ITEM 1. BUSINESS
GENERAL
Franklin Finance Corporation ("Company") is a Michigan corporation incorporated on September 25, 1997, and created for the purpose of acquiring and holding real estate mortgage assets. The Company elected to be treated as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended ("Code"), and generally will not be subject to Federal income tax to the extent that it distributes its earnings to its shareholders and maintains its qualification as a REIT. All of the shares of the Company's common stock, par value $300.00 per share ("Common Stock"), are owned by Franklin Bank, N.A., a nationally chartered and federally insured national bank ("Bank"). The Company was formed by the Bank to provide the Bank with a cost-effective means of raising capital.
On December 22, 1997, the Company offered to the public and sold 2,070,000 shares of the Company's 8.70% noncumulative exchangeable preferred stock, Series A, liquidation preference $10.00 per share ("Series A Preferred Shares"). On or after December 22, 2002, the Series A Preferred shares may be redeemed for cash at the option of the Company, in whole or in part, at any time and from time to time at redemption price of $10.00 per share, plus the accrued and unpaid dividends for the most recent quarter, if any, thereon. Simultaneous with the consummation of the preferred stock offering, the Bank purchased Common Stock in the amount of $20.9 million, net of offering costs.
The Company used the net proceeds raised from the initial public offering of the Series A Preferred Shares and the sale of the Common Stock in the Bank to purchase from the Bank the Company's initial portfolio of $41.5 million residential and commercial mortgage loans ("Mortgage Loans") at their estimated fair value.
The Company's principal executive office is located at 24725 Twelve Mile Road, Southfield, Michigan 48034. The Company's telephone number at such address is (248) 358-4710.
The Company's principal business is to acquire, hold and manage mortgage loans that will generate net income for distribution to shareholders. The Company currently acquires all of its mortgage loans from the Bank, consisting of whole loans secured by first mortgages or deeds of trust on single-family (one-to-four-unit) residential real estate properties ("Residential Mortgage Loans") or by commercial real estate properties consisting of retail strip centers, multi-family residential rental properties, warehouse, industrial and office center properties ("Commercial Mortgage Loans"). The Company also from time to time acquires investment grade mortgage securities that qualify as real estate assets under Section 856(c)(6)(B) of the Internal Revenue Code of 1986, as amended ("Code"). Mortgage loans underlying the mortgage securities are secured by single-family residential, multifamily, or commercial real estate properties located in the United States.
The Company's policy is not to acquire any commercial mortgage loan if such commercial mortgage loan constitutes more than 5% of the total book value of the Mortgage Loans of the Company at the time of its acquisition. The Company's policy also prohibits the acquisition of any mortgage loan or any interest in a Mortgage Loan (other than an interest resulting from the acquisition of Mortgage securities), which mortgage loan (i) is delinquent in the payment of principal or interest: (ii) is or was at any time during the preceding 12 months (a) classified, (b) in nonaccrual status, or (c) renegotiated due to financial deterioration of the borrower; or (iii) has been, more than once during the preceding 12 months, more than 30 days past due in the payment of principal or interest. Loans that are in nonaccrual status are generally loans that are past due 90 days or more in principal or interest and classified loans are troubled loans which are deemed substandard or doubtful and where the full collectibility of principal and interest on such loan is doubtful.
Substantially all of the real estate properties underlying the Company's Residential Mortgage Loans and all of the commercial properties underlying the Company's Commercial Mortgage Loans included in the current portfolio are located in Michigan. Consequently, these Mortgage Loans may be subject to a greater risk of default than other comparable mortgage loans in the event of adverse economic, political or business developments and natural hazards in Michigan that may affect the ability of property owners in Michigan to make payments of principal and interest on the underlying mortgages.
Mortgage-backed securities represent an ownership interest in mortgage loans by financial institutions such as savings and loans, commercial banks or mortgage companies to finance the borrowers purchase of a home or other real estate.
The majority of Mortgage-backed securities are issued and/or guaranteed by an agency of the U.S Government, the Government National Mortgage Association ("GNMA"), or by government-sponsored enterprises such as the Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). GNMA is a government-owned corporation within the Department of Housing and Urban Development.
Issuers of mortgage-backed securities are typically very selective in choosing the mortgages that make up their pools. Beyond the basic security of the mortgage loans themselves, mortgage-backed securities issued by GNMA, FNMA and FHLMC carry additional guarantees, which enhance their credit worthiness. These guarantees pertain to the timely payment of principal and interest.
Unlike GNMA's guarantee, neither FNMA's nor FHLMC's guarantees are backed by the full faith and credit of the U.S. Government. However, the credit markets consider the securities of these two entities to be nearly equivalent to those issued by agencies which have the full faith and credit guarantee. Thus, they carry an implied AAA rating.
The mortgage-backed securities owned by the Company at December 31, 2001 were issued by FNMA and FHLMC.
TAX STATUS OF THE COMPANY
The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 1997. As a REIT, the Company generally will not be subject to Federal income tax on its net income (excluding capital gains) provided that it distributes annually 90 (95% in taxable years prior to January 1, 2001) of its REIT taxable income to its shareholders, and meets certain organizational, stock ownership and operational requirements. If in any taxable year the Company fails to qualify as a REIT, the Company would not be allowed a deduction for distributions to shareholders in computing its taxable income and would be subject to Federal and state income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. In addition, the Company would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost.
The Company does not anticipate that it will engage in the business of originating mortgage loans and does not expect to compete with mortgage conduit programs, investment banking firms, savings and loan associations, banks, mortgage bankers, thrift and loan associations, finance companies, or insurance companies in acquiring its mortgage loans. As described above, the Company anticipates that it will purchase all mortgage loans from the Bank.
EMPLOYEES
The Company has one officer. The officer of the Company is also an officer of the Bank. The Company does not anticipate that it will require any additional employees because it has retained the Bank to perform certain functions pursuant to an Advisory Agreement ("Advisory Agreement").
THE ADVISOR
On December 22, 1997, the Company entered into an Advisory Agreement with the Bank to administer the day-to-day operations of the Company,(i) monitoring the credit quality of the mortgage loans held by the Company, (ii) advising the Company with respect to the acquisition, management, financing and disposition of the Company's mortgage loans and (iii) maintaining custody of the documents related to the Company's mortgage loans. The Advisory Agreement has an initial term of five years, and will be renewed automatically
for additional five-year periods unless notice of nonrenewal is delivered to the Bank by the Company. The Bank will be entitled to receive an annual advisory fee equal to $125,000 with respect to the advisory and management services provided by it to the Company.
The Company also entered into two servicing agreements with the Bank to service the Residential Mortgage Loans and Commercial Mortgage Loans. Pursuant to each servicing agreement the Bank receives a fee equal to .375% per annum on the principal balances of the mortgage loans serviced.
The servicing agreements require the mortgage loans to be serviced in a manner generally consistent with accepted secondary market practices, with any servicing guidelines promulgated by the Company and, in the case of Residential Mortgage Loans, with FNMA and FHLMC guidelines and procedures. The servicing agreements can be terminated without cause with at least thirty days notice to the Bank and payment of a termination fee.
The Company intends to operate in a manner that will not subject it to regulation under the Investment Company Act of 1940. The Company may, under certain circumstances, purchase the Series A Preferred Shares and other shares of its capital stock in the open market or otherwise, provided, however, that the Company will not redeem or repurchase any shares of its Common Stock for so long as any Series A Preferred Shares are outstanding without the approval of a majority of the Independent Directors (as defined in the Certificate of Designation relating to the Series A Preferred Shares). The Company has no present intention of causing the Company to repurchase any shares of its capital stock, and any such action would be taken only in conformity with applicable federal and state laws and regulations and the requirement for qualifying as a REIT.
The Company currently intends to make investments and operate its business at all times in such a manner as to be consistent with the requirements of the Code to qualify as a REIT. However, future economic, market, legal, tax or other considerations may cause the Board of Directors, subject to approval by a majority of independent directors, to determine that it is in the best interest of the Company and its shareholders to revoke its REIT status. As of December 31, 2001, management of the Company believes that it was in full compliance with the REIT tax rules and that it will continue to qualify as a REIT under the provisions of the Code.
The Company has no foreign operations.
ITEM 2.
ITEM 2. PROPERTIES
None.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not the subject of any material litigation. None of the Company, the Bank or any affiliate of the Bank is currently involved in nor, to the Company's knowledge, is currently threatened with any material litigation with respect to the mortgage loans included in the Company's portfolio which litigation would have a material effect on the business or operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
GENERAL
The Company is authorized to issue up to 60,000 shares of common stock, $300.00 par value per share, and 2,500,000 shares of Preferred Stock, $10.00 liquidation preference per share. Preferred Stock totaling 2,070,000 shares have been issued as the Series A Preferred Shares. The Bank owns 100% of the Company's 22,077 shares of Common Stock outstanding at December 31, 2001 and accordingly, there is no trading market for the Common Stock.
In addition, the Bank intends that, as long as any Series A Preferred Shares are outstanding, it will maintain ownership of the outstanding Common Stock of the Company. Subject to the rights, if any, of the holders of the Series A Preferred Shares, all voting rights are vested in the Common Stock. The holders of the Common Stock are entitled to one vote per share.
Holders of Common Stock are entitled to receive dividends when, as and if declared by the Board of Directors of the Company out of funds legally available therefore, provided that, so long as any shares of Preferred Shares are outstanding, no dividends or other distributions (including redemptions and purchases) may be made with respect to the Common Stock unless full dividends on the shares of all series of Preferred Stock have been paid for the prior four quarters. In order to remain qualified as a REIT, the Company must distribute annually at least 95% of its annual "REIT Taxable Income" (not including capital gains) to shareholders.
In the event of the liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, after there have been paid or set aside for the holders of all series of Preferred Stock the full preferential amounts to which such holders are entitled, the holders of Common Stock will be entitled to share equally and ratable in any assets remaining after the payment of all debts and liabilities.
RESTRICTIONS ON OWNERSHIP AND TRANSFER
The Company's Articles of Incorporation contain certain restrictions on the number of shares of Common Stock and Preferred Stock that individual shareholders may own. For the Company to qualify as a REIT under the Code, no more that 50% in number or value of its outstanding shares of capital stock my be owned, directly or indirectly, by five or fewer individuals (as defined in the Code to include certain entities) during the last half of a taxable year (other that the first year) or during a proportionate part of a shorter taxable year (the "Five or Fewer Test"). The capital stock of the Company must also be beneficially owned by 100 or more persons during at least 335 days of a taxable year or during a proportionate part of a shorter taxable year (the "one Hundred Persons Test"). The ownership by the Bank of 100% of the shares of Common Stock of the REIT will not adversely affect the Company's REIT qualification because each shareholder of the Bank counts as a separate beneficial owner for purposes of the Five or Fewer Test and the capital stock of the Bank is widely held. Further, the Articles of Incorporation of the Company contain restrictions on the acquisition of Preferred Stock intended to ensure compliance with the One Hundred Persons Test. Such provisions include a restriction that if any transfer of shares of capital stock of the Company would cause the Company to be beneficially owned by fewer that 100 persons, such transfer shall be null and void and the intended transferee will acquire no rights to the stock.
COMMON STOCK
There is no established public trading market in the Company's Common Stock. As of March 26, 2002, there were 22,077 issued and outstanding shares of Common Stock held by one shareholder, the Bank. On December 31, 2001, 2000 and 1999, the Company declared a cash dividend of $58.49, $47.40 and $30.18 per common share of Common Stock to the shareholders of record on December 31, 2001, 2000 and 1999, respectively. The dividends' were paid on January 31, 2002, 2001 and 2000, respectively.
PREFERRED STOCK
The Series A Preferred Shares are listed on the Nasdaq Bulletin Board under the trading symbol "FSVBP". As of March 22, 2002, there were 2,070,000 issued and outstanding Series A Preferred Shares held by approximately 76 holders of record, which excludes preferred shares held in street name. The following table reflects the respective high and low sales prices for the Series A Preferred Shares for the years ended December 31, 2001 and 2000. The table also indicates the dividends paid by the Company during 2001 and 2000.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Company herein has been derived from the Financial Statements of the Company, which statements have been audited by Grant Thornton LLP, independent certified public accountants, as indicated by their report with respect thereto included elsewhere in this form 10-K. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Financial Statements included in this form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
RESIDENTIAL MORTGAGE LOANS. At December 31, 2001 and 2000, the Company had $10.2 million and $11.2 million, respectively, invested in Residential Mortgage Loans. The decrease is due to repayments of mortgage loans in 2001. The Company reinvested a portion of the proceeds recovered from the repayment of Residential Mortgage Loans and Commercial Mortgage Loans into additional fixed rate Commercial Mortgage Loans.
At December 31, 2001 and 2000, there were no delinquent or nonaccrual Residential Mortgage Loans.
COMMERCIAL MORTGAGE LOANS. At December 31, 2001 and 2000, the Company had $22.9 million and $15.7 million, respectively, invested in Commercial Mortgage Loans. The net increase is due to the purchase of $9.9 million during 2001, along with principal paydowns of $2.7 million during 2001. The Company reinvested the proceeds recovered from the repayment of Commercial Mortgage Loans into new Commercial Mortgage Loans.
The following table reflects the composition of Mortgage Loans at December 31, 2001 and 2000;
Of the Residential Mortgage Loans included in the Residential Portfolio; approximately 47.01% and 60.30% bear interest at fixed rates as of December 31, 2001 and 2000, respectively. The interest rates of the fixed rate Residential Mortgages Loans included in the Residential Portfolio range from 6.50% per annum to 10.49% per annum as of December 31, 2001 and 6.00% per annum to 10.49% per annum as of December 31, 2000. The weighted average interest rate of the fixed rate Residential Mortgage Loans included in the Residential Portfolio was approximately 7.94% and 7.74% as of December 31, 2001 and 2000, respectively. The following table contains certain additional data as of December 31, 2001 and 2000, with respect to the interest rates of the fixed rate Residential Mortgage Loans included in the Residential Portfolio.
INTEREST RATE OF FIXED RATE RESIDENTIAL MORTGAGE LOANS
Of the Residential Mortgage Loans included in the Residential Portfolio, approximately 52.99% and 39.70% bear interest at adjustable rates as of December 31, 2001 and 2000, respectively. The interest rates on the "adjustable rate mortgages" or "ARMs" contained in the Residential Portfolio are all tied to the one-year Treasury Index (defined below) ("One-Year ARM"), and adjust periodically. ARMs are typically subject to limitations on lifetime interest rates as well as periodic interest rate adjustments. The current interest rates of the Residential Mortgage Loans included in the Residential Portfolio that are ARMs ranged from 4.13% per annum to 9.50% per annum as of December 31, 2001 and 4.00% per annum to 9.99% per annum as of December 31, 2000. As of December 31, 2001 and 2000, the weighted average current interest rate of the Residential Mortgage Loans included in the Residential Portfolio that are ARMs was approximately 6.60% per annum and 8.40% per annum, respectively. The following table contains certain additional data as of December 31, 2001 and 2000 with respect to the interest rates of the Residential Mortgage Loans included in the Residential Portfolio that are ARMs:
INTEREST RATE OF VARIABLE RATE RESIDENTIAL MORTGAGE LOANS
The following tables set forth certain information with respect to each type of Residential Mortgage Loan included in the Residential Portfolio:
TYPE OF RESIDENTIAL MORTGAGE LOANS
Of the Commercial Mortgage Loans included in the Commercial Portfolio, approximately 78.82% and 77.33% bear interest at fixed rates as of December 31, 2001 and 2000, respectively. The interest rates of the fixed rate Commercial Mortgage Loans included in the Commercial Portfolio range from 7.25% per annum to 12.75% per annum as of December 31, 2001 and 7.00% per annum to 12.99% per annum as of December 31, 2000. The following tables contain certain additional data with respect to the interest rates of the fixed rate Commercial Mortgage Loans included in the Commercial Portfolio (including those variable rate Commercial Mortgage Loans that have been converted, pursuant to their terms, to fixed rates):
INTEREST RATE OF FIXED RATE COMMERCIAL MORTGAGE LOANS
Of the Commercial Mortgage Loans included in the Commercial Portfolio, as of December 31, 2001 and 2000, 21.18% and 22.67%, respectively, bear interest at variable rates which are typically tied to an index (such as the Bank's Prime Rate or the U.S. Treasury Index adjusted for a constant maturity of either one year or three years) and are adjustable periodically. The current interest rates borne by the variable rate Commercial Mortgage Loans included in the Commercial Portfolio ranged from 5.00% per annum to 8.00% per annum as of December 31, 2001 and 5.00% per annum to 11.49% per annum as of December 31, 2000. The following table contains certain additional data as of December 31, 2001 and 2000 with respect to the interest rates of the variable rate Commercial Mortgage Loans included in the Commercial Portfolio:
INTEREST RATE OF VARIABLE RATE COMMERCIAL MORTGAGE LOANS
The following tables set forth certain information with respect to each type of commercial property underlying each Commercial Mortgage Loan included in the Commercial Portfolio as of December 31, 2001 and 2000:
TYPE OF COMMERCIAL MORTGAGE LOAN
MORTGAGE-BACKED SECURITIES. At December 31, 2001 and 2000, the Company had $9.3 million and $15.5 million, respectively, invested in mortgage-backed securities. The decrease in 2001 and 2000 is due to the Company's reinvestment of mortgage-backed securities repayments into new mortgage loans. The weighted average maturity of these investments at December 31, 2001 and 2000 are 1.87 years and 2.69 years with a yield of 6.30% and 6.83%, respectively.
INTEREST RATE RISK. The Company's income consists primarily of interest payments on mortgage loans. Currently, the Company does not use any derivative products or manage its interest rate risk. If there is a decline in interest rates (as measured by the indices upon which the interest rates of the adjustable rate mortgage loans are based), then the Company will experience a decrease in income available to be distributed to its shareholders. There can be no assurance that an interest rate environment in which there is a significant decline in interest rates, over an extended period of time, would not adversely affect the Company's ability to pay dividends on the Series A Preferred Shares.
SIGNIFICANT CONCENTRATION OF CREDIT RISK. Concentration of credit risk arises when a number of customers engage in similar business activities, or activities in the same geographical region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Concentration of credit risk indicates the relative sensitivity of the Company's performance to both positive and negative developments affecting a particular industry.
Geographically, the Company's Mortgage Loans are generally located in Michigan. Geographic concentration of loans may present risks in addition to those present with respect to Mortgage Loans generally. Mortgage Loans secured by properties located in Michigan may be subject to a greater risk of default than other comparable mortgage loans in the event of adverse economic, political or business developments or natural hazards that may affect Michigan and the ability of property owners in Michigan to make payments of principal and interest on the underlying mortgages.
LIQUIDITY AND CAPITAL RESOURCES. The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company's financial commitments. In managing liquidity, the Company takes into account various legal limitations and requirements placed on a REIT.
The Company's principal liquidity needs are to maintain the current portfolio size through the acquisition of additional mortgage loans as Mortgage Loans currently in the portfolio mature or prepay and to pay dividends on the Series A Preferred Shares. The acquisition of additional mortgage loans is intended to be funded with the proceeds obtained from repayment of principal balances by the individual mortgagees. The Company does not have and does not anticipate having any material capital expenditures.
To the extent that the Board of Directors determines that additional funding is required, the Company may raise such funds through additional equity offerings, debt financing or retention of cash flows (after consideration of provisions of the Code requiring the distribution by a REIT of at least 90 (95% in taxable years prior to January 1, 2001) of its "REIT taxable income" and taking into account taxes that would be imposed on undistributed income), or a combination of these methods, subject to certain approvals as described in the Company's organizational documents.
RESULTS OF OPERATIONS
For the years ended December 31, 2001, 2000 and 1999, the Company reported net income available to common shareholders of $1.3 million, $1 million and $666,347, respectively. Interest income on Residential Mortgage Loans totaled $837,622, $887,819, and $923,300 for the years ended December 31, 2001, 2000 and 1999, respectively, which represents an average yield on such loans of 7.84%, 7.89%, and 7.26% respectively. Interest income on Commercial Mortgage Loans totaled $1.5 million, $1.2 million and $969,145 for the years ended December 31, 2001, 2000, and 1999, respectively, which represents an average yield on such loans of 7.65%, 8.62%, and 8.38%, respectively. Interest income on mortgage-backed securities totaled $932,186, $1.0 million and $850,352 for the years ended December 31, 2001, 2000 and 1999, respectively. The yield on mortgage-backed securities for the year-end December 31, 2001, 2000 and 1999 were 6.30%, 6.43% and 6.10%, respectively. The average loan balance of the Residential Mortgage Loan portfolio for the years ended December 31, 2001 and 2000 was $310,024 and $82,691, respectively. The average loan balance of the Commercial Mortgage Loan portfolio for the years ended December 31, 2001 and 2000 was $1.5 million and $1.2 million, respectively.
Operating expenses totaled $325,128, 283,845 and $296,127, respectively, for the years ended December 31, 2001, 2000 and 1999.
QUARTERLY SUMMARY OF SELECTED FINANCIAL DATA
The following tables set forth a quarterly summary of selected financial data:
QUARTERLY SUMMARY OF SELECTED FINANCIAL DATA (UNAUDITED)
QUARTERLY SUMMARY OF SELECTED FINANCIAL DATA (UNAUDITED) (CONTINUED)
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company considers that its primary business objective is to ensure the availability of sufficient cash flows to meet the obligations mandated by the Series A Preferred Shares. In managing its investments, the Company accepts a certain credit risk posture and assumes some interest rate risk.
Interest rate risk generally refers to the potential volatility in net interest income resulting from changes in interest rates. The Company's risk occurs when it must replace amortized loans with current production mortgages. These replacement loans are chosen in a manner to maintain an interest rate risk posture similar to the Initial Portfolio. The Company must monitor the ratio of fixed costs (the Series A Preferred Shares' dividends, advisory fees, and servicing fees) to the interest income potential of the Mortgage Loans. When, in management's opinion, the coverage ratio is at risk of being depleted, the Company must look to its parent company, the Bank, for support or utilize the investment powers of the Company.
The Company will generally record higher levels of interest income in a rising interest rate environment and will experience declining interest income during periods of falling interest rates.
At December 31, 2001 the Company had a coverage ratio (Net income divided by REIT Preferred stock dividends) of 1.72 compared to 1.58 and 1.37 at December 31, 2000 and 1999, respectively.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors and Shareholders of Franklin Finance Corporation:
We have audited the accompanying statements of financial condition of Franklin Finance Corporation as of December 31, 2001 and 2000, and the related statements of income, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Franklin Finance Corporation as of December 31, 2001 and 2000, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
/s/ Grant Thornton LLP - ------------------------- Grant Thornton LLP Southfield, Michigan January 24, 2002
FRANKLIN FINANCE CORPORATION STATEMENTS OF FINANCIAL CONDITION
The accompanying notes are an integral part of these financial statements.
FRANKLIN FINANCE CORPORATION STATEMENTS OF INCOME
FRANKLIN FINANCE CORPORATION STATEMENTS OF COMPREHENSIVE INCOME
The accompanying notes are an integral part of these financial statements.
FRANKLIN FINANCE CORPORATION STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
FRANKLIN FINANCE CORPORATION STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
FRANKLIN FINANCE CORPORATION NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 2001, 2000 and 1999
NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION:
Franklin Finance Corporation (the "Company") is a Michigan corporation which was incorporated on September 25, 1997 and created for the purpose of acquiring and holding real estate mortgage assets. The Company is a wholly-owned subsidiary of Franklin Bank, N.A. (the "Bank"), a nationally chartered commercial bank.
On September 25, 1997, the Company was initially capitalized with the issuance to the Bank of 1,000 shares of the Company's common stock (the "Common Stock"), $1.00 par value. On December 22, 1997, the Company commenced its operations upon consummation of an initial public offering of 2,070,000 shares of the Company's 8.70% Noncumulative Preferred Stock, Series A (the "Series A Preferred Shares"), $10.00 liquidation preference. These offerings, together with a separate capital contribution made by the Bank on December 22, 1997, raised net capital of $42.0 million.
The Company used the proceeds from the initial public offering of the Series A Preferred Shares, the sale of Common Stock to the Bank and the additional capital contribution to the Company by the Bank to pay the expenses related to the offering and the formation of the Company and to purchase from the Bank the Company's initial portfolio of residential and commercial mortgage loans.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The following summarizes the significant accounting policies of the Company.
RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS:
Mortgage loans are carried at the principal amount outstanding. Interest income is accrued and recognized using the interest method or on a basis approximating a level rate of return over the term of the loan.
Loans are reviewed on a monthly basis and are placed on non-accrual status when, in the opinion of management, the full collection of principal or interest has become unlikely. Uncollectible accrued interest receivable on non-accrual loans is charged against current period income. The Company had no non-accrual loans at December 31, 2001 and 2000.
ALLOWANCE FOR LOAN LOSSES:
Management periodically reviews the mortgage loan portfolio to establish an allowance for loan losses if deemed necessary. An allowance is provided after considering such factors as the economy in lending areas, delinquency statistics, past loss experience and estimated future losses. The allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates. As adjustments to the allowance become necessary, provisions for loan losses are reported in operations in the periods they are determined to be necessary.
MORTGAGE-BACKED SECURITIES
Mortgage-backed securities purchased by the Company are classified as available for sale and carried at fair market value. Unrealized gains and losses on available for sale securities are excluded from income and recorded as an amount in a separate component of other comprehensive income or loss until realized.
CONCENTRATIONS OF CREDIT:
Substantially all of the real estate properties underlying the Company's Mortgage Loans are located in Michigan. Consequently, these Mortgage Loans may be subject to a greater risk of default than other comparable Mortgage Loans in the event of adverse economic, political or business developments and natural hazards in Michigan that may affect the ability of residential property owners in Michigan to make payments of principal and interest on the underlying mortgages.
DUE FROM PARENT COMPANY:
Due from parent company represents principal and interest payments received from borrowers by the Bank as servicer of the mortgage loans which are being held by the servicer in a custodial account pending remittance to the Company.
DIVIDENDS:
Preferred Stock. Dividends on the Series A Preferred Shares are payable at a rate of 8.70% per annum of the liquidation preference (an amount equal to $0.87 per annum per share), if, when and as declared by the Board of Directors of the Company. Dividends are not cumulative and, if declared, are payable quarterly in arrears on March 31, June 30, September 30 and December 31.
Common Stock. The shareholder is entitled to receive dividends when, as and if declared by the Board of Directors out of funds legally available after all preferred dividends have been paid.
INCOME PER COMMON SHARE:
Income per common share is computed by dividing net income after preferred dividends by the weighted average number of common shares outstanding. There are no dilutive securities which would require a diluted earnings per share computation. The Company had 22,077 weighted average common shares outstanding during 2001, 2000 and 1999.
RECLASSIFICATIONS:
Certain reclassifications have been made to the 2000 and 1999 accounts to conform to the 2001 presentation.
INCOME TAXES:
The Company has elected for Federal income tax purposes to be treated as a Real Estate Investment Trust ("REIT") and intends to comply with the provisions of the Internal Revenue Code of 1986 (the "IRC"), as amended. Accordingly, the Company will not be subject to Federal corporate income taxes to the extent it distributes 90% of its REIT taxable income to shareholders and as long as certain asset, income and stock ownership tests are met in accordance with the IRC. During the periods ended December 31, 2001, 2000 and 1999, the Company distributed 100% of its taxable income. Because the Company believes it qualifies as a REIT for Federal income tax purposes, no provision for income taxes is included.
USE OF ESTIMATES:
The financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the date of the statement of financial condition and income and expenses for the reporting period. Actual results could differ from those estimates.
ISSUED BUT NOT YET ADOPTED ACCOUNTING STANDARDS:
In June of 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141, "Business Combinations." Statement 141 requires that the purchase method of accounting be used for business combinations initiated after June 30, 2001. In June of 2001, the FASB also issued Statement No. 142, "Goodwill and Other Intangible Assets" which is effective generally beginning January 1, 2002. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized but, instead, tested for impairment at least annually in accordance with the provisions of Statement 142. The Company has no goodwill at December 31, 2001 or 2000; therefore, the adoption of these statements is not expected to impact the Company's results of operations or financial position.
In June of 2001, the FASB issued Statement No. 143, "Accounting for Asset Retirement Obligations." Statement 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes the cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period and the capitalized cost is depreciated over the remaining useful life of the related asset. Upon settlement of the liability, the entity either settles the obligation for the amount recorded or incurs a gain or loss. Statement 143 is effective for fiscal years beginning after June 15, 2002. Adoption of this statement is not expected to impact the Company's results of operations or financial position.
In August of 2001, the FASB issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Statement 144 supersedes certain previously issued accounting pronouncements. The statement was issued to establish a single accounting model for long-lived assets to be disposed of by sale. It broadens the presentation of discontinued operations in the income statement to include a component of an entity (rather than a segment of a business). A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Statement 144 also requires that discontinued operations be measured at the lower of the carrying amount or fair value less cost to sell. The statement is effective prospectively for fiscal years beginning after December 15, 2001 and will only impact the Company if future transactions occur that involve disposal of long-lived assets.
NOTE 3 - RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS:
The following reflects the composition of the Company's Mortgage Loans:
The properties collateralizing the Company's Commercial Mortgage Loans consist of retail strip centers, multi-family residential rental properties, warehouse, industrial and office center properties located in Michigan.
NOTE 4 -- MORTGAGE-BACKED SECURITIES
The amortized cost and estimated fair value of the mortgage-backed securities available for sale at December 31, 2001 and 2000 are shown below.
The scheduled maturities of available for sale securities at December 31, 2001 were as follows:
There were approximately $4.2 million and $0 pledged securities carried at December 31, 2001 and 2000, respectively.
NOTE 5 - RELATED PARTY TRANSACTIONS:
The Company has entered into an advisory agreement (the "Advisory Agreement") with the Bank. The Bank provides advice to the Board of Directors and manages the operations of the Company as defined in the Advisory Agreement. The Advisory Agreement has an initial term of five years which began on December 22, 1997 and will automatically renew for additional five-year periods unless the Company delivers a notice of nonrenewal to the Bank. The Advisory Agreement may be terminated by the Company at any time upon ninety days' prior written notice. The advisory fee is $125,000 per annum payable in equal quarterly installments.
The Company also entered into servicing agreements with the Bank for the servicing of its residential mortgage loans and its commercial mortgage loans (the "Servicing Agreements"). Pursuant to the Servicing Agreements, the Bank performs the servicing of the residential and commercial mortgage loans owned by the Company, in accordance with normal industry practice. The Servicing Agreements can be terminated without cause with at least thirty days notice to the Bank and payment of a termination fee. The servicing fee rate is .375% of the outstanding principal balance of the residential and commercial mortgage loans.
The Company has cash balances of $328,566 and $12,666 as of December 31, 2001 and 2000, respectively, held in deposit accounts with the Bank.
From time to time the Company may pledge loans and mortgage-backed securities to the extent they exceed $20.7 million as collateral for short term borrowings of the Bank.
NOTE 6 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS:
The majority of the Company's assets and liabilities are financial instruments; however, certain of these financial instruments lack an available trading market. Significant estimates, assumptions and present value calculations were therefore used for the purposes of deriving the Company's fair values, resulting in a great degree of subjectivity inherent in the indicated fair value amounts. Since the fair value is estimated as of the balance sheet date, the amount, which will actually be realized or paid upon settlement or maturity could be significantly different. Comparability among REITs may be difficult due to the wide range of permitted valuation techniques and the numerous estimates and assumptions which must be made.
The following methods and assumptions were used to estimate the fair value amounts at December 31, 2001 and 2000.
CASH AND DUE FROM BANK: Carrying amount approximates fair value.
RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS: Fair value of the residential and commercial mortgage loans is estimated using discounted cash flow analyses based on contractual repayment schedules. The discount rates used in these analyses are based on either the interest rates paid on U.S. Treasury securities of comparable maturities adjusted for credit risk and non-interest operating costs, or the interest rates currently offered for loans with similar terms to borrowers of similar credit quality. The carrying amount reflected on the balance sheet at December 31, 2001 and 2000 are at cost. The approximate fair value of the total loans at December 31, 2001 and 2000 were $34.4 million and $26.6 million, respectively.
MORTGAGE-BACKED SECURITIES: For securities available for sale, fair values are based on quoted market prices or dealer quotes.
OTHER FINANCIAL ASSETS: The carrying amounts of due from parent company and accrued interest receivable approximate fair value.
FINANCIAL LIABILITIES: The carrying amounts of dividends payable - common and dividends payable - preferred approximate fair value.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The persons who are directors and executive officers of the Company are as follows:
Name Age Position and Offices Held
Robert M. Walker 58 Director Lloyd A. Schwartz 73 Director David L. Shelp 55 Director and President and CEO David F. Simon 55 Director and Secretary
The following is a summary of the experience of the executive officers and directors of the Company:
Robert M. Walker, age 58, is a certified public accountant and certified fraud examiner. He has over 29 years of experience in public accounting, financial and management consulting, and the financial services industry. Mr. Walker is a member of the Company's Audit Committee.
Lloyd A. Schwartz, age 73, is a certified public accountant and has served as the Deputy Receiver/Rehabilator of two Michigan-based insurance companies since 1993. Mr. Schwartz has also served as a Technical Reviewer for the Michigan Association of Certified Public Accountants peer review program since 1990. Prior to 1990, Mr. Schwartz was a partner with the accounting firm of Coopers & Lybrand, LLP. Mr. Schwartz is a member of the Company's Audit Committee.
David L. Shelp, age 55, President and CEO of the Bank since November 2001, had been the Treasurer of the Bank since its inception in 1983. Mr. Shelp was an Assistant Treasurer of another financial institution in Lansing, Michigan from 1975 to 1981 and its Controller from 1981 to 1983. Mr. Shelp is a member of the Company's Credit Committee.
David F. Simon, age 55, is Chairman of the Board of the Bank and has held this position since its inception in 1983. Mr. Simon is a member of the Company's Credit Committee. He formerly was an attorney in private practice specializing in securities and financial institutions law from 1971 to 1991.
INDEPENDENT DIRECTORS
The Company's Certificate of Designation establishing the Series A Preferred Shares requires that, so long as any Series A Preferred Shares are outstanding, certain actions by the Company be approved by a majority of the Independent Directors of the Company. Messrs. Walker and Schwartz are the Company's only Independent Directors. For so long as there are only two Independent Directors, any action that requires the approval of a majority of the Independent Directors must be approved by both Independent Directors.
If at any time the Company fails to pay or declare and set aside for payment a quarterly cash dividend payment on the Series A Preferred shares, the number of directors constituting the Board of Directors of the Company will be increased by two at the
Company's next annual meeting and the holders of Series A Preferred Shares, voting together with the holder of any other outstanding series of Preferred Stock as a single class, will be entitled to elect two additional directors to serve on the Company's Board of Directors. Any member of the Board of Directors elected by holders of the Company's Preferred Stock will be deemed to be an Independent Director for purposes of the actions requiring the approval of a majority of the Independent Directors. Each director elected by the holders of shares of the Preferred Stock shall continue to serve as such director until the later of (i) the full term for which he or she shall have been elected or (ii) the payment of four quarterly dividends on the Preferred Stock, including the Series A Preferred Shares.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires the Company's officers, directors and persons who own more than ten percent of either the Common Stock or the Series A Preferred Shares to file reports of ownership on Form 3 and changes in ownership on Form 4 or 5 with the SEC. Such officers, directors and ten percent shareholders are also required by SEC rules to furnish the Company with copies of all Section 16(a) forms that they file.
Based solely on its review of copies of such reports received or representations from certain reporting persons, the Company believes that, during the fiscal year ended December 31, 2001, all of its officers, directors and ten percent shareholders complied with all Section 16(a) filing requirements applicable to them with respect to transactions during fiscal 2001.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Company pays only the Independent outside Directors a fee of $500 for attendance (in person or by telephone) at each meeting of the Board of Directors.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The Bank owns 100% of the Common Stock of the Company. All voting rights are vested in the Common Stock.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Set forth below are certain transactions between the Company and its directors and affiliates. Management believes that the transactions with related parties described herein have been conducted on substantially the same terms as similar transactions with unrelated parties. See Note 5 to the financial statements.
The Bank administers the day-to-day operations of the Company and is entitled to receive fees in connection with the Advisory Agreement. Advisory fees paid to the Bank for the period ended December 31, 2001, 2000 and 1999 totaled $125,000 for each year.
The Bank services the residential and commercial mortgage loans included in the Company's loan portfolio, and is entitled to receive fees in connection with the respective Servicing Agreements. The Company paid the Bank $115,886, $89,809 and $81,549, respectively, in servicing fees, for the period ended December 31, 2001, 2000 and 1999.
The Company had cash balances of $328,567 and $12,666 as of December 31, 2001 and 2000 held in deposit accounts with the Bank.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following financial statements of the Company are included in Item 8 of this report:
Report of Independent Certified Public Accountants
Statements of Financial Condition at December 31, 2001 and 2000
Statements of Income for the years ended December 31, 2001, 2000 and
Statements of Comprehensive Income for the years ended December 31, 2001, 2000 and 1999
Statements of Shareholders' Equity for the years ended December 31, 2001, 2000 and 1999
Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999
Notes to Financial Statements
(a)(2) All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and therefore have been omitted.
(a)(3) Exhibits: See Exhibit Index.
Sequential page number Exhibit where attached exhibits No. Document are located in the 10-K
3.1 Articles of Incorporation of the Company, as amended (incorporated herein by reference to Exhibit 3(a) of Form S-11 (file number 333-10495) filed by the company).
3.2 Bylaws of the Company (incorporated herein by reference to Exhibit 3(b) of Form S-11 (file number 333-10495)filed by the company).
4.1 Certificate of Designation of 8.70% Noncumulative Exchangeable Preferred Stock, Series A (incorporated herein by reference to Exhibit 3(a)(1) of Form S-11 (file number 333-10495)filed by the company).
10.1 Residential Mortgage Loan Purchase Agreement and Commercial Mortgage Loan Purchase Agreement (incorporated herein by reference to Exhibits 10.1 and 10.2 of Form S-11 (file number 333-10495)filed by the company).
10.2 Residential Mortgage Loan Servicing Agreement and Commercial Mortgage Loan Servicing Agreement (incorporated herein by reference to Exhibit 10.3 and 10.4 of Form S-11(file number 333-10495)filed by the company).
10.3 Advisory Agreement between the Company and the Bank (incorporated herein by reference to Exhibit 10.5 of Form S-11(file number 333-10495)filed by the company).
11 Computation of net income per common share.
12 Computation of ratio of income to fixed charges and Preferred Stock dividend Requirements.
(b) No reports on Form 8-K were issued during the year ended December 31, 2001
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, in Southfield, Michigan on March 28, 2002.
FRANKLIN FINANCE CORPORATION (Registrant)
By: /s/ David L. Shelp ----------------------------------------- President and CEO
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following officers and directors of the Registrant and in the capacities and on the dates indicated.
March 28, 2002 By: /s/ Lloyd A. Schwartz ----------------------------------------- Lloyd A. Schwartz Director
March 28, 2002 By: /s/ David L. Shelp ----------------------------------------- David L. Shelp Director, President and CEO
March 28, 2002 By: /s/ David F. Simon ----------------------------------------- David F. Simon Director and Secretary
March 28, 2002 By: /s/ Robert M. Walker ----------------------------------------- Robert M. Walker Director
EXHIBITS INDEX