ITEM 1. BUSINESS
ROYAL BANCSHARES
Royal Bancshares of Pennsylvania, Inc. ("Royal Bancshares"), is a Pennsylvania business corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "Holding Company Act"). Royal Bancshares is supervised by the Board of Governors of the Federal Reserve System (Federal Reserve Board). Its legal headquarters is located at 732 Montgomery Avenue, Narberth, PA. On June 29, 1995, pursuant to the plan of reorganization approved by the shareholders of Royal Bank America, formerly Royal Bank of Pennsylvania ("Royal Bank"), all of the outstanding shares of common stock of Royal Bank were acquired by Royal Bancshares and were exchanged on a one-for-one basis for common stock of Royal Bancshares. The principal activities of Royal Bancshares is owning and supervising Royal Bank, which engages in a general banking business principally in Montgomery, Philadelphia and Berks counties in Pennsylvania and in Northern and Southern New Jersey. Royal Bancshares also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities. During 2005, Royal Bancshares received permission to offer Mezzanine loans by the Federal Reserve Board. At December 31, 2005, Royal Bancshares had consolidated total assets of approximately $1.3 billion, total deposits of approximately $697 million and shareholders' equity of approximately $156 million. Royal Bancshares two Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II, are not consolidated per requirements under FIN 46(R).
From time to time, Royal Bancshares may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. When we use words such as "believes", "expects," "anticipates" or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, Royal Bancshares notes that a variety of factors could cause Royal Bancshares' actual results and experience to differ materially from the anticipated results or other expectations expressed in Royal Bancshares forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of Royal Bancshares' business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations: business conditions in the banking industry; the regulatory environment; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures and similar items.
Royal Bancshares has three reportable operating segments, Community Banking, Tax Liens, and Equity Investments which resulted from the adoption of FIN46(R) as described in Note B of the Notes to Consolidated Financial Statements included in this Report. The segment reporting information in Note B is incorporated by reference into this Item 1.
ROYAL BANK AMERICA
Royal Bank was incorporated in the Commonwealth of Pennsylvania on July 30, 1963, was chartered by the Commonwealth of Pennsylvania Department of Banking and commenced operation as a Pennsylvania state-chartered bank on October 22, 1963. Royal Bank is the successor of the Bank of King of Prussia, the principal ownership of which was acquired by The Tabas Family in 1980. Royal Bank is an insured bank by the Federal Deposit Insurance Corporation (the "FDIC").
During the third quarter of 2005 the Bank formed a subsidiary called Royal Bank America Leasing LP to originate small business product leases. The Bank owns 60% of the subsidiary.
During 2004, Royal Bank started a banking division called Royal Asian Bank ("Royal Asian") which operates three branches in Pennsylvania and one branch in Fort Lee, New Jersey. During the second quarter of 2006 Royal Bancshares anticipates that Royal Asian will begin operating under a separate bank charter under the laws of the Commonwealth of Pennsylvania. This will result in Royal Bancshares becoming a two bank holding company.
Royal Bank derives its income principally from interest charged on loans, investment securities, and fees received in connection with the origination of loans and other services. Royal Bank's principal expenses are interest expense on deposits and operating expenses. Operating revenues, deposit growth, investment maturities, loan sales and the repayment of outstanding loans provide the majority funds for activities.
Service Area. Royal Bank's primary service area includes Montgomery, Chester, Bucks, Delaware, Berks and Philadelphia counties, New Jersey and the State of Delaware. This area includes residential areas and industrial and commercial businesses of the type usually found within a major metropolitan area. Royal Bank serves this area from twenty branches located throughout Montgomery, Philadelphia and Berks counties and New Jersey. Royal Bank also considers the states of Pennsylvania, New Jersey, New York, Florida, Washington DC, Maryland, Northern Virginia and Delaware as a part of its service area for certain products and services. Frequently, Royal Bank will do business with clients located outside of its service area. Royal Bank has loans in twenty-four states via participations with other lenders who have broad experience in those respective markets. Royal Bank's legal headquarters are located at 732 Montgomery Avenue, Narberth, PA.
Royal Bank conducts business operations as a commercial bank offering checking accounts, savings and time deposits, and loans, including residential mortgages, home equity and SBA loans. Royal Bank also offers safe deposit boxes, collections, internet banking and bill payment along with other customary bank services (excluding trust) to its customers. Drive-up, ATM, and night depository facilities are available. Services may be added or deleted from time to time. The services offered and the business of Royal Bank is not subject to significant seasonal fluctuations. Royal Bank is a member of the Federal Reserve Fedline Wire Transfer System.
Competition. The financial services industry in our service area is extremely competitive. Competitors within our service area include banks and bank holding companies with greater resources. Many competitors have substantially higher legal lending limits.
In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, leasing companies, finance companies and other financial services companies offer products and services similar to those offered by Royal Bank, on competitive terms.
Many bank holding companies have elected to become financial holding companies under the Gramm-Leach-Bliley Act of 1999, which give a broader range of products with which Royal Bank must compete. Although the long-range effects of this development cannot be predicted, it will likely further narrow the differences and intensify competition among commercial banks, investment banks, insurance firms and other financial services companies.
Employees. Royal Bancshares employed approximately 169 persons on a full-time equivalent basis as of December 31, 2005.
Deposits. At December 31, 2005, total deposits of Royal Bank were distributed among demand deposits (11%), money market deposit accounts, savings and Super Now (43%) and time deposits (46%). At year-end 2005, deposits decreased $45 million from year-end 2004, or 6%, primarily due to an increased use of overnight borrowings at lower interest rates paid compared to offering higher rates to the Money Market accounts which caused a reduction in the average balance during the year.
Lending. At December 31, 2005, Royal Bancshares had a total loan portfolio of $550 million, representing 42% of total assets. The loan portfolio is categorized into commercial demand, commercial mortgages, residential mortgages (including home equity lines of credit), construction, real estate tax liens and installment loans. At year-end 2005, loans increased $81 million from year end 2004, or 17% primarily due to the addition of the Royal Asian division and increasing the size of the lending staff along with offering additional loan products and more competitive rates.
Current market and regulatory trends in banking are changing the basic nature of the banking industry. Royal Bank intends to keep pace with the banking industry by being competitive with respect to interest rates and new types or classes of deposits insofar as it is practical to do so consistent with Royal Bank's size, objective of profit maintenance and stable capital structure.
NON-BANK SUBSIDIARIES
On June 30, 1995, Royal Bancshares established a special purpose Delaware investment company, Royal Investment of Delaware ("RID"), as a wholly owned subsidiary. Its legal headquarters is at 103 Springer Building, 3411 Silverside Road, Wilmington, DE. RID buys, holds and sells investment securities. At December 31, 2005, total assets of RID were $20.9 million, of which $1.2 million was held in cash and cash equivalents and $19.1 million was held in investment securities.
Royal Bancshares, through its wholly owned subsidiary Royal Bank holds a 60% ownership interest in Crusader Servicing Corporation ("CSC"). Its legal headquarters is at 732 Montgomery Avenue, Narberth, PA. CSC acquires, through auction, delinquent property tax liens in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens on the property, and obtaining certain foreclosure rights as defined by local statute. At December 31, 2005, total assets of CSC were $52.2 million.
On June 23, 2003, Royal Bancshares, through its wholly owned subsidiary Royal Bank, established Royal Investments of Pennsylvania, LLC ("RIP") as a wholly owned subsidiary. Its legal headquarters is at 732 Montgomery Avenue, Narberth, Pennsylvania. RIP was formed to invest in equity real estate ventures subject to limitations imposed by regulation. At December 31, 2005, total assets of RIP prior to consolidation under FIN 46(R) were $13.8 million. During the early part of 2005, RIP changed its name to Royal Investments America, LLC.
On October 27, 2004, Royal Bancshares formed two Delaware trust affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II from the completion of an aggregate of $25.0 million of a private placement of trust preferred securities.
On July 25, 2005, Royal Bancshares through its wholly owned subsidiary Royal Bank formed Royal Bank America Leasing, LP ("Royal Leasing"). Royal Bank holds a 60% ownership interest in Royal Leasing. Its legal headquarters is 550 Township Line Road, Blue Bell, Pennsylvania. Royal Leasing was formed to originate small business leases. At December 31, 2005, total assets of Royal Leasing were $3 million.
WEBSITE ACCESS TO COMPANY REPORTS
We post publicly available reports required to be filed with the SEC on our website, www.royalbankamerica.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website.
PRODUCTS AND SERVICES WITH REPUTATION RISK
Royal Bancshares offers a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies become dissatisfied or object to any product or service offered by Royal Bancshares or any of its subsidiaries, whether legally justified or not, negative publicity with respect to any such product or service could have a negative impact on Royal Bancshares's reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on Royal Bancshares' reputation.
FUTURE ACQUISITIONS
Royal Bancshares' acquisition strategy consists of identifying financial institutions, insurance agencies and other financial companies with business philosophies that are similar to our business philosophies, which operate in strong markets that are geographically compatible with our operations, and which can be acquired at an acceptable cost. In evaluating acquisition opportunities, we generally consider potential revenue enhancements and operating efficiencies, asset quality, interest rate risk, and management capabilities. Royal Bancshares currently has no formal commitments with respect to future acquisitions although discussions with acquisition candidates take place occasionally.
CONCENTRATIONS, SEASONALITY
Royal Bancshares does not have any portion of its business dependent on a single or limited number of customers, the loss of which would have a material adverse effect on its business. No substantial portion of loans or investments is concentrated within a single industry or group of related industries, except a significant majority of loans are secured by real estate much of which is located in southeastern Pennsylvania. The business of Royal Bancshares and its subsidiaries is not seasonal in nature.
ENVIRONMENT COMPLIANCE
Royal Bancshares and its subsidiaries' compliance with federal, state and local environment protection laws had no material effect on capital expenditures, earnings or their competitive position in 2005, and is not expected to have a material effect on such expenditures, earnings or competitive position in 2006.
SUPERVISION AND REGULATION
Bank holding companies and banks operate in a highly regulated environment and are regularly examined by federal and state regulatory authorities.
The following discussion concerns various federal and state laws and regulations and the potential impact of such laws and regulation on Royal Bancshares and its subsidiaries.
To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. Royal Bancshares cannot determine the likelihood or timing of any such proposals or legislations or the impact they may have on Royal Bancshares and its subsidiaries. A change in law, regulations or regulatory policy may have a material effect on Royal Bancshares' business.
Holding Company. Royal Bancshares, as a Pennsylvania business corporation, is subject to the jurisdiction of the Securities and Exchange Commission (the "SEC") and of state securities commissions for matters relating to the offering and sale of its securities. Accordingly, if Royal Bancshares wishes to issue additional shares of its Common Stock, in order, for example, to raise capital or to grant stock options, Royal Bancshares will have to comply with the registration requirements of the Securities Act of 1933 as amended, or find an applicable exemption from registration.
Royal Bancshares is subject to the provisions of the Holding Company Act, and to supervision, regulation and examination by the Federal Reserve Board. The Holding Company Act requires Royal Bancshares to secure the prior approval of the Federal Reserve Board before it owns or controls, directly or indirectly, more than 5% of the voting shares of any corporation, including another bank. In addition, the Holding Company Act prohibits Royal Bancshares from acquiring more than 5% of the voting shares of, or interest in, or all or substantially all of the assets of, any bank located outside Pennsylvania, unless such an acquisition is specifically authorized by laws of the state in which such bank is located.
A bank holding company also is prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any such company engaged in non-banking activities unless the Federal Reserve Board, by order or regulation, has found such activities to be closely related to banking or managing or controlling banks as to be a proper incident thereto. In making this determination, the Federal Reserve Board considers whether the performance of these activities by a bank holding company would offer benefits to the public that outweigh possible adverse effects.
As a bank holding company, Royal Bancshares is required to file an annual report with the Federal Reserve Board and any additional information that the Federal Reserve Board may require pursuant to the Holding Company Act. The Federal Reserve Board may also make examinations of the holding company and any or all of subsidiaries. Further, under the Holding Company Act and the Federal Reserve Board's regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit or provision of credit of any property or services. The so called "anti-tying" provisions state generally that a bank may not extend credit, lease, sell property or furnish any service to a customer on the condition that the customer obtain additional credit or service from Royal Bank, its bank holding company or any other subsidiary of its bank holding company, or on the condition that the customer not obtain other credit or services from a competitor of Royal Bank, its bank holding company or any subsidiary of its bank holding company.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act and by state banking laws on any extensions of credit to the bank holding company or any of the holding company's subsidiaries, on investments in the stock or other securities of the bank holding company and on taking of such stock or securities as collateral for loans to any borrower.
Under the Pennsylvania Banking Code of 1965, as amended, the ("Code"), Royal Bancshares is permitted to control an unlimited number of banks. However, Royal Bancshares would be required under the Holding Company Act to obtain the prior approval of the Federal Reserve Board before it could acquire all or substantially all of the assets of any bank, or acquiring ownership or control of any voting shares of any bank other than Royal Bank, if, after such acquisition, the registrant would own or control more than 5% of the voting shares of such bank. The Holding Company Act has been amended by the Riegle-Neal Interstate Banking and Branching Act of 1994, which authorizes bank holding companies, subject to certain limitations and restrictions, to acquire banks located in any state.
In 1995, the Code was amended to harmonize Pennsylvania law with the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 to enable Pennsylvania institutions to participate fully in interstate banking and to remove obstacles to the choice by banks from other states engaged in interstate banking to select Pennsylvania as a head office location.
A bank holding company located in Pennsylvania, another state, the District of Columbia or a territory or possession of the United States may control one or more banks, bank and trust companies, national banks, interstate banks and, with the prior written approval of the Pennsylvania Department of Banking, may acquire control of a bank and trust company or a national bank located in Pennsylvania. A Pennsylvania-chartered institution may maintain a bank, branches in any other state, the District of Columbia, or a territory or possession of the United States upon the written approval of the Pennsylvania Department of Banking.
Federal law also prohibits the acquisition of control of a bank holding company without prior notice to certain federal bank regulators. Control is defined for this purpose as the power, directly or indirectly, to direct the management or policies of a bank or bank holding company or to vote 25% or more of any class of voting securities of a bank or bank holding company.
Royal Bank. The deposits of Royal Bank are insured by the FDIC. Royal Bank is subject to supervision, regulation and examination by the Pennsylvania Department of Banking and by the FDIC. In addition, Royal Bank is subject to a variety of local, state and federal laws that affect its operation.
The Pennsylvania Department of Banking and the FDIC routinely examine Pennsylvania state-chartered, non-member banks such as Royal Bank in areas such as reserves, loans, investments, management practices and other aspects of operations. These examinations are designed for the protection of depositors rather that Royal Bancshares' shareholders.
Federal and state banking laws and regulations govern, among other things, the scope of a bank's business, the investments a bank may make, the reserves against deposits a bank must maintain, the types and terms of loans a bank may make and the collateral it may take, the activities of banks with respect to mergers and consolidations, and the establishment of branches. Pennsylvania law permits statewide branching.
