Item 1. Business.
This report, including information included or incorporated by reference in this document, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in our forward-looking statements include, but are not limited, to the following:
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our ability to comply with our Consent Order, including the capital directive therein, and potential regulatory actions if we fail to comply;
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general economic conditions, either nationally or regionally and especially in our primary service area, being less favorable than expected, resulting in, among other things, a deterioration in credit quality;
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greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;
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greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;
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the amount of our loan portfolio collateralized by real estate and weakness in the real estate market;
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the rate of delinquencies and amount of loans charged-off;
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the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
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the rate of loan growth in recent years and the lack of seasoning of our loan portfolio;
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our ability to attract and retain key personnel;
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our ability to retain our existing customers, including our deposit relationships;
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significant increases in competitive pressure in the banking and financial services industries;
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adverse changes in asset quality and resulting credit risk related losses and expenses;
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changes in the interest rate environment which could reduce anticipated or actual margins;
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changes in political conditions or the legislative or regulatory environment, including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and regulations adopted thereunder, changes in federal and/or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking and financial services industries;
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changes occurring in business conditions and inflation;
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increased funding costs due to market illiquidity, increased competition for funding, and/or increased regulatory requirements with regard to funding;
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changes in deposit flows;
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changes in technology;
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changes in monetary and tax policies;
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changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;
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loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions; and
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other risks and uncertainties detailed in Part I, Item 1A
Item 1A. Risk Factors.
Our failure to comply with provisions of our Consent Order with the OCC could subject us to further enforcement action and reputational damage.
We entered into a Consent Order with the OCC on November 14, 2011, which requires the Bank, among other things, to: achieve and maintain Tier 1 capital at least equal to 9% of adjusted total assets, Tier 1 risk based capital at least equal to 10%, and total risk based capital at least equal to 12% of risk-weighted assets by March 31, 2012; ensure that the Bank has competent and effective Board oversight and management; prepare a written analysis on the Board’s decision whether to sell, merge, liquidate or remain independent, and in the event the Board determines that the Bank is to remain independent, to prepare an updated three-year strategic plan including a capital plan; ensure adherence to a written profit plan to improve and sustain the earnings of the Bank; maintain a comprehensive liquidity risk management program; ensure adherence to a written program to reduce the credit risk in the Bank; ensure adherence to a written program to improve the bank’s loan portfolio management; ensure adherence to a written concentrations of credit management program; obtain current and complete credit information on all loans lacking such information; and satisfy certain conditions prior to granting, extending, renewing, altering or restructuring any loan or other extension of credit. As a result of the Consent Order, we no longer meet the regulatory requirements to be eligible for expedited processing of branch applications and certain other regulatory approvals, and we are required to get OCC or FDIC approval before making certain payments to departing executives and before adding new directors or senior executives.
If we fail to comply with the terms of the Consent Order, the OCC has the authority to subject us to a cease and desist order with more restrictive terms, to impose civil money penalties on us and our directors and officers, and, under certain circumstances, to remove directors and officers from their positions with the Bank, which could have a material adverse effect on our business.
We are required to maintain high capital levels.
Under the terms of our Consent Order with the OCC, we are required to achieve and maintain by March 31, 2012, minimum capital ratios for the Bank that are higher than the minimum and well capitalized ratios generally applicable to banks: a Tier 1 leverage ratio of at least 9%, a Tier 1 risk based capital ratio of at least 10%, and a total risk based capital ratio of at least 12% of risk-weighted assets. Although the Bank’s capital levels remain the well capitalized ratios generally applicable to banks, the Bank is not considered to be well capitalized by the OCC due to the formal capital directive in the Consent Order, and the Bank must raise additional capital, continue to limit our growth, and/or sell assets to increase our capital ratios by March 31, 2012, in order to meet these standards set forth by the OCC. Noncompliance with the required minimum capital ratios may be deemed an unsafe and unsound banking practice by the OCC, which could result in the Bank becoming subject to other administrative actions or sanctions as the OCC considers necessary. It is uncertain what actions, if any, the OCC will take with respect to noncompliance with these ratios, what action steps the OCC might require the Bank to take to remedy this situation, and whether such actions would be successful.
We may be required to raise additional capital in the future but that capital may not be available when it is needed.
As described above, we are required by regulatory authorities to maintain certain levels of capital considered adequate to support our operations. Our ability to raise additional capital, when needed, will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to meet the minimum capital ratios in the Consent Order could be materially impaired.
If we do not generate positive cash flow and earnings, there will be an adverse effect on our future results of operations.
For the years ended December 31, 2011 and 2010, we incurred net losses of $2.1 million and $6.3 million, respectively. In light of the current economic environment, significant additional provisions for loan losses may be necessary to supplement the allowance for loan losses in the future. As a result, we may incur significant additional credit costs in 2012, which could adversely impact our financial condition, results of operations, and the value of our common stock.
If our nonperforming assets increase, our earnings will be adversely affected.
At December 31, 2011, our nonperforming assets (which consist of nonaccrual loans and other real estate owned) totaled $10.4 million, or 9.3% of total assets. At December 31, 2010, our nonperforming assets were $14.6 million, or 12.0% of total assets. Our nonperforming assets adversely affect our net income in various ways:
 
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We do not record interest income on nonaccrual loans or real estate owned.
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We must provide for probable loan losses through a current period charge to the provision for loan losses.
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Noninterest expense increases when we must write down the value of properties in our other real estate owned portfolio to reflect changing market values.
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There are legal fees associated with the resolution of problem assets, as well as carrying costs, such as taxes, insurance, and maintenance fees related to other real estate owned.
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The resolution of nonperforming assets requires the active involvement of management, which can distract them from more profitable activity.
If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our nonperforming assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our results of operations.
We have sustained losses from a decline in credit quality and may see further losses.
Our ability to generate earnings is significantly affected by our ability to properly originate, underwrite and service loans. We have sustained losses primarily because borrowers, guarantors or related parties have failed to perform in accordance with the terms of their loans and we failed to detect or respond to deterioration in asset quality in a timely manner. We could sustain additional losses for these reasons. Further problems with credit quality or asset quality could cause our interest income and net interest margin to further decrease, which could adversely affect our business, financial condition and results of operations. We have recently identified credit deficiencies with respect to certain loans in our loan portfolio which are primarily related to the downturn in the residential housing industry. As a result of the decline of the residential housing market, property values for this type of collateral have declined substantially. In response to this determination, we increased our loan loss reserve throughout 2010 and the first six months of 2011 to a total loan loss reserve of $2.1 million, or 2.74% of gross loans, at December 31, 2011 to address the risks inherent within our loan portfolio. Although credit quality indicators generally showed signs of stabilization in the second half of 2011, further deterioration in the South Carolina real estate market as a whole may cause management to adjust its opinion of the level of credit quality in our loan portfolio. Such a determination may lead to an additional increase in our provisions for loan losses, which could also adversely affect our business, financial condition, and results of operations.
Negative developments in the financial industry and the domestic and international credit markets have adversely affected our operations and results.
Negative developments beginning in the latter half of 2007 in the global credit and securitization markets have resulted in uncertainty in the financial markets. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have deteriorated at many institutions and the competition for deposits and quality loans has increased significantly. In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. Global securities markets, and bank holding company stock prices in particular, have been negatively affected, as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets. As a result, significant new federal laws and regulations relating to financial institutions have been adopted. Furthermore, the potential exists for additional federal or state laws and regulations regarding, among other matters, lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the continued issuance of formal enforcement orders. Negative developments in the financial industry and the domestic and international credit markets, and the impact of new legislation in response to those developments, may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance. We can provide no assurance regarding the manner in which any new laws and regulations will affect us.
A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market hurt our business.
A significant portion of our loan portfolio is secured by real estate. As of December 31, 2011, 83% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in our primary market area has resulted in an increase in the number of borrowers who have defaulted on their loans and a reduction in the value of the collateral securing their loans, which in turn has adversely affected our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt
during a period of reduced real estate values, our earnings and capital could be adversely affected. Acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.
Our decisions regarding credit risk and reserves for loan losses may materially and adversely affect our business.
Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, our loans and other extensions of credit may not be repaid. The risk of nonpayment is affected by a number of factors, including:
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the duration of the credit;
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credit risks of a particular customer;
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changes in economic and industry conditions; and
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in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.
We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:
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an ongoing review of the quality, mix, and size of our overall loan portfolio;
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historical loan loss experience;
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evaluation of economic conditions;
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regular reviews of loan delinquencies; and
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the amount and quality of collateral, including guarantees, securing the loans.
There is no precise method of predicting credit losses since any estimate of loan losses is necessarily subjective and the accuracy of the estimate depends on the outcome of future events. Therefore, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would adversely affect our results of operations and financial condition, and possibly cause a decrease in our capital.
While we generally underwrite the loans in our portfolio in accordance with our own internal underwriting guidelines and regulatory supervisory guidelines, in certain circumstances we have made loans which exceed either our internal underwriting guidelines, supervisory guidelines, or both. We are permitted to hold loans that exceed supervisory guidelines up to 100% of our regulatory capital. We have made loans that exceed our internal guidelines to a limited number of our customers who have significant liquid assets, net worth, and amounts on deposit with the Bank. As of December 31, 2011, approximately $4.0 million of our loans, or 42.0% of our Bank’s regulatory capital, had loan-to-value ratios that exceeded regulatory supervisory guidelines. In addition, supervisory limits on commercial loan-to-value exceptions are generally set at 30% of our Bank’s capital. At December 31, 2011, $2.3 million of our commercial loans, or 24.4% of our Bank’s regulatory capital, exceeded the supervisory loan-to-value ratio. The number of loans in our portfolio with loan-to-value ratios in excess of supervisory guidelines, our internal guidelines, or both could increase the risk of delinquencies and defaults in our portfolio.
There can be no assurance that recently enacted legislation will help stabilize the U.S. financial system.
As described above under Part I, Item 1, “Supervision and Regulation”, in response to the challenges facing the financial services sector, a number of regulatory and governmental actions have been enacted or announced. There can be no assurance that these government actions will achieve their purpose. The failure of the financial markets to stabilize, or a continuation or worsening of the current financial market conditions, could have a material adverse effect on our business, our financial condition, the financial condition of our customers, our common stock trading price, as well as our ability to access credit. It could also result in declines in our investment portfolio which could be “other-than-temporary impairments.”
Continuation of the economic downturn could reduce our customer base, our level of deposits, and demand for financial products such as loans.
Our success significantly depends upon the growth in population, income levels, deposits, and housing starts in our markets. The current economic downturn has negatively affected the markets in which we operate and, in turn, the quality of our loan portfolio. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally remain unfavorable, our business may not succeed. A continuation of the economic downturn or prolonged recession would likely result in the continued deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would hurt our business. Interest received on loans represented approximately 93% of our interest income for the
year ended December 31, 2011. If the economic downturn continues or a prolonged economic recession occurs in the economy as a whole, borrowers will be less likely to repay their loans as scheduled. Moreover, in many cases the value of real estate or other collateral that secures our loans has been adversely affected by the economic conditions and could continue to be negatively affected. Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies. A continued economic downturn could, therefore, result in losses that materially and adversely affect our business.
Our small- to medium-sized business target markets may have fewer financial resources to weather a downturn in the economy.
We target the banking and financial services needs of small- and medium-sized businesses. These businesses generally have fewer financial resources in terms of capital borrowing capacity than larger entities. If general economic conditions continue to negatively impact these businesses in the markets in which we operate, our business, financial condition, and results of operation may be adversely affected.
We are subject to extensive regulation that could limit or restrict our activities.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various regulatory agencies. Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans, interest rates charged on loans, interest rates paid on deposits, and locations of offices. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth.
The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.
Proposals for further regulation of the financial services industry are continually being introduced in the Congress of the United States of America and the General Assembly of the State of South Carolina. The agencies regulating the financial services industry also periodically adopt changes to their regulations. See the “Supervision and Regulation” section of this Form 10-K for a summary description of proposed regulations and legislative action that has been introduced and/or adopted over the past two years. It is possible that additional legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on our business.
Lack of seasoning of our loan portfolio may increase the risk of credit defaults in the future.
Due to our short operating history, all of the loans in our loan portfolio and our lending relationships are of relatively recent origin. In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process we refer to as “seasoning.” As a result, a portfolio of older loans will usually behave more predictably than a newer portfolio. Because our loan portfolio is relatively new, the current level of delinquencies and defaults may not be representative of the level that will prevail when the portfolio becomes more seasoned, which may be higher than current levels. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition.
We depend on the accuracy and completeness of information about customers and counterparties and our financial condition could be adversely affected if we have been provided misleading information.
In deciding whether to extend credit or to enter into other transactions with customers and counterparties, we may rely on information furnished to us by or on behalf of customers and counterparties, including financial statements and other financial information, which we do not independently verify. We also may rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to customers, we may assume that a customer’s audited financial statements conform with generally accepted accounting principles (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.
Changes in interest rates affect our interest margins, which can adversely affect our profitability.
Our results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve. Our profitability depends to a significant extent on our net interest income, which is the difference between interest income on interest-earning assets, such as loans and investments, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Interest rates are highly sensitive to many factors beyond our control, including general economic conditions and policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the interest paid on deposit and borrowings, but those changes could also affect our ability to originate loans and obtain deposits. Our net interest income will be adversely affected if market interest rates change such that the interest paid on deposits and borrowings increases faster than interest earned on loans and investments.
We face strong competition for clients, which could prevent us from obtaining clients and may cause us to pay higher interest rates to attract deposits.
The banking business is highly competitive, and we experience competition in our market from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in our primary market areas and elsewhere. We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our client base from other existing financial institutions and from new residents. Many of our competitors are well-established, larger financial institutions. These institutions offer some services, such as extensive and established branch networks, that we do not provide. There are also a number of other relatively new community banks in our market that share our general marketing focus on small- to medium-sized businesses and individuals. There is a risk that we will not be able to compete successfully with other financial institutions in our market, and that we may have to pay higher interest rates to attract deposits, resulting in reduced profitability. In addition, competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us.
Liquidity needs could adversely affect our results of operations and financial condition.
Our primary funding sources are customer deposits and loan repayments. Deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. Scheduled loan repayments are a relatively stable source of funds; however, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors outside of our control, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Those sources may include borrowings from the Federal Home Loan Bank or Federal Reserve Bank, federal funds lines of credit from correspondent banks and brokered deposits, to the extent allowable by regulatory authorities. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands, particularly if we were to experience atypical deposit withdrawal demands, increased loan demand or if regulatory decisions should limit available funding sources such as brokered deposits. We may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should those sources not be adequate.
Our FDIC Deposit Insurance premiums have risen significantly in the recent past and may continue to increase in the future as a result of our risk assessment category and increased assessment rates imposed by the FDIC.
As a member institution of the FDIC, we are required to pay deposit insurance premium assessments to the FDIC. We are generally unable to control the amount of premiums that are required to be paid for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than recently increased levels. Any future increases may materially and adversely affect our results of operations. Additionally, the Dodd-Frank Act changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital. It is too early to predict how new regulations in this area may affect our results of operations.
We are dependent on key individuals and the loss of one or more of these key individuals could curtail our growth and adversely affect our prospects.
Lawrence R. Miller, our president and chief executive officer, has extensive and long-standing ties within our primary service areas and provides us with an important medium through which to market our products and services. If we lose the services of Mr. Miller, he could be difficult to replace and our business and development could be materially and adversely affected.
Our success also depends, in part, on our continued ability to attract and retain experienced loan originators, as well as other management personnel. Competition for personnel can be intense, and we may not be successful in attracting or retaining qualified personnel. Our failure to compete for these personnel, or the loss of the services of several of such key personnel, could adversely affect our growth strategy and seriously harm our business, results of operations, and financial condition.
Negative public opinion could damage our reputation and adversely impact earnings.
Reputation risk, or the risk to our business, earnings and capital from negative public opinion, is inherent in our operations. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action and adversely impact our results of operations. Although we take steps to minimize reputation risk in dealing with our clients and communities, this risk will always be present given the nature of our business.
We may be adversely affected by the soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by the Bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Bank. Any such losses could have a material adverse effect on our financial condition and results of operations.
There is no public market for our shares, and we do not believe that we have enough shareholders or outstanding shares to support an active trading market, even if we are eventually listed on a recognized trading exchange.
There is currently no established market for our common stock, and we have no current plans to list our stock on NASDAQ or any other exchange. For these reasons, we do not expect a liquid market for our common stock to develop for several years, if at all.
We are exposed to the possibility of technology failure.
We rely on our computer systems and the technology of outside service providers. Our daily operations depend on the operational effectiveness of their technology. We rely on our systems to accurately track and record our assets and liabilities. If our computer systems or outside technology sources become unreliable, fail, or experience a breach of security, our ability to maintain accurate financial records may be impaired, which could materially affect our business operations and financial condition.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not Applicable.
Item 2.
Item 2. Properties.
Our main office facility is located at the corner of East Washington and Mordecai Streets in downtown Greenville, South Carolina. The building is a full service banking facility with two drive-through banking stations. Our address is 500 East Washington Street, Greenville, South Carolina 29601. The site is in excess of one acre in size, and the building is approximately 6,500 square feet.
The Bank has a four-year operating lease, with three two-year renewal options, on this main office facility which began in October 2004.
On November 17, 2004, we purchased approximately one acre of land in downtown Greenville for approximately $1.2 million. We acquired rights to purchase this property after being assigned an option, at par, from Focus Investment Group, LLC, a business interest of one of our organizers, Vivian A. Wong. On February 28, 2012, we sold this property for $1.75 million and recognized a gain on sale of approximately $573,000, net of sales costs.
We lease a branch facility at 2801B Wade Hampton Boulevard in Taylors, South Carolina. The building is a full service banking facility with two drive-through banking stations as well as a 24-hour Automated Teller Machine (“ATM”). This office is approximately 3,250 square feet. The Bank has a ten-year operating lease on this branch office which began in August 2007.
In November 2007, we purchased approximately one acre of land in Simpsonville, South Carolina for approximately $986,000. We opened a full service branch facility on this site in February 2009. The building is a full service banking facility with three drive-through banking stations as well as a 24-hour ATM. This office is approximately 4,500 square feet.
We believe that all of our properties are adequately covered by insurance.
Item 3.
Item 3. Legal Proceedings.
In the ordinary course of operations, we may be a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.
Item 4.
Item 4. Mine Safety Disclosures.
Not Applicable.
Item 5.
Item 5. Market for Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.
We are currently quoted on the OTC Bulletin Board under the symbol "IEBS" and have a sponsoring broker-dealer to match buy and sell orders for our common stock. Although we are quoted on the OTC Bulletin Board, the trading markets on the OTC Bulletin Board lack the depth, liquidity, and orderliness necessary to maintain a liquid market. We have no current plans to seek listing on any stock exchange, and we do not expect to qualify for listing on NASDAQ or any other exchange for at least several years. The OTC Bulletin Board prices are quotations, which reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not represent actual transactions.
As of March 5, 2012, there were 2,085,010 shares of common stock outstanding held by approximately 540 shareholders of record. All of our currently issued and outstanding common stock was issued in our initial public offering which was completed in May 2005. The price per share in our initial public offering was $10.00.
There is currently no established public trading market in our common stock and trading and quotations of our common stock have been limited and sporadic. Because there has not been an established market for our common stock, we may not be aware of all prices at which our common stock has been traded. We have not determined whether the trades of which we are aware were the result of arm’s-length negotiations between the parties. Based on information available to us from a limited number of sellers and purchasers of common stock who have engaged in privately negotiated transactions of which we are aware, there were approximately 40 stock trades in 2011 ranging from $0.05 to $0.65. These trades occurred throughout the year.
We have not declared or paid any cash dividends on our common stock since our inception. For the foreseeable future, we do not intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen our capital base. Our ability to pay dividends depends on the ability of our subsidiary, Independence National Bank, to pay dividends to us. As a national bank, the Bank may only pay dividends out of its net profits, after deducting expenses, including losses and bad debts. In addition, the Bank is prohibited from declaring a dividend on its shares of common stock until its surplus equals its stated capital, unless there has been transferred to surplus no less than one-tenth of the Bank’s net profits of the preceding two consecutive half-year periods (in the case of an annual dividend). The approval of the OCC will be required if the total of all dividends declared in any calendar year by the Bank exceeds the Bank’s net profits to date for that year combined with its retained net profits for the preceding two years less any required transfers to surplus. The OCC also has the authority under federal law to enjoin a national bank from engaging in what in its opinion constitutes an unsafe or unsound practice in conducting its business, including the payment of a dividend under certain circumstances. Further, under the terms of the Consent Order, we were required to present a dividend policy to the OCC that permits the declaration of a dividend only when the Bank is in compliance with its approved Capital Plan, with the aforementioned restrictions, and upon receipt of no supervisory objection by the OCC. Currently, the Company also has to obtain the prior written approval of the Federal Reserve Bank of Richmond before declaring or paying any dividends.
Item 6.
Item 6. Selected Financial Data.
Not applicable.
Item 7.
Item 7. Management’s Discussion and Analysis or Plan of Operation.
CRITICAL ACCOUNTING POLICIES
We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in Note 1 to our audited consolidated financial statements as of December 31, 2011.
Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.
Allowance for Loan Losses
We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.
Other Real Estate Owned and Repossessed Assets
Real estate and other property acquired in settlement of loans is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis when acquired. Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell. Recoveries of value are recorded only to the extent of previous write-downs on the property in accordance with FASB ASC Topic 360 “Property, Plant, and Equipment”. Write-downs or recoveries of value resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.
Income Taxes
We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in our consolidated financial statements and income tax returns, and income tax benefit or expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets. These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized. No assurance can be given that either the tax returns submitted by us or the income tax reported on the financial statements will not be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service. We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.
General
Our Bank opened for business on May 16, 2005. We completed our stock offering in May 2005, upon the issuance of 2,085,010 shares with net proceeds totaling $20.5 million. We capitalized the Bank with $18 million of the proceeds from the stock offering. Since December 2009 we have invested another $2.5 million of equity from the stock offering into the Bank.
Like most community banks, we derive the majority of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income earned on our interest-earning assets, such as loans and investments, and the expense cost of our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.
We have included a number of tables to assist in our description of these measures. For example, the “Average Balances” table shows the average balance during 2011 and 2010 of each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we have channeled a substantial percentage of our earning assets into our loan portfolio. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included a table to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, and our deposits and other borrowings.
There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section we have included a detailed discussion of this process.
In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this non-interest income, as well as our non-interest expenses, in the following discussion.
Markets in the United States and elsewhere have experienced extreme volatility and disruption for the last three plus years. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. Dramatic slowdowns in the housing industry, with falling home prices and increasing foreclosures and unemployment, have created strains on financial institutions. Many borrowers are now unable to repay their loans, and the collateral securing these loans has, in some cases, declined below the loan balance. The following discussion and analysis describes our performance in this challenging economic environment.
Throughout our discussion we have identified significant factors that we believe have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in this report.
Results of Operations
General
Our net loss for the year ended December 31, 2011 was $2.1 million, or $1.00 per share, a decrease of $4.3 million, or 67.2%, compared to a net loss of $6.3 million for the year ended December 31, 2010, or $3.04 per share. This decrease in net loss for the year was primarily driven by an increase in net interest income due to a decrease in interest expense, a decrease in loan provision expense, a decrease in real estate owned activity, and a decrease in income tax expense. Each of these components is discussed in greater detail below.
