Item 1. Business.
REGISTRANT. LSB Bancshares, Inc. (“Bancshares”) is a bank holding company incorporated under the laws of the State of North Carolina on December 8, 1982, headquartered in Lexington, North Carolina and registered under the Federal Bank Holding Company Act of 1956, as amended (the “FBHCA”). Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. Its telephone number is (336) 248-6500.
Bancshares’ principal business is providing banking and other financial services through its banking subsidiary, Lexington State Bank (“Bank”). The principal assets of Bancshares are all outstanding shares of the Bank’s common stock. As part of its operations, Bancshares is not dependent upon a single customer or a few customers whose loss would have a material adverse effect on Bancshares. At December 31, 2006, Bancshares and its subsidiaries had consolidated assets of $988 million and 407 full-time equivalent employees.
SUBSIDIARY BANK. The Bank is chartered under the laws of the State of North Carolina to engage in the business of general banking. As of December 31, 2006, the Bank had 381 full-time equivalent employees. Founded in 1949, the Bank offers a wide array of services in commercial banking including accepting deposits, corporate cash management, discount brokerage, IRA plans, mortgage production, secured and unsecured loans and trust functions through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. The Bank also provides banking services through automated teller machines (“ATMs”) and cash dispensers, “LSB By Net” online banking and 24-hour “LSB By Phone” banking. To the Bank’s knowledge, it operates the only independent trust department in Davidson County, providing estate planning, estate and trust administration, IRA trusts, personal investment accounts and pension and profit-sharing trusts.
NON-BANK SUBSIDIARIES. The Bank has two wholly-owned, North Carolina non-bank subsidiaries: Peoples Finance Company of Lexington, Inc. (“Peoples Finance”) and LSB Investment Services, Inc. (“LSBIS”). The Bank acquired Peoples Finance on January 1, 1984. Peoples Finance employs 15 people and operates from three offices located in Lexington, King and Archdale, North Carolina as a finance company licensed under the laws of the State of North Carolina. As a finance company, Peoples Finance offers secured and unsecured loans to individuals up to a maximum of $10,000, as well as dealer originated loans.
LSBIS offers a full range of uninsured, nondeposit investment products, including mutual funds, annuities, stocks and bonds and insurance services. LSBIS employs 11 people and operates from the Bank’s home office, as well as offices located in Welcome, Winston-Salem, King and Wallburg, North Carolina. LSBIS offers products through Uvest Investment Services, an independent broker-dealer, which is a member of the National Association of Securities Dealers, Inc. (“NASD”) and the Securities Investor Protection Corporation (“SIPC”). Investments are neither deposits nor obligations of the Bank, nor are they guaranteed or insured by any depository institution, the Federal Deposit Insurance Corporation (“FDIC”), or any other government agency.
COMPETITION. Commercial banking in the Bank’s service area is highly competitive. The Bank and Bancshares face competition from national and state banks, thrift institutions, credit unions, investment banking and brokerage firms, and mortgage and finance companies in the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. The Bank’s most direct competition for deposits has historically derived from other commercial banks located in and around the markets in which it maintains banking offices. The Bank also competes for deposits with regional and super-regional banks, money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and
around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances have, for example, lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.
GENERAL HIGHLIGHTS OF BUSINESS IN 2006.
Financial Summary. Net income for 2006 was $6.000 million or $0.71 per diluted share, compared to $9.637 million or $1.12 per diluted share in 2005, a decrease of 36.6% in earnings per share. Net interest income for 2006 decreased 1.3% compared with net interest income for 2005, reflecting a decline in the net interest margin, partially offset by growth in earning assets of Bancshares. Noninterest income in 2006 increased 3.6% from 2005. Noninterest expense increased 8.9% during the same period. The provision for loan losses was $5.510 million in 2006 compared to $3.219 million in 2005. Nonperforming assets (including nonaccrual loans, accruing loans more than 90 days past due, renegotiated troubled debt and other real estate owned) totaled $9.891 million at December 31, 2006, up 22.3% from $8.087 million at December 31, 2005. Included in the $9.891 million for 2006 was the previously disclosed write-down of certain credits at the Bank and at Peoples Finance. Included in the $8.087 million from 2005 was $4.391 million in other real estate owned, most of which related to the acquisition, by means of deed-in-lieu of foreclosure, of coastal condominium units by the Bank during the second quarter of 2005. The allowance for loan losses was $9.564 million or 1.3% of loans, at the end of 2006, compared to $8.440 million, or 1.1% of loans, at the end of 2005. In 2006, return on average assets was 0.61% and return on average shareholders’ equity was 6.47%. As of December 31, 2006, assets increased 1.2%, deposits decreased 0.6% and loans increased 0.6% compared to December 31, 2005. As of December 31, 2006, shareholders’ equity totaled $89.309 million. For additional financial information, please review Item 6, “Selected Financial Data,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 14 and page 37 below, respectively.
Business Developments during the Last Fiscal Year. Progress continued during 2006 in many areas regarding Impact ’05, which is the Bank’s multi-year initiative to improve performance, particularly in its retail delivery system, operations, technology and service. The Bank’s Model Branch project, which is standardizing the procedures in the branches, is providing branch sales and service employees with better tools for increased sales, improved customer service and operational efficiencies. The installation of a state-of-the-art Enterprise Relationship Management System, which was completed in the second quarter of 2006, has become the primary sales and service platform used by all customer service employees. A new user-friendly business internet banking system is providing additional features and functionality for business customers.
The Bank continued to benefit from the implementation of the LSB Call Center with the expansion of services to include answering customer inquiries on credit card and electronic banking services. Work is also underway to incorporate loan inquiries as well as to begin routing branch calls to the LSB Call Center.
For additional information regarding the business of Bancshares and its subsidiaries during 2006, please review Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 15 below.
SUBSEQUENT EVENTS
On February 26, 2007, the Board of Directors of Bancshares entered into a definitive agreement to combine in a merger of equals with FNB Financial Services Corporation (the “Merger”). The Merger is scheduled to be completed during the third quarter of 2007. In connection with the Merger, Bancshares will file a registration
statement, which will include a joint proxy statement/prospectus to be sent to the shareholders of Bancshares and FNB Financial Services Corporation (“FNB”), and each of Bancshares and FNB may file other relevant documents concerning the Merger with the Securities and Exchange Commission (the “SEC”). Stockholders are urged to read the registration statement and the joint proxy statement/prospectus regarding the Merger when they become available and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they will contain important information. You will be able to obtain a free copy of the joint proxy statement/prospectus, as well as other filings containing information about Bancshares and FNB, at the SEC’s website, www.sec.gov. You will also be able to obtain these documents, free of charge, by accessing Bancshares’ website, www.lsbnc.com, or by accessing FNB’s website, www.fnbsoutheast.com.
REGULATION
General. As a bank holding company, Bancshares is subject to supervision, examination and regulation by the Board of Governors of the Federal Reserve System (“Federal Reserve”). The Bank is also subject to supervision, examination and regulation by the Office of the Commissioner of Banks of the State of North Carolina (the “Banking Commission”). The Bank is a member of the FDIC as well and is therefore subject to supervision and examination by that agency. In addition to federal and state banking laws and regulations, Bancshares and its subsidiaries are subject to other federal and state laws and regulations, and supervision and examination by other state and federal regulatory agencies, including the SEC, the NASD and state securities regulators.
The following is a brief summary of some of the statutes, rules and regulations which directly or indirectly affect the operations and management of Bancshares and its subsidiaries. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions cited below and is not intended to be an exhaustive description of all applicable statutes or regulations. Any change in applicable laws or regulations may have a material adverse effect on Bancshares’ business and prospects.
Regulation of Bancshares. As a bank holding company, under the FBHCA, Bancshares’ activities, and the activities of the companies which it controls or in which it holds more than five percent of the voting stock, are limited to banking, managing, controlling banks, furnishing services to, performing services for its subsidiaries, or any other activity which the Federal Reserve determines to be a proper incident to the business of banking. Some of the activities that the Federal Reserve has determined by regulation to be proper incidents to the business of banking, and thus permissible for bank holding companies such as Bancshares, include (a) making or servicing loans and certain types of leases and related activities; (b) engaging in certain insurance and discount brokerage activities; (c) underwriting and dealing in government securities and certain other securities and financial instruments; (d) providing certain data processing and data transmission services; (e) acting in certain circumstances as a fiduciary or investment or financial advisor; (f) management consulting and counseling activities; (g) issuing and selling retail monetary instruments such as money orders, savings bonds and travelers’ checks and providing check printing and courier services; (h) operating trust companies and non-bank depository institutions such as savings associations; and (i) making investments in corporations or projects designed primarily to promote community welfare. Generally, a bank holding company is required to obtain prior approval from the Federal Reserve to engage in any new activity not previously approved by the Federal Reserve or to acquire more than five percent of any class of voting stock of any company or any bank which is not already majority-owned by such bank holding company.
Bancshares is also registered under the North Carolina Bank Holding Company Act of 1984 (the “NCBHCA”). The NCBHCA prohibits Bancshares from acquiring or controlling certain non-bank banking institutions which have offices in North Carolina.
Regulation of the Bank. As mentioned above, the Bank is subject to regulation, supervision and examination by the Federal Reserve and the Banking Commission and to regulation by the FDIC. Federal and state laws and regulations impose various requirements upon the Bank, including those related to required reserves against deposits, allowable investments, loans, mergers, consolidations, issuance of securities, payment of dividends, establishment of branches, limitations on credit to subsidiaries and other aspects of the business of such subsidiaries. The federal and state banking agencies have broad authority and discretion in connection with their supervisory and enforcement activities and examination policies, including policies involving the classification of assets and the establishment of loan loss allowances for regulatory purposes. Such actions by these regulators prohibit member banks from engaging in unsafe or unsound banking practices. The Bank is also subject to certain reserve requirements established by the Federal Reserve.
Other Regulations. The operations and management of Bancshares and its subsidiaries are subject to additional statutes, rules and regulations briefly summarized below.
Check Clearing for the 21st Century Act. Most banks, such as the Bank, use check-imaging technology to capture digital images of the fronts and backs of checks as they are processed through high-speed check sorters. The Check Clearing for the 21st Century Act (the “Check 21 Act”) authorizes banks to replace the physical transportation of checks with an electronic transfer of check images.
The key feature of the Check 21 Act is the creation of a new negotiable instrument called a “substitute check.” A substitute check is a paper reproduction of an original check that meets certain content and format requirements imposed by the Check 21 Act. Under the Check 21 Act, banks are able to create substitute checks from the original deposited paper checks and process them electronically under a uniform electronic processing system. All banks are required to accept substitute checks. However, no bank is required to create substitute checks and may continue to use the paper check clearing process instead. The Bank has taken advantage of the Check 21 regulations by converting to a Fed Forward Imaged Cash Letter for all foreign checks deposited. The Bank is currently exploring the ability to receive the Bank’s checks from the Federal Reserve in an image format along with imaged return item processing. It is anticipated that imaging technology will also be deployed to the Bank’s branch network, which will enable the Bank to provide customers with same day credit for their transactions.
Under the Check 21 Act, substitute checks are subject to all of the consumer protections granted in the Uniform Commercial Code and certain regulations promulgated by the Federal Reserve. The Check 21 Act also requires banks to provide a brief notice about substitute checks to customers and establishes further warranties and indemnifications to protect consumers.
Gramm-Leach Bliley Financial Modernization Act of 1999. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”) modernized the federal bank regulatory framework by allowing the consolidation of banking institutions with other types of financial services firms, subject to various restrictions and requirements. In general, the GLB Act repealed most of the federal statutory barriers which separated commercial banking firms from insurance and securities firms and authorized the consolidation of such firms in a financial services holding company.
The USA PATRIOT Act. After the September 11, 2001 terrorist attacks in New York and Washington, D.C., the United States government acted in several ways to tighten control on activities perceived to be connected to money laundering and terrorist funding by enacting the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”). A series of orders were issued under the USA PATRIOT Act which identify terrorists and terrorist organizations and require the blocking of property and assets of, as well as prohibiting all transactions or dealings with, such terrorists, terrorist organizations and those that assist or sponsor them. The USA PATRIOT Act also requires each financial institution (a) to create a risk based Customer Identification Program to verify the identity of any
person or entity seeking to open an account to the extent reasonable and practical; (b) to establish an anti-money laundering program; (c) to establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (d) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, the United States Treasury Department issued regulations in cooperation with the federal banking agencies, the SEC, the Commodity Futures Trading Commission and the Department of Justice to require customer identification and verification, expand the money-laundering program requirement to the major financial services sectors, and facilitate and permit the sharing of information between law enforcement and financial institutions, as well as among the financial institutions themselves. The United States Treasury Department also has created the Treasury USA PATRIOT Act Task Force to work with other financial regulators, the regulated community, law enforcement and consumers to continually improve the regulations.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (“SOX”) comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Exchange Act (such as Bancshares). In particular, SOX established (a) new requirements for audit committees, including independence, expertise, and responsibilities; (b) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (c) new standards for auditors and regulation of audits; (d) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (e) new and increased civil and criminal penalties for violations of the securities laws.
Various Consumer Protection Laws. In connection with its lending and leasing activities, Bancshares and its subsidiaries are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.
Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, aside from certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.
AVAILABLE INFORMATION. Bancshares’ Internet address is www.lsbnc.com. Bancshares makes available, free of charge, on or through its website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and beneficial ownership reports on Forms 3, 4 and 5 as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These filings are also accessible on the SEC’s website, www.sec.gov. In addition, Bancshares makes available on www.lsbnc.com (i) its Corporate Governance Guidelines, (ii) its Code of Business Conduct and Ethics, which applies to all directors and officers of Bancshares and its subsidiaries, (iii) its Code of Business Conduct and Ethics for CEO and Senior Financial Officers, which applies to Bancshares’ Chief Executive Officer and Chief Financial Officer and principal accounting officers, and (iv) the charters of the Executive Committee, the Stock Option and Compensation Committee, the Audit Committee and the Corporate Governance and Nominating Committee of its Board of Directors. These materials are also available free of charge in print to shareholders who request them by writing to: Monty J. Oliver, Secretary and Treasurer, One LSB Plaza, Lexington, North Carolina 27292. You may read and copy any materials
Bancshares files with the SEC at the SEC’s Public Reference Room at 100 F. Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at (800) 732-0330.
Item 1A.
Item 1A. Risk Factors.
The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect our business, financial condition, results of operations or prospects. If any of the following risks were to occur, our business, financial condition, results of operations or prospects could be materially and adversely affected.
Our operating results and financial condition would likely suffer if there is deterioration in the general economic condition of the areas in which we do business. Our primary markets are in Davidson, Forsyth, Guilford, Randolph and Stokes counties in North Carolina. Because our lending and deposit-gathering activities are concentrated in these markets, we will be affected by the business activity, population, income levels, deposits and real estate activity in these markets. These markets are heavily dependent on the manufacturing industry and adverse developments in local industry have had and could continue to have a negative affect on our financial condition and results of operations. Even though our customers’ business and financial interest may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations. A significant decline in general economic conditions in North Carolina or the entire country caused by inflation, recession, unemployment or other factors which are beyond our control would also impact these local economic conditions and could have an adverse affect on our financial condition and results of operations.
Our operating results would likely suffer if management determines that there needs to be an increase in allowance for loan losses due to certain factors. Management periodically makes a determination of our allowance for loan losses based on available information, including the quality of our loan portfolio, economic conditions, the value of the underlying collateral and the level of our nonaccruing loans. If our assumptions prove to be incorrect, our allowance may not be sufficient. Increases in this allowance will result in an expense for the period. If, as a result of economic conditions or an increase in non-performing loans, management determines that an increase in our allowance for loan losses is necessary it could have an adverse affect on our results of operations.
Our financial condition, results of operations and liquidity would be adversely affected if, due to changes in economic conditions or otherwise, a material number of our borrowers or borrowers with a material amount of loans outstanding with us defaulted on their loans and the security, if any, supporting such loans proved insufficient to pay those loans, and our costs related thereto, in full. A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most loans originated by us are secured, but some loans are unsecured depending on the nature of the loan. With secured loans, the collateral securing the repayment may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government and several other events. These changes could have a material adverse effect on our financial condition, results of operations and liquidity.
Changes in interest rates could materially adversely affect our results of operations and cash flows. Our primary source of income from operations is net interest income, which equals the difference between the interest income we generate on loans, investments and other interest-bearing assets and the interest expense we incur on deposits, borrowing and other interest-bearing liabilities. Our net interest income is affected by
changes in market interest rates. These rates are highly sensitive to many factors beyond our control, including general economic conditions and the monetary and fiscal policies of various governmental and regulatory agencies.
The businesses in which we are engaged are highly competitive and our financial condition and results of operations could be materially adversely affected by actions taken by our competitors. We face competition for banking services from national and state banks, thrift institutions, credit unions, investment banking and brokerage firms, and mortgage and finance companies in the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Our most direct competition for deposits has historically derived from other commercial banks located in and around the markets in which we maintain banking offices. We also compete for deposits with regional and super-regional banks, money market instruments and mutual funds. We compete for loans principally through the interest rates and loan fees we charge and the efficiency and quality of services we provide borrowers. Our competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around our markets. If we are unable to continually attract and retain sufficient numbers of banking customers we may be unable to continue our loan growth and level of deposits and our results of operations and financial condition may otherwise be negatively affected.
Changes in the various laws and regulations that govern our businesses could have a material adverse affect on our financial condition and results of operations. We are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of our operations. During 2006, we closed in on the threshold of a billion dollar bank holding company and are now subject to annual joint examinations by the state of North Carolina and the FDIC along with heightened focus during those examinations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact us and/or our ability to increase the value of our business.
