ITEM 1. BUSINESS.
Company Overview
We are a financial holding company headquartered in Franklin, Tennessee. Through our wholly owned bank subsidiary, Franklin Synergy Bank, a Tennessee-chartered commercial bank and a member of the Federal Reserve System, we provide a full range of banking and related financial services with a focus on service to small businesses, corporate entities, local governments and individuals. We operate through 12 branches in the demographically attractive and growing Williamson and Rutherford Counties within the Nashville metropolitan area. As used in this report, unless the context otherwise indicates, any reference to “Franklin Financial,” “our company,” “the company,” “us,” “we” and “our” refers to Franklin Financial Network, Inc. together with its consolidated subsidiaries (including Franklin Synergy), any reference to “FFN” refers to Franklin Financial Network, Inc. only and any reference to “Franklin Synergy” or the “Bank” refers to our banking subsidiary, Franklin Synergy Bank.
As of December 31, 2015, we had consolidated total assets of $2.2 billion, total loans, including loans held for sale, of $1.3 billion, total deposits of $1.8 billion and total shareholders’ equity of $188.8 million.
Our principal executive office is located at 722 Columbia Avenue, Franklin, Tennessee 37064-2828, and our telephone number is (615) 236-2265. Our website is www.franklinsynergybank.com. The information contained on or accessible from our website does not constitute a part of this report and is not incorporated by reference herein.
Our History and Growth
We were formed as a Tennessee corporation in April 2007 and commenced banking operations through the newly-formed Franklin Synergy Bank in November 2007. Our shareholders are predominantly comprised of individuals, many of whom are customers of the Bank and reside in our target markets.
We were established with the objective of building a locally-managed commercial bank to service the needs of Franklin, Tennessee and the greater Williamson County area. Our mission statement is to build a legacy company by creating shareholder value, cultivating strong customer relationships and fostering an extraordinary team of directors, officers and employees. We were formed by a core management team of veteran bankers based in Middle Tennessee led by our Chairman and Chief Executive Officer, Richard Herrington. Many of our founders built Franklin Financial Corporation (which is not directly affiliated with our company), which was founded in 1988, and grew the newly-formed real estate-oriented bank to nine branches and $785 million in assets as of June 30, 2002, before announcing the sale of the bank to Fifth Third Bancorp in July 2002. Mr. Herrington and certain members of this management team subsequently joined Cumberland Bancorp (later renamed Civitas BankGroup, Inc.), a troubled Tennessee-based bank holding company, in December 2002, to lead its restructuring. The team led a dramatic improvement of Cumberland’s asset quality and profitability, by decreasing nonperforming loans to total loans from 2.25% in 2003 to 0.31% in 2006 and growing net income from $1.1 million in 2003 to $6.7 million in 2006, before it was acquired by Greene County Bancshares, Inc. in May 2007.
MidSouth Acquisition
On July 1, 2014, we completed our acquisition of MidSouth Bank (“MidSouth”) which enabled us to increase our footprint in Middle Tennessee and in the Nashville metropolitan area, specifically in the attractive Rutherford County market. The acquisition also diversified our revenue mix by expanding our retail customer base and increasing our capacity to provide wealth management services, including trust powers which we believe is a competitive advantage to drive new relationships with higher income customers. Headquartered in Murfreesboro, Tennessee and founded in 2004, MidSouth had five branches located throughout Rutherford County, which is adjacent to Williamson County. Although MidSouth operated in close proximity to us, there was no overlap of branch locations and MidSouth’s customer base complemented ours with minimal overlap.
Immediately prior to closing the acquisition, MidSouth had total assets of $281 million, total loans of $199 million, including loans held for sale, and total deposits of $244 million. MidSouth’s loan portfolio, like ours, was primarily comprised of real estate loans. For the six-month period ended June 30, 2014, MidSouth’s balance of nonperforming loans to total loans was 1.34% and net recoveries to average loans, on an annualized basis, was 0.17%.
As a result of the MidSouth acquisition, and as of July 1, 2014, the Company, after giving effect to purchase accounting:
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grew our consolidated total assets from $872 million to $1.17 billion;
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increased our total loans, including loans held for sale, from $502 million to $693 million;
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increased our total deposits from $747 million to $992 million; and
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expanded our employee base from 126 full-time equivalent employees to 227 full-time equivalent employees.
Our Market
We operate 12 branches in Williamson and Rutherford Counties within the Nashville metropolitan area. Our markets are among the most attractive, both in Tennessee, and the Southeast, and compare favorably to some of the more well-known and higher-profile markets in the U.S., although our markets are not dependent on commodity pricing. We believe that our focus on, and success in, growing market share in Williamson and Rutherford Counties will enhance our long-term value and profitability compared to financial institutions of our size in other regions of the country. The markets in which we operate are characterized by strong demographics including high incomes, increasing population, a growing workforce and unemployment that tends to be below the national rate.
Our Business Strategy
We consider ourselves to be bankers, not just lenders. Our core business strategy is to provide our banking customers with a full suite of financial services by cultivating strong long-term customer relationships and by developing an extraordinary team of officers and employees focused on the customer experience. We are focused on providing convenience and personal service to our customers that is superior to that of the out-of-state super-regional and national financial institutions operating in our markets, while simultaneously managing risk and profitability by remaining selective when expanding our customer base and making loans. We also prioritize our client’s financial security and privacy and assist the communities in which we do business through socially responsible leadership. Our unique culture is a cornerstone to our business and has resulted in substantial but stable growth and profitability.
By continuing to offer several value-added products and services within our core areas of strength, such as mortgage lending and wealth management, to invest in technology to improve our systems and the customer experience, and to leverage strong relationships with consumers, professionals, local governments and businesses within our community, we believe we can gain greater market share, which will improve our operational efficiency and increase profitability. As evidence of the success of our strategy, our deposit market share in Williamson County has increased from 3.4% in 2009 to a market-leading approximately 18.2% per the Federal Deposit Insurance Corporation’s (“FDIC’s”) Summary of deposits report as of June 30, 2015, despite the presence of more institutions competing for deposits.
Our Competitive Strengths
We believe that we have a unique operating culture that differentiates us from our competitors and enables us to organically grow our business and enhance shareholder value. This unique operating culture includes:
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a commitment to provide superior and personal service to our customers, both through our employees and via our continued investment in cutting edge technologies in areas of deposit taking, loan origination and risk management;
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a focus on building long-term relationships with our customers; and
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community leadership, as we look to engage with local civic, professional and charitable organizations and exhort our employees to do so as well.
Our culture forms the basis for our competitive strengths, which we believe allow us to leverage our market opportunity and grow our business profitability. In particular, we believe that the following strengths differentiate us from our competitors and provide a strong foundation from which to deliver growth and profitability, all while enhancing shareholder value:
Well Positioned in Attractive Markets
We believe that we are well positioned to grow our business profitably in the demographically attractive and growing markets within the Nashville metropolitan area in which we operate. We believe that our target market segments, small to medium size for profit businesses and the consumer base working or living in and near our geographical footprint, demand the convenience and personal service that a smaller, independent financial institution such as we can offer. We believe the heavy out-of-state banking presence (out-of-state super-regional and national financial institutions control approximately 52.9% of local deposits in the Nashville metropolitan area) provides an opportunity for a strong local bank like us to add greater market share from customers who are looking for more personal banking services and a more customer-friendly experience. Through our efforts to expand our deposit base, we currently have the largest market share of deposits in Williamson County.
Experienced Management Team
We have an experienced management team with a history of working together in our target markets and a track record of delivering growth and shareholder value. Many members of our executive leadership team have been with us since inception and many have worked together at previous banks, including both large financial institutions and community banks. Our Chief Executive Officer, President, Chief Mortgage Officer, Chief Financial Officer, Chief Investment Officer and Chief Credit Officer have worked in our local market for an average of twenty-three years and experienced a variety of economic cycles. This deep local experience has given us the ability to understand and react to market changes and maintain strong profitability and growth without sacrificing asset quality. The MidSouth acquisition has bolstered our team, as several key managers have extensive experience working together in the Rutherford County market with MidSouth and other area banks.
Our management team has a proven track record of delivering shareholder value. Richard Herrington co-founded Franklin Financial Corporation (Franklin National Bank) in 1988, where he and his management team grew assets by a compound annual growth rate (“CAGR”) of 27.5% from 1995 - 2002 and positioned the bank to eventually be sold to Fifth Third, which was announced in 2002 and closed in 2004, for 5.4 times tangible book value. According to SNL Financial, this multiple represents the 9th highest price to book multiple for all bank transactions announced in the past 20 years where deal value was in excess of $50 million. He then served as Chief Executive Officer at Cumberland Bancorp (later renamed Civitas BankGroup, Inc.), where he and his team restructured the bank and significantly bolstered profitability, growing net income by a CAGR of 82% from 2003 - 2006, before selling the bank to Greene County Bancshares in 2007 for 3.0 times tangible book value.
The members of our Board of Directors have diverse industry experiences and have deep and long-term ties to the local community. We believe that we have an ideal blend of directors that have been with our management team at previous banks as well as directors that have joined our Board in recent years.
Local Real Estate Lending Expertise
We are real estate bankers that have focused on Middle Tennessee collateral since 1989. Our in-depth knowledge of the commercial customers, real estate development and credit in Williamson and Rutherford Counties gives us a competitive advantage in loan production, deposit attraction and ancillary revenue generation as we grow
market share. Even when the local loan market gets competitive, we do not compromise on pricing and structuring of loan facilities, as our bankers are able to provide customized solutions delivered with a relatively quick turnaround time, as a result of the fact that our underwriting and banking operations occur locally.
With our firm principles of lending on Middle Tennessee collateral, our local real estate expertise and our localized delivery apparatus, we are poised to capture greater market share in the demographically-attractive and growing Williamson and Rutherford Counties.
Successful Balance of Growth and Profitability
We understand the importance of successfully balancing growth and profitability with asset quality to enhance shareholder value. The following highlights the key aspects of our approach to maintaining this balance:
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Consistent, Strong and Disciplined Growth. Our approach balances both disciplined growth and profitability. Our community-focused business model has resulted in loan growth with a CAGR of 42% from December 31, 2009 to December 31, 2015. The MidSouth acquisition has provided us an immediate presence in the attractive Rutherford County market. Additionally, we have increased focus on small business lending and have grown our C&I loans, which represent approximately 22% of our portfolio at December 31, 2015, by a CAGR of 72% since 2009. We have grown our deposit market share in Williamson County and are now the top local financial institution in the county by deposits with a market share of 18%. Our growth has resulted in improved profitability, as reflected by return on average assets increasing from negative in 2009 to 0.92% for 2015.
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Disciplined Credit Risk Management. Our robust approach to risk management has enabled growth of our loan portfolio without compromising credit. Our credit risk management strategy is based on prudent underwriting criteria and local knowledge. Our lending decisions are centralized and committee-focused, with committees meeting multiple times per week. We are collateral lenders, with strong focus on secondary sources of repayment, especially collateral based in Williamson and Rutherford Counties. As a result of the implementation of our risk management strategy, less than 2% of our current total loans are unsecured.
We believe that by maintaining our consistent origination and underwriting strategy, we will be able to maintain our consistent growth across shifting market environments.
Products and Services
The Bank operates as a full-service financial institution for its customers in its expanded market area with a full line of financial products, including:
Commercial Banking
Traditional commercial banking services are the mainstay of the Bank. The Bank’s focus is to service small to medium-sized businesses and self-employed professionals. Certain not-for-profit and governmental entities also find the Bank’s services attractive.
The Bank’s focus in the commercial banking market is to provide high quality service for its customers supported by the latest bank technology. In the credit service area, the Bank endeavors to give its commercial customers access to a highly-trained team of credit and deposit service specialists who remain with the customer relationship for long periods of time. Credit decision-making is customized to meet the borrower’s financial needs and designed for rapid response. Credit judgments involve the Bank’s senior management and, where legally required, involve the directors of the Bank. Government guaranteed lending services such as the Small Business Administration (“SBA”) may be utilized as needed.
Consumer Banking
The Bank offers a broad range of financial services designed to meet the credit, savings, and transactional needs of local consumers. First mortgage real estate loans, home equity loans, and other personal loans are the focus of consumer lending. Consumer depository and transaction needs are met through dual delivery systems of traditional branches and the Internet, including mobile banking.
Mortgage Loans
Our mortgage loan department originates single-family, fixed rate residential mortgage loans that we sell in the secondary market. Construction loans also are available for residential and commercial purposes.
Deposits
The Bank’s deposit products include demand, interest-bearing transaction accounts, money market accounts, certificates of deposit (“CDs”), municipal deposits, savings, and deposit accounts. CDs offer various maturities ranging from thirty days to five years. The Bank generates relationships by personal contacts within the conventional trading markets for such services by its officers, directors, and employees, who include persons with banking experience in these markets. The Bank also solicits local deposits through the Internet and offers Internet-only deposit accounts to supplement traditional depository accounts. Loan customers are encouraged to bring their deposit business to the Bank, including transaction accounts, CDs, and retirement accounts. This practice further increases the deposit base for the Bank and assists in controlling overall market costs related to deposit acquisition.
Wealth Management/Trust Services
As a result of the MidSouth acquisition, the Bank has increased its capacity to provide wealth management services, including trust services, as the Bank is now authorized to exercise trust powers, which provides the Bank with a competitive advantage. As of December 31, 2015, our wealth management and trust services division managed $210 million in assets.
Other Products and Services
In order to meet all financial needs of the customers, the Bank offers retirement planning, financial planning, investment services and insurance products through its financial services department. Some of these products may be outsourced through relationships with other financial institutions.
Recent Trends
From a financial perspective, management believes the Bank has reached key milestones significantly faster than most banks in the United States during their first eight full years of operation. As of December 31, 2015, the Bank had $1.3 billion in loans, including loans held for sale; assets of $2.2 billion, $1.8 billion in deposits, $188.8 million of shareholders’ equity, and achieved a number one deposit market share in Williamson County based on deposits at June 30, 2015. Challenges and expectations expand as the Bank becomes more mature. On March 26, 2015, we launched an initial public offering for our common stock and began trading on the New York Stock Exchange under the ticker symbol “FSB.” In the offering, we issued 2,640,000 shares of our common stock at a price of $21.00 per share. The initial public offering was completed during March 2015.
Management addresses changes in banking over recent years and embarks on new initiatives as appropriate. In the past, banks needed branches on every corner; today that is considered an outdated way of doing business. Many of the Bank’s customers like to visit with personnel at the Bank, and the Bank will continue to offer a welcoming environment. Other customers prefer to bank online and through mobile channels. The Bank provides a full range of banking products designed to attract all types of customers.
The Bank continues to enhance banking convenience by offering the option of opening accounts online and through mobile channels (savings accounts, checking accounts and CDs). Customers can access banking services at their convenience. The Bank’s remote deposit system allows consumers to deposit checks online without the need to come to a branch. Business customers enjoy this convenience as well.
Local businesses are important to the Bank. The Bank has many products that can help its corporate customers become more profitable, including sweep accounts, credit card processing, remote capture and automated lock box. A unique offering is workplace banking, which allows employers to offer a special banking benefits package to their employees. The Bank also can meet the borrowing needs of businesses through traditional working capital loans, as well as account receivable loans and business expansion loans. One of the Bank’s specialties is customizing services to the unique needs of the business.
Competition
All phases of FFN’s and the Bank’s business are highly competitive. FFN and the Bank are subject to intense competition from various financial institutions and other companies or firms that offer financial services. The Bank competes for deposits with other commercial banks, savings and loan associations, credit unions and issuers of commercial paper and other securities, such as money-market and mutual funds. In making loans, the Bank competes with other commercial banks, savings and loan associations, consumer finance companies, credit unions, leasing companies, and other lenders. Information about specific competition in Williamson County and Rutherford County is included under “RISK FACTORS-Competition For Deposits and Loans is Expected To Be Intense, and No Assurance Can Be Given That We Will Be Successful in Our Efforts to Compete with Other Financial Institutions.”
The banking industry continues to see consolidation, and the Board of Directors believes the trend of having either extremely large regional banks or smaller community banks will continue. The successful implementation of our business plan and the growth of the target market should combine to produce opportunities for FFN and the Bank.
While the direction of recent and proposed federal legislation seems to favor increased competition between banks and different types of financial or other institutions for both deposits and loans, it is not possible to forecast the impact such developments may have on commercial banking in general or as to the Bank or FFN in particular. The Bank will continue to compete with these and other financial institutions, many of which have far greater assets and financial resources than the Bank and whose common stock may be more widely traded than that of FFN. See “BUSINESS-Supervision and Regulation.” No assurance can be given that the Bank will be successful in its efforts to compete with such other institutions.
Enterprise Risk Management
We place significant emphasis on risk mitigation as an integral component of our organizational culture. We believe that our emphasis on risk management is manifested in our solid asset quality statistics and our credit risk management procedures discussed above.
We also focus on risk management in numerous other areas throughout our organization, including with respect to asset/liability management, regulatory compliance and internal controls. We have implemented an extensive asset/liability management process aided by simulation models provided by reputable third parties. We engage in ongoing internal audit and review of all areas of our operations and regulatory compliance.
We have implemented management assessment and testing of internal controls consistent with the Sarbanes-Oxley Act and have engaged an experienced independent public accounting firm to assist us with respect to compliance.
Employees
Management employs officers who have substantial experience and proven records in the banking industry and proven histories in business and commerce, and pays competitive salaries to attract and retain such persons. It is not anticipated that we will experience any substantial difficulty in attracting and retaining the desired caliber of officers and other employees. We offer a typical health and disability insurance plan to our employees and those of our subsidiary, as well as a 401(k) Plan and officer equity-based incentive awards.
FFN currently has eight directors and the Bank currently has 11 directors, and, as of December 31, 2015, we and our subsidiary had 224 full-time employees and 2 part-time employees. We consider our relationship with our employees to be excellent. Furthermore, we are not subject to any collective bargaining agreements.
Trademarks
We obtained registrations with the United States Patent and Trademark Office for the protection of the trademarks “FRANKLIN SYNERGY BANK®” and “FRANKLIN FINANCIAL NETWORK®.” Management does not believe these trademarks are confusingly similar to trademarks used by other institutions in the financial services business and intends to protect the use of these trademarks nationwide.
Policies and Procedures
The Board of Directors of the Bank has established a statement of lending policies and procedures being used by loan officers of the Bank when making loans. Asset quality is of utmost importance and an independent loan review process has been established to monitor the Bank’s lending function. It is imperative that the Board of Directors and management have an independent and objective evaluation of the quality of specific individual loans and of the overall quality of the total portfolio.
The Board of Directors of the Bank also has established an investment policy that guides the Bank officers in determining the investment portfolio of the Bank. Other policies include a code of ethics policy, audit policy, loan policy, fair lending, compliance, bank secrecy, personnel and information system policies.
Under the Community Reinvestment Act of 1977 (the “CRA”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) evaluates the Bank’s record of helping to meet the credit needs of its community consistent with safe and sound operations. The Federal Reserve also takes this record into account when deciding on certain applications submitted by the Bank. The Bank’s assessment area is Williamson County, Rutherford County and Davidson County for business loans, mortgage, and general financial services.
The Bank is a fair and equal credit lender. Management’s lending objectives are to make credit products available to all segments of the Bank’s market and community. Williamson County has one moderate census tract, Davidson County has thirty-eight moderate income census tracts and twenty-nine low income tracts, and Rutherford County has seven moderate census tract and two low census tracts. Products are being developed and marketed to individuals and businesses located in those census tracts.
Supervision and Regulation
The following summaries of statutes and regulations affecting banks and their holding companies do not purport to be complete. Such summaries are qualified in their entirety by reference to the statutes and regulations described.
Bank Holding Company Regulation
FFN is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Holding Company Act”), and is registered with the Federal Reserve. Banking subsidiaries of bank holding companies are subject to restrictions under federal law, which limit the transfer of funds by the subsidiary banks to their respective holding companies and non-banking subsidiaries, whether in the form of loans, extensions of credit, investments or asset purchases. Under Section 23A of the Federal Reserve Act, such transfers by any subsidiary bank to its holding company or any nonbanking subsidiary are limited in amount to 10% of the subsidiary bank’s capital and surplus and, with respect to FFN and all such non-banking subsidiaries, to an aggregate of 20% of such bank’s capital and surplus. Also, banking subsidiaries of bank holding companies are also subject to the provisions of Section 23B of the Federal Reserve Act, which, among other things, prohibits an institution from engaging in certain transactions with certain affiliates unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies. Furthermore, such loans and extensions of credit are required to be secured in specified amounts. The Holding Company Act also prohibits, subject to certain exceptions, a bank holding company from engaging in or acquiring direct or indirect control of more than 5% of the voting stock of any company engaged in non-banking activities. An exception to this prohibition is for activities expressly found by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be a proper incident thereto, such as consumer lending and other activities that have been approved by the Federal Reserve by regulation or order. Certain servicing activities are also permissible for a bank holding company if conducted for or on behalf of the bank holding company or any of its affiliates. FFN has elected to be a financial holding company under Regulation Y, allowing FFN to engage in certain financial activities without the prior approval of the Federal Reserve.
As a holding company, FFN is required to file with the Federal Reserve semi-annual reports and such additional information as the Federal Reserve may require. The Federal Reserve may also make examinations of FFN and its non-bank affiliates.
According to federal law and Federal Reserve policy, holding companies are expected to act as a source of financial and managerial strength to each of its subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a holding company may not be able to provide such support. Furthermore, in the event of a loss suffered or anticipated by the FDIC-either as a result of default of a banking or thrift subsidiary of FFN or related to FDIC assistance provided to a subsidiary in danger of default-the other banking subsidiaries of FFN may be assessed for the FDIC’s loss, subject to certain exceptions.
Regulation Y generally requires persons acting directly or indirectly or in concert with one or more persons to give the Federal Reserve 60 days advanced written notice before acquiring control of a holding company. Under the regulation, control is defined as the ownership or control with the power to vote 25% or more of any class of voting securities of the holding company. The regulation also provides for a presumption of control if a person owns, controls, or holds with the power to vote 10% or more (but less than 25%) of any class of voting securities. A bank holding company may be limited to ownership of 5% ownership of voting securities. If the person or persons making the acquisition is a company, prior approval from the Federal Reserve may be required.
Various federal and state statutory provisions limit the amount of dividends subsidiary banks can pay to their holding companies without regulatory approval. The payment of dividends by any bank also may be affected by other factors, such as the maintenance of adequate capital for such subsidiary bank. In addition to the foregoing restrictions, the Federal Reserve has the power to prohibit dividends by holding companies if their actions constitute unsafe or unsound practices. The Federal Reserve has issued a policy statement on the payment of cash dividends by holding companies, which expresses the Federal Reserve’s view that a holding company experiencing earnings weaknesses should not pay cash dividends that exceed its net income or that could only be funded in ways that weaken the holding company’s financial health, such as by borrowing. The Federal Reserve may also order a bank holding company to terminate an activity or control of a non-bank subsidiary if such activity or control constitutes a significant risk to the financial safety, soundness, or stability of a subsidiary bank and is inconsistent with sound banking principles. Furthermore, the TDFI also has authority to prohibit the payment of dividends by a Tennessee bank when it determines such payment to be an unsafe and unsound banking practice.
A holding company and its subsidiaries are also prohibited from acquiring any voting shares of, or interest in, any banks located outside of the state in which the operations of the holding company’s subsidiaries are located, unless the holding company and its subsidiaries are well-capitalized and well managed.
In approving acquisitions by holding companies of banks and companies engaged in the banking-related activities described above, the Federal Reserve considers a number of factors, including the expected benefits to the public such as greater convenience, increased competition, or gains in efficiency, as weighed against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. The Federal Reserve is also empowered to differentiate between new activities and activities commenced through the acquisition of a going concern.