Net Interest Income
Net interest income is the Company’s primary source of revenue. Net interest income is the difference between income earned on assets and interest paid on deposits and borrowings used to support such assets. Net interest income is determined by the rates earned on the Company’s interest-earning assets and the rates paid on its interest-bearing liabilities, the relative amounts of interest-earning assets and interest-bearing liabilities, and the degree of mismatch and the maturity and repricing characteristics of its interest-earning assets and interest-bearing liabilities. Net interest income was $3.2 million for the year ended December 31, 2011, an increase of $526,863, or 19.5%, over net interest income of $2.7 million in 2010. Although total interest income decreased by $373,850, or 7.3%, during the year, this decrease was more than offset by a reduction in interest expense of $900,713, or 37.3%.
Our consolidated net interest margin for the year ended December 31, 2011 was 3.05%, a 78 basis point increase over the net interest margin for the year ended December 31, 2010 of 2.27%. The net interest margin is calculated as net interest income divided by year-to-date average earning assets. Earning assets averaged $105.8 million in 2011, a decrease of $13.5 million, or 11.3%, from $119.3 million in 2010. This decrease in earning assets is due to the $14.0 million decrease in average loans between years, offset by the combined increase in investment securities and federal funds sold and other assets of approximately $453,000. During 2009, we adopted measures to promote the long term stability of the Bank. These measures included restructuring the balance sheet to focus on credit quality and management of our funding sources to increase liquidity and the net interest margin. As a result, average gross loans decreased in both 2010 and 2011, with funds from net loan payoffs used to repay FHLB advances as well as to strengthen our liquidity position though cash and the investment securities portfolio.
Our yield on earning assets increased during the year, moving to 4.48% for the year ended December 31, 2011 from 4.29% for the year ended December 31, 2010. This increase is largely attributable to the overall decrease in nonaccrual loans due to payoffs, transfers to other real estate owned or placement back into accruing status due to policy guidelines. However, our yield on earnings assets continues to be negatively affected by the impact of loans in nonaccrual status during the period (foregone interest on nonaccrual loans in 2011 was $511,224), as well as the retention of higher levels of cash for improved liquidity, on which we earn a low rate of interest.
These increases were coupled with a decrease in the cost of interest-bearing liabilities, which moved to 1.50% for the year ended December 31, 2011 from 2.17% for the year ended December 31, 2010. Improvement in this area was a result of several factors, including a reduction in average brokered time deposits, which decreased $13.9 million during the year, and the repricing of deposits, specifically money market accounts and retail time deposits, which decreased to a rate of 1.04% and 1.45%, respectively, for the year ended December 31, 2011 from 1.63% and 2.00%, respectively, for the year ended December 31, 2010. In pricing deposits, we considered our liquidity needs, the direction and levels of interest rates and local market conditions. At times, higher rates are paid initially to attract deposits. Borrowings averaged $7.1 million for the year ended December 31, 2011, decreasing from $10.0 million for the year ended December 31, 2010, a decrease of $2.9 million, or 29%. Our net interest spread was 2.98% for 2011 compared to 2.12% in 2010. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.
The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. The net amount of capitalized loan fees are amortized into interest income on loans.
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(1)
The average balances for investment securities exclude the unrealized gain recorded for available for sale securities.
(2)
Nonaccrual loans are included in average balances for yield computations.
Rate/Volume Analysis
Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.
Provision for Loan Losses
We have established an allowance for loan losses through a provision for loan losses charged as a non-cash expense to our statement of operations. We review our loan portfolio at least quarterly to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under “Provision and Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.
Our provision for loan losses was $730,000 for the year ended December 31, 2011, a decrease of $2.3 million or 76% from provision for loan losses of $3.1 million for the year ended December 31, 2010. The decrease in provision for loan losses is due to the decrease in average loans between comparable periods combined with a lack of new required specific reserves and an overall decrease in non-performing loans. During 2010, we increased our allowance for loan losses as a result of a significant overall increase in impaired and nonaccrual loans due to declining economic conditions and increased charge-off levels. The allowance as a percentage of gross loans decreased to 2.74% at December 31, 2011 from 3.24% at December 31, 2010. This decline is due to charge-offs taken against specific reserves as well as payoffs in our commercial real estate portfolio which carries a higher historical loss ratio and consequently a higher reserve factor within our allowance model. Specific reserves were $563,675 million on impaired loans of $8.9 million as of December 31, 2011 compared to specific reserves of approximately $1.6 million on impaired loans of $12.8 million as of December 31, 2010. As of December 31, 2011, the general reserve allocation was 2.27% of gross loans not impaired compared to 1.82% as of December 31, 2010. The provision for loan losses is discussed further below under “Provision and Allowance for Loan Losses.”
Non-interest Income
Non-interest income for the year ended December 31, 2011 was $217,545, a decrease of 19.0% from non-interest income of $268,570 for the year ended December 31, 2010. Our largest component of non-interest income is residential loan origination fees, which were $79,607 for 2011, or approximately 36.6% of total non-interest income. Residential loan origination fees decreased by approximately $72,892, or 47.8%, during the year due to the changes in mortgage loan underwriting and compensation regulations as well as customer demand. During 2011, the Company received proceeds from sales of securities of $524,374 for a total gain of $32,515.
For the year ended December 31, 2011, service fees on deposit accounts totaled $49,080, a decrease of $10,027, or 17.0%, from 2010 due to a decrease in NSF charges as a result of changes in our client base. Other income was $56,343 for 2011, a very slight decrease of $621, or 1%, compared to $56,964 for the year ended December 31, 2010. Other income includes ATM surcharges, wire fees, and commissions on insurance referrals. Also included in other income for the year ended December 31, 2011 was $28,795 in rental income related to the lease of our land at South Irvine Street.
Non-interest Expenses
The following table sets forth information related to our non-interest expenses for the years ended December 31, 2011 and 2010.
Non-interest expenses decreased by $70,775, or 1.5%, for the year ended December 31, 2011. This decrease was primarily due to a decrease in compensation and benefits as well as a decrease in real estate owned activity which was offset by a significant increase in professional fees directly related to recapitalization efforts and compliance with the Consent Order. During 2011, real estate owned activity decreased by $456,476 due to the successful sale of several properties resulting in net gains of approximately $120,000 as well as less deterioration in appraised values during 2011 when compared to 2010. Write-downs and losses are charged against income, if necessary, as a result of our regular review of the fair value of repossessed property. Compensation and benefits decreased by $228,831 due to a time lag in replacing several vacant branch staff positions, a decrease in stock option expense and a decrease in payroll tax expense. Professional fees increased $652,727 due
to legal and consulting expenses related to strategic initiatives. In addition, we incurred legal and consulting fees related to compliance with the Consent Order. Insurance expense decreased $80,935 due to a decrease in our FDIC insurance assessment base which was somewhat offset by higher rates. Other non-interest expense was $188,466 for the year ended December 31, 2011, an increase of $35,808, or 23.5%, from 2010. This increase was a result of increased travel expenses related to strategic initiatives. We have continued to focus attention on expense control over the past year. This has resulted in relatively stable occupancy and equipment, data processing, marketing, and telephone and supplies expenses.
Income Tax Expense
No income tax benefit or expense was recognized for the year ended December 31, 2011, compared to income tax expense of $1.4 million for the year ended December 31, 2010. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. During our September 30, 2010 quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned, and booked a 100% valuation allowance against the deferred tax asset. We will continue to analyze our deferred tax assets and related valuation allowance each quarter taking into account performance compared to forecast and current economic or internal information that would impact forecasted earnings.
Balance Sheet Review
General
At December 31, 2011, we had total assets of $112.3 million, a decrease of $9.5 million, or 7.8%, from total assets of $121.8 million at December 31, 2010. This decrease in assets was driven by a $16.6 million, or 18.2%, decrease in net loans, which decreased from $91.4 million at December 31, 2010 to $74.8 million at December 31, 2011. Other assets at December 31, 2011 consisted of cash and due from banks of $5.7 million; federal funds sold of $9.6 million, investment securities available for sale of $12.6 million, non-marketable equity securities of $918,350, property and equipment of $2.3 million, other real estate owned and repossessed assets of $5.4 million and accrued interest receivable and other assets of $1.1 million. Total liabilities at December 31, 2011 were $103.9 million compared to $111.4 million at December 31, 2010, a decrease of $7.5 million, or 6.7%. At December 31, 2011, liabilities consisted of deposits of $96.6 million, FHLB Advances of $7.0 million, securities sold under agreements to repurchase of $107,777, and accrued interest payable and other liabilities of $200,559. Shareholders' equity at December 31, 2011 was $8.4 million, compared to $10.5 million at December 31, 2010, a decrease of $2.0 million or 19.4%. This decrease was primarily a result of our net loss for the year ended December 31, 2011 offset by an increase in the unrealized gain on investment securities. Our management closely monitors and seeks to maintain appropriate levels of interest-earning assets and interest-bearing liabilities so that maturities of assets are such that adequate funds are provided to meet customer withdrawals and demand. A more detailed analysis of the primary components of our balance sheet follows.
Investments
The purpose of the investment portfolio is to provide liquidity and stable returns through the purchase of high quality investment securities. At December 31, 2011, our investment portfolio of $12.6 million represented approximately 11.2% of total assets. The portfolio increased from $10.7 million at December 31, 2010, or 8.7% of total assets. Increases in investment balances during 2011 were due to the purchase of new investment securities with excess liquidity, offset by normal investment maturities and repayments. At December 31, 2011 and 2010, we held government-sponsored enterprise securities, mortgage-backed securities, and taxable municipal bonds as investment securities available for sale. The amortized costs and the fair value of our investments at December 31, 2011 and 2010 are shown in the following table.
Contractual maturities and yields on our investment securities available for sale at December 31, 2011 are shown in the following table. Expected maturities may differ from contractual maturities as issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2011 and 2010, we also held non-marketable equity securities, which consisted of Federal Reserve Bank stock of $271,550 and $416,350, respectively, and Federal Home Loan Bank stock of $646,800 and $984,000, respectively. These investments are carried at cost, which approximates fair maket value.
Loans
Since loans typically provide higher interest yields than other types of interest-earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Average loans for the year ended December 31, 2011 were $86.0 million, a decrease of $14.0 million, or 14.0%, compared to average loans of $99.9 million for the year ended December 31, 2010. Before allowance for loan losses, gross loans outstanding at December 31, 2011 were $76.9 million, or 68.5% of total assets, compared to $94.5 million, or 77.6% of total assets at December 31, 2010. During 2009, we adopted measures to promote the long term stability of the Bank. These measures included restructuring the balance sheet to focus on credit quality and management of our funding sources to increase liquidity and net interest margin. As a result, gross loans decreased $13.5 million during 2010 and $17.6 million during 2011. Funds from net loan payoffs were used to repay brokered deposits and FHLB advances, as well as to strengthen our liquidity position through cash and the investment securities portfolio.
The principal component of our loan portfolio is loans secured by real estate mortgages. Most of our real estate loans are secured by residential or commercial property. We do not generally originate traditional long term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. We obtain a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans we make to 80%.
The following table summarizes the composition of our loan portfolio as of December 31, 2011 and 2010.
The largest component of our loan portfolio at year-end was commercial real estate loans, which represented 35.9% of the portfolio. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration of certain types of collateral. Refer to Item 1, “Lending Activities”, for a detailed discussion regarding the risks inherent in each loan category noted above. Due to the short time our portfolio has existed, the current mix may not be indicative of the ongoing portfolio mix.
Maturities and Sensitivity of Loans to Changes in Interest Rates
The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.
The following table summarizes the loan maturity distribution by type and related interest rate characteristics at December 31, 2011.
Loan Performance and Asset Quality
The downturn in general economic conditions over the past three plus years has resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declining real estate market has had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, in our current market the value of the collateral has deteriorated during the time the credit is extended. There is a risk that this trend will continue, which could result in additional losses of earnings and increases in our provision for loan losses and loans charged-off.
Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees.
Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. Foregone interest income related to nonaccrual loans equaled $511,224 and $743,315 for the years ended December 31, 2011 and 2010, respectively. No interest income was recognized on nonaccrual loans during 2011 and 2010. At both December 31, 2011 and 2010, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.
The following table summarizes delinquencies and nonaccruals, by portfolio class, as of December 31, 2011 and 2010.
Total delinquent and nonaccrual loans decreased from $12.7 million at December 31, 2010 to $6.4 million at December 31, 2011, a decrease of $6.3 million or 49.7%. This decrease was a result of movement in nonaccrual loans, which decreased by $7.0 million, or 58.1%, from 2010 to 2011. Nonaccrual decreases were seen in both single and multifamily residential real estate loans as well as construction and development loans primarily as a result of successful foreclosure of the properties collateralizing these loans and their transfer to other real estate owned. The remainder of the decrease in nonaccrual loans is due to payoffs and the return of three loans to accrual status due to satisfactory payment history. At December 31, 2011, nonaccrual loans represented 6.6% of gross loans. Loans past due 30-89 days are considered potential problem loans and amounted to $1.4 million at December 31, 2011 compared to $697,558 at December 31, 2010. The increase in 30-89 delinquent loans is due to two larger loans in the process of renewal as of December 31, 2011. These two loans were successfully renewed under normal terms, including principal and interest payments, in January 2012.
Another method used to monitor the loan portfolio is credit grading. As part of the loan review process, loans are given individual credit grades, representing the risk we believe is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. The following table summarizes management’s internal credit risk grades, by portfolio class, as of December 31, 2011 and 2010.
Loans graded one through four are considered “pass” credits. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. At December 31, 2011, approximately 84% of the loan portfolio had a credit grade of “pass” compared to 79% at December 31, 2010. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.
Loans with a credit grade of five are not considered classified; however they are categorized as a special mention or watch list credit, and are considered potential problem loans. This classification is utilized by us when we have an initial concern about the financial health of a borrower. These loans are designated as such in order to be monitored more closely than other credits in our portfolio. We then gather current financial information about the borrower and evaluate our current risk in the credit. We will then either reclassify the loan as “substandard” or back to its original risk rating after a review of the information. There are times when we may leave the loan on the watch list, if, in management’s opinion, there are risks that cannot be fully evaluated without the passage of time, and we determine to review the loan on a more regular basis. Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of December 31, 2011, we had loans totaling $1.6 million on the watch list compared to $6.9 million as of December 31, 2010.
Loans graded six or greater are considered classified credits. At December 31, 2011 and 2010, classified loans totaled $10.7 million and $12.9 million, respectively, with the vast majority of these loans being collateralized by real estate. Classified credits are evaluated for impairment on a quarterly basis.
A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of
collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The resultant shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.
At December 31, 2011, impaired loans totaled $8.9 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. During 2011, the average recorded investment in impaired loans was $11.3 million compared to $10.6 million during 2010. As of December 31, 2011 and December 31, 2010, we had loans totaling approximately $1.8 million and $74,473, respectively that were classified in accordance with our loan rating policies but were not considered impaired. The following table summarizes information relative to impaired loans, by portfolio class, at December 31, 2011 and 2010.
TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.
As a result of adopting the amendments in ASU 2011-02, we reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are TDRs under the amended guidance. We did not identify any new TDRs during our assessment. As noted below, all outstanding TDRs as of December 31, 2011 were restructured prior to the adoption of ASU 2011-02.
At December 31, 2011, the principal balance of TDRs totaled $1.2 million. All TDRs were considered classified, impaired, and in nonaccrual status at December 31, 2011. No TDRs went into default during the year ended December 31, 2011. A TDR can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.
Provision and Allowance for Loan Losses
We have established an allowance for loan losses through a provision for loan losses charged to expense on our consolidated statement of operations. At December 31, 2011, the allowance for loan losses was $2.1 million, or 2.74% of gross loans, compared to $3.1 million at December 31, 2010, or 3.24% of gross loans. This decrease in the allowance for loan losses is due to charge-ofs taken against specific reserves, as well as payoffs in our commercial real estate portfolio, which carries a higher historical loss ratio and, consequently, a higher reserve factor within our allowance model.
The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. We strive to follow a comprehensive, well-documented, and consistently applied analysis of our loan portfolio in determining an appropriate level for the allowance for loan losses. Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate. Our determination of the allowance for loan losses is based on what we believe are all significant factors that impact the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical loan loss experience, and a review of specific problem loans. We also consider subjective issues such as changes in lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and Board of Director oversight, concentrations of credit, and peer group comparisons.
Our allowance for loan losses consists of both specific and general reserve components. The specific reserve component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. Loans determined to be impaired are excluded from the general reserve calculation described below and evaluated individually for impairment. Impaired loans totaled $8.9 million at December 31, 2011, with an associated specific reserve of $563,675. See above discussion under “Loan Performance and Asset Quality” for additional information related to impaired loans.
The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors. Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio. The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.
The following table summarizes activity related to our allowance for loan losses for the years ended December 31, 2011 and 2010, by portfolio segment.
Net loan charge-offs decreased during 2011, from $1.9 million for the year ended December 31, 2010 to $1.7 million for the twelve months ended December 31, 2011, a decrease of $178,052 or 9.6%. This continued elevated level of net charge-offs, though decreased from 2010, was due to the impact of the extended duration of this economic deterioration on our borrowers as well as poor asset quality trends in our loan portfolio. The majority of charge-offs in 2011 were partial charge-offs taken on certain collateral-dependent loans within our real estate portfolio segments. Partial charge-offs were based on recent appraisals and evaluations on commercial real estate loans in the process of foreclosure. Loans with partial charge-offs are typically considered impaired loans and remain on nonaccrual status. In addition, when collateral is obtained in satisfaction of a loan, a charge-off is taken through the allowance at the time of repossession to move the collateral to other real estate owned at fair value less costs to sell.
The allowance as a percentage of gross loans decreased from 3.24% at December 31, 2010 to 2.74% at December 31, 2011. The decrease in the reserve percentage is due to the decrease in impaired and nonaccrual loans and their related specific reserves. The general reserve as a percentage of loans has increased from 1.82% at December 31, 2010 to 2.27% at December 31, 2011.
Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charge-off. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.
Other Real Estate Owned and Repossessed Assets
As of December 31, 2011, we had $5.4 million in other real estate owned and $39,457 in repossessed assets. This compares to $2.5 million in other real estate owned and $70,212 in repossessed assets as of December 31, 2010. During 2011, collateral was obtained from eight loan relationships that went through the foreclosure process. We also completed the sale of four repossessed properties. In addition, we transferred land with a cost basis of $1.2 million from property and equipment as this land was under contract for sale as of December 31, 2011. This property was sold in February 2012 for a gain of approximately $525,000. The following table summarizes changes in other real estate owned and repossessed assets during the periods noted:
The following table summarizes the composition of other real estate owned and repossessed assets as of the dates noted.
These assets are being actively marketed with the primary objective of liquidating the collateral at a level which most accurately approximates fair value and allows recovery of as much of the unpaid principal loan balance as possible upon the sale of the asset within a reasonable period of time. Based on currently available valuation information, the carrying value of these assets is believed to be representative of their fair value less estimated costs to sell, although there can be no assurance that the ultimate proceeds from the sale of these assets will be equal to or greater than their carrying values, particularly in the current real estate environment and the downward, though stabilizing, trends in third party appraised values.
Deposits and Other Interest-Bearing Liabilities
Our primary source of funds for loans and investments is our deposits and short-term repurchase agreements. Average total deposits for the years ended December 31, 2011 and 2010 were $100.3 million and $106.1 million, respectively. The following table shows the balance outstanding and the weighted-average rates paid on deposits held by us as of December 31, 2011 and 2010.
Core deposits, which exclude time deposits of $100,000 or more, provide a relatively stable funding source for our loan portfolio and other earning assets. Core deposits increased $6.7 million, or 11.6%, from $57.6 million at December 31, 2010 to $64.2 million at December 31, 2011. Total retail, or customer, deposits increased $9.0 million during 2011, or 11.6%. Beginning in the fourth quarter of 2006, we chose to obtain deposits outside of our local market area in the form of brokered time deposits. Due to the interest rate environment in our market, as well as strong competition from other banking and financial services companies in gathering deposits, brokered time deposits allowed us to obtain funding at a lower interest rate in order to support loan growth. However, due to regulatory constraints, including as a result of our Consent Order, we can no longer accept brokered time deposits without prior approval from the FDIC. At December 31, 2011, we had $9.5 million in brokered time deposits, a decrease of $16.6 million, or 63.6%, from $26.0 million as of December 31, 2010. Our strong customer deposit growth during 2011 along with the decrease in our loan portfolio enabled us to maintain a strong liquidity position while decreasing our reliance on brokered deposits, thereby lowering our cost of interest-bearing liabilities. We will continue to reduce our reliance on brokered time deposits and other noncore funding sources, while focusing our efforts to gather core deposits in our local market. Our loan-to-deposit ratio was 79.6% and 90.8% at December 31, 2011 and 2010, respectively.
Since January 20, 2010, we have had to obtain written approval from the OCC to accept, renew or rollover brokered time deposits, and as a result of the Consent Order we are no longer permitted to renew or rollover brokered time deposits without the permission of the FDIC. During the first four months of 2012, we have $5.8 million of brokered deposits maturing. We believe we have adequate funding sources available to pay off brokered deposits as they mature. See additional discussion below under “Liquidity.”
All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $100,000 or more at December 31, 2011 is as follows:
Short-Term Borrowings
At December 31, 2011 and 2010, respectively, the Bank had sold $107,777 and $65,479 of securities under agreements to repurchase with brokers with a weighted rate of 0.30% and 0.50%, respectively that mature in less than 90 days. These agreements were secured with approximately $194,000 and $186,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $114,735 during 2011, with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2011 was 0.55%. The securities, under agreements to repurchase, averaged $117,455 during 2010, with $188,826 being the maximum amount outstanding at any month-end. The average rate paid in 2010 was 0.75%.
At December 31, 2011, the Bank had an unused line of credit to purchase federal funds of $2.0 million that is secured by investment securities even though it has not been utilized. The line of credit is available on a one to fourteen day basis for general corporate purposes of the Bank. The lender has reserved the right to withdraw the line at its option. At December 31, 2011, the Bank had pledged $10.1 million in loans to the Federal Reserve Bank’s Borrower-in-Custody of Collateral program. In June 2011, as a result of the FRB’s quarterly review, the Bank was downgraded from Primary to Secondary credit meaning each advance request would require review by the FRB prior to approval. Our available credit under this line was approximately $8.1 million as of December 31, 2011.
Federal Home Loan Bank Advances
At December 31, 2011 and 2010, the Bank had $7.0 million of advances from the FHLB, with a weighted average rate of 2.98%. The Bank utilizes FHLB advances as a long-term source of funding. Advances outstanding as of December 31, 2011 and 2010 were secured with approximately $50.0 million and $59.6 million, respectively, of first and second mortgage loans and $646,800 and $984,000, respectively, of stock in the FHLB. FHLB advances averaged $7.0 million during 2011, with $7.0 million being the maximum amount outstanding at any month-end. FHLB advances averaged $9.9 million during 2010, with $14.0 million being the maximum amount outstanding at any month-end. The average rate paid in 2011 and 2010 was 3.02% and 3.81%, respectively.
Capital Resources
Total shareholders’ equity was $8.4 million at December 31, 2011, a decrease of $2.0 million or 19.4% from $10.5 million at December 31, 2010. Shareholders’ equity decreased during 2011 primarily due to the net loss for the year ended December 31, 2011 of $2.1 million. Other components of the change in shareholders’ equity related to an increase in the unrealized gain on investment securities, net of tax, of $49,725 and compensation expense related to stock options granted of $6,600.
The Federal Reserve guidelines contain an exemption from the capital requirements for "small bank holding companies" which in 2006 were amended to cover most bank holding companies with less than $500 million in total assets that do not have a material amount of debt or equity securities outstanding registered with the SEC. Although our class of common stock is registered under Section 12 of the Securities Exchange Act, we believe that because our stock is not listed on any exchange or otherwise actively traded, the Federal Reserve Board will interpret its new guidelines to mean that we qualify as a small bank holding company. Nevertheless, our Bank remains subject to these capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.
At the bank level, we are subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “well-capitalized,” we must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, we must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, we must maintain a minimum Tier 1 leverage ratio of at least 4%.
On November 14, 2011, the Bank entered into a Consent Order with its primary regulator, the OCC, which contains a requirement that the Bank maintain minimum capital requirements that exceed the minimum regulatory capital ratios for “well-capitalized” banks. The Consent Order requires the Bank to achieve Tier 1 capital at least equal to 9% of adjusted total assets, Tier 1 risk based capital at least equal to 10%, and total risk based capital at least equal to 12% of risk-weighted assets by March 31, 2012. As a result of the Consent Order, the Bank is no longer deemed “well-capitalized” regardless of its capital levels. Therefore, in order to meet these standards set forth by the OCC, we will need to raise additional capital, continue to limit our growth, and/or sell assets to increase our capital ratios by March 31, 2012. If we fail to comply with the terms of the Consent Order, the OCC has the authority to subject us to further enforcement actions. See additional discussion above under “Supervision and Regulation.”
The following table sets forth the Bank’s and Holding Company’s various capital ratios at December 31, 2011 and 2010.
Since December 31, 2011, no conditions or events have occurred, of which we are aware, that have resulted in a material change in the Company’s or the Bank’s category, other than as reported in this Annual Report on Form 10-K.
We believe that our capital is sufficient to fund the activities of our Bank’s operations for at least the next twelve months; however, the rate of net losses have deteriorated our capital base below our required minimum capital ratios as discussed in greater detail above. We have not been immune to the unprecedented levels of extended volatility and disruption in the capital and credit markets and can give no assurances with respect to our capital levels. As of December 31, 2011, there were no significant firm commitments outstanding for capital expenditures.
Return on Equity and Assets
The following table shows the return on average assets (net income (loss) divided by average total assets), return on average equity (net income (loss) divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the years ended December 31, 2011 and 2010. Since our inception, we have not paid cash dividends.
Effect of Inflation and Changing Prices
The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on a historical cost basis in accordance with GAAP.
Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude.
Off-Balance Sheet Risk
Commitments to extend credit are agreements to lend to a client as long as the client has not violated any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2011, unfunded commitments to extend credit were $11.2 million, of which approximately $996,000 is at fixed rates and $10.2 million is at variable rates. A significant portion of the unfunded commitments related to consumer equity lines of credit and commercial lines of credit. Based on historical experience, we anticipate that a significant portion of these lines of credit will not be funded. We evaluate each client’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.
Except as disclosed in this document, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.
Market Risk
Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.
We actively monitor and manage our interest rate risk exposure principally by measuring our interest sensitivity “gap,” which is the positive or negative dollar difference between assets and liabilities that are subject to interest rate repricing within a given period of time. Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available for sale, replacing an asset or liability at maturity, or adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities repricing in this same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates. We generally would benefit from increasing market rates of interest when we have an asset-sensitive gap position and generally would benefit from decreasing market rates of interest when we are liability-sensitive.
Approximately 68% of our loans were variable rate loans at December 31, 2011, a slight decrease from 69% at December 31, 2010. As of December 31, 2011, our ratio of cumulative gap to total earning assets after 12 months was (23.2)% because in a rate change scenario, $23.2 million more liabilities would reprice in a 12 month period than assets. However, our gap analysis is not a precise indicator of our interest sensitivity position. The analysis presents only a static view of the timing of maturities and repricing opportunities, without taking into consideration that changes in interest rates do not affect all assets and liabilities equally. For example, rates paid on a substantial portion of core deposits may change contractually within a relatively short time frame, but those rates are viewed by us as significantly less interest-sensitive than market-based rates such as those paid on noncore deposits. Net interest income may be affected by other significant factors in a given interest rate environment, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities.
Liquidity and Interest Rate Sensitivity
Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.
At December 31, 2011, our liquid assets, consisting of cash and due from banks and federal funds sold, amounted to $15.2 million, or 13.5% of total assets, a significant increase from our cash liquidity ratio of 8.8% as of December 31, 2010. During 2011, loan payoffs of $10.5 million and were used with growth in retail deposits to pay off maturating brokered deposits of $16.6 million and increase the investment securities portfolio by $2.0 million. We carefully focused on liquidity management during 2010 and 2011. We plan to continue reducing brokered time deposits during 2012, and have set aside liquid assets to pay the $5.8 million in brokered deposits that are scheduled to mature by April 30, 2012. As brokered deposits and advances have matured in 2011, we have not replaced these funds with wholesale funding as we have sought to reduce our reliance on brokered time deposits and other noncore funding sources.
Since January 20, 2010, we have had to obtain written approval from the OCC to accept, renew or rollover brokered time deposits, and under the terms of the Consent Order we are no longer permitted to renew or rollover brokered time deposits. During the first four months of 2012, we have $5.8 million of brokered deposits maturing. We believe we have adequate funding sources available to pay off brokered deposits as they mature.
Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments and the generation of deposits within our market. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. Our investment securities available for sale at December 31, 2011 amounted to $12.6 million, or 11.2% of total assets. Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner. At December 31, 2011, $2.7 million of our investment portfolio was pledged against outstanding debt. Therefore, the related debt would need to be repaid prior to the securities being sold and converted to cash.
We are a member of the Federal Home Loan Bank of Atlanta (“FHLB”), from which applications for borrowings can be made for leverage purposes. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. At December 31, 2011, we had collateral that would support approximately $6.3 million in additional borrowings. Like all banks, we are subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. During the fourth quarter of 2010, the FHLB downgraded our credit risk rating, which resulted in decreased borrowing availability (total line reduced to 15% of total assets from 20% of total assets) and increased collateral requirements (moved to 125% of borrowings from 115%). Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.
At December 31, 2011, the Bank had pledged $10.1 million in loans to the Federal Reserve Bank’s Borrower-in-Custody of Collateral program. Our available credit under this line was approximately $8.1 million as of December 31, 2011. We also have federal funds purchased lines of credit through a correspondent bank for $2.0 million that is secured by investment securities even though it has not been utilized. The Federal Reserve Bank as well as our correspondent banks review our financial results and could limit our credit availability based on their review.
Asset/liability management is the process by which we monitor and control the mix and maturities of our assets and liabilities. The essential purposes of asset/liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. Our asset/liability management committee (“ALCO”) monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a Board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within Board-approved limits.
The following table sets forth information regarding our rate sensitivity, as of December 31, 2011, at each of the time intervals. The information in the table may not be indicative of our rate sensitivity position at other points in time. In addition, the maturity distribution indicated in the table may differ from the contractual maturities of the earning assets and interest-bearing liabilities presented due to consideration of prepayment speeds under various interest rate change scenarios in the application of the interest rate sensitivity methods described above.
Accounting, Reporting, and Regulatory Matters
The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:
In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in its interim and annual financial statements. See Note 3, Loans, for applicable disclosures.
Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011, the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present. Disclosures related to TDRs under ASU 2010-20 were required beginning with the quarter ended September 30, 2011. See Note 3, Loans, for applicable disclosures.
In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.
ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or
requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and requires consecutive presentation of the statement of net income and other comprehensive income. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements. Companies should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the amendments while FASB redeliberates future requirements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data.
FOR THE YEARS ENDED DECEMBER 31, 2011 and 2010
Page(s)
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Independence Bancshares, Inc.
Greenville, South Carolina
We have audited the accompanying consolidated balance sheets of Independence Bancshares, Inc. and subsidiary (the “Company”) as of December 31, 2011 and 2010 and the related consolidated statements of operations, changes in shareholders’ equity and comprehensive income (loss) and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Independence Bancshares, Inc. and subsidiary as of December 31, 2011 and 2010 and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ Elliott Davis, LLC
Greenville, South Carolina
March 5, 2012
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2011 AND 2010
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES
Independence Bancshares, Inc. (the “Company”) is a South Carolina corporation organized to operate as a bank holding company pursuant to the Federal Bank Holding Company Act of 1956 and the South Carolina Bank Holding Company Act, and to own and control all of the capital stock of Independence National Bank (the “Bank”). The Bank is a national association organized under the laws of the United States to conduct general banking business in Greenville, South Carolina. On May 31, 2005, the Company sold 2,085,010 shares of its common stock in its initial public offering. All shares were sold at $10.00 per share. The offering raised approximately $20.5 million, net of offering costs. The Bank operates three full service branch offices in Greenville, South Carolina.
The following is a description of the more significant accounting and reporting policies that the Company follows in preparing and presenting consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Independence National Bank. In consolidation, all significant intercompany transactions have been eliminated. The accounting and reporting policies conform to accounting principles generally accepted in the United States of America and to general practices in the banking industry.
Subsequent Events
Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date. On February 28, 2012, other real estate owned of $1,165,312 was sold resulting in a gain on sale of approximately $573,000. This gain has not been reflected in the financial statements as of and for the year ended December 31, 2011. No other subsequent events occurred requiring accrual or disclosure through the date of this filing.
Reclassifications
Certain amounts have been reclassified to state all periods on a comparable basis. Reclassifications had no effect on shareholders’ equity or net loss.
Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amount of income and expenses during the reporting periods. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, including valuation allowances for impaired loans, and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed real estate, management obtains independent appraisals for significant properties and takes into account other current market information. Management must also make estimates in determining the useful lives and methods for depreciating premises and equipment.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Estimates, continued
While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowance for loan losses and changes to valuation of foreclosed real estate may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and valuation of foreclosed real estate. Such agencies may require the Company to recognize additions to the allowance for loan losses or additional write-downs on foreclosed real estate based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowance for loan losses and valuation of foreclosed real estate may change materially in the near term.
Risks and Uncertainties
In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default within the Company’s loan portfolio that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company.
The Company is subject to the regulations of various governmental agencies. These regulations can change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to changes with respect to valuation of assets, amount of required loss allowance and operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examinations. The Bank makes loans to individuals and businesses in and around “Upstate” South Carolina for various personal and commercial purposes. The Bank has a diversified loan portfolio. Borrowers’ ability to repay their loans is not dependent upon any specific economic sector.
Regulatory Considerations
On November 14, 2011, the Bank entered into the Consent Order with its primary regulator, the OCC which contains a requirement that the Bank maintain minimum capital ratios that exceed the minimum regulatory capital ratios for “well-capitalized” banks. The Consent Order requires the Bank to achieve Tier 1 capital at least equal to 9% of adjusted total assets, Tier 1 risk based capital at least equal to 10%, and total risk based capital at least equal to 12% of risk-weighted assets by March 31, 2012. As a result of the Consent Order, the Bank is no longer deemed “well-capitalized” regardless of its capital levels. Therefore, in order to meet these standards set forth by the OCC, the Bank will need to raise additional capital, continue to limit its growth, and/or sell assets to increase our capital ratios by March 31, 2012. If we fail to comply with the terms of the Consent Order, the OCC has the authority to subject us to further enforcement actions.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes cash, due from banks and federal funds sold. Generally, federal funds are sold for one-day periods. Due to the short term nature of cash and cash equivalents, the carrying amount of these instruments is deemed to be a reasonable estimate of fair value.
At December 31, 2011 and 2010, the Company had restricted cash totaling $2,000 with the Federal Home Loan Bank of Atlanta (“FHLB”). Also at December 31, 2011, the Company had restricted cash totaling $500,000 with Pacific Coast Bankers Bank, the Company’s primary correspondent bank. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Investment Securities
Investment securities are accounted for in accordance with FASB ASC Topic 320, “Investments - Debt and Equity Securities.” Management classifies securities at the time of purchase into one of three categories as follows: (1) Securities Held to Maturity: securities which the Company has the positive intent and ability to hold to maturity, which are reported at amortized cost; (2) Trading Securities: securities that are bought and held principally for the purpose of selling them in the near future, which are reported at fair value with unrealized gains and losses included in earnings; and (3) Securities Available for Sale: securities that may be sold under certain conditions, which are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity as accumulated other comprehensive income (loss). The amortization of premiums and accretion of discounts on investment securities are recorded as adjustments to interest income. Gains or losses on sales of investment securities are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. Unrealized losses on securities, reflecting a decline in value or impairment judged by the Company to be other-than-temporary, are charged to earnings in the consolidated statements of operations.
Non-Marketable Equity Securities
The Bank, as a member of the Federal Reserve Bank ("FRB") and the FHLB, is required to own capital stock in these organizations. The amount of FRB stock owned is based on the Bank’s capital levels and totaled $271,550 and $416,350 at December 31, 2011 and 2010, respectively. The amount of FHLB stock owned is determined based on the Bank’s balances of residential mortgages and advances from the FHLB and totaled $646,800 and $984,000 at December 31, 2011 and 2010, respectively. No ready market exists for these stocks, and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value.
Loans Receivable
Loans are stated at their unpaid principal balance net of any charge-offs.Interest income is computed using the simple interest method and is recorded in the period earned. Fees earned and direct costs incurred on loans are amortized using the effective interest method over the life of the loan.
When serious doubt exists as to the collectability of a loan or when a loan becomes contractually 90 days past due as to principal or interest, interest income is generally discontinued unless the estimated net realizable value of collateral exceeds the principal balance and accrued interest. When interest accruals are discontinued, income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. Generally, loans are returned to accrual status when the loan is brought current and ultimate collectability of principal and interest is no longer in doubt.
Allowance for Loan Losses
An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Allowance for Loan Losses, continued
The allowance consists of both a specific and a general component. The specific component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. For such loans, an allowance is established when either the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors. Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio. The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.
The Company identifies impaired loans through its normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans on the Company's problem loan watch list are considered potentially impaired loans. Generally, once loans are considered impaired, they are moved to nonaccrual status and recognition of interest income is discontinued. Impairment is measured on a loan-by-loan basis based on the determination of the most probable source of repayment which is usually liquidation of the underlying collateral, but may also include discounted future cash flows, or in rare cases, the market value of the loan itself.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.
The Company designates loan modifications as troubled debt restructurings (“TDRs”) when, for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that would not otherwise be considered. Upon initial restructuring, TDRs are considered classified and impaired and are placed in nonaccrual status if not already categorized. TDRs are returned to accrual status when there is economic substance to the restructuring, any portion of the debt not expected to be repaid has been charged off, the remaining note is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated sustained repayment performance in accordance with the modified terms for a reasonable period of time (generally six months).
Property and Equipment
Land is reported at cost. Buildings and improvements, furniture and equipment, and automobiles are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method, based on the estimated useful lives of 40 years for buildings and 3 to 15 years for furniture, equipment and automobiles. Leasehold improvements are amortized over the life of the lease. The cost of assets sold or otherwise disposed of, and the related allowance for depreciation, are eliminated from the accounts and the resulting gains or losses are reflected in the statement of operations when incurred. Maintenance and repairs are charged to current expense. The costs of major renewals and improvements are capitalized.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Other Real Estate Owned and Repossessed Assets
Real estate and other property, generally acquired in settlement of loans, is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis at the time of acquisition. Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell. Write-downs resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.
Securities Sold Under Agreements to Repurchase
The Bank enters into sales of securities under agreements to repurchase. Repurchase agreements are treated as financing, with the obligation to repurchase securities sold being reflected as a liability and the securities underlying the agreements remaining as assets.
Fair Value
The Company determines the fair market values of its financial instruments based on the fair value hierarchy established in FASB ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”), which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).
ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1 - Valuations are based on quoted prices in active markets for identical assets or liabilities.
Level 2 - Valuations are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Valuations include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
The Company carries securities available for sale at fair value on a recurring basis.
Residential Loan Origination Fees
The Company offers residential loan origination services to its customers. The loans are offered on terms and prices offered by the Company's correspondents and are closed in the name of the correspondents. The Company receives fees for services it provides in conjunction with these origination services. The fees are recognized at the time the loans are closed by the Company's correspondent. Residential loan origination fees are included in other income on the Company’s consolidated statements of operations.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Income Taxes
The Company accounts for income taxes in accordance with FASB ASC Topic 740, “Income Taxes". Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized.
Net Loss per Share
Basic loss per share represents net loss divided by the weighted-average number of common shares outstanding during the period. Diluted loss per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method. For the years ended December 31, 2011 and 2010 as a result of the Company’s net loss, all of the potential common shares (112,505 and 128,815 stock options, respectively, and 337,500 and 337,500 warrants, respectively) were considered anti-dilutive.
Recently Issued Accounting Pronouncements
The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:
In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in its interim and annual financial statements. See Note 3, Loans, for applicable disclosures.
Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011, the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present. Disclosures related to TDRs under ASU 2010-20 were required beginning with the quarter ended September 30, 2011. See Note 3, Loans, for applicable disclosures.
In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Recently Issued Accounting Pronouncements, continued
ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and requires consecutive presentation of the statement of net income and other comprehensive income. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements. Companies should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the amendments while FASB redeliberates future requirements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
NOTE 2 - INVESTMENT SECURITIES
The amortized costs and fair values of investment securities available for sale are as follows:
At December 31, 2011, investment securities with a fair value of $2.2 million and unrealized losses of $52,531 had been in a continuous loss position for less than twelve months. At December 31, 2011, all remaining investment securities were in an unrealized gain position. The Company believes, based on industry analyst reports and credit ratings that the deterioration in the fair value of these investment securities available for sale is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary. The Company has the ability and intent to hold these securities until such time as the values recover or the securities mature. At December 31, 2010, investment securities with a fair value of $5.0 million and unrealized losses of $61,595 had been in a continuous loss position for less than twelve months. At December 31, 2010, all remaining investment securities were in an unrealized gain position.
The amortized costs and fair values of investment securities available for sale at December 31, 2011, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers have the right to prepay the obligations.
During 2011, the Company received proceeds from sales of securities of $524,374 for a total gain of $32,515. The Company sold no investment securities in 2010. Accordingly, no gains or losses were recorded in 2010. At December 31, 2011, $5.6 million in securities were pledged as collateral for repurchase agreements, a credit line and public deposits.
The Company’s investment portfolio consists principally of obligations of the United States of America, its agencies or enterprises it sponsors. In the opinion of management, there is no concentration of credit risk in its investment portfolio.
NOTE 3 - LOANS
The composition of net loans by major category is as follows:
The Company, through the Bank, makes loans to individuals and small- to mid-sized businesses for various personal and commercial purposes primarily in Greenville County, South Carolina. Credit concentrations can exist in relation to individual borrowers or groups of borrowers, certain types of collateral, certain types of industries, certain loan products, or certain regions of the country. Credit risk associated with these concentrations could arise when a significant amount of loans, related by similar characteristics, are simultaneously impacted by changes in economic or other conditions that cause their probability of repayment to be adversely affected. The Company regularly monitors its credit concentrations. The Company does not have a significant concentration to any individual client. The major concentrations of credit arise by collateral type. As of December 31, 2011, management has determined that the Company has a concentration in commercial real estate loans, including construction and development loans. At December 31, 2011, the Company had $40.7 million in commercial real estate loans, representing 52.9% of gross loans. Management has extensive experience in commercial real estate lending, and has implemented and continues to maintain heightened portfolio monitoring and reporting, and strong underwriting criteria with respect to its commercial real estate portfolio.
In addition to monitoring potential concentrations of loans to a particular borrower or groups of borrowers, industries and geographic regions, management monitors exposure to credit risk that could arise from potential concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Management has determined that there is no concentration of credit risk associated with its lending policies or practices.
The composition of gross loans, before the deduction for deferred origination fees, by rate type is as follows:
NOTE 3 - LOANS, Continued
Directors, executive officers and associates of such persons are customers of and have transactions with the Bank in the ordinary course of business. Included in such transactions are outstanding loans and commitments, all of which were made under substantially the same credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectability. The aggregate dollar amount of these outstanding loans was $4.9 million and $5.7 million at December 31, 2011 and 2010, respectively. During 2011, new loans and advances on these lines of credit totaled $1.1 million and repayments were approximately $1.9 million. At December 31, 2011, there were commitments to extend additional credit to related parties in the amount of approximately $1.2 million.
The Bank has a line of credit with the FHLB to borrow funds, subject to the pledge of qualified collateral. Acceptable collateral includes certain types of commercial real estate, consumer residential and home equity loans. At December 31, 2011, approximately $50.0 million of first and second mortgage loans were specifically pledged to the FHLB, resulting in $13.3 million in lendable collateral. At December 31, 2011, the Bank had also pledged $10.1 million of commercial loans to the FRB’s Borrower-in-Custody of Collateral program, resulting in $8.1 million in lendable collateral. The Bank had $7.0 million in outstanding advances from the FHLB as of December 31, 2011 and no outstanding borrowings from the FRB.
Credit Quality
The following table summarizes delinquencies and nonaccruals, by portfolio class, as of December 31, 2011 and 2010.
At December 31, 2011 and 2010, there were nonaccrual loans of $5.0 million and $12.0 million, respectively, included in the above loan balance. Foregone interest income related to nonaccrual loans equaled $511,224 and $743,315 for the years ended December 31, 2011 and 2010, respectively. No interest income was recognized on nonaccrual loans during 2011 and 2010. At both December 31, 2011 and 2010, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.
As part of the loan review process, loans are given individual credit grades, representing the risk the Company believes is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade.
NOTE 3 - LOANS, Continued
The following table summarizes management’s internal credit risk grades, by portfolio class, as of December 31, 2011 and 2010.
Loans graded one through four are considered “pass” credits. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. At December 31, 2011, approximately 84% of the loan portfolio had a credit grade of “pass” compared to 79% at December 31, 2010. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment. Loans totaling $1.6 million and $6.9 million, respectively, were classified as special mention at December 31, 2011 and 2010. This classification is utilized when an initial concern is identified about the financial health of a borrower. Loans are designated as such in order to be monitored more closely than other credits in the loan portfolio. At December 31, 2011 and 2010, substandard loans totaled $10.7 million and $12.9 million, respectively, with the vast majority of these loans being collateralized by real estate. Substandard credits are evaluated for impairment on a quarterly basis.
NOTE 3 - LOANS, Continued
The following table summarizes information relative to impaired loans, by portfolio class, at December 31, 2011 and 2010.
NOTE 3 - LOANS, Continued
TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.
As a result of adopting the amendments in ASU 2011-02, we reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are TDRs under the amended guidance. We did not identify any new TDRs during our assessment. As noted below, all outstanding TDRs as of December 31, 2011 were restructured prior to the adoption of ASU 2011-02.
At December 31, 2011, the principal balance of TDRs totaled $1.2 million. All TDRs were considered classified, impaired, and in nonaccrual status at December 31, 2011. No TDRs went into default during the year ended December 31, 2011. A TDR can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.
Provision and Allowance for Loan Losses
The following table summarizes activity related to our allowance for loan losses for the years ended December 31, 2011 and 2010, by portfolio segment.
NOTE 3 - LOANS, Continued
NOTE 4 - PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation. Components of property and equipment included in the consolidated balance sheets are as follows:
Depreciation expense for the years ended December 31, 2011 and 2010 was $196,992 and $192,934, respectively. There were no disposals or asset retirements during 2011; however, land with a cost basis of $1,165,312 was transferred to other real estate owned as this property is held for sale as of December 31, 2011. During 2010, fully depreciated assets no longer in service of $228,367 were written off.
NOTE 5 - OTHER REAL ESTATE OWNED AND REPOSESSED ASSETS
The following table summarizes the composition of other real estate owned and repossessed assets as of the dates noted.
Changes in other real estate owned and repossessed assets are presented below:
NOTE 6 - DEPOSITS
Deposits at December 31 are summarized as follows:
Interest expense on time deposits greater than $100,000 was $342,667 and $438,230 for the years ended December 31, 2011 and 2010, respectively.
NOTE 6 - DEPOSITS, Continued
At December 31, 2011 the scheduled maturities of certificates of deposit (including brokered time deposits) are as follows:
At December 31, 2011, $2.5 million in securities were pledged as collateral for public deposits.
NOTE 7 -SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
At December 31, 2011 and 2010, respectively, the Bank had sold $107,777 and $65,479 of securities under agreements to repurchase with brokers with a weighted rate of 0.30% and 0.50%, respectively that mature in less than 90 days. These agreements were secured with approximately $194,000 and $186,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $114,735 during 2011, with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2011 was 0.55%. The securities, under agreements to repurchase, averaged $117,455 during 2010, with $188,826 being the maximum amount outstanding at any month-end. The average rate paid in 2010 was 0.75%.
NOTE 8 - FEDERAL HOME LOAN BANK ADVANCES
At December 31, 2011 and 2010 the Bank had advances of $7,000,000 from the FHLB. The Bank utilizes FHLB advances as long-term sources of funding. At December 31, 2011, these advances are secured with approximately $50.0 million of first and second mortgage loans and $646,800 of stock in the FHLB. As of December 31, 2010, these advances were secured with approximately $59.6 million of first and second mortgage loans and $984,000 of stock in the FHLB. Listed below is a summary of the terms and maturities of the advances:
NOTE 9 - UNUSED LINES OF CREDIT
At December 31, 2011, the Bank had an unused line of credit to purchase federal funds of $2.0 million that is secured by investment securities even though it has not been utilized. The line of credit is available on a one to fourteen day basis for general corporate purposes of the Bank. The lender has reserved the right to withdraw the line at its option.
The Bank has a line of credit with the FHLB to borrow funds, subject to the pledge of qualified collateral. At December 31, 2011, approximately $50.0 million of first and second mortgage loans were specifically pledged to the FHLB, resulting in $13.3 million in lendable collateral. The Bank has collateral that would support $6.3 million in additional borrowings after reducing our lendable collateral by $7.0 million in outstanding advances at December 31, 2011. In addition, the Bank could pledge investment securities or cash for additional borrowing capacity of $3.5 million.
NOTE 9 - UNUSED LINES OF CREDIT, Continued
The Bank is subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. During the fourth quarter of 2010, the Bank’s credit risk rating was downgraded by the FHLB, which resulted in decreased borrowing availability (total line reduced to 15% of total assets from 20% of total assets) and increased collateral requirements (moved to 125% of borrowings from 115%). The Bank’s ability to access available borrowing capacity from the FHLB in the future is subject to its rating and any subsequent changes based on financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.
At December 31, 2011, the Bank had pledged $10.1 million in loans to the FRB’s Borrower-in-Custody of Collateral program. In June 2011, as a result of the FRB’s quarterly review, the Bank was downgraded from Primary to Secondary credit meaning each advance request would require review by the FRB prior to approval. Our available credit under this line was approximately $8.1 million as of December 31, 2011. The Bank had no outstanding borrowings from the FRB as of December 31, 2011.
NOTE 10 - INCOME TAXES
The Company had no currently taxable income for the years ended December 31, 2011 and 2010. The following is a summary of the items that caused recorded income taxes to differ from taxes computed using the Company’s statutory federal income tax rate of 35%:
The components of the net deferred tax liability are as follows:
The valuation allowance for deferred tax assets as of December 31, 2011 and 2010 was $4.1 million and $3.4 million, respectively. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on the weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. As of December 31, 2011, the Company determined that it is not more likely than not that deferred tax assets will be recognized in future years. During third quarter 2009, it became evident that unprecedented economic conditions affecting the banking industry had
NOTE 10 - INCOME TAXES, Continued
increased uncertainty as to the timing of the expected recovery period of the industry as a whole. Although later than many areas of the United States, it also became more evident that our local market and our Bank were affected by these deteriorating economic conditions. Analyses of many factors, including forecasts of future earnings, led to the recordation of a valuation allowance of 100% on all deferred tax assets generated beginning July 1, 2009. During third quarter 2010, based on continued losses and updated forecasts of future earnings, the Company recorded a valuation allowance of 100% on all prior deferred tax assets (those generated prior to July 1, 2009). The Company will continue to analyze deferred tax assets and the related valuation allowance on a quarterly basis, taking into account performance compared to forecasted earnings as well as current economic and internal information.
The change in the net deferred tax liability relates to the increase in the tax effect of the unrealized gain on investment securities available for sale of $25,615. The net deferred tax liability is recorded in other liabilities in the Company’s consolidated balance sheets. At December 31, 2011, the Company has federal operating loss carry-forwards of approximately $9.2 million that may be used to offset future taxable income and expire beginning in 2025.
The Company has analyzed the tax positions taken or expected to be taken and its tax returns and concluded it has no liability related to uncertain tax positions in accordance with FIN 48. With limited exceptions, income tax returns for 2008 and subsequent years are subject to examination by the taxing authorities.
NOTE 11- RELATED PARTY TRANSACTIONS
On December 31, 2011 and 2010, the Bank had various loans outstanding to directors and officers. All of these loans were made under normal credit terms and did not involve more than normal risk of collection. See Note 3 for further details.
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF BALANCE SHEET RISK
In the ordinary course of business, and to meet the financing needs of its customers, the Company is a party to various financial instruments with off balance sheet risk. These financial instruments, which include commitments to extend credit and standby letters of credit, involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheets. The contract amount of those instruments reflects the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amounts of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2011, unfunded commitments to extend credit were $11.2 million, of which approximately $996,000 is at fixed rates and $10.2 million is at variable rates. The Company evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. The fair value of these off-balance sheet financial instruments is considered immaterial.
The Company does not have any commitments to lend additional funds to borrowers whose loans have been modified as a TDR.
NOTE 13 - COMMITMENTS AND CONTINGENCIES
The Bank has a two-year operating lease on its main office facility which began in October 2008. The Bank exercised one of two remaining two-year renewal options in September 2010. The monthly rent under the lease amendment is $9,967 from October 1, 2010 through September 30, 2012. The Bank has one remaining two-year renewal option. The Bank has a ten-year operating lease on a branch facility which began in August 2007. The monthly rent under the lease is $8,025 through July 2012, and $9,229 from August 1, 2012 through July 31, 2017. Rent expense of $215,909 and $214,345 was recorded for the years ended December 31, 2011 and 2010, respectively.
Future minimum lease payments under these operating leases are summarized as follows:
As of December 31, 2011, there were no significant firm commitments outstanding for capital expenditures.
The Board of Directors has approved employment agreements with the president and chief executive officer and the retail banking officer. The agreements include provisions regarding term, compensation, benefits, annual bonus, incentive program, stock option plan and severance and non-compete upon early termination.
The Bank may become party to litigation and claims in the normal course of business. As of December 31, 2011, management believes there is no material litigation pending.
NOTE 14 - STOCK COMPENSATION PLANS
On July 26, 2005, the Company adopted a stock option plan for the benefit of the directors, officers and employees. The Board may grant up to 260,626 options at an option price per share not less than the fair market value on the date of grant. The options granted to officers and employees vest over a three year period from the date of grant, or the anniversary of the Bank’s opening for certain officers. The options expire 10 years from the grant date.
A summary of the status of the plan and changes for the years ended December 31, 2011 and 2010 is presented below:
NOTE 14 - STOCK COMPENSATION PLANS, Continued
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company's closing stock price on the last trading day of 2011 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2011. This amount changes based on the fair market value of the Company's stock. Fair market value is based on the most recent trade of common stock reported through the OTC Bulletin Board. As of December 31, 2011, the Company’s closing stock price was $0.20 resulting in zero intrinsic value.
Compensation expense related to stock options granted was $6,600 and $98,350 for the years ended December 31, 2011 and 2010, respectively. Compensation expense is based on the fair value of the option estimated at the date of grant using the Black-Scholes option-pricing model. Compensation expense is recognized on a straight line basis over the vesting period of the option. No stock options were granted in 2011 or 2010.
Upon completion of the stock offering in 2005, the Company issued warrants to each of its organizers to purchase up to an additional 412,500 shares of common stock at $10.00 per share. These warrants vested six-months from the date the Bank opened for business, or May 16, 2005, and they are exercisable in whole or in part until May 16, 2015. No warrants have been exercised. During the past several years, 75,000 warrants were forfeited when the directors retired from the Board or declined to stand for reelection upon the completion of their terms.
NOTE 15 - EMPLOYEE BENEFIT PLAN
The Bank maintains an employee benefit plan for all eligible employees of the Bank under the provisions of Internal Revenue Code Section 401(k). The Independence National Bank 401(k) Profit Sharing Plan (the “Plan”), adopted in 2005, allows for employee contributions. Upon annual approval of the Board of Directors, the Company also matches 50% of employee contributions up to a maximum of 6% of annual compensation. As of April, 2010, the Company suspended the 401(k) match. For the year ended December 31, 2011 and 2010, zero and $9,497, respectively, was charged to operations for the Company’s matching contribution. Employees are immediately vested in their contributions to the Plan and become fully vested in the employer matching contribution after six years of service.
NOTE 16 - REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance-sheet exposures, adjusted for risk weights ranging from 0% to 100%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, less certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 and 8% for total risk-based capital.
The Bank is also required to maintain capital at a minimum level based on average assets, which is known as the leverage ratio. Only the strongest banks are allowed to maintain capital at the minimum requirement of 3%. All others are subject to maintaining ratios 1% to 2% above the minimum.
NOTE 16 - REGULATORY MATTERS, Continued
On November 14, 2011, the Bank entered into the Consent Order with its primary regulator, the OCC which contains a requirement that the Bank maintain minimum capital ratios that exceed the minimum regulatory capital ratios for “well-capitalized” banks. The Consent Order requires the Bank to achieve Tier 1 capital at least equal to 9% of adjusted total assets, Tier 1 risk based capital at least equal to 10%, and total risk based capital at least equal to 12% of risk-weighted assets by March 31, 2012. As a result of the Consent Order, the Bank is no longer deemed “well-capitalized” regardless of its capital levels. Therefore, in order to meet these standards set forth by the OCC, the Bank will need to raise additional capital, continue to limit its growth, and/or sell assets to increase our capital ratios by March 31, 2012. If we fail to comply with the terms of the Consent Order, the OCC has the authority to subject us to further enforcement actions.
The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements at December 31, 2011 and 2010.
The Federal Reserve Board has similar requirements for bank holding companies. The Company is currently not subject to these requirements because the Federal Reserve guidelines contain an exemption for bank holding companies of less than $500 million in consolidated assets, subject to certain limitations.
Since December 31, 2011, no conditions or events have occurred, of which we are aware, that have resulted in a material change in the Company’s or the Bank’s category, other than as reported in this Annual Report on Form 10-K.
NOTE 17 - RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS, OR ADVANCES
The ability of Independence Bancshares, Inc. to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. However, certain restrictions exist regarding the ability of the subsidiary to transfer funds to Independence Bancshares, Inc. in the form of cash dividends, loans, or advances. The approval of the OCC is required to pay dividends in excess of the Bank’s net profits (as defined) for the current year plus retained net profits (as defined) for the preceding two years, less any required transfers to surplus. Under the terms of the Consent Order, the Bank is required to continue following a dividend policy that permits the declaration of a dividend only when it is in compliance with the Bank’s approved Capital Program, with the aforementioned restrictions, and upon receipt of no supervisory objection by the OCC. Currently, the Company also has to obtain the prior written approval of the Federal Reserve Bank of Richmond before declaring or paying any dividends.
NOTE 18 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Assets and Liabilities Measured at Fair Value
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value are detailed in Note 1.
Available-for-sale investment securities ($12,621,404 at December 31, 2011) are carried at fair value and measured on a recurring basis using Level 2 inputs (other observable inputs). Fair values are estimated by using bid prices and quoted prices of pools or tranches of securities with similar characteristics.
We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and a specific reserve within the allowance for loan losses is established or the loan is charged down to the fair value less costs to sell. At December 31, 2011, all impaired loans were evaluated on a nonrecurring basis based on the market value of the underlying collateral. Market values are generally obtained using independent appraisals or other market data, which the Company considers to be level 2 inputs (other observable inputs). The aggregate carrying amount, net of specific reserves, of impaired loans carried at fair value at December 31, 2011 was $5.6 million.
Other real estate owned and repossessed assets, generally consisting of properties or other collateral obtained through foreclosure or in satisfaction of loans, are carried at fair value and measured on a non-recurring basis. Market values are generally obtained using independent appraisals or other current market information, including but not limited to offers received on a property, which the Company considers to be level 2 inputs (other observable inputs). The carrying amount of other real estate owned and repossessed assets carried at fair value at December 31, 2011 was $5,389,501.
The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis. The Company also has no assets or liabilities whose fair values are measured using Level 1 or Level 3 inputs.
Disclosures about Fair Value of Financial Instruments
FASB ASC Topic 825, “Financial Instruments” requires disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. FASB ASC Topic 825 defines a financial instrument as cash, evidence of an ownership interest in an entity or contractual obligations which require the exchange of cash or other financial instruments. Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, property and equipment and other assets and liabilities.
Fair value approximates carrying value for the following financial instruments due to the short-term nature of the instrument: cash and due from banks, federal funds sold, and securities sold under agreements to repurchase. Investment securities are valued using quoted market prices. No ready market exists for non-marketable equity securities, and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value. Fair value of loans is based on the discounted present value of the estimated future cash flows. Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality.
Fair value for demand deposit accounts and interest bearing accounts with no fixed maturity date is equal to the carrying value. The fair value of certificate of deposit accounts are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments. Fair value for FHLB Advances is based on discounted cash flows using the Company’s current incremental borrowing rate.
NOTE 18 - FAIR VALUE OF FINANCIAL INSTRUMENTS, Continued
The Company has used management’s best estimate of fair value based on the above assumptions. Thus, the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair value presented.
The estimated fair values of the Company’s financial instruments at December 31, 2011 and 2010 are as follows:
NOTE 19 - PARENT COMPANY FINANCIAL INFORMATION
Following is condensed financial information of Independence Bancshares, Inc. (parent company only):
NOTE 19 - PARENT COMPANY FINANCIAL INFORMATION, Continued
PART II
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e). Based upon that evaluation, our Chief Executive Officer and Acting Chief Financial Officer have concluded that our current disclosure controls and procedures are effective as of December 31, 2011. There have been no significant changes in our internal controls over financial reporting during the fourth fiscal quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
Management’s Annual Report on Internal Controls over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in the Exchange Act Rules 13a-15(f). A system of internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and the principal financial officer, the Company’s management has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2011 based on the criteria established in a report entitled “Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission” and the interpretive guidance issued by the Commission in Release No. 34-55929. Based on this evaluation, the Company’s management has evaluated and concluded that the Company's internal control over financial reporting was effective as of December 31, 2011.
The Company is continuously seeking to improve the efficiency and effectiveness of its operations and of its internal controls. This results in modifications to its processes throughout the Company. However, there has been no change in its internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
This annual report does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management's report in this annual report.
Item 9B.
Item 9B. Other Information.
On March 5, 2012, the Board amended and restated the Company's bylaws to update outdated corporate information and make a few additional ministerial changes. The following amendments that were adopted are: (i) Article 1: Offices, Section 1: Registered Office and Agent, change the name on record of the designated registered office to that of the Company’s current principal office address and change the name on record of the Company’s registered agent to the Company’s Chief Executive Officer; (ii) Article 2: Shareholders, Section 8: Record Date, fix the Record Date in accordance with Section 33-7-107 of the South Carolina Business Corporation Act of 1988 to allow for the record date to not be more than 70 days prior to the date on which the particular action, requiring a determination of shareholders, is to be taken; and (iii) Article 3: Directors, include a retirement provision in the bylaws, under new Section 6. The Amended and Restated Bylaws are attached to this Annual Report as Exhibit 3.2.
PART III
Item 10.
Item 10. Directors, Executive Officers, Promoters and Corporate Governance.
The information required by Item 10 is hereby incorporated by reference from our proxy statement for our 2012 annual meeting of shareholders to be held on May 16, 2012.
Item 11.
Item 11. Executive Compensation.
The information required by Item 11 is hereby incorporated by reference from our proxy statement for our 2012 annual meeting of shareholders to be held on May 16, 2012.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The following table sets forth equity compensation plan information at December 31, 2011.
Equity Compensation Plan Information
(1)
At our annual meeting of shareholders held on May 16, 2006 shareholders approved the Independence Bancshares, Inc. 2005 Stock Incentive Plan. The 260,626 of shares of common stock available for issuance under the plan will automatically increase each time we issue additional shares so that it continues to equal 12.5% of our total outstanding shares.
(2)
Each of our organizers received, for no additional consideration, a warrant to purchase one share of common stock for $10.00 per share for each share purchased during our initial public offering up to a maximum of 25,000 warrants. The warrants are represented by separate warrant agreements. The warrants vested six months from the date our Bank opened for business, or May 16, 2005, and they are exercisable in whole or in part until May 16, 2015. The warrants may not be assigned, pledged, or hypothecated in any way. The 337,500 of shares issued pursuant to the exercise of such warrants are transferable, subject to compliance with applicable securities laws. If the South Carolina Board of Financial Institutions or the FDIC issues a capital directive or other order requiring the Bank to obtain additional capital, the warrants will be forfeited, if not immediately exercised.
The additional information required by this Item 12 is hereby incorporated by reference from our proxy statement for our 2012 annual meeting of shareholders to be held on May 16, 2012.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required by Item 13 is hereby incorporated by reference from our proxy statement for our 2012 annual meeting of shareholders to be held on May 16, 2012.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information required by Item 14 is hereby incorporated by reference from our proxy statement for our 2012 annual meeting of shareholders to be held on May 16, 2012.
Item 15.
Item 15. Exhibits.
3.1.
Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form SB-2, File No. 333-121485).
3.2.
Amended and Restated Bylaws as of March 5, 2012.
4.1.
See Exhibits 3.1 and 3.2 for provisions in Independence Bancshares, Inc.’s Articles of Incorporation and Bylaws defining the rights of holders of the common stock (incorporated by reference to Exhibit 4.1 of the Company’s Form SB-2, File No. 333-121485).
4.2.
Form of certificate of common stock (incorporated by reference to Exhibit 4.2 of the Company’s Form SB-2, File No. 333-121485).
10.1
Amended and Restated Employment Agreement between Independence Bancshares, Inc. and Lawrence R. Miller dated December 10, 2008 (incorporated by reference to Exhibit 10.11 of the Company's Form 10-K for the fiscal year ended December 31, 2008).*
10.2
Amended and Restated Employment Agreement between Independence Bancshares, Inc. and Schaefer M. Carpenter dated December 10, 2008 (incorporated by reference to Exhibit 10.12 of the Company's Form 10-K for the fiscal year ended December 31, 2008).*
10.3
Employment Agreement between Independence Bancshares, Inc. and Katie N. Tuttle dated May 4, 2009 (incorporated by reference to the Company's Form 10-Q for the period ended March 31, 2009).*
10.4
Form of Stock Warrant Agreement (incorporated by reference to Exhibit 10.4 of the Company’s Form SB-2, File No. 333-121485).*
10.5
Independence Bancshares, Inc. 2005 Stock Incentive Plan and Form of Option Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Form 10-QSB for the period ended June 30, 2005). *
10.6
Stock Warrant Agreement between Lawrence R. Miller and the Company dated May 16, 2005 (incorporated by reference to Exhibit 10.2 of the Company’s Form 10-QSB for the period ended June 30, 2005).*
10.7
Amendment No. 1 to the Independence Bancshares, Inc. 2005 Stock Incentive Plan (incorporated by reference to the Company's Form 10-Q for the period ended September 30, 2008).*
10.8
Formal Agreement by and between Independence National Bank and the Comptroller of the Currency dated January 20, 2010 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on January 22, 2010.
10.9
Consent Order by and between Independence National Bank and the Comptroller of the Currency dated November 14, 2011 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on November 18, 2011.
21.1
Subsidiaries of the Company.
23.1
Consent of Elliott Davis, LLC.
24.1
Power of Attorney (filed as part of the signature page herewith).
31.1
Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2
Rule 13a-14(a) Certification of the Principal Financial Officer.
Section 1350 Certifications.
The following materials from the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, formatted in eXtensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at December 31, 2011 and December 31, 2010, (ii) Consolidated Statements of Income (Loss) for the years ended December 31, 2011, 2010, and 2009, (iii) Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2011, 2010, and 2009, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010, and 2009, and (iv) Notes to Consolidated Financial Statements*.
* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
*
Management contract of compensatory plan or arrangement required to be filed as an Exhibit to this Annual Report on Form 10-K.
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.
INDEPENDENCE BANCSHARES, INC.
Dated: March 5, 2012
By: /s/ Lawrence R. Miller
Lawrence R. Miller
Chief Executive Officer
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Lawrence R. Miller, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Robert M. Austell
Robert M. Austell
Director
March 5, 2012
/s/ Kimberly D. Barrs
Kimberly D. Barrs
Acting Chief Financial Officer
(Principal Financial Officer)
March 5, 2012
/s/ John W. Burnett
John W. Burnett
Director
March 5, 2012
/s/ Billy J. Coleman
Billy J. Coleman
Director
March 5, 2012
/s/ Jose De Ocampo
Jose De Ocampo
Director
March 5, 2012
/s/ H. Neel Hipp, Jr.
H. Neel Hipp, Jr.
Director
March 5, 2012
/s/ James D. King
James D. King
Director
March 5, 2012
/s/ William R. Mathis
William R. Mathis
Director
March 5, 2012
/s/ A. Alexander McLean
A. Alexander Mclean
Director
March 5, 2012
/s/ Lawrence R. Miller
Lawrence R. Miller
Chief Executive Officer, Director
March 5, 2012
/s/ Sudhirkumar C. Patel
Sudhirkumar C. Patel
Director
March 5, 2012
/s/ Hasmukh P. Rama
Hasmukh P. Rama
Director
March 5, 2012
/s/ Donald H. Rex, Jr.
Donald H. Rex, Jr.
Director
March 5, 2012
/s/ Charles D. Walters
Charles D. Walters
Director
March 5, 2012
/s/ Roger W. Walters
Roger W. Walters
Director
March 5, 2012
/s/ Vivian A. Wong
Vivian A. Wong
Director
March 5, 2012
EXHIBIT INDEX
Exhibit
Description
3.2.
Amended and Restated Bylaws as of March 5, 2012.
21.1
Subsidiaries of the Company.
23.1
Consent of Elliott Davis, LLC.
24.1
Power of Attorney (filed as part of the signature page herewith).
31.1
Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2
Rule 13a-14(a) Certification of the Principal Financial Officer.
Section 1350 Certifications.
The following materials from the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, formatted in eXtensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at December 31, 2011 and December 31, 2010, (ii) Consolidated Statements of Income (Loss) for the years ended December 31, 2011, 2010, and 2009, (iii) Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2011, 2010, and 2009, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010, and 2009, and (iv) Notes to Consolidated Financial Statements*.
* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.