Item 1 - Business.
Four Oaks Bank & Trust Company (referred to herein as the “bank”) was incorporated under the laws of the State of North Carolina in 1912. On February 5, 1997, the bank formed Four Oaks Fincorp, Inc. (referred to herein as the “Company”; references herein to “we,” “us” and “our” refer to the Company and its consolidated subsidiaries, unless the context otherwise requires) for the purpose of serving as a holding company for the bank. Our corporate offices and banking offices are located in eastern and central North Carolina. We have no significant assets other than cash, the capital stock of the bank and its membership interest in Four Oaks Mortgage Services, L.L.C., as well as $1,942,000 in securities available for sale.
In addition, we have an interest in Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the “Trust”), for the sole purpose of issuing trust preferred securities. The Trust is not included in the consolidated financial statements of the Company. We formed the Trust for the sole purpose of issuing $12.0 million of trust preferred securities (the “Trust Preferred Securities”). The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the “Debentures”) issued by us and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which are recorded as interest expense, are deductible for income tax purposes.
The bank continues to remain a community-focused bank engaging in general commercial banking business to the communities we serve. The bank provides a full range of banking services, including such services as:
·
checking accounts;
·
savings accounts;
·
individual retirement accounts;
·
NOW accounts;
·
money market accounts;
·
certificates of deposit;
·
a student checking and savings program;
·
e-statements;
·
loans for businesses, agriculture, real estate, personal uses, home improvement and automobiles;
·
mortgage loans;
·
equity lines of credit;
·
credit cards;
·
safe deposit boxes;
·
electronic funds transfer services, including wire transfers;
·
internet banking, bill pay services and mobile banking;
·
telephone banking;
·
gift cards;
·
cashier’s checks;
·
traveler’s check cards; and
·
free notary services to all bank customers.
The bank also provides its customers access to automated teller machines (“ATMs”) through its own ATMs throughout its communities served as well as access to worldwide ATMs for cash withdrawals through the services of the Star, Cirrus, or Visa networks by using ATM or Visa check cards. The Visa check cards may also be used at merchant locations worldwide through the Star, Cirrus, or Visa networks. Through an arrangement with Lincoln Financial Securities Corporation acting as a registered broker-dealer performing the brokerage services, the bank also makes available a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRA’s, discount brokerage services, employee benefit plans, 401(k)’s and simplified employee pension plans. The securities involved in these services are not deposits or other obligations of the bank, and are not insured by the Federal Deposit Insurance Corporation (the “FDIC”). At present, the bank does not provide the services of a trust department.
We maintain a website at www.fouroaksbank.com where our periodic reports on Form 10-Q and 10-K and our current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available under “Investor Relations.” We are registered as a bank holding company with the Federal Reserve System. We are a state-chartered member of the Federal Reserve System and the FDIC insures the bank’s deposits up to applicable limits. Our corporate offices are located at 6114 US 301 South, Four Oaks, North Carolina, 27524. Our common stock is traded on the OTC Bulletin Board under the symbol “FOFN”.
Our market area is concentrated in eastern and central North Carolina. From its headquarters located in Four Oaks and its eighteen locations in Four Oaks, Clayton, Smithfield, Garner, Benson, Fuquay-Varina, Wallace, Holly Springs, Harrells, Sanford, Zebulon, Dunn, Rockingham and Southern Pines, the bank serves a major portion of Johnston County, and parts of Wake, Harnett, Duplin, Sampson, Lee, Moore and Richmond counties. Johnston County is contiguous to Wake, Wayne, Wilson, Harnett, Sampson, and Nash counties. Wake County is contiguous to Johnston, Durham, Harnett, Nash, Franklin, Granville and Chatham counties. Sampson County is contiguous to Duplin, Pender, Bladen, Harnett, Cumberland, Johnston, and Wayne counties. Lee County is contiguous to Chatham, Moore and Harnett counties. Duplin County is contiguous to Pender, Sampson, Wayne, Lenoir, Jones and Onslow counties. Harnett County is contiguous to Cumberland, Moore, Lee, Chatham, Wake, Johnston and Sampson counties. Moore County is contiguous to Harnett, Lee, Chatham, Randolph, Montgomery, Richmond, Hoke, Cumberland and Scotland counties. Richmond County is contiguous to Anson, Stanley, Montgomery, Moore, Hoke and Scotland counties.
Johnston County has a diverse economy and is not dependent on any one particular industry. The leading industries in the area include retail trade, manufacturing, pharmaceuticals, government, services, construction, wholesale trade and agriculture. The population for Johnston County in 2009 was estimated in excess of 168,000. As of June 2009, the bank ranked first in deposit market share for Johnston County at 33.4%.
In Four Oaks, the main office is located at 6144 US 301 South and an additional branch is located at 111 North Main Street. The bank also operates a branch office in Clayton at 102 East Main Street, two in Smithfield at 128 North Second Street, and 403 South Brightleaf Boulevard, three in Garner at 200 Glen Road, 574 Village Court, and 1408 Garner Station Boulevard, one in Benson at 200 East Church Street, one in Fuquay-Varina at 325 North Judd Parkway Northeast, one in Wallace at 406 East Main Street, one in Holly Springs at 201 West Center Street, one in Harrells at 590 Tomahawk Highway, one in Sanford at 830 Spring Lane, one in Zebulon at 805 North Arendell Avenue, one in Dunn at 604-A Erwin Road, one in Rockingham at 1401 Fayetteville Road and one in Southern Pines at 105 Commerce Avenue.
The majority of the bank’s customers are individuals and small to medium-size businesses. The deposits and loans are well diversified with no material concentration in a single industry or group of related industries. There are no seasonal factors that would have any material adverse effect on the bank’s business, and the bank does not rely on foreign sources of funds or income.
On August 17, 2009, we entered into a joint venture with PrimeLending to provide mortgage lending services. Through this partnership, Four Oaks Mortgage Services, LLC, offers a competitive product line of secondary marketing-type mortgages.
Amounts spent on research activities relating to the development or improvement of services has been immaterial over the past two years. At December 31, 2009, the bank employed 206 full time equivalent employees. Our employees are extremely important to our continued success and the bank considers its relationship with its employees to be good. Management continually seeks ways to improve upon their benefits and well being.
The following table sets forth certain of our financial data and ratios for the years ended December 31, 2009 and 2008 derived from our audited financial statements and notes. This information should be read in conjunction with and is qualified in its entirety by reference to the more detailed audited financial statements and notes thereto included in this report:
Merger with Nuestro Banco
On December 31, 2009, the Company completed the merger with Nuestro Banco, headquartered in Garner, North Carolina. The Company acquired all outstanding shares of Nuestro’s capital stock in exchange for approximately 357,099 shares of the Company’s common stock. In connection with this merger, the Company acquired approximately $16.2 million in assets and assumed approximately $8.3 million in liabilities. The acquisition was accounted for under the acquisition method of accounting in accordance with FASB ASC 805, Business Combinations. The Company recorded a “bargain purchase” gain totaling $6.0 million resulting from the acquisition, which is a component of noninterest income on the statement of income. The amount of the gain is equal to the amount by which the estimated fair value of assets purchased exceeded the estimated fair value of liabilities assumed and consideration paid.
A summary of the total purchase price of the transaction is as follows:
A summary of the fair value of the assets acquired and liabilities assumed is as follows:
Total acquisition-related costs through December 31, 2009 were approximately $386,000, which is included in other non-interest expenses.
Merger with Longleaf Community Bank
On April 17, 2008, the Company completed the merger with LongLeaf Community Bank (“LongLeaf”), headquartered in Rockingham, North Carolina. Under the terms of the merger agreement, each share of LongLeaf common stock was converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of the Company’s common stock multiplied by an exchange ratio of 1.1542825 or (iii) 0.60 shares of the Company’s common stock multiplied by an exchange ratio of 1.1542825 plus an amount equal to $6.60 in cash. As a result of the acquisition, the Company paid $4.9 million in cash and issued 609,770 additional shares of common stock. The acquisition was accounted for using the purchase method of accounting, with the operating results of LongLeaf subsequent to April 17, 2008 included in the Company’s financial statements. Because the merger of LongLeaf Community Bank occurred early in 2008, the pro forma impacts on consolidated operating results of its results during the portion of the year prior to the merger are not significant.
A summary of the total purchase price of the transaction is as follows:
Competition
Commercial banking in North Carolina is extremely competitive due in large part to North Carolina’s early adoption of statewide branching. As a result, many commercial banks have branches located in several communities. The bank competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions. At June 2009, we operated branches in Johnston, Wake, Sampson, Duplin, Lee, Harnett, Moore and Richmond counties, North Carolina. At that time in Johnston County, North Carolina, the bank’s primary market, there were a total of approximately $1.5 billion in deposits and 43 branches represented by the top thirteen financial institutions in the county based on deposit share, all commercial banks. The bank operated seven of the 43 branches with deposits of $503.5 million, placing the bank first in the top thirteen based on deposit share. Many of the bank’s competitors have broader geographic markets and higher lending limits than those of the bank and are also able to provide more services and make greater use of media advertising. Therefore, in our market area, the bank has significant competition for deposits and loans from other depository institutions. Other financial institutions such as credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit with varying degrees of regulatory restrictions also compete in our market area. Additionally, credit unions have been permitted to expand their membership criteria and expand their loan services to include traditional bank services such as commercial lending creating a greater competitive disadvantage to tax-paying financial institutions.
The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the bank’s competitors. See “Holding Company Regulation” below for a description of this legislation. In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina.
Although the competition in its market areas is expected to continue to be significant, the bank believes that it has certain competitive advantages that distinguish it from its competition. The bank believes that its primary competitive advantages are its strong local identity, its affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The bank offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The bank offers many personalized services and attracts and retains customers by being responsive and sensitive to their individualized needs. The bank also relies on goodwill and referrals from our shareholders and the bank’s satisfied customers, as well as traditional media, to attract new customers. To enhance a positive image in the community, the bank supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations.
Governmental Regulation
Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules, and regulations affecting us and the bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and are not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company or bank. Supervision, regulation and examination of the company and the bank by bank regulatory agencies is intended primarily for the protection of the bank’s depositors rather than the Company’s shareholders.
Holding Company Regulation
General. Four Oaks Fincorp, Inc. is a holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (the “BHCA”). As such, we are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The bank is also subject to the BHCA. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company.
The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities.
Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including us, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company.
Effective December 2, 2009, we have elected to become a bank holding company, and therefore we are not subject to the regulatory framework under the GLBA. In addition to creating the more flexible financial holding company structure, the GLBA introduced several additional customer privacy protections that apply to us and the bank. The GLBA’s privacy provisions require financial institutions to, among other things: (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information.
Pursuant to the GLBA’s rulemaking provisions, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision adopted regulations, establishing standards for safeguarding customer information. Such regulations provide financial institutions guidance in establishing and implementing administrative, technical, and physical safeguards to protect the security, confidentiality, and integrity of customer information.
Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “IBBEA”) permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five (5) years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than ten percent (10%) of the total amount of deposits of insured depository institutions in the U.S. and no more than thirty percent (30%) of such deposits in any state (or such lesser or greater amount set by state law).
In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. In 1995, the state of North Carolina “opted in” to such legislation. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina having opted-in, unrestricted interstate de novo branching is permitted in North Carolina.
Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries.
The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements.
Under the provisions of the North Carolina law, we are registered with and subject to supervision by the North Carolina Commissioner of Banks.
Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent (8%). At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill items and certain other items (“Tier 1 capital”). The remainder (“Tier 2 capital”) may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves.
In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts (“Leverage Ratio”) equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent.
The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 Leverage Ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised us of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to us.
As of December 31, 2009, we had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 10.73%, 13.65% and 8.21%, respectively, all in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions.
Dividends. During 2009, we paid cash dividends of $.25 per share on our common stock, a 23.1% decrease over 2008. North Carolina banking law requires that dividends be paid out of retained earnings as determined pursuant to North Carolina General Statues Section 53-87. At present, the Company has sufficient cash from its operations to pay cash dividends on its common stock. In the past, we have received cash dividends from our bank and may continue to do so from time to time in the future as necessary for cash flow purposes. Also, applicable federal banking law contains additional limitations and restrictions on the payment of dividends by a bank holding company. Accordingly, shareholders receive dividends from us only to the extent that funds are available from our operations or the bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition.