The Attorney General of the United States may, within 30 days after approval by the Federal Reserve of an acquisition, bring an action challenging such acquisition under the federal antitrust laws, in which case the effectiveness of such approval is stayed pending a final ruling by the courts. Failure of the Attorney General to challenge an acquisition does not, however, exempt the holding company from complying with both state and federal antitrust laws after the acquisition is consummated or immunize the acquisition from future challenge under the anti-monopolization provisions of the Sherman Act.
Capital Guidelines
The Federal Reserve has issued risk-based capital guidelines for bank holding companies and member banks. Under the guidelines, the minimum ratio of capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. To be considered a “well capitalized” bank or bank holding company under the guidelines, a bank or bank holding company must have a total risk-based capital ratio of 10% or greater. At least half of the total capital is to be comprised of common equity, retained earnings, and a limited amount of perpetual preferred stock, after subtracting goodwill and certain other adjustments (“Tier I capital”). The remainder may consist of perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock not qualifying for Tier I capital, and a limited amount of loan loss reserves (“Tier II capital”). The Bank is subject to similar capital requirements adopted by the Federal Reserve. In addition, the Federal Reserve and the FDIC have adopted a minimum leverage ratio (Tier I capital to total assets) of 3% or 4% based on supervisory considerations. Generally, banking organizations are expected to operate well above the minimum required capital level of 3% unless they meet certain specified criteria, including that they have the highest regulatory ratings. Most banking organizations are required to maintain a leverage ratio of 3% or 4%, as applicable, plus an additional cushion of at least 1% to 2%. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance upon intangible assets.
In July 2013, the federal banking regulators, in response to the statutory requirements of Dodd-Frank, adopted regulations implementing the Basel Capital Adequacy Accord (“Basel III”), which had been approved by the Basel member central bank governors in 2010 as an agreement among the countries’ central banks and bank regulators on the amount of capital banks must hold as a cushion against losses and insolvency. The new minimum capital to risk-weighted assets (“RWA”) requirements are a common equity Tier 1 capital ratio of 4.5% and a Tier 1 capital ratio of 6.0%, and a total capital ratio of 8.0%. The minimum leverage ratio (Tier 1 capital to total assets) is 4.0%. The new rule also changes the definition of capital, mainly by adopting stricter eligibility criteria for regulatory capital instruments, and new constraints on the inclusion of minority interests, mortgage-servicing assets, deferred tax assets, and certain investments in the capital of unconsolidated financial institutions. In addition, the new rule requires that most regulatory capital deductions be made from common equity tier 1 capital.
Under the Basel III, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to RWA. Phase-in of the capital conservation buffer requirements will begin on January 1, 2016 and the requirements will be fully phased in on January 1, 2019. A banking organization with a buffer greater than 2.5% once the capital conservation buffer is fully phased in would not be subject to limits on capital distributions or discretionary bonus payments; however, a banking organization with a buffer of less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The new rule also prohibits a banking organization from making distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. Effectively, the Basel III framework will require us to meet minimum capital ratios of (i) 7% for common equity Tier 1 capital, (ii) 8.5% Tier 1 capital, and (iii) 10.5% total capital. The eligible retained income of a banking organization is defined as its net income for the four calendar quarters preceding the current calendar quarter, based on the organization’s quarterly regulatory reports, net of any distributions and associated tax effects not already reflected in net income. When the new rule is fully phased in, the minimum capital requirements plus the capital conservation buffer will exceed the prompt corrective action (“PCA”) well-capitalized thresholds.
Under the new rule, mortgage-servicing assets and deferred tax assets are subject to stricter limitations than those applicable under the current general risk-based capital rule. More specifically, certain deferred tax assets arising from temporary differences, mortgage-servicing assets, and significant investments in the capital of unconsolidated financial institutions in the form of common stock are each subject to an individual limit of 10% of common equity tier 1 capital elements and are subject to an aggregate limit of 15% of common equity tier 1 capital elements. The amount of these items in excess of the 10% and 15% thresholds are to be deducted from common equity tier 1 capital. Amounts of mortgage-servicing assets, deferred tax assets, and significant investments in unconsolidated financial institutions that are not deducted due to the aforementioned 10% and 15% thresholds must be assigned a 250% risk weight. Finally, the new rule increases the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.
The new minimum capital requirements of Basel III are effective on January 1, 2015, whereas the capital conservation buffer and the deductions from common equity tier 1 capital phase in over time. Similarly, nonqualifying capital instruments phase out over time, except as described above.
Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits, and other restrictions on its business.
Tennessee Banking Act; Federal Deposit Insurance Act
The Bank is incorporated under the banking laws of the State of Tennessee and, as such, is subject to the applicable provisions of those laws. The Bank is subject to the supervision of the TDFI and to regular examination by that department. The Bank is a member of the Federal Reserve and therefore is subject to Federal Reserve regulations and policies and is subject to regular exam by the Federal Reserve. The Bank’s deposits are insured by the FDIC through DIF, and the Bank is, therefore, subject to the provisions of the Federal Deposit Insurance Act (“FDIA”).
The FDIC has adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. Under the Dodd-Frank Act, the FDIC was required to adopt regulations that would base deposit insurance assessments on total assets less capital rather than deposit liabilities and to include off-balance sheet liabilities of institutions and their affiliates in risk-based assessments. EESA (as defined below) provided for a temporary increase in the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. This increased level of basic deposit insurance was made permanent by the Dodd-Frank Act. The Dodd-Frank Act also repealed the prohibition on paying interest on demand transaction accounts, but did not extend unlimited insurance protection for these accounts.
The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Tennessee statutes and the federal law regulate a variety of the banking activities of the Bank, including required reserves, investments, loans, mergers and consolidations, issuances of securities, payments of dividends, and the establishment of branches. There are certain limitations under federal and Tennessee law on the payment of dividends by banks. A state bank, with the approval of the TDFI, may transfer funds from its surplus account to the undivided profits (retained earnings) account or any part of its paid-in-capital account. The payment of dividends by any bank is dependent upon its earnings and financial condition and, in addition to the limitations referred to above, is subject to the statutory power of certain federal and state regulatory agencies to act to prevent what they deem unsafe or unsound banking practices. The payment of dividends could, depending upon the financial condition of the Bank, be deemed to constitute such an unsafe or unsound practice. Also, without regulatory approval, a dividend only can be paid to the extent of the net income of the bank for that year plus the net income of the prior two years. The FDIA prohibits a state bank, the deposits of which are insured by the FDIC, from paying dividends if it is in default in the payment of any assessments due the FDIC.
State banks also are subject to regulation respecting the maintenance of certain minimum capital levels (see above), and the Bank is required to file annual reports and such additional information as the Tennessee Banking Act and Federal Reserve regulations require. The Bank also is subject to certain restrictions on loan amounts, interest rates, “insider” loans to officers, directors and principal shareholders, tie-in arrangements, privacy, transactions with affiliates, and many other matters. Strict compliance at all times with state and federal banking laws is required.
Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the types of investments which may be made. The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices. All Tennessee banks must become and remain insured banks under the FDIA. (See 12 U.S.C. § 1811, et seq.).
Under Tennessee law, state banks are prohibited from lending to any one person, firm, or corporation amounts more than 15% of its equity capital accounts, except (i) in the case of certain loans secured by negotiable title documents covering readily marketable nonperishable staples or (ii) the Bank may make a loan to one person, firm or corporation of up to 25% of its equity capital accounts with the prior written approval of the Bank’s Board of Directors or finance committee (however titled).
The TDFI and the Federal Reserve will examine the Bank periodically for compliance with various regulatory requirements. Such examinations, however, are for the protection of the DIF and for depositors and not for the protection of investors and shareholders.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)
The FDICIA substantially revised the depository institution regulatory and funding provisions of the FDIA, and made revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take “prompt corrective action” in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” Under applicable regulations, a FDIC-insured depository institution is defined to be well capitalized if it maintains a Leverage Ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and is not subject to a directive, order or written agreement to meet and maintain specific capital levels. An insured depository institution is defined to be adequately capitalized if it meets all of its minimum capital requirements as described above in the first paragraph of the section entitled “Capital Guidelines.” In addition, an insured depository institution is considered undercapitalized if it fails to meet any minimum required measure; significantly undercapitalized if it has a total risk-based capital ratio of less than 6%, a tier 1 risked-based capital ratio less than 3% or a leverage ratio less than 3%; and critically undercapitalized if it fails to maintain a level of tangible equity equal to not less than 2% of total assets. An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating.
FDICIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution’s holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator generally within 90 days of the date on which they became critically undercapitalized.
The capital-based prompt corrective action provision of FDICIA and their implementing regulations apply to FDIC-insured depository institutions and are not directly applicable to the holding companies which control those institutions. However, the Federal Reserve has indicated that, in regulating bank holding companies, it will take appropriate action at the holding company level based on an assessment of the effectiveness of supervisory actions imposed upon subsidiary depository institutions pursuant to these provisions and regulations.
The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits and pass-through insurance. Under the regulations, a bank cannot accept or rollover or renew brokered deposits unless it is well capitalized or it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer “pass-through” insurance on certain employee benefit accounts. Whether or not it has obtained this waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain index prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized.
FDICIA contains numerous other provisions, including accounting, audit and reporting requirements, limitations on the FDIC’s payment of deposits at foreign branches, new regulatory standards in such areas as asset quality, earnings and compensation and revised regulatory standards for, among other things, powers of state banks, real estate lending and capital adequacy. FDICIA also requires that a depository institution provide 90 days prior notice of the closing of any branches.
The Dodd-Frank Act
In July 2010, the Dodd-Frank Act was signed into law, incorporating numerous financial institution regulatory reforms. Many of these reforms were implemented over the course of 2011-13 and continue to be implemented through regulations being adopted by various federal banking and securities regulations. The following discussion describes the material elements of the regulatory framework. Many of the Dodd-Frank Act provisions are stated to only apply to larger financial institutions and do not directly impact community-based institutions like the Bank. For instance, provisions that regulate derivative transactions and limit derivatives trading activity of federally-insured institutions, enhance supervision of “systemically significant” institutions, impose new regulatory authority over hedge funds, limit proprietary trading by banks, and phase-out the eligibility of trust preferred securities for Tier 1 capital are among the provisions that do not directly impact the Bank either because of exemptions for institutions below a certain asset size or because of the nature of the Bank’s operations. Other provisions that will impact the Bank will:
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Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling and increase the size of the floor of the DIF, and offset the impact of the increase in the minimum floor on institutions with less than $10 billion in assets.
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Make permanent the $250,000 limit for federal deposit insurance.
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Repeal the federal prohibition on payment of interest on demand deposits, thereby permitting depositing institutions to pay interest on business transaction and other accounts.
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Centralize responsibility for consumer financial protection by creating the Consumer Financial Protection Bureau (the “CFPB”), responsible for implementing federal consumer protection laws, although banks below $10 billion in assets will continue to be examined and supervised for compliance with these laws by their federal bank regulator.
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Restrict the preemption of state law by federal law and disallow national bank subsidiaries from availing themselves of such preemption.
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Impose new requirements for mortgage lending, including new minimum underwriting standards, prohibitions on certain yield-spread compensation to mortgage originators, special consumer protections for mortgage loans that do not meet certain provision qualifications, prohibitions and limitations on certain mortgage terms and various new mandated disclosures to mortgage borrowers.
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Apply the same leverage and risk based capital requirements that apply to insured depository institutions to holding companies.
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Permit national and state banks to establish de novo interstate branches at any location where a bank based in that state could establish a branch, and require that bank holding companies and banks be well-capitalized and well managed in order to acquire banks located outside their home state.
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Impose new limits on affiliated transactions and cause derivative transactions to be subject to lending limits.
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Implement corporate governance revisions, including with regard to executive compensation and proxy access to shareholders that apply to all public companies not just financial institutions.
Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, and their impact on the Bank or the financial industry is difficult to predict before such regulations are adopted. However, there is a significant possibility that the Dodd-Frank Act will, in the long run, increase regulatory burden, compliance costs, and interest expense for community banks.
Gramm-Leach-Bliley Act
The Gramm-Leach-Bliley Act ratified new powers for banks and bank holding companies, especially in the areas of securities and insurance. This law also includes requirements regarding the privacy and protection of customer information held by financial institutions, as well as many other providers of financial services. There are provisions providing for functional regulation of the various services provided by institutions among different regulators. There are other provisions which limit the future expansion of unitary thrift holding companies which now prevent companies like Wal-Mart from owning a thrift institution. Finally, among many other sections of this law, there is some relief for small banks from the regulatory burden of the CRA.
USA PATRIOT Act, International Money Laundering Abatement and Financial Anti-Terrorism Act, and Bank Secrecy Act
The Patriot Act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”). The IMLAFA substantially broadens existing anti-money laundering legislation, specifically related to the BSA, and the extraterritorial jurisdiction of the United States, imposes new compliance and due diligence obligations, creates new crimes and penalties, compels the production of documents located both inside and outside the United States, including those of foreign institutions that have a correspondent relationship in the United States, and clarifies the safe harbor from civil liability to customers. The U.S. Treasury Department has issued a number of regulations implementing the Patriot Act that apply certain of its requirements to financial institutions such as FFN’s banking and broker-dealer subsidiaries. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. The Treasury Department expects to issue a number of additional regulations which will further clarify the Patriot Act’s requirements.
The IMLAFA requires all “financial institutions,” as defined, to establish anti-money laundering compliance and due diligence programs. Such programs must include, among other things, adequate policies, the designation of a compliance officer, employee training programs, and an independent audit function to review and test the program.
The Housing and Economic Recovery Act of 2008 (the “Housing Act”)
The Housing Act contained three distinct divisions: Division A, which addressed housing finance reform and provided for the rescue of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”); Division B, which provided for foreclosure prevention; and Division C, which contained tax incentives, reforms and revenue offsets. The Housing Act was intended to help stabilize the nation’s housing markets and provide relief for homeowners. The legislation offered emergency financing to Fannie Mae and Freddie Mac, set up a $300-billion fund for the Federal Housing Administration (the “FHA”) to insure new 30-year fixed-rate mortgages for at-risk borrowers in owner-occupied homes if their lenders agree to write down loan balances to 90% of the homes’ current appraised value, and restored banks’ authority to make investments designed primarily to promote the public welfare through the provision of housing, services, or jobs, including distressed middle-income communities. To free up safer and more affordable mortgage credit, the Housing Act permanently increased to $625,500 (from $417,000) the size of home loans that Fannie Mae and Freddie Mac can buy and the FHA can insure. They also could buy and back mortgages 15% higher than the median home price in certain areas. The measure included $15 billion in tax cuts, including a significant expansion of the low-income housing tax credit and a credit of up to $7,500 for first-time home buyers for houses purchased between April 9, 2008, and July 1, 2009. Provisions of this law were updated by later legislation.
Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009
The Emergency Economic Stabilization Act of 2008 (“EESA”) provided authority to the Treasury Secretary to restore liquidity and stability to the U.S. financial system and to ensure the economic well-being of Americans. EESA authorized the Secretary to establish a Troubled Asset Relief Program (“TARP”) to purchase troubled assets from financial institutions and establish an Office of Financial Stability within the Treasury Department to implement the TARP. EESA required the Treasury Secretary to establish guidelines and policies to carry out the purposes of EESA, including a program to guarantee troubled assets of financial institutions and the establishment of risk-based premiums for such guarantees sufficient to cover anticipated claims.
EESA required federal entities to work with servicers to encourage loan modifications, considering net present value to the taxpayer. For mortgages and mortgage-backed securities acquired through TARP, the Secretary was required to implement a plan to mitigate foreclosures and to encourage servicers of mortgages to modify loans through Hope for Homeowners and other programs. The Secretary was authorized to loan guarantees and credit enhancement to avoid foreclosures. The Secretary was required to coordinate with other federal entities that hold troubled assets in order to identify opportunities to modify loans, considering net present value to the taxpayer.
Other provisions of EESA increased FDIC insurance from $100,000 to $250,000 on deposits, protected the Exchange Stabilization Fund (the “ESF”) from incurring any losses due to the temporary money market mutual fund guarantee by requiring the program created in the EESA to reimburse the ESF, restated the SEC’s authority to suspend the application of Statement Number 157 of the Financial Accounting Standards Board (mark to market) if the SEC determines that it is in the public interest and protects investors, changed the tax treatment of losses on the preferred stock of certain government sponsored entities, such as Freddie Mac and Fannie Mae, for financial institutions, applied limits on executive compensation and golden parachutes for certain executives of employers who participate in the auction program, and extended current law tax forgiveness on the cancellation of mortgage debt.
The American Recovery and Reinvestment Act of 2009 (“ARRA”) amended the EESA and was intended to provide a stimulus to the U.S. economy in the wake of the economic downturn. ARRA includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, health care, and infrastructure, including the energy sector. ARRA also included numerous non-economic recovery related items that were either part of longer-term plans (e.g., a study of the effectiveness of medical treatments) or desired by Congress (e.g., a limitation on executive compensation in federally-aided banks).
Small Business Jobs and Credit Act of 2010
In July 2010, the U.S. Congress passed the Small Business Jobs and Credit Act of 2010, which includes as a part thereof, the establishment of a $30 billion Small Business Lending Fund (“SBLF”) program. The SBLF is a fund created by Congress to be used by the Treasury to make preferred stock investments in banks and bank holding companies that are not on the FDIC’s troubled bank list to stimulate small business lending. Eligible banks and holding companies with less than $10 billion in assets can receive an investment totaling up to 3% of the institution’s risk-weighted assets. The size of the investment can be increased to 5% of risk-weighted assets for institutions under $1 billion in total assets. The Treasury’s guidelines related to the SBLF permit participants in the Capital Purchase Program (“CPP”) to refinance securities issued to the Treasury under the CPP. However, CPP investments would be required to be paid in full since simultaneous participation in the CPP and the SBLF is not permissible. Dividends will be payable quarterly on the preferred stock issued to the Treasury under the SBLF, but unlike dividends owed on preferred stock issued to the Treasury under the CPP, dividends payable on the preferred stock issued under the SBLF will be non-cumulative, meaning that the issuer can miss a regular dividend payment and not have to subsequently make the payment before it pays the next quarterly dividend. Accordingly, the preferred stock issued under the SBLF will qualify for Tier 1 capital treatment under the more stringent capital standards imposed under the Dodd-Frank Act. Although dividends on the preferred stock are non-cumulative, the failure to pay dividends causes certain consequences including prohibitions on repurchasing shares of the issuer’s stock or paying dividends on shares of the issuer’s stock that are pari passu or junior to the shares issued to the Treasury under the SBLF.
The initial dividend rate on the preferred stock issued under the SBLF program will be at most 5.0% but is subject to a reduction to as low as 1.0% during a participant’s first years after the investment depending on the amount of increase in the institution’s small business lending following its issuance of the preferred stock to the Treasury. After the initial four-and-a half year period the rate will increase to 9.0%. Under the SBLF, small business lending means lending as defined by and reported in an eligible institutions’ quarterly call report, where each loan comprising such lending is one of the following types: (i) C&I loans; (ii) owner-occupied nonfarm, nonresidential real estate loans; (iii) loans to finance agricultural production and other loans to farmers; and (iv) loans secured by farmland. Loans greater than $10 million or to businesses with more than $50 million in revenue are excluded. If any part of the loan is guaranteed by a U.S. government agency or enterprise, the guaranteed portion is subtracted from the loan amounts.
The JOBS Act
The JOBS Act increased the threshold under which a bank or bank holding company may terminate registration of a security under the Exchange Act to 1,200 shareholders of record from 300. The JOBS Act also raised the threshold requiring banks and bank holding companies to register to 2,000 shareholders from 500. Since the JOBS Act was signed, numerous banks or bank holding companies have filed to deregister their common stock.
FDIC Insurance Premiums
The Bank is required to pay quarterly FDIC deposit insurance assessments to the DIF. The FDIC merged the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”) to form the DIF on March 31, 2006, in accordance with the Federal Deposit Insurance Reform Act of 2005. The FDIC maintains the DIF by assessing depository institutions an insurance premium. The amount each institution is assessed is based upon statutory factors that include the balance of insured deposits as well as the degree of risk the institution poses to the insurance fund. The FDIC uses a risk-based premium system that assesses higher rates on those institutions that pose greater risks to the DIF.
Effective April 1, 2009, the FDIC revised its risk-based assessment system to adjust the risk-based calculation of an institution’s unsecured debt, secured liabilities and brokered deposits. On November 12, 2009, the FDIC announced a final rule to increase by 3 basis points the deposit assessment base rate, beginning January 1, 2011. Additional increases in premiums will impact FFN’s earnings adversely. Depending on any future losses that the FDIC insurance fund may suffer due to failed institutions, there can be no assurance that there will not be additional significant premium increases in order to replenish the fund.
Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by a federal bank regulatory agency.
Privacy
Under the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records, financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing personal financial information with nonaffiliated third parties except for third parties that market the institutions’ own products and services. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing through electronic mail to consumers.
The CRA
The CRA requires that, in connection with examinations of financial institutions within its jurisdiction, the FDIC and the state banking regulators, as applicable, evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate-income neighborhoods. These facts are also
considered in evaluating mergers, acquisitions and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on us. Additionally, we must publicly disclose the terms of various CRA-related agreements.
Other Regulations
Interest and other charges that our subsidiary bank collects or contracts for are subject to state usury laws and federal laws concerning interest rates. Our bank’s loan operations are also subject to federal laws applicable to credit transactions, such as:
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The federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
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The Home Mortgage Disclosure Act, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
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The Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
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The Fair Credit Reporting Act, governing the use and provision of information to credit reporting agencies;
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The Fair Debt Collection Practices Act, governing the manner in which consumer debts may be collected by collection agencies; and
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The rules and regulations of the various governmental agencies charge with the responsibility of implementing these federal laws.
In addition, our bank subsidiary’s deposit operations are subject to the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement this act, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.
Effects of Governmental Policies
The Bank’s earnings are affected by the difference between the interest earned by the Bank on its loans and investments and the interest paid by the Bank on its deposits or other borrowings. The yields on its assets and the rates paid on its liabilities are sensitive to changes in prevailing market rates of interest. Thus, the earnings and growth of the Bank are influenced by general economic conditions, fiscal policies of the federal government, and the policies of regulatory agencies, particularly the Federal Reserve, which establishes national monetary policy. The nature and impact of any future changes in fiscal or monetary policies cannot be predicted.
Commercial banks are affected by the credit policy of various regulatory authorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. Government securities, changes in reserve requirements on bank deposits, changes in the discount rate on bank borrowings and limitations on interest rates that banks may pay on time and savings deposits. The Federal Reserve uses these means in varying combinations to influence overall growth of bank loans, investments and deposits, and also to affect interest rates charged on loans, received on investments or paid for deposits.
The monetary and fiscal policies of regulatory authorities, including the Federal Reserve, also affect the banking industry. Through changes in the reserve requirements against bank deposits, open market operations in U.S. Government securities and changes in the discount rate on bank borrowings, the Federal Reserve influences the cost and availability of funds obtained for lending and investing. No prediction can be made with respect to possible future changes in interest rates, deposit levels or loan demand or with respect to the impact of such changes on the business and earnings of the Bank.
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial institutions. With the enactments of EESA, AARA, and the Dodd-Frank Act and the significant amount of regulations that are to come from the passage of this legislation, the nature and extent of the future legislative and regulatory changes affecting financial institutions and the resulting impact on those institutions is very unpredictable at this time. Bills are currently pending which may have the effect of changing the way the Bank conducts its business.
Recent Developments
Civic Acquisition
On December 14, 2015, FFN and the Bank entered into an Agreement and Plan of Reorganization and Bank Merger (the “Merger Agreement”) with Civic Bank & Trust (“Civic”), a Tennessee banking corporation. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Civic will merge with and into the Bank, with the Bank as the surviving entity and wholly owned subsidiary of FFN (the “Civic Merger”).
Pursuant to the terms and subject to the conditions of the Merger Agreement, the shares of common stock and options to purchase shares of common stock of Civic shall be converted into shares of common stock or options to purchase shares of common stock of FFN, as applicable (the “Merger Consideration”), based upon an exchange ratio calculated by dividing the Merger Consideration by the market value per share of FFN’s common stock as follows: (1) all outstanding shares of common stock of Civic shall be exchanged for that number of shares of common stock of FFN with an aggregate value of $28,625,000, whereby the market value per share of common stock of FFN shall be equal to the volume weighted average closing price of common stock of FFN for the 20 consecutive trading days ending on and including the tenth trading day preceding the Effective Time (as defined in the Merger Agreement); and (2) each option to purchase a share of common stock of Civic shall be converted into an option to purchase a share of common stock of FFN multiplied by the Exchange Ratio (as defined in the Merger Agreement), and the exercise price will become the exercise price of such option divided by the Exchange Ratio. The above notwithstanding, the market value per share of common stock of FFN used to determine the Exchange Ratio shall be no more than $29.50 per share, and no less than $26.50 per share.
The Merger Agreement contains various representations and warranties from each of FFN, the Bank and Civic, and each have agreed to various covenants, including, among others, covenants relating to (1) the conduct of Civic’s business during the interim period between the execution of the Merger Agreement and the completion of the Civic Merger; and (2) Civic’s obligation to obtain any consents, approvals, permits, or authorizations which are required to be obtained, in order to complete the Civic Merger under any applicable federal or state laws or regulations. From the date of the Merger Agreement until the earlier of the termination of the Merger Agreement or the Effective Time, Civic has also agreed not to, subject to certain exceptions: (1) solicit, initiate or encourage any proposals relating to any alternative acquisition proposals; (2) participate in any discussions or negotiations regarding any alternative acquisition proposals; or (3) make or authorize any statement, recommendation or solicitation in support of any alternative acquisition proposals.
Completion of the Civic Merger is subject to certain various conditions, including, among others: (1) approval of the Merger Agreement by Civic’s shareholders; (2) receipt of required regulatory approvals without the imposition of conditions or consequences that would materially impair FFN’s or its subsidiaries’ conduct of their business after the Effective Time of the Civic Merger; and (3) the absence of any law or order prohibiting the completion of the Civic Merger. Each party’s obligation to complete the Civic Merger is also subject to certain additional conditions, including: (1) subject to certain exceptions, the accuracy of the representations and warranties of the other party; (2) performance in all material respects by the other party of its obligations under the Merger Agreement; and (3) the effectiveness of the registration statement on Form S-4 filed with the SEC in connection with the issuance of shares of FFN’s common stock to Civic’s shareholders. FFN is not required to consummate the Civic Merger if Civic’s shareholders holding more than 10.0% of its outstanding common stock exercise dissenter’s rights (and do not withdraw or otherwise forfeit such rights).
The Merger Agreement contains certain termination rights for FFN, the Bank and Civic, as the case may be, applicable upon: (1) mutual agreement of the boards of directors of FFN, the Bank and Civic; (2) failure to
obtain regulatory approval, or any other event or condition rendering performance of the Civic Merger impossible, which arises or exists without the fault of any party; (3) a material breach by the other party that has not or cannot be promptly cured or has not been waived after notice thereof, subject to certain exceptions; (4) failure to consummate the Civic Merger on or before June 30, 2016; or (5) Civic’s recommendation, endorsement, acceptance or agreement to a superior acquisition proposal with any person other than FFN or the Bank. In addition, the Merger Agreement provides that, upon termination of the Merger Agreement in certain circumstances, Civic may be required to pay us a termination fee of $1,250,000.
On February 12, 2016, FFN filed a registration statement on Form S-4 (the “Civic Registration Statement”) with the SEC for the issuance of shares of FFN’s common stock to Civic’s shareholders upon the closing of the Civic Merger. The SEC has not yet declared the Civic Registration Statement effective.
New Offices and Branches
On January 14, 2016, the Bank opened a branch in Nolensville, Tennessee in Williamson County, located at 7177 Nolensville Pike, Suite A-3, Nolensville, Tennessee 37135. In addition, on February 15, 2016, the Bank opened a loan production office at 3325 West End Avenue, Nashville, Tennessee 37203.
Available Information
Our website is located at www.franklinsynergybank.com. We make available free of charge through this website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Reference to our website does not constitute incorporation by reference of the information contained on the site and should not be considered part of this document.
All filings made by us with the SEC may be copied or read at the SEC’s Public Reference Room at 100 F Street NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC as we do. The website is http://www.sec.gov.
ITEM 1A.
ITEM 1A. RISK FACTORS.
Our business and its future performance may be affected by various factors, the most significant of which are discussed below.
Risks Related to Our Business
We May Not Be Able to Implement Our Growth Strategy Effectively
Our business has grown quickly. Furthermore, our strategy focuses on organic growth, supplemented by opportunistic acquisitions. We may not be able to execute aspects of our growth strategy to sustain our historical rate of growth or may not be able to grow at all. More specifically, we may not be able to generate sufficient new loans and deposits within acceptable risk and expense tolerances, obtain the personnel or funding necessary for additional growth or find suitable acquisition candidates. Various factors, such as economic conditions and competition, may impede or prohibit the growth of our operations, the opening of new branches and the consummation of acquisitions.
Our Limited Operating History as an Integrated Company May Make it Difficult for Investors to Evaluate Our Business, Financial Condition and Results of Operations and Also Impairs Our Ability to Accurately Forecast Our Future Performance
Our limited operating history as an integrated company following our acquisition of MidSouth on July 1, 2014 may not provide an adequate basis for investors to evaluate our business, financial condition and results of operations. Our future operating results depend upon a number of factors, including our ability to manage our growth, retain our customer base and successfully identify and respond to emerging trends in our primary product
lines and markets. It may also be difficult for us to evaluate trends that may affect our business and to determine whether our expansion may be profitable. Thus, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.
Competition For Deposits and Loans Is Expected To Be Intense, and No Assurance Can Be Given That We Will Be Successful in Our Efforts to Compete with Other Financial Institutions
The commercial banking industry in Williamson County, Tennessee consists of 32 banks and 2 savings and loan institutions, with 102 total offices and total deposits of $6.8 billion as of June 30, 2015, which is the most recent date such information has been released by the FDIC. The commercial banking industry in Rutherford County, Tennessee consists of 20 banks and no savings and loan institutions, with 76 total offices and total deposits of $3.5 billion as of June 30, 2015, which is the most recent date such information has been released by the FDIC. Offices affiliated with out-of-state financial institutions have entered Tennessee in recent years to offer all financial services, including lending and deposit gathering activities. Also, changes to laws on interstate banking and branching now permit banks and bank holding companies headquartered outside Tennessee to move into Williamson County and Rutherford County more easily. In addition, there are credit unions, finance companies, securities brokerage firms, and other types of businesses offering financial services. Technological advances and the growth of e-commerce have made it possible for non-financial institutions to offer products and services that traditionally have been offered by banking institutions. Competition for deposit and loan opportunities in our market area is expected to be intense because of existing competitors and the geographic expansion into the market area by other institutions. See “BUSINESS-Supervision and Regulation.” No assurance can be given that we will be successful in our efforts to compete with other such institutions.
We Have Incurred and Will Incur Substantial Expenses Related to Our Pending Acquisition of Civic
We have incurred and will incur substantial expenses in connection with our pending acquisition of Civic and integrating the operations of the acquired business of Civic with our operations. There are a number of factors beyond our control that could affect the total amount or the timing of our transaction and integration expenses and such expenses may exceed our initial projections. Many of the expenses that will be incurred, by their nature, are difficult to accurately estimate at the present time. As a result, the transaction and integration expenses associated with our pending acquisition of Civic could exceed the savings that we expect to achieve from the realization of economies of scale and cost savings related to the integration of the acquired business of Civic following the completion of the acquisition.
There Can Be No Assurance That the Bank Will Not Incur Excessive Loan Losses
An allowance for loan losses account is accumulated through monthly provisions against income. This account is a valuation allowance established for probable incurred credit losses inherent in the loan portfolio. Banks are susceptible to risks associated with their loan portfolios. The Bank’s loan customers may include a disproportionate number of individuals and entities seeking to establish a new banking relationship because they are dissatisfied with the amount or terms of credit offered by their current banks, or they may have demonstrated less than satisfactory performance in previous banking relationships. If the Bank lends to individuals who have demonstrated less than satisfactory performance in previous banking relationships, the Bank could experience disproportionate loan losses, which could have a significantly negative impact on the Bank’s earnings. Although management is aware of the potential risks associated with extending credit to customers with whom they have not had a prior lending relationship, there can be no assurance that the Bank will not incur excessive loan losses. Bank regulators may disagree with the Bank’s characterization of the collectability of loans and may require the Bank to downgrade credits and increase our provision for loan losses that would negatively impact results of operations and capital levels.
Changes in Interest Rates May Reduce the Bank’s Profitability
We incur interest rate risk. The Bank’s profitability is dependent, to a large extent, upon net interest income, which is the difference between its interest income on interest-earning assets, such as loans and investment securities and interest expense on interest-bearing liabilities, such as deposits and borrowings. The Bank will
continue to be affected by changes in interest rates and other economic factors beyond its control, particularly to the extent that such factors affect the overall volume of our lending and deposit activities. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring an institution’s interest rate sensitivity “gap.” An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income. Furthermore, an increase in interest rates may negatively affect the market value of securities in our investment portfolio. A reduction in the market value of our portfolio will increase the unrealized loss position of our available-for-sale investments. Any of these events could materially adversely affect our results of operations or financial condition.
If We Fail to Effectively Manage Credit Risk and Interest Rate Risk, Our Business and Financial Condition Will Suffer
We must effectively manage credit risk. There are risks inherent in making any loan, including risks with respect to the period of time over which the loan may be repaid, risks relating to proper loan underwriting and guidelines, risks resulting from changes in economic and industry conditions, risks inherent in dealing with individual borrowers and risks resulting from uncertainties as to the future value of collateral. There is no assurance that our credit risk monitoring and loan approval procedures are, or will be, adequate or will reduce the inherent risks associated with lending. Our credit administration personnel, policies and procedures may not adequately adapt to changes in economic or any other conditions affecting customers and the quality of our loan portfolio. Any failure to manage such credit risks may materially adversely affect our business and our consolidated results of operations and financial condition.
The Bank Depends on Its Ability to Attract Deposits
The acquisition of local deposits is a primary objective of the Bank. If customers move money out of bank deposits and into other investments, we would lose a relatively low-cost source of funds, increasing our funding costs and reducing our net interest income and net income. In addition to the traditional deposit accounts solicited in its community, the Bank also solicits local deposits through the Internet and will offer Internet-only deposit accounts to supplement traditional depository accounts. The Bank is a member of the FHLB for use as a general funding source and may use Internet funds and brokered deposits to balance funding needs. The ability of the Bank to accept brokered deposits is dependent on its ability to be “well capitalized.”
The Bank May Be Required to Rely on Secondary Sources of Liquidity to Meet Withdrawal Needs or Fund Operations, and There Can Be No Assurance That These Sources Will Be Sufficient to Meet Future Liquidity Demands
The primary source of the Bank’s funds is customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, 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, including changes in general 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. Additionally, 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. Accordingly, the Bank may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. These sources include Internet funds, brokered certificates of deposit, investment securities, borrowings from the Federal Reserve, FHLB advances, and federal funds lines of credit from correspondent banks. While management believes that these sources are currently adequate, there can be no assurance that they will be sufficient to meet future liquidity demands. The Bank may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should these sources not be adequate.
Economic Challenges, Especially Those Affecting the Local Economy Where We Operate, Could Affect Our Financial Condition and Results of Operations
If the communities in which we operate do not grow or if prevailing local or national economic conditions are unfavorable, our business may not succeed. Adverse economic conditions to the extent they develop in our primary market area, which currently is limited to Williamson County and Rutherford County, Tennessee and the surrounding areas, could reduce our growth rate, affect the ability of our customers to repay their loans, and generally affect our financial condition and results of operations. Moreover, management cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market area if they do occur. Continued adverse market or economic conditions may increase the risk that the Bank’s borrowers will be unable to timely make their loan payments. Furthermore, even if the Bank’s borrowers continue to make timely loan payments, a deterioration in the real estate market could cause a decline in the appraised values of such mortgaged properties. In the event of such a deterioration, the Bank may be forced to write down the value of the loans, which could have a negative effect on the Bank’s capital ratios and earnings.
The Bank’s loan portfolio is real-estate focused. While real estate lending is the expertise of our lending staff and management, risks associated with this type of lending are heavily influenced by the economic environment. In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions.
As of December 31, 2015, approximately 78% of the Bank’s total loans were real-estate secured. One-to-four family residential properties accounted for 21% of the Bank’s portfolio, owner-occupied commercial real estate was 6% and other commercial real estate was 21% of the total loan portfolio. Total construction and land development lending accounted for 29% of total loans with custom-built residential homes representing 6%, other residential construction lending totaling 14%, commercial construction lending totaling 6% and land development lending totaling 3%. Other real estate lending, including multi-family and farmland, accounted for less than 1% of the total loan portfolio. A sustained period of increased payment delinquencies, foreclosures, or losses caused by continuing adverse market or economic conditions in the state of Tennessee, or more specifically the Bank’s market area in Williamson County and Rutherford County in Middle Tennessee, could adversely affect the value of our assets, revenues, results of operations, and financial condition.
Our Financial Condition and Results of Operations Could be Affected if Long-Term Business Strategies Are Not Effectively Executed
Although the Bank’s primary focus in the near term will be organically growing its balance sheet, over the longer term, management may pursue a growth strategy for the Bank’s business through de novo branching. The Bank’s prospects must be considered in light of the risks, expenses, and difficulties occasionally encountered by financial services companies in growth stages, which may include the following:
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Operating Results: There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances, or other operating results necessary to avoid losses or produce profits. The Bank’s growth strategy necessarily entails growth in overhead expenses as it routinely adds new offices and staff. Historical results may not be indicative of future results or results that may be achieved as the Bank continues to increase the number and concentration of the Bank’s branch offices.
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Development of Offices: There are considerable costs involved in opening branches, and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, de novo branches may be expected to negatively impact earnings during this period of time until the branches reach certain economies of scale.
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Regulatory and Economic Factors: Growth and expansion plans may be adversely affected by a number of regulatory and economic developments or other events. Failure to obtain required regulatory approvals, changes in laws and regulations, or other regulatory developments and changes in prevailing economic conditions or other unanticipated events may prevent or adversely affect
continued growth and expansion. Failure to successfully address the issues identified above could have a material adverse effect on the Bank’s business, future prospects, financial condition, or results of operations, and could adversely affect the Bank’s ability to successfully implement its longer term business strategy.
The Accuracy of Our Financial Statements and Related Disclosures Could be Affected if the Judgments, Assumptions or Estimates Used in Our Critical Accounting Policies are Inaccurate
The preparation of financial statements and related disclosure in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are included in the section entitled “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” in this report, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider “critical” because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures.
Negative Public Opinion or Failure to Maintain Our Reputation in the Communities We Serve Could Adversely Affect Our Business and Prevent Us from Growing Our Business
As a community bank, our reputation within the communities we serve is critical to our success. We have set ourselves apart from our competitors by building strong personal and professional relationships with our customers and by being an active member of the communities we serve. As such, we strive to enhance our reputation by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve and delivering superior service to our customers. If our reputation is negatively affected by the actions of our employees or otherwise, we may be less successful in attracting new customers, and our business, financial condition, results of operations and prospects could be materially and adversely affected. Further, negative public opinion can expose us to litigation and regulatory action as we seek to implement our growth strategy, such as delays in regulatory approval based on unfounded complaints, which could impede the timeliness of regulatory approval for acquisitions we may make.
The Obligations Associated with Being a Public Company Will Require Significant Resources and Management Attention, Which Will Increase Our Costs of Operations and May Divert Focus from Our Business Operations
We have only recently been required to file periodic reports with the SEC. As a public company, we are required to file periodic reports containing our consolidated financial statements with the SEC within a specified time following the completion of quarterly and annual periods. As a public company, we also now incur significant legal, accounting, insurance and other expenses. Compliance with these reporting requirements and other rules of the SEC and the rules of the New York Stock Exchange (“NYSE”) or any exchange on which our common stock may be listed in the future will increase our legal and financial compliance costs and make some activities more time consuming and costly. Furthermore, the need to establish the corporate infrastructure demanded of a public company may divert management’s attention from implementing our growth strategy, which could prevent us from successfully implementing our strategic initiatives and improving our business, results of operations and financial
condition. We have made, and will continue to make, changes to our internal controls and procedures for financial reporting and accounting systems to meet our reporting obligations as a public company. However, we cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements. We anticipate that these costs will materially increase our general and administrative expenses.
If We Fail to Correct Any Material Weakness That We Identify in Our Internal Control over Financial Reporting or Otherwise Fail to Maintain Effective Internal Control over Financial Reporting, We May Not Be Able to Report Our Financial Results Accurately and Timely
Our management is responsible for establishing and maintaining adequate internal control over financial reporting and for evaluating and reporting on our system of internal control. Our internal control processes are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles (“GAAP”). As a public company, we are required to comply with the Sarbanes-Oxley Act and other rules that govern public companies. In particular, beginning with this Annual Report on Form 10-K, we are required to certify our compliance with Section 404 of the Sarbanes-Oxley Act, which requires us to furnish annually a report by management on the effectiveness of our internal control over financial reporting. In addition, unless we remain an emerging growth company and elect additional transitional relief available to emerging growth companies, our independent registered public accounting firm will be required to report on the effectiveness of our internal control over financial reporting, beginning as of the first annual report after ceasing to be an emerging growth company.
If we identify material weaknesses in our internal control over financial reporting in the future and we cannot comply with the requirements of the Sarbanes-Oxley Act in a timely manner or attest that our internal control over financial reporting is effective, or if our independent registered public accounting firm cannot express an opinion as to the effectiveness of our internal control over financial reporting when required, we may not be able to report our financial results accurately and timely. As a result, investors, counterparties and customers may lose confidence in the accuracy and completeness of our financial reports; our liquidity, access to capital markets and perceptions of our creditworthiness could be adversely affected; and the market price of our common stock could decline. In addition, we could become subject to investigations by the stock exchange on which our securities are listed, the SEC, the Board of Governors of the Federal Reserve, the FDIC, or other regulatory authorities, which could require additional financial and management resources. These events could have an adverse effect on our business, financial condition and results of operations.
A Failure in, or Breach of, Our Operational or Security Systems or Infrastructure, or Those of Our Third Party Vendors and Other Service Providers or Other Third Parties, Including as a Result of Cyber Attacks, Could Disrupt Our Businesses, Result in the Disclosure or Misuse of Confidential or Proprietary Information, Damage Our Reputation, Increase Our Costs, and Cause Losses
We rely heavily on communications and information systems to conduct our business. Information security risks for financial institutions such as us have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, and terrorists, activists, and other external parties. As customer, public, and regulatory expectations regarding operational and information security have increased, our operating systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, and data processing systems, or other operating systems and facilities, may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunication outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and as described below, cyber attacks.
Our business relies on its digital technologies, computer and email systems, software and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems and networks and our customers’ devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of our or our customers’ or other third parties’ confidential information. Third parties with whom we do business or who
facilitate our business activities, including financial intermediaries, or vendors that provide service or security solutions for our operations, and other unaffiliated third parties, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. In addition, hardware, software or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information security.
While we have disaster recovery and other 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. Our risk and exposure to these matters remain heightened because of the evolving nature of these threats. As a result, cyber security and the continued development and enhancement of our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and clients, or cyber attacks or security breaches of the networks, systems or devices that our clients use to access our products and services, could result in client attrition, regulatory fines, penalties or intervention, reputation damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could have a material effect on our results of operations or financial condition. Furthermore, if such attacks are not detected immediately, their effect could be compounded. To date, to our knowledge, we have not experienced any material impact relating to cyber-attacks or other information security breaches.
The Bank Is Subject to General Banking Risks
Several risks are inherent in the business of banking. Factors outside the Bank’s control, such as instability in interest rates, a depressed economy, government regulation, and federal monetary policy, for example, could adversely impact the banking industry. Banks are also exposed to risk of loss as a result of fraud, embezzlement, insider abuse, and mismanagement. Extensions of credit create a risk that loans cannot, or will not, be repaid.
Earnings are affected by the ability of the Bank to properly originate, underwrite and service loans. The Bank could sustain losses if it incorrectly assesses the creditworthiness of its borrowers or fails to detect or respond to deterioration in asset quality in a timely manner. Rapid changes in loan and deposit terms could result in a risk of loss from changes in interest rates. In managing its loans and investments (assets) and its borrowings and deposits (liabilities), the Bank will run the risk of having insufficient liquid assets to meet withdrawal requests.
Beyond general banking risk, we will take limited risk in mortgage banking, wealth management, trust services or other financial services being offered. Such risks could have a material adverse effect on our business, financial condition, results of operations and prospects.
Because We Engage in Lending Secured By Real Estate and May Be Forced to Foreclose on the Collateral Property and Own The Underlying Real Estate, We May Be Subject to the Increased Costs and Risk Associated with the Ownership of Real Property, Which Could Have an Adverse Effect on Our Business or Results of Operations
A significant portion of our loan portfolio is secured by real estate property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans, in which case, we are exposed to the risks inherent in the ownership of real estate. The amount that we, as a mortgagee, may realize after a default is dependent upon factors outside of our control, including:
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general or local economic conditions;
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environmental cleanup liability;
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neighborhood values;
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interest rates;
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real estate tax rates;
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operating expenses of the mortgaged properties;
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supply of and demand for rental units or properties;
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ability to obtain and maintain adequate occupancy of the properties;
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zoning laws;
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governmental rules, regulations and fiscal policies; and
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tornadoes or other natural or man-made disasters.
Certain expenditures associated with the ownership of real estate, principally real estate taxes and maintenance costs, may also adversely affect our operating expenses.
We Are Subject to Environmental Liability Risk Associated with Lending Activities
A significant portion of our loan portfolio is secured by real estate, and we could become subject to environmental liabilities with respect to one or more of these properties. During the ordinary course of business, we may foreclose on and take title to properties securing defaulted loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous conditions or toxic substances are found on these properties, we may be liable for remediation costs, as well as for personal injury and property damage, civil fines and criminal penalties regardless of when the hazardous conditions or toxic substances first affected any particular property. Environmental laws may require us to incur substantial expenses to address unknown liabilities and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on us.
Our Loan Portfolio Includes a Meaningful Amount of Real Estate Construction and Development Loans, Which Have a Greater Credit Risk Than Residential Mortgage Loans
The percentage of loans in real estate construction and development in our portfolio was approximately 29% of total loans at December 31, 2015. These loans make up approximately 59% of our non-performing loans at December 31, 2015. This type of lending is generally considered to have relatively high credit risks because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and operation of the related real estate project. The credit quality of many of these loans deteriorated during the challenging economic period of 2008 to 2012 due to the adverse conditions in the real estate market during that period and that type of deterioration could occur again. Weakness in residential real estate market prices in the Middle Tennessee area as well as demand could result in price reductions in home and land values adversely affecting the value of collateral securing the construction and development loans that we hold. Should we experience the return of these adverse economic and real estate market conditions we may experience increases in non-performing loans and other real estate owned, increased losses and expenses from the management and disposition of non-performing assets (“NPAs”), increases in provision for loan losses, and increases in operating expenses as a result of the allocation of management time and resources to the collection and work out of loans, all of which would negatively impact our financial condition and results of operations.
We Are Dependent on Key Personnel
We are materially dependent on the performance of our executive management team, loan officers, and other support personnel. The loss of the services of any of these employees could have a material adverse effect on our business, results of operations, and financial condition. Many of these key officers have important customer relationships, which are instrumental to the Bank’s operations. Changes in key personnel and their responsibilities
may be disruptive to our business and could have a material adverse effect on our business, financial condition, and results of operations. Management believes that future results also will depend, in part, upon attracting and retaining highly skilled and qualified management, especially in the new market areas into which we may enter, as well as in sales and marketing personnel. Competition for such personnel is intense, and management cannot be sure that we will be successful in attracting or retaining such personnel.
Risks Related to the Regulation of Our Business
We Are Subject to Extensive Regulation
We are subject to extensive governmental regulation and control. Compliance with state and federal banking laws has a material effect on our business and operations. Our operations will at all times be subject to state and federal banking laws, regulations, and procedures. The laws and regulations applicable to the banking industry could change at any time and are subject to interpretation, and management cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the cost of compliance could adversely affect our ability to operate profitably. Non-banking financial institutions, such as securities brokerage firms, insurance companies, and money market funds are now permitted to offer services which compete directly with services offered by banks. See “BUSINESS-Supervision and Regulation.”
The Regulatory Environment for the Financial Services Industry Is Being Significantly Impacted by Financial Regulatory Reform Initiatives, Which May Adversely Impact Our Business, Results of Operations and Financial Condition.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) contains comprehensive provisions governing the practices and oversight of financial institutions and other participants in the financial markets. See “BUSINESS-Supervision and Regulation.” The Dodd-Frank Act established, among other requirements, a new financial industry regulator, the CFPB, to centralize responsibility for consumer financial protection with broad rulemaking authority to administer and carry out the purposes and objectives of the “Federal consumer financial laws and to prevent evasions thereof,” with respect to all financial institutions that offer financial products and services to consumers, including deposit products, residential mortgages, home-equity loans and credit cards and contains provisions on mortgage-related matters, such as steering incentives, determinations as to a borrower’s ability to repay and prepayment penalties. The CFPB is also authorized to prescribe rules applicable to any covered person or service provider, identifying and prohibiting “unfair, deceptive, or abusive acts or practices” in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service (“UDAAP authority”). The ongoing broad rulemaking powers of the CFPB and its UDAAP authority have the potential to have a significant impact on the operations of financial institutions offering consumer financial products or services. The CFPB has indicated that they are examining proposing new rules on overdrafts and other consumer financial products or services and if any such rule limits our ability to provide such financial products or services it may have an adverse effect on our business. Additional legislative or regulatory action that may impact our business may result from the multiple studies mandated under the Dodd-Frank Act. Although the applicability of certain elements of the Dodd-Frank Act is limited to institutions with more than $10 billion in assets, there can be no guarantee that such applicability will not be extended in the future or that regulators or other third parties will not seek to impose such requirements on institutions with less than $10 billion in assets.
The evolving regulatory environment causes uncertainty with respect to the manner in which we conduct our businesses and requirements that may be imposed by our regulators. Regulators have implemented and continue to propose new regulations and issue supervisory guidance and have been increasing their examination and enforcement action activities. We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or findings. We are unable to predict the nature, extent or impact of any additional changes to statutes or regulations, including the interpretation, implementation or enforcement thereof, which may occur in the future.
The impact of the evolving regulatory environment on our business and operations depends upon a number of factors including final implementing regulations, guidance and interpretations of the regulatory agencies,
supervisory priorities and actions, the actions of our competitors and other marketplace participants, and the behavior of consumers. The evolving regulatory environment could require us to limit or change our business practices, limit our product offerings, require continued investment of management time and resources in compliance efforts, limit fees we can charge for services, require us to meet more stringent capital, liquidity and leverage ratio requirements, increase costs, impact the value of our assets, or otherwise adversely affect our businesses. The regulatory environment and enhanced examination and supervisory expectations and scrutiny can also potentially impact our ability to pursue business opportunities and obtain required regulatory approvals for potential investments and acquisitions.
Compliance and other regulatory requirements and expenditures have increased significantly for us and other financial services firms, and we expect them to continue to increase as regulators adopt new rules, interpret existing rules and increase their scrutiny of financial institutions, including controls and operational processes. We may face additional compliance and regulatory risk to the extent that we enter into new lines of business or new business arrangements with third-party service providers, alternative payment providers or other industry participants, including providers or participants that may not be regulated financial institutions. The additional expense, time and resources needed to comply with ongoing regulatory requirements may adversely impact our business and results of operations. In addition, regulatory findings and ratings could negatively impact our business strategies.
We Are Affected by Governmental Monetary Policies
Like all regulated financial institutions, we are affected by monetary policies implemented by the Federal Reserve and other federal instrumentalities. A primary instrument of monetary policy employed by the Federal Reserve is the restriction or expansion of the money supply through open market operations. This instrument of monetary policy frequently causes volatile fluctuations in interest rates, and it can have a direct, adverse effect on the operating results of financial institutions. Borrowings by the United States government to finance the government debt may also cause fluctuations in interest rates and have similar effects on the operating results of such institutions. See “BUSINESS-Supervision and Regulation.”
The Impact of the Changing Regulatory Capital Requirements and Recently Adopted Capital Rules Is Uncertain
Under recently adopted rules by the Federal Reserve and FDIC, the leverage and risk-based capital ratios of bank holding companies may not be lower than the leverage and risk-based capital ratios for insured depository institutions. These rules became effective as to FFN and the Bank on January 1, 2015 and include new minimum risk-based capital and leverage ratios. Moreover, these rules refine the definition of what constitutes “capital” for purposes of calculating those ratios. The new minimum capital level requirements applicable to bank holding companies and banks subject to the rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 risk-based capital ratio of 6% (increased from 4%); (iii) a total risk-based capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The rules also establish a “capital conservation buffer” of 2.5% (to be phased in over three years) above the new regulatory minimum capital ratios, and result in the following minimum ratios once the capital conservation buffer is fully phased in: (i) a common equity Tier 1 risk-based capital ratio of 7.0%, (ii) a Tier 1 risk-based capital ratio of 8.5%, and (iii) a total risk-based capital ratio of 10.5%. The capital conservation buffer requirement is to be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if its capital levels fall below the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.
The application of these more stringent capital requirements to FFN and the Bank could, among other things, result in lower returns on invested capital, require the raising of additional capital, and result in regulatory actions if FFN or the Bank were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of the final rules could result in FFN or the Bank having to lengthen the term of their funding, restructure their business models and/or increase their holdings of liquid assets. Implementation of changes to asset risk weightings for risk-based capital calculations, items included or deducted in calculating regulatory capital and/or additional capital conservation buffers could result in management modifying its business strategy and could limit FFN’s and the Bank’s ability to make distributions, including paying dividends or buying back shares. See “BUSINESS-Supervision and Regulation.”
The Expanding Body of Federal, State and Local Regulation and/or the Licensing of Loan Servicing, Collections or Other Aspects of Our Business May Increase the Cost of Compliance And the Risks of Noncompliance
We service our own loans, and loan servicing is subject to extensive regulation by federal, state and local governmental authorities as well as to various laws and judicial and administrative decisions imposing requirements and restrictions on those activities. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan servicing activities including delaying or temporarily preventing foreclosures or forcing the modification of certain mortgages. If regulators impose new or more restrictive requirements, we may incur additional significant costs to comply with such requirements which may further adversely affect us. In addition, our failure to comply with these laws and regulations could possibly lead to: civil and criminal liability; loss of licensure; damage to our reputation in the industry; fines and penalties and litigation, including class action lawsuits; and administrative enforcement actions. Any of these outcomes could materially and adversely affect our business, financial condition, results of operations and prospects.
Federal and State Regulators Periodically Examine Our Business and We May Be Required to Remediate Adverse Examination Findings
The Federal Reserve, the FDIC, and the Tennessee Department of Financial Institutions (“TDFI”) periodically examine our business, including our compliance with laws and regulations. If, as a result of an examination, a banking agency were to determine that our financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we were in violation of any law or regulation, they may take a number of different remedial actions as they deem appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to assess civil money penalties, to fine or remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance and place us into receivership or conservatorship. Any regulatory action against us could have an adverse effect on our business, financial condition and results of operations.
Our FDIC Deposit Insurance Premiums and Assessments May Increase
The deposits of our subsidiary bank are insured by the FDIC up to legal limits and, accordingly, subject our bank subsidiary to the payment of FDIC deposit insurance assessments. The Bank’s regular assessments are based on its average consolidated total assets minus average tangible equity as well as by risk classification, which includes regulatory capital levels and the level of supervisory concern. High levels of bank failures since the beginning of the financial crisis and increases in the statutory deposit insurance limits have increased resolution costs to the FDIC and put significant pressure on the Deposit Insurance Fund (“DIF”). In order to maintain a strong funding position and restore the reserve ratios of the DIF, the FDIC has, in the past, increased deposit insurance assessment rates and charged a special assessment to all FDIC-insured financial institutions. Further increases in assessment rates or special assessments may occur in the future, especially if there are significant additional financial institution failures. Any future special assessments, increases in assessment rates or required prepayments in FDIC insurance premiums could reduce our profitability or limit our ability to pursue certain business opportunities, which could have an adverse effect on our business, financial condition and results of operations.
We Are Required to Act As a Source of Financial and Managerial Strength For Our Bank in Times of Stress
Under federal law and longstanding Federal Reserve policy, we are expected to act as a source of financial and managerial strength to our bank, and to commit resources to support our bank if necessary. We may be required to commit additional resources to our bank at times when we may not be in a financial position to provide such resources or when it may not be in our, or our shareholders’ or creditors’, best interests to do so. Providing such support is more likely during times of financial stress for us and our bank, which may make any capital we are
required to raise to provide such support more expensive than it might otherwise be. In addition, any capital loans we make to our bank are subordinate in right of payment to depositors and to certain other indebtedness of our bank. In the event of our bankruptcy, any commitment by us to a federal banking regulator to maintain the capital of our bank will be assumed by the bankruptcy trustee and entitled to priority of payment. See “BUSINESS-Supervision and Regulation-Bank Holding Company Regulation.”
Future Acquisitions Generally Will Require Regulatory Approvals and Failure to Obtain Them Would Restrict Our Growth
We may decide to explore complementing and expanding our products and services by pursuing strategic acquisitions. Generally, any acquisition of target financial institutions, branches or other banking assets by us will require approval by and cooperation from, a number of governmental regulatory agencies, possibly including the Federal Reserve, and the FDIC, as well as state banking regulators. In acting on applications, federal banking regulators consider, among other factors:
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The effect of the acquisition on competition;
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The financial condition, liquidity, results of operations, capital levels and future prospects of the applicant and the bank(s) involved;
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The quantity and complexity of previously consummated acquisitions;
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The managerial resources of the applicant and the bank(s) involved;
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The convenience and needs of the community, including the record of performance under the CRA;
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The effectiveness of the applicant in combating money-laundering activities;
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The applicant’s regulatory compliance record; and
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The extent to which the acquisition would result in greater or more concentrated risk to the stability of the United States banking or financial system.
Such regulators could deny our application based on the above criteria or other considerations, which would restrict our growth, or the regulatory approvals may not be granted on terms that are acceptable to us. For example, we could be required to sell branches as a condition to receiving regulatory approvals and such a condition may not be acceptable to us or may reduce the benefit of any acquisition.
We Face a Risk of Noncompliance and Enforcement Action with the Bank Secrecy Act and Other Anti-Money Laundering Statutes and Regulations
The Bank Secrecy Act (the “BSA”), the USA PATRIOT Act of 2001 (the “Patriot Act”) and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network 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. We are also subject to increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include 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. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have an adverse effect on our business, financial condition and results of operations.
There Are Substantial Regulatory Limitations on Changes of Control of a Bank Holding Company
With certain limited exceptions, federal regulations prohibit a person, a company or a group of persons deemed to be “acting in concert” from, directly or indirectly, acquiring more than 10% (5% if the acquirer is a bank holding company) of any class of our voting stock or obtaining the ability to control in any manner the election of a majority of our directors or otherwise direct the management or policies of FFN without prior notice or application to and the approval of the Federal Reserve. Companies investing in banks and bank holding companies receive additional review and may be required to become bank holding companies, subject to regulatory supervision. Accordingly, prospective investors must be aware of and comply with these requirements, if applicable, in connection with any purchase of shares of our common stock. These provisions effectively inhibit certain mergers or other business combinations, which, in turn, could adversely affect the market price of our common stock.
Risks Related to the Civic Merger
Fluctuations in the Trading Price of FFN Common Stock Preceding the Effective Time of the Civic Merger Will Change the Number of Shares of FFN Common Stock That Civic Shareholders Will Receive in the Civic Merger.
At the effective time of the Civic Merger, all outstanding shares of common stock of Civic will be exchanged for that number of shares of common stock of FFN with an aggregate value of $28,625,000, calculated by dividing this aggregate value by the volume weighted average closing price of FFN’s common stock for the 20 consecutive trading days ending on and including the 10th trading day preceding the effective date of the Civic Merger; provided, however, that the market value per share of FFN’s common stock used to determine the number of shares of FFN common stock to be issued will be no more than $29.50 per share, and no less than $26.50 per share. Accordingly, the value of the shares of FFN common stock Civic shareholders will receive will not change, although the number of shares of common stock received will vary with the market price for FFN common stock, within the $26.50 to $29.50 range of market value, such that the number of shares of FFN common stock issued in the Civic Merger to holders of Civic common stock will be between 970,338 and 1,080,188 shares.
The market price of FFN’s common stock at the time the Civic Merger is completed may vary from the price of FFN’s common stock on the date the merger agreement was executed and/or on the date of the Civic special meeting as a result of various factors that are beyond the control of FFN and Civic, including but not limited to general market and economic conditions, changes in our respective businesses, operations and prospects, and regulatory considerations. In addition to the approval of the Civic Merger Agreement by Civic shareholders, completion of the Civic Merger is subject to satisfaction of other conditions that may not occur until after the Civic special meeting. Therefore, at the time of the Civic special meeting Civic shareholders will not know or be able to calculate the precise consideration they will receive at the effective time of the Civic Merger.
Before or after the Civic Merger, the market value of FFN common stock may decrease and be lower than the FFN Market Price that is used in calculating the consideration to be received by holders of Civic common stock in the Civic Merger.
FFN May Not Be Able to Successfully Integrate Civic or to Realize the Anticipated Benefits of the Civic Merger
The Civic Merger involves the combination of two banks that previously have operated independently. A successful combination of the operations of the two entities will depend substantially on FFN’s ability to consolidate operations, systems and procedures and to eliminate redundancies and costs. FFN also intends to utilize most if not all of Civic’s employees, a plan that may or may not be completely feasible as the growth of the banks and FFN continues and the demands of the marketplace dictate. FFN may not be able to combine the operations of Civic and FSB without encountering difficulties, such as:
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the loss of key employees;
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disruption of operations and business;
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inability to maintain and increase competitive presence;
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deposit attrition, customer loss and revenue loss;
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possible inconsistencies and disruptions during the period needed to integrate standards, control procedures and policies;
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unexpected problems with costs, operations, personnel, technology and credit; and/or
•
problems with the assimilation of new operations, sites or personnel, which could divert resources from regular banking operations.
Additionally, general market and economic conditions or governmental actions affecting the financial industry generally may inhibit the successful integration of Civic and the Bank.
Further, FFN, the Bank and Civic entered into the merger agreement with the expectation that the Civic Merger will result in various benefits including, among other things, benefits relating to enhanced revenues, a strengthened market position for the combined company, cross-selling opportunities, technology, cost savings and operating efficiencies. Achieving the anticipated benefits of the merger is subject to a number of uncertainties, including whether FFN integrates Civic in an efficient and effective manner, and general competitive factors in the marketplace. Failure to achieve these anticipated benefits could result in increased costs, decreases in the amount of expected revenues and diversion of management’s time and energy and could materially impact FFN’s business, financial condition and operating results. Finally, any cost savings that are realized may be offset by losses in revenues or other charges to earnings.
Regulatory Approvals May Not Be Received, May Take Longer Than Expected or May Impose Conditions That Are Not Presently Anticipated or Cannot Be Met
Before the transactions contemplated in the merger agreement may be completed, including the Civic Merger, prior approval of our applications and notices filed with the FRB and TDFI must be obtained. These governmental agencies may impose conditions on the completion of the merger or require changes to the terms of the merger agreement. Although FFN does not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the transactions contemplated in the merger agreement or imposing additional costs on or limiting the Bank’s or Civic’s revenues, any of which might have a material adverse effect on FFN following the Civic Merger. There can be no assurance as to whether the regulatory approvals will be received, the timing of those approvals, or whether any conditions will be imposed.
The Combined Company Will Incur Significant Transaction and Merger-Related Costs in Connection With the Merger
FFN and Civic expect to incur costs associated with combining the operations of Civic and the Bank. FFN and Civic have just recently begun collecting information in order to formulate detailed integration plans to deliver planned synergies. Additional unanticipated costs may be incurred in the integration of the businesses of FFN and Civic. Although FFN and Civic expect that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, may offset incremental transaction and merger-related costs over time, this net benefit may not be achieved in the near term, or at all.
Whether or not the Civic Merger is consummated, FFN and Civic will incur substantial expenses, such as legal, accounting and financial advisory fees, in pursuing the merger. Completion of the Civic Merger is conditioned upon the receipt of all material governmental authorizations, consents, orders and approvals, including approval by federal and state banking regulators.
Directors and Officers of Civic have Potential Conflicts of Interest in the Merger
You should be aware that some directors and officers of Civic have interests in the Civic Merger that are different from, or in addition to, the interests of Civic shareholders generally.
For example, certain of the executive officers of Civic have been offered change in control agreements by the Bank that provide the executive officer with payments upon a change in control of FFN or the Bank. Also, FFN
has agreed to add Anil Patel, MD, to the boards of FFN and the Bank, and Dr. Patel will receive compensation for serving on these boards. These agreements may create potential conflicts of interest by creating vested interests in those persons in the completion of the Civic Merger. In addition, FFN agreed in the merger agreement to provide liability insurance to Civic officers and directors. These and certain other additional interests of Civic’s directors and officers may cause some of these persons to view the proposed transaction differently than you view it, although Civic’s board and officers currently have comparable director and officer insurance coverages.
Failure to Complete the Civic Merger Could Cause FFN’s Stock Price to Decline
If the Civic Merger is not completed for any reason, FFN’s stock price may decline because costs related to the Civic Merger, such as legal, accounting and financial advisory fees, must be paid even if the Civic Merger is not completed. In addition, if the Civic Merger is not completed, FFN’s stock price may decline to the extent that the current market price reflects a market assumption that the Civic Merger will be completed or due to questions about why (or whose “fault” it was that) the Civic Merger was not completed.
Risks Related to an Investment in Our Common Stock
Shares of Our Common Stock Are Not Insured
Shares of our common stock are not deposits and are not insured by the FDIC or any other entity and you will bear the risk of loss if the value or market price of our common stock is adversely affected.
An Active, Liquid Market for our Common Stock May Not Develop or Be Sustained, Which May Impair the Ability of our Shareholders to Sell Their Shares
Before the listing of our common stock on the NYSE on March 26, 2015, our common stock had very little liquidity, with only limited trading of our common stock on the OTCQB of the OTC Markets Group. Even though our common stock is now listed on the NYSE under the symbol “FSB”, there is limited trading volume and an active, liquid trading market for our common stock may not develop or be sustained. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace and independent decisions of willing buyers and sellers of our common stock, over which we have no control. If an active, liquid trading market for our common stock does not develop, shareholders may not be able to sell their shares at the volume, prices and times desired. Moreover, the lack of an established market could materially and adversely affect the value of our common stock. The market price of our common stock could decline significantly due to actual or anticipated issuances or sales of our common stock in the future.
The Market Price of Our Common Stock May Fluctuate Significantly
The market price of our common stock could fluctuate significantly due to a number of factors, including, but not limited to:
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our quarterly or annual earnings, or those of other companies in our industry;
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actual or anticipated fluctuations in our operating results, financial condition or asset quality;
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changes in economic or business conditions;
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the public reaction to our press releases, our other public announcements and our filings with the SEC;
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perceptions in the market place involving our competitors and/or us;
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changes in business, legal or regulatory conditions, or other developments affecting participants in our industry, and publicity regarding our business or any of our significant customers or competitors;
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changes in governmental monetary policies, including the policies of the Federal Reserve;
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changes in financial estimates and recommendations by securities analysts following our stock, or the failure of securities analysts to cover or continue to cover our common stock after our initial public offering;
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the failure of securities analysts to cover, or continue to cover, us after our initial public offering;
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changes in earnings estimates by securities analysts or our ability to meet those estimates;
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significant acquisitions or business combinations, strategic partnerships, joint ventures, or capital commitments by or involving our competitors or us;
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the trading volume of our common stock;
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future sales of our common stock;
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our treatment as an “emerging growth company” under federal securities laws;
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additions or departures of key personnel;
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changes in accounting standards, policies, guidance, interpretations or principles;
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failure to integrate acquisitions or realize anticipated benefits from our acquisitions;
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rapidly changing technology; and
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other news, announcements or disclosures (whether by us or others) related to us, our competitors, our core market or the bank and non-bank financial services industries.
If any of the foregoing occurs, it could cause our stock price to fall and expose us to litigation that, even if our defense is successful, could distract management and be costly to defend.
Shares of Our Common Stock are Subject to Dilution and the Market Price of Our Common Stock Could Decline Due to the Number of Outstanding Shares of Our Common Sock Eligible for Future Sale
Actual or anticipated issuances or sales of additional amounts of our common stock in the future could cause the market price of our common stock to decline significantly and make it more difficult for us to sell equity securities in the future at a time and on terms that we deem appropriate. The issuance of any shares of our common stock in the future also would dilute the percentage ownership interest held by shareholders prior to such issuance. As of December 31, 2015, we had 10,571,377 shares of common stock issued and outstanding. Of the outstanding shares of common stock, all of the 2,640,000 shares that were sold in our initial public offering are freely tradable, except that any shares purchased by “affiliates” (as that term is defined in Rule 144 under the Securities Act), may be sold publicly only in compliance with certain limitations. In addition, 2,766,191 shares of our outstanding common stock were issued pursuant to a registration statement on Form S-4 in connection with the acquisition of MidSouth and are freely tradable. On October 28, 2015, we filed a registration statement on Form S-8 under the Securities Act to register an aggregate of 4,000,000 shares of our common stock for issuance under our 2007 Omnibus Equity Incentive Plan (the “Plan”). In addition, on November 30, 2015, we filed a registration statement on Form S-3 under the Securities Act to register, among other things, an aggregate of 1,690,598 shares of our common stock held by our existing shareholders that are currently freely tradeable. The remaining shares of our common stock may be sold in the market over time in accordance with Rule 144 under the Securities Act or otherwise in future public offerings. Accordingly, the market price of our common stock could be adversely affected by actual or anticipated sales of a significant number of shares of our common stock in the future.
Securities Analysts May Not Initiate or Continue Coverage on Our Common Stock, Which Could Adversely Affect the Market for Our Common Stock
The trading market for our common stock depends in part on the research and reports that securities analysts publish about us and our business. We do not have any control over these securities analysts and they may not cover our common stock. If securities analysts do not cover our common stock, the lack of research coverage may adversely affect our market price. If we are covered by securities analysts and our common stock is the subject of an unfavorable report, the price of our common stock may decline. If one or more of these analysts cease to cover us or fail to publish regular reports on us, we could lose visibility in the financial markets, which could cause the price or trading volume of our common stock to decline.
The Rights of Our Common Shareholders Are Subordinate to the Rights of the Holders of Our Series A Preferred Stock and Any Debt Securities That We May Issue and May Be Subordinate to the Holders of Any Other Class of Preferred Stock That We May Issue in the Future
We have issued 10,000 shares of our Senior Non-Cumulative Perpetual Preferred Stock, Series A, liquidation preference of $1,000 per share (“Series A Preferred Stock”). These shares have rights that are senior to our common stock. As a result, we must make payments on the preferred stock before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the Series A Preferred Stock must be satisfied in full before any distributions can be made to the holders of our common stock. Our Board of Directors has the authority to issue in the aggregate up to 1,000,000 shares of preferred stock and to determine the terms of each issue of preferred stock without shareholder approval. Accordingly, you should assume that any shares of preferred stock that we may issue in the future will also be senior to our common stock and could have a preference on liquidating distributions or a preference on dividends that could limit our ability to pay dividends to the holders of our common stock. Because our decision to issue debt or equity securities or incur other borrowings in the future will depend on market conditions and other factors beyond our control, the amount, timing, nature or success of our future capital-raising efforts is uncertain. Thus, common shareholders bear the risk that our future issuances of debt or equity securities or our incurrence of other borrowings will negatively affect the market price of our common stock.
There Is No Certainty of Return on Investment
No assurance can be given that a holder of shares of our common stock will realize a substantial return on his or her investment, or any return at all. Further, as a result of the uncertainty and risks associated with our operations as described in this “RISK FACTORS” section, it is possible that an investor will lose his or her entire investment.
We Cannot Ensure When Or If We Will Pay Dividends
Our ability to pay dividends is highly dependent on the Bank’s ability to pay dividends and may be limited based upon restrictions of the SBLF and based upon our earnings and capital needs. As a result of our participation in the SBLF, the likelihood of our declaring dividends to our shareholders is contingent on the anticipated growth and capital preservation strategy to maintain a strong capital level for both the Bank and FFN. The Bank is also subject to various legal, regulatory and other restrictions on its ability to pay dividends and make other distributions and payments to us and may require regulatory approval to do so. As a result, we cannot project or guarantee when dividends will be declared in the future, if at all. Our Board of Directors has also decided to not pay dividends on common stock at this time.
We May Require Additional Capital
The Board of Directors believes that the current level of capital will be adequate at the present time to sustain the operations and projected growth of FFN and the Bank. If FFN or the Bank fails to meet sufficient financial performance (including as a result of significant provision expense as a result of deterioration in asset quality) or if the assets of the Bank grow more quickly than projected, management may determine, or government regulators may require, FFN or the Bank to raise additional capital. In the event FFN or the Bank falls below certain regulatory capital adequacy standards, they may become subject to regulatory intervention and restrictions. We can give no assurance that such additional capital is available at prices that will be acceptable to us, if at all. In the event of the issuance of additional shares, then current shareholders will not have the first right to subscribe to new shares (preemptive rights), so their ownership percentage may be diluted in the future.
We Are an Emerging Growth Company and We Cannot Be Certain if the Reduced Disclosure Requirements Applicable to Emerging Growth Companies Will Make Our Common Stock Less Attractive to Investors
We are an emerging growth company. For as long as we continue to be an emerging growth company, among other things, we may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and
exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if we comply with the greater obligations of public companies that are not emerging growth companies, we may avail ourselves of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as we are an emerging growth company. We will remain an emerging growth company for up to five years following the effectiveness of our Registration Statement on Form S-4 filed on May 14, 2014, though we may cease to be an emerging growth company earlier under certain circumstances, including if, before the end of such five years, we are deemed to be a large accelerated filer under the rules of the SEC (which depends on, among other things, having a market value of common stock held by non-affiliates in excess of $700 million) or if our total annual gross revenues equal or exceed $1 billion in a fiscal year. We cannot predict if investors will find our common stock less attractive because we will rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2.
ITEM 2. PROPERTIES.
FFN’s and the Bank’s main office and headquarters operation is located at 722 Columbia Avenue, Franklin, Tennessee 37064. This location is leased by the Bank. The Bank operates branches at the following locations: 3359 Aspen Grove Drive, Suite 100, Franklin, Tennessee 37067; 134 Pewitt Drive, Suite 100, Brentwood, Tennessee 37027; 1015 Westhaven Blvd., Suite 150, Franklin, Tennessee 37064; 40 Moss Lane, Suite 100, Franklin, Tennessee 37064; 2035 Wall Street, Spring Hill, Tennessee 37174; 7177 Nolensville Road, Suite A3, Nolensville, Tennessee 37135; One East College Street, Murfreesboro, Tennessee 37130; 724 President Place, Smyrna, Tennessee 37167; 2415 Memorial Boulevard, Murfreesboro, Tennessee 37129; 2782 South Church Street, Murfreesboro, Tennessee 37127; and 2610 Old Fort Parkway, Murfreesboro, Tennessee 37128. The Bank also operates a mortgage loan office at 123 East College Street, Murfreesboro, Tennessee 37130, and a loan production office at 3325 West End Avenue, Nashville, Tennessee 37203. Twelve of these locations are leased by the Bank; two are owned. Certain lease agreements for these properties are with entities owned by related parties of FFN and the Bank.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Neither we nor any subsidiary is aware of any pending or threatened material legal proceeding to which we or any such subsidiary is a party. Similarly, none of the properties of us or any subsidiary is subject to such proceedings.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES.
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market Information and Holders
Our common stock began trading on the New York Stock Exchange (“NYSE”) on March 26, 2015, under the ticker symbol “FSB”. Prior to March 26, 2015, our common stock traded on the OTCQB of the OTC Markets Group. The following table sets forth the range of high and low sale prices of our common stock as reported on the NYSE and OTCQB, as applicable, for the periods indicated since January 1, 2014. The OTCQB prices set forth in the table below reflect sporadic, limited trading of our common stock, without retail mark-up, mark-down or commissions.
As of December 31, 2015, we had 1,571 shareholders of record of our common stock.
Dividend Policy
We have not declared or paid any dividends on our common stock. We currently intend to retain all of our future earnings, if any, for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future; however, our Board of Directors may decide to declare dividends in the future. Payments of future dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our business, operating results and financial condition, current and anticipated cash needs, plans for expansion, tax considerations, general economic conditions and any legal or contractual limitations on our ability to pay dividends. We are not obligated to pay dividends on our common stock.
As a bank holding company, our ability to pay dividends is affected by the policies and enforcement powers of the Federal Reserve. In addition, because we are a holding company, we are dependent upon the payment of dividends by the Bank to us as our principal source of funds to pay dividends in the future, if any, and to make other payments. The Bank is also subject to various legal, regulatory and other restrictions on its ability to pay dividends and make other distributions and payments to us. See “BUSINESS-Supervision and Regulation.” In addition, in the future we may enter into borrowing or other contractual arrangements that restrict our ability to pay dividends.
As a result of our participation in the SBLF program, we are obligated to pay quarterly non-cumulative dividends on our Series A Preferred Stock held by the U.S. Treasury. Payments are due each January 1, April 1, July 1 and October 1. The dividend rate on our Series A Preferred Stock is 1.0% per annum as of December 31, 2015 and will increase to 9.0% beginning March 27, 2016. Failure to pay quarterly dividends on the Series A Preferred Stock may limit our ability to pay dividends on our common stock in the future.
Recent Sales of Unregistered Securities
Shares of the Company’s common stock were issued during the fourth quarter of 2015 pursuant to the exercise of warrants and options issued by the Company, as follows:
Neither the exercises of the warrants and options nor their original issuances involved any underwriters, underwriting discounts or commissions, or any public offering, and the Company believes that such transactions were exempt from the registration requirements of the Securities Act in reliance on Section 4(a)(2) of the Securities Act (or Rule 506 of Regulation D promulgated thereunder) as transactions by an issuer not involving a public offering.
Equity Compensation Plan Information as of December 31, 2015
Performance Graph
This performance graph shall not be deemed “soliciting material” or to be “filed” with the SEC for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any filing of Franklin Financial Network, Inc. under the Securities Act or the Exchange Act.
The following graph shows a comparison from March 26, 2015 (the date our common stock commenced trading on the NYSE) through December 31, 2015 of the cumulative total return for our common stock, the NYSE Composite Index and the KBW Regional Banks Index. The graph assumes that $100 was invested at the market close on March 26, 2015 in the common stock of Franklin Financial Network, Inc., the NYSE Composite Index and the KBW Regional Banks Index and data assumes reinvestments of dividends. The stock price performance of the following graph is not necessarily indicative of future stock price performance.
ITEM 6.
ITEM 6. SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA.
The following selected historical consolidated financial data as of and for the years ended December 31, 2015, 2014, 2013 and 2012, is derived from the audited consolidated financial statements of FFN.
(amounts are in thousands, except ratios, per share data, banking locations and full time equivalent employees)
(1) Average loans include both loans held in the Bank’s portfolio and mortgage loans held for sale and are net of deferred origination fees and costs.
(2) Efficiency ratio is non-interest expense divided by the sum of net interest income before the provision for loan losses plus non-interest income.
(3) Net interest margin is net interest income (annualized for interim periods) divided by total average earning assets.
(4) Net interest spread is the difference between the average yield on interest-earning assets and the average yield on interest-bearing liabilities.
(5) Interest income and rates for 2015 include the effects of tax-equivalent adjustments, which adjust tax-exempt interest income on tax-exempt loans and investment securities to a fully taxable basis. Due to immateriality, interest income and rates for 2014 exclude the effects of tax-equivalent adjustments.
(6) Capital ratios calculated on consolidated financial statements for December 31, 2015, 2014 and 2013. Prior capital ratios calculated on bank-only data.
Period end loans exclude loans held for sale and exclude deferred fees and costs.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis identifies significant factors that 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 Item 8 “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” as well as other information included in this Annual Report on Form 10-K. Unless otherwise noted, all amounts in this discussion are stated in thousands, with the exception of number of shares or per share amounts.
Critical Accounting Policies
The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses and fair value of financial instruments are particularly subject to change.
The Company’s accounting policies are integral to understanding the results reported. Accounting policies are described in detail in Note 1 of the notes to the consolidated financial statements included elsewhere in this report. The critical accounting policies require judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. Management has established policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief summary of the more significant policies:
Principles of Consolidation
The consolidated financial statements include Franklin Financial Network, Inc. and its wholly owned subsidiaries, Franklin Synergy Bank and Franklin Synergy Risk Management, Inc., together referred to as “the Company.” The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.
Purchased Loans
In accordance with the accounting guidance for business combinations, because we recorded all acquired loans at fair value as of the date of the MidSouth acquisition, we did not establish an allowance for loan losses on any of the loans we purchased as of the acquisition date as any credit deterioration evident in the loans was included in the determination of the acquisition date fair values. For purchased credit-impaired loans accounted for under ASC 310-30, management establishes an allowance for loan losses subsequent to the date of acquisition by re-estimating expected cash flows on these loans on a quarterly basis, with any decline in expected cash flows due to credit triggering impairment recorded as provision for loan losses. The allowance established is the excess of the loan’s carrying value over the present value of projected future cash flows, discounted at the current accounting yield of the loan. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. While the determination of specific cash flows involves estimates, each estimate is unique to the individual loan, and none is individually significant. For non-purchased credit-impaired loans acquired in the MidSouth transaction and that are accounted for under ASC 310-20, the historical loss estimates are based on the historical losses experienced by MidSouth for loans with similar characteristics as those acquired other than purchased credit-impaired loans. We record an allowance for loan losses only when the calculated amount exceeds the remaining credit mark established at acquisition.
Allowance for Loan Losses
The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
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.
All loans classified by management as substandard or worse are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on a combination of the Bank’s loss history and loss history from the Bank’s peer group over the past three years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.
Mortgage Servicing Rights
When loans are sold with servicing retained, servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of loans. Fair value is based on market prices for comparable servicing contracts. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported with loan servicing fees on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income, which is reported on the income statement as loan servicing fees, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against mortgage loan servicing fee income.
Overview
The Company reported net income of $16,080 for the year ended December 31, 2015, compared to $8,414 for the year ended December 31, 2014, and $4,561 for the year ended December 31, 2013. After the payment of
preferred dividends on the senior preferred stock issued to the Treasury pursuant to Small Business Lending Fund (“SBLF”), the Company’s net earnings available to common shareholders years ended December 31, 2015, 2014 and 2013 was $15,980, $8,314, and $4,452, respectively. The primary reason for the increase in net earnings available to common shareholders was increased interest income on loans and investment securities due to significant organic growth in each of these portfolios during 2015 and a combination of organic growth and the acquisition of MidSouth during 2014, which is discussed in the paragraphs that follow.
Acquisition of MidSouth
On July 1, 2014, the acquisition of MidSouth was completed, expanding the Company’s presence in in the Nashville-Davidson-Murfreesboro-Franklin, TN Metropolitan Statistical Area, specifically in the Rutherford County market. Headquartered in Murfreesboro, Tennessee and founded in 2004, MidSouth had five branches located throughout Rutherford County, which is adjacent to Williamson County. As of June 30, 2014, MidSouth had total assets of $281,051, total loans of $191,692 and total deposits of $244,242. MidSouth held a loan portfolio that was primarily comprised of real estate loans. Immediately prior to the closing of the acquisition, as of June 30, 2014, MidSouth’s nonperforming loans totaled 1.34% of total loans, and net recoveries to average loans, on an annualized basis, was 0.17% for the first six months of 2014.
As a result of the MidSouth acquisition, the Company:
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grew consolidated total assets from $872,142 to $1,165,972 as of July 1, 2014, after giving effect to purchase accounting adjustments;
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increased total loans from $485,589 to $669,934 as of July 1, 2014;
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increased total deposits from $747,324 to $991,739 as of July 1, 2014; and
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expanded its employee base from 126 full time equivalent employees to 227 full time equivalent employees as of July 1, 2014.
Acquisition of Civic Bank & Trust
On December 14, 2015, the Company and Civic entered into a definitive merger agreement pursuant to which the Company will acquire Civic in an all-stock transaction valued at approximately $28.6 million. Under the terms of the agreement, Civic will be merged with and into Franklin Synergy Bank, with Franklin Synergy Bank continuing as the surviving institution in the Merger.
According to the terms of the merger agreement, each Civic common shareholder will have the right to receive shares of Franklin Synergy common stock for each share of Civic common stock based on an exchange ratio that will range from 0.4114 to 0.3695 using the minimum market price of $26.50 of the Company’s common stock and a maximum market price of $29.50 of the Company’s common stock, to be determined at the time of the merger. The merger is expected to qualify as a tax-free reorganization for Civic shareholders.
Civic operates two branch offices in the Nashville metropolitan area and as of December 31, 2015, had $145.1 million in total assets, which included $85.7 million in total loans, and $104.6 million in total deposits.
The acquisition is expected to close in the second quarter of 2016 and is subject to regulatory approval, Civic shareholder approval, and other customary conditions set forth in the merger agreement.
Net Interest Income/Margin
Net interest income consists of interest income generated by earning assets, less interest expense. Net interest income for the years ended December 31, 2015, 2014 and 2013 totaled $59,415, $37,693, and $21,045, respectively, which are increases of $21,722, or 57.6%, and $16,648, or 79.1%, respectively.
For the years ended December 31, 2015 and 2014, interest income increased $25,289 and $18,450 due to growth in both the loan and investment securities portfolios. These were offset by increases of $3,567 and $1,802 in interest expense, which totaled $9,306, $5,739 and $3,937, respectively, for the years ended December 31, 2015, 2014 and 2013, as a result of increases in both interest-bearing deposits and borrowings.
Interest-earning assets averaged $1,685,073, $1,008,156 and $616,880 during the years ended December 31, 2015, 2014 and 2013, which are increases of $676,917, or 67.1%, and $391,276, or 63.4%, respectively. The increase in 2015 was primarily due to significant organic growth in loans and investment securities, and the increase in 2014 was due to substantial organic growth and to the acquisition of MidSouth.
For the years ended December 31, 2015 and 2014, average loans increased 65.5% and 72.1%, respectively, and investment securities increased 71.6% and 49.9%, respectively. The yield on average interest-earning assets decreased 14 basis points to 4.17% during the year ended December 31, 2015, increased 26 basis points to 4.31% during the year ended December 31, 2014, compared to 4.05% for the year ended December 31, 2013. The yields on average loans decreased 19 basis points during the year ended December 31, 2015 and 16 basis points during the year ended December 31, 2014.
For the years ended December 31, 2015, 2014 and 2013, the yield on available for sale securities was 2.44%, 2.59% and 1.79%, respectively. The primary driver for the decrease during 2015 was the decline in coupon rate on the Company’s securities. During 2015, the yield related to coupon rate declined from 4.45% in 2014 to 4.14% in 2015. The primary driver for the increase during 2014 was the slowing of prepayment amortization. During the year ended December 31, 2014, prepayment amortization of available for sale securities was $2,650, which represented a yield reduction of 86 basis points when compared to 2013.
Interest-bearing liabilities averaged $1,409,753, $848,993 and $525,906, respectively, during the years ended December 31, 2015, 2014 and 2013, which are increases of $560,760, or 66.1%, during 2015 and $323,087, or 61.4%, during 2014. The increase during 2015 was primarily attributed to growth of average interest-bearing deposits. The increase for 2014 was due primarily to the acquisition of MidSouth.
During 2015, total average interest-bearing deposits grew $517,948, which included increases in average interest checking of $69,913, average money market accounts of $163,945, and average time deposits outstanding of $272,399. During 2014, total average interest-bearing deposits grew $307,720, which included increases in average interest checking of $87,325, average money market accounts of $85,386, and average time deposits outstanding of $124,572.
Rapid growth in the loan portfolio also resulted in an increase in average Federal Home Loan Bank advances of $17,937 and $9,031, respectively in 2015 and 2014. The loan growth also resulted in increases in average Federal funds purchased and other borrowings, including securities sold under agreement to repurchased, of $24,875 and $6,336, respectively, during 2015 and 2014.
The cost of average interest-bearing liabilities decreased two basis points to 0.66% during 2015 and seven basis points to 0.68% during 2014. The favorable decline in 2015 was attributable to decreases in rates paid on money market accounts, time deposits, Federal Home Loan Bank advances and Federal funds purchase and other borrowings. The favorable decline in 2014 was primarily due to decreases in the rates paid on money market accounts and time deposits.
The tables below summarize average balances, yields, cost of funds, and the analysis of changes in interest income and interest expense for the years ended December 31, 2015, 2014, and 2013:
Average Balances(7)-Yields & Rates
(Dollars in thousands)
(1) Loan balances include both loans held in the Bank’s portfolio and mortgage loans held for sale and are net of deferred origination fees and costs. Non-accrual loans are included in total loan balances.
(2) Includes federal funds sold, capital stock in the Federal Reserve Bank and Federal Home Loan Bank, and interest-bearing deposits at the Federal Reserve Bank and the Federal Home Loan Bank.
(3) Includes repurchase agreements.
(4) Represents the average rate earned on interest-earning assets minus the average rate paid on interest-bearing liabilities.
(5) Represents net interest income divided by total average earning assets.
(6) Interest income and rates for 2015 include the effects of tax-equivalent adjustments to adjust tax-exempt interest income on tax-exempt loans and investment securities to a fully taxable basis. Due to immateriality, interest income and rates for 2014 exclude the effects of tax-equivalent adjustments to adjust tax-exempt interest income on tax-exempt loans and investment securities to a fully taxable basis.
(7) Average balances are average daily balances.
The tables below detail the components of the changes in net interest income for the periods indicated. For each major category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes due to average volume and changes due to rates, with the changes in both volumes and rates allocated to these two categories based on the proportionate absolute changes in each category. The changes noted in the table below include tax equivalent adjustments, and as a result, will not agree to the amounts reflected on the Company’s consolidated statements of income for the categories that have been adjusted to reflect tax equivalent income.
Analysis of Changes in Interest Income and Expenses
Provision for Loan Losses
The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for probable losses incurred in the loan portfolio. The allowance is increased by the provision for loan losses and is decreased by charge-offs, net of recoveries on prior loan charge-offs.
The provision for loan losses was $5,030, $2,374 and $907 for the years ended December 31, 2015, 2014 and 2013, respectively. The higher provision amounts for 2015 and 2014 are due primarily to higher loan growth during 2015 and 2014. Nonperforming loans at December 31, 2015, 2014 and 2013 totaled $3,286, $1,151 and $2,601, representing 0.3%, 0.1% and 0.6% of total loans, respectively.
Non-Interest Income
Non-interest income for the years ended December 31, 2015, 2014 and 2013 was $12,830, $10,051 and $6,819, respectively. The following is a summary of the components of non-interest income (in thousands):
Service charges on deposit accounts increased 113.2% in 2015 due to changes made to the Company’s schedule of service charges and to the reduction of the amount of service charges waived.
Other service charges and fees for the year ended December 31, 2015 increased 48.8% from 2014, due to increased ATM surcharge income and to the increase in nonsufficient funds charges collected during the year. Other service charges and fees for the year ended December 31, 2014 increased 59.8% from 2013, primarily due to the MidSouth acquisition, which contributed to increases in ATM fees and investment management fees.
Net gains on the sale of loans include net gains realized from the sales of mortgage loans and SBA loans. Net gains on the sale of mortgage loans are based, in part, on differences between the carrying value of loans being sold to third-party investors and the selling price. Also included are changes in the fair value of mortgage banking derivatives entered into by the Company to hedge the change in interest rates on loan commitments prior to their sale in the secondary market. Fluctuations in mortgage interest rates, changes in the demand for certain loans by investors, and whether servicing rights associated with the loans being sold are retained or released all affect the net gains on mortgage loan sales. Net gains for year ended December 31, 2015 was $6,959, an increase of $1,145, or 19.7%, from the year ended December 31, 2014, primarily attributed to the volume of mortgage loans sold during 2015. Net gains for year ended December 31, 2014 was $5,814, an increase of $1,411, or 32.0%, from the year ended December 31, 2013. The increase was primarily due to improved pricing spread on mortgage loans sold. The Company recognized $5,636 in pricing adjustment gains during 2015, compared to $3,455 during 2014, an increase of $2,181 or 63.1%. The Company recognized $3,455 in pricing adjustment gains during 2014, compared to $1,413 during 2013, an increase of $2,042, or 144.5%. Residential refinancing activity that began to surge during the second half of 2011 in response to historically low interest rates remained significant into 2013 but began to decrease in the second half of 2013.
Wealth management income is the commission earned based on the investment brokerage activities and volume related to the Company’s wealth management clients. These commissions are also impacted by market conditions and will fluctuate from time to time due to rises and declines in the investment markets. Wealth management income for 2015 was $1,283, an increase of 100.8% when compared with 2014. The increase is attributable to the growth experienced in the increase of assets under management and in the growth in the investment markets during 2015. Wealth management income for 2014 was $639, an increase of 165.1% when compared with 2013. The increase in investment services income is attributable to the acquisition of MidSouth, which included an established trust and investment division.
Loan servicing fees are fees earned for servicing residential mortgages and SBA loans offset by the amortization of mortgage servicing rights. These servicing rights are initially recorded at fair value and then amortized in proportion to, and over the period of, the estimated life of the underlying loans. In addition, impairment
to the mortgage servicing rights may be recognized through a valuation allowance, and adjustments to the allowance can affect the net loan servicing fees. For the year ended December 31, 2015, net loan servicing fees were $227 compared to $254 for the year ended December 31, 2014. The decrease in servicing fees in 2015 is attributable to the increase in amortization during the year. For the year ended December 31, 2014, net loan servicing fees were $254 compared to ($365) for the year ended December 31, 2013. The favorable increase to loan servicing fees was primarily related to a decrease in amortization as a result of a decrease in residential refinancing activity.
Non-interest Expense
Non-interest expense for the years ended December 31, 2015, 2014 and 2013 was $42,114, $31,822 and $19,662, respectively. This increase was the result of the following components listed in the table below (in thousands):
The increase in non-interest expense noted in the table above is relative to the Company’s overall current growth. One of the major increases was in salaries and employee benefits. During 2015, salaries and employee benefits expense increased 25.5%, with increases in salary expense and mortgage commissions being the largest attributes of the increase. Salary expense increased due to the addition of experienced lenders and their related support personnel, including a lending team that specialized in healthcare and other types of commercial lending. Mortgage commissions increased due to increased volume of mortgage loans sold during 2015. During 2014, salaries and employee benefits increased with the acquisition of MidSouth, increasing the Company’s full-time equivalent employees from 123 as of December 31, 2013, to 218 as of December 31, 2014. The increased number of personnel was due to the retention of the majority of the MidSouth employees that were needed to support the expansion in the number of branches as well as additional operational staff needed to handle the Company’s growth in loans and deposits.
The increase in occupancy and equipment expense during 2015 is attributable to: (1) increases in building rent expense from the expansion of the Company’s headquarters in Franklin, Tennessee and the Rutherford County properties sold and leased back during 2015; and (2) increased depreciation expenses related to the furniture, equipment and leasehold improvements that have been added as a result of the Company’s growth. The increase in occupancy and equipment expenses during 2014 is attributed to the addition of six branches, five of which were added with the acquisition of MidSouth, the relocation of two branch offices, and the expansion of the Company’s headquarters in downtown Franklin, Tennessee.
The Company’s FDIC assessment increased in 2015 due to the Company’s growth in assets during the year, and 2014 primarily due to the acquisition of MidSouth and the related growth in assets.
Net loss on sale and write-down of foreclosed assets consists of losses from the sale of Other Real Estate Owned (“OREO”) properties and other foreclosed assets and from valuation adjustments against the carrying costs of foreclosed assets. For the year ended December 31, 2015, there was a gain on the sale of OREO of $26 compared to a loss of $96 for the year ended December 31, 2014 and a loss of $223 for the year ended December 31, 2013.
The increase in marketing expenses during 2015 is attributed to increased marketing and public relations efforts to further the growth of the Company. The increase in marketing expenses during 2014 is primarily attributed to the acquisition of MidSouth, since the Company increased its marketing efforts in the Rutherford County, Tennessee market around the time the acquisition was completed.
The 18.9% increase in professional fees during 2015 is attributed to increases in legal fees ($255), audit/accounting fees ($283) and brokerage settlement expenses ($188), the latter of which is related to the Company’s wealth management division being operational for a full year after being added as part of the MidSouth acquisition. These increases were offset by a decrease of $429 in other professional fees due to level of expenses incurred in 2014 related to the MidSouth acquisition. The increase in professional fees during 2014 is primarily from fees associated with the acquisition of MidSouth. These expenses totaled $2,040 for the year ended December 31, 2014, compared to $596 for the same period in 2013, and included investment banker fees, consulting fees and various legal and accounting fees. Expenses related to the Company’s acquisition of MidSouth totaled $926. These expenses were related to the systems conversions and various professional fees for legal, accounting and investment banking consultants. In addition, the Company experienced increases in other professional fees, specifically in brokerage settlement expenses ($159), legal fees ($96), and accounting fees ($144).
Other noninterest expense increased $2,494, or 55.8%, during 2015 and $2,197, or 96.7%, during 2014 due to a number of different types of expenses. During 2015, the larger increases included the following: loan-related expenses ($434); insurance expense ($366); indirect costs associated with the Company’s IPO ($326); amortization of core deposit intangible ($293); electronic banking expense ($218); franchise taxes ($177); and telecommunications ($122). During 2014, the larger increases included the following: amortization of core deposit intangible ($361); mortgage lending expense ($288); electronic banking expense ($275); telecommunications ($265); loan-related expenses ($234); and franchise taxes ($171).
Income Tax Expense
The Company recognized an income tax expense for the years ended December 31, 2015, 2014, and 2013 of $9,021, $5,134 and $2,734, respectively. The Company’s year-to-date income tax expense for the years ended December 31, 2015, 2014, and 2013 reflects effective income tax rates 35.9%, 37.9%, and 37.5%, respectively. The decrease in the effective tax rate for 2015 is attributed to the increase in the Company’s tax-exempt investment securities, and the increase in the effective tax rate in 2014 resulted from unfavorable permanent differences arising from expenses associated with the MidSouth acquisition and from stock-based compensation expense incurred from the vesting of incentive stock options as a result of employee retirement.
Return on Equity and Assets
The following schedule details selected key ratios for the years ended December 31, 2015, 2014 and 2013:
The minimum leverage capital ratio required by the regulatory agencies is 4.00%.
Under guidelines developed by regulatory agencies a “risk weight” is assigned to various categories of assets and commitments ranging from 0% to 100% based on the risk associated with the asset. The following schedule details the Bank’s risk-based capital at December 31, 2015 excluding the net unrealized gain on available-for-sale securities which is shown as an addition in stockholders’ equity in the consolidated financial statements:
The minimum Common Equity Tier 1 risk-based capital ratio required by the regulatory agencies is 4.50%. Tier 1 risk-based capital ratio required by the regulatory agencies is 6.00%, and the minimum total risk-based capital ratio required is 8.00%. At December 31, 2015, the Company was in compliance with these requirements.
COMPARISON OF BALANCE SHEETS AT DECEMBER 31, 2015 and DECEMBER 31, 2014
Overview
The Company’s total assets increased by $811,965, or 59.9%, from December 31, 2014 to December 31, 2015. The increase in total assets was the result of the Company’s initial public offering that was completed in the first quarter of 2015 and from organic growth in both the loan portfolio and the investment portfolio.
The following table presents the growth experienced by the Company when comparing selected balance sheet totals from December 31, 2015 and 2014.
Loans Held For Sale
At December 31, 2015, the Company had $14,079 in mortgage loans held for sale, compared to $18,462 as of December 31, 2014, a decrease of 23.7%. The decrease is attributable to the volume of loans closed and in the process of being sold to investors at December 31, 2015. For the years ended December 31, 2015, 2014 and 2013, the Company realized gains from sales of mortgage loans totaling $6,859, $5,814 and $4,403, respectively.
Loans
Lending-related income is the most important component of the Company’s net interest income and is a major contributor to profitability. The loan portfolio is the largest component of earning assets, and it therefore generates the largest portion of revenues. The absolute volume of loans and the volume of loans as a percentage of earning assets is an important determinant of net interest margin as loans are expected to produce higher yields than securities and other earning assets. Total loans, net of deferred fees, at December 31, 2015 and 2014 were $1,303,826 and $787,188, respectively, an increase of $516,638, or 65.6%. This growth in the loan portfolio is due to increased market penetration and a healthy local economy, as well as the addition of experienced lending officers, including a team of lenders that specialize in healthcare and commercial lending.
The table below provides a summary of the loan portfolio composition for the periods noted.
note 1: PCI accounted for pursuant to ASC Topic 310-30.
As presented in the above table, gross loans increased $518,055, or 65.7%, during 2015. During 2015, the Company experienced growth in real estate loans of 44.4%, with the growth occurring in the construction and land development (55.8%), commercial real estate (47.4%) and residential real estate (28.4%) segments. The Company
also experienced very strong growth of 265.4% in the commercial and industrial segment during 2015. The healthcare lending team that joined the Company in the second quarter of 2015 contributed 62.9% of the growth in the commercial and industrial segment.
Real estate loans comprised 77.6% of the loan portfolio at December 31, 2015. The largest portion of the real estate segments of the portfolio as of December 31, 2015, was construction and land development loans, which totaled 36.8% of real estate loans. Construction and land development loans totaled $372,845 at December 31, 2015, and comprised 28.5% of the total loan portfolio. Loans in this classification provide financing for the construction and development of residential properties and commercial income properties, multi-family residential development, and land designated for future development.
Commercial real estate loans totaled $365,683 at December 31, 2015, and comprised 36.1% of real estate loans and 28.0% of the total loan portfolio. The commercial real estate loan classification primarily includes commercial-based mortgage loans that are secured by nonfarm, nonresidential real estate properties and multi-family residential properties.
The residential real estate classification primarily includes 1-4 family residential loans which are typically conventional first-lien home mortgages, not including loans held-for-sale in the secondary market. Residential real estate loans totaled $275,497 and comprised 27.2% of real estate loans and 21.1% of total loans at December 31, 2015.
Commercial and industrial loans grew 265.4% during 2015, primarily due to the addition of the healthcare lending team in the second quarter of 2015. At December 31, 2015, this team’s commercial and industrial loans totaled $130,421, which was 45.6% of total commercial and industrial loans. The commercial and industrial classification consists of commercial loans to various sizes of businesses that are primarily secured by commercial assets, such as inventories, business equipment, receivables and other commercial assets.
The repayment of loans is a source of additional liquidity for the Company. The following table sets forth the loans maturing within specific intervals at December 31, 2015, excluding unearned net fees and costs.
Loan Maturity Schedule
The information presented in the above table is based upon the contractual maturities of the 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 their maturity. Consequently, management believes this treatment presents fairly the maturity structure of the loan portfolio.
Allowance for Loan Losses
The Company maintains an allowance for loan losses that management believes is adequate to absorb the probable incurred losses inherent in the Company’s loan portfolio. The allowance is increased by provisions for loan losses charged to earnings and is decreased by loan charge-offs net of recoveries of prior period loan charge-offs. The level of the allowance is determined on a quarterly basis, although management is engaged in monitoring the adequacy of the allowance on a more frequent basis. In estimating the allowance balance, the following factors are considered:
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past loan experience;
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the nature and volume of the portfolio;
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risks known about specific borrowers;
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underlying estimated values of collateral securing loans;
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current and anticipated economic conditions; and
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other factors which may affect the allowance for probable incurred losses.
The allowance for loan losses consists of two primary components: (1) a specific component which relates to loans that are individually classified as impaired and (2) a general component which covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on a combination of the Company’s loss history and loss history from peer group over the past three years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment.
The following loan portfolio segments have been identified: (1) Construction and land development loans, (2) Commercial real estate loans, (3) Residential real estate, (4) Commercial and industrial loans, and (5) Consumer and other loans. Management evaluates the risks associated with these segments based upon specific characteristics associated with the loan segments. These risk characteristics include, but are not limited to, the value of the underlying collateral, adverse economic conditions, and the borrower’s cash flow. While the total allowance consists of a specific portion and a general portion, both portions of the allowance are available to provide for probable incurred loan losses in the entire portfolio.
In the table below, the components, as discussed above, of the allowance for loan losses are shown at December 31, 2015 and 2014.
note 1: Loans acquired pursuant to the July 1, 2014 acquisition of MidSouth that are not PCI loans. These are performing loans recorded at estimated fair value at the acquisition date. This amount is accreted into interest income over the remaining lives of the related loans on a level yield basis. The remaining fair value discount balance at December 31, 2015 related to the non-PCI acquired loans was $2,561, or 2.6% of the outstanding aggregate loan balances. One of the purchased loans has been identified as impaired beyond the extent of the recorded discounts, and an allowance for loan loss of $9 was recorded at December 31, 2015 related to the acquired loans.
At December 31, 2015, the allowance for loan losses was $11,587, compared to $6,680 at December 31, 2014. The allowance for loan losses as a percentage of total loans was 0.89% and 0.85% at December 31, 2015 and 2014, respectively. Loan growth during this period is the primary reason for the increase in the allowance amount.
The table below sets forth the activity in the allowance for loan losses for the years presented.
(Note 1) Loan balances exclude loans held for sale
While no portion of the allowance is in any way restricted to any individual loan or group of loans, and the entire allowance is available to absorb losses from any and all loans, the following table summarizes the allocation of allowance for loan losses by loan category and loans in each category as a percentage of total loans, for the periods presented.
Fluctuations in the allocations during the periods presented are due, in part, to changes in the specific reserve factors assigned to each category of loans. The Corporation has relied heavily on the loss history of peer groups due to the lack of its own history of losses; therefore, reserve factors have been adjusted in accordance with the loss performance experienced by a select group of local peer banks. Allocations between categories of loans have also been affected by the change in the mix of loans among the categories.
As of December 31, 2015, the largest component of the allowance for loan losses was associated with commercial and industrial loans, followed closely by construction and land development loans and commercial real estate loans. The increase on these reserves as a percentage of the total allowance in these categories was primarily due to significant loan growth in these portfolio segments. Commercial and industrial loans grew 265.4% from $78,194, or 9.9% of total loans at the end of 2014, to $285,700, or 21.9% of total loans at year-end 2015. During 2015, construction and land development loans increased from $239,302 at December 31, 2014 to $372,845 at December 31, 2015, an increase of 55.8%. During the same period, commercial real estate loans increased 47.4%, from $248,150 at December 31, 2014 to $365,683 at December 31, 2014.
Nonperforming Assets
Nonperforming loans consist of non-accrual loans and loans that are past due 90 days or more and still accruing interest. Nonperforming assets consist of nonperforming loans plus OREO (i.e. real estate acquired through foreclosure or deed in lieu of foreclosure). Loans are placed on non-accrual status when they are past due 90 days and management believes the borrower’s financial condition, after giving consideration to economic conditions and collection efforts, is such that collection of interest is doubtful. When a loan is placed on non-accrual status, interest accruals cease and uncollected interest is reversed and charged against current income. The interest on these loans is accounted for on the cash-basis, or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
The primary component of nonperforming loans is non-accrual loans, which as of December 31, 2015 totaled $908. The other component of nonperforming loans are loans past due greater than 90 days and still accruing interest. Loans past due greater than 90 days are placed on non-accrual status unless they are both well-secured and in the process of collection. There were outstanding loans totaling $2,378 that were past due 90 days or more and still accruing interest at December 31, 2015.
The table below summarizes nonperforming loans and assets for the periods presented.
As of December 31, 2015, there were three loans on non-accrual status. The amount and number are further delineated by collateral category and number of loans in the table below.
Troubled debt restructurings (TDRs) are modified loans in which a concession is provided to a borrower experiencing financial difficulties. Loan modifications are considered TDRs when the concession provided is not available to the borrower through either normal channels or other sources; however, not all loan modifications are TDRs. Our standards relating to loan modifications consider, among other factors, minimum verified income requirements, cash flow analysis, and collateral valuations; however, each potential loan modification is reviewed individually and the terms of the loan are modified to meet a borrower’s specific circumstances at a point in time. TDRs can be classified as either accrual or non-accrual loans. Non-accrual TDRs are included in non-accrual loans whereas accruing TDRs are excluded because the borrower remains contractually current. The Company had no TDRs as of December 31, 2015 and 2014.
Generally, loans that are current as to principal and interest are not included in our nonperforming assets categories; however, a loan that is current may be classified as a potential problem loan if doubts arise about the borrower’s future performance under the terms of the loan contract. Loans are assigned risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans are analyzed individually when classifying the loans as to credit risk.
The following definitions are used for assigning risk ratings to loans:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be “Pass” rated loans. All loans in all loan categories are assigned risk ratings. As of December 31, 2015, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
Investment Securities
The investment securities portfolio is intended to provide the Company with adequate liquidity, flexible asset/liability management and a source of stable income. The portfolio is structured with minimal credit exposure to the Company and consists of both securities classified as available-for-sale and securities classified as held-to-maturity. All available-for sale securities are carried at fair value and may be used for liquidity purposes should management deem it to be in the Company’s best interest. Securities available-for-sale, consisting primarily of U.S. government sponsored enterprises and mortgage-backed securities, were $575,838 at December 31, 2015, compared to $395,705 at December 31, 2014, an increase of $180,133, or 45.5%. The increase in available-for-sale securities was primarily attributed to the Company’s leverage program, which was enacted to invest funds received in the Company initial public offering at the end of first quarter 2015.
The Company’s held-to-maturity securities are carried at amortized cost. This portfolio, consisting of U.S. government sponsored enterprises, mortgage-backed securities and municipal securities, totaled $158,200 at December 31, 2015, compared to $53,332 at December 31, 2014, an increase of $104,868, or 196.6%, also as a part of the Company’s leverage program and as a strategy to provide tax-exempt income.
The combined portfolios represented 33.9% and 33.1% of total assets at December 31, 2015, and December 31, 2014, respectively. At December 31, 2015, the Company had no securities that were classified as having Other Than Temporary Impairment.
The following table summarizes the fair value of the available for sale securities portfolio at December 31, 2015, 2014 and 2013:
The following table summarizes the amortized cost of the held to maturity securities portfolio at December 31, 2015, 2014 and 2013:
The table below presents the maturities and yield characteristics of the Company’s available-for-sale securities as of December 31, 2015. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(1) Mortgage-backed securities are grouped into average lives based on December 2015 prepayment projections.
(2) The weighted average yields are based on amortized cost and municipal securities are calculated on a full tax-equivalent basis.
The table below presents the maturities and yield characteristics of the Company’s held-to-maturity securities as of December 31, 2015. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(1) Mortgage-backed securities are grouped into average lives based on December 2015 prepayment projections.
(2) The weighted average yields are based on amortized cost and municipal securities are calculated on a full tax-equivalent basis.
Securities pledged at December 31, 2015 and 2014 had a carrying amount of $595,523 and $366,764, respectively, and were pledged to secure public deposits and repurchase agreements.
At December 31, 2015 and 2014, there were no holdings of securities of any one issuer, other than the U.S. government-sponsored entities and agencies, in an amount greater than 10% of shareholders’ equity.
Restricted Equity Securities
The Company also had other investments of $7,998 and $5,349 at December 31, 2015, and December 31, 2014, respectively, consisting of capital stock in the Federal Reserve and the Federal Home Loan Bank (required as members of the Federal Reserve Bank System and the Federal Home Loan Bank System). The Federal Home Loan Bank and Federal Reserve investments are “restricted” in that they can only be sold back to the respective institutions or another member institution at par, and are thus, not liquid, have no ready market or quoted market value, and are carried at cost.
Bank Premises and Equipment
Bank premises and equipment totaled $7,640 at December 31, 2015 compared to $9,664 at December 31, 2014, a decrease of $2,024, or 20.9%. This decrease was primarily due to reclassifying as assets held for sale $1,640 in bank premises at the Company’s College Street location, which included two buildings, land and land improvements. These assets were reclassified as held for sale since they had been identified for sale, and the sale of the properties was probable.
Bank Owned Life Insurance
As of December 31, 2015, the Company had $22,619 in bank owned life insurance (“BOLI”), compared to $11,664 at December 31, 2014. The increase in BOLI is primarily attributed to additional BOLI purchased during 2015 as part of the directors’ pre- and post-retirement split dollar plans and to provide coverage for additional officers within the Company.
Goodwill and Intangible Assets
As of December 31, 2015 and 2014, the Company had $9,124 in goodwill. The goodwill is related to the acquisition of MidSouth and is presented in tabular format NOTE 2 of the footnotes to the financial statements. At December 31, 2015, there were no circumstances or significant changes that have occurred in the last six months of 2015 related to the acquisition of MidSouth that, in management’s assessment, would necessitate recording impairment of goodwill. The fair values initially assigned to the assets acquired and liabilities assumed were preliminary and based on appraisals received subsequent to the acquisition date, the Company adjusted its initial fair value estimate of foreclosed assets that were acquired, which increased goodwill by $160 during the fourth quarter of 2014.
As of December 31, 2015 and 2014, the Company had net core deposit intangible of $2,043 and $2,698, respectively, all of which is attributed to the acquisition of MidSouth. At the time of the acquisition as of July 1, 2014, the Company recorded a core deposit intangible of $3,060, and that intangible is being amortized over 8.2 years. Through December 31, 2015, the Company has recognized amortization of $1,017 related to the core deposit intangible.
The following table represents acquired intangible assets at December 31, 2015 and 2014:
Aggregate amortization expense was $655 for 2015 and $362 for 2014. There was no amortization expense for 2013.
The following table presents estimated amortization expense for each of the next five years:
Deposits
Deposits represent the Company’s largest source of funds. The Company competes with other bank and nonbank institutions for deposits, as well as with a growing number of non-deposit investment alternatives available to depositors, such as mutual funds, money market funds, annuities, and other brokerage investment products. Challenges to deposit growth include price changes on deposit products given movements in the rate environment and other competitive pricing pressures, and customer preferences regarding higher-costing deposit products or non-deposit investment alternatives.
At December 31, 2015, total deposits were $1,814,039, an increase of $641,806, or 54.8%, compared to $1,172,233 at December 31, 2014. Included in the Company’s funding strategy are brokered deposits and public funds deposits. Total brokered deposits increased from $86,383 at December 31, 2014 to $478,257 at December 31, 2015, primarily due to the brokered deposits that were added in 2015 as part of the Company’s leverage program. Public funds deposits decreased from $342,179 at December 31, 2014 to $327,766 at December 31, 2015.
Time deposits, excluding brokered deposits, as of December 31, 2015, amounted to $470,284, as compared to $268,101 as of December 31, 2014.
The average amounts for deposits for 2015, 2014 and 2013 are detailed in the following schedule.
The following table shows time deposits, excluding brokered deposits, of $100 or more by category based on time remaining until maturity.
Liquidity, Other Borrowings, and Capital Resources
Federal Funds Purchased and Repurchase Agreements
As of December 31, 2015, the Company had Federal funds purchased from correspondent banks totaling $39,825 compared to $16,825 outstanding as of December 31, 2014. The average Federal funds rate at December 31, 2015 was 0.76%.
Securities sold under agreements to repurchase had an outstanding balance of $61,261 as of December 31, 2015, compared to $22,253 as of December 31, 2014. Securities sold under agreements to repurchase are financing arrangements that mature daily. At maturity, the securities underlying the agreements are returned to the Company. The Company repurchase agreements at December 31, 2015 were composed of two types of agreements: customer repurchase agreements and a correspondent bank repurchase agreement, the latter of which serves as a short-term funding instrument for the Company. The weighted average rate for repurchase agreements was 0.64% as of December 31, 2015.
Federal Home Loan Bank Advances
The Company has established a line of credit with the Federal Home Bank of Cincinnati which is secured by a blanket pledge of 1-4 family residential mortgages. At December 31, 2015, advances totaled $57,000 compared to $19,000 as of December 31, 2014.
At December 31, 2015, the scheduled maturities of these and advances and interest rates were as follows:
Capital
Shareholders’ equity was $188,816 at December 31, 2015, an increase of $67,017, or 55.0%, from $121,799 at December 31, 2014. No common dividends were paid during 2015.
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Management believes as of December 31, 2015, the Company and Bank meet all capital adequacy requirements to which they are subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At December 31, 2015, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category. Actual and required capital amounts and ratios are presented below as of December 31, 2015 and 2014 for the Company and Bank.
Contractual Obligations
The following table summarizes our contractual obligations and other commitments to make future payments as of December 31, 2015:
FHLB advances include arrangements under various FHLB credit programs. Long-term FHLB debt is more fully described under the caption “Federal Home Loan Bank Advances” in Note 9 of our Consolidated Financial Statements. Lease commitments include the leases in place for certain branch sites.
Interest Rate Sensitivity
The following schedule details the Company’s interest rate sensitivity at December 31, 2015:
 Loans, net of unearned income excludes non-accrual loans.
Liquidity
Liquidity is defined as the ability to meet anticipated customer demands for funds under credit commitments and deposit withdrawals at a reasonable cost and on a timely basis.
Liquidity risk involves the risk of being unable to fund assets with the appropriate duration and rate-based liabilities, as well as the risk of not being able to meet unexpected cash needs. Liquidity planning and management are necessary to ensure the ability to fund operations cost-effectively and to meet current and future potential obligations such as loan commitments, lease obligations, and unexpected deposit outflows. In this process, management focuses on both assets and liabilities and on the manner in which they combine to provide adequate liquidity to meet the Company’s needs.
Funds are available from a number of basic banking activity sources including the core deposit base, the repayment and maturity of loans, payments of principal and interest as well as sales of investments classified as available-for-sale, and sales of brokered deposits. As of December 31, 2015, $575,838 of the investment securities portfolio was classified as available-for-sale and is reported at fair value on the consolidated balance sheet. Another $158,200 of the portfolio was classified as held-to-maturity and is reported at amortized cost. Approximately $595,524 of the total $734,038 investment securities portfolio on hand at December 31, 2015, was pledged to secure public deposits and repurchase agreements. Other funding sources available include repurchase agreements, federal funds purchased, and borrowings from the Federal Home Loan Bank.
Effects of Inflation and Changing Prices
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on the performance of a financial institution than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates. In addition, inflation affects financial institutions’ increased cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and shareholders’ equity. Commercial and other loan originations and refinancings tend to slow as interest rates increase, and can reduce the Company’s earnings from such activities.
Off Balance Sheet Arrangements
The Company generally does not have any off-balance sheet arrangements other than approved and unfunded loans and lines and letters of credit to customers in the ordinary course of business. At December 31, 2015, the Company had unfunded loan commitments outstanding of $42,486, unused lines of credit of $384,979, and outstanding standby letters of credit of $14,473.
GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
Some of the financial data included in our selected historical consolidated financial information are not measures of financial performance recognized by GAAP. Our management uses these non-GAAP financial measures in its analysis of our performance:
•
“Common shareholders’ equity” is defined as total shareholders’ equity at end of period less the liquidation preference value of the preferred stock;
•
“Tangible common shareholders’ equity” is common shareholders’ equity less goodwill and other intangible assets;
•
“Total tangible assets” is defined as total assets less goodwill and other intangible assets;
•
“Other intangible assets” is defined as the sum of core deposit intangible and SBA servicing rights;
•
“Tangible book value per share” is defined as tangible common shareholders’ equity divided by total common shares outstanding. This measure is important to investors interested in changes from period-to-period in book value per share exclusive of changes in intangible assets;
•
“Tangible common shareholders’ equity ratio” is defined as the ratio of tangible common shareholders’ equity divided by total tangible assets. We believe that this measure is important to many investors in the marketplace who are interested in relative changes from period-to period in common equity and total assets, each exclusive of changes in intangible assets;
•
“Return on Average Tangible Common Equity” is defined as net income available to common shareholders divided by average tangible common shareholders’ equity;
•
“Efficiency ratio” is defined as noninterest expenses divided by our operating revenue, which is equal to net interest income plus noninterest income;
•
“Adjusted yield on loans” is our yield on loans after excluding loan accretion from our acquired loan portfolio. Our management uses this metric to better assess the impact of purchase accounting on our yield on loans, as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off of our balance sheet;
•
“Net interest margin” is defined as annualized net interest income divided by average interest-earning assets for the period; and
•
“Adjusted net interest margin” is net interest margin after excluding loan accretion from the acquired loan portfolio and premiums for acquired time deposits. Our management uses this metric to better assess the impact of purchase accounting on net interest margin, as the effect of loan discount accretion and accretion of net discounts and premiums related to deposits is expected to decrease as the acquired loans and deposits mature or roll off of our balance sheet.
We believe these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations and cash flows computed in accordance with
GAAP; however, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use.
The following reconciliation table provides a more detailed analysis of these non-GAAP financial measures:
(1) Net interest margins shown in the table above do not include tax-equivalent adjustments.
Emerging Growth Company Status
The Company is an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if the Company complies with the greater obligations of public companies that are not emerging growth companies, the Company may avail itself of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as the Company is an emerging growth company. The Company will continue to be an emerging growth company until the earliest to occur of: (1) the end of the fiscal year following the fifth anniversary of the effectiveness of our Form S-4
filed with the SEC on May 14, 2014; (2) the last day of the fiscal year in which we have more than $1.0 billion in annual revenues; (3) the date on which we are deemed to be a “large accelerated filer” under the Exchange Act; or (4) the date on which we have, during the previous three-year period, issued publicly or privately, more than $1.0 billion in non-convertible debt securities. Management cannot predict if investors will find the Company’s common stock less attractive because it will rely on these exemptions. If some investors find the Company’s common stock less attractive as a result, there may be a less active trading market for its common stock and the Company’s stock price may be more volatile.
Further, the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a Securities Act registration statement declared effective or do not have a class of securities registered under the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. The Company has elected to opt out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, it adopts the new or revised standard at the time public companies adopt the new or revised standard. This election is irrevocable.
Impact of Recent Accounting Guidance
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606): Revenue from Contracts with Customers. ASU 2014-09 created a new topic in the FASB Accounting Standards Codification® (“ASC”), Topic 606. In addition to superseding and replacing nearly all existing U.S. GAAP revenue recognition guidance, including industry-specific guidance, ASU 2014-09 established a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, ASU 2014-09 added a new Subtopic to the ASC, Other Assets and Deferred Costs: Contracts with Customers (“ASC 340-40”), to provide guidance on costs related to obtaining a contract with a customer and costs incurred in fulfilling a contract with a customer that are not in the scope of another ASC Topic. The new guidance does not apply to certain contracts within the scope of other ASC Topics, such as lease contracts, insurance contracts, financing arrangements, financial instruments, guarantee other than product or service warranties, and non-monetary exchanges between entities in the same line of business to facilitate sales to customers. The amendments are effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.
In June 2014, FASB issued ASU 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, which changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements to secured borrowing accounting. ASU 2014-11 also required enhanced disclosures about repurchase agreements and other similar transactions. The accounting changes in this update became effective for the first interim or annual period beginning after December 31, 2014. The disclosure for transactions accounted for as a sale was effective for the first interim or annual period beginning on or after December 15, 2014; the disclosure for transactions accounted for as secured borrowings was required to be presented for annual periods after December 15, 2014, and interim periods after March 15, 2015. Early application was not permitted. The adoption of this amendment did not have a material effect on the Company’s financial statements.
In January 2016, FASB issued ASU 2016-01, Financial Instruments (Topic 825): Recognition and Measurement of Financial Assets and Financial Liabilities, which amends prior guidance to require an entity to measure its equity investments (except those accounted for under the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income. An entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of same issuer. The new guidance simplifies the impairment assessment of equity investments without readily determinable fair values, requires public entities to use the exit price notion when measuring fair value of financial instruments for disclosure purposes, requires an entity to present separately in other comprehensive income the
portion of the total change in fair value of a liability resulting from changes in the instrument-specific credit risk when the entity has selected fair value option for financial instruments and requires separate presentation of financial assets and liabilities by measurement category and form of financial asset. The new guidance will be effective for reporting periods after January 1, 2018 and is not expected to have a significant impact on the Company’s financial statements.
On February 25, 2016, FASB issued ASU 2016-02 which creates Topic 842, Leases and supersedes Topic 840, Leases. ASU 2016-02 is intended to improve financial reporting about leasing transactions, by increasing transparency and comparability among organizations. Under the new guidance, a lessee will be required to record all leases with lease terms of more than 12 months on their balance sheet as lease liabilities with a corresponding right-of-use asset. ASU 2016-02 maintains the dual model for lease accounting, requiring leases to be classified as either operating or finance, with lease classification determined in a manner similar to existing lease guidance. The new guidance will be effective for public companies for fiscal years beginning on or after December 15, 2018, and for private companies for fiscal years beginning on or after December 15, 2019. Early adoption is permitted for all entities. Management is evaluating the impact ASU 2016-02 will have on the Company’s financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on a large portion of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which possess a short term to maturity. Based upon the nature of our operations, we are not subject to foreign currency exchange or commodity price risk.
Management seeks to maintain profitability in both immediate and long-term earnings through funds management/interest rate risk management. Interest rate risk (sensitivity) management deals with the potential impact on earnings associated with changing interest rates using various rate change (shock) scenarios. Our rate sensitivity position has an important impact on earnings. Senior management monitors our rate sensitivity position throughout each month, and then the Asset Liability Committee (“ALCO”) of the Bank meets on a quarterly basis to analyze the rate sensitivity position and other aspects of asset/liability management. These meetings cover the spread between the cost of funds (primarily time deposits) and interest yields generated primarily through loans and investments, rate shock analyses, liquidity and dependency positions, and other areas necessary for proper balance sheet management.
Management believes interest rate risk is best measured by earnings simulation modeling. The simulation is run using the prime rate as the base with the assumption of rates increasing 100, 200, 300 and 400 basis points or decreasing 100 and 200 basis points. All rates are increased or decreased parallel to the change in prime rate. As a result of the simulation, over a 12-month time period ending December 31, 2016, net interest income was estimated to decrease 1.06% and 2.97% if rates were to increase 100 basis points and 200 basis points, respectively, and was estimated to decrease 2.61% and 13.84% in a 100 basis points and 200 basis points declining rate assumption, respectively. These results are in line with the Company’s guidelines for rate sensitivity.
The following chart reflects the Company’s sensitivity to changes in interest rates as indicated as of December 31, 2015.
The preceding sensitivity analysis is a modeling analysis, which changes periodically and consists of hypothetical estimates based upon numerous assumptions including interest rate levels, changes in the shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of pay downs and maturities of loans, investments and deposits, changes in spreads between key market rates, and other assumptions. In addition, there is no input for growth or a change in asset mix. While assumptions are developed based on the current economic and market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change. As market conditions vary from those assumed in the sensitivity analysis, actual results will differ. Also, these results do not include any management action that might be taken in responding to or anticipating changes in interest rates. The simulation results are one indicator of interest rate risk, and actual net interest income is largely impacted by the allocation of assets, liabilities, and product mix.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements required by this Item are included as a separate section of this report commencing on page.
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
Our management, with the participation of our principal executive officer and principal financial officer, has concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the Act)) were effective as of December 31, 2015, based on the evaluation of these controls and procedures required by Rule 13a-15(b) or 15d-15(b) of the Act.
Management’s Report on Internal Control Over Financial Reporting
The management of Franklin Financial Network, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Franklin Financial Network, Inc.’s internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Franklin Financial Network, Inc.’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013).
Based on our assessment we believe that, as of December 31, 2015, the Company’s internal control over financial reporting was effective based on those criteria.
This Annual Report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm due to a transition period established by rules of the SEC for an Emerging Growth Company.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the fourth quarter of 2015 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.
The information called for by this item is incorporated herein by reference to the definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 26, 2016, which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information called for by this item is incorporated herein by reference to the definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 26, 2016, which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information called for by this item is incorporated herein by reference to the definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 26, 2016, which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The information called for by this item is incorporated herein by reference to the definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 26, 2016, which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information called for by this item is incorporated herein by reference to the definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 26, 2016, which will be filed with the SEC pursuant to Regulation 14A under the Exchange Act.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
Financial Statements
The list of financial statements contained herein is set forth on page hereof.
Financial Statement Schedules
None
Exhibits
Exhibits required by Item 601 of Regulation S-K are incorporated herein by reference and are listed on the Exhibit Index below.
EXHIBIT INDEX
 Filed herewith.
 Furnished herewith.
* Indicates a management contract or compensatory plan or arrangement.
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.
March 15, 2016
FRANKLIN FINANCIAL NETWORK, INC.
By:
/s/ Richard E. Herrington
Richard E. Herrington
Chief Executive Officer and Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
INDEX TO FINANCIAL STATEMENTS
The following financial statements are included in Part II, Item 8:
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Franklin Financial Network, Inc.
Franklin, Tennessee
We have audited the accompanying consolidated balance sheets of Franklin Financial Network, Inc. as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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 audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2015 and 2014, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles.
Crowe Horwath LLP
Franklin, Tennessee
March 15, 2016
FRANKLIN FINANCIAL NETWORK, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 2015 and 2014
(Dollar amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
FRANKLIN FINANCIAL NETWORK, INC.
CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 2015, 2014 and 2013
(Dollar amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
FRANKLIN FINANCIAL NETWORK, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Years ended December 31, 2015, 2014 and 2013
(Dollar amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
FRANKLIN FINANCIAL NETWORK, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31, 2015, 2014 and 2013
(Dollar amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
FRANKLIN FINANCIAL NETWORK, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2015, 2014 and 2013
(Dollar amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
FRANKLIN FINANCIAL NETWORK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollar amounts in thousands, except share and per share data)
(Unaudited)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation: The consolidated financial statements include Franklin Financial Network, Inc. and its wholly owned subsidiary, Franklin Synergy Bank, together referred to as “the Company.” Intercompany transactions and balances are eliminated in consolidation.
Franklin Financial Network, Inc. was incorporated under the laws of the State of Tennessee on April 5, 2007. Franklin Synergy Bank was incorporated under the laws of the State of Tennessee and received its Certificate of Authority from the Tennessee Department of Financial Institutions and approval of FDIC insurance on November 2, 2007. Franklin Synergy Bank is also a Federal Reserve member bank.
The Company provides financial services through its offices in Franklin, Brentwood, Spring Hill, Murfreesboro, Nashville, Nolensville, and Smyrna, Tennessee. Its primary deposit products are checking, savings, and certificate of deposit accounts, and its primary lending products are commercial and residential construction, commercial, installment loans and lines secured by home equity. Substantially all loans are secured by specific items of collateral including commercial and residential real estate, business assets, and consumer assets. Commercial loans are expected to be repaid by cash flow from operations of businesses. There are no significant concentrations of loans to any one industry or customer. However, the customers’ ability to repay their loans is dependent on the real estate and general economic conditions in the area. The Company also focuses on electronic banking products such as internet banking, remote deposit capture and lockbox services.
The Company purchased the assets of Banc Compliance Group LLC in May 2008 forming a wholly-owned subsidiary, Banc Compliance Group, Inc., which provided bank compliance and consulting services to community banks. The Company sold the assets of Banc Compliance Group, Inc. at December 31, 2014.
On July 1, 2014 the Company completed its acquisition of MidSouth Bank, which was merged with and became part of Franklin Synergy Bank.
On December 28, 2015, the Company invested in a wholly-owned subsidiary, Franklin Synergy Risk Management, Inc., which provides risk management services to the Company in the form of enhanced insurance coverages.
Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.
Cash Flows: Cash and cash equivalents include cash, deposits with other financial institutions with maturities under 90 days, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions and federal funds purchased.
Interest-Bearing Deposits in Financial Institutions: Interest-bearing deposits in other financial institutions mature within one year and are carried at cost.
Securities: Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Management assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
Loans Held for Sale: Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.
Certain loans held for sale are sold with servicing rights retained. The carrying value of loans sold with retained servicing is reduced by the amount allocated to the servicing right. Gains and losses on sales of loans are based on the difference between the selling price and the carrying value of the related loan sold.
Loans held for sale, for which the fair value option has been elected, are recorded at fair value as of each balance sheet date. The fair value includes the servicing value of the loans.
Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of purchase discounts, deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.
Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment.
All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Concentration of Credit Risk: Most of the Company’s business activity is with customers located within Williamson County and Rutherford County; therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in the Williamson County and Rutherford County areas.
Purchased Credit Impaired Loans: The Company purchases individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses.
Such purchased credit impaired loans are accounted for individually or aggregated into pools of loans based on common risk characteristics such as, credit score, loan type, and date of origination. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).
Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows in greater than the carrying amount, it is recognized as part of future interest income.
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
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 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.
If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral
Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on a combination of the Bank’s loss history and loss history from the Bank’s peer group over the past three years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified:
Construction and land development loans include loans to finance the process of improving loans preparatory to erecting new structures or the on-site construction of industrial, commercial, residential or farm buildings. Construction and land development loans also include loans secured by vacant land, except land known to be used or usable for agricultural purposes. Construction loans generally are made for relatively short terms. They generally are more vulnerable to changes in economic conditions. Further, the nature of these loans is such that they are more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. Periodic site inspections are made on construction loans.
Commercial real estate loans include loans secured by non-residential real estate, including farmland and improvements thereon. Often these loans are made to single borrowers or groups of related borrowers, and the repayment of these loans largely depends on the results of operations and management of these properties. Adverse economic conditions may affect the repayment ability of these loans.
Residential real estate loans include loans secured by residential real estate, including single-family and multi-family dwellings. Mortgage title insurance and hazard insurance are normally required. Adverse economic conditions in the Company’s market area may reduce borrowers’ ability to repay these loans and may reduce the collateral securing these loans.
Commercial and industrial loans include loans for commercial, industrial or agricultural purposes to business enterprises that are not secured by real estate. Commercial loans are typically made on the basis of the borrower’s ability to repay from the cash flow of the borrower’s business. Commercial and Agriculture loans are generally secured by accounts receivable, inventory and equipment. The collateral securing loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
Consumer and other loans include loans to individuals for household, family and other personal expenditures that are not secured by real estate. Consumer loans are generally secured by customer deposit accounts, vehicles and other household goods. The collateral securing consumer loans may depreciate over time.
Servicing Rights: When loans are sold with servicing retained, servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of loans. Fair value is based on market prices for comparable servicing contracts. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported with loan servicing fees on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income, which is reported on the income statement as loan servicing fees, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against mortgage loan servicing fee income. Late fees and ancillary fees related to loan servicing are not material.
Transfers of Financial Assets: Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Foreclosed Assets: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Assets Held for Sale: Assets held for sale are stated at fair value less estimated costs to sell at the time the assets are determined to be held for sale. If fair value declines subsequent to designation, a valuation allowance is recorded through expense. Operating costs after designation are expensed.
Premises and Equipment: Premises and equipment are stated at cost less accumulated depreciation and are depreciated using the straight-line method. Depreciation periods are shorter of the asset’s useful life or lease period, ranging from three to fifteen years.
Restricted Equity Securities: The Bank is a member of the Federal Reserve Bank (FRB) and the Federal Home Loan Bank (FHLB) system. Members of the FHLB are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. The stock ownership in FRB and FHLB are carried at cost, classified as restricted securities, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Company Owned Life Insurance: The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Goodwill and Other Intangible Assets: Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected December 31 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the balance sheet.
Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank and branch acquisitions are amortized on an accelerated method over their estimated useful lives, which range from 7 to 10 years.
Long-Term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives. The fair value of the interest rate lock is recorded at the time the commitment to fund the mortgage loan is executed and is adjusted for the expected exercise of the commitment before the loan is funded. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge the change in interest rates resulting from its commitments to fund the loans. Changes in the fair values of these derivatives are included in net gains on sale of mortgage loans.
Stock-Based Compensation: Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Income Taxes: Income tax expense or benefit is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
Retirement Plans: Employee 401(k) and profit sharing plan expense is the amount of matching contributions. The matching contributions are paid with employer stock.
Comprehensive Income: Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale which is recognized as a separate component of equity.
Earnings Per Common Share: Basic earnings per common share is net income available to common shareholders divided by the weighted average number of common shares outstanding during the period. All outstanding unvested share-based payment awards that contain rights to non-forfeitable dividends are considered participating securities for this calculation. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options and warrants. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.
Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements.
Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders.
Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Operating Segments: While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.
NOTE 2 - ACQUISITIONS
Acquisition of MidSouth Bank
On July 1, 2014 the Company completed the acquisition of MidSouth Bank (“MidSouth”), pursuant to the terms of the Agreement and Plan of Reorganization and Bank Merger (the “merger agreement”) dated November 19, 2013.
The acquisition was accounted for under the acquisition method of accounting in accordance with ASC Topic 805, Business Combinations. The Company recognized goodwill on this acquisition of $9,124, after consideration of a measurement period adjustment discussed below, which is nondeductible for tax purposes as this acquisition was a nontaxable transaction. The goodwill is calculated based on the fair values of the assets acquired and liabilities assumed as of the acquisition date. Fair value estimates are based on the information available, and are subject to change for up to one year after the closing date of the acquisition as additional information relative to closing date fair values becomes available.
The Company acquired 100% of the outstanding preferred and common stock of MidSouth. The purchase price consisted of both cash and stock. MidSouth’s common shareholders received 0.425926 shares of FFN common stock for each share of MidSouth common stock. MidSouth’s preferred shareholders received 0.851852 shares of FFN common stock for each share of MidSouth preferred stock. Each MidSouth Series 2009A warrant holder
received 0.18 shares of FFN common stock for each MidSouth Series 2009A warrant, and each Series 2011-A warrant holder received 0.146667 shares of FFN common stock for each MidSouth Series 2011-A warrant. In lieu of issuing fractional shares of FFN common stock, FFN paid former MidSouth shareholders an amount in cash determined by multiplying (i) $13.50 by (ii) the fraction of a share (rounded to the nearest ten thousandth when expressed in decimal form) of FFN common stock.
MidSouth common stock options were converted into options to purchase shares of FFN common stock based on the 0.425926 exchange ratio, with the new exercise price becoming the exercise price of the MidSouth options divided by the exchange ratio. On the date of the merger, 2,766,191 shares of FFN common stock were exchanged for the common and preferred stock, and common stock warrants of MidSouth in accordance with the proration and allocation procedures contained in the merger agreement and as noted above. Subsequently, cash totaling $100 was paid to dissenting MidSouth shareholders representing 7,427 shares of FFN common stock. In addition, $18 of cash was paid to MidSouth shareholders for fractional shares in accordance with the merger agreement.
Based on a valuation of the FFN’s common stock as of July 1, 2014, the resulting purchase price was $41,094. The following table summarizes the purchase price calculation:
On July 1, 2014 the Company purchased MidSouth. As previously disclosed, the fair values initially assigned to the assets acquired and liabilities assumed were preliminary and subject to refinement for up to one year after the closing date of the acquisition as new information relative to closing date fair values became available. Based on appraisals received subsequent to the acquisition date, the Company adjusted its initial fair value estimate of foreclosed assets that were acquired. The table below summarizes the fair value of the assets purchased, including goodwill, and liabilities assumed as of the July 1, 2014 purchase date.
At December 31, 2015, there were no circumstances or significant changes that have occurred in 2015 related to the acquisition of MidSouth that, in management’s assessment, would necessitate recording impairment of goodwill.
In the acquisition, the Company purchased $184,345 of loans at fair value, net of $7,347 estimated discount to the outstanding principal balance. Of the total loans acquired, management identified loans totaling $5,527 as credit impaired. All loans that were on non-accrual status and all loan relationships that were identified as substandard or impaired as of the acquisition date were considered by management to be credit-impaired and are accounted for pursuant to ASC Topic 310-30. The table below summarizes the total contractually required principal and interest cash payments, management’s estimate of expected total cash payments and fair value of the loans as of July 1, 2014 for purchased credit-impaired (“PCI”) loans. Contractually required principal and interest payments have been adjusted for estimated prepayments.
The table below presents information with respect to the fair value of acquired loans, as well as their unpaid principal balance at acquisition date.
In its assumption of the deposit liabilities, the Company believed the deposits assumed from the acquisition have an intangible value. The Company applied ASC Topic 805, which prescribes the accounting for goodwill and other intangible assets such as core deposit intangibles, in a business combination. The Company determined the estimated fair value of the core deposit intangible asset totaled $3,060, which will be amortized utilizing an accelerated amortization method over an estimated economic life of 8.2 years. When determining the valuation amount, deposits were analyzed based on factors such as type of deposit, deposit retention, interest rates and age of deposit relationships.
Pro-forma information
Pro-forma data for the years ended December 31, 2014 and 2013 listed in the table below presents pro-forma information as if the MidSouth acquisition occurred at the beginning of 2013. Because the MidSouth transaction closed on July 1, 2014, and its actual results are included in the Company’s actual operating results for the year ended December 31, 2015, there is no pro forma information for that period.
Supplemental pro forma earnings for 2014 were adjusted to exclude $2,157 of acquisition-related costs incurred in 2014, $1,478 of discount accretion and $250 of premium amortization related to the fair value adjustments to acquisition-date assets and liabilities. Supplemental pro forma earnings for 2013 were adjusted to include these items, as appropriate.
Acquisition of Civic Bank & Trust
On December 14, 2015, the Company and Civic Bank & Trust (“Civic”), a Tennessee state bank headquartered in Nashville, Tennessee, jointly announced the signing of a definitive merger agreement pursuant to which the Company will acquire Civic in an all-stock transaction valued at approximately $28.6 million. Under the terms of the agreement, Civic will be merged with and into Franklin Synergy Bank, with Franklin Synergy Bank continuing as the surviving institution in the Merger.
According to the terms of the merger agreement, each Civic common shareholder will have the right to receive shares of Franklin Synergy common stock for each share of Civic common stock based on conversion ratio that has not yet been determined. The merger is expected to qualify as a tax-free reorganization for Civic shareholders.
Civic operates two branch offices in the Nashville metropolitan area and as of December 31, 2015, had $145.1 million in total assets, which included $85.7 million in total loans, and $104.6 million in total deposits.
The acquisition is expected to close in the second quarter of 2016 and is subject to regulatory approval, Civic shareholder approval, and other customary conditions as set forth in the merger agreement. In addition, the merger agreement provides that, upon termination of the merger agreement in certain circumstances, Civic may be required to pay the Company a termination fee of $1.25 million.
NOTE 3 - SECURITIES
The following table summarizes the amortized cost and fair value of the available for sale securities portfolio at December 31, 2015 and 2014 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss).
The amortized cost and fair value of the held to maturity securities portfolio at December 31, 2015 and 2014 and the corresponding amounts of gross unrecognized gains and losses were as follows:
Sales and calls of available for sale securities were as follows:
Calls of held to maturity securities resulted in gross gains of $148 during 2015.
The amortized cost and fair value of the investment securities portfolio are shown by contractual maturity. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
Securities pledged at December 31, 2015 and 2014 had a carrying amount of $595,524 and $366,764 and were pledged to secure public deposits and repurchase agreements.
At December 31, 2015 and 2014, there were no holdings of securities of any one issuer, other than the U.S. government-sponsored entities and agencies, in an amount greater than 10% of shareholders’ equity.
The following table summarizes the securities with unrealized and unrecognized losses at December 31, 2015 and 2014, aggregated by major security type and length of time in a continuous unrealized loss position:
Unrealized losses on debt securities have not been recognized into income because the issuers bonds are of high credit quality (rated AA or higher), management does not intend to sell and it is likely that management will not be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions. The fair value is expected to recover as the bonds approach maturity.
NOTE 4 - LOANS
Loans at December 31, 2015 and 2014 were as follows:
The following table presents the activity in the allowance for loan losses by portfolio segment for the years ended December 31, 2015, 2014 and 2013:
For the years ended December 31, 2015 or 2014, there was $9 and $0, respectively, in allowance for loan losses for PCI loans.
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2015 and 2014. Purchased and PCI loans are also included in the table. For purposes of this disclosure, recorded investment in loans excludes accrued interest receivable and loan fees, net due to immateriality.
Loans collectively evaluated for impairment reported at December 31, 2015 include certain loans acquired from MidSouth on July 1, 2014. The acquired loans were recorded at estimated fair value at date of acquisition, which included an estimated credit discount. On July 1, 2014, acquired non-PCI loans were recorded at an estimated fair value of $178,818, comprised of contractually unpaid principal totaling $183,832 net of estimated discounts totaling $5,014 which included both credit and interest rate discount components. As of December 31, 2015, these non-PCI loans had a carrying value of $99,328, comprised of contractually unpaid principal totaling $101,889 and discounts totaling $2,561. Management evaluated these loans for credit deterioration since acquisition and determined that no allowance for loan losses was necessary at December 31, 2015.
The following table presents information related to impaired loans by class of loans as of December 31, 2015 and 2014:
The following table presents the average recorded investment of impaired loans by class of loans for the years ended December 31, 2015, 2014 and 2013:
The impact on net interest income for these loans was not material to the Company’s results of operations for the years ended December 31, 2015, 2014 and 2013.
The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2015 and 2014:
Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.
The following table presents the aging of the recorded investment in past due loans as of December 31, 2015 and 2014 by class of loans:
Credit Quality Indicators: The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes non-homogeneous loans, such as commercial and commercial real estate loans as well as non-homogeneous residential real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. The following table includes PCI loans, which are included in the “Substandard” column. Based on the most recent analysis performed, the risk category of loans by class of loans is as follows as of December 31, 2015 and 2014:
Purchased Credit-Impaired (“PCI”) Loans
Income is recognized on PCI loans pursuant to ASC Topic 310-30. A portion of the fair value discount has been recognized as an accretable yield that is accreted into interest income over the estimated remaining life of the loans. The remaining non-accretable difference represents cash flows not expected to be collected.
The table below summarizes the total contractually required principal and interest cash payments, management’s estimate of expected total cash payments and carrying value of the loans as of December 31, 2015 and 2014. Contractually required principal and interest payments have been adjusted for estimated prepayments.
Management adjusted estimates of future expected losses, cash flows and renewal assumptions during the year ended December 31, 2015. These adjustments resulted in an increase in expected cash flows and accretable yield, and a decrease in the non-accretable difference. The table below summarizes the changes in total contractually required principal and interest cash payments, management’s estimate of expected total cash payments and carrying value of the loans during the years ended December 31, 2015 and 2014.
Troubled Debt Restructurings
The Company’s loan portfolio contains no loans that have been modified in a troubled debt restructuring as of December 31, 2015, 2014 and 2013.
NOTE 5 - LOAN SERVICING
Loans serviced for others are not reported as assets. The principal balances of these loans at December 31, 2015 and 2014 are as follows:
Custodial escrow balances maintained in connection with serviced loans were $2,494 and $1,968 at year-end 2015 and 2014.
The related loan servicing rights activity for the years ended December 31, 2015, 2014 and 2013 were as follows:
The components of net loan servicing fees for the years ended December 31, 2015, 2014 and 2013 were as follows:
The fair value of servicing rights was estimated by management to be approximately $4,635 at December 31, 2015. Fair value for 2014 was determined using a weighted average discount rate of 10.5% and a weighted average prepayment speed of 10.2%. At December 31, 2014, the fair value of servicing rights was estimated by management to be approximately $4,180. Fair value for 2014 was determined using weighted average discount rate of 10.5% and a weighted average prepayment speed of 10.8%.
NOTE 6 - PREMISES AND EQUIPMENT AND RELATED PARTY LEASES
Year-end premises and equipment were as follows:
Depreciation and amortization expense was $1,325, $931 and $653 for the years ended December 31, 2015, 2014 and 2013, respectively.
Operating Leases: The Company leases most of its branches, loan production, and administrative offices under operating leases. Rent expense was $2,912, $2,049 and $1,311 for 2015, 2014 and 2013, respectively. Rent commitments, over the initial lease terms and intended renewal periods were as follows:
As of December 31, 2015, the Company transferred the buildings, land and land improvements associated with its properties located at 1 East College Street and 123 East College Street in Murfreesboro to assets held for sale. As of December 31, 2015, these assets were classified totaled $1,640. The buildings involved in this transfer will likely be leased by the Company upon completion of the sale transaction.
NOTE 7 - GOODWILL AND INTANGIBLE ASSETS
Goodwill: The change in goodwill during the year is as follows:
Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value. At December 31, 2015, the Company’s reporting unit had positive equity and the Company elected to perform a qualitative assessment to determine if it was more likely than not that the fair value of the reporting unit exceeded its carrying value, including goodwill. The qualitative assessment indicated that it was more likely than not that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment.
Acquired Intangible Assets: As of December 31, 2015 and 2014, the Company had net core deposit intangibles of $2,043 and $2,698, respectively, all of which is attributed to the acquisition of MidSouth. At the time of the acquisition as of July 1, 2014, the Company recorded a core deposit intangible of $3,060, which is being amortized over 8.2 years. Through December 31, 2015, the Company has recognized amortization of $1,017 related to the core deposit intangible.
The following table represents acquired intangible assets at December 31, 2015 and 2014:
Aggregate amortization expense was $655 for 2015 and $362 for 2014. There was no amortization expense for 2013.
The following table presents estimated amortization expense for each of the next five years:
NOTE 8 - DEPOSITS
At December 31, 2015 and 2014, time deposits in denominations of $250 or greater totaled $310,741 and $105,711, respectively. At December 31, 2015 and 2014, the Company had $290 and $371, respectively, of deposit accounts in overdraft status and thus have been reclassified to loans on the accompanying consolidated balance sheets.
Scheduled maturities of time deposits for the next five years were as follows:
NOTE 9 - FEDERAL FUNDS PURCHASED AND REPURCHASE AGREEMENTS
As of December 31, 2015 and 2014, the Bank had federal funds lines (or the equivalent thereof) with correspondent banks totaling $134,400 and $115,400, respectively. There was $39,825 and $16,825 in outstanding federal funds purchased at December 31, 2015 and 2014, respectively.
Our subsidiary bank enters into borrowing arrangements with our retail business customers and correspondent banks through agreements to repurchase (“securities sold under agreements to repurchase”) under which the bank pledges investment securities owned and under its control as collateral against these short-term borrowing arrangements. At maturity the securities underlying the agreements are returned to the Company. At December 31, 2015 and December 31, 2014, these short-term borrowings totaled $61,261 and $22,253, respectively, and are secured by securities with carrying amounts of $73,478 and $26,187, respectively. At December 31, 2015, the Company had $36,261 in repurchase agreements that had one-day maturities and $25,000 in a repurchase agreement that had a 30-day maturity.
Information concerning securities sold under agreements to repurchase is summarized as follows:
The following table provides additional details as of December 31, 2015:
NOTE 10 - FEDERAL HOME LOAN BANK ADVANCES
The Bank has established a line of credit with the Federal Home Loan Bank of Cincinnati (“FHLB”), which is secured by a blanket pledge of 1-4 family residential mortgage loans. The extent of the line is dependent, in part, on available collateral. The arrangement is structured so that the carrying value of the loans pledged amounts 125% on residential 1-4 family loans of the principal balance of the advances from the FHLB.
At December 31, 2015 and 2014, the Company had received advances from the FHLB totaling $57,000 and $19,000, respectively. At December 31, 2014, the schedule maturities of these advances and interest rates were as follows:
Each FHLB advance is payable at its maturity date, with a prepayment penalty for fixed rate advances. Qualifying loans totaling approximately $162,305 were pledged as security under a blanket pledge agreement with the FHLB at December 31, 2015. Based on this collateral and the Company’s holdings of FHLB stock, the Bank is eligible to borrow up to an additional $38,503 as of December 31, 2015.
NOTE 11 - BENEFIT PLANS
A 401(k) benefit plan was adopted to begin benefits on May 1, 2008. The 401(k) benefit plan allows employee contributions of their compensation subject to certain limitations. Employee contributions are matched in the Company’s common stock equal to 100% of the first 2% of the compensation contributed and 50% of the next 4% of the compensation contributed. Expense for the years ending December 31, 2015, 2014 and 2013 was $466, $387 and $270, respectively.
NOTE 12 - INCOME TAXES
A reconciliation of the income tax expense for the years ended December 31, 2015, 2014 and 2013 to the “expected” tax expense, which was computed by applying the statutory federal income tax rate of 35 percent for 2015 and 2014 and 34 percent for 2013 to income before income tax expense, is as follows:
Income tax expense (benefit) was as follows:
The sources of deferred income tax assets (liabilities) at December 31, 2015 and 2014 and the tax effect is as follows:
At December 31, 2015, the federal net operating loss remaining from the acquisition of MidSouth Bank totaled $13.7 million, which will expire at various dates from 2025 to 2031. Deferred tax assets are recognized for net operating losses because the benefit is more likely than not to be realized.
The Company does not have any uncertain tax positions and does not have any interest and penalties recorded in the income statement for the years ended December 31, 2015, 2014 and 2013. The Company and its subsidiary are subject to U.S. federal income tax as well as income tax of the state of Tennessee. The Company is no longer subject to examination by taxing authorities for years before 2012.
NOTE 13 - RELATED PARTY TRANSACTIONS
The Company enters into various credit arrangements with its executive officers, directors and their affiliates. These arrangements generally take the form of commercial lines of credit, personal lines of credit, mortgage loans, term loans or revolving arrangements secured by personal residences.
Loans to principal officers, directors, and their affiliates during 2015 were as follows:
Deposits from principal officers, directors, and their affiliates at year end 2015 and 2014 were $6,441 and $5,543.
The Company entered into a 15-year lease agreement for a branch and administrative facility in downtown Franklin, Tennessee on May 7, 2010. The Company also entered into a 15-year lease for its Berry Farms branch in Franklin, Tennessee, on June 12, 2013 with certain outside directors of the Company. The Berry Farms branch opened during 2013. During 2014, the Company entered into 15-year lease agreements for an addition to its branch and administrative facility in downtown Franklin and for its Cool Springs branch in Franklin, Tennessee. During 2015, the Company entered into 15 year lease agreements for three of its Rutherford County branches that were acquired during the acquisition of MidSouth Bank during 2014. As of December 31, 2014, these buildings were classified as held-for-sale and the lease agreements were executed upon completion of the sale in 2015. During 2015, the Company also entered into a lease agreement to expand its downtown Franklin location by adding a mortgage facility and parking garage. The expansion to the downtown Franklin location was not complete as of December 31, 2015. Rent expense attributable to the related party leases in 2015, 2014 and 2013, was $2,296, $1,222 and $559, respectively. Rent commitments to related parties, before considering renewal options that generally are present, are disclosed in Note 6. The Company also paid a company affiliated with an outside director $369 and $3,152 for construction of leasehold improvements during 2015 and 2014. In addition, the Company also paid a company affiliated with an outside director $666 and $212 for the procurement of various insurance policies during the years ending December 31, 2015 and 2014.
NOTE 14 - SHARE-BASED PAYMENTS
In connection with the Company’s 2010 private offering, 32,425 warrants were issued to shareholders, one warrant for every twenty shares of common stock purchased. Each warrant allows the shareholders to purchase an additional share of common stock at $12.00 per share. The warrants were issued with an effective date of March 30, 2010 and will be exercisable in whole or in part up to seven years following the date of issuance. The warrants are detachable from the common stock. There were 6,570 warrants exercised during the year ended December 31, 2015, for which the Company received cash proceeds of $79. The exercised warrants had an intrinsic value of $71 at the date of exercise. No warrants were exercised during 2014. At December 31, 2015, there were 25,307 outstanding warrants associated with the 2010 offering.
Since the common stock of the Company is registered under the Securities Act and has been traded on a national securities exchange at $15.00 or more for forty-five (45) consecutive days, the Company may redeem the 2010 warrants at any time with not less than thirty (30) days’ written notice to the holders of such 2010 warrants, in whole or in part, at a redemption price of $1.00 per warrant; provided, however, that the holder of the 2010 warrant may exercise the 2010 warrant, in whole or in part, during such thirty (30) day period.
The Company has two share based compensation plans as described below. Total compensation cost that has been charged against income for those plans was $860, $611, and $364, respectively, for 2015, 2014, and 2013. The total income tax benefit was $533, $29, and $83, respectively, for 2015, 2014 and 2013.
Stock Option Plan: The Company’s 2007 Stock Option Plan (“stock option plan” or the “Plan”), which was shareholder-approved, permitted the grant of share options to its employees, organizers and directors for up to 551,250 shares of common stock. The Plan was amended during April 2010 to increase the number of shares available for issuance to 1,000,000. In April 2013, the Plan was amended to offer additional forms of equity compensation, to change the Plan’s name to the Franklin Financial Network, Inc. 2007 Omnibus Equity Incentive Plan, and to increase the number of authorized shares to 1,500,000. The Company believes that such awards better align the interests of its employees with those of its shareholders. Shareholders approved amendments to the Plan to increase the number of authorized shares to 2,000,000 in June 2014 and to 4,000,000 in February 2015. At December 31, 2015, there were 2,345,825 authorized shares available for issuance.
Employee, organizer and director awards are generally granted with an exercise price equal to the market price of the Company’s common stock at the date of grant; those option awards have a vesting period of three to five years and have a ten-year contractual term. The Company assigns discretion to its Board of Directors to make grants either as qualified incentive stock options or as non-qualified stock options. All employee grants are intended to be treated as qualified incentive stock options, if allowable. All other grants are expected to be treated as non-qualified.
The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the assumptions noted in the table below. Expected stock price volatility is based on historical volatilities of a peer group. The Company uses historical data to estimate option exercise and post-vesting termination behavior.
The expected term of options granted represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
On the date of the merger, 322,300 MidSouth common stock options were converted into 137,280 options to purchase shares of FFN common stock with an exercise price of $8.57 per option pursuant to the terms of the merger agreement (see Note 2). Using the Black-Scholes option valuation model, the grant date fair value was estimated to be $6.31 per converted option based on the $14.50 fair value per share of FFN common stock at July 1, 2014. No post combination expense was required related to the converted options.
The fair value of options granted was determined using the following weighted-average assumptions as of grant date.
The weighted average fair value of options granted for the years ending December 31, 2015, 2014 and 2013 was $6.44, 4.12, and $1.92, respectively.
A summary of the activity in the stock option plans for the year ended December 31, 2015 follows:
As of December 31, 2015, there was $1,718 of total unrecognized compensation cost related to non-vested stock options granted under the Plan. The cost is expected to be recognized over a weighted-average period of 1.6 years.
Restricted Share Award Plan: Additionally, the Company’s 2007 Omnibus Equity Incentive Plan provides for the granting of restricted share awards and other performance related incentives. When restricted shares are awarded, a participant receives voting and dividend rights with respect to the shares, but is not able to transfer the shares until the restrictions have lapsed. These awards have a vesting period of three to five years and vest in equal annual installments on the anniversary date of the grant.
A summary of activity for non-vested restricted share awards for the year ended December 31, 2015 is as follows:
Compensation expense associated with the restricted share awards is recognized on a straight-line basis over the time period that the restrictions associated with the awards lapse based on the total cost of the award at the grant date. As of December 31, 2015, there was $1,408 of total unrecognized compensation cost related to non-vested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 3.3 years. The total fair value of shares vested during the years ended December 31, 2015 and 2014 was $560 and $124. There were no restricted shares that vested during 2013.
NOTE 15 - REGULATORY CAPITAL MATTERS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel Committee on Banking Supervision’s capital guidelines for U.S. Banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital. Capital amounts and ratios for December 31, 2014 are calculated using Basel I rules. Management believes as of December 31, 2015, the Company and Bank meet all capital adequacy requirements to which they are subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At December 31, 2015, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category. Actual and required capital amounts and ratios are presented below as of December 31, 2015 and 2014 for the Company and Bank.
Dividend Restrictions: The Company’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. During 2016 the Bank could declare, without prior approval, dividends of approximately $25,887 plus any 2016 net profits retained to the date of declaration.
NOTE 16 - FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (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. There are three levels of inputs that may be used to measure fair values:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other 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.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate the fair value of each type of asset and liability:
Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), using matrix pricing. Matrix pricing is a mathematical technique commonly used to price debt securities that are not actively traded, values debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).
Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).
Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly. Appraisals for impaired loans are generally obtained annually but may be obtained more frequently based on changing circumstances as part of the aforementioned quarterly evaluation.
Foreclosed Assets: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Foreclosed assets are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Appraisals for both collateral-dependent impaired loans and real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been review and verified by the Company. Once received, a member of the credit administration department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.
Loans Held For Sale: During 2014 the Company elected the fair value option for loans held for sale to align with other accounting policies related to mortgage banking, such as mortgage banking derivatives. These loans are typically sold to an investor following loan origination and the fair value of such accounts are readily available based on direct quotes from investors or similar transactions experienced in the secondary loan market. Fair value adjustments, as well as realized gains and losses are recorded in current earnings. Fair value is determined by market prices for similar transactions adjusted for specific attributes of that loan (Level 2).
Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:
As of December 31, 2015, the unpaid principal balance of loans held for sale was $13,754, resulting in an unrealized gain of $325 included in gains on sale of loans. None of these loans are 90 days or more past due or on nonaccrual as of December 31, 2015. At December 31, 2014, the unpaid principal balance of loans held for sale was $17,898, resulting in an unrealized gain of $564 included in gains on sale of loans. There were no loans held for sale carried at fair value as of December 31, 2013.
There were no transfers between level 1 and 2 during 2015 and 2014.
At December 31, 2015 and 2014, there were no collateral dependent impaired loans carried at fair value.
Foreclosed assets measured at fair value less costs to sell, had a net carrying amount of $200 and $715 as of December 31, 2015 and 2014, respectively. There were no properties at December 31, 2015 that had required write-downs to fair value resulting in no write downs for the years ended December 31, 2015 and 2014. Foreclosed assets measured at fair value less costs to sell were written down to fair value resulting in a write-down of $190 for the year ended December 31, 3013.
The carrying amounts and estimated fair values of financial instruments, at December 31, 2015 and 2014 are as follows:
The methods and assumptions not previously described used to estimate fair value are described as follows:
(a) Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.
(b) Loans: Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
(c) Restricted Equity Securities: It is not practical to determine the fair value of Federal Home Loan Bank or Federal Reserve Bank stock due to restrictions placed on its transferability.
(d) Mortgage Servicing Rights: Fair value of mortgage servicing rights is based on valuation models that calculate the present value of estimated net cash flows based on industry market data. The valuation model incorporates assumptions that market participants would use in estimating future net cash flows resulting in a Level 2 classification.
(e) Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. The carrying amounts of fixed-term money market accounts approximate their fair values at the reporting date resulting in a Level 1 classification. Fair values for certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.
(f) Federal Funds Purchased and Repurchase Agreements: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.
(g) Federal Home Loan Bank Advances: The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.
(h) Accrued Interest Receivable/Payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 1, Level 2 or Level 3 classification based on the asset/liability with which they are associated.
(i) Off-balance Sheet Instruments: Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.
NOTE 17 - MORTGAGE BANKING DERIVATIVES
Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. At year-end 2015, the Company had approximately $42,486 of interest rate lock commitments and approximately $41,236 of forward commitments for the future delivery of residential mortgage loans. The fair value of these mortgage banking derivatives was reflected by a derivative asset and liability of $411 and $29, respectively, at December 31, 2015. At year-end 2014, the Company had approximately $28,182 of interest rate lock commitments and approximately $36,849 of forward commitments for the future delivery of residential mortgage loans. The fair value of these mortgage banking derivatives was reflected by a derivative asset and liability of $285 and $132, respectively, at December 31, 2014. Fair values were estimated based on changes in mortgage interest rates from the date of the commitments. Changes in the fair values of these mortgage-banking derivatives are included in net gains on sale of loans.
The net gains (losses) relating to free-standing derivative instruments used for risk management is summarized below:
The following table reflects the amount and market value of mortgage banking derivatives included in the consolidated balance sheet as of December 31:
NOTE 18 - LOAN COMMITMENTS AND OTHER RELATED ACTIVITIES
Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.
The contractual amounts of financial instruments with off-balance-sheet risk at year end were as follows:
Commitments to make loans are generally made for periods of 365 days or less. The fixed rate loan commitments have interest rates ranging from 3.125% to 5.125% and maturities ranging from 10 years to 30 years.
NOTE 19 - PREFERRED STOCK
On September 27, 2011, as part of the Small Business Lending Fund (“SBLF”), the Company entered into a Small Business Lending Fund Securities Purchase Agreement (“SBLF Purchase Agreement”) with the United States Department of the Treasury (“Treasury”). Under the SBLF Purchase Agreement, the Company issued 10,000 shares of preferred stock series A to the Treasury. The preferred stock series A shares qualify as Tier 1 capital and will pay quarterly dividends. The initial dividend rate was 3.96%. As of December 31, 2015, the dividend rate was 1%. The dividend rate can fluctuate between 1% and 5% during the next four quarters based on the growth in qualified small business loans. As of December 31, 2015 and 2014, the Company had dividends in arrears of $25 and $25, respectively.
NOTE 20 - PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION
Condensed financial information of Franklin Financial Network, Inc. follows:
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
CONDENSED STATEMENTS OF CASH FLOWS
NOTE 21 - EARNINGS PER SHARE
The two-class method is used in the calculation of basic and diluted earnings per share. Under the two-class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared (or accumulated) and participation rights in undistributed earnings. The factors used in the earnings per share computation follow:
Stock options for 245,992, 2,000, and 124,869 shares of common stock were not considered in computing diluted earnings per common share for the year ended December 31, 2015, 2014, and 2013, because they were antidilutive.
NOTE 22 - CAPITAL OFFERING
The Company commenced its initial public offering on March 26, 2015. The Company issued 2,640,000 shares of common stock at a price of $21.00 per share and began trading on the New York Stock Exchange on March 26, 2015, under the ticker symbol “FSB”. Net proceeds were as follows:
The proceeds of the offering were used primarily to provide capital to Franklin Synergy Bank to support continued growth.
NOTE 23 - QUARTERLY FINANCIAL RESULTS (UNAUDITED)
The following table provides a summary of selected consolidated quarterly financial data for the years ended December 31, 2015 and 2014: