ITEM 1. BUSINESS - ------- --------
Forward-Looking Statements - --------------------------
East Penn Financial Corporation (the "Company") may from time to time make written or oral "forward-looking statements", including statements contained in the Company's filings with the Securities and Exchange Commission ("SEC") (including the Annual Report and this Form 10-K and the exhibits hereto and thereto), in its reports to stockholders and in other communications by the Company, which are made in good faith by the Company pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995.
Because of the possibility of change in the underlying assumptions, actual results could differ materially from these forward-looking statements. Factors that could cause actual results to differ materially from forward-looking statements include, but are not limited to, the following, as well as those discussed elsewhere herein:
- operating, legal, and regulatory risks, - economic, political, and competitive forces affecting the Company's services, and - the risk that management's analyses of these risks could be incorrect and/or that the strategies developed to address them could be unsuccessful.
The Company cautions that the foregoing list of factors is not exclusive. The Company's forward-looking statements are relevant only as of the date on which such statements are made. By making any forward-looking statements, the Company assumes no duty to update them to reflect new, changing or unanticipated events or circumstances.
History - -------
The Company is a Pennsylvania business corporation, which is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "Holding Company Act"). The Company was incorporated on January 27, 2003 for the purpose of forming a one-bank holding company. On July 1, 2003, the Company completed the reorganization and merger of East Penn Bank (the "Bank") into the holding company form of ownership. In the reorganization, the Bank became a wholly owned banking subsidiary of the Company. The Company's profitability is dependent on the financial results of its primary operating subsidiary, which is the Bank. In the future, the Company may decide to acquire or establish additional subsidiaries, including other banks. The Company's headquarters and principal place of business is located at 731 Chestnut Street, P.O. Box 869, Emmaus, Lehigh County, Pennsylvania 18049.
On July 31, 2003, the Company formed East Penn Statutory Trust I (the "Trust"), a Connecticut statutory business trust, for the purpose of issuing $8 million in capital pass-through securities to investors.
The Bank, which was incorporated in the Commonwealth of Pennsylvania on November 9, 1990 and commenced operations on November 1, 1991, is a state chartered banking institution and a member bank of the Federal Reserve System. Deposits held by the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC") to the maximum extent provided by law. The Bank's principal place of business is the same location as the Company's location.
The Bank formed East Penn Mortgage Company (the "Mortgage Company"), a wholly owned subsidiary, which was incorporated in the Commonwealth of Pennsylvania on June 2, 1995. This subsidiary engages in the originating, processing and brokering of first and second mortgage loans, where such loans are either maintained within the Bank's loan portfolio or sold in the secondary market. In 2004, the Bank commenced selling mortgages service retained through the Federal Home Loan Bank's Mortgage Partnership Finance Program ("MPF").
East Penn Home Settlements, LLC is a Pennsylvania limited liability company. The Bank and Mortgage Company each have a 20% interest in the limited liability company, which represents an aggregate investment of $3,000. This investment is a joint venture title insurance agency with Home Settlement Services located in Macungie and Allentown, Pennsylvania. The Bank and the Mortgage Company entered into this arrangement on
November 15, 1999. Income generated from this investment was $24,950 for 2005 and $14,500 for 2004, and is included in other income.
Description of Business - -----------------------
The Company has one reportable segment, Community Banking, which consists of commercial and retail banking, and other non-reportable operating segments, as described in Note 1 of the Notes to Consolidated Financial Statements included at the end of this Report. The Segment Reporting information in Note 1 is incorporated by reference into this Item 1.
The Bank's principal business consists of attracting deposits from the general public through its banking offices and using these deposits to originate loans. The Bank engages in a full service retail and commercial banking business, which includes providing the following services:
o accepting time and demand deposits,
o providing personal and business checking accounts at competitive rates, and
o making secured and unsecured commercial, real estate, mortgage and retail loans and credit cards.
The Bank derives its income principally from interest charged on loans and to a lesser degree, from interest and dividends earned on investments. In addition, the Bank is increasingly deriving income from other non-interest sources such as mortgage banking services, customer service fees, bank owned life insurance and, from time to time, gains on the sale of available for sale securities. The Bank's principal expenses are interest expense on deposits, borrowings and securities sold under repurchase agreements. Funds for activities are provided principally by deposits, advances from correspondent banks, securities sold under agreements to repurchase and amortization and prepayments of outstanding loans and investment securities.
The Bank's primary service area is known as the Lehigh Valley, and is located in the counties of Lehigh, Northampton and Northeastern Berks in eastern Pennsylvania. The Lehigh Valley is a vibrant, growing region strategically located near the center of the northeastern corridor of New York, Philadelphia and Washington, D.C. The Lehigh Valley local economy generally mirrors the national economy like many other communities in the nation. Over the past 10 years, the Lehigh Valley has experienced a change in the types of businesses that have traditionally resided in the region. Historically, the area was dominated by large manufacturers, whereas now, there are more service-based companies, and this trend is expected to continue. According to statistics, population trends are positive in both size and age demographics, with municipal population in the Bank's service area expected to grow 22.6% from 2000 to 2030, with most of the growth centered in suburban areas where there are substantial tracts of land readily available for future development.
Within the Bank's defined service area, the banking business is highly competitive. The Bank is the only financial institution headquartered in Emmaus, Pennsylvania, where five other financial institutions have branches. Additionally, the Bank competes with regionally based commercial banks, which generally have greater assets, capital and lending limits, as well as other types of financial institutions, including savings banks, credit unions, finance companies, insurance companies and brokerage firms that have expanded their product offerings to include traditional bank products and services. Deposit deregulation has intensified the competition for deposits among banks in recent years. Further, eastern Pennsylvania has experienced increased bank merger and acquisition activity in recent years. The Bank believes that as a result of the shift in business entities, population growth and the trend in bank mergers and acquisitions within its geographic area, the need for a strong community banking presence continues to exist in its primary service area. The Bank's business development strategy has been focused on competing with larger banks, other community banks, thrift institutions and credit unions, by providing comparable retail and commercial banking products and services, coupled with exceptional customer service, with an orientation towards relationship banking and the development of customer loyalty. Rather than expanding into new areas of financial services, the Bank has focused on further developing its personnel, resources and capabilities in providing traditional banking products and services.
This strategy has proven to be a successful tactic in that it has provided the Bank with consistent core deposit growth, which has allowed the Bank to more efficiently fund asset growth, while preserving credit quality. The Bank's business model has and will continue to focus on the consumer and the small and medium-sized business markets, where referrals received from existing customers have proven to be a major source for developing business.
The Bank's focus for the future is to continue to focus on its community activities and to further penetrate the market within its geographic footprint. The Bank's commitment to remain an independent community bank with local management and local decision-making, is a beneficial attribute that has proven to attract new business, while satisfying existing customers.
Supervision and Regulation - --------------------------
The following discussion sets forth certain of the material elements of the regulatory framework applicable to bank holding companies and their subsidiaries, and provides certain specific information relevant to the Company. The regulatory framework is intended primarily for the protection of depositors, other customers and the Federal Deposit Insurance Funds and not for the protection of security holders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. A change in applicable statutes, regulations or regulatory policy may have a material effect on the business of the Company.
The Company - -----------
The Company is subject to the jurisdiction of the SEC and state securities commissions for matters relating to the offering and sales of its securities, and is subject to the SEC's rules and regulations relating to periodic reporting, reporting to shareholders, proxy solicitations and insider trading.
The Company is also subject to the provisions of the Holding Company Act and to supervision and examination by the Federal Reserve Board ("FRB"). Under the Holding Company Act, the Company must secure the prior approval of the FRB before it may own or control, directly of indirectly, more than 5% of the voting shares or substantially all of the assets of any institution, including another bank (unless it already owns a majority of the voting stock of the bank).
Satisfactory financial condition, particularly with regard to capital adequacy, and satisfactory Community Reinvestment Act ("CRA") ratings are generally prerequisites in obtaining federal regulatory approval to make acquisitions.
The Company is required to file an annual report with the FRB and any additional information that the FRB may require pursuant to the Holding Company Act. The FRB may also make inspections of the Company and examinations of any or all of its subsidiaries. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit or provision for any property or service. Thus, an affiliate of the Company may not impose conditions as to the extension of credit, the lease or sale of property or furnishing of any services in (i) the customer's obtaining or providing some additional credit, property or services from or to the Company or other subsidiaries of the Company, or (ii) the customer's refraining from doing business with a competitor of the Company or its subsidiaries. The Company may impose conditions to the extent necessary to reasonably assure the soundness of credit extended.
Subsidiary banks of the bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on (i) any extension of credit to the bank holding company or any of its subsidiaries, (ii) investments in the stock or other securities of the bank holding company, and (iii) taking the stock or securities of the bank holding company as collateral for loans to any borrower.
The Bank - --------
As a Pennsylvania chartered, Federal Reserve Bank member, the Bank is subject to supervision, regulation and examination by the Pennsylvania Department of Banking, the FRB and the FDIC. The Bank is also subject to requirements and restrictions under federal and state law, including:
o requirements to maintain reserves against loans and lease losses,
o restrictions on the types and amounts of loans that may be granted and the interest that may be charged on the loans,
o limitations on the types of investments the Bank may make and the types of services the Bank may offer, and
o restrictions on loans to insiders of the Company and other insider transactions.
The following discussion concerns provisions of State and Federal laws and certain regulations, and the potential impact of these provisions and regulations on the Company 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. A change in applicable statutes, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiaries.
State Banking Law - -----------------
The laws of Pennsylvania applicable to the Bank include, among other things, provisions that:
- require the maintenance of certain reserves against deposits, - limit the type and amount of loans that may be made and the interest that may be charged thereon, - restrict investments and other activities, and - limit the payment of dividends.
The amount of funds that the Bank may lend to a single borrower is limited generally, in accordance with Pennsylvania law, to 15% of the aggregate of its capital, surplus, undivided profits and loan loss reserves and capital securities of the Bank (as defined by statute and regulation).
The Bank may establish or acquire branch offices, subject to certain limitations in any county of the state. Branches may be established only after approval by the Pennsylvania Department of Banking and the FRB. Applicable Pennsylvania law also requires that a bank obtain the approval of the Department of Banking prior to effecting any merger where the surviving bank would be a Pennsylvania-chartered bank.
Federal law also prohibits acquisitions or control of a bank or 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 of policies of the bank or bank holding company or to vote twenty-five percent (25%) or more of any class of voting securities of the bank holding company.
Federal Banking Law - -------------------
The federal laws applicable to the Bank include the following among others:
A. The Federal Reserve System The Federal Reserve System is managed through a tripartite hierarchy headed by the FRB, which oversees the entire system. The second level of hierarchy is the twelve Federal Reserve banks and their branches, which are spread throughout the nation's twelve Federal Reserve districts. The third element in the Federal Reserve System's structure is the member banks of each district which act in concert with the Federal Reserve banks to perform the actual operations of the Federal Reserve System, including such functions as furnishing an elastic currency and affording a means of rediscounting commercial paper. The Federal Reserve System is at the center of the nation's financial and economic systems, and the Federal Reserve banks are the means through which the Federal Reserve System effectuates its goals of maintaining financial and economic stability.
B. Monetary Policy The earnings of the Bank are affected by domestic economic conditions and the monetary and fiscal policies of the United States Government and its agencies. An important function of the Federal Reserve System is to regulate the money supply and interest rates. Among the instruments used to implement these objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits. Their use may also affect rates charged on loans or paid on deposits. The policies and regulations of the FRB have a significant effect on the Bank's
deposits, loans and investments growth, as well as the rate of interest earned and paid, and are expected to affect the Bank's operations in the future. The effect of such policies and regulations upon the future business and earnings of the Bank cannot be predicted.
C. Deposit Insurance The Bank's deposits are insured by the FDIC to the maximum extent provided by the law, pursuant to the system of federal deposit insurance initially established by the Banking Act of 1933. The Bank pays insurance premiums into the Bank Insurance Fund ("BIF") in accordance with rates established by the FDIC.
D. FDIA Under the Federal Deposit Insurance Act (the "FDIA"), the FDIC possesses the power to prohibit institutions that it regulates (such as the Bank) from engaging in any activity that would be an unsafe and unsound banking practice or would otherwise be in violation of the law.
E. CRA The CRA rules emphasize performance over process and documentation. Under the rules utilizing the Intermediate Small Institution Examination Procedures adopted by the Board of Governors as of September 1, 2005, compliance is determined by utilizing a two-part test whereby examiners evaluate a bank's performance in lending and community development, where the greatest weight is placed on the lending aspect of the test. The lending test includes an analysis of:
o The loan-to-deposit ratio; o The volume of loans extended inside and outside of the Bank's assessment areas; o The geographic distribution of loans in the assessment areas, including lending in low- and moderate-income census tracts; and o The extent of lending to borrowers of different incomes, including low- and moderate-income borrowers, and businesses of different sizes, including small businesses.
The community development part of the test includes an analysis of the following factors:
o The number and amount of community development loans; o The number and amount of qualified investments; o The extent to which the Bank provides community development services; and o The Bank's responsiveness to the community development needs of its assessment areas through community development loans, qualified investments and community development services.
F. BSA Under the 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 that occur and which the bank becomes aware in any one day that aggregate in excess of $10,000. 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.
G. Regulatory Capital The FDIC and other federal bank regulatory agencies have issued risk-based capital guidelines, which supplement leverage capital requirements. The guidelines require all United States banks and bank holding companies to maintain a minimum risk-based capital ratio of 8% (of which at least 4% must be in the form of common stockholders' equity). Assets are assigned to four risk categories, with higher levels of capital required for the categories perceived as representing greater risk. The required capital ratios represent equity and (to the extent permitted) non-equity capital as a percentage of total risk-weighted assets. The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, and to minimize disincentives for holding liquid assets. The risk-based capital rules have not had a material effect on the Company's business and capital plans.
FDICIA - ------ Capital Categories - ------------------
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provides that financial institutions must be classified in one of five defined categories, namely, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized based on their various capital ratios as set forth below.
Total Tier I Under a Risk Risk- Tier I Capital Based Based Leverage Order or Ratio Ratio Ratio Directive ----- ----- ----- ---------
CAPITAL CATEGORY Well capitalized >=10.0 >= 6.0 >= 5.0 No Adequately capitalized >= 8.0 >= 4.0 >= 4.0* Undercapitalized < 8.0 < 4.0 < 4.0* Significantly undercapitalized < 6.0 < 3.0 < 3.0 Critically undercapitalized <= 2.0 *3.0 for those banks having the highest available regulatory rating.
Prompt Corrective Action - ------------------------
In the event a company's capital deteriorates to the undercapitalized category or below, the FDICIA prescribes an increasing amount of regulatory intervention. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver. For well capitalized companies, FDICIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receive a less than satisfactory examination report rating for asset quality, management, earnings or liquidity. All but well capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval. As of December 31, 2005, the Company is considered to be well capitalized as defined by these capital rules.
Operational Controls - --------------------
Under FDICIA, financial institutions are subject to increased regulatory scrutiny and must comply with certain operational, managerial and compensation standards to be developed by FRB regulations.
Legislation and Regulatory Changes - ----------------------------------
From time to time, legislation is enacted that could result in additional regulation of and restrictions on the Company. No prediction can be made as to the likelihood of the adoption of any legislative changes or, if adopted, the impact such changes might have on the business of the Company. Certain changes of potential significance to the Company, any of which have been enacted recently and others, which are currently under consideration by Congress or various regulatory or professional agencies, are discussed below. Management does not believe that these provisions of law and regulation have had a material impact on liquidity, capital resources or reported results of operation.
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 all financial institutions 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. In July 2002, the Sarbanes-Oxley Act of 2002 was enacted (the "SOA"). The stated goals of the SOA 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 disclosure pursuant to the securities laws.
The SOA is the most far-reaching U.S. securities legislation enacted in some time. The SOA 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 (the "Exchange Act"). The impact of SOA is expected to be minimal if all provisions are implemented for companies with our market capitalization.
Effects of Inflation - --------------------
Inflation has some impact on the Company's operating costs. Unlike many industrial companies, however, substantially all of the Company's assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Company's performance than the general levels 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.
Federal Taxation - ----------------
The Company is subject to those rules of federal income taxation generally applicable to corporations, and reports its respective income and expenses on the accrual method of accounting. The Company and its subsidiary file a consolidated federal income tax return on a calendar year basis. Inter-company distributions and certain other items of income and loss derived from inter-company transactions are eliminated upon the consolidation of all group members' respective taxable income and losses.
The Internal Revenue Code ("IRC") imposes a corporate alternative minimum tax ("AMT"). The corporate AMT only applies if such tax exceeds a corporation's regular tax liability. In general, AMT is calculated by multiplying the corporate AMT rate of 20% by an amount equal to the excess of (1) the sum of (a) regular taxable income plus (b) certain adjustments and tax preference items ("alternative minimum taxable income" or "AMTI") over (ii) an exemption amount ($40,000 for a corporation, that such amount is reduced by 25% of the excess of AMTI over $150,000 and is completely eliminated when AMTI exceeds $310,000). The excess of the AMT over the regular tax for the taxable year is the taxpayer's net minimum tax liability.
State Tax - ---------
The Bank is subject to the Commonwealth of Pennsylvania's shares and loan tax for financial institutions. The tax is assessed on the Bank's average shareholders' equity over the prior six years, as adjusted for certain types of investments. Presently the tax rate is 1.25%.
Disclosure of Significant Policies - ----------------------------------
Disclosure of the Company's significant accounting policies is included in Note 1 of the Notes to Consolidated Financial Statements included in this Report. Some of these policies are particularly sensitive requiring significant judgments, estimates and assumptions to be made by management. Additional information is contained in Management's Discussion and Analysis for the most sensitive of these issues, including the provision and allowance for loan losses.
Significant estimates are made by management in determining the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate. In estimating the allowance for loan losses, management considers current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan review, financial and managerial strengths of borrowers, adequacy of collateral, if collateral dependent, or present value of future cash flows and other relevant factors.
Statistical Data - ----------------
The following disclosures are included in Management's Discussion and Analysis, Item 7, hereof, and are incorporated by reference in this Item 1:
o Interest Rate Sensitivity Analysis.
o Interest Income and Expense, Volume and Rate Analysis.
o Investment Portfolio.
o Loan Maturity and Interest Rate Sensitivity.
o Loan Portfolio.
o Allocation of Allowance for Loan Losses.
o Deposits.
o Short-Term Borrowings.
Employees - ---------
As of February 28, 2006, the Company employed 121 full-time employees and 24 part-time employees. The Company enjoys a good relationship with its employees, who are not represented by a collective bargaining agreement.
AVAILABLE INFORMATION - ---------------------
Upon a shareholder's written request, a copy of the Company's 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 the Company's website: www.eastpennbank.com, or by contacting Theresa M. Wasko, Treasurer and Chief Financial Officer, East Penn Financial Corporation, 731 Chestnut Street, P.O. Box 869, Emmaus, PA 18049 or via e-mail: twasko@eastpennbank.com.
ITEM 1A.
ITEM 1A. RISK FACTORS - -------- ------------
An investment in the Company's common stock is subject to risks inherent to the Company's business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties summarized below together with all of the other information included or incorporated by reference herein this report. While management takes a proactive approach to manage risk, other additional risks and uncertainties that management is not aware of or that it may deem to be immaterial may also impair the Company's business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company's consolidated financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company's common stock could be negatively impacted and have an adverse effect on an investor's holdings.
Changes in Interest Rates May Have an Adverse Effect on Profitability - ---------------------------------------------------------------------
The Company's earnings and cash flows, like most financial institutions, are significantly dependent on its net interest income. Net interest income is the difference between interest income earned on interest earning assets, such as loans and investment securities, and interest expense paid on interest bearing liabilities, such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions, competition and policies of various governmental and regulatory agencies, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Company receives on its loans and investment securities and pays on its deposits and borrowings, but could also affect (i) the Company's ability to originate loans and obtain deposits, (ii) the fair or economic value of the Company's financial assets and liabilities, and (iii) the average duration of the Company's mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster pace than the interest rates received on loans and investment securities, the
Company's net interest income, and therefore its earnings, could be adversely affected. Earnings could also be adversely impacted if interest rates received on loans and investment securities fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies to mitigate the potential effects that interest rate changes may have on the Company's results of operations, any substantial, unexpected, or prolonged change in market interest rates could have a materially adverse impact on the Company's financial condition and results of operations.
The Company is Subject to Lending Risk - --------------------------------------
There are inherent risks associated with the Company's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in economic conditions in the markets where the Company operates as well as those across the Commonwealth of Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or could negatively affect the value of the collateral securing those loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties assessed against the Company.
The Company's Allowance for Possible Loan Losses May Be Insufficient - --------------------------------------------------------------------
The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management's best estimate of probable losses within the existing loan portfolio. In management's judgment, the allowance is necessary to reserve for estimated losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses that may be inherent within the current loan portfolio. The determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Although the Company believes it has in place underwriting standards to manage normal lending risks, changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Company's control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies review the Company's allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different from those of management. In addition, if charge-offs in future periods exceed the allowance for possible loan losses, the Company will need to initiate additional provisions to increase the allowance. Any increases in the allowance for possible loan losses will result in a decrease to net income and possibly capital, and may have a materially adverse effect on the Company's financial condition and results of operations.
The Company is Subject to Environmental Liability Risk Associated with Lending - ------------------------------------------------------------------------------ Activities - ----------
The Company does not anticipate that compliance with environmental laws and regulations will have any material effect on capital, expenditures, earnings, or on its competitive position. However, environmentally related hazards have become a source of high risk and potentially unlimited liability for financial institutions. Environmentally contaminated properties owned by an institution's borrowers may result in a drastic reduction in the value of the collateral securing the institution's loans to such borrowers, and liability to the institution for clean-up costs if it forecloses on the contaminated property. To minimize the risk, the Company may require an environmental examination of and report with respect to the property of any borrower or prospective borrower if circumstances affecting the property indicate a potential for contamination, taking into consideration a potential loss to the institution in relation to the borrower. The Company is not aware of any borrower who is currently subject to any environmental investigation or clean-up proceeding that is likely to have a materially adverse effect on the financial condition or results of operations of the Company.
There are several federal and state statutes that regulate obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, the Company may be held liable under certain circumstances for the actions of its borrowers, or third parties,
when such actions result in environmental problems on properties that collateralize loans held by the Company. Further, the liability has the potential to far exceed the original amount of the loan issued by the Company.
The Company Operates in a Highly Competitive Market - ---------------------------------------------------
The financial services industry is extremely competitive and could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. The Company faces substantial competition within its service area where such competitors not only include larger banks and bank holding companies, but also savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, leasing companies, insurance companies, finance companies and other financial service companies. Such competitors offer products and services similar to those offered by the Company, on competitive terms. Many competitors have substantially greater resources than the Company, or they operate under less stringent regulatory environments. The differences in resources and regulations may make it harder for the Company to compete profitably. In addition there is always a risk that aggressive competition could result in the Company controlling a smaller share of the market. A decline in market share could lead to a decline in net income which could potentially have a negative impact on stockholder value.
The Company's Ability to Pay Dividends Depends Primarily on Dividends from it - ----------------------------------------------------------------------------- Banking Subsidiary - ------------------
The Company is a bank holding company and its operations are conducted by its subsidiary. Its ability to pay dividends depends on its receipt of dividends from its subsidiary. Dividend payments from its 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 its subsidiary to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. There is no assurance that its subsidiary will be able to pay dividends in the future or that the Company will generate adequate cash flow to pay dividends in the future. The Company's failure to pay dividends on its common stock could have a materially adverse effect on the market price of its common stock.
The Company's Stock Price and Trading Volume Can Be Volatile - ------------------------------------------------------------
The trading volume of the Company's common stock, which is listed on the Nasdaq Capital Market, is less than that of other larger and older financial service companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Company's common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the lower trading volume of the Company's common stock, significant sales of the Company's common stock, or the expectation of these sales, could cause the Company's stock price to fall. General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause a change in the Company's stock price, regardless of its operating results.
Extensive Regulation and Supervision - ------------------------------------
The Company is subject to extensive federal and state regulation and supervision. These regulations affect almost every aspect of the Company's existence. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products its may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a materially adverse effect on the Company's business, financial condition and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS - -------- -------------------------
None.
ITEM 2.
ITEM 2. PROPERTIES - ------- ----------
The Company's headquarters and principal place of business is located at 731 Chestnut Street, P.O. Box 869, Emmaus, and Lehigh County, Pennsylvania, 18049. The Company does not directly own or lease any properties in its own name, but rather, in the name of the Bank. The Bank owns the main office building clear of any lien. The main office, which is in good condition, was constructed in 1993, and is a brick construction consisting of approximately 9,100 square feet of retail operation and executive office space.
In addition to the main office, the Bank owns or leases eight branch locations, two administrative office structures, a building to house the retention of records and four parking lots as follows:
Management believes that these buildings and properties are in good condition and are adequate for the Company's current purposes.
The Bank has signed an agreement to purchase property located at 2985 MacArthur Road, Whitehall, Pennsylvania to build a branch office. The total cost of this purchase will be $950,000. The property development and the construction of the branch facility are not expected to be completed until 2007.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS - ------- -----------------
The nature of the Company's business generates some litigation involving matters arising in the ordinary course of business. Management is not aware of any litigation that would have a materially adverse effect on the consolidated financial position of the Company. There are no proceedings pending other than ordinary routine litigation incidental to the business of the Company. In addition, no material proceedings against the Company are known to be contemplated by governmental authorities.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- ---------------------------------------------------
No matter was submitted to a vote of shareholders during the fourth quarter of the fiscal year covered by this Report.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND - ------- ---------------------------------------------------------------------- ISSUER PURCHASES OF EQUITY SECURITIES -------------------------------------
The Company's common stock trades on the NASDAQ Capital Market under the symbol "EPEN".
The information provided below reflects the actual high, low and closing prices and the status of dividends declared for each share of the Company's common stock for each quarter of 2005 and 2004. The prices do not include retail mark-ups or markdowns or any commissions to broker-dealers.
Stock Price Range ---------------------- Closing High Low Price -------- -------- -------- - ---- First Quarter $ 9.11 $ 8.42 $ 8.87 Second Quarter 9.25 8.55 8.55 Third Quarter 9.10 8.50 8.84 Fourth Quarter 9.25 8.50 9.15
- ---- First Quarter $ 9.50 $ 8.00 $ 9.25 Second Quarter 10.35 8.30 8.97 Third Quarter 8.95 7.90 8.35 Fourth Quarter 9.13 8.17 8.75
During 2005, the Company declared a semi-annual cash dividend for the second consecutive year. The first of the two cash dividends was in the amount of $0.09 per share, payable February 28, 2005 to all shareholders of record as of February 4, 2005. The second cash dividend paid during 2005 was in the amount of $0.10 per share payable August 31, 2005 to all shareholders of record as of August 10, 2005. The aggregate dividends paid in 2005 were $1,198,000. The Company initiated the payment of a semi-annual cash dividend in 2004. The first of the two cash dividends was in the amount of $0.08 per share and was paid on February 28, 2004 to all shareholders of record as of January 31, 2004. The second cash dividend paid during 2004 was in the amount of $0.08 per share payable August 31, 2004 to all shareholders of record as of August 4, 2004. The aggregate dividends paid in 2004 were $1,008,000.
The future dividend policy of the Company is subject to the discretion of the Board of Directors, who will incorporate into their decision such factors as future earnings, financial conditions, cash needs, capital requirements and general business conditions. Holders of common stock will be entitled to receive dividends as and when declared by the Company's Board of Directors out of funds legally available for that purpose. The Company is dependent on dividends from the Bank in order to declare its own dividends. Such payment from the Bank, however, will be subject to the regulatory restrictions set forth in the Pennsylvania Banking Code of 1965, the Federal Reserve Act and the FDIA.
The Pennsylvania Banking Code provides that cash dividends may be declared and paid only out of accumulated net earnings, which were $11,085,000 at December 31, 2005. Cash dividends must be approved by the FRB if the total of all cash dividends declared by the Company in any calendar year, including the proposed cash dividend, exceeds the total of the Company's net profits for that year plus its retained net profits from the preceding two years less any required transfers to surplus or to a fund for the retirement of preferred stock, if any. The FDIA generally prohibits all payment of dividends by any bank, which is in default of any assessment of the FDIC. As of December 31, 2005, the Company was not in default of any FDIC assessments.
As of December 31, 2005, there were approximately 2,750 shareholders of record of the Company's common stock.
Securities Authorized for Issuance Under Equity Compensation Plans - ------------------------------------------------------------------
The information required to be set forth hereunder is incorporated by reference to page 9 of East Penn Financial Corporation's Proxy Statement.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA - ------- -----------------------
The following selected financial data should be read in conjunction with the Company's audited consolidated financial statements and the accompanying notes presented elsewhere herein.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS - ------- ----------------------------------------------------------------------- OF OPERATIONS OF EAST PENN FINANCIAL CORPORATION FOR THE YEARS ENDED -------------------------------------------------------------------- DECEMBER 31, 2005, 2004 AND 2003 --------------------------------
Information required under this Item 7 is incorporated by reference to the Registrant's 2005 Annual Report to Shareholders under the heading, "Management's Discussion and Analysis of Financial Condition and Results of Operations of East Penn Financial Corporation".
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------- ----------------------------------------------------------
Information required under this Item 7A is incorporated by reference to the Registrant's 2005 Annual Report to Shareholders under the heading, "Quantitative and Qualitative Disclosures About Market Risk".
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- -------------------------------------------
Information required under this Item 8 is incorporated by reference to the Registrant's 2005 Annual Report to Shareholders under the heading, "Financial Statements".
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------- --------------------------------------------------------------- FINANCIAL DISCLOSURE --------------------
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES - -------- -----------------------
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of December 31, 2005. Based on that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of December 31, 2005. There have been no material changes in the Company's internal control over financial reporting during the fourth quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION - -------- -----------------
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- --------------------------------------------------
The information required by this Item is incorporated by reference herein to the Registrant's Proxy Statement, under the heading, "Election of Directors", and "Section 16(a) Beneficial Ownership Reporting Compliance" for its 2006 Annual Meeting of Shareholders to be held May 11, 2006.
The Registrant has adopted a Code of Ethics, which is incorporated by reference as Exhibit 14 to the Company's Annual Report on Form 10-K for the year ended December 31, 2003.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION - -------- ----------------------
The information required by this Item is incorporated by reference herein, to the Registrant's Proxy Statement, under the heading, "Compensation and Plan Information", "Shareholder Return Performance Graph" and "Board Compensation Committee Report on Executive Compensation", for its 2006 Annual Meeting of Shareholders to be held May 11, 2006.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND - -------- ------------------------------------------------------------------ RELATED STOCKHOLDER MATTERS ---------------------------
The information required by this Item is incorporated by reference herein, to the Registrant's Proxy Statement, under the heading, "Share Ownership", for its 2006 Annual Meeting of Shareholders to be held May 11, 2006.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ----------------------------------------------
The information required by this Item is incorporated by reference herein, to the Registrant's Proxy Statement, under the heading, "Election of Directors", "Compensation and Plan Information" and "Transactions with Directors and Executive Officers", for its 2006 Annual Meeting of Shareholders to be held May 11, 2006.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES - -------- --------------------------------------
The information required by this item is incorporated by reference to the Registrant's Proxy Statement under the heading, "Report of the Audit Committee", for its 2006 Annual Meeting of Shareholders to be held May 11, 2006.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES - -------- ------------------------------------------
(a) 1. Financial statements are incorporated by reference in Part II, Item 8 hereof. Independent Auditor's Report Consolidated Balance Sheets Consolidated Statements of Income
Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Consolidated Financial Statements
2. The financial statement schedules, required by Regulation S-X, are omitted because the information is either not applicable or is included elsewhere in the consolidated financial statements.
3. The following Exhibits are filed as part of this filing on Form 10-K, or incorporated by reference hereto:
3(i) Registrant's Articles of Incorporation, as amended, are incorporated herein by reference to Annex B to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
3(ii)Registrant's By-Laws are incorporated by reference to Annex C to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.1 East Penn Financial Corporation's 1999 Stock Incentive Plan for the benefit of officers and key employees is incorporated by reference to Exhibit 10.2 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.2 East Penn Financial Corporation's 1999 Independent Directors Stock Option Plan for the benefit of non-employee directors is incorporated by reference to Exhibit 10.1 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.3 Executive Employment Agreement between East Penn Bank and Brent L. Peters, dated April 12, 2001, is incorporated by reference to Exhibit 10.3 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.4 The Supplemental Executive Retirement Agreement ("SERP") between East Penn Bank and Brent L. Peters, dated May 31, 2001, is incorporated herein by reference to Exhibit 10.4 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.5 East Penn Financial Corporation's Dividend Reinvestment and Stock Purchase Plan is incorporated by reference to the Registrant's Registration Statement on Form S-3 (Registration No. 333-116754) as filed with the Securities and Exchange Commission on June 23, 2004.
10.6 Agreement of sale between East Penn Bank and WAWA, Inc. dated November 10, 2005.
11 Statement re: Computation of per share earnings is incorporated by reference herein from Note 1 of the Consolidated Financial Statements contained in the Company's 2005 Annual Report.
13 2005 Annual Report.
14 East Penn Financial Corporation's Board of Directors and Senior Management Code of Ethics is incorporated by reference to Exhibit 14 to the Registrant's
Annual Report on Form 10-K for the year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 29, 2004.
21 Subsidiaries.
23.1 Consent of Independent Registered Public Accounting Firm.
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-15(e)/15d-15(e).
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-15(e)/15d-15(e).
32.1 Certification of Chief Executive Officer pursuant to Section 1350 of the Sarbanes Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to Section 1350 of the Sarbanes Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of Section 12 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.
East Penn Financial Corporation (Registrant)
By: /s/ Brent L. Peters ------------------------------------- Brent L. Peters President and Chief Executive Officer (Principal Executive Officer)
Date: March 16, 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.
DATE
By: /s/ Brent L. Peters March 16, 2006 -------------------------------------------- ------------------- Brent L. Peters President, Chief Executive Officer and Director (Principal executive officer)
By: /s/ Theresa M. Wasko March 16, 2006 -------------------------------------------- ------------------- Theresa M. Wasko Treasurer and Chief Financial Officer (Principal financial and principal accounting officer)
By: /s/ Dale A. Dries March 16, 2006 -------------------------------------------- ------------------- Dale A. Dries Director
By: /s/ Thomas R. Gulla March 16, 2006 -------------------------------------------- ------------------- Thomas R. Gulla Director
By: /s/ Allen E. Kiefer March 16, 2006 -------------------------------------------- ------------------- Allen E. Kiefer Director
By: /s/ Forrest A. Rohrbach March 16, 2006 -------------------------------------------- ------------------- Forrest A. Rohrbach Chairman of the Board and Director
By: /s/ Gordon K. Schantz March 16, 2006 -------------------------------------------- ------------------- Gordon K. Schantz Director
By: /s/ Linn H. Schantz March 16, 2006 -------------------------------------------- ------------------- Linn H. Schantz Director
By: /s/ Donald R. Schneck March 16, 2006 -------------------------------------------- ------------------- Donald R. Schneck Director
By: /s/ Peter L. Shaffer March 16, 2006 -------------------------------------------- ------------------- Peter L. Shaffer Director
By: /s/ Konstantinos A. Tantaros March 16, 2006 -------------------------------------------- ------------------- Konstantinos A. Tantaros Director
By: /s/ F. Geoffrey Toonder March 16, 2006 -------------------------------------------- ------------------- F. Geoffrey Toonder Director
By: /s/ Donald S. Young March 16, 2006 -------------------------------------------- ------------------- Donald S. Young Director
Exhibit Index
3(i) Registrant's Articles of Incorporation, as amended, are incorporated herein by reference to Annex B to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
3(ii) Registrant's By-Laws are incorporated by reference to Annex C to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.1 East Penn Financial Corporation's 1999 Stock Incentive Plan for the benefit of officers and key employees is incorporated by reference to Exhibit 10.2 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.2 East Penn Financial Corporation's 1999 Independent Directors Stock Option Plan for the benefit of non-employee directors is incorporated by reference to Exhibit 10.1 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.3 Executive Employment Agreement between East Penn Bank and Brent L. Peters, dated April 12, 2001, is incorporated by reference to Exhibit 10.3 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.4 The Supplemental Executive Retirement Agreement ("SERP") between East Penn Bank and Brent L. Peters, dated May 31, 2001, is incorporated herein by reference to Exhibit 10.4 to the Registrant's Registration Statement on Form S-4 (Registration No. 333-103673) as filed with the Securities and Exchange Commission on March 7, 2003.
10.5 East Penn Financial Corporation's Dividend Reinvestment and Stock Purchase Plan is incorporated by reference to the Registrant's Registration Statement on Form S-3 (Registration No. 333-116754) as filed with the Securities and Exchange Commission on June 23, 2004.
10.6 Agreement of sale between East Penn Bank and WAWA, Inc. dated November 10, 2005.
11 Statement re: Computation of per share earnings is incorporated by reference herein from Note 1 of the Consolidated Financial Statements contained in the Company's 2005 Annual Report.
13 2005 Annual Report.
14 East Penn Financial Corporation's Board of Directors and Senior Management Code of Ethics is incorporated by reference to Exhibit 14 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 29, 2004.
21 Subsidiaries.
23.1 Consent of Independent Registered Public Accounting Firm.
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-15(e)/15d-15(e).
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-15(e)/15d-15(e).
32.1 Certification of Chief Executive Officer pursuant to Section 1350 of the Sarbanes Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to Section 1350 of the Sarbanes Oxley Act of 2002.