USA Patriot Act of 2001. Title III of the USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”). The anti-money laundering provisions of IMLAFA impose affirmative obligations on a broad range of financial institutions, including banks, brokers, and dealers. Among other requirements, IMLAFA requires all financial institutions to establish anti-money laundering programs that include, at minimum, internal policies, procedures, and controls; specific designation of an anti-money laundering compliance officer; ongoing employee training programs; and an independent audit function to test the anti-money laundering program. IMLAFA requires financial institutions that establish, maintain, administer, or manage private banking accounts for non-United States persons or their representatives to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Additionally, IMLAFA provides for the Department of Treasury to issue minimum standards with respect to customer identification at the time new accounts are opened. As of the date of this filing, we believe that IMLAFA has not had a material impact on the bank’s operations. The bank has established policies and procedures to ensure compliance with the IMLAFA, which are overseen by an Anti-Money Laundering Officer who was appointed by our Board of Directors.
Bank Regulation
The bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the North Carolina Commissioner of Banks and the Federal Reserve. The Federal Reserve and the North Carolina Commissioner of Banks regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the North Carolina Commissioner of Banks regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the CRA, as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates.
The deposit accounts of the bank are insured by the Deposit Insurance Fund (the “DIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) up to a maximum of two hundred fifty thousand dollars ($250,000) per insured depositor, through December 31, 2013, with the exception of non-interest bearing accounts and NOW accounts paying .5% or less, which are 100% FDIC insured, through June 30, 2010. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose.
Under the North Carolina Business Corporation Act, we may not pay a dividend or distribution, if after giving it effect we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than our liabilities. All dividends paid by the bank are paid to us, the sole shareholder of the bank. In general, our ability to pay cash dividends is dependent in part upon the amount of dividends paid to us by the bank. The ability of the bank to pay dividends to us is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the bank's payment of dividends. The amount of future dividends paid to us by the bank will in general be a function of the profitability of the bank, which cannot be accurately estimated or assured. We expect the bank will continue to pay us dividends in the foreseeable future from time to time as needed to pay cash dividends to our shareholders.
Like us, the bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the bank are the same as those required of us. At December 31, 2009, the bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 10.21%, 13.14% and 7.88%, respectively, in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions.
The bank is subject to insurance assessments imposed by the FDIC, including a risk-based assessment schedule providing for annual assessment rates ranging from 5 to 43 cents per $100 in assessable deposits, applicable to institutions insured by the DIF. The FDIC may change the assessment schedule quarterly. The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered “well capitalized,” “adequately capitalized” or “under capitalized,” as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the DIF (Subgroup B) or whether such weaknesses pose a substantial probability of loss to the DIF unless effective corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments as set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987.
The FDIC has designated the DIF long-term target reserve ratio at 1.25% of insured deposits. Due to recent bank failures, the FDIC insurance fund reserve ratio has fallen below 1.15%, the statutory minimum. Effective January 1, 2009, the FDIC adopted a restoration plan that uniformly increased insurance assessments. The FDIC adopted changes to the deposit insurance assessment system beginning with the second quarter of 2009 to make the increase in assessments fairer by requiring riskier institutions to pay a larger share. Given the current deficient funded condition of the DIF and expected continued bank failures, the Bank expects premiums for deposit insurance to remain elevated. In addition, in May 2009, the FDIC imposed a special assessment of 5 basis points (“bp”) of each institution’s assets minus Tier 1 capital as of June 30, 2009, not to exceed 10 bp times its assessment base for the quarter. In November 2009, the FDIC adopted a rule requiring prepayment of assessments for 2010, 2011, and 2012.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a “prompt corrective action” system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums.
A central feature of FDICIA is the requirement that the federal banking agencies take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: “well capitalized,” “adequately capitalized,” “under capitalized,” “significantly undercapitalized,” or “critically undercapitalized.” An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution.
Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application.
In addition, the GLBA’s “CRA Sunshine Requirements” call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000.
Monetary Policy and Economic Controls
Both the Company and the bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks’ lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits.
Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks’ cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, or loan demand on our business and earnings or those of the bank. As a result, banks, including the bank, face a significant challenge to maintain acceptable net interest margins.
Executive Officers of the Registrant
The following table sets forth certain information with respect to our executive officers:
Item 1A.
Item 1A. Risk Factors
Our Results Are Impacted by the Economic Conditions of Our Principal Operating Regions
The majority of our customers are individuals and small to medium-size businesses located in North Carolina’s Johnston, Wake, Duplin, Sampson, Harnett, Lee, Moore and Richmond counties and surrounding areas. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Declines in these markets’ economic conditions may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations.
We Are Exposed to Risks in Connection with the Loans We Make
A significant source of risk for us arises from the possibility that loan losses will be sustained because borrowers, guarantors, and related parties fail to perform in accordance with the terms of their loans. Our policy dictates that we maintain an allowance for loan losses. The amount of the allowance is based on management’s evaluation of our loan portfolio, the financial condition of the borrowers, current economic conditions, past and expected loan loss experience, and other factors management deems appropriate. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations.
If the value of real estate in our core market areas were to decline materially, a significant portion of our loan portfolio could become undercollateralized, which could have a material adverse effect on us. With most of our loans concentrated in the Coastal Plain region of North Carolina, a decline in local economic conditions could adversely affect the values of our real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures loans with real estate collateral. At December 31, 2009, approximately 88% of the Bank's loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.
We Compete with Larger Companies for Business
Commercial banking in North Carolina is extremely competitive due in large part to North Carolina’s early adoption of statewide branching. The bank competes in the North Carolina market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of these competitors have broader geographic markets, higher lending limits, more services, and more media advertising. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition.
We Are Exposed to Certain Market Risks
Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market prices and interest rates. Our market risk stems primarily from interest rate risk inherent in our lending and deposit-taking activities. Our policy allows that we may maintain derivative financial instruments, such as interest rate swap agreements, to manage such risk.
U.S. and International Credit Markets and Economic Conditions Could Affect the Company’s Liquidity and Financial Condition
As described in Part I, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Impact of Recent Developments on the Banking Industry,” global market and economic conditions continue to be disruptive and volatile and the disruption has particularly had a negative impact on the financial sector. The possible duration and severity of this adverse economic cycle is unknown. Although the Company remains well-capitalized and has not suffered any liquidity issues as a result of these recent events, the cost and availability of funds may be adversely affected by illiquid credit markets. For example, the Company lost access to several Federal Funds lines during the year due to deteriorating conditions at correspondent banks and our bank. Continued turbulence in U.S. and international markets and economies may adversely affect the Company’s liquidity, financial condition, and profitability.
In addition, federal and state governments could pass additional legislation responsive to current credit conditions. The Company could experience higher credit losses because of legislation or regulatory action that reduces the amounts borrowers are contractually required to pay under existing loan contracts or that limits its ability to foreclose on property or other collateral or makes foreclosure less economically feasible.
Technological Advances
The banking industry undergoes frequent technological changes with introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors, however, have substantially greater resources to invest in technological improvements.
Compliance with Changing Laws, Regulations and Standards May Result in Additional Risks and Expenses
We are subject to changing laws, regulations and standards, including the BHCA, the GLBA, the IBBEA, the USA Patriot Act of 2001, the FDIC, the CRA, the North Carolina Business Corporation Act, the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), and new SEC regulations to name a few.
Sarbanes-Oxley and new SEC regulations, in particular, are creating uncertainty for companies such as ours because they are subject to varying interpretations in many cases. As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations, and standards have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention. We expect these efforts to require the continued commitment of significant resources. Further, the members of our board of directors, members of the audit or compensation committees, our chief executive officer, our chief financial officer, and certain other of our executive officers could face an increased risk of personal liability in connection with the performance of their duties. In addition, it may become more difficult and more expensive to obtain director and officer liability insurance. As a result, our ability to attract and retain executive officers and qualified board and committee members could be more difficult.
Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways
Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and a periodic examination by the Federal Reserve Bank and the North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as:
·
payment of dividends to our shareholders;
·
possible mergers with or acquisitions of or by other institutions;
·
our desired investments;
·
loans and interest rates on loans;
·
payment of interest, interest rates on deposits;
·
the possible expansion of branch offices; and/or
·
our ability to make other financial services available.
We also are subject to capitalization guidelines set forth in federal regulations, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably.
We Depend Heavily on our Key Management Personnel
Our success depends in part on our ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. We expect to compete effectively in this area by offering competitive financial packages that include incentive-based compensation.
Our Allowance for Probable Loan Losses May Be Insufficient
We maintain an allowance for probable loan losses, which is a reserve established through a provision for probable loan losses charged to expense. This allowance represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan 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 inherent in the current loan portfolio. The determination of the appropriate level of the allowance for probable loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates and assumptions regarding current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside our control, may require an increase in the allowance for probable loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for probable loan losses; we will need additional provisions to increase the allowance for probable loan losses. Any increases in the allowance for probable loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to our process for determining the appropriate level of the allowance for probable loan losses.
We Are Subject To Environmental Liability Risk Associated With Lending Activities
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
Our Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
The Holders of Our Subordinated Debentures Have Rights That Are Senior to Those of Our Shareholders
As described below, we have issued $12.0 million of subordinated debentures in connection with a trust preferred securities issuance by our subsidiary, the Trust. We unconditionally guarantee payments of the principal and interest on the trust preferred securities. Our subordinated debentures are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock.
The Company sold $12.0 million aggregate principal amount of subordinated promissory notes to certain accredited investors between May and August 2009. These notes are due ten years after the date of issuance, beginning May 15, 2019, and the Company is obligated to pay interest at an annualized rate of 8.5% payable in quarterly installments beginning on the third month anniversary of the date of issuance. The Company may prepay the notes at any time after the fifth anniversary of the date of issuance, subject to compliance with applicable law.
Our Information Systems May Experience an Interruption or Breach in Security
We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
An Investment in Our Common Stock Is Not an Insured Deposit
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.
Consumers May Decide Not To Use Banks to Complete Their Financial Transactions
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that historically would have been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Item 1B
Item 1B - Unresolved Staff Comments.
Not applicable.
Item 2
Item 2 - Properties.
The bank owns its main office, which is located at 6144 US 301 South, Four Oaks, North Carolina. The main office, which was constructed by the bank in 1985, is a 12,000 square foot facility on 1.64 acres of land. The bank leases a limited-service facility in downtown Four Oaks located at 111 North Main Street from M.S. Canaday, who is a former director of the company as well as a former director of the bank. Under the terms of the lease, which the bank believes to be arms-length, the bank paid $1,037 per month in rent in 2009. The lease is month-to-month and we review its terms on an annual basis. The bank also leases a branch office located at 201 West Center Street, Holly Springs, North Carolina. Under the terms of the lease, the bank will pay $2,652 per month for a period of five years ending April 1, 2013, with a 3% increase per year for the next five years until March 31, 2013. The bank’s Harrells office located at 590 Tomahawk Highway, Harrells, North Carolina is under a lease with terms specifying the bank will pay $600 each month for periods of one year duration until the lease is terminated by one of the parties. In addition, the bank has entered into a ten year lease on its Sanford office located at 830 Spring Lane, Sanford, North Carolina. Under the terms of the lease, the bank will pay $7,600 each month with an annual rate increase not to exceed 2.5% over a 10 year period. On September 17, 2009, the bank entered into a two year lease on its Dunn office located at 604-A Erwin Road, Dunn, North Carolina. Under the terms of the lease, the bank will pay $1,500 each month for the period beginning September 17, 2009 and ending August 31, 2011. In addition, the bank has leased additional space for its Dunn location for a one year term beginning September 8, 2009 at $400 per month. On February 25, 2008, the bank entered into a five year lease on its Garner Village office, located at 574 Village Court, Garner, North Carolina. Under the terms of the lease, the bank will pay $3,000 each month with an annual rate increase not to exceed 3% over a five year period. In the merger with Nuestro Banco, the bank assumed the remaining twelve years on the fifteen year lease on the building at 1408 Garner Station Boulevard, which expires on June 30, 2022. The bank will pay $11,733 each month until September 2010, with a 3% increase each consecutive year thereafter.
The bank owns a 5,000 square foot facility renovated in 1992 on 1.15 acres of land located at 5987 US 301 South, Four Oaks, North Carolina, which houses its training center. The bank also owns a 15,000 square foot facility built in 2000 located at 6114 US 301 South, Four Oaks, North Carolina, which houses its administrative offices, data operations, loan operations, and wide area network central link. In addition, the bank owns the following:
On September 1, 2008, the bank leased three offices of its Fuquay-Varina branch office to PrimeLending. Under the terms of the agreement, the bank receives $1,000 per month in rent from PrimeLending, renewable each month.
Management believes each of the properties referenced above is adequately covered by insurance. In addition to the above locations, we have one ATM located inside Blackmon’s Country store in Four Oaks and 15 ATMs in Food Lion grocery stores in the cities and towns of Clayton, Benson, Sanford, Wallace, Fuquay-Varina, Holly Springs, Garner, Zebulon, and Wendell, North Carolina. The net book value for our properties, including land, buildings, and furniture and equipment was $17.6 million at December 31, 2009. Additional information is disclosed in Note D “Bank Premises and Equipment” to our consolidated financial statements presented under Item 8 of Part II of this Form 10-K.
Item 3
Item 3 - Legal Proceedings.
We are not involved in any material legal proceedings at the present time.
Item 4
Item 4 - (Reserved)
PART II
Item 5
Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock trades on the OTC Bulletin Board under the symbol “FOFN.” The range of high and low bid prices of our common stock for each quarter during the two most recent fiscal years, as published by the OTC Bulletin Board, adjusted for stock splits, is as follows (prices reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions):
As of March 5, 2010, the approximate number of holders of record of our common stock was 2,300. We have no other issued class of equity securities. The bank’s ability to declare a dividend to us and the company’s ability to pay dividends are subject to the restrictions of the North Carolina Business Corporation Act. There also are state banking laws that require a surplus of at least 50% of paid-in capital stock be maintained in order for the bank to declare a dividend to the company. Subject to the legal availability of funds to pay dividends, cash dividends paid by us in 2009 and 2008 were $.25 and $0.325 per share, respectively.
We did not sell any securities in 2009 that were not registered under the Securities Act of 1933 as amended. During 2009, we repurchased no shares of our equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended. We made no purchases on behalf of the Company or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Exchange Act) of the Company's common stock during the three months ended December 31, 2009.
Item 6
Item 6 - Selected Financial Data
Not applicable.
Item 7
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion and analysis provides information about the major components of our results of operations and financial condition, liquidity and capital resources and should be read in conjunction with our audited consolidated financial statements and notes thereto which are contained in this report. Additional discussion and analysis related to fiscal year 2009 is contained in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2009, June 30, 2009 and September 30, 2009, respectively.
Impact of Recent Developments on the Banking Industry
The banking industry, including the Company, is operating in a challenging and volatile economic environment. The effects of the downturn in the housing market have adversely impacted credit markets, consumer confidence, and the broader economy. Along with other financial institutions, the Company’s stock price has suffered as a result. Management cannot predict when these market difficulties will subside. While the current economic downturn and the difficulties it presents for the Company and others in the banking industry are unprecedented, management believes that the business is cyclical and must be viewed and measured over time. The Company’s primary focus at this time is to manage the business safely during the economic downturn and be poised to take advantage of any market opportunities that may arise.
The Federal Deposit Insurance Corporation (“FDIC”), which imposes insurance assessments on the Company’s wholly-owned subsidiary, Four Oaks Bank & Trust Company (the “Bank”), recently voted to amend the restoration of the Deposit Insurance Fund. The FDIC’s Board of Governors imposed a special assessment on insured institutions of 5 basis points; implemented changes to the risk-based assessment system, and increased regular premium rates for 2009, which banks must pay on top of the special assessment. The 5 basis point special assessment on the industry was assessed on the Bank’s assets less Tier 1 capital as of June 30, 2009 which was payable September 30, 2009. As a result of the special assessment and increased regular assessments the Company experienced an increase in FDIC assessment by approximately $1.5 million from 2008 to 2009. The 5 basis point special assessment represents $445,000 of this increase. In November 2009, the FDIC adopted a rule requiring prepayment of assessments of $4.4 million for a period of three years.
Overview
As a community-focused commercial bank, our primary business consists of providing a full range of banking services to our customers with an emphasis on quality personal service. Our core products consist of loans secured by real estate and commercial and consumer loans as well as various deposit products to meet our customers’ needs. Our primary source of income is generated from net interest income, the difference between interest income received on our loans and securities and interest expense paid on deposits and borrowings. Our income is also affected by our ability to price our products competitively and maximize the interest rate spread between the interest yield on loans and securities and the interest rate paid on deposits and borrowings. Our products also generate other income through product related fees and commissions. We incur operating expenses consisting primarily of salaries and benefits, occupancy and equipment and other professional and miscellaneous expenses.
Our assets have increased from $924.8 million at December 31, 2008 to $976.8 million at December 31, 2009, primarily due to increased loan demand, while our total deposits have increased from $722.7 million to $766.0 million over that same period. In addition, for 73 consecutive years, we have paid dividends (prior to 1997 when we reorganized into a holding company, it was our wholly owned subsidiary, Four Oaks Bank & Trust Company, which paid dividends). For the past five years, dividends have averaged 40.7% of our average net income. Return on average equity and return on average assets for 2009 were (3.07%)% and (.22)%, respectively, decreasing from returns of 6.40% and .51%, respectively, for 2008.
We set interest rates on deposits and loans at competitive rates. We have maintained spreads of 2.96% and 2.85% in 2009 and 2008, respectively, between interest earned on average loans and investments and interest paid on average interest-bearing deposits and borrowings. Our gross loans have increased from $681.5 million at December 31, 2008 to $715.1 million at December 31, 2009; while our average net annual charge-offs over the same period were approximately $5.6 million. The sustained growth provided by operations resulted in increases in total assets of 5.6%, and 30.6%, for 2009, and 2008, respectively.
Our gross loans grew 4.9% and 25.0% in 2009 and 2008, respectively. Our total investments (including interest-earning deposits and FHLB stock) increased 4.5% in 2009 over 2008, due to the acquisition of Nuestro Banco, cash, assets, and higher interest-earning cash balances at the Federal Reserve Bank. We closely monitor changes in the financial markets in order to maximize the yield on our assets. The growth in loans for 2009 and 2008 was funded by deposit growth of 6.0% and 34.4%, respectively. Earnings decreased in 2009, ending the year with net loss of $2.1 million, a decrease of 149.3% over 2008’s net income of $4.2 million, as a result of a challenging economic environment.
On April 17, 2008, the Company completed the merger with LongLeaf Community Bank (“LongLeaf”), headquartered in Rockingham, North Carolina. Under the terms of the merger agreement, each share of LongLeaf common stock was converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of the Company’s common stock multiplied by an exchange ratio of 1.1542825 or (iii) 0.60 shares of the Company’s common stock multiplied by an exchange ratio of 1.1542825 plus an amount equal to $6.60 in cash. As a result of the acquisition, the Company paid $4.9 million in cash and issued 609,770 additional shares of common stock. The acquisition was accounted for using the purchase method of accounting, with the operating results of LongLeaf subsequent to April 17, 2008 included in the Company’s financial statements.
On December 31, 2009, the Company completed the merger with Nuestro Banco, headquartered in Garner, North Carolina. The Company acquired all outstanding shares of Nuestro’s capital stock in exchange for approximately 356,425 shares of the Company’s common stock. In connection with this merger, the Company acquired approximately $16.2 million in assets and assumed approximately $8.3 million in liabilities. The acquisition was accounted for under the acquisition method of accounting in accordance with FASB ASC 805, Business Combinations. The Company recorded a “bargain purchase” gain totaling $6.0 million resulting from the acquisition, which is a component of noninterest income on the statement of income. The amount of the gain is equal to the amount by which the estimated fair value of assets purchased exceeded the estimated fair value of liabilities assumed. See Note V of the Notes to Consolidated Financial Statements for additional information regarding the acquisition.
Management historically has attempted to monitor and control increases in overhead expenses while being committed to developing the skills and enhancing the professionalism of our employees. Employee turnover has been minimal historically, while the number of our full-time equivalent employees has increased from 156 at December 31, 2006 to 206 at December 31, 2009.
Results of Operations
Comparison of Financial Condition at December 31, 2009 and 2008
During 2009, our total assets increased by $52.0 million, or 5.6%, from $924.8 million at December 31, 2008 to $ 976.8 million at December 31, 2009. This increase in our total assets resulted primarily from growth in our net loans, which increased from $672.0 million at December 31, 2008 to $699.5 million at December 31, 2009, an increase of $27.5 million, or 4.1%. The sustained growth in our loan portfolio continued to reflect a trend towards growth in 1-4 family real estate lending. Loans secured by real estate at December 31, 2009 grew $28.1 million over 2008 of which $71.8 million of the increase was related to increases in real estate loans, offset by a decrease of $43.6 million in construction and land development loans. Our securities portfolio decreased $46.2 million to $125.8 million at December 31, 2009 from $172.0 million at December 31, 2008. Our loan growth was primarily funded by deposit growth of $43.3 million, or 6.0%, during 2009 to $766.0 million at December 31, 2009 compared with $722.7 million at December 31, 2008. Our local market customers continue to be our primary source for deposit growth, funding deposit growth predominantly in time deposits. Deposits from our local market customers provided $34.1 million of the December 31, 2009 increase in deposits over December 31, 2008, and with the remaining $9.2 million increase coming from deposits outside our local customer base. We believe the growth in deposits was encouraged by targeted deposit campaigns and branch calling efforts within our competitive market, as prime remained unchanged at 3.25% as of December 31, 2009.
Shareholders’ equity decreased by $796,000 as of December 31, 2009 as compared to December 31, 2008. This decrease in shareholders’ equity resulted principally from a net operating loss of $2.1 million and the payment of dividends of $1.7 million. Offsetting the decrease was the issuance of shares of common stock and stock options valued at $1.9 million in connection with the merger with Nuestro Banco, issuance of common stock valued at $1.1 million through the dividend reinvestment plan and other comprehensive gain of $33,000 comprised of unrealized gains on securities available for sale.
Net Income
During 2009, the Company reported a net loss of $2.1 million, or $.30 basic net loss per share, which was a 149.3% decrease from 2008 net income of $4.2 million, or $.65 basic net income per share. The 2009 results included a $1.5 million increase in FDIC insurance assessments, a $6.1 million write off of goodwill, and a $12.1 million increase in the provision for loan losses, offset by a “bargain purchase” gain of $6.0 million resulting from the acquisition of Nuestro Banco.
Net Interest Income
Like most financial institutions, the primary component of earnings for the bank is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of non-interest-bearing liabilities and capital.
Net interest income increased by $3.4 million to $29.1 million in 2009, with a net yield of 3.25% compared to $25.7 million and a net yield of 3.28% in 2008. The yield for 2009 decreased an overall 3 basis points from 2008 due to the low rate environment. The increase in net interest income was generated by a 110 basis point decrease in rates on interest bearing deposits and borrowings. The national prime rate remained at 3.25% at December 31, 2009.
On average, our interest-earning assets grew $114.6 million during 2009 over 2008. A substantial portion of the increase in interest-earning assets was achieved through increased loan demand. Average loans increased by $82.4 million during 2009 over 2008 to $710.9 million, of the increase $6.9 million was attributable to the merger with Nuestro Banco. Although the volume of interest-bearing liabilities increased $103.2 million, of which $8.3 million was attributable to the merger with Nuestro Banco in 2009, a significant decrease in interest expense resulted from the repricing of interest bearing deposits.
Provision for Loan Losses and Asset Quality
Our provision for loan losses was $15.5 million during 2009 and $3.3 million during 2008. Net charge-offs in 2009 increased to $9.3 million compared to $1.8 million in 2008. As a percent of average loans, net charge-offs were 1.30%, the highest level in the past five years, an increase of 351.7% from 2008. The higher level of net charge-offs and nonperforming assets is attributable to the challenging economic environment especially in the real estate and commercial construction sectors caused by recessionary conditions such as increased unemployment and declines in asset values.
The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management’s consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination. See “Allowance for Loan Losses and Summary of Loan Loss Experience” below. We evaluate our loan portfolio in accordance with FASB ASC 310-10. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan’s observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change.
Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, increased to $32.0 million at December 31, 2009 from $23.0 million at December 31, 2008. This increase was primarily due to the contraction of the housing market and subsequent slowdown of real estate construction, resulting from the current economic environment. Our allowance for loan losses, expressed as a percentage of gross loans, was 2.19% and 1.40% at December 31, 2009 and 2008 respectively. At December 31, 2009, the allowance for loan losses amounted to $15.7 million, which management believes is adequate to absorb losses inherent in our loan portfolio.
Non-interest Income
Non-interest income before gains and losses on sales of securities, gain on merger acquisitions, and loans increased $853,000 or 17.7%, from $4.8 million during 2008 to $5.6 million in 2009. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, changes in the value of bank-owned life insurance and various other sources of miscellaneous operating income. Net gains of $1.8 million on sales of investment securities and the gain from the acquisition of Nuestro Banco of $6.0 million were recognized in 2009, which are the primary components of the increase in non-interest income.
Non-interest Expense
Our non-interest expense increased from $22.0 million in 2008 to $30.6 million in 2009, an increase of $8.6 million. Excluding the goodwill impairment loss related to the merger in 2008 with LongLeaf Community Bank, our non-interest expense as a percent of our average assets is down to 2.6% for 2009, our lowest level in the last five years. Of the $8.6 million increase in non-interest expense over 2008, $6.1 million was due to the aforementioned goodwill impairment loss, a $1.5 million increase in the FDIC premium, and a $700,000 increase in professional and consulting fees. There were no other significant increases in the remaining other non-interest expense categories.
Income Taxes
The Company’s provision for income taxes, as a percentage of income (loss) before income taxes, was 56.82% and 28.04% for 2009 and 2008, respectively. The increase resulted because non-taxable income from investment securities and life insurance caused the taxable loss to exceed the book loss before income taxes, resulting in a larger percentage tax benefit.
Liquidity and Capital Resources
As of the filing date of this report, we have withdrawn our application to participate in the Troubled Asset Relief Program’s Capital Purchase Program.
Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources. The term "liquidity" refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.
Sources of liquidity include cash and cash equivalents, (net of federal requirements to maintain reserves against deposit liabilities), investment securities eligible for pledging to secure borrowings, investments available for sale, loan repayments, loan sales, deposits and borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate sensitive deposits, the Company's primary demand for liquidity is anticipated funding under credit commitments to customers.
We have maintained a sufficient level of liquidity in the form of cash, federal funds sold, and investment securities. These aggregated $209.9 million at December 31, 2009, compared to $200.9 million at December 31, 2008. The increase resulted from an increase in interest-earning deposits, $5.0 million in federal funds sold as a result of the merger with Nuestro Banco, offset by a decline in the investment portfolio.
Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $17.0 million. As of December 31, 2009, the Bank has the credit capacity to borrow up to $195.3 million, from the Federal Home Loan Bank of Atlanta (“FHLB”), with $112.6 million outstanding as of that date. At December 31, 2008 we had FHLB borrowings outstanding of $114.3 million.
At December 31, 2009, our outstanding commitments to extend credit consisted of loan commitments of $53.5 million, undisbursed lines of credit of $17.1 million, financial stand-by letters of credit of $320,000 and performance stand-by letters of credit of $1.9 million. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.
In recent years, we have relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. In late 2008, we began to shift our focus from certificates of deposits to expanding our nonmaturity deposit base. Certificates of deposits represented 65.1% of our total deposits at December 31, 2009, an increase from 64.3% at December 31, 2008. Brokered and out-of-market certificates of deposit totaled $168.2 million at year-end 2009 and $144.3 million at year-end 2008, which comprised 22.0% and 20.0% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 39.9% of our total deposits at December 31, 2009 and 38.5% at December 31, 2008. Large certificates of deposits are generally considered rate sensitive. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.
The Company sold $12.0 million aggregate principal amount of subordinated promissory notes to certain accredited investors between May and August 2009. These notes are due ten years after the date of issuance, beginning May 15, 2019, and the Company is obligated to pay interest at an annualized rate of 8.5% payable in quarterly installments beginning on the third month anniversary of the date of issuance. The Company may prepay the notes at any time after the fifth anniversary of the date of issuance, subject to compliance with applicable law.
Off-Balance Sheet Arrangements
As part of its normal course of business to meet the financing needs of its customers, the bank is at times a party to financial instruments with off-balance sheet credit risk. Such instruments include commitments to extend credit and standby letters of credit. At December 31, 2009, the bank’s outstanding commitments to extend credit consisted of undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit of $72.9 million. Additional detail regarding the bank’s off-balance sheet risk exposure is presented in Notes K and L to the accompanying consolidated financial statements.
Inflation
The effect of inflation on financial institutions differs somewhat from the effect it has on other businesses. The performances of banks, with assets and liabilities that are primarily monetary in nature, are affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits. Also, general increases in the price of goods and services will generally result in increased operating expenses.
Distribution of Assets, Liabilities, and Shareholders’ Equity; Interest Rates and Interest Differential
The following schedule presents average balance sheet information for the years 2009,2008, and 2007, along with related interest earned and average yields for interest-earning assets and the interest paid and average rates for interest-bearing liabilities. Nonaccrual notes are included in loan amounts.
The following table shows changes in interest income and expense by category and rate/volume variances for the years ended December 31, 2009, 2008 and 2007. The changes due to rate and volume were allocated on their absolute values:
Investment Portfolio
The valuations of investment securities at December 31, 2009, 2008, and 2007 respectively, were as follows (in thousands):
The following table sets forth the carrying value of our available for sale investment portfolio at December 31, 2009 (in thousands):
The following table sets forth the weighted average yield by maturity of our available for sale investment portfolio at December 31, 2009 amortized cost:
Loan Portfolio
Loans consisted of the following, as extracted from the Call Reports of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Certain Loan Maturities
The maturities and carrying amounts of certain loans as of December 31, 2009 are summarized as follows (in thousands):
Nonperforming Assets
Past due and nonaccrual loans, as extracted from the Call Reports of December 31, 2009, 2008, 2007, 2006, and 2005 were as follows (in thousands):
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. The gross interest income that would have been recorded for loans accounted for on a nonaccrual basis at December 31, 2009 was approximately $1.7 million. This amount represents interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of the period. In addition, the Company has $52.7 million in loans in the coastal North Carolina region which are collateralized by properties that have seen significant declines in value. The Company has evaluated these loans in determining its allowance for loan losses as of December 31, 2009, and has determined that its exposure to loss on these loans is either mitigated by the values of the underlying collateral or reflected in our increased provision.
Foreclosed assets were $10.7 million, $1.2 million, $1.7 million, $327,000, and $247,000, at December 31, 2009, 2008, 2007, 2006, and 2005, respectively. The amount of interest recognized on impaired loans during the portion of 2009 was approximately $320,000.
Allowance for Loan Losses and Summary of Loan Loss Experience
As a matter of policy, the bank maintains an allowance for loan losses. The allowance for loan losses is created by direct charges to income and by recoveries of amounts previously charged off. The allowance is reduced as losses on loans are charged against the allowance when realized.
In evaluating our loan portfolio, we consider a loan to be impaired based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan’s observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change.
The loan portfolio and the adequacy of the allowance are evaluated by management at least quarterly. In addition, our Loan Committee reviews our loan portfolio and credit quality quarterly. The amount of the allowance is based on management’s evaluation of the loan portfolio including trends in composition, growth, and terms, historical and expected loan loss experience, economic conditions and conditions that may affect the borrowers’ ability to pay, and other factors management deems appropriate. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. The bank’s management believes its allowance for loan losses is adequate under existing economic conditions to absorb loan losses inherent in its loan portfolio. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio.
The allowance for loan loss is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers’ ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses it is possible that management’s assessment of the allowance may change.
The following table summarizes the bank’s loan loss experience for the years ending December 31, 2009, 2008, 2007, 2006, and 2005 (in thousands, except ratios):
The following table summarizes the bank’s allocation of allowance for loan losses at December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands, except ratios):
(1) Represents total of all outstanding loans in each category as a percentage of total loans outstanding.
Deposits
Time certificates in amounts of $100,000 or more outstanding at December 31, 2009, 2008 and 2007, by maturity were as follows (in thousands):
Borrowings
The bank borrows funds principally from the FHLB. Information regarding such borrowings at December 31, 2009, 2008 and 2007, are as follows (in thousands, except rates):
There were no short-term advances outstanding from the FHLB at December 31, 2009, 2008 and 2007. For 2009, there were no overnight borrowings. For 2008 and 2007, average outstanding short-term balances were $1,144,000 and $973,000, respectively.
In addition, the bank may purchase federal funds through unsecured federal funds lines of credit with various banks aggregating $17.0 million. These lines are intended for short-term borrowings and are payable on demand and bear interest based upon the daily federal funds rate. For 2009, 2008, and 2007, average federal funds purchased were $1.5 million, $6.9 million, and $3.6 million, respectively. At December 31, 2009 and December 31, 2008, the bank had no federal funds borrowings outstanding under these lines.
The Company completed a $12 million offering of Subordinated Promissory Notes on August 12, 2009.
Return on Equity and Assets
The following table indicates the ratios for return on average assets and average equity, dividend payout, and average equity to average assets for 2009, 2008, and 2007:
Critical Accounting Estimates and Policies
We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Critical accounting estimates and policies are those we believe are both most important to the portrayal of our financial condition and results, and require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We believe that the allowance for loan losses represents a particularly sensitive accounting estimate. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the maturity of the loan portfolio, credit concentration, trends in historical loss experience, specific impaired loans and general economic conditions. See Note A to the consolidated financial statements for a comprehensive discussion of our accounting policy for the allowance for loan losses.
Additionally, we believe that intangible assets represent a sensitive accounting estimate. Intangible assets include goodwill and other identifiable assets, such as core deposit premiums, resulting from acquisitions. Core deposit premiums are amortized primarily on a straight-line basis over a ten-year life based upon historical studies of core deposits. Goodwill is not amortized but is tested annually for impairment or at any time an event occurs or circumstances change that may trigger a decline in the value of the reporting unit. Examples of such events or circumstances include adverse changes in legal factors, business climate, unanticipated competition, change in regulatory environment, or loss of key personnel.
The Company tests for impairment on an annual basis. Potential impairment of goodwill exists when the carrying amount of a reporting unit exceeds its fair value. In testing for impairment, an estimate of the fair value of the reporting unit under a business combination is done using one of two approaches. The Market Approach is based on the actual market capitalization of the Company, adjusted for a control premium. The Discounted Cash Flow Approach is derived from the present value of future dividends over a five year time horizon and the projected terminal value at the end of the fifth year. The goodwill that would arise from this estimate is compared to the carrying value of the goodwill currently on the books to determine impairment.
To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired, and a second step of impairment test will be performed. In the second step, the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of reporting unit goodwill is lower than its carrying amount, goodwill is impaired and is written down to its implied fair value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair value will not result in the reversal of previously recognized losses.
The Company also reviews its investment portfolio for other than temporary impairments. On a quarterly basis, management reviews the investment portfolio for any investments that are in a loss position and have shown a loss greater than twelve months. In determining whether or not the investment is other than temporarily impaired, management reviews the current market for the investment and events that could have an impact on the investment’s performance in the future. If the impairment is considered other than temporary, the investment is written down to the current value.
Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense.
New Accounting Standards
In June 2009, the FASB issued FASB Statement No. 166, Accounting for Transfers of Financial Assets-an amendment of the provisions contained in FASB ASC 860, Transfer and Servicing and FASB Statement No. 167, Amendments to FASB ASC 810, Consolidation. ASC 860, Transfers and Servicing, has been amended to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. Specifically to address: (1) practices that have developed since initial issuance , that are not consistent with the original intent and key requirements of that Standard and (2) concerns of financial statement users that many of the financial assets (and related obligations) that have been derecognized should continue to be reported in the financial statements of transferors. This Standard must be applied to transfers occurring on or after the effective date. Additionally, on and after the effective date, the concept of a qualifying special-purpose entity is no longer relevant for accounting purposes.
ASC 810 Consolidation, has been amended to improve financial reporting by enterprises involved with variable interest entities. Specifically to address: (1) the effects on certain provisions as a result of the elimination of the qualifying special-purpose entity concept in ASC 860, Transfers and Servicing, and (2) constituent concerns about the application of certain key provisions of the Standard, including those in which the accounting and disclosures do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity.
The provisions of both Standards must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter with early application prohibited. Management does not expect the adoption of these Standards to have a material effect on the Company’s financial statement at the date of adoption, January 1, 2010.
Item 7A
Item 7A - Quantitative and Qualitative Disclosures About Market Risk.
This information is included under Item 7 of this report under the captions “Interest Rate Sensitivity Analysis,” “Market Risk,” and “Derivative Financial Instruments.”
Item 8
Item 8 - Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Four Oaks Fincorp, Inc.
Four Oaks, North Carolina
We have audited the accompanying consolidated balance sheets of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2009 and 2008 and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
We were not engaged to examine management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009, included in the accompanying Management’s Report on Internal Control over Financial Reporting and, accordingly, we do not express an opinion thereon.
As discussed in Note V to the financial statements, effective January 1, 2009 the Company changed its method of accounting and reporting for business combinations as a result of adopting new accounting guidance.
Raleigh, North Carolina
March 30, 2010
Four Oaks Fincorp, Inc.
Consolidated Statements of Operations
For the Years Ended December 31, 2009 and 2008
Four Oaks Fincorp, Inc.
Consolidated Statements of Operations
For the Years Ended December 31, 2009 and 2008
Four Oaks Fincorp, Inc.
Consolidated Statements of Comprehensive Income (Loss)
For the Years Ended December 31, 2009 and 2008
Four Oaks Fincorp, Inc.
Consolidated Statements of Shareholders’ Equity
For the Years Ended December 31, 2009 and 2008
Four Oaks Fincorp, Inc.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2009 and 2008
(Supplemental information Note T)
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc. (the “Company”), a bank holding company incorporated under the laws of the State of North Carolina, and its wholly owned subsidiaries, Four Oaks Bank & Trust Company, Inc. (the “Bank”) and Four Oaks Mortgage Services, LLC, the Company’s mortgage origination subsidiary. All significant intercompany transactions have been eliminated. In March 2006, the Company formed Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the “Trust”), for the sole purpose of issuing Trust Preferred Securities (as defined in Note H below). The Trust is not included in the consolidated financial statements of the Company.
Nature of Operations
The Company was incorporated under the laws of the State of North Carolina on February 5, 1997. The Company’s primary function is to serve as the holding company for its wholly owned subsidiaries, the bank and Four Oaks Mortgage Services, LLC. The bank operates eighteen offices in eastern and central North Carolina, and its primary source of revenue is derived from loans to customers and from its securities portfolio. The loan portfolio is comprised mainly of real estate, commercial, and consumer loans. These loans are primarily collateralized by residential and commercial properties, commercial equipment, and personal property.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
Preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses.
Cash and Cash Equivalents
For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions cash and due from banks, Fed Funds sold, and interest-earning deposits.
Federal regulations require institutions to set aside specified amounts of cash as reserves against transactions and time deposits. As of December 31, 2009, the daily average gross reserve requirement was $3.4 million.
Investment Securities
Investment securities are classified into three categories:
(1) Held to Maturity - Debt securities that the Company has the positive intent and the ability to hold to maturity are classified as held to maturity and reported at amortized cost;
(2) Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and
(3) Available for Sale - Debt and equity securities not classified as either securities held to maturity or trading securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of income taxes, as other comprehensive income, a separate component of shareholders' equity. The Company has historically classified all securities as available for sale. Gains and losses on sales of securities, computed based on specific identification of adjusted cost of each security, are included in income at the time of the sale. Premiums and discounts are amortized into interest income using a method that approximates the interest method over the period to maturity.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans and Allowance for Loan Losses
Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding.
Loan origination fees are deferred, as well as certain direct loan origination costs. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans utilizing the interest method.
A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loan’s observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses.
Purchased loans acquired in a business combination, which include loans purchased in the Nuestro Banco (“Nuestro”) acquisition, are recorded at estimated fair value on their purchase date; the purchaser cannot carry over the related allowance for loan losses for acquisitions subsequent to January 1, 2009. Purchased loans are accounted for under Financial Accounting Standards Board Accounting Standard Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (formerly American Institute of Certified Public Accountants (“AICPA”) Statement of Position 03-3), when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccural status. Generally, acquired loans that meet the Company’s definition for nonaccrual status fall within the scope of FASB ASC 310-30. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference which is included in the carrying amount of the loans. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges, or a reclassification of the difference from nonaccretable to accretable with a positive impact on interest income. Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows. For all other acquired loans that do not fall under the definition of ASC 310-30, the Company will account for these loans as describe in the previous paragraphs.
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers’ ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality. If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination.
Income Recognition on Impaired and Nonaccrual Loans
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms.
While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.
Foreclosed Assets
Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis. After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense.
Bank Premises and Equipment
Land is carried at cost. Buildings, furniture, and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of assets. Useful lives range from 5 to 10 years for furniture and equipment and 40 years for buildings. Expenditures for repairs and maintenance are charged to expense as incurred.
Goodwill and Other Intangibles
Goodwill and identified intangible assets are subject to impairment testing. When appropriate, a projected cash flow valuation method is used in the completion of impairment testing. This valuation method requires a significant degree of management judgment. In the event the projected undiscounted net operating cash flows are less than the carrying value, the asset is recorded at fair value as determined by the valuation model. As such, the Company classifies goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3. At December 31, 2009 there were no fair value adjustments related to intangible assets of $406,000. The goodwill of $6.1 million was considered completely impaired at December 31, 2009. See Note E for further discussion of goodwill and other intangibles.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax assets are also recognized for operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized.
The Company did not recognize any interest or penalties related to income tax during the years ended December 31, 2008 and 2009, and did not accrue any interest or penalties as of December 31, 2009 or 2008. The Company did not have an accrual for uncertain tax positions as deductions taken and benefits accrued are based on widely understood administrative practices and procedures, and are based on clear and unambiguous tax law. Tax returns for all years 2006 and thereafter are subject to possible future examinations by tax authorities.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock in Federal Home Loan Bank of Atlanta
As a requirement for membership, the Company invests in stock of the FHLB of Atlanta. This investment is carried at cost. Due to the redemptive provisions of the FHLB, the Company estimated that fair value equals approximate cost and that this investment was not impaired as of December 31, 2009.
Comprehensive Income
Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Company’s available for sale securities portfolio and unrealized gains and losses, net of taxes, in the Company’s cash flow hedge instruments.
Accumulated other comprehensive income (loss) at December 31, 2009 and 2008 consists of the following:
Stock Compensation Plans
The Company applies accounts for stock based awards granted to employees using the fair value method. The cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (usually the vesting period). The cost of employee services received in exchange for an award is based on the grant-date fair value of the award. Excess tax benefits are reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.
Net Income (Loss) Per Common Share and Common Shares Outstanding
Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options.
Basic and diluted net income (loss) per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock options that have exercise prices greater than the average market price of the common shares or stock options outstanding do not have a dilutive effect and are considered antidilutive. There were 165,605 antidilutive shares outstanding for the years ended December 31, 2008. Outstanding options had no dilutive effect in 2009 because the Company reported a net loss for the year.
Derivative Instruments
The Company utilizes interest rate swaps in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. Swap terms generally range from one year to ten years depending on the need.
The net interest payable or receivable on interest rate swaps that are designated as hedges is accrued and recognized as an adjustment to the interest income or expense of the related asset or liability. Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument. Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income. Unrealized holding gains and losses on derivatives designated as cash flow hedges are reported, net of applicable income tax effect, in accumulated other comprehensive income.
Derivative financial instruments that fail to qualify or are not designated for hedge accounting are carried at fair value with gains and losses recognized in current earnings.
Acquisitions
As described in Note V below, the Company acquired assets and assumed liabilities of the former Nuestro Banco on December 31, 2009. The acquired assets and assumed liabilities of Nuestro were recorded at estimated fair values. Management made significant estimates and exercised significant judgment in accounting for the acquisition of Nuestro. Management judgmentally assigned risk ratings to loans. The assigned risk ratings, appraised collateral values, expected cash flows, current interest rates, and statistically derived loss factors were used to measure fair values for loans. Management considered an appraisal performed by an independent third party in order to record an identifiable intangible asset representing the value of the core deposit customer base of Nuestro. In determining the value of the identifiable intangible asset, the third-party appraiser used significant estimates including average lives of depository accounts, future interest rate levels, the cost of servicing various depository products, and other significant estimates. Management used quoted market prices to determine the fair value of investment securities, FHLB advances and other borrowings.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
The Company acquired assets and assumed liabilities of the former LongLeaf Community Bank on April 17, 2008. The Company accounted for the acquired assets and assumed liabilities of LongLeaf under the purchase method of accounting. See Note W for further details.
New Accounting Standards
Accounting Standards Codification
In June 2009, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No. 162,” (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification (“Codification”) as the source of authoritative generally accepted accounting principles (“GAAP”) for nongovernmental entities. The Codification does not change GAAP. Instead, it takes the thousands of individual pronouncements that currently comprise GAAP and reorganizes them into approximately 90 accounting Topics, and displays all Topics using a consistent structure. Contents in each Topic are further organized first by Subtopic, then Section and finally Paragraph. The Paragraph level is the only level that contains substantive content. Citing particular content in the Codification involves specifying the unique numeric path to the content through the Topic, Subtopic, Section and Paragraph structure. FASB suggests that all citations begin with “FASB ASC,” where ASC stands for Accounting Standards Codification. Changes to the ASC subsequent to June 30, 2009 are referred to as Accounting Standards Updates (“ASU”).
In conjunction with the issuance of SFAS 168, the FASB also issued its first Accounting Standards Update No. 2009-1, “Topic 105 - Generally Accepted Accounting Principles” (“ASU 2009-1”), which includes SFAS 168 in its entirety as a transition to the ASC. ASU 2009-1 is effective for interim and annual periods ending after September 15, 2009 and did not have an impact on the Company’s financial position or results of operations but will change the referencing system for accounting standards. Certain of the following pronouncements were issued prior to the issuance of the ASC and adoption of the ASUs. For such pronouncements, citations to the applicable Codification by Topic, Subtopic and Section are provided where applicable in addition to the original standard type and number.
Business Combinations
In December 2007, the Financial Accounting Standards Board (FASB) issued amended accounting guidance relating to business combinations. The new standard applies to all transactions or other events in which an entity obtains control of one or more businesses. Additionally, the new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement date for all assets acquired and liabilities assumed; and requires the acquirer to disclose additional information needed to evaluate and understand the nature and financial effect of the business combination. The Company adopted this change on January 1, 2009 and the acquisition method of accounting was applied in accounting for the acquisition of Nuestro Banco by the Company during 2009.
Noncontrolling Interests
In December 2008, the FASB issued new accounting guidance relating to noncontrolling interests in consolidated financial statements. This guidance clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and was effective for fiscal years beginning on or after December 15, 2008. The Company adopted these provisions effective January 1, 2009. This adoption did not have a material effect on the Company’s financial condition, results of operations or cash flows.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Derivative Instruments and Hedging Activities
In March 2008, the FASB issued new accounting guidance relating to derivative instruments and hedging activities. This guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements, and was effective for fiscal years beginning after November 15, 2008. The Company adopted these provisions effective January 1, 2009 and this adoption had no effect on the Company’s financial position or results of operations.
Fair Value Measurement and Disclosure
In April 2009, the FASB issued new guidance for determining when a transaction is not orderly and for estimating fair value when there has been a significant decrease in the volume and level of activity for an asset or liability. The new guidance requires disclosure of the inputs and valuation techniques used, as well as any changes in valuation techniques and inputs used during the period, to measure fair value in interim and annual periods. In addition, the presentation of the fair value hierarchy is required to be presented by major security type as described in ASC 320, Investments - Debt and Equity Securities. The provisions of the new standard were effective for the Company’s interim period ending on June 30, 2009. The adoption of the new standard did not have a material impact on the Company’s financial position or results of operations.
In April 2009, the FASB issued new accounting guidelines for disclosures relating to the fair value of financial instruments. The new standard requires disclosures of the fair value of financial instruments for interim reporting periods of publicly traded companies in addition to the annual disclosure required at year-end. The provisions of the new standard were effective for the Company’s interim period ending on June 30, 2009. The Company’s adoption of this new accounting standard did not have a material effect on the Company’s financial position or results of operations.
Other-Than-Temporary Impairments
In April 2009, the FASB issued new accounting guidance that amended the other-than-temporary impairment guidance for debt securities to be more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in financial statements. Under the new guidance, an other-than-temporary impairment is recognized when an entity has the intent to sell a debt security or when it is more likely than not that an entity will be required to sell the debt security before its anticipated recovery in value. The new guidance does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities and is effective for interim and annual reporting periods ending after June 15, 2009. These provisions were adopted for the Company’s interim period ending June 30, 2009. This adoption did not have a material impact on the Company’s financial statements.
Subsequent Events
In May 2009, the FASB issued new accounting guidance relating to management's assessment of subsequent events. This guidance clarifies that management must evaluate, as of each reporting period, events or transactions that occur after the balance sheet date through the date the financial statements are issued or are available to be issued, and was effective for interim and annual periods ending after June 15, 2009. The statement was effective and adopted for the period ending June 30, 2009. This adoption had no material financial impact on the Company’s financial position or, results of operations or cash flows.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Accounting for Transfers of Financial Assets
In June 2009, the FASB issued accounting guidance on the accounting for transfers of financial assets. This guidance improves the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. The guidance is effective for periods ending after November 15, 2009. Management is currently evaluating the effect this guidance may have on the Company’s financial position and results of operations.
Accounting for Variable Interest Entities
In June 2009, the FASB issued guidance that significantly changes the criteria for determining whether the consolidation of a variable interest entity is required. This guidance also addresses the effect of changes on consolidation of variable interest entities and concerns regarding the application of certain provisions in previously issued accounting guidance, including concerns that the accounting and disclosures do not always provide timely and useful information about an entity’s involvement in a variable interest entity. This guidance is effective for interim and annual reporting periods that begin after November 15, 2009. Management is currently assessing the impact of this guidance on the Company’s financial position and results of operations.
Other accounting standards that have been issued by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations and cash flows.
From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.
Reclassifications
Certain items included in the 2008 consolidated financial statements have been reclassified to conform to the 2009 presentation. These reclassifications have no effect on the net income or shareholders’ equity previously reported.
NOTE B - INVESTMENT SECURITIES
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities available for sale as of December 31, 2009 and 2008 are as follows:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE B - INVESTMENT SECURITIES (Continued)
The following table shows gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2009 and 2008. As of December 31, 2009, the unrealized losses relate to three mortgage-backed securities, twenty-five municipal securities and thirteen marketable equity securities. Six of the marketable equity securities had continuous unrealized losses for more than twelve months. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased.
For the year ended December 31, 2009, the Company determined five marketable equity securities were other than temporarily impaired resulting in a cumulative impairment loss of $850,000. Two of the six marketable equity securities, which represented $27,000 of the impairment loss, were written off in their entirety since the issuing companies were taken into receivership. Another two investments were evaluated for other than temporary impairment due to the severity and significant length of time in which the securities were in an unrealized loss position that resulted in approximately $313,000 of impairment loss. The cumulative fair values of these two investments at December 31, 2009 are $108,000. The final investment was deemed to be other than temporarily impaired given the severity, significant length of time and deferral of interest payments mandated by regulators, which resulted in approximately $510,000 of impairment loss. The fair value of this investment at December 31, 2009 is $3,000.
The Company also took an impairment charge of $154,000 on a non-marketable equity security. The investment was written off in its entirety since the issuing company was taken into receivership. The Company considered all other than temporary impairment losses of debt securities at December 31, 2009 credit related, and there are no unrealized losses in accumulated other comprehensive income related to debt securities deemed other than temporarily impaired. There were no investments determined to be other than temporarily impaired during 2008.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE B - INVESTMENT SECURITIES (Continued)
The amortized cost and fair value of available for sale securities at December 31, 2009 by contractual maturities are shown below. 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.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE B - INVESTMENT SECURITIES (Continued)
Securities with a carrying value of approximately $100.9 million and $120.9 million at December 31, 2009 and 2008, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.
Sales and calls of securities available for sale during 2009, and 2008 generated gross realized gains of $2.4 million and $635,000, respectively and gross realized losses of $23,000 and $59,000, respectively.
NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES
Major classifications of loans as of December 31, 2009 and 2008 are summarized as follows:
Nonperforming assets at December 31, 2009 and 2008 consist of the following:
At December 31, 2009, the recorded investment in loans considered impaired totaled $30.2 million. This amount consisted of both accrual and nonaccrual loans. At December 31, 2008, the investment in loans considered impaired consisted of both accrual and nonaccrual loans in the amount of $20.8 million. Impaired loans of $22.7 million and $17.0 million had related allowances for loan losses of $6.4 million and $2.9 million at December 31, 2009 and 2008, respectively. For the years ended December 31, 2009 and 2008, the average recorded investment in impaired loans was approximately $24.1 million and $9.9 million, respectively. The amount of interest recognized on impaired loans during the portion of the year that they were considered impaired was approximately $320,000.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)
The following table represents the non impaired purchased loans receivable acquired in Nuestro Banco at the acquisition date of December 31, 2009. The amounts include principal only and do not reflect accrued interest as of the date of acquisition or beyond (dollars in thousands):
Contractual loan payments receivable, estimates of amounts not expected to be collected, other fair value adjustments and the resulting fair values of acquired loans that were impaired at acquisition date of December 31, 2009 are provided in the following table:
A summary of the allowance for loan losses for the years ended December 31, 2009 and 2008 is as follows:
The Company had loan and deposit relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. The following is a reconciliation of loans directly outstanding to executive officers, directors, and their affiliates (amounts in thousands):
As a matter of policy, these loans and credit lines are approved by the Company’s Board of Directors and are made with interest rates, terms, and collateral requirements comparable to those required of other borrowers. In the opinion of management, these loans do not involve more than the normal risk of collectibility. At December 31, 2009, the Company had pre-approved but unused lines of credit totaling $557,000 to executive officers, directors and their affiliates.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE D - BANK PREMISES AND EQUIPMENT
Company premises and equipment at December 31, 2009 and 2008 are as follows:
Depreciation expense was $1.2 million and $1.1 million for the years ended December 31, 2009 and 2008, respectively.
NOTE E - GOODWILL AND OTHER INTANGIBLES
Management is required to test goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment. If the carrying amount of the reporting unit’s goodwill is found to exceed its implied fair value, the Company would recognize an impairment loss in an amount equal to that excess.
When the Company completed its annual test of goodwill for impairment as of December 31, 2008, the results of that test indicated that the Company's goodwill was not impaired. During 2009, management monitored the decline in the price of the Company’s common stock and the disparity between the stock price and stated book value, but did not identify any other triggering events that would result in an interim test of the Company’s goodwill.
In December 2009, management engaged external valuation specialists to assist in its goodwill assessments. At December 31, 2009 the Company again tested its goodwill for impairment due to the continued disparity between the value of the Company's stock and stated book value. The indicated fair value of the Company at December 31, 2009 was determined using two methods. The first is a market approach based on the actual market capitalization of the Company, adjusted for a control premium. The second is an income approach based on discounted cash flow models with estimated cash flows based on internal forecasts of net income. Both methods were considered and weighted to estimate the fair value of the Company. Based on testing, management determined that the indicative fair value of the Company was less than its carrying value and management performed a second step analysis to compare the implied fair value of the goodwill with the carrying amount of that goodwill. The results of this second step analysis indicated a range of goodwill impairment that supported a charge of $6.1 million to write off all of its goodwill.
There were several significant assumption changes between the analysis performed at December 31, 2008 and 2009. The discount rate used in the income approach based on discounted cash flows increased from 12.75% to 16.30%. The external valuation specialist had an established method of determining the discounted rate which considered factors not previously utilized. Between the higher discount rate to compensate for increased risk due to higher levels of nonperforming loans and adjustments made to projected cash flows, the indicative value per the income approach declined by approximately $31.5 million. The inclusion of the market approach in the December 31, 2009 analysis resulted in a significant decrease in the implied fair value. When considering how to weight the two approaches, half of the consideration was given to the market approach during the 2009 analysis as opposed to no consideration in 2008. These factors led to a lower estimated fair value of equity at December 31, 2009 compared to December 31, 2008.
This write off of goodwill has no effect on our cash flows, our regulatory capital, and the operation of our business or our ability to service our customers.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE E - GOODWILL AND OTHER INTANGIBLES (Continued)
There was no accumulated loss for goodwill as of January 1, 2009 and 2008, respectively. The following is a summary of goodwill and other intangible assets at December 31, 2009 and 2008:
The other intangibles acquired in connection with the LongLeaf and Nuestro acquisitions had estimated lives of 120 and 60 months, respectively. Other intangibles amortization expense for the years ended December 31, 2009 and 2008 amounted to $58,000 and $46,000, respectively. Estimated amortization expense for other intangibles for future years are as follows (amounts in thousands):
NOTE F - DEPOSITS
At December 31, 2009, the scheduled maturities of time deposits are as follows (amounts in thousands):
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE G - BORROWINGS
At December 31, 2009 and 2008, borrowed funds included the following FHLB advances (amounts in thousands):
The above advances are secured by a floating lien covering the Company’s loan portfolio of qualifying residential (1-4 units) first mortgage loans. At December 31, 2009, the Company has available lines of credit totaling $82.8 million with the FHLB for borrowing dependent on adequate collateralization. The weighted average rates for the above borrowings at December 31, 2009 and 2008 were 3.58% and 3.60%, respectively.
In addition to the above advances, the Company has lines of credit of $17.0 million from various financial institutions to purchase federal funds on a short-term basis. The Company has no federal fund purchases outstanding as of December 31, 2009.
NOTE H - TRUST PREFERRED SECURITIES
On March 30, 2006, $12.0 million of trust preferred securities (“Trust Preferred Securities”) were placed through the Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (“the Trust”). The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the “Debentures”) issued by the Company and recorded in borrowings on the accompanying consolidated balance sheet. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%. The dividends paid to holders of the Trust Preferred Securities, which will be recorded as interest expense, are deductible for income tax purposes. The Trust Preferred Securities are redeemable on June 15, 2011 or afterwards in whole or in part, on any June 15, September 15, December 15, or March 15. Redemption is mandatory by June 15, 2036. The Company has fully and unconditionally guaranteed the Trust Preferred Securities through the combined operation of the Debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The Trust Preferred Securities qualify as Tier I capital for regulatory capital purposes subject to certain limitations.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE I - SUBORDINATED PROMISSORY NOTES
The Company sold $12.0 million aggregate principal amount of subordinated promissory notes to certain accredited investors between May and August 2009. These notes are due ten years after the date of issuance, beginning May 15, 2019, and the Company is obligated to pay interest at an annualized rate of 8.5% payable in quarterly installments beginning on the third month anniversary of the date of issuance. The Company may prepay the notes at any time after the fifth anniversary of the date of issuance, subject to compliance with applicable law.
NOTE J - INCOME TAXES
Allocation of income tax expense between current and deferred portions is as follows:
The reconciliation of expected income tax at the statutory federal rate of 34% with income tax expense is as follows:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE J - INCOME TAXES (Continued)
Deferred income taxes consist of the following:
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. For the years ended December 31, 2009 and 2008, there were no uncertain tax positions taken by the Company.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE K - REGULATORY RESTRICTIONS
The Bank, as a North Carolina banking corporation, may pay dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure the financial soundness of the bank.
Current Federal regulations require that the Bank maintain a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulations. In addition, the Bank must maintain a leverage ratio of 4%. As of December 31, 2009, the Bank’s capital exceeded the current capital requirements. The Bank currently expects to continue to exceed these minimums without altering current operations or strategy.
The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2009, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2009, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank’s category.
The Bank’s actual capital amounts and ratios are also presented in the table below (dollars in thousands):
The Company is also subject to these capital requirements. At December 31, 2009 and 2008, the Company’s total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets were 13.7%, 10.7%, and 8.21%, and 11.5%, 10.1%, and 8.0%, respectively.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE L - DERIVATIVES
Derivative Financial Instruments
From time to time, the Company has stand-alone derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments, and the value of the derivative are based. Notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which represents the fair value of the derivative instruments, is reflected on the Company’s consolidated balance sheets as derivative assets and derivative liabilities.
The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations. The Company deals only with primary dealers.
Derivative instruments are generally either negotiated over-the-counter (“OTC”) contracts or standardized contracts executed on a recognized exchange. Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreements terms, including the underlying instruments, amount, exercise prices, and maturity.
Risk Management Policies - Hedging Instruments
The primary focus of the Company’s asset/liability management program is to monitor the sensitivity of the Company’s net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned over a twelve-month period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates.
Interest Rate Risk Management - Cash Flow Hedging Instruments
The Company originates variable rate loans for its loan portfolio. These loans expose the Company to variability in cash flows, primarily from interest receipts due to changes to interest rates. If interest rates increase, interest income increases. Conversely, if interest rates decrease, interest income decreases. Management believes it is prudent to limit the variability of a portion of its cash flows on variable rate loans therefore, generally hedges a portion of its variable-rate receipts. To meet this objective, management enters into interest rate swap agreements whereby the Company receives fixed rate payments and makes variable rate payments during the contract period.
At December 31, 2009 and 2008 there were no outstanding interest rate swap agreements used to hedge variable rate loans.
Interest Rate Risk Management - Fair Value Hedging Instruments
The Company uses funds from fixed rate time deposits in its lending and investment activities and for other general purposes. These debt obligations expose the Company to variability in their fair value due to changes in the level of interest rates. Management believes that it is prudent to limit the variability in the fair value of a portion of its fixed-rate funding. It is the Company’s objective to hedge the change in fair value of fixed-rate funding coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this liability to other liabilities of the Company. To meet this objective, the Company utilized interest rate swaps as an asset/liability management strategy to hedge the change in value of the funding due to changes in expected interest rate assumptions. These interest rate swap agreements are contracts to make a series of floating rate payments in exchange for receiving a series of fixed rate payments. All interest rate swap agreements were terminated during 2008.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE L - DERIVATIVES (Continued)
These agreements required the Company to make payments at variable-rate determined by a specified index (LIBOR) in exchange for receiving payments at a fixed-rate.
The interest rate swap agreement used to hedge variable rate loans expired July 30, 2008. No other interest rate swaps were terminated during 2008.
NOTE M - COMMITMENTS AND CONTINGENCIES
The Company is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit.
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed.
Stand-by letters of credit are conditional lending commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
Financial instruments whose contract amounts represent credit risk:
NOTE N - FAIR VALUE MEASUREMENTS
As discussed in Note A to the consolidated financial statements, the Company adopted ASC 820 and SFAS No. 159 on January 1, 2008 (ASC 825 - “Financial Instruments). ASC 820 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. ASC 820 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, ASC 820 does not expand the use of fair value in any new circumstances. ASC 825 provides companies with an option to report selected financial assets and liabilities at fair value. As of December 31, 2009, the Company had not elected to measure any financial assets or liabilities using the fair value option under ASC 825; therefore the adoption of ASC 825 had no effect on the Company’s financial condition or results of operations.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE N - FAIR VALUE MEASUREMENTS (Continued)
The Company records securities available for sale and derivative assets and liabilities at fair value on a recurring basis. Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the assets or owes the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in the market.
ASC 820 establishes a fair value hierarchy to prioritize the inputs of valuation techniques used to measure fair value. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of how market-observable the fair value measurement is and defines the level of disclosure. ASC 820 clarifies fair value in terms of the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability at the measurement date (an exit price). In order to determine the fair value or the exit price, entities must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy.
Outlined below is the application of the fair value hierarchy established by ASC 820 to the Company’s financial assets that are carried at fair value.
Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. As of December 31, 2009 and 2008, the Company carried marketable equity securities available for sale at fair value hierarchy Level 1.
Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. As of December 31, 2009 and 2008, the types of financial assets and liabilities the Company carried at fair value hierarchy Level 2 included securities available for sale.
Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are supported by little or no market activity or by the entity’s own assumptions. As of December 31, 2009 and 2008, while the Company did not carry any financial assets or liabilities, measured on a recurring basis, at fair value hierarchy Level 3, the Company did value certain financial assets, measured on a non-recurring basis, at fair value hierarchy Level 3.
Fair Value on a Recurring Basis. The Company measures certain assets at fair value on a recurring basis, as described below.
Investment Securities Available for Sale
Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE N - FAIR VALUE MEASUREMENTS (Continued)
Derivative Assets and Liabilities
Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies derivatives instruments held or issued for risk management purposes as Level 2. As of December 31, 2009 and 2008, the Company had no derivative assets or liabilities.
The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
Fair Value on a Recurring Basis. Below is a table that presents information about assets measured at fair value on a recurring basis at December 31, 2009 and 2008:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE N - FAIR VALUE MEASUREMENTS (Continued)
Value on a Nonrecurring Basis. The Company measures certain assets at fair value on a nonrecurring basis, as described below.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 2. There were no loans held for sale at December 31, 2009 and no fair value adjustments related to loans held for sale as of or for the year ended December 31, 2009.
Loans
The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC 310, “Receivables” and ASC 450, “Contingencies”. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2009, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with ASC 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans totaled $30.2 million at December 31, 2009. Of such loans, $22.7 million had specific loss allowances aggregating $6.4 million at that date for a net fair value of $16.3 million. Of those specific allowances, all were determined using Level 3 inputs.
Goodwill and Other Intangible Assets
Goodwill and identified intangible assets are subject to impairment testing. When appropriate, a projected cash flow valuation method is used in the completion of impairment testing. This valuation method requires a significant degree of management judgment. In the event the projected undiscounted net operating cash flows are less than the carrying value, the asset is recorded at fair value as determined by the valuation model. As such, the Company classifies goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3. At December 31, 2009 there were no fair value adjustments related to intangible assets other than goodwill of $406,000. The goodwill of $6.1 million was considered completely impaired at December 31, 2009.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE N - FAIR VALUE MEASUREMENTS (Continued)
Foreclosed Assets
Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3. At December 31, 2009 and 2008, there was no additional fair value adjustments required after transfer related to foreclosed real estate of $10.7 million.
NOTE O - STOCK OPTION PLAN
The Company has a non-qualified stock option plan for certain key employees under which it is authorized to issue options for up to 1,542,773 shares of common stock. Options are granted at the discretion of the Company’s Board of Directors at an exercise price approximating market value, as determined by a committee of Board members. All options granted subsequent to a 1997 amendment will be 100% vested one year from the grant date and will expire after such a period as is determined by the Board at the time of grant. Options granted prior to the amendment have ten year lives and a five year level vesting provision. Options granted for 2009 and 2010 have a two year vesting provision.
A summary of option activity under the Plan for the year ended December 31, 2009, is presented below:
The weighted average exercise price of all exercisable options at December 31, 2009 is $16.24. There were 371,323 shares reserved for future issuance at December 31, 2009.
As of December 31, 2009 and 2008, there was $66,966 and $14,000 of unrecognized compensation cost related to non-vested share-based compensation arrangements, respectively.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE O - STOCK OPTION PLAN (Continued)
Additional information concerning the Company’s stock options at December 31, 2009 is as follows:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2009, and 2008:
The weighted average fair value of options granted during 2009, and 2008 was $3.74 and $2.97, respectively.
NOTE P - OTHER EMPLOYEE BENEFITS
Supplemental Retirement
In 1998, the Company’s subsidiary, Four Oaks Bank & Trust Company, adopted a Supplemental Executive Retirement Plan (“SERP”) for its president. The Company has purchased life insurance policies in order to provide future funding of benefit payments. SERP benefits will accrue and vest during the period of employment and will be paid in annual benefit payments over the officer’s remaining life commencing with the officer’s retirement. The liability accrued under the SERP plan amounts to $274,000 and $207,000 at December 31, 2009 and 2008, respectively. During 2009 and 2008, the expense attributable to the SERP amounted to $67,000 and $32,000, respectively.
Employment Agreements
The Company has entered into employment agreements with certain of its executive officers to ensure a stable and competent management base. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Company’s Board of Directors, except for cause, without prejudicing the officers’ rights to receive certain vested rights, including compensation. In addition, the Company has entered into severance compensation agreements with certain of its executive officers and key employees to provide them with severance pay benefits in the event of a change in control of the Company, as outlined in the agreements; the acquirer will be bound to the terms of the contracts.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE P - OTHER EMPLOYEE BENEFITS (Continued)
Defined Contribution Plan
The Company sponsors a contributory profit-sharing plan in effect for substantially all employees. Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code. The plans provide for employee contributions up to $15,500 of the participant's annual salary and an employer contribution of 25% matching of the first 6% of pre-tax salary contributed by each participant. Expenses related to these plans for the years ended December 31, 2009 and 2008 were $188,000 and $149,000, respectively. Contributions under the plan are made at the discretion of the Company’s Board of Directors.
Employee Stock Ownership Plan
The Company sponsors an employee stock ownership plan (ESOP) which makes the employees of the Company, owners of stock in the Company. The Four Oaks Bank & Trust Company’s Employee Stock Ownership Trust is available to full-time employees at least 21 years of age after six months of service. Contributions are voluntary by the Company and employees cannot contribute. Stock issued is purchased on the open market and the Company does not issue new shares in conjunction with this plan.
Voluntary contributions are determined by the Company’s Board of Directors annually based on Company performance and are allocated to employees based on annual compensation. Contribution expenses for this plan for the year ended 2008, was $331,000. The Board of Directors determined that due to the projected net operating loss for 2009, no contribution would be made to the plan.
Employee Stock Purchase and Bonus Plan
The Employee Stock Purchase and Bonus Plan (the “Purchase Plan”) is a voluntary plan that enables full-time employees of the Company and its subsidiaries to purchase shares of the Company’s common stock. The Purchase Plan is administered by a committee of the Board of Directors, which has broad discretionary authority to administer the Purchase Plan. The Company’s Board of Directors may amend or terminate the Purchase Plan at any time. The Purchase Plan is not intended to be qualified as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended.
Once a year, participants in the Purchase Plan purchase the Company’s common stock at fair market value. Participants are permitted to purchase shares under the Purchase Plan up to (5%) of their compensation, with a maximum purchase amount of $1,000 per year. The Company matches, in cash, fifty percent (50%) of the amount of each participant’s purchase, up to $500. After withholding for income and employment taxes, participants use the balance of the Company’s matching grant to purchase shares of the Company’s common stock.
As of December 31, 2009, 368,544 shares of the Company’s common stock had been reserved for issuance under the Purchase Plan, and 203,619 shares had been purchased. During the years ended December 31, 2009 and 2008, 23,603 and 9,628 shares, respectively, were purchased under the Purchase Plan.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE Q - LEASES
The Company has entered into non-cancelable operating leases for six branch facilities. Future minimum lease payments under the leases for future years are as follows (amounts in thousands):
In addition, the Company has leased a building from one of its former directors for approximately $1,000 per month in 2009 and 2008, under an operating lease on a month-to-month basis.
Total rental expense under operating leases for the years ended December 31, 2009 and 2008 amounted to $206,000 and $192,000, respectively.
NOTE R- PARENT COMPANY FINANCIAL INFORMATION
Condensed financial information of Four Oaks Fincorp, Inc. at December 31, 2009 and 2008 and for the years ended December 31, 2009 and 2008 is presented below:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE R- PARENT COMPANY FINANCIAL INFORMATION (Continued)
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE S - FAIR VALUE OF FINANCIAL INSTRUMENTS
ASC 825-10-65-1, requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company’s financial instruments, the fair value of such instruments has been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments’ values and should not be considered an indication of the fair value of the Company taken as a whole. The following methods and assumptions were used to estimate the fair value of each class of financial instrument.
Cash and Cash Equivalents
The carrying amounts of cash and cash equivalents are equal to the fair value due to the liquid nature of the financial instruments.
Investment Securities Available for Sale
Fair values of investment securities available for sale are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans
Fair values have been estimated by type of loan: residential real estate loans, consumer loans, and commercial and other loans. For variable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of fixed rate loans are estimated by discounting the future cash flows using the current rates at which loans with similar terms would be made to borrowers with similar credit ratings and for the same remaining maturities, adjusted for current liquidity and market conditions. The Company has assigned no fair value to off-balance sheet financial instruments since they are either short term in nature or subject to immediate repricing.
FHLB Stock
The carrying amount of FHLB stock approximates fair value.
Investment in Life Insurance
The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.
Deposits
The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at year-end. Fair value of time deposits is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same maturities.
Borrowings and Subordinated Debentures
The fair values are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collection requirements.
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate fair value.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE S - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
Derivative Financial Instruments
Fair values for interest rate swap agreements are based upon the amounts required to settle the contracts.
The following table presents information for financial assets and liabilities as of December 31, 2009 and 2008:
NOTE T - CASH FLOW SUPPLEMENTAL DISCLOSURES
The following information is supplemental information regarding the cash flows for the years ended December 31, 2009 and, 2008:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE U - STOCK PURCHASE PLAN
On November 26, 2007 the Board of Directors increased the purchase authorization to 500,000 shares and on December 22, 2008 authorized the extension of the Company’s Stock Purchase Program through December 31, 2009. During 2008, the Company purchased 6,020 shares at an average cost of $12.49. No stock was repurchased during the calendar year 2009. At December 31, 2009, there were 344,949 shares available for repurchase.
NOTE V - MERGER WITH NUESTRO BANCO
On December 31, 2009, the Company completed the merger with Nuestro Banco, headquartered in Garner, North Carolina. The Company acquired all outstanding shares of Nuestro’s capital stock in exchange for approximately 357,099 shares of the Company’s common stock. In connection with this merger, the Company acquired approximately $16.2 million in assets and assumed approximately $8.3 million in liabilities. The acquisition was accounted for under the acquisition method of accounting in accordance with FASB ASC 805, Business Combinations. The Company recorded a “bargain purchase” gain totaling $6.0 million resulting from the acquisition, which is a component of noninterest income on the statement of income. The amount of the gain is equal to the amount by which the estimated fair value of assets purchased exceeded the estimated fair value of liabilities assumed and consideration paid.
A summary of the total purchase price of the transaction is as follows:
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE V - MERGER WITH NUESTRO BANCO (Continued)
A summary of the fair value of the assets acquired and liabilities assumed is as follows:
Total acquisition-related costs through December 31, 2009 were approximately $386,000, which is included in other non-interest expenses.
Certain unaudited pro forma consolidated operating results for the Company and Nuestro Banco for the years ended December 31, 2009 and 2008, are as follows: total interest income of $48.2 million and $49.9 million, respectively; net interest income of $29.8 million and $26.3 million, respectively; noninterest income of $12.3 million and $5.6 million, respectively; net income (loss) of ($9.2 million) and $2.0 million, respectively; basic and diluted net loss per share for 2009 of $1.25, and basic and diluted net income per share for 2008 of $.30. The unaudited pro forma information presented does not necessarily reflect the results of operations that would have resulted had the acquisition been completed at the beginning of the applicable periods presented, nor does it indicate the results of operations in future periods. The pro forma purchase accounting adjustments related to loans and deposits are being accreted or amortized into income using methods that approximate a level yield over their respective estimated lives. Purchase accounting adjustments related to core deposit intangibles are being amortized and recorded as noninterest expense over the estimated lives using accelerated methods. The unaudited pro forma consolidated operating results for the year ended December 31, 2009 do not include the gain of $6.0 million recognized in the acquisition of Nuestro Banco. The unaudited pro forma consolidated operating results do not reflect any adjustments to Nuestro Banco’s historical provisions for credit losses.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE V - MERGER WITH NUESTRO BANCO (Continued)
NOTE W - MERGER WITH LONGLEAF COMMUNITY BANK
On April 17, 2008, the Company completed the merger with LongLeaf Community Bank (“LongLeaf”), headquartered in Rockingham, North Carolina. Under the terms of the merger agreement, each share of LongLeaf common stock was converted into the right to receive either (i) $16.50 in cash, without interest, (ii) 1.0 share of the Company’s common stock multiplied by an exchange ratio of 1.1542825 or (iii) 0.60 shares of the Company’s common stock multiplied by an exchange ratio of 1.1542825 plus an amount equal to $6.60 in cash. As a result of the acquisition, the Company paid $4.9 million in cash and issued 609,770 additional shares of common stock. The acquisition was accounted for using the purchase method of accounting, with the operating results of LongLeaf subsequent to April 17, 2008 included in the Company’s financial statements. Because the merger of LongLeaf Community Bank occurred early in 2008, the pro forma impacts on consolidated operating results of its results during the portion of the year prior to the merger are not significant.
Four Oaks Fincorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2009 and 2008
NOTE W - MERGER WITH LONGLEAF COMMUNITY BANK (Continued)
A summary of the total purchase price of the transaction is as follows:
NOTE X - RECENT DEVELOPMENTS WITH THE U.S. TREASURY
The Company has withdrawn its application to participate in the CPP Program (the “Program”) effective December 2, 2009.
Item 9
Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
Not Applicable.
Item 9A
Item 9A (T) - Controls and Procedures.
Disclosure Controls and Procedures
As required by paragraph (b) of Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), an evaluation was carried out under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Annual Report. As defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s (the “SEC’s”) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this Annual Report, the Company’s disclosure controls and procedures are effective, in that they provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods required by the SEC’s rules and forms.
Management’s Report on Internal Control Over Financial Reporting
Management of Four Oaks Fincorp, Inc. (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. 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 U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control - Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting as of December 31, 2009.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. 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.
Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws and during the year ended December 31, 2009.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control Over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13d-15(f) and 15d-15(f) under the Exchange Act) that occurred during the fourth quarter of 2008 that the Company believes have materially affected or is likely to materially affect, its internal control over financial reporting.
Item 9B
Item 9B - Other Information.
From time to time, the Company makes stock option awards to officers and directors of the Company and its subsidiaries pursuant to its Amended and Restated Nonqualified Stock Option Plan, as amended (the “Plan”). The Company filed the Plan with the SEC on August 16, 2004 as Exhibit 10.2 to its Quarterly report on Form 10-QSB for the quarterly period ended June 30, 2004 and filed Amendment No. 1 to the Plan with the SEC on September 29, 2009 as Exhibit 10.1 to its Amendment No. 1 to Current Report on Form 8-K/A. The Company is filing as Exhibits 10.28 and 10.29, respectively, to this Form 10-K the form of stock option agreement used under the Plan for grants of non-qualified stock options to non-employee directors and the form of stock option agreement to be used under the Plan for grants of non-qualified stock options to employees.
On February 24, 2010, the Company granted non-qualified stock options under the Plan to directors and executive officers pursuant to the form of agreement attached hereto as exhibit 10.29. The options expire on February 24, 2015, the exercise price of each option is $5.50 per share and each option vests and becomes exercisable in full on February 24, 2012. The specific grants to named executive officers are as follows:
PART III
The information called for in Items 10 through 14 is incorporated by reference from the definitive proxy statement for the Company’s 2010 Annual Meeting of Shareholders, to be filed with the SEC within 120 days after the end of the Company’s fiscal year.
Item 10
Item 10 - Directors, Executive Officers and Corporate Governance.
Item 11
Item 11 - Executive Compensation.
Item 12
Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.
Item 13
Item 13 - Certain Relationships and Related Transactions, and Director Independence.
Item 14
Item 14 - Principal Accountant Fees and Services
Item 15
Item 15 - Exhibits, Financial Statement Schedules.
(a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8 of Part II of this Annual Report on Form 10-K.
Financial Statements
Form 10-K Page
Report of Independent Registered Public Accounting Firm, Dixon Hughes PLLC, dated March 31, 2010
Consolidated Balance Sheets as of December 31, 2009 and 2008
Consolidated Statements of Operations for the years ended December 31, 2009 and 2008
Consolidated Statements of Comprehensive Income for the years ended December 31, 2009 and 2008
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2009 and 2008
Consolidated Statements of Cash Flows for the years ended December 31, 2009 and 2008
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules. All applicable financial statement schedules required under Regulation S-X have been included in the Notes to Consolidated Financial Statements.
(a)(3) Exhibits. The following exhibits are filed as part of this Annual Report on Form 10-K.
Exhibit No.
Description of Exhibit
2.1
Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on December 13, 2007)
2.2
List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed on December 13, 2007)
2.3
First Amendment to Merger Agreement, dated as of October 26, 2009, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and Nuestro Banco (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on October 27, 2009)
2.4
Second Amendment to Merger Agreement, dated as of November 24, 2009, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and Nuestro Banco (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on November 30, 2009)
3.1
Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation.
3.2
Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)
Specimen of Certificate for Four Oaks Fincorp, CommonStock (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)
10.1
Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)
10.2
Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)
10.3
Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)
10.4
Amendment No. 1, effective September 1, 2009 to Amended and Restated Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.1 to the Company’s Amendment No. 1 to Current Report on Form 8-K/A filed with the SEC on September 29, 2009) (management contract or compensatory plan, contract or arrangement)
10.5
Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)
10.6
Amendment No. 1, effective September 1, 2009 to Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company’s Amendment No. 1 to Current Report on Form 8-K/A filed with the SEC on September 29, 2009) (management contract or compensatory plan, contract or arrangement)
Exhibit No.
Description of Exhibit
10.7
Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement)
10.8
Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement)
10.9
Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement)
10.10
Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company’s Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement)
10.11
Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)
10.12
Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)
10.13
Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)
10.14
Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)
10.15
Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2009) (management contract or compensatory plan, contract or arrangement)
10.16
Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.17
Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.18
Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.19
Amended and Restated Severance Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on February 26, 2008) (management contract or compensatory plan, contract or arrangement)
10.20
Summary of the Material Terms of the 2008 Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2008) (management contract or compensatory plan, contract or arrangement)
Exhibit No.
Description of Exhibit
10.21
Consulting Agreement with John W. Bullard (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2008)
10.22
Third Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2008) (management contract or compensatory plan, contract or arrangement)
10.23
Amended and Restated Executive Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.24
Amended and Restated Executive Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.25
Amended and Restated Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.26
Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.27
Form of Capital Purchase Program Letter Agreement with Senior Executive Officers (incorporated by reference to Exhibit 10.7 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.28
Form of Stock Option Agreement (Non-Employee Director) (management contract or compensatory plan, contract or arrangement)
10.29
Form of Stock Option Agreement (Employee) (management contract or compensatory plan, contract or arrangement)
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]
32.1
Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: March 31, 2010
/s/ Ayden R. Lee, Jr.
Ayden R. Lee, Jr.
Chairman, President and Chief Executive Officer
Date: March 31, 2010
/s/ Nancy S. Wise
Nancy S. Wise
Executive Vice President and Chief Financial Officer
Date: March 31, 2010
/s/ William J. Edwards
William J. Edwards
Director
Date: March 31, 2010
/s/ Warren L. Grimes
Warren L. Grimes
Director
Date: March 31, 2010
/s/ Dr. R. Max Raynor, Jr.
Dr. R. Max Raynor, Jr.
Director
Date: March 31, 2010
/s/ Percy Y. Lee
Percy Y. Lee
Director
Date: March 31, 2010
/s/ Paula C. Bowman
Paula C. Bowman
Director
Date: March 31, 2010
/s/ John W. Bullard
John W. Bullard
Director
Date: March 31, 2010
/s/ Michael A. Weeks
Michael A. Weeks
Director
EXHIBIT INDEX
Exhibit No.
Description of Exhibit
2.1
Merger Agreement, dated as of December 10, 2007, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and LongLeaf Community Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on December 13, 2007)
2.2
List of Schedules Omitted from Merger Agreement included as Exhibit 2.1 above (incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed on December 13, 2007)
2.3
First Amendment to Merger Agreement, dated as of October 26, 2009, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and Nuestro Banco (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on October 27, 2009)
2.4
Second Amendment to Merger Agreement, dated as of November 24, 2009, by and among Four Oaks Fincorp, Inc., Four Oaks Bank & Trust Company and Nuestro Banco (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on November 30, 2009)
3.1
Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation.
3.2
Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)
Specimen of Certificate for Four Oaks Fincorp, CommonStock (incorporated by reference to Exhibit 4 to the Company’s Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)
10.1
Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)
10.2
Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)
10.3
Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)
10.4
Amendment No. 1, effective September 1, 2009 to Amended and Restated Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 10.1 to the Company’s Amendment No. 1 to Current Report on Form 8-K/A filed with the SEC on September 29, 2009) (management contract or compensatory plan, contract or arrangement)
10.5
Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)
10.6
Amendment No. 1, effective September 1, 2009 to Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company’s Amendment No. 1 to Current Report on Form 8-K/A filed with the SEC on September 29, 2009) (management contract or compensatory plan, contract or arrangement)
Exhibit No.
Description of Exhibit
10.7
Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement)
10.8
Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement)
10.9
Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement)
10.10
Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Company’s Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement)
10.11
Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)
10.12
Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)
10.13
Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)
10.14
Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)
10.15
Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2009) (management contract or compensatory plan, contract or arrangement)
10.16
Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.17
Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.18
Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed with the SEC on April 4, 2006)
10.19
Amended and Restated Severance Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on February 26, 2008) (management contract or compensatory plan, contract or arrangement)
10.20
Summary of the Material Terms of the 2008 Bonus Plan (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2008) (management contract or compensatory plan, contract or arrangement)
Exhibit No.
Description of Exhibit
10.21
Consulting Agreement with John W. Bullard (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2008)
10.22
Third Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2008) (management contract or compensatory plan, contract or arrangement)
10.23
Amended and Restated Executive Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.24
Amended and Restated Executive Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.25
Amended and Restated Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.26
Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.27
Form of Capital Purchase Program Letter Agreement with Senior Executive Officers (incorporated by reference to Exhibit 10.7 to the Company’s Current Report on Form 8-K filed with the SEC on December 16, 2008) (management contract or compensatory plan, contract or arrangement)
10.28
Form of Stock Option Agreement (Non-Employee Director) (management contract or compensatory plan, contract or arrangement)
10.29
Form of Stock Option Agreement (Employee) (management contract or compensatory plan, contract or arrangement)
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]
32.1
Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]