ITEM 1. BUSINESS
Background
Pacific Mercantile Bancorp is a California corporation that owns 100% of the stock of Pacific Mercantile Bank, a California state chartered commercial bank (which, for convenience, will sometimes be referred to in this report as the “Bank”). The capital stock of the Bank is our principal asset and substantially all of our business operations are conducted by the Bank which, as a result, accounts for substantially all of our revenues and income. As the owner of a commercial bank, Pacific Mercantile Bancorp is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”) and, as such, our operations are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). See “Supervision and Regulation” below in this Report. For ease of reference, we will sometimes use the terms “Company,” “we” or “us” in this Report to refer to Pacific Mercantile Bancorp on a consolidated basis and “PM Bancorp” or the “Bancorp” to refer to Pacific Mercantile Bancorp on a “stand-alone” or unconsolidated basis.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (commonly known as the “FDIC”).
At December 31, 2011, our total assets, net loans (which exclude loans held for sale) and total deposits were $1.025 billion, $641 million and $862 million, respectively. Additionally, as of that date a total of approximately 8,200 deposit accounts were being maintained at the Bank by our customers, of which approximately 34% were business customers. Currently we operate seven full service commercial banking offices (which we refer to as “financial centers”) and an online banking branch at www.pmbank.com. Due to the Bank’s online presence, the Bank has customers who are located in 49 states and the District of Columbia, although the vast majority of our customers are located in Southern California.
The Bank commenced business in March 1999, with the opening of its first financial center, located in Newport Beach, California, and in April 1999 it launched its online banking site, at www.pmbank.com, where our customers are able to conduct many of their business and personal banking transactions, more conveniently and less expensively, with us, 24 hours a day, 7 days a week. Between August 1999 and July 2005, we opened six additional financial centers as part of an expansion of our banking franchise into Los Angeles, San Diego and San Bernardino counties in Southern California. Set forth below is information regarding our current financial centers.
According to data published by the FDIC, at December 31, 2011 there were approximately 124 commercial banks operating with banking offices located in the counties of Los Angeles, Orange, San Diego, Riverside and San Bernardino in Southern California. Of those commercial banks, 14 had assets in excess of $2 billion; 91 had assets under $500 million (which are often referred to as “community banks”); 11 had assets between $500 million and $1 billion, and 8, including our Bank, had assets ranging between $1 billion and $2 billion. As a result, we believe that we are well-positioned to achieve further growth in Southern California.
Our Business Strategy
Our growth and expansion are the result of our adherence to a business plan which was created by our founders, who include both experienced banking professionals and individuals who came out of the computer industry. That business plan is to build and grow a banking organization that offers its customers the best attributes of a community bank, which are personalized and responsive service, while taking advantage of advances in computer technology to reduce costs and at the same time extend the geographic coverage of our banking franchise, initially within Southern California, by opening additional financial centers and benefiting from opportunities that may arise in the future to acquire other banks.
In furtherance of that strategy:
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We offer at our financial centers and at our interactive online banking website, a broad selection of financial products and services that address, in particular, the banking needs of business customers and professional firms, including services that are typically available only from larger banks in our market areas.
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We provide a level of convenience and access to banking services that we believe are not typically available from the community banks with which we compete, made possible by the combination of our full service financial centers and the online banking capabilities coupled with personal services we offer our customers.
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We have built a technology and systems infrastructure that we believe will support the growth and further expansion of our banking franchise in Southern California.
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We continue to review and analyze additional opportunities to further enhance our profitability including a return in 2009 to business of originating single family mortgage loans that qualify for resale into the secondary mortgage market.
We plan to continue to focus our services and offer products primarily to small to mid-size businesses in order to achieve internal growth of our banking franchise. We believe this focus will enable us to grow our loans and other earning assets and increase our core deposits (consisting of non-interest bearing demand, and lower cost savings and money market deposits), with the goal of increasing our net interest margins and improving our profitability. We also believe that, with our technology systems in place, we have the capability to significantly increase the volume of banking transactions without having to incur the cost or disruption of a major computer enhancement program.
Our Commercial Banking Operations
We seek to meet the banking needs of small and moderate size businesses, professional firms and individuals by providing our customers with:
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A broad range of loan and deposit products and banking and financial services, more typical of larger banks, in order to gain a competitive advantage over independent or community banks that do not provide the same range or breadth of services that we are able to provide to our customers;
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A high level of personal service and responsiveness, more typical of independent and community banks, which we believe gives us a competitive advantage over large out-of-state and other large multi-regional banks that are unable, or unwilling, due to the expense involved, to provide that same level of personal service to this segment of the banking market; and
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The added flexibility, convenience and efficiency of conducting banking transactions with us over the Internet, which we believe further differentiates us from many of the community banks with which we compete and enables us to reduce the costs of providing services to our customers.
Deposit Products
Deposits are a bank’s principal source of funds for making loans and acquiring other interest earning assets. Additionally, the interest expense that a bank must incur to attract and maintain deposits has a significant impact on its operating results. A bank’s interest expense, in turn, will be determined in large measure by the types of deposits that it offers to and is able to attract from its customers. Generally, banks seek to attract “core deposits” which consist of demand deposits that bear no interest and low cost interest-bearing checking, savings and money market deposits. By comparison, time deposits (also sometimes referred to as “certificates of deposit”), including those in denominations of $100,000 or more, usually bear much higher interest rates and are more interest-rate sensitive and volatile than core deposits. A bank that is not able to attract significant amounts of core deposits must rely on more expensive time deposits or alternative sources of cash, such as Federal Home Loan Bank borrowings, to fund interest-earning assets, which means that its costs of funds will be higher and, as a result, its net interest margin is likely to be lower than a bank with higher proportion of core deposits. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS - Results of Operations-Net Interest Income.”
The following table sets forth information regarding the composition, by type of deposits, maintained by our customers during the year ended and as of December 31, 2011:
(1) Includes savings accounts and money market accounts. Excludes money market deposits maintained at the Bank by PM Bancorp with an annual average balance of $4.4 million for the year ended and a balance of $3.3 million at December 31, 2011.
(2) Comprised of time certificates of deposit in varying denominations under and over $100,000. Excludes certificates of deposit maintained by PM Bancorp at the Bank with an average balance of $250,000 for the year ended and a balance at December 31, 2011 of $250,000.
Loan Products
We offer our customers a number of different loan products, including commercial loans and credit lines, accounts receivable and inventory financing, SBA guaranteed business loans, commercial real estate, residential mortgage loans, and consumer loans. The following table sets forth the types and the amounts of our loans that were outstanding:
Commercial Loans
The commercial loans we offer generally include short-term secured and unsecured business and commercial loans with maturities ranging from 12 to 24 months, accounts receivable financing for terms of up to 18 months, equipment and automobile term loans and leases which generally amortize over a period of up to 7 years, and SBA guaranteed business loans with terms of up to 10 years. The interest rates on these loans generally are adjustable and usually are indexed to The Wall Street Journal’s prime rate and will vary based on market conditions and commensurate to the credit risk. However, since 2003 it generally has been our practice to establish an interest rate floor on a best effort basis on our commercial loans. In order to mitigate the risk of borrower default, we generally require collateral to support the credit or, in the case of loans made to businesses, personal guarantees from their owners, or both. In addition, all such loans must have well-defined primary and secondary sources of repayment. Generally, lines of credit are granted for no more than a 12-month period.
Commercial loans, including accounts receivable financing, generally are made to businesses that have been in operation for at least three years. To qualify for such loans, prospective borrowers generally must have debt-to-net worth ratios not exceeding 4-to-1, operating cash flow sufficient to demonstrate the ability to pay obligations as they become due, and good payment histories as evidenced by credit reports.
We also offer asset-based lending products, which involve a higher degree of risk because they generally are made to businesses that are growing rapidly, but cannot internally fund their growth without borrowings. These loans are collateralized primarily by the borrower’s accounts receivable and inventory. We control our risk by generally requiring loan-to-value ratios of not more than 80% and by closely and regularly monitoring the amount and value of the collateral in order to maintain that ratio.
Commercial loan growth is important to the growth and profitability of our banking franchise because, although not required to do so, commercial loan borrowers often establish noninterest-bearing (demand) and interest-bearing transaction deposit accounts and banking services relationships with us. Those deposit accounts help us to reduce our overall cost of funds and those banking services relationships provide us with a source of non-interest income.
Commercial Real Estate Loans
The majority of our commercial real estate loans are secured by first trust deeds on nonresidential real property. Loans secured by nonresidential real estate often involve loan balances to single borrowers or groups of related borrowers, and generally involve a greater risk of nonpayment than do mortgage loans secured by multi-family dwellings. Payments on these loans depend to a large degree on the results of operations and cash flows of the borrowers, which are generated from a wide variety of businesses and industries. As a result, repayment of these loans can be affected adversely by changes in the economy in general or by the real estate market more specifically. Accordingly, the nature of this type of loan makes it more difficult to monitor and evaluate. Consequently, we typically require personal guarantees from the owners of the businesses to which we make such loans.
Customers desiring to obtain commercial real estate loans are required to have good payment records with a debt coverage ratio generally of at least 1.25 to 1. In addition, we require adequate insurance on the properties securing those loans to protect the collateral value. These loans are generally adjustable rate loans with interest rates tied to a variety of independent indexes. However, in some instances, the interest rates on these loans are fixed for an initial five year period and then adjust thereafter based on an applicable index. These loans are generally written for terms of up to 10 years, with loan-to-value ratios of not more than 75% in the case of owner occupied properties and 65% on non-owner occupied properties.
Residential Mortgage Loans - Multi-family
We make multi-family residential mortgage loans primarily in Southern California for terms up to 30 years. These loans generally are adjustable rate loans with interest rates tied to a variety of independent indexes; although in some cases these loans have fixed interest rates for an initial five-year period and adjust thereafter based on an applicable index. These loans generally have interest rate floors, payment caps, and prepayment penalties. The loans are underwritten based on a variety of borrower and property criteria. Borrower criteria include liquidity and cash flow analysis and credit history verifications. Property criteria generally include loan to value limits under 75% and debt coverage ratios of 1.20 to 1 or greater.
Residential Mortgage Loans - Single-family
During the second quarter of 2009, we commenced a new mortgage banking business to originate residential real estate mortgage loans. Residential mortgage loans consist of loans secured by single-family residential properties. The majority of loans are held for sale to third-party investors into the secondary mortgage markets; however, a percentage of adjustable rate mortgage loans are held for investment.
We offer a variety of loan products catering to the specific needs of borrowers, including fixed rate and adjustable rate, conventional and government insured (Federal Housing Administration (FHA) and Veteran Affairs (VA)) mortgages with either 30-year or 15-year terms. We also offer jumbo loans that meet conventional underwriting criteria except that the loan amount exceeds Fannie Mae or Freddie Mac limits.
Mortgage loans originated by the Bank are generally secured by a first lien on the underlying property. The Bank does not originate loans defined as high cost by state or federal regulators or that do not comply with applicable agency or investor-specific underwriting guidelines. The majority of residential mortgage loans originated by the Bank have been made to finance the purchase of, or the refinance of existing loans on, owner-occupied homes, with a smaller percentage used to finance non-owner occupied homes. The majority of the Bank’s loan originations are collateralized by real properties located in Southern California; however the Bank originates loans throughout California and in 17 states. The mortgage lending business is subject to seasonality, and the overall demand for mortgage loans is driven largely by the applicable interest rates at any given time.
The Bank handles loan processing, underwriting and closings at its headquarters in Costa Mesa. The Bank sells a majority of the mortgage loans it originates to various investors in the secondary market and does not service these loans after sale of the loans. Loans sold are subject to certain indemnification provisions with investors, including the repurchase of loans sold and the repayment of sales proceeds to investors under certain conditions. In addition, if a customer defaults on a mortgage payment shortly after the loan is originated, the purchaser of the loan may require us to repurchase the loan at the full amount paid by the purchaser. Mortgage loans held for investment are serviced by the Bank.
The Bank has grown its residential mortgage business from originating approximately $217 million in loans in 2010 with approximately 94 employees at December 31, 2010, to originating approximately $370 million in loans in 2011 with approximately 212 employees at December 31, 2011.
Real Estate Construction and Land Development Loans
To reduce our exposure to the deteriorating conditions in the real estate markets, in the fourth quarter of 2007, we began reducing the volume of single family residential and real estate construction loans that we were making, while at the same time increasing our commercial and business lending. Moreover, in 2009 we essentially ceased all real estate construction lending.
Consumer Loans
We offer a variety of loan and credit products to consumers including personal installment loans, lines of credit, credit cards, and to high net-worth individuals for estate planning based upon cash surrender value life insurance. We design these products to meet the needs of our customers, and some are made at fixed rates of interest and others at adjustable rates of
interest. Consumer loans often entail greater risk than real estate mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles, that may not provide an adequate source of repayment in the event of a default by the consumer. Consumer loan collections are dependent on the borrower’s ongoing financial stability. Furthermore, in the event a consumer files for bankruptcy protection, the bankruptcy and insolvency laws may limit the amount which can be recovered on such loans. To qualify for a consumer loan a prospective borrower must have a good payment record and, typically, debt ratios of not more than 45%.
Consumer loans and credit products are important because consumers are a source of noninterest-bearing checking accounts and low cost savings deposits. Additionally, banking relationships with consumers tend to be stable and longer lasting than banking relationships with businesses, which tend to be more sensitive to price competition.
Business Banking Services
We offer various banking and financial services designed primarily for our business banking customers. Those services include:
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Financial management tools and services that include multiple account control, account analysis, transaction security and verification, wire transfers, bill payment, payroll and lock box services, most of which are available at our Internet website, www.pmbank.com; and
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Automated clearinghouse (ACH) origination services which enable businesses that charge for their services or products on a recurring monthly or other periodic basis, to obtain payment from their customers through an automatic, pre-authorized debit from their customers’ bank accounts anywhere in the United States.
Convenience Banking Services
We also offer a number of services and products that make it more convenient to conduct banking transactions with us, such as online banking services, ATMs, night drop services, courier and armored car services that enable our business customers to order and receive cash without having to travel to our banking offices, and Remote Deposit Capture (PMB Xpress Deposit) which enables business customers to image checks they receive for electronic deposit at the Bank, thereby eliminating the need for customers to travel to our offices to deposit checks into their accounts.
Online Banking Services
Our customers can securely access our online bank at www.pmbank.com to:
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Use financial cash management tools and services
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View account balances and account history
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Transfer funds between accounts
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Pay bills and order wire transfers of funds
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Transfer funds from credit lines to deposit accounts
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Make loan payments
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Print bank statements
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Place stop payments
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Purchase certificates of deposit
Security Measures
Our ability to provide customers with secure and uninterrupted financial services is of paramount importance to our business. We believe our computer banking systems, services and software meet the highest standards of bank and electronic systems security. The following are among the security measures that we have implemented:
Bank-Wide Security Measures
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Service Continuity. In order to better ensure continuity of service, we have located our critical servers and telecommunications systems at an offsite hardened and secure data center. This center provides the physical environment necessary to keep servers up and running 24 hours a day, 7 days a week. This data center has raised floors, temperature control systems with separate cooling zones, seismically braced racks, and generators to keep the system operating during power outages and has been designed to withstand fires and major earthquakes. The center also has a wide range of physical security features, including smoke detection and fire suppression
systems, motion sensors, and 24x7 secured access, as well as video camera surveillance and security breach alarms. The center is connected to the Internet by redundant high speed data circuits with advanced capacity monitoring.
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Physical Security. All servers and network computers reside in secure facilities. Only employees with proper identification may enter the primary server areas.
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Monitoring. All customer transactions on our online servers and internal computer systems produce one or more entries into transactional logs. Our personnel routinely review these logs as a means of identifying and taking appropriate action with respect to any abnormal or unusual activity. We believe that, ultimately, vigilant monitoring is the best defense against fraud.
Internet Security Measures
We maintain electronic and procedural safeguards that comply with federal regulations to guard nonpublic personal information. We regularly assess and update our systems to improve our technology for protecting information. On our website, the security measures include:
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Secure Sockets Layer (SSL) protocol,
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Digital certificates,
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Multi-factor authentication (MFA),
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Intrusion detection/prevention systems, and
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Firewall protection.
We believe the risk of fraud presented by online banking is not materially different from the risk of fraud inherent in any banking relationship. Potential security breaches can arise from any of the following circumstances:
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misappropriation of a customer’s account number or password;
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compromise of the customer’s computer system;
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penetration of our servers by an outside “hacker;”
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fraud committed by a new customer in completing his or her loan application or opening a deposit account with us; and
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fraud committed by employees or service providers.
Both traditional banks and internet banks are vulnerable to these types of fraud. By establishing the security measures described above, we believe we can minimize, to the extent practicable, our vulnerability to the first three types of fraud. To counteract fraud by employees and service providers, we have established internal procedures and policies designed to ensure that, as in any bank, proper control and supervision is exercised over employees and service providers. We also maintain insurance to protect us from losses due to fraud committed by employees or through breaches in our cyber security.
Additionally, the adequacy of our security measures is reviewed periodically by the Federal Reserve Board and the California Department of Financial Institutions (“DFI”), which are the federal and state government agencies, respectively, with supervisory authority over the Bank. We also retain the services of third party computer security firms to conduct periodic tests of our computer and online banking systems to identify potential threats to the security of our systems and to recommend additional actions that we can take to improve our security measures.
Competition
Competitive Conditions in the Traditional Banking Environment
The banking business in California generally, and in our service area in particular, is highly competitive and is dominated by a relatively small number of large multi-state and California-based banks that have numerous banking offices operating over wide geographic areas. We compete for deposits and loans with those banks, with community banks that are based or have branch offices in our market areas, and with savings banks (also sometimes referred to as “thrifts”), credit unions, money market and other mutual funds, stock brokerage firms, insurance companies, and other traditional and nontraditional financial service organizations. We also compete for customers’ funds with governmental and private entities issuing debt or equity securities or other forms of investments which may offer different and potentially higher yields than those available through bank deposits.
Major financial institutions that operate throughout California and that have offices in our service areas include Bank of America, Wells Fargo Bank, Jpmorgan Chase, Union Bank of California, Bank of the West, U. S. Bancorp, Comerica Bank and Citibank. Larger independent banks and other financial institutions with offices in our service areas include, among others, OneWest Bank, City National Bank, Citizens Business Bank, Manufacturers Bank, and California Bank and Trust.
These banks, as well many other financial institutions in our service areas, have the financial capability to conduct extensive advertising campaigns and to shift their resources to regions or activities of greater potential profitability. Many of them also offer diversified financial services which we do not presently offer directly. The larger banks and financial institutions also have substantially more capital and higher lending limits than our Bank.
In order to compete with the banks and other financial institutions operating in our service areas, we rely on our ability to provide flexible, more convenient and more personalized service to customers, including online banking services and financial tools. At the same time, we:
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emphasize personal contacts with existing and potential new customers by our directors, officers and other employees;
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develop and participate in local promotional activities; and
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seek to develop specialized or streamlined services for customers.
To the extent customers desire loans in excess of our lending limits or services not offered by us, we attempt to assist them in obtaining such loans or other services through participations with other banks or assistance from our correspondent banks or third party vendors.
Competitive Conditions in Online Banking
There are a number of banks that offer services exclusively over the internet, such as E*TRADE Bank, and other banks, such as Bank of America and Wells Fargo Bank, that market their internet banking services to their customers nationwide. We believe that only the larger of the commercial banks with which we compete offer the comprehensive set of online banking tools and services that we offer to our customers. However, an increasing number of community banks offer internet banking services to their customers by relying on third party vendors to provide the functionality they need to provide such services. Additionally, many of the larger banks have greater market presence and greater financial resources to market their internet banking services than do we. Moreover, new competitors and competitive factors are likely to emerge, particularly in view of the rapid development of internet commerce. On the other hand, there have been some recently published reports indicating that the actual rate of growth in the use of the internet banking services by consumers and businesses is lower than had been previously predicted and that many customers still prefer to be able to conduct at least some of their banking transactions at local banking offices. We believe that these findings support our strategic decision, made at the outset of our business, to offer customers the benefits of both traditional and online banking services. We also believe that this strategy has been an important factor in our growth to date and will contribute to our growth in the future. See “BUSINESS - Our Business Strategy” earlier in this Section of this Report.
Impact of Economic Conditions, Government Policies and Legislation on our Business
Government Monetary Policies. Our profitability, like that of most financial institutions, is affected to a significant extent by our net interest income, which is the difference between the interest income we generate on interest-earning assets, such as loans and investment securities, and the interest we pay on deposits and other interest-bearing liabilities, such as borrowings. Our interest income and interest expense, and hence our net interest income, depends to a great extent on prevailing market rates of interest, which are highly sensitive to many factors that are beyond our control, including inflation, recession and unemployment. Moreover, it is often difficult to predict, with any assurance, how changes in economic conditions of this nature will affect our future financial performance.
Our net interest income and operating results also are affected by monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies to curb inflation, or to stimulate borrowing and spending in response to economic downturns, through its open-market operations by adjusting the required level of reserves that banks and other depository institutions must maintain, and by varying the target federal funds and discount rates on borrowings by banks and other depository institutions. These actions affect the growth of bank loans, investments and deposits and the interest earned on interest-earning assets and paid on interest-bearing liabilities. The nature and impact of any future changes in monetary and fiscal policies on us cannot be predicted with any assurance.
Legislation Generally. From time to time, federal and state legislation is enacted which can affect our operations and our operating results by materially increasing the costs of doing business, limiting or expanding the activities in which banks and other financial institutions may engage, or altering the competitive balance between banks and other financial services providers.
Economic Conditions and Recent Legislation and Other Government Actions.
The recent economic recession, which is reported to have begun at the end of 2007, created wide ranging consequences and difficulties for the banking and financial services industry, in particular, and the economy in general. The recession led to significant write-downs of the assets and an erosion of the capital of a large number of banks and other lending and financial institutions which, in turn, significantly and adversely affected the operating results of banking and other financial institutions, many of which reported losses for the three years ended December 31, 2010, and led to steep declines in their stock prices. In addition, bank regulatory agencies have been very aggressive in responding to concerns and trends identified in their bank examinations, which has resulted in the increased issuance of enforcement orders requiring banks to take actions to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns. All of these conditions, moreover, led the U.S. Congress, the U.S. Treasury Department and the federal banking regulators, including the FDIC, to take broad actions, to address systemic risks and volatility in the U.S. banking system.
The Dodd-Frank Act
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act significantly changes federal banking regulation. Among other things, the Dodd-Frank Act created a new Financial Stability Oversight Council to identify systemic risks in the banking and financial system and gives federal regulators new authority to take control of and liquidate banking institutions and other financial firms facing the prospect of imminent failure that would create systemic risks to the U.S. financial system. The Dodd-Frank Act also creates a new independent federal regulator to administer federal consumer protection laws.
The Dodd-Frank Act is expected to have a significant impact on banks and bank holding companies generally and we expect that many of its provisions will impact our business operations as they take effect. However, many aspects of the Dodd-Frank Act are subject to further rulemaking and will take effect over several years, making it difficult to anticipate the overall impact of that Act on the Company and the Bank. Set forth below is a summary description of some of the key provisions of the Dodd-Frank Act that may affect us. The description does not purport to be complete and is qualified in its entirety by reference to the Dodd-Frank Act itself.
Imposition of New Capital Standards on Bank Holding Companies. The Dodd-Frank Act requires the FRB to apply consolidated capital requirements to depository institution holding companies, such as us, that are no less stringent than those currently applied to depository institutions, such as the Bank. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less
than $15 billion in assets. Since our trust preferred securities were issued prior to 2010 and our assets total approximately $1 billion, our trust preferred securities will continue to be included in our Tier 1 capital. The Dodd-Frank Act also requires that capital be increased in times of economic expansion and allowed to decrease in times of economic contraction, consistent with safety and soundness.
Increase in Deposit Insurance and Changes Affecting the FDIC Insurance Fund. The Dodd-Frank Act permanently increased the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, and extended unlimited deposit insurance to non-interest bearing transaction accounts through December 31, 2012. Additionally, the Dodd-Frank Act eliminates the federal statutory prohibition against the payment of interest on business checking accounts, which is likely to increase the competition for and interest that banks pay on such accounts. The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution, which may result in increases in FDIC insurance assessments for many FDIC insured banks. The Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds.
Say-on-Pay and other Executive Compensation Provisions. The Dodd-Frank Act requires publicly traded companies, including those that are depository institutions or bank holding companies, to give their shareholders a non-binding votes (i) on executive compensation and (ii) on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions that will trigger such payments. The SEC has already promulgated its rules for implementing these “say-on-pay” provisions, which required all public companies, other than smaller reporting companies, to give their shareholders the opportunity to vote on executive compensation at their shareholders meetings held in 2011. Smaller reporting Companies will have to begin holding say on pay votes at their first annual shareholders’ meetings held on or after January 21, 2013. The Dodd-Frank Act also directs federal banking regulators to promulgate rules prohibiting the payment of excessive compensation to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, whether or not they are publicly traded.
Limitation on Conversion of Bank Charters. The Dodd-Frank Act prohibits a depository institution from converting from a state to federal charter or vice versa while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state regulatory agency that issued the enforcement action and that agency does not object within 30 days.
Interstate Banking. The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will be able to enter new markets more freely.
Restrictions on Derivative Transactions. Effective 18 months after enactment, the Dodd-Frank Act prohibits state-chartered banks from engaging in derivatives transactions unless the legal lending limits of the state in which the bank is chartered take into consideration credit exposure to derivatives transactions. For this purpose, derivative transactions include any contract, agreement, swap, warrant, note or option that is based in whole or in part on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities securities, currencies, interest or other rates, indices or other assets.
Extension of Limitations on Banking Transactions by Banks with their Affiliates. The Dodd-Frank Act will apply Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transactions that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries will be eliminated. Additionally, the Dodd-Frank Act expands the definition of affiliate for purposes of quantitative and qualitative limitations of Section 23A of the Federal Reserve Act to include mutual funds advised by a depository institution or its affiliates.
Debit Card Fees. The Dodd-Frank Act provides that the amount of any interchange fee charged by a debit card issuer with respect to a debit card transaction must be reasonable and proportional to the cost incurred by the card issuer and requires, the Federal Reserve Board to establish standards for reasonable and proportional fees which may take into account the costs of preventing fraud. As a result, the Federal Reserve Board adopted a rule, effective October 1, 2011, which limits interchange fees on debit card transactions to a maximum of 21 cents per transaction plus 5 basis points of the transaction amount. A debit card issuer may recover an additional one cent per transaction for fraud prevention purposes if the issuer complies with certain fraud-related requirements prescribed by the Federal Reserve Board. Although, as a technical matter, this new limitation applies only to institutions with assets of more than $10 billion, it is expected that many smaller institutions will reduce their interchange fees in order to remain competitive with the larger institutions that are required to comply with this new limitation.
Consumer Protection Provisions. The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act also (i), authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay and (ii) will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
Supervision and Regulation
Both federal and state laws extensively regulate bank holding companies and banks. Such regulation is intended primarily for the protection of depositors and the FDIC’s deposit insurance fund and is not for the benefit of shareholders. Set forth below is a summary description of the material laws and regulations that affect or bear on our operations. The description does not purport to be complete and is qualified in its entirety by reference to the laws and regulations that are summarized below.
Pacific Mercantile Bancorp
General. Pacific Mercantile Bancorp is a registered bank holding company subject to regulation under the Bank Holding Company Act of 1956, as amended. Pursuant to that Act, we are subject to supervision and periodic examination by, and are required to file periodic reports with, the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or the “FRB”).
As a bank holding company, we are allowed to engage, directly or indirectly, only in banking and other activities that the Federal Reserve Board deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Business activities designated by the Federal Reserve Board to be closely related to banking include securities brokerage services and products and data processing services, among others.
As a bank holding company, we also are required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities, or of substantially all of the assets, by merger or purchases of (i) any bank or other bank holding company and (ii) any other entities engaged in banking-related businesses or that provide banking-related services.
Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve Board’s policy that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. For that reason, among others, the Federal Reserve Board requires all bank holding companies to maintain capital at or above certain prescribed levels. A bank holding company’s failure to meet these requirements will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board’s regulations or both, which could lead to the imposition of restrictions on the offending bank holding company, including restrictions on its further growth. See the discussion below under the caption “-Capital Standards and Prompt Corrective Action.”
Additionally, among its powers, the Federal Reserve Board may require any bank holding company to terminate an activity or terminate control of, or liquidate or divest itself of, any subsidiary or affiliated company that the Federal Reserve Board determines constitutes a significant risk to the financial safety, soundness or stability of the bank holding company or
any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of a bank holding company’s debt, including authority to impose interest ceilings and reserve requirements on such debt. Subject to certain exceptions, bank holding companies also are required to file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming their common stock or other equity securities. A bank holding company and its non-banking subsidiaries also are prohibited from implementing so-called tying arrangements whereby customers may be required to use or purchase services or products from the bank holding company or any of its non-bank subsidiaries in order to obtain a loan or other services from any of the holding company’s subsidiary banks.
The Company also is a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, we are subject to examination by, and may be required to file reports with, the California Department of Financial Institutions.
Financial Services Modernization Legislation. The Financial Services Modernization Act, which also is known as the Gramm-Leach-Bliley Act, was enacted into law in 1999. The principal objectives of that Act were to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities and investment banking firms, and other financial service providers. Accordingly, the Act revised and expanded the Bank Holding Company Act to permit a bank holding company system, meeting certain specified qualifications, to engage in broader range of financial activities to foster greater competition among financial services companies. To accomplish those objectives, among other things, the Act repealed the two affiliation provisions of the Glass-Steagall Act that had been adopted in the early 1930s during the Depression: Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms “engaged principally” in specified securities activities; and Section 32, which restricted officer, director, or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities. The Financial Services Modernization Act also contains provisions that expressly preempt and make unenforceable any state law restricting the establishment of financial affiliations, primarily related to insurance. That Act also:
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broadened the activities that may be conducted by national banks, bank subsidiaries of bank holding companies, and their financial subsidiaries;
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provided an enhanced framework for protecting the privacy of consumer information;
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adopted a number of provisions related to the capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system;
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modified the laws governing the implementation of the Community Reinvestment Act (which is described in greater detail below); and
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addressed a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of banking institutions.
Before a bank holding company may engage in any of the financial activities authorized by that Act, it must file an application with its Federal Reserve Bank that confirms that it meets certain qualitative eligibility requirements established by the FRB. A bank holding company that meets those qualifications and files such an application will be designated as a “financial holding company”, as a result of which it will become entitled to affiliate with securities firms and insurance companies and engage in other activities, primarily through non-banking subsidiaries, that are financial in nature or are incidental or complementary to activities that are financial in nature. According to current Federal Reserve Board regulations, activities that are financial in nature and may be engaged in by financial holding companies, through their non-bank subsidiaries, include:
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securities underwriting; dealing and market making;
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sponsoring mutual funds and investment companies;
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engaging in insurance underwriting and brokerage; and
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engaging in merchant banking activities.
A bank holding company that does not qualify as a financial holding company may not engage in such financial activities. Instead, as discussed above, it is limited to engaging in banking and such other activities that have been determined by the Federal Reserve Board to be closely related to banking.
We have no current plans to engage in any activities not permitted to traditional bank holding companies, including those expressly permitted by the Financial Services Modernization Act and we are not a financial holding company.
Privacy Provisions of the Financial Services Modernization Act. As required by the Financial Services Modernization Act, federal banking regulators have adopted rules that limit the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. Pursuant to the rules, financial institutions must provide:
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initial notices to customers about their privacy policies, describing the conditions under which banks and other financial institutions may disclose non-public personal information about their customers to non-affiliated third parties and affiliates;
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annual notices of their privacy policies to current customers; and
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a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.
The Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (i) established requirements with respect to oversight and supervision of public accounting firms, and (ii) required the implementation of measures designed to improve corporate governance of companies with securities registered under the Securities and Exchange Act of 1934, as amended (“public companies”) and which, therefore, apply to us. Among other things, the Sarbanes-Oxley Act:
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Provided for the establishment of a five-member oversight board, known as the Public Company Accounting Oversight Board (the “PCAOB”), which is appointed by the Securities and Exchange Commission and that is empowered to set standards for and has investigative and disciplinary authority over accounting firms that audit the financial statements of public companies.
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Prohibits public accounting firms from providing various types of consulting services to their public company clients and requires accounting firms to rotate partners among public company clients every five years in order to assure that public accountants maintain their independence from managements of the companies whose financial statements they audit.
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Increased the criminal penalties for financial crimes and securities fraud.
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Requires public companies to implement disclosure controls and procedures designed to assure that material information regarding their business and financial performance is included in the public reports they file under the Securities and Exchange Act of 1934 (“Exchange Act Reports”).
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Requires the chief executive and chief financial officers of public companies to certify as to the accuracy and completeness of the Exchange Act Reports that their companies file, the financial statements included in those Reports and the effectiveness of their disclosure procedures and controls.
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Requires, pursuant to Section 404 of the Act, that (i) the chief executive and chief financial officer of a public company to test and certify to the effectiveness of their company’s internal control over financial reporting, and (ii) a public company’s outside auditors to independently test and issue a report as to whether the company’s internal control over its financial reporting is effective and whether there are any material weaknesses or significant deficiencies in those financial controls.
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Requires a majority of the directors of public company to be independent of the company’s management and that the directors that serve on a public company’s audit committee meet standards of independence that are more stringent than those that apply to non-management directors generally.
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Requires public companies whose publicly traded securities have a value in excess of $75 million to file their Exchange Act Reports on a more accelerated basis than had been required prior to the adoption of the Sarbanes-Oxley Act.
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Requires more expeditious reporting by directors and officers and other public company insiders regarding their trading in company securities.
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Established statutory separations between investment banking firms and financial analysts.
We have taken the actions required by, and we believe we are in compliance with the provisions of the Sarbanes-Oxley Act that are applicable to us. Among other things, we have implemented disclosure controls and procedures and taken other actions to meet the expanded disclosure requirements and certification requirements of the Sarbanes-Oxley Act, such as testing our internal control over financial reporting. We also have determined that eight of our nine directors meet the independence requirements of, and that all members of our audit committee meet the more stringent standards of independence applicable to audit committee membership pursuant to, the Sarbanes-Oxley Act.
In January 2010, we determined that it was necessary to increase the allowance for loan losses and, therefore, restate our previously issued unaudited consolidated financial statements as of and for the three and nine months ended September 30, 2009 based on a determination that greater weight should have been given to qualitative reserve factors in determining the allowance for loan losses at September 30, 2009. As a result, we reassessed, and identified a material weakness in the Company’s disclosure controls and in its internal control over financial reporting as of September 30, 2009. To remediate that material weakness, management modified its policies and procedures for assessing the adequacy of the Company’s allowance for loan losses to give greater weight to the impact that qualitative factors can reasonably be expected to have on the performance and collectability of loans in the loan portfolio. As a result of these actions, management concluded that this material weakness had been satisfactorily remediated as of June 30, 2010 and management has determined that there has been no recurrence of that or any other material weakness in our disclosure controls or internal control over financial reporting since then. See Item 9A in Part II of this Report regarding our disclosure controls and internal control over financial reporting as of December 31, 2011.
Pacific Mercantile Bank
General. Pacific Mercantile Bank (the “Bank”) is subject to primary supervision, periodic examination and regulation by (i) the Federal Reserve Board, which is its primary federal banking regulator, because the Bank is a member of the Federal Reserve Bank of San Francisco and (ii) the DFI, because the Bank is a California state chartered bank. The Bank also is subject to certain of the regulations promulgated by the FDIC, because its deposits are insured by the FDIC.
Various requirements and restrictions under the Federal and California banking laws affect the operations of the Bank. These laws and the implementing regulations, which are promulgated by Federal and State regulatory agencies, cover most aspects of a bank’s operations, including the reserves a bank must maintain against deposits and for possible loan losses and other contingencies; the types of deposits it obtains and the interest it is permitted to pay on different types of deposit accounts; the loans and investments that a bank may make; the borrowings that a bank may incur; the number and location of banking offices that a bank may establish; the rate at which it may grow its assets; the acquisition and merger activities of a bank; the amount of dividends that a bank may pay; and the capital requirements that a bank must satisfy, which can determine the extent of supervisory control to which a bank will be subject by its federal and state bank regulators. A more detailed discussion regarding capital requirements that are applicable to us and the Bank is set forth below under the caption “Capital Standards and Prompt Corrective Action.” and “Action by the FRB and DFI.”
Permissible Activities and Subsidiaries. California law permits state chartered commercial banks to engage in any activity permissible for national banks. Those permissible activities include conducting many so-called “closely related to banking” or “nonbanking” activities either directly or through their operating subsidiaries.
Interstate Banking and Branching. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, bank holding companies and banks generally have the ability to acquire or merge with banks in other states; and, subject to certain state restrictions, banks may also acquire or establish new branches outside their home states. Interstate branches are subject to certain laws of the states in which they are located. The Bank presently does not have any interstate branches.
Federal Home Loan Bank System. The Bank is a member of the Federal Home Loan Bank (“FHLB”) of San Francisco. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region and makes available loans or advances to its member banks. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. As an FHLB member, the Bank is required to own a certain amount of capital stock in the FHLB. At December 31, 2011, the Bank was in compliance with the FHLB’s stock ownership requirement. Historically, the FHLB has paid dividends on its capital stock to its members.
FRB Deposit Reserve Requirements. The Federal Reserve Board requires all federally-insured depository institutions to maintain noninterest bearing reserves at specified levels against their transaction accounts. At December 31, 2011, the Bank was in compliance with these requirements.
If, as a result of an examination of a federally regulated bank, its primary federal bank regulatory agency, such as the Federal Reserve Board, were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations had become unsatisfactory or that the bank or its management was in violation of any law or regulation, that agency has the authority to take a number of different remedial actions as it deems appropriate under the circumstances. These actions include the power to enjoin “unsafe or unsound” banking practices; to require that affirmative action be taken to correct any conditions resulting from any violation or practice; to issue an administrative order that can be judicially enforced; to require the bank to increase its capital; to restrict the bank’s growth; to assess civil monetary penalties against the bank or its officers or directors; to remove officers and directors of the bank; and, if the federal agency concludes that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate a bank’s deposit insurance, which in the case of a California chartered bank would result in revocation of its charter and require it to cease its banking operations. Additionally, under California law the DFI has many of the same remedial powers with respect to the Bank, because it is a California state chartered bank.
Dividends and Other Transfers of Funds. Cash dividends from the Bank constitute the primary source of cash available to PM Bancorp for its operations and to fund any cash dividends that the board of directors might declare in the future. PM Bancorp is a legal entity separate and distinct from the Bank and the Bank is subject to various statutory and regulatory
restrictions on its ability to pay cash dividends to PM Bancorp. Those restrictions would prohibit the Bank, subject to certain limited exceptions, from paying cash dividends in amounts that would cause the Bank to become undercapitalized. Additionally, the Federal Reserve Board and the DFI have the authority to prohibit the Bank from paying dividends, if either of those authorities deems the payment of dividends by the Bank to be an unsafe or unsound practice. See “Action by the FRB and DFI” below and “Dividend Policy-Restrictions on the Payment of Dividends” in Item 5 of this Report.
Additionally, it is FRB policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also an FRB policy that bank holding companies should not maintain dividend levels that undermine their ability to be a source of strength to their banking subsidiaries. Additionally, due to the current financial and economic environment, the FRB has indicated that bank holding companies should carefully review their dividend policies and has discouraged dividend payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
The Federal Reserve Board also has established guidelines with respect to the maintenance of appropriate levels of capital by banks and bank holding companies under its jurisdiction. Compliance with the standards set forth in those guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of federal law could limit the amount of dividends which the Bank or the Company may pay. See “-Capital Standards and Prompt Corrective Action” and “Action by the FRB and DFI” below in this Section of this Report.
Single Borrower Loan Limitations. With certain limited exceptions, the maximum amount of obligations, secured or unsecured, that any borrower (including certain related entities) may owe to a California state bank at any one time may not exceed 25% of the sum of the shareholders’ equity, allowance for loan losses, capital notes and debentures of the bank. Unsecured obligations may not exceed 15% of the sum of the shareholders’ equity, allowance for loan losses, capital notes and debentures of the bank.
Restrictions on Transactions between the Bank and the Company and its other Affiliates. The Bank is subject to restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, the Company or any of its other subsidiaries; the purchase of, or investments in, Company stock or other Company securities and the taking of such securities as collateral for loans; and the purchase of assets from the Company or any of its other subsidiaries. These restrictions prevent the Company and any of its subsidiaries from borrowing from the Bank unless the loans are secured by marketable obligations in designated amounts, and such secured loans and investments by the Bank in the Company or any of its subsidiaries are limited, individually, to 10% of the Bank’s capital and surplus (as defined by federal regulations) and, in the aggregate, for all loans made to and investments made in the Company and its other subsidiaries, to 20% of the Bank’s capital and surplus. California law also imposes restrictions with respect to transactions involving the Company and other persons deemed under that law to control the Bank.
Safety and Soundness Standards
Banking institutions may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices or for violating any law, rule, regulation, or any condition imposed in writing by its primary federal banking regulatory agency or any written agreement with that agency. The federal banking agencies have adopted guidelines designed to identify and address potential safety and soundness concerns that could, if not corrected, lead to deterioration in the quality of a bank’s assets, liquidity or capital. Those guidelines set forth operational and managerial standards relating to such matters as:
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internal controls, information systems and internal audit systems;
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loan documentation;
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credit underwriting;
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asset growth;
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earnings; and
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compensation, fees and benefits.
In addition, federal banking agencies have adopted safety and soundness guidelines with respect to asset quality. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an FDIC-insured depository institution is expected to:
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conduct periodic asset quality reviews to identify problem assets, estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb those estimated losses;
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compare problem asset totals to capital;
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take appropriate corrective action to resolve problem assets;
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consider the size and potential risks of material asset concentrations; and
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provide periodic asset quality reports with adequate information for the bank’s management and the board of directors to assess the level of asset risk.
These guidelines also establish standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.
Capital Standards and Prompt Corrective Action
The Federal Deposit Insurance Act (“FDIA”) provides a framework for regulation of depository institutions and their affiliates, including parent holding companies, by their federal banking regulators. Among other things, it requires the relevant federal banking regulator to take “prompt corrective action” with respect to a depository institution if that institution does not meet certain capital adequacy standards, including requiring the prompt submission of an acceptable capital restoration plan if the depository institution’s bank regulator has concluded that it needs additional capital.
Supervisory actions by a bank’s federal regulator under the prompt corrective action rules generally depend upon an institution’s classification within one of five capital categories, which is determined on the basis of a bank’s total capital ratio, Tier 1 capital ratio and leverage ratio. Tier 1 capital consists principally of common stock and nonredeemable preferred stock, retained earnings and, subject to certain limitations, subordinated long term debentures or notes that meet certain conditions established by the Federal Reserve Board. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS - Capital Resources” in Item 7 in Part II of this Report.
A depository institution’s capital category under the prompt corrective action regulations will depend upon how its capital levels compare with various relevant capital measures and the other factors established by the relevant regulations. Those regulations provide that a bank will be:
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“well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure;
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“adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”;
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“undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%;
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“significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and
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“critically undercapitalized” if its tangible equity is equal to or less than 2.0% of average quarterly tangible assets.
If a bank that is classified as a well-capitalized institution is determined (after notice and opportunity for hearing), by its federal regulatory agency to be in an unsafe or unsound condition or to be engaging in an unsafe or unsound practice, that agency may, under certain circumstances, reclassify the bank as adequately capitalized. If a bank has been classified as adequately capitalized or undercapitalized, its federal regulatory agency may nevertheless require it to comply with bank supervisory provisions and restrictions that would apply to a bank in the next lower capital classification, if that regulatory agency has obtained supervisory information regarding the bank (other than with respect to its capital levels) that raises safety or soundness concerns. However, a significantly undercapitalized bank may not be treated by its regulatory agency as critically undercapitalized.
The FDIA generally prohibits a bank from making any capital distributions (including payments of dividends) or paying any management fee to its parent holding company if the bank would thereafter be “undercapitalized.” “Undercapitalized” banks are subject to growth limitations and are required to submit a capital restoration plan. The federal regulatory agency for such a bank may not accept its capital restoration plan unless it determines, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the bank’s capital. In addition, for a capital restoration plan to be acceptable, the bank’s parent holding company must guarantee that the bank will comply with its capital restoration plan. The bank holding company also is required to provide appropriate assurances of performance. Under such a guarantee and assurance of performance, if the bank fails to comply with its capital restoration plan, the parent holding company may become subject to liability for such failure in an amount up to the lesser of (i) 5.0% of the its bank subsidiary’s total assets at the time it became undercapitalized, and (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all applicable capital standards as of the time it failed to comply with the plan.
If a bank fails to submit an acceptable capital restoration plan, it will be treated as if it is “significantly undercapitalized.” In that event, the bank’s federal regulatory agency may impose a number of additional requirements and restrictions on the bank, including orders or requirements (i) to sell sufficient voting stock to become “adequately capitalized,” (ii) to reduce its total assets, and (iii) cease the receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
The following table sets forth, as of December 31, 2011, the regulatory capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) and compares those capital ratios to the federally established capital requirements that must be met for a bank holding company or a bank to be deemed “adequately capitalized” or “well capitalized” under the prompt corrective action regulations that are described above:
As the above table indicates, at December 31, 2011 the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company (on a consolidated basis) continued to exceed the capital ratios applicable to bank holding companies, under federally mandated capital standards and federally established prompt corrective action regulations.
Basel III Capital Requirements
The current risk-based capital guidelines which apply to the Company and the Bank are based upon the 1988 capital accord of the International Basel Committee on Banking Supervision, a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. A new international accord, referred to as Basel II, which emphasizes internal assessment of credit, market and operational risk; supervisory assessment and market discipline in determining minimum capital requirements, became mandatory for large or “core” international banks outside the U.S. in 2008 (total assets of $250 billion or more or consolidated foreign exposures of $10 billion or more); and optional for other banks. In January 2009, the Basel Committee proposed to reconsider regulatory-capital standards, supervisory and risk-management requirements and additional disclosures in the final new accord in response to recent worldwide developments.
In December 2010 and January 2011, the Basel Committee on Banking Supervision published the final texts of reforms on capital and liquidity generally referred to as “Basel III”. The rules adopted to implement these reforms, which will be phased in over a period of years, set new standards for common equity, tier 1 and total capital, determined on a risk-weighted basis for internationally active banks. However, the Basel III rules are likely to be considered by federal banking regulators in the United States in developing new capital standards and regulations applicable to other banks in the United States. However, until such new standards and regulations are adopted, it will not be possible for us to determine the impact that the Basel III rules might have on the Company and the Bank.
For internationally active banks based in the United States, some of the more significant of the Basel III capital requirements include:
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A minimum ratio of common equity-to-risk weighted assets of 4.5%, plus an additional 2.5% as a capital conservation buffer, by 2019 after a phase-in period;
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A minimum ratio of Tier 1 capital-to-risk weighted assets of 6.0% by 2019 after a phase-in period:
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A minimum ratio of total capital-to-risk weighted assets, plus the additional 2.5% capital conservation buffer, of 10.5% by 2019 after a phase-in period;
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An additional countercyclical capital buffer to be imposed by applicable national banking regulators periodically at their discretion, with advance notice;
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Restrictions on capital distributions and discretionary bonuses applicable when capital ratios fall within the buffer zone;
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A deduction from common equity of deferred tax assets that depend on future profitability to be realized;
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Increased capital requirements for counterparty credit risk relating to OTC derivatives, repos and securities financing activities; and
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A loss-absorbency requirement for capital instruments issued on or after January 13, 2013 (other than common equity) which would require the instrument to be written off or converted to common equity if a trigger event occurs, either pursuant to applicable law or at the direction of the banking regulator.
Basel III also establishes rules with respect to bank liquidity. Those rules include complex criteria establishing (i) a liquidity coverage ratio (LCR) the primary purpose of which is to ensure that banks maintain adequate unencumbered, high quality liquid assets to meet their liquidity needs for 30 days under a severe liquidity stress scenario; and (ii) a net stable funding ratio (NSFR), the primary purpose of which is to promote more medium and long-term funding of assets and activities, using a one-year time horizon.
Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by United States banking regulators, including decisions as to whether and to what extent it will apply to United States banks that are not large, internationally active banks. The foregoing description of Basel III does not purport to be complete and is qualified in its entirety by reference to the text of Basel III itself.
FDIC Deposit Insurance
The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions in order to safeguard the safety and soundness of the banking and savings industries. The FDIC insures customer deposits through the Deposit Insurance Fund (the “DIF”) up to prescribed limits for each depositor. The Dodd-Frank Act increased the maximum deposit insurance amount from $100,000 to $250,000 and extended unlimited deposit insurance coverage to non-interest bearing transaction accounts through December 31, 2012. The DIF is funded primarily by FDIC assessments paid by each DIF member institution. The amount of each DIF member’s assessment is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.50% of estimated insured deposits. The FDIC may increase or decrease the assessment rate
schedule on a semi-annual basis. The Dodd-Frank Act increased the minimum reserve ratio (the ratio of the net worth of the DIF to estimated insured deposits) from 1.15% of estimated deposits to 1.35% of estimated deposits (or a comparable percentage of the asset-based assessment base described above). The Dodd-Frank Act requires the FDIC to offset the effect of the increase in the minimum reserve ratio when setting assessments for insured depository institutions with less than $10 billion in total consolidated assets, such as the Bank. The FDIC has until September 30, 2020 to achieve the new minimum reserve ratio of 1.35%.
Additionally, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. The FICO assessment rates, which are determined quarterly, averaged 0.0925% of insured deposits in fiscal 2011. These assessments will continue until the FICO bonds mature in 2017.
The FDIC may terminate a depository institution’s deposit insurance upon a finding that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices that pose a risk to the DIF or that may prejudice the interest of the bank’s depositors. Pursuant to California law, the termination of a California state chartered bank’s FDIC deposit insurance would result in the revocation of the bank’s charter, forcing it to cease conducting banking operations.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to fair lending requirements and the evaluation of its small business operations under the Community Reinvestment Act (“CRA”). That Act generally requires the federal banking agencies to evaluate the record of a bank in meeting the credit needs of its local communities, including those of low- and moderate-income neighborhoods in its service area. A bank may be subject to substantial penalties and corrective measures for a violation of fair lending laws. Federal banking agencies also may take compliance with fair lending laws into account when regulating and supervising other activities of a bank or its bank holding company.
A bank’s compliance with its CRA obligations is based on a performance-based evaluation system which determines the bank’s CRA ratings on the basis of its community lending and community development performance. When a bank holding company files an application for approval to acquire a bank or another bank holding company, the Federal Reserve Board will review the CRA assessment of each of the subsidiary banks of the applicant bank holding company, and a low CRA rating may be the basis for denying the application.
USA Patriot Act of 2001
In October 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot Act) of 2001 was enacted into law in response to the September 11, 2001 terrorist attacks. The USA Patriot Act was adopted to strengthen the ability of U.S. law enforcement and intelligence agencies to work cohesively to combat terrorism on a variety of fronts.
Of particular relevance to banks and other federally insured depository institutions are the USA Patriot Act’s sweeping anti-money laundering and financial transparency provisions and various related implementing regulations that:
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establish due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts and foreign correspondent accounts;
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prohibits US institutions from providing correspondent accounts to foreign shell banks;
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establish standards for verifying customer identification at account opening;
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set rules to promote cooperation among financial institutions, regulatory agencies and law enforcement entities in identifying parties that may be involved in terrorism or money laundering;
Under implementing regulations issued by the U.S. Treasury Department, banking institutions are required to incorporate a customer identification program into their written money laundering plans that includes procedures for:
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verifying the identity of any person seeking to open an account, to the extent reasonable and practicable;
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maintaining records of the information used to verify the person’s identity; and
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determining whether the person appears on any list of known or suspected terrorists or terrorist organizations.
Consumer Laws
The Company and the Bank are subject to a broad range of federal and state consumer protection laws and regulations prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition. Those laws and regulations include:
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The Home Ownership and Equity Protection Act of 1994, or HOEPA, which requires additional disclosures and consumer protections to borrowers designed to protect them against certain lending practices, such as practices deemed to constitute “predatory lending.”
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Laws and regulations requiring banks to establish privacy policies which limit the disclosure of nonpublic information about consumers to nonaffiliated third parties.
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The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, or the FACT Act, which requires banking institutions and financial services businesses to adopt practices and procedures designed to help deter identity theft, including developing appropriate fraud response programs, and provides consumers with greater control of their credit data.
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The Truth in Lending Act, or TILA, which requires that credit terms be disclosed in a meaningful and consistent way so that consumers may compare credit terms more readily and knowledgeably.
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The Equal Credit Opportunity Act, or ECOA which generally prohibits, in connection with any consumer or business credit transaction, discrimination on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), or the fact that a borrower is receiving income from public assistance programs.
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The Fair Housing Act, which regulates many lending practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status.
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The Home Mortgage Disclosure Act, or HMDA, which includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
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The Real Estate Settlement Procedures Act, or RESPA, which requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits certain abusive practices, such as kickbacks.
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The National Flood Insurance Act, or NFIA, which requires homes in flood-prone areas with mortgages from a federally regulated lender to have flood insurance.
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The Secure and Fair Enforcement for Mortgage Licensing Act of 2008, or SAFE Act, which requires mortgage loan originator employees of federally insured institutions to register with the Nationwide Mortgage Licensing System and Registry, a database created by the states to support the licensing of mortgage loan originators, prior to originating residential mortgage loans.
The Bank Holding Company Act of 1956, as amended, and the Change in Bank Control Act of 1978, as amended, together with regulations of the FRB, require that, depending on the particular circumstances, FRB approval must be obtained
prior to any person or company acquiring “control” of a Federal Reserve member bank, such as the Bank, subject to exemptions for some transactions. Control is conclusively presumed to exist if an individual or company (i) acquires 25% or more of any class of voting securities of the bank or (ii) has the direct or indirect power to direct or cause the direction of the management and policies of the bank, whether through ownership of voting securities, by contract or otherwise; provided that no individual will be deemed to control a bank solely on account of being director, officer or employee of the bank. Control is presumed to exist if a person acquires 10% or more but less than 25% of any class of voting securities of a bank holding company with securities registered under Section 12 of the Exchange Act or if no other person will own a greater percentage of that class of voting securities immediately after the transaction.
Regulation W
The FRB has adopted Regulation W to comprehensively implement sections 23A and 23B of the Federal Reserve Act.
Sections 23A and 23B and Regulation W limit transactions between a bank and its affiliates and limit a bank’s ability to transfer to its affiliates the benefits arising from the bank’s access to insured deposits, the payment system and the discount window and other benefits of the Federal Reserve system. The statute and regulation impose quantitative and qualitative limits on the ability of a bank to extend credit to, or engage in certain other transactions with, an affiliate (and a non-affiliate if an affiliate benefits from the transaction). However, certain transactions that generally do not expose a bank to undue risk or abuse the safety net are exempted from coverage under Regulation W.
Historically, a subsidiary of a bank was not considered an affiliate for purposes of Sections 23A and 23B, since their activities were limited to activities permissible for the bank itself. However, the Gramm-Leach-Bliley Act authorized “financial subsidiaries” that may engage in activities not permissible for a bank. These financial subsidiaries are now considered affiliates. Certain transactions between a financial subsidiary and another affiliate of a bank are also covered by sections 23A and 23B and under Regulation W.
Regulatory Action by the FRB and DFI
As previously reported in a Current Report on Form 8-K dated August 31, 2010 and filed with the SEC on August 31, 2010, the members of the respective Boards of Directors of the Company and the Bank entered into a Written Agreement (the “FRB Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”). On the same date, the Bank consented to the issuance of a Final Order by the DFI (the “DFI Order”). The principal purposes of the Agreement and DFI Order, which constitute formal supervisory actions by the FRB and the DFI, were to require us to adopt and implement formal plans and take certain actions, as well as to continue implementing measures that we previously adopted, to address the adverse consequences that the economic recession had on the performance of our loan portfolio and our operating results and to increase our capital to strengthen our ability to weather any further adverse conditions that might arise if the economic recovery remains weak or economic conditions deteriorate.
The FRB Agreement and DFI Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB and the DFI that addressed the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices and improving credit administration policies and procedures; (iii) improving the Bank’s position with respect to problem assets; (iv) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (v) improving the capital position of the Bank and, in the case of the FRB Agreement, the capital position of the Company; (vi) adopting and implementing a new strategic plan; and (vii) submitting a funding contingency plan for the Bank that identified available sources of liquidity and a plan for dealing with potential adverse economic and market conditions. In addition, the FRB Agreement and the DFI Order placed restrictions on lending by the Bank to borrowers who had loans that were criticized in an joint examination of the Bank conducted by the FRB and DFI in 2010 and required the Bank to charge off or collect loans that were classified as “loss” in that examination (to the extent that the Bank had not already done so). The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and without the prior approval of the FRB the Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt.
The DFI Order also states that if the Bank were to violate or fail to comply with the Order, the Bank could be deemed to be conducting business in an unsafe manner which could subject the Bank to further regulatory enforcement action.
The Company and the Bank already have made substantial progress with respect to most of the requirements of the FRB Agreement and DFI Order and both the Board and management are committed to achieving the remaining requirements on a timely basis.
Under the DFI Order, the Bank was required to achieve a ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0% by January 31, 2011, by raising additional capital, generating earnings or reducing the Bank’s tangible assets (subject to a 15% limitation on such a reduction) or a combination thereof and, upon achieving that ratio, to thereafter maintain that ratio during the Term of the Order.
As previously reported, on August 26, 2011 we completed the sale of a total of $11.2 million of shares of a newly created Series B Convertible 8.4% Noncumulative Preferred Stock (the “Series B Preferred Stock”) to three institutional investors in a private placement. We then contributed the net proceeds from the sale of those shares of Series B Preferred Stock to the Bank to enable it to increase the ratio of its adjusted tangible shareholders’ equity to its tangible assets above 9% and thereby meet the capital requirement under the DFI Order. At December 31, 2012 that ratio had increased to 9.4% primarily as a result of the earnings generated by the Bank during the fourth quarter of 2011.
A copy of the FRB Agreement is attached as Exhibit 10.1, and a copy of the DFI Order is attached as Exhibit 10.2, to the Current Report on Form 8-K dated August 31, 2011. The foregoing summary of the FRB Agreement and the DFI Order is qualified in its entirety by reference to those Exhibits.
Employees
As of December 31, 2011, we employed 346 persons on a full-time equivalent basis. None of our employees are covered by a collective bargaining agreement. We believe relations with our employees are good.
Information Available on our Website
Our Internet address is www.pmbank.com. We make available on our website, free of charge, our filings made with the SEC electronically, including those on Form 10-K, Form 10-Q, and Form 8-K, and any amendments to those filings. Copies of these filings are available as soon as reasonably practicable after we have filed or furnished these documents to the SEC (at www.sec.gov).
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business is subject to a number of risks and uncertainties that could cause our financial condition or operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in the forward looking statements contained in this Report. Set forth below is a summary description of many of those risks and uncertainties.
The United States recently experienced a severe economic recession the effects of which continue to adversely impact the banking and financial services industry in general, and our business and financial performance, in particular, and has created substantial uncertainties and risks for our business and future financial performance.
The United States recently experienced a severe economic recession. The recession created wide-ranging consequences and difficulties which continue to adversely affect the banking and financial services industry, in particular, and the economy, in general, including significant decreases in economic activity and in residential and commercial real estate prices and increases in unemployment, which led to increases in loan delinquencies and foreclosures. Those conditions and circumstances necessitated significant write-downs of the carrying values of assets by, and caused an erosion of the capital of, a large number of lending and other financial institutions. Like many other banks, due primarily to these conditions, we experienced substantial increases in non-performing loans and in loan losses in 2008, 2009 and 2010. Those loan losses required us (and many other banks) to significantly increase loan loss reserves by charges to income. In addition, as the economy contracted, loan demand decreased and net interest margins declined as the Federal Reserve Board reduced interest rates in an effort to stimulate the economy, resulting in decreases in our net interest income. As a result, we incurred net losses of $12.0 million, $17.3 million and $14.0 million in 2008, 2009 and 2010, respectively.
Although, according to economists, the economic recession is over, the economic recovery has been weak, real estate prices continue to decline, unemployment and real estate foreclosures remain high and consumer confidence is at an all time low. As a result, there are concerns that the economy may again fall into recession. Additionally, due to these conditions and the prospect that economic and market conditions will not soon recover, we face a number of risks that could adversely affect our operating results and financial condition in the future, including the following:
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We could experience further increases in non-performing loans and other non-performing assets, consisting primarily of real properties acquired on foreclosure of non-performing loans, that would require us to write down the carrying values of such loans and other non-performing assets and to set aside additional reserves, which could adversely affect our results of operations and cause us to incur operating losses in the future.
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Due to the continuing uncertainties about economic conditions, there is an increased risk that the judgments we might make in estimating loan losses inherent in our loan portfolio and in establishing loan loss reserves will prove to be incorrect, requiring us to set aside additional reserves that would adversely affect our results of operations in 2011 and 2012.
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Possible further declines in economic activity in the United States, generally, and in our markets, in particular, due to weak business and consumer spending and high unemployment, which could lead to:
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reductions in loan demand and a further tightening of credit that would result in declines in interest income and a further compression of our net interest margins that would result in reductions in our net interest income; and
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increases in deposit withdrawals by customers to meet their operating or living expenses or to shift cash into higher yielding financial instruments offered by competing financial services organizations, which could reduce our liquidity and, therefore, the funds we would have available for lending and could cause our interest income to decline, possibly significantly, and our costs of funds to increase, thereby adversely affecting our operating results and financial condition.
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In response to the causes of the credit and foreclosure crises and the economic recession, Congress enacted the Dodd-Frank Act, which will increase the regulation of and impose new restrictions on banks and other financial institutions and could, as a result, increase our costs of doing business and limit our ability to pursue business and growth opportunities.
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We continue to have a substantial dollar amount of non-performing assets, consisting of non-performing loans and real properties that we have acquired by foreclosure during the three years ended December 31, 2011. A failure to meaningfully improve the quality of the loans in our loan portfolio or to sell those real properties without incurring substantial losses could result in further write down in the carrying values of those assets, which could (i) cause us to incur losses in 2012, and (ii) lead to the imposition, by federal and state bank regulators, of additional restrictions on our operations that could adversely affect our operating results and require us to raise additional capital that could dilute our existing shareholders. See “ - Risks and Uncertainties Posed by the FRB Agreement and DFI Order to which we and the Bank are subject” below in this Item 1A.
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We, as well as all other federally insured banks, may be required to pay significantly higher FDIC premiums to replenish the FDIC’s deposit insurance fund, which would increase our operating expenses and, thereby, reduce our income.
The recent downgrade of the U.S. government’s sovereign credit rating by Standard & Poor’s Ratings Services, and any future rating agency action with respect to the U.S. government’s sovereign credit rating, could have a material adverse effect on us. Further, the current debt crisis in Europe, and the risk that certain countries may default on their sovereign debt, and the resulting impact on the financial markets, could have a material adverse effect on our business, results of operations and financial condition.
On August 5, 2011, Standard & Poor’s downgraded the United States long-term debt rating from its AAA rating to AA+. On August 8, 2011, Standard & Poor’s downgraded the credit ratings of certain long-term debt instruments issued by Fannie Mae and Freddie Mac and other U.S. government agencies linked to long-term U.S. debt. These downgrades, any future downgrades, as well as any perceived concerns about the creditworthiness of U.S. government-related obligations, could impact our ability to obtain, and the pricing with respect to, funding that is collateralized by affected instruments and obtained through the secured and unsecured markets. We cannot predict how this or any further downgrades to the U.S. government’s sovereign credit rating, or such concerns about the creditworthiness of U.S. government-related obligations, will impact economic or capital markets conditions generally. It is possible that any such impact could have a material adverse effect on our business, results of operation, and financial position.
In addition, the current crisis in Europe has created uncertainties with respect to the ability of certain European Union countries to continue to service their sovereign debt obligations. These uncertainties have adversely impacted and have created substantial volatility in the financial markets has had, a negative impact on global economic activity. Moreover, concerns have arisen that a failure of the European Union to satisfactorily resolve this debt crisis could lead to a global economic recession which could spread to the United States. As a result, even though neither we nor the Bank hold or have any exposure to any European sovereign debt, if not satisfactorily resolved this debt crisis could have an adverse effect, which could be material, on our business, financial condition and future results of operations.
We could incur losses on the loans we make.
Loan defaults and the incurrence of losses on the loans we make are an inherent risk of the banking business. That risk has been exacerbated by the significant slowdown in the housing markets and significant increases in real estate loan foreclosures in Los Angeles, Orange, Riverside and San Diego counties of California where most of our customers are based. This slowdown is attributable to declining real estate prices, excess inventories of unsold homes, high vacancy rates at commercial properties and increases in unemployment and a resulting loss of confidence about the future among businesses and consumers that have combined to adversely affect business and consumer spending. These conditions led to an increase in our non-performing assets in 2008, 2009 and 2010, which required us to record loan charge-offs and write-downs in the carrying values of real properties that we acquired by or in lieu of foreclosure and caused us to incur losses in that three year period. A further deterioration or even a continuing weakness in economic conditions could result in additional loan charge-offs and asset write-downs that would require us to increase the provisions we make for loan losses and losses on real estate owned that would have a material adverse effect on our future operating results, financial condition and capital.
We may be required to increase our reserve for loan losses which would adversely affect our financial performance in the future.
On a quarterly basis we evaluate and conduct an analysis to estimate the losses inherent in our loan portfolio. However, this evaluation requires us to make a number of estimates and judgments regarding the financial condition of our larger borrowers, the fair value of the properties collateralizing our outstanding loans and economic trends that could affect the ability of our borrowers to meet their payment obligations to us. Based on those estimates and judgments, we make determinations, which are necessarily subjective, with respect to (i) the adequacy of our loan loss reserve to provide for write-downs in the carrying values and charge-offs of loans that may be required in the future and (ii) the need to increase that reserve by means of a charge to income (commonly referred to as the provision for loan losses). If, due to events or circumstances outside of our control or otherwise, those estimates or judgments prove to have been incorrect or the Bank’s regulators come to a different conclusion than us regarding the adequacy of the Bank’s loan loss reserve, we would have to increase the provisions we make for loan losses, which would reduce our income or could cause us to incur operating losses in the future.
Risks and Uncertainties Posed by the FRB Agreement and DFI Order to which we and the Bank are subject.
As previously reported and described in our Current Report on Form 8-K dated August 31, 2010, we entered into a written regulatory agreement (the “FRB Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”), and the Bank consented to the issuance by the DFI of a Final Order (the “DFI Order”), due primarily to the increases in loan losses and other non-performing assets and the net losses we incurred in 2008, 2009 and the first half of 2010. Set forth below is a description of material risks and uncertainties created for us by the FRB Agreement and DFI Order.
We are subject to increased regulatory oversight which increases our costs of doing business and restricts our ability to grow our banking franchise. Under the terms of the FRB Agreement and DFI Order, we and the Bank are required to implement certain corrective and remedial measures within strict time frames and to maintain certain levels of liquidity, loan loss reserves and capital. In addition, we are required to increase management oversight of our operations and are subject to more frequent regulatory examinations. These requirements have had and in the future may have the effect of increasing our expenses and adversely affecting our operating results.
The Bank is restricted from paying dividends to us and we are restricted from paying dividends to our shareholders and from making interest payments on our subordinated debt securities. Dividends from the Bank to us comprise our primary source of funds for paying dividends to our shareholders and paying interest on our junior subordinated debentures (the “Junior Subordinated Debentures”), which we issued in connection with sales of trust preferred securities in 2002 and 2004. Pursuant to the FRB Agreement and DFI Order, the Bank may not pay cash dividends to us without the prior approval of the FRB and DFI and we may not pay cash dividends to our shareholders or interest on the Junior Subordinated Debentures without the prior approval of the FRB. As previously reported, we began to defer interest payments on the Junior Subordinated Debentures in mid-2010, when we were advised by the FRB that it would not approve further interest payments
pending an improvement in our operating results and increases in the Bank’s capital and we cannot predict when the FRB will permit us to resume such payments. We are permitted to defer interest payments on the Junior Subordinated Debentures for up to 20 consecutive quarters; however, if we are not permitted by the FRB to pay the deferred interest and resume making interest payments on a current basis by the end of that five year period, then we would be in default of our obligations under the Junior Subordinated Debentures, in which event the entire $17.5 million principal amount of, and accrued but unpaid interest on, the Junior Subordinated Debentures would become immediately due and payable.
Failure to satisfy the requirements of the FRB Agreement or the DFI Order could subject us to regulatory enforcement actions and additional restrictions on our business. Although we succeeded in satisfying a requirement, under the DFI Order, to increase the Bank’s capital with the net proceeds from the sale of $11.2 million of Series B Preferred Shares in August 2011, we are required to maintain the Bank’s capital ratios and continue to meet other requirements under the DFI Order and the FRB Agreement. There is no assurance that we will be able to do so. If we do not, the FRB and DFI could subject us and the Bank to regulatory enforcement actions, which could include the assessment of civil money penalties on us and the Bank, as well as on our directors, officers and other affiliated parties, and impose further restrictions on our business. Any such regulatory actions would increase our operating costs, restrict our ability to grow, make it more difficult for us to recruit officers and directors in the event the need to do so arises in the future, and could result in decreases in our income or cause us to incur losses in the future.
Liquidity risk could adversely affect our ability to fund operations and hurt our financial condition.
Liquidity is essential to our business, as we use cash to fund loans and investments and other interest-earning assets and deposit withdrawals that occur in the ordinary course of our business. Our principal sources of liquidity include deposits, Federal Home Loan Bank borrowings, sales of loans or investment securities held for sale, repayments to the Bank of loans it makes to borrowers and sales of equity securities by us. If our ability to obtain funds from these sources becomes limited or the costs to us of those funds increases, whether due to factors that affect us specifically, including our financial performance or the imposition of regulatory restrictions on us, or due to factors that affect the financial services industry in general, including weakening economic conditions or negative views and expectations about the prospects for the financial services industry as a whole, then, our ability to grow our banking business would be adversely affected and our financial condition and results of operations could be harmed.
We face intense competition from other banks and financial institutions that could hurt our business.
We conduct our business operations in Southern California, where the banking business is highly competitive and is dominated by large multi-state and in-state banks with operations and offices covering wide geographic areas. We also compete with other financial service businesses, mutual fund companies, and securities brokerage and investment banking firms that offer competitive banking and financial products and services as well as products and services that we do not offer. The larger banks and many of those other financial institutions have greater financial and other resources that enable them to conduct extensive advertising campaigns and to shift resources to regions or activities of greater potential profitability. They also have substantially more capital and higher lending limits than we do, which enable them to attract larger customers and offer financial products and services that we are unable to offer, putting us at a disadvantage in competing with them for loans and deposits. Increased competition may prevent us (i) from achieving increases, or could even result in decreases, in our loan volume or deposit balances, or (ii) from increasing interest rates on the loans we make or reducing the interest rates we pay to attract or retain deposits, either or both of which could cause a decline in our interest income or an increase in our interest expense and, therefore, lead to reductions in our net interest income and earnings.
Adverse changes in economic conditions in Southern California could disproportionately harm our business.
The substantial majority of our customers and the properties securing a large proportion of our loans are located in Southern California, where foreclosure rates and unemployment have remained high relative to most other regions of the country. A downturn in economic conditions or the occurrence of natural disasters, such as earthquakes or fires, which are more common in Southern California than in other parts of the country, could harm our business by:
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reducing loan demand which, in turn, would lead to reduced net interest margins and net interest income;
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adversely affecting the financial capability of borrowers to meet their loan obligations to us, which could result in increases in loan losses and require us to make additional provisions for possible loan losses, thereby adversely affecting our operating results or causing us to incur losses, as occurred in 2008, 2009 and 2010; and
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causing reductions in real property values that, due to our reliance on real property to collateralize many of our loans, could make it more difficult for us to prevent losses from being incurred on non-performing loans through the foreclosure and sale of such real properties.
Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
A substantial portion of our income is derived from the differential or “spread” between the interest we earn on loans, securities and other interest-earning assets, and the interest we pay on deposits, borrowings and other interest-bearing liabilities. Due to the differences in the maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and, in turn, our profitability. In addition, as a general rule, loan origination volumes are affected by market interest rates. Rising interest rates, generally, are associated with a lower volume of loan originations while lower interest rates are usually associated with higher loan originations. Conversely, in rising interest rate environments, loan repayment rates may decline and in falling interest rate environments, loan repayment rates may increase. Also, in a rising interest rate environment, we may need to accelerate the pace of rate increases on our deposit accounts as compared to the pace of future increases in short-term market rates. Accordingly, changes in market interest rates could materially and adversely affect our net interest spread, asset quality and loan origination volume.
However, in the current economic environment, loan demand has been relatively weak despite the fact that interest rates are relatively low, due largely to the financial difficulties encountered by prospective borrowers as a result of the economic recession and the weakness of the hoped for economic recovery, the unwillingness of businesses and consumers to borrow due to uncertainties and a lack of confidence about future economic conditions and a tightening of loan underwriting standards by us, as well as other banks and lending institutions, in response to these conditions. As a result, it has become more difficult to predict the impact that changes in interest rates will have on interest rate spreads and on the future financial performance of banks, including our Bank, which has added to the volatility of and adversely affected the stock prices of many banking institutions, including our own. It is also not possible to predict how long these conditions will continue to affect us.
Government regulations may impair our operations, restrict our growth or increase our operating costs.
We are subject to extensive supervision and regulation by federal and state bank regulatory agencies. The primary objective of these agencies is to protect bank depositors and other customers and not shareholders, whose respective interests often differ. The regulatory agencies have the legal authority to impose restrictions which they believe are needed to protect depositors and customers of banking institutions, even if those restrictions would adversely affect the ability of the banking institution to expand its business or pay cash dividends, or result in increases in its costs of doing business or hinder its ability to compete with less regulated financial services companies. Additionally, due to the complex and technical nature of many of the government regulations to which banking organizations are subject, inadvertent violations of those regulations may and sometimes do occur. In such an event, we would be required to correct or implement measures to prevent a recurrence of such violations. If more serious violations were to occur, the regulatory agencies could limit our activities or growth, fine us or ultimately put us out of business in the event we were to encounter severe liquidity problems or a significant erosion of our capital below the minimum amounts required under applicable bank regulatory guidelines.
The enactment of the Dodd-Frank Act poses uncertainties for our business and is likely to increase our costs of doing business in the future.
On July 21, 2010, the President signed the Dodd-Frank Act into law. Changes made by the Dodd-Frank Act include, among others: (i) new requirements on banking, derivative and investment activities, including modified capital requirements, the repeal of the prohibition on the payment of interest on business demand accounts, and limitations on debit card interchange fees; (ii) enhanced financial institution safety and soundness regulations and increases in assessment fees and deposit insurance coverage; (iii) corporate governance and executive compensation requirements; and (iv) the establishment of new regulatory bodies, such as the Bureau of Consumer Financial Protection (the “BCFP”). The BCFP has been granted rulemaking authority over several federal consumer financial protection laws and, in some instances, has the authority to examine and enforce compliance by banks and other financial service organizations with these laws and regulations. Certain provisions of the Dodd-Frank Act were made effective immediately; however, much of the Dodd-Frank Act is subject to further rulemaking and/or studies. As a result, we cannot fully assess the impact that the Dodd-Frank Act will have on us until final rules are adopted and implemented, which could be up to 24 months from the enactment of the Dodd-Frank Act, or possibly even later.
We expect that the provisions of the Dodd-Frank Act repealing the prohibition on the payment by banks of interest on business demand deposits will result in price competition among banks for such deposits, which could increase the costs of funds to us (as well as to other banks) and result in a reduction in our net interest income in the future. However, we do not have sufficient information, as yet, to make any reliable predictions as to the impact that these provisions will have on our results of operations and financial performance in the future. See “BUSINESS - Economic Conditions and Recent Legislation and Other Government Actions - The Dodd-Frank Act” in Item 1 of this Report.
The Dodd-Frank Act also permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and permits state attorneys general to, in certain circumstances, enforce compliance with both the state and federal laws and regulations. We cannot predict whether California state agencies will adopt consumer protection laws and standards that are more stringent than those adopted at the federal level or, if any are adopted, what impact they may have on us, our business or operating results.
Premiums for federal deposit insurance have increased and may increase even more.
The FDIC uses the Deposit Insurance Fund (the “DIF”) to cover insured deposits in the event of bank failures, and maintains the DIF by assessing insurance premiums on FDIC-insured banks and depository institutions. The increase in bank failures during the three years ended December 31, 2010 caused the DIF to fall below the minimum balance required by law, forcing the FDIC to raise the insurance premiums assessed on FDIC-insured banks in order to rebuild the DIF. Depending on the frequency and severity of bank failures in the future, the FDIC may further increase premiums or assessments, which would increase our costs of business and could negatively affect our earnings and financial performance in the future.
The loss of key personnel could hurt our financial performance.
Our success depends to a great extent on the continued availability of our existing management and, in particular, on Raymond E. Dellerba, our President and Chief Executive Officer. In addition to their skills and experience as bankers, our executive officers provide us with extensive community ties upon which our competitive strategy is partially based. As a result, the loss of the services of any of these officers could harm our ability to implement our business strategy or our future operating results.
Risks posed by our residential mortgage lending business.
Our residential mortgage lending business, pursuant to which we originate and purchase residential real estate mortgage loans that qualify for resale into the secondary mortgage market, poses a number of potentially significant risks that could adversely affect our business and future financial performance.
Those risks include, among others: the risk that the growth of our mortgage lending business will strain our cash and management resources; the risk that management’s time and efforts will be diverted from our commercial banking business, which could hurt our operating results; the risk that our mortgage lending business will not generate revenues in amounts sufficient to enable us to recover the substantial expenditures we have made to add experienced mortgage loan officers and administrators; the risk that our residential mortgage lending business will not grow sufficiently to contribute to earnings in relation to our investment; the risk that we will be unable to sell the mortgage loans we originate into the secondary mortgage market at a profit due to changes in interest rates or a reduction in the flow of funds into the secondary mortgage market, whether due to a further weakening in the residential real estate market or a tightening in the availability of credit or otherwise; the risk that we will be required to repurchase mortgage loans in the event that they do not conform to representations and warranties we made with respect to such loans at the time of their sale, or borrowers default on the first few mortgage loan payments; and the risks that there will be a decline in demand for residential mortgage loans or an increase in defaults by borrowers, due to increasing interest rates, an economic downturn, or declining real estate values. Accordingly, there is no assurance that our residential mortgage lending business will not hurt our earnings or cause us to incur losses in the future.
There is no assurance that the sales of the Additional Series B Preferred Shares and Common Stock to the Carpenter Funds and SBAV LP will be consummated.
In order to increase the Bank’s capital and support the future growth of our banking franchise, on August 26, 2011, we entered into (i) an Additional Series B Stock Purchase Agreement which provides for the purchase from us of $11.8 million of Series B Preferred Shares by SBAV LP and by Carpenter Community Bancfund, L.P. and Carpenter Community Bancfund-A, L.P., which are affiliated with each other (collectively, the “Carpenter Funds”) and (ii) a Common Stock Purchase Agreement which provides for the purchase by the Carpenter Funds of $15.5 million of shares of our common stock at a per share price equal to the greater of (i) the per share book value of our common stock, which was $6.26 as of December 31, 2011, or (ii) $5.31 per share. Consummation of those equity financings is subject to the satisfaction of a number of conditions, including the receipt by the Carpenter Funds of regulatory approvals they need before they can acquire those Series B Preferred Shares and the common stock. We do not know whether those conditions will be satisfied and, therefore, there continues to be a risk that the sales of the $11.8 million of Series B Preferred Shares and the $15.5 million of common stock will not be consummated. In that event, it may become necessary for us to raise additional capital from other sources before we will be released from the restrictions of the FRB Agreement and DFI Order and to support the growth of our banking franchise. However, our ability to raise additional capital from other sources will be affected by our future financial performance and by economic and market conditions over which we do not have control. As a result, there is no assurance that, if needed, we would be able to raise additional capital in a meaningful amount from other sources on acceptable terms, if at all.
We may be unable to resume the implementation of our strategy to grow our banking franchise in the future.
A key element of our business strategy has been to grow our banking franchise primarily by (i) opening new banking offices, (ii) offering new revenue generating products or services, such as the commencement, in the second quarter of 2009, of our mortgage banking operations, and (iii) adding banking professionals at our existing banking offices, with the objective of attracting additional customers including, in particular, small-to-medium size businesses, that would add to our profitability. Due to the losses we incurred during the three years ended December 31, 2010, the need to dedicate more personnel to the management and reduction of non-performing loans, and our increased focus on raising additional capital and returning the Bank to profitability, we have had to significantly curtail our growth strategy and we cannot predict how long it will be before we will able to resume the implementation of that strategy. Among other things we will need to substantially increase our capital to support the growth of our banking franchise. If the sales of the additional Series B Shares and Common Stock to the Carpenter Funds cannot be consummated and we are not able to raise substantial additional capital from other sources, we may be unable to resume the implementation of our growth strategy for a considerable period of time.
Expansion of our banking franchise might not achieve expected growth or increases in profitability and may adversely affect our future operating results.
If the equity financings described in the two immediately preceding paragraphs are consummated, the implementation of our growth strategy, either through organic growth or the acquisition of other banks, will pose a number of risks for us, including:
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the risk that any newly established banking offices will not generate revenues in amounts sufficient to cover the costs of those offices, which would reduce our income or cause us to incur operating losses;
•
the risk that any bank acquisitions we might consummate in the future will prove not to be accretive to or may reduce our earnings if we do not realize anticipated cost savings or if we incur unanticipated costs in integrating the acquired banks into our operations or a substantial number of the customers of the acquired banks move their banking business to our competitors;
•
the risk that such expansion efforts will divert management time and effort from our existing banking operations, which could adversely affect our future financial performance; or
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the risk that the additional capital we may need to support our growth or the issuance of shares in any bank acquisitions will be dilutive to the share ownership of our existing shareholders.
We rely on communications, information, operating and financial control systems technology from third-party service providers, and we may suffer an interruption in those systems.
We rely heavily on third-party service providers for much of our communications, information, operating and financial control systems technology, including our online banking services and data processing systems. Any failure or interruption, or breaches in security, of these systems could result in failures or interruptions in our customer relationship management, general ledger, deposit, servicing and/or loan origination systems and, therefore, could harm our business, operating results and financial condition. Additionally, interruptions in service and security breaches could lead existing customers to terminate their banking relationships with us and could make it more difficult for us to attract new banking customers.
We are exposed to risk of environmental liabilities with respect to real properties which we may acquire.
Due to the continued weakness of the U.S. economy and, more specifically, the California economy, including high levels of unemployment and the continuing declines in real estate values, many borrowers have been unable to meet their loan repayment obligations and, as a result, we have had to initiate foreclosure proceedings with respect to and take title to an increased number of real properties that had collateralized their loans. Moreover, if the economic conditions remain weak or worsen, we may have to continue to foreclose and take title to additional real properties. As an owner of such properties, we could become subject to environmental liabilities and incur substantial costs for any property damage, personal injury, investigation and clean-up that may be required due to any environmental contamination that may be found to exist at any of those properties, even though we did not engage in the activities that led to such contamination. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties seeking damages for environmental contamination emanating from the site. If we were to become subject to significant environmental liabilities or costs, our business, financial condition, results of operations and prospects could be adversely affected.
Managing reputational risk is important to attracting and maintaining customers, investors and employees.
Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies and questionable or fraudulent activities of our customers. We have policies and procedures in place to promote ethical conduct and protect our reputation. However, these policies and procedures may not be fully effective. Negative publicity regarding our business, employees, or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.
The price of our common stock may be volatile or may decline, which may make it more difficult to realize a profit on your investment in our shares of common stock.
The trading prices of our common stock may fluctuate widely as a result of a number of factors, many of which are outside our control. In addition, our stock price has not only been volatile, but also has declined significantly during the three years ended December 31, 2010, due to the losses we incurred during that period and uncertainties about how long it will take us to achieve sustained profitability. The volatility of our stock price in the future may increase due to the recent
sales of the $11.2 million of Series B Convertible Preferred Stock and, if consummated, the pending sales of the $11.8 million of additional Series B Preferred Shares and the $15.5 million of common stock to the Carpenter Funds, because the common stock into which Series B Preferred Shares are convertible and the common stock to be sold to the Carpenter Funds will be saleable in the open market. Moreover our stock price in the future could be adversely affected by other factors, some of which are outside of our control, including:
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quarterly fluctuations in our operating results or financial condition;
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failure to meet analysts’ revenue or earnings estimates;
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the restrictions, described below, on our ability to pay cash dividends on our common stock;
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the imposition of additional regulatory restrictions on our business and operations or an inability to meet regulatory requirements such as those contained in the FRB Agreement and DFI Order;
•
an inability to resume our growth strategy in the near term or to successfully implement that strategy in the future;
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strategic actions by us or our competitors, such as acquisitions or restructurings;
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fluctuations in the stock prices and operating results of our competitors;
•
general market conditions and, in particular, developments related to market conditions for the financial services industry stocks;
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proposed or newly adopted legislative or regulatory changes or developments aimed at the financial services industry;
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any future proceedings or litigation that may involve or affect us; and
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continuing concerns and a lack of confidence among investors that economic and market conditions will improve.
We are currently restricted from paying dividends, and do not anticipate paying any cash dividends on our common stock for the foreseeable future.
Dividends from the Bank will be the principal source of funds available to us to pay cash dividends to our shareholders in the future. However, as described above, pursuant to the FRB Agreement and DFI Order, the Bank may not pay cash dividends to us without the prior approval of the FRB and DFI and we may not pay cash dividends to our shareholders without the prior approval of the FRB. There is no assurance when those restrictions might be lifted, if at all. Additionally, we and the Bank are subject to additional restrictions which currently and in the future may prevent us from paying cash dividends on our common stock:
•
As described above, we began deferring interest payments on our Junior Subordinated Debentures in mid-2010. Under the terms of the indentures governing the Junior Subordinated Debentures, we are precluded from paying cash dividends on our common stock or preferred stock unless and until we have paid all of the deferred interest in full and thereafter make interest payments on the Junior Subordinated Debentures as and when they become due.
•
No dividends may be declared or paid on shares of our common stock unless we first pay dividends to the holders of the outstanding shares of our preferred stock. There is no assurance if or when we will be able to pay such dividends on our preferred stock, however.
•
California laws also place restrictions on the ability of California corporations to pay cash dividends on preferred or common stock. Subject to certain limited exceptions, a California corporation may pay cash dividends only to the extent of (i) the amount of its retained earnings or (ii) the amount by which the fair value of the corporation’s assets exceeds its liabilities. Although the fair value of our assets exceeded our liabilities at December 31, 2011, due to the restrictions under the FRB Agreement and DFI Order which preclude us from paying dividends to shareholders and interest on the Junior Subordinated Debentures and the Bank from paying dividends to us, as well as the dividend preference of the holders of our outstanding preferred stock, there is no assurance as to when we might be able to pay dividends on our common stock in the future.
Finally, even if the regulatory and other restrictions on the payment of dividends by us and the Bank are lifted and we generate retained earnings in the future, it is our intention to retain cash to increase our capital and fund our operations and the expansion of our banking franchise. As a result, we have no intention to pay cash dividends at least for the foreseeable future on our common stock.
If the pending sales of additional preferred stock and common stock are completed, or we otherwise sell additional shares of our common stock, our shareholders could be subject to significant dilution in their share ownership and voting power.
Potential Dilutive Effects of Sales of Additional Equity Securities. If we succeed in consummating the sales of additional Series B Preferred Shares and common stock to the Carpenter Funds and SBAV LP (the “Equity Investors”) pursuant to the definitive securities purchase agreements we entered into on August 26, 2011, those sales will dilute the percentage ownership and voting power of our existing shareholders and, depending on the prices paid by our existing shareholders for their shares of common stock, also in terms of the differences between the amounts they paid for their shares and the prices that the Equity Investors will have paid for their shares. This dilution also could have an adverse impact on the trading prices of our common stock.
Moreover, subject to market conditions and other factors, we may seek to sell additional common stock or other equity securities in the future to meet capital requirements or to fund the growth of our business. The sales or issuances of additional common stock or other equity securities could also be dilutive of our existing shareholders depending largely on the prices at which, and the number of, additional shares or other equity securities we may sell or issue.
At December 31, 2011, options to purchase a total of 1,153,741 shares of our common stock, at an average exercise price of $7.39 per share, were outstanding and an additional 550,814 shares were available for the grant of options or other equity incentives in the future under our 2010 Equity Incentive Plan. The issuance of shares pursuant to any of those options or pursuant to any other equity incentives we may grant in the future may dilute our existing shareholders.
Risks Associated with the Increase in Voting Power of the Equity Investors. If the sales of the Additional Series B Preferred Shares and common stock to the Equity Investors are consummated, the “Carpenter Funds” will own a total of approximately 28% of our voting stock and will be the largest shareholder of the Company.
Further, as previously reported in our Current Report on Form 8-K dated August 26, 2011, concurrently with the sale of the Series B Preferred Shares, we entered into certain investor rights agreements with the Equity Investors. If the Carpenter Funds purchase the Additional Series B Preferred Shares and the shares of common stock pursuant to the Additional Series B and the Common Stock Purchase Agreements, respectively, they will become entitled to designate three individuals to serve on the respective Boards of Directors of both the Company and the Bank (subject to any required regulatory approvals). Due to the appointment of three representatives on the Board of Directors and their ownership of our voting stock, the Carpenter Funds will have the ability to significantly influence the outcome of matters requiring approval of our Board of Directors and matters requiring the approval of our shareholders, including the approval of mergers and acquisitions or changes in corporate control, and could have significant influence over our operations. There is no assurance that the interests of the Carpenter Funds will be consistent with the interests of our other shareholders or that the Carpenter Funds will not exercise their voting power in ways that could adversely affect our other shareholders. Moreover, this concentration of ownership also could have additional adverse consequences, including (i) discouraging a potential acquirer from attempting to acquire us, which could impede or prevent transactions in which our shareholders might otherwise receive a premium for their shares, and (ii) making it more difficult for us to sell additional shares at prices in excess of those paid by the selling shareholders for their shares of common stock, even if our financial performance significantly improves.
Our articles of incorporation permit our Board of Directors to authorize and sell additional shares of preferred stock on terms that could discourage a third party from making a takeover offer that may be beneficial to our shareholders.
Our Board of Directors has the power, under our articles of incorporation, to create and authorize the sale of one or more new series of preferred stock without having to obtain shareholder approval for such action. As a result, the Board could authorize the issuance of and issue shares of a new series of preferred stock to implement a shareholders rights plan (often referred to as a “poison pill”) or could sell and issue preferred shares with special voting rights or conversion rights that could deter or delay attempts by our shareholders to remove or replace management, and attempts of third parties to engage in proxy contests and effectuate changes in control of us.
Our business may face other risks.
Our business and financial performance could be materially and adversely affected in the future by other risks or developments that either are not known to us at the present time or are currently immaterial to our business. Such risks could include, but are not necessarily limited to, unexpected changes in government regulations, the commencement of litigation against us and unexpected adverse changes in local, national or global economic or market conditions.
For further discussion of risks that can affect our financial performance or financial condition, also see “Item 7. - Management’s Discussion and Analysis of Financial Condition and the Results of Operations” below in this Report.
Due to these and other possible uncertainties and risks, you are cautioned not to place undue reliance on the forward looking statements contained in this Report, which speak only as of the date of this Report. We also disclaim any obligation to update or revise forward-looking statements contained in this Report, except as may be required by law or by NASDAQ.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Set forth below is information regarding our headquarters office and our seven existing financial services centers. All of our offices are leased. We believe that our current facilities are sufficient for our company, if headcount increases above capacity we may need to lease additional space.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Mark Zigner vs. Pacific Mercantile Bank, et al., filed in January, 2010, in the California Superior Court for the County of Orange (Case No. 0337433). As previously reported in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, this lawsuit was filed by plaintiff asserting that the Bank had wrongfully exercised certain remedies in its efforts to recover borrowings owed by plaintiff to the Bank under (i) a $2.215 million construction loan which was secured by a first trust deed on real property owned by plaintiff, and (ii) a $200,000 unsecured line of credit. Plaintiff also maintained deposit accounts with the Bank.
Plaintiff failed to repay outstanding borrowings of approximately $191,000 due at the maturity date of his line of credit in April 2009. When plaintiff refused demands to repay those borrowings, the Bank set off that amount against plaintiff’s deposit accounts in accordance with the express terms of his line of credit agreement with the Bank. Plaintiff also failed to repay his construction loan when it matured in August 2009 and, in October 2009, the Bank commenced foreclosure proceedings against the real property collateralizing that loan.
In his lawsuit, plaintiff claimed that the set off by the Bank against plaintiff’s deposit accounts was wrongful based on allegations that the Bank had (i) agreed to extend the line of credit and breached that agreement when it exercised its set off rights, and (ii) failed to provide him with prior notice of the set off and an opportunity to cure his default under the line of credit. Plaintiff also asserted certain related claims, including an alleged breach by the Bank of an implied covenant of good faith and fair dealing.
The case was tried before a jury in August, 2011. However, as we reported in our third quarter 2011 10-Q, (i) before the case went to the jury for a decision, the trial judge ruled that the Bank had wrongfully exercised its set off rights and based on that finding, the jury awarded plaintiff $100,000 of compensatory damages, and (ii) the jury later found that the Bank’s exercise of its set off rights also constituted a wrongful conversion of plaintiff’s funds and as a result, that the plaintiff also was entitled to awards of $150,000 in compensatory damages and $1.87 million in punitive damages against the Bank.
In response to a proposed statement of decision submitted to the trial judge by plaintiff following the jury verdict, the Bank asserted that the judge’s ruling with respect to the Bank’s set off rights and the jury’s findings with respect
to plaintiff’s claims of wrongful conversion were erroneous and that, as a result, plaintiff was not entitled, as a matter of law, to an award of either compensatory or punitive damages. The Bank also asserted that if the trial judge were to determine that plaintiff was entitled to punitive damages, the $1.87 million punitive damage award, which was nearly 12.5 times the $150,000 compensatory damage award for conversion, was excessive as a matter of California law, which provides that punitive damage awards may range from one to four times the amount of compensatory damages. Nevertheless, the trial judge initially sustained the plaintiff’s statement of decision.
The Bank then filed motions with the court for a judgment notwithstanding the verdict and, in the alternative, for a new trial, as well as a motion to vacate the findings set forth in the statement of decision. A hearing on these motions was held on February 8, 2012. The court thereafter rejected the Bank’s motion for a judgment notwithstanding the verdict and, while it sustained the rulings on compensatory damages, the trial court ruled that the jury’s punitive damage award was excessive and that the Bank’s motion for a new trial would be granted, unless the plaintiff agreed to accept a reduction in the punitive damage award from $1.87 million to $950,000. On February 21, 2011 we learned that the plaintiff had agreed to accept that reduction in the punitive damage award and a final judgment has been entered against the Bank in the amount of $1.2 million. In addition, the trial court entered an award to plaintiff of his attorneys fees and costs, in the amount of $540,000.
Following the entry of the final judgment by the trial court, the Bank filed an appeal of the trial court’s rulings and the jury verdict, asserting that those rulings and the jury’s verdict were erroneous and that plaintiff is not entitled, as a matter of law, to an award of either compensatory or punitive damages. Because the appeals process has just begun, it is not possible at this time to predict, with any certainty, how the appellate courts will ultimately rule on our appeal. However, we believe that the judgment entered by the court against the Bank will be overturned on appeal.
Other Legal Actions. We are subject to legal actions that arise from time to time in the ordinary course of our business. Currently there are no such pending legal proceedings that we believe will have a material adverse effect on our financial condition or results of operations.
EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below is information, as of January 26, 2012, regarding our principal executive officers:
There is no family relationship between the above-named officers.
Raymond E. Dellerba has served as President, Chief Executive Officer and a Director of the Company and the Bank since the dates of their inception, which were January 2000 and November 1998, respectively, pursuant to a multi-year employment agreement. From February 1993 to June 1997, Mr. Dellerba served as the President, Chief Operating Officer and director of Eldorado Bank, and as Executive Vice President and a Director of its parent company, Eldorado Bancorp. Mr. Dellerba has more than 30 years of experience as a banking executive, primarily in Southern California and in Arizona.
Nancy Gray, who is a certified public accountant, has been a Senior Executive Vice President and the Chief Financial Officer of the Company and the Bank since May 2002. From 1980 through 2001, Ms. Gray was Senior Vice President and Financial Executive of Bank of America in Southern California, Missouri, Georgia, and Texas.
Robert W. Bartlett, joined Pacific Mercantile Bank as its Senior Executive Vice President and Chief Operating Officer on October 31, 2008. In his banking career spanning some 34 years, Mr. Bartlett has held key senior management positions in Orange and Los Angeles County banks including Commercial Banking Manager, Area Credit Administrator, Chief Credit Officer and Chief Operating Officer.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES
Trading Market for the Company’s Shares
Our common stock is traded on the NASDAQ Global Select Market under the symbol “PMBC.” The following table presents the high and low sales prices of our common stock, as reported on the NASDAQ Global Select Market, for each of the calendar quarters indicated below:
The high and low per share sale prices of our common stock on the NASDAQ Global Select Market on February 21, 2012, were $3.90 and $4.09 per share, respectively and, as of that same date, there were approximately 149 holders of record of our common stock.
Stock Price Performance
The graph on the following page compares the stock performance of our common stock, in each of the years in the five year period ended December 31, 2011, with that of (i) the Russell Microcap Index, which is comprised of the smallest 1,000 members of the Russell 2000 and the next smallest 1,000 companies, by market cap, which include the Company, and (ii) an index, published by SNL Securities L.C. (“SNL”) and known as the SNL Western Bank Index, which is comprised of 59 banks and bank holding companies (including the Company), the shares of which are listed on NASDAQ or the New York Stock Exchange and most of which are based in California and the remainder of which are based in nine other western states, including Oregon, Washington and Nevada.
(1) The source of the above graph and chart is SNL Securities, L.C. (“SNL”).
The Stock Performance Graph assumes that $100 was invested in Company common stock on December 31, 2006, and, at that same date, in the Russell Microcap Index and the SNL Western Bank Index and that any dividends paid in the indicated periods were reinvested. Shareholder returns shown in the Performance Graph are not necessarily indicative of future stock price performance.
Dividend Policy and Share Repurchase Programs
Our Board of Directors has followed the policy of retaining earnings to maintain capital and, thereby, support the growth of the Company’s banking franchise. On occasion, the Board also considered paying cash dividends out of cash generated in excess of those capital requirements and, in February 2008, the Board of Directors declared a cash dividend, in the amount of $0.10 per share of common stock, that was paid on March 14, 2008.
The Board also authorized share repurchase programs in June 2005 and in October 2008, when the Board concluded that, at the then prevailing market prices, the Company’s shares represented an attractive investment opportunity and, therefore, that share repurchases would be a good use of Company funds.
In the first quarter of 2009, the Board of Directors decided that the prudent course of action, in light of the economic recession, was to preserve cash and earnings to enhance the Bank’s capital position and to be in a position to take advantage of improved economic and market conditions in the future. In addition, in August 2010, both the Bank and the Company entered into a Written Agreement with the FRB, their primary federal banking regulator; and the DFI, the Bank’s state banking regulator, issued a regulatory order (the “DFI Order”) imposing restrictions on the Company and the Bank. The FRB Agreement and DFI Order, among other things, prohibits the payment of cash dividends and share repurchases without the approval of the
FRB and the DFI. See “Item 1 - Business - Supervision and Regulation - Pacific Mercantile Bancorp - Regulatory Action Taken by the FRB and the DFI.” Accordingly, we do not expect to pay cash dividends or make share purchases at least for the foreseeable future.
Restrictions on the Payment of Dividends
Cash dividends from the Bank represent the principal source of funds available to the Bancorp, which it might use to pay cash dividends to shareholders or for other corporate purposes, such as expansion of its business. Therefore, government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state chartered banks, limit the amount of funds that the Bank would be permitted to dividend to the Bancorp. As a result, those laws also affect the ability our to pay cash dividends to our shareholders or fund other expenditures. In particular, under California law, cash dividends by a California state chartered bank may not exceed, in any calendar year, the lesser of (i) the sum of its net income for the year and its retained net income from the preceding two years (after deducting all dividends paid during the period), or (ii) the amount of its retained earnings.
Moreover, as a California corporation, the Company’s ability to pay cash dividends is subject to restrictions under the California Corporations Code. Those restrictions provide that a California corporation may pay a cash dividend (a) if the amount of the dividend does not exceed the sum of the corporation’s retained earnings plus (ii) the amount, if any, of dividends in arrears on shares which have preferential dividend rights over the rights of shareholders that will be receiving the dividend; or (b) if, immediately after the dividend is paid, the greater of the book or fair value of the corporation’s assets equals or exceeds the sum of (i) its total liabilities plus (ii) the liquidation preference of any shares which have a preference upon dissolution over the rights of shareholders receiving the dividend.
Additionally, because the payment of cash dividends has the effect of reducing capital, the capital requirements imposed on bank holding companies and commercial banks often operate, as a practical matter, to preclude the payment, or limit the amount of, cash dividends that might otherwise be permitted by California law; and the federal bank regulatory agencies, as part of their supervisory powers, generally require insured banks to adopt dividend policies which limit the payment of cash dividends much more strictly than do applicable state laws. As previously discussed above, we are prohibited from paying cash dividends to shareholders without the prior approval of the FRB and the DFI. Moreover, we have had to defer interest payments on junior subordinated debentures that we issued in 2002 and 2004 as a result of restrictions contained in the FRB Agreement. Under the terms of those debentures, we may not pay cash dividends on our common stock or preferred stock unless and until we have paid all of the deferred interest in full and thereafter make interest payments on the debentures as and when they become due. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONŞ-Contractual Obligations-Junior Subordinated Debentures” in Item 7 of this Report for additional information regarding the junior subordinated debentures. Accordingly, we do not expect to pay cash dividends for at least the foreseeable future.
The shares of our Series B Preferred Stock are entitled to receive dividends payable in cash at a rate of 8.4% per annum if, as and when declared by the Board of Directors. If, however, due to legal or regulatory restrictions, such as the dividend restrictions under California law or under the FRB Agreement, the Company is unable to pay cash dividends on the Series B Preferred Stock for two semi-annual dividend periods, then the Company will be required to pay such dividends in shares of Series C Preferred Stock. The issuance of shares of Series C Preferred Stock would be dilutive of the ownership that our existing common shareholders have in the Company. In addition, no dividends may be declared or paid on shares of the Company’s common stock unless dividends are first paid (either in cash or in shares of Series C Preferred Stock) on the shares of Series B Preferred Stock and any shares of Series C Preferred Stock that may have been issued and are then outstanding.
Restrictions on Inter-Company Transactions
Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary’s capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company - See “BUSINESS-Supervision and Regulation-Restrictions on Transactions between the Bank and the Company and its other Affiliates”. We do not have any present intention to obtain any borrowings from the Bank.
Equity Compensation Plans
Certain information, as of December 31, 2011, with respect to our equity compensation plans is set forth in Item 12, in Part III, of this Report.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected statement of operations data for the fiscal years ended December 31, 2011, 2010 and 2009, the selected balance sheet data as of December 31, 2011 and 2010, and the selected financial ratios (other than tangible book value per share), that follow below were derived from our audited consolidated financial statements included in Item 8 of this Report and should be read in conjunction with those audited consolidated financial statements, together with the notes thereto, and with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
Forward Looking Statements
The following discussion contains statements (which are commonly referred to as “forward looking statements”) which discuss our beliefs or expectations about (i) our future financial performance and future financial condition and (ii) operating trends in our markets and in economic conditions more generally. The consequences of those operating trends on our business and the realization of our expected future financial results, as discussed in those forward looking statements, are subject to a number of risks and uncertainties including those described above in Item 1A of this Report under the caption “RISK FACTORS.” Due to those risks and uncertainties, our future financial performance may differ, possibly significantly, from the performance that is currently expected as set forth in the forward looking statements. As a result, you should not place undue reliance on those forward looking statements. We disclaim any obligation to update or revise any of the forward looking statements, whether as a result of new information, future events or otherwise, except as may be required by applicable law or Nasdaq rules.
Background
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 8
ITEM 8. FINANCIAL STATEMENTS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Pacific Mercantile Bancorp and subsidiaries
We have audited the accompanying consolidated statements of financial condition of Pacific Mercantile Bancorp (a California Corporation) and subsidiaries (collectively, the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Mercantile Bancorp and subsidiaries as of December 31, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America.
As more fully described in Notes 3 and 17 to the consolidated financial statements, in August 2010, the Company and its wholly owned subsidiary, Pacific Mercantile Bank, (the “Bank”) entered into a written agreement (the “Written Agreement”) with its regulators. The Written Agreement includes certain requirements of the Company and the Bank which include (i) strengthening board oversight, (ii) improving the Bank’s position with respect to problem assets and maintaining adequate reserves for loan and lease losses, (iii) improving the Bank’s capital position, and (iv) improving the Bank’s earnings. The Company and the Bank have taken measures towards complying with the provisions of the Written Agreement, however the Company and Bank cannot predict the future impact of the Written Agreement upon their business, financial condition or results of operations, and there can be no assurance when or if the Company and Bank will be in compliance with the Written Agreement, or whether the regulators might take further action against the Company or Bank. The accompanying financial statements do not reflect the impact of this uncertainty.
/s/ SQUAR, MILNER, PETERSON, MIRANDA & WILLIAMSON, LLP
Newport Beach, California
February 24, 2012
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except for per share data)
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Shares and dollars in thousands)
For the Three Years Ended December 31, 2011
(1) Impact on prior period of adopting ASC 320-10, Recognition and Presentation of Other-Than-Temporary Impairments (see Note 5).
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS-continued
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Business
Organization
Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”) is engaged in commercial banking and conducts a mortgage banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended. The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PMBC and the Bank, are sometimes referred to, together, in this report as the “Company” or as “we”, “us” or “our”.
Substantially all of our operations are conducted and substantially all our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and expenses, and earnings. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego Counties of California and is subject to competition from other banks and financial institutions and from financial services organizations conducting operations in those same markets.
During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $5.155 million, $5.155 million and $7.217 million, respectively, principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10.310 million principal amount of junior subordinated debentures, with a maturity date in 2034. In accordance with applicable accounting standards, the financial statements of these trusts are not included in the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies - Principles of Consolidation” below.
In July 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of Pacific Mercantile Capital Trust I and in August 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of PMB Capital Trust I. Those trusts were dissolved as a result of those redemptions.
2. Significant Accounting Policies
The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-K and in accordance with generally accepted accounting principles, in effect in the United States (“GAAP”), on a basis consistent with prior periods.
Use of Estimates
The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of the allowance for loan losses, the fair values of securities available for sale and mortgage loans held for sale, and the determination of reserves pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.
Principles of Consolidation
The consolidated financial statements for the years ended December 31, 2011, 2010 and 2009, include the accounts of PMBC and its wholly owned subsidiary, Pacific Mercantile Bank. All significant intercompany balances and transactions were eliminated in consolidation.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. Significant Accounting Policies (Cont-)
Cash and Cash Equivalents
For purposes of the statements of cash flow, cash and cash equivalents consist of cash due from banks and federal funds sold. Generally, federal funds are sold for a one-day period. As of December 31, 2011 and 2010 the Bank maintained required reserves with the Federal Reserve Bank of San Francisco of approximately $282,000 and $477,000, respectively, which are included in cash and due from banks in the accompanying Consolidated Statements of Financial Condition.
Interest-Bearing Deposits with Financial Institutions
Interest-bearing deposits with financial institutions mature within one year or have no stated maturity date and are carried at cost.
Securities Available for Sale
Securities available for sale are those that management intends to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks and other similar factors. The securities are recorded at fair value, with unrealized gains and losses excluded from earnings and reported as other comprehensive income or loss net of taxes. Purchased premiums and discounts are recognized as interest income using the interest method over the term of these securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Declines in the fair value of securities below their cost that are other than temporary are reflected in earnings as realized losses. In determining other-than-temporary losses, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at the time such determinations are made.
Federal Home Loan Bank Stock and Federal Reserve Bank Stock
The Bank, as a member of the Federal Home Loan Bank System, is required to maintain an investment in capital stock of the Federal Home Loan Bank of San Francisco (“FHLB”) in varying amounts based on asset size and on amounts borrowed from the FHLB. Because no ready market exists for this stock and it has no quoted market value, the Bank’s investment in this stock is carried at cost.
The Bank also maintains an investment in capital stock of the Federal Reserve Bank. Because no ready market exists for these stocks and they have no quoted market values, the Bank’s investment in these stocks is carried at cost.
Fair Value Option
The fair value option provides an option to elect fair value as an alternative measurement for selected financial assets, financial liabilities, unrecognized firm commitments and written loan commitments not previously carried at fair value. The Bank has elected the fair value option on its mortgage loans held for sale (“LHFS”) that were originated subsequent to December 1, 2011. The election was made to better reflect the underlying economics and to mitigate operational complexities of risk management activities related to its LHFS pursuant to ASC 815, Derivatives and Hedging.
Mortgage Loans Held for Sale and Mortgage Banking Revenues
On December 1, 2011, the Bank elected to measure its LHFS at fair value beginning December 1, 2011. As of December 31, 2011, these loans totaled $42.0 million. LHFS originated prior to December 1, 2011 (accounted for at the lower of cost or market) remaining on the accompanying balance sheet as of December 31, 2011 totaled $24.2 million. With the election of the fair value option for LHFS originated on or subsequent to December 1, 2011, fees and costs associated with the origination of LHFS are earned and expensed as incurred. For loans originated prior to December 1, 2011, such fees and costs are netted and recorded in operations in the period the LHFS is sold.
Revenue derived from the Bank’s mortgage loan origination division includes the origination (funding either a purchase or refinancing) and sale of residential mortgage loans. Mortgage fees consist of fee income earned on all loan originations, including loans closed to be sold and fee-based closings. Gain (loss) on sales of mortgage loans includes the realized and unrealized gains and losses on LHFS for which the fair value option has been elected. For LHFS for which the fair value option has not been elected, gain (loss) includes the realized gains (losses) as well as any lower-of-cost-or-market valuation adjustments. The valuation of the Bank’s LHFS approximates a whole-loan price, which includes the value of the related mortgage servicing rights. Both mortgage fee income and gain (or loss) on sales of loans is included in mortgage banking revenues in the accompanying statements of operations.
The Bank principally sells its originated mortgage loans to investors and to government-sponsored entities. We evaluate sales of such loans for sales treatment. To the extent the transfer of assets qualifies as a sale, we derecognize the asset and record the gain or loss on the sale date. In the event we determine that the transfer of assets does not qualify as a sale, the transfer would be treated as a secured borrowing. LHFS are placed on nonaccrual status when any portion of the principal or interest is 90 days past due or earlier if factors indicate that the ultimate collectability of the principal or interest is not probable. Interest received from LHFS on nonaccrual status is recorded as a reduction of principal. LHFS on non-accrual status are returned to accrual status when the principal and interest become current and it is probable that the amounts are fully collectible.
Mortgage Servicing Rights
The Bank sells LHFS in the secondary market and may retain the right to service the loans sold. Upon sale, the mortgage servicing rights asset is capitalized at the then current fair value of future net cash flows expected to be realized for performing servicing activities. Mortgage servicing rights are carried at estimated fair value with the difference in carrying cost and estimated fair value recorded in the statement of operations.
Loan Loss Obligation on Loans Previously Sold
The Bank sells LHFS it originates to investors on a servicing released basis and the risk of loss due to default by the borrower is generally transferred to the investor. However, the Bank is required by these investors to make certain representations relating to credit information, loan documentation and collateral. These representations and warranties may extend through the contractual life of the mortgage loan. If subsequent to the sale of such a loan, any underwriting deficiencies, borrower fraud or documentation defects are discovered in, the Bank may be obligated to repurchase the mortgage loan or indemnify the investors for any losses from borrower defaults if such deficiency or defect cannot be cured within the specified period following discovery. In the case of early loan payoffs and early defaults on certain loans, the Bank may be required to repay all or a portion of the premium initially paid by the investor. The estimated obligation associated with early loan payoffs and early defaults is calculated based on historical loss experience by type of loan.
The obligation for losses attributable to any erroneous representations and warranties or other provisions discussed above is recorded at its estimated projection of expected future losses using historical and projected loss frequency and loss severity ratios to estimate its exposure to losses on loans previously sold.
Accounting for Derivative Instruments and Interest Rate Lock Commitments
The Company does not utilize derivative instruments for hedging the fair value or interest rate exposures within its mortgage banking business. In this business, the Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is set prior to funding (interest rate lock commitments or “IRLCs”). IRLCs on mortgage loan funding commitments for mortgage loans that are intended to be sold are considered to be derivative instruments under GAAP and are recorded at fair value on the balance sheet with any change in fair value between reporting periods recorded to operations.
Unlike most other derivative instruments, there is no active market for the mortgage loan commitments that can be used to determine their fair value. The Company has developed a methodology for estimating the fair value by calculating the change in market value from a commitment date to a measurement date based upon changes in applicable interest rates during the period, adjusted for a fallout factor (loans committed to funding that ultimately do not fund). At December 31, 2011, the Company’s IRLC’s recognized in the Company’s results of operations totaled $36,000.
Loans and Allowance for Loan Losses
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off, are stated at principal amounts outstanding, net of unearned income. Interest is accrued daily as earned, except where reasonable doubt exists as to collectability of the loan. A loan with principal or interest that is 90 days or more past due based on the contractual payment due dates is placed on nonaccrual status in which case accrual of interest is discontinued, except that management may elect to continue the accrual of interest when the estimated net realizable value of collateral securing the
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. Significant Accounting Policies (Cont-)
loan is expected to be sufficient to enable us to recover both principal and accrued interest balances and those balances are in the process of collection. Generally, interest payments received on nonaccrual loans are applied to principal. Once all principal has been received, any additional interest payments are recognized as interest income on a cash basis. A loan is generally classified as impaired when, in management’s opinion, the principal or interest will not be collectible in accordance with the contractual terms of the loan agreement.
Loans that the Bank modifies or restructures where the debtor is experiencing financial difficulties and makes a concession to the borrower in the form of changes in the amortization terms, reductions in the interest rates, the acceptance of interest only payments and, in limited cases, concessions to the outstanding loan balances are classified as troubled debt restructurings or “TDRs”. TDRs are loan modified for the purpose of alleviating temporary impairments to the borrower’s financial condition. A workout plan between a borrower and the Bank is designed to provide a bridge for the cash flow shortfalls in the near term. If the borrower works through the near term issues, in most cases, the original contractual terms of the loan will be reinstated.
An allowance for loan losses is established by means of a provision for loan losses that is charged against income. If management concludes that the collection, in full, of the carrying amount of a loan has become unlikely, the loan, or the portion thereof that is believed to be uncollectible, is charged against the allowance for loan losses. We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers and the history of the performance of the portfolio in determining the adequacy of the allowance for loan losses. Additionally, as the volume of loans increases, additional provisions for loan losses may be required to maintain the allowance at levels deemed adequate. Moreover, if economic conditions were to deteriorate, causing the risk of loan losses to increase, it would become necessary to increase the allowance to an even greater extent, which would necessitate additional charges to income. The Company also evaluates the unfunded portion of loan commitments and establishes a loss reserve in other liabilities through a charge against noninterest expense in connection with such unfunded loan commitments. The loss reserve for unfunded loan commitments at December 31, 2011 and 2010, was $181,000 and $249,000, respectively.
The allowance for loan losses is based on estimates and ultimate loan losses may vary from current estimates. These estimates are reviewed periodically and, as adjustments become necessary, they are recorded in earnings in the periods in which they become known. We believe that the allowance for loan losses was adequate as of December 31, 2011 and 2010. In addition, the FRB and the DFI, as an integral part of their examination processes, periodically review the allowance for loan losses for adequacy. These agencies may require us to recognize additions to the allowance based on their judgments in light of the information available at the time of their examinations.
We also evaluate loans for impairment, where principal and interest are not expected to be collected in accordance with the contractual terms of the loan. We measure and reserve for impairment on a loan-by-loan basis using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. We exclude smaller, homogeneous loans, such as consumer installment loans and lines of credit, from these impairment calculations. Also, loans that experience insignificant payment delays or shortfalls are generally not considered impaired.
Loan Origination Fees and Costs
All loan origination fees and related direct costs are deferred and amortized to interest income as an adjustment to yield over the respective lives of the loans using the effective interest method, except for loans that are revolving or short-term in nature for which the straight line method is used, which approximates the interest method.
Investment in Unconsolidated Subsidiaries
Investment in unconsolidated subsidiaries are stated at cost. The unconsolidated subsidiaries are comprised of two grantor trusts established in 2002 and 2004, respectively, in connection with our issuance of subordinated debentures in each of those years. See Note 9 “- Borrowings and Contractual Obligations - Junior Subordinated Debentures”.
Other Real Estate Owned
Other real estate owned (“OREO”), consists of real properties acquired by us through foreclosure or in lieu of foreclosure in satisfaction of loans. OREO is recorded on the balance sheet at fair value less selling costs at the time of acquisition. Loan balances in excess of fair value less selling costs are charged to the allowance for loan losses. Any subsequent operating expenses or income, reductions in estimated fair values and gains or losses on disposition of such properties are charged or credited to current operations.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. Significant Accounting Policies (Cont-)
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization which are charged to expense on a straight-line basis over the estimated useful lives of the assets or, in the case of leasehold improvements, over the term of the leases, whichever is shorter. For income tax purposes, accelerated depreciation methods are used. Maintenance and repairs are charged directly to expense as incurred. Improvements to premises and equipment that extend the useful lives of the assets are capitalized.
When assets are disposed of, the applicable costs and accumulated depreciation thereon are removed from the accounts and any resulting gain or loss is included in current operations. Rates of depreciation and amortization are based on the following estimated useful lives:
Furniture and equipment
Three to seven years
Leasehold improvements
Lesser of the lease term or estimated useful life
Income Taxes
Deferred income taxes and liabilities are determined using the asset and liability method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax basis of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
Earnings (Loss) Per Share
Basic income (loss) per share for any fiscal period is computed by dividing net income (loss) available to common shareholders for such period by the weighted average number of common shares outstanding during that period. Fully diluted income (loss) per share reflects the potential dilution that could have occurred assuming all outstanding options or warrants to purchase our shares of common stock, at exercise prices that were less than the market price of our shares, were exercised into common stock, thereby increasing the number of shares outstanding during the period determined using the treasury method. Although accumulated undeclared dividends on our preferred stock are not recorded in the accompanying consolidated statement of operations, such dividends are included for purposes of computing earnings (loss) per share available to common shareholders.
Stock Option Plans
The Company follows the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 718-10, “Share-Based Payment”, which requires entities that grant stock options or other equity compensation awards to employees to recognize in their financial statements the fair values of those options or share awards as compensation cost over their requisite service (vesting) periods. Since stock-based compensation that is recognized in the statements of operations is to be determined based on the equity compensation awards that we expect will ultimately vest, that compensation expense has been reduced for estimated forfeitures of unvested options that typically occur due to terminations of employment of optionees and recognized on a straight-line basis over the requisite service period for the entire award. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For purposes of the determination of stock-based compensation expense for the year ended December 31, 2011, we estimated no forfeitures of options granted to members of the Board of Directors and forfeitures of 7.9% with respect to other unvested options.
Significant Adjustments
On a quarterly basis, the Company evaluates all of its significant adjustments that were identified during that quarter in order to determine whether the adjustments should be recorded in their entirety during the current quarter or whether any or all of such adjustments should be recorded in one or more preceding quarters. During the fourth quarter of 2011, management evaluated two significant adjustments: a negative provision expense related to the allowance for loan losses (Note 6), and the recognition of an income tax benefit as a result of a reduction in the valuation allowance the Company had previously recorded against its deferred tax assets (Note 11). Management determined that the adjustments described in this paragraph only affected the quarter ended December 31, 2011.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. Significant Accounting Policies (Cont-)
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. However, certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet, net of income taxes, and such items, along with net income, are components of comprehensive income (loss).
The components of other comprehensive income (loss) and related tax effects were as follows:
The components of accumulated other comprehensive income (loss) included in stockholders’ equity are as follows:
Recent Accounting Pronouncements
In April 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU No. 2011-02”). ASU No. 2011-02 requires a creditor to separately conclude that 1) the restructuring constitutes a concession and 2) the debtor is experiencing financial difficulties in order for a modification to be considered a troubled debt restructuring (“TDR”). The guidance was issued to provide clarification and to address diversity in practice in identifying TDR’s. This standard is effective for the Company beginning in the third quarter of 2011 and is applied retrospectively to the beginning of the year. The adoption of this standard did not have a material impact on the Company’s results of operations, financial position, or disclosures.
In May 2011, the FASB issued ASU 2011-04 - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements (“ASU 2011-04”), clarifying how to measure and disclose fair value. This guidance amends the application of the “highest and best use” concept to be used only in the measurement of fair value of nonfinancial assets, clarifies that the measurement of the fair value of equity-classified financial instruments should be performed from the perspective of a market participant who holds the instrument as an asset, clarifies that an entity that manages a group of financial assets and liabilities on the basis of its net risk exposure can measure those financial instruments on the basis of its net exposure to those risks, and clarifies when premiums and discounts should be taken into account when measuring fair value. The fair value disclosure requirements also were amended. For public entities, the amendments in ASU 2011-04 are effective prospectively for interim and annual periods beginning after December 15, 2011. The Company does not believe that the adoption of the amended guidance will have a significant impact on its consolidated financial statements.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. Regulatory Actions
On August 31, 2010, the Company and the Bank entered into a Written Agreement (the “Agreement”) with FRB. On the same date, the Bank consented to the issuance of a DFI Order. The principal purposes of the Written Agreement and DFI Order, which constitute formal supervisory actions by the FRB and the DFI, were to require us to adopt and implement formal plans and take certain actions, as well as to continue to implement other measures that we previously adopted, to address the adverse consequences that the economic recession has had on the performance of our loan portfolio and our operating results, to improve our operating results, and to increase our capital to strengthen our ability to weather any further adverse economic conditions that might arise in the future.
The Agreement and Order contain substantially similar provisions. They required the Boards of Directors of the Company and the Bank to prepare and submit written plans to the FRB and the DFI to address the following matters: (i) strengthening board oversight of the management operations of the Bank; (ii) strengthening credit risk management practices; (iii) improving credit administration policies and procedures; (iv) improving the Bank’s position with respect to problem assets; (v) maintaining adequate reserves for loan losses in accordance with applicable supervisory guidelines; (vi) improving the capital position of the Bank and, in the case of the FRB Agreement, the capital position of the Company; (vii) improving the Bank’s earnings through the formulation, adoption and implementation of a new strategic plan, and (viii) submitting a satisfactory funding contingency plan for the Bank that would identify available sources of liquidity and a plan for dealing with adverse economic and market conditions. The Bank is also prohibited from paying dividends to the Company without the prior approval of the DFI, and the Company may not declare or pay cash dividends, repurchase any of its shares, make payments on its trust preferred securities or incur or guarantee any debt, without the prior approval of the FRB.
The Company and the Bank already have made substantial progress with respect to several of these requirements and both the Board and management are committed to achieving all of the requirements on a timely basis. However, a failure by the Company or the Bank to meet any of the requirements of the FRB Agreement or a failure by the Bank to meet any of the requirements of the DFI Order could be deemed, by the FRB or the DFI, to be conducting business in an unsafe manner which could subject the Company or the Bank to further regulatory enforcement action.
Under the DFI Order, the Bank was required to achieve a ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0% by January 31, 2011, by raising additional capital, generating earnings or reducing the Bank’s tangible assets (subject to a 15% limitation on such a reduction) or a combination thereof and, upon achieving that ratio, to thereafter maintain that ratio during the term of the Order.
In August 2011, we completed the sale of $11.2 million of Series B Convertible 8.4% Series B Preferred Stock (the “Series B Preferred Stock”) and contributed the net proceeds from that sale to the Bank, thereby increasing its ratio of adjusted tangible shareholders’ equity to its tangible assets to 9.0%, as required by the DFI Order. At December 31, 2011, that ratio had increased to 9.4%.
Additional information regarding the FRB Agreement and the DFI Order is set forth above in the Section entitled “Supervision and Regulation” in Part I of this report, under the caption “Regulatory Action by the FRB and DFI”.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. Interest-Bearing Deposits and Interest-Bearing Time Deposits with Financial Institutions
At December 31, 2011, the Company had $86.2 million in interest bearing deposits at other financial institutions, as compared to $25.4 million at December 31, 2010. The weighted average percentage yields on these deposits for the years ended December 31, 2011 and December 31, 2010 were 0.25% and 0.26%, respectively. Interest bearing deposits with financial institutions can be withdrawn by the Company on demand and are considered cash equivalents for purposes of the consolidated statements of cash flows.
At December 31, 2011, we had $1.4 million of interest-bearing time deposits at other financial institutions, which were scheduled to mature within one year or had no stated maturity date. By comparison, as of December 31, 2010, time deposits at other financial institutions totaled $2.1 million. The weighted average percentage yields on these deposits were 0.57% and 0.69% at December 31, 2011 and 2010, respectively.
5. Securities Available For Sale
The following are summaries of the major components of securities available for sale and a comparison of amortized cost, estimated fair market values, and gross unrealized gains and losses at December 31, 2011 and 2010:
(1) Secured by closed-end first liens on 1-4 family residential mortgages.
(2) Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies.
(3) Consists primarily of mutual fund investments in closed-end first lien 1-4 family residential mortgages.
At December 31, 2011 and 2010, U.S. agencies/mortgage backed securities and collateralized mortgage obligations with an aggregate fair market value of $12 million and $13 million, respectively, were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits and Treasury, tax and loan accounts.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. Securities Available for Sale (Cont-)
The amortized cost and estimated fair values of securities available for sale at December 31, 2011 and December 31, 2010 are shown in the table below by contractual maturities and historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, may cause future prepayment rates to differ from historical prepayment rates.
The Company recognized net gains on sales of securities available for sale of $405,000 on sale proceeds of $96 million during the year ended December 31, 2011, and $1.5 million on sale proceeds of $243 million during the year ended December 31, 2010.
The table below shows, as of December 31, 2011, the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. Securities Available for Sale (Cont-)
The table below shows, as of December 31, 2010, the gross unrealized losses and fair values of our investments, in thousands of dollars, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
The securities with unrealized losses for 12 months or more are comprised of GNMA and FNMA adjustable rate securities purchased at large premiums that are susceptible to prepayments in a lower interest rate environment.
We regularly monitor investments for significant declines in fair value. We have determined that declines in the fair values of these investments below their respective amortized costs, as set forth in the tables above, are temporary because (i) those declines were due to interest rate changes and not to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values or until their maturity.
We recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities in accordance with ASC 320-10. When there are credit losses associated with, but we have no intention to sell, an impaired debt security, and it is more likely than not that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income (loss).
Through the impairment assessment process, we determined that the available-for-sale securities discussed below were other-than-temporarily impaired at December 31, 2011. We recorded in our consolidated statements of operations for the year ended December 31, 2011 impairment credit losses of $169,000 on available-for-sale securities. The OTTI related to factors other than credit losses, in the aggregate amount of $2 million, was recognized as other comprehensive loss in our balance sheet.
The table below presents a roll-forward of OTTI where a portion was attributable to non-credit related factors and, therefore, was recognized in other comprehensive loss for the year ended December 31, 2011:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. Securities Available for Sale (Cont-)
In determining the component of OTTI related to credit losses, we compare the amortized cost basis of each OTTI security to the present value of its expected cash flows, discounted using the effective interest rate implicit in the security at the date of acquisition.
As a part of our OTTI assessment process with respect to securities held for sale with unrealized losses, we consider available information about (i) the performance of the collateral underlying each such security, including credit enhancements, (ii) historical prepayment speeds, (iii) delinquency and default rates, (iv) loss severities, (v) the age or “vintage” of the security, and, (vi) rating agency reports on the security. Significant judgments are required with respect to these and other factors in order to make a determination of the future cash flows that can be expected to be generated by the security.
Based on our OTTI assessment process, we determined that there were two different investment securities in our portfolio of securities held for sale that had become or were impaired as of December 31, 2011: An asset-backed security and a non-agency collateralized mortgage obligation (“CMO”).
Asset-Backed Security. At December 31, 2011, we had one asset backed security in our portfolio of investment securities available for sale. This security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers consisting of 45 U.S. depository institutions and 11 insurance companies at the time of the security’s issuance in November 2007. This security was part of a $363 million issuance. The security that we own (CUSIP 74042CAE8) is the mezzanine class B piece security with a variable interest rate of 3 month LIBOR +60 basis points and a rating of Aa2/AA by Moody’s and Fitch at the time of issuance. We purchased $3.0 million face value of this security in November 2007 at a price of 95.21% for a total purchase price of $2,856,420.
As of December 31, 2011 the amortized cost of this security was $2.3 million with a fair value of $379,000 for an approximate unrealized loss of $1.9 million. Currently, the security has a Ca rating from Moody’s and CC rating from Fitch and has experienced $47.5 million in defaults (13% of total current collateral) and $42.5 million in deferring securities (12% of total current collateral) from issuance to December 31, 2011. The security did not pay its scheduled fourth quarter interest payment. The Company is not currently accruing interest on this security. The Company estimates that the security could experience another $64 million in defaults before the issuer would not receive all of the contractual cash flows under this security. This analysis is based on the following assumptions: future default rates of 2%, prepayment rates of 1% until maturity, and 15% recovery of future defaults. We have recognized impairment losses in earnings of $169,000, $199,000, and $24,000 for the years ended December 31, 2011, December 31, 2010, and December 31, 2009 relating to this security.
Non-Agency CMO. Through our impairment analysis, we identified one non-agency collateralized mortgage obligation security (a “CMO”) with respect to which we recognized OTTI at December 31, 2011. This CMO is a “Super Senior Support” bond, which was originated in 2005, was then rated AAA by Standard & Poor’s and Aa1 by Moody’s, and had a credit support of 2.5% of the total balance at issuance. As of December 31, 2011, the security was rated BBB and Caa3 by Standard and Poor’s and Moody’s, respectively, and was determined to have a fair value of $654,000, as compared to an amortized cost of $762,000, resulting in an unrealized loss of approximately $108,000. The CMO is collateralized by a pool of one-to-four family, fully amortizing residential first mortgage loans that bear interest at a fixed rate for approximately five years, after which they bear interest at variable rates with annual resets.
At December, 31, 2011, credit support underlying this CMO was approximately 5.3% and delinquencies that were 60 days or over totaled approximately 7%. Factors considered in determining that this security was impaired included the changes in the ratings of the security, the current level of subordination from other CMO classes, anticipated prepayment rates, cumulative default rates and the loss severity given a default. Based on our impairment assessment and analysis, we
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
5. Securities Available for Sale (Cont-)
recorded no impairment charge in our statement of operations in 2011 with respect to this security. Because all contractual principal and interest on this security for 2011 was paid, the impaired losses in both securities decreased compared to 2010. The unrealized loss on this security, of $108,000, was recognized in other comprehensive loss on our balance sheet, because we concluded that this loss was attributable to non-credit factors, such as external market conditions, the limited liquidity of the security and risks of potential additional declines in the housing market.
We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of December 31, 2011 are not other-than-temporarily impaired, because we have concluded that we have the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).
6. Loans and Allowance for Loan Losses
The loan portfolio consisted of the following at:
At December 31, 2011 and 2010, real estate loans of approximately $161 million and $211 million, respectively, were pledged to secure borrowings obtained from the Federal Home Loan Bank.
Allowance for Loan Losses
The allowance for loan losses (“ALL”) represents our estimate of credit losses inherent in the loan portfolio at the balance sheet date. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the allowance for loan losses and the amount of the provisions that are required to be made for potential loan losses.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
The allowance for loan losses is first determined by analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal credit quality grading parameters - See below) on non-accrual for loss exposure and establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less closing costs to sell, with a specific reserve established for the “shortfall” amount. Other methods can be used in estimating impairment, including market price, and the present value of expected future cash flows discounted at the loan’s original interest rate.
On a quarterly basis, we utilize a classification migration model and individual loan review analysis tools as starting points for determining the adequacy of the allowance for homogenous pools of loans that are not subject to specific reserve allocations. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans. We then apply these calculated loss factors, together with a qualitative factor based on external economic factors and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal credit quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We also conduct individual loan review analysis, as part of the allowance for loan losses allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios. Set forth below is a summary of the Company’s activity in the allowance for loan losses during the years ended:
We steadily increased the provisions for loan losses during the three years ended December 31, 2010, due to the economic recession and the resulting increases in loan losses and the uncertainties as to when economic conditions would strengthen. By contrast, we were able to reverse the provision for loan losses by $833,000 in the year ended December 31, 2011, as a result of multi-year lows in loan delinquencies, nonaccrual loans and outstanding loan balances.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
Set forth below is information regarding loan balances and the related allowance for loan losses, by portfolio type, for the years ended December 31, 2011 and 2010.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
Credit Quality
The quality of the loans in the Company’s loan portfolio is assessed as a function of net credit losses and the levels of nonperforming assets and delinquencies, as defined by the Company. These factors are an important part of the Company’s overall credit risk management process and its evaluation of the adequacy of the allowance for loan losses.
The following table provides a summary of the delinquency status of the Bank’s loans by portfolio type at December 31 2011 and 2010:
As the above table indicates, total past due loans decreased by $6.7 million, to $11.2 million as of December 31, 2011, from $17.9 million as of December 31, 2010. The year-over-year decrease in loan delinquencies was primarily attributable to the foreclosure of $10 million of commercial real estate loans that were 30 - 59 days past due. There were no loans that were past due 90 days or more and still accruing interest at December 31, 2011 and $250,000 as of at December 31, 2010. Loans 90 days or more past due declined by $735,000, whereas loans 60 - 89 days past due increased by $3.2 million, during the year ended December 31, 2011 as loans past due 30-59 days moved through the delinquency cycle. The Bank’s outstanding loan balance declined by $83 million from December 31, 2010 to December 31, 2011.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless management believes the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at December 31, 2011. At December 31, 2010, $250,000 of loans 90 days or more past due were still accruing interest. In certain instances, when a loan is placed on non-accrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case interest payments are credited to income. Non-accrual loans may be restored to accrual status when principal and interest become current and full repayment is expected. The following table provides information as of December 31, 2011 and 2010, with respect to loans on nonaccrual status, by portfolio type:
There were no multi-family residential mortgage loans on non-accrual status at December 31, 2011 or 2010.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
The Company classifies its loan portfolios using internal credit quality ratings, as discussed above under Allowance for Loan Losses. The following table provides a summary of loans by portfolio type and the Company’s internal credit quality ratings as of December 31, 2011 and 2010.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
The disaggregation of the loan portfolio by risk rating as set forth in the table above reflects the following changes that occurred between December 31, 2011 and December 31, 2010:
•
Loans rated “pass” totaled $576.3 million at December 31, 2011, down from $655.9 million at December 31, 2010, due primarily to the decline in total loans outstanding and net transfers of approximately $10.1 million in loans to the “special mention” category and $6.5 million of loans to “substandard” category. These net transfers were primarily attributable to emerging weaknesses that we identified in the financial condition or cash flows of the borrowers or in their identified secondary sources of repayment.
•
The “special mention” category increased by approximately $8.8 million at December 31, 2011 as compared to December 30, 2010, due primarily to the above-described net transfers of loans from “pass” to “special mention,” partially offset by net transfers of $2.4 million of loans from “special mention” to “substandard” category.
•
Loans classified “substandard” decreased by $12.5 million to $54.7 million at December 31, 2011 from $67.2 million at December 31, 2010. This year over year decrease was primarily due to the foreclosure of $16.5 million of commercial real estate loans, partially offset by net increases of loans transferred from the “pass” and “special mention” categories.
•
Loans classified as “doubtful” increased to approximately $662,000 at December 31, 2011 from $129,000 at December 31, 2010, due to the classification of one loan as “doubtful.”
We analyzed the allowance for loan losses and determined that the credit risks inherent in our loan portfolio had declined in 2011 as compared to 2010 and that the allowance for loan losses was appropriate at December 31, 2011. Those determinations was based on (i) an $83 million decrease in total loans outstanding to $657.5 million at December 31, 2011 from approximately $741 million at December 31, 2010; (ii) an $8.9 million decline in net loan charge-offs to $1.6 million in 2011 from $10.5 million in 2010; (iii) an $8.0 million decline in nonaccrual loans to $14.1 million at December 31, 2011, from $22.1 million at December 31, 2010; and (iv) a $6.7 million decline in delinquent loans to $11.2 million at December 31, 2011 from $17.9 million at December 31, 2010. For these reasons, in 2011 we reversed the provisions made for loan losses by $833,000.
Impaired Loans
A loan is generally classified as impaired and placed on nonaccrual status when, in management’s opinion, the principal or interest will not be collectible in accordance with the contractual terms of the loan agreement. The Company measures and reserves for impairments on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.
The following table sets forth information regarding nonaccrual loans and restructured loans, at December 31, 2011 and December 31, 2010:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
The table below contains additional information with respect to impaired loans, by portfolio type, for the years ended December 31, 2011 and 2010:
(a) When the discounted cash flows, collateral value or market price equals or exceeds the recorded investment in the loan, then the loan does not require an allowance. This typically occurs when the impaired loans have been partially charged-off and/or there have been interest payments received and applied to the principal loan balance.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Loans and Allowance for Loan Losses (Cont-)
The allowance for loan losses at December 31, 2011 included $2.8 million of reserves for $18.4 million in impaired loans as compared to $3.4 million of reserves for $31.5 million of impaired loans at December 31, 2010. At December 31, 2011 and December 31, 2010 there were impaired loans of $8.5 million and $5.9 million, respectively, for which no specific reserves were allocated because payment of those loans was, in management’s judgment, sufficiently collateralized. Of the $8.5 million in impaired loans at December 31, 2011, for which no specific reserves were allocated, $2.4 million had been deemed impaired in prior quarters.
We had average investments in impaired loans of $44.3 million and $52.3 million during the years ended December 31, 2011 and December 31, 2010, respectively. The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $678,000 in 2011 and $1.7 million in 2010.
Troubled Debt Restructurings
Pursuant to ASU No. 2011-02, if a creditor separately concludes that (i) a loan restructuring constitutes a concession, and (ii) the borrower is experiencing financial difficulties, the loan restructuring will be considered a troubled debt restructuring or a “TDR”. The modifications that the Bank has historically extended to borrowers in loan restructurings have come in the form of a changes in the amortization terms, reductions in the interest rates, the acceptance of interest only payments and, in limited cases, concessions to the outstanding loan balances. A workout plan between a borrower and the Bank is designed to provide a bridge for the cash flow shortfalls in the near term. If the borrower works through the near term issues, in most cases, the original contractual terms will be reinstated.
Troubled debt restructurings declined to $4.2 million at December 31, 2011 from $16.5 million at December 31, 2010. That decline was attributable to (i) our foreclosure of the real properties collateralizing two of the restructured loans, the aggregate principal amount of which was $10.1 million, and (ii) repayments, or the reinstatement of the original loan terms, of the remaining $6.4 million of the restructured loans.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
7. Premises and Equipment
The major classes of premises and equipment are as follows:
The amount of depreciation and amortization included in operating expense was $499,000, $504,000 and $492,000 for the years ended December 31, 2011, 2010 and 2009, respectively.
8. Deposits
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2011 and 2010 were $418 million and $397 million, respectively.
The scheduled maturities of time certificates of deposit at December 31, 2011 were as follows:
9. Borrowings and Contractual Obligations
Borrowings consisted of the following:
Securities sold under agreements to repurchase, which are classified as secured borrowings and mature within one day from the transaction date, are reflected at the amount of cash received in connection with the transaction.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. Borrowings and Contractual Obligations (Cont-)
Borrowings. As of December 31, 2011, we had $34 million of outstanding short-term borrowings and $15 million of outstanding long-term borrowings that we had obtained from the Federal Home Loan Bank. The table below sets forth the amounts (in thousands of dollars) of, the interest rates we pay on, and the maturity dates of these Federal Home Loan Bank borrowings. These borrowings, along with the securities sold under agreements to repurchase, have a weighted-average annualized interest rate of 1.19%.
At December 31, 2011, U.S. Agency and Mortgage Backed securities, U.S. Government agency securities, collateralized mortgage obligations with an aggregate fair market value of $3.4 million, and $144 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, and treasury, tax and loan accounts.
As of December 31, 2011, we had unused borrowing capacity of $102 million with the Federal Home Loan Bank. The highest amount of borrowings outstanding at any month end during the year ended December 31, 2011 consisted of $114 million of borrowings from the Federal Home Loan Bank and no overnight borrowings in the form of securities sold under repurchase agreements.
As of December 31, 2010, we had $68 million of outstanding short-term borrowings and $44 million of outstanding long-term borrowings that we had obtained from the Federal Home Loan Bank. These borrowings, along with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 0.82%.
As of December 31, 2010 we had unused borrowing capacity of $59.9 million with the Federal Home Loan Bank. The highest amount of borrowings outstanding at any month-end during the year ended December 31, 2010 consisted of $132 million of borrowings from the Federal Home Loan Bank and $11.8 million of overnight borrowings in the form of securities sold under repurchase agreements.
These Federal Home Loan Bank borrowings were obtained in accordance with the Company’s asset/liability management objective to reduce the Company’s exposure to interest rate fluctuations.
Junior Subordinated Debentures. In 2002, we formed grantor trusts to sell and issue to institutional investors a total of approximately $17.5 million of floating junior trust preferred securities (“trust preferred securities”). In October 2004, the Company established another grantor trust that sold an additional $10.3 million of trust preferred securities to an institutional investor. The Company received the net proceeds from the sales of the trust preferred securities in exchange for our issuance to the grantor trusts, of a total $27.5 million principal amount of our junior subordinated floating rate debentures (the “Debentures”). The payment terms of the Debentures mirror those of the trust preferred securities and the payments that we make of interest and principal on the Debentures are used by the grantor trusts to make the payments that come due to the holders of the trust preferred securities pursuant to the terms of those securities. The Debentures also were pledged by the grantor trusts as security for the payment obligations of the grantor trusts under the trust preferred securities.
During the year ended December 31, 2007, we voluntarily redeemed, at par, $10.3 million principal amount of the Debentures, and the corresponding trust preferred securities, that we issued in 2002.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. Borrowings and Contractual Obligations (Cont-)
Set forth below are the respective principal amounts, in thousands of dollars, and certain other information regarding the terms of the Debentures that remained outstanding as of December 31, 2011 and 2010:
(1) Interest rate resets quarterly.
These Debentures require quarterly interest payments, which are used to make quarterly distributions required to be paid on the corresponding trust preferred securities. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments, and the corresponding distributions on the trust preferred securities, for up to five years. Exercise of this deferral right does not constitute a default of our obligations to pay the interest on the Debentures or the corresponding distributions that are payable on the trust preferred securities.
As previously reported, since July 2009 we have been required to obtain the prior approval of FRB to make interest payments on the Debentures. During the twelve months ended December 31, 2011, we were unable to obtain regulatory approvals to pay, and it became necessary for us to defer, quarterly interest payments on the Debentures issued in 2002 and quarterly interest payments on the Debentures that we issued in 2004. We cannot predict when the FRB will approve our resumption of such interest payments and until such approval can be obtained it will be necessary for us to continue deferring interest payments on the Debentures. Since we have the right, under the terms of the Debentures, to defer interest payments for up to twenty (20) quarters, the deferrals of interest payments to date have not, and any deferral of future interest payments through January, 2015, will not constitute a default under or with respect to the Debentures. However, if by that date we have not been able to obtain regulatory approval to pay all of the deferred interest payments, we would then be in default under the Debentures. Information regarding the FRB Agreement and the requirements and restrictions imposed on us by that Agreement is set forth above in this report under the subcaption “-Supervision and Regulation in Part I of this Report under the caption “Regulatory Action by the FRB and DFI” and in the Section entitled “RISK FACTORS” contained in Item 1A of this Report.
Under the Federal Reserve Board rulings, the borrowings evidenced by the Debentures, which are subordinated to all of our other borrowings that are outstanding or which we may obtain in the future, are eligible (subject to certain dollar limitations) to qualify and, at December 31, 2011 and 2010, $16.8 million of those Debentures qualified as Tier I capital, for regulatory purposes. See discussion above in Item 7 of this report under the subcaption “Capital Resources-Capital Regulatory Requirements Applicable to Banking Institutions.”
10. Transactions with Board of Directors
The Directors of the Company and the Bank, and certain of the businesses with which they are associated, conduct banking transactions with the Company in the ordinary course of business. All loans and commitments to loan included in such transactions are made in accordance with applicable laws and on substantially the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions with persons of similar creditworthiness that were not affiliated with the Company, and did not present any undue risk of collectability.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. Transactions with Board of Directors (Cont-)
The following is a summary of loan transactions with the Board of Directors of the Company and certain of their associated businesses:
(1) Includes loans made to executive officers who are not also directors totaling zero and $56 thousand in 2011 and 2010, respectively.
Deposits by Board of Directors and executive officers held by the Bank were $1.3 and $1.0 million at December 31, 2011 and 2010, respectively.
11. Income Taxes
The components of income tax expense (benefit) consisted of the following for the years ended December 31:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
11. Income Taxes (Cont-)
The components of our net deferred tax asset are as follows at:
The reasons for the differences between the statutory federal income tax rate and the effective tax rates are summarized as follows:
We recognize deferred tax assets and liabilities using estimated future tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities, including net operating loss carry forwards.
We record as a “deferred tax asset” on our balance sheet an amount equal to the tax credit and tax loss carryforwards and tax deductions (“tax benefits”) that we believe will be available to us to offset or reduce the amounts of our income taxes in future periods. Under applicable federal and state income tax laws and regulations, such tax benefits will expire if not used within specified periods of time. Accordingly, the ability to fully use our deferred tax asset depends on the amount of taxable income that we generate during those time periods. At least once each year, or more frequently, if warranted, we make estimates of future taxable income that we believe we are likely to generate during those future periods. If we conclude, on the basis of those estimates and the amount of the tax benefits available to us, that it is more likely than not that we will be able to fully utilize those tax benefits prior to their expiration, we recognize the deferred tax asset in full on our balance sheet. On the other hand, if we conclude on the basis of those estimates and the amount of the tax benefits available to us that it has become more likely than not that we will be unable to utilize those tax benefits in full prior to their expiration, then, we would establish (or increase any existing) valuation allowance to reduce the deferred tax asset on our balance sheet to the amount which we believe we are more likely than not to be able to utilize. Such a reduction is implemented by recognizing a non-cash charge that would have the effect of increasing the provision, or reducing any credit, for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
11. Income Taxes (Cont-)
income taxes that we would otherwise have recorded in our statements of operations. The determination of whether and the extent to which we will be able to utilize our deferred tax asset involves significant management judgments and assumptions that are subject to period to period changes as a result of changes in tax laws, changes in market or economic conditions that could affect our operating results or variances between our actual operating results and our projected operating results, as wells as other factors.
During the fourth quarter of 2008, we concluded that it had become more likely than not that our taxable income in the foreseeable future would not be sufficient to enable us to realize our deferred tax asset in its entirety. That conclusion was based on our consideration of the relative weight of the available evidence, including the rapid deterioration in market and economic conditions, and the uncertainties regarding the duration of and how our future operating results would be affected by those conditions. As a result, we recorded a $3.0 million valuation allowance against our deferred tax asset for the portion of the tax benefits which, based on our assessment, we were more likely, than not, to be unable to use prior to their expiration.
At June 30, 2010 we conducted an assessment of the realizability of our remaining deferred tax asset. Based on that assessment and due, in part, to continued weakness in the economy and financial markets, we concluded that it had become more likely, than not, that we would be unable to utilize our remaining tax benefits comprising our deferred tax asset prior to their expiration. Therefore, we recorded an additional valuation allowance against our net deferred tax asset in the amount of $10.7 million by means of a non-cash charge to income tax expense in the quarter ended June 30, 2010.
During the fourth quarter of 2011, we conducted another assessment of the realizability of our deferred tax asset, due to a strengthening of economic conditions, an improvement in the quality of our loan portfolio, as reflected in declines in loan losses and loan delinquencies, and the earnings we were generating from operations. Based on that assessment, we determined that it had become more likely, than not, that we would be able to use approximately $7.0 million of the income tax benefits comprising our deferred tax asset to offset or reduce taxes in future years. As a result we reduced, by a corresponding amount, the valuation allowance that we had previously established against our deferred tax asset which resulted in the recognition of a non-cash income tax benefit for 2011 in the amount of $6.4 million.
Adjustments to the remaining valuation allowance could be required in the future if we were to conclude, on the basis of our assessment of the realizability of the deferred tax asset, that the amount of that asset which is more likely, than not, to be available to offset or reduce future taxes has increased or decreased. Any such increase could result in a reduction in our provision for income taxes or an income tax benefit, as occurred in 2011; and any such reduction could result in an increase in our provision for income taxes, as occurred in 2010.
We file income tax returns with the U.S. federal government and the state of California. As of December 31, 2011, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns for the 2008 to 2010 tax years. As of December 31, 2011, we were subject to examination by the Franchise Tax Board for California state income tax return for 2009 and 2010 tax years. We do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.
Net operating losses (“NOLs”) on U.S. federal income tax returns for tax years 2010 and 2011 may be carried back five years and forward twenty years. We filed an amended prior year U.S. federal tax return for the tax year 2010 and to carryback the U.S. federal NOLs for five years. NOLs on our California state income tax returns for tax year 2009 and 2010 may be carried forward twenty years. However, the state of California has suspended net operating carryover deductions for 2008 through 2011, although corporate taxpayers were permitted to compute and carryover their NOLs during that suspension period. Beginning in 2012, California taxpayers may carryback losses for two years and carryforward for twenty years, which will conform to the U.S. tax laws by 2013. We expect (although no assurance can be given) that we will generate taxable income in future years to offset the California NOL generated in prior years.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the years ended 2011 and 2010. Our effective tax rate differs from the federal statutory rate primarily due to tax free income on municipal bonds and certain non-deductible expenses recognized for financial reporting purposes and state taxes.
12. Stock-Based Employee Compensation Plans
At the Company’s 2010 Annual Meeting, held on May 25, 2010, our shareholders approved a 2010 Equity Incentive Plan (the “2010 Plan”), which provides for the grant of equity incentives, consisting of options, restricted shares and stock appreciation rights (“SARs”) to officers, other key employees and directors of the Company and the Bank. The 2010 Plan sets aside, for the grant or awarding of such equity incentives, 400,000 shares of our common stock, plus an additional 158,211 shares of common stock which was equal to the total of the shares that were then available for the grant of equity incentives under our shareholder-approved 2008 and 2004 Plans (the “Previously Approved Plans”). At the same time, those 158,211 shares ceased to be issuable under the Previously Approved Plans. As a result, upon approval of the 2010 Plan by our shareholders, a total of 558,211 shares were available for the grant or awarding of equity incentives under that plan.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. Stock-Based Employee Compensation Plans (Cont-)
Options to purchase a total of 1,146,344 shares of our common stock granted under the Previously Approved Plans were outstanding at March 31, 2010. Those plans had provided that, if any of the outstanding options were to expire or otherwise terminate, rather than being exercised, the shares that had been subject to those options would become available for the grant of new options under those plans. However, the 2010 Plan provides that if any of the outstanding options granted under the Previously Approved Plans expire or are terminated for any reason, then, the number of shares that would become available for grants or awards of equity incentives under the 2010 Plan would be increased by an equivalent number of shares, instead of becoming available for new equity incentive grants under the Previously Approved Plans. Assuming that all of the options that were outstanding under the Previously Approved Plans on the date the 2010 Plan was adopted were to expire or be cancelled, then the maximum number of shares that could be issued pursuant to equity incentives under the 2010 Plan would be 1,704,555 shares.
Stock options entitle the recipients to purchase common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the respective grant dates of the stock options. Restricted shares may be granted at such purchase prices and on such other terms, including restrictions and Company repurchase rights, as are fixed by the Compensation Committee at the time rights to purchase such restricted shares are granted. SARs entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to fair market value of the Company’s shares on the date of grant), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Options, restricted shares and SARs may vest immediately or in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards the options, the restricted shares or the SARs. Stock options and SARs may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option or SAR. The Company will become entitled to repurchase any unvested restricted shares, at the same price that was paid for the shares by the recipient, in the event of a termination of employment or service of the holder of such shares or if any performance goals specified in the award are not satisfied. To date, the Company has not granted any restricted shares or any SARs.
Under ASC 718-10, we recognize in our financial statements the fair values of the options or any restricted shares that we grant as compensation cost over their respective service periods.
The fair values of the options that were outstanding at December 31, 2011 under the 2010 Plan or the Previously Approved Plans were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. Stock-Based Employee Compensation Plans (Cont-)
The following tables summarize the stock option activity under the Company’s 2010 Plan and Previously Approved Plans (which are collectively referred as the “Plans”) during the years ended December 31, 2011, 2010 and 2009, respectively.
There were no options exercised during either of the years ended December 31, 2011 and December 31, 2010. The fair values of vested options at December 31, 2011, 2010 and 2009 were $287,000, 244,000 and $313,000, respectively.
The following table provides additional information regarding the vested and unvested options that were outstanding at December 31, 2011.
(1) The weighted average remaining contractual life of the options that were exercisable as of December 31, 2011 was 4.01 years.
The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at December 31, 2011 and 2010 were $31,000 and $39,000, respectively.
A summary of the status of the unvested options as of December 31, 2011, and changes in the number of shares subject to and in the weighted average grant date fair values of the unvested options during the year ended December 31, 2011, are set forth in the following table.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. Stock-Based Employee Compensation Plans (Cont-)
The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the years ended December 31, 2011, 2010 and 2009 were $278,000, $167,000 and $176,000 respectively, in each case net of taxes. At December 31, 2011, the weighted average period over which nonvested awards were expected to be recognized was 1.27 years.
The following table sets forth the compensation expense which is expected to be recognized during the periods presented below in respect of non-vested stock options outstanding at December 31, 2011:
13. Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted to common stock that would then share in our earnings. For the years ended December 31, 2011, 2010 and 2009 outstanding options to purchase 984,619, 1,177,642 and 1,162,744 shares, respectively, were not considered in computing diluted earnings (loss) per common share because they were antidilutive.
The following table shows how we computed basic and diluted EPS for the years ended December 31, 2011, 2010 and 2009.
14. Shareholders’ Equity
Preferred Stock.
Series A Preferred Stock. In August 2010, we completed a private offering to a limited number of accredited investors of shares of a newly authorized series of preferred stock, designated as the Company’s Series A Convertible 10% Cumulative Preferred Stock (the “Series A Shares”), at a price of $100.00 per Series A Share. We sold a total of 126,550 Series A Shares in that private offering, raising a total of $12.655 million (before offering expenses). Cash dividends on the Series A Shares were payable if, as and when declared by the Board of Directors out of funds legally available therefor at a rate equal to 10% of
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. Shareholders’ Equity (Cont-)
the issue price per annum of the Series A Shares and, if not declared, would accumulate until paid. Unless and until any accrued but unpaid dividends on the Series A Shares were paid, no cash dividends could be paid on the Company’s outstanding common stock. Effective July 1, 2011 the holders of 115,500 of the 126,500 shares of Series A Preferred Stock outstanding voluntarily converted their Series A Shares, at a conversion price of $7.65 per common share, into a total of 1,510,238 shares of common stock of the Company. At the same time the Company issued to those Series A holders a total of 328,100 additional shares of common stock in exchange for the waiver of their rights to receive the payment in cash of the undeclared dividends that had accumulated on those Series A Shares. As a result of the conversion of those Series A Shares, dividends on those shares ceased to accrue as of July 1, 2011 and only 11,000 shares of the Series A Shares remained outstanding.
On January 26, 2012, the Company’s shareholders, voting together as a single class, and the holders of the Series A Shares, voting as a separate class, approved an amendment to the rights, preferences and privileges of the Series A Preferred Shares to permit the Company to pay accumulated, but unpaid, dividends on the Series A Preferred Stock in shares of common stock, in lieu of having to pay such dividends in cash. Following the effectiveness of that amendment, on January 26, 2012, the Company’s Board of Directors declared a dividend in the amount of all of the accumulated but unpaid dividends, which totaled $206,861, on the 11,000 Series A Preferred Shares that were still outstanding, which was paid by the issuance of a total of 37,272 shares of common stock of the Company on January 30, 2012. As a result of the payment of those dividends, the remaining 11,000 Series A Preferred Shares then outstanding converted automatically into a total of 143,790 shares of the Company’s common stock and, as a result no Series A Preferred Shares remain outstanding.
Series B Preferred Stock On August 26, 2011 we completed the sale of a total of $11.2 million of Series B Preferred Stock to three institutional investors in a private placement: SBAV, LP (“SBAV”) and Carpenter Community Bancfund LP and Carpenter Community Bancfund-A LP (collectively the “Carpenter Funds”). We then contributed the net proceeds from the sale of those shares of Series B Preferred Stock to the Bank to enable it to increase the ratio of its adjusted tangible shareholders’ equity to its tangible assets above 9% and thereby meet the capital requirement under the DFI Order.
In order to provide additional capital above the 9% required by the DFI Order, as previously reported, on August 26, 2011, the Company also entered into (i) an Additional Series B Purchase Agreement with SBAV and the Carpenter Funds which provides for the sale by the Company, subject to satisfaction of certain conditions, of a total of $11.8 million of additional shares of Series B Preferred Stock of $10.8 million to the Carpenter Funds and $1.0 million to SBAV (the “Additional Series B Shares”) at the same purchase price and on the same terms as the Series B Shares that were sold on August 26, 2011, and (ii) a Common Stock Purchase Agreement with the Carpenter Funds which provides for the sale by the Company, subject to satisfaction of certain conditions, of a total of $15.5 million of its shares of common stock to the Carpenter Funds at a price equal to the greater of (i) $5.31 per common share or (ii) the book value of the Company’s common stock as determined from the Company’s most recent periodic report filed with the SEC prior to the closing of the sale of those shares. Additionally, the Company will be issuing common stock purchase warrants (the “Warrants”) that, subject to certain conditions, will entitle the Carpenter Funds and SBAV to purchase up to 408,834 and 399,436 shares, respectively, of the Company’s common stock at a price of $6.38 per share.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. Shareholders’ Equity (Cont-)
If these sales of the Additional Series B Shares and Common Shares are consummated, the Carpenter Funds will own approximately 28% of the Company’s voting securities and will be the Company’s largest shareholder. Consummation of the sales of the Additional Series B Shares and those Common Shares is subject to a number of conditions including, in addition to customary conditions, the receipt of required regulatory approvals by the Carpenter Funds and the achievement by the Bank of certain specified financial ratios. There is no assurance that these conditions will be satisfied and if either of these Agreements is terminated due to a failure of any of the conditions, the sale of the Additional Series B Shares and the Common Shares may not be consummated.
In connection with the sale of the Series B Shares on August 26, 2011, the Company entered into the following additional agreements with the Investors, which may have a significant impact on our operating results as a result of the accounting required under GAAP.
Investor Rights Agreements. The Company has entered into an Investor Rights Agreement with each of SBAV and the Carpenter Funds (the “SBAV Investor Rights Agreement” and the “Carpenter Investor Rights Agreement” respectively), which grant to SBAV and the Carpenter Funds the right to purchase (subject to certain exceptions) a pro-rata portion of any additional equity securities the Company may sell during the next four years in order to enable the Investors to maintain their respective percentage ownership interests in the Company. The SBAV Investor Rights Agreement entitles SBAV to designate an individual, who is acceptable to the Company, to be appointed as a member of the Boards of Directors of the Company and the Bank, subject to regulatory approval. The Carpenter Investor Rights Agreement provides that, if the purchases by the Carpenter Funds of the $10.8 million of Additional Series B Shares and the $15.5 million of shares of Company common stock are consummated, then the Carpenter Funds will become entitled to designate three individuals, who are reasonably acceptable to the Company, to serve on the Boards of Directors of both the Company and the Bank, effective upon receipt of any required regulatory approvals and clearances therefor.
If the sales of the Additional Series B Shares pursuant to the Additional Series B Purchase Agreement and the shares of Company common stock pursuant to the Common Stock Purchase Agreement are consummated, it will become necessary for Raymond E. Dellerba, who is President and CEO of both the Company and the Bank, to devote more of his time and energies, as the Company’s CEO, to the formulation and implementation of Company-wide strategic initiatives. As a result, upon consummation of the sales of the Additional Series B Shares and the shares of Common Stock, a search will be conducted for a new Bank CEO who would be responsible for the day to day operations of the Bank. The appointment of a new Bank CEO will be subject to the receipt of any then required regulatory approvals or clearances. At the time of that appointment, in addition to continuing as the Company’s CEO, Mr. Dellerba will become the Vice Chairman of the Bank and will continue, in that capacity as well, to be involved in oversight of its operations. The Carpenter Investor Rights Agreement provides that the individual selected to become the new Bank CEO must be reasonably acceptable to the Carpenter Funds.
Registration Rights Agreements. The Company also entered into a Registration Rights Agreement with both SBAV and the Carpenter Funds which required the Company (i) to file a Registration Statement on Form S-3 with the SEC to register for resale, under the Securities Act of 1933, as amended (the “Securities Act”), the shares of Company common stock that are issuable upon conversion of the Series B Shares and (ii) to use its commercially reasonable efforts to have that Registration Statement declared effective by the SEC within 120 days of the filing date. The Company filed the Registration Statement with the SEC on September 7, 2011, and it was declared effective by the SEC on October 21, 2011. If the sales of the Additional Series B Shares pursuant to the Additional Series B Purchase Agreement and the shares of Company common stock pursuant to the Common Stock Purchase Agreement are consummated, the Company also will enter into a second Registration Rights Agreement providing for it to register, for resale, the shares of common stock that will be issuable upon conversion of the Additional Series B Shares, the shares of common stock issuable pursuant to the Common Stock Purchase Agreement and the shares of common stock that will be issuable upon exercise of the Warrants.
A summary of the respective rights, preferences and privileges of the Series B Preferred Shares and Series C Preferred Shares is set forth above in Item 7 of this report under the subcaptions “Capital Resources-Summary of the Series B Rights, Preferences and Privileges-Summary of the Rights, Preferences and Privileges of the Series C Shares”.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. Shareholders’ Equity (Cont-)
Payment of Cash Dividends by the Company. California laws place restrictions on the ability of California corporations to pay cash dividends on preferred or common stock. Subject to certain limited exceptions, a California corporation may pay cash dividends only to the extent of (i) the amount of its retained earnings or (ii) the amount by which the fair value of the corporation’s assets exceeds its liabilities. However, as described in Note 3 above and earlier in this Note, the FRB Written Agreement prohibits the Company from paying any cash dividends to any of its preferred or common shareholders without the prior approval of the FRB. Moreover, as discussed in Note 9 above, we have had to defer interest payments on our Junior Subordinated Debentures as a result of restrictions contained in the FRB Agreement. Under the terms of those debentures, we may not pay cash dividends on our common stock or preferred stock unless and until we have paid all of the deferred interest in full and thereafter make interest payments on the debentures as and when they become due. We cannot predict when we might be able to obtain FRB approval to resume paying interest on the Debentures or to pay cash dividends on the Series B Preferred Stock or our common stock in the future.
Payment of Dividends by the Bank to the Company. Generally, the principal source of cash available to a bank holding company are cash dividends from its bank subsidiaries. Under California law, the Board of Directors of the Bank may declare and pay cash dividends to the Company, which is its sole shareholder, subject to the restriction that the amount available for the payment of cash dividends may not exceed the lesser of (i) the Bank’s retained earnings or (ii) its net income for its last three fiscal years (less the amount of any dividends paid made during such period). Cash dividends to shareholders in excess of that amount may be made only with the prior approval of the California Commissioner of Financial Institutions (“Commissioner”). If the Commissioner finds that the shareholders’ equity of the Bank is not adequate, or that the payment by the Bank of cash dividends to the Company would be unsafe or unsound for the Bank, the Commissioner can order the Bank not to pay such dividends.
The ability of the Bank to pay dividends is further restricted under the Federal Deposit Insurance Corporation Improvement Act of 1991 which prohibits an FDIC-insured bank from paying dividends if, after making such payment, the bank would fail to meet any of its minimum capital requirements. Under the Financial Institutions Supervisory Act and Federal Financial Institutions Reform, Recovery and Enforcement Act of 1989, federal banking regulators also have authority to prohibit FDIC-insured financial institutions from engaging in business practices which are considered to be unsafe or unsound. Under the authority of this Act, federal bank regulatory agencies, as part of their supervisory powers, generally require FDIC insured banks to adopt dividend policies which limit the payment of cash dividends much more strictly than do applicable state laws and, therefore, it is unlikely that the Bank would ever be permitted pay dividends in amounts that might otherwise, as a technical matter, be permitted under California law.
Moreover, the DFI Order prohibits the Bank from paying any cash dividends without the DFI’s prior approval, even if the payment of such dividends would otherwise be permitted under California law. As a result, it is not expected that the Bank will be permitted to pay cash dividends for the foreseeable future.
Stock Repurchase Program. In July 2005, the Company’s Board of Directors approved a share repurchase program, which authorized the Company to purchase up to two percent (2%), or approximately 200,000, of its outstanding common shares. That program provides for share repurchases to be made in the open market or in private transactions, in accordance with applicable Securities and Exchange Commission rules, when opportunities become available to purchase shares at prices believed to be attractive. The Company is under no obligation to repurchase any shares under the share repurchase program and the timing, actual number and value of shares that are repurchased by the Company under this program will depend on a number of factors, including the Company’s future financial performance and available cash resources, competing uses for its corporate funds, prevailing market prices of its common stock and the number of shares that become available for sale at prices that the Company believes are attractive, as well as any regulatory requirements applicable to the Company. Over the two years ended December 31, 2008, the Company purchased a total of 148,978 shares of its common stock in the open market under this program for an aggregate purchase price of approximately $1.4 million, which results in an average per share price of $9.30.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. Shareholders’ Equity (Cont-)
In October 2008, the Company’s Board of Directors approved a share repurchase program (the “2008 Share Repurchase Plan”) which authorized (but did not require) the Company to purchase up to $2 million of its shares of common stock. However, no shares were repurchased under this Share Repurchase Plan. The restrictions on the payment of cash dividends by the Company under the FRB Agreement also prohibit the Company from repurchasing any of its shares without the prior approval of the FRB. As a result, it is not expected that the Company will be permitted to repurchase its shares for the foreseeable future. See Note 3 above and the discussion above in this Note 14 for additional information regarding the FRB Agreement.
15. Commitments and Contingencies
The Company leases certain facilities and equipment under various non-cancelable operating leases, which generally include 3% to 5% escalation clauses in the lease agreements. Rent expense for the years ended December 31, 2011, 2010 and 2009 was $2.2 million, $2.4 million, and $2.4 million, respectively. Sublease income for the year ended December 31, 2009 was $15,000. The Company did not sublease facilities in years 2011 or 2010.
Future minimum non-cancelable lease commitments were as follows at December 31, 2011:
To meet the financing needs of our customers in the normal course of business, the Company is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At December 31, 2011 and 2010, the Company was committed to fund certain loans including letters of credit amounting to approximately $121 million and $141 million, respectively. The contractual amounts of credit-related financial instruments such as commitments to extend credit, credit-card arrangements, and letters of credit represent the amounts of potential accounting loss should the contracts be fully drawn upon, the customers default, and the value of any existing collateral become worthless.
The Company uses the same credit policies in making commitments to extend credit and conditional obligations as it does for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The 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 customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income-producing commercial properties.
The Company is required to purchase stock in the Federal Reserve Bank in an amount equal to 6% of its capital, one-half of which must be paid currently with the balance due upon request.
The Bank is a member of the FHLB and therefore, is required to purchase FHLB stock in an amount equal to the lesser of 1% of the Bank’s real estate loans that are secured by residential properties, or 5% of total advances.
The Company is subject to legal actions normally associated with financial institutions. At December 31, 2011 and 2010, the Company did not have any pending legal proceeding which if adversely determined against the Company, were expected to be material to its consolidated financial condition or results of operations, except as disclosed below.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
15. Commitments and Contingencies
Mark Zigner vs. Pacific Mercantile Bank, et al., filed in January, 2010, in the California Superior Court for the County of Orange (Case No. 0337433). As previously reported in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 (our “Third Quarter 2011 10-Q”), this lawsuit was filed by plaintiff asserting that the Bank had wrongfully exercised certain remedies in its efforts to recover borrowings owed by plaintiff to the Bank under (i) a $2.215 million construction loan which was secured by a first trust deed on real property owned by plaintiff, and (ii) a $200,000 unsecured line of credit. Plaintiff also maintained deposit accounts with the Bank.
Plaintiff failed to repay outstanding borrowings of approximately $191,000 due at the maturity date of his line of credit in April 2009. When plaintiff refused demands to repay those borrowings, the Bank set off that amount against plaintiff’s deposit accounts in accordance with the express terms of his line of credit agreement with the Bank. Plaintiff also failed to repay his construction loan when it matured in August 2009 and, in October 2009, the Bank commenced foreclosure proceedings against the real property collateralizing that loan.
In his lawsuit, plaintiff claimed that the set off by the Bank against plaintiff’s deposit accounts was wrongful based on allegations that the Bank had (i) agreed to extend the line of credit and breached that agreement when it exercised its set off rights, and (ii) failed to provide him with prior notice of the set off and an opportunity to cure his default under the line of credit. Plaintiff also asserted certain related claims, including an alleged breach by the Bank of an implied covenant of good faith and fair dealing.
The case was tried before a jury in August, 2011. As we reported in our Third Quarter 2011 10-Q, (i) before the case went to the jury for a decision, the trial judge ruled that the Bank had wrongfully exercised its set off rights and based on that finding, the jury awarded plaintiff $100,000 of compensatory damages, and (ii) the jury later found that the Bank’s exercise of its set off rights also constituted a wrongful conversion of plaintiff’s funds and, as a result, that the plaintiff was entitled to awards of $150,000 in compensatory damages and $1.87 million in punitive damages against the Bank.
In response to a proposed statement of decision submitted to the trial judge by plaintiff following the jury verdict, the Bank asserted that the judge’s ruling with respect to the Bank’s set off rights and the jury’s findings with respect to plaintiff’s claims of wrongful conversion were incorrect and that, as a result, plaintiff was not entitled, as a matter of law, to an award of either compensatory or punitive damages. The Bank also asserted that if the trial judge were to determine that plaintiff was entitled to punitive damages, the $1.87 million punitive damage award, which was nearly 12.5 times the $150,000 compensatory damage award for conversion, was excessive as a matter of California law, which provides that punitive damage to may range from one to four times the amount of compensatory damages. Nevertheless, the trial judge initially sustained the plaintiff’s statement of decision.
The Bank then filed motions with the court for a judgment notwithstanding the verdict and, in the alternative, for a new trial, as well as a motion to vacate the findings set forth in the statement of decision. A hearing on these motions was held on February 8, 2012. The court thereafter rejected the Bank’s motion for a judgment notwithstanding the verdict and, while it sustained the rulings on compensatory damages, the trial court ruled that the jury’s punitive damage award was excessive and that the Bank’s motion for a new trial would be granted, unless the plaintiff agreed to accept a reduction in the punitive damage award from $1.87 million to $950,000. On February 21, 2011 we learned that the plaintiff had agreed to accept that reduction in the punitive damage award and a final judgment has been entered against the Bank in the amount of $1.2 million. In addition, the trial court entered an award to plaintiff of his attorneys fees and costs, in the amount of $540,000.
Following the entry of the final judgment by the trial court, the Bank filed an appeal of the trial court’s rulings and the jury verdict, asserting that those rulings and the jury’s verdict were erroneous and that plaintiff is not entitled, as a matter of law, to an award of either compensatory or punitive damages. Because the appeals process has just begun, it is not possible at this time to predict, with any certainty, how the appellate courts will ultimately rule on our appeal. However, we believe that the judgment entered by the court against the Bank will be overturned on appeal.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
16. Employee Benefit Plans
The Company has a 401(k) plan that covers substantially all full-time employees. That plan permits voluntary contributions by employees, a portion of which are matched by the Company. The Company’s expenses relating to its contributions to the 401(k) plan for the years ended December 31, 2011, 2010 and 2009 were $19,000, $79,000 and $464,000, respectively.
In January 2001 the Bank established an unfunded Supplemental Retirement Plan (“SERP”) for its President and CEO, Raymond E. Dellerba. The SERP was amended and restated in April 2006 to comply with the requirements of new Section 409A of Internal Revenue Code. The SERP provides that, subject to meeting certain vesting requirements described below, upon reaching age 65 Mr. Dellerba will become entitled to receive 180 equal successive monthly retirement payments, each in an amount equal to 60% of his average monthly base salary during the three years immediately preceding the date of his retirement or other termination of his employment (his “normal retirement benefit”). Mr. Dellerba’s right to receive that normal retirement benefit vests monthly during the term of his employment at a rate equal to 1.5 monthly retirement payments for each month of service with the Bank.
The Company follows FASB ASC 715-30-35, which requires us to recognize in our balance sheet the funded status of any post-retirement plans that we maintain and to recognize, in other comprehensive income, changes in funded status of any such plans in any year in which changes occur.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
16. Employee Benefit Plans (Cont-)
The changes in the projected benefit obligation of other benefits under the Plan during 2011, 2010 and 2009, its funded status at December 31, 2011, 2010 and 2009, and the amounts recognized in the balance sheet at December 31, 2011 and December 31, 2010, were as follows:
As of December 31, 2011, $1.2 million benefits are expected to be paid in the next five years and a total of $1.8 million of benefits are expected to be paid from year 2017 to year 2022. In 2012, $342,000 is expected to be recognized in net periodic benefit cost.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
17. Regulatory Matters and Capital/Operating Plans
The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. A failure to meet minimum capital requirements is likely to lead to the imposition, by federal and state regulators, of (i) certain requirements, such as an order requiring additional capital to be raised, and (ii) operational restrictions that could have a direct and material adverse effect on operating results. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Also, as mentioned in Note 3, as a result of the Written Agreement issued in August 2010, the Company is taking actions designed to maintain capital and return the Company to profitability, including, among others, strategy planning and budgeting, and capital and profit planning.
Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes that, as of December 31, 2011, the Company and the Bank met all capital adequacy requirements to which they are subject and have not been notified by any regulatory agency that would require the Company or the Bank to maintain additional capital.
The actual capital amounts and ratios of the Company and the Bank at December 31, 2010 are presented in the following table:
As the above tables indicate, at December 31, 2011 and 2010, the Bank (on a stand-alone basis) qualified as a “well-capitalized” institution, and the capital ratios of the Company (on a consolidated basis) exceeded the capital ratios mandated for bank holding companies, under federally mandated capital standards and federally established prompt corrective action regulations. There are no conditions or events that management believes have changed the Company’s or the Bank’s classification as well-capitalized since December 31, 2011.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
18. Parent Company Only Information
Condensed Statements of Financial Condition
Condensed Statements of Operations
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
18. Parent Company Only Information (Cont-)
Condensed Statements of Cash Flows
19. Fair Value Measurements
Fair Value Hierarchy. Under ASC 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1
Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
Assets Measured at Fair Value on a Recurring Basis
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 investments 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 investment 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.
Loans Held for Sale (LHFS). Effective December 1, 2011, in connection with the adoption of ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825), the Company elected to measure new LHFS at fair value. The remaining LHFS are carried at the lower of cost or market. Fair value is based on quoted market prices. We classify those loans subjected to recurring fair value adjustments as Level 2.
The following table shows the recorded amounts of assets measured at fair value on a recurring basis.
The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:
(1) Amount reported as an other than temporary impairment loss in the noninterest income portion of the income statement
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:
(1) Amount reported as other than temporary impairment loss in the noninterest income portion of the income statement.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
Assets Recorded at Fair Value on a Nonrecurring Basis
The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market or that were recognized at a fair value below cost at the end of the period.
We have elected to use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.
Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan 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 for possible losses represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at 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, we record the impaired loan at Level 3.
Foreclosed Assets. Foreclosed assets are adjusted to fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined 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, we record the foreclosed asset at 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, we record the foreclosed asset at Level 3.
Loans Held for Sale. Loans held for sale and funded prior to December 1, 2011 are carried at the lower of cost or market value. The fair value of these 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.
Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.
(1) Includes foreclosed assets
There were no transfers in or out of level 3 measurements for nonrecurring items during the twelve months ended December 31, 2011.
We have elected to use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally unexpected changes in events or circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.
In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned.
The following methods and assumptions were used to estimate the fair value of financial instruments.
Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.
Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.
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.
Federal Home Loan Bank and Federal Reserve Bank Stock. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). As members, we are required to own stock of the FHLB and the FRB, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRB; however, to date, we have not done so. The fair values of that stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.
Loans Held for Sale (LHFS). Effective December 1, 2011, in connection with the adoption of ASU 825, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (ASU 825), the Company elected to measure new LHFS at fair value. The remaining LHFS are carried at the lower of cost or market value. Fair value is based on quoted market prices.
Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the discounted value of future cash flows expected to be received by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.
Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, “Accounting by Creditors for Impairment of a Loan”, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent) less selling cost. The fair value of an impaired loan 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 for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at nonrecurring Level 2.
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
Foreclosed Assets. Foreclosed assets are adjusted to the lower of cost or fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value, less estimated costs to sell. Fair value is determined on the basis of independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.
Deposits. The fair value of demand deposits, savings deposits, and money market deposits is defined as the amounts payable on demand. The fair value of fixed maturity certificates of deposit is estimated based on the discounted value of the future cash flows expected to be paid on the deposits.
Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.
Junior Subordinated Debentures. The fair value of the junior subordinated debentures is defined as the carrying amount. These securities are variable rate in nature and reprice quarterly.
Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These fees were not material in amount either at December 31, 2011, and 2010.
The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:
PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
19. Fair Value Measurements (Cont-)
Fair Value Option. The following table reflects the differences between the fair value carrying amount of LHFS measured at fair value under ASU 825 and the aggregate unpaid principal amount we are contractually entitled to receive at maturity.
The assets accounted for under the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The changes in fair value related to initial measurement and subsequent changes in fair value included in earnings for these assets measured at fair value are shown, by income statement line item, below.
20. Business Segment Information
The Company has two reportable business segments, the commercial banking division and the mortgage banking division, which began operations in the second quarter of 2009. The commercial bank segment provides small and medium-size businesses, professional firms and individuals with a diversified range of products and services such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services. The mortgage banking segment originates and purchases residential mortgages that, for the most part, are resold within 30 days to long-term investors in the secondary residential mortgage market.
Since the Company derives all of its revenues from interest and noninterest income and interest expense is its most significant expense, these two segments are reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of loans held for sale and fee income) for the years ended December 31, 2011, 2010 and 2009. The Company does not allocate general and administrative expenses or income taxes to the segments.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
ITEM 9A(T).
ITEM 9A(T). CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the “SEC”), and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC rules, an evaluation was performed under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness, as of December 31, 2011, of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2011, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting
Management’s Annual Report on Internal Control Over Financial Reporting
Management of Pacific Mercantile Bancorp is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our 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 accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those written policies and procedures that:
•
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America;
•
provide reasonable assurance that our receipts and expenditures are being made only in accordance with authorization of our management and board of directors; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on our consolidated financial statements.
Internal control over financial reporting includes the controls themselves, monitoring and internal auditing practices and actions taken to correct deficiencies as identified. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or because the degree of compliance with the policies or procedures may deteriorate.
Management’s Assessment of Internal Control over Financial Reporting
Our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2011, based on criteria for effective internal control over financial reporting described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design and the testing of the operational effectiveness of the Company’s internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of our Board of Directors.
Based on that assessment, management determined that, as of December 31, 2011, Pacific Mercantile Bancorp maintained effective internal control over financial reporting.
The foregoing report on internal control over financial reporting shall not be deemed “filed” for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section.
Section 989G of the Dodd-Frank Act, signed into law in July 2011, permanently exempts smaller reporting companies, such as the Company, and other non-accelerated filers, from Section 404(b) of the Sarbanes-Oxley Act requiring SEC reporting companies to obtain and include in their annual reports on Form 10-K, an attestation report from their independent registered accountants with respect to the effectiveness of their internal control over financial reporting. As a result, no such attestation report is included in this Annual Report.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this Item 10 is hereby incorporated by reference to Pacific Mercantile Bancorp’s definitive proxy statement, expected to be filed with the SEC on or before April 30, 2012, for its Annual Meeting of Shareholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is hereby incorporated by reference to Pacific Mercantile Bancorp’s definitive proxy statement, expected to be filed with the SEC on or before April 30, 2012, for its Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Except for the information below regarding our equity compensation plans, the information required by Item 12 is incorporated herein by reference from our definitive proxy statement expected to be filed with the SEC on or before April 30, 2012, for its Annual Meeting of Shareholders.
The following table provides information relating to our equity compensation plans as of December 31, 2011:
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item 13 is hereby incorporated by reference to Pacific Mercantile Bancorp’s definitive proxy statement expected to be filed with the SEC on or before April 30, 2012, for its Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this Item 14 is hereby incorporated by reference to Pacific Mercantile Bancorp’s definitive proxy statement expected to be filed with the SEC on or before April 30, 2012, for its Annual Meeting of Shareholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following documents are filed as part of this Report:
(1) Financial Statements. The Consolidated Financial Statements of Pacific Mercantile Bancorp: See Index to Financial Statements on Page 68 of this Annual Report.
(2) Financial Statement Schedules. No financial statement schedules are included in this Annual Report as such schedules are not required or the information that would be included in such schedules is not material or is otherwise furnished.
(3) Exhibits. See Index to Exhibits, elsewhere in this Report, for a list and description of (i) exhibits previously filed by the Company with the Commission and (ii) the exhibits being filed with this Report.
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, on the 24th day of February 2012.
PACIFIC MERCANTILE BANCORP
By:
/S/ RAYMOND E. DELLERBA
Raymond E. Dellerba
President and Chief Executive Officer
POWER OF ATTORNEY
Each person whose signature appears below hereby appoints Raymond E. Dellerba, and Nancy Gray, and each of them individually, to act severally as his or her attorneys-in-fact and agent, with full power and authority, including the power of substitution and resubstitution, to sign and file on his or her behalf and in each capacity stated below, all amendments and/or supplements to this Annual Report on Form 10-K, which amendments or supplements may make changes and additions to this Report as such attorneys-in-fact, or any of them, may deem necessary or appropriate.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons in their respective capacities and on the date or dates indicated below.
S-1
EXHIBIT INDEX
E-1
E-2
(1) Incorporated by reference to the same numbered exhibit to the Company’s Registration Statement (No. 333-33452) on Form S-1 filed with the Commission on June 14, 2000 (the “S-1 Registration Statement”).
(2) Incorporated by reference to the Exhibit 10.8 to the above referenced S-1 Registration Statement.
(3) Incorporated by reference to Exhibit 10.11 to Registration Statement on Form S-2 (No. 333-110377) filed with the Commission on November 10, 2003 (the “S-2 Registration Statement”).
(4) Incorporated by reference to Exhibit 10.12 to the above referenced S-2 Registration Statement.
(5) Incorporated by reference to Exhibit 10.13 to the above referenced S-2 Registration Statement.
(6) Incorporated by reference to Exhibits 10.1 and 10.2, respectively, to a Current Report on Form 8-K dated April 6, 2007.
E-3