ITEM 1. BUSINESS
I.General
Boston Private Financial Holdings, Inc. (the “Company,” “BPFH,” “we,” “us,” or “our”) was incorporated on September 2, 1987, under the laws of The Commonwealth of Massachusetts. On July 1, 1988, the Company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and became the parent holding company (the “Holding Company”) of Boston Private Bank & Trust Company (the “Bank” or “Boston Private Bank”), a trust company chartered by The Commonwealth of Massachusetts and insured by the Federal Deposit Insurance Corporation (the “FDIC”).
We are a private banking and wealth management company that offers a full range of private banking and wealth management services to high net worth individuals, families, businesses, and select institutions through a financial umbrella that helps to preserve, grow, and transfer assets over the financial lifetime of a client through our four functional segments: Private Banking, Wealth Management and Trust, Investment Management, and Wealth Advisory. Each reportable segment reflects the services provided by the Company to a distinct segment of the wealth management market as described below.
Private Banking
The Private Banking segment has one affiliate, Boston Private Bank. The Private Banking segment primarily operates in three geographic markets: New England, the San Francisco Bay Area, and Southern California. The Private Banking segment is principally engaged in providing private banking services to high net worth individuals, privately-owned businesses and partnerships, and nonprofit organizations. In addition, the Private Banking segment is an active provider of financing for affordable housing, first-time homebuyers, economic development, social services, community revitalization and small businesses.
Wealth Management and Trust
The Wealth Management and Trust segment is comprised of Boston Private Wealth LLC (“Boston Private Wealth”), an independent registered investment adviser (“RIA”), which is a wholly-owned subsidiary of the Bank. This segment also includes the trust operations of Boston Private Bank. Boston Private Wealth was formed from the combination of the Bank’s wealth management business and those of Banyan Partners, LLC (“Banyan”), which the Bank acquired in the fourth quarter of 2014. The segment provides comprehensive wealth management solutions for high net worth individuals and families, including customized investment solutions, wealth planning, trust, and family office services. The Wealth Management and Trust segment operates in New England; South Florida; California; and Madison, Wisconsin.
Investment Management
The Investment Management segment currently has two affiliates: Dalton, Greiner, Hartman, Maher & Co., LLC (“DGHM”), and Anchor Capital Advisors LLC (“Anchor”), both of which are RIAs (together, DGHM and Anchor are referred to as the “Investment Managers”). The Investment Managers serve the needs of pension funds, endowments, trusts, foundations and select institutions, mutual funds and high net worth individuals and their families throughout the United States (“U.S.”) and abroad. The Investment Managers specialize in value-driven equity portfolios with products across the capitalization spectrum. The specific mix of products, services and clientele varies between affiliates. The Investment Managers are located in New England and New York, with one affiliate administrative office in South Florida.
In December 2017, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority-owned by members of its management team. The transaction is expected to close in the first quarter of 2018. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions. Anchor’s assets and liabilities are classified as held for sale at December 31, 2017 which are included within other assets and other liabilities in the consolidated balance sheets, respectively.
Wealth Advisory
The Wealth Advisory segment has two affiliates: KLS Professional Advisors Group, LLC (“KLS”), and Bingham, Osborn & Scarborough, LLC (“BOS”), both of which are wealth management firms and RIAs (together, the “Wealth Advisors”). The Wealth Advisors provide comprehensive, planning-based financial strategies to high net worth individuals and their families, and nonprofit institutions. The services the firms offer include fee-only financial planning, tax planning, tax
preparation, estate and insurance planning, retirement planning, charitable planning and intergenerational gifting and succession planning. The Wealth Advisors manage investments covering a wide range of asset classes for both taxable and tax-exempt portfolios. The Wealth Advisors are located in New York, Southern California, and Northern California.
Collectively, the Wealth Management and Trust, Investment Management, and Wealth Advisory segments are referred to as the “Wealth and Investment” businesses.
For revenue, net income, assets, and other financial information for each of the Company’s reportable segments, see Part II. Item 8. “Financial Statements and Supplementary Data - Note 20: Reportable Segments.”
The Company’s Internet address is www.bostonprivate.com. The Company makes available on or through its Internet website, without charge, its annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission (the “SEC”). The Company’s reports filed with, or furnished to, the SEC are also available at the SEC’s website at www.sec.gov. The quarterly earnings release conference call can also be accessed from the Company’s website. Press releases are also maintained on the Company’s website for one year. Information on our website is not incorporated by reference into this document and should not be considered part of this Report.
II.Acquisitions, Asset Sales, and Divestitures
In December 2017, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority-owned by members of its management team. The Company will receive at closing approximately $32 million of cash and future revenue share payments that, at signing, had a net present value of approximately $15 million, subject to purchase price adjustments. The Company’s annual goodwill impairment test for Anchor resulted in a fourth quarter of 2017 goodwill impairment charge of $24.9 million. The Company also recorded a loss on sale of $1.3 million representing estimated closing costs upon completion of the sale. Income tax expense of approximately $11.4 million will be recorded at the time of the closing of the transaction as a result of a book to tax basis difference associated with nondeductible goodwill. The transaction is expected to close in the first quarter of 2018. The estimated loss on sale as well as the income tax expense could change depending upon the book value of Anchor at the time of closing. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions. The rationale for the sale is to focus the Company’s resources in businesses where we can offer holistic financial advice, along with integrated wealth management, trust, and private banking capabilities. Upon closing, this transaction will also generate additional capital for us to reinvest in a more focused Company.
In November 2016, the Bank sold two of its Southern California offices, one located in Granada Hills, CA and the other located in Burbank, CA, together with approximately $104 million of deposits. The rationale for the sale was to better position the Company’s resources within the Southern California market.
In October 2014, Boston Private Bank acquired Banyan. Banyan and the wealth management operations from Boston Private Bank were combined to form Boston Private Wealth, which now operates in the Wealth Management and Trust reportable segment of the Company along with the trust operations of Boston Private Bank. Boston Private Wealth is a wholly-owned subsidiary of Boston Private Bank.
In 2009, the Company divested its interest in Westfield Capital Management Company, LP, formerly known as Westfield Capital Management Company, LLC (“Westfield”). The Company retained a 12.5% share in Westfield’s revenues (up to an annual maximum of $11.6 million) through December 2017 subject to certain conditions. The Company defers gains related to these payments until determinable. Such revenue share payments are included in net income from discontinued operations in the consolidated statements of operations for the period in which the revenue is recognized. After the December 2017 payments are received in the first quarter of 2018, the Company will not receive additional net income from Westfield.
For further details relating to the Company’s divestitures, see Part II. Item 8. “Financial Statements and Supplementary Data - Note 3: Acquisitions, Asset Sales, and Divestitures.”
III. Competition
The Company operates in the highly competitive private banking and wealth management marketplaces. In the private banking industry, the Bank encounters competition from larger national and regional commercial banking organizations, savings banks, credit unions, and other financial institutions and non-bank financial service companies, which may offer lower interest rates on loans and higher interest rates on deposits. The Bank’s competitors also include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services, including through the Internet. These technological advances may diminish the importance of depository institutions and other financial intermediaries, among other industry sectors, in the transfer of funds among parties. To compete effectively, the Bank relies on local promotional activity, personal contacts by officers, directors, and employees, customized service, and the Bank’s reputation within the communities that it serves.
In the wealth management and trust industry, the Company competes with a wide variety of firms, including national and regional financial services firms, commercial banks and trust companies, mutual fund companies, investment advisory firms, stock brokerage firms, accounting firms, and law firms. There has also been a trend toward online internet financial services and financial services that are based on mobile applications or automated processes as clients increasingly seek to manage their investment portfolios digitally. This is leading to increased utilization of “robo” adviser platforms. The Company believes that the ability of its Wealth Management and Trust segment to compete effectively with other firms is dependent upon the quality and level of service, personal relationships, and investment performance.
The Company’s principal competitors with respect to investment management services are primarily commercial banks and trust companies, mutual fund companies, investment advisory firms, stock brokerage firms, other financial companies, online financial services companies, and law firms. The Company has also faced competition in recent years from lower fee, passive investment strategies. Investment advisers that emphasize passive products have gained, and may continue to gain, market share from active managers like us, which could have a material impact on our business. The Company believes that its ability to compete effectively with other investment management firms is dependent upon its products, level of investment performance and client service, as well as the marketing and distribution of the investment products.
In the wealth advisory industry, the Company competes with a wide variety of firms, including national and regional financial services firms, accounting firms, trust companies, and law firms. As in the Wealth Management and Trust segment, the Wealth Advisory segment has seen a trend toward the utilization of online financial services and increased utilization of “robo” adviser platforms. The Company believes that the ability of its wealth advisory affiliates to compete effectively with other firms is dependent upon the quality and level of service, personal relationships, and investment performance.
IV. Employees
At December 31, 2017, the Company had 925 employees. The Company’s employees are not subject to a collective bargaining agreement, and the Company believes its employee relations are good.
V. Supervision and Regulation
The following discussion addresses elements of the regulatory framework applicable to bank holding companies and their subsidiaries. This regulatory framework is intended primarily to protect the safety and soundness of depository institutions, the federal deposit insurance system, and depositors, rather than the shareholders of a bank holding company such as the Company.
As a bank holding company, the Company is subject to regulation, supervision and examination by the Federal Reserve under the BHCA. The Company is also subject to examination and supervision by the Massachusetts Division of Banks (the “MDOB”) under Massachusetts law. As a Massachusetts-chartered trust company and Federal Reserve member bank, the Bank is subject to regulation, supervision and examination by the Massachusetts Commissioner of Banks (the “Commissioner”) and the Federal Reserve. The Bank’s California branches are also subject to regulation, supervision and examination by the California Department of Business Oversight Division of Financial Institutions (the “DFI”).
The Company’s Wealth Management and Trust, Investment Management, and Wealth Advisory segments are subject to extensive regulation by the SEC, the Financial Industry Regulatory Authority and state securities regulators.
The following is a summary of certain aspects of the various statutes and regulations applicable to the Company and its subsidiaries. This summary is not a comprehensive analysis of all applicable laws, and is qualified by reference to the full text of statutes and regulations referenced below.
Regulation of the Company
The Company is subject to regulation, supervision and examination by the Federal Reserve, which has the authority, among other things, to order bank holding companies to cease and desist from unsafe or unsound banking practices; to assess civil money penalties; and to order termination of non-banking activities or termination of ownership and control of a non-banking subsidiary by a bank holding company.
Source of Strength. Under the BHCA, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Company is required to serve as a source of financial strength for the Bank. This support may be required at times when the Company may not have the resources to provide support to the Bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a bank subsidiary will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Acquisitions and Activities. The BHCA prohibits a bank holding company, without prior approval of the Federal Reserve, from acquiring all or substantially all the assets of a bank; acquiring control of a bank; merging or consolidating with another bank holding company; or acquiring direct or indirect ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, the acquiring bank holding company would control more than 5% of any class of the voting shares of such other bank or bank holding company.
The BHCA also prohibits a bank holding company from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiary banks. However, a bank holding company may engage in and may own shares of companies engaged in certain activities that the Federal Reserve determines to be closely related to banking or managing and controlling banks.
Limitations on Acquisitions of Company Common Stock. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the Federal Reserve has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve, the acquisition of 10% or more of a class of voting securities of a bank holding company with a class of securities registered under Section 12 of the Exchange Act would constitute the acquisition of control of a bank holding company.
In addition, the BHCA prohibits any company from acquiring control of a bank or bank holding company without first having obtained the approval of the Federal Reserve. Among other circumstances, under the BHCA, a company has control of a bank or bank holding company if the company owns, controls or holds with power to vote 25% or more of a class of voting securities of the bank or bank holding company; controls in any manner the election of a majority of directors or trustees of the bank or bank holding company; or the Federal Reserve has determined, after notice and opportunity for hearing, that the company has the power to exercise a controlling influence over the management or policies of the bank or bank holding company.
Regulation of the Bank
The Bank is subject to the regulation, supervision, and examination of the Commissioner and the Federal Reserve, and with respect to its California branches, the DFI. The Bank is also subject to regulations issued by the Bureau of Consumer Financial Protection, as enforced by the Federal Reserve. The Federal Reserve may also directly examine the other subsidiaries of the Company. The enforcement powers available to federal and state banking regulators include, among other things, the ability to issue cease and desist or removal orders, to terminate insurance of deposits, to assess civil money penalties, to issue directives to increase capital, to place the bank into receivership, and to initiate injunctive actions against banking organizations and institution-affiliated parties.
Deposit Insurance. Deposit obligations of the Bank are insured by the FDIC’s Deposit Insurance Fund (“DIF”) up to $250,000 per separately insured depositor for deposits held in the same right and capacity. The Federal Deposit Insurance Act (the “FDIA”), as amended by the Federal Deposit Insurance Reform Act and the Dodd-Frank Act, requires the FDIC to take steps as may be necessary to cause the ratio of deposit insurance reserves to estimated insured deposits - the designated reserve ratio - to reach 1.35% by September 30, 2020, and it mandates that the reserve ratio designated by the FDIC for any year thereafter may not be less than 1.35%. Further, the Dodd-Frank Act required that, in setting assessments, the FDIC offset the effect of the increase in the minimum reserve ratio from 1.15% to 1.35% on banks with less than $10 billion in assets. To satisfy these requirements, on March 15, 2016, the FDIC’s Board of Directors approved a final rule to increase the DIF’s reserve ratio to the statutorily required minimum ratio of 1.35% of estimated insured deposits. The final rule imposes on large banks a surcharge of 4.5 basis points of their assessment base, after making certain adjustments. Large banks, which are generally banks with $10 billion or more in assets, will pay quarterly surcharges in addition to their regular risk-based assessments. Overall regular risk-based assessment rates will decline once the reserve ratio reaches 1.15 percent. Small banks, such as the Bank, will receive credits to offset the portion of their assessments that help to raise the reserve ratio from 1.15
percent to 1.35 percent. After the reserve ratio reaches 1.38 percent, the FDIC will automatically apply a small bank’s credits to reduce its regular assessment up to the entire amount of the assessment. The revised deposit insurance assessment pricing became effective on July 1, 2016.
Deposit premiums are based on assets. To determine its deposit insurance premium, the Bank computes the base amount of its average consolidated assets less its average tangible equity (defined as the amount of Tier 1 capital) and the applicable assessment rate. On April 26, 2016, the FDIC’s Board of Directors adopted a final rule that changed the manner in which deposit insurance assessment rates are calculated for established small banks, generally those banks with less than $10 billion of assets that have been insured for at least five years. Under this method, each of seven financial ratios and a weighted average of CAMELS composite ratings will be multiplied by a corresponding pricing multiplier. The sum of these products will be added to a uniform amount, with the resulting sum being an institution’s initial base assessment rate (subject to minimum or maximum assessment rates based on a bank’s CAMELS composite rating). This method takes into account various measures, including an institution’s leverage ratio, brokered deposit ratio, one year asset growth, the ratio of net income before taxes to total assets and considerations related to asset quality. Under the small bank pricing rule, beginning with the first assessment period after June 30, 2016, where the DIF’s reserve ratio has reached 1.15% assessments for established small banks with a CAMELS rating of 1 or 2 will range from 1.5 to 16 basis points after adjustments, while assessment rates for established small institutions with a CAMELS composite rating of 1 or 5 may range from 11 to 30 basis points, after adjustment. Assessments for established banks with a CAMELS rating of 3 will range from 3 to 30 basis points. The Company’s FDIC deposit insurance premium declined 32% in the first quarter that the new rules were enacted.
The FDIC has the power to adjust deposit insurance assessment rates at any time. In addition, under the FDIA, the FDIC may terminate deposit insurance 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 the FDIC. For 2017, the FDIC insurance expense for the Bank was $3.0 million.
Acquisitions and Branching. Prior approval from the Commissioner and the Federal Reserve is required in order for the Bank to acquire another bank or establish a new branch office. Well capitalized and well managed banks may acquire other banks in any state, subject to certain deposit concentration limits and other conditions, pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended by the Dodd-Frank Act. In addition, the Dodd-Frank Act authorizes a state-chartered bank, such as the Bank, to establish new branches on an interstate basis to the same extent a bank chartered by the host state may establish branches.
Activities and Investments of Insured State-Chartered Banks. Section 24 of the FDIA generally limits the types of equity investments that FDIC-insured state-chartered member banks, such as the Bank, may make and the kinds of activities in which such banks may engage, as a principal, to those that are permissible for national banks. Further, the Gramm-Leach-Bliley Act of 1999 (the “GLBA”) permits state banks, to the extent permitted under state law, to engage - through “financial subsidiaries” - in certain activities which are permissible for subsidiaries of a financial holding company. In order to form a financial subsidiary, a state-chartered bank must be well capitalized, and must comply with certain capital deduction, risk management and affiliate transaction rules, among other requirements. In addition, the Federal Reserve Act provides that state member banks are subject to the same restrictions with respect to purchasing, selling, underwriting and holding of investment securities as national banks.
Lending Restrictions. Federal law limits a bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. The terms of such extensions of credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the bank’s capital. The Dodd-Frank Act explicitly provides that an extension of credit to an insider includes credit exposure arising from a derivatives transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction or securities borrowing transaction. Additionally, the Dodd-Frank Act requires that asset sale transactions with insiders must be on market terms, and if the transaction represents more than 10% of the capital and surplus of the Bank, approved by a majority of the disinterested directors of the Bank.
Brokered Deposits. Section 29 of the FDIA and FDIC regulations generally limit the ability of an insured depository institution to accept, renew or roll over any brokered deposit unless the institution’s capital category is “well capitalized” or, with the FDIC’s approval, “adequately capitalized.” Depository institutions that have brokered deposits in excess of 10% of total assets will be subject to increased FDIC deposit insurance premium assessments. However, for institutions that are well capitalized and have a CAMELS composite rating of 1 or 2, reciprocal deposits are deducted from brokered deposits.
Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the Federal Reserve to evaluate the Bank’s performance in helping to meet the credit needs of the entire communities it serves, including low and moderate-income neighborhoods, consistent with its safe and sound banking operations, and to take this record into consideration when evaluating certain applications. The Federal Reserve’s CRA regulations are generally based upon objective criteria of the performance of institutions under three key assessment tests: (i) a lending test, to evaluate the institution’s record of making loans in its service areas; (ii) an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution’s delivery of services through its branches, ATMs, and other offices. The Bank’s most recent performance evaluation from the FDIC, which was the Bank’s primary federal regulator at the time of the evaluation, was a “satisfactory” rating. Massachusetts has also enacted a similar statute that requires the Commissioner to evaluate the performance of the Bank in helping to meet the credit needs of its entire community and to take that record into account in considering certain applications.
Capital Adequacy and Safety and Soundness
Regulatory Capital Requirements. The Federal Reserve has issued risk-based and leverage capital rules applicable to U.S. banking organizations such as the Company and the Bank. These rules are intended to reflect the relationship between the banking organization’s capital and the degree of risk associated with its operations based on transactions recorded on-balance sheet as well as off-balance sheet. The Federal Reserve may from time to time require that a banking organization maintain capital above the minimum levels discussed below, due to the banking organization’s financial condition or actual or anticipated growth.
The capital adequacy guidelines define qualifying capital instruments and specify minimum amounts of capital as a percentage of assets that banking organizations are required to maintain. Common equity Tier 1 capital generally includes common stock and related surplus, retained earnings and, in certain cases and subject to certain limitations, minority interest in consolidated subsidiaries, less goodwill, other non-qualifying intangible assets and certain other deductions. Tier 1 capital for banks and bank holding companies generally consists of the sum of common equity Tier 1 capital, non-cumulative perpetual preferred stock, and related surplus, and, in certain cases and subject to limitations, minority interests in consolidated subsidiaries that do not qualify as common equity Tier 1 capital, less certain deductions. Tier 2 capital generally consists of hybrid capital instruments, perpetual debt and mandatory convertible debt securities, cumulative perpetual preferred stock, term subordinated debt and intermediate-term preferred stock, and, subject to limitations, allowances for loan losses. The sum of Tier 1 and Tier 2 capital less certain required deductions represents qualifying total risk-based capital. Prior to the effectiveness of certain provisions of the Dodd-Frank Act, bank holding companies were permitted to include trust preferred securities and cumulative perpetual preferred stock in Tier 1 capital, subject to limitations. However, the Federal Reserve’s capital rule applicable to bank holding companies permanently grandfathered non-qualifying capital instruments, including trust preferred securities, issued before May 19, 2010 by depository institution holding companies with less than $15 billion in total assets as of December 31, 2009, subject to a limit of 25% of Tier 1 capital. In addition, under rules that became effective January 1, 2015, accumulated other comprehensive income (positive or negative) must be reflected in Tier 1 capital; however, the Company and the Bank were permitted to make a one-time, permanent election to continue to exclude accumulated other comprehensive income from capital. The Company and the Bank have made this election.
Under the capital rules, risk-based capital ratios are calculated by dividing common equity Tier 1, Tier 1 risk-based capital, and total risk-based capital, respectively, by risk-weighted assets. Assets and off-balance sheet credit equivalents are assigned to one of several categories of risk-weights, based primarily on relative credit risk. The Tier 1 leverage ratio is calculated by dividing Tier 1 risk-based capital by average assets less certain items such as goodwill and intangible assets, as permitted under the capital rules.
Under the Federal Reserve’s capital rules applicable to the Company and the Bank, the Company and the Bank are each required to maintain a minimum common equity Tier 1 capital to risk-weighted assets ratio of 4.5%, a minimum total Tier 1 capital to risk-weighted assets ratio of 6.0%, a minimum total capital to risk-weighted assets ratio of 8% and a minimum leverage ratio of 4%. Additionally, subject to a transition schedule, these rules require an institution to establish a capital conservation buffer of common equity Tier 1 capital in an amount above the minimum risk-based capital requirements for “adequately capitalized” institutions equal to 2.5% of total risk weighted assets, or face restrictions on the ability to pay dividends, pay discretionary bonuses, and to engage in share repurchases.
Under the Federal Reserve’s rules, a Federal Reserve supervised institution, such as the Bank, is considered “well capitalized” if it (i) has a total risk-based capital ratio of 10.0% or greater; (ii) a Tier 1 risk-based capital ratio of 8.0% or greater; (iii) a common Tier 1 equity ratio of at least 6.5% or greater, (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a
specific capital level for any capital measure. The Bank is currently considered “well capitalized” under all regulatory definitions.
Generally, a bank, upon receiving notice that it is not adequately capitalized (i.e., that it is “undercapitalized”), becomes subject to the prompt corrective action provisions of Section 38 of FDIA that, for example, (i) restrict payment of capital distributions and management fees, (ii) require that its federal bank regulator monitor the condition of the institution and its efforts to restore its capital, (iii) require submission of a capital restoration plan, (iv) restrict the growth of the institution’s assets and (v) require prior regulatory approval of certain expansion proposals. A bank that is required to submit a capital restoration plan must concurrently submit a performance guarantee by each company that controls the bank. A bank that is “critically undercapitalized” (i.e., has a ratio of tangible equity to total assets that is equal to or less than 2.0%) will be subject to further restrictions, and generally will be placed in conservatorship or receivership within 90 days.
Current capital rules do not establish standards for determining whether a bank holding company is well capitalized. However, for purposes of processing regulatory applications and notices, the Federal Reserve Board’s Regulation Y provides that a bank holding company is considered “well capitalized” if (i) on a consolidated basis, the bank holding company maintains a total risk-based capital ratio of 10% or greater; (ii) on a consolidated basis, the bank holding company maintains a tier 1 risk-based capital ratio of 6% or greater; and (iii) the bank holding company is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the Board to meet and maintain a specific capital level for any capital measure.
Safety and Soundness Standards. The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, these guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the federal banking agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order restricting asset growth, requiring an institution to increase its ratio of tangible equity to assets or directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of the FDIA. See “-Regulatory Capital Requirements” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Dividend Restrictions
The Company is a legal entity separate and distinct from the Bank and our other subsidiaries. The revenue of the Company (on a parent-only basis) is derived primarily from dividends paid to it by those other entities. The right of the Company, and consequently the right of shareholders of the Company, to participate in any distribution of the assets or earnings of the Bank and our other subsidiaries through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the Bank (including depositors) and our other subsidiaries, except to the extent that certain claims of the Company in a creditor capacity may be recognized.
Restrictions on Bank Holding Company Dividends. The Federal Reserve has the authority to prohibit bank holding companies from paying dividends if such payment is deemed to be an unsafe or unsound practice. The Federal Reserve has indicated generally that it may be an unsafe or unsound practice for bank holding companies to pay dividends unless the bank holding company’s net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the organization’s capital needs, asset quality and overall financial condition. Further, under the Federal Reserve’s capital rule, the Company’s ability to pay dividends is restricted if it does not maintain capital above the conservation buffer. See “-Capital Adequacy and Safety and Soundness -Regulatory Capital Requirements” above.
Restrictions on Bank Dividends. The Federal Reserve has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. In addition, a state bank that is a member of the Federal Reserve System may not declare or
pay a dividend if the total of all dividends declared during the calendar year, including the proposed dividend, exceeds the sum of the bank’s net income (as reportable in its Reports of Condition and Income) during the current calendar year and the retained net income of the prior two calendar years, unless the dividend has not been objected to by the FRB following receipt of advance notice. A state member bank may not declare and pay a dividend that would exceed its individual profits (as reportable on its Reports of Condition and Income) unless it has provided advance notice to the Federal Reserve and the Federal Reserve has not objected. Payment of dividends by a bank is also restricted pursuant to various state regulatory limitations.
Certain Transactions by Bank Holding Companies with their Affiliates
There are various statutory restrictions on the extent to which bank holding companies and their non-bank subsidiaries may borrow, obtain credit from or otherwise engage in “covered transactions” with their insured depository institution subsidiaries. The Dodd-Frank Act amended the definition of affiliate to include an investment fund for which the depository institution or one of its affiliates is an investment adviser. An insured depository institution (and its subsidiaries) may not lend money to, or engage in covered transactions with, its non-depository institution affiliates if the aggregate amount of covered transactions outstanding involving the bank, plus the proposed transaction exceeds the following limits: (i) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 10% of the capital stock and surplus of the insured depository institution; and (ii) in the case of all affiliates, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 20% of the capital stock and surplus of the insured depository institution. For this purpose, “covered transactions” are defined by statute to include a loan or extension of credit to an affiliate; a purchase of or investment in securities issued by an affiliate; a purchase of assets from an affiliate unless exempted by the Federal Reserve; the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any person or company; the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate; securities borrowing or lending transactions with an affiliate that creates a credit exposure to such affiliate; or a derivatives transaction with an affiliate that creates a credit exposure to such affiliate. Covered transactions are also subject to certain collateral security requirements. Covered transactions as well as other types of transactions between a bank and a bank holding company must be on market terms and not otherwise unduly favorable to the holding company or an affiliate of the holding company. Moreover, Section 106 of the BHCA provides that, to further competition, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit, lease or sale of property of any kind, or furnishing of any service.
Consumer Protection Regulation
The Company and the Bank are subject to federal and state laws designed to protect consumers and prohibit unfair, deceptive or abusive business practices, including the Equal Credit Opportunity Act, Fair Housing Act, Home Ownership Protection Act, Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”), the GLBA, the Truth in Lending Act, the CRA, the Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, National Flood Insurance Act and various state law counterparts. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must interact with clients when taking deposits, making loans, collecting loans and providing other services. Further, the Dodd-Frank Act established the Consumer Financial Protection Bureau (“CFPB”), which has the responsibility for making rules and regulations under the federal consumer protection laws relating to financial products and services. The CFPB also has a broad mandate to prohibit unfair or deceptive acts and practices and is specifically empowered to require certain disclosures to consumers and draft model disclosure forms. Failure to comply with consumer protection laws and regulations can subject financial institutions to enforcement actions, fines and other penalties. The Federal Reserve will examine the Bank for compliance with CFPB rules and will enforce CFPB rules with respect to the Bank.
Mortgage Reform. The Dodd-Frank Act prescribes certain standards that mortgage lenders must consider before making a residential mortgage loan, including verifying a borrower’s ability to repay such mortgage loan, and allows borrowers to assert violations of certain provisions of the Truth in Lending Act as a defense to foreclosure proceedings. Under the Dodd-Frank Act, prepayment penalties are prohibited for certain mortgage transactions and creditors are prohibited from financing insurance policies in connection with a residential mortgage loan or home equity line of credit. In addition, the Dodd-Frank Act prohibits mortgage originators from receiving compensation based on the terms of residential mortgage loans and generally limits the ability of a mortgage originator to be compensated by others if compensation is received from a consumer. The Dodd-Frank Act requires mortgage lenders to make additional disclosures prior to the extension of credit, in each billing statement and for negative amortization loans and hybrid adjustable rate mortgages.
Privacy and Customer Information Security. The GLBA requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to nonaffiliated third parties. In general, the Bank must provide its clients with an initial and annual disclosure that explains its policies and procedures
regarding the disclosure of such nonpublic personal information, and, except as otherwise required or permitted by law, the Bank is prohibited from disclosing such information unless otherwise provided in such policies and procedures. However, an annual disclosure is not required to be provided by a financial institution if the financial institution only discloses information under exceptions from GLBA that do not require an opt out to be provided and if there has been no change in its privacy policies and practices since its most recent disclosure provided to consumers. The GLBA also requires that the Bank develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of client information (as defined under GLBA), to protect against anticipated threats or hazards to the security or integrity of such information and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any client. The Bank is also required to send a notice to clients whose “sensitive information” has been compromised if unauthorized use of the information is “reasonably possible.” Most states, including the states in which the Bank operates, have enacted legislation concerning breaches of data security and the duties of the Bank in response to a data breach. In addition, Massachusetts has promulgated data security regulations with respect to personal information of Massachusetts residents. Pursuant to the FACT Act, the Bank has developed and implemented a written identity theft prevention program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts. Additionally, the FACT Act amends the Fair Credit Reporting Act to generally prohibit a person from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and a reasonable opportunity and a reasonable and simple method to opt out of the making of such solicitations.
Anti-Money Laundering
The Bank Secrecy Act. Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report to the U.S. Treasury any cash transactions involving more than $10,000. In addition, financial institutions are required to file suspicious activity reports for any transaction or series of transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), which amended the BSA, together with the implementing regulations of various federal regulatory agencies, has caused financial institutions, such as the Bank, to adopt and implement additional policies or amend existing policies and procedures with respect to, among other things, anti-money laundering compliance, suspicious activity, currency transaction reporting, customer identity verification and customer risk analysis. In evaluating an application under Section 3 of the BHCA to acquire a bank or an application under the Bank Merger Act to merge banks or effect a purchase of assets and assumption of deposits and other liabilities, the applicable federal banking regulator must consider the anti-money laundering compliance record of both the applicant and the target. In addition, under the USA PATRIOT Act, financial institutions are required to take steps to monitor their correspondent banking and private banking relationships as well as, if applicable, their relationships with “shell banks.”
OFAC. The U.S. has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These sanctions, which are administered by the U.S. Treasury’s Office of Foreign Assets Control (“OFAC”), take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial or other transactions relating to a sanctioned country, or with certain designated persons and entities; (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons); and (iii) restrictions on certain transactions with or involving certain persons or entities. Blocked assets (for example, property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences for the Company.
Regulation of Other Activities
Investment Management, Wealth Advisory, and Wealth Management and Trust. Certain subsidiaries of the Company are registered with the SEC as investment advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Advisers Act imposes numerous obligations on RIAs, including fiduciary, recordkeeping, operational, and disclosure obligations. Certain Investment Management, Wealth Advisory, and Wealth Management and Trust subsidiaries of the Company are also subject to regulation under the securities laws and fiduciary laws of certain states.
The Dodd-Frank Act requires the SEC to study the standard of care for brokers and investment advisers and report its findings to Congress. Further, the Dodd-Frank Act permits the SEC to impose a uniform standard of care on brokers and investment advisers based on the study’s findings. Pursuant to the Dodd-Frank Act, the SEC must also harmonize the enforcement of fiduciary standard violations under the Exchange Act and the Advisers Act. It is unclear how the studies and
rulemaking relating to the fiduciary duties of brokers and investment advisers will affect the Company and its Investment Management, Wealth Advisory, and Wealth Management and Trust subsidiaries.
Each of the mutual funds for which one or more of the Company’s Investment Management subsidiaries acts as sub-adviser is registered with the SEC under the Investment Company Act of 1940, as amended (the “1940 Act”). Shares of each such fund are registered with the SEC under the Securities Act, and the shares of each fund are qualified for sale (or exempt from such qualification) under the laws of each state and the District of Columbia to the extent such shares are sold in any of such jurisdictions.
The Company, the Bank, and their subsidiaries are also subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), and to regulations promulgated thereunder, insofar as they are a “fiduciary” under ERISA with respect to certain of their clients. ERISA and the applicable provisions of the Internal Revenue Code of 1986, as amended (the “Code”), impose certain duties on persons who are fiduciaries under ERISA and prohibit certain transactions by the fiduciaries (and certain other related parties) to such plans.
As sub-advisers to registered investment companies, the Company’s Investment Management subsidiaries are subject to requirements under the 1940 Act and related SEC regulations. Under provisions of the 1940 Act and Advisers Act governing advisory contracts, an assignment terminating the Company’s sub-advisory contract can occur as a result of the acquisition of a firm by the Company.
The foregoing laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict certain subsidiaries of the Company from conducting their business in the event that they fail to comply with such laws and regulations. Possible sanctions that may be imposed in the event of such noncompliance include the suspension of individual employees; limitations on the business activities for specified periods of time; revocation of registration as an investment adviser, commodity trading adviser and/or other registrations; and other censures and fines.
Volcker Rule Restrictions on Proprietary Trading and Sponsorship of Hedge Funds and Private Equity Funds. The Dodd-Frank Act prohibits banking organizations, such as the Company, from engaging in proprietary trading and from sponsoring and investing in hedge funds and private equity funds, except as permitted under certain circumstances, pursuant to a provision commonly referred to as the “Volcker Rule.” Under the Dodd-Frank Act, proprietary trading generally means trading by a banking entity or its affiliate for its trading account. Hedge funds and private equity funds are described by the Dodd-Frank Act as funds that would be registered under the 1940 Act but for certain enumerated exemptions. The Volcker Rule restrictions apply to the Company, the Bank, and all of their subsidiaries and affiliates.
VI.Taxation
Federal Taxation
The Company and its incorporated affiliates are subject to federal income taxation generally applicable to corporations under the Code. In addition, the Bank is subject to Subchapter H of the Code, which provides specific rules for the treatment of securities, reserves for loan losses, and any common trust funds.
The Company and its incorporated affiliates are members of an affiliated group of corporations within the meaning of Section 1504 of the Code and file a consolidated federal income tax return. Some of the advantages of filing a consolidated tax return include the avoidance of tax on intercompany distributions and the ability to offset operating and capital losses of one company against operating income and capital gains of another company.
The Company’s taxable income includes its share of the taxable income or loss from its subsidiaries that are limited liability companies.
On December 22, 2017, the Tax Cuts and Jobs Act, (the “Tax Act”) was enacted by the U.S. government. The Tax Act includes significant changes to the Code, including amendments which significantly change the taxation of business entities. The most significant change that impacts the Company is the reduction in the federal corporate tax rate from 35% to 21% and the elimination of Code Section 162(m)’s exemption for performance-based executive compensation, both of which are effective January 1, 2018.
State and Local Taxation
The Company and its affiliates are subject to the tax rate established in the states in which they do business. Substantially all of the Company’s taxable state and local income is derived from Massachusetts, California, Florida, New York, and the City of New York.
The Massachusetts tax rate is 9.0% on taxable income apportioned to Massachusetts. Massachusetts’ taxable income is defined as federal taxable income subject to certain modifications. These modifications include a deduction for 95% of dividends received from entities in which the Company owns 15% or more of the voting stock, income from federally tax-exempt obligations and deductions for certain expenses allocated to federally tax-exempt obligations.
The California tax rate is 8.84% for corporations that are not financial institutions and 10.84% for financial institutions. The California tax is on California taxable income, which is defined as federal taxable income subject to certain modifications. These modifications include income from federally tax-exempt obligations and deductions for certain expenses allocated to federally tax-exempt obligations.
The Florida tax rate is 5.5% on taxable income apportioned to Florida. Florida’s taxable income is defined as federal taxable income subject to certain modifications. These modifications include income from federally tax-exempt obligations and deductions for certain expenses allocated to federally tax-exempt obligations.
The New York state tax rate is 6.5% on taxable income apportioned to New York (subject to alternative minimum taxes that may be based on business capital or a fixed dollar minimum), plus a surcharge for business operations in the Metropolitan Commuter Transportation district. New York taxable income is defined as federal taxable income subject to certain modifications. These modifications include income from federally tax-exempt obligations and deductions for certain expenses allocated to federally tax-exempt obligations. Combined reporting requirements began in 2015.
The New York City tax rate is 8.85% on taxable income apportioned to New York City (subject to alternative minimum taxes that may be based on business capital or a fixed dollar minimum). New York City taxable income is defined as federal taxable income subject to certain modifications. These modifications include income from federally tax-exempt obligations and deductions for certain expenses allocated to federally tax-exempt obligations. Combined reporting requirements began in 2015.
ITEM 1A.
ITEM 1A.RISK FACTORS
Before deciding to invest in us or deciding to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the SEC. The risks and uncertainties described below and in our other filings are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occur, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose some or all of your investment.
Risks Related to our Banking Business
Our banking business is highly regulated, which could limit or restrict our activities, and changes in banking laws and regulations could have an adverse effect on our business.
We are subject to regulation and supervision by the Federal Reserve, and the Bank is subject to regulation and supervision by the Commissioner, the Federal Reserve, and the FDIC. Federal and state laws and regulations govern numerous matters affecting us, including changes in the ownership or control of banks and bank holding companies; maintenance of adequate capital and the financial condition of a financial institution; permissible types, amounts and terms of extensions of credit and investments; permissible non-banking activities; the level of reserves against deposits; and restrictions on dividend payments. The Federal Reserve and the Commissioner have the power to issue cease and desist orders to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulation, and the Federal Reserve possesses similar powers with respect to bank holding companies. These and other restrictions limit the manner in which we and the Bank may conduct business and obtain financing.
The laws, rules, regulations and supervisory guidance and policies applicable to us are subject to regular modification and change. These changes could adversely impact us. Such changes could subject us to additional costs, including costs of compliance, limit the types of financial services and products we may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations, policies, or supervisory guidance could result in enforcement and other legal actions by federal or state authorities, including criminal and civil penalties, the loss of FDIC insurance, revocation of a banking charter, other sanctions by regulatory agencies, civil money penalties, and/or reputational damage, which could have an adverse effect on our business, financial condition, and results of operations. See Part I. Item 1. “Business - Supervision and Regulation.”
We are subject to capital and liquidity standards that require banks and bank holding companies to maintain more and higher quality capital and greater liquidity than has historically been the case.
We became subject to new capital requirements in 2015. These new standards, which now apply and are being fully phased-in over the next several years, require bank holding companies and their bank subsidiaries to maintain substantially higher levels of capital as a percentage of their assets, with a greater emphasis on common equity as opposed to other components of capital. The need to maintain more and higher quality capital, as well as greater liquidity, and generally increased regulatory scrutiny with respect to capital levels, may at some point limit our business activities, including lending, and our ability to grow our business. It could also result in our being required to take steps to increase our regulatory capital and may dilute shareholder value or limit our ability to pay dividends or otherwise return capital to our investors through stock repurchases.
We are subject to numerous laws designed to protect consumers, including the Community Reinvestment Act and fair lending laws, and any failure to comply with these laws could lead to a wide variety of sanctions.
The Community Reinvestment Act, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose community investment and nondiscriminatory lending requirements on financial institutions. The Consumer Financial Protection Bureau, the Department of Justice and other federal agencies are responsible for enforcing these laws and regulations. A successful regulatory challenge to an institution’s performance under the Community Reinvestment Act, the Equal Credit Opportunity Act, the Fair Housing Act or other fair lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions, restrictions on expansion and restrictions on entering new business lines. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have an adverse effect on our business, reputation, financial condition, and results of operations.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different financial institutions, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, other commercial banks, investment banks, mutual and hedge funds, and other financial institutions. As a result, defaults by, or even negative rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by us or by other institutions and organizations. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be liquidated or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due to us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Changes in the business and economic conditions, particularly those in our local economies, could negatively impact our financial condition and results of operations.
The Private Banking segment primarily serves individuals and smaller businesses located in three geographic regions: New England, the San Francisco Bay Area, and Southern California. The ability of the Bank’s clients to repay their loans is impacted by the economic conditions in these areas.
The Bank’s commercial loans are generally concentrated in the following client groups:
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real estate developers and investors;
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financial service providers;
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technology companies;
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manufacturing and communications companies;
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professional service providers;
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general commercial and industrial companies; and
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individuals.
The Bank’s commercial loans, with limited exceptions, are secured by real estate (usually income producing residential and commercial properties), marketable securities, or corporate assets (usually accounts receivable, equipment or inventory). Substantially all of the Bank’s residential mortgage and home equity loans are secured by residential property. Consequently, the Bank’s ability to continue to originate real estate loans may be impaired by the weakening or deterioration in
local and regional economic conditions in the real estate markets, including as a result of, among other things, real or threatened acts of war, natural disasters, and adverse weather. Due to the concentration of real estate collateral in the geographic regions in which we operate, these events could have an adverse impact on the ability of the Bank’s borrowers to repay their loans and affect the value of the collateral securing these loans.
Competition in the banking industry may impair our ability to attract and retain banking clients at current levels.
Competition in the markets in which the Bank operates may limit the ability of the Bank to attract and retain banking clients. The Bank’s competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are able to serve the credit and investment needs of larger clients. The Bank also faces competition from out-of-state financial intermediaries that have opened low-end production offices or that solicit deposits in its respective market areas from other remote locations. There is also increased competition by out-of-market competitors through the Internet. Because the Bank maintains a smaller staff and has fewer financial and other resources than larger institutions with which it competes, it may be limited in its ability to attract clients. In addition, the Bank’s current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than the Bank can accommodate. If the Bank is unable to attract and retain banking clients, it may be unable to continue its deposit and loan growth and its results of operations and financial condition may otherwise be negatively impacted.
Market changes may adversely affect demand for the Bank’s services and impact results of operations.
Channels for servicing the Bank’s customers are evolving rapidly, with less reliance on traditional branch facilities, more use of online and mobile banking, and increased demand for universal bankers and other relationship managers who can service multiple product lines. The Bank competes with larger providers that are rapidly evolving their service offerings and escalating the costs of the Bank’s efforts to keep pace. The Bank has a process for evaluating the profitability of its branch system and other office and operational facilities. The identification of unprofitable operations and facilities can lead to restructuring charges and introduce the risk of disruptions to revenues and customer relationships.
Our cost of funds for banking operations may increase as a result of general economic conditions, interest rates and competitive pressures.
The Bank has traditionally obtained funds principally through deposits and borrowings. As a general matter, deposits are a cheaper source of funds than borrowings, because interest rates paid for deposits are typically less than interest rates charged for borrowings. We compete with banks and other financial institutions for deposits. If, as a result of general economic conditions, market interest rates, competitive pressures, or otherwise, the amount of deposits at the Bank decreases relative to its overall banking operations, the Bank may have to rely more heavily on higher cost borrowings as a source of funds in the future. Higher funding costs reduce our net interest margin, net interest income, and net income.
Potential downgrades of U.S. government securities by one or more of the credit ratings agencies could have an adverse effect on our operations, earnings and financial condition.
A possible future downgrade of the sovereign credit ratings of the U.S. government and a decline in the perceived creditworthiness of U.S. government-related obligations could impact our ability to obtain funding that is collateralized by these affected instruments held by us, as well as affect the pricing of that funding when it is available. A downgrade may also adversely affect the market value of such instruments held by us. We cannot predict if, when or how any changes to the credit ratings or perceived creditworthiness of these organizations will affect economic conditions. Such ratings actions could result in a significant adverse impact on us. Among other things, a downgrade in the U.S. government’s credit rating could adversely impact the value of our securities portfolio and may trigger requirements that the Company post additional collateral for trades relative to these securities. A downgrade of the sovereign credit ratings of the U.S. government or the credit ratings of related institutions, agencies or instruments would significantly exacerbate the other risks to which we are subject and any related adverse effects on our business, financial condition and results of operations.
Defaults in the repayment of loans may require additional loan loss reserves and negatively impact our banking business.
A borrower’s default on its obligations under one or more Bank loans may result in lost principal and interest income and increased operating expenses as a result of the allocation of management time and resources to the collection and work-out of the loan. In certain situations, where collection efforts are unsuccessful or acceptable work-out arrangements cannot be reached, the Bank may have to charge-off the loan in whole or in part. In such situations, the Bank may acquire real estate or other assets, if any, which secure the loan through foreclosure or other similar available remedies. In such cases, the amount owed under the defaulted loan may exceed the value of the assets acquired.
On at lease a quarterly basis, the Bank’s management makes a determination of an allowance for loan losses based on available information, including the quality of its loan portfolio, certain economic conditions, the historical rate of defaulted loans, the value of the underlying collateral, and the level of its nonaccruing and criticized loans. We rely on our loan quality reviews, our experience and our evaluation of economic conditions, among other factors, in determining the level required for the allowance for loan losses. If management determines that further increases in the allowance for loan losses are necessary, we will incur additional expenses.
If it is determined that the Bank should sell certain loans or a portfolio of loans, we are required to classify those loans as “held for sale” which requires us to carry such loans at the lower of their amortized cost or market value. If we decide to sell loans at a time when the fair value of those loans is less than their carrying value, the adjustment will result in a charge to the allowance for loan losses if the decline in value is due to credit issues. We may from time to time decide to sell particular loans or groups of loans, and the required adjustment could negatively affect our financial condition or results of operations.
In addition, bank regulatory agencies periodically review the Bank’s allowance for loan losses and the values it attributes to real estate acquired through foreclosure or other similar remedies. Such regulatory agencies may require the Bank to adjust its determination of the value for these items. These adjustments could negatively impact our results of operations or financial condition.
Fluctuations in interest rates may negatively impact our banking business.
The Bank’s earnings and financial condition are largely dependent on net interest income, which represents the difference between the interest income earned on interest-bearing assets (usually loans and investment securities) and the interest expense incurred in connection with interest-bearing liabilities (usually deposits and borrowings). The relative rates of interest we earn and pay are highly sensitive to many factors beyond our control, including general economic conditions, and changes in monetary or fiscal policies of the Federal Reserve and other governmental authorities. A narrowing of this interest rate spread could adversely affect the Bank’s net interest income, which also could negatively impact its earnings and financial condition. As a result, the Bank has adopted asset and liability management policies to mitigate the potential adverse effects of changes in interest rates on net interest income, primarily by altering the mix and maturity of loans, investments, funding sources, and derivatives. However, even with these policies in place, a change in interest rates can impact our results of operations or financial condition.
An increase in interest rates could also have a negative impact on the Bank’s results of operations by reducing the ability of borrowers to repay their current floating loan obligations, which could not only result in increased loan defaults, foreclosures, and charge-offs, but also necessitate increases to our allowances for loan losses.
Similarly, rising interest rates may increase the cost of deposits, which are a primary source of funding. While we actively manage against these risks through hedging and other risk management strategies, if our assumptions regarding borrower behavior are wrong or overall economic conditions are significantly different than anticipated, our risk mitigation techniques may be insufficient.
A decrease in interest rates could also have a negative impact on the Bank’s results of operations if clients refinance their loans at lower rates or prepay their loans and we are unable to lend or invest those funds at equivalent or higher rates.
Prepayments of loans may negatively impact our banking business.
Generally, the Bank’s clients may prepay the principal amount of their outstanding loans at any time. The rate at which such prepayments occur, as well as the size of such prepayments, are within our clients’ discretion. Fluctuations in interest rates, in certain circumstances, may also lead to high levels of loan prepayments, which may also have an adverse impact on our net interest income. If clients prepay the principal amount of their loans, and we are unable to lend those funds to other borrowers or invest the funds at the same or higher interest rates, our interest income will be reduced. A significant reduction in interest income could have a negative impact on our results of operations and financial condition.
Our loan portfolio includes commercial loans, commercial real estate loans, and construction and land loans, which are generally riskier than other types of loans.
At December 31, 2017, our commercial loans, commercial real estate loans, and construction and land loans portfolios comprised 54% of total loans. Commercial loans generally carry larger loan balances and involve a higher risk of nonpayment or late payment than residential mortgage loans. These loans may lack standardized terms and may include a balloon payment feature. The ability of a borrower to make or refinance a balloon payment may be affected by a number of factors, including the financial condition of the borrower, prevailing economic conditions, interest rates, and collateral values. Repayment of these loans is generally more dependent on the economy and the successful operation of the underlying business. Because of the risks associated with commercial loans, we may experience higher rates of default than if our loan portfolio were more heavily weighted toward residential mortgage loans. Higher rates of default could have an adverse effect on our financial condition and results of operations.
Environmental liability associated with commercial lending could result in losses.
In the course of business, the Bank may acquire, through foreclosure or other similar proceedings, properties securing loans it has originated or purchased which are in default. Particularly in commercial real estate lending, there is a risk that material environmental violations could be discovered at these properties. In this event, we or the Bank might be required to remedy these violations at the affected properties at our sole cost and expense. The cost of this remedial action could substantially exceed the value of affected properties. We may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties as a result of their condition. These events could have an adverse effect on our business, results of operations and financial condition.
Risks Related to our Investment Management, Wealth Advisory, and Wealth Management and Trust Businesses
Our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses are highly regulated, and the regulators have the ability to limit or restrict our activities and impose fines or suspensions on the conduct of our business.
Our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses are highly regulated, primarily at the federal level. The failure of any of our subsidiaries that provide investment management, wealth advisory, or wealth management and trust services to comply with applicable laws or regulations could result in fines, suspensions of individual employees or other sanctions including revocation of such affiliate’s registration as an investment adviser.
All of our Investment Management, Wealth Advisory, and Wealth Management and Trust affiliates are RIAs under the Advisers Act. The Advisers Act imposes numerous obligations on RIAs, including fiduciary, record keeping, operational and disclosure obligations. These subsidiaries, as investment advisers, are also subject to regulation under the federal and state securities laws and the fiduciary laws of certain states. In addition, the affiliates acting as sub-advisers to mutual funds are subject to certain provisions and regulations of the 1940 Act.
We are also subject to the provisions and regulations of ERISA to the extent that we act as a “fiduciary” under ERISA with respect to certain of our clients. ERISA and the applicable provisions of the federal tax laws, impose a number of duties on persons who are fiduciaries under ERISA and prohibit certain transactions involving the assets of each ERISA plan which is a client, as well as certain transactions by the fiduciaries (and certain other related parties) to such plans.
In addition, applicable law provides that all investment contracts with mutual fund clients may be terminated by the clients, without penalty, upon no more than 60 days’ notice. Investment contracts with institutional and other clients are typically terminable by the client, also without penalty, upon 30 days’ notice.
Changes in these laws or regulations could have an adverse impact on our profitability and mode of operations.
Our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses may be negatively impacted by changes in economic and market conditions.
Our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses may be negatively impacted by changes in general economic and market conditions because the performance of such business is directly affected by conditions in the financial and securities markets. The financial markets and businesses operating in the securities industry are highly volatile (meaning that performance results can vary greatly within short periods of time) and are directly affected by, among other factors, domestic and foreign economic conditions and general trends in business and finance, all of which are beyond our control. We cannot assure you that broad market performance will be favorable in the future. Declines in the financial markets or a lack of sustained growth may result in a corresponding decline in our performance and may adversely affect the assets that we manage.
In addition, our management contracts generally provide for fees payable for investment management, wealth advisory, and wealth management and trust services based on the market value of assets under management, although there are a portion of our contracts that provide for the payment of fees based on investment performance in addition to a base fee. Because most contracts provide for a fee based on market values of securities, fluctuations in the underlying securities values may have an adverse effect on our results of operations and financial condition.
We may not be able to attract and retain investment management, wealth advisory, and wealth management and trust clients due to competition.
Due to intense competition, our Investment Management, Wealth Advisory, and Wealth Management and Trust subsidiaries may not be able to attract and retain clients. Competition is especially strong in our geographic market areas because there are numerous well-established, well-resourced, well-capitalized, and successful investment management, wealth advisory, and wealth management and trust firms in these areas.
Our ability to successfully attract and retain investment management, wealth advisory, and wealth management and trust clients is dependent upon our ability to compete with competitors’ investment products, level of investment performance, client services and marketing and distribution capabilities. If we are not successful, our results of operations and financial condition may be negatively impacted.
Investment management contracts are typically terminable upon less than 30 days’ notice. Most of our investment management clients may withdraw funds from accounts under management generally in their sole discretion. Wealth advisory client contracts must typically be renewed on an annual basis and are terminable upon relatively short notice. The combined financial performance of our Investment Management, Wealth Advisory, and Wealth Management and Trust affiliates is a significant factor in our overall results of operations and financial condition.
Our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses are highly dependent on investment managers to produce investment returns and to solicit and retain clients, and the loss of a key investment manager or wealth advisor could adversely affect our Investment Management, Wealth Advisory, and Wealth Management and Trust business.
We rely on our investment managers and wealth advisors to produce investment returns and to advise clients. We believe that investment performance is one of the most important factors for the growth of our assets under management. Poor investment performance could impair our revenues and growth because existing clients might withdraw funds in favor of better performing products, which would result in lower investment management fees, or our ability to attract funds from existing and new clients might diminish.
The market for investment managers is extremely competitive and is increasingly characterized by frequent movement of investment managers among different firms. In addition, our individual investment managers and wealth advisors often have regular direct contact with particular clients, which can lead to a strong client relationship based on the client’s trust in that individual manager or advisor. The loss of a key investment manager or wealth advisor could jeopardize our relationships with our clients and lead to the loss of client accounts. Losses of such accounts could have an adverse effect on our results of operations and financial condition.
Risks Related to Our Overall Business and Operations
Our business and earnings have been adversely affected, and may in the future be adversely affected, by the U.S. and international financial markets and economic conditions.
The performance of our business has been and may in the future be adversely affected by general business and economic conditions in the U.S., including the level and volatility of short- and long-term interest rates, inflation, home prices, unemployment and under-employment levels, bankruptcies, household income, consumer spending, fluctuations in both debt and equity capital markets, liquidity of the global financial markets, the availability and cost of credit, and investor confidence. While in recent years there has been gradual improvement in the U.S. economy, deterioration of any of these conditions can adversely affect our results of operations and financial condition.
We may incur significant losses as a result of ineffective risk management processes and strategies.
We seek to monitor and control our risk exposure through a risk and control framework encompassing a variety of separate but complementary financial, credit, operational, compliance, and legal reporting systems; internal controls; management review processes; and other mechanisms. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application may not be effective and may not anticipate every economic and financial outcome in all market environments or the specifics and timing of such outcomes. Market conditions over the last several years have involved unprecedented dislocations and highlight the limitations inherent in using historical data to manage risk.
We may be unable to attract and retain key employees.
Our success depends, in large part, on our ability to attract and retain key employees. Competition for the best people can be intense and we may not be able to hire or retain the key employees that we depend upon for success. The unexpected loss of services of one or more of our key employees could have an adverse impact on our business because of their skills, knowledge of the customers and the markets in which we operate, years of industry experience, and the difficulty of promptly finding qualified replacement employees.
Our ability to attract and retain clients and employees, and to maintain relationships with vendors, third-party service providers and others, could be adversely affected to the extent our reputation is harmed.
We are dependent on our reputation within our market area, as a trusted and responsible financial company, for all aspects of our relationships with clients, employees, vendors, third-party service providers, and others with whom we conduct business or potential future business. Our ability to attract and retain clients and employees at our Private Banking, Wealth Management and Trust, Investment Management, and Wealth Advisory subsidiaries could be adversely affected to the extent our reputation is damaged. Our actual or perceived failure to address various issues could give rise to reputational risk that could cause harm to us and our business prospects. These issues include, but are not limited to, legal and regulatory requirements; privacy; properly maintaining client and employee personal information; record keeping; money-laundering; sales and trading practices; ethical issues; appropriately addressing potential conflicts of interest; and the proper identification and disclosure of the legal, reputational, credit, liquidity, and market risks inherent in our products. Failure to appropriately address any of these issues could also give rise to additional regulatory restrictions, reputational harm, and legal risks, which could, among other consequences, increase the size and number of litigation claims and damages asserted or subject us to enforcement actions, fines, and penalties and cause us to incur related costs and expenses. In addition, our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses are dependent on the integrity of our asset managers and our employees. If an asset manager or employee were to misappropriate any client funds or client information, the reputation of our asset management business could be negatively affected, which may result in the loss of accounts and have an adverse effect on our results of operations and financial condition.
We may not be able to successfully implement future information technology system enhancements, which could adversely affect our business operations and profitability.
We invest significant resources in information technology system enhancements in order to provide functionality and security at an appropriate level. We may not be able to successfully implement and integrate future system enhancements, which could adversely impact the ability to provide timely and accurate financial information in compliance with legal and regulatory requirements and result in possible sanctions from regulatory authorities. Such sanctions could include fines and suspension of trading in our stock, among others. In addition, future system enhancements could have higher than expected costs, fail to achieve their intended operating efficiencies, and/or even result in operating inefficiencies, which could increase the costs associated with the implementation as well as ongoing operations.
Failure to properly utilize system enhancements that are implemented in the future could result in impairment charges that adversely impact our financial condition and results of operations and could result in significant costs to remediate or replace the defective components. In addition, we may incur significant training, licensing, maintenance, consulting and amortization expenses during and after systems implementations, and any such costs may continue for an extended period of time.
We rely on other companies to provide key components of our business infrastructure.
Third-party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, using established criteria and complying with applicable regulatory guidance to evaluate each vendor’s overall risk profile, capabilities, financial stability, and internal control environment, we do not control their daily business environment and actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers, impair our ability to conduct our business efficiently and effectively, and/or result in regulatory action, financial loss, litigation, and loss of reputation. Replacing these third party vendors could also entail significant delay and expense.
We face continuing and growing security risks to our information base, including the information we maintain relating to our customers.
In the ordinary course of business, we rely on electronic communications and information systems to conduct our business and to store sensitive data, including our confidential information and financial and personal information regarding customers. Our electronic communications and information systems infrastructure could be susceptible to cyberattacks, hacking, identity theft, computer viruses, malicious code, phishing attacks, terrorist activity or other information security breaches. This risk has increased significantly due to the use of online, telephonic and mobile banking channels by clients and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties. We have implemented and regularly review and update extensive systems of internal controls and procedures as well as corporate governance policies and procedures intended to protect our business operations, including the security and privacy of all confidential customer information. In addition, we rely on the services of a variety of vendors to meet our data processing and communication needs. No matter how well designed or implemented our controls are, we cannot provide an absolute guarantee to protect our business operations from every type of problem in every situation. A failure or circumvention of these controls could have an adverse effect on our business operations and financial condition.
We regularly assess and test our security systems and disaster preparedness, including back-up systems, but the risks are substantially escalating. As a result, cybersecurity and the continued enhancement of our controls and processes to protect our systems, data and networks from attacks, unauthorized access or significant damage remain a priority. Accordingly, we may be required to expend additional resources to enhance our protective measures or to investigate and remediate any information security vulnerabilities or exposures. Any breach of our system security could result in disruption of our operations, unauthorized access to confidential customer information, violations of applicable privacy and other laws, significant regulatory costs, litigation exposure and other possible damages, loss or liability. Such costs or losses could exceed the amount of our available insurance coverage, if any, and would adversely affect our earnings. Also, any failure to prevent a security breach or to quickly and effectively deal with such a breach could negatively impact customer confidence, damaging our reputation and undermining our ability to attract and keep customers.
We are subject to extensive and expanding government regulation and supervision, which can lead to costly enforcement actions while increasing the cost of doing business and limiting our ability to generate revenue.
The financial services industry faces intense and ongoing scrutiny from bank supervisors in the examination process and aggressive enforcement of regulations on both the federal and state levels, particularly with respect to compliance with anti-money laundering, BSA and OFAC regulations, and economic sanctions against certain foreign countries and nationals. Enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. We maintain systems and procedures designed to ensure that we comply with applicable laws and regulations; however, some legal/regulatory frameworks provide for the imposition of fines or penalties for noncompliance even though the noncompliance was inadvertent or unintentional and even though there were systems and procedures designed to ensure compliance in place at the time. Failure to comply with these and other regulations, and supervisory expectations related thereto, may result in fines, penalties, lawsuits, regulatory sanctions, reputational damage, or restrictions on our business.
We face significant legal risks, both from regulatory investigations and proceedings and from private actions brought against us.
From time to time we are named as a defendant or are otherwise involved in various legal proceedings, including class actions and other litigation or disputes with third parties. There is no assurance that litigation with private parties will not increase in the future. Future actions against us may result in judgments, settlements, fines, penalties or other results adverse to us, which could adversely affect our business, financial condition or results of operations, or cause serious reputational harm to us. As a participant in the financial services industry, it is likely that we could experience a high level of litigation related to our businesses and operations.
To the extent that we acquire or seek to acquire other companies in the future, our business may be negatively impacted by certain risks inherent in such acquisitions.
We continue to consider the acquisition of other private banking, wealth management and trust, investment management, and wealth advisory companies as well as companies with other potential capabilities in the financial services industry. To the extent that we acquire or seek to acquire other companies in the future, our business may be negatively impacted by certain risks inherent in such acquisitions. These risks include, but are not limited to, the following:
•
the risk that we will incur substantial expenses in pursuing potential acquisitions without completing such acquisitions;
•
the risk that we may lose key clients or employees of the acquired business as a result of the change of ownership to us;
•
the risk that the acquired business will not perform in accordance with our expectations;
•
the risk that difficulties will arise in connection with the integration of the operations of the acquired business with our existing businesses;
•
the risk that we will need to make significant investments in infrastructure, controls, staff, emergency backup facilities or other critical business functions that become strained by our growth;
•
the risk that management may divert its attention from other aspects of our business;
•
the risk that unanticipated costs relating to potential acquisitions could reduce our earnings per share;
•
the risk associated with entering into geographic and product markets in which we have limited or no direct prior experience;
•
the risk that we may assume potential and unknown liabilities of the acquired company as a result of the acquisition; and
•
the risk that an acquisition will dilute our earnings per share, in both the short and long term, or that it will reduce our regulatory and tangible capital ratios.
As a result of these risks, any given acquisition, if and when consummated, may adversely affect our results of operations or financial condition. In addition, because the consideration for an acquisition may involve cash, debt or the issuance of shares of our stock and may involve the payment of a premium over book and market values, existing stockholders may experience dilution in connection with any acquisition.
Natural disasters, acts of terrorism and other external events could harm our business.
Natural disasters can disrupt our operations, result in damage to our properties, reduce or destroy the value of the collateral for our loans and negatively affect the economies in which we operate, which could have an adverse effect on our results of operations and financial condition. A significant natural disaster, such as a tornado, hurricane, earthquake, fire or flood, could have an adverse impact on our ability to conduct business, and our insurance coverage may be insufficient to compensate for losses that may occur. Acts of terrorism, war, civil unrest, violence or human error could cause disruptions to our business or the economy as a whole. While we have established and regularly test disaster recovery procedures, the occurrence of any such event could have an adverse effect on our business, operations and financial condition.
Risks Related to Accounting and Accounting Changes
Our financial statements are based in part on assumptions and estimates, which, if wrong, could cause unexpected losses in the future.
Pursuant to accounting principles generally accepted in the U.S. (“GAAP”), we are required to use certain assumptions and estimates in preparing our financial statements, including in determining loan loss reserves, reserves related to litigation, if any, and the fair value of certain assets and liabilities, among other items. If assumptions or estimates underlying our financial statements are incorrect, we may experience material fluctuations in our results of operations. For additional information, see Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies.”
Changes in accounting standards can be difficult to predict and can materially impact how we record and report our financial condition and results of operations.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time, the Financial Accounting Standards Board changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to anticipate and implement and can materially impact how we record and report our financial condition and results of operations.
Goodwill and other intangible asset impairment would negatively affect our financial condition and results of operations.
Generally, the acquirer in a business combination is willing to pay more for a business than the sum of the fair values of the individual assets and liabilities because of other inherent value associated with an assembled business. The resulting excess of the consideration paid over the net fair value of the identifiable assets acquired and liabilities assumed as of the date of acquisition, is recognized as goodwill. An essential part of the acquisition method is the recognition and measurement of identifiable intangible assets, separate from goodwill, at fair value. At December 31, 2017, our goodwill and net intangible assets totaled $91.7 million, not including Anchor’s remaining goodwill and intangible assets of $47.1 million which are classified as held for sale and included within other assets in the consolidated balance sheets.
Under current accounting standards, goodwill acquired in a business combination is recognized as an asset and not amortized. Instead, goodwill is tested for impairment on an annual basis, or more frequently if there is a triggering event that may indicate the possibility of impairment. Long-lived intangible assets are amortized and are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable.
If we determine goodwill or intangible assets are impaired, we will be required to write down the value of these assets. In the fourth quarter of 2017, we incurred a $24.9 million goodwill impairment charge at Anchor as part of our annual impairment testing. In December 2016, we incurred a $9.5 million goodwill impairment charge at Boston Private Wealth as part of our annual impairment testing. We cannot assure you that we will not be required to take further impairment charges in the future. Any impairment charge would have a negative effect on our shareholders’ equity and financial results.
Net outflows of assets under management at Anchor and Boston Private Wealth in recent years have negatively impacted their financial results. In addition, any decline in the U.S. equity markets would have a further negative impact on assets under management at these firms. In addition to current financial results, other information such as forecasted earnings and market comparisons for these types of firms is used to determine the fair value of these firms and whether there is indication of impairment.
In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, an entity assesses relevant events and circumstances, such as the following:
•
Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets.
•
Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (considered in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.
•
Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.
•
Other relevant entity-specific events, such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation.
•
Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
Material negative changes in the assumptions or inputs in to the valuation models will increase the risk of impairment. The Company will continue to monitor the events and circumstances at Anchor, Boston Private Wealth, and its other subsidiaries with goodwill and/or intangibles for indication of a triggering event that would necessitate impairment testing prior to the usual testing in the fourth quarter.
Changes in tax law and differences in interpretation of tax laws and regulations may adversely impact our financial statements.
From time to time, local, state or federal tax authorities change tax laws and regulations, which may result in a decrease or increase to our deferred tax asset. At December 31, 2017, our net deferred tax asset was $29.0 million, reflecting a decrease of $12.5 million in connection with the enactment of the Tax Act. We assess the likelihood that our deferred tax asset will be realizable based primarily on future taxable income and, if necessary, establish a valuation allowance for those deferred tax assets determined to not likely be realizable. Management judgment is required in determining the appropriate recognition of deferred tax assets and liabilities, including projections of future taxable income, as well as the character of that income.
Local, state or federal tax authorities may interpret tax laws and regulations differently than we do and challenge tax positions that we have taken on tax returns. This may result in differences in the treatment of revenues, deductions, credits and/or differences in the timing of these items. The differences in treatment may result in payment of additional taxes, interest or penalties that could have an adverse effect on our results.
Risks Related to Our Liquidity
We are a holding company and depend on our subsidiaries for dividends.
We are a legal entity that is separate and distinct from the Bank and our other subsidiaries and depend on dividends from those entities to fund dividend payments on our common and preferred stock, to fund share repurchases, and to fund all payments on our other obligations. Our revenue (on a parent-only basis) is derived primarily from dividends paid to us by the Bank and our other subsidiaries. Our right, and consequently the right of our shareholders, to participate in any distribution of the assets or earnings of the Bank and our other subsidiaries through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the Bank (including depositors) and our other subsidiaries, except to the extent that certain claims of ours in a creditor capacity may be recognized.
Holders of our common stock are entitled to receive dividends only when, as, and if declared by our board of directors. Although we have historically declared cash dividends on our common and preferred stock, we are not required to do so. Our board of directors may reduce or eliminate our common stock dividend in the future. Further, if we do not pay dividends on our preferred stock, we may not pay any dividends on our common stock. The Federal Reserve has authority to prohibit bank holding companies from paying dividends if such payment is deemed to be an unsafe or unsound practice. Additionally, the Federal Reserve has the authority to use its enforcement powers to prohibit the Bank from paying us dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. The current capital regulations require banks and bank holding companies to maintain a 2.5% common equity Tier 1 capital conservation buffer above the minimum risk-based capital requirements for adequately capitalized institutions to avoid restrictions on the ability to pay dividends, discretionary bonuses, and to engage in share repurchases. The Company and the Bank met these requirements as of December 31, 2017. A reduction or elimination of dividends could adversely affect the market price of our common stock. See Part I. Item 1. “Business - Supervision and Regulation - Dividend Restrictions” and “Business - Supervision and Regulation - Regulatory Capital Requirements.”
Risks Related to Our Common Stock
Future capital offerings may adversely affect the market price of our common stock.
In the future, we may attempt to increase our capital resources or, if our or the Bank’s capital ratios fall below required minimums, we or the Bank could be required to raise additional capital by making additional offerings of debt, common or preferred stock, or senior or subordinated notes. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive distributions of our available assets prior to the holders of our common stock.
Additional future equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common stock, or both. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings.
We cannot assure you that such capital will be available to us on acceptable terms or at all. Our inability to raise sufficient additional capital on acceptable terms when needed could adversely affect our businesses, financial condition, and results of operations.
The market price and trading volume of our common stock may be volatile.
The market price of our common stock may be volatile. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:
•
quarterly variations in our operating results or the quality of our assets;
•
operating results that vary from the expectations of management, securities analysts, and investors;
•
changes in expectations as to our future financial performance;
•
announcements of innovations, new products, strategic developments, significant contracts, litigation, acquisitions, and other material events by us or our competitors;
•
the operating and securities price performance of other companies that investors believe are comparable to us;
•
our past and future dividend and share repurchase practices;
•
future sales of our equity or equity-related securities; and
•
changes in global financial markets and global economies and general market conditions, such as interest rates, stock, commodity or real estate valuations or volatility.
Anti-takeover provisions could negatively impact our shareholders.
Provisions of Massachusetts law, the BHCA, and provisions of our articles of organization and by-laws could make it more difficult for a third party to acquire control of us or have the effect of discouraging a third party from attempting to acquire control of us. Our articles of organization authorize our board of directors to issue preferred stock without shareholder approval and such preferred stock could be issued as a defensive measure in response to a takeover proposal. These and other provisions could make it more difficult for a third party to acquire us, even if an acquisition might be in the best interest of our shareholders.
ITEM 1B.
ITEM 1B.UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.PROPERTIES
The Company and its subsidiaries primarily conduct operations in leased premises; however, the Bank owns the building in which one of its offices is located. The Bank leases the land upon which this building is located. The Company’s headquarters is located at Ten Post Office Square, Boston, Massachusetts. The premises for our Wealth and Investment affiliates are generally located in the vicinity of the headquarters of such affiliates. See “Private Banking,” “Wealth Management and Trust,” “Investment Management,” and “Wealth Advisory” in Part I. Item 1. “Business - General” for further detail.
Generally, the initial terms of the leases for our leased properties range from five to fifteen years. Most of the leases also include options to renew at fair market value for periods of five to ten years. In addition to minimum rentals, certain leases
include escalation clauses based upon various price indices and include provisions for additional payments to cover real estate taxes.
ITEM 3.
ITEM 3.LEGAL PROCEEDINGS
The Company is involved in routine legal proceedings occurring in the ordinary course of business. In the opinion of management, final disposition of these proceedings will not have a material adverse effect on the consolidated balance sheets or consolidated statements of operations of the Company.
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
I.Market for Common Stock
The Company’s common stock, par value $1.00 per share, is traded on the NASDAQ Global Select Market (“NASDAQ”) under the symbol “BPFH.” At February 23, 2018, there were 84,264,182 shares of common stock outstanding. The number of holders of record of the Company’s common stock as of February 23, 2018 was 934. The closing price of the Company’s common stock on February 23, 2018 was $15.10.
The following table sets forth the high and low sale prices for the Company’s common stock for the periods indicated, as reported by NASDAQ:
II.Dividends
The Company paid dividends on its common stock of $0.44 and $0.40 in 2017 and 2016, respectively. On January 17, 2018, the Company announced an increase in its quarterly dividend from $0.11 per share to $0.12 per share for the fourth quarter of 2017.
The Company is a legal entity separate and distinct from its subsidiaries. These subsidiaries are the principal assets of the Company and, as such, provide the main source of payment of dividends by the Company. See Part I. Item 1. “Business - Supervision and Regulation - Dividend Restrictions,” which is incorporated by reference herein, for a discussion of statutory restrictions on the payment of dividends by the Company and the Bank. The payment of dividends by the Company and the Bank may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. There are no such comparable statutory restrictions on the Company’s Investment Managers’ and Wealth Advisors’ ability to pay dividends.
III.Securities Authorized for Issuance Under Equity Compensation Plans
Information regarding securities authorized for issuance under our equity compensation plans will be included in the definitive Proxy Statement (the “Proxy Statement”) for the 2018 Annual Meeting of Shareholders to be held on April 19, 2018 and is incorporated herein by reference.
IV.Recent Sales of Unregistered Securities
None.
V.Issuer Repurchases
The Company received a notice of non-objection from the Federal Reserve for a share repurchase program of up to $20 million of the Company’s outstanding common shares. Under the program, shares may be repurchased from time to time in the open market for a two-year period. The Company’s board of directors approved the program on January 27, 2016.
There were no shares repurchased under this program in 2017. The current repurchase program expired on February 22, 2018.
VI.Performance Graph
The Total Return Performance Graph set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on the Company’s common stock, based on the market price of the Company’s common stock, with the total return on companies within the NASDAQ Composite Index and companies within the SNL $5B-$10B Bank Index. The calculation of cumulative return assumes a $100 investment in the Company’s common stock, the NASDAQ Composite Index, and the SNL $5B-$10B Bank Index on December 31, 2012. It also assumes that all dividends are reinvested during the relevant periods.
___________
Source: SNL
ITEM 6.
ITEM 6.SELECTED FINANCIAL DATA
The following table represents selected financial data for the last five fiscal years ended December 31, 2017. The data set forth below does not purport to be complete. It should be read in conjunction with, and is qualified in its entirety by, the more detailed information appearing elsewhere herein, including the Company’s Consolidated Financial Statements and related notes.
____________
(1)
Cash and investments includes the following line items from the consolidated balance sheets: cash and cash equivalents, investment securities, and stock in Federal Home Loan Bank and Federal Reserve Bank.
(2)
The Company’s income tax expense was higher in 2017 than in prior years primarily due to the the impact of the Tax Act that was enacted on December 22, 2017. Among the significant changes to the Code, the Tax Act reduces the federal corporate tax rate from 35% to 21% effective January 1, 2018. The Company re-measured its deferred tax assets and liabilities at the lower federal corporate tax rate of 21% and recorded the additional tax expense impact in the fourth quarter of 2017, the period in which the Tax Act was enacted.
(3)
Book value per share is calculated by reducing the Company’s total equity by the preferred stock balance, then dividing that value by the total common shares outstanding as of the end of that period.
(4)
The Company uses certain non-GAAP financial measures, such as the Return on Average Common Equity ratio and the Return on Average Tangible Common Equity ratio, to provide information for investors to effectively analyze financial trends of ongoing business activities, and to enhance comparability with peers across the financial sector.
The Company calculates Average Common Equity by adjusting Average Equity to exclude Average Non-convertible Preferred Equity. When Average Non-convertible Preferred Equity is excluded, the Company also reduces Net Income Attributable to the Company by dividends paid on that preferred equity.
The Company calculates Average Tangible Common Equity by adjusting Average Equity to exclude Average Non-convertible Preferred Equity and Average Goodwill and Intangible Assets, net. When Average Non-convertible Preferred Equity and Average Goodwill and Intangible Assets, net are excluded, the Company also reduces Net Income Attributable to the Company by dividends paid on that preferred equity and adds back amortization of intangibles, net of tax.
Reconciliations from the Company’s GAAP Return on Average Equity ratio to the Non-GAAP Return on Average Common Equity ratio, and the Non-GAAP Return on Average Tangible Common Equity ratio are presented below:
_______________
(a)
Tax effect applied to all adjusting items except for the 2017 impairment of goodwill due to the nature of the goodwill impaired during that time period.
(5)
The Company uses certain non-GAAP financial measures, such as the Efficiency Ratio on a Fully Taxable Equivalent (“FTE”) basis, to provide information for investors to effectively analyze financial trends of ongoing business activities, and to enhance comparability with peers across the financial sector. The Company excludes impairment of goodwill and amortization of intangibles in the calculation.
The Company calculates the Efficiency Ratio, FTE basis, by reducing operating expenses by amortization of intangibles, impairment of goodwill, and restructuring expense and increasing total revenue by the FTE adjustment. A reconciliation from the Unadjusted Efficiency Ratio to the Efficiency Ratio, FTE Basis, as Adjusted, is presented below:
(6)
Net interest margin represents net interest income on a fully-taxable equivalent basis as a percent of average interest-earning assets.
(7)
Total revenue is defined as net interest income plus fees and other income.
(8)
The Company uses certain non-GAAP financial measures, such as the Tangible Common Equity to Tangible Assets ratio, to provide information for investors to effectively analyze financial trends of ongoing business activities, and to enhance comparability with peers across the financial sector.
The Company calculates tangible assets by adjusting total assets to exclude goodwill and intangible assets. The Company calculates tangible common equity by adjusting total shareholders’ equity to exclude goodwill, intangible assets, and, the equity from the Series D preferred stock (non-convertible).
A reconciliation from the Company’s GAAP Total Shareholders’ Equity to Total Assets ratio to the Non-GAAP Tangible Common Equity to Tangible Assets ratio and to the Non-GAAP Tier 1 Common Equity to Risk Weighted Assets ratio is presented below:
____________
(a)
Risk Weighted Assets were calculated under the regulatory rules in effect at the time of the original filing of the Federal Reserve report for the respective periods. Components of Tier 1 Common Equity, for all years presented, are based on the capital rules currently in effect.
(9)
Includes the goodwill and intangibles, net for Anchor. For regulatory reporting, the goodwill and intangibles for Anchor are reclassed from other assets held for sale to goodwill and intangibles in regulatory reports and ratios.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements, the notes thereto, and other statistical information included in this annual report.
Executive Summary
The Company offers a wide range of private banking and wealth management services to high net worth individuals, families, businesses and select institutions through its four reportable segments: Private Banking, Wealth Management and Trust, Investment Management, and Wealth Advisory. This Executive Summary provides an overview of the most significant aspects of our operating segments and the Company’s operations in 2017. Details of the matters addressed in this summary are provided elsewhere in this document and, in particular, in the sections immediately following.
Net income attributable to the Company was $40.6 million for the year ended December 31, 2017, compared to net income attributable to the Company of $71.6 million in 2016 and $64.9 million in 2015. The Company recognized diluted earnings per share of $0.42 for the year ended December 31, 2017, compared to diluted earnings per share of $0.81 in 2016 and $0.74 in 2015.
Key items that affected the Company’s 2017 results include:
▪
Net interest income for the year ended December 31, 2017 was $224.7 million, an increase of $24.2 million, or 12%, compared to 2016. The 2017 increase was due to higher volume in the loan portfolio, particularly commercial real estate and residential loans, higher yields on loans and investments, and higher volume of investments. This was partially offset by higher rates paid on deposits and borrowings, and an increase in the average volume of interest-bearing deposits and borrowings. Net interest margin (“NIM”) increased eleven basis points to 3.04% in 2017 from 2.93% in 2016, after increasing one basis point from 2.92% in 2015.
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Recurring fees and income, which includes investment management fees, wealth advisory fees, wealth management and trust fees, other banking fee income, and gain on sale of loans, net, for the year ended December 31, 2017 were $152.8 million, an increase of $1.1 million, or 1%, from 2016. The 2017 increase was due to increases in wealth advisory fees, wealth management and trust fees, and investment management fees, partially offset by decreases in other banking fee income and lower gains on sale of loans.
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The Company recorded a credit to the provision for loan losses of $7.7 million for the year ended December 31, 2017, compared to a credit to the provision for loan losses of $6.9 million in 2016. The 2017 credit to the provision for loan losses was primarily due to net recoveries and an improvement in loss factors, partially offset by an increase in criticized loans and commercial and residential loan growth.
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In December 2017, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority-owned by members of its management team. The Company’s annual goodwill impairment test resulted in a fourth quarter 2017 goodwill impairment charge of $24.9 million. The Company will receive at closing approximately $32 million of cash and future revenue share payments that, at signing, have a net present value of approximately $15 million, subject to purchase price adjustments. In addition to the goodwill impairment charge the Holding Company recorded a $1.3 million loss on sale for the estimated closing expenses related to this transaction. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions.
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The Company recorded total operating expenses of $299.9 million for the year ended December 31, 2017, compared to total operating expenses of $265.0 million in 2016. Excluding goodwill impairment charges in 2017 and goodwill impairment and restructuring charges in 2016, total operating expenses increased $21.6 million, or 9% in 2017 from 2016. This increase in operating expense was due to increases in salaries and employee benefits, information systems, occupancy and equipment, and professional fees expenses.
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In December 2017, the Tax Act was enacted by the U.S. government. Substantially all of the provisions of the Tax Act are effective as of January 1, 2018. The more significant changes in the Tax Act that impact the Company are the reduction in the federal corporate tax rate from 35% to 21% and the changes to the deductibility of executive compensation, both of which are effective as of January 1, 2018. Under ASC 740, the tax effects of changes in tax laws must be recognized in the period in which the law is enacted, or December 2017 for the Tax Act. ASC 740 also requires deferred tax assets and liabilities to be measured at
the enacted tax rate expected to apply when temporary differences are to be realized or settled. The Company re-measured its deferred tax assets and liabilities at the 21% federal corporate tax rate, reevaluated its investments in affordable housing projects using the 21% federal corporate tax rate, and reduced its deferred tax assets associated with executive compensation that is no longer deductible. As a result of these changes, the Company recorded a federal tax expense of $12.9 million in the fourth quarter of 2017, which is the primary driver of the higher income tax expense for the year ended December 31, 2017 as compared to 2016 and 2015.
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Assets under management and advisory (“AUM”), excluding Anchor, increased $2.4 billion, or 13%, for the year ended December 31, 2017 to $21.2 billion due to net flows of $0.5 billion and market appreciation of $2.0 billion. Positive net flows were seen in all three wealth management segments.
Private Banking
The following table presents a summary of selected financial data for the Private Banking segment for 2017, 2016, and 2015.
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(1)
Deposits presented in this table do not include intercompany eliminations related to deposits in the Bank from Wealth and Investment affiliates or the Holding Company.
The Company’s Private Banking segment reported net income attributable to the Company of $53.4 million in the year ended December 31, 2017, compared to net income attributable to the Company of $70.3 million in 2016 and $58.0 million in 2015. The Private Banking segment reported higher income tax expense due to the re-measurement of deferred tax assets at the new, lower, federal corporate tax rate enacted with the Tax Act. The re-measurement amounted to $14.2 million for the Private Banking segment and is reflected in the higher income tax expense for the year ended December 31, 2017. Income before income taxes decreased $6.7 million in 2017 as a result of a $23.9 million, or 19%, increase in operating expenses, a decline of $8.1 million, or 43%, in fees and other income, partially offset by an increase of $24.6 million, or 12% in net interest income. The increase in operating expenses we primarily due to increased salaries and employee benefits, information systems, occupancy and equipment, and professional services. The decline in fees in other income was primarily due to lower swap fees. The increase in net interest income was primarily due to increased volume of loans and higher net interest margin. The 2016 increase was due to increased net interest income, increased banking fee income, a higher credit to the provision for loan losses, and a $2.9 million gain on sale of offices in Southern California, partially offset by increased operating expenses, including in particular higher salaries and employee benefits and occupancy and equipment expenses.
Total loans at the Bank increased $0.4 billion, or 6%, to $6.5 billion. Total loans were 80% of total assets at the Bank at December 31, 2017 up from 78% of total assets at December 31, 2016. A discussion of the Company’s loan portfolio can be found below in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Portfolio and Credit Quality.”
Deposits at the Bank increased $0.4 billion, or 7%, to $6.6 billion in 2017 from $6.2 billion in 2016. A discussion of the Company’s deposits can be found below in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition.”
Wealth Management and Trust
The following table presents a summary of selected financial data for the Wealth Management and Trust segment for 2017, 2016, and 2015.
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The Company’s Wealth Management and Trust segment reported a net loss attributable to the Company of $3.0 million in the year ended December 31, 2017, compared to a net loss attributable to the Company of $12.2 million in 2016 and a net loss attributable to the Company of $0.8 million in 2015. The 2017 improvement in operating results was due to an 8% decrease in operating expenses, primarily salaries and benefits, before restructuring and impairment of goodwill as well as a 3% increase in total revenues. The 2016 net loss attributable to the Company was primarily due to a $9.5 million goodwill impairment charge and a $7.3 million decrease in wealth management and trust fee revenue due to the decrease in AUM. Additionally, there were increases in salaries and employee benefits, and occupancy and equipment expenses, partially offset by lower restructuring expense in 2016 as compared to 2015.
AUM increased $0.9 billion, or 12%, to $7.9 billion at December 31, 2017 from $7.0 billion at December 31, 2016. In 2017, the increase in AUM was primarily the result of market appreciation of $0.6 billion and net flows of $0.3 billion. In 2016, the decrease in AUM was primarily the result of net outflows of $0.7 billion and the disposition of $0.4 billion of certain accounts, partially offset by market appreciation of $0.1 billion.
Investment Management
The following table presents a summary of selected financial data for the Investment Management segment for 2017, 2016, and 2015.
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The Company’s Investment Management segment reported a net loss attributable to the Company of $19.2 million in the year ended December 31, 2017, compared to net income attributable to the Company of $5.7 million in 2016 and $5.8 million in 2015. The $25.0 million decrease in 2017 was due to the $24.9 million impairment of goodwill at Anchor. In December 2017, the Company entered into an agreement to sell its interest in Anchor and Anchor’s assets and liabilities are classified as held for sale at December 31, 2017. The final testing indicated goodwill impairment that resulted in Anchor’s carrying value being reduced to the expected approximate sale price per the sale agreement. Excluding the impairment of goodwill, the Investment Management segment reported a decrease in pre-tax income of $0.2 million, primarily due to a 4% increase in operating expenses before impairment of goodwill, partially offset by a 2% increase in investment management fee income. Results presented in the table above include the results of Anchor, except for the AUM data noted as excluding Anchor.
AUM, excluding Anchor, increased $0.2 billion, or 11%, to $2.0 billion at December 31, 2017 from $1.8 billion at December 31, 2016. In 2017, the increase in AUM, excluding Anchor, was primarily the result of market appreciation of $0.2 billion, with immaterial net flows. In 2016, the decrease in AUM, excluding Anchor, was primarily the result of net outflows of $0.4 billion, offset by market appreciation of $0.4 billion.
Wealth Advisory
The following table presents a summary of selected financial data for the Wealth Advisory segment for 2017, 2016, and 2015.
The Company’s Wealth Advisory segment reported net income attributable to the Company of $8.1 million in the year ended December 31, 2017, compared to net income attributable to the Company of $7.7 million in 2016 and $7.2 million in 2015. A 4% increase in total revenues, partially offset by a 3% increase in operating expenses in 2017, led to the 4% increase in net income attributable to the Company in 2017 as compared to 2016.
AUM increased $1.4 billion, or 14%, to $11.4 billion at December 31, 2017 from $10.0 billion at December 31, 2016. In 2017, the increase in AUM was the result of market appreciation of $1.2 billion and net flows of $0.2 billion. In 2016, the increase in AUM was the result of market appreciation of $0.4 billion, partially offset by net outflows of $0.1 billion.
The Wealth Advisory segment revenue is more resistant to fluctuations in market conditions than Investment Management segment revenue since financial planning fees are typically less correlated to the equity markets.
Critical Accounting Policies
Critical accounting policies are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. The Company believes that its most critical accounting policies upon which its financial condition depends, and which involve the most complex or subjective decisions or assessments, are as follows:
Allowance for Loan and Lease Losses
The allowance for loan losses (“allowance”) is an estimate of the inherent risk of loss in the loan portfolio as of the consolidated balance sheet dates. Management estimates the level of the allowance based on all relevant information available. Changes to the required level in the allowance result in either a provision for loan loss expense, if an increase is required, or a credit to the provision, if a decrease is required. Loan losses are charged to the allowance when available information confirms that specific loans, or portions thereof, are uncollectible. Recoveries on loans previously charged-off are credited to the allowance when received in cash.
The Company’s allowance is accounted for in accordance with guidance issued by various regulatory agencies, including: the Federal Financial Institutions Examination Council Policy Statement on the Allowance for Loan and Lease Losses (December 2006); SEC Staff Accounting Bulletin No. 102, Selected Loan Loss Methodology and Documentation Issues; Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 310, Receivables (“ASC 310”); and ASC 450, Contingencies.
The allowance consists of three primary components: general reserves on pass graded loans, allocated reserves on non-impaired special mention and substandard loans, and the specific reserves on impaired loans. The calculation of the allowance involves a high degree of management judgment and estimates designed to reflect the inherent risk of loss in the loan portfolio at the measurement date.
General reserves are calculated for each loan pool consisting of pass graded loans segregated by portfolio segment by applying estimated net loss percentages based upon the Bank’s actual historical net charge-offs and, adjusted as appropriate, on a consistent manner based upon consideration of qualitative factors to arrive at a total loss factor for each portfolio segment. The rationale for qualitative adjustments is to more accurately reflect the current inherent risk of loss in the respective portfolio segments than would be determined through the sole consideration of the Bank’s actual historical net charge-off rates. The numerical factors assigned to each qualitative factor are based upon observable data, if applicable, as well as management’s analysis and judgment. The qualitative factors considered by the Company include:
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Volume and severity of past due, nonaccrual, and adversely graded loans,
•
Volume and terms of loans,
•
Concentrations of credit,
•
Management’s experience, as well as loan underwriting and loan review policy and procedures,
•
Economic and business conditions impacting the Bank’s loan portfolio, as well as consideration of collateral values, and
•
External factors, including consideration of loss factor trends, competition, and legal and regulatory requirements.
The Bank makes a determination of the applicable loss rate for these factors based on relevant local market conditions, credit quality, and portfolio mix. Each quarter, management reviews the loss factors to determine if there have been any changes in its loan portfolio, market conditions, or other risk indicators which would result in a change to the current loss factor.
Allocated reserves on non-impaired special mention and substandard loans reflect management’s assessment of increased risk of losses associated with these types of adversely graded loans. An allocated reserve is assigned to these pools of loans based upon management’s consideration of the credit attributes of individual loans within each pool of loans, including consideration of loan to value ratios, past due status, strength and willingness of the guarantors, and other relevant attributes, as well as the qualitative factors considered for the general reserve as discussed above. These considerations are determined separately for each type of portfolio segment. The allocated reserves are a multiple of the general reserve for each respective portfolio segments, with a greater multiple for loans with increased risk (i.e., special mention loans versus substandard loans).
A loan is considered impaired in accordance with ASC 310 when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment is measured based on the fair value of the loan, expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, impairment may be determined based upon the observable market price of the loan, or the fair value of the collateral, less estimated costs to sell, if the loan is “collateral dependent.” A loan is collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral or sale of the underlying collateral. For collateral dependent loans, appraisals are generally used to determine the fair value. When a collateral dependent loan becomes impaired, an updated appraisal of the collateral is obtained, if appropriate. Appraised values are generally discounted for factors such as the Bank’s intention to liquidate the property quickly in a foreclosure sale or the date when the appraisal was performed if the Bank believes that collateral values have declined since the date the appraisal was done. The Bank may use a broker opinion of value in addition to an appraisal to validate the appraised value. In certain instances, the Bank may consider broker opinions of value as well as other qualitative factors while an appraisal is being prepared.
If the loan is deemed to be collateral dependent, generally the difference between the book balance (client balance less any prior charge-offs or client interest payments applied to principal) and the fair value of the collateral is taken as a partial charge-off through the allowance for loan losses in the current period. If the loan is not determined to be collateral dependent, then a specific allocation to the general reserve is established for the difference between the book balance of the loan and the expected future cash flows discounted at the loan’s effective interest rate. Charge-offs for loans not considered to be collateral dependent are made when it is determined a loss has been incurred. Impaired loans are removed from the general loan pools. There may be instances where the loan is considered impaired although based on the fair value of underlying collateral or the discounted expected future cash flows there is no impairment to be recognized. In addition, all loans which are classified as troubled debt restructurings (“TDRs”) are considered impaired.
In addition to the three primary components of the allowance for loan losses discussed above (general reserve, allocated reserves on non-impaired special mention and substandard loans, and the specific reserves on impaired loans), the Bank may also maintain an insignificant amount of additional allowance for loan losses (the unallocated allowance for loan
losses). The unallocated reserve reflects the fact that the allowance for loan losses is an estimate and contains a certain amount of imprecision risk. It represents risks identified by Management that are not already captured in the qualitative factors discussed above. The unallocated allowance for loan losses is not considered significant by the Company and will remain at zero unless additional risk is identified.
While this evaluation process utilizes historical and other objective information, the classification of loans and the establishment of the allowance for loan losses rely to a great extent on the judgment and experience of management. While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses as well as loan grades/classifications. Such agencies may require the financial institution to recognize additions to the allowance for loan losses or increases to adversely graded loans based on their judgments about information available to them at the time of their examination.
Valuation of Goodwill/Intangible Assets and Analysis for Impairment
The Company allocates the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Other intangible assets identified in acquisitions generally consist of advisory contracts, trade names, and non-compete agreements. The value attributed to advisory contracts is based on the time period over which they are expected to generate economic benefits. The advisory contracts are generally amortized over 8-15 years, depending on the contract. Trade names are not amortized.
Long-lived intangible assets are subject to the impairment provisions of ASC 360-10, Property, Plant, and Equipment (“ASC 360”). Long-lived intangible assets are tested for recoverability by comparing the net carrying value of the asset or asset group to the undiscounted net cash flows to be generated from the use and eventual disposition of that asset (asset group) when events or changes in circumstances indicate that its carrying amount may not be recoverable. If the carrying amount of the asset exceeds its net undiscounted cash flows, then an impairment loss is recognized for the amount by which the carrying amount exceeds its fair value, determined based upon the discounted value of the expected cash flows generated by the asset. The intangible impairment test is performed at the reporting unit level, and each affiliate with goodwill and/or intangible assets is considered a reporting unit for goodwill and intangible impairment testing purposes.
The excess of the purchase price for acquisitions over the fair value of the net assets acquired, including other intangible assets, is recorded as goodwill. Goodwill is not amortized but is tested for impairment at the reporting unit level, defined as the affiliate level, at least annually in the fourth quarter or more frequently when events or circumstances occur that indicate that it is more likely than not that an impairment has occurred, based on the guidance in ASC 350, Intangibles -Goodwill and Other (“ASC 350”), as updated by ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). Goodwill impairment exists when a reporting unit’s carrying value of goodwill exceeds its implied fair value. In accordance with ASC 350, intangible assets with an indefinite useful economic life are not amortized, but are subject to impairment testing at the reporting unit on an annual basis, or when events or changes in circumstances indicate that the carrying amounts are impaired.
An entity may assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount, including goodwill (“Step 0”). In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, an entity assesses relevant events and circumstances, such as the following:
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Macroeconomic conditions, such as a deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets.
•
Industry and market considerations, such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (considered in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.
•
Overall financial performance, such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.
•
Other relevant entity-specific events, such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation.
•
Events affecting a reporting unit, such as a change in the composition or carrying amount of its net assets; a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit; the testing for recoverability of a significant asset group within a reporting unit; or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
If, after assessing the totality of events or circumstances such as those described in the preceding paragraph, an entity determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the quantitative goodwill impairment test, as described below, is unnecessary.
Goodwill is tested for impairment by estimating the fair value of a reporting unit. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions, and selecting an appropriate control premium. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the weightings that are most representative of fair value.
Quantitative impairment testing requires a comparison of each reporting unit’s fair value to carrying value to identify potential impairment. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, an impairment loss is recognized. In adopting ASU 2017-04, the Company measures that loss as an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. Additionally, the Company considers the income tax effect from any tax deductible goodwill on the carrying amount of the reporting unit, if applicable, when measuring the goodwill impairment loss.
The fair value of the reporting unit is determined using generally accepted approaches to valuation commonly referred to as the income approach, market approach, and cost approach. Within each category, a variety of methodologies exist to assist in the estimation of fair value. Generally a valuation consultant will be engaged to assist with the valuation.
BPFH has three reportable segments that have goodwill: Wealth Management and Trust, Investment Management, and Wealth Advisory. Boston Private Wealth is the only reporting unit within the Wealth Management and Trust segment. Anchor and DGHM are the reporting units within the Investment Management segment. DGHM does not have any remaining goodwill. BOS and KLS are the reporting units within the Wealth Advisory segment. Because discrete financial information is available and segment management regularly reviews the operating results of Anchor, KLS, and BOS, they are all considered reporting units.
For the reporting units within the Investment Management, Wealth Advisory, and Wealth Management and Trust segments, the Company utilizes both the income and market approaches to determine fair value of the reporting units. The income approach is primarily based on discounted cash flows derived from assumptions of income statement activity. For the market approach, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and revenue multiples of comparable companies are selected and applied to the financial services reporting unit’s applicable metrics.
The aggregate fair values of the reporting units are compared to market capitalization as an assessment of the appropriateness of the fair value measurements. A control premium analysis is performed to determine whether the implied control premium was within range of overall control premiums observed in the market place.
If the carrying amount of the reporting unit’s goodwill is greater than the fair value of the reporting unit’s goodwill, an impairment loss must be recognized for the excess (i.e., recorded goodwill must be written down to the implied fair value of the reporting unit’s goodwill). After a goodwill impairment loss for a reporting unit is measured and recognized, the adjusted carrying amount of the reporting unit’s goodwill becomes the new accounting basis for that goodwill.
Income Tax Estimates
The Company accounts for income taxes in accordance with ASC 740, Income Taxes (“ASC 740”). The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting basis for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes for a change in tax rates is recognized in income tax expense/ (benefit) attributable to continuing operations in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded against our deferred tax assets.
In accordance with ASC 740, deferred tax assets are to be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The
realization of the tax benefit depends upon the existence of sufficient taxable income of the appropriate character within the carry-forward periods.
Management considered the following items in evaluating the need for a valuation allowance:
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The Company had cumulative pre-tax income, as adjusted for permanent book-to-tax differences, during the period 2015 through 2017.
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Deferred tax assets are expected to reverse in periods when there will be taxable income.
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The Company projects sufficient future taxable income to be generated by operations during the available carry-forward period.
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Certain tax planning strategies are available, such as reducing investments in tax-exempt securities.
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The Company has not had any operating loss or tax credit carryovers expiring unused in recent years.
The Company believes that it is more likely than not that the net deferred tax asset as of December 31, 2017 will be realized based primarily upon the ability to generate future taxable income. The Company does not have any capital losses in excess of capital gains as of December 31, 2017.
Results of Operations
Comparison of Years Ended December 31, 2017, 2016 and 2015
Net Income. The Company recorded net income from continuing operations for the year ended December 31, 2017 of $40.2 million, compared to net income from continuing operations of $70.2 million and $62.9 million in 2016 and 2015, respectively. Net income attributable to the Company, which includes income from both continuing and discontinued operations, for the year ended December 31, 2017 was $40.6 million, compared to income of $71.6 million and $64.9 million in 2016 and 2015, respectively.
The Company recognized diluted earnings per share from continuing operations for the year ended December 31, 2017 of $0.36 per share, compared to earnings of $0.74 per share and $0.66 per share in 2016 and 2015, respectively. Diluted earnings per share attributable to common shareholders, which includes both continuing and discontinued operations, for the year ended December 31, 2017 was $0.42 per share, compared to earnings of $0.81 per share and $0.74 per share in 2016 and 2015, respectively. Net income from continuing operations in 2017, 2016 and 2015 was offset by dividends paid on preferred stock and increases in the redemption value of certain redeemable noncontrolling interests, which reduce income available to common shareholders. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 16: Earnings Per Share” for further detail on the charges made to arrive at income attributable to the common shareholder.
