Item 1. Business.
General
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 Banking and Branching Efficiency Act of 1996, and to own and control all of the capital stock of Independence National Bank (the “Bank”). Our Bank is a national association organized under the laws of the United States and provides banking services to consumers and small- to mid-size businesses, principally in Greenville County, South Carolina. The Bank opened for business on May 16, 2005.
On December 31, 2012, the Company sold 17,648,750 shares of common stock at a price of $0.80 per share to certain investors in a private placement, including members of our board of directors, for gross proceeds of approximately $14.1 million (the “Private Placement”). On August 1, 2013, the Company sold 769,000 shares of common stock at a price of $0.80 per share to certain existing shareholders in a follow-on public offering for gross proceeds of approximately $615,200 (the “Follow-on Offering”). Upon closing the Private Placement, the Company made a capital contribution of $2.3 million to the Bank in order to increase the Bank’s capital levels above the amounts specified in the Bank’s consent order (the “Consent Order”) with the Office of the Comptroller of the Currency (the “OCC”). In addition, the Company made a capital contribution to the Bank of $750,000 during the quarter ended March 31, 2013. The Company is using the remaining proceeds of the Private Placement and the proceeds from the Follow-on Offering build a digital payment technology platform and explore transaction services business opportunities. In conjunction with our efforts to pursue these opportunities, we have begun offering services under the trade name “nD bancgroup” and, as described below, have taken steps to protect our intellectual property rights to that name.
We began offering digital banking, payments and transaction services in October 2013 on a limited basis and are focused on expanding and growing this line of business. Notwithstanding our efforts to expand our transaction services, the Bank will continue as a full-service traditional community bank, fulfilling the financial needs of individuals and small business owners in our existing market area. We will continue to provide traditional checking and savings products and commercial, consumer and mortgage loans to the general public, as well as ATM and online banking services, commercial cash management, remote deposit capture, safe deposit boxes, bank official checks, traveler’s checks, and wire transfer capabilities.
The Company intends to pursue additional financings in the near future to support and expand its business. These financings may include the offering of additional common shares, preferred shares, or the issuance of debt. If we raise additional capital in the near future, in addition to building reserves for regulatory capital, we anticipate using a material amount of proceeds to expand our operations support and our sales, marketing, and advertising efforts, which may include the addition of new management team members or other employees. At our 2013 annual shareholder meeting, our shareholders approved an increase in the number of authorized shares of common stock from 100 million shares to 300 million shares. If the Company raises additional capital in the near future, our board of directors generally has the authority, without action by or the vote of the shareholders, to issue all or part of any authorized but unissued shares of common stock for any corporate purpose. Future financings may also require regulatory approval. Even if we are successful in obtaining a significant amount of additional financing, we expect operating losses on a consolidated basis to continue for a significant period of time as the Company continues to invest in product research and development and customer marketing. At times, these operating losses could be significant. On an unconsolidated basis, we continue to prioritize maintaining sustainable profitability at the Bank level, even if other operating subsidiaries or the Company operate at a loss. The Company seeks to maintain capital resources at both the Bank and at the Company, as well as at any future subsidiary, to adequately finance their operations.
We may also pursue the listing of our common shares on a nationally recognized securities exchange in the future, once eligible.
Recent Developments
We began offering digital banking, payments and transaction services in October 2013 on a limited basis. In addition to the online bill pay, person-to-person payments, ACH services, debit and credit cards, and merchant services which we already provided, we now also offer mobile bill pay and person-to-person payments as well as mobile remote deposit capture. We may need to obtain approval from the OCC or the Board of Governors of the Federal Reserve System (the “Federal Reserve”) to expand these services to any significant extent. There can be no assurance that we will receive approval or be successful in implementing the steps necessary to expand our business.
In March 2013, we filed a provisional patent application with the U.S. Patent and Trademark Office covering several different potentially patentable concepts, including concepts associated with mobile wallet messages among different software platforms, temporary electronic currency messages, digital identities, improved credit score data collected from a mobile device and/or individual activities, improved interfaces for carrying out mobile financial transactions, closed loop mobile enablement bridging, software-related building blocks for performing financial transactions, social networking, encryption protocols and insurance risk analysis. On March 15 and 17, 2014, we filed three patent applications covering these concepts. The Company has not been granted any form of intellectual property protection from the U.S. Patent and Trademark Office or other government entity that grants intellectual property protections and is continuing to explore its alternatives regarding the type of protection to pursue regarding its proprietary technology and software.
On July 16, 2013, the Company’s board of directors approved the appointment of Richard J. Garside as the Company’s President and Chief Operating Officer, subject to regulatory non-objection, and on February 10, 2014, the Company filed the application for the appointment of Mr. Garside with the Federal Reserve. Following the receipt of regulatory non-objection, Mr. Garside may become the President and Chief Operating Officer of the Company and work with the Company’s and the Bank’s current directors and executive officers to further explore the development of the Company’s expanded business model. Mr. Garside has previously assisted the Company as an independent consultant on technology matters related to the expanded business model. Prior to working with the Company, Mr. Garside was the Global Head of Consumer Operations and Technology for Citigroup Inc.
During 2013, the Company entered into multiple contracts with third party technology developers and vendors to support its business operations. These contracts provide for technology and services to process payments on a real-time basis. These contracts also facilitate better processing functionality, data management, business integration, mobile transaction development, API management, in-memory large data processing and analytics, complex business rules processing and security, compliance and anti-fraud protection. Specifically, the Company has entered into an agreement with a major U.S. mobile network operator pursuant to which the mobile network operator will provide us with security, validation and identity related services as part of our research and development activities. In addition, as part of the Company’s research and development efforts, we plan to explore technology integration functionality with Near Field Communications as well as Host Card Emulation protocols to support multiple secure data transmission and payment activities for connected mobile and other devices.
The Bank has received approval from the Federal Reserve for an additional ABA number to support its operations, including its transaction services. We may seek to set up additional subsidiaries or affiliates of the Company, including transactions processing subsidiaries, captive insurers, or acquisition companies or to build, sponsor, or form associations or partnerships with other banks to create more efficient bank-to-bank and peer-to-peer payment capabilities. We may also enter into agreements with vendors, payment networks and payment gateways as well as marketing and distribution partners and work with other banks and financial institutions in offering transaction and payment services or other forms of digital banking services, in each case subject to the discretion of the board of directors and management and the receipt of any necessary regulatory approvals or non-objections.
Banking Services
Market
Our primary focus and target market is to fulfill the financial needs of small business owners, the legal community, the medical community, insurance agencies, and clients owning and developing income producing properties primarily in the City of Greenville and the broader Greenville metropolitan area. In the past, we have also focused on real estate developers, including clients involved in residential construction and acquisition/development; however due to the current real estate market, we have limited our focus in these areas over the last several years. While most of our loans still involve real estate, our level of construction and acquisition/development loans has decreased significantly. We intend to use our “closeness” to the market via local ownership, quick response time, pricing discretion, person-to-person relationships and an experienced, well known senior management team in leveraging our market share in the greater Greenville area while looking for ways to differentiate the Bank from our competition.
Location and Service Area
Our primary market is Greenville County, which is located in the upstate region of South Carolina. The cities of Fountain Inn, Greenville, Greer, Mauldin, Simpsonville, and Travelers Rest make up Greenville County. The Greenville metropolitan area, positioned on the I-85 corridor, is home to one of the strongest manufacturing centers in the country, including approximately 250 international companies, such as the North American headquarters of BMW and Michelin, as well as Fluor Corporation, General Electric, and Lockheed Martin. Greenville County has a population of approximately 450,000, with a five-year projected annual growth rate of almost 3%, according to the South Carolina Community Profiles published by the South Carolina Budget and Control Board’s Office of Research and Statistics. The area’s demographics have changed considerably over the past 10 years and currently over 42,000 businesses are operating within the county limits, according to the U.S. Census Bureau.
Our main office is located in Greenville, South Carolina, one block off a major artery, and provides excellent visibility for the Bank. We also have full-service branches on Wade Hampton Boulevard in Taylors, South Carolina and in Simpsonville, South Carolina. These branch offices have extended the market reach of our Bank and have increased our personal service delivery capabilities to all of our customers. We plan to continue to take advantage of existing contacts and relationships with individuals and companies in this area to more effectively market the banking services of the Bank.
Competition
The Greenville market is highly competitive, with all of the largest banks in the state, as well as super regional banks, represented in our market area. The competition among the various financial institutions is based upon a variety of factors, including interest rates offered on deposit accounts, interest rates charged on loans, credit and service charges, the quality of services rendered, the convenience of banking facilities and, in the case of loans to large commercial borrowers, relative lending limits. In addition to banks and savings associations, we compete with other financial institutions including securities firms, insurance companies, credit unions, leasing companies and finance companies. Size gives larger banks certain advantages in competing for business from large corporations. These advantages include higher lending limits and the ability to offer services in other areas of South Carolina. As a result, we do not generally attempt to compete for the banking relationships of large corporations, but concentrate our efforts on small- to medium-sized businesses and retail customers. We believe we have competed effectively in this market by offering quality and personal service.
Products and Services
The Bank is primarily engaged in the business of accepting demand and time deposits and providing commercial, consumer and mortgage loans to the general public. Deposits in the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to a maximum amount, which is currently set at $250,000 per depositor. Other services which the Bank offers include mobile banking, online banking, commercial cash management, remote deposit capture, safe deposit boxes, bank official checks, traveler’s checks, and wire transfer capabilities.
Credit Cards
The Bank offers MasterCard branded credit cards for personal and business clients in coordination with a third party vender known as Card Assets, LLC. Credit cards are offered with no annual fee and have reward options available for cash back or reward points redeemable for airfare, merchandise and gift cards. Clients enjoy the freedom of MasterCard acceptance worldwide with available 24/7 customer support as well as protection and security services.
Merchant Services
The Bank offers merchant transaction processing and equipment for clients in coordination with a third party vendor known as Merchants’ Choice Payment Solutions. Clients enjoy the capability, as well as the specialized equipment, to accept debit and credit card transactions to conduct business with speed, ease and security. Clients are able to accept payments from Visa, MasterCard, American Express and Discover. Equipment and services available include POS terminals, wireless units, web based processing, on-line debit and TeleCheck services.
Lending Activities
General. We emphasize a range of lending services, including commercial, real estate, and equity-line consumer loans to individuals and small- to medium-sized businesses and professional firms that are located in or conduct a substantial portion of their business in our market area. The larger, well-established banks in our service area make proportionately more loans to medium- to large-sized businesses than we do. Our small- to medium-sized borrowers may be less able to withstand competitive, economic, and financial conditions than larger borrowers. Our underwriting standards vary for each type of loan, as described below. We compete for these loans with competitors who are well established in our service area and have greater resources and lending limits.
Loan Approval. Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, the loan request will be considered by an executive officer with a higher lending limit, executive officers combining authority or the directors’ loan committee. We do not make any loans to any director or executive officer of the Bank unless the loan is approved by the full board of directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.
Credit Administration and Loan Review. We maintain a continuous loan review system. We also apply a credit grading system to each loan, and we use an independent consultant to review the loan files on a test basis to confirm our loan grading. Each loan officer is responsible for each loan he or she makes, regardless of whether other individuals or committees joined in the approval. This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.
Lending Limits. Our lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. These limits will increase or decrease in response to increases or decreases in the Bank’s level of capital. Our ability to sell participations in our larger loans to other financial institutions, which allows us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.
Real Estate Mortgage Loans. The principal component of our loan portfolio is loans secured by real estate mortgages. We obtain a security interest in real estate whenever possible, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan. At December 31, 2013, loans secured by mortgages on real estate - first mortgages of approximately $44.8 million and second mortgages of approximately $3.9 million - made up approximately 80% of our loan portfolio.
These loans generally fall into one of four categories: commercial real estate loans, construction and development loans (including land loans), residential real estate loans, or home equity loans. Most of our real estate loans are secured by residential or commercial property. Interest rates for all categories may be fixed or adjustable, and will more likely be fixed for shorter-term loans. We generally charge an origination fee for each loan. Other loan fees consist primarily of late charge fees. Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, credit-worthiness, and ability to repay the loan.
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Commercial Real Estate Loans. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, does not exceed 85%. We generally require that debtor cash flow exceed 120% of monthly debt service obligations. We typically review all of the personal financial statements of the principal owners and require their personal guarantees. These reviews generally reveal secondary sources of payment and liquidity to support a loan request.
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Construction and Development Real Estate Loans (Including Land Loans). We offered adjustable and fixed rate residential and commercial construction loans in the past. We continue to offer construction and development loans on a limited basis to certain qualified borrowers. The terms of construction and development loans have generally been limited to eighteen months, although some payments have been structured on a longer amortization basis. Most loans mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long term financing of existing properties. Repayment depends on the ultimate completion of the project and usually on the sale of the property. Specific risks include:
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inferior or improper construction techniques;
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economic changes or downturns during construction;
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rising interest rates which may prevent sale of the property; and
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failure to sell completed projects in a timely manner.
We attempted to reduce risk by obtaining personal guarantees where possible, and by keeping the loan-to-value ratio of the completed project below specified percentages. We previously reduced risk by selling participations in larger loans to other institutions when possible.
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Residential Real Estate Loans and Home Equity Loans. We generally do not originate traditional long term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We typically offer these fixed rate loans through a third party rather than originating and retaining these loans ourselves. We typically originate and retain residential real estate loans only if they have adjustable rates. We also offer home equity lines of credit. Our underwriting criteria and the risks associated with home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity lines of credit typically have terms of fifteen years or less. We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.
Commercial Business Loans. We make commercial loans across various lines of business. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the security may be difficult to assess and more likely to decrease than real estate.
Equipment loans typically will be made for a term of five years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 80% or less. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.
Consumer Loans. We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit. Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral. Consumer rates are both fixed and variable, with terms negotiable. Our installment loans typically amortize over periods up to 60 months. We will offer consumer loans with a single maturity date when a specific source of repayment is available. We typically require monthly payments of interest and a portion of the principal on our revolving loan products. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.
Deposit Services
Our principal source of funds is core deposits. We offer a full range of deposit services, including checking accounts, commercial accounts, NOW accounts, savings accounts, and time deposits of various types, ranging from daily money market accounts to long-term certificates of deposit. We solicit these accounts from individuals, businesses, associations, organizations and governmental authorities. Deposit rates are reviewed regularly by senior management of the Bank and the asset/liability management committee (“ALCO”) of the Bank’s board of directors. We believe that the rates we offer are competitive with those offered by other financial institutions in our area.
Other Banking Services
We offer other community bank services including cashier’s checks, banking by mail, direct deposit, remote deposit capture, United States Savings Bonds, and travelers’ checks. We earn fees for most of these services, in addition to fees earned from debit and credit card transactions, sales of checks, and wire transfers. We are associated with the Plus and Star ATM networks, which are available to our clients throughout the
country. We offer merchant banking and credit card services through a correspondent bank. We also offer online banking services, bill payment services, and cash management services.
Market Share
As of June 30, 2013, the most recent date for which FDIC deposit market share data is available, total deposits in the Greenville-Anderson-Mauldin, South Carolina MSA were over $13.7 billion, an increase of approximately 1.48% from $13.5 billion as of June 30, 2012. At June 30, 2013 and 2012, the Bank’s deposits represented 0.72% of this market.
Digital Banking, Payments & Transaction Services Business
Our Strategy
With digital payments in the United States growing, check usage decreasing, and a significant portion of consumer transactions in the United States still being initiated in cash, we believe there are opportunities for business efforts configured to provide more efficient digital banking, payments and transaction services. We expect to continue to invest in and focus on developing these channels and services, including transaction processing, credit management, data and loyalty programs, compliance services and risk management. In order to pursue these at the desired level of investment, the Company will need to raise additional capital. We also believe the lower cost and deeper penetrations of mobile banking and payments enabled by smart phones will accelerate a shift toward mobile payments mainly among the younger generation as well as under-banked and under-serviced market segments.
Research and Development
We have made and plan to continue to make substantial investments in research and development, and we expect to focus our future research and development efforts on enhancing existing products and services and on developing new products and services. We expect to continue to develop technologies and operating functionalities to improve the efficiencies of and reduce the cost of transaction services, mobile and digital payments, data management and compliances services. These services may include expanding or introducing prepaid debit programs, decoupled debit and real time processing capabilities as well as expanding our traditional debit card issuance programs to generate additional interchange income. We may also seek to develop types of accounts and channels that reduce fraud, credit and settlement risks including near real time settlement accounts as well as those that reduce the types and amount of potential charge-backs. We also anticipate expanding marketing and sales capabilities and customer support programs which may involve expansion of activities and offices in Greenville, New York City, and other geographic locations as well as forming associations with other banks and financial institutions to establish policies and procedures and infrastructure services for more efficient payment networks and operations. We expect to continue to focus significant research and development efforts on ongoing projects to update the technology platforms for several of our offerings. During the year ended December 31, 2013, we incurred product research and development expenses of approximately $3.0 million. There were no research and development expenses in 2012.
Business Segments
The Company reports its activities as four business segments - Banking, Transaction Services, Asset Management and Holding Company. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment. Please refer to “Note 18 - Business Segments” for further information on the reporting for the four business segments.
Intellectual Property
We rely on a combination of intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and products and services. We have registered or have applied for the registration in the United States certain trademarks, service marks, and domain names used by the Company. The Company owns an incontestable United States trademark registration for “Independence National Bank”, U.S. Reg. No.. 3234648, and pending United States trademark applications for our trade names “nDNA,” Serial No. 86075369 and “nD bancgroup,” Serial No. 86075221. As described above, from time to time we have filed, and may in the future file, patent applications to protect our proprietary technology and products and services. The Company has not been granted any form of patent protection from the U.S. Patent and Trademark Office or other government entity that grants intellectual property protections and is continuing to explore its alternatives regarding the type of protection to pursue regarding its proprietary technology and products and services. Intellectual property is a key component of our digital banking and transaction services business and any impairment in our ability to protect our proprietary technology or products and services, or any third-party claim of infringement or misappropriation against our products and services, could harm our business or our ability to compete. See “Risk Factors - We will need to adequately protect our brand and the intellectual property rights related to our products and services and avoid infringing or misappropriating the intellectual property rights of others” for more information regarding our potential risks relating to intellectual property.
Employees
As of March 24, 2014, we had 37 full-time employees and two part-time employees.
Capital
As of December 31, 2013, the Company had total shareholders’ equity of $14.3 million. The Company’s and the Bank’s regulatory capital ratios as of December 31, 2013 were as follows:
Currently, the Company must obtain the prior written approval of the Federal Reserve Bank of Richmond before declaring or paying any dividends, directly or indirectly accepting dividends or any other form of payment representing a reduction in capital from the Bank, making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, directly or indirectly, incurring, increasing or guaranteeing any debt, and directly or indirectly, purchasing or redeeming any shares of its stock. Once certain financial performance and capital adequacy metrics have been met and the Company has either received the necessary regulatory approvals to engage in such activities or such regulatory approvals are no longer required, the Company may engage in some of these activities in the future, such as paying dividends to our shareholders or purchasing shares of our stock, provided these activities could be conducted in a safe and sound manner while maintaining prudent capital levels in order to support the Bank and its operations and to maintain the Company’s research and development, acquisition, regulatory, and legal costs and marketing efforts. The Company currently has no plans to engage in such activities, and there can be no assurances that the Company will take any such actions in the future.
Supervision and Regulation
Both the Company and the Bank are subject to extensive state and federal banking laws and regulations that impose specific requirements or restrictions on and provide for general regulatory oversight of virtually all aspects of our operations. These laws and regulations are generally intended to protect depositors, federal
insurance deposit funds, and the banking system as a whole and not our shareholders. Changes in applicable laws or regulations may have a material effect on our business and prospects.
The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on our operations. It is intended only to briefly summarize some material provisions. The following summary is qualified by reference to the statutory and regulatory provisions discussed.
Our Digital Banking, Payments & Transaction Services Business
We currently offer digital banking, payments and transaction services, including online and mobile bill pay, mobile person-to-person payments, ACH services, debit and credit cards, and merchant services, on a limited basis. As discussed in our strategy above, we may need to obtain approval from the OCC or the Federal Reserve to expand these services to any significant extent. There can be no assurance that we will receive approval or be successful in implementing the steps necessary to expand this line of business. In addition, we will need to establish robust compliance controls and procedures in connection with the implementation of any new digital banking, payments, and transaction services business.
Compliance with legal and regulatory requirements is a highly complex and integral part of our day-to-day operations. Our products and services are generally subject to federal, state and local laws and regulations, including:
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anti-money laundering laws;
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privacy and information safeguard laws;
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consumer protection laws; and
These laws are often evolving and sometimes ambiguous or inconsistent, and the extent to which they apply to us or our customers is at times unclear. Any failure to comply with applicable law - either by us or by our third-party vendors and service providers, over which we have limited legal and practical control - could result in restrictions on our ability to provide our products and services, as well as the imposition of civil fines and criminal penalties and the suspension or revocation of a license or registration required to sell our products and services. See “Risk Factors” under Part I, Item 1A
Item 1A. Risk Factors.
The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently now to us or that we currently deem immaterial may also impact our business operations. If any of the following risks occur, our business, financial condition, operating results, and cash flows could be materially adversely affected.
Risks Related to Our Banking Business
If we do not generate positive earnings and cash flow, there will be an adverse effect on our future results of operations.
For the years ended December 31, 2013 and 2012, we incurred net losses of $6.0 million and $0.6 million, respectively. For 2013, the $6.0 million loss was largely due to $3.0 million in expenses for product research and developments, a $1.5 million increase in expenses to carry other real estate owned, and approximately $472,000 in expenses related to equity-based compensation. In light of potential adverse economic conditions, our Bank may be required to take significant additional provisions for loan losses to
supplement the allowance for loan losses in the future. As a result, the Bank may incur significant future credit costs, which could adversely impact our financial condition, results of operations, and the value of our common stock. In addition, the Company is not currently generating cash flows from its activities. Therefore, the Company will need to produce cash flows to sustain our operations, or we will be forced to slow our growth, raise additional capital, or discontinue certain activities.
Liquidity needs could adversely affect our results of operations and financial condition.
Due to the uncertainty of timing and amount of cash that might be received from the conversion of the held for sale assets, the current commitments outstanding, the current run rate on fixed expenses, and the prohibition within Regulation W, we believe that the Company does not have sufficient liquidity to fund its current activities without a modification of our current operating strategy or without raising additional capital. The Company’s cash balances were $2.4 million and its loan and real estate held for sale were $2.8 million at December 31, 2013.
Our primary funding sources are customer deposits and loan repayments. Under Regulation W, the Bank may not be a source of cash or capital for the Company. 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 (the “FRB”), 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.
A continuation of the current low interest rate environment or subsequent movements in interest rates may have an adverse effect on our profitability.
Changes in the interest rate environment may materially affect our business. Changes in interest rates affect the following areas, among others, of our business:
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the level of net interest income we earn;
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the volume of loans originated and prepayment of loans;
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the market value of our securities holdings; and
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gains from sales of loans and securities.
In recent years, it has been the policy of the Federal Reserve to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, yields on securities we have purchased, and market rates on the loans we have originated, have been at levels lower than were available prior to 2008. Consequently, the average yield on our interest-earning assets has decreased during the recent low interest rate environment. As a general matter, our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets; however, our ability to lower our interest expense has been limited at these interest rate levels, while the average yield on our interest-earning assets has
continued to decrease. If a low interest rate environment persists, our net interest income may further decrease, which may have an adverse effect on our profitability.
Our net interest margin would narrow if our cost of funding increases without a correlative increase in the interest we earn from loans and investments. Because we rely extensively on deposits to fund our operations, our cost of funding would increase if there is an increase in the interest rate we are required to pay our customers to retain their deposits. In addition, if the interest rates we are required to pay in respect of our other sources of funding, either in the interbank or capital markets, increases, our cost of funding would increase. If either of these risks occurs, our net interest margin would narrow without a correlative increase in the interest we earn from our loans and investments. Our assets currently reprice faster than our liabilities, which would result in a benefit to net interest income as interest rates rise; however, the benefit from rising rates could be less than assumed as interest rates rise if increased competition for deposits causes the deposit expense to rise faster than assumed.
In addition, increases in interest rates may decrease customer demand for loans as the higher cost of obtaining credit may deter customers from new loans. Further, higher interest rates might also lead to an increased number of delinquent loans and defaults, which would impact the value of our loans.
We cannot control or predict with certainty changes in interest rates. Global, national, regional and local economic conditions, competitive pressures and the policies of regulatory authorities, including monetary policies of the Federal Reserve, affect interest income and interest expense. Although we have policies and procedures designed to manage the risks associated with changes in market interest rates, changes in interest rates still may have an adverse effect on our profitability.
If our assumptions regarding borrower behavior are wrong or overall economic conditions are significantly different than we anticipate, then our risk mitigation may be insufficient to protect against interest rate risk and our net income would be adversely affected.
Our planned expansion of our digital banking, payments and transaction services business could strain our management resources and distract our management team from our traditional banking business.
We began offering digital banking, payments and transaction services in October 2013 on a limited basis and are focused on expanding and growing this line of business. The challenges of expanding this line of business could strain our management resources, distract our management team and disrupt our traditional banking business. For example, we may need to obtain approval from the OCC or the Federal Reserve to significantly expand these services, which could require significant management engagement. In addition, we will need to establish robust compliance controls and procedures in connection with the expansion of our digital banking, payments, and transaction services business. As a result, management may need to focus on training and managing an increasing number of employees. A prolonged strain on management resources or distraction of management’s attention, and any delays or difficulties encountered in connection with the expansion of this line of business, could have a material adverse effect on our overall business, financial condition and results of operations.
Competition with other financial institutions may have an adverse effect on our ability to retain and grow our client base, which could have a negative effect on our financial condition or results of operations.
The banking and financial services industry is very competitive and includes services offered from other banks, savings and loan associations, credit unions, mortgage companies, other lenders, and institutions offering uninsured investment alternatives. Legal and regulatory developments have made it easier for new and sometimes unregulated competitors to compete with us. The financial services industry has and is experiencing an ongoing trend towards consolidation in which fewer large national and regional banks and other financial institutions are replacing many smaller and more local banks. These larger banks and other financial institutions hold a large accumulation of assets and have significantly greater resources and a wider geographic presence or greater accessibility. In some instances, these larger entities operate without the
traditional brick and mortar facilities that restrict geographic presence. Some competitors have more aggressive marketing campaigns and better brand recognition, and are able to offer more services, more favorable pricing or greater customer convenience than the Bank. In addition, competition has increased from new banks and other financial services providers that target our existing or potential customers. As consolidation continues among large banks, we expect other smaller institutions to try to compete in the markets we serve. This competition could reduce our net income by decreasing the number and size of the loans that we originate and the interest rates we charge on these loans. Additionally, these competitors may offer higher interest rates, which could decrease the deposits we attract or require us to increase rates to retain existing deposits or attract new deposits.
Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations which could increase our cost of funds.
The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge as part of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Technological developments have allowed competitors, including some non-depository institutions, to compete more effectively in local markets and have expanded the range of financial products, services and capital available to our target customers. If we are unable to implement, maintain and use such technologies effectively, we may not be able to offer products or achieve cost-efficiencies necessary to compete in the industry. In addition, some of these competitors have fewer regulatory constraints and lower cost structures.
Clients could pursue alternatives to bank deposits, causing us to lose a relatively inexpensive source of funding.
Checking and savings account balances and other forms of client deposits could decrease if clients perceive alternative investments, such as the stock market, provide superior expected returns. When clients move money out of bank deposits in favor of alternative investments, we can lose a relatively inexpensive source of funds, increasing our funding costs.
Higher FDIC deposit insurance premiums and assessments could adversely impact our financial condition.
Our deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain deposit insurance. As an FDIC-insured institution, we are required to pay quarterly deposit insurance premium assessments to the FDIC. Although we cannot predict what the insurance assessment rates will be in the future, deterioration in our risk-based capital ratios or adjustments to the base assessment rates could have a material adverse impact on our business, financial condition, results of operations, and cash flows.
We may be adversely affected by credit exposures to 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.
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 are subject to a variety of operational risks, including reputational risk, legal risk and regulatory and compliance risk, and the risk of fraud or theft by employees or outsiders, which may adversely affect our business and results of operations.
We are exposed to many types of operational risks, including reputational risk, legal, regulatory and compliance risk, the risk of fraud or theft by employees or outsiders, including unauthorized transactions by employees, or operational errors, such as clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Negative public opinion can result from the 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. In addition, negative public opinion can adversely affect our ability to attract and keep customers and can expose it to litigation and regulatory action. Actual or alleged conduct by us can result in negative public opinion about our other business. Negative public opinion could also affect our credit ratings, which are important to its access to unsecured wholesale borrowings.
Our business involves storing and processing sensitive consumer and business customer data. If personal, non-public, confidential or proprietary information of customers in its possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
Because the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions and its large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. We also may be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control, such as computer viruses, electrical or telecommunications outages, natural disasters, or other damage to property or physical assets which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that its external vendors may be unable to fulfill our contractual obligations, or will be subject to the same risk of fraud or operational errors by their respective employees as it is, and to the risk that we, or our vendors’, business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability of us to operate our business, as well as potential liability to clients, reputational damage and regulatory intervention, which could adversely affect our business, financial condition or results of operations.
Our operational or security systems may experience an interruption or breach in security.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, deposit, loan, and other systems. While we have policies and procedures designed to
prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
Our controls and procedures may fail or be circumvented.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
Our failure to comply with provisions of our Consent Order with the OCC could subject us to further enforcement action and reputational damage.
On November 14, 2011, the Bank entered into the Consent Order with the OCC which, among other things, contains a requirement that the Bank minimum capital levels exceed the minimum regulatory capital ratios for “well capitalized” banks. The minimum capital ratios for a bank are generally 8% for total capital, 4% for Tier 1 capital and 4% for leverage. To be eligible to be classified as “well capitalized,” a bank must generally maintain a total capital ratio of 10% or more, a Tier 1 capital ratio of 6% or more, and a leverage ratio of 5% or more. The Consent Order required the Bank to achieve and maintain Tier 1 capital at least equal to 9% of adjusted total average 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. Our capital levels are currently 10.2%, 14.5%, and 15.7%, respectively. However, as we are still subject to the Consent Order, the OCC has the authority to subject us to further enforcement remedies, including civil money penalties or other sanctions the OCC considers appropriate. Further, as long as the Consent Order remains in place, the Bank will not be deemed “well capitalized” regardless of its capital levels.
If we fail to comply with the terms of the Consent Order, the OCC has the authority to subject us to further regulatory actions, including imposing civil money penalties on us and our directors and officers, and, under certain circumstances, removing directors and officers from their positions with the Bank, both of which could have a material adverse effect on our business.
If our nonperforming assets increase, our earnings will be adversely affected.
At December 31, 2013, our nonperforming assets (which consist of nonaccrual loans and other real estate owned) totaled $3.8 million, or 3.7% of total assets. At December 31, 2012, our nonperforming assets were $9.2 million, or 7.4% 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.
If we are unable to generate additional noninterest income, it could have a material adverse effect on our business.
In order to thrive in a competitive banking market, we will need to general additional sources of noninterest income. For the years ended December 31, 2013 and 2012, we generated noninterest income of $225,144 and $466,273, respectively. Our largest component of noninterest income is residential loan origination fees. Due to the changes in mortgage loan underwriting and compensation regulations, as well as customer demand, there can be no assurance that the Bank will continue to generate additional residential loan origination fees.
We intend to enhance our ability to generate additional noninterest income, including through offering consumer finance, payments, digital banking and transaction services. We also expect to offer other products and services which may include secured credit cards, general purpose reloadable prepaid cards, loyalty cards and services. To the extent we propose to offer these services through the Bank, under our Consent Order, the Bank must obtain OCC approval to expand its existing business model, and there can be no assurance that the Bank will receive OCC approval or be successful in implementing the steps necessary to expand its business model. If we are unable to generate additional noninterest income by expanding our business model or through other means, it could have a material adverse effect on our business.
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 real estate 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 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. Throughout 2012 and 2013, we consistently applied our formulaic methodology in calculating the reserve, and because charge offs are beginning to drop, our reserve is gradually matching the experience factors. At December 31, 2013, our loan loss reserve was $1.7 million, or 2.63% of gross loans. Although credit quality indicators generally have showed signs of stabilization, further deterioration in the South Carolina real estate market as a whole or individual deterioration in the financial condition of our borrowers 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.
A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market hurt our business.
As of December 31, 2013, approximately 80% 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. Due to the weakened real estate market in our primary market area over the past few years, we experienced 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.
We are subject to certain risks related to originating and selling mortgages. We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, or borrower fraud, and this could harm the our liquidity, results of operations and financial condition.
We originate and often sell mortgage loans. When we sell mortgage loans, we are required to make customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event that we breach certain of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud or in the event of early payment default of the borrower on a mortgage loan. Therefore, if a purchaser enforces its remedies against us, we may not be able to recover our losses from third parties. We have received repurchase and indemnity demands from purchasers. These have resulted in an increase in the amount of losses for repurchases. While we have taken steps to enhance its underwriting policies and procedures, these steps will not reduce risk associated with loans sold in the past. If repurchase and indemnity demands increase materially, then our results of operations may be adversely affected.
Our decisions regarding the allowance for loan losses and credit risk 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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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, but not limited to:
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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 loan portfolio quality;
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ongoing review of financial information provided by borrowers; and
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the amount and quality of collateral, including guarantees, securing the loans.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations. See “Allowance for Loan Losses” in Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located elsewhere in this report for further discussion related to our process for determining the appropriate level of the allowance for loan losses.
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, 2013, approximately $3.0 million of our loans, or a loan balance equal to 26.7% 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, 2013, $2.1 million of our commercial loans, or a loan balance equal to 18.9% 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.
An economic downturn, in particular an economic downturn in South Carolina, 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 economic downturn over the past few years negatively affected the markets in which we operate in South Carolina 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 are unfavorable, our business may not succeed. An economic downturn or prolonged recession would likely result in further 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 87% of our interest income for the year ended December 31, 2013. If we experience an economic downturn 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 the real estate or other collateral that secures our loans was adversely affected by the economic conditions over the past few years, and an economic downtown or a prolonged economic recession could further negatively affect such values. Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies. An 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 financial stress.
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.
Lack of seasoning of loans may increase the risk of credit defaults in the future.
Due to the periodic addition of new loans in our loan portfolio, there is a relatively short credit history on some of our loans. 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 includes new loans, 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 face increased risk under the terms of the CRA as we accept additional deposits in new geographic markets.
Under the terms of the CRA, each appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess such bank’s record in assessing and meeting the credit needs of the communities served by that bank, including low- and moderate-income neighborhoods. During these examinations, the regulatory agency rates such bank’s compliance with the CRA as “Outstanding,” “Satisfactory,” “Needs to Improve” or “Substantial Noncompliance.” The regulatory agency’s assessment of the institution’s record is part of the regulatory agency’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, or to open or relocate a branch office. As we accept additional deposits in new geographic markets, we will be required to maintain an acceptable CRA rating. Maintaining an acceptable CRA rating may become more difficult as our deposits increase across new geographic markets.
Risks Related to Our Digital Banking, Payments & Transaction Services Businesses
We may face regulatory restrictions and other obstacles in expanding and growing our business model.
Our aim is to expand and grow our digital banking, payments and transaction services business as well as our consumer finance business. The Bank is subject to oversight by the OCC and is subject to the Consent Order, and the Company is subject to oversight by the Federal Reserve, and, therefore, in many cases we must obtain prior approval or nonobjection to engage, grow, or expand our business activities. There can be no assurances that these approvals or nonobjections can be obtained or that, if they are obtained, they would be on terms that would allow us to engage in the proposed activities to the extent requested in our application.
Even if we do receive these approvals, there can be no assurances that we will be successful in implementing the steps necessary to expand and grow our business model. Revenues, if any, from the expanded business model may occur materially later than initial expenses from the implementation of the expanded business model. As a result, the Company may incur material operating losses during the development of the expanded business model, and these expenses may not be recouped if we are unsuccessful in implementation. In addition, we will remain subject to supervision by the OCC and the Federal Reserve, and this supervision could affect our ability to expand our business model. For example, the OCC or the Federal Reserve could limit our growth if it believes we are growing too quickly, especially in comparison to our banking business, or without sufficient internal controls, or it could limit the expansion of our business
model if it were to conclude that we lack appropriate managerial resources and expertise, risk management controls, policies, and procedures, and other assessment tools.
We will need to raise a significant amount of additional capital in order to implement our growth objective to expand our business and that capital may not be available on favorable terms, if at all.
Our growth objective in expanding our business model requires additional capital. The Company does not currently generate internal capital to finance such objectives. Future business opportunities are intended to include both traditional banking services as well as opportunities in consumer finance, transaction processing services, digital payments and mobile banking. Therefore, we will need additional capital, primarily in the form of common equity, in the near future in order to actually complete development and implement our new business model and to support our growth and operations. Our ability to raise additional capital will depend on a number of factors, including conditions in the capital markets, which are outside of our control. There is a risk we will not be able to raise the capital we need at all or upon favorable terms. If we cannot raise this additional capital, we will not be able to implement our growth objective for our business, and we may be subject to increased regulatory supervision and restriction. These restrictions would most likely have a material adverse effect on our ability to grow and expand which would negatively impact our financial condition and results of operations.
Even if we are successful in raising a significant amount of additional capital, we expect operating losses on a consolidated basis to continue for a significant period of time as the Company continues to invest in product research and development and customer marketing. At times, these operating losses could be significant. On an unconsolidated basis, we continue to prioritize maintaining sustainable profitability at the Bank level, even if other operating subsidiaries or the Company operate at a loss. The Company seeks to maintain capital resources at both the Bank and at the Company, as well as at any future subsidiary, to adequately finance their operations.
Further, we may seek to raise additional capital through, among other things, the issuance of additional shares of common stock, securities convertible into shares of common stock, or preferred stock in public or private transactions. These issuances would dilute the percentage ownership interests of our shareholders and could dilute the per share book value of our common stock. In addition, new investors could have rights, preferences, and privileges senior to our common stock, which may also adversely impact our current shareholders.
The market for digital banking, payments and transaction services may not develop as we expect.
Although we believe that digital banking, payments and transaction services may be a large market opportunity with potential for future growth, there can be no assurances that this industry will develop in the manner that we anticipate or, if it does, that the revenue opportunity will be significant. We will be operating from an unproven business model, and there can be no assurances that any or all of our strategies will be successful.
Our chief executive officer is also the principal executive of MPIB Holdings, LLC (“MPIB”) and, as such, there may be a conflict of interest in connection with our proposed acquisition of MPIB or its assets.
Gordon A. Baird, the Company’s chief executive officer, is the primary decision maker with regard to the day-to-day operations of the Company. Mr. Baird is also the managing member of MPIB, which he formed in July 2011, and we are currently in negotiations with MPIB to purchase or license all of its assets and intellectual property. In conjunction with its affiliated transaction policy, our board of directors appointed a committee of disinterested directors to engage in negotiations on behalf of the Company with Mr. Baird and MPIB. Mr. Baird has not negotiated on behalf of the Company with MPIB, and MPIB has engaged its own legal counsel. Nevertheless, insofar as Mr. Baird is chief executive officer of the Company, there is a risk of a conflict of interest arising between the duties of Mr. Baird in his role as our chief executive officer and his
own personal financial and business interests as the managing member of MPIB. His personal interests may not, during the ordinary course of business, coincide with the interests of the Company and our shareholders and, in the absence of the effective segregation of such duties, there is a risk of a conflict of interest.
We may not be successful in purchasing or licensing the intellectual property necessary to expand our digital banking and transaction services business.
We have used assets and intellectual property of MPIB over the past year to pursue a mobile payments and transaction services business. These assets include market research material, customer lists, regulatory analysis, compliance research, and certain technology. In March 2014, the Company filed three patent applications which included information and property that was developed by MPIB. MPIB has permitted the Company to use these assets to pursue the business with the expectation that the Company would purchase such assets as funding became available following a future capital raise. There can be no assurances that we will be able to negotiate an agreement with MPIB on terms that we find acceptable, or at all, or that the agreement will receive any necessary regulatory approval. Without this agreement, our ability to expand our business in digital banking, payments and transaction services would be significantly diminished. Any disputes or disagreements regarding our relationship with MPIB or our use of MPIB’s intellectual property may lead MPIB to contest our rights in our patent applications or other related intellectual property, and may give rise to allegations that we have infringed, misappropriated or otherwise violated MPIB’s intellectual property rights. See “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters - Transactions with Related Persons” for additional discussion regarding our potential transaction with MPIB, and “Risk Factors - We will need to adequately protect our brand and the intellectual property rights related to our products and services and avoid infringing or misappropriating the intellectual property rights of others” for more information regarding our potential risks from using MPIB’s intellectual property.
We may not be able to attract and retain qualified personnel.
We anticipate that the success of implementing our expanded business model will be largely dependent upon our executive management team members, including Gordon A. Baird, as well as other senior executives. We will need to attract senior industry professionals with extensive banking, payment, credit, technology, and marketing expertise to join our board of directors and executive management team, and we may lack the capital or other resources necessary to recruit or retain these professionals. If we fail to attract and retain these industry professionals, we may not be able to expand our business model, which could have a material adverse effect on our business, financial condition, and results of operations. Moreover, even if we are able to grow and expand our management team by attracting these industry professionals, the resources required to retain these employees may adversely affect our operating margins. We anticipate that, if we are successful in raising a material amount of additional capital and growing our business, our compensation structure, as well as our levels of compensation, will materially increase.
We may not be able to manage our growth, which may adversely affect our results of operations and financial condition.
Although we intend to develop our new business model in a controlled and measured manner, even modest success will nevertheless result in a significant increase in our size. There is a risk we will not be successful in expanding our business model at acceptable risk levels and upon acceptable terms or in managing the costs and implementation risks associated with the expanded business model.
We expect to depend on third-party providers, and the inability of these providers to deliver, or their refusal to deliver, necessary technological and customer services support for our systems in a timely manner at prices, quality levels, and volumes acceptable to us could have material adverse effects on our financial condition and operating results.
If we expand our business to include digital banking, payments and transaction services, we expect that we will obtain essential technological and customer services support for the systems we use from third-party providers. We also outsource our check processing, check imaging, electronic bill payment, statement rendering, internal audit and other services to third-party vendors. While we believe that such providers will be able to continue to supply us with these essential services, they may be unable to do so in the short term or at prices or costs that are favorable to us, or at all.
In addition, our agreements with each service provider are generally cancelable without cause by either party upon specified notice periods. If one of our third-party service providers terminates its agreement with us and we are unable to replace it with another service provider, our operations may be interrupted. In particular, while we believe that we will be able to secure alternate providers for most of this essential technological and customer services support in a relatively short time frame, qualifying alternate providers or developing our own replacement technology services may be time consuming, costly, and may force us to change our services offered. If an interruption were to continue for a significant period of time, our earnings could decrease, we could experience losses, and we could lose customers.
In addition, we are obligated to exercise comprehensive risk management and oversight of third-party providers involving critical activities, including through the adoption of risk management processes commensurate with the level of risk and complexity of our third-party providers. As we develop and expand our new business model and our dependence on third-party providers increases, we will need more robust compliance policies and procedures to monitor our new business.
We will need to adequately protect our brand and the intellectual property rights related to our products and services and avoid infringing or misappropriating the intellectual property rights of others.
Our brand will be important to our business, and we intend to use trademark restrictions and other means to protect it. Our business would be harmed if we were unable to protect our brand against infringement and its value was to decrease as a result. We have filed several patents with the U.S. Patent and Trademark Office, and we will rely on a combination of trademark and copyright laws, trade secret protection and confidentiality and license agreements to protect the intellectual property rights related to our products and services. There is no guarantee that any of our patent applications will result in issued patents, or if they do that they will be sufficient to allow us to enforce our rights against third parties or effectively compete and some of our intellectual property rights may not be protected by intellectual property laws at all, particularly in foreign jurisdictions. Additionally, third parties may challenge, invalidate, circumvent, infringe, misappropriate or challenge our rights in our proprietary technology and intellectual property, or such proprietary technology or intellectual property may not be sufficient to permit us to take advantage of current market trends or otherwise to provide competitive advantages, which could result in costly redesign efforts, discontinuance of certain offerings or other competitive harm. Others, including our competitors, may independently develop similar technology, duplicate our products or services or design around our intellectual property, and in such cases we could not assert our intellectual property rights against such parties. Further, our contractual arrangements may not effectively prevent disclosure of our confidential information or provide an adequate remedy in the event of unauthorized disclosure of our confidential information. We may have to litigate to enforce or determine the scope and enforceability of our intellectual property rights, trade secrets and know-how, which is expensive, could cause a diversion of resources and may not prove successful. Also, aspects of our business and our products and services rely on technologies and intellectual property rights developed by or licensed from third parties, and we may not be able to obtain or continue to obtain licenses or access to such technologies or intellectual property from these third parties on reasonable terms or at all. The loss of our intellectual property
or the inability to secure or enforce our intellectual property rights could harm our business, results of operations, financial condition and prospects.
We may, or may be alleged to, infringe, misappropriate or otherwise violate the intellectual property or other proprietary rights of others, and thus may be subject to claims by third parties. Even if such claims are without merit, they would require us to devote significant time and resources to defending against these claims or to protecting or enforcing our own rights and would result in the diversion of the time and attention of our management and employees. Additionally, in recent years, individuals and groups have been purchasing intellectual property assets for the sole purpose of making claims of infringement and attempting to extract settlements from companies like ours. Claims of intellectual property infringement also might require us to redesign affected products or services, enter into costly settlement or license agreements, pay costly damage awards, or face a temporary or permanent injunction prohibiting us from marketing or selling certain of our products or services. Even if we have an agreement for indemnification against such costs, the indemnifying party, if any, in such circumstances, may be unable to uphold its contractual obligations. Moreover, in some cases, we may be required to indemnify our customers or other third parties from third parties claims of infringement, misappropriation or other violation of intellectual property rights. Our inability to defend successfully against an infringement or misappropriation action could harm our business, results of operations, financial condition and prospects.
Additionally, we and our partners may use open source software in connection with our products and services. Companies that incorporate open source software into their products have, from time to time, faced claims challenging the ownership of open source software. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Some open source software licenses require users who distribute open source software as part of their software to publicly disclose all or part of the source code to such software and/or make available any derivative works of the open source code on unfavorable terms or at no cost. Any requirement to disclose our proprietary source code could be harmful to our business, financial condition and results of operations.
Our business is subject to laws and regulations regarding privacy, data protection, and other matters. Many of these could result in claims, changes to our business practices, increased cost of operations, or otherwise harm our business.
We are subject to a variety of laws and regulations in the United States that involve matters central to our business, including user privacy, electronic contracts and other communications, consumer protection, taxation, and online payment services. These U.S. federal and state laws and regulations, which can be enforced by private parties or government entities, are constantly evolving and can be subject to significant change. In addition, the application and interpretation of these laws and regulations are often uncertain, particularly in the new and rapidly evolving industry in which we operate. For example, the interpretation of some laws and regulations that govern mobile payments is unsettled and developments in this area could affect the manner in which market and sell our products and services. These existing and proposed laws and regulations can be costly to comply with and can delay or impede the development of new products, and a failure to comply with such laws and regulations could result in negative publicity, increase our operating costs, require significant management time and attention, and subject us to inquiries or investigations, claims or other remedies, including fines or demands that we modify or cease existing business practices.
If our security is breached, our business could be disrupted, our operating results could be harmed, and customers could be deterred from using our products and services.
Our business relies on the secure electronic transmission, storage, and hosting of sensitive information, including financial information and other sensitive information relating to our customers. As a result, we face the risk of a deliberate or unintentional incident involving unauthorized access to our computer systems that could result in misappropriation or loss of assets or sensitive information, data corruption, or other disruption of business operations. To its knowledge, the Company has not experienced a data breach. In light of this risk,
we have devoted significant resources to protecting and maintaining the confidentiality of our information, including implementing security and privacy programs and controls, training our workforce, and implementing new technology. We have no guarantee that these programs and controls will be adequate to prevent all possible security threats. We believe that any compromise of our electronic systems, including the unauthorized access, use, or disclosure of sensitive information or a significant disruption of our computing assets and networks, would adversely affect our reputation and our ability to fulfill contractual obligations, and would require us to devote significant financial and other resources to mitigate such problems, and could increase our future cyber security costs. Moreover, unauthorized access, use or disclosure of such sensitive information could result in significant contractual, supervisory or other liability, or exposure of our trade secrets or other confidential or proprietary information. In addition, any real or perceived compromise of our security or disclosure of sensitive information may result in lost revenues by deterring customers from using or purchasing our products and services in the future or prompting them to use competing service providers.
Our success depends in part on our timely introduction of new products and technologies and our results can be impacted by the effectiveness of our significant investments in new products and technologies.
The markets for certain of our products are characterized by rapidly changing technologies and evolving industry standards. In addition, new technologies and new competitors continue to enter our markets at a faster pace than we have experienced in the past, resulting in increased competition. New products are expensive to develop and bring to market and additional complexities are added when this process is outsourced as we have done in many cases. Our success depends, in substantial part, on the timely and successful introduction of new products and upgrades of current products to comply with emerging industry standards, laws and regulations, and to address competing technological and product developments carried out by our competitors. The research and development of new, technologically-advanced products is a complex and uncertain process requiring high levels of innovation and investment, as well as the accurate anticipation of technology and market trends. Many of our products and systems are complex and we may experience delays in completing development and introducing new products or technologies in the future. We may focus our resources on technologies that do not become widely accepted or are not commercially viable or involve compliance obligations with additional areas of regulatory requirements.
Our results are subject to risks related to our significant investment in developing and introducing new products. These risks include among others: (i) difficulties and delays in the development, production, testing and marketing of products, particularly when such activities are done through the use of third-party joint developers; (ii) customer acceptance of products; (iii) the development of, approval of, and compliance with industry standards and regulatory requirements; (iv) the significant amount of resources we must devote to the development of new technologies; and (v) the ability to differentiate our products and compete with other companies in the same markets.
The expansion of our solutions and services business creates new competitors and new and increased areas of risk that we have not been exposed to in the past and that we may not be able to properly assess or mitigate.
We plan to continue to expand our solutions and services business by offering additional and expanded managed services for existing and new types of customers. The offering of services involves the integration of multiple services, multiple vendors and multiple technologies, requiring that we partner with other solutions and services providers, often on multi-year projects. In some cases we must compete with a company in some business areas and cooperate with the same company in other business areas. From time to time such projects may require that we form a joint venture with our partners. Risks associated with expanding our managed services offerings include:
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We may be required to agree to specific performance metrics that meet the customer’s requirement for network security, availability, reliability, maintenance and support and, in some cases, if these performance metrics are not met we may not be paid.
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The managed services business is one characterized by large subcontracting arrangements and we may not be able to obtain favorable contract terms or adequate indemnities or other protections from our subcontractors to adequately mitigate our risk to our customers.
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Expansion will bring us into contact with new regulatory requirements and restrictions with which we will have to comply and may increase the costs and delay or limit the range of new solutions and services which we will be able to offer.
We may become exposed to fluctuations in currency exchange rates, which could negatively affect our financial condition and results of operations.
In the future, we expect to receive international revenue, which will typically be denominated in U.S. dollars. Fluctuations in currency exchange rates could cause our products and services to become relatively more expensive to customers in a particular country, leading to a reduction in revenue or profitability from sales in that country. We currently do not do foreign currency exchange or enter into hedging arrangements to minimize the impact of foreign currency fluctuations. Our exposure to foreign currency fluctuation may change over time as our business practices evolve and could have a material adverse impact on our financial condition and results of operations. Gains and losses on the conversion to U.S. dollars of accounts payable and other monetary assets and liabilities arising from international operations may contribute to fluctuations in operating results.
The Bank Secrecy Act and the implementing regulations and guidance may impose increasing compliance costs on our digital banking, payments and transaction services business, which may disrupt this business or decrease the economic return on the business.
We are subject to the BSA, as amended by the USA PATRIOT Act, and to reporting requirements related to anti-money laundering compliance obligations arising under the USA PATRIOT Act and its implementing regulations. We anticipate that our digital banking, payments and transactions services business will grow in size and complexity and may lead us to establish new nonbank subsidiaries to handle some or all of the business. As part of this growth, we are likely to engage third party vendors to a greater degree. These developments may give rise to more complicated requirements for compliance with the BSA and related anti-money laundering regulations, including possible new registration and compliance program requirements for new subsidiaries. Moreover, regardless of the growth of our business, the regulators could impose more onerous standards or undertake more aggressive enforcement of the BSA and other federal anti-money laundering and terrorist financing prevention laws. These developments could increase our compliance costs or those of our third party vendors. Any such developments might also require changes in, or place limits upon, the products and services we offer. Increases in compliance costs or restrictions on the services that we provide through our digital banking, payments and transaction services business could have a material adverse effect on our business and results of operations.
Risks Related to the Legal and Regulatory Environment
We are subject to extensive regulation that could limit or restrict our activities, have an adverse impact on our operations, and impose financial requirements or limitations on the conduct of our business.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various regulatory agencies. We are subject to Federal Reserve regulation. The Bank is subject to extensive regulation, supervision, and examination by our primary federal regulators, the OCC and the FDIC, the regulating authority that insures customer deposits. Also, as a member of the FHLB, the Bank must comply with applicable regulations of the Federal Housing Finance Board and the FHLB. Regulation by these agencies is intended primarily for the protection of our depositors and the Deposit Insurance Fund and not for the benefit of our shareholders. The Bank’s activities are also regulated under consumer protection laws
applicable to our lending, deposit, and other activities. A sufficient claim against us under these laws could have a material adverse effect on our results of operations.
Further, changes in laws, regulations and regulatory practices affecting the financial services industry could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
The Dodd-Frank Act and the implementing regulations may affect our business and have a material adverse effect on the results of our operations.
On July 21, 2010, the President signed the Dodd-Frank Act into law, which made wide-ranging changes to the regulation and supervision of banking and other financial institutions. Although much of the Dodd-Frank Act is designed to address systemic risks presented by the very largest banking and financial institutions, the law has begun to have an impact on the ways in which we do business. As the regulators continue to implement the law, they may impose new costs that will adversely affect the results of our operations. The Dodd-Frank Act notably creates a new Consumer Financial Protection Bureau with the power to write new regulations to implement provisions in the Dodd-Frank Act relating to consumer credit and to interpret existing consumer financial laws and regulations, such as the Truth in Lending Act. The OCC will continue to monitor the Bank’s compliance with all new rules and the regulations, but the CFPB may participate in OCC examinations on a “sampling basis” and may refer potential enforcement actions against us to the OCC. Certain aspects of our business and operations could be affected in particular by the Dodd-Frank Act and the implementing regulations, as follows:
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Residential Real Estate Loans and Home Equity Loans. Title XIV of the Dodd-Frank Act imposes a wide range of new underwriting and disclosure requirements on most residential mortgage lending, and the CFPB recently complete a series of rulemakings to implement these provisions, most of which took effect in January 2014. The new regulations have resulted in changes to our underwriting of residential mortgage loans and to our disclosures. Although we do not originate loans secured by first mortgages in any significant amount, the new rules also apply to second mortgage loans and, to a limited extent, to the HELOCs that we offer. Because the rules have only recently taken effect, we have not been able to assess their full impact, but it is possible that they will increase the costs of originating mortgage loans and HELOCs.
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Consumer Loans. Although the Dodd-Frank Act does not explicitly require changes to the rules governing loans to consumers (other than residential mortgage loans and HELOCs), the statute transfers authority for writing the federal rules governing such loans to the CFPB from the Federal Reserve. The CFPB is perceived generally to take a more aggressive approach to the substance and application of these rules, and any changes made by the CFPB likely would impose additional compliance costs on our consumer lending business. In addition, any regulations issued by the CFPB to implement its authority to prohibit “abusive” practices, as well as unfair or deceptive ones, could result in new restrictions on and reduced profits from our consumer lending. We also could be exposed to civil actions in federal district court by the South Carolina Attorney General which (like all state attorneys general) received additional enforcement authority over national (and state) banks in the Dodd-Frank Act.
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Debit Cards. A provision of the Dodd-Frank Act, popularly known as the Durbin Amendment, directed the Federal Reserve to place limits on the interchange fees that the issuers of debit cards may charge to merchants. The Federal Reserve finalized regulations in 2011 that had the effect of reducing the economic return on our debit card business. Since that time, a group of merchants has challenged the regulations in court, seeking to require the Federal Reserve to amend the regulation to further limit interchange fees. The litigation has been largely unsuccessful so far, but the litigation has not yet come to a conclusion. It remains possible that as a result of the litigation or for other reasons, the Federal Reserve will impose greater restrictions on the interchange fees that we may charge, which would adversely affect the return on our debit card business.
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Insured Deposits. The modifications in the Dodd-Frank Act to the assessment base on which the FDIC calculates the Bank’s deposit insurance premiums may over time make our deposit business more costly, which could have an adverse effect on our overall profitability.
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Executive Compensation. The Dodd-Frank Act gives shareholders of public companies non-binding or advisory votes on certain executive compensation matters, which a board of directors takes into account as appropriate. These provisions could hinder our ability to recruit, hire, and retain qualified senior management.
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Preemption. The Bank’s lending business relies in part on the preemption of South Carolina law by federal law, including the National Bank Act and the regulations of the OCC. The Dodd-Frank Act places restrictions on the preemption doctrine. Although the impact on national banks of the changes to the preemption doctrine has yet to be fully assessed, it is possible that the provisions of the Dodd-Frank addressing preemption could require changes to the Bank’s lending business.
New capital rules that were recently issued generally require insured depository institutions and their holding companies with total consolidated assets of $500 million or more to hold more capital. The impact of the new rules on our financial condition and operations is uncertain but could be materially adverse.
On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the OCC also adopted a final rule and the FDIC adopted the same provisions in the form of an “interim final rule.” These rules substantially amend the regulatory risk-based capital rules applicable to the Bank. The rules phase in over time beginning in 2015 and will become fully effective in 2019.
The final rules increase capital requirements and generally include two new capital measurements that will affect us, a risk-based common equity Tier 1 ratio and a capital conservation buffer. Common Equity Tier 1 (“CET1”) capital is a subset of Tier 1 capital and is limited to common equity (plus related surplus), retained earnings, accumulated other comprehensive income and certain other items. Other instruments that have historically qualified for Tier 1 treatment, including non-cumulative perpetual preferred stock, are consigned to a category known as Additional Tier 1 capital and must be phased out over a period of nine years beginning in 2014. The rules permit bank holding companies with less than $15 billion in assets (such as us) to continue to include trust preferred securities and non-cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not CET1. Tier 2 capital consists of instruments that have historically been placed in Tier 2, as well as cumulative perpetual preferred stock.
The final rules adjust all three categories of capital by requiring new deductions from and adjustments to capital that will result in more stringent capital requirements and may require changes in the ways we do business. Among other things, the current rule on the deduction of mortgage servicing assets from Tier 1 capital has been revised in ways that are likely to require a greater deduction than we currently make and that will require the deduction to be made from CET1. This deduction phases in over a three-year period from 2015 through 2017. We closely monitor our mortgage servicing assets, and we expect to maintain our mortgage servicing asset at levels below the deduction thresholds by a combination of sales of portions of these assets from time to time either on a flowing basis as we originate mortgages or through bulk sale transactions. Additionally, any gains on sale from mortgage loans sold into securitizations must be deducted
in full from CET1. This requirement phases in over three years from 2015 through 2017. Under the earlier rule and through 2014, no deduction is required.
Beginning in 2015, the minimum capital requirements for the Company and the Bank will be (i) a CET1 ratio of 4.5%, (ii) a Tier 1 capital (CET1 plus Additional Tier 1 capital) of 6% (up from 4%) and (iii) a total capital ratio of 8% (the current requirement). Our leverage ratio requirement will remain at the 4% level now required. Beginning in 2016, a capital conservation buffer will phase in over three years, ultimately resulting in a requirement of 2.5% on top of the CET1, Tier 1 and total capital requirements, resulting in a require CET1 ratio of 7%, a Tier 1 ratio of 8.5%, and a total capital ratio of 10.5%. Failure to satisfy any of these three capital requirements will result in limits on paying dividends, engaging in share repurchases and paying discretionary bonuses. These limitations will establish a maximum percentage of eligible retained income that could be utilized for such actions. While the final rules will result in higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to us.
In addition to the higher required capital ratios and the new deductions and adjustments, the final rules increase the risk weights for certain assets, meaning that we will have to hold more capital against these assets. For example, commercial real estate loans that do not meet certain new underwriting requirements must be risk-weighted at 150%, rather than the current 100%. There are also new risk weights for unsettled transactions and derivatives. We also will be required to hold capital against short-term commitments that are not unconditionally cancelable; currently, there are no capital requirements for these off-balance sheet assets. All changes to the risk weights take effect in full in 2015.
In addition, in the current economic and regulatory environment, bank regulators may impose capital requirements on bank holding companies and banks that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for us could, among other things, result in lower returns on invested capital, require the issuance of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Implementation of changes to asset risk weightings for risk-based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, could result in management modifying our business strategy and could limit our ability to make distributions, including paying dividends or buying back our shares.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulation, which risk increases as we expand our business model.
The federal Bank Secrecy Act, the USA PATRIOT Act, and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the U.S. Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by the OFAC. Federal and state bank regulators also have begun to focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient or the policies, procedures and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.
Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Over the course of 2013, the CFPB has issued several rules on mortgage lending, notably a rule requiring all home mortgage lenders to determine a borrower’s ability to repay the loan. Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations. In either case, we may find it necessary to tighten our mortgage loan underwriting standards in response to the CFPB rules, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.
We are subject to federal and state fair lending laws, and failure to comply with these laws could lead to material penalties.
Federal and state fair lending laws and regulations, such as the Equal Credit Opportunity Act and the Fair Housing Act, impose nondiscriminatory lending requirements on financial institutions. The Department of Justice, CFPB and other federal and state agencies are responsible for enforcing these laws and regulations. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. A successful challenge to our performance under the fair lending laws and regulations could adversely impact our rating under the CRA and result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on merger and acquisition activity and restrictions on expansion activity, which could negatively impact our reputation, business, financial condition and results of operations.
The Federal Reserve may require us to commit capital resources to support the Bank.
The Federal Reserve requires a bank holding company to act as a source of financial and managerial strength to a subsidiary bank and to commit resources to support such subsidiary bank. Under the “source of strength” doctrine, the Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. In addition, the Dodd-Frank Act directs the federal bank regulators to require that all companies that directly or indirectly control an insured depository institution serve as a source of strength for the institution. Under these requirements, in the future, we could be required to provide financial assistance to our Bank if the Bank experiences financial distress.
A capital injection may be required at times when we do not have the resources to provide it, and therefore we may be required to borrow the funds. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of its note obligations. Thus, any borrowing that must be done by the holding company in order to make the required capital injection becomes more difficult and expensive and will adversely impact the holding company’s cash flows, financial condition, results of operations and prospects.
The downgrade of the U.S. credit rating could negatively impact our business, results of operations and financial condition.
Recent U.S. debt ceiling and budget deficit concerns together with signs of deteriorating sovereign debt conditions in Europe, have increased the possibility of additional credit-rating downgrades and economic slowdowns in the U.S. Although U.S. lawmakers passed legislation to raise the federal debt ceiling in 2011, Standard & Poor’s Ratings Services lowered its long-term sovereign credit rating on the U.S. from “AAA” to “AA+” in August 2011. The impact of any further downgrades to the U.S. government’s sovereign credit rating or its perceived creditworthiness could adversely affect the U.S. and global financial markets and economic conditions. The U.S. government has adopted legislation to suspend the debt limit numerous times since January 2013. Currently, the debt ceiling is suspended without conditions through March 15, 2015. Moody’s and Fitch have each warned that they may downgrade the U.S. government’s rating if the federal debt is not stabilized. A downgrade of the U.S. government’s credit rating or a default by the U.S. government to satisfy its debt obligations likely would create broader financial turmoil and uncertainty, which would weigh heavily on the global banking system. It is possible that any such impact could have a material adverse effect on our business, results of operations and financial condition.
Failure to comply with government regulation and supervision could result in sanctions by regulatory agencies, civil money penalties, and damage to our reputation.
Our operations are subject to extensive regulation by federal, state, and local governmental authorities. Given the current disruption in the financial markets, we expect that the government will continue to pass new regulations and laws that will impact us. Compliance with such regulations may increase our costs and limit our ability to pursue business opportunities. Failure to comply with laws, regulations, and policies could result in sanctions by regulatory agencies, civil money penalties, and damage to our reputation. While we have policies and procedures in place that are designed to prevent violations of these laws, regulations, and policies, there can be no assurance that such violations will not occur.
Changes in accounting principles and financial reporting requirements could result in material changes to our reported results and financial condition.
U.S. GAAP and related financial reporting requirements are complex, continually evolving and may be subject to varied interpretation by the relevant authoritative bodies. Such varied interpretations could result from differing views related to specific facts and circumstances. Changes in U.S. GAAP and financial reporting requirements, or in the interpretation of U.S. GAAP or those requirements, could result in material changes to our reported results and financial condition.
Risks Related to Our Common Stock
We are a holding company and depend on the Bank for dividends, distributions, and other payments.
Substantially all of our activities are conducted through the Bank, and consequently, as the parent company of the Bank, we receive substantially all of our revenue as dividends from the Bank. The Bank is currently prohibited from paying dividends to the Company without prior approval from the OCC. In addition, the Company is currently prohibited from paying dividends without the prior approval Federal Reserve Bank of Richmond. There can be no assurance such approvals would be granted or with regard to how long these restrictions will remain in place. In the future, any declaration and payment of cash dividends will be subject to the board’s evaluation of the Company’s operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. The payment of cash dividends by the Company in the future will also be subject to certain other legal and regulatory limitations (including the requirement that the Company’s capital be maintained at certain minimum levels) and ongoing review by the Company’s banking regulators.
We may issue additional shares of common stock to our executive officers, other employees, and directors as equity compensation, which may reduce certain shareholders’ ownership in the Company.
On February 27, 2013, we adopted a new equity incentive plan, the Independence Bancshares, Inc. 2013 Equity Incentive Plan (the “2013 Incentive Plan”), and we amended the Independence Bancshares, Inc. 2005 Stock Incentive Plan (the “2005 Incentive Plan”) to cap the number of shares issuable thereunder. The 2013 Incentive Plan reserves 2,466,720 shares for the issuance of equity compensation awards, including stock options, to our executive officers, other employees, and directors and includes an evergreen provision that provides that the number of shares of common stock available for issuance under the 2013 Incentive Plan automatically increases each time the Company issues additional shares of common stock so that the number of shares available for issuance under the 2013 Incentive Plan (plus any shares reserved under the 2005 Incentive Plan) continues to equal 20% of the Company’s total outstanding shares on an as-diluted basis. The 2013 Incentive Plan is an omnibus plan and therefore also provides for the issuance of other equity compensation, including restricted stock and stock appreciation rights, to our employees and directors. We anticipate that we will grant awards for virtually all of these shares to our executive officers, other employees, and directors over the next two years. In addition, we anticipate that the 2013 Incentive Plan may be amended in the future to accommodate future hires by increasing the amount and percentage that can be reserved under the plan. There is also a risk that if the Company conducts a stock buy-back in the future that the 20% threshold could be exceeded as a result of the Company repurchasing outstanding shares.
There is no liquid market for our shares.
There is currently no established trading market for our common stock. As a result, any investor in shares of our common stock may find it difficult or impossible to resell such shares.
The Company’s securities are not FDIC insured.
The Company’s securities, including the outstanding shares of common stock, are not savings or deposit accounts or other obligations of the Company and are not insured by the Deposit Insurance Fund, the FDIC, or any other governmental agency, and therefore are subject to investment risk, including the possible loss of the entire investment.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not Applicable.
Item 2.
Item 2. Properties.
Our principal executive offices consist of 6,500 square feet of leased space in downtown Greenville, South Carolina. The Company also has an office located in New York, New York. The Bank has two branch offices located in Taylors, South Carolina, and Simpsonville, South Carolina. We lease our Greenville and Taylors offices in South Carolina, as well as our office in New York. We believe these premises will be adequate for present and anticipated needs and that we have adequate insurance to cover our owned and leased premises. For each property that we lease, we believe that upon expiration of the lease we will be able to extend the lease on satisfactory terms or relocate to another acceptable location.
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.
PART II
Item 5.
Item 5. Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information, Holders, and Dividends
No established public trading market exists for our common stock, and there can be no assurance that a public trading market for our common stock will develop. Our common stock is quoted on the OTC Bulletin Board under the symbol “IEBS,” and we 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, and trading and quotations of our common stock have been limited and sporadic. 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.
The following table sets forth for the period indicated the high and low bid prices for our common stock reported by the OTC Bulletin Board for the periods indicated:
As of March 24, 2014, there were 20,502,760 shares of common stock outstanding held by approximately 580 shareholders of record.
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 the 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.
Equity-Based Compensation Plan Information
For information regarding equity-based compensation awards outstanding and available for future grants at December 31, 2013, see Part III, Item 12 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” included in this Annual Report on Form 10-K.
Item 6.
Item 6. Selected Financial Data.
Not applicable.
Item 7.
Item 7. Management’s Discussion and Analysis or Plan of Operation.
Overview
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.
At December 31, 2013, we had total assets of $104.3 million, a decrease of $20.6 million, or 16.5%, from total assets of $124.9 million at December 31, 2012. This decrease in assets was primarily driven by a decrease in cash and due from banks of $13.6 million, a decrease in net loans (including loans held for sale) of $5.2 million, a decrease in investment securities of $5.3 million, and a decrease in real estate assets owned of $2.0 million, partially offset by an increase in fed funds of $5.4 million. Total assets at December 31, 2013 consisted of cash and due from banks of $6.5 million, federal funds sold of $7.9 million, investment securities available for sale of $20.1 million, non-marketable equity securities of $424,200, property and equipment of $2.5 million, other real estate owned and repossessed assets of $2.5 million, loans net of allowances for loan losses of $62.4 million, loans held for sale of $900,000, and accrued interest receivable and other assets of $1.0 million. Total liabilities at December 31, 2013 were $90.0 million compared to $104.3 million at December 31, 2012, a decrease of $14.4 million, or 13.8%. At December 31, 2013, liabilities consisted of deposits of $89.2 million, securities sold under agreements to repurchase of $96,879, and accrued interest payable and accounts payable and accrued expenses of $696,123. Shareholders’ equity at December 31, 2013 was $14.3 million, compared to $20.6 million at December 31, 2012, a decrease of $6.3 million or 30.4%. This decrease was primarily a result of the recognition of a net loss of $6.0 million and the decrease in the unrealized gain on investment securities.
Our net loss for the year ended December 31, 2013 was $6,027,749, or $0.31 per share, an increase in loss of $5.4 million, or 883.3%, compared to a net loss of $613,036 for the year ended December 31, 2012, or $0.29 per share. Although the Bank was profitable for the last seven months of the year, the Company’s increase in net loss for the year was primarily driven by an increase in non-interest expenses. Product research and development increased $3.0 million, real estate owned activity increased $1.5 million, which includes expenses to carry other real estate owned, gains and losses on sales of other real estate owned, and write-downs on other real estate owned, and compensation and benefits expenses increased $0.6 million, which includes expenses related to additional stock options granted and the filling of open positions during the year. Each of these components is discussed in greater detail below.
We have included a number of tables to assist in our description of our results of operations. For example, the “Average Balances” table shows the average balance during 2013 and 2012 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 several 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, loss of investor confidence and severely constrained credit and capital markets, particularly for financial institutions. 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.
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, 2013.
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 judgments 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.
Research and Development
All costs incurred to establish the technological feasibility of computer software to be sold, leased or otherwise marketed as research and development are expensed as incurred. Once technological feasibility has been established, the subsequent costs of producing, coding and testing the products should be capitalized. The expensing of computer software costs is discontinued when the product is available for general release to customers. Currently, the Company has not achieved technological feasibility and is expensing all computer software purchases related to research and development. Once technological feasibility is reached, the Company will capitalize costs as incurred.
Results of Operations
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 and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income was $3.5 million for the year ended December 31, 2013, an increase of $246,467, or 7.5%, over net interest income of $3.3 million in 2012. Although total interest income decreased
by $230,096, or 5.4%, during the year, primarily due to a decrease in interest income on loans, partially offset by an increase in interest earned on investments, this decrease in interest income was more than offset by a $0.5 million decrease in interest expense.
Our consolidated net interest margin for the year ended December 31, 2013 was 3.50%, a 22 basis point increase over the net interest margin for the year ended December 31, 2012 of 3.28%. The net interest margin is calculated as net interest income divided by year-to-date average earning assets. Earning assets averaged $100.6 million in 2013, an increase of $799,388, or 8.0%, from $99.8 million in 2012. This increase in earning assets is due to the $6.4 million increase in investment securities available for sale and an increase in federal funds sold of $1.5 million, partially offset by a decrease in net loans between years of $7.1 million. 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 2012 and 2013, 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 decreased during the year, moving to 3.99% for the year ended December 31, 2013 from 4.25% for the year ended December 31, 2012. This decrease is largely attributable to one loan that returned to accrual in 2012 and positively impacted the yield as well as due to a decrease in yield on investment securities available for sale. In addition, our loan portfolio continues to experience payoffs as borrowers find other lenders willing to lend at reduced rates, thus creating higher levels of investments (a lower earning asset) and cash (a very low- to non-earning asset).
These decreases were coupled with a decrease in the cost of interest-bearing liabilities, which moved to 0.55% for the year ended December 31, 2013 from 1.01% for the year ended December 31, 2012. The decline in this area was a result of several factors, including a reduction in average brokered time deposits less than $100,000, which decreased $2.9 million during the year, and the repricing of deposits, specifically money market accounts and retail time deposits, which decreased to a rate of 0.31% and 0.77%, respectively, for the year ended December 31, 2013 from 0.70% and 1.00%, respectively, for the year ended December 31, 2012. 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 $2.8 million for the year ended December 31, 2013 compared to $7.1 million for the year ended December 31, 2012, primarily as a result of the repayment of the FHLB advances. Our net interest spread was 3.45% for 2013 compared to 3.25% in 2012. 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 is amortized into interest income on loans.
(1)
Nonaccrual loans are included in average balances for yield computations.
(1)
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.
(1)
Nonaccrual loans are included in average balances for yield computations.
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.
We recorded a provision for loan losses of $105,424 for the year ended December 31, 2013, an increase of $127,424, or 579% from a net recovery of provision for loan losses of $22,000 for the year ended December 31, 2012. The increase in provision for loan losses is primarily due to the recognition of specific reserves on three impaired loans, two of which were classified as held for sale as of December 31, 2013. Previously in 2012, we had seen a decrease in the amount of charge-offs and specific reserves needed due to the apparent stabilization of nonperforming loans. The allowance as a percentage of gross loans decreased slightly to 2.04% at December 31, 2013 from 2.64% at December 31, 2012. This decline is due to 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 approximately $192,000 on impaired loans
of $1.5 million as of December 31, 2013 compared to specific reserves of approximately $442,000 on impaired loans of $8.5 million as of December 31, 2012. As of December 31, 2013, the general reserve allocation was 1.78% of gross loans not impaired compared to 2.28% as of December 31, 2012. 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, 2013 was $225,144, a decrease of 51.7% from non-interest income of $466,273 for the year ended December 31, 2012. Our largest component of non-interest income in 2013 is from residential loan origination fees, which were $150,284 for 2013, or approximately 66.8% of total non-interest income. Residential loan origination fees decreased by approximately $19,528, or 11.5%, during the year due to the changes in mortgage loan underwriting and compensation regulations as well as customer demand. The remaining decrease is due to the gain on sale of investment securities in 2012 of $225,086. There were no sales of investment securities during 2013.
For the year ended December 31, 2013, service fees on deposit accounts totaled $41,475, an increase of $818, or 2.0%, from 2012 due primarily to an increase in stop payment fees. Other income was $33,385 for 2013, an increase of $2,667, or 8.7%, compared to $30,718 for the year ended December 31, 2012. Other income includes ATM surcharges, wire fees, and commissions on insurance referrals.
Non-interest Expenses
The following table sets forth information related to our non-interest expenses for the years ended December 31, 2013 and 2012.
Non-interest expenses increased by $5.3 million, or 120.9%, for the year ended December 31, 2013. This increase was primarily due to increases in product research and development, real estate owned activity, and compensation and benefits expense, partially offset by a decrease in insurance expense. Product research and development expenses increased $3.0 million due to the Company’s efforts to develop its payments processing business. Product research and development expenses consisted primarily of outside service fees to developers, consulting fees and research and development expense. During 2013, real estate owned activity increased by $1.6 million primarily due to $1.4 million of write-downs and losses incurred during 2013, which were charged against income as a result of our regular review of the fair value of repossessed property. Approximately $800,000 of these write downs were as a result of receiving updated appraisals for properties and the remainder of the losses were recognized when we sold properties at a loss. In addition, we had $521,000 in gains on real estate owned during 2012 that contributed to the increase. No gains were recognized during 2013. Compensation and benefits increased due to $551,487 in expense incurred related to the additional stock options granted during 2013 (an increase of $304,198) and the filling of open positions with benefits in 2013.
Income Tax Expense
No income tax benefit or expense was recognized for the year ended December 31, 2013 or 2012. 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 weighing 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. During 2013, we experienced losses from our product research and development segment and during 2012 we experienced losses specifically related to credit quality that impaired our ability to generate earnings. 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
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, 2013, our investment portfolio of $20.1 million represented approximately 19.3% of total assets. The portfolio decreased from $25.5 million at December 31, 2012, or 20.4% of total assets. Decreases in investment balances during 2013 were due to normal investment maturities and repayments. At December 31, 2013 and 2012, we held government-sponsored enterprise securities, mortgage-backed securities, non-taxable and taxable municipal bonds as investment securities available for sale. The amortized costs and the fair value of our investments at December 31, 2013, 2012, and 2011 are shown in the following table.
Contractual maturities and yields on our investment securities available for sale at December 31, 2013 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, 2013 and 2012, we also held non-marketable equity securities, which consisted of FRB stock of $149,900 and $251,800, respectively, and Federal Home Loan Bank stock of $274,300 and $483,500, respectively. These investments are carried at cost, which approximates fair market value.
Loans
At December 31, 2013, the Company had approximately $900,000 classified as loans held for sale that are not included in the loan balances disclosed below. At December 31, 2013, the Company was in the process of soliciting bids to sell approximately $1.3 million of loans to unaffiliated third party investors, and it was the Company’s intent to accept the highest bid received assuming it was greater than $900,000. As of December 31, 2013, these loans were reclassified out of the loans held for investment category and segregated on the balance sheet as held for sale. These loans are carried at their liquidation value based on the minimum acceptable bid threshold set by the Company with the remaining difference of approximately $407,000 being charged-off through the allowance for loan losses.
Since loans typically provide higher interest yields than other types of interest-earning assets, a significant percentage of our earning assets are invested in our loan portfolio. Average loans for the year ended December 31, 2013 were $64.5 million, a decrease of $8.5 million, or 11.6%, compared to average loans of $73.0 million for the year ended December 31, 2012. Before allowance for loan losses, gross loans outstanding at December 31, 2013 were $63.8 million, or 61.2% of total assets, compared to $70.4 million, or 56.4% of total assets at December 31, 2012.
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, 2013, 2012, 2011, 2010 and 2009.
The largest component of our loan portfolio at year-end was commercial real estate loans, which represented 34.2% 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, 2013.
Loan Performance and Asset Quality
The downturn in general economic conditions over the past several 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 $72,525 and $364,856 for the years ended December 31, 2013 and 2012, respectively. No interest income was recognized on nonaccrual loans during 2013 and 2012. At both December 31, 2013 and 2012, 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, 2013, 2012, 2011, 2010, and 2009.
Total delinquent and nonaccrual loans decreased from $4.8 million at December 31, 2012 to $2.0 million at December 31, 2013, a decrease of $2.8 million or 59.1%. This decrease was a result of movement in nonaccrual loans to other real estate owned, which decreased by $3.3 million from 2012 to 2013, partially offset by an increase in loans past due 30-59 days of $511,478 as discussed below as well as the reclassification of $900,000 in loans held for sale as of December 31, 2013. Nonaccrual decreases were seen in single and multifamily residential real estate loans due to successful foreclosure of the properties collateralizing these loans and their transfer to other real estate owned. Nonaccrual increases were seen in commercial real estate loans. At December 31, 2013, nonaccrual loans represented 2.2% of gross loans. Loans past due 30-89 days are considered potential problem loans and amounted to $566,972 and $57,035 at December 31, 2013 and 2012, respectively. The increase in 30-89 delinquent loans is due to one large loan moving into the 30-89 days delinquent category. This loan returned to current status in January 2014.
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, 2013 and 2012.
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, 2013, approximately 92% of the loan portfolio had a credit grade of “pass” compared to 86% at December 31, 2012. 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, 2013, we had loans totaling $1.5 million on the watch list compared to $1.2 million as of December 31, 2012.
Loans graded six or greater are considered classified credits. At December 31, 2013 and 2012, classified loans totaled $3.4 million and $8.8 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, 2013, impaired loans totaled $1.5 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 2013, the average recorded investment in impaired loans was $4.2 million compared to $8.7 million during 2012. As of December 31, 2013 and December 31, 2012, we had loans totaling approximately $256,589 and $317,180, 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, 2013 and 2012.
Troubled debt restructurings (“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 a result of the amended guidance.
At December 31, 2013, the principal balance of TDRs was zero as these loans had been reclassified as loans held for sale as of that date. All TDRs were considered classified and impaired at December 31, 2012. No TDRs went into default during the year ended December 31, 2013. 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. As of December 31, 2012, the carrying balance consisted of three performing loans within two relationships.
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, 2013, the allowance for loan losses was $1.3 million, or 2.04% of gross loans, compared to $1.9 million at December 31, 2012, or 2.64% of gross loans. [This decrease in the allowance for loan losses 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.]
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 directors 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 $1.5 million at December 31, 2013, with an associated specific reserve of $192,000. 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. The total general reserve is based upon the individual loan categories and their historical loss factors over an eight quarter moving average, adjusted for other risk factors as well. Therefore, the general allocation will move among the categories depending on if some loss factors increased while others decreased. 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, 2013, 2012, 2011, 2010, and 2009 by portfolio segment.
Net loan charge-offs increased during 2013 from $230,108 for the year ended December 31, 2012 to $661,954 for the twelve months ended December 31, 2013, an increase of $431,846. The majority of charge-offs in 2013 were partial charge-offs taken on certain collateral-dependent loans within our real estate portfolio segments as well as those recognized in connection with the reclassifying of approximately $1.3 million of loans to held for sale classification at their liquidation value of $900,000. 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 2.64% at December 31, 2012 to 2.04% at December 31, 2013. The decrease in the reserve percentage is due to a decrease in gross loans of $6.7 million and a decrease in allowance for loan losses of $556,530. The decrease in allowance is attributed to the recognition of a provision for loan losses and charge-offs taken against specific reserves of $763,554, partially offset by recoveries received of $101,600. The general reserve as a percentage of loans has decreased from 2.28% at December 31, 2012 to 1.78% at December 31, 2013.
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, 2013, we had $2.5 million in other real estate owned. This compares to $4.4 million in other real estate owned and $39,457 in repossessed assets as of December 31, 2012. During 2013, collateral was obtained from five loan relationships that went through the foreclosure process. We also completed the sale of eight repossessed properties.
During the quarter ended June 30, 2013, the Company purchased certain classified assets totaling approximately $5.5 million from the Bank (under terms that meet the Market Terms Requirement as described in Regulation W covering transactions between affiliates), resulting in a significant reduction in the Bank’s adversely classified assets. The following tables, other than the net loss on sale of repossessed property in 2013, do not reflect the effect of this transaction because it was an inter-company transaction.
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:
During 2013, the Bank completed an asset sale transaction (under terms that meet the Market Terms Requirement as described in Regulation W covering transactions between affiliates) to the Company for a purchase price of $5.5 million. Real estate owned of $3.3 million was transferred to the Company as a result of this sale. No gains or losses were recognized as a result of the asset sale as the assets were sold at current carrying value. During 2013, six pieces of real estate have been sold for proceeds of $1.4 million. The remaining 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, 2013 and 2012 were $92.8 million and $95.6 million, respectively. The following table shows the balance outstanding and the weighted-average rates paid on deposits held by us as of December 31, 2013, 2012, and 2011.
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 decreased $2.7 million, or 3.8%, from $71.0 million at December 31, 2012 to $68.3 million at December 31, 2013. Total retail, or customer, deposits increased $1.3 million during 2013, or 2.3%. 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, 2013, we had $1.6 million in brokered time deposits, remaining constant from $1.6 million as of December 31, 2012. Our strong customer deposit growth during 2013 along with the decrease in our loan portfolio enabled us to maintain a strong liquidity position, 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 72.9% and 73.0% at December 31, 2013 and 2012, 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. Our one remaining brokered deposit of $1.6 million matures in the first quarter of 2014. 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, excluding brokered deposits, at December 31, 2013 is as follows:
Short-Term Borrowings
At December 31, 2013, 2012, and 2011, respectively, the Bank had sold $96,879, $108,680, and $107,777 of securities under agreements to repurchase with brokers with a weighted rate of 0.10%, 0.10%, and 0.30%, respectively that mature in less than 90 days. These agreements were secured with approximately $150,000, $235,000, and $194,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $109,289 during 2013, with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2013 was 0.10%. The securities, under agreements to repurchase, averaged $118,430 during 2012, with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2012 was 0.34%. 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%.
At December 31, 2013, the Bank had an unused unsecured line of credit to purchase federal funds of $2.0 million. 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, 2013, the Bank had pledged $10.9 million in loans to the FRB’s Borrower-in-Custody of Collateral program. Our available credit under this line was approximately $8.7 million as of December 31, 2013.
Federal Home Loan Bank Advances
At December 31, 2013, the Bank had no advances from the FHLB as one of the two advances for $2 million reached maturity and was repaid in April 1, 2013. The additional FHLB advance was repaid in full in June 2013 which resulted in a prepayment penalty of $87,308. At December 31, 2012 and 2011, the Bank had $7.0 million of advances from the FHLB, with a weighted average rate of 1.67% for 2012 and 2.98% for 2011. The Bank utilizes FHLB advances as a long-term source of funding. Advances outstanding as of December 31, 2012 were secured with approximately $45.5 million of first and second mortgage loans and $483,500 of stock in the FHLB. FHLB advances averaged $7.0 million during 2012, and 2011, with $7.0 million being the maximum amount outstanding at any month-end. The average rate paid in 2012 and 2011 was 2.70% and 2.70%, respectively.
Capital Resources
Total shareholders’ equity was $14.3 million at December 31, 2013, a decrease of $6.3 million, or 30.4%, from $20.6 million at December 31, 2012. Shareholders’ equity decreased during 2013 primarily due to the recognition of a net loss of $6.0 million and the increase in the unrealized loss on investment securities of $1.2 million, partially offset by an increase due to the issuance of common stock and paid-in capital from the follow-on offering with funds of $0.6 million, net of offering costs. For 2013, the $6.0 million net loss was the result of an increase in product research and development expenses of $3.0 million, and a $1.5 million increase in expenses to carry other real estate owned, gains and losses of other real estate owned, and write-downs on other real estate owned. Our shareholders’ equity is also affected by fluctuations in our other comprehensive income (loss). The highest month end reported unrealized loss in other comprehensive income during calendar 2013 was $1.7 million in August 2013, as compared to the highest month end unrealized gain in April 2013 of $8,686.
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 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.
The Bank is 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 the 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. With funds from the Private Placement, the Company was able to make two capital contributions totaling $3 million to the Bank. As a result, the Bank’s capital levels are now above the minimum amounts specified in the Consent Order. However, as long as the Consent Order remains in place, the Bank will not be deemed “well capitalized” regardless of its capital levels. See additional discussion above under “Business - Supervision and Regulation.”
The following table sets forth the Bank’s and the Company’s various capital ratios at December 31, 2013, 2012, and 2011.
Since December 31, 2013, 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 our current ability to generate internal capital combined with our existing capital levels is not sufficient to sustain the Company’s current level of activities without raising additional capital or materially reducing its operating and development expenses. If the Company does not raise additional capital and elects to materially reduce its development and operating expenses to maintain compliance with regulatory requirements, the growth prospects of the business and Company will be materially impaired and significantly reduced. As of December 31, 2013, there were firm commitments of $1.3 million outstanding, some of which were capitalizable software and some of which were maintenance costs and developmental software. Since December 31, 2013, payments of $226,000 have been made against those commitments, and new commitments of $210,000 have been added for outstanding total commitments of $1.3 million as of March 24, 2014. Under Regulation W, the Bank may not be a source of cash or capital for the Company. As disclosed in “Note 20 - Parent Company Financial Information,” the Company’s cash balances were $2.4 million and its loan and real estate held for sale were $2.0 million at December 31, 2013. Due to the uncertainty of timing and amount of cash that might be received from the conversion of the held for sale
assets, the current commitments outstanding, the current run rate on fixed expenses, and the prohibition within Regulation W, we believe that the Company does not have sufficient liquidity to fund its current activities without a modification of our current operating strategy or without raising additional capital.
As noted above, in December 2010, the Basel Committee adopted the Basel III capital rules, which set new capital requirements for banking organizations. On June 7, 2012, the Federal Reserve requested comment on three proposed rules that, taken together, would establish an integrated regulatory capital framework implementing the Basel III regulatory capital reforms in the United States. As proposed, the U.S. implementation of Basel III would lead to significantly higher capital requirements and more restrictive leverage and liquidity ratios than those currently in place. The proposed rules indicated that the final rule would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019. However, due to the volume of public comments received, the final rule did not go into effect on January 1, 2013. The ultimate impact of the U.S. implementation of the new capital and liquidity standards on the company and the bank is currently being reviewed and is dependent upon the terms of the final regulations, which may differ from the proposed regulations. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact our net income and return on equity.
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, 2013, 2012 and 2011. 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, 2013 unfunded commitments to extend credit were $2.4 million, of which approximately $1.7 million is at fixed rates and $695,000 is at variable rates. A significant portion of the unfunded commitments related to 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.
Other than the significant firm commitments related to our software and development disclosed above under “ - Capital Resources,” we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements, or other 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 57% of our loans were variable rate loans at December 31, 2013, a decrease from 66% at December 31, 2012. As of December 31, 2013, our ratio of cumulative gap to total earning assets after 12 months but within five years was (4.96%) because in a rate change scenario, $4.6 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.
Interest rate risk is the Company’s primary market risk exposure. As part of interest rate risk management, the Company may enter into swap agreements to provide protection from rising rates and the impact on the current gap. Currently, the Company’s exposure to market risk is reviewed on a regular basis by management, and at the Bank level, the ALCO.
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, 2013, our liquid assets, consisting of cash and due from banks and federal funds sold, amounted to $14.4 million, or 13.8% of total assets, a significant decrease from our cash liquidity ratio of 18.1% as of December 31, 2012. During 2013, loan payoffs of $9 million, proceeds from the follow-on offering were used to pay off advances from the FHLB of $7 million in 2013. We carefully focused on
liquidity management during 2012 and 2013. As brokered deposits and advances have matured, 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. We have one remaining brokered deposit of $1,594,000 that is scheduled to mature by March 31, 2014.
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, 2013 amounted to $20.1 million, or 19.3% 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, 2013, $2.5 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, 2013, we had collateral that would support approximately $13 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%). During the third quarter of 2013, the FHLB upgraded our credit risk rating, which resulted in increased borrowing availability (total line increased from 15% of total assets to 20% of total assets) and decreased collateral requirements (moved to 115% of borrowings from 125%). 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, 2013, the Bank had an unused line of credit to purchase federal funds of $2.0 million. 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, 2013, the Bank had pledged $10.9 million in loans to the FRB’s Borrower-in-Custody of Collateral program. Our available credit under this line was approximately $8.7 million as of December 31, 2013.
Under Regulation W, the Bank may not be a source of cash or capital for the Company. As disclosed in “Note 20 - Parent Company Financial Information,” the Company’s cash balances were $2.4 million and its loans and real estate held for sale were $2.8 million at December 31, 2013. Due to the uncertainty of the timing and amount of cash that might be received from the conversion of the held for sale assets, the current commitments outstanding, the current run rate on fixed expenses, and the prohibition within Regulation W, we believe the Company does not have sufficient capital to fund its current activities for at least the remainder of the year without a modification of our current operating strategy or without raising additional capital.
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 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, 2013, 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:
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminated the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and required consecutive presentation of the statement of net income and other comprehensive income. The amendments were applicable to the Company January 1, 2012 and have been 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 while the FASB redeliberated the presentation requirements for the reclassification adjustments. In February 2013, the FASB further amended the Comprehensive Income topic clarifying the conclusions from such redeliberations. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments were effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012. These amendments did not have a material effect on the Company’s financial statements.
In April 2013, the FASB issued guidance addressing application of the liquidation basis of accounting. The guidance is intended to clarify when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting. The amendments will be effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein and those requirements should be applied prospectively from the day that liquidation becomes imminent. Early adoption is permitted. The Company does not expect these amendments to have any effect on its financial statements.
In July 2013, the FASB issued guidance to eliminate the diversity in practice regarding presentation of unrecognized tax benefits in the statement of financial position. Under the clarified guidance, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, will be presented in the financial statements as a reduction to a deferred tax asset unless certain criteria are met. The requirements should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The amendments will be effective for the Company for reporting periods beginning after December 15, 2013. The Company does not expect these amendments to have a material effect on its financial statements.
In December 2013, the FASB amended the Master Glossary of the FASB Codification to define “Public Business Entity” to minimize the inconsistency and complexity of having multiple definitions of, or a diversity in practice as to what constitutes, a nonpublic entity and public entity within U.S. GAAP. The amendment does not affect existing requirements, however will be used by the FASB, the Private Company Council (“PCC”), and the Emerging Issues Task Force (“EITF”) in specifying the scope of future financial accounting and reporting guidance. The Company does not expect this amendment to have any effect on its financial statements.
In January 2014, the FASB amended the Receivables - Troubled Debt Restructurings by Creditors subtopic of the Codification to address the reclassification of consumer mortgage loans collateralized by residential real estate upon foreclosure. The amendments clarify the criteria for concluding that an in substance repossession or foreclosure has occurred, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. The amendments also outline interim and annual disclosure requirements. The amendments will be effective for the Company (for interim and annual reporting periods beginning after December 15, 2014. Companies are allowed to use either a modified retrospective transition method or a prospective transition method when adopting this update. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.
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, 2013 and
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
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, 2013 and 2012, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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, 2013 and 2012, 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 31,
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
AND COMPREHENSIVE INCOME (LOSS)
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
FOR THE YEARS ENDED DECEMBER 31, 2013 AND 2012
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. On December 31, 2012, the Company sold 17,648,750 shares of its common stock to certain accredited investors in the Private Placement (the “Private Placement”), which equated to gross proceeds of $14.1 million. All shares were sold at $0.80 per share. On August 1, 2013, the Company sold 769,000 shares of its common stock at a price of $0.80 per share to certain existing shareholders in a follow-on offering for gross proceeds of approximately $615,200 (the “Follow-on Offering”). The Bank operates three full service branch offices in Greenville, South Carolina.
The following is a description of the 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.
Reclassifications
Certain amounts have been reclassified to state all periods on a comparable basis. Reclassifications had no effect on previously reported 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.
Business Segments
The Company reports its activities as four business segments - Banking, Transaction Services, Asset Management and Holding Company. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment. Please refer to “Note 18 - Business Segments” for further information on the reporting for the four business segments.
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 of at least equal to 9% of adjusted total average assets, Tier 1 risk based capital of at least equal to 10%, and total risk based capital of at least equal to 12% of risk-weighted assets The Bank’s capital levels are now above the minimum amounts specified in the Consent Order. However, as we are still subject to the Consent Order, the OCC has the authority to subject us to further enforcement remedies, including civil money penalties or other sanctions the OCC considers appropriate. Further, as long as the Consent Order remains in place, the Bank will not be deemed “well capitalized” regardless of its capital levels.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes cash, amounts 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, 2013 and 2012, the Company had restricted cash totaling $2,000 with the FHLB of Atlanta. Also at December 31, 2013 and 2012, 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.
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. 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 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 $274,300 and $251,800 at December 31, 2013 and 2012, 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 $149,900 and $483,500 at December 31, 2013 and 2012, 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.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Loans Held for Sale
At December 31, 2013, the Company held approximately $900,000 in loans classified as held for sale because the Company was in the process of soliciting bids to sell approximately $1.3 million of loans to unaffiliated third party investors, and it was the Company’s intent to accept the highest bid received assuming it was greater than $900,000. As of December 31, 2013, these loans were reclassified out of the loans held for investment category and segregated on the balance sheet as held for sale. These loans are carried at their liquidation value based on the minimum acceptable bid threshold set by the Company with the remaining difference of approximately $407,000 being charged off through the allowance for loan losses.
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.
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 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.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Allowance for Loan Losses, continued
The Company designates loan modifications as 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 and Software
Land is reported at cost. Buildings and improvements, furniture and equipment, software, 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 software, 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.
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 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 GAAP. 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.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Fair Value, continued
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.
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.
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, 2013 and 2012 as a result of the Company’s net loss, all of the potential common shares (3,273,505 and 473,505 stock options, respectively, and 312,500 and 337,500 warrants, respectively) were considered anti-dilutive.
Research and Development
All costs incurred to establish the technological feasibility of computer software to be sold, leased or otherwise marketed as research and development are expensed as incurred. Once technological feasibility has been established, the subsequent costs of producing, coding and testing the products should be capitalized. The expensing of computer software costs is discontinued when the product is available for general release to customers. Currently, the Company has not achieved technological feasibility and is expensing all computer software purchases related to research and development. Once technological feasibility is reached, the Company will capitalize costs as incurred.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Recently Issued Accounting Pronouncements
The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminated the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and required consecutive presentation of the statement of net income and other comprehensive income. The amendments were applicable to the Company January 1, 2012 and have been 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 while the FASB redeliberated the presentation requirements for the reclassification adjustments. In February 2013, the FASB further amended the Comprehensive Income topic clarifying the conclusions from such redeliberations. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments were effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012. These amendments did not have a material effect on the Company’s financial statements.
In April 2013, the FASB issued guidance addressing application of the liquidation basis of accounting. The guidance is intended to clarify when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting. The amendments will be effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein and those requirements should be applied prospectively from the day that liquidation becomes imminent. Early adoption is permitted. The Company does not expect these amendments to have any effect on its financial statements.
In July 2013, the FASB issued guidance to eliminate the diversity in practice regarding presentation of unrecognized tax benefits in the statement of financial position. Under the clarified guidance, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, will be presented in the financial statements as a reduction to a deferred tax asset unless certain criteria are met. The requirements should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The amendments will be effective for the Company for reporting periods beginning after December 15, 2013. The Company does not expect these amendments to have a material effect on its financial statements.
In December 2013, the FASB amended the Master Glossary of the FASB Codification to define “Public Business Entity” to minimize the inconsistency and complexity of having multiple definitions of, or a diversity in practice as to what constitutes, a nonpublic entity and public entity within U.S. GAAP. The amendment does not affect existing requirements, however will be used by the FASB, the PCC, and the EITF in specifying the scope of future financial accounting and reporting guidance. The Company does not expect this amendment to have any effect on its financial statements.
In January 2014, the FASB amended the Receivables - Troubled Debt Restructurings by Creditors subtopic of the Codification to address the reclassification of consumer mortgage loans collateralized by residential real estate upon foreclosure. The amendments clarify the criteria for concluding that an in substance repossession or foreclosure has occurred, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. The amendments also outline interim and annual disclosure requirements. The amendments will be effective for the Company (for interim and annual reporting periods beginning after December 15, 2014). Companies are allowed to use
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES, Continued
Recently Issued Accounting Pronouncements, continued
either a modified retrospective transition method or a prospective transition method when adopting this update. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.
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:
The following table presents information regarding securities with unrealized losses at December 31, 2013:
NOTE 2 - INVESTMENT SECURITIES, Continued
The following table presents information regarding securities with unrealized losses at December 31, 2012:
At December 31, 2013, investment securities with a fair value of $9.2 million and unrealized losses of $498,207 had been in a continuous loss position for less than twelve months. At December 31, 2013, investment securities with a fair value of approximately $9.8 million and unrealized losses of $766,322 had been in a continuous loss position for more than one year. 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, 2012, investment securities with a fair value of $13.0 million and unrealized losses of $189,670 had been in a continuous loss position for less than twelve months. At December 31, 2012, 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, 2013, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers have the right to prepay the obligations.
During 2012, the Company received proceeds from sales of securities of $7.5 million for a total gain of $225,086. The Company did not receive any proceeds from sales of securities during 2013. At December 31, 2013 and 2012, $2.5 million and $5.3 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, 2013, management has determined that the Company has a concentration in commercial real estate loans, including construction and development loans. At December 31, 2013, the Company had $31.8 million in commercial real estate loans, representing 50.0% 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.
At December 31, 2013, the Company held approximately $900,000 classified as loans held for sale that are not included in the loan balances disclosed above or in the disclosures presented in the remainder of Note 3. At December 31, 2013, the Company was in the process of soliciting bids to sell approximately $1.3 million of loans to unaffiliated third party investors, and it was the Company’s intent to accept the highest bid received assuming it was greater than $900,000. As of December 31, 2013, these loans were reclassified out of the loans held for investment category and segregated on the balance sheet as held for sale. These loans are carried at their liquidation value based on the minimum acceptable bid threshold set by the Company with the remaining difference of approximately $407,000 being charged off through the allowance for loan losses.
During 2013, the Bank completed an asset sale transaction (under terms that meet the Market Terms Requirement as described in Regulation W covering transactions between affiliates) to the Company for a purchase price of $5.5 million. Real estate owned of $3.3 million was transferred to the Company as a result of this sale. No gains or losses were recognized as a result of the asset sale as the assets were sold at current carrying value. During 2013, six pieces of real estate have been sold for proceeds of $1.4 million. The remaining assets are being actively marketed for sale.
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
NOTE 3 - LOANS, Continued
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:
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 $1.7 million and $4.0 million at December 31, 2013 and 2012, respectively. During 2013, there were no new loans and advances on these lines of credit and repayments were approximately $2.2 million. At December 31, 2013, there were commitments to extend additional credit to related parties in the amount of approximately $168,000.
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, 2013, approximately $39.5 million of first and second mortgage loans, commercial loans and home equity lines of credit were specifically pledged to the FHLB, resulting in $13.0 million in lendable collateral. At December 31, 2013, the Bank had also pledged $10.9 million of commercial loans to the FRB’s Borrower-in-Custody of Collateral program, resulting in $8.7 million in lendable collateral. The Bank had no outstanding borrowings from the FRB and FHLB as of December 31, 2013.
Credit Quality
The following table summarizes delinquencies and nonaccruals, by portfolio class, as of December 31, 2013 and 2012.
NOTE 3 - LOANS, Continued
At December 31, 2013 and 2012, there were nonaccrual loans of $1.4 million and $4.8 million, respectively, included in the above loan balances. Foregone interest income related to nonaccrual loans equaled $72,525 and $364,856 for the years ended December 31, 2013 and 2012, respectively. No interest income was recognized on nonaccrual loans during 2013 and 2012. At both December 31, 2013 and 2012, 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.
The following table summarizes management’s internal credit risk grades, by portfolio class, as of December 31, 2013 and 2012.
Loans graded one through four are considered “pass” credits. At December 31, 2013, approximately 92% of the loan portfolio had a credit grade of “pass” compared to 86% at December 31, 2012. 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 $1.5 million and $1.2 million, respectively, were classified as special mention at December 31, 2013 and 2012. 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
NOTE 3 - LOANS, Continued
be monitored more closely than other credits in the loan portfolio. At December 31, 2013 and 2012, substandard loans totaled $3.4 million and $8.8 million, respectively, with the vast majority of these loans being collateralized by real estate. Substandard credits are evaluated for impairment on a quarterly basis.
The following table summarizes information relative to impaired loans, by portfolio class, at December 31, 2013 and 2012.
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 a result of new guidance.
At December 31, 2013, the principal balance of TDRs was zero as these loans had been reclassified as loans held for sale as of that date. At December 31, 2012, the principal balance of TDRs totaled $2.5 million. All TDRs were considered classified or impaired at December 31, 2012. No TDRs went into default during the years ended December 31, 2013 and 2012. 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. As of December 31, 2012, the carrying balance consisted of three performing loans within two relationships.
Provision and Allowance for Loan Losses
The following table summarizes activity related to our allowance for loan losses for the years ended December 31, 2013 and 2012, by portfolio segment.
NOTE 3 - LOANS, Continued
NOTE 4 - PROPERTY, EQUIPMENT AND SOFTWARE
Property, equipment and software are stated at cost less accumulated depreciation. Components of property, equipment and software included in the consolidated balance sheets are as follows:
Depreciation expense for the years ended December 31, 2013 and 2012 was $130,110 and $156,952, respectively. There was one asset disposal for $11,543 and no asset retirements during 2013. In 2013, we entered into contracts with two software vendors for use in the digital payments processing business. These contracts required upfront payments totaling $576,000, some of which was capitalizable software and some of which was maintenance. During 2014, another $1.3 million is due in varying installments, most of which will not be capitalizable.
NOTE 5 - OTHER REAL ESTATE OWNED AND REPOSSESSED 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:
During the quarter ended June 30, 2013, we purchased certain classified assets totaling approximately $5.5 million from the Bank (under terms that meet the Market Terms Requirement as described in Regulation W covering transactions between affiliates), resulting in a significant reduction in the Bank’s adversely classified assets. The table above, other than the net loss on sale of repossessed assets in 2013, does not reflect the effect of this transaction because it was an inter-company transaction.
NOTE 6 - DEPOSITS
Deposits at December 31, 2013 and 2012 are summarized as follows:
Interest expense on time deposits greater than $100,000 was $185,010 and $248,977 for the years ended December 31, 2013 and 2012, respectively.
At December 31, 2013 the scheduled maturities of certificates of deposit (including brokered time deposits) are as follows:
NOTE 6 - DEPOSITS, Continued
At December 31, 2013, $2.4 million in securities were pledged as collateral for public deposits.
NOTE 7 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
At December 31, 2013 and 2012, respectively, the Bank had sold $96,879 and $108,680 of securities under agreements to repurchase with brokers with a weighted rate of 0.10% and 0.10%, respectively that mature in less than 90 days. These agreements were secured with approximately $150,000 and $235,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $109,289 during 2013 with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2013 was 0.10%. The securities, under agreements to repurchase, averaged $118,430 during 2012, with $218,426 being the maximum amount outstanding at any month-end. The average rate paid in 2012 was 0.34%.
NOTE 8 - FEDERAL HOME LOAN BANK ADVANCES
At December 31, 2012 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, 2012 these advances were secured with approximately $45.5 million of first and second mortgage loans and $483,500 of stock in the FHLB. At December 31, 2013, the Bank had no advances from the FHLB as one of the two advances for $2 million reached maturity and was repaid in April 1, 2013. The additional FHLB advance was repaid in full in June 2013 which resulted in a prepayment penalty of $87,308.
NOTE 9 - UNUSED LINES OF CREDIT
At December 31, 2013, the Bank had an unused unsecured line of credit to purchase federal funds of $2.0 million that 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, 2013, approximately $45.5 million of first and second mortgage loans were specifically pledged to the FHLB, resulting in $11.1 million in lendable collateral. At December 31, 2013, the Bank had no advances from the FHLB as one of the two advances for $2 million reached maturity and was repaid in April 1, 2013. The additional FHLB advance was repaid in full in June 2013 which resulted in a prepayment penalty of $87,308. In addition, the Bank could pledge investment securities or cash for additional borrowing capacity of $5.3 million.
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%). During the third quarter of 2013, the FHLB upgraded our credit risk rating, which resulted in increased borrowing availability (total line increased from 15% of total assets to 20% of total assets) and decreased collateral requirements (moved to 115% of borrowings from 125%). 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, 2013, the Bank had pledged $10.9 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. In May 2013, we were informed by the Federal Reserve that as a result of our improving financial condition our available credit under the Borrower-in-Custody of Collateral program had been moved back to Primary Credit from Secondary Credit, which also resulted in a decrease in our collateral requirements. Our
NOTE 9 - UNUSED LINES OF CREDIT, Continued
available credit under this line was approximately $10.9 million and $10.6 million as of December 31, 2013 and 2012, respectively. The Bank had no outstanding borrowings from the FRB as of December 31, 2013.
NOTE 10 - INCOME TAXES
The components of income tax expense were as follows:
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, 2013 and 2012 was $7.0 million and $4.4 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, 2013 and 2012, the Company determined that it is not more likely than not that deferred tax assets will be recognized in future years.
NOTE 10 - INCOME TAXES, Continued
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 decrease in the tax effect of the unrealized gain on investment securities available for sale of $4,138. The net deferred tax liability is recorded in other liabilities in the Company’s consolidated balance sheets. At December 31, 2013, the Company has federal operating loss carry-forwards of approximately $15.4 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 on 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 2009 and subsequent years are subject to examination by the taxing authorities.
We have generated significant net operating losses, or NOLs, as a result of our recent losses. We are generally able to carry NOLs forward to reduce taxable income in future years. However, the ability to utilize the NOLs is subject to the rules of Section 382 of the Internal Revenue Code. Section 382 generally restricts the use of NOLs after an “ownership change.” An ownership change occurs if, among other things, the shareholders (or specified groups of shareholders) who own or have owned, directly or indirectly, 5% or more of a corporation’s common stock or are otherwise treated as 5% shareholders under Section 382 and U.S. Treasury regulations promulgated thereunder because of an increase of their aggregate percentage ownership of that corporation’s stock by more than 50 percentage points over the lowest percentage of the stock owned by these shareholders over a rolling three-year period. In the event of an ownership change, Section 382 imposes an annual limitation on the amount of taxable income a corporation may offset with NOL carryforwards. This annual limitation is generally equal to the product of the value of the corporation’s stock on the date of the ownership change, multiplied by the long-term tax-exempt rate published monthly by the Internal Revenue Service. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOL carryforwards. We do not believe that the Private Placement (see Note 1) caused an “ownership change” at the Company, within the meaning of Section 382.
NOTE 11 - RELATED PARTY TRANSACTIONS
On December 31, 2013 and 2012, 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.
In July 2011, Gordon A. Baird formed MPIB, a Delaware limited liability company for the purpose of developing the business and regulatory plans for a digital transaction services business. On December 31, 2012, Mr. Baird was appointed chief executive officer and director of the Company. The Company is currently negotiating the purchase of MPIB to obtain the exclusive rights in all the property of MPIB. The Company has appointed an independent committee of the board as well as hired a nationally recognized independent audit and valuation firm to support the Company’s negotiation and valuation process. If we are able to negotiate an agreement with MPIB on terms that we find acceptable, we would acquire MPIB or its assets for an upfront fee that would not exceed $7 million and earnout payments that would not exceed 7% of the revenue generated by any digital payments business over a period of not longer than seven years.
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.
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF BALANCE SHEET RISK, Continued
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, 2013, unfunded commitments to extend credit were $9.5 million, of which approximately $8.8 million is at fixed rates and $695,000 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 its remaining two-year renewal options in September 2012. The monthly rent under the lease amendment is $9,967 from October 1, 2010 through September 30, 2012 and $10,370 from October 1, 2012 through September 30, 2014. The Bank expects to be able to renegotiate on terms similar to the current lease. 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. The Company has a 21- month operating lease on its New York office which began in May 2013. The monthly rent under the lease agreement allows for one month free rent from May 23, 2013 through June 22, 2013, an installment of $2,680 for June 23, 2013 through June 30, 2013, and fixed monthly installments of $9,450 from July 1, 2013 through February 27, 2015. Rent expense of $294,568 and $209,545 was recorded for the years ended December 31, 2013 and 2012, respectively.
Future minimum lease payments under these operating leases are summarized as follows:
As of December 31, 2013, there were firm commitments of $1.3 million outstanding, primarily for systems and development software, most of which will be expensed in 2014. Since December 31, 2013, payments of $226,000 have been made, and commitments of $210,000 have been added for outstanding total commitments of $1.3 million as of March 24, 2014.
The board of directors has approved employment agreements with the chief executive officer of the Company, the president and chief executive officer of the Bank, and the Bank’s 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, 2013, management believes there is no material litigation pending.
NOTE 14 - STOCK COMPENSATION PLANS
On July 26, 2005, the Company adopted the 2005 Incentive Plan for the benefit of the directors, officers and employees. The 2005 Incentive Plan initially reserved up to 260,626 shares of the Company’s common stock for the issuance of stock options and contained evergreen provision, which provided that the maximum number of shares to be issued under the 2005 Incentive Plan would automatically increase each time the Company issues additional shares of common stock such that the total number of shares issuable under the 2005 Incentive Plan would at all times equal 12.5% of the then outstanding shares of common stock. Accordingly, with the closing of the Private Placement on December 31, 2012, the number of shares reserved for the issuance of stock options under the 2005 Incentive Plan increased from 260,626 shares to 2,466,720 shares.
The board may grant up to 2,466,720 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.
In February 2013, our board of directors amended the 2005 Incentive Plan to cap the number of shares issuable thereunder at 2,466,720 and adopted the 2013 Incentive Plan. The 2013 Incentive Plan is an omnibus equity incentive plan which provides for the granting of various types of equity compensation awards, including stock options, restricted stock, and stock appreciation rights, to the Company’s employees and directors. Initially, the maximum number of shares of common stock that may be issued under the 2013 Incentive Plan will be 2,466,720, and such number will automatically adjust each time the Company issues additional shares of common stock so that the number of shares of common stock available for issuance under the 2013 Incentive Plan (plus the 2,466,720 shares reserved for issuance under the 2005 Incentive Plan) continues to equal 20% of the Company’s total outstanding shares, assuming all shares under the 2005 Incentive Plan and the 2013 Incentive Plan are exercised. Our board of directors submitted the 2013 Incentive Plan to the shareholders of the Company for their consideration at the 2013 annual shareholders’ meeting and it was approved.
As of December 31, 2012, there were 473,505 stock options outstanding with a weighted average exercise price of $2.75 per share, all of which were vested. During the year ended December 31, 2013, the Company granted an additional 2,800,000 stock options to certain employees and an advisor to the Company under the 2005 Incentive Plan and the 2013 Incentive Plan, for a total outstanding of 3,273,505 options at a weighted average price of $1.08. Of the 3,273,505 options issued, as of December 31, 2013, 1,168,505 options have vested.
On August 1, 2013, the Company sold 769,000 shares of common stock at a price of $0.80 per share to certain existing shareholders in a Follow-On Offering for gross proceeds of approximately $615,200. As a result of the evergreen provision of the 2013 Incentive Plan, the total shares available for grant under the 2013 Incentive Plan increased by 192,250 shares to 2,658,970 as of the close of the Follow-On Offering.
In February 2014, the Company granted an additional 155,000 stock options at a price of $1.59 to certain employees and to a third-party contractor, for a total outstanding of 3,428,505 options at a price of $1.11. Of the 3,428,505 options issued, only 1,306,005 options have vested.
NOTE 14 - STOCK COMPENSATION PLANS, Continued
A summary of the status of the plans and changes for the years ended December 31, 2013 and 2012 are presented below:
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 2013 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, 2013. 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, 2013, the Company’s closing stock price was $1.50 resulting in $0.70 intrinsic value.
Compensation expense related to stock options granted was $472,948 and $168,750 for the years ended December 31, 2013 and 2012, 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. On December 31, 2012, 375,000 stock options were granted to the Company’s chief executive officer as part of the capital raise. During the year ended December 31, 2013, 2,800,000 stock options were granted to certain employees and an advisor to the Company under the 2005 Incentive Plan and the 2013 Incentive Plan. In February 2014, the Company granted an additional 155,000 stock options to certain employees and to a third-party contractor. These options were awarded with a fair market value exercise price based on the valuation methodology established by the board of directors, which uses a model based on then current and historical prices of the Company’s stock transacted between two independent parties.
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, and reinstated it starting in 2012. For the year ended December 31, 2013 and 2012, $13,438 and $9,483, 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.
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 average 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. The Bank’s capital levels are now above the minimum amounts specified in the Consent Order. However, as long as the Consent Order remains in place, the Bank will not be deemed “well capitalized” regardless of its capital levels. As of December 31, 2013, the Bank was deemed “adequately capitalized.”
The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements at December 31, 2013 and 2012.
NOTE 16 - REGULATORY MATTERS, Continued
The Federal Reserve 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, 2013, 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 the Company 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 - BUSINESS SEGMENTS
The Company reports its activities as four business segments - Banking, Transaction Services, Asset Management and Holding Company - as defined in “Item 1. Business“. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment.
The following table presents selected financial information for the Company’s reportable business segments for the year ended December 31, 2013. There were no revenues or expenses outside of the Banking segment for the year ended December 31, 2012.
NOTE 18 - BUSINESS SEGMENTS, Continued
The sole activity conducted within our Asset Management business segment is the resolution of assets acquired from the Bank including, but not limited to, those certain classified assets totaling approximately $5.5 million purchased by the Company in the second quarter of 2013 from the Bank.
NOTE 19 - 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 ($20,125,470 and $25,484,115 at December 31, 2013 and 2012, respectively) 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, 2013, 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 3 inputs. The aggregate carrying amount, net of specific reserves, of impaired loans carried at fair value at December 31, 2013 and 2012 was $1.3 million and $8.1 million, respectively.
Loans held for sale ($900,000 at December 31, 2013) are carried at fair value and measured on a non-recurring basis using Level 2 inputs. The carrying value of loans held for sale as of December 31, 2013 approximates fair value as these loans were discounted to their liquidation value which is equal to the minimum acceptable bid price established by the Company in connection with the Company’s intent to sell these loans to unaffiliated third party investors.
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 the lower or market value and measured on a non-recurring basis. Market values are generally obtained using independent appraisals which are generally prepared using the income or market valuation approach, adjusted for estimated selling costs which the Company considers to be Level 3 inputs. The carrying amount of other real estate owned and repossessed assets carried at fair value at December 31, 2013 and 2012 was $2,508,170 and $4,468,294, respectively. The Company utilizes two methods to determine carrying values, either appraised value, or if lower, current net listing price.
The Company has no assets whose fair values are measured using Level 1 inputs. The Company also has no liabilities carried at fair value or measured at fair value.
NOTE 19 - FAIR VALUE OF FINANCIAL INSTRUMENTS, Continued
For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2013, the significant observable inputs used in the fair value measurements were as follows:
For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2012, the significant unobservable inputs used in the fair value measurements were as follows:
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.
The carrying value of loans held for sale as of December 31, 2013 approximates fair value as these loans were discounted to their liquidation value which is equal to the minimum acceptable bid price established by the Company in connection with the Company’s intent to sell these loans to unaffiliated third party investors.
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.
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
NOTE 19 - FAIR VALUE OF FINANCIAL INSTRUMENTS, Continued
settlement, are not taken into consideration in the fair value presented. The estimated fair values of the Company’s financial instruments at December 31, 2013 and 2012 are as follows:
NOTE 20 - PARENT COMPANY FINANCIAL INFORMATION
Following is condensed financial information of Independence Bancshares, Inc. (includes transaction service, asset management and holding company segments - for further detail, see “Note 17 - Business segments”):
Condensed Balance Sheets
Condensed Statements of Operations
NOTE 20 - PARENT COMPANY FINANCIAL INFORMATION, Continued
Condensed Statements of Cash Flows
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
Based on our management’s evaluation (with participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer as appropriate to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Controls over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. 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 GAAP. Internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management (with the participation of the principal executive officer and principal financial officer) conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2013.
The effectiveness of the internal control over financial reporting as of December 31, 2013 was not required to be, and has not been, audited by Elliott Davis, LLC, the Company’s independent registered public accounting firm.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting during our fourth quarter of fiscal 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers, and Corporate Governance.
Directors and Executive Officers
The following table sets forth information about our directors, executive officers, and other officers. Our directors are elected by a plurality of the votes cast at our annual shareholders’ meetings and serve for one-year terms, which expire at the next annual shareholders’ meeting.
Set forth below is certain information about our directors, executive officers, and proposed executive officer, including their age, their business experience for at least the past five years, the names of other publicly-held companies where they currently serve as a director or served as a director during the past five years, and additional information about the specific experience, qualifications, attributes, or skills that led to the board’s conclusion that such person should serve as a director for the Company.
Gordon A. Baird, 45, director and the Company’s chief executive officer, has served as the Company’s chief executive officer since December 2012. Mr. Baird has had an extensive career in banking and financial services, starting early in technology designing and developing custom systems applications, databases and financial models and moving on to positions in banking, lending, credit, trading, capital markets and structured finance. Prior to joining our Company in December 2012, Mr. Baird served as an operating advisor to Thomas H. Lee Partners from January 2011 through October 2012. From 2003 to 2011, he served as chief executive officer and partner of Paramax Capital Group, LLC, a private capital, advisory and asset finance company focused exclusively on the financial services sector. Previously, he was a director in the Financial Institutions Group at Citigroup Global Markets and Assistant Vice President, Product Manager at State Street Bank & Trust Company in Boston, MA. Mr. Baird is also currently director and Chairman of the Audit Committee of the Macquarie Total Return Global Infrastructure Fund, a NYSE-listed closed-end mutual fund. Mr. Baird is a Chartered Financial Analyst and member of the New York Security Analyst Society and holds a B.S. in economics from Emory University. Mr. Baird’s extensive knowledge of transaction services banks led the board to conclude that he should serve as a director as the Company explores the expansion of its business model.
Alvin G. Hageman, 71, director, is currently Co-Chief Investment Officer and Partner of MPIB Holdings, LLC, a company he formed in 2011 with Mr. Baird to develop proprietary software that will support transaction services banks. From 2003 to 2011, he served as Co-Chief Investment Officer and Partner of Paramax Capital Group, LLC, a private capital, advisory and asset finance company focused exclusively on the financial services sector. Prior to that role, Mr. Hageman spent 34 years at Citigroup managing multiple Citigroup regional offices and ultimately co-headed the Global Securitization, Asset-backed and Mortgage Group, managing 300 professional employees located in New York, London, Tokyo, and Hong Kong. Mr. Hageman has extensive experience with all asset-backed sectors, including credit cards, auto loans, student loans, equipment loans and leases, and foreign and domestic trade receivables. Mr. Hageman holds a B.A., from Williams College and a M.B.A. from Harvard Business School. Mr. Hageman also previously served on the boards of directors of American Honda Receivables Corp. and American Honda Receivables Corp. II, companies which arranged consumer financing facilities for Honda Motor Corporation. Mr. Hageman’s extensive knowledge of transaction services banks led the board to conclude that he should serve as a director as the Company explores the expansion of its business model.
H. Neel Hipp, Jr., 62, director and chairman of the Bank’s board, is the former vice president of Liberty Corporation and former chairman of Liberty Life Insurance Company with over 29 years of experience with the Liberty companies. He is the current owner of Hipp Investments, LLC, which he founded in 1998. Mr. Hipp was a founder and a director of Greenville Financial Corporation and Greenville National Bank. He received his B.A. in economics from Furman University, his M.B.A. from the University of North Carolina, Chapel Hill, and he also attended the Harvard Business School Program for Management Development. Mr. Hipp is actively involved in the community. He currently serves on the Wofford College board of trustees and the board of the Aircraft Owners and Pilots Association of Frederick, Maryland. Mr. Hipp was appointed chairman of the South Carolina Aeronautics Commission in 2006 by Governor Sanford. He has also served as a member of the South Carolina Chamber of Commerce, the South Carolina Historical Society board, the Greenville Downtown Airport Commission (chair), the Greenville County United Way, and the Furman University board of trustees. Mr. Hipp’s extensive business experience in a regulated industry, his past experience in the banking industry, including service as a bank director, as well as his ties to the Greenville community led the board to conclude that he should serve as a director.
A. Alexander McLean, III, 62, director, is chairman and chief executive officer of World Acceptance Corporation, a national consumer finance company. Mr. McLean has held various positions with World Acceptance Corporation, including chief financial officer, during his service with the company beginning in 1989. Prior to joining World Acceptance Corporation, he worked in banking for six years and public accounting for four years. Mr. McLean received his B.S. in economics from Davidson College and a Masters of Accountancy from University of South Carolina School of Business. He currently resides in Greenville, South Carolina and is active in various community organizations. Mr. McLean’s extensive business experience in the financial services industry, particularly his financial expertise in public company reporting, as well as his ties to the Greenville community led the board to conclude that he should serve as a director.
Keith Stock, 61, director, is chairman and chief executive officer of First Financial Investors, Inc., a financial services investment firm, a position he has held since February 2011. In addition, since February 2011 he has served as senior executive advisor with The Brookside Group and since January 2014 as chairman and chief executive officer of Clarien Group Limited as well as chairman of its wholly-owned subsidiary, Capital G Bank Limited. Mr. Stock is a registered securities professional with J.V.B. Financial Group, a full service investment bank. Previously, from March 2009 until February 2011, Mr. Stock served as chief strategy officer and member of the Office of the CEO at TIAA-CREF and, from 2004 until May 2008, as president of MasterCard Advisors, LLC, a unit of MasterCard Worldwide. He was a member of the MasterCard Operating Committee and Management Council. Prior to that, Mr. Stock served as chairman and chief executive officer of St. Louis Bank, FSB, chairman of Treasury Bank Ltd., and as a director of Severn Bancorp, Inc. and Severn Savings Bank. He has also held global management roles with AT Kearney, Capgemini, Ernst & Young and McKinsey & Company after beginning his career with BNY Mellon. He is a
director of Sun Bancorp, Inc. and its wholly-owned subsidiary Sun National Bank, the Bermuda Stock Exchange (BSX), and the Foreign Policy Association. He is a member of the Economic Club of New York, the Advisory Board of the Institute for Ethical Leadership at Rutgers University Business School, and the International Trustee Election Commission of AFS Intercultural Programs, Inc. (formerly known as the American Field Service). He is a graduate of Princeton University and received his MBA from The University of Pennsylvania Wharton School. Mr. Stock’s prior service as an executive officer and director of other banks, as well as his extensive payments services experience with MasterCard, led the board to conclude that he should serve as a director as the Company explores the expansion of its business model.
Robert B. Willumstad, 68, director and chairman of the Company’s board, has over 35 years of experience in the banking and financial services industry, and he presently serves as a partner with Brysam Global Partners, a specialty private equity firm that focuses in financial services, which he co-founded in 2005, and as senior advisor of Commercial International Bank (Egypt) S.A.E. Mr. Willumstad also previously served as the chairman, and briefly as chief executive officer, of American International Group until 2008. Mr. Willumstad served as Chief Executive Officer of CitiCorp. Credit Services, Inc., CitiCorp. and Citibank N.A. He served as Chief Executive Officer of Citi Private Bank, President and Chief Operating Officer of Citigroup Asset Management, and President and Chief Operating Officer of Global Investment Management and Head of Global Consumer Lending at Citigroup Inc. Mr. Willumstad served as the Chief Operating Officer and President at Citigroup Inc. from October 2003 to July 2005 and from 2002 to July 2005, and as the Chief Executive Officer of Travelers Group Consumer Finance Services and The Citigroup Private Bank. He joined Commercial Credit in 1987 and served as the Chief Executive Officer from 1993 to 1998. Mr. Willumstad also served for over 20 years with Chemical Bank in various capacities of operations, retail banking and computer systems, and prior to that, he also served with JPMorgan &Chase Co. He currently serves as chairman of the Board of Trustees of Adelphi University in Long Island, NY. Mr. Willumstad’s extensive banking and financial services experience led the board to conclude that he should serve as a director and as chairman of the board of directors.
Additional information is set forth below regarding certain other executive officers or proposed executive officer of our Company and our Bank:
Martha L. Long, 55, has served as the Company’s chief financial officer since December 30, 2013 and the Bank’s chief financial officer since 2012. Ms. Long previously assisted the Company as the principal financial officer until obtaining regulatory approval and the Bank with financial accounting matters as an independent contractor beginning in June 2011. She has over 31 years of experience in various senior financial officer roles. Prior to her work with the Bank, Ms. Long served in various accounting capacities, including most recently working for her own CPA firm from 2009 to 2012. Prior to that, she served as Senior Vice President for AIMCO, a publicly held real estate investment trust from 1998 to 2009 in various financial capacities. She has also served as Senior Vice President and Controller for two SEC-registered companies, The First Savings Bank and Insignia Financial Group, Inc., an owner and operator of multi-family housing facilities. Ms. Long is a graduate of Bob Jones University with a degree in Accounting and is a certified public accountant in South Carolina.
Lawrence R. Miller, 67, is the Bank’s president and chief executive officer. Mr. Miller also served as the Company’s president and chief executive officer until December 31, 2012. He has over 43 years of banking experience, having held various positions in the banking industry since November 1971. He was most recently market chief executive officer for SouthTrust Bank from 1995 until he retired in March 2004. In June 2004, he joined our Bank. While with SouthTrust Bank, Mr. Miller successfully opened seven offices in 10 years. He has lived in Upstate South Carolina for over 40 years and has been actively involved in the community and its future planning. He is a former trustee for the College of Charleston and is past board chairman of Christ School, Arden, North Carolina. Mr. Miller has also served as a member of the South Carolina Bankers Association Council and a board member of the South Carolina Bankers Association. He has served on both the economic development board of the Greenville Chamber of Commerce and the board of directors of the Greer Chamber of Commerce. Mr. Miller graduated from Newberry College, from the School of Banking of
the South at Louisiana State University, and from the National Commercial Lending Graduate School at the University of Oklahoma.
Richard J. Garside, 54, is the Company’s proposed president and chief operating officer. Since early 2013, Mr. Garside has served as a consultant to the Company regarding the development of its expanded business model. Previously, from March 2008 to January 2013, Mr. Garside served as the Global Head of Consumer Operations and Technology for Citigroup Inc. He had previously served as Chief Operating Officer of North America Consumer Operations and Technology for Citigroup Inc. from September 2005 to February 2008 and the Chief Operating Officer of Citicards from November 2002 to August 2005. Mr. Garside currently serves on the board of directors of The University of Sioux Falls, in Sioux Falls, SD, the Georgia Tech Advisory Board, and the advisory board of the I.M. Sulzbacher Center for the Homeless in Jacksonville, FL. Mr. Garside graduated from The University of Sioux Falls with a degree in Business Administration.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires the Company’s officers and directors and persons who own more than 10% of the Company’s common stock to file reports of ownership and changes in ownership with the SEC. Based solely on the Company’s review of these forms and written representations from the officers and directors, the Company believes that all Section 16(a) filing requirements were met during fiscal 2013.
Code of Ethics
We expect all of our directors, executive officers, and other employees to conduct themselves honestly and ethically, particularly in handling actual and apparent conflicts of interest and providing full, accurate, and timely disclosure to the public.
We have adopted a Code of Ethics that is applicable to our directors, executive officers, principal shareholders, and other employees, including our principal executive officer and our principal financial officer. A copy of this Code of Ethics is available without charge to shareholders upon request to the secretary of the Company, at Independence Bancshares, Inc., 500 East Washington St., Greenville, South Carolina 29601.
Audit Committee and Audit Committee Financial Expert
Our audit committee is currently composed of Messrs. Stock, McLean, and Hipp. Each of these members is considered “independent” under NASDAQ Rule 5605(c)(2). The board of directors has determined that Mr. Stock is an “audit committee financial expert” as defined in Item 407(d)(5) of the SEC’s Regulation S-K. The audit committee met five times in 2013.
The audit committee functions are set forth in its charter, which was adopted on May 5, 2005 and ratified on November 3, 2011. A copy of the audit committee charter is attached as Appendix A to our 2012 proxy statement. The audit committee has the responsibility of reviewing financial statements, evaluating internal accounting controls, reviewing reports of regulatory authorities, and determining that all audits and examinations required by law are performed. The committee recommends to the board the appointment of the independent auditors for the next fiscal year, reviews and approves the auditor’s audit plans, and reviews with the independent auditors the results of the audit and management’s responses. The audit committee is responsible for overseeing the entire audit function and appraising the effectiveness of internal and external audit efforts. The audit committee reports its findings to the board of directors.
Item 11.
Item 11. Executive Compensation.
Summary Compensation Table
The following table summarizes the compensation paid to or earned by each of the named executive officers for the year ended December 31, 2013:
(1)
Effective as of December 31, 2012, Mr. Baird joined the Company as its chief executive officer, and Lawrence R. Miller stepped down from this role. Mr. Miller continues in his role as the Bank’s president and chief executive officer.
(3)
Includes 401(k) matching contributions, excess premiums for life insurance at two times salary and premiums for long-term and short-term disability insurance policies. All of these benefits are provided to all full-time Bank employees on a non-discriminatory basis.
Employment Agreements
Gordon A. Baird
On March 27, 2013, the Company entered into an employment agreement with Gordon A. Baird under which Mr. Baird agreed to serve as president and chief executive officer of the Company for a term of two years. Mr. Baird’s employment with the Company will be automatically extended for additional terms of one year each unless the Company delivers a notice of termination at least three months prior to the end of the term. Under the agreement, Mr. Baird is entitled to an annual base salary of $360,000 per year, and the board of directors (or an appropriate committee thereof) will review Mr. Baird’s annual base salary at least annually for upward adjustment. He is eligible to receive an annual bonus of up to 200% of his annual base salary, with a target annual bonus of 100% of his annual base salary, if the Bank achieves certain performance levels. He is also eligible to participate in any long-term equity incentive program and is eligible for grants of stock options, restricted stock, or other awards thereunder. As of March 24, 2014, Mr. Baird has been granted options to purchase a total of 1,500,000 shares of common stock. These options were granted in 2012 and 2013, under our 2005 Incentive Plan and were immediately vested. The options have a term of 10 years. Additionally, Mr. Baird participates in the Company’s retirement, welfare, and other benefit programs and is entitled to reimbursement for travel and business expenses.
Mr. Baird’s employment agreement also provides that during his employment and for a period of 12 months following termination, he may not (a) solicit customers of the Bank (other than for any transaction and financial technology services businesses), or (b) solicit employees of the Bank for employment with a competing business. Upon a termination of his employment for any reason, Mr. Baird is not entitled to any severance payments.
Lawrence R. Miller
We entered into an employment agreement with Lawrence R. Miller on December 10, 2008, for an initial one-year term, annually renewing thereafter, pursuant to which he served as the president and the chief executive officer of the Company and the Bank. On December 31, 2012, the Company, the Bank and Mr. Miller entered into an amendment to his employment agreement solely to remove references to his position as the Company’s president and chief executive officer. As of March 24, 2014, Mr. Miller receives an annual salary of $160,600, plus a portion of his yearly medical insurance premium. He is eligible to receive an annual increase in his salary as determined by the board of directors. He is eligible to receive an annual bonus of up to 50% of his annual salary if the Bank achieves certain performance levels to be determined from time to time by the board of directors. He is also eligible to participate in any management incentive program of the Bank or any long-term equity incentive program and is eligible for grants of stock options and other awards thereunder. As of March 24, 2014, Mr. Miller has been granted options to purchase a total of 92,885 shares of common stock. These options were granted in 2005, 2007, 2008 and 2013 under our 2005 Incentive Plan, with each grant vesting over a three-year period beginning on the date of grant. All options have a term of 10 years. Additionally, Mr. Miller participates in the Bank’s retirement, welfare, and other benefit programs and is entitled to a life insurance policy and an accident liability policy and reimbursement for automobile expenses, club dues, and travel and business expenses.
Mr. Miller’s employment agreement also provides that during his employment and for a period of 12 months following termination, he may not (a) compete with the Company, the Bank, or any of its affiliates by, directly or indirectly, forming, serving as an organizer, director or officer of, or consultant to, or acquiring or maintaining more than 1% passive investment in, a depository financial institution or holding company thereof if such depository institution or holding company has one or more offices or branches within a radius of 30 miles from the main office of the Company or any branch office of the Company, (b) solicit customers of the Bank with which he has had material contact for the purpose of providing financial services, or (c) solicit employees of the Bank for employment. If we terminate the employment agreement for Mr. Miller without cause, he will be entitled to severance in an amount equal to his then current monthly base salary multiplied by 12, excluding any bonus. If, following a change in control of the Company, Mr. Miller terminates his employment for good cause as that term is defined in the employment agreement, he will be entitled to severance compensation of his then current monthly salary multiplied by 24, plus accrued bonus, all outstanding options and incentives will vest immediately, and for a period of two years, we would continue his medical, life, disability, and other benefits.
Outstanding Equity Awards at Fiscal Year-End
The following table sets forth information concerning equity awards that were outstanding to our named executive officers at December 31, 2013.
With respect to the 1,125,000 options granted to Mr. Baird on May 16, 2013, 187,500 options were to vest every six months beginning on June 30, 2013, provided that certain regulatory restrictions at the Company were removed. If such restrictions were or are not reserved prior to an applicable vesting date, then no options shall vest on such vesting date. Upon the date that these restrictions are met, all options that would have otherwise vested shall immediately vest. The 375,000 options granted to Mr. Baird on December 31, 2012 were immediately vested on the grant date.
Ten percent of the options granted to each of Ms. Long and Mr. Miller on July 16, 2013 were to immediately vest on the grant date, with the remaining 90% subject to incremental vesting over a 3-year period (30% to vest annually on the first three anniversaries of the grant date); provided, in each case, that the Consent Order with the OCC had been removed. If the Consent Order has not been removed prior to the applicable vesting date, including the grant date, then all options that would have otherwise vested shall vest upon the date that the Consent Order is removed by the OCC.
The options previously granted to Mr. Miller, vested at a rate of 33% each year on the first three anniversaries of the date of grant.
In addition to the awards described in the table above, as an organizer, Lawrence R. Miller received a warrant to purchase one share of common stock at a purchase price of $10.00 per share for every share he purchased, up to a maximum of 25,000 warrants, in our initial public offering as compensation for the risks taken in forming the Bank, including his personal guarantees of the original line of credit. Mr. Miller purchased 12,500 shares in our initial public offering and so received, and continues to hold, 12,500 warrants. The warrants are exercisable until May 16, 2015. These warrants were not granted as compensation for services as an executive officer and so are not deemed to be equity awards for purpose of the Outstanding Equity Awards at Fiscal Year End table.
We anticipate that, if we are successful in raising a material amount of additional capital and growing our business, our compensation structure, as well as our levels of compensation, will materially increase.
Director Compensation
In 2013, we paid Mr. Willumstad an annual retainer of $70,000 as the chairman of the board. No other directors received any form of compensation.
In July 2008, we granted 5,000 stock options to Mr. McLean. These options were granted at an exercise price of $10.00 per share, vested at a rate of 33% each year on the first three anniversaries of the date of grant, and expire on July 22, 2018.
In conjunction with the opening of the Bank in 2005, each director in office at that time, as well as the Bank’s organizer, received a warrant to purchase one share of common stock at a purchase price of $10.00 per share for every share of our common stock purchased by that individual, up to a maximum of 25,000 shares. In total, we granted our initial directors and the Bank’s organizer warrants to purchase 412,500 shares of common stock exercisable until May 16, 2015. At December 31, 2013, 337,500 warrants remained outstanding.
Ultimately, after we raise additional capital, we anticipate that we will begin paying market director fees and that we will grant options or other equity incentives to our directors as compensation for their service on our board of directors.
Potential Payments upon Termination or Change in Control
For information regarding the potential payments that would be due upon Termination or Change in Control, see “Employment Agreements” in this Part III, Item 11 “Executive Compensation” included in this Annual Report on Form 10-K.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.
Equity Based Compensation Plan Information
The following table sets forth equity-based compensation plan information at December 31, 2013:
(3)
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 312,500 of shares issued pursuant to the exercise of such warrants are transferable, subject to compliance with applicable securities laws. If the OCC or other federal or state regulatory authority issues a capital directive or other order requiring the Bank to obtain additional capital, such regulator, or the Company, may require that the warrants be forfeited or immediately exercised.
See Item 8. Financial Statements and Supplementary Data, Note 1, Summary of Significant Accounting Policies, and Note 14, Equity-Based Compensation, for a discussion regarding matters related to our equity-based compensation.
Security Ownership of Certain Beneficial Owners and Management
The following tables set forth information known to the Company with respect to beneficial ownership of the Company’s common stock as of March 27, 2013 for (i) each current director of the Company, (ii) each of the Company’s named executive officers, (iii) each holder of 5.0% or greater of the Company’s common stock, and (iv) all of the Company’s directors and executive officers as a group. Unless otherwise indicated, the mailing address for each beneficial owner is care of Independence Bancshares, Inc., 500 East Washington St., Greenville, South Carolina 29601.
(1)
Includes shares for which the named person has sole voting and investment power, has shared voting and investment power with a spouse, or holds in an IRA or other retirement plan program, unless otherwise indicated in these footnotes.
(2)
Includes shares that may be acquired within 60 days of the date of this proxy statement by exercising vested stock options and warrants but does not include any unvested stock options or warrants.
(3)
For each individual, this percentage is determined by assuming the named person exercises all options and warrants which he or she has the right to acquire within 60 days, but that no other persons exercise any options or warrants. For the directors and executive officers as a group, this percentage is determined by assuming that each director and executive officer exercises all options and warrants which he or she has the right to acquire within 60 days, but that no other persons exercise any options or warrants. The calculations are based on 20,502,760 shares of common stock outstanding on March 27, 2014.
(4)
Consists of 900,000 shares held by Baird Hageman & Co. Series 1, LLC and 172,250 shares individually owned by Gordon A. Baird. Mr. Baird and Alvin G. Hageman are the members of the board of managers of Baird Hageman & Co., LLC and therefore share voting and investment power over the shares. The foregoing is not an admission by Mr. Baird that he is the beneficial owner of the shares held by Baird Hageman & Co., LLC. The address of Baird Hageman & Co., LLC is c/o Baird Hageman & Co., LLC, 33 Christie Hill Road, Darien, CT 06820.
(5)
Consists of 900,000 shares held by Baird Hageman & Co. Series 1, LLC and 490,250 shares individually owned by Alvin G. Hageman. Mr. Hageman and Gordon A. Baird are the members of the board of managers of Baird Hageman & Co., LLC and therefore share voting and investment power over the shares. The foregoing is not an admission by Mr. Hageman that he is the beneficial owner of the shares held by Baird Hageman & Co., LLC. The address of Baird Hageman & Co., LLC is c/o Baird Hageman & Co., LLC, 33 Christie Hill Road, Darien, CT 06820.
Transactions with Related Persons
The Bank has had, and expects to have in the future, loans and other banking transactions in the ordinary course of business with directors (including our independent directors) and executive officers of the Company and its subsidiaries, including members of their families or corporations, partnerships or other organizations in which such officers or directors have a controlling interest. These loans are made on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with unrelated parties. Such loans do not involve more than the normal risks of repayment nor present other unfavorable features.
Loans to individual directors and officers must also comply with our Bank’s lending policies and statutory lending limits, and directors with a personal interest in any loan application are excluded from the consideration of the loan application.
In July 2011, Gordon A. Baird formed MPIB, a Delaware limited liability company for the purpose of developing the business and regulatory plans for a digital transaction services business. On December 31, 2012, Mr. Baird was appointed Chief Executive Officer and director of the Company. The Company is currently negotiating the purchase of MPIB to obtain the exclusive rights in all the property of MPIB. The Company has appointed an independent committee of the board as well as hired a nationally recognized independent audit and valuation firm to support the Company’s negotiation and valuation process. If we are able to negotiate an agreement with MPIB on terms that we find acceptable, we would acquire MPIB or its assets for an upfront fee that would not exceed $7 million and earnout payments that would not exceed 7% of the revenue generated by any digital payments business over a period of not longer than seven years.
Director Independence
We apply the definition of independent director as defined by NASDAQ Rule 5605(a)(2). In accordance with this guidance, all directors of the Company are considered independent with the exception of Gordon A. Baird, the Company’s chief executive officer.
Item 14.
Item 14. Principal Accounting Fees and Services.
Elliott Davis, LLC was our auditor during the fiscal year ended December 31, 2013. A representative of Elliott Davis, LLC will be present at the 2014 annual shareholders’ meeting and will be available to respond to appropriate questions and will have the opportunity to make a statement if he or she desires to do so. The following table shows the fees that we paid for services performed in fiscal years ended December 31, 2013 and 2012:
Audit Fees
This category includes the aggregate fees billed for professional services rendered by the independent auditors during the Company’s 2013 and 2012 fiscal years for the audit of the Company’s consolidated annual financial statements and quarterly reports on Form 10-Q.
Audit-Related Fees
This category includes the aggregate fees billed for non-audit services, exclusive of the fees disclosed relating to audit fees, during the fiscal years ended December 31, 2013 and 2012. These services principally include the assistance for various filings with the SEC and consultations regarding accounting and disclosure matters.
Tax Fees
This category includes the aggregate fees billed for tax services rendered in the preparation of federal and state income tax returns for the Company and its subsidiaries and consultations regarding tax and disclosure matters.
Oversight of Accountants; Pre-Approval of Accounting Fees
Under the provisions of its charter, the audit committee is responsible for the retention, compensation, and oversight of the work of the independent auditors. The charter provides that the audit committee must pre-approve the fees paid for the audit. The audit committee may delegate approval of non-audit services and fees to one or more designated audit committee members. The designated committee member is required to report such pre-approval decisions to the full audit committee at the next scheduled meeting. The policy specifically prohibits certain non-audit services that are prohibited by securities laws from being provided by an independent auditor. All of the accounting services and fees reflected in the table above were reviewed and approved by the audit committee, and none of the services were performed by individuals who were not employees of the independent auditor.
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)(1)
Financial Statements
The following consolidated financial statements are included in Item 8 of this report:
•
Report of Independent Registered Public Accounting Firm
•
Notes to Consolidated Financial Statements
(2)
Financial Statement Schedules
These schedules have been omitted because they are not required, are not applicable or have been included in our consolidated financial statements.
See the “Exhibit Index” immediate following the signature page to this report, which is incorporated by reference herein.
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.
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Gordon A. Baird, 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.
EXHIBIT INDEX
*
Management contract of compensatory plan or arrangement required to be filed as an Exhibit to this Annual Report on Form 10-K.