Our fee revenue from LSBIS is highly dependent on the value of assets under our care and the trading volume of our customers in their brokerage accounts, which in turn could be materially adversely affected by national and local economic conditions. The fee revenue of LSBIS is largely dependent on the fair market value of assets in our customers’ accounts and the trading volumes of the brokerage business. General economic conditions and their subsequent effect on the securities markets tend to act in tandem. When general economic conditions deteriorate, consumer and corporate confidence in securities markets erodes, and LSBIS’ revenues are negatively impacted as asset values and trading volumes decrease.
We are subject to security and operational risks related to the technology we use that could result in a loss of customers, increased costs and other damages which could be material. We depend on data processing, software and communication and information exchange on a variety of platforms, networks and over the internet. Despite safeguards, we cannot be certain that all of our systems are entirely free from vulnerability to attack or other technological difficulties or failures. Any failure or interruptions or breach of security of these systems could result in failures or disruptions in our customer relationships, general ledger, deposits and servicing or loan origination systems. The occurrence of any difficulties or failures could result in a loss of customer business and have a material adverse effect on our results of operations and financial condition.
Item 1B.
Item 1B. Unresolved Staff Comments. Not Applicable.
Item 2.
Item 2. Properties.
Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. This five-story office building totals 74,800 square feet and also serves as the home office of the Bank. A majority of the staff functions are located within this office complex, which is owned by the Bank.
The Bank operates twenty-five branches, one mortgage origination office and ten off-premise ATM locations. The Bank owns sixteen of the twenty-five branches, while nine branches, the mortgage origination office and the off-premise ATM locations are leased. The Bank’s leased properties are subject to leases that expire on various dates from 2007 to 2012. The Bank operates branches at the following locations:
ARCADIA*
ARCHDALE*
CLEMMONS*
3500 Old Salisbury Road
11651-D North Main Street
2386 Lewisville-Clemmons Road
Arcadia, NC 27292
Archdale, NC 27263
Clemmons, NC 27012
CORPORATE OFFICE*
DANBURY*
HIGH POINT*
One LSB Plaza
1101 North Main Street
200 Westchester Drive
Lexington, NC 27292
Danbury, NC 27016
High Point, NC 27262
JAMESTOWN*
KERNERSVILLE*
KING*
120 East Main Street
131 East Mountain Street
647 South Main Street
Jamestown, NC 27282
Kernersville, NC 27284
King, NC 27021
MIDWAY*
Old U.S. Highway 52
Midway, NC 27295
NATIONAL HIGHWAY*
724 National Highway
Thomasville, NC 27360
PIEDMONT
RETIREMENT CENTER
100 Hedrick Drive
Thomasville, NC 27360
RALEIGH
805 Spring Forest Road
Suite 800
Raleigh, NC 27609
RANDOLPH STREET*
941 Randolph Street
Thomasville, NC 27360
REYNOLDA*
2804 Fairlawn Drive
Winston-Salem, NC 27106
RURAL HALL*
SHERWOOD PLAZA*
SOUTH LEXINGTON*
8055 Broad Street
3384 Robinhood Road
1926 Cotton Grove Road
Winston-Salem, NC 27045
Winston-Salem, NC 27106
Lexington, NC 27292
STRATFORD ROAD*
TALBERT BOULEVARD*
TYRO*
161 South Stratford Road
285 Talbert Boulevard
4481 Highway 150 South
Winston-Salem, NC 27104
Lexington, NC 27292
Tyro, NC 27295
UPTOWN EXPRESS
DRIVE-THRU*
500 South Main Street
Lexington, NC 27292
WALKERTOWN*
3000 Old Hollow Road
Walkertown, NC 27051
WALLBURG*
10335 North NC Highway 109
Wallburg, NC 27373
WELCOME*
WEST SIDE*
6123 Old US Highway 52
60 New US Highway 64 West
Welcome, NC 27374
Lexington, NC 27292
Peoples Finance operates from (a) a 3,200 square foot, one-story building located at 126 Forest Hill Road, Lexington, North Carolina 27295; (b) a 1,200 square foot, one-story building located at 614 South Main Street, King, North Carolina 27021; and (c) a 1,000 square foot, one story building located at 11234 North Main Street, Suite 306, Archdale, North Carolina 27263. All premises are leased.
LSBIS operates from (a) a 800 square foot space in the principal office of the Bank; (b) a 100 square foot space in the building located at 10335 North N.C. Highway 109, Wallburg, North Carolina 27373; (c) a 250 square foot space in the building located at 6123 Old U.S. Highway 52, Welcome, North Carolina 27374; (d) a 300 square foot space in the building located at 161 South Stratford Road, Winston-Salem, North Carolina 27104; and (e) a 100 square foot space in the building located at 647 South Main Street, King, North Carolina 27021. All premises are leased.
Except as described herein, Bancshares, the Bank, Peoples Finance and LSBIS own all of their properties free and clear of encumbrances.
Item 3.
Item 3. Legal Proceedings.
From time to time, Bancshares and its subsidiaries are involved in litigation arising from the ordinary course of their business. As of the date of this report, neither Bancshares nor any of its subsidiaries are involved in any material legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to a vote of shareholders during the quarter ended December 31, 2006.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.
Bancshares’ common stock is traded on the Nasdaq Global Select Market under the symbol LXBK. The following table shows the high, low and closing sales prices reported on the Nasdaq Global Select Market and cash dividends declared per share for the indicated periods.
As of February 28, 2007, there were 2,221 record holders of Bancshares’ common stock.
The following table sets forth certain information regarding outstanding options and shares for future issuance under equity compensation plans as of December 31, 2006. Individual equity compensation arrangements are aggregated and included within this table. This table excludes any plan, contract or arrangement that provides for the issuance of options, warrants or other rights that are given to Bancshares’ shareholders on a pro rata basis and any employee benefit plan that is intended to meet the qualification requirements of Section 401(a) of the Internal Revenue Code of 1986, as amended.
The Board of Directors of Bancshares has authorized a repurchase plan for shares of its common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market conditions and subject to compliance with all applicable securities laws and regulations. The repurchase plan is intended to help Bancshares achieve its goal of building shareholder value and maintaining appropriate capital levels. The plan was originally announced in November 1998 with extensions approved in August 1999 and May 2004, and expired on May 31, 2006. The original plan as well as each of the extensions authorized 300,000 shares to be repurchased, for a total authorized repurchase amount of 900,000 shares. As of May 16, 2006, Bancshares had repurchased a total of 708,955 shares under this plan. A new plan was approved by the Board of Directors effective May 17, 2006 and set to expire on May 31, 2008 that allows for the repurchase of up to 400,000 shares. As of December 31, 2006, Bancshares had repurchased a total of 112,476 shares under the new plan, leaving an additional 287,524 shares available to be repurchased.
The following table shows a breakdown of the shares that have been repurchased by Bancshares during the fourth quarter of 2006.
Issuer Purchases of Equity Securities
Shareholder Return Performance Presentation
The graph presented below compares the cumulative total shareholder return on Bancshares’ common stock to the cumulative total return of the S&P 500 Index and the S&P 500 Diversified Banks Index for the five-year period ended December 31, 2006. The cumulative total shareholder return assumes the investment of $100 in Bancshares’ common stock and in each index on December 31, 2001 and assumes reinvestment of dividends.
COMPARISON OF CUMULATIVE FIVE YEAR TOTAL RETURN
Item 6.
Item 6. Selected Financial Data.
The following table should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 15 and page 37 below, respectively.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with Item 1A, “Risk Factors”, Item 6, “Selected Financial Data,” Item 8, “Financial Statements and Supplementary Data,” and the audit report of Turlington and Company, L.L.P., Bancshares’ independent registered public accounting firm which begin on pages 8, 14, 37 and 39, respectively.
Forward-looking Statements
This Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of Bancshares including but not limited to Bancshares’ operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimate”, “believe” and variations of these words and other similar statements. For this purpose, any statements contained in this Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. These forward-looking statements involve estimates, assumptions by management, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation: (1) the strength of the United States economy generally and the strength of the local economies in which Bancshares conducts operations may be different than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit, including the resultant effect on Bancshares’ loan portfolio and allowance for loan losses; (2) the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (3) inflation, interest rate, market and monetary fluctuations; (4) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate conditions) and the impact of such conditions on Bancshares’ capital markets and capital management activities, including, without limitation, Bancshares’ private equity investment activities and brokerage activities; (5) the timely development of competitive new products and services by Bancshares and the acceptance of these products and services by new and existing customers; (6) the willingness of customers to accept third party products marketed by Bancshares; (7) the willingness of customers to substitute competitors’ products and services for Bancshares’ products and services and vice versa; (8) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (9) technological changes; (10) changes in consumer spending and saving habits; (11) the effect of corporate restructurings, acquisitions and/or disposition, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (12) the growth and profitability of Bancshares’ noninterest or fee income being less than expected; (13) unanticipated regulatory or judicial proceedings; (14) the impact of changes in accounting policies by the SEC; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; and (16) Bancshares’ success at managing the risks involved in the foregoing. Bancshares cautions that the foregoing list of important factors is not exclusive. See also “Risk Factors” which begins on page 8 above. Bancshares undertakes no obligation to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Bancshares.
Introduction
Bancshares is a bank holding company headquartered in Lexington, North Carolina. Its principal assets are all of the outstanding shares of common stock of the Bank. The Bank operates as a North Carolina chartered commercial bank serving customers through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. At December 31, 2006 construction of a new branch in Archdale, NC was in the final stages. This larger full service branch opened in January 2007
and allows the Bank to better serve its growing customer base in this community. The installation of a state-of-the-art Enterprise Relationship Management System was completed in the second quarter of 2006 and has become the primary sales and service platform used by all customer service employees. The system also supports the small business lending process. Two new deposit products, Indexed Certificates of Deposit (“ICDs”) and Easy Sweep Accounts, provide customers with new opportunities to increase the return of their deposits. A cash management internet banking system is providing additional features and functionality for business customers including customer initiated wire transfers, Treasury, Tax, and Loan (“TT&L”) payments and positive pay. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individuals and corporate customers.
Bancshares’ results of operations are dependent primarily on the results of operations of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. The Bank’s noninterest income has become increasingly important to its performance through fees earned by its non-bank subsidiary LSBIS. Results of operations are also affected by Bancshares’ provision for loan losses, mortgage loan sales activities, service charges and other fee income, and noninterest expense. Bancshares’ noninterest expense principally consists of compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Bancshares’ results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.
The Bank faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Its most direct competition for deposits has historically been derived from other commercial banks located in and around the markets in which it maintains banking offices. The Bank also competes for deposits with both regional and super-regional banks, money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the Bank’s markets. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.
Critical Accounting Policies
The accounting and reporting policies of Bancshares and its subsidiaries comply with generally accepted accounting principles in the United States and conform to standards within the industry. Bancshares believes that its most significant accounting policies deal with:
•
The allowance for loan loss, as it requires the most subjective and complex judgments from senior management. Management considers several factors in determining the allowance for loan loss. These include economic conditions, advice of regulators, historical experience and factors affecting particular borrowers. Changes in the assumptions of these policies could result in a significant impact on Bancshares’ financial statements. For further information, see the Asset Quality and Allowance for Loan Losses section and Note 1, “Summary of Significant Accounting Policies,” in the “Notes to Consolidated Financial Statements.”
•
Pension and postretirement benefit plans to employees, (the “Benefit Plans”). Bancshares utilizes actuarial methods required by Statement of Financial Accounting Standards 87, “Employers’ Accounting for Pensions”, to account for its noncontributory defined benefit pension plan (the “Pension Plan”), which covers substantially all employees and Bancshares follows Statement of Financial Accounting Standards No 106, “Employer’s Accounting for Postretirement Benefits Other than Pensions” to account for its postretirement life and health benefits. The actuarial methods for the Benefits Plans require numerous assumptions to calculate the net periodic benefit expense and the related benefit obligation for the Benefit Plans. Inherent to these valuations are key assumptions, including the discount rate and expected long-term rate of return on plan assets. Material changes in the costs of the Benefits Plans may occur in the future due to changes in these assumptions, changes in the number of participants, changes in the level of benefits provided, changes in asset levels and changes in legislation.
During the fourth quarter of 2006, Bancshares froze its pension plan and accounted for the freeze in accordance with Statement of Financial Accounting Standards No. 88 “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits” (“SFAS 88”). The application of this statement also required certain actuarial assumptions. Further, as of December 31, 2006, Bancshares adopted Statement of Financial Accounting Standards No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”. This statement requires that the funded status of defined benefit and other postretirement plans be fully recognized in the balance sheet. The adoption of this statement also required the use of certain actuarial assumptions.
Since future pension and postretirement liabilities are calculated using an assumed discounted rate, the discount rate is a significant assumption. The discount rate is selected using various market indicators and reflects the available cost in the marketplace of settling all pension obligations. The discount rate of 5.75% for 2006 was selected based upon reviewing trends in the interest indexes of AAA and AA bond rates and the 30-yr Treasury rate and analysis of the duration of the Pension Plan’s liabilities.
The expected long-term rate of return on the Pension Plan’s assets should, over time, approximate the actual long-term returns on assets of the Pension Plan. Assumptions are developed by the Pension Plan’s investment consultant for each investment style category as to rate of return, risk, yield and correlation with other categories that serve as components of the long-term strategy. Based upon these assumptions, eligible components are tested over the desired time horizon given the acceptable tolerance for risk as determined by the Plan Sponsor. The expected long-term rate of return of 7.5% reflects assumptions as to continued execution of the current strategic asset allocation, modern portfolio theory and the Pension Plan’s investment policy.
Please refer to Note 13, “Pension and Employee Benefit Plans;” in the “Notes to the Consolidated Financial Statements” for disclosures related to Bancshares’ Benefit Plans, including quantitative disclosures reflecting the impact of adopting the above referenced accounting pronouncements as well as other quantitative disclosures.
Overview
The discussion presented herein is intended to provide an overview of the financial condition, changes in financial condition and results of operations of Bancshares and the Bank for the years 2006, 2005 and 2004. The consolidated financial statements include the accounts and results of operations of the Bank’s wholly-owned subsidiaries, Peoples Finance and LSBIS. The intent of the discussion and analysis is to provide the reader with pertinent information about Bancshares and its subsidiaries in the areas of liquidity, capital resources, results of operation, off-balance sheet arrangements, contractual obligations, financial position, asset quality and interest sensitivity. It should be read in conjunction with the audited financial statements, notes and supplemental tables provided herein.
Results of Operations
For 2006, Bancshares reported net income of $6.000 million or $0.71 per diluted share compared to $9.637 million or $1.12 per diluted share for 2005 and $8.380 million or $.97 per diluted share for 2004. The decrease in net income for the current year was the result of lower net interest income, a higher provision for loan losses that included a one-time write down of $1.9 million in the fourth quarter of 2006, and higher noninterest expense. Net interest income for 2006 decreased by $571,000, or 1.3%, as compared to 2005.
The net interest margin decreased 16 basis points during 2006, ending the year at 4.75%, compared to 4.91% for 2005, and 4.75% for 2004. Noninterest income increased $498,000, or 3.6%, in 2006 compared to a decrease in 2005 of $271,000, or 1.9%. Noninterest expense for 2006 increased $3.554 million, or 8.9% compared to $2.083 million or 5.5% for 2005. The provision for loan losses in 2006 was $5.510 million, up $2.291 million, or 71.2% from 2005. Return on average assets for 2006 was 0.61% compared to 1.00% for 2005 and 0.94% in 2004. Return on average shareholders’ equity for 2006 was 6.47% compared to 10.49% in 2005 and 9.26% in 2004.
Balance sheet growth was generally modest during 2006. There was an increase in loans of $4.580 million, or 0.6% compared to growth in 2005 of $43.213 million, or 6.1%. Consolidated assets in 2006 increased $11.951 million, or 1.2% compared to 2005, which increased $60.807 million, or 6.7% over 2004. Deposits decreased in 2006 by $4.490 million, or 0.5% compared to a 2005 increase of $99.898 million, or 13.8%.
Net Interest Income
Net interest income for the Bank represents the dollar amount by which income generated from earning assets exceeds its cost of funds. Net interest income is the Bank’s primary source of revenue. Interest-earning assets consist primarily of loans and investment securities. These assets are subject to credit risk and interest rate risk, which are discussed in detail in “Asset Quality and Allowance for Loan Losses.” Net interest income is affected by various factors, among which are the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned and paid on those assets and liabilities. Table 1 provides an analysis of average volumes, yields and rates and net interest income that has been adjusted to a tax-equivalent basis for the three years ended December 31, 2006, 2005 and 2004.
Average Balances and Net Interest Income Analysis
[TABLE 1]
Fully taxable equivalent basis1 (In thousands)
Net interest income for 2006, on a tax-equivalent basis, decreased $706,000, or 1.6%, compared to an increase of $4.660 million, or 11.8%, for 2005. Outstanding loans remained relatively flat for 2006 as compared to 2005 reflecting on-going economic softness that is affecting the Bank’s customers in many of its markets.
Net interest margin for 2006 decreased to 4.75%, compared to 4.91% for 2005 and 4.75% for 2004. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. Since June of 2004, the Federal Reserve has increased the federal funds rate 17 times for a total of 425 basis points. Changes in the prime and federal funds rates effect variable interest assets and liabilities. The net interest margin decreased 16 basis points in 2006 after an increase of 16 basis points in 2005 and a decline of 14 basis points in 2004. In 2006, the average yield on earning assets increased by 62 basis points while the average rate on interest-bearing liabilities increased at a higher rate of 104 basis points. This resulted in a decrease of the interest rate spread in 2006 of 42 basis points compared to a 2 basis point increase in 2005 and a 12 basis point reduction in 2004.
Average earning assets in 2006 increased $16.408 million or 1.8% compared to an increase of $66.531 million or 8.0% in 2005. Interest-bearing liabilities for 2006 decreased $9.739 million or 1.3% compared to an increase of $44.098 million or 6.2% for 2005. A more detailed discussion of the volume and rate variance is provided under the “Earning Assets” and “Interest-Bearing Liabilities” sections.
Earning Assets
The following table shows the relative impact on net interest revenue for changes in the average outstanding balances (volume) of interest-earning assets and interest-bearing liabilities and the rates earned and paid on such assets and liabilities (rate). Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amounts of the change in each category.
Volume and Rate Variance Analysis
[TABLE 2]
Income related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%, and is then reduced by the non-deductible portion of interest expense.
The volume/rate variance for each category has been allocated on a consistent basis between rate and volume variances, based on the percentage of rate, or volume, variance to the sum of the two absolute variances.
In 2006, the average balance of the loan portfolio increased $3.668 million, or .5% compared to an increase of $63.386 million, or 9.2% in 2005. During 2006, strong loan growth in small business and mortgage loans were offset by declines in commercial and other consumer loans, resulting in the total loan portfolio remaining relatively flat compared to 2005. As shown in Table 2, both the loan portfolio’s volume and rate variances were positive for 2006, with particular strength in the rate variance. The 2006 gain in the average balance of the loan portfolio produced a positive volume variance of $266,000, while the increase in the average balance from 2005 resulted in a positive volume variance of $4.302 million. The total variance of loans receivable for 2006 was a positive $5.828 million. The average yield on loan receivables increased 74 basis points in 2006 compared to an increase of 84 basis points in 2005.
The average balance of the total investment securities portfolio was $142.661 million in 2006 compared to $129.924 million in 2005. Funds invested in securities increased steadily during 2006. Investment securities held-to-maturity at December 31, 2006 were $29.893 million compared to $27.427 million at December 31, 2005. The market value of investment securities available-for-sale at December 31, 2006 was $117.236 million compared to $100.732 million December 31, 2005. The average balance of the taxable investment securities portfolio increased $13.354 million, or 14.3% in 2006 resulting in a positive volume variance of $550,000. Yields on the portfolio increased 37 basis points in 2006 producing a positive rate variance of $368,000, resulting in a total positive variance of $918,000. The average balance of the tax-exempt securities portfolio in 2006 increased $375,000, or 1.2% compared to 2005, and yields declined 98 basis points. The increase in the average balance of this portfolio produced a positive volume variance of $23,000 while the decrease in yields produced a negative rate variance of $307,000. The result for 2006 was a negative total variance in tax-exempt securities of $284,000.
On average, funds invested in the Federal Home Loan Bank of Atlanta (“FHLB”) decreased $992,000, or 17.7%, in 2006 producing a negative volume variance of $44,000, while an increase of 213 basis points in the average yield resulted in a positive rate variance of $103,000 and a total positive variance of $59,000.
In 2006, the average balance of overnight investments in securities purchased under resale agreements increased by $548,000, or 3.4%. The volume variance produced by this increase was a positive $18,000. Yields on these overnight investments increased 163 basis points in 2006 producing a positive rate variance of $273,000 and a resulting total positive variance of $291,000.
Interest Sensitivity Analysis 1
[TABLE 3]
Interest sensitivity is computed using assets and liabilities having interest rates that can be adjusted during the period indicated.
Maturity of deposits without a contractual maturity date was computed using an asset/liability simulation model.
Summary of Investment Securities Portfolio
[TABLE 4]
Investment Securities Portfolio Maturity Schedule
[TABLE 5]
The yield related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%.
Interest Bearing Liabilities
The interest-bearing liabilities average balance in 2006 decreased $9.739 million or 1.3% compared to an increase of $44.098 million or 6.2% in 2005. The average rate paid on interest-bearing liabilities in 2006 increased 104 basis points compared to an increase of 76 basis points in 2005 and a decline of 14 basis points in 2004.
The majority of the interest-bearing liabilities portfolio is comprised of savings and time deposit accounts. In 2006, these average deposits increased $15.358 million or 2.3% compared to an increase of $37.527 million or 6.0% in 2005. The average rate paid on these deposits increased 112 basis points in 2006 compared to an increase of 85 basis points in 2005 and a decrease of 15 basis points in 2004. The increase in savings and time deposits in 2006 produced a positive volume variance of $307,000, while the increase in interest rates resulted in a positive rate variance of $7.630 million. Total variance for savings and time deposits in 2006 was a positive $7.937 million.
Funds borrowed from the FHLB averaged $59.521 million in 2006, a decrease of $24.824 million or 29.4% from 2005. The Bank’s ability to rely less on funds borrowed from the FHLB resulted in a negative volume variance of $1.195 million in 2006, while rates paid on these borrowings increased 99 basis points producing a positive rate variance of $727,000. The total variance for 2006 was a negative $468,000, which is reflected as a reduction to net interest expense.
Average Total Deposits
[TABLE 6]
Table 6, Average Total Deposits, shown above, contains the breakdown of average deposits for the years 2006, 2005 and 2004, respectively. Overall average total deposits increased $42.307 million, or 5.4% in 2006 compared to 2005. The growth consisted of increases in core deposits of $22.893 million, or 4.4% and time deposits of $19.414 million, or 7.5%. Average core deposit growth in 2006 was primarily due to growth in demand deposits of $27.049 million, or 23.8% compared to 2005. Money market deposits increased by 3.3% in 2006 compared to a 2.1% increase in 2005, and time deposits increased 7.5% in 2006 following an increase of 21.1% in 2005. During 2006 NOW account deposits declined 6.1% and savings deposits declined 8.5% as consumers sought higher rates in CD deposits.
Risk Management
It is the design of risk management to ensure long-range profitability performance and minimize risk, adhere to proper liquidity and maintain sound capital. To meet these objectives, the process of asset/liability management monitors the exposure to interest rate risk, balance sheet trends, pricing policies and liquidity position. Reports regarding Credit, Asset/Liability, Market, and Operational Risks are provided to the Bank’s Board of Directors.
Risk management practices include key elements such as independent checks and balances, formal authority limits, policies and procedures, and portfolio management performed by experienced personnel.
Interest Rate Risk Management
The primary purpose of managing interest rate risk is to minimize the volatility to earnings from changes in interest rates and preserve the value of Bancshares’ capital. Interest rate movements and balance sheet composition affect profitability and performance. Management’s responsibility for both liquidity and interest sensitivity reside with a designated Asset/Liability Management Committee (“ALCO”). As a part of its decision-making process, ALCO evaluates market conditions, interest rate trends and the economic environment. Based upon its view of existing and expected market conditions, ALCO adopts balance sheet strategies intended to optimize net interest income to the extent possible while minimizing the risk associated with unanticipated changes in interest rates.
Bancshares also uses simulation analysis to compute net interest income at risk under a variety of market interest rate scenarios to identify interest rate risk exposures. This simulation, which considers forecasted balance sheet changes, deposit mix, pricing impacts, and other changes in the net interest spread, provides an estimate of the annual net interest income at risk for given changes in interest rates. The results help Bancshares develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a number of assumptions and judgments. In this case, the assumptions relate primarily to loan and deposit growth and interest rates. Management believes the assumptions used in its simulations are reasonable. Nevertheless, simulation modeling provides only a sophisticated estimate, not a precise calculation of exposure to changes in interest rates.
The simulation models used to analyze Bancshares’ net interest income create various at-risk scenarios looking at increases and/or decreases in interest rates from an instantaneous movement. The models are updated to incorporate management action and on-going assumptions. A 200 basis instantaneous increase or decrease in interest rates over a one-year period is a key scenario analyzed. Based on the rate sensitivity position on December 31, 2006, net interest income exposure over the next 12 months to an instantaneous increase in interest rates of 200 basis points is estimated to be approximately five percent of base net interest income which is well inside the Bank’s maximum tolerable decline of 15%. These scenarios are used as one estimate of risk, and do not necessarily represent management’s current view of future interest rates or market developments. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions, and management’s strategies, among other factors, including those presented in the Risk Factors and Forward-Looking Statements sections of this report.
Other than the impact related to the immediate change in value of balance sheet accounts, such as mortgage servicing rights, these simulation models exclude the dynamics related to how fee income and noninterest expense may be affected by actual changes in interest rates or expectations of changes. Mortgage banking revenue, which is generated from originating, selling and servicing residential mortgage loans, is highly sensitive to changes in interest rates due to the direct effect changes in interest rates have on loan demand. In general, low or declining interest rates typically lead to increased origination and sales income but potentially lower servicing-related income due to the impact of higher loan prepayments on the value of mortgage servicing assets. Conversely, high or rising interest rates typically reduce mortgage loan demand and hence origination and sales income while servicing-related income may rise due to lower prepayments. The effect on origination and sales income to total earnings is more significant than servicing related income.
Asset/Liability management includes analyzing interest sensitivity, which pertains to possible changes in the rates of certain assets and liabilities before their scheduled maturities. The ALCO process seeks to match maturities and re-pricing opportunities of interest-sensitive assets and liabilities to minimize risk of interest rate movements. Full discussion of the effects of these respective portfolios on the Bank’s performance for 2006 can be found under the Earning Assets and Interest-Bearing Liabilities headings. The interest sensitivity gap schedule analyzing the interest rate risk as of December 31, 2006, is presented in Table 3, Interest Sensitivity Analysis. Within this analysis, projected runoff of deposits that do not have a contractual maturity date were
computed using the Bank’s simulation model. As interest sensitivity is continually changing, Table 3 reflects the Bank’s balance sheet position at one point in time and is not necessarily indicative of its position on other dates. On December 31, 2006, the one-year cumulative interest sensitivity gap was a negative $100.137 million for a ratio of interest-sensitive assets to interest-sensitive liabilities of 0.80.
Bancshares began using derivatives in the fourth quarter of 2005. The derivatives are being used in conjunction with the Bank’s sale of ICDs. ICDs pay no periodic interest payments. Instead, any interest is paid at maturity and is calculated based on the positive price movements, if any, of the Dow Jones Industrial AverageSM (DJIA) over the entire term of the ICD, which is five years. The goal is to curtail the interest rate risk of the ICD to Bancshares by engaging in “perfectly matched” hedges or option contracts tied to the underlying index with creditworthy hedge providers who will support the inherent performance of the ICD at maturity of the issuances.
This approach will mitigate any exposure to unintended market risk and essentially fix Bancshares’ cost of funds at inception for the term of the ICD without concern over the performance of the DJIA. Bancshares has also looked at the risk associated with any default in payment by the hedge providers. This risk is mitigated by all hedge providers having investment grade ratings. If the hedge providers fall below an investment grade rating collateral must be posted. Bancshares uses multiple hedge providers to spread the risk, all of which are publicly traded and have been in operation for over 60 years.
Liquidity Risk Management
Liquidity risk is the risk of being unable to fund assets with liabilities of the appropriate duration and interest rate, as well as the risk of not being able to meet unexpected cash needs. The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers, and the requirements of ongoing operations. This objective is met by maintaining liquid assets in the form of trading securities and securities available for sale, maintaining sufficient unused borrowing capacity, growing core deposits, and the repayment of loans and the capability to sell loans. The Bank’s Funding Committee is responsible for managing these needs by taking into account the marketability of assets; the sources, stability and availability of funding; and the level of unfunded commitments. Funds are available from a number of sources. The principal sources include cash and cash equivalents, maturing investments and loans, core deposits and the securities available for sale portfolio. Correspondent relationships are also maintained with several large banks in order to have access to federal funds purchases as a secondary source of liquidity. Traditionally, the Bank has been a seller of excess investable funds in the federal funds market and uses these funds as a part of its liquidity management.
The Bank also has available lines of credit maintained with the FHLB which can be used for funding and/or liquidity needs. This credit is collateralized by a blanket lien on qualifying loans secured by first mortgages on 1-4 family residences as well as qualified multi-family and home equity lines. At December 31, 2006, the Bank had an available line of credit with the FHLB totaling $161 million with $103 million outstanding and $73 million funded. While traditionally the FHLB is used for longer-term borrowings, it can be used for short-term liquidity needs. At year-end, overnight borrowings from the FHLB totaled $42 million. The Bank has one $10 million and one $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits.
The Bank has federal funds lines of credit facilities established with four other banks that total $40 million, as well as access to the Federal Reserve Bank of Richmond’s discount window. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and term of advances. At December 31, 2006, there were no borrowings from these lines of credit. Another source of liquidity is the Bank’s securities available for sale portfolio. In addition, the Bank has access to retail brokered certificates of deposit, dealer and
commercial customer repurchase agreements and internet certificates of deposit. The Bank can seek additional liquidity through the sale of loans.
Net cash provided by operating activities, a primary source of liquidity, was $19.107 million in 2006 compared to $11.516 million in 2005 and $16.480 million in 2004. The increase in net cash provided by operating activities in 2006 was primarily attributable to the decrease in mortgage loans held for sale and the net decrease in other assets. The decrease in net cash provided by operating activities in 2005 was primarily the result of an increase in other assets attributable to the prepayment of yearly service contracts related to the increase in technology efficiencies due to the Impact ’05 initiatives such as the implementation of an Enterprise Relationship Management system, a new financial management reporting package and others. Details of cash flows for the years 2006, 2005 and 2004 are provided in the Consolidated Statements of Cash Flows located in Item 8, which begins on page 37 below.
Off-Balance Sheet Transactions
Certain financial transactions are entered into by the Bank in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet transactions as of December 31, 2006, and December 31, 2005, were commitments to extend credit and standby letters of credit. The Bank does not have any ownership interest in any off-balance sheet subsidiaries or special purpose entities.
Commitments
[TABLE 7]
Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates. These include both loan commitments and credit card lines. Since many of the commitments expire without being funded, the commitment amounts do not necessarily represent liquidity requirements.
Standby letters of credit are conditional commitments guaranteeing the performance of a customer to a third party. Those guarantees are primarily issued to customers as a part of their normal course of business. Funding for draws from standby letters of credit would be funded through normal sources of deposit growth or borrowings and would not have a material impact on liquidity.
In the normal course of business, the Bank has executed irrevocable letters of credit through the FHLB. These letters of credit are issued to secure public deposits placed with the Bank by one or more public depositors. As of December 31, 2006, the Bank has one $10 million and one $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits. The securing of public deposits through the use of irrevocable letters of credit is a part of the Bank’s overall liquidity management.
Contractual Obligations
The following disclosure shows the contractual obligations that the Bank had outstanding at December 31, 2006. At December 31, 2006, the Bank had no outstanding capital lease obligations, purchase obligations, or other long-term obligations reflected on Bancshares’ balance sheet under generally accepted accounting principles.
Contractual Obligations
[TABLE 8]
Capital Resources and Shareholders’ Equity
Shareholders’ equity at December 31, 2006, was $89.309 million compared to $91.829 million at December 31, 2005, a decrease of 2.7%. Average shareholders’ equity as a percentage of average total assets at December 31, 2006, was 9.4%, compared to 9.5% at December 31, 2005.
Regulatory guidelines require minimum levels of capital based on a risk weighting of each asset category and off-balance sheet contingencies. Regulatory agencies divide capital into Tier 1 or core capital and total capital. Tier 1 capital, as defined by regulatory agencies, consists primarily of common shareholders’ equity less goodwill and certain other intangible assets. Total capital consists of Tier 1 capital plus the allowable portion of the allowance for loan losses and certain long-term debt. Additional regulatory capital measures include the Tier 1 leverage ratio. Tier 1 leverage ratio is defined as Tier 1 capital divided by average total assets less goodwill and certain other intangibles and has a regulatory minimum of 3.0%, with most institutions required to maintain a ratio of at least 4.0% to 5.0%, depending primarily upon risk profiles. In addition to the aforementioned risk-based capital requirements, the Bank is subject to a leverage capital requirement, requiring a minimum ratio of Tier 1 Capital (as defined previously) to total adjusted average assets of 3.0% to 5.0%. The Bank’s capital requirements are summarized in Table 9 below, Capital Ratios.
Capital Ratios
[TABLE 9]
Percentage of total adjusted average assets. The Federal Reserve’s minimum leverage ratio requirement is 3.0% to 5.0%, depending on the institutions composite rating as determined by its regulators. The Federal Reserve has not advised the Bank of any specific requirement applicable to it.
Percentage of risk-weighted assets.
The number of beneficial shareholders holding Bancshares stock totaled approximately 5,121 at December 31, 2006. At December 31, 2006, participants in Bancshares’ dividend reinvestment plan totaled 1,520, representing 29.7% of total beneficial shareholders, and held a total of 788,109 shares.
Noninterest Income
In 2006 noninterest income increased $498,000 or 3.6% compared to a decline of $271,000 or 1.9% in 2005. Fee income from service charges on deposit accounts for 2006 increased slightly to $6.884 million, an increase of $68,000, or 1.0%, as compared to a decrease of $109,000, or 1.6% in 2005. Gains on sales of mortgage loans for 2006 decreased $164,000 or 29.6% compared to an increase of $24,000 or 4.5% for 2005. Other operating income for 2006 increased $594,000, or 9.2% compared to a decrease of $186,000, or 2.8% for 2005. For the detailed change in Other Operating Income see Table 10, Other Operating Income and Expenses, presented below.
Noninterest Expense
In 2006, noninterest expense increased $3.554 million or 8.9% compared to $2.083 million or 5.5% in 2005. Included in noninterest expense for 2006 was a one-time charge of $589,000 related to freezing Bancshares’ defined benefit plan, as well as an additional $1.166 million from the write-down of certain assets. The freezing of the defined benefit plan is expected to result in ongoing expense savings of as much as $750,000 per year for Bancshares. Personnel expense in 2006, consisting of employee salaries and benefits, increased $1.071 million or 5.0% compared to an increase of $1.172 million or 5.8% in 2005. The increase in personnel expense in 2006 is largely due to increases in salaries, medical insurance, life insurance, stock-based compensation, and the previously mentioned one-time charge for Bancshares’ defined benefit plan. These increases were offset by a decrease in incentive compensation. Full-time equivalent employees for Bancshares totaled 407 at December 31, 2006, compared to 417 at December 31, 2005, and 420 at December 31, 2004. Occupancy expense for 2006 increased $55,000 or 3.0% compared to an increase of $88,000, or 4.9% for 2005. This increase in occupancy expense is a normal gain experienced as the result of growth. Equipment depreciation and maintenance expense decreased $57,000 or 2.5% in 2006 compared to $33,000 or 1.4% in 2005. For the changes in other operating expenses, please see Table 10, Other Operating Income and Expenses, below.
Other Operating Income and Expenses
[TABLE 10]
Asset Quality and Allowance for Loan Losses
Summary of Loan Portfolio
[TABLE 11]
The Bank has no foreign loan activity.
Maturities and Sensitivities of Loans to Changes in Interest Rates
At December 31, 2006, the allowance for loan losses was $9.564 million, or 1.3% of loans outstanding, compared to $8.440 million, or 1.1% of loans outstanding at December 31, 2005, and $7.962 million, or 1.1% of loans outstanding, at December 31, 2004. Net charge-offs for 2006 were $4.386 million, or 0.6% of average loans outstanding, compared to 2005 net charge-offs of $2.741 million, or 0.4% of average loans outstanding, and 2004 net charge-offs of $2.901 million, or 0.4% of average loans outstanding. Additional information regarding the allowance for loan losses is contained in Table 12, Analysis of Allowance for Loan Losses, below.
Analysis of Allowance for Loan Losses
[TABLE 12]
In the fourth quarter of 2006 the provision for loan losses included $1.900 million in write downs on credits at both the Bank and Peoples Finance and an additional provision of $1.050 million to increase the loan loss allowance to 1.3% of outstanding loans. The additional provision was made due to the increase in delinquencies and credit risks within both the Bank and Peoples Finance.
Peoples Finance is the Bank’s consumer financing subsidiary servicing the markets of Lexington, King and Archdale. Auto loan delinquency within previously performing credits began to increase in late 2005 due in part to softness in the economy in some of those markets. Management has addressed staffing strength, portfolio size and credit cultures so as to better manage credits within the current environment.
During the fourth quarter of 2006, the Bank experienced deterioration in the quality of a number of credits. While the credits were not concentrated in any one sector, they were nonetheless interwoven in the overall economy of the Bank’s markets. With the transition of the furniture industry, there have come to be pockets of softness within the local economy. To address this transition phase of the Bank’s local economy, management has taken action to strengthen its credit administration and to improve collection efforts.
The provision for loan losses charged to operations in 2006 totaled $5.510 million compared to $3.219 million in 2005 and $3.017 million in 2004. At December 31, 2006, the allowance for loan losses was 0.97 times nonperforming assets compared to 1.04 and 1.94 times at December 31, 2005 and 2004, respectively. Management’s practice is to maintain the allowance for loan losses at a level sufficient to reflect the estimated probable incurred losses in the loan portfolio. Based on analysis of the current loan portfolio and levels of current problem assets and potential problem loans, management believes the allowance for loan losses to be adequate. In Management’s judgment, the allocation of the allowance for loan losses for 2006, reflected in Table 14 below, Allocation of Allowance for Loan Losses, accurately reflects the inherent risks associated with each of the various lending categories.
Nonperforming Assets
[TABLE 13]
Allocation of Allowance for Loan Losses
[TABLE 14]
The allowance for loan losses has been allocated only on an approximate basis. The entire amount of the allowance is available to absorb losses occurring in any category. The allocation is not necessarily indicative of future losses.
Total nonperforming assets at December 31, 2006 were $9.891 million compared to $8.087 million at December 31, 2005 and $4.111 million at December 31, 2004 (see Table 13 above, Nonperforming Assets, for the breakdown).
Nonperforming assets are defined as nonaccrual loans, restructured loans, other real estate acquired through foreclosed properties and accruing loans ninety days or more past due. With the exception of certain loans at Peoples Finance, which operates under state law that allows for collection of up to 90 days interest on loans that are refinanced, the accrual of interest is generally discontinued on all loans that become ninety days past due as to principal or interest unless collection of both principal and interest is assured by way of collateralization, guarantees or other security and the loan is considered to be in the process of collection.
During the second quarter of 2006, $2.500 million in loans to a borrower in the furniture industry were moved to nonaccrual status as a result of the borrower’s failure to satisfy the terms of a liquidation agreement. A liquidation of the inventory was completed during the second quarter of 2006 and as of December 31, 2006 this borrower was in involuntary bankruptcy, which delayed foreclosure proceedings. Following the bankruptcy waiting period, the Bank will work with the guarantor through the foreclosure of the property to restructure the debt and reduce credit exposure. While these loans are secured, the extent of losses on the loans, if any, can not be determined as of the current date.
The Bank made loans to a long time customer in connection with a condominium development project in Georgetown, SC. The loans were secured by the residential condominium units being developed. During the second quarter of 2005, the Bank acquired 18 residential condominium units by means of a deed-in-lieu of foreclosure. These 18 units, together with two others owned by third parties, are located on the second and third floors of a three-story building. The ground floor of the building has been developed into retail condominium units by a third party.
At the time of the Bank’s acquisition of the 18 condominium units, the defaulted loans had a $3.400 million principal balance due. After evaluating its potential net realizable value of these condominium units, the Bank took an immediate $400,000 charge against earnings and booked the remaining $3.000 million balance in other real estate owned. Subsequently, during the second quarter of 2006, the Bank discovered, for the first time, that a portion of the condominium development assets had not been conveyed to the Bank as the Bank had previously been advised and the Bank took an additional write-down of $1.000 million, which reduced the carrying value from $3.000 million to $2.000 million.
In the fourth quarter of 2006 the Bank was able to acquire that portion of the condominium development assets that had not been conveyed to the Bank at a cost of $525,000. With the value of the added assets in place, the carrying value was increased from $2.000 million to $2.525 million. The Bank incurred expenses of approximately $620,000 in 2006 and $700,000 in 2005 related to its investigation and remediation related to these condominiums. Subsequent to year-end and based on current data, the Bank embarked on plans to build out the 18 units at an estimated cost of between $1.750 million and $2.250 million in preparation for future sale. It is estimated that the build out and sale would occur in 2007. The Bank continues to actively pursue recovery of the losses incurred with this project.
Credit Risk Management
As a part of Credit Administration, management regularly reviews and grades its loan portfolio for purposes of determining asset quality and the need to make additional provisions for loan losses. The review process is performed both internally and externally, through the employment of independent credit review professionals. The first of two external reviews took place in the second quarter of 2006. This review focused primarily on loans of $250,000 or greater originated since the previous review in 2005, and represented a total exposure of 11.8% of the Bank’s loan portfolio as of December 31, 2005. An additional review was conducted in the third quarter of 2006. This review focused primarily on loans or $100,000 or greater originated since the previous review, and represented a total exposure of 9.4% of the bank’s loan portfolio as of June 30, 2006.
The allowance for loan losses represents management’s estimate of an adequate amount to provide for the risk of future losses inherent in the loan portfolio. In its on-going analysis of the allowance for loan losses and its adequacy, management considers historic loan loss experience, economic risks associated with each of the lending categories, amount of past due and nonperforming loans, underlying collateral values securing loans, credit concentrations and other factors which might affect potential credit losses. The Bank is also subject to regulatory examinations and determinations as to the adequacy of its allowance for loan losses, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by the regulatory agencies.
There are, however, additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy and factors affecting particular borrowers, management’s judgment as to the adequacy of the allowance for loan losses is necessarily approximate and imprecise. In its oversight of the credit review process, management has not identified any undue economic risks associated with the various lending categories, nor any significant credit concentrations within these categories.
Loans classified for regulatory purposes as loss, doubtful, substandard or special mention that have not been disclosed in Table 13, Nonperforming Assets, do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.
Income Taxes
Note 9 to the consolidated financial statements provides a reconciliation between the amount of taxes computed using the statutory tax rate and the actual tax expense. The expense for income tax is recorded based on amounts payable, current and deferred. In 2006, the income tax expense was $2.584 million compared to $4.865 million in 2005 and $3.931 million in 2004. The effective tax rate for 2006 was 30.1% compared to 33.6% for 2005 and 31.9% for 2004. In 2003, Bancshares purchased an investment tax credit partnership interest through SunTrust Bank of Atlanta, Georgia. The partnership holds four projects within the North Carolina that qualify for North Carolina State historic and low-income housing tax credits. The purchase price of the partnership interest was $540,000 and is expected to yield $1.000 million in North Carolina tax credits over the years 2003 to 2009. Tax credit amounts were $228,478 for 2006 compared to $185,000 for 2005 and $187,000 for 2004.
Inflation
For financial institutions, the effects of inflation and governmental programs to control it tend to vary from non-bank companies. The impact is more likely to be felt by banking institutions in interest rates associated with earning assets and interest-bearing liabilities. Reduced inflation tends to improve interest margins associated with interest-bearing assets and liabilities. There has been no material effect from inflation on Bancshares’ revenues, income from continuing operations, or financial statements for Bancshares’ last three fiscal years.
Broad-ranged economic conditions such as inflation, and governmental efforts to spur economic growth, are difficult for individual companies to respond to effectively. Consistent long-term management is the key to dealing with such conditions. The objective of management in such times is to remain positioned for growth when the economy rebounds. Management seeks to do this through its long-range budget and profit-planning process.
Accounting and Regulatory Issues
At its November 3, 2005 meeting, the Financial Accounting Standards Board (“FASB”) issued FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which replaces the guidance previously set forth in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. FSP FAS 115-1 effectively eliminates the accounting guidance provided in EITF 03-1 in favor of existing impairment recognition guidance under SFAS No. 115, SAB No. 59, APB No. 18, and EITF Topic D-44. FSP FAS 115-1 was effective for periods beginning after December 15, 2005. Its adoption by Bancshares has not had a material impact on our consolidated financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS 123 and supersedes APB Opinion No. 25. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. In addition, compensation cost for the unvested portion of previously granted awards that remain outstanding on the effective date of SFAS 123(R) shall be recognized on or after the effective date, as the related services are rendered, based on the awards’ grant-date fair value as previously calculated for the pro-forma disclosure under SFAS 123. SFAS 123(R) is effective for all stock-based awards granted on or after January 1, 2006. The Bank has implemented SFAS 123(R) as of January 1, 2006.
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), which is an amendment of FASB Statement No. 140 (“SFAS 140”). SFAS 156 deals with the servicing of financial assets and liabilities. This applies to Bancshares’ sales and servicing of mortgage loans. The Statement requires all separately recognized servicing assets and liabilities to be initially measured at fair value, if practicable. This was also required under SFAS 140 and therefore already implemented by Bancshares. The Statement now permits an entity to choose either the amortization method or the fair value measurement method for subsequent measurement. Previously, the only subsequent method available was the amortization method which calls for amortizing servicing assets or liabilities in proportion to and over the period of estimated net servicing income or loss and assess servicing assets or liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method measures servicing assets and liabilities at fair value at each reporting date and reports changes in fair value in earnings in the period in which the changes occur. Since Bancshares does not use derivative instruments to mitigate risk associated with their mortgage servicing rights, they will continue to use the amortization method upon adoption of SFAS 156 on January 1, 2007. Bancshares believes that adopting SFAS 156 will not result in any material effect on their financial position or operating results.
In September 2006, the FASB issued SFAS No. 158. “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”), which is an amendment of SFAS Nos. 87, 88, 106 and 123(R). SFAS 158 requires that employers recognize the funded status of their defined benefit and other postretirement plans as an asset or liability on their balance sheet with a corresponding adjustment to “Other Comprehensive Income” effective at the end of 2006. As of December 31, 2006, Bancshares had adopted SFAS 158.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.
Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The structure of Bancshares’ loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. Bancshares does not maintain a trading account nor is it subject to currency exchange risk or commodity price risk. Responsibility for monitoring interest rate risk rests with the ALCO Committee, which is appointed by Bancshares’ Board of Directors. The ALCO Committee meets on a regular basis to review interest rate risk exposure and liquidity positions. Balance sheet management and funding strategies are reviewed to ensure that any potential impact on earnings and liquidity, resulting from a fluctuation in interest rates, is within acceptable standards.
Additional information called for by Item 7A is set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 15 above.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The following consolidated financial statements and notes related thereto should be read in conjunction with Item 6, “Selected Financial Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” which begin on pages 14 and 15, respectively.
Statement of Management Responsibility
The management of Bancshares and its subsidiaries is responsible for the preparation of the consolidated financial statements, related financial data and other information in this annual report on Form 10-K. The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s estimates and judgment where appropriate. Other information in the annual report is consistent with that contained in the financial statements. In fulfilling its responsibility for the integrity and fairness of these statements and information, management relies on the accounting system and related internal controls that are designed to provide reasonable assurances that transactions are authorized and recorded in accordance with established procedures, assets are safeguarded, and proper and reliable records are maintained.
Bancshares maintains a professional staff of internal auditors who independently assess the effectiveness of the internal controls and recommend possible improvements thereto. The Audit Committee is appointed by the Board of Directors to assist the Board in monitoring: the integrity of the financial statements of Bancshares; the independent auditor’s qualifications and independence; the performance of Bancshares’ internal audit function and independent auditors; and the compliance by Bancshares with legal and regulatory requirements. The independent auditors, internal auditors and banking regulators have direct access to the Audit Committee with or without management present.
The consolidated financial statements have been audited by Turlington and Company, L.L.P., independent auditors, who render an independent, professional opinion on management’s financial statements and internal control over financial reporting. Their report expresses an opinion as to, among other things, the fairness of the financial position and results of operations of Bancshares and its subsidiaries based on their audit conducted in accordance with auditing standards generally accepted in the United States of America.
Please also review our assessment on internal control over financial reporting included in Item 9A, “Controls and Procedures,” which begins on page 65 below.
LSB BANCSHARES, INC.
March 14, 2007
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
LSB Bancshares, Inc.
Lexington, North Carolina
We have audited the accompanying consolidated balance sheets of LSB Bancshares, Inc. and subsidiaries (the “Corporation”) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. We also have audited management’s assessment, included in Item 9A below, entitled “Controls and Procedures,” that the Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Corporation’s internal control over financial reporting 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 and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the corporation; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the corporation are being made only in accordance with authorizations of management and directors of the corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the corporation’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LSB Bancshares, Inc. and subsidiaries as of December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, management’s assessment that LSB Bancshares, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, LSB Bancshares, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
TURLINGTON AND COMPANY, L.L.P.
Lexington, North Carolina
March 14, 2007
Consolidated Balance Sheets
Commitments and Contingencies Note 8
Notes to consolidated financial statements are an integral part hereof.
Consolidated Statements of Income
Notes to consolidated financial statements are an integral part hereof.
Consolidated Statements
Of Changes in Shareholders’ Equity
Notes to consolidated financial statements are an integral part hereof.
Consolidated Statements of Cash Flows
Notes to consolidated financial statements are an integral part hereof.
Notes To Consolidated Financial Statements
As of or for the Years Ended December 31, 2006, 2005 and 2004
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Policies
The accounting and financial reporting policies of Bancshares and its subsidiaries conform to accounting principles generally accepted in the United States of America and prevailing industry practices. The following is a description of significant accounting policies.
Nature of Operations
Bancshares is a bank holding company organized under the laws of the State of North Carolina and registered under the FBHCA. Bancshares conducts its domestic financial services business through its wholly owned subsidiary the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS. Bancshares serves customers primarily in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake Counties, North Carolina.
Consolidation
The consolidated financial statements include the accounts of Bancshares and its direct and indirect wholly-owned subsidiaries, after eliminating inter-company balances and transactions. Securities and other property held in a fiduciary or agency capacity are not included in the consolidated balance sheets since these are not assets or liabilities of Bancshares. Certain prior year amounts have been reclassified to conform to current year presentation.
Use Of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 period. Actual results could differ from those estimates.
Cash and Cash Equivalents
Bancshares considers cash and due from banks and interest-bearing bank balances as cash and cash equivalents for purposes of the consolidated statements of cash flows. Due from bank balances and interest-bearing bank balances are maintained in other financial institutions.
Investment Securities
Management determines the appropriate classification of investment securities at the time of purchase. Securities that may be sold in response to or in anticipation of changes in interest rates or other factors are classified as available for sale and carried at market value. The unrealized gains and losses on these securities are reported net of applicable taxes as a separate component of shareholders’ equity. Securities that Bancshares has the positive intent and ability to hold to maturity are carried at amortized cost. Bancshares does not have any securities held for trading. Interest income on securities, including amortization of premiums and accretion of discounts, is recognized using the interest method. Gains and losses on the sale of securities are recognized on a specific identification basis.
Loans
Loans are generally carried at the principal amount outstanding, net of deferred loan fees and certain direct origination costs on originated loans and unamortized discounts and premiums on purchased loans. Mortgage loans held for sale are carried at the lower of cost or market value, as determined by outstanding commitments from investors. Loan origination fees and origination costs are capitalized and recognized as an adjustment of the yield of the related loan. Discounts and premiums on any purchased commercial, residential real estate and consumer loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments of principal and interest as they become due.
Allowance for Loan Losses
The allowance for loan losses is that amount which is considered adequate to provide for potential losses in the portfolio. Management’s evaluation of the adequacy of the allowance is based on several factors, including an analysis of the loss experience in relation to outstanding amounts, a review of impaired loans, regular examinations and appraisals of the portfolio and current conditions.
Foreclosed Real Estate
Foreclosed real estate only includes formally foreclosed property. At the time of foreclosure, foreclosed real estate is recorded at the lower of the Bank’s cost or the asset’s fair value less costs to sell, which becomes the property’s new basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, these assets are carried at the lower of their new cost basis or fair value less cost to sell. Costs incurred in maintaining foreclosed real estate and subsequent write-downs to reflect declines in the fair value of the property are charged to operations.
Premises and Equipment
Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed by use of the straight-line method, using the following estimated lives: buildings, 20 to 40 years; equipment, 3 to 10 years; and vaults, 10 to 40 years. Leasehold improvements are amortized by use of the straight-line method over the lesser of the estimated useful lives of the improvements or the terms of the respective leases.
Income Taxes
The provision for income taxes is based on income and expenses and assets and liabilities for financial statement purposes. Deferred income taxes are computed under the provisions of SFAS No. 109, “Accounting for Income Taxes”.
Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted average number of common shares outstanding for the period plus the number of additional dilutive common shares that would have been outstanding if potentially dilutive options had been exercised. All references to shares outstanding have been adjusted to give effect to stock splits that may have occurred during the periods.
Stock-Based Compensation
Effective January 1, 2006, Bancshares adopted the fair value method of accounting for stock-based compensation arrangements in accordance with SFAS 123(R) using the modified prospective method of transition. Under the provisions of SFAS 123(R), the estimated fair value of share-based awards granted under the Comprehensive Equity Compensation Plan for Directors and Employees (“Comprehensive Benefit Plan”), discussed in Note 15 - Capital Stock, is recognized as compensation expense over the vesting period. Using the modified prospective method, compensation expense is recognized beginning with the effective date of adoption of SFAS 123(R) for all share-based payments (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption that remain unvested on the date of adoption.
Prior to January 1, 2006, Bancshares accounted for stock-based employee compensation plans using the intrinsic value method of accounting in accordance with APB 25, “Accounting for Stock Issued to Employees” (“APB 25”), and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized since the stock options were granted with exercise prices equal to the market value on the date of grant.
Pursuant to the provisions of SFAS 123(R), Bancshares recorded $172,000, or less than $0.01 per diluted share of total stock-based compensation expense during 2006. The stock-based compensation expense is calculated on a ratable basis over the vesting periods of the related options. This expense had no impact on Bancshares’ reported cash flows. The stock-based compensation expense for the twelve months ended December 31, 2006 is reported under personnel expense. During the twelve-month period ended December 31, 2005, Bancshares recorded no stock compensation expense pursuant to APB 25.
Under the modified prospective method of transition under SFAS 123(R), Bancshares is not required to restate its prior period financial statements to reflect expensing of share-based compensation under SFAS 123(R). Therefore, the results as of December 31, 2006 are not directly comparable to the same period in the prior year.
As required by SFAS 123(R), Bancshares has presented pro forma disclosures of its net income and net income per share for the prior year period assuming the estimated fair value of the options granted prior to January 1, 2006 was amortized to expense over the option-vesting period as illustrated below (In thousands, except per share amounts).
To determine the above pro forma amounts, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
There were 47,000 options granted during 2006. As of December 31, 2006, there was $273,000 of total unrecognized compensation expense related to stock option arrangements granted under the Comprehensive Benefit Plan. This expense will be fully amortized by December of 2010.
Accounting for Derivatives
The Bank accounts and reports for derivative instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS 133”). SFAS 133 requires recognition of all derivatives as either assets or liabilities in the balance sheet and requires measurement of those instruments at fair value through adjustments to accumulated other comprehensive income and/or current earnings, as appropriate. As of the date of this report, Bancshares only used fair value hedging. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged liability are recorded in current period net income. If a derivative has ceased to be highly effective, hedge accounting is discontinued prospectively.
Note 2 - REGULATORY RESTRICTIONS
Bancshares and the Bank are subject to certain requirements imposed by state and federal banking statutes and regulations.
The Bank is required to maintain a certain weekly average clearing account balance with the Federal Reserve Bank of Richmond. The required weekly average clearing account balance for the years ended December 31, 2006 and 2005 were $175,000 and $56.000 million, respectively. The amount is negotiated by the Bank with the Federal Reserve Bank of Richmond.
Certain regulatory requirements restrict the lending of funds by and between Bancshares and the Bank and the amount of dividends which can be paid to Bancshares by the Bank. On December 31, 2006, the Bank had available retained earnings of $68.184 million for the payment of dividends without obtaining prior regulatory approval.
The Bank is a member of the FHLB. Member institutions are required to maintain an investment in the common stock of the FHLB based on the member’s outstanding loan amount with the FHLB. Member institutions must also maintain adequate collateral in qualifying 1-4 family residential loans and other loans that meet the guidelines of the FHLB. At December 31, 2006, the Bank owned $5.235 million of FHLB common stock.
Bancshares and the Bank are subject to certain regulatory capital requirements administered by federal and state banking agencies. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, Bancshares and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Failure to meet minimum capital requirements can result in certain mandatory and possible discretionary actions by regulators that, if undertaken, could have a direct material effect on Bancshares’ financial statements.
At December 31, 2006, the most recent notifications from regulatory authorities categorized Bancshares and the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes has changed Bancshares’ or the Bank’s well capitalized status. Management believes that Bancshares and the Bank meet all capital adequacy requirements to which they are subject.
The Bank’s capital amounts and ratios approximate Bancshares’ capital amounts and ratios, which are summarized as follows (Dollars in thousands):
*
under Prompt Corrective Action provisions
Note 3 - INVESTMENT SECURITIES
The valuations of investment securities as of December 31, 2006 and 2005 were as follows (In thousands):
The following table shows United States government agency obligations and municipal securities unrealized losses and fair value, aggregated by length of time individual securities have been in a continuous loss position at December 31, 2006. The current year unrealized losses on these securities are the result of volatility in the market during 2006. Management believes that all unrealized losses are temporary considering the credit ratings on these investment securities.
The following is a maturity schedule of investment securities at December 31, 2006 by contractual maturity (In thousands):
The Bank owned stock in FHLB with book and market values of $5.235 million and $4.214 million at December 31, 2006 and 2005, respectively. The stock is included in equity securities and classified as available for sale.
A recap of the sales and maturities of held to maturity securities follows (In thousands):
A recap of the sales and maturities of available for sale securities follows (In thousands):
Investment securities with amortized costs of $103.386 million and $92.705 million and market values of $102.219 million and $91.101 million as of December 31, 2006 and 2005, respectively, were pledged to secure public deposits and for other purposes.
Note 4 - LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans are summarized as follows (In thousands):
Nonperforming assets are summarized as follows (In thousands):
Impaired loans and related information are summarized in the following tables (In thousands):
An analysis of the changes in the allowance for loan losses follows (In thousands):
Bancshares’ policy for impaired loan accounting subjects all loans to impairment recognition except for large groups of smaller balance homogeneous loans such as credit card, residential mortgage and consumer loans. Bancshares generally considers loans 90 days or more past due and all nonaccrual loans to be impaired.
At December 31, 2006, Bancshares had no significant commitments to loan additional funds to the borrowers of impaired loans.
Note 5 - PREMISES AND EQUIPMENT
The following is a summary of premises and equipment (In thousands):
Note 6 - TIME DEPOSITS AND SHORT-TERM BORROWED FUNDS
The scheduled maturities of time deposits at December 31, 2006, were as follows (In thousands):
Short-term borrowed funds outstanding consisted of securities sold under agreements to repurchase. These short-term borrowings by the Bank are collateralized by U.S. Government agency obligations with amortized cost of $5.011 million and market value of $4.928 million at December 31, 2006. The securities collateralizing the short-term borrowings have been delivered to a third party custodian for safekeeping. The following table presents certain information for securities sold under agreements to repurchase (In thousands):
Note 7 - BORROWINGS
The Bank has established secured credit availability with the FHLB totaling approximately $160.604 million at year-end. At December 31, 2006 and 2005, the outstanding balances under this arrangement were $73.000 million and $53.000 million, respectively. For 2006 and 2005, the effective interest rates incurred were 5.29% and 4.75%, respectively. Maturities are as follows (In thousands):
Borrowings under this line of credit are secured by the Bank’s stock in the FHLB and a blanket floating lien on certain qualifying 1-4 family mortgage loans as well as other qualifying loans.
The Bank has obtained one $10.000 million and one $20.000 million irrevocable letters of credit, which will expire on May 10, 2015 and September 3, 2014, respectively. These letters of credit were issued by the FHLB in favor of the State of North Carolina to secure public deposits.
Note 8 - COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, the Bank is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit, both of which involve elements of credit and interest rate risk not reflected in the Consolidated Balance Sheets. The Bank uses the same credit policies in making commitments and issuing standby letters of credit as it does for on-balance sheet instruments. The Bank’s exposure to credit loss in the event of nonperformance by the party to whom commitments and standby letters of credit have been extended is represented by the contractual amount of the financial instrument.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon or fully utilized, the total commitment amounts do not necessarily represent future cash requirements. Collateral, if deemed necessary, is determined on a case-by-case basis and is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Unfunded commitments to extend credit totaled $210.118 million at December 31, 2006. The Bank determines the fair value of these commitments using an estimation of the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. However, the Bank does not charge a fee on a commitment to extend credit; therefore, the carrying amount and estimated fair value of such commitments were zero at December 31, 2006 and 2005.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Standby letters of credit generally have fixed expiration dates and may require payment of a fee. The credit risk involved is essentially the same as that involved in extending loan commitments to customers. The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit. Standby letters of credit totaled $4.242 million at December 31, 2006. The Bank determines the fair value of standby letters of credit by using an estimation of fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the present creditworthiness of the counterparties. At December 31, 2006 and 2005, the Bank had standby letters of credit with estimated fair values of $16,000 and $24,000, respectively.
The following table summarizes outstanding unfunded commitments at December 31, 2006 and 2005 (In thousands):
The Bank and Peoples Finance together grant commercial, installment and mortgage loans to customers throughout their service area. The Bank and Peoples Finance have a diversified loan portfolio with no specific concentration of credit risk. The Bank does have a concentration of credit risk by maintaining cash balances with other banks, which are $33.972 million in excess of FDIC limits and has federal funds sold of $6.845 million at December 31, 2006.
Neither Bancshares nor any of its subsidiaries are involved in any material pending legal proceedings.
Note 9 - INCOME TAXES
The components of income tax expense (benefits) are as follows (In thousands):
A reconciliation of the federal statutory tax rate to the effective tax rate follows:
The components of the net deferred tax asset follow (In thousands):
During 2003, the Bank purchased an investment tax credit partnership interest for $540,000. The partnership is expected to yield $1.000 million in North Carolina state tax credits over the years 2003 to 2009. Bancshares accounts for tax credits using the flow-through method, thereby reducing income tax expense in the year in which the credits are received. Tax credit amounts were $228,478 for 2006, $185,000 for 2005 and $187,000 for 2004.
Note 10 - RELATED PARTY TRANSACTIONS
The Bank had loans outstanding to executive officers, directors and their affiliated companies. An analysis of the activity with respect to such aggregate loans to related parties is as follows (In thousands):
Note 11 - INTANGIBLE ASSETS
The following tables summarize information about intangible assets which are included in Other Assets on the Consolidated Balance Sheets (In thousands):
The summary of estimated amortization expense for existing intangibles, excluding goodwill, for the five years subsequent to 2006 follows (In thousands):
Note 12 - FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” requires that Bancshares disclose estimated fair values for its financial instruments. Fair value estimates, methods and assumptions are set forth below for Bancshares’ financial instruments.
Cash and Short-Term Investments
For cash and short-term investments, including federal funds sold, the carrying amount is a reasonable estimate of fair value.
Investment Securities
For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans Receivable
The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Deposit Liabilities
The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at December 31, 2006. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The estimated fair values of Bancshares’ financial instruments are as follows (In thousands):
Note 13 - PENSION AND EMPLOYEE BENEFIT PLANS
Bancshares has a noncontributory defined benefit pension plan, which covers substantially all employees. The benefits are based on years of service and the average of the highest five consecutive years of compensation paid during the ten years preceding normal retirement. The Bank froze the plan for all participants with less than 30 years of service effective December 31, 2006. The freeze was accounted for in accordance with the provisions of SFAS 88. This transaction required a one time charge to income (which was added to pension expense) of $589,000 during the year ended December 31, 2006.
Bancshares has a plan to provide some healthcare benefits and life insurance for employees for the period between early retirement and normal retirement. Only those employees who retire after age 55 and have completed 10 years of service will be eligible for these benefits. The benefits are provided through a self-insured plan administered by an insurance company whose premiums are based on claims paid during the year.
Bancshares adopted the recognition and measurement date provisions of SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” as of December 31, 2006. SFAS No. 158 requires that the funded status of defined benefit and other postretirement plans be fully recognized in the balance sheet. The incremental effects of applying the statement to certain line items in the balance sheet at December 31, 2006 are as follows:
The following tables set forth the changes in the projected benefit obligations and the fair value of plan assets for the Bank’s defined benefit pension plan and postretirement benefits provided for certain retired employees and the amounts recognized in the consolidated financial statements at December 31 (In thousands):
The following table sets forth the projected benefits payments for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter (In thousands):
Bancshares expects to contribute $500,000 to its pension plan in 2007.
The pension plan’s investments are managed by the Trust Department of the Bank (the “Trust Department”). The Trust Department acts under the direction of the Trust Committee of the Board of Directors for the Bank (the “Trust Committee”). The Trust Committee approves the investment strategy and asset allocation guidelines for the plan, which is currently 40% in fixed income securities and cash equivalents and 60% in equity securities.
The fixed income portion consists primarily of individual debt securities from U.S. Government, Government Agencies and corporate debt securities rated A or better at the time of purchase by a nationally recognized rating service. High yield and foreign debt securities may be held in the portfolio, and are acquired through mutual funds. The equity portion consists of individual stocks and mutual funds. Equity securities are selected
from a list of high quality companies meeting specific characteristics. Mutual funds are selected that have acceptable ratings from nationally recognized fund analytic companies.
The current diversification criteria allows for no more than 20% of the portfolio holdings in any one issuer with the exception of government, government agency, or insured fixed income instruments.
The plan’s sponsor uses an expected annual rate of return on plan assets of 7.5% in determining the plan’s Net Periodic Pension Cost under SFAS No. 87, “Employers’ Accounting for Pensions.” This assumption is a long-term assumption, and the plan sponsor believes it is consistent with and within the reasonable range of the expected nominal returns for any portfolio with similar investment strategies.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects (In thousands):
Bancshares expects to pay $72,500 to cover claims under the postretirement plan in 2007.
The Bank and its subsidiaries have a defined contribution retirement plan covering substantially all employees with one year of service. Participating employees may contribute a percentage of their compensation to the plan, with the Bank and its subsidiaries matching a portion of the employee contribution. Prior to October 6, 2006 the Bank’s matching contribution was invested only in Bancshares common stock. Subsequent to this date the matching contribution is invested at the discretion of the participant from a list of approved equities. Bancshares’ stock held by the plan as of December 31, 2006 and 2005 was 249,838 and 153,142 shares, respectively. Total expense under the plan was $318,000, $294,000 and $271,000 for 2006, 2005, and 2004, respectively.
Note 14 - LEASES
The Bank is obligated under several lease agreements, which expire in 2007 through 2012. The leased property is for land, building, and equipment use. Rental payments under these leases amounted to $895,000, $505,000 and $504,000 for the years ended December 31, 2006, 2005, and 2004, respectively.
A summary of non-cancelable lease commitments for the Bank follows (In thousands):
Note 15 - CAPITAL STOCK
Preferred Stock
The Board of Directors may issue Bancshares preferred stock in one or more classes or series. The Board of Directors has the authority, without the need for shareholder approval, to determine and vary the voting rights, designations, preferences, qualifications, privileges, limitations, options, conversion rights and other special rights of each series of preferred stock, including, but not limited to, dividend rates and manner of payment, preferential amounts payable upon voluntary or involuntary liquidation, voting rights, conversion rights, redemption prices, terms and conditions, and sinking fund and stock purchase prices, terms and conditions.
Common Stock
The common stock of Bancshares represents voting shares, and dividends on the common stock are paid at the discretion of the Board of Directors.
During 2006, 2005 and 2004, Bancshares repurchased common stock in the amounts of 17,458, 106,408, and 19,800 shares respectively, under a repurchase program authorized by the Board of Directors for up to 900,000 shares of common stock. As of May 16, 2006, Bancshares had repurchased a total of 708,955 shares under the previous plans. A new plan was approved by the Board of Directors effective May 17, 2006 for up to 400,000 shares which will expire May 31, 2008. As of December 31, 2006, Bancshares had repurchased a total of 112,476 shares under the new plan leaving an additional 287,524 shares available to be repurchased in future years.
Rights
On February 10, 1998, the Board of Directors of Bancshares declared a dividend distribution of one right (each, a “Right”) or (a) each outstanding share of Bancshares’ common stock at the close of business on March 10, 1998 and (b) each share of Bancshares’ common stock issued after March 10, 1998 until the earliest of the following dates (the “Distribution Date”): (i) 10 business days after a public announcement that a person or group acquired, or has obtained the right to acquire 20% or more of Bancshares’ outstanding shares of common stock (the “Stock Acquisition Date”); (ii) 10 business days after the beginning of a tender offer or exchange offer that would, if consummated, result in a person or group acquiring 20% or more of Bancshares’ outstanding common shares of stock; or (iii) 10 business days after the Board of Directors declares that a person or entity is an “Adverse Person,” which is generally defined as a person or entity who owns Bancshares’ common stock for purposes deemed by the Board to be detrimental to the best interests of Bancshares. A Right entitles its registered holder to purchase from Bancshares 0.01 of a share of common stock at a purchase price per full share of $100.00, subject to adjustment; provided, however, that all Rights that are, or were, beneficially owned by any person, group or entity who is a party to any event listed under (b)(i) or (b)(ii) in the immediately preceding sentence or who the Board of Directors declares to be an Adverse Person will be null and void.
The description and terms of the Rights are more particularly set forth in a Rights Agreement dated as of February 10, 1998 by and between Bancshares and Wachovia Bank, N.A., as rights agent (the “Rights Agreement”). Generally, Rights holders may exercise their Rights upon the occurrence of either of the following events (the “Trigger Dates”): (a) the Board determines that a person or entity is an Adverse Person or (b) a person or group becomes the beneficial owner of 25% or more of Bancshares’ common stock after Distribution Date. After the Trigger Dates, the Rights holders may exercise their Rights by (a) purchasing shares of Bancshares’ common stock in an amount equal to two times the exercise price of the Right or (b) at the Board’s discretion, receiving shares of Bancshares’ common stock that equal the difference between the exercise price of the Right and the value of the consideration that a Rights holder would pay under section(a) of this sentence. For example, if on the Trigger Dates, the exercise price of each Right is $100.00 per full share of Bancshares’ common stock, a Rights holder would have the right to (a) purchase $200.00 of Bancshares’ common stock for $100.00 or (b) at the Board’s discretion, receive $100.00 of Bancshares’ common stock without payment of any exercise price. In addition, at any time after the Stock Acquisition Date, if Bancshares is acquired in a merger or other business combination transaction or if 50% or more of Bancshares’ assets are sold or transferred, each Rights holder will have the right to purchase shares of the acquiring company’s common stock in an amount equal to two times the exercise price of the Right.
The Rights will expire on December 31, 2007, and may be redeemed by Bancshares at a price of $0.01 at any time prior to the acquisition by a person or group of 20% or more of Bancshares’ common stock.
Stock-Based Compensation
Prior to the approval of the Comprehensive Benefit Plan, Bancshares’ Amended and Restated Deferred Compensation Plan for Directors (the “Deferral Plan”) allowed directors to defer part of the compensation they receive from Bancshares for their services as directors. After Bancshares’ shareholders approved the Comprehensive Benefit Plan on April 21, 2004, the Deferral Plan was terminated (except with respect to outstanding grants). The Comprehensive Benefit Plan authorizes the directors to defer part of the compensation they receive for their services as Bancshares directors. If a director elects to defer part of his or her compensation, Bancshares creates a bookkeeping account for the director and credits this account with a certain number of shares of Bancshares’ common stock, which is adjusted periodically to reflect the payment and reinvestment of dividends on the common stock. Directors have only an unsecured contractual commitment of Bancshares to pay the deferred amounts due under the Deferral Plan and the Comprehensive Benefit Plan. However, Bancshares maintains a “grantor” trust in connection with shares to be issued under its previous and current deferred compensation plans. This trust has purchased, and intends to continue to purchase, shares on the open market in an amount necessary to provide to directors future benefits that accrue under these plans (although the assets of the trust are subject to the claims of Bancshares’ general creditors in the event of Bancshares’ insolvency). The following table summarizes the common stock held in the trust, which is presented as a reduction of Shareholders’ Equity:
Bancshares administers the following stock-based compensation plans to the extent that there are outstanding awards to plan participants: (a) the 1986 Employee Incentive Stock Option Plan; (b) the 1994 Director Stock Option Plan; and (c) the 1996 Omnibus Stock Incentive Plan (collectively, the “Previous Benefit Plans”). After shareholders approved the Comprehensive Benefit Plan, the Previous Benefit Plans were terminated (except with respect to outstanding grants). The Comprehensive Benefit Plan gives the Compensation Committee the
authority to issue 750,000 shares of common stock and an indeterminate amount of plan interests to plan participants in the form of stock options, restricted stock, restricted stock units, performance units and other stock-based awards. The Compensation Committee has the authority pursuant to the Comprehensive Benefit Plan to grant options, with such durations and vesting schedules as the Compensation Committee deems appropriate (provided, however, that such durations may not exceed ten years).
The following table summarizes information about outstanding and exercisable stock options at December 31, 2006:
A summary of the status of Bancshares’ stock-based compensation plans as of December 31, 2006 and 2005 and changes during the years then ended is presented below:
Note 16 - QUARTERLY FINANCIAL DATA
Quarterly financial data for 2006 and 2005 is summarized below (in thousands, except per share data). The sum of the quarterly earnings per share amounts may not equal the annual earnings per share amounts due primarily to changes in the number of shares outstanding from quarter to quarter.
Note 17 - LSB BANCSHARES, INC. (PARENT COMPANY)
The condensed balance sheets for Bancshares as of December 31, 2006 and 2005, and the related condensed statements of income and cash flows for the years ended December 31, 2006, 2005 and 2004, are as follows (in thousands):
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME
CONDENSED STATEMENTS OF CASH FLOWS
Note 18 - DERIVATIVES
Bancshares began using derivatives in the fourth quarter of 2005. The derivatives are being used in conjunction with the Bank’s sale of ICDs. ICDs do not pay periodic interest payments. Instead, any interest is paid at maturity and is calculated based on the positive price movements, if any, of the DJIA over the entire term of the ICD. The goal is to curtail the interest rate risk of the ICD to the Bank by engaging in “perfectly matched” hedges or option contracts tied to the underlying index with creditworthy hedge providers who will support the inherent performance of the ICD at maturity of the issuances.
This approach will mitigate any exposure to unintended market risk and essentially fix Bancshares’ cost of funds at inception for the term of the ICD without concern over the performance of the DJIA. Bancshares has also looked at the risk associated with any default in payment by the hedge providers. This risk is mitigated by all hedge providers having investment grade ratings. If the hedge providers fall below an investment grade rating, collateral must be posted. Bancshares uses multiple hedge providers to spread the risk, and all providers are publicly traded and have been in operation for over 60 years.
The following table reflects risk management derivative financial instruments for the years ended December 31, 2006 and 2005:
Note 19 - SUBSEQUENT EVENTS
On February 27, 2007, the Board of Directors of Bancshares announced a definitive agreement to combine in a merger of equals with FNB Financial Services Corporation. The transaction is scheduled to be completed during the third quarter of 2007.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
Not applicable.
Item 9A.
Item 9A. Controls and Procedures.
As of the end of the period covered by this report, Bancshares has evaluated, under the supervision and with the participation of Bancshares’ management, including Bancshares’ Chief Executive Officer and Chief Financial Officer, the effectiveness of Bancshares’ disclosure controls and procedures (as defined in Rule 13A-15(e) promulgated under the Exchange Act). Based upon that evaluation, Bancshares’ Chief Executive Officer and Chief Financial Officer have concluded that Bancshares’ disclosure controls and procedures are effective to ensure that information required to be disclosed by Bancshares in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the rules and forms of the SEC.
Bancshares’ management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13A-15(f) promulgated under the Exchange Act). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Bancshares’ management assessed the effectiveness of Bancshares’ internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework.
Based on this assessment, Bancshares’ management believes that, as of December 31, 2006, Bancshares’ internal control over financial reporting is effective.
Bancshares’ independent auditor, Turlington and Company L.L.P., has issued an audit report on management’s assessment of Bancshares’ internal control over financial reporting. This Report of Independent Registered Public Accounting Firm begins on page 37 in Item 8 above.
During the quarter ended December 31, 2006, there have been no changes in Bancshares’ internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, Bancshares’ internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
Not Applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Board of Directors of Bancshares
Executive Officers of Bancshares
Robert F. Lowe (age 64 as of March 15, 2007) is the Chairman, President and Chief Executive Officer of Bancshares and Chairman and Chief Executive Officer of the Bank. Mr. Lowe joined the Bank in 1970 and was elected Vice President in 1973. He was elected Senior Vice President of the Bank in 1980 and Executive Vice President of the Bank in 1982. On January 1, 1984, he was elected President and Chief Executive Officer of Bancshares and the Bank, and on January 1, 1990, Mr. Lowe was elected Chairman of both Bancshares and the Bank. Mr. Lowe also serves as Chairman of Peoples Finance and President and a Director of LSBIS.
H. Franklin Sherron, Jr. (age 52 as of March 15, 2007) is the Vice President of Bancshares, having been elected to that position in April of 1991. Mr. Sherron joined the Bank in 1990 as Senior Vice President. He was elected Executive Vice President of the Bank in 1996 and was elected President of the Bank in 2002. Mr. Sherron is also President and a Director of Peoples Finance and Senior Vice President of LSBIS.
Monty J. Oliver (age 66 as of March 15, 2007) is the Secretary and Treasurer of Bancshares, having been elected to that position in April of 1991. Mr. Oliver joined the Bank as Vice President in 1978. He was elected Cashier of the Bank in 1980. In 1986, he was elected Senior Vice President of the Bank and in 1996 he was
elected Executive Vice President of the Bank. Mr. Oliver is also Secretary and a Director of Peoples and Secretary and Assistant Treasurer of LSBIS.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) requires the executive officers and directors of Bancshares and persons who beneficially own more than ten percent of the outstanding shares of common stock to file with the SEC reports disclosing their initial ownership of common stock, as well as subsequent reports disclosing changes in such ownership.
To Bancshares’ knowledge, based solely on a review of copies of such reports furnished to Bancshares and written representations from executive officers and directors, Bancshares believes that during the fiscal year ended December 31, 2006, all of its executive officers and directors complied with all applicable Section 16(a) filing requirements.
Code of Business Conduct and Ethics
Bancshares has maintained a written Code of Ethics for many years. The Board of Directors recently conducted its annual review and approved two codes, one entitled “Code of Business Conduct and Ethics” which applies to all directors, executives, officers and employees of Bancshares and all of its direct and indirect subsidiaries (the “General Code”), and one entitled “Code of Business Conduct and Ethics for CEO and Senior Financial Officers” which applies to Bancshares’ Chief Executive Officer and senior financial officers including Bancshares’ Chief Financial Officer and principal accounting officers (the “Officer Code”). Copies of both Codes of Ethics are available on Bancshares’ website, www.lsbnc.com. The General Code outlines many standards, including those related to addressing compliance with laws, regulations, policies and procedures; conflicts of interest; confidentiality; accuracy of financial statements and other records; and procedures for reporting violations of the General Code or any illegal or unethical business or workplace conduct. The Officer Code imposes additional policies on Bancshares’ CEO and senior financial officers concerning Bancshares’ accounting and financial reporting. Generally, the Officer Code requires those individuals to bring to the attention of the CEO and CFO, and in certain circumstances, the Audit Committee, any material information which comes to their attention that (1) affects disclosures made by Bancshares in its public filings; (2) demonstrates significant deficiencies in Bancshares’ internal controls; (3) concerns fraud or a violation of the General Code by management or employees with a significant role in financial reporting, disclosure or internal controls; or (4) involves a material violation of law, including securities laws. Under the Officer Code, the Board of Directors, or its designee, determines the appropriate actions to be taken in the event the Officer Code or the General Code is violated by the CEO or the senior financial officers, which actions may include termination of employment.
Changes in Shareholder Nominations of Directors
There were no material changes to the procedures by which shareholders may recommend nominees to Bancshares’ Board of Directors.
Audit Committee
Bancshares has a separately-designated standing Audit Committee established in accordance with the Exchange Act. The members of the Audit Committee are: Michael S. Albert, Chairman, Robert C. Clark, Samuel R. Harris, Walter A. Hill, Sr., Mary E. Rittling, Robert B. Smith, Jr., and Julius S. Young, Jr. The Audit Committee held 10 meetings in 2006. The Audit Committee’s primary responsibilities are to assist the Board in overseeing the accounting and financial reporting processes and the audits of the financial statements of Bancshares, including oversight of (1) the integrity of the financial reports and other financial information of
Bancshares; (2) compliance by Bancshares with legal and regulatory requirements; (3) Bancshares’ systems of internal controls regarding finance, accounting, legal compliance and ethics that management and the Board have established; (4) the structure, staffing and performance of Bancshares’ internal audit function; (5) the independence and performance of Bancshares’ registered public accounting firm engaged to audit and review Bancshares’ financial statements; and (6) Bancshares’ auditing, accounting and financial reporting processes generally. In addition, the Audit Committee has been appointed as Bancshares’ Qualified Legal Compliance Committee within the meaning of the Exchange Act and the rules and regulations of the SEC promulgated thereunder. As such, the Audit Committee is responsible for handling any reports of evidence of a material violation of the securities laws and conducting any investigation thereof that it deems appropriate. Further, the Audit Committee has been appointed to oversee treatment of, and any necessary investigation concerning, any employee complaints or concerns regarding Bancshares’ accounting and auditing matters.
On March 14, 2007, Bancshares conducted its annual review and approval of the Employee Complaint Procedures for Accounting and Auditing Matters, which encourages any employee with such complaints or concerns to report them, anonymously if they desire, to the Chair of the Audit Committee for investigation, and appropriate corrective action, if necessary. On March 14, 2007, the Audit Committee also conducted its annual performance evaluation and reviewed its written charter. The Audit Committee determined that it was discharging its duties as set forth in the charter and will recommend to the Board on March 20, 2007 that no charter revisions be made. A copy of the charter is available on Bancshares’ website, www.lsbnc.com. Each of the members of the Audit Committee is “independent” as determined by the Board under the applicable rules and listing standards of the Nasdaq Stock Market, Inc. and Section 10A(m) of the Exchange Act and the rules and regulations of the SEC promulgated thereunder. In addition, the Board of Directors has determined that Mr. Michael S. Albert, Chairman of the Audit Committee, is an “audit committee financial expert” within the meaning of applicable SEC regulations.
Item 11.
Item 11. Executive Compensation
Compensation Committee Interlocks and Insider Participation
No member of the Compensation Committee is or has been an employee or an employee of Bancshares or any of its subsidiaries. None of our executive officers serve on the compensation committee or as a director of another entity of which an officer or director of Bancshares serves on the Compensation Committee.
Robert B. Smith, Jr., a director of Bancshares and Chairman of its Compensation Committee, is a member of a limited liability company that leases certain real estate to the Bank pursuant to a lease agreement dated August 1, 1999. The lease agreement expires July 31, 2009, subject to the Bank’s right to renew the lease for up to three additional terms of five years each. During 2006, this limited liability company received approximately $28,510 in rent for this real estate.
Compensation Disclosure and Analysis
Overview
The following Compensation Disclosure and Analysis (“CD&A”) provides information with respect to the compensation paid to Bancshares’ Chief Executive Officer, Robert F. Lowe, its Chief Financial Officer, Monty J. Oliver and to its other executive officer, H. Franklin Sherron, Jr.
Bancshares’ executive compensation program is administered by the Compensation Committee. Each member of the Compensation Committee is “independent” as determined by the Board under the rules and listing standards of the Nasdaq Stock Market, Inc. Additionally, each Compensation Committee member qualifies as a
“non-employee director” for purposes of Rule 16b-3 under the Exchange Act and as an “outside director” for purposes of Section 162(m) of the Code.
Bancshares’ executive compensation program consists of the following elements: salary, performance-based cash awards under the Management Incentive Plan (the Annual Incentive Plan prior to 2006), grants of options or other appropriate stock awards under the Comprehensive Benefit Plan, matching contributions under the Lexington State Bank Employees’ 401(k) Plan (the “Bank Savings Plan”), retirement benefits under the Lexington State Bank Employees’ Pension Plan (the “Pension Plan”), Employment Continuity Agreements, universal life insurance benefits, and group life, health and other insurance benefits. The above elements of each named executive officer’s compensation are not inter-related. For example, if the targeted Management Incentive award is not achieved, the executive’s base salary is not increased to make up the difference. Similarly, the value of previously granted options is not considered by the Committee in recommending the other elements of the compensation package. The Compensation Committee has exclusive discretion and authority to grant stock options or other appropriate stock awards under the Comprehensive Benefit Plan to the executive officers. The Compensation Committee has full and complete discretionary authority to administer the Management Incentive Plan (and had the same authority to administer the Annual Incentive Plan prior to 2006). The Compensation Committee recommends to the Bank’s Board of Directors the total compensation to be paid to executive officers.
Bancshares’ executive compensation program is designed to enable Bancshares to attract, retain and reward qualified executive officers. The Compensation Committee intends to keep compensation levels competitive with the compensation provided by banks of comparable size to the Bank (based on total assets). The Compensation Committee’s strategy is to maintain a structure within the executive compensation program that strengthens the links among executive compensation, Bancshares’ performance, individual performance of the executive officers and shareholder interests. In accordance with this strategy, the Compensation Committee on December 20, 2005, approved the Management Incentive Plan to provide performance-based compensation to selected management employees beginning in 2006. A copy of the Management Incentive Plan was filed with the SEC on December 23, 2005 as an exhibit to a Current Report on Form 8-K.
Compensation Program.
Base Salary. Executive officers receive a base salary for their services to Bancshares and its subsidiaries. Base salaries for executive officers are reviewed and approved by the Bank’s Board of Directors based upon recommendations by the Compensation Committee. Although there is no predetermined point at which the Compensation Committee targets salaries, the Compensation Committee recommends base salaries based upon a review of base salaries earned by executive officers within banks of comparable size (based on total assets). In determining base salaries, the Compensation Committee does not establish performance thresholds or other measures that directly relate base salaries to operating performance.
Incentive Compensation. Under the Management Incentive Plan, selected management employees have the opportunity to earn bonuses based on the achievement of specific corporate goals of Bancshares and/or individual performance goals. The Compensation Committee annually designates management employees eligible for participation in the Management Incentive Plan and determines each participant’s target bonus and the applicable performance objectives, adjustment factors and other measurement criteria that are used in calculating the actual bonus. Bonuses may range from $0.00 to 175% of the employee’s target. A participating employee’s actual bonus for a given year is determined at the end of the year according to the pre-determined formula. Bonuses are paid in cash immediately following the end of the year.
Incentive compensation awards granted under the Management Incentive Plan in 2006 were approved by the Compensation Committee based on each participant’s achievement of individual performance objectives which were established at the beginning of the year. These objectives were tied to measurements of corporate
objectives, such as return on average equity, return on average assets, asset growth, core deposit growth, efficiency ratio and delinquency and charge off percentages, and, in some instances, other objectives that were specific to the executive officer’s job function. The maximum cash incentive award under the Management Incentive Plan is determined based on Bancshares’ net income and reflects the Compensation Committee’s commitment to maintaining a strong incentive compensation plan that is directly related to maximizing long-term shareholder value.
Stock Options. The Compensation Committee awards stock options to executive officers as a long-term incentive to align the executives’ interests with those of other shareholders and to encourage significant stock ownership. Under the Comprehensive Benefit Plan, the Compensation Committee has the flexibility to grant incentive stock options and non-qualified options, stock appreciation rights, restricted stock, restricted stock units, performance units, deferred stock and any other kind of stock-based award the Compensation Committee finds to be consistent with the purpose of the Comprehensive Benefit Plan. In practice, the Compensation Committee has granted to selected key employees options to purchase Bancshares’ Common Stock at a price equal to the fair market value of Bancshares’ Common Stock on the date of grant. The Compensation Committee has granted options to key employees who, in the judgment of the Compensation Committee, are in a position to materially affect the overall success of Bancshares and its subsidiaries by reason of the nature and extent of their duties. In deciding upon the option grant to executive officers, the Compensation Committee considers a number of factors, including Bancshares’ operating performance, the executive officer’s prior contributions and potential to contribute in the future, and practices of other banks of similar size with respect to granting options, although none of these factors is individually determinative.
The Bank Savings Plan. The Bank Savings Plan is a tax-qualified defined contribution plan designed to provide eligible employees of the Bank a vehicle for increasing their retirement savings. All Bank employees are eligible to participate in the Bank Savings Plan after attaining the age of 21 and completing 30 days of qualifying service; however, eligibility to receive the Bank’s matching contribution requires completing one year of qualifying service. Employees may join the Bank Savings Plan at the beginning of each calendar quarter. The executive officers of Bancshares participate in the Bank Savings Plan on the same basis as all other eligible employees of the Bank. Each eligible employee of the Bank may elect to contribute on a pre-tax basis to the Bank Savings Plan 2% to 25% of his or her compensation, subject to certain limitations imposed by the Code. Effective January 1, 2007, the Bank amended it’s matching contribution formula and is now obligated under the terms of the Bank Savings Plan to match 100% of each eligible employee’s pre-tax contributions on the first 3% deferral and 50% on the next 2% deferral, with a maximum match of 4%. The Bank Savings Plan is subject to certain IRS mandated nondiscrimination tests to ensure that the Average Contribution Percentage (“ACP”) for highly compensated participates does not exceed the relationship to the ACP of all non-highly compensated participants for the preceding plan year. For 2006, the maximum match for highly compensated participants was $6,600. The difference in the amounts contributed to the executive officer’s retirement plans as compared to the maximum match for 2006 was forfeited and will be applied to their respective 2007 plan contribution.
Pension Plan. The Bank maintains a tax-qualified defined benefit retirement plan (the “Pension Plan”). All employees of the Bank and certain affiliates accrue Pension Plan benefits after attaining the age of 21 and completing one qualifying year of service. Contributions to the Pension Plan are computed on an actuarial basis.
A participant’s normal retirement benefit under the Pension Plan at age 65 is an amount payable monthly for life equal to one-twelfth of the sum of (a) 0.9% of final average compensation multiplied by the years of credited service with the Bank and certain affiliates not to exceed 40 years, plus (b) 0.65% of final average compensation in excess of Social Security “covered compensation” multiplied by the years of credited service with the Bank and certain affiliates not to exceed 35 years. Participants who have at least 30 years of vesting service may receive an unreduced normal retirement benefit beginning at age 62. Final average compensation
is the average of the participant’s five highest consecutive calendar years of compensation paid during the ten calendar years preceding retirement. Compensation for any calendar year includes total salary, wages, bonuses and incentive compensation, but excludes fringe benefits, income attributable to the exercise of stock options or other forms of equity compensation, and amounts in excess of applicable limits imposed by the Internal Revenue Service.
The Bank froze the Pension Plan for all participants with less than 30 years of service effective December 31, 2006. Although Mr. Lowe has more than 30 years of service with the Bank and qualified to continue his participation in the Pension Plan, he elected to have the Pension Plan freeze apply to himself as well. The freeze was accounted for in accordance with the provisions of SFAS 88. See the pension discussion under “Critical Accounting Policies” on page 17, and “Pension and Employee Benefit Plans” in Note 13 to the Consolidated Financial Statements beginning on page 56.
Employment Continuity Agreements
Bancshares has entered into an Employment Continuity Agreement with each of the named executive officers and with certain other employees of Bancshares and the Bank. Each of these agreements with the named executive officers is effective as of January 1, 2004 and amends and restates prior existing employment continuity agreements between Bancshares and the named executive officers.
The Employment Continuity Agreements (collectively, the “Employment Agreements”) provide for evergreen employment terms of three years for Mr. Lowe and two years for each of Messrs. Sherron and Oliver. Under their respective Employment Agreements, Mr. Lowe is entitled to an annual base salary of $325,000 and Messrs. Sherron and Oliver are entitled to annual base salaries of $205,000 and $203,000, respectively, each subject to adjustment from time to time. In addition, during their employment terms, each named executive officer is entitled to participate in the various employee benefit plans and fringe benefits offered by Bancshares from time to time. For additional information on the Employment Agreements, see “Potential Payments upon Termination or Change in Control” on page 78.
Other Benefits
Executive officers are entitled to participate in fringe benefit plans offered to employees including Health and Dental Insurance plans and Life, Accidental Death and Dismemberment and Long-Term Disability plans. In addition, executives receive the use of company vehicles and participate in the Supplemental Executive Retirement Plan (“SERP”), which is an additional life insurance policy provided to supplement the executives’ retirement income to reach a target percentage level of 70%, as determined by the Board of Directors.
Compensation Committee Report
The Compensation Committee has reviewed and discussed the CD&A with management and has recommended that the CD&A be included in the proxy statement and this Form 10-K.
Robert B. Smith, Jr., Chair
John W. Thomas III
Michael S. Albert
G. Alfred Webster
Burr W. Sullivan
Julius S. Young, Jr.
Summary Compensation Table
The following table shows, for the fiscal years indicated, the cash compensation paid by Bancshares, as well as certain other compensation paid or accrued for those years, to (i) the Chief Executive Officer, Robert F. Lowe, (ii) the Chief Financial Officer, Monty J. Oliver and (iii) all other executive officers of Bancshares whose cash compensation exceeded $100,000 in the fiscal years indicated for services in all capacities.
SUMMARY COMPENSATION TABLE
Amounts reported for Mr. Lowe do not include compensation earned for services as Chairman of the Board of Directors. See “Director Compensation” on page 78 for amounts earned by Mr. Lowe for his services as Chairman of the Board of Directors.
Grants of Plan-Based Awards Table
The following table shows certain information for those grants of plan-base awards made by Bancshares to Messrs. Lowe, Oliver and Sherron during the fiscal year ended December 31, 2006.
GRANTS OF PLAN-BASED AWARDS
Represents amounts the executive officers were eligible to receive under the Management Incentive Plan. These amounts were not paid to the executive officers under the Management Incentive Plan for the fiscal year ended December 31, 2006, as the executive officers did not reach their respective pre-determined performance goals.
The base salary paid to Bancshares’ Chief Executive Officer, Robert F. Lowe, during 2006 reflects the base salary policies described above. Mr. Lowe’s 2006 salary was 112% of the median base salary paid to chief executive officers of banks of comparable size. The Compensation Committee believes that the base salary paid to Mr. Lowe gives fair consideration to his individual contributions and level of experience and is competitive with salaries paid to chief executive officers of banks of comparable size. Mr. Lowe’s base salary during 2006 reflected a 5.9% increase over his 2005 base salary. Mr. Lowe’s base salary represents 57.0% of the total compensation earned by Mr. Lowe for the fiscal year ended December 31, 2006. Mr. Lowe’s 2006 total compensation, which included his base salary and all other compensation, decreased 14.1% in relation to his 2005 total compensation. The decrease in Mr. Lowe’s 2006 total compensation is primarily due to $0 paid out under the 2006 Management Incentive Plan, as well as a decrease in life insurance premiums paid by Bancshares for 2006.
The base salary paid to Bancshares’ Chief Financial Officer, Monty J. Oliver, is recommended by Mr. Lowe to the Compensation Committee and approved by Bancshares’ Board of Directors. The 2006 base salary paid to Mr. Oliver was 129% of the median base salary paid to chief financial officers of banks of comparable size, and was based on his years of experience. Mr. Oliver’s base salary during 2006 reflected a 6.2% increase over his 2005 base salary. Mr. Oliver’s base salary represents 89.2% of the total compensation earned by Mr. Oliver for the fiscal year ended December 31, 2006. The Compensation Committee believes that the base salary paid to Mr. Oliver gives fair consideration to his individual contributions and level of experience and is competitive with salaries paid to chief financial officers of banks of comparable size. Mr. Oliver’s 2006 total compensation, which included his base salary and all other compensation, decreased 32.7% in relation to his 2005 total compensation. The decrease in Mr. Oliver’s total compensation is primarily due to $0 paid out under the 2006 Management Incentive Plan, as well as $0 paid in life insurance premiums due to Mr. Oliver aging out of the plan in July 2005.
The base salary paid to Bancshares’ President and Chief Operating Officer, H. Franklin Sherron, Jr., is recommended by Mr. Lowe to the Compensation Committee and approved by Bancshares’ Board of Directors. The 2006 base salary paid to Mr. Sherron was 110% of the median base salary paid to chief operating officers of banks of comparable size, and was based on his years of experience. Mr. Sherron’s base salary during 2006 reflected a 7.2% increase over his 2005 base salary. Mr. Sherron’s base salary represents 82.0% of the total compensation earned by Mr. Sherron for the fiscal year ended December 31, 2006. The Compensation Committee believes that the base salary paid to Mr. Sherron gives fair consideration to his individual contributions and level of experience and is competitive with salaries paid to executive officers of banks of comparable size. Mr. Sherron’s 2006 total compensation, which included his base salary and all other compensation, decreased 13.5% in relation to his 2005 total compensation. The decrease in Mr. Sherron’s 2006 total compensation is primarily due to $0 paid out under the 2006 Management Incentive Plan.
The references to “total compensation” discussed above for Messrs. Lowe, Oliver and Sherron exclude the amounts listed in the “Change in Pension Value and Nonqualified Deferred Compensation Earnings” column of the Summary Compensation Table above.
For performance during 2006, Bancshares awarded cash incentive compensation under the Management Incentive Plan totaling $36,532 to 14 participants. Of this amount, nothing was paid to Messrs. Lowe, Sherron and Oliver as they did not reach their respective pre-determined performance goals. Other participants in the Management Incentive Plan in 2006 were key employees who, in the judgment of the Compensation Committee, made a substantial contribution to the success of Bancshares and its subsidiaries and who the Compensation Committee believed should participate in that success and be motivated to contribute to future successes.
Pursuant to its authority under the Comprehensive Benefit Plan, on December 11, 2006, the Compensation Committee approved the grant of incentive stock options to purchase 49,000 shares of Bancshares’ Common Stock to employees of Bancshares and the Bank pursuant to the terms and conditions of a form Incentive Option Grant Agreement for each such employee. Incentive stock options were not granted to Messrs. Lowe, Sherron and Oliver during fiscal year 2006.
The Bank Savings Plan is subject to certain IRS mandated non-discrimination tests to ensure that the Average Contribution Percentage (“ACP”) for highly compensated participants does not exceed the relationship to the ACP of all non-highly compensated participants for the preceding plan year. For 2006, the maximum match for highly compensated participants was $6,600. The difference in the amounts contributed for Messrs. Lowe, Sherron, and Oliver as compared to the maximum match for 2006 was forfeited and will be applied to their respective 2007 plan contributions.
Salary and bonus as listed in the Summary Compensation Table above for Messrs. Lowe, Sherron and Oliver are included in total compensation to determine their level of benefits under the Pension Plan, subject to certain limitations imposed by the Code. As of December 31, 2006, annual payments under the Pension Plan would be based on final average compensation of approximately $362,000 for Mr. Lowe, $223,000 for Mr. Sherron and
$216,000 for Mr. Oliver. Years of credited service for Messrs. Lowe, Sherron and Oliver are as follows: Mr. Lowe (37); Mr. Sherron (16); and Mr. Oliver (28).
For information on material terms of each executive officer’s Employment Agreement, see “Employment Continuity Agreements” on page 71 and “Potential Payments upon Termination or change in Control” on page 78.
Outstanding Equity Awards at Fiscal Year-End Table
The following table shows certain information for those outstanding equity awards at December 31, 2006.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
Option Exercises and Stock Vested Table
The following table sets forth certain information related to options that were exercised by Messrs. Lowe, Oliver and Sherron during the fiscal year ended December 31, 2006.
OPTION EXERCISES AND STOCK VESTED
Shares listed represent a stock swap.
Pension Benefits Table
The following table shows, for the fiscal year ended December 31, 2006, the pension benefits paid or earned by Messrs. Lowe, Oliver and Sherron.
PENSION BENEFITS
As to the Bank Pension Plan:
Eligibility Requirements: Each Employee becomes a Participant on the Plan Entry Date on or next following the attainment of age 21 years and completion of 1 Year of Service.
The annual retirement benefit payable as a Life Annuity commencing at age 65 is calculated as follows:
•
0.9% of Final Average Compensation (FAC) multiplied by Years of Credited Service (max 40 years), plus
•
0.65% of Final Average Compensation in excess of Covered Compensation multiplied by Years of Credited Service (max 35 years). Final Average Compensation = average of the highest 5 consecutive Plan Years’ Compensation out of the last 10 Plan Years in which a Year of Credited Service was earned. Covered Compensation = the average of Social Security Taxable Wage Base for the 35-year period ending at the Participant’s Social Security Retirement Age.
As to the Supplemental Executive Retirement Plan:
Potential Payments upon Termination or Change in Control
Under the Employment Agreements discussed above, if the named executive officer’s employment terminates due to the employee’s disability, death, voluntary termination by the employee or termination by Bancshares for “cause” (as defined in the Employment Agreements) or for any other reason that does not constitute a “Covered Termination” (discussed below), the named executive officer is entitled to receive his annual base salary and vested rights to fringe benefits for the period prior to his termination of employment. If the named executive officer’s employment is terminated in a way that constitutes a “Covered Termination”, the named executive officer is entitled to receive his base salary and vested rights to fringe benefits for the period prior to such termination and monthly severance payments during the severance period (which is three years for Mr. Lowe and two years for each of Mr. Sherron and Mr. Oliver unless the termination occurs within six months after a change in control of Bancshares, in which case the severance period is three years instead of two years).
The monthly severance payment equals 1/12th of the named executive officer’s then annual base salary plus 1/12th of the amount of any bonuses or other taxable cash compensation other than annual base salary which was awarded to the named executive officer during the calendar year prior to his termination of employment. In addition, during the period when the named executive officer is receiving severance, Bancshares generally must reimburse the executive for the costs of premiums for the executive and his dependents to maintain continuation coverage under Bancshares’ group health plans. Bancshares’ obligation to make these severance payments is conditioned on the named executive officer’s compliance with a noncompete agreement. If the severance payments would result in the executive being subject to a section 4999 excise tax under the Code, the severance payments are automatically reduced to $1.00 less than three times the executive’s “base amount” (as defined in Code Section 208G(b)(3)) but only if the executive would be economically better off, on an after-tax basis, by such reduction. In addition, if the amounts to be paid to the executive under the Employment Agreement would cause the executive to receive a payment in violation of 12 C.F.R. §359 then, after seeking the approval of the Federal Deposit Insurance Corporation to nonetheless pay such amounts, if such approval is not forthcoming, such amounts will be limited so that no violation of the regulation will occur.
Generally, a “Covered Termination” is defined as the following: any termination by Bancshares without cause and without an offer of comparable employment with a successor employer or affiliated employer (as defined in the Employment Agreements), the named executive officer voluntarily terminates his employment for “good reason” (as defined in the Employment Agreements) within six months after the occurrence of the event (or the last in a series of events) constituting the good reason, or the named executive officer terminates his employment if Bancshares or its Board, without the named executive officer’s written consent, violates or takes direct action or inaction that would violate Bancshares’ code of ethics as in effect immediately prior to a change in control of Bancshares (as defined in the Employment Agreements).
In 2006, if a Covered Termination event occurred that was not the result of a change in control, then Mr. Lowe would have been entitled to receive total compensation of $1.979 million, Mr. Oliver would have been entitled to receive total compensation of $676,000 and Mr. Sherron would have been entitled to receive total compensation of $578,000. However, if a Covered Termination event occurred as a result of a change in control, then Mr. Lowe would have been entitled to receive total compensation of $1.979 million, Mr. Oliver would have been entitled to receive total compensation of $1.013 million and Mr. Sherron would have been entitled to receive total compensation of $867,000. All amounts are calculated based on each executive’s 2005 total compensation as shown in the Summary Compensation Table, excluding the amounts listed in the “Change in Pension Value and Nonqualified Deferred Compensation Earnings” column, on page 72 and the amount of 2005 health insurance premiums paid by Bancshares, which totaled $3,678 for each executive.
Director Compensation
The following table shows, for the fiscal year indicated, the cash compensation paid by Bancshares, as well as certain other compensation paid or accrued for the year, to directors.
DIRECTOR COMPENSATION TABLE
Amount listed represents (a) $5,000 for annual retainer fee and (b) $3,600 for one-half of the regular monthly meeting fees. The aggregate total goes towards the purchase of Bancshares’ Common Stock for each director. Mr. Branch, Ms. Rittling and Mr. Webster joined the Board of Directors in April 2006, therefore were eligible for 75% of this compensation.
Represents amounts earned by Mr. Lowe for his services as Chairman of the Board of Directors. For all other amounts paid by Bancshares to Mr. Lowe, see the Summary Compensation Table on page 72.
As compensation for serving on the Board of Directors of Bancshares, each member in 2006 received annual director fees of $12,200, plus $600 for each special Board meeting attended. The 2006 compensation was paid to each director as follows: (1) Bancshares paid $300 in cash to each director each month for attendance at regular meetings; and (2) Bancshares paid the balance ($8,600) to each director in shares of Common Stock of Bancshares based on the shares’ then-current fair market value (the “2006 Stock Compensation”). Bancshares paid the 2006 Stock Compensation to each director at one time, in full, during the first quarter 2006. The 2006 Stock Compensation was prorated for newly-elected directors and directors who retired during the year. Each non-management director also received a fee of $250 in cash for each committee meeting of Bancshares and the Bank that he or she attended. This fee was paid on the dates such committee meetings were held.
At its meeting on December 19, 2006, and upon the recommendation of the Compensation Committee, the Board approved a restated director compensation schedule for 2007. Pursuant to this schedule, each member of the Bancshares Board receives the following director fees and other compensation:
•
$300 in cash for each regular monthly meeting of the Board that the director attends, paid at the time of the meeting;
•
$300 for each regular monthly meeting of the Board scheduled for the year, converted into shares of Bancshares Common Stock based on the shares’ then-current fair market value (the “Board Stock Fees”). The total number of shares is determined in the first quarter, and the shares are delivered to directors at that time. If the director’s service on the Board terminates for any reason prior to the payment, the Board Stock Fee is prorated based on the number of regular monthly Board meetings attended during the year. For a director scheduled to retire during the year, the Board Stock Fee is prorated based on the number of regular monthly Board meetings prior to the scheduled retirement date. For a new director, the Board Stock Fee is prorated based on the number of
regular monthly Board meetings remaining in the year and is paid as soon as practicable after the director’s election or appointment;
•
$5,000 annual retainer, converted into shares of Bancshares Common Stock based on the shares’ then-current fair market value (the “Board Retainer”). The number of shares is determined in the first quarter and the shares are delivered to the director at that time. If the director’s service on the Board terminates for any reason prior to the payment, the Board Retainer is prorated based on the number of regular monthly Board meetings attended during the year. For a director scheduled to retire during the year, the Board Retainer is prorated based on the number of regular monthly Board meetings prior to the scheduled retirement date. For a new director, the Board Retainer is prorated based on the number of full months remaining in the year after he assumes office, and is paid as soon as practicable thereafter;
•
$600 in cash for each called special meeting of the Board that the director attends, paid at the time of the meeting;
•
For each non-employee director serving as chairman of a standing committee of the Board, $1,000 annual retainer, paid in the first quarter in cash;
•
For each non-employee director serving on standing committees of the Board, $250 in cash for each meeting the committee member attends, paid at the time of the meeting; and
•
$600 in cash for each called special meeting of the Bank’s Board of Directors that the director attends, paid at the time of the meeting.
The Comprehensive Benefit Plan authorizes the Compensation Committee to give directors the right to defer payment of all or part of their compensation. Pursuant to this authority, on December 29, 2004, the Compensation Committee approved a form of director fee deferral agreement, a copy of which was filed with the SEC on December 29, 2004 as an exhibit to a Current Report on Form 8-K (the “Director Fee Deferral Agreement”). On December 20, 2005, the Compensation Committee determined that the form of Director Fee Deferral Agreement should be amended to address issues arising under the new federal income tax laws governing deferred compensation and approved an amended and restated form of Director Fee Deferral Agreement, a copy of which was filed with the SEC on December 23, 2005 as an exhibit to a Current Report on Form 8-K (the “Restated Director Fee Deferral Agreement”).
By entering into a Director Fee Deferral Agreement (with respect to 2006 Stock Compensation) or a Restated Director Fee Deferral Agreement (with respect to Board Stock Fees and Board Retainers), the director can elect to have all or a portion of his or her 2006 Stock Compensation, Board Stock Fees or Board Retainers deferred. Under the Director Fee Deferral Agreements and the Restated Director Fee Deferral Agreements (collectively the “Deferral Agreements”), Bancshares creates a bookkeeping account for the director and credits this account with a hypothetical number of shares of Common Stock (the “deferred stock units”) based on the amounts deferred and the shares’ then current fair market value. The number of deferred stock units credited to the director’s bookkeeping account is increased periodically to mimic the payment and reinvestment of dividends on Common Stock. Directors have only an unsecured contractual commitment of Bancshares to pay the amounts due under the Deferral Agreements. However, Bancshares maintains a “grantor” trust and makes contributions to this trust which may be used to pay future benefits under the Deferral Agreements. The Bank’s trust department serves as trustee of the trust, and in that capacity the Bank uses amounts contributed to the trust to purchase shares of Bancshares Common Stock. The trust has purchased, and subject to the availability of funds intends to continue to purchase, shares on the open market in an amount equivalent to the benefits that accrue under the Deferral Agreements. The assets of this trust are subject to the claims of Bancshares’ general creditors in the event of Bancshares’ insolvency.
The Deferral Agreements provide that the director’s account is paid in a single sum in the year following the year of the director’s separation from the Board, or at the director’s election in installments over five years. Under each
arrangement a director may elect to receive installment payments only if the director is entitled to receive at least 1,000 shares. A director’s ability to elect installment payments under the Deferral Agreements is limited to comply with Section 409A of the Code. For instance, a director who elects to receive installment payments of his or her deferred compensation generally may not receive his or her first installment payment until at least five years after the date that the benefits would have otherwise been payable. When benefits are due under the Deferral Agreements, Bancshares instructs the trustee of the trust to pay such benefits to the director, in the form of Common Stock.
Under the Comprehensive Benefit Plan, the Compensation Committee has the flexibility to grant to directors non-qualified options, stock appreciation rights, restricted stock, restricted stock units, performance units, deferred stock and any other kind of stock-based award the Compensation Committee finds to be consistent with the purpose of the Comprehensive Benefit Plan. Pursuant to this authority, on December 21, 2004, the Compensation Committee recommended, and Bancshares’ Board of Directors approved, a Form Director Option Grant Agreement, a copy of which was filed with the SEC on December 23, 2004 as an exhibit to a Current Report on Form 8-K (the “Director Option Grant Agreement”). Under the terms of the form Director Option Grant Agreement, the exercise price per share of Common Stock for each option is the fair market value of the Common Stock on the date of grant. On December 21, 2004, the Board granted to each non-management director a ten-year option to purchase 1,250 shares of Common Stock pursuant to the terms and conditions of the form Director Option Grant Agreement.
On December 20, 2005, the Compensation Committee approved a form of stock appreciation rights award agreement for directors, a copy of which was filed with the SEC on December 23, 2005 as an exhibit to a Current Report on Form 8-K (the “Stock Appreciation Rights Award Agreement”). On the same date, the Compensation Committee awarded 1,000 stock appreciation rights to each non-employee director pursuant to the terms and conditions of the form Stock Appreciation Rights Award Agreement. Each stock appreciation right generally remains exercisable for five years. Each stock appreciation right entitles the grantee to receive, upon exercise, shares of Common Stock of Bancshares with a fair market value equal to the excess, if any, of (a) the fair market value of one share of Common Stock of Bancshares on the date of exercise over (b) the fair market value of one share of the Common Stock of Bancshares on the date of grant. The Compensation Committee did not grant stock options or award stock appreciation rights for directors in 2006.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners
Equity Compensation Plan Information
The following table sets forth certain information regarding outstanding options and shares for future issuance under equity compensation plans as of December 31, 2006. Individual equity compensation arrangements are aggregated and included within this table. This table excludes any plan, contract or arrangement that provides for the issuance of options, warrants or other rights that are given to Bancshares’ shareholders on a pro rata basis and any employee benefit plan that is intended to meet the qualification requirements of Section 401(a) of the Code.
Management’s Ownership of Common Stock
The following table sets forth information as of March 1, 2007 concerning the beneficial ownership of Common Stock by each director who held office during 2006 and each named executive officer (i.e., those named under the heading “Executive Officers of Bancshares” herein) and by all directors and executive officers as a group. Management is
aware of no person who beneficially owns more than five percent of the outstanding shares of Bancshares’ Common Stock. According to rules promulgated by the Securities and Exchange Commission (the “SEC”), a person is the “beneficial owner” of securities if the person has or shares the power to vote them or to direct their investment, or has the right to acquire ownership of such securities within 60 days through the exercise of an option, warrant, right of conversion of a security or otherwise.
*
Represents less than 1% of the outstanding Common Stock.
(1)
Unless otherwise noted, all shares are owned directly of record by the named individuals.
Changes in Control
On February 26, 2007, the Board of Directors of Bancshares entered into a definitive agreement to combine in a merger of equals with FNB. The Merger is scheduled to be completed during the third quarter of 2007. See “Subsequent Events” in Item 1 on page 4 and in Note 19 to the Consolidated Financial Statements on page 65.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Certain directors, nominees for director and executive officers of Bancshares, companies with which directors, nominees for director or executive officers are associated, and/or the immediate family members of directors, nominees for directors and/or executive officer of Bancshares are customers of the Bank and as such may from time to time borrow funds from the Bank within prescribed limitations, including those imposed by Section 402 of the Sarbanes-Oxley Act of 2002. Any such loans and commitments are made in the ordinary course of business, on terms no more favorable to such borrowers, including interest rates and collateral, than those prevailing at the time for comparable transactions with other persons, and do not involve more than the normal risk of collectability or present to the Bank other unfavorable features. See “Compensation Committee Interlocks and Insider Participation” in Item 11 on page 68.
Director Independence
See “Board of Directors of Bancshares” in Item 10 above on page 66 for a complete list of each director of Bancshares. All members of the Board of Directors are “independent” as defined under the rules and listing standards of the Nasdaq Stock Market, Inc. All members of the Stock Option and Compensation Committee, the Audit Committee and the Corporate Governance and Nominating Committee are “independent” as defined under the rules and listing standards of the Nasdaq Stock Market, Inc.
Item 14.
Item 14. Principal Accounting Fees and Services.
Audit Fees Paid to Independent Auditors
The following table represents fees for professional services rendered by Turlington and Company, L.L.P. for the audit of Bancshares’ annual financial statements and review of Bancshares’ financial statements included in its Form 10-Q’s for the years ended December 31, 2006 and 2005 and fees billed for audit-related services, tax services and all other services rendered by Turlington and Company, L.L.P. for each of such years.
Represents amounts paid for the audits of Bancshares’ pension plan and 401(k) Plan.
Represents amounts paid for assistance in the preparation of Bancshares’ and the Bank’s various federal, state and local tax returns.
Represents amounts paid for assistance with Bancshares’ financial statement preparation, management incentive plan computations, consultation on option expensing issues, attendance at various meetings, pension plan changes and other miscellaneous assistance.
All audit related services, tax services and other services giving rise to the fees listed under “Audit-Related Fees”, “Tax Fees” and “All Other Fees” in the table above were pre-approved by the Audit Committee, which concluded that the provision of such services by Turlington and Company, L.L.P. was compatible with the maintenance of that firm’s independence in the conduct of its auditing functions. The Audit Committee’s Charter provides for pre-approval of all audit and non-audit services to be provided by Bancshares’ independent auditors. The Charter authorizes the Audit Committee to delegate to one or more of its members pre-approval authority with respect to permitted services, provided that any such approvals are presented to the Audit Committee at its next scheduled meeting.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)
The following documents are filed (or, with respect to Exhibit 32, furnished) as part of this report:
(1)
Financial Statements:
(2)
Financial Statement Schedules: None
(3)
Exhibits
3.1
Articles of Incorporation of Bancshares, as amended, which are incorporated by reference to Exhibit 4.1 of Bancshares’ Registration Statement on Form S-8 filed with the Securities and Exchange Commission (the “SEC”) on May 16, 2001 (SEC File No. 333-61046).
3.2
Amended and Restated Bylaws of Bancshares, which are incorporated by reference to Exhibit 3.2 of Bancshares’ Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the SEC on November 4, 2004 (SEC File No. 000-11448).
4.1
Specimen certificate of common stock, $5.00 par value, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-1 (SEC File No. 2-99312).
4.2
Rights Agreement dated as of February 10, 1998 by and between Bancshares and Wachovia Bank, N.A., as Rights Agent, which is incorporated by reference to Exhibit 1 of Bancshares’ Registration Statement on Form 8-A filed with the SEC on March 6, 1998 (SEC File No. 000-11448).
10.1*
1994 Director Stock Option Plan of Bancshares, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on July 15, 1994 (SEC File No. 33-81664).
10.2*
1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1995 filed with the SEC on March 28, 1996 (SEC File No. 000-11448).
10.3*
Amendment Number 1 to 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 4.5 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on May 16, 2001 (SEC File No. 333-61046).
10.4*
Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Appendix VI of Bancshares’ 2003 Proxy Statement filed with the SEC on March 16, 2004 (SEC File No. 000-11448).
10.5*
Form of Stock Option Award Agreement for a Director adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).
10.6*
Form of Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).
10.7*
Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 29, 2004 (SEC File No. 000-11448).
10.8*
Employment Continuity Agreement effective as of December 24, 1997 between Bancshares and Nicholas A. Daves, which is incorporated by reference to Exhibit 10.8 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).
10.9*
Employment Continuity Agreement effective as of June 9, 1998 between Bancshares and Suzanne J. Bullotta, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1998 filed with the SEC on March 25, 1999 (SEC File No. 000-11448).
10.10*
Employment Continuity Agreement effective as of October 15, 2001 between Bancshares and M. Jack Smith, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).
10.11*
Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert F. Lowe, which is incorporated by reference to Exhibit 10.7 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).
10.12*
Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Monty J. Oliver and H. Franklin Sherron, Jr. with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.8 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).
10.13*
Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Kathy V. Richardson with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.9 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).
10.14*
Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert E. Lineback, Jr. and Philip G. Gibson with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).
10.15*
Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Ronald E. Coleman, D. Gerald Sink, Robin A. Huneycutt and Ronald W. Sink with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.11 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).
10.16*
Employment Continuity Agreement effective as of August 16, 2004 between Bancshares and David P. Barksdale, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).
10.17*
Employment Continuity Agreement effective as of December 22, 2004 between Bancshares and Andrew G. McDowell, which is incorporated by reference to Exhibit 10.17 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).
10.18*
Restated Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).
10.19*
Form of Stock Appreciation Rights Award Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).
10.20*
Bancshares’ Management Incentive Plan, which is incorporated by reference to Exhibit 99.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).
10.21*
2006 Director Compensation Schedule of Bancshares and Lexington State Bank, which is incorporated by reference to Exhibit 99.4 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).
10.22*
April 11, 2005 Amendment to Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).
10.23*
Form of Amendment to the applicable Grant Agreements under the 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).
10.24*
Form of Amendment to the Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).
10.25
Agreement and Plan of Merger by and between Bancshares and FNB Financial Services Corporation, which is incorporated by reference as Exhibit 2.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on February 27, 2007 (SEC File No. 000-11448).
10.26
Agreement and Plan of Bank Merger by and between FNB Southeast, Lexington State Bank, Bancshares and FNB Financial Services Corporation, which is incorporated by reference as Exhibit 2.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on February 27, 2007 (SEC File No. 000-11448).
21+
List of Subsidiaries at December 31, 2006.
23+
Consent of Turlington and Company, L.L.P.
31.1+
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2+
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32+
Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*
Indicates a management contract or compensatory plan, contract or arrangement.
+
Indicates the exhibit is being filed herewith.
[SIGNATURES BEGIN ON THE NEXT PAGE]
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX