal payments

On the Bankruptcy Petition Date, the aggregate outstanding principal under the 2011 Notes was $85.9 million and the aggregate recorded interest liability was $2.0 million. As of June 30, 2017, the principal and recorded unpaid interest ($5.8 million) are classified as liabilities subjectbusinesses will be sufficient to compromisesustain our operations in the Company's consolidated balance sheet.

As of the end of the period covered by this report, our executive chairman and our chief financial officer conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on their evaluation of our disclosure controls and procedures, our executive chairman and chief financial officer, with the participation of the Company’s management, concluded that are designedour disclosure controls and procedures were not effective as of March 31, 2018, to ensure that information required to be disclosed by the Company in the reports that it fileswe file or submitssubmit under the federal securities laws, including this report,Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the applicableSEC’s rules and forms and that it is(b) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow for timely decisions regarding required disclosure.

The Company's principal executive officerAs discussed in Management's Discussion and principalAnalysis of Financial Condition and Results of Operations above and in Note 3 to the condensed consolidated financial officer evaluatedstatements, in July 2017, we acquired HCS, which now is our primary business activity. Prior to the effectivenessacquisition, HCS was a privately-owned business with limited administrative and accounting resources, accounting software inappropriate for the size of the Company's disclosurebusiness and generally weak accounting processes, procedures and controls. Specifically, material weaknesses existed in HCS's processes, procedures and controls with respect to revenue, receivables, payment of payroll taxes and estimating various accrued expenses.

We are working to improve the processes, procedures and controls at HCS and remediate this material weakness. Since the acquisition of HCS in July 2017, we have implemented improvements in processes, procedures and controls and procedures (as definedwe will continue to do so. We are evaluating the accounting professionals at the Company and HCS and will determine if additional professionals with relevant experience are needed. We will disclose in Exchange Act Rules 13a-15(e) and 15d-15(d)) as offuture periods the end of the period covered byprogress we have made in efforts to remediate this report and, based on such evaluation, concluded that the Company's disclosure controls and procedures were effective as of such date.material weakness.

As a result of the HCS acquisition and the generally weak controls at HCS discussed above, we determined that we have a material weakness in our internaldisclosure controls and procedures. We are working to remediate this material weakness as discussed above.

It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In designing and operating a control over financial reporting duringsystem, one must consider the quarter ended June 30, 2017potential benefits of controls relative to their costs and the reality of limited resources available to allocate to control activities, particularly in smaller companies. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that have materially affected, any control will meet its objectives under all potential future conditions. Because of such inherent limitations in any control system, there can be no absolute assurance that control issues, misstatements, and/or are reasonably likely to materially affect, our internal control over financial reporting.

On February 28, 2013, the Federal Housing Finance Agency, as conservator for the Federal Home Loan Mortgage Corporation

(Freddie Mac) and purportedly on behalf of the Trustee of the NovaStar Mortgage Funding Trust, Series 2007-1 (the “Trust”), a securitization

aggregate, original principal balance of about $6.5 million. On August 19, 2013, Deutsche Bank National

See the "Corporate Overview" section of the MD&AManagement's Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to the condensed consolidated financial statements for a

There have been no material changes to the risk factors included in the 20162017 Form 10-K.

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