ITEM 1. BUSINESS.
GENERAL
Tower Financial Corporation (the "Company") was incorporated as an Indiana corporation on July 8, 1998. The Company owns all of the issued and outstanding stock of Tower Bank & Trust Company (the "Bank") and is a bank holding company, and a financial holding company under the Federal Bank Holding Company Act of 1956, as amended. The Bank is an Indiana chartered bank with depository accounts insured by the Federal Deposit Insurance Corporation ("FDIC") and is a member of the Federal Reserve System.
The Bank provides a range of commercial and consumer banking services from six locations in market area comprised of the metropolitan area of Fort Wayne, Indiana. Those services reflect the Bank's strategy of focusing on small- to medium-sized businesses and individual customers. The Bank's lending strategy is focused on commercial loans and, to a lesser extent, on consumer and residential mortgage loans. The Bank offers a broad array of deposit products, including checking, savings, and money market accounts, certificates of deposit and direct deposit services. The Bank also provides personal trust services.
The Bank's main office is located at 116 East Berry Street in downtown Fort Wayne, Indiana, and serves as the Company's corporate headquarters.
EXPANSION
The bank has four branch locations and one mortgage loan production office. During 2004, the Bank opened its fourth branch on the south side of Fort Wayne, in Waynedale and its mortgage loan production office in Angola, Indiana.
PRIMARY LINES OF BUSINESS
Commercial Lending. The Bank's lending activities focus primarily on providing small- and medium-sized businesses in its market area with commercial loans. These loans are both secured and unsecured and are made available for general operating purposes, including acquisition of fixed assets including real estate, equipment and machinery, lines of credit collateralized by inventory and accounts receivable. Typically, the Bank's customers' financing requirements range from $100,000 to $2.0 million. Approximately 39.6% of the Bank's commercial loans are commercial real estate loans secured by a first lien on the commercial real estate. The majority of commercial loans that are not mortgage loans are secured by a lien on equipment, inventory and/or other assets of the commercial borrower. Commercial loans may also be further secured by junior liens on real estate. The Bank's commercial loans have both fixed and floating interest rates and typically have maturities of 1 to 5 years. Commercial and commercial real estate loans comprised approximately 78.5% of the Bank's total loan portfolio at December 31, 2004.
Mortgage Banking. The Bank provides both fixed and variable rate, long-term residential mortgage loans to its customers. The Bank's general policy, which is subject to review by management as a result of changing market and economic conditions and other factors, is to retain a portion of fixed rate balloon maturity mortgage loans in its loan portfolio and to sell or broker the majority of long-term, fixed rate and
variable rate loans in the secondary market. In late 2003, the Bank made a decision to no longer sell residential mortgage loans on the secondary market. Loans are either retained in the Bank's loan portfolio or direct brokered. The Bank does not retain servicing rights with respect to any of the residential mortgage loans that it brokers or sells. During 2004, the Bank originated $9.1 million of residential mortgage loans, of which all were retained, and none were sold in the secondary market. The Bank brokered $22.8 million of residential mortgage loans during 2004. The following table reflects residential real estate mortgage loans originated, sold and retained or brokered for the periods indicated.
Personal Loans and Lines of Credit. The Bank makes personal loans and lines of credit available to consumers for various purposes, such as the purchase of automobiles, boats and other recreational vehicles, and to make home improvements and personal investments. The majority of the Bank's personal loans are home equity loans and secured by a second lien on real estate. The Bank retains all of such loans in its loan portfolio.
Investment Management and Trust Services. The Bank's investment management and trust services (IM&T) department offers a wide range of traditional personal trust services to customers in its market area. The Bank's trust services include estate planning and money management. The Bank's IM&T products and services include traditional revocable trusts, irrevocable trusts, charitable trusts, estate administration, guardianship administration, IRA administration, personal and institutional investment management, and custodial services. The Bank believes that by offering IM&T services through personalized client service, an experienced professional staff, and a tailored approach to investments that it can enhance and leverage client relationships. The Bank believes that its approach to investment management and trust services has contributed to growth in assets under management to $354 million at December 31, 2004. More importantly, the Bank believes that this approach should allow for continued growth in assets under management and IM&T revenues.
The following table reflects assets under management and revenue of the Bank's IM&T department for the periods indicated.
Tower Investment Services: In July of 2004, the Bank began offering securities and insurance brokerage services under the private label name of Tower Investment Services, through PrimeVest Financial Services, Inc., and ING company. Tower Investment Services offers the Bank's clients comprehensive brokerage capabilities. PrimeVest is a self-clearing broker dealer that works exclusively with banks and
financial institutions. Tower Investment Services had $18.7 million in assets under management at December 31, 2004.
Deposit Generation. The Bank generates deposits primarily through offering a broad array of deposit products to individuals, businesses, associations, financial institutions, and government entities in its primary market area. The Bank generally seeks a comprehensive banking relationship from its lending customers, which has contributed to its internal deposit growth. This often includes encouraging new customers to consider both business and personal checking accounts and other deposit services. The Bank's deposit services include checking, savings, and money market accounts, certificates of deposit, direct deposit services, and telephone and Internet banking. The Bank also generates certificates of deposit through national, out-of-market sources developed during 2002, 2003, and 2004. These deposits include brokered deposits, which the Bank began accepting during 2003. These out-of-market deposits are generated by direct negotiation with out-of-market banks and credit unions and through negotiated transactions with brokers. The Bank also offers a courier service for the deposit convenience of its business customers as well as wholesale lockbox and other business deposit and cash management services. At December 31, 2004, approximately 77.0% of the Bank's deposits were generated in-market, while 23.0% were out-of-market deposits. Deposits at December 31, 2004, 2003 and 2002 are summarized as follows:
LENDING PRACTICES
The Bank makes loans to individuals and businesses located within its market area. The Bank's loan portfolio at December 31, 2004 consisted of commercial and commercial real estate loans (78.5%), residential mortgage loans (11.3%) and personal loans (10.2%). The Bank's legal lending limit under applicable federal banking regulations is approximately $7.6 million, based on the legal lending limit of 15% of total risk based capital of the Bank.
Commercial Loans. Commercial loans are made primarily to small- and medium-sized businesses within the Bank's market area. These loans may be secured or unsecured and are made available for general operating purposes, acquisition of fixed assets including real estate, equipment and machinery, financing of inventory and accounts receivable, as well as any other purposes considered appropriate by management. The Bank generally looks to a borrower's business operations as the principal source of repayment, but also receives, when appropriate, mortgages on real estate, security interests in inventory, accounts receivable and other personal property and/or personal guarantees. Approximately 39.6% of the Bank's commercial loans are commercial real estate loans secured by a first lien on the commercial real estate. In addition, commercial loans that are not mortgage loans are typically secured by a lien on equipment, inventory and/or other assets of the commercial borrower.
Commercial real estate lending involves more risk than residential lending because loan balances are greater and repayment is dependent upon the borrower's operations. The Bank endeavors to reduce the risk associated with these transactions by generally limiting its exposure to owner-operated properties of customers with an established profitable history. In many cases, the Bank may further reduce this risk by
(i) limiting the amount of credit to any one borrower to an amount less than the Bank's legal lending limit and (ii) avoiding certain types of commercial real estate financing.
Residential Mortgage Loans. The Bank originates residential mortgage loans which are generally long-term, with either fixed or variable interest rates. The Bank's general policy, which is subject to review by management as a result of changing market and economic conditions and other factors, is to retain a portion of fixed rate balloon maturity mortgage loans in its loan portfolio and to sell or broker the majority of long-term, fixed rate and variable rate loans in the secondary market. Residential real estate loans are secured by a first lien on the real estate. The Bank does not retain servicing rights with respect to any of the residential mortgage loans that it sells or brokers.
Personal Loans and Lines of Credit. The Bank makes personal loans and lines of credit available to consumers for various purposes, such as the purchase of automobiles, boats and other recreational vehicles, and to make home improvements and personal investments. The majority of the Bank's personal loans are home equity loans or home equity lines of credit secured by a second lien on real estate. The Bank retains all of such loans.
Consumer loans generally have shorter terms and higher interest rates than residential mortgage loans and, except for home equity lines of credit, usually involve more credit risk than mortgage loans because of the type and nature of the collateral. Consumer lending collections are dependent on a borrower's continuing financial stability and are thus likely to be adversely affected by job loss, illness and personal bankruptcy. In many cases, repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of depreciation of the underlying collateral. The Bank has a policy of careful loan underwriting, with a strong emphasis on the amount of the down payment, credit quality, employment stability, and monthly income. These loans are generally repaid on a monthly repayment schedule with the payment amount tied to the borrower's periodic income. The Bank believes that the generally higher yields earned on consumer loans help to compensate for the increased credit risk associated with such loans and that consumer loans are important to its efforts to serve the credit needs of its customer base.
Loan Policies. Although the Bank takes a progressive and competitive approach to lending, it stresses high quality in its loans. Because of the Bank's local nature, management believes that quality control is achieved while still providing prompt and personal service. The Bank is subject to written loan policies that contain general lending guidelines and are subject to periodic review and revision by the Bank's Loan and Investment Committee and its Board of Directors. These policies relate to loan administration, documentation, approval and reporting requirements for various types of loans.
The Bank's loan policies include procedures for oversight and monitoring of the Bank's lending practices and loan portfolio. The Bank seeks to make sound loans, while recognizing that lending money involves a degree of business risk. The Bank's loan policies are designed to assist in managing the business risk involved in making loans. These policies provide a general framework for the Bank's loan operations, while recognizing that not all loan activities and procedures can be anticipated. The Bank's loan policies instruct lending personnel to use care and prudent decision-making and to seek the guidance of the President or Chief Executive Officer of the Bank where appropriate.
The Bank's loan policies provide guidelines for loan-to-value ratios that limit the size of certain types of loans to a maximum percentage of the value of the collateral securing the loans, which percentage varies by the type of collateral. The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes regulatory and supervisory loan-to-value limits. The Bank's internal loan-to-value limitations follow those limits and, in certain cases, are more restrictive than those required by regulators.
The Bank's loan policies also establish an "in-house" limit on the aggregate amount of loans to any one borrower. This limit is a guideline that currently does not exceed $4.0 million. This internal limit is subject to review and revision by the Board of Directors from time to time. In addition, the Bank's loan policies provide guidelines for (i) personal guarantees, (ii) loans to employees, executive officers and directors, (iii) problem loan identification, (iv) maintenance of an allowance for loan losses and (v) other matters relating to the Bank's lending practices.
Loan Review Policies. To ensure that lending practices adhere to loan policies and guidelines, and to ensure that loans are risk rated correctly, the Bank established a Loan Review Department. The primary activities of the Loan Review Department include (i) conducting reviews of specific loans, (ii) assessing the adequacy of loan ratings assigned by lending personnel, (iii) monitoring portfolio concentrations and (iv) monitoring loans subject to Regulation O. To complete these activities, the Bank employs several management tools, primarily a loan grading system, a loan review memorandum and a formalized watch list.
DEPOSITS AND OTHER SERVICES
Deposits. The Bank offers a broad range of deposit services, including checking, savings, and money market accounts, certificates of deposit and direct deposit services. Transaction accounts and certificates of deposit are tailored to the Bank's primary market area at rates competitive with those offered in Allen County. The Bank also offers certificate of deposit accounts to select national and brokered markets at rates competitive with the national market as well as those in the greater Fort Wayne metropolitan area. All depositors are insured by the FDIC up to the maximum amount permitted by law. The Bank solicits deposit accounts from individuals, businesses, associations, financial institutions and government entities in and around the greater Fort Wayne metropolitan area, as well as certificate of deposit accounts nationally through deposit brokers and a rate-posting system.
Other Services. The Bank offers a courier service for the deposit convenience of its business customers. The Bank also offers investment management and trust services and telephone and Internet banking to its customers. The Bank has established relationships with correspondent banks and other independent financial institutions to provide other services requested by its customers, including loan participations where the requested loan amounts exceed the Bank's policies or legal lending limits.
INVESTMENTS
The principal investment of the Company is its ownership of all of the common stock of the Bank. Funds retained by the Company from time to time may be invested in various debt instruments, including but not limited to obligations guaranteed by the United States, general obligations of a state or political subdivision thereof, bankers' acceptance of deposit of United States commercial banks, or commercial paper of United States issuers rated in the highest category by a nationally recognized statistical rating organization. Although the Company is permitted to make limited portfolio investments in equity securities and to make equity investments in subsidiary corporations engaged in certain non-banking activities (which may include real estate-related activities such as mortgage banking, community development, real estate appraisals, arranging equity financing for commercial real estate, and owning or operating real estate used substantially by the Bank or acquired for future use), the Company has no present plans to make any such equity investments except for a $100,000 investment in a statewide economic development venture capital limited partnership and a $20,000 investment in an economic development venture capital limited partnership focusing on businesses located in Northeast Indiana, both of which were recorded in other assets.
The Bank may invest its funds in a wide variety of debt instruments and may participate in the federal funds market with other depository institutions. Subject to certain exceptions, the Bank is prohibited from investing in equity securities. Real estate acquired by the Bank in satisfaction of, or foreclosure upon, loans may be held by the Bank for no longer than 10 years after the date of acquisition without the written consent of the Indiana Department of Financial Institutions (the "Department"). The Bank is also permitted to invest an aggregate amount not in excess of 50% of the "sound capital" of the Bank in such real estate and buildings as are necessary for the convenient transaction of its business. The Bank's Board of Directors may alter the Bank's investment policy without shareholders' approval.
FUNDING SOURCES
During 2002, 2003 and 2004, the Company contributed $7,000,000, $0 and $5,000,000, respectively, to the Bank as capital to support the balance sheet growth. On an ongoing basis, the Bank funds its operations primarily with local deposits. Secondarily, the Bank uses alternative funding sources as
needed, including advances from the Federal Home Loan Bank, out-of-market deposits (including national market CDs and brokered CDs) and other forms of wholesale financing.
EFFECT OF GOVERNMENT MONETARY POLICIES
The earnings of the Company and the Bank are affected by domestic economic conditions and the monetary and fiscal policies of the United States government, its agencies and the Federal Reserve Board. The Federal Reserve Board's monetary policies have had, and will continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation and avoid a recession. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowing and changes in reserve requirements against deposits held by all federally insured banks. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary fiscal authorities including the Federal Reserve Board, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.
REGULATION AND SUPERVISION
General. Financial institutions and their holding companies are extensively regulated under federal and state law. Consequently, the growth and earnings performance of the Company and the Bank can be affected not only by management decisions and general economic conditions, but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities. Those authorities include but are not limited to the Federal Reserve Board, the FDIC, the Department, the Internal Revenue Service and the state taxing authorities. The effect of such statutes, regulations and policies can be significant and cannot be predicted with any high degree of certainty. Federal and state laws and regulations generally applicable to the Company and the Bank regulate among other things:
- the scope of permitted businesses,
- investments,
- reserves against deposits,
- capital levels relative to operations,
- lending activities and practices,
- the nature and amount of collateral for loans,
- the establishment of branches,
- mergers and consolidations, and
- dividends.
The system of supervision and regulation applicable to the Company and the Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC's deposit insurance funds, the depositors of the Bank and the public, rather than shareholders of the Company. Any change in government regulation may have a material adverse effect on the business of the Company and the Bank.
The Company. As a bank holding company, the Company is subject to regulation by the Federal Reserve Board under the Federal Bank Holding Company Act of 1956, as amended (the "BHCA"). Under the BHCA, the Company is subject to examination by the Federal Reserve Board and is required to file reports of its operations and such additional information as the Federal Reserve Board may require. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where the Company might not do so absent such policy.
Any loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
With certain limited exceptions, the BHCA prohibits bank holding companies from acquiring direct or indirect ownership or control of voting shares or assets of any company other than a bank, unless the company involved is engaged in one or more activities which the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks as to be incidental to these operations. Under current Federal Reserve Board regulations, such permissible non-bank activities include such things as mortgage banking, equipment leasing, securities brokerage, and consumer and commercial finance company operations. As a result of recent amendments to the BHCA, many of these acquisitions may be affected by bank holding companies that satisfy certain statutory criteria concerning management, capitalization, and regulatory compliance, if written notice is given to the Federal Reserve within 10 business days after the transaction. In other cases, prior written notice to the Federal Reserve Board will be required.
The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish banks or non-bank businesses. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Sources."
The Gramm-Leach-Bliley Act ("Gramm-Leach") was signed into law on November 12, 1999 and authorizes bank holding companies that meet specified conditions to elect to become "financial holding companies" and thereby engage in a broader array of financial activities than previously permitted. Such activities include selling and underwriting insurance (including annuities), underwriting and dealing in securities, and merchant banking. Gramm-Leach also authorizes banks to engage through "financial subsidiaries" in certain of the activities permitted for financial holding companies. The Company is registered as a financial holding company; however, the Company has no current plans to pursue any of the expanded activities available to financial holding companies under Gramm-Leach.
Gramm-Leach contains provisions intended to safeguard consumer financial information in the hands of financial service providers by, among other things, requiring these entities to disclose their privacy policies to their customers and allowing customers to "opt out" of having their financial service providers disclose their confidential financial information to non-affiliated third parties, subject to certain exceptions. Final regulations implementing the new financial privacy regulations became effective during 2001. Similar to most other consumer-oriented laws, the regulations contain some specific prohibitions and require timely disclosure of certain information. The Company believes it is in compliance with these requirements.
The Bank. The Bank is an Indiana banking corporation and a member of the Federal Reserve System. As a state-chartered member bank, the Bank is subject to the examination, supervision, reporting and enforcement jurisdiction of the Department, as the chartering authority for Indiana banks, and the Federal Reserve Board as the primary federal bank regulatory agency for state-chartered member banks. The Bank's deposit accounts are insured by the Bank Insurance Fund ("BIF") of the FDIC, which also has jurisdiction over BIF-insured banks. These agencies, and federal and state law, extensively regulate various aspects of the banking business including, among other things:
- permissible types and amounts of loans,
- investments and other activities,
- capital adequacy,
- branching,
- interest rates on loans and on deposits,
- the maintenance of noninterest bearing reserves on deposit, and
- the safety and soundness of banking practices.
Federal law and regulations, including provisions added by the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") and regulations promulgated thereunder, establish supervisory standards applicable to the lending activities of the Bank, including internal controls, credit underwriting, loan documentation, and loan-to-value ratios for loans secured by real property.
The Bank is subject to certain federal and state statutory and regulatory restrictions on any extension of credit to the Company or its subsidiaries, on investments in the stock or other securities of the Company or its subsidiaries, and on the acceptance of the stock or other securities of the Company or its subsidiaries as collateral for loans to any person. Limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal shareholders of the Company, and to "related interests" of such persons. In addition, such legislation and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal shareholder of the Company may obtain credit from banks with which the Company maintains a correspondent relationship. Also, in certain circumstances, an Indiana banking corporation may be required by order of the Department to increase its capital or reduce the amount of its deposits.
The federal banking agencies have published guidelines implementing the FDICIA requirement that the federal banking agencies establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines establish standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. In general, the guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution's primary federal bank regulator may require the institution to submit a plan for achieving and maintaining compliance. The preamble to the guidelines states that the agencies expect to require a compliance plan from an institution whose failure to meet one or more of the standards is of such severity that it could threaten the safe and sound operation of the institution. Failure to submit an acceptable compliance plan, or failure to adhere to a compliance plan that has been accepted by the appropriate regulator, would constitute grounds for further enforcement action.
Insurance of Deposit Accounts. Under FDICIA, as an FDIC-insured institution, the Bank is required to pay deposit insurance premiums based on the risk it poses to BIF. The FDIC also has authority to raise or lower assessment rates on insured deposits to achieve the statutorily required reserve ratios in insurance funds and to impose special additional assessments. Each depository institution is assigned to one of three capital groups: "well capitalized," "adequately capitalized" or "undercapitalized." An institution is considered well capitalized if it has a total risk-based capital ratio of 10% or greater, has a Tier 1 risk-based capital ratio of 6% of greater, has a leverage ratio of 5% or greater and is not subject to any order or written directive to meet and maintain a specific capital level. An "adequately capitalized" institution has a total risk-based capital ratio of 8% or greater, has a Tier 1 risk-based capital ratio of 4% or greater, has a leverage ratio of 4% or greater and does not meet the definition of a well capitalized bank. An institution is considered "undercapitalized" if it does not meet the definition of "well capitalized" or "adequately capitalized." Within each capital group, institutions are assigned to one of three supervisory subgroups: "A" (institutions with few minor weaknesses), "B" (institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the insurance funds), and "C" (institutions that pose a substantial probability of loss to the insurance funds unless effective corrective action is taken). There are nine combinations of capital groups and supervisory subgroups to which varying assessment rates may apply. A bank's assessment rate depends on the capital category and supervisory category to which it is assigned.
Consumer and Other Laws. The Bank's business includes making a variety of types of loans to individuals. In making these loans, the Bank is subject to state usury and regulatory laws and to various federal statutes, such as the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act, and the regulations promulgated thereunder, which prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs and regulate the mortgage loan servicing activities of the Bank, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing. The Riegle Act imposed new escrow requirements on depository and non-depository mortgage lenders and services under the National Flood Insurance Program. In receiving deposits, the Bank is subject to extensive regulation under state and federal law and regulations, including the Truth in Savings Act, the Expedited Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer Act, and the Federal Deposit Insurance Act. Violation of these laws could result in the imposition of significant damages and fines upon the Bank, its directors and officers.
Under the Community Reinvestment Act (the "CRA") and the implementing regulations, the Bank has a continuing and affirmative obligation to help meet the credit needs of its local community, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. The CRA requires the board of directors of financial institutions, such as the Bank, to adopt a CRA statement for each assessment area that, among other things, describes its efforts to help meet community credit needs and the specific types of credit that the institution is willing to extend. The Bank's service area is designated as all of Allen County, Indiana. The Bank's offices are located in Allen County. The Bank's Board of Directors is required to review the appropriateness of this delineation at least annually. The CRA also requires that all financial institutions publicly disclose their CRA ratings. The Bank received a "satisfactory" rating on its most recent CRA performance evaluation.
USA Patriot Act of 2001. On October 6, 2001, the "Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot) Act of 2001" was enacted. The statute increased the power of the United States Government to obtain access to information and to investigate a full array of criminal activities. In the area of money laundering activities, the statute added terrorism, terrorism support, and foreign corruption to the definition of money laundering offenses and increased the civil and criminal penalties for money laundering; applied certain anti-money laundering measures to United States bank accounts used by foreign persons; prohibited financial institutions from establishing, maintaining, administering or managing a correspondent account with a foreign shell bank; provided for certain forfeitures of funds deposited in United States interbank accounts by foreign banks; provided the Secretary of the Treasury with regulatory authority to ensure that certain types of bank accounts are not used to hide the identity of customers transferring funds and to impose additional reporting requirements with respect to money laundering activities; and included other measures. On October 28, 2002, the Department of Treasury issued a final rule concerning compliance by covered United States financial institutions with the new statutory anti-money laundering requirement regarding correspondent accounts established or maintained for foreign banking institutions, including the requirement that financial institutions take reasonable steps to ensure that correspondent accounts provided to foreign banks are not being used to indirectly provide banking services to foreign shell banks. The Company believes that compliance with the new requirements will not have a material adverse impact on its operations or financial condition.
Sarbanes-Oxley Act of 2002. The passage of the Sarbanes-Oxley Act of 2002 and subsequent actions of the Securities and Exchange Commission and stock exchanges have had a significant impact on the Company's corporate governance and related matters. In June 2003, the Securities and Exchange Commission adopted final rules under Section 404 of the Sarbanes-Oxley Act of 2002. Commencing with its 2005 Annual Report on Form 10-K, the Company will be required to include a report of management on the Company's internal control over financial reporting. The internal control report must include a statement of management's responsibility for establishing and maintaining adequate control over financial reporting as of year-end; of the framework used by management to evaluate the effectiveness of the Company's internal control over financial reporting; and that the Company's independent accounting firm has issued an attestation report on management's assessment of the Company's internal control over financial reporting, which report is also required to be filed as part of the Annual Report.
COMPETITION
All phases of the business of the Bank are highly competitive. The Bank competes with numerous financial institutions, including other commercial banks in the greater Fort Wayne metropolitan area. The Bank, along with other commercial banks, competes with respect to its lending activities and competes in attracting demand deposits. The Bank faces competition from thrift institutions, credit unions and other banks as well as finance companies, insurance companies, mortgage companies, securities brokerage firms, money market funds, trust companies and other providers of financial services. Most of the Bank's competitors have been in business a number of years, have established customer bases, are larger and have larger lending limits than the Bank. The Bank competes for loans principally through its ability to communicate effectively with its customers and understand and meet their needs. The Bank offers personal attention, professional service, off-site ATM capability and competitive interest rates.
Management believes that its personal service philosophy enhances the Bank's ability to compete favorably in attracting individuals and small- to medium-sized businesses.
EMPLOYEES
As of December 31, 2004, the Company had 132 employees, including 115 full-time employees. None of the Company's employees is covered by a collective bargaining agreement. Management believes that its relationship with the Company's employees is good.
STATISTICAL DISCLOSURE
The statistical disclosure concerning the Company and the Bank, on a consolidated basis, included in response to Item 7 of this report is hereby incorporated by reference herein.
AVAILABLE INFORMATION
The Company's Internet website address is www.towerbank.net. The Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available or may be accessed free of charge through the TOFC Investor Relations section of the Company's Internet website as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC. The Company's Internet website and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.
The following corporate governance documents are also available through the TOFC Investor Relations section of the Company's Internet website or may be obtained in print form by written request addressed to Secretary, Tower Financial Corporation, 116 East Berry Street, Fort Wayne, Indiana 46802: Code of Business Conduct and Ethics (the "Code"), Audit Committee Charter, Compensation Committee Charter, and Nominating and Corporate Governance Committee Charter. The Company intends to post any amendments to the foregoing documents on its website and will report any waivers of the Code for directors and executive officers on a Current Report on Form 8-K.
ITEM 2.
ITEM 2. PROPERTIES.
The Company is leasing the first and second floors of the Lincoln Tower, a landmark building located at 116 East Berry Street in downtown Fort Wayne, Indiana, for use as its headquarters and the Bank's main office. The headquarters facility consists of drive-up banking windows and approximately 33,400 square feet of usable office space. The lease had an initial term of 10 years, with one renewal option for an additional 10 years. During 2001, the original lease term was extended to 15 years with an expiration date of December 2013 and the same renewal option as prior to the extension. In March 2004 the Company signed an additional amendment to the lease to occupy an additional 8,336 square feet of space on the first floor at rates similar to the original lease. The amendment also contains a right of first refusal to buy the entire building in the event the landlord wishes to divest the property.
The Bank leases a bank branch office location in the northwest section of Fort Wayne at 1545 W. Dupont Road. The branch office occupies 2,600 square feet of space and has two drive-up lanes. The lease has an initial term of five years, expires May 2005 and has two consecutive five-year renewal options. The Bank also leases a bank branch office location in the southwest section of Fort Wayne at 10373 Illinois Road. The branch office occupies 2,400 square feet and has two drive-up lanes. The lease has an initial term of 10 years, expires January 2011 and has two consecutive five-year renewal options. The Bank leases a branch office located in the south side of Fort Wayne in the Waynedale area. The branch occupies 2,600 square feet of space and has two drive-up lanes. The lease has an initial term of 10 years expiring December 31, 2013, with an option to extend the lease for two additional consecutive five-year periods each. The Bank leases 450 square feet of office space in Angola, Indiana for use as a mortgage loan production office. The office space is leased on a month-to-month basis.
The Bank owns a bank branch on 1.4 acres of land in northeast Fort Wayne at 4303 Lahmeyer Road. This branch office contains 3,000 square feet of space and has two drive-up lanes.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Bank may be involved from time to time in various routine legal proceedings incidental to its business. Neither the Company nor the Bank is engaged in any legal proceeding that is expected to have a material adverse effect on the results of operations or financial position of the Company or the Bank.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES.
MARKET INFORMATION
The Company's common stock is traded on the Nasdaq National Market System under the symbol "TOFC." As of February 11, 2005, there were 645 shareholders of record and approximately 2,109 beneficial owners of the common stock.
The following table also presents the high and low sales prices for the common stock on the Nasdaq National Market System by quarter for 2004 and 2003.
HIGH/LOW STOCK PRICE
DIVIDENDS
The Company does not pay cash dividends on its common stock, and the Company does not anticipate paying any cash dividends on its common stock in the foreseeable future. The declaration and payment of future dividends will be at the discretion of the Company's board of directors and must comply with applicable law. Future dividend payments will depend upon the Company's financial condition, results of operations, future liquidity needs, potential acquisitions, regulatory and capital requirements and other factors deemed relevant by its board of directors.
In addition, the Company is a holding company and substantially all of its assets are held by the Bank. The Company's ability to pay dividends to its shareholders, if it determines in the future to do so, will depend primarily on the Bank's ability to pay dividends to the Company. Dividend payments and extensions of credit to the Company from the Bank are subject to legal and regulatory limitations, generally based on capital levels and profits, imposed by law and regulatory agencies with authority over the Bank. The ability of the Bank to pay dividends is also subject to its profitability, financial condition,
capital expenditures and other cash flow requirements. In addition, under the terms of the debentures issued in connection with the issuance of the 9% trust preferred securities due 2031 issued by the Company's statutory trust subsidiary, the Company would be precluded from paying dividends on its common stock (other than dividends in the form of additional shares of common stock) if it was in default under the debentures, if it exercised its right to defer payments of interest on the debentures, or if certain related defaults occurred.
The information required by this Item concerning equity compensation plans is incorporated by reference to Item 12 of this report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
CONSOLIDATED SUMMARY OF OPERATIONS AND SELECTED STATISTICAL DATA
n/a - not applicable
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. ($ in thousands except for share data)
INTRODUCTION
The following discussion presents management's discussion and analysis of the consolidated financial condition and results of operations of the Company as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002. This discussion should be read in conjunction with the Company's audited consolidated financial statements and the related notes appearing elsewhere in this report.
FORWARD-LOOKING STATEMENTS
This report includes "forward-looking statements." All statements regarding the Company's expected financial position, business and strategies are forward-looking statements and the Company intends for them to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. The words "anticipates," "believes," "estimates," "seeks," "expects," "plans," "intends," and similar expressions, as they relate to the Company, the Bank or its management, are intended to identify forward-looking statements. Although the Company believes that the expectations reflected in these forward-looking statements are reasonable and have based these expectations on its beliefs as well as assumptions it has made, these expectations may prove to be incorrect. Important factors that could cause actual results to differ materially from the Company's expectations include, without limitation, the following:
- the Company's limited operating history;
- the effect of extensive banking regulation on the Bank's ability to grow and compete;
- the effect of changes in federal economic and monetary policies on the Bank's ability to attract deposits, make loans and achieve satisfactory interest spreads;
- the competitive disadvantage resulting from the Company's status as a highly regulated, start-up company;
- the Company's dependence on key management personnel;
- the increased risk of losses due to loan defaults caused by the Bank's commercial loan concentration;
- the Company's dependence on a favorable local economy in the Bank's primary service area;
- the Bank's dependence on net interest spread for profitability;
- the Bank's ability to implement developments in technology to be competitive;
- failure of a significant number of borrowers to repay their loans;
- general changes in economic conditions, including interest rates and real estate values; and
- restrictions imposed on the Company by regulators or regulations of the banking industry.
Readers are also directed to other risks and uncertainties discussed in other documents filed by the Company with the Securities and Exchange Commission. The Company undertakes no obligation to update or revise any forward-looking information, whether as a result of new information, future developments or otherwise.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of its financial statements. Actual results may differ from these estimates under different assumptions or conditions. Certain policies inherently have a greater reliance on the use of estimates, and as such have a greater possibility of producing results that could be materially different than originally reported. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Management believes that its critical accounting policies are limited to those described below. For a detailed discussion on the application of these and other accounting policies, see Note 1 - -- Summary of Significant Accounting Policies to the audited consolidated financial statements included in this report.
Allowance for Loan Losses. The Company's allowance for loan losses represents management's estimate of probable incurred losses inherent in the loan portfolio at the balance sheet date. Additions to the allowance may result from recording provision for loan losses and recoveries, while charge offs are deducted from the allowance. Allocation of the allowance is made for analytical purposes only, and the entire allowance is available to absorb any loan charged off.
The Company has an established process for determining the adequacy of the allowance for loan losses that relies on various procedures and pieces of information to arrive at a range of probable outcomes. No single statistic or measurement, in itself, determines the adequacy of the allowance. The allowance has two components: identified specific allocations and a percentage allocation based on loss history for different loan groups.
To determine the allocated component of the allowance, the Company combines estimated allowances required for specifically identified loans that are analyzed individually and loans that are analyzed on a group basis. First, management allocates specific portions of the allowance for loan losses based on identifiable problem loans. Problem loans are identified through a loan risk rating system and monitored through watchlist reporting. Specific allocations of allowance for loan losses are determined for each identified credit based on delinquency rates, collateral and other risk factors identified for that credit. Second, management's evaluation of the allowance for different loan groups is based on consideration of actual loss experience, the present and prospective financial condition of borrowers, industry concentrations within the loan portfolio and general economic conditions, and absent the ability of some of those factors, based upon peer industry data of comparable banks. Lastly, the unallocated component of the allowance is maintained to supplement the allocated component and to recognize the imprecision of estimating and measuring loss when evaluating loss allocations for individual loans or pools of loans. The allocated and the unallocated components represent the total allowance for loan losses that would adequately cover losses inherent in the loan portfolio.
The determination of the level of allowance and, correspondingly, the provision for loan losses, rests upon estimates and assumptions, including past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in the aggregate for smaller-balance loans of a similar nature such as residential mortgage and consumer loans, and on an individual loan basis for other loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of a borrower's operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, the loan is evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing interest rate or at the fair value of collateral if repayment is expected solely from the collateral.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. Although management believes its process for determining the allowance adequately considers all of the potential factors that could potentially result in credit losses, the process includes subjective elements and may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect earnings or financial position in future periods.
FINANCIAL CONDITION
The Company experienced significant growth during 2004. Total assets of the Company were $481,117 at December 31, 2004 compared to $ 436,469 at December 31, 2003, an increase of $44,648 or 10.2%. The significant increase in assets was mainly attributable to growth in the loan portfolio and was funded by a significant growth in deposits and FHLB advances. Asset growth has been substantial during each year since the Bank began operations. Management anticipates that, in the near-term, assets will increase at a rate similar to the Bank's historical trends as management continues to market its institution, products and banking expertise, deliver a high level of customer service and develop its branch network.
Earning Assets. The Company's loan portfolio experienced another year of significant growth during 2004. Loans were $400,510 at December 31, 2004 compared to $376,839 at December 31, 2003, an increase of $23,671, or 6.3%. The loan portfolio, which equaled 86.3% and 90.5% of earning assets at December 31, 2004 and 2003, respectively, was primarily comprised of commercial and commercial real estate loans at both dates. At December 31, 2004, commercial and commercial real estate loans were approximately 78.5% of the loan portfolio and represented loans to business interests generally located within the Bank's market area. Approximately 47.4% of the loan portfolio at December 31, 2004 consisted of general commercial and industrial loans primarily secured by inventory, receivables and equipment, while 31.2% of the loan portfolio consisted of commercial loans primarily secured by real estate. The largest concentrations of credit within the commercial category are represented by owner-occupied and investment real estate at $124,625, or 31.1% of total loans, and building, development and general contracting at $63,777, or 15.9% of total loans. The concentration and growth in commercial credits is in keeping with the Bank's strategy of focusing a substantial amount of efforts on commercial banking. Business banking is an area of expertise for the Bank's management and lending team. Residential mortgage and home equity lending, while only 18.4% of loans at December 31, 2004, also experienced significant growth. Consumer loans, only 3.1% of total loans at December 31, 2004, reflected a slight increase during 2004 from 2003 levels. Management believes that loan growth should continue as the Bank expands its distribution network during 2005; however, the Company's main strategy for growth and profitability is expected to come largely from the commercial loan sector. The following table presents loans outstanding as of December 31, 2004, 2003, 2002, 2001 and 2000.
LOANS OUTSTANDING
The following table presents the maturity of total loans outstanding as of December 31, 2004, according to scheduled repayments of principal and also based upon repricing opportunities.
MATURITIES OF LOANS OUTSTANDING
The Bank's credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, the Bank must rely on estimates, appraisals and evaluation of loans and the possibility that changes could occur because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on an internal "watchlist." Senior management reviews this list regularly and adjusts for changing conditions. At December 31, 2004, there were $12,597 of potential problem loans outstanding classified on the watchlist.
Nonperforming loans at December 31, 2004 were $2,257, including $1,580 of loans placed on nonaccrual status and categorized as impaired and $677 of loans past due 90 days and still accruing which are not categorized as impaired. Total impaired loans are $5,095, which includes all nonaccrual loans plus commercial loans impaired of $3,515 that are still accruing but restructured. Gross interest for 2004 for nonaccrual loans would have been $147. Interest actually received on nonaccrual loans was $43 resulting in lost interest to date of $104. Nonperforming loans at December 31, 2003 were $1,905, including $1,615 of loans placed on nonaccrual status and categorized as impaired and $290 of loans past due 90 days and still accruing which are not categorized as impaired. Total impaired loans are $2,156, which includes all nonaccrual loans plus commercial loans impaired of $541 that are still accruing but restructured. Gross interest for 2003 for nonaccrual loans would have been $102. Interest actually received on nonaccrual loans was $14 resulting in lost interest to date of $88. Nonperforming loans at December 31, 2002 were $719, including $632 of loans placed on nonaccrual status and categorized as impaired and $87 of loans past due 90 days and still accruing which are not categorized as impaired. Gross interest for 2002 for nonaccrual loans would have been $61.
During 2004, the Bank experienced $2,011 in net charged-off loans compared to $1,671 of net charge-offs in 2003 and $500 in 2002. The 2004 ratio of net charge-offs to total average loans was 0.52%. Of the loans charged off during 2004, $1,000 was attributable to one commercial credit. Of the loans charged off during 2003, $600 was attributable to the unauthorized mortgage activity loss and $563 was attributable to one commercial credit, which was identified during the year and restructured at year-end.
In each quarter, the allowance for loan losses is adjusted by management to the amount management believes is necessary to maintain the allowance at adequate levels. Management allocates specific portions of the allowance for loan losses to specifically identified problem loans. Management's evaluation of the allowance is further based on consideration of actual loss experience, the present and prospective financial condition of borrowers, industry concentrations within the portfolio and general
economic conditions. Management believes that the present allowance is adequate, based on the broad range of considerations listed above, and further, based upon peer industry data of comparable banks.
The following table illustrates the breakdown of the allowance for loan losses by loan type.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES ($ in thousands)
See Note 3 to the Consolidated Financial Statements for detail of activity in allowance for loan losses
The primary risk element considered by management with respect to each installment and residential real estate loan is lack of timely payment. Management has a reporting system that monitors past due loans and has adopted policies to pursue its creditor's rights in order to preserve the Bank's position. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and lack of timely payment. Management has a policy of requesting and reviewing periodic financial statements from its commercial loan customers, and periodically reviews the sufficiency of collateral and its value.
Although management considers the allowance for loan losses to be adequate to absorb losses that are incurred, there can be no assurance that charge-offs in future periods will not exceed the allowance. Additionally, banking regulators can require an increase to the allowance for loan losses if they deem necessary to satisfy regulatory safety and soundness concerns. The Company experienced $2,057 of charge-offs and $46 of recoveries during 2004. The Company experienced $1,705 of charge-offs and $34 of recoveries during 2003. Prior to 2003, the Company only experienced an aggregate amount of $505 in loan charge-offs during its first four years of operations.
TOTAL SECURITIES PORTFOLIO
Securities available for sale at fair value increased during 2004, and totaled $35,025 at December 31, 2004 compared to $24,325 at December 31, 2003 and $11,171 at December 31, 2002. The Company maintains a modest securities portfolio to provide for secondary liquidity and for interest rate risk management. During 2004, the Company again expanded the size and length of maturity of the portfolio as it continued to develop a more diversified portfolio. The portfolio will continue to include some short-term liquid holdings from time to time as loan demand remains strong and more liquidity is needed. Since
the inception of the Company, all securities have been designated as "available for sale" as defined in Statement of Financial Accounting Standards ("SFAS") No.115 Accounting for Certain Investments in Debt and Equity Securities. Securities designated as available for sale are stated at fair value, with the unrealized gains and losses, net of income tax, reported as a separate component of stockholders' equity. A net unrealized gain on this portfolio was recorded at December 31, 2004 in the amount of $34 compared to a net unrealized gain in the amount of $42 at December 2003, and a net unrealized gain of $372 at December 31, 2002. There were no interest-bearing deposits with other banks at December 31, 2004, 2003, or 2002. The table above presents the total securities portfolio as of December 31, 2004, 2003 and 2002. During 2004, the Company sold $10,212 of available for sale agency securities and recorded a $154 gain from the sales. During 2003, the Company sold $3,175 of available for sale agency securities and recorded a $191 gain from the sales.
Federal funds sold, consisting of excess funds sold overnight to correspondent banks, and short-term investments and interest-bearing deposits, consisting of certificates of deposit with maturities less than 90 days and interest-bearing accounts at correspondent banks, are used to manage daily liquidity needs and interest rate sensitivity. Together, these short-term assets, which recorded an increase of $10,181 during 2004, were $25,314 and $15,133 at December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, these short-term assets were approximately 5.5% and 3.6% of earning assets, respectively. The increase in short term assets during 2004 was primarily due to a large increase in Federal funds sold.
SOURCE OF FUNDS
The Bank's major source of funds is from core deposits of local businesses, governmental and municipal public fund entities, and consumers within the market area. The Bank also generates certificates of deposit through national out-of-market sources (outside Allen and surrounding counties) developed during 2003 and 2004. The out-of-market deposits are generated by direct negotiation with out-of-market banks and credit unions, and through negotiated transaction with brokers. Total deposits were $386,380 at December 31, 2004 and $362,877 at December 31, 2003, an increase of $23,503, or 6.5%.
Noninterest-bearing deposits totaled $57,800 at December 31, 2004, a 7.7% decrease from $62,638 at December 31, 2003. At December 31, 2004, noninterest-bearing deposits were approximately 15% of total deposits, a decrease from the 2003 level of 17.3%. Noninterest-bearing deposits at December 31, 2004 were comprised of $52,635 in business checking accounts, $1,287 in public funds and $3,878 in consumer accounts.
Interest-bearing deposits grew during 2004 and were $328,580 at December 31, 2004, a 9.4% increase over $300,239 at December 31, 2003. Interest-bearing deposits at December 31, 2004 were comprised of approximately 22.5% in money market accounts, 12.4% in interest-bearing checking and savings accounts, and 65.1% in certificates of deposit. The December 31, 2004 percentages reflect a modest change in the deposit mix from 2003, when the percentages were 32.7%, 11.4%, and 55.9%, respectively. In 2004, all deposit categories reflected balance increases over 2003 levels with the exception of noninterest-bearing deposits and money market accounts. The most significant increase from 2003 was in of certificates of deposit over $100. CDs under $100 grew by $6,192 from 2003 year-end levels and CDs $100 and over increased by $39,779. The balance of money market accounts at December 31, 2004 was $74,018 compared to $98,250 at December 31, 2003, a decrease of $24,232. While total interest-bearing deposits increased $28,341 from 2003, mainly a result of new accounts established in the business and consumer sectors, the shift in interest-bearing deposits from money markets to CDs was reflective of the low interest rate environment as customers from all segments sought better returns. The total of interest-bearing deposits at December 31, 2004 reflected $158,158 in business accounts, $133,724 in consumer accounts and $36,698 in public fund accounts compared to $124,868, $121,260 and $54,111, respectively, at December 31, 2003. As of December 31, 2004, the Company had $144,619 in certificates of deposit of $100 or more, of which $44,911 mature within three months; $57,851 mature over three months through twelve months; and $41,857 mature over twelve months.
Short-term borrowings at December 31, 2004 were $200, a significant decrease from $1,060 at December 31, 2003, and were entirely comprised of overnight federal funds purchased from one correspondent bank. In addition to federal funds purchased, the Company also had borrowings in the amount of $45,000 in Federal Home Loan Bank ("FHLB") callable and bullet advances at December 31,
2004 compared to $27,000 at December 31, 2003. The increase of $18,000 in FHLB borrowings from the 2003 levels was a result of the Company's efforts to diversify its funding base and desire to lock in funding costs. The FHLB bullet advances mature in various years from March 2004 to June 2006. There were $6,500 in FHLB callable advances outstanding at December 31, 2004. The callable advances mature in 2011, and each contains a quarterly call feature.
The Company had $3,608 aggregate principal amount in junior subordinated debenture outstanding at December 31, 2004 and 2003, the Company's statutory trust subsidiary, TCT1, sold a private placement offering of $3,500 in Trust Preferred Securities on November 16, 2001. The proceeds were loaned to the Company in exchange for junior subordinated debentures with similar terms to the Trust Preferred Securities. These securities are considered Tier I capital (with certain limitations applicable) under current regulatory guidelines.
The junior subordinated debentures are subject to mandatory redemption, in whole or in part, upon repayment of the Trust Preferred Securities at maturity or their earlier redemption at the par amount. The maturity date of the Trust Preferred Securities is November 15, 2031. Subject to the Company having received prior approval of the Federal Reserve Bank, if then required, the Trust Preferred Securities are redeemable prior to the maturity date beginning November 15, 2006 and each year thereafter at the option of the Company.
Stockholders' equity was $44,013 at December 31, 2004 and $40,909 at December 31, 2003. The increase of $3,104 was mainly attributable to 2004 net income of $2,479 and $630 from the net exercise of stock options. The only other item affecting stockholders' equity was a $(5) change in net unrealized appreciation on securities available for sale, net of tax. The Company issued 1,395,232 shares of common stock in conjunction with its rights offering and limited public offering during 2002, providing net proceeds of $13,657 after deducting marketing agent fees and offering expenses. No additional shares were issued during 2000 or 2001. At December 31, 2004, the Company had a balance of $6,040 in retained earnings while at December 31, 2003 the balance was $3,561, an increase of $2,479 from 2003 due to net income generated during 2004. See "Results of Operations."
RESULTS OF OPERATIONS
Summary. The Company reported net income of $2,479, or $.61 per diluted share, for the year ended December 31, 2004. This reflects an increase in net income from $1,800 in 2003 and net income of $1,716 posted during 2002. Net income per diluted share reflects a $0.16 increase from the $.45 reported in 2003 and a $.05 increase from the $.56 posted in 2002. Per share earnings in 2002 reflect a significantly lower number of average shares outstanding. In August 2002 a rights offering and limited public offering were completed, which increased the average number of outstanding shares by 31.8% from 2002 to 2004 and 30.5% from 2002 to 2003.
The 2004 results reflected a 38.3% growth in net income compared to 2003. The improvement in net income over 2004 was mainly the result of substantial revenue growth due to loan volume growth along with increases in interest rates during the last six months of the year. Net interest income in 2004 was $14,316 compared to $11,765 in 2003, an increase of $2,551 due mainly from an increase in loans outstanding and the increase in interest rates. Noninterest income in 2004 was $4,274 compared to $3,642 in 2003, an increase of $632. The increase was due primarily to a $285 increase in trust fees and an $860 insurance settlement on the previously disclosed unauthorized mortgage activity. This was offset by a reduction of $486 in loan broker fees due to a reduction in volume from 2003. Offsetting the improvements in revenue during 2004 was a $175 increase from 2003 in the provision for loan losses and a $2,046 increase in noninterest expenses related mainly to infrastructure growth costs for compensation, occupancy and equipment. Additionally, loan and professional expenses increased during 2004 due to administrative expenses relating to the unauthorized mortgage activity and other matters.
The asset growth of the Company is expected to result in an increased level of net interest income, which, coupled with noninterest income, is expected to exceed the growth and level of noninterest expense and provision for loan losses.
Net Interest Income. Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is the Company's primary source of earnings. Interest income and interest expense for the year ended December 31, 2004 were $20,965 and $6,649, respectively, netting $14,316 in net interest income. Interest income and interest expense for the year ended December 31, 2003 were $17,826 and $6,061, respectively, resulting in $11,765 in net interest income. Interest income and interest expense for the year ended December 31, 2002 totaled $16,494 and $6,444, respectively, providing for net interest income of $10,050. The substantial increase of $2,551 in net interest income in 2004 from 2003 and the increase over net interest income from 2002 were primarily attributable to an increase in the loans outstanding in both years, as well as an increase in the prime lending rate during 2004.
The net yield on average earning assets during 2004 was 3.31% compared to 3.04% for 2003 and 3.17% for 2002. The increase in margin during 2004 was attributable to net interest spread expansion caused by the increase in general interest rates and its effects on the Company's mostly variable rate mix of loans. Management anticipates that margins will continue to improve due to the Company's current asset-sensitive balance sheet, assuming interest rates increase.
The level of net interest income is primarily a function of asset size, as the weighted-average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate risk, liquidity, and customer behavior also impact net interest income as well as the net yield.
The following table reflects the average balance, interest earned or paid, and yields or costs of the Company's assets, liabilities and stockholders' equity during 2004, 2003 and 2002.
AVERAGE BALANCE, INTEREST AND YIELD/COST ANALYSIS
(1) Computed on a tax equivalent basis for tax equivalent securities using a 34% statutory tax rate.
The following table shows the changes in interest income, interest expense, and net interest income due to variances in rate and volume of average earning assets and interest-bearing liabilities. The change in interest not solely due to changes in rate or volume has been allocated in proportion to the absolute dollar amounts of the change in each.
CHANGES IN NET INTEREST INCOME DUE TO RATE AND VOLUME
Interest income is primarily generated from the loan portfolio. Average loans comprised 88%, 91% and 89% of average earning assets during 2004, 2003 and 2002, respectively. During 2004, the loan portfolio had an average yield of 4.97%, and earned $19,205, or 91% of total interest income, an increase of $2,106 from 2003. The improvement in net interest income was mainly due to the increase in average loans along with the impact from the increase in the prime lending rate during 2004. During 2003, the loan
portfolio had an average yield of 4.82% and earned $17,099, or 96% of total interest income while the loan portfolio had an average yield of 5.49% and earned $15,593, or 94% of total interest income during 2002.
The total securities portfolio and total short-term investments equaled 9% and 3%, respectively, of average earning assets during 2004. With an average tax-equivalent yield of 4.86%, total securities contributed $1,835, or 8% of total interest income in 2004, while total short-term investments had a combined average yield of 1.15% and earned $177, or 1% of total interest income, in 2004. During 2003, the total securities portfolio and total short-term investments equaled 4% and 5%, respectively, of average earning assets. With an average yield of 3.93%, securities contributed $545, or 3% of total interest income in 2003, while total short-term investments had a combined average yield of 0.98% and earned 1% of total interest income in 2003. During 2002, the total securities portfolio and total short-term investments equaled 3% and 7%, respectively, of average earning assets. With an average yield of 4.70%, securities contributed $446, or 3% of total interest income in 2002, while total short-term investments had a combined average yield of 1.79% and earned 2% of total interest income in 2002.
Interest expense is primarily generated from money market deposits and certificates of deposit, which equaled 26% and 56%, respectively, of average interest-bearing liabilities during 2004; 34% and 49%, respectively of average interest-bearing liabilities during 2003; and 41% and 44%, respectively, of average interest-bearing liabilities during 2002. The percentage change within the money market category reflects the decrease in this type of funding during 2004, 2003, and 2002, with reductions mainly from business and municipal funds as these depositors sought greater yields. CD balances grew during 2004 and 2003 as a percent of earning assets reflective of growth from brokered and national market sources. Total borrowings were 7% of average earning assets during 2004, up from the 6% level in 2003 and 2002.
Money market balances had an average rate of 1.03% and cost $965, or 15% of total interest expense, in 2004 compared to an average rate of 1.14% and cost $1,253, or 21% of total interest expense, in 2003. Certificates of deposit had an average rate of 2.25% and cost $4,520, or 68% of total interest expense, in 2004 compared to an average rate of 2.44% and cost $3,806, or 63% of total interest expense, in 2003. Interest expense on savings and interest-bearing checking totaled 1% of total interest expense during 2004, down slightly from 2% in 2003. The Company paid $1,042 of interest expense on borrowings, or 16% of total interest expense, during 2003 and paid $876 of interest expense on borrowings, or 14% of total interest expense, during 2003. The increase in borrowing cost during 2004 compared to 2003 is reflective of the higher levels of FHLB advances.
During 2002, money market accounts had an average rate of 1.75% and cost $1,877 or 29% of total interest expense, while certificates of deposit had an average rate of 3.09% and cost $3,562, or 55% of total interest expense. Savings deposits and interest-bearing checking accounts totaled 8% of average interest-bearing liabilities during 2002 with an average rate of 1.10%, or 3% of total interest expense in 2002. Total borrowings had an average rate of 4.00% during 2002.
Provision for Loan Losses. Driven by net charge-offs and continued significant loan growth, the provision for loan losses was $2,360 for 2004, $2,185 for 2003 and $1,765 for 2002. This reflects a $175, or 8.0%, increase from 2004 to 2003. The allowance for loan losses as a percentage of total loans outstanding was 1.40%, 1.40% and 1.48% at December 31, 2004, 2003, and 2002, respectively. The Company maintains the allowance for loan losses at a level management feels is adequate to absorb losses incurred in the loan portfolio. The evaluation is based upon the Company's and the banking industry's historical loan loss experience, known and inherent risks contained in the loan portfolio, composition and growth of the loan portfolio, current and projected economic conditions and other factors. Given the lack of seasoning of the Bank's portfolio in addition to considering the Company's loss history, management has established the provision and allowance for loan losses in part based on the loss experience of peer financial institutions with similar heavy concentrations in commercial lending and in part based on general trends in the economy.
The Company had $1,580 of nonperforming loans at December 31, 2004, a decrease of $325 from the $1,905 of nonperforming loans at December 31, 2003. The Company reported $2,011 of net charge-offs,
or .52% of average loans during 2003 compared to $1,671 in net charge offs or ..47% of average loans during 2003.
Noninterest Income. Noninterest income recorded substantial growth during 2004 as all major categories reflected improved performance. Total noninterest income was $4,274 for the year ended December 31, 2004 compared to $3,642 and $2,954 for the years ended December 31, 2003 and 2002, respectively. Fees from trust services grew 20.3% resulting from an increasing base of accounts and assets under management and was $1,687 for 2004 compared to $1,402 for 2003 and $1,085 in 2002. Mortgage broker fees were $327 during 2004, a decrease of $486 or 59.8% from $813 for 2003. Mortgage broker fees were $782 for 2002. The decrease was attributable to a rising interest rate environment, as well as a decline in the number of applicants due to the high volume in previous years. Deposit service charges remained relatively flat in 2004, showing a decrease of $16 or 2.6% from 2003. Deposit service charges increased $218 or 52.3% between 2003 and 2002. Service charge income increased in 2003 due to an overall expanded account base, a higher level of fees generated on business accounts and increased activity from NSF/OD charges. In November 2004, the Bank received a reimbursement from its insurance carrier against losses recorded for the unauthorized mortgage issue detected in 2002. The reimbursement received was for $860, however the Bank incurred expenses and losses against this claim of $241, $1,055, and $428 in 2004, 2003, and 2002 respectively. Other fee income increased mainly as a result of income generated from bank-owned life insurance (BOLI). In addition to the above, 2004 noninterest income results included $154 in gains on the sale of securities available for sale compared to gains on the sale of securities and loans totaling $191 during 2003 and $276 in 2002.
Noninterest Expense. Noninterest expense totaled $12,399 for the year ended December 31, 2004 compared to $10,353 and $8,416 for the years ended December 31, 2003 and 2002, respectively, an increase of $2,046 or 19.8% during 2004 over 2003. The increase in expenses is mainly attributable to the infrastructure growth of the Company, including the addition of the fourth branch and mortgage loan origination office. This is evidenced by salary and benefit costs, which increased $1,351, or 24.5%, and occupancy and equipment costs which increased $384, or 31.0%, over their respective 2003 levels. Salary and benefits costs were $6,867 or 55.4% of total expenses for 2004, while occupancy and equipment costs were $1,621 or 13.1% of total expenses. Loan and professional costs increased during 2004 from prior year levels by $439 or 51.3%. The increase was attributable to litigation costs related to the unauthorized mortgage issue insurance settlement, increased accounting and auditing fees, nonrecurring upfront consulting costs for future loan and fee origination processes, and legal and accounting expenses related to exploring various strategic alternatives considered by the Company. Other various expense categories increased during 2004, such as marketing, data processing, office supplies and postage, and courier services, but to a lesser dollar amount than those mentioned above. Other expense was $830 for 2004, $1,172 for 2003 and a $1,086 for 2002, which reflected a $342, or 29.2% decrease in 2004 and, $86 or 7.9% increase in 2003, as compared to the prior year. Other expense for both 2003 and 2002 included losses recorded for the unauthorized mortgage activity in the amount of $365 and $428, respectively.
During 2003, salaries and benefits costs were $5,516, while occupancy and equipment expenses totaled $1,237. Additional large overhead expenses in 2003 included costs for loan and professional fees and services, which amounted to $856, and marketing expenses of $353. Significant noninterest expenses during 2002 were $4,604 for salary and benefit costs, $1,044 for occupancy and equipment costs, and $471 for loan and professional costs.
Monitoring and controlling overhead expenses while providing high quality service to customers is of the utmost importance to the Company. The efficiency ratio, computed by dividing noninterest expense by net interest income plus noninterest income, was 66.7% in 2004 compared to 67.2% in 2003 and 64.7% in 2002. The overall level of efficiency ratio continues to be high, but reflects expected infrastructure costs associated with growth as well as certain non-recurring costs discussed above. As anticipated, improvement in the efficiency ratio is dependent upon the growth in earning assets along with the development of fee-based products and the resulting increases in revenue. Management expects that as additional asset growth and operating efficiencies are realized, the Company will earn more on the larger base of earning assets while operating costs will increase at a lesser rate, resulting in an improved efficiency ratio.
Income Taxes Expense. During 2004, 2003 and 2002, the Company recorded $1,351, $1,069 and $1,108 respectively, in income taxes expense. The effective tax rate recorded for 2004 was 35.3% as compared to 37.3% for 2003 and 39.2% for 2002. The effective tax rate decreased from the prior years as the Company grew its tax-exempt security portfolio in 2002, 2003 and 2004 and purchased bank-owned life insurance (BOLI) during 2003.
CAPITAL SOURCES
Stockholders' equity is a noninterest-bearing source of funds, which provides support for asset growth. Stockholders' equity was $44,013 and $40,909 at December 31, 2004 and 2003, respectively. Affecting the increase in stockholders' equity during 2004 was net income of $2,479 and $630 from the net exercise of stock options. Stockholders' equity increased during 2003 primarily from net income amounting to $1,800.
The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.Currently, both the Company and the Bank have been categorized as "Well Capitalized," the highest classification contained within the banking regulations. The capital ratios of the Company and the Bank as of December 31, 2004 and 2003 are disclosed in Note 15 of the Notes to Consolidated Financial Statements.
The ability of the Company to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. No cash or stock dividends were paid in 2004 or 2003. The Company expects that its future earnings and those of the Bank, if any, would be retained to finance future growth and operations. The Company does not anticipate paying any cash dividends on the common stock in the foreseeable future.
LIQUIDITY
Liquidity is measured by the Company's ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet depositor withdrawals, maintain reserve requirements, fund loans and operate the Company. Liquidity is primarily achieved through the growth of deposits and liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximize profitability, while providing adequate liquidity.
The Company's liquidity strategy is to fund growth with deposits (from both in-market and out-of-market sources), FHLB borrowings and to maintain an adequate level of short-term and medium-term investments to meet typical daily loan and deposit activity needs. Deposit growth was substantial during 2004 and 2003. The Company mainly generated deposits from in-market sources; however, it expanded its funding base during 2002 to include national, non-brokered certificates of deposit, borrowings from the FHLB and trust preferred securities. During 2003 the Company further expanded its funding base to include brokered deposits. At December 31, 2004, the balance of non-brokered national market CDs, brokered CDs, and FHLB borrowings were $25,491, $63,286 and $45,000 respectively, as compared to $45,970, $25,208 and $27,000, respectively, at December 31, 2003. At December 31, 2004 and 2003,
total deposits were $386,380 and $362,877, respectively, and the loan-to-deposit ratio was 103.7% and 103.8%, respectively. The Company expects to continue to experience loan growth. Funding for the loan growth will continue to come from in-market sources through the marketing of products and the development of branch locations. The Company will also continue to develop wholesale and out-of-market deposits and borrowing capacities and use them to augment its interest rate sensitivity strategy and liquidity capabilities and to diversify the funding base of the Bank.
The Company has the ability to borrow money on a daily basis through correspondent banks (federal funds purchased), and had balances of $200 at December 31, 2004 and $1,060 at December 31, 2003. Additional capacity to borrow overnight in the form of unused lines of commitment from correspondent banks totaled $45,000 and $27,000 at December 31, 2004 and 2003, respectively. This type of funding is viewed by the Company as only a secondary and temporary source of funds.
CONTRACTUAL OBLIGATIONS, COMMITMENTS AND OFF-BALANCE SHEET RISK
In addition to normal loan funding and deposit flow, the Company also needs to maintain liquidity to meet the demands of certain unfunded loan commitments and standby and commercial letters of credit. The Bank maintains off-balance-sheet financial instruments in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan commitments to extend credit are agreements to lend to a customer at any time, as the customer's needs vary, as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We monitor fluctuations in loan balances and commitment levels and include such data in our overall liquidity management.
These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. The Bank's maximum exposure to loan loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the face amount of these instruments. Commitments to extend credit are recorded when they are funded and standby letters of credit are recorded at fair value.
The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Collateral, such as accounts receivable, securities, inventory, property and equipment is generally required based on management's credit assessment of the borrower.
The Company and the Bank occupy their respective headquarters, offices and other facilities under long-term operating leases and, in addition, are parties to long-term contracts for data processing and operating systems.
Under the terms of certain employment contracts, upon the occurrence of certain events resulting in the severance of certain executive officers' employment with the Company, payments may be required to be made in excess of amounts that have been accrued.
The following tables represent the Company's contractual obligations and commitments at December 31, 2004.
CONTRACTUAL OBLIGATIONS at December 31, 2004
COMMITMENTS at December 31, 2004
RELATED PARTY TRANSACTIONS
Certain directors and executive officers of the Company, including their immediate families and companies in which they are principal owners, are loan customers of the Bank. At December 31, 2004 and 2003, the Bank had $21,831 and $23,260, respectively, in loan commitments to directors and executive officers, of which $16,363 and $17,617 were funded at the respective period-ends. These loans have been made in the Bank's ordinary course of business with similar terms to the Bank's similarly situated customers.
The Bank leases its headquarters facility from Tippmann Properties, Inc., agent for John V. Tippmann, Sr., a director. The original lease was a 10-year lease commencing on January 1, 1999. During 2001, the original lease term was extended to 15 years with provisions for one renewal term of 10 years at then prevailing market rates. In March 2004, an amendment was executed to add 8,336 square feet to the leased premises under the same terms as the original lease. The total amount paid to Tippmann Properties by the Company and the Bank for rent and maintenance was $484, $416 and $348 during 2004, 2003 and 2002, respectively. The lease is accounted for as an operating lease. Refer to the table above for a summary of future lease payment commitments under this and other leases.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
MARKET RISK ANALYSIS
The Company's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of the Company's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. The Company has no agricultural-related loan assets and therefore has no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant.
Interest rate risk is the exposure of the Company's financial condition to adverse movements in interest rates. The Company derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest-bearing liabilities. The rates of interest the Company earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, the Company is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and
stockholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company's earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Company's safety and soundness.
Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Company's interest rate risk management process seeks to ensure that appropriate policies, procedures, management information and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, the Company assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity and overall asset quality.
There are two interest rate risk measurement techniques which may be used by the Company. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amount of interest-sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to the Company's net interest margin during periods of changing market interest rates.
The following table depicts the Company's GAP position as of December 31, 2004:
RATE SENSITIVITY ANALYSIS
A second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. A simulation model assesses the direction and magnitude of variations in net interest income
resulting from potential changes in market interest rates. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, a model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and the Company's strategies, among other factors. As growth has dictated, the Company began utilizing simulation analysis as a tool for measuring the effects of interest rate risk on the income statement at the end of 2003.
In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.
The following table provides information about the Company's financial instruments used for purposes other than trading that are rate sensitive to changes in interest rates as of December 31, 2004. It does not provide when these items may actually reprice. For loans receivable, securities, and liabilities with contractual maturities, the table presents principal cash flows and related weighted-average interest rates by contractual maturities as well as the Company's historical experience of the impact of interest rate fluctuations on the prepayment of loans and mortgage backed securities. For core deposits (demand deposits, interest-bearing checking, savings, and money market deposits) that have no contractual maturity, the table presents principal cash flows and, as applicable related weighted-average interest rates based upon the Company's historical experience, and management's judgment as applicable, concerning their most likely withdrawal behaviors. The current historical interest rates for core deposits have been assumed to apply for future periods in this table as the actual interest rates that will need to be paid to maintain these deposits are not currently known. Weighted average variable rates are based upon contractual rates existing at the report date.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Tower Financial Corporation CONSOLIDATED BALANCE SHEETS At December 31, 2004 and 2003
The following notes are an integral part of the financial statements.
Tower Financial Corporation CONSOLIDATED STATEMENTS OF OPERATIONS For the years ended December 31, 2004, 2003 and 2002
The following notes are an integral part of the financial statements.
Tower Financial Corporation CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the years ended December 31, 2004, 2003 and 2002
The following notes are an integral part of the financial statements.
Tower Financial Corporation CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2004, 2003 and 2002
The following notes are an integral part of the financial statements.
Tower Financial Corporation
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS, INDUSTRY SEGMENTS, AND CONCENTRATIONS OF CREDIT RISK: Tower Financial Corporation (the "Company") was incorporated on July 8, 1998. The Company's wholly owned banking subsidiary, Tower Bank & Trust Company (the "Bank"), opened on February 19, 1999 after receiving federal and state bank regulatory approvals to commence its banking operations. The Company's wholly-owned, statutory trust subsidiary, Tower Capital Trust 1 ("TCT1"), was formed on November 1, 2001 for the single purpose of issuing trust preferred securities.
While the Company's management monitors the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of the Company's financial services operations are considered by management to be aggregated in one reportable segment. The Company accepts deposits and grants commercial, real estate, and installment loans to customers primarily in northeastern Indiana. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Real estate loans are secured by both residential and commercial real estate. At December 31, 2004, commercial and commercial real estate loans totaled approximately 78.5% of total loans, residential real estate loans totaled approximately 11.3% and home equity and consumer loans totaled approximately 10.2%. Categories by industry of commercial loans at December 31, 2004 exceeding 30% of year-end stockholders' equity are as follows: real estate (including owner-occupied and investment) - $124.6 million, or 31.1% of total loans; wholesale and retail trade - $46.0 million, or 11.5% of total loans; building, development and general contracting - $63.7 million, or 15.9% of total loans; health care and social assistance - $26.9 million, or 6.7% of total loans; manufacturing - $16.2 million, or 4.0% of total loans; and professional, scientific and technical services - $12.2 million, or 3.0% of total loans. Other financial instruments that potentially represent concentrations of credit risk include deposit accounts in other financial institutions and federal funds sold. The Company also provides trust services to customers.
PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial statements include the accounts of the Company and the Bank. As further discussed in Note 8, TCT1 had previously been consolidated with the Company and is now reported separately. All significant intercompany balances and transactions have been eliminated in consolidation.
USE OF ESTIMATES: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided; future results could differ. The allowance for loan losses, impaired loan disclosures, and the fair values of securities and other financial instruments are particularly subject to change.
CASH FLOW REPORTING: Cash and cash equivalents include cash on hand, demand deposits with other financial institutions, short-term investments and federal funds sold. Cash flows are reported net for customer loan and deposit transactions, interest-earning deposits and short-term borrowings with maturities of 90 days or less.
SECURITIES: Securities available for sale consist of those securities which might be sold prior to maturity due to changes in interest rates, prepayment risks, yield, availability of alternative investments, liquidity needs and other factors. Securities classified as available for sale are reported at their fair value and the related unrealized holding gain or loss is reported as other comprehensive income (loss) and stockholders' equity, net of tax, until realized. Other securities, such as Federal Reserve Bank stock and Federal Home Loan Bank stock, are carried at cost. Premiums and discounts on securities are recognized as interest income using the interest
method over the estimated life of the security. Gains and losses on the sale of securities available for sale are determined based upon amortized cost of the specific security sold. Securities are written down to fair value when a decline in fair value is not temporary. Declines in fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the Company's ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.
LOANS: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs and an allowance for loan losses. Loans held for sale are reported at the lower of cost or market, on an aggregate basis. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when the loan is impaired or payments are past due over 90 days (180 days for residential mortgages). In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not received for loans placed on nonaccrual are reversed against income. Interest received on such loans is accounted for on the cash-basis or cost recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
ALLOWANCE FOR LOAN LOSSES: The Company's allowance for loan losses represents management's estimate of probable incurred losses in the loan portfolio at the balance sheet date. Additions to the allowance may result from recording provision for loan losses and recoveries, while charge offs are deducted from the allowance. Allocation of the allowance is made for analytical purposes only, and the entire allowance is available to absorb probable and estimated credit losses inherent in the loan portfolio.
The Company has an established process for determining the adequacy of the allowance for loan losses that relies on various procedures and pieces of information to arrive at a range of probable outcomes. First, management allocates specific portions of the allowance for loan losses to identified problem loans. Problem loans are identified through a loan risk rating system and monitored through watchlist reporting. Specific reserves are determined for each identified credit based on delinquency rates, collateral and other risk factors identified for that credit. Second, management's evaluation of the allowance for different loan groups is based on consideration of actual loss experience, the present and prospective financial condition of borrowers, industry concentrations within the loan portfolio and general economic conditions, and absent the ability of some of those factors, as well as peer industry data of comparable banks.
The determination of the level of allowance and, correspondingly, the provision for loan losses, rests upon estimates and assumptions, including past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed.
A loan is impaired when full payment under the loan terms is not expected. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not identified for impairment disclosures. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of a borrower's operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, the loan is evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of
estimated future cash flows using the loan's existing interest rate or at the fair value of collateral if repayment is expected solely from the collateral.
FORECLOSED ASSETS: Assets acquired through or instead of loan foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed.
PREMISES AND EQUIPMENT: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using both the straight-line method and accelerated methods over the estimated useful lives of the buildings, 39 years; site improvements, 15 years; leasehold improvements, 10 years; furniture and equipment, 5 to 8 years; and software and computer equipment, 3 years. Maintenance, repairs, and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. These assets are reviewed for impairment when events indicate the carrying amount may not be recoverable.
BANK OWNED LIFE INSURANCE: The Bank has purchased life insurance policies for on certain executives. Bank owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Bank owned life insurance totaled $3,205,785 and $3,127,384, at December 31, 2004 and 2003 and is included in other assets in the consolidated balance sheets.
BENEFIT PLANS: Bonus and 401(k) plan expense is the amount contributed determined by formula. Deferred compensation plan expense and supplemental employee retirement plan expense is allocated over years of service.
STOCK COMPENSATION: Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in the net income, as all options had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation.
The pro forma effects are computed using option pricing models, which incorporate the following weighted average assumptions as of grant date.
INCOME TAXES: Income taxes expense is the sum of current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
DERIVATIVES: All derivative instruments are recorded at their fair values. If derivative instruments are designated as hedges of fair values, both the change in fair value of the hedge and the hedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in other comprehensive income and reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of hedges are reflected in earnings as they occur. There were no derivatives or hedge activity during the years 2004 or 2003.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS: Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer financial needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
FAIR VALUES OF FINANCIAL INSTRUMENTS: Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on- and off-balance-sheet financial instruments do not include the value of anticipated future business or the value of assets and liabilities not considered financial instruments.
DIVIDEND RESTRICTION: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to its shareholders. The Company does not anticipate paying any cash dividends on its common stock in the foreseeable future.
EARNINGS PER COMMON SHARE: Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive impact of any additional potential common shares issuable under stock options.
COMPREHENSIVE INCOME: Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes the net change in net unrealized appreciation (depreciation) on securities available for sale, net of reclassification adjustments and tax, which is also recognized as a separate component of stockholders' equity.
LOSS CONTINGENCIES: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the consolidated financial statements.
RESTRICTIONS ON CASH: Cash on hand or on deposit with the Federal Reserve Bank of $3.7 million and $4.0 million was required to meet regulatory reserve and clearing requirements at December 31, 2004 and 2003, respectively. These balances do not earn interest.
ADOPTION OF NEW ACCOUNTING STANDARDS: During 2004, the Company did not adopt any new standards.
EFFECT OF NEWLY ISSUED BUT NOT YET EFFECTIVE ACCOUNTING STANDARDS: FAS 123, Revised, requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the
vesting period of the options. This will apply to awards granted or modified after the first quarter or year beginning June 15, 2005.
Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. Existing options that will vest after adoption date are expected to result in additional compensation expense of approximately $131,000 during the balance of 2005, $71,400 in 2006, $36,000 in 2007, and $17,000 in 2008. There will be no significant effect on financial position as total equity will not change.
RECLASSIFICATIONS: Certain items from the prior period financial statements were reclassified to conform to the current presentation.
Note 2 - SECURITIES AVAILABLE FOR SALE
The fair value of securities available for sale at December 31, 2004 and 2003 were as follows:
The fair values of debt securities available for sale at December 31, 2004, by contractual maturity are shown below. Securities not due at a single date, primarily mortgage-backed securities, are shown separately. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.
Note 2 - SECURITIES AVAILABLE FOR SALE (CONTINUED)
(1) Computed on a tax-equivalent basis for tax-exempt securities using a 34% statutory tax rate
Proceeds from the sale of securities available for sale during 2004 totaled $6,507,180. Gross gains and losses realized were $154,338 and $0, with an approximate tax provision of $55,550 and $0. Proceeds from the sale of securities available for sale during 2003 totaled $3,174,780. Gross gains and losses realized were $190,766 and $0, with an approximate tax provision of $68,700 and $0. Proceeds from the sale of securities available for sale during 2002 totaled $3,176,070. Gross gains and losses realized were $180,351 and $0, with an approximate tax provision of $65,000 and $0.
Securities with a carrying value of $16,823,718 and $12,434,104 were pledged to secure borrowings from the FHLB at December 31, 2004 and 2003, respectively. At December 31, 2004, there were no holdings of any one issue, other than the U.S. Government and its agencies and corporations, in an amount greater than 10% of stockholders' equity.
Securities with unrealized losses at year end 2004 not recognized in income are as follows:
Securities with unrealized losses at year end 2003 not recognized in income are as follows:
Unrealized losses on U. S. government agencies, state and municipality bonds have not been recognized into income because the issuers' bonds are of high credit quality, management has the intent and ability to hold for the foreseeable future, and the decline in fair value is largely due to increased market interest rates. The fair value is expected to recover as the bonds approach their maturity and/or as market rates decline.
The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and extent to which fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer's financial condition, the Company may consider whether the securities issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer's financial condition.
Note 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans at December 31, 2004 and 2003 were as follows:
Activity in the allowance for loan losses during 2004, 2003, 2002, 2001 and 2000 was as follows:
Note 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)
Impaired loans were as follows:
Information regarding interest income recognized during impairment and cash-basis interest is not considered significant to this presentation.
Nonperforming assets were as follows:
Nonperforming loans and impaired loans are defined differently. Some loans may be included in both categories, whereas other loans may only be included in one category. There was one troubled debt restructuring at December 31, 2004 and 2003 for $253,131, included in impaired loans. There were no troubled debt restructurings at December 31, 2002. There were two other real estate owned properties at December 31, 2004 for $430,000 and one at December 31, 2003 for $80,000. There was no other real estate owned property at year-end in prior years.
Note 4 - PREMISES AND EQUIPMENT, NET
Premises and equipment at December 31, 2004 and 2003 were as follows:
Information regarding lease commitments and commitments to purchase fixed assets is provided in Note 12.
Note 5 - DEPOSITS
Deposits at December 31, 2004 and 2003 are summarized as follows:
The following table shows the maturity distribution for certificates of deposit at December 31, 2004.
Deposits accepted from brokers totaled $63.3 million and $25.2 at December 31, 2004 and 2003, respectively.
Note 6 - SHORT-TERM BORROWINGS
Information relating to short-term borrowings, comprised of federal funds purchased at December 31, 2004 and 2003 is summarized below:
At December 31, 2004 and 2003, the Bank had $23,500,000 and $27,000,000, respectively, in lines of credit available from correspondent banks to purchase federal funds.
Note 7 - FEDERAL HOME LOAN BANK ADVANCES
At December 31, 2004 and 2003, advances from the Federal Home Loan Bank ("FHLB") were:
Of the total FHLB borrowings at December 31, 2004 and 2003, two advances totaling $6,500,000 had callable options on a quarterly basis. The call options for each of these advances, which initiated during March of 2002, can be executed on a quarterly basis with at least four days notice. These advances have not been called to-date by the FHLB as current interest rates deem the advances more favorable to hold. It is anticipated that the FHLB will call these advances at the appropriate time if and when interest rates rise.
At December 31, 2004 scheduled principal reductions on these FHLB advances were as follows:
At December 31, 2004, in addition to FHLB stock, the Company pledged securities with the FHLB totaling $16.8 million. In addition, as of December 31, 2004, the Company pledged loans totaling approximately $129.9 million under a blanket collateral agreement to secure advances outstanding. Also, the Company had unpledged interest-bearing deposits with the FHLB at December 31, 2004 totaling $8.4 million.
Note 8 - JUNIOR SUBORDINATED DEBENTURES AND TRUST PREFERRED SECURITIES
On November 16, 2001, TCT1 sold 3,500 of 9.00% fixed rate Trust Preferred Securities with a par value of $1,000. The proceeds of the sale and the initial equity investment were loaned to the Company in exchange for junior subordinated debentures of $3,608,000 with similar terms to the Trust Preferred Securities. The sole assets of TCT1 are the junior subordinated debentures of the Company and payments thereunder as well as certain unamortized issuance costs. The junior subordinated debentures are subject to mandatory redemption, in whole or in part, upon repayment of the Trust Preferred Securities at maturity or their earlier redemption at the par amount. The maturity date of the Trust Preferred Securities is November 15, 2031. Subject to the Company having received prior approval of the Federal Reserve Bank, if then required, the Trust Preferred Securities are redeemable prior to the maturity date beginning November 15, 2006 and each year thereafter at the option of the Company. The Company has the option to defer interest payments on the Trust Preferred Securities from time to time for a period not to exceed 40 consecutive quarterly periods.
Prior to 2003, TCT1 was consolidated in the Company's financial statements, with the Trust Preferred Securities issued by TCT1 reported in liabilities as Trust Preferred Securities and the subordinated debentures eliminated in consolidation. Under new accounting guidance, FASB Interpretation No. 46, as revised in December 2003, TCT1 is no longer consolidated with the Company. Accordingly, the Company does not report the securities issued by TCT1 as liabilities, and instead reports as liabilities the junior subordinated debentures issued by the Company and held by TCT1, as these are no longer eliminated in consolidation. Amounts previously reported as Trust Preferred Securities in liabilities have been recaptioned "junior subordinated debt" and continue to be presented in liabilities on the balance sheet. The effect of no longer consolidating TCT1 does not significantly change the amounts reported as the Company's assets, liabilities, equity, or interest expense.
Note 9 - INCOME TAXES
The consolidated provision for income taxes for the following years ended December 31 are as follows:
The effective tax rate differs from the statutory tax rate applicable to corporations as a result of permanent and other differences between accounting and taxable income as shown below:
The net deferred tax asset included the following amounts of deferred tax assets and liabilities at December 31, 2004 and 2003:
Note 10 - STOCK OPTION PLANS
Options to buy stock are granted to directors, officers and employees under the 1998 and 2001 Stock Option and Incentive Plans (the "Plans"), which together provide for issuance of up to 435,000 shares of common stock of the Company. The exercise price of stock options granted under the Plans may not be less than the market price at the date of grant. The maximum option term is ten years. Option vesting occurs over various periods of time ranging from immediate to four years. A summary of options granted pursuant to the Plans is as follows:
Options outstanding at December 31, 2004 were as follows:
Note 11 - RELATED PARTY TRANSACTIONS
Certain directors and executive officers of the Company, including their immediate families and companies in which they are principal owners, are loan customers of the Bank. At December 31, 2004 and 2003, the Bank had $19,722,902 and $23,260,123, respectively in loan commitments to directors and executive officers, of which $14,656,372 and $17,617,429 were funded at the respective year-ends, as reflected in the following table.
LOANS TO DIRECTORS AND EXECUTIVE OFFICERS
Other changes include adjustments for loans applicable to one reporting period that are excludable from the other reporting period.
During 2004, 2003 and 2002, the Company and the Bank engaged in transactions with entities controlled by their respective directors or their affiliates. The Bank leases its headquarters facility from Tippmann Properties, Inc., agent for John V. Tippmann, Sr. The original lease was a 10-year lease commencing on January 1, 1999. During 2001, the original lease term was extended to 15 years with provisions for one renewal term of 10 years at then prevailing market rates. In March 2004, an amendment was executed to add 8,336 square feet to the leased premises under the same terms as the original lease. The total amount paid to Tippmann Properties by the Company and the Bank for rent and maintenance was $483,901, $415,824 and $348,130 during 2004, 2003 and 2002, respectively. The lease is accounted for as an operating lease. Refer to Note 12 for a summary of future lease payment commitments under this and other leases.
Note 12 - COMMITMENTS AND OFF-BALANCE-SHEET RISK
COMMITMENTS TO EXTEND CREDIT AND STANDBY LETTERS OF CREDIT: The Bank maintains off-balance-sheet investments in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan 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. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. The Bank's maximum exposure to loan loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the face amount of these instruments. Commitments to extend credit are recorded when they are funded and stand by letters of credit are carried at fair value.
The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Collateral, such as accounts receivable, securities, inventory, property and equipment, is generally obtained based on management's credit assessment of the borrower.
Fair value of the Bank's off-balance-sheet instruments (commitments to extend credit and standby letters of credit) is based on rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. At December 31, 2004 and 2003, the rates on existing off-balance-sheet instruments were equivalent to current market rates, considering the underlying credit standing of the counterparties.
The Bank's maximum exposure to credit losses for loan commitments and standby letters of credit outstanding at December 31, 2004 and 2003 was as follows:
Management does not anticipate any significant losses as a result of these commitments.
LEASE AND OTHER CONTRACTED COMMITMENTS: The Company and the Bank occupy their respective headquarters, offices and other facilities under long-term operating leases and, in addition, are parties to long-term contracts for data processing and operating systems. The future minimum annual commitments under all operating leases as of December 31, 2004 are as follows:
The lease expense paid for operating leases for the facilities leased were $615,227, $489,976 and $417,316 for 2004, 2003 and 2002, respectively.
EMPLOYMENT CONTRACTS: Under the terms of certain employment contracts, upon the occurrence of certain events resulting in the severance of certain senior officers' employment with the Company, payments may be required to be made in excess of amounts that have been accrued.
Note 13 - BENEFIT PLANS
BONUS PLAN: The Company maintains a bonus plan covering substantially all officers. Payments to be made under the bonus plan are determined by a formula approved by the Board of Directors and are based on the results of the operations of the Company and on individual performance. As of December 31, 2004 and 2003, management had accrued a liability for this plan of approximately $191,000 and $180,000, respectively, which is included in other liabilities in the consolidated balance sheets. While the increase from 2003 is minimal, the total bonus calculated for 2004 was $520,000, of which $329,000 was paid out in December 2004.
401(K) PLAN: The Company established a 401(k) plan effective March 1, 1999 covering substantially all of its employees. The plan allows employees to contribute up to 15% of their compensation. The Company may match a portion of the employees' contributions and provides investment choices for the employees, including investment in common stock of the Company. Matching contributions are vested equally over a six-year period. Company matching contributions to the 401(k) plan are determined annually by management and approved by the Board of Directors. The Board of Directors approved annually an employer contribution for the 2004, 2003 and 2002 plan year matching 50% of the first 6% of the compensation contributed.
This contribution was also approved for 2004. The total contribution made by the Company during 2004, 2003 and 2002 was approximately $107,000, $102,000 and $83,000, respectively.
DEFERRED COMPENSATION PLAN: Effective January 1, 2002, a deferred compensation plan covers certain officers. Under the plan, the Company pays each participant, or their beneficiary, the amount of compensation deferred by the employee or contributed by the employer on a discretionary basis, plus interest, beginning with the individual's termination of service. Payments are to be made either immediately or over a five-year period, depending upon the amount to be paid. A liability is accrued for the obligation under this plan and is reported in other liabilities in the consolidated balance sheets. The expense incurred for the deferred compensation plan in 2004, 2003 and 2002 was approximately $10,000, $(1,000) and $22,000 respectively, resulting in a deferred compensation liability of approximately $42,000 and $31,000 as of December 31, 2004 and 2003.
DEFERRED DIRECTORS' FEES PLAN: Effective January 1, 2002, a deferred directors' fee plan covers all non-employee directors of the Company for a period of 10 years. Under the plan, the Company pays each participant, or their beneficiary, the amount of directors' fees deferred plus interest, beginning with the director's termination of service. Payments are to be made either immediately or over a five-year period. A liability is accrued for the obligation under this plan and is reported in other liabilities in the consolidated balance sheets. The expense incurred for the deferred directors' fee plan for 2004 and 2003 was approximately $82,000 and $66,000 resulting in a deferred compensation liability of approximately $185,000 and $103,000 as of December 31, 2004 and 2003 respectively.
SUPPLEMENTAL EMPLOYMENT RETIREMENT PLAN: Effective January 1, 2002, a supplemental employee retirement plan covers one officer. The Company is recording an expense equal to the projected present value of the payments due at retirement based on the projected remaining years of service. The obligation under the plan's was approximately $216,000 and $139,000 at December 31, 2004 and 2003 respectively, and is included in other liabilities in the consolidated balance sheet. The expense attributable to the plan is included in salaries and other employee benefits and was approximately $77,000 in 2004 and $72,000 in 2003.
Note 14 - FAIR VALUES OF FINANCIAL INSTRUMENTS
The following schedule reflects the carrying values and estimated fair values of the Company's financial instruments at December 31, 2004 and 2003. Items which are not financial instruments are not shown.
Estimated fair value for securities available for sale is based on quoted market values for the individual securities or for equivalent securities. Estimated fair value for loans is based on the rates charged at year-end for new loans with similar maturities, applied until the loan is assumed to reprice or be paid and the allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. Estimated fair value for IRAs, CDs, short-term borrowings, fixed rate advances from the FHLB and the junior subordinated debt is based on the rates at year-end for new deposits or borrowings, applied until maturity. Estimated fair value for other financial instruments and off-balance-sheet loan commitments is considered to approximate carrying value.
Note 15 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If only adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.
Management believes, as of December 31, 2004 and 2003, that the Company and the Bank had met all capital adequacy requirements to which they are subject.
As of December 31, 2004, the most recent notification from the Federal Reserve Bank of Chicago and the Indiana Department of Financial Institutions categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. There have been no conditions or events since that notification which management believes have changed the Bank's category.
Actual and required capital amounts and ratios are presented in the schedule below as of December 31, 2004 and 2003:
Note 16 - EARNINGS PER SHARE
The following table reflects the calculation of basic and diluted earnings per common share for the years ended December 31, 2004, 2003 and 2002. Options for 0, 0, and 40,000 shares of common stock were not included in the computation of diluted earnings per share for the years 2004, 2003 and 2002, respectively, because they were not dilutive.
Note 17 - PARENT COMPANY-ONLY CONDENSED FINANCIAL STATEMENTS
Following are condensed parent company (the Company's) financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003, 2002:
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF OPERATIONS
CONDENSED STATEMENTS OF CASH FLOWS
Note 18 - OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) components and related taxes were as follows.
Note 19 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Note: Earnings per share data may not agree to annual amounts due to rounding
Net income and diluted earnings per share results for the first quarter of 2004 were significantly higher than the same quarterly period in 2003 mainly as a result of pretax expenses of $720,000 recorded in the 2003 period for losses associated with discovery of unauthorized mortgage activity. Additionally, earnings per share for the fourth quarter 2004 was significantly higher due to the rise in interest rates, along with an $860,000 insurance reimbursement against losses recorded for the unauthorized mortgage activity.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders Tower Financial Corporation Fort Wayne, Indiana
We have audited the accompanying consolidated balance sheets of Tower Financial Corporation as of December 31, 2004 and 2003 and the related consolidated statements of operations, comprehensive income, changes in stockholders' equity, and cash flows for the years ended December 31, 2004, 2003 and 2002. 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 the standards of the Public Company Accounting Oversight Board, United States. 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 that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tower Financial Corporation as of December 31, 2004 and 2003 and the results of its operations and its cash flows for the years ended December 31, 2004, 2003 and 2002 in conformity with U.S. generally accepted accounting principles.
South Bend, Indiana /s/ Crowe Chizek and Company LLC February 10, 2005
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
We maintain a set of disclosure controls and procedures, which are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. As of December 31, 2004, we carried out an evaluation, under the supervision and with the participation of our management, including our Chairman, President and Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act. Based on that evaluation, our Chairman, President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective.
There was no change in our internal control over financial reporting during the fourth quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this Item concerning the directors nominees for director and executive officers of the Company and concerning disclosure of delinquent filers is incorporated herein by reference to the Company's definitive Proxy Statement for its 2005 Annual Meeting of Shareholders, to be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's last fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this Item concerning remuneration of the Company's officers and directors and information concerning material transactions involving such officers and directors is incorporated herein by reference to the Company's definitive Proxy Statement for its 2005 Annual Meeting of Shareholders which will be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's last fiscal year.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS.
The information required by this Item concerning the stock ownership of management and five percent beneficial owners and the Company's common stock that may be issued under existing equity compensation plans is incorporated herein by reference to the Company's definitive Proxy Statement for its 2005 Annual Meeting of Shareholders which will be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's last fiscal year.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item concerning certain relationships and related transactions is incorporated herein by reference to the Company's definitive Proxy Statement for its 2005 Annual Meeting of Shareholders which will be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's last fiscal year.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by this Item concerning principal accountant fees and services is incorporated herein by reference to the Company's definitive Proxy Statement for its 2005 Annual Meeting of Shareholders, to be filed with the Commission pursuant to Regulation 14A within 120 days after the end of the Company's last fiscal year.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) 1. Financial Statements. The following consolidated financial statements of Registrant are included herein under Item 8 of Part II:
2. Financial Statement Schedules.
All financial statement schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto.
(b) Exhibits:
A list of exhibits required to be filed as part of this Annual Report is set forth in the Index to Exhibits, which immediately precedes such exhibits and is incorporated herein by reference.
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.
TOWER FINANCIAL CORPORATION
By: /s/ Donald F. Schenkel ------------------------------------ Date: March 10, 2005 Donald F. Schenkel Chairman of the Board, President and Chief Executive Officer
Pursuant to the requirements of 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.
INDEX TO EXHIBITS
* The indicated exhibit is a management contract compensatory plan or arrangement required to be filed by Item 601 of Regulation S-K.
(1) The copy of this exhibit filed as the same exhibit number to the Company's Registration Statement on Form SB-2 (Registration No. 333-67235) is incorporated herein by reference.
(2) The copy of this exhibit filed as the same exhibit number to the Company's Quarterly Report on Form 10-QSB for the three months ended March 31, 2002 is incorporated herein by reference.
(3) The copy of this exhibit filed as the same exhibit number to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999, is incorporated herein by reference.
(4) The copy of this exhibit filed as the same exhibit number to the Company's Quarterly Report on Form 10-QSB for the three months ended September 30, 2000, is incorporated herein by reference.
(5) The copy of this exhibit filed as the same exhibit number to the Company's Quarterly Report on Form 10-QSB for the three months ended June 30, 2001, is incorporated herein by reference.
(6) The copy of this exhibit filed as the same exhibit number to the Company's Quarterly Report on Form 10-QSB for the three months ended September 30, 2001, is incorporated herein by reference.
(7) The copy of this exhibit filed as Exhibit 4.3 to the Company's Registration Statement on Form S-8 (Registration No. 333-64194) is incorporated herein by reference.
(8) The copy of this exhibit filed as the same exhibit number to the Company's Annual Report on Form 10-KSB for the year ended December 31, 2001 is incorporated herein by reference.
(9) The copy of this exhibit filed as Exhibit 4.3 to the Company's Registration Statement on Form S-8 (Registration No. 333-64318) is incorporated herein by reference.
(10) The copy of this exhibit filed as the same exhibit number to the Company's Form 10-K for the year ended December 31, 2003 is incorporated herein by reference.