Under the Federal Deposit Insurance Act ("FDIC Act"), the FDIC possesses the power to prohibit institutions regulated by it (such as Royal Bank) from engaging in any activity that would be an unsafe and unsound banking practice or in violation of applicable law. Moreover, the FDIC Act: (i) empowers the FDIC to issue cease-and-desist or civil money penalty orders against Royal Bank or its executive officers, directors and/or principal shareholders based on violations of law or unsafe and unsound banking practices; (ii) authorizes the FDIC to remove executive officers who have participated in such violations or unsound practices; (iii) restricts lending by Royal Bank to its executive officers, directors, principal shareholders or related interests thereof; and (iv) restricts management personnel of a bank from serving as directors or in other management positions with certain depository institutions whose assets exceed a specified amount or which have an office within a specified geographic area. Additionally, the FDIC Act provides that no person may acquire control of Royal Bank unless the FDIC has been given 60-days prior written notice and within that time has not disapproved the acquisition or extended the period for disapproval.
Under the Community Reinvestment Act ("CRA"), the FDIC uses a five-point rating scale to assign a numerical score for a bank's performance in each of three areas: lending, service and investment. Under the CRA, the FDIC is required to: (i) assess the records of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community (including low-and moderate-income neighborhoods) which they serve, and (ii) take this record into account in its evaluation of any application made by any such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of another bank. The CRA also requires the federal banking agencies to make public disclosures of their evaluation of each bank's record of meeting the credit needs of its entire community, including low-and moderate-income neighborhoods. This evaluation will include a descriptive rate ("outstanding," "satisfactory," "needs to improve" or "substantial noncompliance") and a statement describing the basis for the rating. After its most recent examination of Royal Bank under CRA, the FDIC gave Royal Bank a CRA rating of satisfactory.
A subsidiary bank of a holding company is subject to certain restrictions imposed by the Federal Reserve Act, as amended, on any extensions of credit to the bank holding company or its subsidiaries, on investments in the stock or other securities of the bank holding company or its subsidiaries, and on taking such stock or securities as collateral for loans. The Federal Reserve Act, as amended, and Federal Reserve Board regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person who becomes a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship.
From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of Royal Bank. It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of Royal Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, Royal Bank's business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business.
Under Bank Secrecy Act ("BSA"), banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions in any one day of which Royal Bank is aware that exceed $10,000 in the aggregate. Civil and criminal penalties are provided under the BSA for failure to file a required report, for failure to supply information required by the BSA or for filing a false or fraudulent report.
FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991
GENERAL. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDIC Improvement Act") includes several provisions that have a direct impact on Royal Bank. The most significant of these provisions are discussed below.
The FDIC is required to conduct periodic full-scope, on-site examinations of Royal Bank. In order to minimize losses to the deposit insurance funds, the FDIC Improvement Act establishes a format to monitor FDIC-insured institutions and to enable "prompt corrective action" by the appropriate federal supervisory agency if an institution begins to experience any difficulty. The FDIC Improvement Act establishes five "capital" categories. They are: (1) well capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. The overall goal of these capital measures is to impose scrutiny and operational restrictions on banks as they descend the capital categories from well capitalized to critically undercapitalized.
Under current regulations, a "well-capitalized" institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio, a 5% Tier 1 Leverage Ratio, and is not subject to any written order or final directive by the FDIC to meet and maintain a specific capital level. Royal Bank is presently categorized as a "well-capitalized" institution.
An "adequately capitalized" institution is one that meets the required minimum capital levels, but does not meet the definition of a "well-capitalized" institution. The existing capital rules generally require banks to maintain a Tier 1 Leverage Ratio of at least 4% and an 8% total risk-based capital ratio. Since the risk-based capital requirement is measured in the form of Tier 1 capital, this also will mean that a bank would need to maintain at least 4% Tier 1 risk-based capital ratio. An institution must meet each of the required minimum capital levels in order to be deemed "adequately capitalized."
An "undercapitalized" institution is one that fails to meet one or more of the required minimum capital levels for an "adequately capitalized" institution. Under the FDIC Improvement Act, an "undercapitalized" institution must file a capital restoration plan and is automatically subject to restrictions on dividends, management fees and asset growth. In addition, the institution is prohibited from making acquisitions, opening new branches or engaging in new lines of business without the prior approval of its primary federal regulator. A number of other restrictions may be imposed.
A "critically undercapitalized" institution is one that has a tangible equity (Tier 1 capital) ratio of 2% or less. In addition to the same restrictions and prohibitions that apply to "undercapitalized" and "significantly undercapitalized" institutions, any institution that becomes "critically undercapitalized" is prohibited from taking the following actions without the prior written approval of its primary federal supervisory agency: engaging in any material transactions other than in the usual course of business; extending credit for highly leveraged transactions; amending its charter or bylaws; making any material changes in accounting methods; engaging in certain transactions with affiliates; paying excessive compensation or bonuses; and paying interest on liabilities exceeding the prevailing rates in the institution's market area. In addition, a "critically undercapitalized" institution is prohibited from paying interest or principal on its subordinated debt and is subject to being placed in conservatorship or receivership if its tangible equity capital level is not increased within certain mandated time frames.
REAL ESTATE LENDING GUIDELINES. Pursuant to the FDIC Improvement Act, the FDIC has issued real estate lending guidelines that establish loan-to-value ("LTV") ratios for different types of real estate loans. A LTV ratio is generally defined as the total loan amount divided by the appraised value of the property at the time the loan is originated. If a bank does not hold a first lien position, the total loan amount would be combined with the amount of all senior liens when calculating the ratio. In addition to establishing the LTV ratios, the FDIC's real estate guidelines require all real estate loans to be based upon proper loan documentation and a recent independent appraisal of the property.
The FDIC's guidelines establish the following limits for LTV ratios:
Loan Category LTV Limit ------------- ---------
Raw Land 65% Land Development Construction: Commercial, Multifamily (includes condos and co-ops), and other Nonresidential 80% Improved Property 85% Owner occupied 1-4 Family and Home Equity (without credit enhancements) 90%
The guidelines provide exceptions to the LTV ratios for government-backed loans; loans facilitating the sale of real estate acquired by the lending institution in the normal course of business; loans where Royal Bank's decision to lend is not based on the offer of real estate as collateral and such collateral is taken only out of an abundance of caution; and loans renewed, refinanced, or restructured by the original lender to the same borrower, without the advancement of new money. The regulation also allows institutions to make a limited amount of real estate loans that do not conform to the proposed LTV ratios. Under this exception, Royal Bank would be allowed to make real estate loans that do not conform to the LTV ratio limits, up to an amount not to exceed 100% of Royal Bank's total capital.
TRUTH IN SAVINGS ACT. The FDIC Improvement Act also contains the Truth in Savings Act. The purpose of this Act is to require the clear and uniform disclosure of the rates of interest that are payable on deposit accounts by Royal Bank and the fees that are assessable against deposit accounts, so that consumers can make a meaningful comparison between the competing claims of banks with regard to deposit accounts and products. This Act requires Royal Bank to include, in a clear and conspicuous manner, the following information with each periodic statement of a deposit account: (1) the annual percentage yield earned, (2) the amount of interest earned, (3) the amount of any fees and charges imposed and (4) the number of days in the reporting period. This Act allows for civil lawsuits to be initiated by customers if Royal Bank violates any provision or regulation under this Act.
GRAMM-LEACH-BLILEY ACT OF 1999. On November 12, 1999, President Clinton signed the Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act. The Financial Services Modernization Act repeals the two anti-affiliation provisions of the Glass-Steagall Act:
o Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms "engaged principally" in specified securities activities; and
o Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities.
In addition, the Financial Services Modernization Act contains provisions that expressly preempt any state insurance law. The law establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers. It revises and expands the framework of the Holding Company Act to permit a holding company to engage in a full range of financial activities through a new entity known as a Financial Holding Company. "Financial activities" is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
In general, the Financial Services Modernization Act:
o Repeals historical restrictions on, and eliminates many federal and state law barriers to, affiliations among banks, securities firms, insurance companies, and other financial service providers;
o Provides a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies;
o Broadens the activities that may be conducted by national banks, banking subsidiaries of bank holding companies, and their financial subsidiaries;
o Provides an enhanced framework for protecting the privacy of consumer information;
o Adopts a number of provisions related to the capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system;
o Modifies the laws governing the implementation of the CRA; and
o Addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions.
In order for Royal Bancshares to take advantage of the ability to affiliate with other financial service providers, Royal Bancshares must become a "Financial Holding Company." To become a Financial Holding Company, a company must file a declaration with the Federal Reserve, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because all of its insured depository institution subsidiaries are well-capitalized and well-managed. In addition, the Federal Reserve Board must determine that each insured depository institution subsidiary of Royal Bancshares has at least a "satisfactory" CRA rating. Royal Bancshares currently meets the requirements to make an election to become a Financial Holding Company. Royal Bancshares' management has not determined at this time whether it will seek an election to become a Financial Holding Company. Royal Bancshares continues to examine its strategic business plan to determine whether, based, among other factors, on market conditions, the relative financial conditions of Royal Bancshares and its subsidiaries, regulatory capital requirements and general economic conditions, Royal Bancshares desires to utilize any of the expanded powers provided in the Financial Service Modernization Act.
The Financial Services Modernization Act also includes a new section of the FDIC Act governing subsidiaries of state banks that engage in "activities as principal that would only be permissible" for a national bank to conduct in a financial subsidiary. It expressly preserves the ability of a state bank to retain all existing subsidiaries. Because Pennsylvania permits commercial banks chartered by the state to engage in any activity permissible for national banks, Royal Bank will be permitted to form subsidiaries to engage in the activities authorized by the Financial Services Modernization Act, to the same extent as a national bank. In order to form a financial subsidiary, Royal Bank must be well-capitalized, and Royal Bank would be subject to the same capital deduction, risk management and affiliate transaction rules as applicable to national banks.
Although the long-range effect of the Financial Services Modernization Act cannot be predicted, Royal Bancshares and Royal Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on its operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that Royal Bancshares and Royal Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than Royal Bancshares and Royal Bank.
USA PATRIOT ACT OF 2001. In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington D.C., which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcements' and the intelligence communities' abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
SARBANES-OXLEY ACT OF 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted ("SOX"). The stated goals of the SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.
SOX is the most far-reaching U.S. securities legislation enacted in some time. SOX generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the SEC under the Securities Exchange Act of 1934, or the Exchange Act. Given the extensive SEC role in implementing rules relating to many of SOX's new requirements, the final scope of the requirements remains to be determined.
The SOX addresses, among other matters:
- New requirements for audit committees of reporting companies, including independence, expertise, and responsibilities;
- Certification of financial statements by the chief executive officer and chief financial officer;
- The forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;
- Increased disclosure and reporting obligations for the reporting company and their directors and executive officers with other banks regulatory requirements;
- Disclosure of off-balance sheet transactions;
- A prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulatory requirements;
- Disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;
- "Real time" filing of periodic reports;
- The formation of an independent public accounting oversight board;
- New standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; and
- Various increased civil and criminal penalties for fraud and other violations of securities laws.
Section 404 of SOX requires Royal Bancshares to include in its Annual Report on Form 10-K for fiscal years ending after November 15, 2004, a report by its management and an attestation report by its independent registered public accounting firm on the adequacy of Royal Bancshares' internal control over financial reporting. Management's internal control report must, among other things, set forth management's assessment of the effectiveness of Royal Bancshares' internal control over financial reporting as of the end of its most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. See Item 9A of this Report.
REGULATION W. Transactions between a bank and its "affiliates" are quantitatively and qualitatively restricted under the Sections 23A and 23B of Federal Reserve Act. The FDIC Act applies Sections 23A and 23B to insured nonmember banks in the same manner and to the same extent as if they were members of the Federal Reserve System. The Federal Reserve Board has also recently issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions. Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, the bank's holding company and companies that are under common control with the bank. Royal Bancshares is considered to be an affiliate of Royal Bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in "covered transactions" with affiliates:
- To an amount equal to 10% of Royal Bank's capital and surplus, in the case of covered transactions with any one affiliate; and
- To an amount equal to 20% of Royal Bank's capital and surplus, in the case of covered transactions with all affiliates.
In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A "covered transaction" includes:
- A loan or extension of credit to an affiliate;
- A purchase of, or an investment in, securities issued by an affiliate;
- A purchase of assets from an affiliate, with some exceptions;
- The acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and
- This issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, under Regulation W:
- A bank and its subsidiaries may not purchase a low-quality asset from an affiliate;
- Covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and
- With some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.
Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates.
Concurrently with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of Royal Bank's capital and surplus.
MONETARY POLICY
The earnings of Royal Bank are affected by the policies of regulatory authorities including the Federal Reserve Board. An important function of the Federal Reserve System is to influence the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities, changes in reserve requirements against member bank deposits and limitations on interest rates that member banks may pay on time and savings deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans and investments and deposits. Their use may also affect rates charged on loans or paid for deposits.
The policies and regulations of the Federal Reserve Board have had and will probably continue to have a significant effect on its reserve requirements, deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect Royal Bank's operations in the future. The effect of such policies and regulations upon the future business and earnings of Royal Bank cannot be predicted.
EFFECTS OF INFLATION
Inflation has some impact on Royal Bancshares' operating costs. Unlike many industrial companies, however, substantially all of Royal Bancshares' assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on Royal Bancshares' performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.
CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
The accounting and reporting policies of Royal Bancshares conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry. Critical accounting policies, judgments and estimates relate to loans, the allowance for loan losses and deferred tax assets. The policies which significantly affect the determination of Royal Bancshares' financial position, results of operations and cash flows are summarized in Note A "Summary of Significant Accounting Polices" of the Notes to Consolidated Financial Statements and are discussed in the section captioned "Recent Accounting Pronouncements" of Management's Discussion and Analysis of Financial Condition and Results of Operations, included in Items 7 and 8 of this Report, each of which is incorporated herein by reference.
Royal Bancshares considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb estimated credit losses. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts of timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required that would adversely impact earnings in future periods.
Royal Bancshares recognizes deferred tax assets and liabilities for the future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management's judgment based upon available evidence that future realization is more likely than not. If management determines that Royal Bancshares may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.
AVAILABLE INFORMATION
Upon a shareholder's written request, a copy of Royal Bancshares' Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as required to be filed with the SEC pursuant to Exchange Act Rule 13a-1, may be obtained without charge on our website www.royalbankamerica.com or from Jeffrey T. Hanuscin, Chief Financial Officer, Royal Bank America, 732 Montgomery Avenue, Narberth, PA 19072.
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ITEM 1A.
ITEM 1A. RISK FACTORS.
An investment in our common stock involves risks. Before making an investment decision, investors should carefully consider the risks described below in conjunction with the other information in this report, including our consolidated financial statements and related notes. If any of the following risks or other risks, which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. In such a case, the trading price of our common stock could decline, and investors may lose all or part of their investment.
RISKS RELATED TO OUR BUSINESS
OUR RECENT OPERATING RESULTS MAY NOT BE INDICATIVE OF FUTURE OPERATING RESULTS.
Royal Bancshares may not be able to sustain its growth. Various factors (discussed below) such as increased size, economic conditions, regulatory and legislative considerations, competition and the ability to find and retain people that can make Royal Bancshares' community-focused operating model successful, may impede its ability to expand its market presence. If we experience a significant decrease in our growth rate, our results of operations and financial condition may be adversely affected.
OUR BUSINESS IS SUBJECT TO THE SUCCESS OF THE LOCAL ECONOMIES AND REAL ESTATE MARKETS IN WHICH WE OPERATE.
Our success significantly depends on the growth in population, income levels, loans and deposits and on the continued stability in real estate values in our markets. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may be adversely affected. Adverse economic conditions in our specific market areas, specifically decreases in real estate property values due to the nature of our loan portfolio, over 94% of which is secured by real estate, could reduce our growth rate, affect the ability of customers to repay their loans and generally affect our financial condition and results of operations. Royal Bancshares is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.
OUR CONCENTRATION OF COMMERCIAL AND CONSTRUCTION LOANS IS SUBJECT TO UNIQUE RISKS THAT COULD ADVERSELY AFFECT OUR EARNINGS.
Our commercial and construction loan portfolio was $505 million at December 31, 2005, comprising 92% of total loans. Commercial and construction loans are often riskier than home equity loans or residential mortgage loans to individuals. In the event of a general economic slowdown, they would represent higher risk due to slower sales and reduced cash flow that could impact the borrowers' ability to repay on a timely basis.
OUR ABILITY TO PAY DIVIDENDS DEPENDS PRIMARILY ON DIVIDENDS FROM OUR BANKING SUBSIDIARY, WHICH ARE SUBJECT TO REGULATORY LIMITS.
We are a bank holding company and our operations are conducted by direct and indirect subsidiaries, each of which is a separate and distinct legal entity. Substantially all of our assets are held by our direct and indirect subsidiaries.
Our ability to pay dividends depends on our receipt of dividends from our direct and indirect subsidiaries. Our banking subsidiary, Royal Bank, including the Royal Asian Bank division, is our primary source of dividends. Dividend payments from our banking subsidiary are subject to legal and regulatory limitations, generally based on net profits and retained earnings, imposed by the various banking regulatory agencies. The ability of Royal Bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. At December 31, 2005, approximately $30 million was available without the need for regulatory approval for the payment of dividends to us from our banking subsidiary. There is no assurance that our subsidiaries will be able to pay dividends in the future or that we will generate adequate cash flow to pay dividends in the future. Failure to pay dividends on our common stock could have a material adverse effect on the market price of our common stock.
COMPETITION FROM OTHER FINANCIAL INSTITUTIONS MAY ADVERSELY AFFECT OUR PROFITABILITY.
We face substantial competition in originating loans, both commercial and consumer. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.
In attracting business and consumer deposits, Royal Bank faces substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.
Royal Bancshares' banking and non-banking subsidiaries also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, credit unions, insurance agencies and governmental organizations which may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our banking operations. As a result, such non-bank competitors may have advantages over Royal Bancshares' banking and non-banking subsidiaries in providing certain products and services. This competition may reduce or limit our margins on banking and non-banking services, reduce our market share and adversely affect our earnings and financial condition.
OUR ALLOWANCE FOR LOAN LOSSES MAY NOT BE ADEQUATE TO COVER ACTUAL LOSSES.
Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, current economic conditions and geographic concentrations within the portfolio. Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect our financial results.
WE MAY SUFFER LOSSES IN OUR LOAN PORTFOLIO DESPITE OUR UNDERWRITING PRACTICES.
Royal Bancshares seeks to mitigate the risks inherent in its loan portfolio by adhering to specific underwriting practices. These practices often include: analysis of a borrower's credit history, financial statements, tax returns and cash flow projections; valuation of collateral based on reports of independent appraisers; and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for the various kinds of loans we make, Royal Bancshares may incur losses on loans that meet these criteria.
NEGATIVE PUBLICITY COULD DAMAGE OUR REPUTATION AND ADVERSELY IMPACT OUR BUSINESS AND FINANCIAL RESULTS.
Reputation risk, or the risk to Royal Bancshares' earnings and capital from negative publicity, is inherent in our business. Negative publicity can result from Royal Bancshares' actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and actions taken by government regulators and community organizations in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose Royal Bancshares to litigation and regulatory action. Although Royal Bancshares takes steps to minimize reputation risk in dealing with customers and other constituencies, Royal Bancshares, as a larger diversified financial services company with a high industry profile, is inherently exposed to this risk.
RISKS RELATED TO OUR INDUSTRY
OUR BUSINESS IS SUBJECT TO INTEREST RATE RISK AND VARIATIONS IN INTEREST RATES MAY NEGATIVELY AFFECT OUR FINANCIAL PERFORMANCE.
Changes in the interest rate environment may reduce profits. The primary source of our income for is the differential or "spread" between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. As prevailing interest rates change, net interest spreads are affected by the difference between the maturities and re-pricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. An increase in the general level of interest rates may also adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially adversely affect our net interest spread, asset quality, loan origination volume and overall profitability.
FUTURE GOVERNMENTAL REGULATION AND LEGISLATION COULD LIMIT OUR FUTURE GROWTH.
Royal Bancshares and our subsidiaries are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of the operations of Royal Bancshares and our subsidiaries. These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. Any changes to these laws may negatively affect our ability to expand our services and to increase the value of our business. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on Royal Bancshares, these changes could be materially adverse to Royal Bancshares' shareholders.
CHANGES IN CONSUMER USE OF BANKS AND CHANGES IN CONSUMER SPENDING AND SAVING HABITS COULD ADVERSELY AFFECT THE COMPANY'S FINANCIAL RESULTS.
Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This "disintermediation" could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and Royal Bancshares may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.
ACTS OR THREATS OF TERRORISM AND POLITICAL OR MILITARY ACTIONS TAKEN BY THE UNITED STATES OR OTHER GOVERNMENTS COULD ADVERSELY AFFECT GENERAL ECONOMIC OR INDUSTRY CONDITIONS.
Geopolitical conditions may also affect our earnings. Acts or threats or terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions.
OTHER RISKS.
OUR DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL SHAREHOLDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK AND CAN INFLUENCE SHAREHOLDER DECISIONS.
Our directors, executive officers and principal shareholders, as a group, beneficially owned approximately 65% of our fully diluted outstanding common stock as of February 28, 2006. As a result of their ownership, the directors, executive officers and principal shareholders will have the ability, by voting their shares in concert, to influence the outcome of any matter submitted to our shareholders for approval, including the election of directors. The directors and executive officers may vote to cause Royal Bancshares to take actions with which the other shareholders do not agree or that are not beneficial to all shareholders.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
There have been no written comments from the Securities and Exchange Commission staff regarding Royal Bancshares' periodic or current reports under the Exchange Act that Royal Bancshares believes are material, were issued more than 180 days before December 31, 2005, and remain unresolved as of the date of filing of this Annual Report on Form 10-K.
ITEM 2.
ITEM 2. PROPERTIES
Royal Bank has twenty-one banking offices, which are located in Pennsylvania and New Jersey.
(1) Owned (2) Used for employee training
Royal Bank owns eleven of the above properties, one property is subject to a mortgage. The remaining twelve properties are leased with expiration dates between 2006 and 2012. During 2005, Royal Bank made aggregate lease payments of approximately $716,000. Royal Bank believes that all of its properties are attractive, adequately insured, and well maintained and are adequate for Royal Bank's purposes. Royal Bank also owns a property located at 144 Narberth Avenue, Narberth, PA, which may serve as a site for future expansion.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Management, after consulting with Royal Bancshares' legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of Royal Bancshares. There are no proceedings pending other than routine litigation incident to the business of Royal Bancshares. In addition, no material proceedings are known to be contemplated by governmental authorities against Royal Bancshares.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Royal Bancshares' shareholders during the fourth calendar quarter of 2005.
PART II
ITEM 5.
ITEM 5. MARKET FOR ROYAL BANCSHARES' COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
On September 6, 1988, Royal Bancshares' Class A Common Stock commenced trading on the NASDAQ National Market System (NASDAQ/NMS). Royal Bancshares' NASDAQ Symbol is RBPAA and is included in the NASDAQ National Market Stock Table, which is published in most major newspapers. There is no market for Royal Bancshares' Class B Common Stock, as such is prohibited by the terms of the Class B Common Stock. The following table shows the range of high, low-end and closing bid prices for Royal Bancshares' stock as reported by NASDAQ.
BID PRICES
2005 HIGH LOW CLOSE - ---- ---- --- -----
First Quarter ............................... $27.431 $21.422 $22.265 Second Quarter .............................. 24.020 21.569 23.284 Third Quarter ............................... 24.353 21.578 21.902 Fourth Quarter .............................. 24.020 21.853 22.706
2004 HIGH LOW CLOSE - ---- ---- --- -----
First Quarter ............................... $25.952 $23.453 $24.510 Second Quarter .............................. 25.087 20.521 23.837 Third Quarter ............................... 24.404 21.194 23.328 Fourth Quarter .............................. 28.729 22.982 25.971
(Source: This summary reflects information supplied by YAHOO)
The bid information shown above is derived from statistical reports of the NASDAQ Stock Market and reflects inter-dealer prices without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions. The bid prices reflect the 2% stock dividends that were declared on December 18, 2005, . The NASDAQ Stock Market, Inc., is a wholly-owned subsidiary of National Association of Securities Dealers, Inc.
The approximate number of recorded holders of Royal Bancshares' Class A and Class B Common Stock, as of February 28, 2006, is shown below:
TITLE OF CLASS NUMBER OF RECORD HOLDERS -------------------- ------------------------
Class A Common Stock 357 Class B Common Stock 147
Because substantially all of the holders of Class B Common Stock are also holders of Class A Common stock the number of record holders of the two classes on a combined basis was approximately 420 as of February 28, 2006.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following two tables disclose the number of outstanding options, warrants and rights granted by Royal Bancshares to participants in equity compensation plans, as well as the number of securities remaining available for future issuance under the plans. The tables provide this information separately for equity compensation plans that have and have not been approved by security holders.
DIVIDENDS
Subject to certain limitations imposed by law, the Board of Directors of Royal Bancshares may declare a dividend on shares of common stock.
Stock dividends. On January 17, 2001, the Board of Directors of Royal Bancshares declared a 5% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 12, 2001, to shareholders of record on January 29, 2001. The stock dividend resulted in the issuance of 408,197 additional shares of Class A Common Stock and 86,614 additional shares of Class B Common Stock.
On January 16, 2002, the Board of Directors of Royal Bancshares declared a 6% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 8, 2002, to shareholders of record on January 28, 2002. The stock dividend resulted in the issuance of 517,635 additional shares of Class A common stock and 108,282 additional shares of Class B common stock.
On January 15, 2003, the Board of Directors of Royal Bancshares declared a 3% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 12, 2003, to shareholders of record on January 29, 2003. The stock dividend resulted in the issuance of 281,196 additional shares of Class A common stock and 55,820 additional shares of Class B common stock.
On January 21, 2004, the Board of Directors of Royal Bancshares declared a 2% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 18, 2004, to shareholders of record on February 4, 2004. The stock dividend resulted in the issuance of 195,861 additional shares of Class A common stock and 38,216 additional shares of Class B common stock.
On December 15, 2004, the Board of Directors of Royal Bancshares declared a 2% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on January 12, 2005, to shareholders of record on December 29, 2004. The stock dividend resulted in the issuance of 200,814 additional shares of Class A common stock and 38,865 additional shares of Class B common stock.
On December 18, 2005, the Board of Directors of Royal Bancshares declared a 2% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on January 17, 2006, to shareholders of record on January 4, 2006. The stock dividend resulted in the issuance of 205,120 additional shares of Class A common stock and 19,426 additional shares of Class B common stock. There were 20,117 Class B shares deferred (agreed to by the Tabas Family Trust) until the Annual Shareholders Meeting where Management will request the company's shareholders to approve amending the Company's Articles of Incorporation to increase the number of Class B shares authorized. Future stock dividends, if any, will be at the discretion of the Board of Directors and will be dependent on the level of earnings and compliance with regulatory requirements.
Cash Dividends. Royal Bancshares paid cash dividends in each quarter of 2005 and 2004 for holders of Class A Common Stock and for holders of Class B Common Stock. This resulted in a charge to retained earnings of approximately $12.9 million and $12.2 million for 2005 and 2004, respectively. The following table sets forth on a quarterly basis dividends paid to holders of each Class A and Class B Common Stock for 2005 and 2004, adjusted to give effect to the stock dividends paid.
CASH DIVIDENDS PER SHARE ------------------------ 2005 CLASS A CLASS B - ---- ------- ------- First Quarter .................................. $.2500 $.2875 Second Quarter ................................. $.2500 $.2875 Third Quarter .................................. $.2750 $.31625 Fourth Quarter ................................. $.2750 $.31625
CASH DIVIDENDS PER SHARE ------------------------ 2004 CLASS A CLASS B - ---- ------- ------- First Quarter................................... $.2500 $.2875 Second Quarter.................................. $.2500 $.2875 Third Quarter................................... $.2500 $.2875 Fourth Quarter.................................. $.2500 $.2875
Future dividends must necessarily depend upon net income, capital requirements, and appropriate legal restrictions and other factors relevant at the time the Board of Directors of Royal Bancshares considers dividend policy. Cash necessary to fund dividends available for dividend distributions to the shareholders of Royal Bancshares must initially come from dividends paid by Royal Bank to Royal Bancshares. Therefore, the restrictions on Royal Bank's dividend payments are directly applicable to Royal Bancshares. Under the Pennsylvania Banking Code of 1965, as amended, Royal Bank places a restriction on the availability of capital surplus for payment of dividends.
Under the Pennsylvania Business Corporation Law of 1988, as amended, Royal Bancshares may pay dividends only if after payment Royal Bancshares would be able to pay its debts as they become due in the usual course of business and the total assets are greater than the sum of its total liabilities plus the amount that would be needed if Royal Bancshares were to be dissolved at the time of the dividend to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the dividend. See Regulatory Matters Note to the Consolidated Financial Statements in Item 8 of this report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial and operating information for Royal Bancshares should be read in conjunction with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and accompanying notes in Item 8:
(1) Earnings per share has the weighted average number of shares used in the calculation adjusted to reflect a 2% stock dividend in December 2005, a 2% stock dividend in December 2004, a 2% stock dividend in January 2004, a 3% stock dividend in 2003, a 6% stock dividend in 2002, and a 5% stock dividend in 2001.
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ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of Royal Bancshares and related notes (see Item 8).
FINANCIAL CONDITION
Total assets increased $96 million, or 8%, to $1.3 billion at December 31, 2005 from $1.21 billion at year-end 2004.
Cash and Cash Equivalents. Cash and cash equivalents are comprised of cash on hand, and cash in interest bearing and non-interest bearing accounts in banks, in addition to federal funds sold. Cash and cash equivalents increased $3.8 million, to $30.9 million at December 31, 2005. The average balance of cash and cash equivalents was approximately $16.3 million for 2005 versus $53.1 million for 2004. The majority of this average balance is held in non-interest-bearing accounts with the Federal Reserve Bank as collateral for deposit processing and operating cash held at the branches. The excess cash is invested daily in overnight fed funds. The average balance of these funds that earn interest was $3.9 million in 2005. The increase in the balance of cash and cash equivalents at year end was primarily due to larger balances maintained with the Federal Reserve Bank along with pending funding needs.
Investment Securities Held to Maturity. Held to maturity ("HTM") investment securities represents approximately 21.5% of average earning assets during 2005 and are comprised of primarily government agency bonds and corporate debt securities of investment grade quality, at the time of purchase. During 2005, HTM investment securities increased by $43.2 million to $255.4 million at December 31, 2005, from $212.2 million at December 31, 2004. The increase was primarily due to the purchase of $50 million of investments funded by brokered deposits as part of a leverage strategy.
Investment Securities Available for Sale. AFS investment securities represent 32.1% of average earning assets during 2005 and are primarily comprised of government secured agency bonds and government secured mortgaged-backed securities, capital trust security issues of regional banks, domestic corporate debt and U.S. denominated foreign corporate debt. At December 31, 2005, AFS investment securities were $326.2 million as compared to $360.9 million at December 31, 2004, a decrease of $34.7 million. This decrease was primarily due to maturities and principal payments from mortgage backed securities from the existing portfolio.
Loans. Royal Bancshares' primary earning assets are loans, representing approximately 46.1% of average earning assets during 2005. The loan portfolio is comprised primarily of business demand loans and commercial mortgages secured by real estate and to a significantly lesser extent, residential loans comprised of one to four family residential and home equity loans. During 2005, total loans increased $82.3 million to $549.6 million at December 31, 2005 from $467.3 million at December 31, 2004 primarily due to an increased lending staff and products along with the addition of the Royal Asian Bank Division.
Allowance for loan losses. The Company considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. Management determines the allowance for loan losses with the objective of maintaining a reserve level sufficient to absorb estimated probable credit losses. Management has determined the Company's balance in the allowance for loan losses based on management's detailed analysis and review of loan portfolio. Management considers all known relevant internal and external factors that may affect loan collectibility. The periodic analysis and review includes an evaluation of the loan portfolio in relation to historical loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including Management's assumptions as to future delinquencies, recoveries and losses. Management's evaluation is inherently subjective and all of these factors may be susceptible to significant change. To the extent actual outcomes differ from management's the Company may be required to make additional provisions for loan losses that could adversely impact earnings in future periods.
During 2005, the allowance for loan loss decreased $2.2 million to $10.3 million at December 31, 2005 from $12.5 million at December 31, 2004. The $2.2 million charge to allowance was attributed to a loan the Company had in Texas. The level of allowance for loan loss reserve represents approximately 1.8% of total loans at December 31, 2005 versus 2.7% at December 31, 2004. As of December 31, 2005 the Company had four loans in the amount of $5.6 million that are considered to be potential problem loans with a specific reserve of $1.3 million. The decrease in the percentage in the allowance was related to the $2.2 million charge off as well as an increase in the balance of outstanding loans of approximately $82 million. Management believes that, based on information currently available, including the potential problem loans, the allowance for loan loss is sufficient to cover losses inherent in the Company's loan portfolio at this time, no assurances can be given that the level of allowance will be sufficient to cover future loan losses or that future adjustments to the allowance will be sufficient to cover future loan losses or that future adjustments to the allowance will not be necessary if economic and/or other conditions differ substantially from the economic and other conditions considered by management in evaluating the adequacy of the current level of the allowance.
Analysis of the Allowance for Loan losses by loan type
An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Deposits. Royal Bancshares' deposits are an important source of funding. Total deposits decreased $45.0 million, or 6.1%, from $742.4 million at December 31, 2004 to $697.4 million at December 31, 2005. This decrease in deposits is primarily due to a financial benefit from allowing money market accounts to be replaced by overnight borrowings. At December 31, 2005, brokered deposits were $152.0 million as compared to $65.3 million at December 31, 2004. Certificate of deposit accounts increased $119.4 million, or 59.0% from $202.5 million at December 31, 2004 to $321.9 million at December 31, 2005. The increase in brokered deposits and certificates of deposits was primarily due to the $50 million investment strategy and use of these deposits to fund increased loan demand. Other deposit categories comprised of demand, NOW, money markets and savings deposits decreased $164.4 million during 2005 over their levels at December 31, 2004. The decrease in all savings categories is primarily due to a reduction in interest rates offered.
FHLB Borrowings. Borrowings are comprised of long-term borrowings (advances) and short-term borrowings (overnight borrowings, advances). Long-term FHLB borrowings increased $45.0 million to $249.5 million at December 31, 2005 from $204.5 million at December 31, 2004 due to converting overnight borrowings to long-tern borrowings which allowed Royal Bancshares to take advantage of the flat yield curve by locking in interest rates. At December 31, 2005 short term FHLB borrowings were $104.5 million. The average balance of borrowings during 2005 was $312.8 million versus $221.7 million for 2004.
Other Borrowings. Royal Bancshares previous completed a private placement of trust preferred securities in the aggregate amount of $25 million for a term of 30 years with a call feature of 5 years. In addition, as result of the adoption of FIN 46(R) Royal Bancshares consolidated into its statement of condition $47.4 million of debt related to real estate equity investment of which $0 is guaranteed by Royal Bancshares.
Other Liabilities. During 2005, Royal Bancshares increased its unfunded pension obligation by $930 thousand as a result to modification the pension plan, increased it profit sharing obligation by $760, and $676 third quarter posting to from its posting an expense for the fair value of derivatives.
Shareholders' Equity. Shareholders' equity increased $14.6 million or 10.4% in 2005 to $155.5 million primarily due to net income of $32.1 million partially offset by $12.9 million in cash dividends paid in 2005. Additionally, shareholders' equity was affected by the decrease in market value of AFS investment securities during 2005, which resulted in a downward adjustment of $4.8 million.
RESULTS OF OPERATIONS
General. Royal Bancshares' results of operations depend primarily on net interest income, which is the difference between interest income on interest earning assets and interest expense on interest bearing liabilities. Interest earning assets consist principally of loans and investment securities, while interest bearing liabilities consist primarily of deposits. Net income is also affected by the provision for loan losses and the level of non-interest income as well as by non-interest expenses, including salary and employee benefits, occupancy expenses and other operating expenses.
Net Income. Net income in 2005 was $32.1 million as compared to $20.0 million in 2004 and $18.5 million in 2003. Basic earnings per share were $2.50, $1.57 and $1.47 for 2005, 2004, and 2003, respectively. The $12.1 million increase in net income for 2005 represents a 60% increase over 2004, and is primarily attributable to the sale of two apartment complex which Royal Bancshares held an equity ownership in. This transaction was disclosed through a Form 8-K filing on October 20, 2005. The $1.5 million increase in net income for 2004 represents an 8% increase over 2003 and was primarily due to an increase in non-interest income specifically with income from Bank Owned Life Insurance and gains from the disposition of Other Real Estate Owned.
Net Interest Income. Net interest income is Royal Bancshares' primary source of income. Its level is a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities, and the spread between the yield on assets and liabilities. In turn, these factors are influenced by the pricing and mix of Royal Bancshares' interest-earning assets and funding sources. Additionally, net interest income is affected by market and economic conditions, which influence rates on loan and deposit growth.
Net interest income was $44.7 million in 2005 as compared to $40.2 million in 2004. The increase in net interest income in 2005 of $4.5 million was primarily due an increase in both the average balance and yield on earning assets along with a one time exit fee in the amount of $1.3 million collected during the second quarter of 2005.
The decrease in 2004 from 2003 of net interest income of $2.2 million is primarily due to the reduction of the yield on earning assets along with a decline in the spread of earning assets as compared to costing liabilities in 2004.
LOANS AND MORTGAGES
2005 2004 2003 ---- ---- ----
Average loan outstandings $510,349,000 $471,526,000 $562,765,000 Interest and fees on loans $46,995,000 $40,044,000 $46,609,000 Average Yield 9.21% 8.49% 8.28%
Royal Bancshares continues to originate both fixed rate and variable rate loans. At December 31, 2005 variable rate loans represented 53% of total loans. Together with some match funding of fixed rate deposits to fixed rate loans, variable rate loans have helped Royal Bancshares manage interest rate risk.
In 2005, the average balance of loans increased $38.8 million to $510.3 million in 2005, primarily due an increase in the lending staff, offering additional lending products and the addition of the Royal Asian Division. The average yield on loans increased by 72 basis points in 2005 primarily due to the increases in the prime rate and the $1.3 million exit fee collected in the second quarter in 2005.
In 2004, the average balance of loans decreased $91.2 million to $471.5 million primarily due a large amount of loans being paid off as interest rates remained at historically low levels. The average yield on loans increased by 21 basis points in 2004 primarily due to the average loan run off being at a lower yield than the 2003 average yield , along with the Federal Reserve increasing the short term rates in the second half of 2004.
HTM INVESTMENT SECURITIES
2005 2004 2003 ---- ---- ----
Average HTM investment securities $237,701,000 $141,799,000 $46,302,000 Interest income $10,122,000 $6,365,000 $3,087,000 Average yield 4.26% 4.49% 6.67%
HTM investment securities are comprised primarily of taxable corporate debt issues and US government agencies. The corporate debt issues are investment grade at the time of purchase. It is Royal Bancshares' expressed intention to hold these securities to maturity.
In 2005, the yield on HTM investment securities decreased 23 basis points to 4.26% from 4.49% in 2004. This decrease was primarily due to the increase in the average balance of U.S. government agency bonds held during the year. The government bonds were purchased with lower yields.
In 2004, the yield on HTM investment securities decreased 218 basis points to 4.49% from 6.67% in 2003. This decrease was primarily due to the purchasing of low credit risk government agency bonds that were yielding 3.0% to 4.5%. The government agency bonds at December 31, 2004 have step up and/or call features.
AFS INVESTMENT SECURITIES
2005 2004 2003 ---- ---- ----
Average AFS investment securities $355,005,000 $399,361,000 $446,210,000 Interest and dividend income $19,229,000 $20,621,000 $22,007,000 Average yield 5.42% 5.16% 4.93%
AFS investment securities are comprised primarily of government secured mortgage-backed securities, government agency bonds, non-rated and rated capital trust security issues of regional banks, rated domestic and US denominated foreign corporate debt securities and to a lesser extent preferred and common stock.
In 2005, the average balance of AFS investment securities decreased $44.4 million to $355.0 million primarily due to maturities and the repayment of principal from the existing mortgaged backed securities. The 26 basis point increase in average yield is primarily due to the lower yield on the principal repayments.
In 2004, the average balance of AFS investment securities decreased $46.8 million to $399.4 million primarily due to classifying new purchases from investment runoff as held to maturity. The 23 basis point increase in average yield is primarily due to higher yields earned on mortgage back securities resulting from slower principal repayments speeds.
INTEREST EXPENSE ON NOW AND MONEY MARKET DEPOSITS
2005 2004 2003 ---- ---- ----
Average NOW & Money Market deposits $355,387,000 $461,076,000 $475,383,000 Interest expense $7,457,000 $7,965,000 $10,000,000 Average cost of funds 2.10% 1.73% 2.10%
In 2005, the average cost of funds on NOW and money market deposits increased 36 basis points to 2.09% from 1.73% in 2004 primarily due to increasing rates as a result of Federal Reserve increasing the overnight rates during the year.
In 2004, the average cost of funds on NOW and money market deposits decreased 37 basis points to 1.73% from 2.10% in 2003 primarily due to a decline in the interest rate paid on these deposits.
INTEREST EXPENSE ON TIME DEPOSITS
2005 2004 2003 ---- ---- ----
Average time deposits $254,031,000 $218,756,000 $269,293,000 Interest expense $9,965,000 $8,577,000 $12,011,000 Average cost of funds 3.92% 3.92% 4.46%
In 2005, the average balance of time deposits increased $35.3 million to $254.0 million. The increase in average time deposits is primarily due to the $50 million brokered deposit used in investment strategy. In 2004, the average balance of time deposits decreased $50.5 million to $218.8 million. This decrease in average time deposits is primarily due to the maturity of higher yielding brokered deposits.
Although short term rates in general continued to move upward in 2005, the long term rates continued to remain flat causing the yield on term deposits to remain the same. At December 31, 2005, 63% of time deposits were comprised of certificates of deposits accounts with balances of $100,000 or more, while in 2004, 45% of time deposits were comprised of certificates of deposit accounts with balances of $100,000 or more. These types of deposit have traditionally been considered more rate volatile than other types of deposits, however Royal Bank's penalty for early redemption somewhat mitigates this volatility.
PROVISION FOR POSSIBLE LOAN LOSSES
The provision for loan losses is an amount charged to expense to provide for future losses on existing loans. In order to determine the amount of the provision for loan loss, Royal Bank conducts a quarterly review of the loan portfolio to evaluate overall credit quality. This evaluation consists of an analysis of individual loans and overall risk characteristics and size of the loan, and takes into consideration current economic and market conditions, changes in non-performing loans, the capability of specific borrowers to repay loan obligations as well as current collateral values.
During 2005, a provision for loan losses was recorded for $1 thousand, as compared to the $6 thousand in 2004. Both provisions were due to charge offs relating to delinquent tax liens held by Crusader Servicing Corporation. Management determined that no additional provision was needed based on its analysis of the reserve for possible loan losses according to documentation required under SAB 102. Net charge-offs were $2.2 million in 2005 as compared to net recoveries $87 thousand in 2004.
In 2004, a provision for loan losses was recorded for $6 thousand, as compared to $674 thousand in 2003 due to charges off's relating to delinquent tax liens. During 2004 senior management determined that loan loss reserve was adequate and no additional provision was required for the period. Net recoveries were $87 thousand in 2004 as compared to net charge-offs of $718 thousand in 2003.
NON-INTEREST INCOME
Non-interest income includes service charges on depositors' accounts, safe deposit rentals and various services such as cashing checks, issuing money orders and traveler's checks, and similar activities. In addition, other forms of non-interest income are derived from changes in the cash value of BOLI, fees collected on the sale of residential mortgages in the secondary market and income relating to the VIE's which Royal Bank has an investment. Most components of non-interest income are a modest and stable source of income, with exceptions of one-time gains and losses from the sale of investments securities and other real estate owned, from period to period these sources of income may vary considerably. Service charges on depositors' accounts, safe deposit rentals and other fees are periodically reviewed by management to remain competitive with other local banks.
In 2005, total non-interest income increased $11.7 million to $24.8 to million at December 31, 2005. This increase is primarily due the sale of two apartment complexes resulting in a pretax gain of $16.7 million from Royal Bancshares' investment in VIE's. This was partially offset by a reduction of $6.4 million due to the deconsolidation of the VIE's in which Royal Bancshares' interest was sold.
In 2004, total non-interest income increased $9.5 million to $13.2 million at December 31, 2004. This increase is primarily due income earned on the purchase of BOLI, income related to the consolidation of the VIEs and the sale of other real estate owned.
NON-INTEREST EXPENSE
Non-interest expense includes compensation and employee benefits, occupancy, advertising, FDIC insurance, state taxes, depreciation, and other expenses such as auditing, automatic teller machines (ATMs), data processing, legal, outside service charges, postage, printing and other expenses relating to other real estate owned. Effective 2004, Royal Bancshares through the adoption of FIN46(R) consolidates the expenses related to equity investments.
Non-interest expenses decreased $648 thousand to $24.8 million in 2005, from $25.4 million in 2004. Salaries and benefits increased $2.7 million primarily due to the increased in the lending staff and Royal Asian Division, an increase to the Company's Profit Sharing Plan due to the results for the year, and a one time charge of approximately $1 million related to modifications to the company's pension plan. Expenses related to equity investments decreased $4.5 million during 2005. This was primarily due to the deconsolidation of three VIE's during the second and fourth quarters. During 2005, the Company has taken some one time charges; $675 thousand for the decline in the fair value of interest rate swaps and $424 thousand for an asset write-down.
Non-interest expense increased $6.5 million to $25.4 million in 2004, from $18.9 million in 2003. Salaries and employee benefits increased $809 thousand to $10.8 million in 2004, from $10.0 million in 2003. This was primarily due to annual salary increases and the addition of the Royal Asian Bank, a division of Royal Bank. Occupancy expense increased $179 thousand to $1.5 million in 2004 primarily due to the addition Royal Asian Bank. Other operating expenses increased $792 thousand to $8.4 million in 2004. As a result of consolidation of the "VIE" non-interest expense increased $4.8 million during 2004.
ACCOUNTING FOR INCOME TAXES
The provision for federal income taxes was $12.6 million in 2005 as compared to $7.9 million for 2004, and $8.0 million for 2003 representing an effective tax rate of 28%, 28% and 30%, respectively. During 2005, a $1.7 million reduction in tax expense was recorded as a result of the completion of an IRS audit, with respect to a valuation allowance against a deferred tax asset derived from net operating loss carryovers.
ACCOUNTING FOR DEBT AND EQUITY SECURITIES
Royal Bancshares accounts for investment securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This standard requires investments in securities to be classified in one of three categories; held to maturity, trading or available for sale. Debt securities that Royal Bancshares has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. As Royal Bancshares does not engage in security trading, the balance of its debt securities and any equity securities are classified as available for sale. Net unrealized gains and losses for such securities, net of tax effect, are required to be recognized as a separate component of shareholders' equity and excluded from the determination of net income.
ASSET LIABILITY MANAGEMENT
The primary functions of asset-liability management are to assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. This process is overseen by the Asset-Liability Committee ("ALCO") which monitors and controls, among other variables, the liquidity, balance sheet structure and interest rate risk of the consolidated company within policy parameters established and outlined in the ALCO Policy which are reviewed by the Board of Directors at least annually. Additionally, the ALCO committee meets periodically and reports on liquidity, interest rate sensitivity and projects financial performance in various interest rate scenarios.
Liquidity. Liquidity is the ability of the financial institution to ensure that adequate funds will be available to meet its financial commitments as they become due. In managing its liquidity position, the financial institution evaluates all sources of funds, the largest of which is deposits. Also taken into consideration is the repayment of loans. These sources provide the financial institution with alternatives to meet its short-term liquidity needs. Longer-term liquidity needs may be met by issuing longer-term deposits and by raising additional capital.
Royal Bancshares generally maintains a liquidity ratio equal to or greater than 25% of total deposits and short-term liabilities. Liquidity is specifically defined as the ratio of net cash, short term and marketable assets to net deposits and short-term liabilities. The liquidity ratio for the years ended December 31, 2005, 2004 and 2003 was 32%, 39% and 60%, respectively. Management believes that Royal Bancshares' liquidity position continues to be adequate, continues to be in excess of its peer group level and meets or exceeds the liquidity target set forth in the Asset/Liability Management Policy. Management believes that due to its financial position, it will be able to raise deposits as needed to meet liquidity demands. However, any financial institution could have unmet liquidity demands at any time.
Contractual Obligations and Other Commitments. The following table sets forth contractual obligations and other commitments representing required and potential cash outflows as of December 31, 2005.
Interest-Rate Sensitivity. Interest rate sensitivity is a function of the repricing characteristics of the financial institution's assets and liabilities. These include the volume of assets and liabilities repricing, the timing of repricing, and the relative levels of repricing. Attempting to minimize the interest rate sensitivity gaps is a continual challenge in a changing rate environment. The interest sensitivity report examines the positioning of the interest rate risk exposure in a changing interest rate environment. Ideally the rate sensitive assets and liabilities will be maintained in a matched position to minimize interest rate risk.
The interest rate sensitivity analysis is an important management tool, however, it does have some inherent shortcomings. It is a "static" analysis. Although certain assets and liabilities may have similar maturities or repricing, they may react in different degrees to changes in market interest rates. Additionally, repricing characteristics of certain assets and liabilities may vary substantially within a given period.
The following table summarizes repricing intervals for interest earning assets and interest bearing liabilities as of December 31, 2005, and the difference or "gap" between them on an actual and cumulative basis for the periods indicated. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net interest income. During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely. At December 31, 2005, Royal Bancshares is in an asset sensitive positive of $301.9 million, which indicates assets will reprice somewhat faster than liabilities within one year.
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INTEREST RATE SENSITIVITY (IN MILLIONS)
(1) Interest earning assets are included in the period in which the balances are expected to be repaid and/or repriced as a result of anticipated prepayments, scheduled rate adjustments, and contractual maturities. (2) Reflects principal maturing within the specified periods for fixed and repricing for variable rate loans; includes nonperforming loans.
The method of analysis of interest rate sensitivity in the table above has a number of limitations. Certain assets and liabilities may react differently to changes in interest rates even though they reprice or mature in the same time periods. The interest rates on certain assets and liabilities may change at different times than changes in market interest rates, with some changing in advance of changes in market rates and some lagging behind changes in market rates. Also, certain assets have provisions, which limit changes in interest rates each time the interest rate changes and for the entire term of the loan. Additionally, prepayments and withdrawals experienced in the event of a change in interest rates may deviate significantly from those assumed in the interest rate sensitivity table. Additionally, the ability of some borrowers to service their debt may decrease in the event of an interest rate increase.
CAPITAL ADEQUACY
The table shown below sets forth Royal Bancshares' consolidated capital level and performance ratios:
Royal Bancshares' sources of capital have been derived from the issuance of stock as well as retained earnings. While Royal Bancshares has not had a stock offering since 1986, total shareholders' equity has increased primarily due to steady increases in retained earnings. At December 31, 2005, Royal Bancshares had an average equity to average asset ratio of 11.6%. Royal Bancshares has no current plans to raise capital through new stock offerings and indeed, seeks ways to leverage its existing capital.
The capital ratios set forth above compare favorably to the minimum required amounts of Tier 1 and total capital to risk-weighted assets and the minimum Tier 1 leverage ratio, as defined by the banking regulators. At December 31, 2005, Royal Bancshares was required to have minimum Tier 1 and total capital ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of 4.0%. In order for Royal Bancshares to be considered well capitalized, as defined by the banking regulators, Royal Bancshares must have Tier 1 and total capital ratios of 6.0% and 10.0%, respectively, and a minimum Tier 1 leverage ratio of 5.0%. At December 31, 2005, Royal Bancshares met the criteria for a well capitalized institution, and management believes that, under current regulations, Royal Bancshares will continue to meet its minimum capital requirements in the foreseeable future.
MANAGEMENT OPTIONS TO PURCHASE SECURITIES
In May 2001, the directors of the Royal Bancshares approved the amended Royal Bancshares of Pennsylvania Non-qualified Stock Option and Appreciation Right Plan (the Plan). The shareholders in connection with the formation of the holding company reapproved the Plan. The Plan is an incentive program under which Bank officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1,500,000 shares of the Royal Bancshares' Class A common stock (but not in excess of 15% of outstanding shares). In May 2005, the shareholders approved to increase the options to purchase to 1,650,000. At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. At December 31, 2005, 737,170 options have been granted which are exercisable at 20% per year. At December 31, 2005, options covering 292,317 shares were exercisable by 95 employees.
In May 2001, the directors of the Royal Bancshares approved an amended non-qualified Outside Directors Stock Option Plan. The shareholders in connection with the formation of the holding company reapproved this Plan. Under the terms of the plan, 250,000 shares of Class A stock are authorized for grants. Each director is entitled to a grant of an option to purchase 1,500 shares of stock annually, which is exercisable one year from the grant date. The options were granted at the fair market value at the date of the grant. At December 31, 2005, 91,068 options were outstanding and options covering 74,238 shares were exercisable.
AVERAGE BALANCES
The following table represents the average daily balances of assets, liabilities and shareholders' equity and the respective interest paid on interest bearing assets and interest bearing liabilities, as well as average rates for the periods indicated:
(1) Nonaccruing loans have been included in the appropriate average loan balance category, but interest on these loans has not been included.
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The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income for the years ended December 31, 2005 and 2004, as compared to respective previous periods, into amounts attributable to both rate and volume variances.
LOANS
The following table reflects the composition of the loan portfolio of Royal Bank and the percent of gross outstanding represented by each category at the dates indicated.
ANALYSIS OF ALLOWANCE FOR LOAN LOSS
Royal Bancshares considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. Management determines the allowance for loan losses with the objective of maintaining a reserve level sufficient to absorb estimated probable credit losses inherent within the loan portfolio. Management has determined the Company's balance in the allowance for loan losses based on management's detailed analysis and review of the loan portfolio. Management considers all known relevant internal and external factors that may affect loan collectibility. The periodic analysis and review includes an evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including Management's assumptions as to future economic conditions, recoveries and losses. Management's evaluation is inherently subjective and all of these factors may be susceptible to significant change. To the extent actual outcomes differ from management's the Company may be required to make additional provisions for loan losses that could adversely impact earnings in future periods.
Royal Bancshares uses the reserve method of accounting for loans losses. The balance in the allowance for loan and lease losses is determined based on management's review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economics events and conditions, and other pertinent factors, including management's assumptions related to future delinquencies, recoveries and losses. Increases to the allowance for loans and leases losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loans losses. Recoveries of amounts previously charged-off are credited to the allowance for loan losses.
While Royal Bank believes that it has established an adequate allowance for loan losses, there can be no assurance that the regulators, in reviewing Royal Bank's loan portfolio, will not request Royal Bancshares to materially increase its allowances for loan losses. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependant upon future events and, as such, further additions to the level of specific and general loss allowances could become necessary.
LOANS AND LEASE FINANCING RECEIVABLES
The following table summarizes the loan portfolio by loan category and amount that corresponds to the appropriate regulatory definitions.
CREDIT QUALITY
The following table presents the principal amounts of nonaccruing loans and other real estate.
(1) Generally, a loan is placed on nonaccruing status when it has been delinquent for a period of 90 days or more unless the loan is both well secured and in the process of collection. (2) If interest had been accrued on these nonaccruing loans, such income would have approximated $506,000 for 2005, $209,000 for 2004, $401,000 for 2003, $473,000 for 2002 and $526,000 for 2001.
INVESTMENT SECURITIES
The contractual maturity distribution and weighted average rate of Royal Bancshares' investments held to maturity and available for sale portfolios at December 31, 2005 are presented in the following table. Weighted average rates on tax-exempt obligations have been computed on a fully taxable equivalent basis assuming a tax rate of 35%.
The following table represents the consolidated book values and approximate fair value at December 31, 2005, 2004 and 2003, respectively, for each major category of Royal Bancshares' investment securities portfolio for held to maturity securities and available for sale securities.
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DEPOSITS
The average balance of Royal Bank's deposits by major classifications for each of the last three years is presented in the following table.
The remaining maturity of Certificates of Deposit of $100,000 or greater: AS OF DECEMBER 31, (IN THOUSANDS) MATURITY 2005 2004 - -------- ---------- ----------
Three months or less $ 8,523 $ 13,309 Over three months through twelve months 41,534 27,426 Over twelve months through five years 152,566 48,590 Over five years 988 1,271 ---------- ---------- Total $ 203,611 $ 90,596 ========== ==========
SHORT AND LONG TERM BORROWINGS
(1) This obligation is consolidated from requirements under FIN (46)R of which $0 is guaranteed by the Company.
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ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
A simulation model is used to estimate the impact of various changes, both upward and downward, in market interest rates and volumes of assets and liabilities on the net income. This model produces an interest rate exposure report that forecast changes in the market value of portfolio equity under alternative interest rate environment. The market value of portfolio is defined as the present value of existing assets and liabilities. The calculated estimates of changes in the market value of portfolio value are as follows:
As of December 31, 2005 (Dollars in Thousands)
Market Value of Percent of Changes in Rates Portfolio Equity Change ---------------- ---------------- ----------
+ 200 basis points 162,005 -6.3% + 100 basis points 168,719 -2.4% Flat rate 172,904 0% - 100 basis points 168,155 -2.7% - 200 basis points 156,574 -9.4%
The assumptions used in evaluating the vulnerability of earnings and capital to changes in interest rates are based on management's considerations of past experience, current position and anticipated future economic conditions. The interest rate sensitivity of assets and liabilities as well as the estimated effect of changes in interest rates on the market value of portfolio equity could vary substantially if different assumptions are used or actual experience differs from what the calculations may be based.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB's Emerging Issues Task Force (EITF) issued EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investors" ("EITF 03-1"), and in March 2004, the EITF issued an update. EITF 03-1 addresses the meaning of other-than-temporary impairment and its application to certain debt and equity securities. EITF 03-1 aids in the determination of impairment of an investment and gives guidance as to the measurement of impairment loss and the recognition and disclosures of other-than-temporary investments. EITF 03-1 also provides a model to determine other-than-temporary impairment using evidence-based judgment about the recovery of the fair value up to the cost of the investment by considering the severity and duration of the impairment in relation to the forecasted recovery of the fair value. In July 2005, FASB adopted the recommendation of its staff to nullify key parts of EITF 03-1. The staff's recommendations were to nullify the guidance on the determination of whether an investment is impaired as set forth in paragraphs 10-18 of Issue 03-1 and not to provide additional guidance on the meaning of other-than-temporary impairment. Instead, the staff recommends entities recognize other-than-temporary impairments by applying existing accounting literature such as paragraph 16 of SFAS 115. Royal Bancshares believes the FSP on FAS 115-1 and FAS 124-1 will not have a material impact on the company's financial condition, results of operations or cash flows.
In June 2005, the EITF reached a consensus on Issue No. 05-6, "Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination" ("EITF 05-6"). This guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. This guidance is applicable only to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. Royal Bancshares is evaluating the impact, if any, of EITF 05-6 on its consolidated financial statements.
In October 2005, the FASB issued FASB Staff Position FAS13-1 ("FSP 13-1"), which requires companies to expense rental costs associated with ground or building operating leases that are incurred during a construction period. As a result, companies that are currently capitalizing these rental costs are required to expense them beginning in its first reporting period beginning after December 15, 2005. FSP FAS 13-1 is effective for our Company as of the first quarter of fiscal 2006. Management has evaluated the provisions of FSP FAS 13-1 and do not believe that its adoption will have a material impact of Royal Bancshares' financial condition or results of operations.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123(R), "Share-Based Payment." Statement No. 123(R) replaces Statement No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." Statement No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. Public companies are required to adopt the new standard using a modified prospective method and may elect to restate prior periods using the modified retrospective method. Under the modified prospective method, companies are required to record compensation cost for new and modified awards over the related vesting period of such awards prospectively and record compensation cost prospectively for the unvested portion, at the date of adoption, of previously issued and outstanding awards over the remaining vesting period of such awards. No change to prior periods presented is permitted under the modified prospective method. Under the modified retrospective method, companies record compensation costs for prior periods retroactively through restatement of such periods using the exact pro forma amounts disclosed in the companies' footnotes. Also, in the period of adoption and after, companies record compensation cost based on the modified prospective method. Royal Bancshares estimates its compensation expense will increase $762,000 during 2006.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB No. 107"), "Share-Based Payment," providing guidance on option valuation methods, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123(R), and the disclosures in MD&A subsequent to the adoption. Royal Bancshares will provide SAB No. 107 required disclosures upon adoption of SFAS No. 123(R) on January 1, 2006.
On April 14, 2005, the Securities and Exchange Commission ("SEC") adopted a new rule that amends the compliance dates for FASB's Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123R"). Under the new rule, the Company is required to adopt SFAS No. 123R in the first annual period beginning after June 15, 2005. The Company has not yet determined the method of adoption or the effect of adopting SFAS No. 123R, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123.
In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations--an interpretation of SFAS No. 143," ("FIN 47"). This Interpretation provides clarification with respect to the timing of liability recognition for legal obligations associated with the retirement of tangible long-lived assets when the timing and/or method of settlement of the obligation are conditional on a future event. FIN 47 is effective for all fiscal years ending after December 15, 2005 (December 31, 2005, for calendar-year companies). Retrospective application for interim financial information is permitted but is not required. Early adoption of this Interpretation is encouraged. We do not expect the adoption of FIN 47 to materially impact our consolidated financial statements.
In May 2005, FASB issued SFAS 154, "Accounting Changes and Error Corrections." The Statement requires retroactive application of a voluntary change in accounting principle to prior period financial statements unless it is impracticable. SFAS 154 also requires that a change in method of depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is affected by a change in accounting principle. SFAS 154 replaces APB Opinion 20, "Accounting Changes," and SFAS 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS 154 will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Management currently believes that adoption of the provisions of SFAS 154 will not have a material impact on Royal Bancshares' consolidated financial statements.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
DECEMBER 31, 2005 AND 2004
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders Royal Bancshares of Pennsylvania, Inc. Narberth, Pennsylvania
We have audited the accompanying consolidated balance sheets of Royal Bancshares of Pennsylvania, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the two-year period ended December 31, 2005. These consolidated 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. The consolidated statements of income, changes in stockholders' equity and cash flows of Royal Bancshares of Pennsylvania, Inc. for the year ended December 31, 2003 were audited by other auditors, whose report dated January 22, 2004, expressed an unqualified opinion on those statements.
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.
As discussed on Note A to the consolidated financial statements, Royal Bancshares of Pennsylvania, Inc. adopted the provisions of Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities," on March 31, 2004.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Royal Bancshares of Pennsylvania, Inc. and its subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their consolidated cash flows for each of the years in the two-year period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Royal Bancshares of Pennsylvania, Inc. internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2006 expressed an unqualified opinion on management's assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.
/s/ Beard Miller Company LLP
Beard Miller Company LLP Reading, Pennsylvania March 14, 2006
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
The accompanying notes are an integral part of these statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Income
The accompanying notes are an integral part of these statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
Years ended December 31, 2005, 2004 and 2003
(In thousands, except per share data)
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity - Continued
Years ended December 31, 2005, 2004 and 2003
(In thousands, except per share data)
The accompanying notes are an integral part of this statement.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Year ended December 31,
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows - Continued
Year ended December 31,
The accompanying notes are an integral part of these statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Royal Bancshares of Pennsylvania, Inc. (Royal Bancshares), through its subsidiary Royal Bank America (Royal Bank), offers a full range of banking services to individual and corporate customers located in Pennsylvania, New Jersey and Delaware. Royal Bank competes with other banking and financial institutions in certain markets, including financial institutions with resources substantially greater than its own. Commercial banks, savings banks, savings and loan associations, credit unions and money market funds actively compete for savings and time deposits and for various types of loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors of Royal Bank with respect to one or more of the services it renders.
1. Basis of Financial Statement Presentation
The accompanying consolidated financial statements include the accounts of Royal Bancshares and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc. and Royal Bank, including Royal Bank's subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investment America, LLC, and Royal Bank America Leasing, LP, and Crusader Servicing Corporation which both are 60% owned by Royal Bank America. Both Royal Bancshares' Trusts' are not consolidated as further discussed in Note A-17. During 2004, Royal Bancshares through Royal Bank started a banking division called Royal Asian Bank which operates three branches in Pennsylvania and one branch in Northern New Jersey. All significant inter-company transactions and balances have been eliminated.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenditures for the period. Therefore, actual results could differ significantly from those estimates.
The principal estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses and the valuation of deferred tax assets. In connection with the allowance for loan losses estimate, when circumstances warrant, management obtains independent appraisals for significant properties. However, future changes in real estate market conditions and the economy could affect Royal Bancshares' allowance for loan losses.
In addition to being subject to competition from other financial institutions, Royal Bancshares is subject to regulations of certain federal agencies and, accordingly, it is periodically examined by those regulatory authorities.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). In general, a variable interest entity is a corporation, partnership, trust or any other legal structures used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 applied immediately to interest entities created after January 31, 2003. In December 2003, the FASB issued FIN 46(R) with respect to variable interest entities created before January 31, 2003, which among other things revised the implementation date to the first fiscal year or interim period ended after March 15, 2004, with the exception of Special Purpose Entities (SPE). Royal Bancshares currently has no SPEs. Royal Bancshares adopted the provisions of FIN 46 effective for the period ended March 31, 2004, which required Royal Bancshares to consolidate its investments in real estate partnerships and deconsolidate its investment un two trusts. Prior to FIN 46 and 46(R), Royal Bancshares accounted for its investments in the real estate partnerships under the equity method of accounting.
Royal Bancshares' investments in real estate partnerships and trusts are further discussed in Note A -17.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement 123(R), "Share-Based Payment," an Amendment of SFAS No. 123 and APB No. 95. The Statement addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires that all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees." This statement is effective for all share-based payment transactions entered into for fiscal years beginning after June 15, 2005 and to any awards modified, repurchased, or cancelled after that date. Royal Bancshares estimates its compensation expense relating to stock options will be $762,000 during 2006.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
2. Investment Securities
Investment securities are classified in one of three categories: held to maturity, available for sale or trading. Debt securities that Royal Bancshares has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. As Royal Bancshares does not engage in security trading, the balance of its debt securities and any equity securities are classified as available for sale. Net unrealized gains and losses for such investment securities available for sale, net of tax effect, are required to be recognized as a separate component of stockholders' equity and excluded from the determination of net income. Gains or losses on disposition are computed by the specific identification method.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near- term prospects of the issuer, and (3) the intent and ability of Royal Bancshares to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
3. Loans held for sale
Residential mortgage loans are only originated for sale to the secondary mortgage loans market. These loans have a prior sales commitment on a best efforts basis in place prior to the loan closing. These loans are classified as loans held for sale and are carried at the lower of cost or estimated fair value. Fair value is determined by the purchase price quoted in the sales agreement.
Royal Bancshares accounts for the transfer of financial assets in accordance with SFAS No. 140 "Accounting for Transfers and Servicing of Assets and Extinguishments of Liabilities." The standard is based on consistent application of a financial-components approach that recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered and derecognizes liabilities when extinguished. The standard provides consistent guidelines for distinguishing transfers of financial assets from transfers that are secured borrowings.
4. Loans and Allowance for Loan Losses
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, reduced by unearned income and an allowance for loan and lease losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, growth, and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income. Decreases in the allowance result from management's determination that the
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
allowance for loan losses exceeds their estimates of potential loan loss. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
Royal Bancshares accounts for its impaired loans in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure," which requires that a creditor measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral-dependent. Regardless of the measurement method, a creditor must measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, Royal Bancshares does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.
Interest on loans is accrued and credited to operations based upon the principal amount outstanding. Accretion of unearned discounts on loans has been added to the related interest income. Accrual of interest is discontinued on a loan when management believes that the borrower's financial condition is such that collection of interest is doubtful and generally when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in the prior year is charged to the allowance for loan losses.
Royal Bancshares accounts for guarantees in accordance with FIN 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others". FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of the interpretation, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. Royal Bancshares has financial and performance letters of credit. Financial letters of credit require a company to make a payment if the customer's condition deteriorates, as defined in agreements. Performance letters of credits require Royal Bancshares to make payments if the customer fails to perform certain non-financial contractual obligations.
5. Other Real Estate
Royal Bancshares carries other real estate at the fair market value less estimated costs for the disposition of the property. Management will monitor cases in which the property value exceeds the book value. Costs relating to holding the property are expensed when incurred. Other real estate owned of approximately $3,834,000 and $5,424,000 at December 31, 2005 and 2004, respectively, is included in other assets on the consolidated balance sheets.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
6. Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on accelerated methods over the estimated useful lives of the assets. Leasehold improvements are amortized on the accelerated methods over the shorter of the estimated useful lives of the improvements or the terms of the related leases.
7. Bank-Owned Life Insurance
Royal Bank has purchased life insurance policies on certain executives. These policies are recorded in other assets at their cash surrender value, or the amount that can be realized. Income from these policies and changes in the cash surrender value are recorded in other income.
8. Income Taxes
Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense is the result of changes in deferred tax assets and liabilities. The principal types of differences between assets and liabilities for financial statement and tax return purposes are the allowance for loan losses, deferred compensation plans, asset valuation reserves and net operating loss carryovers.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
9. Per Share Information
Basic per share data excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period. Diluted per share data takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock, using the treasury stock method.
The Class B shares of Royal Bancshares may be converted to Class A shares at the rate of 1.15 to 1.
10. Stock Option Plans
SFAS No. 123, "Accounting for Stock-Based Compensation," as Amended by SFAS No.148, contains a fair value-based method for valuing stock-based compensation that entities may use to measure compensation cost at the grant date based on the fair value of the award. Compensation is recognized over the service period, which is usually the vesting period. Alternatively, SFAS No. 123 permits entities to continue accounting for employee stock options and similar equity instruments under Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued to Employees." Entities that continue to account for stock options using APB Opinion 25 are required to make a pro forma disclosure of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been applied. Effective January 1, 2006, Royal Bancshares will apply SFAS No. 123(R).
At December 31, 2005, Royal Bancshares had both a director and employee stock-based compensation plan, which are more fully described in Note L. Royal Bancshares accounts for these plans under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. Stock-based employee compensation costs are not reflected in net income, as all options granted under the plan had an exercise price equal to the market value under the underlying common stock of the date of the grant. The following table illustrates the effect on net income and earnings per share if Royal Bancshares had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
11. Benefit Plans
Royal Bancshares has a noncontributory nonqualified, defined benefit pension plan covering certain eligible employees. Net pension expense consists of service costs, interest costs, return on pension assets and amortization of unrecognized initial net assets. Royal Bancshares accrues pension costs as incurred.
12. Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, short-term investments and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.
13. Financial Instruments
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires all entities to disclose the estimated fair value of their assets and liabilities considered to be financial instruments. Financial instruments consist primarily of investment securities, loans, deposits and borrowings.
14. Advertising Costs
Royal Bancshares' expensed advertising costs of $360,000, $289,000 and $314,000 for 2005, 2004 and 2003, respectively.
15. Comprehensive Income
Royal Bancshares reports comprehensive income which includes net income as well as certain other items, which result in a change to equity during the period.
The income tax effects allocated to comprehensive loss is as follows (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
16. Reclassifications
Certain reclassifications of prior year amounts have been made to conform to the current year presentation.
17. Variable Interest Entities (VIE)
Real estate owned via equity investments
Royal Bancshares, together with a real estate development company, formed Brook View Investors, L.L.C. ("Brook View") in May 2001. Brook View was formed to construct 13 apartment buildings with a total of 116 units in a gated apartment community. The development company is the general partner of the project. Royal Bancshares invested 60% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. On October 19, 2005 the Company sold its ownership in Brook View which resulted an after tax gain of approximately $3.3 million. As a result of the sale, the company discontinued consolidating the financial statements of Brook View during the fourth quarter 2005.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Royal Bancshares, together with a real estate development company, formed Burrough's Mill Apartment, L.L.C. ("Burrough's Mill") in December 2001. Burrough's Mill was formed to construct 32 apartment buildings with a total of 308 units in a gated apartment community. The development company is the general partner of the project. Royal Bancshares invested 60% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. On October 19, 2005, the Company sold its ownership in Burrough's Mill which resulted an after tax gain of approximately $7.6 million. As a result of the sale the Company discontinued consolidating the financial statements of Burrough's Mill during the fourth quarter 2005.
Royal Bancshares, together with a real estate development company, formed Main Street West Associates, L.P. ("Main Street") in February 2002. Main Street was formed to acquire, maintain, improve, and operate office space located in Norristown, Pennsylvania. The development company is the general partner of the project. Royal Bancshares invested 93% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. On June 30, 2005, Main Street sold the property and paid back the Company's original investment plus the accrued preferred return in full. As a result of the return of capital the Company discontinued consolidating the financial statements of Main Street during the second quarter 2005.
Royal Bancshares, together with a real estate investment company, formed 212 C Associates, L.P. ("212 C") in May 2002. 212 C was formed to acquire, hold, improve, and operate office space located in Lansdale, Pennsylvania. The investment company is the general partner of the project. Royal Bancshares invested 90% of initial capital contributions with the investment company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the investment company. On June 7, 2005, 212 C made a distribution to the Company of approximately $4.0 million which paid back the Company's original investment and accrued preferred return. In addition, the Company received a profit of $1.8 million as result of this distribution. As a result of the transaction, the Company no longer qualifies as the primary beneficiary and discontinued consolidating this VIE during the second quarter 2005.
Royal Bancshares, together with a real estate development company, formed Royal Scully Associates, G.P. ("Royal Scully") in September 2005. Royal Scully was formed to convert an apartment complex into condominiums in Blue Bell, Pennsylvania. The development company is the general partner of the project. Royal Bancshares invested 66% of initial capital contributions, or $2.5 million, with the development company holding the remaining equity interest. In addition the Company holds two notes totaling $9.2 million with a competitive term and interest rate. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. Royal Scully has total assets of $61.0 million and total borrowings of $47.4 million, of which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has determined that Royal Scully is a VIE and it is the primary beneficiary. Royal Bancshares' exposure to loss due to its investment in and receivables due from Royal Scully is $11.7 million at December 31, 2005.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Trust Preferred Securities
Management has determined that Royal Capital Trust I/II (the Trusts) qualify as VIE's under FASB Interpretation 46 (FIN 46), "Consolidation of Variable Interest Entities," as revised. The Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to Royal Bancshares.
Royal Bancshares adopted the provisions under the revised interpretation, FIN 46(R), in the first quarter of 2004. Accordingly, Royal Bancshares does not consolidate the Trusts. FIN 46(R) precludes consideration of the call option embedded in the preferred stock when determining if Royal Bancshares has the right to a majority of the Trusts' expected residual returns. The deconsolidation resulted in the investment in the common stock of the Trusts to be included in other assets as of December 31, 2005 and the corresponding increase in outstanding debt of $774,000. In addition, the income received on Royal Bancshares' common stock investment is included in other income.
18. Interest Rate Swaps
For asset/liability management purposes, Royal Bancshares uses interest rate swap agreements to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts. Such derivatives are used as part of the asset/liability management process, are linked to specific liabilities, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.
The Company currently utilizes interest rate swap agreements to convert a portion of its fixed rate time deposits to a variable rate (fair value hedge) to fund variable rate loans and investments. Interest rate swap contracts in which a series of interest flows are exchanged over a prescribed period. The notional amount of $60 million on which interest payments are based is not exchanged. During the third quarter ended September 30, 2005 the Company recorded an expense in the amount of $676,000 in other operating expenses which reflects the fair value of the interest rate swaps resulting from the Company not meeting the upfront documentation and the effectiveness assessment requirements of SFAS 133. As of October 1, 2005 and December 31, 2005, the Company had completed documentation determining the effectiveness of each hedge using the Volatility Reduction Measure ("VRM"). It was determined that these swaps are to be effective and should be treated as a fair value hedge.
At December 31, 2005 and 2004, the information pertaining to outstanding interest rate swap agreement used to hedge fixed rate loans and investments is as follows:
The change in the fair value of the swaps from 2004 to 2005 is related to $50 million of new contracts during 2005 along with $15 million of the swaps which were in existence at the end of 2004 maturing during 2005.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE B - SEGMENT INFORMATION
SFAS No. 131, "Segment Reporting," established standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision maker in deciding how to allocate and assess resources and performance. Royal Bancshares' chief operating decision maker is the President and Chief Executive Officer. Royal Bancshares has identified its reportable operating segment as "Community Banking."
Royal Bancshares' community banking segment consists of commercial and retail banking. The community banking business segment is managed as a single strategic unit which generates revenue from a variety of products and services provided by Royal Bank. For example, commercial lending is dependent upon the ability of Royal Bank to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk. This situation is also similar for consumer and residential mortgage lending.
Royal Bancshares' tax lien operation does not meet the quantitative thresholds for requiring disclosure, but has different characteristics than the community banking operation. Royal Bancshares' tax lien operation consists of purchasing delinquent tax certificates from local municipalities at auction. The tax lien segment is managed as a single strategic unit which generates revenue from a nominal interest rate achieved at the individual auctions along with periodic penalties imposed.
As a result of FIN 46(R), as of December 31, 2005 Royal Bancshares is reporting on a consolidated basis its interest in one equity investment as a VIE which has different characteristics than the community banking segment. Royal Bancshares has an investment in an apartment complex that is being converted into condominiums.
As of December 31, 2004, Royal Bancshares reported on a consolidated basis its interest in four equity investments as VIE's which have different characteristics that the community banking segment. Royal Bancshares had investments in two apartment complexes and two buildings leased as a commercial office space.
The accounting policies used in this disclosure of business segments are the same as those described in the summary of significant accounting policies.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE B - SEGMENT INFORMATION - Continued
Selected segment information and reconciliations to consolidated financial information is as follows:
Interest paid to the Community Bank segment by the Tax Lien Operation was approximately $2,862,000, $1,896,000 and $1,879,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES
The amortized cost, gross unrealized gains and losses, and fair value of Royal Bancshares' investment securities held to maturity and available for sale are summarized as follows (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
The amortized cost and estimated fair value of investment securities at December 31, 2005, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sale of investment securities available for sale during 2005, 2004 and 2003 were $15,370,000, $68,576,000 and $91,339,000, respectively, resulting in gross realized gains (losses) of $300,000 ($73,000), $900,000 ($90,000) and $1,016,000 ($297,000) and during 2005, 2004 and 2003, respectively. Royal Bancshares recorded a tax expense equivalent to 35% of the gains which resulted in a tax expense of $79,000, $284,000 and $252,000 during 2005, 2004, and 2003, respectively.
As of December 31, 2005, investment securities with a book value of $10,000,000 were pledged as collateral to secure public deposits and for other purposes required or permitted by law.
The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2005:
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
In management's opinion the unrealized losses reflect changes in interest rates subsequent to the purchase of specific securities. At December 31, 2005, there were 26 securities in the less than twelve month category and 11 in the twelve or more month category and of the $394 million fair value of investments, $333 million consisted of government bonds and government secured mortgage backed securities which maintain a AAA rating. Royal Bancshares has the ability to hold these securities until maturity or market price recovery. Management believes that the unrealized losses represent temporary impairments of the securities.
The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2004:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE D - LOANS
Major classifications of loans are as follows (in thousands):
Loans on which the accrual of interest has been discontinued or reduced amounted to approximately $4,371,000 and $4,526,000 at December 31, 2005 and 2004, respectively. If interest had been accrued, such income would have been approximately $506,000, $209,000 and $401,000 for the years ended December 31, 2005, 2004 and 2003, respectively. Management believes it has adequate collateral to limit its credit risk with these loans.
Royal Bancshares granted loans to the officers and directors of Royal Bancshares and to their associates. In accordance with Regulation O related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The aggregate dollar amount of these loans was $13,338,000 and $5,163,000 at December 31, 2005 and 2004, respectively. During 2005, three new loans totaling $8,658,000 were made and repayments totaled $483,000.
Impaired loans which include the loans on which the accrual of interest has been discontinued, was approximately $10,003,000 and $14,087,000 at December 31, 2005 and 2004, respectively. Royal Bancshares has identified a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreements. The income recognized on impaired loans during 2005 and 2004 was $-0- and $-0-, respectively. During 2005, the average balance of impaired loans was $13,471,000. At December 31, 2005 there was $1,473,000 of the allowance for possible loan loss reserved specifically for impaired loans.
Total cash collected on impaired loans during 2005 was $3,001,000 of which $3,001,000 was credited to the principal balance outstanding on such loans. Royal Bancshares' policy for interest income recognition on impaired loans is to recognize income on currently performing restructured loans under the accrual method. Royal Bancshares recognizes income on non-accrual loans under the cash basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to Royal Bancshares. If these factors do not exist, Royal Bancshares does not recognize income.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE D - LOANS -Continued
Royal Bancshares primarily grants commercial and real estate loans in the greater Philadelphia metropolitan area. Royal Bancshares has concentrations of credit risk in real estate development loans at December 31, 2005. A substantial portion of its debtors' ability to honor these contracts is dependent upon the economic sector.
Changes in the allowance for loan losses were as follows (in thousands):
NOTE E - PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE E - PREMISES AND EQUIPMENT-Continued
Depreciation and amortization in expense, related to premises and equipment, was approximately $1,300,000, $977,000 and $944,000 for the years ended 2005, 2004 and 2003, respectively.
NOTE F - DEPOSITS
Deposits are summarized as follows (in thousands):
Maturities of time deposits for the next five years and thereafter are as follows (in thousands):
NOTE G - BORROWINGS
1. Advances from the Federal Home Loan Bank
At December 31, 2005, advances from the Federal Home Loan Bank (FHLB) totaling $354,000,000 will mature within one to eight years. The advances are collateralized by FHLB stock and certain first mortgage loans, and mortgage-backed securities. These advances had a weighted average interest rate of 4.20%. Royal Bancshares available borrowing capacity is based on qualified collateral as of December 31, 2005.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE G - BORROWINGS - Continued
Outstanding borrowings mature as follows with its corresponding weighted average rate (in thousands):
2006 3.69% $ 104,500 2007 -- -- 2008 -- -- 2009 5.58% 15,000 2010 4.92% 147,500 Thereafter 3.33% 87,000 ----------- $ 354,000 ===========
2. Subordinated Debentures
On October 27, 2004, Royal Bancshares completed a private placement of an aggregate of $25.0 million of Trust Preferred Securities through two newly-formed Delaware trust affiliates, Royal Bancshares Capital Trust I ("Trust I") and Royal Bancshares Capital Trust II ("Trust II") (collectively, the "Trusts"). As part of this transaction, Royal Bancshares issued an aggregate principal amount of $12,887,000 of floating rate junior subordinate debt securities to Trust I, which debt securities bear an interest rate of 6.64% at December 31, 2005, and reset quarterly at 3-month LIBOR plus 2.15%, and an aggregate principal amount of $12,887,000 of fixed/floating rate junior subordinated deferrable interest to Trust II, which debt securities bear an initial interest rate of 5.80% until December 2009 and then which will reset quarterly at 3-month LIBOR plus 2.15%.
Each of Trust I and Trust II issued an aggregate principal amount of $12,500,000 of capital securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to an unaffiliated investment vehicle and an aggregate principal amount of $387,000 of common securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to Royal Bancshares. Royal Bancshares has fully and unconditionally guaranteed all of the obligations of the Trusts, including any distributions and payments on liquidation or redemption of the capital securities.
The Federal Reserve has issued final guidance on the regulatory capital treatment for trust preferred securities issued by Trust as a result of the adoption of FIN 46(R). The rule would retain current maximum percentage of total capital permitted for Trust Preferred Securities at 25%, but would enact other changes to the rules governing Trust Preferred Securities that affect their use as a part of the collection of entities known as "restricted core capital elements." The rule would take effect March 31, 2009; however, a five year transition period starting March 31, 2004 and leading up to that date would allow bank holding companies to continue to count Trust Preferred Securities as Tier 1 Capital after applying FIN 46(R). Management has evaluated the effects of the rule and does not anticipate a material impact on its capital ratios.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE H - LEASE COMMITMENTS
Royal Bancshares leases various premises under non-cancelable operating lease agreements, which expire through 2012 and require minimum annual rentals. The approximate minimum rental commitments under the leases are as follows for the year ended December 31,
2006 $ 661,000 2007 664,000 2008 654,000 2009 475,000 2010 305,000 Thereafter 165,000 ------------- $ 2,924,000 =============
Rental expense for all leases was approximately $716,000, $664,000 and $612,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE I - COMMON STOCK
Each holder of Class A and Class B common stock is entitled to one vote for each Class A share and ten votes for each Class B share held. Holders of either class of common stock are entitled to conversion equivalent per share dividends when declared.
The Class B shares may not be transferred in any manner except to the holder's immediate family. Class B shares may be converted to Class A shares at the rate of 1.15 to 1.
Per share information and weighted average shares outstanding have been restated to reflect the 2% stock dividend of December 2005 and the 2% stock dividend of January 2005.
NOTE J - INCOME TAXES
The components of the income tax expense included in the consolidated statements of income are as follows (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE J - INCOME TAXES - Continued
The difference between the applicable income tax expense and the amount computed by applying the statutory federal income tax rate of 35% in 2005 and 2004, and 34% in 2003 is as follows (in thousands):
Deferred tax assets and liabilities consist of the following (in thousands):
Royal Bancshares has approximately $21,000,000 of net operating loss carryovers from the acquisition of Knoblauch State Bank (KSB). These losses will fully expire in 2009. The utilization of these losses is subject to limitation under Section 382 of the Internal Revenue Code. As a result, a valuation allowance existed at December 31, 2004 to eliminate the deferred tax asset attributable to these net operating losses.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE J - INCOME TAXES - Continued
During 2005 the Company recorded an approximate $1.7 million decrease in tax expense, resulting from the completion of an IRS audit, with respect to a valuation allowance against the deferred tax asset derived from these net operating loss carryovers.
In addition, Royal Bancshares has approximately $15,700,000 of tax goodwill from the acquisition of KSB. The ability to deduct this goodwill for tax purposes will expire in 2015. The utilization of this goodwill for tax purposes was subject to the limitations under Section 382 of the Internal Revenue Code. For 2005, 2004 and 2003 approximately $1,353,000 has been utilized for tax purposes.
NOTE K - EARNINGS PER SHARE
Basic and diluted EPS are calculated as follows (in thousands, except per share data):
All options to purchase shares of common stock were included in the computation of 2005 diluted EPS because the exercise price was less than the average market price of the common stock.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE K - EARNINGS PER SHARE - Continued
All options to purchase shares of common stock were included in the computation of 2004 diluted EPS because the exercise price was less than the average market price of the common stock.
All options to purchase shares of common stock were included in the computation of 2003 diluted EPS because the exercise price was less than the average market price of the common stock.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE L - STOCK OPTION PLANS
Royal Bancshares has two stock-based compensation plans, which are described below. Royal Bancshares accounts for these plans under APB Opinion No. 25.
1. Outside Directors' Stock Option Plan
Royal Bancshares adopted a non-qualified outside Directors' Stock Option Plan (the Director's Plan). Under the terms of the Director's Plan, 250,000 shares of Class A stock are authorized for grants. Each director is entitled to a grant of an option to purchase 1,500 shares of stock annually, which are exercisable one year after the grant date. The options were granted at the fair market value at the date of the grant.
Stock option transactions consist of the following:
The following table summarizes information about options outstanding and exercisable at December 31, 2005:
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE L - STOCK OPTION PLANS - Continued
2. Employee Stock Option and Appreciation Right Plan
Royal Bancshares adopted a Stock Option and Appreciation Right Plan (the Plan). The Plan is an incentive program under which Company officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1,650,000 shares of Royal Bancshares' Class A common stock (but not in excess of 15% of outstanding shares). At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. The options are exercisable at 20% per year beginning one year after the date of grant and must be exercised within ten years of the grant.
Stock option transactions consist of the following:
The following table summarizes information about options outstanding and exercisable at December 31, 2005:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE M - PENSION PLANS
Royal Bancshares has a noncontributory nonqualified defined benefit pension plan covering certain eligible employees. Royal Bancshares-sponsored pension plan provides retirement benefits under pension trust agreements and under contracts with insurance companies. The benefits are based on years of service and the employee's compensation during the highest three consecutive years during the last 10 years of employment. Royal Bancshares' policy is to fund pension costs allowable for income tax purposes. The following table sets forth the plan's funded status and amounts recognized in Royal Bancshares consolidated balance sheets (in thousands):
Weighted-average assumptions used to determine benefit obligations, end of year
The asset allocation for Royal Bancshares pension plans and the end of 2005 and 2004 consists of insurance policies under Royal Bancshares Owned Life Insurance program. The cash surrender value for these policies was approximately $1,462,000 and $1,203,000 for the years ended December 31, 2005 and 2004, respectively.
Net pension cost included the following components (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE M - PENSION PLANS-Continued
Royal Bancshares has a capital accumulation and salary reduction plan under Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the plan, all employees are eligible to contribute up to the maximum allowed by IRS regulation, with Royal Bancshares matching 100% of any contribution between 1% and 5% subject to a $2,500 per employee annual limit. Matching contributions to the plan were approximately $155,000, $162,000 and $199,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK
Royal Bancshares is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement Royal Bancshares has in particular classes of financial instruments.
Royal Bancshares's exposure to credit loss in the event of non-performance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. Royal Bancshares uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
The contract amounts are as follows (in thousands):
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, and others are for staged construction, the total commitment amounts do not necessarily represent immediate cash requirements.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK - Continued
Royal Bancshares evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Royal Bancshares upon extension of credit, is based on management's credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment.
Standby letters of credit are conditional commitments issued by Royal Bancshares to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Most guarantees extend for one year and expire in decreasing amounts through 2006. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Royal Bancshares holds personal or commercial real estate, accounts receivable, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments is approximately 80%.
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107 requires disclosure of the estimated fair value of an entity's assets and liabilities considered to be financial instruments. For Royal Bancshares, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in SFAS No. 107. However, many of such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is Royal Bancshares's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities. Therefore, Royal Bancshares had to use significant estimations and present value calculations to prepare this disclosure.
Changes in the assumptions or methodologies used to estimate fair value may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair value.
Fair values have been estimated using data which management considered the best available and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimation methodologies, resulting fair values and recorded carrying amounts at December 31, 2005 and 2004 were as follows:
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Fair value of financial instruments actively traded in a secondary market has been estimated using quoted market prices as follows (in thousands):
Fair value of financial instruments with stated maturities has been estimated using present value cash flow, discounted at a rate approximating current market for similar assets and liabilities, as follows (in thousands):
The fair value of commitments to extend credit is estimated based on the amount of unamortized deferred loan commitment fees. The fair value of letters of credit is based on the amount of unearned fees plus the estimated cost to terminate the letters of credit. Fair values of unrecognized financial instruments including commitments to extend credit and the fair value of letters of credit are considered immaterial.
Fair value of the net loan portfolio has been estimated using present value cash flow, discounted at the treasury rate adjusted for non-interest operating costs and giving consideration to estimated prepayment risk and credit loss factors, as follows (in thousands):
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
The fair value of accrued interest receivable and payable approximates carrying amounts.
The fair value of interest rate swaps are based on upon the estimated amount Royal Bank would receive or pay to terminate the contract or agreements, taking into account current interest rates and, when appropriate, the current creditworthiness of the counterparties. The fair value of the interest rate swaps as of December 31, 2005 was a negative $1.3 million on a notional amount $60 million. The fair value of the interest rate swaps as of December 31, 2004 was a negative $135 thousand on a notional amount $25 million.
Royal Bancshares' remaining assets and liabilities are not considered financial instruments. No disclosure of the relationship value of Royal Bancshares's deposits is required by SFAS No. 107.
NOTE P - REGULATORY MATTERS
1. Payment of Dividends
Under the Pennsylvania Business Corporation Law, Royal Bancshares may pay dividends only if it is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the Code) and in the Federal Deposit Insurance Act (FDIA) concerning the payment of dividends by Royal Bancshares. Under the Code, no dividends may be paid except from "accumulated net earnings" (generally retained earnings). Under the FDIA, no dividend may be paid if a bank is in arrears in the payment of any insurance assessment due to the Federal Deposit Insurance Corporation (FDIC).
In addition, dividends paid by Royal Bank to Royal Bancshares would be prohibited if the effect thereof would cause Royal Bank's capital to be reduced below applicable minimum capital requirements.
2. Capital Ratios
Royal Bancshares and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Royal Bancshares' financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Royal Bancshares must meet specific capital guidelines that involve quantitative measures of Royal Bancshares' assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Royal Bancshares and Royal Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulations to ensure capital adequacy require Royal Bancshares and Royal Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE P - REGULATORY MATTERS - Continued
in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). As of December 31, 2005, management believes that Royal Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2005, Royal Bank met all regulatory requirements for classification as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, Royal Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed Royal Bank's category.
Royal Bancshares' and Royal Bank's actual capital amounts and ratios are also presented in the table (in thousands).
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE P - REGULATORY MATTERS - Continued
NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
Condensed financial information for the parent company only follows (in thousands).
CONDENSED BALANCE SHEETS
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY - Continued
CONDENSED STATEMENTS OF INCOME
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE R - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
CONDENSED STATEMENTS OF CASH FLOWS
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE R - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
The following summarizes the consolidated results of operations during 2005 and 2004, on a quarterly basis, for Royal Bancshares (in thousands except per share data):
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
As reported on its Report on Form 8-K filed with the SEC on October 21, 2004, on October 18, 2004, Royal Bancshares dismissed its then independent accountants, Grant Thornton, LLP and appointed Beard Miller Company LLP as its new independent accountants, each effective immediately. The decisions to dismiss Grant Thornton and to engage Beard Miller were approved by Royal Bancshares' Audit Committee. The Audit Committee's decision was based upon a response to a competitive bid requested by Royal Bancshares. The reports on Royal Bancshares' financial statements from Grant Thornton for 2003 or any period prior to that period, have not contained an adverse opinion or disclaimer of opinion, nor were qualified or modified as to any uncertainty, audit scope, or accounting principles. There have been no disagreements with Grant Thornton on any matter of accounting principles or practices, financial statement disclosures, or auditing scope of procedure during the two most recent fiscal years, or any subsequent interim period through the date of dismissal or in any of the years prior to that period, which, if not resolved to the satisfaction of Grant Thornton, would have caused Grant Thornton to make reference to the subject matter of the disagreement in connection with its report.
During the two most recent fiscal years, or any subsequent interim period through the date of dismissal of Grant Thornton, there were no disagreements with Grant Thornton on any of the kinds of events listed in Item 304 (a)(1)(v)(A) through (D) of Regulation S-K.
During the years ended December 31, 2003 and the subsequent interim period through the date of engaging Beard Miller, neither Royal Bancshares nor anyone on its behalf consulted Beard Miller on any of the matters or reportable events listed in Item 304 (a) (2) (i) and (ii) of Regulation S-K.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
EFFECTIVENESS OF DISCLOSURE CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable assurance to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, within 90 days prior to the filing date of this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective.
During the quarter ended December 31, 2005, there have been no changes in our internal controls over financial reporting that has materially affected, or are reasonably likely to material affect, these controls.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a - 15(f) under the Securities Exchange Act of 1934. The Company's internal control over financial reporting is a process designed under the supervision of the Company's Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company's financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2005, management assessed the effectiveness of the Company's internal control over financial reporting based on the framework established in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management has determined that the Company's internal control over financial reporting was effective as of December 31, 2005 based on the criteria specified.
Beard Miller Company LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued an attestation report on management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2005.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders Royal Bancshares of Pennsylvania, Inc. Narberth, Pennsylvania
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Royal Bancshares of Pennsylvania, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Royal Bancshares of Pennsylvania, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the asses of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and the receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Royal Bancshares of Pennsylvania, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Royal Bancshares of Pennsylvania, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Royal Bancshares of Pennsylvania, Inc. and subsidiaries as of December 31, 2005 and the related statements of income, stockholders' equity and cash flows for each of the years in the two-year period ended December 31, 2005 and our report dated March 14, 2006 expressed an unqualified opinion.
/s/ Beard Miller Company LLP
Beard Miller Company LLP Reading, Pennsylvania March 14, 2006
PART III.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
The information required in this Item, relating to directors, executive officers, and control persons is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2006 Annual Meeting of Shareholders under the heading "Remuneration of Directors and Officers and Other Transactions", which pages are incorporated herein by reference.
AUDIT COMMITTEE. Royal Bancshares has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The members of the Audit Committee are Gregory T. Reardon (Chairman), Jack R. Loew, Anthony J. Micale and Edward B. Tepper as an advisor each of whom is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.
AUDIT COMMITTEE FINANCIAL EXPERT. Royal Bancshares' Board of Directors has determined that Gregory T. Reardon, the Audit Committee Chairman, is an audit committee financial expert as defined in Item 401(h) of Regulation S-K of the Exchange Act and is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.
BENEFICIAL OWNERSHIP - COMPLIANCE. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires Royal Bancshares' officers and directors, and persons who own more than 10 percent of the registered class of Royal Bancshares' equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10 percent shareholders are required by SEC regulation to furnish the Corporation copies of all Section 16(a) forms they file.
Based solely on its review of forms that were received from certain reporting persons, Royal Bancshares believes that during the period January 1, 2005 through December 31, 2005, its officers and directors were in compliance with all filing requirements applicable to them.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item, relating to executive compensation, is set forth in the Royal Bancshares' Proxy Statement to be used in connection with the 2006 Annual Meeting of Shareholders, under the heading "Renumeration of Directors and Officers and Other Transactions", which pages are incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item, relating to beneficial ownership of the Registrant's Common Stock, is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2006 Annual Meeting of Shareholders, under the heading "Information About Nominees, Continuing Directors and Executive Officers", which pages are incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item, relating to transactions with management and others, certain business relationships and indebtedness of management, is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2006 Annual Meeting of Shareholders, under the heading "Interest of Management and Others in Certain Transactions", which pages are incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item appears under the heading "AUDIT FEES" of the Proxy Statement to be used in connection with the 2006 Annual Meeting of Shareholders, which pages are incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
a. 1. Financial Statements
The following financial statements are included by reference in Part II, Item 8 hereof. Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets. Consolidated Statements of Income. Consolidated Statements of Changes in Stockholders' Equity. Consolidated Statement of Cash Flows. Notes to Consolidated Financial Statements.
2. Financial Statement Schedules
Financial Statement Schedules are omitted because the required information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto.
3. The following Exhibits are filed herewith or incorporated by reference as a part of this Annual Report.
2 Purchase and Assumption Agreement, dated as of March 12, 2001, among Royal Bank of Pennsylvania, Crusader Holding Corporation, Crusader Savings Bank, F.S.B. and Asset Investment Corporation. (Incorporated by reference to Exhibit 2 to Registrant's Report on Form 8-K, filed with the Commission on March 15, 2001.)
3(i) Articles of Incorporation. (Incorporated by reference to Exhibit 3(i) to Registrant's Registration Statement No. 0-26366 on Form S-4.)
3(ii) By-laws. (Incorporated by reference to Exhibit 99 to Registrant's Current Report on Form 8-K, filed with the Commission on March 13, 2001.)
4.1 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.1) filed with the Commission on November 1, 2004.))
4.2 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.2 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.2) filed with the Commission on November 1, 2004.))
4.3 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.4 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.5 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.6 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, October 27, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
10.1 Stock Option and Appreciation Right Plan. As amended on May 16, 2005 (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on November 22, 2005).
10.2 Outside Directors' Stock Option Plan. (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on April 5, 1997).
10.3 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Joseph P. Campbell, President and Chief Executive Officer, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10- Q filed with the Commission on November 9, 2004.)
10.4 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and James J. McSwiggan, Executive Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.5 Employment agreement between Royal Bank America and Robert R. Tabas, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.6 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Murray Stempel, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.7 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and John Decker, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.8 Employment agreement between Royal Bank America and Edward Shin, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
11. Statement Re: Computation of Earnings Per Share. Included at Item 8, hereof, Note K, "Per Share Information".
12. Statement re: Computation of Ratios. (Included at Item 8 here of, Note P, "Regulatory Matters.")
14. Royal Bancshares of Pennsylvania, Inc. Code of Ethics.
21. Subsidiaries of Registrant.
23.1 Consent of Independent Accountants from Beard Miller Company LLP.
23.2 Consent of Independent Accountants from Grant Thornton LLP.
31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief Financial Officer
32.1 Section 1350 Certification of Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer.
99.1 Opinion letter of Independent Accounts Grant Thornton LLP.
(b) Reports on Form 8-K filed by the Registrant during the fourth quarter and through this Form 10K filing are as follows:
Royal Bancshares filed a repot on Form 8-K with the Securities and Exchange Commission as of October 20, 2005, announcing the sale of two equity positions held in Royal Investments America, LLC.
Royal Bancshares filed a repot on Form 8-K with the Securities and Exchange Commission as of October 25, 2005, reporting its third quarter earnings and the declaration of its 42nd consecutive cash dividend.
Royal Bancshares filed a repot on Form 8-K with the Securities and Exchange Commission as of December 22, 2005, announcing the declaration of a 2% stock dividend on both Class A and Class B shares.
Royal Bancshares filed a repot on Form 8-K with the Securities and Exchange Commission as of January 23, 2006, reporting its fourth quarter earnings and the declaration of its 43rd consecutive cash dividend.
Royal Bancshares filed a repot on Form 8-K with the Securities and Exchange Commission as of February 22, 2006, announcing the appointment of Patrick J. McCormick to the Boards of Directors of Royal Bancshares and Royal Bank.
(c) The exhibits required to be filed by this Item are listed under Item 14(a)3 above.
(d) Not applicable.
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.
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
/s/ Joseph P. Campbell - ------------------------------------- Joseph P. Campbell Chief Executive Officer March 14, 2006.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SINATURES
By: /s/ Joseph P. Campbell March 15, 2006 - --------------------------------------- Joseph P. Campbell CEO/ President/Director
By: /s/ Jeffrey T. Hanuscin March 15, 2006 - --------------------------------------- Jeffrey T. Hanuscin Chief Financial Officer
By: /s/ James J. McSwiggan March 15, 2006 - --------------------------------------- James J. McSwiggan Chief Operating Officer/ Director
By: /s/ Robert R. Tabas March 15, 2006 - --------------------------------------- Robert R. Tabas Chairman of the Board
By:/s/ Albert Ominsky March 15, 2006 - --------------------------------------- Albert Ominsky Director
By: /s/ Anthony Micale March 15, 2006 - --------------------------------------- Anthony Micale Director
By: /s/ Gregory Reardon March 15, 2006 - --------------------------------------- Gregory Reardon Director
By: /s/ Murray Stempel, III March 15, 2006 - --------------------------------------- Murray Stempel, III Chief Lending Officer/Director
By: /s/ John M. Decker March 15, 2006 - --------------------------------------- John M. Decker Executive Vice President
By:/s/ Carl M. Cousins March 15, 2006 - --------------------------------------- Carl M. Cousins Director
By: /s/ Lee E. Tabas March 15, 2006 - --------------------------------------- Lee E. Tabas Director
By: /s/ Jack R. Loew March 15, 2006 - --------------------------------------- Jack R. Loew Director
By: /s/ Howard Wurzak March 15, 2006 - --------------------------------------- Howard Wurzak Director
By: /s/ Evelyn R. Tabas March 15, 2006 - --------------------------------------- Evelyn R. Tabas Director
By: /s/ Mitchell L. Morgan March 15, 2006 - --------------------------------------- Mitchell L. Morgan Director
By: /s/ Edward B. Tepper March 15, 2006 - --------------------------------------- Edward B. Tepper Director
By: /s/ Linda Tabas Stempel March 15, 2006 - --------------------------------------- Linda Tabas Stempel Director
By:/s/ Patrick McCormick March 15, 2006 - --------------------------------------- Patrick McCormick Director
ROYAL BANCSHARES OF PENNSYLVANIA, INC. ANNUAL REPORT ON FORM 10-K EXHIBIT INDEX
2. Purchase and Assumption Agreement, dated as of March 12, 2001, among Royal Bank of Pennsylvania, Crusader Holding Corporation, Crusader Savings Bank, F.S.B. and Asset Investment Corporation. (Incorporated by reference to Exhibit 2 to Registrant's Report on Form 8-K, filed with the Commission on March 15, 2001.)
3(i) Articles of Incorporation. (Incorporated by reference to Exhibit 3(i) to Registrant's Registration Statement No. 0-26366 on Form S-4.)
3(ii) By-laws. (Incorporated by reference to Exhibit 99 to Registrant's Current Report on Form 8-K, filed with the Commission on March 13, 2001.)
4.1 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.1) filed with the Commission on November 1, 2004.))
4.2 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.2 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.2) filed with the Commission on November 1, 2004.))
4.3 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.4 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.5 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
4.6 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, October 27, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.)
10.1 Stock Option and Appreciation Right Plan. (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on April 5, 1997).
10.2 Outside Directors' Stock Option Plan. (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on April 5, 1997).
10.3 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Joseph P. Campbell, President and Chief Executive Officer, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.4 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and James J. McSwiggan, Executive Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.5 Employment agreement between Royal Bank America and Robert R. Tabas, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.6 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Murray Stempel, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.7 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and John Decker, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
10.8 Employment agreement between Royal Bank America and Edward Shin, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.)
11. Statement Re: Computation of Earnings Per Share. (Included at Item 8, hereof, Note K, "Per Share Information".)
12. Statements re: Computation of Ratios. (Included at Item 8 here of, Note P, "Regulatory Matters.")
14. Royal Bancshares of Pennsylvania, Inc. Code of Ethics.
21. Subsidiaries of Registrant.
23.1 Consent of Independent Accountants from Beard Miller Company LLP.
23.2 Consent of Independent Accountants Grant Thornton LLP.
31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief Financial Officer
32.1 Section 1350 Certification of Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer.
99.1 Opinion letter of Independent Accounts Grant Thornton LLP.