The Company’s 2017 earnings were impacted by a goodwill impairment charge and higher operating expenses as well as lower banking fee income and the loss on the sale of Anchor. These changes were partially offset by higher net interest income, a larger credit to the provision for loan losses, and higher fee based revenue from the nonbank affiliates. In addition, in December 2017, the Tax Act, was enacted by the U.S. government. The Company re-measured its deferred tax assets and liabilities at the 21% federal corporate tax rate, reevaluated its investments in affordable housing projects using the 21% federal corporate tax rate, and reduced its deferred tax assets associated with executive compensation that is no longer deductible. As a result of these changes, the Company recorded a federal tax expense of $12.9 million in the fourth quarter of 2017, which is the primary driver of the higher income tax expense for the year ended December 31, 2017 as compared to 2016 and 2015.
The Company’s 2016 earnings benefited from higher net interest income, and a larger credit to the provision for loan losses, partially offset by a goodwill impairment charge.
The Company’s 2015 earnings were impacted by higher operating expenses, particularly salaries and employee benefits and occupancy and equipment expenses related to the full year impact of the Banyan acquisition, as well as restructuring expense. These changes were partially offset by higher net interest income, the credit to the provision for loan losses, and increases in fee-based revenue.
The following discussions are based on the Company’s continuing operations, unless otherwise stated.
Condensed Consolidated Statement of Operations
The following table presents selected financial highlights:
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Net Interest Income and Margin
Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate paid on total interest-bearing liabilities. Net interest margin (“NIM”) is the amount of net interest income, on a fully taxable-equivalent (“FTE”) basis, expressed as a percentage of average interest-earning assets. The average rate earned on earning assets is the amount of annualized taxable equivalent interest income expressed as a percentage of average earning assets. The average rate paid on interest-bearing liabilities is equal to annualized interest expense as a percentage of average interest-bearing liabilities. When credit quality declines and loans are placed on nonaccrual status, NIM can decrease because the same assets are earning less income. $53.4 million of loans that were graded substandard but were still accruing interest income at December 31, 2017 could be placed on nonaccrual status if their credit quality declines further.
Net interest income for the year ended December 31, 2017 was $224.7 million, an increase of $24.2 million, or 12%, compared to 2016, after an increase of $14.7 million, or 8%, from 2015 to 2016. The increase in net interest income in 2017 was due to higher rate and volume in the loan and investment portfolios, partially offset by an increase in the volume of and average rate paid on deposits and borrowings. The increase in net interest income in 2016 was due to higher volume in the loan and investment portfolios, a decrease in the average rate paid on borrowings, and higher yields on investments, all of which was partially offset by an increase in the average volume of interest-bearing deposits and borrowings. NIM was 3.04%, 2.93%, and 2.92% for the years ended December 31, 2017, 2016, and 2015, respectively.
The following tables present the composition of the Company’s NIM on a FTE basis for the years ended December 31, 2017, 2016, and 2015; however, the discussion following these tables reflects non-FTE data.
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(1)
Investments classified as available-for-sale and held-to-maturity are shown in the average balance sheet at amortized cost.
(2)
Interest income on non-taxable investments and loans is presented on a FTE basis using statutory rates. The discussion following these tables reflects non-FTE data, except where noted.
(3)
Includes loans held for sale and nonaccrual loans.
(4)
Includes deposits held for sale, if any.
Rate/Volume Analysis
The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volumes (changes in average balance multiplied by prior year average rate) and (ii) changes attributable to changes in rate (change in average interest rate multiplied by prior year average balance), while (iii) changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories. Changes in rate are presented on a non-FTE basis in the table below.
____________
(1)
Interest income on non-taxable investments and loans is presented on a non-FTE basis in this Rate-Volume table. The discussion following this table also reflects non-FTE data, except where noted.
Net Interest Income. Net interest income increased 12% from 2016 to 2017, after increasing 8% from 2015 to 2016. The increase in net interest income in 2017 was due to higher rate and volume in the loan and investment portfolios, partially offset by an increase in the volume of and average rate paid on deposits and borrowings. The increase in net interest income in 2016 was due to higher volume in the loan and investment portfolios, a decrease in the average rate paid on borrowings, and higher yields on investments, all of which was partially offset by an increase in the average volume of interest-bearing deposits and borrowings. These changes are discussed in more detail below.
The Company’s net interest margin, on a FTE basis, increased 11 basis points to 3.04% in 2017 from 2.93% in 2016, after increasing one basis point in 2016 from 2.92% in 2015. The increase in the Company’s net interest margin in 2017 was primarily related to the higher yields on investments and loans, partially offset by higher interest rates paid on deposits, the junior subordinated debt and Federal Home Loan Bank (“FHLB”) and other borrowings. The increase in the Company’s net interest margin in 2016 was primarily related to the higher yields on investments and lower interest rates paid on the junior subordinated debt and FHLB and other borrowings. Due to the lower federal tax rate in 2018, the FTE adjustment will have a
lower impact on the interest gross up for net interest margin purposes. The estimated impact on NIM due to the lower tax rate is 10 basis points.
Total interest and dividend income. Total interest and dividend income for the year ended December 31, 2017 was $258.7 million, an increase of $31.1 million, or 14%, compared to 2016, after an increase of $14.0 million, or 7%, in 2016 from 2015. The 2017 increase was primarily due to higher volume and yields on investments and loans. The 2016 increase was primarily due to higher volume of loans and higher volume and yields on investments, partially offset by lower loan yields on commercial real estate and commercial and industrial loans.
The Bank generally has interest income that is either recovered or reversed related to nonaccruing loans each quarter. Based on the net amount recovered or reversed, the impact on interest income and related yields can be either positive or negative. In addition, the Bank collects prepayment penalties on certain commercial loans that pay off prior to maturity which could also impact interest income and related yields positively. The amount and timing of prepayment penalties varies from quarter to quarter.
Interest income on commercial and industrial loans (including other commercial loans and commercial tax-exempt loans), on a non-FTE basis, for the year ended December 31, 2017 was $33.6 million, a decrease of $2.8 million, or 8%, compared to 2016, after increasing $2.0 million, or 6%, in 2016 from 2015. The 2017 decrease was primarily the result of a 9% decrease in average balance, partially offset by a six basis point increase in average yield. The 2016 increase was primarily the result of an 8% increase in average balance, partially offset by a seven basis point decrease in average yield. The 2017 and 2016 changes in the average yield were the result of market conditions as discussed below in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Portfolio and Credit Quality.” The 2017 decrease in average balance was due to a reclassification of approximately $165.7 million of loans in the Company’s portfolio at December 31, 2016 from commercial and industrial into commercial real estate, partially offest by organic growth. The 2016 increase in average balance was due to organic growth in the loan portfolio in all three regions.
Interest income on commercial real estate loans, on a non-FTE basis, for the year ended December 31, 2017 was $99.2 million, an increase of $19.0 million, or 24%, compared to 2016, after increasing $3.4 million, or 4%, in 2016 from 2015. The 2017 increase was primarily the result of a 20% increase in average balance and a 20 basis point increase in average yield. The 2016 increase was primarily the result of an 8% increase in average balance, partially offset by a 14 basis point decrease in average yield. The 2017 and 2016 changes in the average yield were the result of market conditions, as discussed below in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Portfolio and Credit Quality.” The 2017 increase in average balance was due to organic growth and a reclassification of approximately $165.7 million of loans in the Company’s portfolio at December 31, 2016 from commercial and industrial into commercial real estate. The 2016 increase in average balance was due to organic fluctuations in the loan portfolio.
Interest income on construction and land loans, on a non-FTE basis, for the year ended December 31, 2017 was $5.6 million, an increase of $0.2 million, or 3%, compared to 2016, after remaining flat in 2016 from 2015. In 2017, a 66 basis point increase in average yield was partially offset by an 11% decrease in average balance. In 2016, a 14% decrease in average balance was offset by a 55 basis point increase in average yield. The 2017 and 2016 increases in the average yield were the result of market conditions as discussed below in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Portfolio and Credit Quality.” The 2017 and 2016 decreases in average balance were due to organic fluctuations in the loan portfolio.
Interest income on residential mortgage loans for the year ended December 31, 2017 was $80.2 million, an increase of $9.7 million, or 14%, compared to 2016, after also increasing $2.9 million, or 4%, in 2016 from 2015. The 2017 increase was the result of an 11% increase in average balance and an eight basis point increase in average yield. The 2016 increase was primarily the result of a 5% increase in average balance, partially offset by a one basis point decrease in average yield. The 2017 and 2016 changes in the average yields were primarily due to adjustable rate mortgage (“ARM”) loans repricing to higher rates in 2017 and lower rates in 2016. The changes in U.S. Treasury yields and the London Interbank Offered Rate (“LIBOR”), the indexes to which the ARMs are typically linked, have impacted the yields on these mortgage loans. The 2017 and 2016 increases in the average balances were due to the organic growth of the residential loan portfolio at the Bank. LIBOR is expected to be phased out as an index by the end of 2021. The Company is currently evaluating alternatives to the LIBOR index.
Interest income on home equity loans for the year ended December 31, 2017 was $4.4 million, an increase of $0.1 million, or 2%, compared to 2016, after increasing $0.2 million, or 6%, in 2016 from 2015. The 2017 increase was primarily the result of a 42 basis point increase in average yield, partially offset by a 9% decrease in average balance. The 2016 increase was primarily the result of a nine basis point increase in average yield and a 3% increase in average balance. The 2017 and 2016 increases in the average yield were primarily due to the increases in the Prime rate beginning in December 2015. The
Prime rate increased 25 basis points in December 2015, December 2016, March 2017, June 2017, and December 2017, to the current rate of 4.50%. The 2017 and 2016 changes in average balances were primarily due to client demand.
Interest income on other consumer loans for the year ended December 31, 2017 was $6.0 million, an increase of $1.5 million, or 33%, compared to 2016, after increasing $0.6 million, or 17%, in 2016 from 2015. The 2017 increase was primarily the result of a 62 basis point increase in average yield and a 6% increase in average balance. The 2016 increase was primarily the result of a 25 basis point increase in average yield and a 6% increase in average balance. The 2017 and 2016 increases in average yield were primarily due to the increases in the Prime rate. The 2017 and 2016 increases in average balances were primarily due to client demand.
Investment income, on a non-FTE basis, for the year ended December 31, 2017 was $29.7 million, an increase of $3.4 million, or 13%, compared to 2016, after increasing $4.8 million, or 22%, in 2016 from 2015. The 2017 increase was the result of a 16 basis point increase in the average yield and a 4% increase in average balance. The 2016 increase was the result of a 19 basis point increase in the average yield and a 10% increase in average balance. The changes in the average balances in 2017 and 2016 were primarily due to timing and volume of deposit balances as compared to the level of loans outstanding. The changes in the average yields in 2017 and 2016 were primarily due to increases in the federal discount rate and higher dividends paid on FHLB stock. Additionally, in 2017 the Bank became a member of the Federal Reserve and therefore invested in stock of the Federal Reserve. Investment decisions are made based on anticipated liquidity, loan demand, and asset-liability management considerations.
Total interest expense. Total interest expense on deposits and borrowings for the year ended December 31, 2017 was $34.0 million, an increase of $6.8 million, or 25%, compared to 2016, after decreasing $0.7 million, or 2%, in 2016 from 2015.
Interest expense on deposits for the year ended December 31, 2017 was $20.9 million, an increase of $4.3 million, or 26%, compared to 2016, after increasing $0.6 million, or 4%, in 2016 from 2015. The 2017 increase was primarily the result of a six basis point increase in average rate paid on deposits and an 8% increase in the average balance of deposits. The 2016 increase was primarily the result of a one basis point increase in average rate paid on deposits and a 2% increase in the average balance of deposits. The increase in average balance in 2017 was driven by the increase in money market accounts and certificate of deposit accounts. The increase in rates paid in 2017 was driven by the increase in rates paid on money market accounts and certificate of deposit accounts. The increase in average balance in 2016 was driven by the increase in money market accounts and partially offset by decreases in certificate of deposit accounts. The increase in rates paid in 2016 was also driven by the increase in rates paid on money market accounts.
Interest paid on borrowings for the year ended December 31, 2017 was $13.1 million, an increase of $2.5 million, or 23%, compared to 2016, after decreasing $1.3 million, or 11%, in 2016 from 2015. The 2017 increase was primarily the result of a 15 basis point increase in average rate paid on FHLB borrowings and other and a 43 basis point increase in the average rate paid on junior subordinated debentures, as well as an 11% increase in average balance of FHLB borrowings and other. The average rate paid on FHLB borrowings is affected by both the yield and the structure or term of the borrowing. The 2016 decrease was primarily the result of a 29 basis point decrease in average rate paid on FHLB borrowings and other and a 136 basis point decrease in the average rate paid on junior subordinated debentures. This was partially offset by a 26% increase in average balance of FHLB borrowings and other. The 2017 increase in average rate paid was the result of the increase in index rates. The 2016 decreases in the average rate paid were primarily due to the higher-rate FHLB borrowings maturing and being replaced with current lower rates. Additionally, the 2016 decrease in rate paid on junior subordinated debentures is related to the hedge of $75 million of the outstanding debentures which, prior to maturing on December 30, 2015, effectively fixed the interest rate payments on that portion of the debentures at 4.45%. The Company did not renew the hedge when it matured at the end of 2015, and reverted to the debenture’s stated rate of three-month LIBOR plus 1.68%.
Discussion of Noninterest Condensed Consolidated Statement of Operations
Provision/ (credit) for loan losses. For the year ended December 31, 2017, the provision/ (credit) for loan losses was a credit of $7.7 million, compared to credits of $6.9 million and $1.6 million in 2016 and 2015, respectively. The 2017 credit to the provision for loan losses was primarily due to net recoveries and an improvement in loss factors, partially offset by an increase in criticized loans and commercial and residential loan growth. The 2016 credit to the provision for loan losses was primarily due to net recoveries, a decline in loss factors and a reduction in criticized loans, partially offset by the mix in the loan portfolio and loan growth.
The provision/ (credit) for loan losses is determined as a result of the required level of the allowance for loan losses, estimated by management, which reflects the inherent risk of loss in the loan portfolio as of the balance sheet dates. The factors used by management to determine the level of the allowance for loan losses include the trends in problem loans, economic and business conditions, strength of management, real estate collateral values, and underwriting standards. For further details, see
Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Loan Portfolio and Credit Quality” below.
Total fees and other income. For the year ended December 31, 2017, total fees and other income was $154.0 million, a decrease of $4.8 million, or 3%, compared to 2016, after a decrease of $2.4 million, or 1%, from 2015 to 2016. The 2017 decrease is primarily due to the 2017 loss on sale of affiliate (Anchor), versus the 2016 gain on sale of offices, and decreases in other banking fee income and other, partially offset by increases in wealth management and trust, investment management, and wealth advisory fee income. The 2016 decrease is primarily due to decreases in wealth management and trust fee income and investment management fee income, partially offset by higher other banking fee income and the 2016 gain on sale of offices.
Investment management fee income for the year ended December 31, 2017 was $45.5 million, an increase of $1.1 million, or 2%, compared to 2016, after a decrease of $1.3 million, or 3%, from 2015 to 2016. AUM at the Investment Managers, excluding Anchor, increased $0.2 billion, or 11%, to $2.0 billion at December 31, 2017 from $1.8 billion at December 31, 2016. In 2017, the increase in AUM, excluding Anchor, was primarily the result of market appreciation of $0.2 billion. Changes in revenue generally lag one quarter behind changes in AUM. In 2016, the decrease in AUM, excluding Anchor, was the result of net outflows of $0.4 billion, offset by market appreciation of $0.4 billion. Investment management fees are typically calculated based on a percentage of AUM.
Wealth advisory fee income for the year ended December 31, 2017 was $52.6 million, an increase of $2.0 million, or 4%, compared to 2016, after remaining flat in 2016 as compared to 2015. AUM as of December 31, 2017, managed by the Wealth Advisors was $11.4 billion, an increase of $1.4 billion, or 14%, compared to December 31, 2016. AUM changes for the Wealth Advisors in 2017 were primarily the result of market appreciation of $1.2 billion and net flows of $0.2 billion. AUM changes for the Wealth Advisors in 2016 were primarily the result of market appreciation of $0.4 billion, partially offset by net outflows of $0.1 billion.
Wealth management and trust fee income for the year ended December 31, 2017 was $45.4 million, an increase of $1.4 million, or 3%, after a decrease of $7.3 million, or 14%, from 2015 to 2016. AUM in the Wealth Management and Trust segment increased $0.9 billion, or 12%, to $7.9 billion at December 31, 2017 from $7.0 billion at December 31, 2016. The AUM increase in 2017 was the result of market appreciation of $0.6 billion and net flows of $0.3 billion. The decrease in 2016 was the result of net outflows of $0.7 billion and the disposition of certain accounts of $0.4 billion, partially offset by market appreciation of $0.1 billion. The Wealth Management and Trust segment experienced higher than expected net outflows in 2016 and 2015 related to the integration of the wealth management operations of Boston Private Bank and the operations of Banyan into the newly-created Boston Private Wealth. During integration, Boston Private Wealth experienced the departure of certain client-facing employees over the course of the year which lead to an increase in AUM outflows as a result of certain clients following the departed employees. Wealth management and trust fees are typically calculated based on a percentage of AUM.
Gain/ (loss) on sale of affiliates or offices for the year ended December 31, 2017 was a loss of $1.3 million, compared to a gain of $2.9 million in 2016. In December 2017, the assets and liabilities of Anchor met the criteria to be classified as held for sale. The Company recorded a loss on the sale of Anchor at the Holding Company related to the closing costs such as broker fees, legal fees, and consulting costs. The sale is expected to close in the first quarter of 2018. The rationale for the sale is to focus the Company’s resources in businesses where we can offer holistic financial advice, along with integrated wealth management, trust, and private banking capabilities. Upon closing, this transaction will also generate additional capital for us to reinvest in a more focused Company. The 2016 gain relates to the sale of two Southern California offices during 2016 and included $104 million of deposits. The rationale for the sale was to better position the Company’s resources within the Southern California market.
Other revenue for the year ended December 31, 2017 was $2.1 million, a decrease of $1.3 million, or 38%, compared to 2016, after a decrease of $0.3 million from 2015 to 2016. The decrease in 2017 was due to decreases in the market value adjustments on derivatives, partially offset by gains on the rabbi trust investments. The decrease in 2016 was due to the $2.0 million reversal of contingent consideration related to the acquisition of Banyan in 2015 that was not repeated in 2016, partially offset by increases in the market value adjustments on derivatives and gains on the rabbi trust investments.
Total operating expense. Total operating expense for the year ended December 31, 2017 was $299.9 million, an increase of $35.0 million, or 13%, compared to 2016, after an increase of $9.8 million, or 4%, from 2015 to 2016. Included in operating expense were charges for the impairment of goodwill of $24.9 million in 2017 and $9.5 million in 2016. Also included in operating expense were restructuring expenses of $2.0 million in 2016 and $3.7 million in 2015. Excluding the goodwill impairment and the restructuring expenses, operating expense for the year ended December 31, 2017 increased $21.6 million, or 9%, compared to 2016, after increasing $2.0 million, or 1%, from 2015 to 2016.
Salaries and employee benefits expense, the largest component of operating expense, for the year ended December 31, 2017 was $178.4 million, an increase of $14.6 million, or 9%, compared to 2016, after an increase of $4.4 million, or 3%, from 2015 to 2016. The increases in 2017 and 2016 were due to higher variable and performance based compensation, commissions and sales incentives, and stock compensation. Although the Company incurred severance expense in 2016, the majority of the costs were categorized as restructuring expense, whereas severance expense was categorized as salaries and employee benefits expense in 2017.
Occupancy and equipment expense for the year ended December 31, 2017 was $30.2 million, an increase of $2.2 million, or 8%, compared to 2016, after an increase of $0.1 million, or 1%, from 2015 to 2016. The increases in 2017 and 2016 were due to the increases in rent expense related to new office locations.
Professional services expense for the year ended December 31, 2017 was $13.8 million, an increase of $2.2 million, or 19%, compared to the same period in 2016 after a decrease of $1.3 million, or 10%, from 2015 to 2016. The 2017 increase was due to higher consulting and recruiting fees at the Bank, partially offset by lower loan workout fees. The 2016 decrease was due to lower legal and consulting expenses in the Wealth Management and Trust and Wealth Advisory segments, partially offset by higher consulting fees at the Bank.
In 2017, the Bank began working on an initiative to upgrade its information technology. This initiative required the Bank to hire additional employees with expertise in information technology. Recruiters were generally used in the placement of these professionals. The Bank has utilized consultants and temporary employees to assist with the project in addition to the new hires. Generally, the expenditures in the preliminary project stage were expensed as incurred. Other expenditures related to the application development stage have been capitalized and are included with premises and equipment, net in the consolidated balance sheets. At December 31, 2017 the Company had $2.6 million of expenditures that had not been placed in service. The capitalized expenditures will be depreciated over the useful life of the asset when the asset is placed in service. The Bank anticipates that the capitalized assets will be placed in service beginning in 2018 through 2019.
Information systems expense consists of contract servicing, computer hardware and software charges, and technology service agreements. Information systems expense for the year ended December 31, 2017 was $21.8 million, an increase of $2.6 million, or 13%, compared to 2016, after an increase of $2.2 million, or 13%, from 2015 to 2016. The increase in 2017 was related to higher software depreciation, technology service, and telecommunications costs as compared to 2016. The increase in 2016 was related to higher telecommunications and technology service costs as compared to 2015.
The Company recorded a goodwill impairment charge for the year ended December 31, 2017 of $24.9 million related to goodwill impairment taken at Anchor. The Company recorded a goodwill impairment charge for the year ended December 31, 2016 of $9.5 million related to goodwill impairment taken at Boston Private Wealth. There were no goodwill impairment charges taken in 2015. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for a discussion of the annual goodwill impairment testing and resulting impairment of goodwill.
The Company incurred no restructuring expense in the year ended December 31, 2017. Restructuring expense incurred in 2016 of $2.0 million was related to refining the management structure within the Wealth Management and Trust segment, while $3.7 million of expense was incurred in 2015 related to the acquisition of Banyan. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 2: Restructuring” for further detail.
Other expense for the year ended December 31, 2017 was $14.6 million, an increase of $1.1 million, or 8%, compared to 2016, after decreasing $1.1 million, or 8% from 2015 to 2016. The 2017 increase was primarily due to higher fraud losses at the Bank, a lower provision credit for off balance sheet exposure at the Bank, and employee travel expenses across all segments. The 2016 decrease was primarily due to lower administrative expenses across all segments.
Income Tax Expense. Income tax expense for continuing operations for the year ended December 31, 2017 was $46.2 million. The effective tax rate for continuing operations for the year ended December 31, 2017 was 53.5%, compared to effective tax rates of 30.6% and 32.6% in 2016 and 2015, respectively. The effective tax rate for 2017 was higher than 2016 primarily due to the the impact of the Tax Act that was enacted on December 22, 2017 and the impairment of nondeductible goodwill. Among the significant changes to the Code, the Tax Act reduces the federal corporate tax rate from 35% to 21% effective January 1, 2018. The Company re-measured its deferred tax assets and liabilities at the lower federal corporate tax rate of 21% and recorded the impact in the fourth quarter of 2017, the period in which the Tax Act was enacted. The effective tax rate and expense for 2016 was lower than 2015 primarily due to the 2015 out-of-period adjustment related to the deductibility of executive compensation, as well as an increase in tax credits and tax-exempt interest in 2016. This out-of-period adjustment was partially offset by an increase in earnings from tax-exempt investments in 2015. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 17: Income Taxes” for further detail.
Net Income from Discontinued Operations. Net income from discontinued operations for the year ended December 31, 2017, was $4.9 million, a decrease of $0.7 million, or 12%, compared to 2016, after a decrease of $0.9 million, or 14%, from 2015 to 2016. The 2017 and 2016 fluctuations were due to changes in revenue received from Westfield. All net income from discontinued operations relates to a revenue sharing agreement with Westfield which ended in December 2017. After the December 2017 payment is received in the first quarter of 2018, the Company will not receive additional net income from Westfield.
Financial Condition
Condensed Consolidated Balance Sheets and Discussion
Total assets. Total assets increased $0.3 billion to $8.3 billion at December 31, 2017 from $8.0 billion at December 31, 2016. This increase was due primarily to the increase in loans.
Cash and investments. Total cash and investments (consisting of cash and cash equivalents, investment securities, and stock in the FHLB and Federal Reserve Bank) decreased $82.4 million, or 5%, to $1.4 billion, or 17% of total assets at December 31, 2017 from $1.5 billion, or 19% of total assets at December 31, 2016. The decrease was due to the $93.8 million, or 7%, decrease in available-for-sale securities and the $18.5 million, or 20%, decrease in held-to-maturity securities, partially offset by the $15.9 million, or 36%, increase in stock in the FHLB and Federal Reserve Bank and the $14.0 million, or 13%, increase in cash and cash equivalents. The changes in cash and investments were the net result of short-term fluctuations in liquidity due to changes in levels of deposits, borrowings and loans outstanding. Additionally, on July 28, 2017, the Bank became a member of the Federal Reserve System, which required the purchase of stock in the Federal Reserve Bank of Boston.
The majority of the investments held by the Company are held by the Bank. The Bank’s investment policy requires management to maintain a portfolio of securities which will provide liquidity necessary to facilitate funding of loans, to cover deposit fluctuations, and to mitigate the Bank’s overall balance sheet exposure to interest rate risk, while at the same time earning a satisfactory return on the funds invested. The securities in which the Bank may invest are subject to regulation and are generally limited to securities that are considered “investment grade.”
Purchases of investment securities, net of investment maturities, calls, principal payments, and sales, used $109.9 million of cash during the year ended December 31, 2017, compared to $184.0 million in net purchases for the year ended December 31, 2016. Net proceeds are generally used to purchase new investments or fund a portion of loan growth. The timing of sales and reinvestments is based on various factors, including management’s evaluation of interest rate trends, credit risk, and the Company’s liquidity. The Company’s available-for-sale investment portfolio carried a total of $5.1 million of unrealized gains and $17.2 million of unrealized losses at December 31, 2017, compared to $4.6 million of unrealized gains
and $23.7 million of unrealized losses at December 31, 2016. For information regarding the weighted average yield and maturity of investments, see Part II. Item 8. “Financial Statements and Supplementary Data - Note 4: Investment Securities.”
No impairment losses were recognized through earnings related to investment securities during the years ended December 31, 2017 and 2016. The amount of investment securities in an unrealized loss position greater than 12 months, as well as the total amount of unrealized losses, was primarily due to changes in interest rates since the securities were purchased.
The Company had no intent to sell any securities in an unrealized loss position at December 31, 2017, and it was not more likely than not that the Company would be forced to sell any of these securities prior to the full recovery of all unrealized losses.
The following table summarizes the Company’s carrying value (fair value) of available-for-sale investments at the dates indicated:
______________________
(1)
All mortgage-backed securities are guaranteed by U.S. government agencies or government-sponsored entities.
Additionally, at December 31, 2017 and December 31, 2016, the Company held $74.6 million and $93.1 million, respectively, of held-to-maturity securities at amortized cost. All of the held-to-maturity securities were mortgage-backed securities which were guaranteed by U.S. government agencies or government-sponsored entities.
Loans held for sale. Loans held for sale increased $1.2 million, or 36%, to $4.7 million at December 31, 2017 from $3.5 million at December 31, 2016. The balance of loans held for sale usually relates to the timing and volume of residential loans originated for sale and the ultimate sale transaction which is typically executed within a short period of time following the loan origination.
Goodwill and intangible assets, net. Goodwill and intangible assets decreased $77.6 million, or 46%, to $91.7 million at December 31, 2017 from $169.3 million at December 31, 2016. The decrease was due to the $24.9 million write-down of goodwill at Anchor and the transfer of Anchor's remaining goodwill and intangible assets to held for sale at December 31, 2017. Assets held for sale are included within other assets on the consolidated balance sheet. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for a discussion of the annual goodwill impairment testing and resulting impairment of goodwill.
Goodwill and indefinite-lived intangible assets such as trade names are subject to annual impairment tests, or more frequently, if there is indication of impairment, based on guidance in ASC 350, Intangibles-Goodwill and Other. Long-lived intangible assets such as advisory contracts are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable in accordance with ASC 360, Property, Plant, and Equipment (“ASC 360”).
Management performed its annual goodwill and indefinite-lived intangible asset impairment testing during the fourth quarters of 2017 and 2016 for applicable reporting units. The estimated fair value of BOS, KLS , and Boston Private Wealth each exceeded their carrying value in 2017. In 2016, the fair value of Boston Private Wealth was lower than their carrying value which resulted in goodwill impairment of $9.5 million.
The 2017 goodwill impairment testing resulted in a $24.9 million goodwill impairment charge at Anchor as a result of a fair value of $56.6 million versus a carrying value of $81.5 million. The decline in fair value and the related goodwill impairment was related to the fair market value impacts of the Anchor sale transaction. Due to the limited interest and terms of the transaction that were required for a mutual agreement, the fair value obtained related to the sale transaction was substantially below the carrying value. The fair value was based on the terms of the sale transaction. As a result of the goodwill impairment charge of $24.9 million, the carrying value of goodwill at Anchor was reduced to $42.1 million. This reduced carrying value of $42.1 million, along with the other assets and liabilities of Anchor, are classified as held for sale at December 31, 2017 and are included within other assets and other liabilities, respectively, on the Company’s consolidated balance sheet. In 2016, the fair value of Anchor exceeded their carrying value.
Total other assets. Total other assets, consisting of OREO, if any, premises and equipment, net, fees receivable, accrued interest receivable, deferred income taxes, net, and other assets, which includes assets held for sale, increased $106.1 million, or 42%, to $359.7 million at December 31, 2017, compared to $253.6 million at December 31, 2016.
There were no OREO properties held at December 31, 2017, compared to one property with a value of $1.7 million at December 31, 2016. In 2017, the one property held at December 31, 2016 was sold for a loss of less than $0.1 million in the first quarter of 2017.
Deferred income taxes, net, decreased $26.4 million, or 48%, to $29.0 million at December 31, 2017 from $55.5 million at December 31, 2016. The decrease was primarily due to the re-measurement of deferred tax assets and liabilities at the lower federal corporate tax rate of 21% due to the enactment of the Tax Act on December 22, 2017. At December 31, 2017, no valuation allowance on the net deferred tax asset was required due primarily to the ability to generate future taxable income. The Company does not have any capital losses in excess of capital gains as of December 31, 2017.
Other assets, which consist primarily of Bank-owned life insurance (BOLI), assets held for sale, prepaid expenses, investment in partnerships, interest rate derivatives, and other receivables, increased $128.8 million, or 98%, to $259.5 million at December 31, 2017 from $130.8 million at December 31, 2016. The increase was primarily due to the reclassification of Anchor’s $58.8 million of assets to held for sale at December 31, 2017, as well as the purchase of an additional $50 million of BOLI during 2017, an increase in cost method investments, and an increase in income tax receivables.
Deposits. Total deposits increased $425.1 million, or 7%, to $6.5 billion, at December 31, 2017 from $6.1 billion at December 31, 2016. Deposits are the principal source of the Bank’s funds for use in lending, investments, and liquidity. Certificates of deposits represented approximately 10% and 9% of total deposits at December 31, 2017 and December 31, 2016, respectively. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 10: Deposits” for further information.
The following table sets forth the average balances and interest rates paid on the Bank’s deposits:
Certificates of deposit in denominations of $100,000 or greater had the following schedule of maturities:
Borrowings. Total borrowings (consisting of securities sold under agreements to repurchase, federal funds purchased, FHLB borrowings, and junior subordinated debentures) decreased $118.0 million, or 12%, to $0.9 billion at December 31, 2017 from $1.0 billion at December 31, 2016.
Repurchase agreements decreased $27.5 million, or 46%, to $32.2 million at December 31, 2017 from $59.6 million at December 31, 2016. Repurchase agreements are generally linked to commercial demand deposit accounts with an overnight sweep feature.
From time to time, the Company purchases federal funds from the FHLB and other banking institutions to supplement its liquidity position. At December 31, 2017, the Company had $30.0 million outstanding in federal funds purchased, a decrease of $50.0 million, or 63% from $80.0 million at December 31, 2016.
FHLB borrowings decreased $40.5 million, or 6%, to $693.7 million at December 31, 2017 from $734.2 million at December 31, 2016. FHLB borrowings are generally used to provide additional funding for loan growth when the rate of loan growth exceeds deposit growth and to manage interest rate risk, but can also be used as an additional source of liquidity for the Bank. During 2017, the Company had no prepayment penalties related to the prepayment of FHLB borrowings, compared to $0.3 million of prepayment penalties related to the prepayment of FHLB borrowings in 2016. The purpose of these prepayment transactions was to reduce higher cost borrowings.
Total other liabilities. Total other liabilities, which consist primarily of accrued interest, liabilities held for sale, accrued bonus, interest rate derivatives, and other accrued expenses increased $16.2 million, or 14%, to $135.9 million at December 31, 2017 from $119.7 million at December 31, 2016. The increase was primarily due to liabilities held for sale, deferred rent and landlord allowances, an increase in accrued employee benefits, and an increase in the value of back to back swap derivatives.
Loan Portfolio and Credit Quality
Loans. Total portfolio loans increased $390.7 million, or 6%, to $6.5 billion, or 78% of total assets, at December 31, 2017, from $6.1 billion, or 77% of total assets, at December 31, 2016. Increases were recorded in residential loans of $302.7 million, or 12%, commercial real estate loans of $138.0 million, or 6%, construction and land loans of $60.2 million, or 57%, and commercial tax-exempt loans of $20.1 million, or 5%, partially offset by decreases in commercial and industrial loans of $90.4 million, or 15%, consumer and other loans of $21.0 million, or 11%, and home equity loans of $18.9 million, or 16%.
The Bank specializes in lending to individuals, real estate investors, and middle market businesses, including corporations, partnerships, associations and nonprofit organizations. Loans made by the Bank to individuals may include residential mortgage loans and mortgage loans on investment or vacation properties, unsecured and secured personal lines of credit, home equity loans, and overdraft protection. Loans made by the Bank to businesses include commercial and mortgage loans, revolving lines of credit, working capital loans, equipment financing, community lending programs, and construction and land loans. The types and sizes of loans the Bank originates are limited by regulatory requirements.
The Bank’s loans are affected by the economic and real estate markets in which they are located. Generally, commercial real estate, construction, and land loans are affected more than residential loans in an economic downturn.
The Bank’s commercial real estate loan portfolio, the largest portfolio segment after residential, includes loans secured by the following types of collateral at December 31, 2017: $729.8 million secured by multifamily and residential investment property; $634.8 million secured by retail property; $543.9 million secured by office and medical property; $197.9 million secured by manufacturing, industrial, and warehouse property; $148.4 million secured by hospitality property; and
$185.4 million secured by other property. The Bank’s commercial real estate loan portfolio as of December 31, 2016 included loans secured by the following types of collateral: $674.2 million secured by multifamily and residential investment property; $660.7 million secured by retail property; $466.8 million secured by office and medical property; $195.9 million secured by manufacturing, industrial, and warehouse property; $116.0 million secured by hospitality property; and $188.6 million secured by other property.
Geographic concentration. The following table presents the Company’s outstanding loan balance concentrations at the dates indicated based on the location of the regional offices to which they are attributed.
________________________
(1)
Regional percentage totals may not reconcile due to rounding.
Loan Portfolio Composition. The following table presents the outstanding loan balances by class of receivable at the dates indicated and the percent of each category to total loans.
________________________
(1)
Does not include $0.1 million of loans at the Holding Company.
Commercial and Industrial Loans. Commercial and industrial loans include working capital and revolving lines of credit, term loans for equipment and fixed assets, and Small Business Administration (“SBA”) loans.
Commercial Tax-Exempt Loans. Commercial tax-exempt loans include loans to not-for-profit private schools, colleges, and public charter schools.
Commercial Real Estate Loans. Commercial real estate loans are generally acquisition financing for commercial properties such as office buildings, retail properties, apartment buildings, and industrial/warehouse space. In addition, tax-exempt commercial real estate loans are provided for affordable housing development and rehabilitation. These loans are often supplemented with federal, state, and/or local subsidies.
Construction and Land Loans. Construction and land loans include loans for financing of new developments as well as financing for improvements to existing buildings. In addition, tax-exempt construction and land loans are provided for the construction phase of the commercial tax-exempt and commercial real estate tax-exempt loans described above.
Residential Loans. While the Bank has no minimum size for mortgage loans, it concentrates its origination activities in the “Jumbo” segment of the market. This segment consists of loans secured by single-family and one- to four-unit properties in excess of the amount eligible for purchase by the Federal National Mortgage Association, which was $424 thousand at December 31, 2017 for the “General” limit and $636 thousand for single-family properties for the “High-Cost” limit, depending on from which specific geographic region of the Bank’s primary market areas the loan originated. The majority of the Bank’s residential loan portfolio, including jumbo mortgage loans, are ARMs. The ARM loans the Bank originates generally have a fixed interest rate for the first 3 to 7 years and then adjust annually based on a market index such as U.S. Treasury or LIBOR yields. ARM loans may negatively impact the Bank’s interest income when they reprice if yields on U.S. Treasuries or LIBOR are lower than the yields at the time of origination. If rates reset higher, the Bank could see increased delinquencies if clients’ ability to make payments is impacted by the higher payments.
Home Equity Loans. Home equity loans consist of balances outstanding on second mortgages and home equity lines of credit extended to individual clients. Personal lines of credit are typically for high net worth clients whose assets may not be liquid due to investments or closely held stock. The amount of home equity loans typically depends on client demand.
Consumer and Other Loans. Consumer and other loans consist of balances outstanding on consumer loans including personal lines of credit, and loans arising from overdraft protection extended to individual and business clients. Personal lines
of credit are typically for high net worth clients whose assets may not be liquid due to investments or closely held stock. The amount of consumer and other loans typically depends on client demand.
Portfolio Mix. The portfolio mix of the Bank’s loans as of December 31, 2017 remained stable as compared to prior years as evidenced by the Loan Portfolio Composition table presented above. Residential loans comprised 41% of the total loan portfolio as of December 31, 2017, up from 39% as of December 31, 2016. Commercial real estate loans comprised 37% of the total loan portfolio as of December 31, 2017, down from 38% of the total loan portfolio as of December 31, 2016. Commercial and industrial loans comprised 8% of the total loan portfolio as of December 31, 2017, down from 10% as of December 31, 2016. Commercial tax-exempt loans comprised 6% of the total loan portfolio as of December 31, 2017, unchanged from December 31, 2016. Consumer and other loans comprised 3% of the total loan portfolio as of December 31, 2017, unchanged from December 31, 2016. Construction and land loans comprised 3% of the total loan portfolio as of December 31, 2017, up from 2% as of December 31, 2016. Home equity loans comprised 2% of the total loan portfolio as of December 31, 2017, unchanged from December 31, 2016.
The following tables disclose the scheduled contractual maturities of portfolio loans by class of receivable at December 31, 2017. Loans having no stated maturity are reported as due in one year or less. The following tables also set forth the dollar amounts of loans that are scheduled to mature after one year segregated between fixed and adjustable interest rate loans.
Scheduled contractual maturities typically do not reflect the actual maturities of loans. The average maturity of loans is substantially less than their average contractual terms because of prepayments and, in the case of conventional mortgage loans, due on sale clauses, which generally give the Bank the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage. The average life of mortgage loans tends to increase when current market rates are substantially higher than rates on existing mortgage loans and decrease when current market rates are substantially lower than rates on existing mortgages (due to refinancing of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates. In addition, due to the likelihood that the Bank will, consistent with
industry practice, “rollover” a significant portion of commercial real estate and commercial loans at or immediately prior to their maturity by renewing credit on substantially similar or revised terms, the principal repayments actually received by the Bank are anticipated to be significantly less than the amounts contractually due in any particular period. A portion of such loans also may not be repaid due to the borrowers’ inability to satisfy the contractual obligations of the loan.
The interest rates charged on loans vary with the degree of risk, maturity, and amount of the loan and are further subject to competitive pressures, market rates, the availability of funds, and legal and regulatory requirements. At December 31, 2017, approximately 66% of the Bank’s outstanding loans due after one year had interest rates that were either floating or adjustable in nature. See Part II. Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Sensitivity and Market Risk
The Company considers interest rate risk to be a significant market risk for the Bank. Interest rate risk is the exposure to adverse changes in the net income of the Company as a result of changes in interest rates. Consistency in the Company’s earnings is related to the effective management of interest rate-sensitive assets and liabilities due to changes in interest rates, and on the degree of fluctuation of investment management fee income due to movements in the bond and equity markets.
Fee income from our Investment Management, Wealth Advisory, and Wealth Management and Trust businesses is not directly dependent on market interest rates and may provide the Company a relatively stable source of income in varying market interest rate environments. However, this fee income is generally based upon the value of AUM and, therefore, can be significantly affected by changes in the values of equities and bonds. Furthermore, performance fees and partnership income earned by some of the Company’s affiliates, as managers of limited partnerships, are directly dependent upon short-term investment performance that can fluctuate significantly with changes in the capital markets. The Company does not have any trading operations for its own account.
In addition to directly impacting net interest income (“NII”), changes in the level of interest rates can also affect (i) the amount of loans originated and sold by the Company, (ii) the ability of borrowers to repay adjustable rate loans, (iii) the average maturity of loans and mortgage-backed securities, (iv) the rate of amortization of premiums paid on securities and, (v) the amount of unrealized gains and losses on securities available-for-sale.
The principal objective of the Bank’s asset/liability management (“ALM”) is to maximize profit potential while minimizing the vulnerability of its operations to changes in interest rates by means of managing the ratio of interest rate-sensitive assets to interest rate-sensitive liabilities within specified maturities or repricing dates. The Bank’s actions in this regard are taken under the guidance of its Asset/Liability Committee (“ALCO”), which is composed of members of the Bank’s senior management. This committee is actively involved in formulating the economic assumptions that the Bank uses in its financial planning and budgeting process and establishes policies which control and monitor the sources, uses and pricing of funds. The Bank may utilize hedging techniques to reduce interest rate risk. See Part II. Item 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Boston Private Financial Holdings, Inc. (the “Company” or “BPFH”), is a bank holding company (the “Holding Company”) with four reportable segments: Private Banking, Wealth Management and Trust, Investment Management, and Wealth Advisory.
The Private Banking segment is comprised of the banking operations of Boston Private Bank & Trust Company (the “Bank” or “Boston Private Bank”), a trust company chartered by The Commonwealth of Massachusetts, insured by the Federal Deposit Insurance Corporation (the “FDIC”), and a wholly-owned subsidiary of the Company. Boston Private Bank is a member of the Federal Reserve Bank of Boston. Boston Private Bank currently operates in three geographic markets: New England, the San Francisco Bay Area, and Southern California.
The Wealth Management and Trust segment is comprised of the operations of Boston Private Wealth LLC (“Boston Private Wealth”), a wholly-owned subsidiary of Boston Private Bank, and the trust operations of Boston Private Bank. The segment offers investment management, wealth management, family office, and trust services to individuals, families, and institutions. The Wealth Management and Trust segment operates in New England; South Florida; California; and Madison, Wisconsin.
The Investment Management segment currently has two consolidated affiliates, Dalton, Greiner, Hartman, Maher & Co., LLC (“DGHM”) and Anchor Capital Advisors, LLC (“Anchor”) (together, the “Investment Managers”). In December 2017, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority-owned by members of its management team. The transaction is expected to close in the first quarter of 2018. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions.
The Wealth Advisory segment has two consolidated affiliates, KLS Professional Advisors Group, LLC (“KLS”) and Bingham, Osborn & Scarborough, LLC (“BOS”) (together, the “Wealth Advisors” and, together with the Wealth Management and Trust and Investment Management segments, the “Wealth and Investment” businesses).
Basis of Presentation
The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation, and the portion of income allocated to owners other than the Company is included in “Net income attributable to noncontrolling interests” in the consolidated statements of operations. Redeemable noncontrolling interests in the consolidated balance sheets reflect the maximum redemption value of agreements with other owners. All accounts related to divested affiliates are included within the results of discontinued operations for all periods presented.
The financial statements are prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) (“GAAP”). Reclassifications of amounts in prior years’ consolidated financial statements are made whenever necessary to conform to the current year’s presentation.
Use of Estimates
In preparing the consolidated financial statements, management is required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change, in the near term, relate to the determination of the allowance for loan losses, evaluation of potential impairment of goodwill and other intangibles, and income tax estimates.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Significant Group Concentrations of Credit Risk
Most of the Company’s activities are with clients within the New England, the San Francisco Bay Area, and Southern California regions of the country. The Company does not believe it has any significant concentrations in any one industry, geographic location, or with any one client. Part II. Item 8. “Financial Statements and Supplementary Data - Note 4: Investment Securities,” highlights the types of securities in which the Company invests, and Part II. Item 8. “Financial Statements and Supplementary Data - Note 5: Loan Portfolio and Credit Quality,” describes the concentration of the Private Banking loan data based on the location of the lender.
Statement of Cash Flows
For purposes of reporting cash flows, the Company considers cash and due from banks which have original maturities with 90 days or less to be cash equivalents.
Cash and Due from Banks
The Bank is required to maintain average reserve balances in an account with the Federal Reserve based upon a percentage of certain deposits. As of December 31, 2017 and 2016, the daily amounts required to be held in the aggregate for the Bank were $3.6 million and $5.0 million, respectively.
Investment Securities
Available-for-sale investment securities are reported at fair value, with unrealized gains and losses credited or charged, net of the estimated tax effect, to accumulated other comprehensive income/ (loss). Held-to-maturity investment securities are those which the Company has the positive intent and ability to hold to maturity and are reported at amortized cost.
Premiums and discounts on the investment securities are amortized or accreted into net interest income by the level-yield method. Gains and losses on the sale of the available-for-sale investments are recognized at the trade date on a specific identification basis. Dividend and interest income is recognized when earned and is recorded on the accrual basis.
The Company conducts a quarterly review and evaluation of its investment securities to determine if the decline in fair value of a security below its amortized cost is deemed to be other-than-temporary. Other-than-temporary impairment losses are recognized on securities when: (i) the holder has an intention to sell the security; (ii) it is more likely than not that the security will be required to be sold prior to recovery; or (iii) the holder does not expect to recover the entire amortized cost basis of the security. Other-than-temporary losses are reflected in earnings as a charge against gain on sale of investments, net, to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in accumulated other comprehensive income/ (loss). The Company has no intention to sell any securities in an unrealized loss position at December 31, 2017 nor is it more likely than not that the Company would be required to sell such securities prior to the recovery of the unrealized losses. As of December 31, 2017, the Company believes that all impairments of investment securities are temporary in nature. No other-than-temporary impairment losses were recognized in the consolidated statements of operations for the years ended December 31, 2017, 2016, and 2015.
Loans Held for Sale
Loans originated and held for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Fair value is based on commitments on hand from investors or prevailing market prices. Unrealized losses, if any, are recognized through a valuation allowance by charges to income. Loans transferred to the held for sale category from the loan portfolio are transferred at the lower of cost or fair value, usually as determined at the individual loan level. If fair value is less than cost, then a charge for the difference will be made to the allowance for loan losses if the decline in value is due to credit issues. Gains or losses on the sale of loans are recognized at the time of sale on a specific identification basis. Interest income is recognized on an accrual basis when earned.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Loans
Loans are carried at the principal amount outstanding, net of participations, deferred loan origination fees and costs, charge-offs, and interest payments applied to principal on nonaccrual loans. Loan origination fees, net of related direct incremental loan origination costs, are deferred and recognized into income over the contractual lives of the related loans as an adjustment to the loan yield, using the level-yield method. If a loan is paid off prior to maturity, the unamortized portion of net fees/cost is recognized into interest income. If a loan is sold, the unamortized portion of net fees/cost is recognized at the time of sale as a component of the gain or loss on sale of loans.
When the Company analyzes its loan portfolio to determine the adequacy of its allowance for loan losses, it categorizes the loans by portfolio segment and class of financing receivable based on the similarities in risk characteristics for the loans. The Company has determined that its portfolio segments and classes of financing receivables are one and the same, with the exception of the commercial and industrial portfolio segment, which consists of other commercial and industrial loans and commercial tax-exempt loans. The level at which the Company develops and documents its allowance for loan loss methodology is consistent with the grouping of financing receivables based upon initial measurement attributes, risk characteristics, and the Company’s method for monitoring and assessing credit risks. These portfolio segments and classes of financing receivables are:
•
Commercial and industrial (portfolio segment)
◦
Other commercial and industrial loans (class of financing receivable) - Commercial and industrial loans include working capital and revolving lines of credit, term loans for equipment and fixed assets, and Small Business Administration (“SBA”) loans.
◦
Commercial tax-exempt loans (class of financing receivable) - Commercial tax-exempt loans include loans to not-for-profit private schools, colleges, and public charter schools.
•
Commercial real estate (segment and class) - Commercial real estate loans are generally acquisition financing for commercial properties such as office buildings, retail properties, apartment buildings, and industrial/warehouse space. In addition, tax-exempt commercial real estate loans are provided for affordable housing development and rehabilitation. These loans are often supplemented with federal, state, and/or local subsidies.
•
Construction and land (segment and class) - Construction and land loans include loans for financing of new developments as well as financing for improvements to existing buildings. In addition, tax-exempt construction and land loans are provided for the construction phase of the commercial tax-exempt and commercial real estate tax-exempt loans described above.
•
Residential mortgage (segment and class) - Residential mortgage loans consist of loans secured by single-family and one- to four-unit properties in excess of the amount eligible for purchase by the Federal National Mortgage Association, which was $424 thousand at December 31, 2017 for the “General” limit and $636 thousand for single-family properties for the “High-Cost” limit, depending on which specific geographic region of the Bank’s primary market areas the loan was originated. While the Bank has no minimum size for mortgage loans, it concentrates its origination activities in the “Jumbo” segment of the market.
•
Home equity (segment and class) - Home equity loans consist of balances outstanding on second mortgages and home equity lines of credit extended to individual clients. Personal lines of credit are typically for high net worth clients whose assets may not be liquid due to investments or closely held stock. The amount of home equity loans typically depends on client demand.
•
Consumer and other (segment and class) - Consumer and other loans consist of balances outstanding on consumer loans including personal lines of credit, and loans arising from overdraft protection extended to individual and business clients. Personal lines of credit are typically for high net worth clients whose assets may not be liquid due to investments or closely held stock. The amount of consumer and other loans typically depends on client demand.
The past due status of a loan is determined in accordance with its contractual repayment terms. All portfolio segments are reported past due when one scheduled payment is due and unpaid for 30 days or more.
The Bank’s policy is to discontinue the accrual of interest on a loan when the collectability of principal or interest is in doubt. When management determines that it is probable that the Bank will not collect all principal and interest on a loan in accordance with the original loan terms, the loan is designated as impaired. Impaired loans are usually commercial loans or construction and land loans, for which it is probable that the Company will not collect all amounts due according to the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
contractual terms of the loan agreement, and all loans restructured in a troubled debt restructuring. Accrual of interest income is discontinued and all interest previously accrued but not collected is reversed against current period interest income when a loan is initially classified as nonaccrual. Generally, interest received on nonaccrual loans is applied against principal or, on a limited basis, reported as interest income on a cash basis, when according to management’s judgment, the collectability of principal is reasonably assured. The Bank’s general policy for returning a loan to accrual status requires the loan to be brought current, for the client to show a history of making timely payments (generally six consecutive months), and when the financial position of the borrower and other relevant factors indicate there is no longer doubt as to the collectability of the loan.
The Bank’s loan commitments are generally short-term in nature with terms that are primarily variable. Given the limited interest rate exposure posed by the commitments, the Bank estimates the fair value of these commitments to be immaterial.
Credit Quality Indicators
The Bank uses a risk rating system to monitor the credit quality of its loan portfolio. Loan classifications are assessments made by the Bank of the status of the loans based on the facts and circumstances known to the Bank, including management’s judgment, at the time of assessment. Some or all of these classifications may change in the future if there are unexpected changes in the financial condition of the borrower, including but not limited to, changes resulting from continuing deterioration in general economic conditions on a national basis or in the local markets in which the Bank operates adversely affecting, among other things, real estate values. Such conditions, as well as other factors which adversely affect borrowers’ ability to service or repay loans, typically result in changes in loan default and charge-off rates, and increased provisions for loan losses, which would adversely affect the Company’s financial performance and financial condition. These circumstances are not entirely foreseeable and, as a result, it may not be possible to accurately reflect them in the Company’s analysis of credit risk. Generally, only commercial loans, including commercial real estate, other commercial and industrial loans, commercial tax-exempt loans, and construction and land loans, are given a numerical grade.
A summary of the rating system used by the Bank follows:
Pass - All loans graded as pass are considered acceptable credit quality by the Bank and are grouped for purposes of calculating the allowance for loan losses. For residential, home equity, and consumer loans, the Bank classifies loans as pass unless there is known information such as delinquency or client requests for modifications which, due to financial difficulty, would then generally result in a risk rating such as special mention or more severe depending on the factors.
Special Mention - Loans rated in this category are defined as having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the credit or the Bank’s credit position. These loans are currently protected but have the potential to deteriorate to a substandard rating. For commercial loans, the borrower’s financial performance may be inconsistent or below forecast, creating the possibility of liquidity problems and shrinking debt service coverage. In loans having this rating, the primary source of repayment is still good, but there is increasing reliance on collateral or guarantor support. Collectability of the loan is not yet in jeopardy. In particular, loans in this category are considered more variable than other categories, since they will typically migrate through categories more quickly.
Substandard - Loans rated in this category are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. A substandard credit has a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans may be either still accruing or nonaccruing depending upon the severity of the risk and other factors such as the value of the collateral, if any, and past due status.
Doubtful - Loans rated in this category indicate that collection or liquidation in full on the basis of currently existing facts, conditions, and values, is highly questionable and improbable. Loans in this category are usually on nonaccrual and classified as impaired.
Restructured Loans
When the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a troubled borrower that it would not otherwise consider, the loan is classified as a restructured loan pursuant to Accounting Standards Codification (“ASC”) 470, Debt. The concession either stems from an agreement between the creditor and the Bank or is imposed by law or a court. The concessions may include:
•
Deferral of principal and/or interest payments
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
Lower interest rate as compared to a new loan with comparable risk and terms
•
Extension of the maturity date
•
Reduction in the principal balance owed
All loans whose terms have been modified in a troubled debt restructuring, including commercial, residential, and consumer, are evaluated for impairment under ASC 310, Receivables.
Generally, a nonaccrual loan that is restructured remains on nonaccrual status for a period of at least six months to demonstrate that the borrower can meet the restructured terms. However, performance prior to the restructuring, or significant events that coincide with the restructuring, are considered when assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of the restructuring or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains classified as a nonaccrual loan.
A loan may be removed from a restructured classification after the next fiscal year end, if the restructured terms include a market interest rate and the borrower has demonstrated performance with the restructured terms.
Allowance for Loan and Lease Losses
The allowance for loan losses (“allowance”) is an estimate of the inherent risk of loss in the loan portfolio as of the consolidated balance sheet dates. Management estimates the level of the allowance based on all relevant information available. Changes to the required level in the allowance result in either a provision for loan loss expense, if an increase is required, or a credit to the provision, if a decrease is required. Loan losses are charged to the allowance when available information confirms that specific loans, or portions thereof, are uncollectible. Recoveries on loans previously charged-off are credited to the allowance when received in cash.
The Company’s allowance is accounted for in accordance with guidance issued by various regulatory agencies, including: the Federal Financial Institutions Examination Council Policy Statement on the Allowance for Loan and Lease Losses (December 2006); Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 102, Selected Loan Loss Methodology and Documentation Issues; ASC 310; and ASC 450, Contingencies.
The allowance consists of three primary components: general reserves on pass graded loans, allocated reserves on non-impaired special mention and substandard loans, and the specific reserves on impaired loans. The calculation of the allowance involves a high degree of management judgment and estimates designed to reflect the inherent risk of loss in the loan portfolio at the measurement date.
General reserves are calculated for each loan pool consisting of pass graded loans segregated by portfolio segment, by applying estimated net loss percentages based upon the Bank’s actual historical net charge-offs and, adjusted as appropriate, on a consistent manner based upon consideration of qualitative factors to arrive at a total loss factor for each portfolio segment. The rationale for qualitative adjustments is to more accurately reflect the current inherent risk of loss in the respective portfolio segments than would be determined through the sole consideration of the Bank’s actual historical net charge-off rates. The numerical factors assigned to each qualitative factor are based upon observable data, if applicable, as well as management’s analysis and judgment. The qualitative factors considered by the Company include:
•
Volume and severity of past due, nonaccrual, and adversely graded loans,
•
Volume and terms of loans,
•
Concentrations of credit,
•
Management’s experience, as well as loan underwriting and loan review policy and procedures,
•
Economic and business conditions impacting the Bank’s loan portfolio, as well as consideration of collateral values, and
•
External factors, including consideration of loss factor trends, competition, and legal and regulatory requirements.
The Bank makes a determination of the applicable loss rate for these factors based on relevant local market conditions, credit quality, and portfolio mix. Each quarter, management reviews the loss factors to determine if there have been any changes in its loan portfolio, market conditions, or other risk indicators which would result in a change to the current loss factor.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Allocated reserves on non-impaired special mention and substandard loans reflect management’s assessment of increased risk of losses associated with these types of adversely graded loans. An allocated reserve is assigned to these pools of loans based upon management’s consideration of the credit attributes of individual loans within each pool of loans, including consideration of loan to value ratios, past due status, strength and willingness of the guarantors, and other relevant attributes, as well as the qualitative factors considered for the general reserve as discussed above. These considerations are determined separately for each type of portfolio segment. The allocated reserves are a multiple of the general reserve for each respective portfolio segments, with a greater multiple for loans with increased risk (i.e., special mention loans versus substandard loans).
A loan is considered impaired in accordance with ASC 310 when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impairment is measured based on the fair value of the loan, expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient, impairment may be determined based upon the observable market price of the loan, or the fair value of the collateral, less estimated costs to sell, if the loan is “collateral dependent.” A loan is collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral or sale of the underlying collateral. For collateral dependent loans, appraisals are generally used to determine the fair value. When a collateral dependent loan becomes impaired, an updated appraisal of the collateral is obtained, if appropriate. Appraised values are generally discounted for factors such as the Bank’s intention to liquidate the property quickly in a foreclosure sale or the date when the appraisal was performed if the Bank believes that collateral values have declined since the date the appraisal was done. The Bank may use a broker opinion of value in addition to an appraisal to validate the appraised value. In certain instances, the Bank may consider broker opinions of value as well as other qualitative factors while an appraisal is being prepared.
If the loan is deemed to be collateral dependent, generally the difference between the book balance (client balance less any prior charge-offs or client interest payments applied to principal) and the fair value of the collateral is taken as a partial charge-off through the allowance for loan losses in the current period. If the loan is not determined to be collateral dependent, then a specific allocation to the general reserve is established for the difference between the book balance of the loan and the expected future cash flows discounted at the loan’s effective interest rate. Charge-offs for loans not considered to be collateral dependent are made when it is determined a loss has been incurred. Impaired loans are removed from the general loan pools. There may be instances where the loan is considered impaired although based on the fair value of underlying collateral or the discounted expected future cash flows there is no impairment to be recognized. In addition, all loans which are classified as troubled debt restructurings (“TDRs”) are considered impaired.
In addition to the three primary components of the allowance for loan losses discussed above (general reserve, allocated reserves on non-impaired special mention and substandard loans, and the specific reserves on impaired loans), the Bank may also maintain an insignificant amount of additional allowance for loan losses (the unallocated allowance for loan losses). The unallocated reserve reflects the fact that the allowance for loan losses is an estimate and contains a certain amount of imprecision risk. It represents risks identified by Management that are not already captured in the qualitative factors discussed above. The unallocated allowance for loan losses is not considered significant by the Company and will remain at zero unless additional risk is identified.
While this evaluation process utilizes historical and other objective information, the classification of loans and the establishment of the allowance for loan losses rely to a great extent on the judgment and experience of management. While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses as well as loan grades/classifications. Such agencies may require the financial institution to recognize additions to the allowance for loan losses or increases to adversely graded loans based on their judgments about information available to them at the time of their examination.
Reserve for Unfunded Loan Commitments
The Company maintains a reserve for unfunded loan commitments for such items as unused portion of lines of credit and unadvanced construction loans. The reserve is maintained at a level that reflects the risk in these various commitments. Management determines the reserve percentages on a quarterly basis based on a percentage of the current historical loss rates for these portfolios. Once a loan commitment is funded, the reserve for unfunded loan commitment is reversed and a corresponding allowance for loan loss reserve is established. This unfunded loan commitment reserve is included in other liabilities in the consolidated balance sheets. Net adjustments to the reserve for unfunded commitments are included in other operating expense in the consolidated statements of operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other Real Estate Owned (“OREO”)
OREO is comprised of property acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure in partial or total satisfaction of certain loans. Properties are recorded at the lower of the recorded investment in the loan at the time of acquisition or the fair value, as established by a current appraisal, comparable sales, and other estimates of value obtained principally from independent sources, less estimated costs to sell. Any decline in fair value compared to the carrying value of a property at the time of acquisition is charged against the allowance for loan losses. Any subsequent valuation adjustments to reflect declines in current fair value, as well as gains or losses on disposition are reported in gain/(loss) on OREO, net in the consolidated statements of operations. Expenses incurred for holding or maintaining OREO properties such as real estate taxes, utilities, and insurance are charged as incurred to other operating expenses in the consolidated statements of operations. Rental income earned, although generally minimal, is offset against other operating expenses.
Premises and Equipment
Premises and equipment consists of leasehold improvements, furniture, fixtures, equipment, art, buildings, and land. Equipment consists primarily of computer equipment. Premises and equipment are carried at cost, less accumulated depreciation and amortization. Also included in premises and equipment is technology initiatives in process. Depreciation and amortization are computed primarily by the straight-line method over the estimated useful lives of the assets, or the terms of the leases, if shorter, for leasehold improvements. The estimated useful lives for leasehold improvements and buildings are 5-15 years and 40 years, respectively. The estimated useful life for furniture and fixtures is 2-10 years and is 3-5 years for computer equipment. The costs of improvements that extend the life of an asset are capitalized, while the cost of repairs and maintenance are expensed as incurred. Neither land nor art is depreciated.
Valuation of Goodwill/Intangible Assets and Analysis for Impairment
The Company allocates the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Other intangible assets identified in acquisitions generally consist of advisory contracts, trade names, and non-compete agreements. The value attributed to advisory contracts is based on the time period over which they are expected to generate economic benefits. The advisory contracts are generally amortized over 8-15 years, depending on the contract. Trade names are not amortized.
Long-lived intangible assets are subject to the impairment provisions of ASC 360-10, Property, Plant, and Equipment (“ASC 360”). Long-lived intangible assets are tested for recoverability by comparing the net carrying value of the asset or asset group to the undiscounted net cash flows to be generated from the use and eventual disposition of that asset (asset group) when events or changes in circumstances indicate that its carrying amount may not be recoverable. If the carrying amount of the asset exceeds its net undiscounted cash flows, then an impairment loss is recognized for the amount by which the carrying amount exceeds its fair value, determined based upon the discounted value of the expected cash flows generated by the asset. The intangible impairment test is performed at the reporting unit level, and each affiliate with goodwill and/or intangible assets is considered a reporting unit for goodwill and intangible impairment testing purposes.
The excess of the purchase price for acquisitions over the fair value of the net assets acquired, including other intangible assets, is recorded as goodwill. Goodwill is not amortized but is tested for impairment at the reporting unit level, defined as the affiliate level, at least annually in the fourth quarter or more frequently when events or circumstances occur that indicate that it is more likely than not that an impairment has occurred, based on the guidance in ASC 350, Intangibles -Goodwill and Other (“ASC 350”), as updated by ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). Goodwill impairment exists when a reporting unit’s carrying value of goodwill exceeds its implied fair value. In accordance with ASC 350, intangible assets with an indefinite useful economic life are not amortized, but are subject to impairment testing at the reporting unit on an annual basis, or when events or changes in circumstances indicate that the carrying amounts are impaired.
An entity may assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount, including goodwill (“Step 0”). In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, an entity assesses relevant events and circumstances, such as the following:
•
Macroeconomic conditions, such as a deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets.
•
Industry and market considerations, such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (considered in both
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.
•
Overall financial performance, such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.
•
Other relevant entity-specific events, such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation.
•
Events affecting a reporting unit, such as a change in the composition or carrying amount of its net assets; a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit; the testing for recoverability of a significant asset group within a reporting unit; or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
If, after assessing the totality of events or circumstances such as those described in the preceding paragraph, an entity determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the quantitative goodwill impairment test, as described below, is unnecessary.
Goodwill is tested for impairment by estimating the fair value of a reporting unit. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions, and selecting an appropriate control premium. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the weightings that are most representative of fair value.
Quantitative impairment testing requires a comparison of each reporting unit’s fair value to carrying value to identify potential impairment. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, an impairment loss is recognized. In adopting ASU 2017-04, the Company measures that loss as an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. Additionally, the Company considers the income tax effect from any tax deductible goodwill on the carrying amount of the reporting unit, if applicable, when measuring the goodwill impairment loss.
The fair value of the reporting unit is determined using generally accepted approaches to valuation commonly referred to as the income approach, market approach, and cost approach. Within each category, a variety of methodologies exist to assist in the estimation of fair value. Generally a valuation consultant will be engaged to assist with the valuation.
BPFH has three reportable segments that have goodwill: Wealth Management and Trust, Investment Management, and Wealth Advisory. Boston Private Wealth is the only reporting unit within the Wealth Management and Trust segment. Anchor and DGHM are the reporting units within the Investment Management segment. DGHM does not have any remaining goodwill. BOS and KLS are the reporting units within the Wealth Advisory segment. Discrete financial information is available and segment management regularly reviews the operating results of Anchor, KLS, and BOS, they are all considered reporting units.
For the reporting units within the segments, the Company utilizes both the income and market approaches to determine fair value of the reporting units. The income approach is primarily based on discounted cash flows derived from assumptions of income statement activity. For the market approach, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and revenue multiples of comparable companies are selected and applied to the financial services reporting unit’s applicable metrics.
The aggregate fair values of the reporting units are compared to market capitalization as an assessment of the appropriateness of the fair value measurements. A control premium analysis is performed to determine whether the implied control premium was within range of overall control premiums observed in the market place.
If the carrying amount of the reporting unit’s goodwill is greater than the fair value of the reporting unit’s goodwill, an impairment loss must be recognized for the excess (i.e., recorded goodwill must be written down to the implied fair value of the reporting unit’s goodwill). After a goodwill impairment loss for a reporting unit is measured and recognized, the adjusted carrying amount of the reporting unit’s goodwill becomes the new accounting basis for that goodwill.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Tax Estimates
The Company accounts for income taxes in accordance with ASC 740, Income Taxes (“ASC 740”). The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting basis for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes for a change in tax rates is recognized in income tax expense/ (benefit) attributable to continuing operations in the period that includes the enactment date. Valuation allowances on deferred tax assets are estimated based on our assessment of the realizability of such amounts. Significant management judgment is required in determining the provision for income taxes and, in particular, any valuation allowance recorded against our deferred tax assets.
In accordance with ASC 740, deferred tax assets are to be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of the tax benefit depends upon the existence of sufficient taxable income of the appropriate character within the carry-forward periods.
Management considered the following items in evaluating the need for a valuation allowance:
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The Company had cumulative pre-tax income, as adjusted for permanent book-to-tax differences, during the period 2015 through 2017.
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Deferred tax assets are expected to reverse in periods when there will be taxable income.
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The Company projects sufficient future taxable income to be generated by operations during the available carry-forward period.
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The Company considered the impact the Tax Act will have on the Company’s ability to generate sufficient taxable income in the carry-forward periods.
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Certain tax planning strategies are available, such as reducing investments in tax-exempt securities.
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The Company has not had any operating loss or tax credit carryovers expiring unused in recent years.
The Company believes that it is more likely than not that the net deferred tax asset as of December 31, 2017, which has been re-measured at the federal corporate tax rate of 21%, will be realized based primarily upon the ability to generate future taxable income. The Company does not have any capital losses in excess of capital gains as of December 31, 2017.
Derivative Instruments and Hedging Activities
The Company records derivatives on the consolidated balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives used to hedge exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income/ (loss) (a component of shareholders’ equity), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings, and the ineffective portion, if any, of changes in the fair value of the derivative is recognized directly in earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions. On January 1, 2018, the Company elected to early adopt ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, under the modified retrospective transition. Under the new ASU, the concept of ineffectiveness will no longer be used. In accordance with the guidance, the Company will recognize all reclassifications out of accumulated other comprehensive income/ (loss) (other than those related to a hedge transaction probable of not occurring) in earnings.
For derivatives designated as fair value hedges, changes in the fair value of the derivative are recognized in earnings together with the changes in the fair value of the related hedged item. Therefore, the net amount, if any, representing hedge ineffectiveness, is reflected in earnings.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Investment Management, Wealth Advisory, and Wealth Management and Trust Fees
The Company generates fee income from providing wealth management, investment management and wealth advisory services through the Wealth and Investment businesses and from providing trust services to its clients at the Bank. Investment management fees are generally based upon the value of assets under management and are billed monthly, quarterly, or annually. Asset-based advisory fees are recognized as services are rendered and are based upon a percentage of the fair value of client assets managed. Certain wealth advisory fees are not asset-based and are negotiated individually with clients. Any fees collected in advance are deferred and recognized as income over the period earned. Performance-based advisory fees are generally assessed as a percentage of the investment performance realized on a client’s account, generally over an annual period, and are not recognized until any contingencies in the contract that could require the performance fee to be reduced have been eliminated.
Assets under management and advisory (“AUM”) at the Company’s consolidated affiliates are not included in the consolidated financial statements since they are held in a fiduciary or agency capacity and are not assets of the Company.
Stock-Based Incentive Plans
At December 31, 2017, the Company has three stock-based incentive compensation plans. These plans encourage and enable the officers, employees, and non-employee directors of the Company to acquire an interest in the Company. The Company accounts for share-based awards in accordance with ASC 718, Compensation - Stock Compensation. Costs resulting from the issuance of such share-based payment awards are required to be recognized in the financial statements based on the grant date fair value of the award. Stock-based compensation expense is recognized over the requisite service period, which is generally the vesting period.
Earnings Per Share (“EPS”)
Basic EPS is computed by dividing net income/ (loss) attributable to common shareholders by the weighted average number of common shares outstanding during the year. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock (such as stock warrants, non-participating performance-based restricted stock, certain time-based restricted stock, and stock options, among others) were exercised or converted into additional common shares that would then share in the earnings of the entity. Diluted EPS is computed by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding for the year, plus an incremental number of common-equivalent shares computed using the treasury stock method. Dilutive potential common shares could consist of: stock options, performance-based restricted stock, time-based restricted stock not participating in common stock dividends, warrants or other dilutive securities, and conversion of the convertible trust preferred securities. Additionally, when dilutive, interest expense (net of tax) related to the convertible trust preferred securities is added back to net income attributable to common shareholders. The calculation of diluted EPS excludes the potential dilution of common shares and the inclusion of any related expenses if the effect is antidilutive.
Unvested time-based restricted stock issued prior to 2013, which includes the right to receive non-forfeitable dividends, is considered to participate with common stock in undistributed earnings for purposes of computing EPS. Companies such as BPFH that have such participating securities are required to calculate basic EPS using the two-class method and diluted EPS using the more dilutive amount resulting from the application of either the two-class method or the if-converted method. Calculations of basic and diluted EPS under the two-class method (i) exclude from the numerator any dividends paid or owed on participating securities and any undistributed earnings considered to be attributable to participating securities, and (ii) exclude from the denominator the dilutive impact of the participating securities. Calculations of EPS under the if-converted method (i) include in the numerator any dividends paid or owed on participating securities, and (ii) include the dilutive impact of the participating securities using the treasury stock method.
In 2013, the Company adjusted its time-based restricted stock grant agreements so that dividends would be accumulated and paid only upon vesting, only as to the amount of shares that vest. As a result of this adjustment, time-based restricted stock granted in or after 2013 no longer contains a right to receive non-forfeitable dividends, and therefore is not considered a participating security for purposes of the EPS calculation. Time-based restricted stock issued prior to 2013 was not modified and was still considered a participating security until it vested or was forfeited or canceled. All remaining time-based restricted stock issued prior to 2013 was fully vested, forfeited, or canceled during 2016.
For the calculation of the Company’s EPS, see Part II. Item 8. “Financial Statements and Supplementary Data - Note 16: Earnings Per Share.”
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Recent Accounting Pronouncements
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09 replaces existing revenue recognition standards and expands the disclosure requirements for revenue agreements with customers. ASU 2014-09 has been subsequently amended by additional ASUs, including ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) and ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, collectively, “ASU 2014-09 et al.” Under the new standard, a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration which the company expects to receive in exchange for those goods or services. ASU 2014-09 et al. does not apply to revenue associated with financial instruments such as loans and securities. Therefore, the Company’s net interest income will not be impacted by this new standard. The Company assembled a project team to address the changes pursuant to ASU 2014-09 et al. The project team completed the scope assessment and determined that approximately 60% of our revenue, including all of our interest income and a portion of our noninterest income, is out of scope of the guidance. The contracts that are in scope of the guidance are primarily related to service charges and fees on deposit accounts, wealth management and trust income, wealth advisory income, investment management income, and other service charges, commissions and fees. Our review of these contracts has not identified any material changes in the timing of revenue recognition. On January 1, 2018, we adopted ASU 2014-09 et al. using the modified retrospective transition method, however no cumulative effect adjustment to opening retained earnings as of January 1, 2018 was required. The Company does expect additional financial statement disclosures and associated internal controls to be implemented along with the adoption of this ASU.
In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Instruments - Going Concern (“ASU 2014-15”). ASU 2014-15 requires management to evaluate an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Management must evaluate whether conditions and events raise substantial doubt about an entity’s ability to continue as a going concern and then whether its plans alleviate that doubt. ASU 2014-15 was effective in 2016 and management performed the required evaluation and concluded that there were no such conditions or events that raised substantial doubt about the Company’s ability to continue as a going concern.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This ASU update amends current lease accounting and requires all leases, other than short-term leases, to be reported on the balance sheet through the recognition of a right-of-use asset and a corresponding liability for future lease obligations. The amended guidance will be effective for fiscal years beginning after December 15, 2018, including interim periods within those annual periods and will require transition utilizing a modified retrospective approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. Early adoption of this ASU is permitted although the Company does not plan to early adopt. The Company does not anticipate a material impact to revenue or operating expenses as a result of the adoption of this ASU. The Company expects that this ASU will gross up the assets and liabilities on the balance sheet related to the lease assets and liabilities and reduce regulatory capital ratios.
In March 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This update is intended to simplify several aspects of the accounting for employee share-based plans such as income tax consequences, classification of awards as either liabilities or equity on the balance sheet, and classification on the statement of cash flows. This ASU was effective for fiscal years beginning after December 15, 2016, including interim periods within those years. The Company adopted this ASU on January 1, 2017. The adoption of this ASU has resulted in, and will continue to result in, fluctuations in the Company’s earnings due to changes in the Company’s stock price between issuance date and settlement date of employee share-based transactions. In addition, the Company anticipates that certain stock options will expire unexercised, due to being out of the money, and this ASU requires the previous tax benefits to be reversed. For the year ended December 31, 2017, the impact on the Company’s income tax expense related to the adoption of this ASU was a decrease of $0.3 million.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments (Topic 326) (“ASU 2016-13”). This update is intended to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. This ASU will be effective for fiscal years beginning after December 15, 2019. Early adoption is available as of the fiscal year beginning after December 15, 2018. The Company does not plan on adopting early. The impact of this ASU on the Company’s consolidated financial statements will depend on factors at the time of adoption such as the balance and type of loans on the balance sheet, the Company’s loan loss history, and various qualitative factors.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230) (“ASU 2016-15”). This update is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. This ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted, provided that all of the amendments are adopted in the same period, however the Company did not early adopt. The guidance requires application using a retrospective transition method. The Company does not expect that this ASU will have a significant impact on its consolidated financial statements.
In January 2017, the FASB issued ASU 2017-04. This update is the result of the first phase of a two phase project by the FASB to reduce the cost and complexity of the goodwill impairment test. The objective of Phase 1 of the project, which resulted in ASU 2017-04, is to simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Instead, under the amendments in ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. Under the provisions of this update, an entity still has the option to perform the qualitative assessment, or Step 0 test, for a reporting unit to determine if the quantitative impairment test is necessary. This ASU will be effective for any annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company elected to early adopt this ASU as of January 1, 2017. The adoption of this ASU could increase or decrease the amount of a goodwill impairment charge should any of the Company’s reporting units with goodwill fail a Step 1 test, as compared to the amount of a goodwill impairment charge under the existing standards depending on the fair value of the reporting unit’s assets.
In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities (“ASU 2017-08”). This update amends the amortization period for certain purchased callable debt securities held at a premium. The amortization period for the premium on such securities is being shortened to the earliest call date. Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the instrument. ASU 2017-08 is effective for fiscal years beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted, including in an interim period. The guidance requires application using a modified retrospective transition method through a cumulative-effect adjustment to beginning retained earnings. The Company early adopted this ASU as of July 1, 2017, which had a minimal impact on the consolidated financial statements.
In August 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). The standard is intended to improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities and to reduce the complexity of and simplify the application of hedge accounting by preparers. ASU No. 2017-12 is effective for interim and annual reporting periods beginning after December 15, 2018; early adoption is permitted. The Company elected to early adopt this ASU as of January 1, 2018 with a modified retrospective transition. The Company currently has six interest rate swaps that are designated for hedge accounting and the adoption is not expected to have a significant impact on the consolidated financial statements. This ASU will provide more flexibility in the Company’s risk management activities and we believe it will enhance the Company’s ability to employ risk management strategies, while improving the transparency and understanding of those strategies for financial statement users.
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This update was issued to address a narrow-scope financial reporting issue that arose as a consequence of the change in the tax law. On December 22, 2017, the U.S. federal government enacted the Tax Cuts and Jobs Act (the “Tax Act”) which, among other significant changes, lowers the federal corporate tax rate from 35% to 21% effective January 1, 2018. This update requires a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the enactment of the Tax Act. ASC 740 requires that the tax effects of changes in tax rates be recognized in income tax expense/ (benefit) attributable to continuing operations in the period in which the law is enacted. As a result, the tax effect of accumulated other comprehensive income does not reflect the appropriate tax rate. The amendments in this ASU would eliminate the stranded tax effects associated with the change in the federal corporate income tax rate related to the Tax Act and would improve the usefulness of information reported to financial statement users. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted for public business entities for reporting periods for which financial statements have not yet been issued. The Company adopted this ASU on December 31, 2017 and made a one-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
time reclassification of $1.5 million from accumulated other comprehensive income to retained earnings, which is reflected in the consolidated statement of changes in shareholders’ equity.
2.RESTRUCTURING
In the fourth quarter of 2014, the Company incurred restructuring charges related to the acquisition of Banyan Partners, LLC (“Banyan”). The purpose of this restructuring was to realign the management structure within the Wealth Management and Trust segment. The total cost of the restructuring incurred in the fourth quarter of 2014 was $0.7 million. In 2015, the Company incurred additional restructuring charges to further refine the management structure within the Wealth Management and Trust segment. The total cost of the restructuring charges in 2015 was $3.7 million.
In the first and second quarters of 2016, the Company incurred additional costs of $1.1 million and $0.9 million, respectively, in the continued refinement of the management structure within the Wealth Management and Trust segment. The Company does not anticipate any additional restructuring costs related to this plan as of the date of this filing.
Restructuring expenses incurred since the plans of restructuring were first implemented in 2014 totaled $6.4 million, all within the Wealth Management and Trust segment.
The following table presents a summary of the restructuring activity for the years ended December 31, 2017, 2016 and 2015.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.ACQUISITIONS, ASSET SALES, AND DIVESTITURES
Asset Sales
In December 2017, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority-owned by members of its management team. The Company will receive approximately $32 million of cash at closing and future revenue share payments that, at signing, had a net present value of approximately $15 million, subject to purchase price adjustments. The Company’s annual goodwill impairment test for Anchor resulted in a fourth quarter of 2017 goodwill impairment charge of $24.9 million. Anchor’s $58.8 million of assets and $3.2 million of liabilities have been classified as held for sale at December 31, 2017. The Company also recorded a loss on sale of $1.3 million representing estimated closing costs upon completion of the sale. Income tax expense of approximately $11.4 million will be recorded at the time of the closing of the transaction as a result of a book to tax basis difference associated with nondeductible goodwill. The estimated loss on sale as well as the income tax expense could change depending upon the book value of Anchor at the time of closing. The transaction is expected to close in the first quarter of 2018. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions. The rationale for the sale is to focus the Company’s resources in businesses where we can offer holistic financial advice, along with integrated wealth management, trust, and private banking capabilities. This transaction will also generate additional capital for us to reinvest in a more focused Company.
In 2016, the Company sold two offices in the Southern California market, located in Granada Hills and Burbank, California. The sale consisted of certain assets and $104.0 million of deposits. This sale resulted in a gain of $2.9 million. The rationale for the sale was to better position the Company’s resources within the Southern California market.
Acquisitions
On October 2, 2014, the Bank completed the acquisition of Banyan, a registered investment advisory firm headquartered in Palm Beach Gardens, Florida. At the time of acquisition, Banyan had approximately $4.3 billion in client assets and locations in New England; South Florida; Texas; California; Atlanta, Georgia; and Madison, Wisconsin.
In the transaction, Boston Private Bank acquired 100% of certain assets and liabilities of Banyan through the issuance of approximately 1.7 million shares of the Company’s stock, valued at $21.0 million, and $43.9 million in cash payments to Banyan shareholders, including $5.0 million in a holdback account for potential future claims. The total purchase price, including contingent consideration of $2.0 million, was $66.9 million. In 2015, due to the lower than initially estimated actual financial results for 2015 and projected financial results for 2016, the $2.0 million liability for the contingent consideration was reversed and recorded as Other Income. 2016 was the last year of any contingent consideration and the contractual minimum targets for contingent payments were not met.
Goodwill of $41.9 million was recorded as a result of the transaction. Goodwill of $39.9 million is deductible for tax purposes, representing all of the goodwill except for the portion associated with the reversal of the contingent consideration. Intangible assets for advisory contracts of $23.9 million were also recorded and are expected to be amortized over 10 years.
The rationale for the transaction was that by merging Banyan with the existing Boston Private Bank wealth management business, additional technical expertise and financial acumen would be generated. Banyan has been merged with the existing wealth management business from Boston Private Bank, and the combined company has been renamed Boston Private Wealth. As a wholly-owned subsidiary of the Bank, Boston Private Wealth will also operate as part of the Wealth Management and Trust segment along with the trust operations of the Bank. These operations are reported separately from the Private Banking operations of the Bank.
Divestitures
In 2009, the Company divested its interests in Westfield Capital Management Company, LP, formerly known as Westfield Capital Management Company, LLC (“Westfield”). The Company retained a 12.5% share in Westfield’s revenues (up to an annual maximum of $11.6 million) through December 2017 subject to certain conditions. The Company defers gains related to these payments until determinable. Such revenue share payments are included in net income from discontinued operations in the consolidated statements of operations for the period in which the revenue is recognized. After the December 2017 payments are received in the first quarter of 2018, the Company will not receive additional net income from Westfield.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
4. INVESTMENT SECURITIES
The following tables present a summary of investment securities:
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(1)
All mortgage-backed securities are guaranteed by U.S. government agencies or Government-sponsored entities.
In the tables below, the weighted average yield is calculated based on average amortized cost which does not include the effect of unrealized changes in fair value. Certain securities are callable before their final maturity. Additionally, certain securities (such as mortgage-backed securities) are shown within the table below based on their final (contractual) maturity, but, due to prepayments, are expected to have shorter lives.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present the maturities of available-for-sale investment securities, based on contractual maturity, and the weighted average yields of such securities as of December 31, 2017:
The following table presents the maturities of held-to-maturity investment securities, based on contractual maturity, and the weighted average yields of such securities as of December 31, 2017:
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(1)
Certain securities are callable before their final maturity.
(2)
Mortgage-backed securities are shown based on their final (contractual) maturity, but, due to prepayments, they are expected to have shorter lives.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(3)
Yields shown on a fully taxable equivalent (“FTE”) basis. The tax rate used in the table above was the tax rate in effect on December 31, 2017. The recent enactment of the Tax Act will reduce the rate applied in future periods, which will result in a lower FTE yield.
(4)
Other securities consist of money market mutual funds and equity securities held by certain Wealth Advisory and Investment Management businesses.
The weighted average remaining maturity at December 31, 2017 was 8.1 years for available-for-sale investment securities, with $184.9 million of available-for-sale investment securities callable before maturity. The weighted average remaining maturity at December 31, 2016 was 9.1 years for available-for-sale investment securities, with $140.4 million of available-for-sale investment securities callable before maturity.
The weighted average remaining maturity for held-to-maturity investment securities was 11.9 years and 12.9 years at December 31, 2017 and December 31, 2016, respectively.
The following table presents the proceeds from sales, gross realized gains and gross realized losses for available-for-sale investment securities that were sold during the following years:
The following tables present information regarding securities at December 31, 2017 and 2016 having temporary impairment, due to the fair values having declined below the amortized cost of the individual securities, and the time period that the investments have been temporarily impaired.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
___________________
(1)
All mortgage-backed securities are guaranteed by U.S. government agencies or Government-sponsored entities.
As of December 31, 2017, the U.S. government and agencies securities and government-sponsored entities securities in the first table above had current Moody’s credit ratings of Aaa. The mortgage-backed securities in the first table above had a current Standard and Poor’s credit rating of at least AA. The municipal bonds in the first table above had a current Standard and Poor’s credit rating of at least AA- or a current Moody’s credit rating of at least Aa3. The other securities in the first table above consisted of equity securities. At December 31, 2017, the Company does not consider these investments other-than-temporarily impaired because the decline in fair value on investments is primarily attributed to changes in interest rates and not credit quality.
At December 31, 2017 and December 31, 2016, the amount of investment securities in an unrealized loss position greater than 12 months, as well as in total, was primarily due to changes in interest rates. As of December 31, 2017, the Company had no intent to sell any securities in an unrealized loss position and it is not more likely than not that the Company would be forced to sell any of these securities prior to the full recovery of all unrealized loss amounts. Subsequent to December 31, 2017 and through the date of the filing of this Annual Report on Form 10-K, no securities were downgraded to below investment grade, nor were any securities in an unrealized loss position sold.
The following table presents the concentration of securities with any one issuer that exceeds ten percent of shareholders’ equity as of December 31, 2017:
Cost method investments
The Company invests in low-income housing tax credits, which are included in other assets, to encourage private capital investment in the construction and rehabilitation of low-income housing. The Company makes these investments as an indirect subsidy that allows investors, such as the Company, in a flow-through limited liability entity, such as limited partnerships or limited liability companies that manage or invest in qualified affordable housing projects, to receive the benefits of the tax credits allocated to the entity that owns the qualified affordable housing project. The Company also holds partnership interests in venture capital funds formed to provide financing to small businesses and to promote community development.
The Company amortizes its investment in the low income housing tax credits using the proportional amortization method. Under the proportional amortization method, the Company amortizes the cost of its investment, in proportion to the tax
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
credits and other tax benefits it receives to income tax expense. Included in income tax expense was amortization of $2.7 million, $1.6 million, and $1.3 million for the years ending December 31, 2017, 2016 and 2015, respectively. Also included in income tax expense were the related tax benefits of $2.2 million, $1.7 million and $1.3 million for the years ending December 31, 2017, 2016, and 2015, respectively.
The Company had $39.4 million and $34.2 million in cost method investments included in other assets as of December 31, 2017 and December 31, 2016, respectively. In addition the Company had $11.5 million and $11.3 million in unadvanced funds related to commitments in these investments as of December 31, 2017 and 2016, respectively.
Under the proportional amortization method, an investment must be tested for impairment when events or changes in circumstances indicate that it is more likely than not that the carrying amount of the investment will not be realized. There was no indication of impairment for the years ending December 31, 2017 and 2016.
5. LOAN PORTFOLIO AND CREDIT QUALITY
The Bank’s lending activities are conducted principally in the regions of New England, the San Francisco Bay Area, and Southern California. The Bank originates single and multi-family residential loans, commercial real estate loans, commercial and industrial loans, commercial tax-exempt loans, construction and land loans, and home equity and other consumer loans. Most loans are secured by borrowers’ personal or business assets. The ability of the Bank’s single family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic conditions within the Bank’s lending areas. Commercial, construction, and land borrowers’ ability to repay is generally dependent upon the health of the economy and real estate values, including, in particular, the performance of the construction sector. Accordingly, the ultimate collectability of a substantial portion of the Bank’s loan portfolio is susceptible to changing conditions in the New England, the San Francisco Bay Area, and Southern California economies and real estate markets.
The following table presents a summary of the loan portfolio based on the portfolio segment as of the dates indicated:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents nonaccrual loans receivable by class of receivable as of the dates indicated:
The Bank’s policy is to discontinue the accrual of interest on a loan when the collectability of principal or interest is in doubt. In certain instances, although infrequent, loans that have become 90 days or more past due may remain on accrual status if the value of the collateral securing the loan is sufficient to cover principal and interest and the loan is in the process of collection. There were no loans 90 days or more past due, but still accruing, as of December 31, 2017 and 2016. The Bank’s policy for returning a loan to accrual status requires the loan to be brought current and for the client to show a history of making timely payments (generally six consecutive months). For TDRs, a return to accrual status generally requires timely payments for a period of six months in accordance with the restructured loan terms, along with meeting other criteria.
The following tables present the payment status of loans receivable by class of receivable as of the dates indicated:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Nonaccrual and delinquent loans are affected by many factors, such as economic and business conditions, interest rates, unemployment levels, and real estate collateral values, among others. In periods of prolonged economic decline, borrowers may become more severely affected over time as liquidity levels decline and the borrower’s ability to continue to make payments deteriorates. With respect to real estate collateral values, the declines from the peak, as well as the value of the real estate at the time of origination versus the current value, can impact the level of problem loans. For instance, if the loan to value ratio at the time of renewal has increased due to the decline in the real estate value since origination, the loan may no longer meet the Bank’s underwriting standards and may be considered for classification as a problem loan dependent upon a review of risk factors.
Generally when a collateral dependent loan becomes impaired, an updated appraisal of the collateral, if appropriate, is obtained. If the impaired loan has not been upgraded to a performing status within a reasonable amount of time, the Bank will continue to obtain updated appraisals as deemed necessary, especially during periods of declining property values.
The past due status of a loan is determined in accordance with its contractual repayment terms. All loan types are reported past due when one scheduled payment is due and unpaid for 30 days or more.
The following tables present the loan portfolio’s credit risk profile by internally assigned grade and class of receivable as of the dates indicated:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present, by class of receivable, the balance of impaired loans with and without a related allowance, the associated allowance for those impaired loans with a related allowance, and the total unpaid principal on impaired loans:
___________________
(1)
Recorded investment represents the client loan balance net of historical charge-offs and historical nonaccrual interest paid, which was applied to principal.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
____________________
(1)
Recorded investment represents the client loan balance net of historical charge-offs and historical nonaccrual interest paid, which was applied to principal.
When management determines that it is probable that the Bank will not collect all principal and interest on a loan in accordance with the original loan terms, the loan is designated as impaired.
Loans that are designated as impaired require an analysis to determine the amount of impairment, if any. Impairment would be indicated as a result of the carrying value of the loan exceeding the estimated collateral value, less costs to sell, for collateral dependent loans or the net present value of the projected cash flow, discounted at the loan’s contractual effective interest rate, for loans not considered to be collateral dependent. Generally, shortfalls in the analysis on collateral dependent loans would result in the impairment amount being charged-off to the allowance for loan losses. Shortfalls on cash flow dependent loans may be carried as specific allocations to the general reserve unless a known loss is determined to have occurred, in which case such known loss is charged-off.
Loans in the held for sale category are carried at the lower of amortized cost or estimated fair value in the aggregate and are excluded from the allowance for loan losses analysis.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Bank may, under certain circumstances, restructure loans as a concession to borrowers who are experiencing financial difficulty. Such loans are classified as TDRs and are included in impaired loans. TDRs typically result from the Bank’s loss mitigation activities which, among other things, could include rate reductions, payment extensions, and/or principal forgiveness. As of December 31, 2017 and 2016, TDRs totaled $13.6 million and $18.1 million, respectively. As of December 31, 2017, $11.1 million of the $13.6 million of TDRs were on accrual status. As of December 31, 2016, $12.4 million of the $18.1 million of TDRs were on accrual status. As of December 31, 2017 and 2016, the Company had no commitments to lend additional funds to debtors for loans whose terms had been modified in a troubled debt restructuring.
Since all TDR loans are considered impaired loans, they are individually evaluated for impairment. The resulting impairment, if any, would have an impact on the allowance for loan losses as a specific reserve or charge-off. If, prior to the classification as a TDR, the loan was not impaired, there would have been a general or allocated reserve on the particular loan. Therefore, depending upon the result of the impairment analysis, there could be an increase or decrease in the related allowance for loan losses. Many loans initially categorized as TDRs are already on nonaccrual status and are already considered impaired. Therefore, there is generally not a material change to the allowance for loan losses when a nonaccruing loan is categorized as a TDR.
The following tables present the balance of TDRs that were restructured or defaulted during the periods indicated:
____________________
(1) Represents the following concession: temporary rate reduction.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
____________________
(1)
Combination of concessions includes loans that have had more than one modification, including extension of term, temporary reduction of interest rate, and/or payment deferral.
Any loans to senior management, executive officers, and directors are made in the ordinary course of business, under normal credit terms, including interest rates and collateral requirements prevailing at the time of origination for comparable transactions with other persons and do not represent more than normal credit risk. The Bank’s current policy is generally not to originate these types of loans.
Total loans include deferred loan origination (fees)/ costs, net, of $6.9 million and $5.9 million as of December 31, 2017 and 2016, respectively.
Mortgage loans serviced for others totaled $41.4 million and $58.6 million as of December 31, 2017 and 2016, respectively, and are not included in the Company’s total loans.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6. ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is reported as a reduction of outstanding loan balances, and totaled $74.7 million and $78.1 million at December 31, 2017 and 2016, respectively.
The following table presents a summary of the changes in the allowance for loan losses for the periods indicated:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
__________________
(1)
As of December 31, 2015, the unallocated reserve was allocated to the qualitative factors as part of the general reserve (ASC 450). The allocation had no effect on the 2015 provision/ (credit) for loan losses.
The provision/ (credit) for loan losses and related balance in the allowance for loan losses for tax-exempt commercial and industrial loans are included with commercial and industrial. The provision/ (credit) for loan losses and related balance in the allowance for loan losses for tax-exempt commercial real estate loans are included with commercial real estate. There were no charge-offs or recoveries, for any period presented, for both commercial and industrial and commercial real estate tax-exempt loans.
The following tables present the Company’s allowance for loan losses and loan portfolio at December 31, 2017 and 2016 by portfolio segment, disaggregated by method of analysis. The Company had no loans acquired with deteriorated credit quality at December 31, 2017 or 2016.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
7. PREMISES AND EQUIPMENT
Premises and equipment consisted of the following:
Depreciation and amortization expense related to premises and equipment was $8.1 million, $6.8 million, and $6.6 million for the years ended December 31, 2017, 2016, and 2015, respectively.
The Company is obligated for minimum payments under non-cancelable operating leases. In accordance with the terms of these leases, the Company is currently committed to minimum annual payments as follows:
Rent expense for the years ended December 31, 2017, 2016, and 2015 was $21.4 million, $19.6 million and $19.0 million, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
8. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The following tables detail the changes in carrying value of goodwill by segment during the years ended December 31, 2017 and 2016. There were no changes in the carrying value of goodwill during 2015.
___________________
(1)
Remaining goodwill of Anchor is classified as held for sale as of December 31, 2017.
(2)
Adjusted for rounding.
The following tables detail total goodwill and the cumulative impairment charges thereon as of December 31, 2017 and 2016:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
___________________
(1)
Remaining goodwill of Anchor is classified as held for sale as of December 31, 2017.
(2)
Adjusted for rounding.
In 2017 and 2016, the Company recognized no additional goodwill.
Goodwill and indefinite lived intangible assets such as trade names are subject to annual impairment tests, or more frequently, if there is an indication of impairment, based on the guidance in ASC 350, Intangibles-Goodwill and Other (“ASC 350”). Long-lived intangible assets such as advisory contracts are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable in accordance with ASC 360, Property, Plant, and Equipment (“ASC 360”).
Management performed its annual goodwill and indefinite-lived intangible asset impairment testing during the fourth quarter of 2017 for applicable reporting units. There was no additional testing required for long-lived intangible assets in 2017.
2017 Impairment testing and results
Management performed its annual goodwill and indefinite-lived intangible asset impairment testing during the fourth quarters of 2017 for applicable reporting units. For the 2017 testing, Step 0 was performed for BOS and KLS. A Step 1 test was performed for Boston Private Wealth and Anchor. The results of the Step 1 test for Boston Private Wealth indicated that the fair value exceeded their carrying value therefore no goodwill impairment was evident. Neither Boston Private Bank nor DGHM have any goodwill.
In December 2017, while the Company was performing the Step 1 test for Anchor, the Company entered into an agreement to sell its entire ownership interest in Anchor in a transaction that will result in Anchor being majority owned by members of its management team. The Company will receive approximately $32 million of cash at closing and future revenue share payments that, at signing, had a net present value of approximately $15 million, subject to purchase price adjustments. The Company’s annual goodwill impairment test for Anchor resulted in a fourth quarter of 2017 goodwill impairment charge of $24.9 million. The decline in fair value and the related goodwill impairment was related to the fair market value impacts of the Anchor sale transaction. Due to the limited interest and terms of the transaction that were required for a mutual agreement, the fair value obtained was substantially below the carrying value. The fair value was based on the terms of the sale transaction. The transaction is expected to close in the first quarter of 2018. This transaction has been approved by the Company’s board of directors and is subject to obtaining client consents, Anchor raising debt financing, and customary closing conditions. The rationale for the sale is to focus the Company’s resources in businesses where we can offer holistic financial advice, along with integrated wealth management, trust, and private banking capabilities. This transaction will also generate additional capital for us to reinvest in a more focused Company.
2016 Impairment testing and results
In the 2016 goodwill impairment testing, a Step 0 test was performed for BOS and KLS and a Step 1 test was performed for Anchor and Boston Private Wealth. Neither Boston Private Bank nor DGHM have any goodwill. Based on the qualitative factors assessed in the Step 0 tests for BOS and KLS, no additional testing was required. Anchor passed its Step 1 test although with a lower fair value than the previous year. Boston Private Wealth failed its Step 1 test and the Company performed a Step 2 test to determine the amount of goodwill impairment, if any.
The estimated fair value of Boston Private Wealth was $68.0 million as compared to a carrying value of $76.9 million, resulting in a deficit of $8.9 million, or 11.6%.
Because the estimated fair value of Boston Private Wealth was lower than its carrying value, the Company was required to perform a Step 2 valuation. The results of the Step 2 valuation indicated an implied fair value of goodwill of $34.8 million as compared to the book value of $44.3 million, or a deficiency of $9.5 million. The resulting deficiency was recorded as a goodwill impairment charge within operating expenses in the fourth quarter of 2016. As a result of the goodwill impairment, the carrying value of goodwill at Boston Private Wealth was reduced to $34.8 million.
See Part II. Item 8. “Financial Statements and Supplementary Data - Note 1: “Basis of Presentation and Summary of Significant Accounting Policies” for changes to the rules in goodwill impairment testing as discussed in the Recent Accounting Pronouncements section.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Intangible assets
The following table shows the gross and net carrying amounts of identifiable intangible assets at December 31, 2017 and 2016:
___________________
(1)
Intangible assets of Anchor are classified as held for sale as of December 31, 2017.
The Company recognized no additional identifiable intangible assets in 2017 or 2016.
Consolidated expense related to intangible assets subject to amortization was $5.6 million, $6.3 million, and $6.7 million for 2017, 2016, and 2015, respectively.
Management reviews, and adjusts if necessary, intangible asset amortization schedules to ensure that the remaining life on the amortization schedule accurately reflects the useful life of the intangible asset. The weighted average amortization period of these intangible assets is 6.68 years.
The estimated annual amortization expense for these identifiable intangibles over the next five years is:
9. DERIVATIVES AND HEDGING ACTIVITIES
The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and, to a lesser extent, the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are generally determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to certain loans, deposits, and borrowings.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the fair value of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as of December 31, 2017 and 2016.
___________________
(1)
For additional details, see Part II. Item 8. “Financial Statements and Supplementary Data - Note 21: Fair Value of Financial Instruments.”
The following table presents the effect of the Company’s derivative financial instruments in the consolidated statement of operations for the years ended December 31, 2017 and 2016.
___________________
(1) There was an additional $(11) thousand loss related to the ineffective portion for the year ended December 31, 2017 and an additional $6 thousand gain related to the ineffective portion for the year ended December 31, 2016.
The Bank has agreements with its derivative counterparties that contain provisions where, if the Bank defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Bank could also be declared in default on its derivative obligations. The Bank was in compliance with these provisions as of December 31, 2017 and 2016.
The Bank also has agreements with certain of its derivative counterparties that contain provisions where, if the Bank fails to maintain its status as a well- or adequately-capitalized institution, then the counterparty could terminate the derivative positions and the Bank would be required to settle its obligations under the agreements. The Bank was in compliance with these provisions as of December 31, 2017 and 2016.
Certain of the Bank’s agreements with its derivative counterparties contain provisions where if specified events or conditions occur that materially change the Bank’s creditworthiness in an adverse manner, the Bank may be required to fully collateralize their obligations under the derivative instruments. The Bank was in compliance with these provisions as of December 31, 2017 and 2016.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2017 and 2016, the termination amounts related to collateral determinations of derivatives in a liability position was $3.1 million and $3.4 million, respectively. The Company has minimum collateral posting thresholds with its derivative counterparties and has pledged securities with market values of $2.3 million and $1.9 million, respectively, as of December 31, 2017 and 2016, against its obligations under these agreements. The collateral posted is typically greater than the current liability position; however, due to timing of liability position changes at period end, the funding of a collateral shortfall may take place shortly following period end.
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company has entered into interest rate swaps as part of its interest rate risk management strategy. These interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from a counterparty in exchange for the Company making fixed payments. The Company has entered into interest rate swaps to hedge London Interbank Offered Rate (“LIBOR”) -indexed brokered deposits and the LIBOR component of the total cost of certain FHLB borrowings. The Bank has entered into a total of six interest rate swaps, two during 2017 with effective dates of March 22, 2017 and four during 2013 with effective dates of September 2, 2014, June 1, 2014, March 1, 2014, and August 1, 2013.
The two interest rate swaps entered into during 2017 have notional amounts of $40 million and $60 million with terms of 1.75 and 2.25 years, respectively, from their effective dates. These interest rate swaps will effectively fix the Bank’s interest payments on $100 million in interest-related cash outflows attributable to changes in the LIBOR component of FHLB borrowing liabilities at rates of 1.55% and 1.65%, respectively, with a weighted average rate of 1.61%. The borrowings hedged will initially be expected to be issuances and quarterly rollovers of 3-month FHLB advances but may also then include future issuances of 3-month repurchase agreements with similar characteristics and/or future issuances of either floating or fixed rate borrowings that are issued with the specific intent to replace the quarterly rollovers of the advances or repurchase agreements.
The four interest rate swaps entered into during 2013 each have a notional amount of $25 million and have terms ranging from four to six years from their respective effective dates. The interest rate swaps effectively fix the Bank’s interest payments on $100 million of its LIBOR-indexed liabilities at rates between 1.68% and 2.32%, and a weighted average rate of 1.95%.
The Company uses the “Hypothetical Derivative Method” described in ASC 815, Derivatives and Hedging (“ASC 815”), for quarterly prospective and retrospective assessments of hedge effectiveness, as well as for measurements of hedge ineffectiveness. Under this method, the Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions. The effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (“OCI”) (outside of earnings) and subsequently reclassified to earnings in interest and dividend income when the hedged transactions affect earnings. Ineffectiveness resulting from the hedge is recorded as a gain or loss in the consolidated statement of operations as part of fees and other income. There was an immaterial amount of hedge ineffectiveness during the years ended December 31, 2017 and December 31, 2016. The Company also monitors the risk of counterparty default on an ongoing basis.
A portion of the balance reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made or received on the Company’s interest rate swaps. During the next twelve months, the Company estimates that $0.2 million will be reclassified as a decrease to interest expense.
Non-designated Hedges
Derivatives not designated as hedges are not speculative and result from two different services the Bank provides to qualified commercial clients. The Bank offers certain derivative products directly to such clients. The Bank economically hedges derivative transactions executed with commercial clients by entering into mirror-image, offsetting derivatives with third parties. Derivative transactions executed as part of these programs are not designated in ASC 815-qualifying hedging relationships and are, therefore, marked-to-market through earnings each period. Because the derivatives have mirror-image contractual terms, the changes in fair value substantially offset through earnings. The net effect on earnings is primarily driven by changes in the credit valuation adjustment (“CVA”). The CVA represents the dollar amount of fair value adjustment related to nonperformance risk of both the Bank and its counterparties. Fees earned in connection with the execution of derivatives related to this program are recognized in the consolidated statement of operations in other income. As of December 31, 2017 and 2016, the Bank had 142 and 136 derivatives, respectively, related to this program, comprised of interest rate swaps and caps, with an aggregate notional amount of $1.1 billion for each period. As of December 31, 2017, there were three foreign currency exchange contracts with an aggregate notional amount of $0.2 million and, as of December 31, 2016, there was one foreign currency exchange contract with an aggregate notional amount of less than $0.1 million.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In addition, as a participant lender, the Bank has guaranteed performance on the pro-rated portion of swaps executed by other financial institutions. As the participant lender, the Bank is providing a partial guarantee, but is not a direct party to the related swap transactions. The Bank has no obligations under the risk participation agreements unless the borrower defaults on their swap transaction with the lead bank and the swap is in a liability position to the borrower. In that instance, the Bank has agreed to pay the lead bank a portion of the swap’s termination value at the time of the default. The derivative transactions entered into as part of these transactions are not designated, as per ASC 815, as qualifying hedging relationships and are, therefore, marked-to-market through earnings each period. As of December 31, 2017 there were six of these risk participation agreements with an aggregate notional amount of $48.0 million and, as of December 31, 2016, there were two of these risk participation agreements with an aggregate notional amount of $13.3 million .
The Bank has also participated out to another financial institution a pro-rated portion of two swaps executed by the Bank. The other financial institution has no obligations under the risk participation agreements unless the borrowers default on their swap transactions with the Bank and the swaps are in liability positions to the borrower. In those instances, the other financial institution has agreed to pay the Bank a portion of the swap’s termination value at the time of the default. The derivative transactions entered into as part of these agreements are not designated, as per ASC 815, as qualifying hedging relationships and are, therefore, marked-to-market through earnings each period. The pro-rated notional amount of these risk participation agreements was $6.1 million as of both December 31, 2017 and December 31, 2016.
The following table presents the effect of the Bank’s derivative financial instruments, not designated as hedging instruments, in the consolidated statements of operations for the years ended December 31, 2017 and 2016.
10. DEPOSITS
Deposits are summarized as follows:
___________________
(1)
Includes brokered deposits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Certificates of deposit had the following schedule of maturities:
Interest expense on certificates of deposit $100,000 or greater was $3.1 million, $2.0 million and $2.3 million for the years ended December 31, 2017, 2016, and 2015, respectively. At December 31, 2017 and 2016, there was $0.4 million and $0.2 million of overdrawn deposit accounts reclassified to loans, respectively.
11. FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
The federal funds purchased generally mature within 30 days of the transaction date.
Repurchase agreements are generally linked to commercial demand deposit accounts with an overnight sweep feature. In a repurchase agreement transaction, the Bank will generally sell an investment security, agreeing to repurchase either the same or a substantially identical security on a specified later date at a price slightly greater than the original sales price. The difference in the sale price and repurchase price is the cost of the use of the proceeds, or interest expense. Repurchase
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
transactions are accounted for as financing arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reflected as a liability in the Company’s consolidated balance sheets. The securities underlying the agreements remain under the Company’s control. Investment securities with a fair value of $144.3 million and $182.7 million were pledged as collateral for the securities sold under agreements to repurchase at December 31, 2017 and 2016, respectively.
As of December 31, 2017 and 2016, the Bank had unused federal funds lines with correspondent banks of $435.0 million and $485.0 million, respectively.
12. FEDERAL HOME LOAN BANK BORROWINGS
The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Boston. As a member of the FHLB of Boston, the Bank has access to short- and long-term borrowings. Borrowings from the FHLB are secured by the Bank’s stock investment in the FHLB and a blanket lien on “qualified collateral” defined principally as a percentage of the principal balance of certain types of mortgage loans. The stock investment cannot be used for additional borrowing collateral. The percentage of collateral valuation from the FHLB varies between 50% and 82% based on the underlying collateral. The Bank had loans pledged as collateral with a book value of $2.5 billion and $2.3 billion at December 31, 2017 and 2016, respectively. The Bank had borrowings outstanding of $693.7 million and $734.2 million at December 31, 2017 and 2016, respectively. Based on the collateral and the valuations applied, less the borrowings outstanding, the Bank had available credit with the FHLB of Boston of $1.2 billion and $0.9 billion at December 31, 2017 and 2016, respectively.
A summary of borrowings from the FHLBs is as follows:
As of December 31, 2017, the Company had no FHLB borrowings that were callable by the FHLB prior to maturity. As of December 31, 2016, the Company had $5.0 million of FHLB borrowings that were callable by the FHLB prior to maturity.
FHLB Stock
As a member of the FHLB, the Bank is required to own FHLB stock based on a percentage of outstanding advances in addition to a membership stock ownership requirement. For the borrowings with the FHLB of Boston, the Bank is required to own FHLB stock of at least 3.0% to 4.0% of outstanding advances depending on the terms of the advance. In addition, the Bank is required to have a minimum membership stock investment which is based on a percentage of certain assets as reported in the Bank’s FDIC Call Report. FHLB of Boston stock owned in excess of the minimum requirements can be redeemed at par upon request by a member.
As of December 31, 2017 and 2016, the Bank’s FHLB stock holdings totaled $46.1 million and $44.1 million. respectively. The Bank’s investment in FHLB stock is recorded at cost and is redeemable at par.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13. JUNIOR SUBORDINATED DEBENTURES
The schedule below presents the detail of the Company’s junior subordinated debentures:
All of the Company’s junior subordinated debentures mature in more than five years.
Boston Private Capital Trust II Junior Subordinated Debentures
In September 2005, the Company and Boston Private Capital Trust II, a Delaware statutory trust (“Trust II”) entered into a Purchase Agreement for the sale of $100 million of trust preferred securities issued by Trust II and guaranteed by the Company on a subordinated basis. Trust II’s preferred securities pay interest quarterly and had an annual distribution rate of 6.25% up to, but not including, December 30, 2010. Subsequently, Trust II’s preferred securities converted to a floating rate of a three-month LIBOR plus 1.68%; provided, however, that the interest rate does not exceed the highest rate permitted by New York law, and may be modified by the U.S. law of general application. At December 31, 2017, the interest rate for the Trust II’s preferred securities was 3.02%.
Each of the Trust II preferred securities represents an undivided beneficial interest in the assets of Trust II. The Company owns all of Trust II’s common securities. Trust II’s only assets are the junior subordinated debentures issued to it by the Company on substantially the same payment terms as Trust II’s preferred securities. The Company’s investment in Trust II was $3.1 million at both December 31, 2017 and 2016.
The junior subordinated debentures mature on December 30, 2035 and became redeemable after December 30, 2010.
The Company has the following covenants with regard to Trust II:
•
for so long as Trust II’s preferred securities remain outstanding, the Company shall maintain 100% ownership of the Trust II’s common securities;
•
the Company will use its commercially reasonable efforts to ensure Trust II remains a statutory trust, except in connection with a distribution of debt securities to the holders of the Trust II securities in liquidation of Trust II, the redemption of all Trust II’s securities or mergers, consolidations or incorporation, each as permitted by Trust II’s declaration of trust;
•
to continue to be classified as a grantor trust for U.S. federal income tax purposes; and
•
the Company will ensure each holder of Trust II’s preferred securities is treated as owning an undivided beneficial interest in the junior subordinated debentures.
At December 31, 2017 and 2016, the Company was in compliance with the above covenants.
So long as the Company is not in default in the payment of interest on the junior subordinated debentures, the Company has the right under the indenture to defer payments of interest for up to 20 consecutive quarterly periods. The Company does not currently intend to exercise its right to defer interest payments on the junior debentures issued to Trust II. If the Company defers interest payments, it would be subject to certain restrictions relating to the payment of dividends on or purchases of its capital stock and payments on its debt securities ranking equal with or junior to the junior subordinated debentures.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Boston Private Capital Trust I Junior Subordinated Debentures
In 2004, the Company and Boston Private Capital Trust I, a Delaware statutory trust (“Trust I”), entered into a Purchase Agreement and an option, which was exercised in 2004, for the sale of a combined total of $105 million of convertible trust preferred securities to be issued by Trust I and guaranteed by the Company on a subordinated basis. The convertible trust preferred securities have a liquidation amount of $50.00 per security, pay interest quarterly and have a fixed distribution rate of 4.875%. The quarterly distributions are cumulative. The junior subordinated convertible debentures will mature on October 1, 2034.
As of December 31, 2017, there was an immaterial amount remaining outstanding of the Trust I convertible trust preferred securities. The Company’s investment in Trust I was $3.2 million at both December 31, 2017 and 2016.
14. NONCONTROLLING INTERESTS
At the Company, noncontrolling interests consist of equity owned by management of the Company’s respective majority-owned affiliates. Net income attributable to noncontrolling interests in the consolidated statements of operations represents the net income allocated to the noncontrolling interest owners of the affiliates. Net income allocated to the noncontrolling interest owners was $4.5 million, $4.2 million, and $4.4 million for the years ended December 31, 2017, 2016, and 2015, respectively.
On the consolidated balance sheets, noncontrolling interests are included as the sum of the capital and undistributed profits allocated to the noncontrolling interest owners. Typically, this balance is included in a company’s permanent shareholders’ equity in the consolidated balance sheets. When the noncontrolling interest owners’ rights include certain redemption features, as described in ASC 480, Distinguishing Liabilities from Equity, such redeemable noncontrolling interests are classified as mezzanine equity and are not included in permanent shareholders’ equity. Due to the redemption features of the noncontrolling interests discussed in this footnote, the Company had redeemable noncontrolling interests held in mezzanine equity in the accompanying consolidated balance sheets of $17.5 million and $17.0 million at December 31, 2017 and 2016, respectively. The aggregate amount of such redeemable noncontrolling equity interests are recorded at the estimated maximum redemption values, as discussed below. In addition, as discussed below, the Company had $5.2 million and $4.2 million in noncontrolling interests included in permanent shareholders’ equity at December 31, 2017 and 2016, respectively.
Each non-wholly owned affiliate operating agreement provides the Company and/or the noncontrolling interests with contingent call or put redemption features used for the orderly transfer of noncontrolling equity interests between the affiliate noncontrolling interest owners and the Company at either a contractually predetermined fair value, multiple of EBITDA, or fair value. The Company may liquidate these noncontrolling interests in cash, shares of the Company’s common stock, or other forms of consideration dependent on the operating agreement.
Generally, these put and call redemption features refer to shareholder rights of both the Company and the noncontrolling interest owners of the Company’s majority-owned affiliate companies. The affiliate company noncontrolling interests generally take the form of limited liability company (LLC) units, profits interests, or common stock (collectively, the “noncontrolling equity interests”). In most circumstances, the put and call redemption features generally relate to the Company’s right and, in some cases, obligation to purchase and the noncontrolling equity interests’ right to sell their equity interests. There are various events that could cause the puts or calls to be exercised, such as a change in control, death, disability, retirement, resignation or termination. The puts and calls are generally to be exercised at the then fair value or a contractually agreed upon approximation thereof. The terms of these rights vary and are governed by the respective individual operating and legal documents.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents, by affiliate, the noncontrolling interests included as redeemable noncontrolling interests and noncontrolling interests in mezzanine and permanent equity, respectively, at the periods indicated:
_____________
(1)
Only includes redeemable noncontrolling interests.
The following is a summary, by individual affiliate, of the terms of the put and call options:
Anchor
The Company, through its acquisition of Anchor, acquired approximately an 80% interest in each of Anchor and Anchor Russell on June 1, 2006. Effective January 1, 2013, Anchor Russell merged into Anchor, with Anchor as the surviving entity. Anchor management, employees, and certain retired employees own the remaining noncontrolling equity interests of the firm, approximately 20%. The Anchor operating agreement describes a process for the orderly transfer of noncontrolling equity interests between the Company and the Anchor noncontrolling interest owners at a contractually agreed upon value, with appraisal rights for all parties. Certain events, such as death, disability, retirement, resignation, or termination, may result in repurchase of the noncontrolling equity interests by the Company at the then contractually agreed upon value. The Anchor agreement provides a formulaic mechanism to determine the then value of the noncontrolling equity interests. These noncontrolling equity interests have a five-year vesting period. Beginning six months after vesting, a holder of noncontrolling equity interests may put up to 10% of his or her outstanding equity interests annually to the Company. The six-month holding period ensures the risks and rewards of ownership are transferred to the holder of the noncontrolling equity interests. Holders of noncontrolling equity interests must retain 50% of their total outstanding units until such time as they leave the firm.
In 2013, the Company sold certain repurchased noncontrolling interests to employees at Anchor with modified contingent call and put redemption features. These modified noncontrolling interests have the same terms and conditions as the previously issued noncontrolling interests with the exception that they require the approval of the Company’s CEO in order to be exercised. Therefore, these modified noncontrolling interests are not considered to be mandatorily redeemable and are not included in the redeemable noncontrolling interests within mezzanine equity, but rather within permanent equity.
In December 2017, the Company entered into an agreement to sell its interest in Anchor. The transaction is expected to close in the first quarter of 2018. While the assets and liabilities of Anchor are classified as held for sale on the Company’s consolidated balance sheet as of December 31, 2017, equity interests, including noncontrolling interests, and the related call and put redemption features remain in place.
The maximum redemption value, based on the contractually determined maximum redemption value formula, to repurchase the remaining approximately 20% of Anchor’s noncontrolling equity interests was approximately $9.8 million and $10.9 million as of December 31, 2017 and 2016, respectively. Of the $9.8 million of noncontrolling equity interests at December 31, 2017, $2.9 million is included in permanent equity and the remainder is included in mezzanine equity. Of the $10.9 million of noncontrolling equity interests at December 31, 2016, $2.0 million was included in permanent equity and the remainder was included in mezzanine equity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
BOS
The Company acquired approximately a 70% interest in BOS through a series of purchases dating back to February 5, 2004. The remaining approximate 30% is owned by BOS principals and certain retired principals. The BOS operating agreement describes a procedure for the orderly transfer of noncontrolling equity interests between the BOS noncontrolling interest owners and the Company at the then fair value, with appraisal rights for all parties. Certain events, such as death, disability, retirement, resignation, or voluntary termination, subject to the vesting period, will result in repurchase of the noncontrolling equity interests by the Company at the then fair value, unless another noncontrolling interest owner opts to purchase the noncontrolling equity interests in question. These noncontrolling equity interests have vesting periods of up to seven years. Immediately after vesting, a holder of noncontrolling equity interests may put up to the greater of 10% of his or her outstanding equity interests or 1% of total outstanding equity interests in BOS annually to the Company. Any unexercised portion of the annual put option can be carried forward to future years, provided that noncontrolling interest owners retain approximately 50% of their total outstanding units until such time as they leave the firm.
In 2015, the Company entered into an updated operating agreement with BOS which provides for a certain portion of the BOS noncontrolling interest owners’ to include modified contingent call and put redemption features. These modified noncontrolling interests have the same terms and conditions as the previously issued noncontrolling interests with the exception that they require the approval of the Company’s CEO in order to be exercised. Therefore, these modified noncontrolling interests are not considered to be mandatorily redeemable and are not included in the redeemable noncontrolling interests within mezzanine equity, but rather within permanent equity.
The maximum redemption value, based on fair value, to repurchase the remaining approximately 30% of BOS’ noncontrolling equity interests is approximately $8.1 million and $6.8 million as of December 31, 2017 and 2016, respectively. Of the $8.1 million of noncontrolling equity interests at December 31, 2017, $2.3 million is included in permanent equity and the remainder is included in mezzanine equity. Of the $6.8 million of noncontrolling equity interests at December 31, 2016, $2.2 million was included in permanent equity and the remainder was included in mezzanine equity.
DGHM
The Company acquired an 80% interest in DGHM on February 6, 2004. DGHM management and employees own the remaining 20% interest in DGHM. The DGHM operating agreement describes a process for the orderly transfer of noncontrolling equity interests between the Company and the DGHM noncontrolling interest owners at a contractually agreed upon value, with appraisal rights for all parties. Certain events, such as a change in control, death, disability, retirement, resignation or termination, may result in repurchase of the noncontrolling equity interests by the Company at the then contractually agreed upon value. The DGHM operating agreement provides a formulaic mechanism to determine the then value of the noncontrolling equity interests. These noncontrolling equity interests have a five-year vesting period. Beginning six months after vesting, a holder of noncontrolling equity interests may put up to between 10% and 20% of his or her outstanding units annually to the Company. The six-month holding period ensures the risks and rewards of ownership are transferred to the holder of the noncontrolling equity interests. Beginning in December 2009, the Company has an annual call right under which it may elect to repurchase between 10% and 20% of the non-management and management members’ vested units. No more than 40% of the outstanding noncontrolling equity interests’ units can be put in any one year. Certain key members of DGHM management are contractually obligated to retain 50% of their noncontrolling equity interests until such time as they leave the firm. The maximum redemption value, based on the contractually determined maximum redemption value formula, to repurchase the remaining 20% of DGHM’s noncontrolling equity interests is approximately $4.8 million and $3.4 million as of December 31, 2017 and 2016, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present an analysis of the Company’s redeemable noncontrolling interests for the periods indicated:
Impact on EPS from Certain Changes in Redemption Value
To the extent that the increase in the estimated maximum redemption amounts exceeds the net income attributable to the noncontrolling interests, such excess may reduce net income attributable to the Company’s common shareholders for purposes of the Company’s EPS computations depending upon how the maximum redemption value is calculated. In cases where the maximum redemption value is calculated using a contractually determined value or predefined formula, such as a multiple of EBITDA, there may be a reduction to the net income attributable to the Company’s common shareholders for purposes of the Company’s EPS computations. However, in cases where maximum redemption value is calculated using the then fair value, there is no effect on EPS. Fair value can be derived through an enterprise value using market observations of comparable firms, a discounted cash flow analysis, or a combination of the two, among other things, rather than a contractually predefined formula or multiple of EBITDA.
15. EQUITY
Preferred Stock
The Company has 2,000,000 depositary shares outstanding at both December 31, 2017 and December 31, 2016 (the “Depositary Shares”). Each Depositary Share represents a 1/40th interest in a share of the Company’s 6.95% Non-Cumulative Perpetual Preferred Stock, Series D, par value $1.00 per share and liquidation preference of $1,000 per share (the “Series D preferred stock”). This represents the entire $47.8 million balance of preferred stock on the Company’s balance sheet at both December 31, 2017 and December 31, 2016. The ability of the Company to declare and pay dividends on, or purchase, redeem or otherwise acquire, shares of its preferred stock or any securities of the Company that rank junior to the Series D preferred stock is subject to certain restrictions in the event that the Company does not declare and pay (or set aside) dividends on the Series D preferred stock for the last preceding quarterly dividend period. The Company may redeem the Series D preferred stock on any dividend payment date on or after June 15, 2018; or within 90 days of a change, proposed change, administrative decision, or re-interpretation in the laws, regulations, or guidelines regarding the regulatory capital treatment of the Series D preferred stock.
Common Stock
The Company has 170 million shares of common stock authorized for issuance. At December 31, 2017, it had 84,208,538 shares outstanding and 85,791,462 shares available for future issuance, including shares reserved for future issuance pursuant to the Company’s stock-based compensation plans, as discussed in Part II. Item 8. “Financial Statements and Supplementary Data - Note 18: Employee Benefits.” At December 31, 2016, it had 83,731,769 shares outstanding and 86,268,231 shares available for future issuance.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Warrants to Purchase Common Stock
The Company currently has one class of warrants to purchase common stock outstanding. These warrants were initially issued to the U.S. Department of the Treasury (the “Treasury”) (the “TARP warrants”). The following table summarizes the terms of the TARP warrant agreement outstanding at December 31, 2017:
___________________
(1)
The TARP warrants, while initially issued to the Treasury, were purchased from the Treasury by unrelated third parties at a market rate.
(2)
Per the terms of the TARP warrant agreement, the exercise price and number of shares issuable upon exercise may be adjusted ratably for dividends paid on the Company’s common stock that exceed the dividend rate at the time the warrants were issued, at which time the Company paid quarterly dividends of $0.01 per share. The current warrant share number and current exercise price of the warrant reflect the warrant as adjusted for common stock dividends through February 2, 2018, the latest dividend record date prior to the filing of this Annual Report.
Accumulated Other Comprehensive Income
Other comprehensive income/ (loss) represents the change in equity of the Company during a year from transactions and other events and circumstances from non-shareholder sources. It includes all changes in equity during a year except those resulting from investments by shareholders and distributions to shareholders.
The following table presents the Company’s comprehensive income/ (loss) and related tax effect for the years ended December 31, 2017, 2016, and 2015:
___________________
(1)
Pre-tax net income attributable to the Company is calculated as income before income taxes, plus net income from discontinued operations, less net income attributable to noncontrolling interests.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents a summary of the amounts reclassified from accumulated other comprehensive income/ (loss) for the years ended December 31, 2017, 2016, and 2015:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the after-tax changes in the components of the Company’s accumulated other comprehensive income/ (loss) for the years ended December 31, 2017, 2016, and 2015:
16. EARNINGS PER SHARE
Earnings Per Share (“EPS”)
Basic EPS is computed by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding during the year. Diluted EPS is determined in the same manner as basic EPS except that the number of shares is increased assuming exercise or contingent issuance of the options, warrants or other dilutive securities; and conversion of the convertible trust preferred securities. Additionally, when dilutive, interest expense (net of tax) related to the convertible trust preferred securities is added back to net income attributable to common shareholders. The calculation of diluted EPS excludes the potential dilution of common shares and the inclusion of any related expenses if the effect is antidilutive.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present a reconciliation of the components of basic and diluted EPS computations for the three years ended December 31:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
_____________________
(1)
See Part II. Item 8. “Financial Statements and Supplementary Data - Note 14: Noncontrolling Interests” for a description of the redemption values related to the redeemable noncontrolling interests. In accordance with ASC 480, Distinguishing Liabilities from Equity (“ASC 480”), an increase in redemption values from period to period reduces income attributable to common shareholders. Decreases in redemption value from period to period increase income attributable to common shareholders, but only to the extent that the cumulative change in redemption value remains a cumulative increase since adoption of this standard in the first quarter of 2009.
(2)
The Company presents its EPS based on the treasury stock method. The Company reverted to the treasury stock presentation from the two-class presentation due to the immaterial number of participating shares outstanding as of March 31, 2016. There is no difference between the calculation of EPS based on the treasury stock method and the calculation of EPS based on the two-class method for the year ended December 31, 2017.
If the EPS presentation had been based on the two-class method, the following adjustments would have been made to the presentation of EPS for the year ended December 31, 2016. Net income attributable to common shareholders would have been reduced by an additional $4 thousand, for the year ended December 31, 2016. The allocation of net income to participating securities would have been $8 thousand for the year ended December 31, 2016, reducing net income attributable to common shareholders by a total of $12 thousand for the same period. Basic EPS would not change. Weighted average diluted shared outstanding would have been reduced by 7,185 shares for the year ended December 31, 2016. Diluted EPS would not change.
If the EPS presentation had been based on the two-class method, the following adjustments would have been made to the presentation of EPS for the year ended December 31, 2015. Net income attributable to common shareholders would have been reduced by an additional $90 thousand for the year ended December 31, 2015, and the allocation of net income to participating securities would have been $92 thousand for the same period, reducing net income attributable to common shareholders by a total of $182 thousand, for the same period. Total basic EPS and basic EPS from continuing operations would each decrease by $0.01 per share for the year ended December 31, 2015. Weighted average diluted shares outstanding would have been reduced by 167,937 shares for the same period. Diluted EPS would not change.
(3)
The diluted EPS computations for the years ended December 31, 2017, 2016, and 2015 do not assume the conversion, exercise or contingent issuance of the following shares for the following periods because the result would have been antidilutive for the periods indicated. As a result of the anti-dilution, the potential common shares excluded from the diluted EPS computation are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(a)
If the effect of the conversion of the trust preferred securities would have been dilutive, an immaterial amount of interest expense, net of tax, related to the convertible trust preferred securities would have been added back to net income attributable to common shareholders for the diluted EPS computation for the years presented.
(b)
Options to purchase shares of common stock, non-participating performance- and certain time-based restricted stock, and other dilutive securities that were outstanding at period ends were not included in the computation of diluted EPS or in the above anti-dilution table because their exercise or conversion prices were greater than the average market price of the common shares during the respective periods.
17. INCOME TAXES
The components of income tax expense for continuing operations for the years ended December 31, 2017, 2016, and 2015 are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income tax expense attributable to income from continuing operations differs from the amounts computed by applying the Federal statutory rate to pre-tax income from continuing operations. Reconciliations between the Federal statutory income tax rate of 35% to the effective income tax rate for the years ended December 31, 2017, 2016, and 2015 are as follows:
On December 22, 2017, H.R. 1, the Tax Act, was enacted by the U.S. government. Substantially all of the provisions of the Tax Act are effective as of January 1, 2018. The Tax Act includes significant changes to the Internal Revenue Code of 1986, as amended, including amendments which significantly change the taxation of business entities. The more significant changes in the Tax Act that impact the Company are the reduction in the federal corporate tax rate from 35% to 21% and the changes to the deductibility of executive compensation, both of which are effective as of January 1, 2018. Under ASC 740, the tax effects of changes in tax laws must be recognized in the period in which the law is enacted, or December 22, 2017 for the Tax Act. ASC 740 also requires deferred tax assets and liabilities to be measured at the enacted tax rate expected to apply when temporary differences are to be realized or settled. The Company re-measured its deferred tax assets and liabilities at the 21% federal corporate tax rate, reevaluated its investments in affordable housing projects using the 21% federal corporate tax rate, and reduced its deferred tax assets associated with executive compensation that is no longer deductible. As a result of these changes, the Company recorded a federal tax expense of $12.9 million in the fourth quarter of 2017.
The staff of the SEC has recognized the complexity of reflecting the impacts of the Tax Act, and on December 22, 2017 issued guidance in Staff Accounting Bulletin No. 118 (“SAB 118”) which clarifies accounting for income taxes under ASC 740 if information is not yet available or complete and provides for up to a one year period in which to complete the required analyses and accounting. SAB 118 describes three scenarios associated with a company’s status of accounting for income tax reform: (1) a company is complete with its accounting for certain effects of tax reform, (2) a company is able to determine a reasonable estimate for certain effects of tax reform and records that estimate as a provisional amount, or (3) a company is not able to determine a reasonable estimate and therefore continues to apply ASC 740, based on the provisions of the tax laws that were in effect immediately prior to the Tax Act being enacted. The Company completed its accounting of the effects of the Tax Act which have been reflected in the December 31, 2017 financial statements.
During the third quarter of 2015, the Company reevaluated its executive compensation plans and identified certain executive compensation that was previously treated as fully deductible was non-deductible. The correction resulted in $1.2 million of additional federal tax expense and $0.2 million of additional state tax, net of federal tax benefit, that was related to prior years. After evaluating the quantitative and qualitative aspects of the correction, the Company determined that previously issued consolidated financial statements were not materially misstated and, as a result, recorded the correction in 2015.
On April 13, 2015, New York City enacted legislation that requires corporations that are engaged in unitary business operations to file combined returns with their affiliates for tax years beginning on or after January 1, 2015. Starting in 2015, all of the Company’s affiliates are included in the Company’s New York City tax return instead of just those affiliates with nexus to New York City. The Company incorporated the impact of these New York City tax law changes in 2015 due to the law being enacted in 2015. The Company adjusted the New York City apportionment percentages for purposes of measuring deferred tax assets and liabilities that will reverse after the effective date. As a result of these changes, the Company recorded a state tax benefit of $0.5 million, net of federal tax, in 2015.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The components of gross deferred tax assets and gross deferred tax liabilities at December 31, 2017 and 2016 are as follows:
Of the $26.4 million net decrease in the Company’s net deferred tax asset during 2017, $22.5 million was recognized as deferred income tax expense, $0.3 million was recognized as deferred income tax expense for discontinued operations, and $3.6 million was recognized as a decrease to shareholders’ equity. The $22.5 million deferred income tax expense includes $11.8 million from the re-measurement of deferred tax assets and liabilities due to the reduction in the federal corporate tax rate from 35% to 21% effective January 1, 2018 and $0.7 million from the reduction of deferred tax assets associated with executive compensation that is no longer deductible as a result of the Tax Act.
In accordance with ASC 740, deferred tax assets are to be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of the tax benefit depends upon the existence of sufficient taxable income of the appropriate character within the carry-forward periods.
The Company believes that it is more likely than not that the net deferred tax asset as of December 31, 2017 will be realized, based primarily upon the ability to generate future taxable income. Other positive evidence to support the realization of the Company’s net deferred tax asset includes:
•
The Company had cumulative pre-tax income, as adjusted for permanent book-to-tax differences, in the period 2015 through 2017.
•
Certain tax planning strategies are available to the Company, such as reducing investments in tax-exempt securities.
•
The Company has not had any operating loss or tax credit carryovers expiring unused in recent years.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A reconciliation of the beginning and ending gross amount of unrecognized tax benefits under the provisions of ASC 740-10 is as follows:
The Company does not currently believe there is a reasonable possibility of any significant change to unrecognized tax benefits within the next twelve months.
Excluded from the gross amount of unrecognized tax benefits for the years ended December 31, 2017, 2016, and 2015 are the federal tax benefits associated with the gross amount of state unrecognized tax benefits which, if recognized, would affect the effective tax rate. The net amount of unrecognized tax benefit which, if recognized, would affect the effective tax rate is $0.9 million at December 31, 2017 and $0.8 million at December 31, 2016 and 2015.
The Company classifies interest and penalties, if applicable, related to unrecognized tax benefits as a component of income tax expense in the consolidated statements of operations. Interest and penalties recognized as part of the Company’s income tax expense was immaterial for the years ending December 31, 2017, 2016, and 2015. The accrued amounts for interest and penalties were immaterial as of December 31, 2017, 2016, and 2015.
Federal income tax returns remain subject to examination by the Internal Revenue Service for all tax years subsequent to 2013. The examinations by the Internal Revenue Service for the tax years ended December 31, 2009 and December 31, 2012 were settled in August 2015 and December 2017, respectively. The resolution of these examinations did not have a significant impact on the effective tax rate.
State income tax returns for the Company’s major tax jurisdictions of California, Florida, Massachusetts, and New York have either been examined or remain subject to examination for all the tax years subsequent to 2013. The examination by the State of New York for the tax year ended December 31, 2012 was settled in February 2015 and the examinations by the State of New York for the tax years ended December 31, 2013 and 2014 were settled in June 2017. The resolution of these examinations did not have a significant impact on the effective tax rate.
18. EMPLOYEE BENEFITS
Employee 401(k) Profit Sharing Plan
The Company established a corporate-wide 401(k) Profit Sharing Plan (the “401(k) Plan”) for the benefit of the employees of the Company and its affiliates, which became effective on July 1, 2002. The 401(k) Plan is a 401(k) savings and retirement plan that is designed to qualify as an ERISA section 404(c) plan. Generally, employees who are at least twenty-one (21) years of age are eligible to participate in the plan on their date of hire. Employee contributions may be matched based on a predetermined formula and additional discretionary contributions may be made. 401(k) Plan expense was $3.3 million, $3.0 million, and $2.8 million, in the years ended December 31, 2017, 2016, and 2015, respectively.
Salary Continuation Plans
The Bank maintains a salary continuation plan for certain former officers in the Bank’s San Francisco Bay Area market. The officers became eligible for benefits under the salary continuation plan if they reached a defined retirement age while working for the Bank. The Bank also has a deferred compensation plan for certain former directors of the former private banking affiliate in the San Francisco Bay Area that was merged into the Bank. The compensation expense relating to each contract is accounted for individually. The expense relating to these plans was $0.1 million for each of the years ended December 31, 2017, 2016, and 2015. The amount recognized in other liabilities in the consolidated balance sheets was $1.0 million and $1.1 million at December 31, 2017 and 2016, respectively. The Bank has purchased life insurance contracts to help fund these plans. The Bank has single premium life insurance policies with cash surrender values totaling $6.1 million and $6.3 million, which are included in other assets in the consolidated balance sheets, as of December 31, 2017 and 2016, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Bank also maintains a salary continuation plan for certain former officers of the Bank’s Southern California market. The plan provides for payments to the participants at the age of retirement. The expense relating to these plans was $0.1 million for each of the years ended December 31, 2017, 2016, and 2015. The net amount recognized in other liabilities in the consolidated balance sheets was $1.7 million and $1.9 million at December 31, 2017 and 2016, respectively. The Bank has purchased life insurance contracts to help fund these plans. These life insurance policies have cash surrender values totaling $4.9 million and $4.8 million at December 31, 2017 and 2016, respectively, which are included in other assets in the consolidated balance sheets.
Deferred Compensation Plan
The Company offers a deferred compensation plan (the “Deferred Compensation Plan”) that enables certain executives to elect to defer a portion of their compensation. The amounts deferred are excluded from the employee’s taxable income and are not deductible for income tax purposes by the Company until paid. The net deferred amount related to the Deferred Compensation Plan in other liabilities in the consolidated balance sheets was $7.1 million and $6.1 million at December 31, 2017 and 2016, respectively. Increases and decreases in the value of the Deferred Compensation Plan are recognized as compensation expense in the consolidated statements of operations. The expense relating to the Deferred Compensation Plan was an expense of $0.9 million, an expense of $0.6 million, and an expense credit of $0.1 million for the years ended December 31, 2017, 2016, and 2015, respectively.
The Company has adopted a special trust for the Deferred Compensation Plan called a Rabbi Trust. A Rabbi Trust is an arrangement that is used to accumulate assets that may be used to “fund” the Company’s obligation to pay benefits under the Deferred Compensation Plan. However, to prevent immediate taxation to the executives who participate in the Deferred Compensation Plan, the amounts placed in the Rabbi Trust must remain subject to the claims of the Company’s creditors. The investments chosen by the participants in the Deferred Compensation Plan are mirrored by the Rabbi Trust as a way to minimize the earnings volatility of the Deferred Compensation Plan. The net amount recognized in other assets in the consolidated balance sheets was $7.1 million and $6.1 million at December 31, 2017 and 2016, respectively. Increases and decreases in the value of the Rabbi Trust are recognized in other income in the consolidated statement of operations. The income relating to this plan was a gain of $0.9 million, a gain of $0.6 million, and a loss of $0.1 million for the years ended December 31, 2017, 2016, and 2015, respectively.
Stock-Based Incentive Plans
At December 31, 2017, the Company has three stock-based compensation plans. These plans encourage and enable the officers, employees, and non-employee directors of the Company to acquire a proprietary interest in the Company.
The 2009 Stock Option and Incentive Plan (the “2009 Plan”), replaced the Company’s 2004 Stock Option and Incentive Plan. Under the 2009 Plan, the Company may grant options, stock appreciation rights, restricted stock, restricted stock units, unrestricted stock awards, performance share awards and dividend equivalent rights to its officers, employees, and non-employee directors of the Company for an amount not to exceed 2% of the total shares of common stock outstanding as of the last business day of the preceding fiscal year. The 2009 Plan provides for the authorization and issuance of 4,000,000 shares, along with any residual shares from previous plans. Under the 2009 Plan, the exercise price of each option shall not be less than 100% of the fair market value of the stock on the date the options are granted. Generally, options expire ten years from the date granted and vest over a three-year graded vesting period for officers and employees and a one-year or less period for non-employee directors. Stock grants generally vest over a three-year cliff vesting period. As of December 31, 2017 the maximum number of shares of stock reserved and available for issuance under the Plan was 2,414,842.
Under the Boston Private Financial Holdings, Inc. 2010 Inducement Stock Plan (the “Inducement Plan”), the Company may grant equity awards to new employees as an inducement to join the Company. The Company reserved 1,245,000 shares of the Company’s common stock for issuance under the Inducement Plan. The terms of the Inducement Plan are substantially similar to the terms of the 2009 Plan. In 2015, the Company issued an additional 22,936 shares under this plan in conjunction with an executive new hire. In 2016, the Company issued 37,177 shares under this plan in conjunction with executive new hires. In 2017, the Company issued 24,569 shares under this plan in conjunction with executive new hires. At December 31, 2017, the Inducement Plan had 727,491 reserved and available for issuance.
The Company maintains a qualified Employee Stock Purchase Plan (“ESPP”). Under the ESPP, eligible employees may purchase common stock of the Company at 85 percent of the lower of the closing price of the Company’s common stock on the first or last day of a six month purchase period on The NASDAQ® Global Select Market. Employees pay for their stock purchases through payroll deductions at a rate equal to any whole percentage from 1 percent to 15 percent of after-tax earnings. Participants have a right to a full reimbursement of ESPP deferrals through the end of the offering period. Such a reimbursement would result in a reversal of the compensation expense previously recorded, attributed to that participant. The
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Company issues shares under the ESPP in January and July of each year. As of December 31, 2017, there were 637,442 shares available for issuance in the ESPP. There were 140,284 shares issued to participants under the qualified ESPP in 2017.
Share-based payments recorded in salaries and benefits expense are as follows:
Stock Options
A summary of option activity under the 2009 Plan for the year ended December 31, 2017 is as follows:
The total intrinsic value of options exercised during the years ended December 31, 2017, 2016, and 2015 was $0.9 million, $1.5 million, and $0.7 million, respectively. As of December 31, 2017, there was no unrecognized compensation cost related to stock option arrangements granted under the 2009 Plan.
Restricted Stock
A summary of the Company’s nonvested shares as of December 31, 2017 and changes during the year ended December 31, 2017, including shares under both the 2009 Plan and the Inducement Plan, is as follows:
The fair value of nonvested shares is determined based on the closing price of the Company’s stock on the grant date. The weighted-average grant-date fair value of shares granted during the years ended December 31, 2017, 2016, and 2015 was $15.55, $11.58, and $12.41, respectively. At December 31, 2017, there was $10.8 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements under the 2009 Plan and the Inducement Plan, combined. That cost is expected to be recognized over a weighted-average period of 2.01 years. The total fair value of shares
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
that vested during the years ended December 31, 2017, 2016, and 2015 was $8.0 million, $5.3 million, and $5.3 million, respectively.
Included in the restricted stock balances above are performance shares, which are granted to certain employees within the Company and are accounted for in the same manner as restricted stock. At December 31, 2017, there were 811,286 performance shares outstanding, which could increase up to 1,558,411 shares. If the maximum number of performance shares is issued, the Company would incur an additional $9.8 million of compensation costs related to these additional 747,125 shares. The Company recognizes the expense for performance shares based upon the most likely outcome of shares to be issued based on current forecasts.
Supplemental Executive Retirement Plans
The Company has a non-qualified supplemental executive retirement plan (“SERP”) with a former executive officer of the Company. The SERP, which is unfunded, provides a defined cash benefit based on a formula using average compensation, years of service, and age at retirement of the executive. The estimated actuarial present value of the projected benefit obligation was $7.9 million and $8.2 million at December 31, 2017 and 2016, respectively. The expense associated with the SERP was $0.4 million, $0.5 million, and $0.5 million for the years ended December 31, 2017, 2016, and 2015, respectively. The discount rate used to calculate the SERP liability was 3.60%, 4.10%, and 4.35% for the years ended December 31, 2017, 2016, and 2015, respectively.
The Bank has a SERP with various former executives of the Pacific Northwest market. The SERP, which is unfunded, provides a defined cash benefit based on a formula using compensation, years of service, and age at retirement of the executives. The benefits for each executive under the plan are accrued until the full vesting age of 65. The actuarial present value of the projected benefit obligation was $3.2 million at both December 31, 2017 and 2016. The expense associated with the SERP was $0.2 million for each of the years ended December 31, 2017, 2016, and 2015. The discount rate used to calculate the SERP liability was 3.37%, 3.62%, and 3.81%, for the years ended December 31, 2017, 2016, and 2015, respectively.
KLS has a long term incentive plan (“LTIP”) with certain of its managing directors. This LTIP, which is unfunded, provides for a profit sharing based on current year results as well as a cash benefit at the time of separation of service. The cash payment at separation of service, which is determined based on the profit share and a multiple based on years of service, is payable in three equal annual installments following separation of service. The Company has accrued $8.1 million and $7.6 million at December 31, 2017 and 2016, respectively, for future separation of service payments. The LTIP was effective beginning January 1, 2010. The expense associated with the LTIP was $0.5 million, $(0.2) million, and $1.3 million for the years ended December 31, 2017, 2016, and 2015, respectively. The discount rate used to calculate the SERP liability was 3.33%, 3.70%, and 3.90% for the years ended December 31, 2017, 2016, and 2015, respectively.
19. OTHER OPERATING EXPENSE
Major components of other operating expense are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
20. REPORTABLE SEGMENTS
Management Reporting
The Company has four reportable segments: Private Banking, Wealth Management and Trust, Investment Management, and Wealth Advisory, and the Parent Company (Boston Private Financial Holdings, Inc.) (the “Holding Company”). The financial performance of the Company is managed and evaluated by these four areas. The segments are managed separately as a result of the concentrations in each function.
The Company’s Segment Chief Executive Officers (“CEOs”) manage the segments and have full authority and responsibility for the performance and the allocation of resources within their respective segments. The Company’s CEO is the Company’s Chief Operating Decision Maker (“CODM”) .
The day to day activities of the affiliates are managed by the affiliate CEOs, except in the Private Banking segment. The Company’s CEO is also the Bank’s CEO. The president of the Bank is the Private Banking Segment CEO and reports to the Company CEO. The Segment CEOs have authority with respect to the allocation of capital within their segments, management oversight responsibility, performance assessments, and overall authority and accountability for all of the affiliates, if any, within their segment. The Segment CEO for the non-banks communicates with the affiliate CEOs regarding profit and loss responsibility, strategic planning, priority setting and other matters. The Holding Company’s Chief Financial Officer reviews all affiliate financial detail with the CODM on a monthly basis.
Description of Reportable Segments
Private Banking
The Private Banking segment operates primarily in three geographic markets: New England, the San Francisco Bay Area, and Southern California.
The Bank currently conducts business under the name of Boston Private Bank & Trust Company in all markets. The Bank is chartered by The Commonwealth of Massachusetts and is insured by the FDIC. The Bank is principally engaged in providing private banking services to high net worth individuals, privately owned businesses and partnerships, and nonprofit organizations. In addition, the Bank is an active provider of financing for affordable housing, first-time homebuyers, economic development, social services, community revitalization and small businesses.
Wealth Management and Trust
The Wealth Management and Trust segment is comprised of the trust operations of the Bank and the operations of Boston Private Wealth. The segment offers investment management, wealth management, family office, and trust services to individuals, families, and institutions. The Wealth Management and Trust segment operates in New England; South Florida; California; and Madison, Wisconsin.
Investment Management
The Investment Management segment currently has two consolidated affiliates, including DGHM and Anchor, both of which are registered investment advisers (“RIAs”). After the expected sale of Anchor in the first quarter of 2018, DGHM will be the only affiliate in the Investment Management segment. The Investment Managers serve the needs of pension funds, endowments, trusts, foundations and select institutions, mutual funds and high net worth individuals and their families throughout the U.S. and abroad. The Investment Managers specialize in value-driven equity portfolios with products across the capitalization spectrum. The specific mix of products, services and clientele varies between affiliates. The Investment Managers are located in New England and New York, with one affiliate administrative office in South Florida.
Wealth Advisory
The Wealth Advisory segment has two consolidated affiliates, including KLS and BOS, both of which are RIAs and wealth management firms. The Wealth Advisors provide comprehensive, planning-based financial strategies to high net worth individuals and their families, and non-profit institutions. The services the firms offer include fee-only financial planning, tax planning, tax preparation, estate and insurance planning, retirement planning, charitable planning and intergenerational gifting and succession planning. The Wealth Advisors manage investments covering a wide range of asset classes for both taxable and tax-exempt portfolios. The Wealth Advisors are located in New York, Southern California and Northern California.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Measurement of Segment Profit and Assets
The accounting policies of the segments are the same as those described in Part II. Item 8. “Financial Statements and Supplementary Data - Note 1: Basis of Presentation and Summary of Significant Accounting Policies.”
Reconciliation of Reportable Segment Items
The following tables present a reconciliation of the revenues, profits, assets, and other significant items of reportable segments as of and for the year ended December 31, 2017, 2016, and 2015. Interest expense on junior subordinated debentures is reported at the Holding Company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
___________________
(1)
The Company’s effective tax rate for 2017, 2016, and 2015 is not consistent due to the re-measurement of the deferred tax assets, impairment of goodwill not deductible for tax purposes, earnings from tax-exempt investments, non-deductible compensation, state and local taxes, income tax credits and income attributable to noncontrolling interests having a different impact on the effective tax rate due primarily to the different levels of income before taxes in years 2017, 2016, and 2015. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 17: Income Taxes” for additional details.
(2)
Operating expense related to the Wealth Management and Trust segment includes restructuring expenses of $2.0 million, and $3.7 million for the years ending December 31, 2016 and 2015 respectively, and a goodwill impairment charge of $9.5 million for the year ended December 31, 2016.
(3)
Operating expense related to the Investment Management Segment includes a goodwill impairment charge of $24.9 million for the year ended December 31, 2017.
(4)
Fees and other income for the Holding Company includes a loss on the sale of $1.3 million for the year ended December 31, 2017 related to the classification of Anchor as held for sale.
(5)
The Holding Company and Eliminations calculation of Net Income attributable to the Company includes net income from Discontinued Operations for the years ended December 31, 2017, 2016 and 2015 of $4.9 million, $5.5 million, and $6.4 million, respectively.
21. FAIR VALUE MEASUREMENTS
Fair value is defined under GAAP as the exchange price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments based on the fair value hierarchy established in ASC 820, Fair Value Measurements and Disclosures (“ASC 820”), which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 describes three levels of inputs that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2017 and 2016, aggregated by the level in the fair value hierarchy within which those measurements fall:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2017 and 2016, available-for-sale securities consisted primarily of U.S. government and agency securities, government-sponsored entities securities, municipal bonds, mortgage-backed securities, and other available-for-sale securities. Available-for-sale Level 1 securities are valued with prices quoted in active markets and include U.S. Treasury securities (which are categorized as U.S. government and agencies securities) and equities (which are categorized as other available-for-sale securities). Available-for-sale Level 2 securities generally have quoted prices but are traded less frequently than exchange-traded securities and can be priced using market data from similar assets and include government-sponsored entities securities, municipal bonds, mortgage-backed securities, and certain investments in SBA loans (which are categorized as U.S. government and agencies securities). No investments held at December 31, 2017 or 2016 were categorized as Level 3. There were no changes in the valuation techniques used for measuring the fair value, nor were there any transfers between Levels 1 and 2, of available-for-sale securities in the years ended December 31, 2017 and 2016.
In managing its interest rate and credit risk, the Company utilizes derivative instruments including interest rate customer swaps, interest rate swaps, and risk participation agreements. As a service to its customers. the Company may utilize derivative instruments including customer foreign exchange forward contracts to manage its foreign exchange risk, if any. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities, and therefore, they have been categorized as a Level 2 measurement as of December 31, 2017 and 2016. There were no transfers between Levels 1 and 2 in the years ended 2017 and 2016. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 9: Derivatives and Hedging Activities” for further details.
To comply with the provisions of ASC 820, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees. Counterparty exposure is evaluated by netting positions that are subject to master netting agreements, as well as considering the amount of collateral securing the position.
The Company has determined that the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, although the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. As a result, the Company has
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy as of December 31, 2017 and 2016.
Other investments, which are not considered available-for-sale investments, consist of deferred compensation trusts, which consist of publicly traded mutual fund investments that are valued at prices quoted in active markets. Therefore, they have been categorized as a Level 1 measurement as of December 31, 2017 and 2016. There were no transfers between Levels 1 and 2 in the years ended 2017 and 2016.
There were no Level 3 assets valued on a recurring basis as of December 31, 2017 or 2016.
The following tables present the Company’s assets and liabilities measured at fair value on a non-recurring basis during the periods ended December 31, 2017 and 2016, respectively, aggregated by the level in the fair value hierarchy within which those measurements fall:
___________________
(1)
Collateral-dependent impaired loans held as of December 31, 2017 that had write-downs in fair value or whose specific reserve changed during 2017.
(2)
Goodwill balance at Anchor as of December 31, 2017 that had write-downs in fair value during 2017. The goodwill balance related to Anchor is recorded in other assets held for sale as of December 31, 2017. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for further detail.
___________________
(1)
Collateral-dependent impaired loans held as of December 31, 2016 that had write-downs in fair value or whose specific reserve changed during 2016
(2)
OREO held as of December 31, 2016 that had write-downs in fair value during 2016.
(3)
Goodwill balance at Boston Private Wealth as of December 31, 2016 that had write-downs in fair value during 2016. See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for further detail.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present additional quantitative information about assets measured at fair value on a non-recurring basis for which the Company has utilized Level 3 inputs to determine fair value:
See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for additional quantitative information about the 2017 goodwill impairment charges at Anchor.
See Part II. Item 8. “Financial Statements and Supplementary Data - Note 8: Goodwill and Other Intangible Assets” for additional quantitative information about the 2016 goodwill impairment charges at Boston Private Wealth.
Impaired loans include those loans that were adjusted to the fair value of underlying collateral as required under ASC 310, Receivables. The amount does not include impaired loans that are measured based on expected future cash flows discounted at the respective loan’s original effective interest rate, as that amount is not considered a fair value measurement. The Company uses appraisals, which management may adjust to reflect estimated fair value declines, or apply other discounts to appraised values for unobservable factors resulting from its knowledge of the property or consideration of broker quotes. The appraisers use a market, income, and/or a cost approach in determining the value of the collateral. Therefore they have been categorized as a Level 3 measurement.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables present the carrying values and fair values of the Company’s financial instruments that are not measured at fair value on a recurring basis (other than certain loans, as noted below):
The estimated fair values have been determined by using available quoted market information or other appropriate valuation methodologies. The aggregate fair value amounts presented above do not represent the underlying value of the financial assets and liabilities of the Company taken as a whole as they do not reflect any premium or discount the Company might recognize if the assets were sold or the liabilities sold, settled, or redeemed. An excess of fair value over book value on financial assets represents a premium, or gain, the Company might recognize if the assets were sold, while an excess of book value over fair value on financial liabilities represents a premium, or gain, the Company might recognize if the liabilities were
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
sold, settled, or redeemed prior to maturity. Conversely, losses would be recognized if assets were sold where the book value exceeded the fair value or liabilities were sold where the fair value exceeded the book value.
The fair value estimates provided are made at a specific point in time, based on relevant market information and the characteristics of the financial instrument. The estimates do not provide for any premiums or discounts that could result from concentrations of ownership of a financial instrument. Because no active market exists for some of the Company’s financial instruments, certain fair value estimates are based on subjective judgments regarding current economic conditions, risk characteristics of the financial instruments, future expected loss experience, prepayment assumptions, and other factors. The resulting estimates involve uncertainties and are considered best estimates. Changes made to any of the underlying assumptions could significantly affect the estimates.
Cash and cash equivalents
The carrying value reported in the balance sheet for cash and cash equivalents approximates fair value due to the short-term nature of their maturities and are classified as Level 1.
Held-to-maturity investment securities
Held-to-maturity securities currently include mortgage-backed securities. The mortgage-backed securities are fixed income instruments that are not quoted on an exchange, but may be traded in active markets. The fair value of these securities is based on quoted market prices obtained from external pricing services. The principal market for our securities portfolio is the secondary institutional market, with an exit price that is predominantly reflective of bid level pricing in that market. Accordingly, held-to-maturity mortgage-backed securities are included in the Level 2 fair value category.
Loans held for sale
Loans held for sale are recorded at the lower of cost or fair value in the aggregate. Fair value estimates are based on actual commitments to sell the loans to investors at an agreed upon price or current market prices if rates have changed since the time the loan closed. Accordingly, loans held for sale are included in the Level 2 fair value category.
Loans, net
Fair value estimates are based on loans with similar financial characteristics. Fair values of commercial and residential mortgage loans are estimated by discounting contractual cash flows adjusted for prepayment estimates and using discount rates approximately equal to current market rates on loans with similar credit and interest rate characteristics and maturities. The fair value estimates for home equity and other loans are based on outstanding loan terms and pricing in the local markets. The method of estimating the fair value of the loans disclosed in the table above does not incorporate the exit price concept in the presentation of the fair value of these financial instruments. Net loans are included in the Level 3 fair value category based upon the inputs and valuation techniques used.
Other financial assets
Other financial assets consist of accrued interest and fees receivable, and stock in Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank (“FRB”), for which the carrying amount approximates fair value, and are classified as Level 2.
Deposits
The fair values reported for transaction accounts (demand, NOW, savings, and money market) equal their respective book values reported on the balance sheet and are classified as Level 2. The fair values disclosed are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are based on the discounted value of contractual cash flows. The discount rates used are representative of approximate rates currently offered on certificates of deposit with similar remaining maturities and are classified as Level 2.
Securities sold under agreements to repurchase
The fair value of securities sold under agreements to repurchase are estimated based on contractual cash flows discounted at the Bank’s incremental borrowing rate for FHLB borrowings with similar maturities and have been classified as Level 2.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Federal funds purchased
The carrying amounts of federal funds purchased approximate fair value due to their short-term nature and therefore these funds have been classified as Level 2.
Federal Home Loan Bank borrowings
The fair value reported for FHLB borrowings is estimated based on the discounted value of contractual cash flows. The discount rate used is based on the Bank’s estimated current incremental borrowing rate for FHLB borrowings of similar maturities and therefore these borrowings have been classified as Level 2.
Junior subordinated debentures
The fair value of the junior subordinated debentures issued by Boston Private Capital Trust I and Boston Private Capital Trust II were estimated using Level 3 inputs such as the interest rates on these securities, current rates for similar debt, a consideration for illiquidity of trading in the debt, and regulatory changes that would result in an unfavorable change in the regulatory capital treatment of this type of debt.
Other financial liabilities
Other financial liabilities consists of accrued interest payable for which the carrying amount approximates fair value and is classified as Level 2.
Financial instruments with off-balance sheet risk
The Bank’s commitments to originate loans and for unused lines and outstanding letters of credit are primarily at market interest rates and therefore, the carrying amount approximates fair value.
22. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to originate loans, unadvanced portion of loans, unused lines of credit, standby letters of credit, commitments to sell loans, and rate locks related to loans that if originated will be held for sale. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to originate loans, the unadvanced portion of loans, and the unused lines of credit are agreements to lend to a client, provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the borrower.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a client to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to clients.
Loans sold to investors have recourse to the Company on any loans that are deemed to have been fraudulent or misrepresented. In addition, investors would require the Company to repurchase any loan sold which has a first payment default. The Company has not repurchased any loans during the years ended December 31, 2017 and 2016.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Financial instruments with off-balance sheet risk are summarized as follows:
23. BOSTON PRIVATE FINANCIAL HOLDINGS, INC. (PARENT COMPANY ONLY)
CONDENSED BALANCE SHEETS
___________________
(1)
Includes noncontrolling interests and the maximum redemption value of redeemable noncontrolling interests.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF OPERATIONS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
24. REGULATORY MATTERS
Wealth Management and Trust, Investment Management, and Wealth Advisory
The Company’s Wealth Management and Trust, Investment Management, and Wealth Advisory businesses are highly regulated, primarily at the federal level by the SEC, and by state regulatory agencies. The Company has subsidiaries which are RIAs under the Investment Advisers Act of 1940. The Investment Advisers Act of 1940 imposes numerous obligations on RIAs, including fiduciary, record keeping, operational, and disclosure obligations. The subsidiaries, as investment advisers, are also subject to regulation under the federal and state securities laws and the fiduciary laws of certain states. In addition, the Company has subsidiaries which act as sub-advisers to mutual funds, which are registered under the Investment Company Act of 1940 and are subject to that Act’s provisions and regulations. The Company’s subsidiaries are also subject to the provisions and regulations of ERISA, to the extent any such entities act as a “fiduciary” under ERISA with respect to certain of its clients. ERISA and the related provisions of the federal tax laws impose a number of duties on persons who are fiduciaries under ERISA, and prohibit certain transactions involving the assets of each ERISA plan which is a client, as well as certain transactions by the fiduciaries and certain other related parties to such plans.
Private Banking
The Company and the Bank are subject to extensive supervision and regulation by the Federal Reserve, the FDIC, which insures the deposits of the Bank to the maximum extent permitted by law, and the Massachusetts Commissioner of Banks. The federal and state laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds, and the nature and amount of collateral for certain loans. The laws and regulations governing the Bank generally have been promulgated to foster the safety and soundness of the Bank and protect depositors, and not for the purpose of protecting shareholders of the Company.
As of December 31, 2017, quantitative measures established by regulation to ensure capital adequacy required us to maintain minimum ratios of CET1, Tier 1, and total capital (as defined in the regulations) to risk-weighted assets (as defined in the regulations) and of Tier 1 capital (as defined in the regulations) to average assets (as defined in the regulations).
The following table presents the Company’s and the Bank’s amount of regulatory capital and related ratios as of December 31, 2017 and 2016. Also presented are the minimum requirements established by the Federal Reserve and the FDIC as of those dates for the Company and the Bank, respectively, to meet applicable capital requirements and the requirements of the FDIC as of those dates for the Bank to be considered “well capitalized” under the FDIC’s prompt corrective action provisions. On July 28, 2017, Boston Private Bank became a member of the Federal Reserve System.
The Federal Reserve and the Massachusetts Commissioner of Banks may impose higher capital ratios than those listed below based upon the results of regulatory exams. The Bank was categorized as “well capitalized” under the FDIC’s prompt corrective action provisions as of December 31, 2017 and 2016.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
___________________
n/a
= not applicable
(1)
Required capital ratios under the Basel III capital rules with the fully phased-in capital conservation buffer added to the minimum risk-based capital ratios. The fully phased-in ratios are effective for 2019, with lower requirements during the transition years 2016 through 2018.
Bank regulatory authorities restrict the Bank from lending or advancing funds to, or investing in the securities, of the Company. Further, these authorities restrict the amounts available for the payment of dividends by the Bank to the Company.
The Company has sponsored the creation of two statutory trusts for the sole purpose of issuing trust preferred securities and investing the proceeds in junior subordinated debentures of the Company. In accordance with ASC 810-10-55, Consolidation - Overall - Implementation Guidance and Illustrations - Variable Interest Entities, these statutory trusts created by the Company are not consolidated into the Company’s financial statements; however, the Company reflects the amounts of junior subordinated debentures payable to the preferred stockholders of statutory trusts as debt in its financial statements. As of both December 31, 2017, and 2016, all $100.0 million of the net balance of these trust preferred securities qualified as Tier 1 capital.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
25. LITIGATION AND CONTINGENCIES
The Company is involved in routine legal proceedings occurring in the ordinary course of business. In the opinion of management, final disposition of these proceedings will not have a material adverse effect on the consolidated balance sheets, consolidated statements of operations, or consolidated statements of cash flows of the Company.
26. SELECTED QUARTERLY DATA (UNAUDITED)
The following tables present selected quarterly financial data for 2017 and 2016:
___________________
(1)
Due to rounding, the sum of the four quarters may not add to the year to date total.
(2)
Includes the effect of adjustments to net income attributable to the Company to arrive at net income attributable to common shareholders.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Boston Private Financial Holdings, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Boston Private Financial Holdings, Inc. and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017 and the related notes (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 28, 2018 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ KPMG LLP
We have served as the Company’s auditor since 1987.
Boston, Massachusetts
February 28, 2018
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Boston Private Financial Holdings, Inc.:
Opinion on Internal Control Over Financial Reporting
We have audited Boston Private Financial Holdings, Inc. and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes (collectively, the consolidated financial statements), and our report dated February 28, 2018 expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ KPMG LLP
Boston, Massachusetts
February 28, 2018
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.CONTROLS AND PROCEDURES
A.Disclosure Controls and Procedures
As required by Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934, the Company has evaluated, with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, as of the end of the period covered by this report, the effectiveness of the design and operation of its disclosure controls and procedures.
Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that such disclosure controls and procedures were effective as of December 31, 2017 in ensuring that material information required to be disclosed by the Company, including its consolidated subsidiaries:
a.
was made known to the certifying officers by others within the Company and its consolidated subsidiaries in the reports that it files or submits under the Exchange Act; and
b.
is recorded, processed, summarized, and reported within the time periods specified in the Securities Exchange Commission rules and forms.
On a quarterly basis, the Company evaluates the disclosure controls and procedures, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that the Company’s systems evolve with its business.
B.Management’s Report on Internal Control Over Financial Reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the reliability and preparation of published financial statements in accordance with accounting principles generally accepted in the U.S.
In designing and evaluating the Company’s disclosure controls and procedures, the Company and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only a reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation and may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017. In making this assessment, the Company used the criteria set forth in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on management’s assessment, the Company believes that, as of December 31, 2017, the Company’s internal control over financial reporting is effective based on the criteria established by Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission COSO.
KPMG LLP, the independent registered public accounting firm that reported on the Company’s consolidated financial statements, has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017. This report can be found at the end of Part II. Item 8. “Financial Statements and Supplementary Data.”
C.Changes in Internal Controls over Financial Reporting
There have been no changes in the Company’s internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting in 2017.
ITEM 9B.
ITEM 9B.OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information with respect to Directors and Executive Officers required by Item 10 shall be included in the Proxy Statement and is incorporated herein by reference.
ITEM 11.
ITEM 11.EXECUTIVE COMPENSATION
Information with respect to executive compensation required by Item 11 shall be included in the Proxy Statement and is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information with respect to security ownership and the other matters required by Item 12 shall be included in the Proxy Statement and is incorporated herein by reference.
ITEM 13.
ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information with respect to certain relationships and related transactions required by Item 13 shall be included in the Proxy Statement and is incorporated herein by reference.
ITEM 14.
ITEM 14.PRINCIPAL ACCOUNTING FEES AND SERVICES
Information with respect to principal accountant fees and services required by Item 14 shall be included in the Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
Financial Statements and Exhibits
1.Financial Statements
Page No.
a) Consolidated Balance Sheets
b) Consolidated Statements of Operations
c) Consolidated Statements of Comprehensive Income
d) Consolidated Statements of Changes in Shareholders’ Equity
e) Consolidated Statements of Cash Flows
f) Notes to Consolidated Financial Statements
2.Financial Schedules
None.
3. Exhibits
* Represents management contract or compensatory plan or agreement.
ITEM 16. FORM 10-K SUMMARY.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this day, February 28, 2018.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC.
By:
/s/ CLAYTON G. DEUTSCH
Clayton G. Deutsch
Chief Executive Officer and President
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated.