10-K 1 d318051d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark one)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2016

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 0-30106

 

 

PACIFIC CONTINENTAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

OREGON   93-1269184

(State or Other Jurisdiction

of Incorporation or Organization)

 

(IRS Employer

Identification No)

111 West 7th Avenue

Eugene, Oregon

  97401
(Address of principal executive offices)   (zip code)

(541) 686-8685

(Registrant’s telephone number, including area code)

Securities registered pursuant to section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, No par value per share   NASDAQ Global Select Market

Securities registered pursuant to section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☐    No  ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ☐    No   ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No   ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No   ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ☒

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one)

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer      Smaller Reporting Company  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant at June 30, 2016 (the last business day of the most recently completed second quarter) was $287,950,930 based on the closing price as quoted on the NASDAQ Global Select Market on that date.

The number of shares outstanding of the registrant’s common stock, no par value, as of February 28, 2017, was 22,665,881.

DOCUMENTS INCORPORATED BY REFERENCE

All or a portion of Items 10 through 14 in Part III of this Form 10-K are incorporated by reference to the Registrant’s definitive proxy statement on Schedule 14A, which will be filed within 120 days after the close of the fiscal year covered by this report on Form 10-K, or if the Registrant’s Schedule 14A is not filed within such period, will be included in an amendment to this Report on Form 10-K which will be filed within such 120-day period.

 

 

 


Table of Contents

PACIFIC CONTINENTAL CORPORATION

FORM 10-K

ANNUAL REPORT

TABLE OF CONTENTS

 

            Page  

PART I

          3  

ITEM 1

     Business      3  

ITEM 1A

     Risk Factors      24  

ITEM 1B

     Unresolved Staff Comments      32  

ITEM 2

     Properties      32  

ITEM 3

     Legal Proceedings      32  

ITEM 4

     Mine Safety Disclosures      33  

PART II

          33  

ITEM 5

     Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      33  

ITEM 6

     Selected Financial Data      36  

ITEM 7

     Management’s Discussion and Analysis of Financial Condition and Results of Operation      37  

ITEM 7A

     Quantitative and Qualitative Disclosures About Market Risk      58  

ITEM 8

     Financial Statements and Supplementary Data      61  

ITEM 9

     Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      122  

ITEM 9A

     Controls and Procedures      122  

ITEM 9B

     Other Information      123  

PART III 

          123  

ITEM 10

     Directors, Executive Officers and Corporate Governance      123  

ITEM 11

     Executive Compensation      123  

ITEM 12

     Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      123  

ITEM 13

     Certain Relationships and Related Transactions and Director Independence      123  

ITEM 14

     Principal Accountant Fees and Services      123  

PART IV

          124  

ITEM 15

     Exhibits and Financial Statement Schedules      124  

SIGNATURES

     126  

CERTIFICATIONS

  

 

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PART I

 

ITEM 1 Business

In addition to historical information, this report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements regarding projected results for 2017, factors that could impact the Company’s financial results, the expected interest rate environment, 2017 provision for loan losses and the adequacy of the allowance, the possibility of valuation write-downs on OREO, portfolio structuring, loan origination standards, liquidity and funding, large depositor relationships, management’s plans, objectives, expectations and intentions that are not historical facts, and other statements identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “should,” “projects,” “seeks,” “estimates” or words of similar meaning. These forward-looking statements are based on current beliefs and expectations of management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company’s control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations in the forward-looking statements, including those set forth in this report, or the documents incorporated by reference:

 

    Local, regional and national economic conditions could be less favorable than expected or could have a more direct and pronounced effect on us than expected and adversely affect our ability to continue internal growth at historical rates and maintain the quality of our earning assets.

 

    The local housing or real estate market could decline.

 

    The risks presented by an economic recession, which could adversely affect credit quality, collateral values, including real estate collateral, investment values, liquidity and loan originations, and loan portfolio delinquency rates.

 

    Our concentration in loans to dental professionals exposes us to the risks affecting dental practices in general.

 

    Interest rate changes could significantly reduce net interest income and negatively affect funding sources.

 

    Projected business increases following any future strategic expansion, or combination, or opening of new branches could be lower than expected.

 

    Competition among financial institutions could increase significantly.

 

    The goodwill we have recorded in connection with acquisitions could become impaired, which may have an adverse impact on our earnings.

 

    The reputation of the financial services industry could deteriorate, which could adversely affect our ability to access markets for funding and to acquire and retain customers.

 

    The efficiencies we may expect to receive from any investments in personnel, acquisitions, and infrastructure may not be realized.

 

    The level of nonperforming assets and charge-offs or changes in the estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements may increase.

 

    Changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, executive compensation, and insurance) could have a material adverse effect on our business, financial condition and results of operations.

 

    Acts of war or terrorism, or natural disasters, may adversely impact our business.

 

    The timely development and acceptance of new banking products and services and perceived overall value of these products and services by users may adversely impact our ability to increase market share and control expenses.

 

    Changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters, may impact the results of our operations.

 

    The costs and effects of legal, regulatory and compliance developments, including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews, may adversely impact our ability to increase market share and control expense and my adversely affect our results of operations and future prospects.

 

    Our success at managing the risks involved in the foregoing items will have a significant impact on our results of operations and future prospects.

 

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Additional factors that could cause actual results to differ materially from those expressed in any forward-looking statements are discussed in Risk Factors in this Form 10-K. Please take into account that forward-looking statements speak only as of the date of this report or documents incorporated by reference. The Company does not undertake any obligation to publicly correct or update any forward-looking statement whether as a result of new information, future events or otherwise.

General

Pacific Continental Corporation (the “Company” or the “Registrant”) is an Oregon corporation and registered bank holding company headquartered in Eugene, Oregon. The Company was organized on June 7, 1999, pursuant to a holding company reorganization of Pacific Continental Bank, its wholly owned subsidiary (the “Bank”).

The Company’s principal business activities are conducted through the Bank, an Oregon state-chartered bank with deposits insured by the Federal Deposit Insurance Corporation (the “FDIC”). The Bank has no active subsidiaries.

Results and Financial Data

All dollar amounts in the following sections are in thousands except per share amounts or where otherwise indicated.

Subsequent to the end of the year on January 9, 2017, Pacific Continental Corporation entered into a definitive agreement to merge with Columbia Banking System, Inc., headquartered in Tacoma, Washington. Upon completion of the merger, the combined company will operate under the Columbia Bank name and brand. The agreement was approved by the Board of Directors of each company. Closing of the transaction, which is expected to occur in mid-2017, is contingent on shareholder approval and receipt of necessary regulatory approvals, along with satisfaction of other customary closing conditions.

For the year ended December 31, 2016, the consolidated net income of the Company was $19,776 or $0.95 per diluted share. At December 31, 2016, the consolidated shareholders’ equity of the Company was $273,755 with 22,611,535 shares outstanding and a book value of $12.11 per share. Total assets were $2,541,437 at December 31, 2016. Loans net of allowance for loan losses and unearned fees were $1,835,313 at December 31, 2016, and represented 72.22% of total assets. Deposits totaled $2,148,103 at year-end 2016, with Company-defined core deposits representing $2,035,067, or 94.74% of total deposits. Core deposits are defined as all demand, interest checking, money market, savings and local non-public time deposits, including local non-public time deposits in excess of $100. At December 31, 2016, the Company had a Tier 1 leverage capital ratio, Common Equity Tier 1 risk-based capital ratio, Tier 1 risk-based capital ratio, and total risk-based capital ratio, of 9.01%, 9.52%, 10.08%, and 12.69%, respectively, all of which exceeded the minimum “well-capitalized” level for all capital ratios under FDIC guidelines of 5.00%, 6.50%, 8.00% and 10.00%, respectively.

On September 6, 2016, the Company completed the acquisition of Foundation Bancorp, Inc. (“Foundation Bancorp”). Foundation Bancorp shareholders received either $12.50 per share in cash or 0.7911 shares of Pacific Continental common stock for each share of Foundation Bancorp common stock, or a combination of 30% in the form of cash and 70% in the form of Pacific Continental common stock. Pursuant to the merger agreement, total consideration included cash consideration of $19,337 and stock consideration of 2,853,362 shares of Pacific Continental common stock. Based on the closing price of Pacific Continental common stock on September 6, 2016, the aggregate consideration payable for Foundation Bancorp was valued at $47,794.

On January 9, 2017, Pacific Continental entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Columbia Banking System, Inc., a Washington corporation (“Columbia”), and a to-be-formed Oregon corporation and a wholly owned subsidiary of Columbia (“Merger Sub”). The Merger Agreement provides that, upon the terms and subject to the conditions set forth therein, Merger Sub will merge with and into Pacific Continental, with Pacific Continental as the surviving corporation (the “First Merger”). Immediately following the First Merger, Pacific Continental will merge with and into Columbia (the “Subsequent Merger”), with Columbia continuing as the surviving corporation (the “Surviving Corporation”). Immediately after the Subsequent Merger, the Bank will merge with and into Columbia State Bank, a Washington state-chartered bank and wholly owned subsidiary of Columbia (“Columbia State Bank”) (the “Bank Merger”, and together with the First Merger and Subsequent Merger, the “Mergers”). Consummation of the Mergers is subject to customary conditions, including, among others, approval by Pacific Continental and Columbia shareholders and receipt of required regulatory approvals. For more information regarding the Mergers, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Highlights – Merger” and the Current Report on Form 8-K filed by Pacific Continental on January 10, 2017.

 

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For more information regarding the Company’s financial condition and results of operations, see Management’s Discussion and Analysis of Financial Condition and Results of Operations and Financial Statements and Supplementary Data in Items 7 and 8 of Part II of this Form 10-K.

THE BANK

General

The Bank commenced operations on August 15, 1972. The Bank operates in three primary markets: Eugene, Oregon, Portland, Oregon / Southwest Washington and Puget Sound, Washington. At December 31, 2016, the Bank operated fifteen full-service offices in Oregon and Washington and two loan production offices in Washington and Colorado. The primary business strategy of the Bank is to operate in large commercial markets and to provide comprehensive banking and related services tailored to community-based businesses, nonprofit organizations, professional service providers and banking services for business owners. The Bank emphasizes the diversity of its product lines, high levels of personal service and convenient access through technology typically associated with larger financial institutions, while maintaining local decision-making authority and market knowledge, typical of a community bank. The Bank has developed expertise in lending to dental professionals, and during 2016 continued to expand its national dental lending program. More information on the Bank and its banking services can be found on its website (therightbank.com). Information contained on the Bank’s website is not part of this Form 10-K. The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge upon request on the Bank’s website. The reports are also available on the SEC’s website at www.sec.gov. The Bank operates under the banking laws of the State of Oregon, and the rules and regulations of the FDIC. In addition, operations at its branches and other offices in the State of Washington and Colorado are subject to various consumer protection and other laws of that state.

THE COMPANY

Primary Market Area

The Company’s primary markets consist of metropolitan Eugene, metropolitan Portland, in the State of Oregon and metropolitan Seattle in the State of Washington. During 2016, the Company expanded its lending to dental professionals, and at year-end had loans to dental professionals in 44 states, up from 39 states in 2015. The Company has five full-service banking offices in the metropolitan Portland and Southwest Washington area, seven full-service banking offices in the metropolitan Eugene area, and three full-service offices in the metropolitan Seattle area. It also operates loan production offices in Tacoma, Washington and Denver, Colorado. The Company has its headquarters and administrative office in Eugene, Oregon.

Overall, economic conditions improved in the Company’s markets during 2016 as evidenced by the increased loan demand in all three of the Company’s primary markets. In particular, larger metropolitan areas, such as Portland and Seattle, experienced higher improvement in general economic conditions and job growth than rural areas of Oregon and Washington. As has been typical in the past, the economic conditions in the Eugene market improved, but not at the levels realized in Portland and Seattle.

On a monthly basis, the University of Oregon, located in Eugene, Oregon, produces the Oregon Index of Economic Indicators using the year 1997 as its beginning base of 100. This index attempts to measure various components of the State of Oregon economy, including labor markets, capital goods orders, and consumer confidence, in order to determine if economic conditions in the state are improving or deteriorating, and provides the probability of a recession. This index indicated that economic activity for the State of Oregon fell to its lowest level during the first quarter 2009 when the index reached 85.0 and then generally trended upward. During 2016, the index continued upward on a quarterly basis, and for December 2016 was at 100.5%, an improvement of 0.5% over the prior year-end.

The unemployment rate for the State of Oregon at December 31, 2016, was 4.6%, as compared to 4.7% nationally, and has been improving since early 2009. Portland area unemployment stood at 4.3%, for this same time period, below the state average and national average. For Lane County, Oregon, which includes Eugene, Oregon, the unemployment rate was 4.8%, above both the state and national average at December 31, 2016. The unemployment rate for the State of Washington at December 31, 2016, was 5.2%, above the national averages, and has trended downward on a quarterly basis since early 2009. In King County, Washington, which includes the metropolitan Seattle area, the unemployment rate at year-end 2016 was 3.4%, below the state and national averages. The Seattle market in particular has demonstrated more economic diversity than the other primary markets in which the Company operates. All unemployment rates were provided by the U.S. Bureau of Labor Statistics.

 

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At December 31, 2016, approximately 65% of the Company’s loan portfolio in principal amount was secured by real estate, thus the condition and valuation trends of commercial and residential real estate markets in the Pacific Northwest have had a significant impact on the overall credit quality of the Company’s primary assets in that, in the event of default, the value of real estate collateral and its salability is typically the primary source of repayment. At December 31, 2016, approximately $167 million, or 9.00% of the Company’s loan portfolio, was categorized as residential and commercial construction loans, which also included land development and acquisition loans. During 2016, the Company experienced an increase in construction lending, centered in commercial real estate construction and acquisition and development construction.

Real estate markets in the Pacific Northwest, particularly the Portland and Puget Sound markets, have shown steady improvement in virtually every segment year over year. Industrial commercial real estate in both Portland and Seattle continued elevated pre-leasing activity, strong absorption rates, and increasing rental and lease rates during 2016. Industrial vacancy rates in the Puget Sound region fell to 2.6% by the end of 2016, even with the addition of over 4 million square feet of new space. In the Eugene market, vacancy trends continued to show stability through year end. The office commercial real estate market showed maturing in the Portland metropolitan region in 2016, and pre-leasing was steady, with vacancy rates remaining stable at 8%, despite over 1 million square feet being added during the year. The Puget Sound region was robust, with the regional vacancy rate remaining 8.6% despite the addition of over 4.4 million square feet added. For Eugene, demand for office space was moderate to steady, with building or refurbishing continuing, and vacancy rates remaining generally stable. With regard to multifamily commercial real estate, the diverse Eugene, Portland and Puget Sound demographics and continued inward migration with limited availability of multifamily units, led to private and institutional investment in all three regions. Rents increased, but at a more moderate pace in 2016, and the Eugene and Portland markets began to experience slower lease up, still however reflecting stable markets at year end. These multifamily vacancy rates in the Portland and Eugene markets remain generally in the 2.5% range, while the vacancy rate in the Puget Sound market is near record lows. There was some evidence of overcapacity developing in the Eugene student housing market in 2016. Residential development continued, with single-family and multi-family building permit issuance remaining solid in all of our markets, dominated primarily by the national home builders in the Portland and Puget Sound regions. Normalized to limited supply of single family residences was evident during the year. Similar trends are suggested into 2017, subject to various market and economic forces.

Residential housing prices in all three of the Company’s primary markets showed marked improvement in 2016, to the point where values have generally recovered to their pre-recession levels in each market, with some values exceeding pre-recession levels in areas of Portland and Seattle. A moderate level of new residential construction continued in each market as well due to the improving market conditions, continued low interest rates, and the slow return of bank financing to a wider range of residential developers.

Competition

Commercial banking in the States of Oregon and Washington is highly competitive. The Company competes with other banks, as well as with savings and loan associations, savings banks, credit unions, mortgage companies, investment banks, insurance companies, and other financial institutions. Banking in Oregon and Washington is dominated by several large banking institutions including U.S. Bank, Wells Fargo Bank, Bank of America, Key Bank and Chase. Together these banks account for a majority of the total commercial and savings bank deposits in Oregon and Washington. These competitors have significantly greater financial resources and offer a much greater number of branch locations. The Company offsets the advantage of the larger competitors by focusing on certain market segments, providing high levels of customization and personal service, and tailoring its technology, products and services to the specific market segments that the Company serves.

In addition to larger institutions, numerous “community” banks and credit unions operated, expanded or moved into the Company’s three primary markets and have developed a similar focus to that of the Company. These institutions have further increased competition in all three of the Company’s primary markets. This number of similar financial institutions and an increased focus by larger institutions in the Company’s primary markets has led to intensified competition in all aspects of the Company’s business. During 2016, the Company saw increased competition, specifically regarding loan pricing. The Company saw competitors willing to accept yields or terms not desirable to the Company and some deals were lost due to the Company’s unwillingness to compromise on deal pricing. The Company remained diligent in its underwriting standards during the year and did not loosen credit standards to achieve growth.

 

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The adoption of the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”) led to further intensification of competition in the financial services industry. The GLB Act eliminated many of the barriers to affiliation among providers of various types of financial services and has permitted business combinations among financial service providers such as banks, insurance companies, securities or brokerage firms and other financial service providers. Additionally, the rapid adoption of financial services through the Internet has reduced or even eliminated many barriers to entry by financial service providers physically located outside our market areas. For example, remote deposit services allow depository companies physically located in other geographical markets to service local businesses with minimal cost of entry. Although the Company has been able to compete effectively in the financial services business in its markets to date, it may not be able to continue to do so in the future.

The financial services industry has experienced widespread consolidation over the last decade. Following consolidation due to FDIC failures between 2008 and 2011, the banking industry began to see acquisition consolidation in 2012. Beginning in 2012, consolidation continued in the form of bank acquisitions throughout the Northwest. The Company anticipates consolidation among financial institutions in its market areas will continue. In addition, with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), smaller financial institutions may find it difficult to continue to operate due to higher anticipated regulatory costs. The Dodd-Frank Act also authorized nationwide de novo branching by national and state banks and certain foreign banks operating in the U.S., which could also result in new entrants to the markets served by the Bank.

As of June 30, 2016, the most recent FDIC Summary of Deposit survey indicated, the Company had 17.08% of the Lane County deposit market share, which currently is serviced by seven branches in the Eugene community. This was the highest deposit market share of any bank in Lane County. In Multnomah County, which is serviced by three of the Company’s offices in the Portland Market, the Company had 1.42% of the deposit market share, ranking ninth in the Multnomah County, Oregon Market. In King County, Washington, the Company had 0.27% of the deposit market share, serviced by the Seattle and Bellevue offices, ranking 22rd in the King County Market as of June 30, 2016.

In addition, the Company anticipates more competitive pressure for new loans in its markets. While the Bank’s loan demand improved throughout 2016, healthy banks with ample capital and liquidity are expected to aggressively seek new loan customers. This may cause pressure on loan pricing and make it more difficult to retain existing loan customers or attract new ones and may create compression in the Company’s net interest margin.

Services Provided

The Company offers a wide array of financial service products to meet the banking needs of its targeted segments in the market areas served. The Company regularly reviews the profitability and desirability of various product offerings, particularly new product offerings, in an effort to assure ongoing viability.

Deposit Services

The Company offers a wide range of deposit services that are typically available in most banks and other financial institutions including checking, savings, money market accounts and time deposits. The transaction accounts and time deposits are tailored to the Company’s primary markets and market segments at rates competitive with those offered in the area. Additional deposits are generated through national networks for institutional deposits. All deposit accounts are insured by the FDIC to the maximum amount permitted by law, currently $250 per depositor. The Company provides online cash management, remote deposit capture and banking services to businesses and consumers. The Company also allows 24-hour customer access to deposit and loan information via telephone and online cash management products.

Lending Activities

The Company emphasizes specific areas of lending within its primary markets. Commercial loans are made primarily to professionals, community-based businesses and nonprofit organizations. These loans are available for general operating purposes, acquisition of fixed assets, purchases of equipment and machinery, financing of inventory and accounts receivable and other business purposes. The Company also originates U.S. Small Business Administration (“SBA”) loans and is a national SBA preferred lender.

Within its primary markets, the Company also originates construction and permanent loans financing commercial facilities, including investor and owner-occupied projects. The Company also originates pre-sold, custom and, on a limited basis, speculative home construction. The major thrust of residential construction lending is smaller in-fill construction projects in

 

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inner-city urban neighborhoods, and consisting of single-family residences. During 2016, as commercial real estate prices continued to stabilize and improve, the Company expanded construction financing activity in commercial real estate and multifamily residential construction financing. During 2016, the housing markets in Portland and Seattle experienced very low inventory and high rates of appreciation, thus the Company was selective in financing single-family housing projects in both of these markets.

Due to the Company’s concentration in real estate secured loans, the Company strategically focuses on increasing its commercial and industrial (“C & I”) loan lending. In particular, the Company has developed a specialty in C & I lending to dental professionals. Loans to dental professionals include loans for such purposes as starting up a practice, acquisition of a practice, equipment financing, owner-occupied facilities, and working capital. Loans for dental office startups are typically SBA loans as these loans represent additional risk. During 2016, the Company continued to expand its national dental lending program. At year-end 2016, the Company had active dental loans in 44 states which totaled $377,478, of which $227,210 were located outside of the Company’s primary markets in Oregon and Washington. Since inception of the national dental lending program, lending has been limited to loans to dental professionals for acquisition of practices by experienced dental professionals, owner-occupied commercial real estate or seasoned practice refinance loans.

The Company makes secured and unsecured loans to individuals for various purposes, including purchases of automobiles, mobile homes, boats, and other recreational vehicles, home improvements, education, and personal investment.

Inter-agency guidelines adopted by federal bank regulators mandate that financial institutions establish real estate lending policies with maximum allowable real estate loan-to-value limits, subject to an allowable amount of non-conforming loans as a percentage of capital. The Board of Directors has approved specific lending policies and procedures for the Company, and management is responsible for implementation of these policies. The lending policies and procedures include guidelines for loan term, loan-to-value ratios that are within established federal banking guidelines, collateral appraisals, and cash flow coverage. The loan policies also vest varying levels of loan authority in management, the Company’s Loan Committee and the Board of Directors. Company management monitors lending activities through management meetings, loan committee meetings, monthly reporting, and periodic review of loans by third-party contractors.

Merchant and Card Services

In December 2013, the Company entered into an agreement with Vantiv, a third-party provider of merchant services, to outsource all merchant processing for the Bank’s clients. The agreement provides for a portion of the revenue generated from existing and new clients to be shared with the Company. Through the agreement, the Company’s existing merchant portfolio was converted onto the Vantiv platform.

Wealth Management

During 2015, the Company began offering wealth management services through a strategic partnership with Transamerica Financial Advisors (“TFA”) and World Financial Group (“WFG”). This partnership provides for employees of the Bank to also be Investment Advisors, Registered Representatives, and/or Agents with TFA and WFG. The products available include: individual investment advisory services, Company retirement plans, employee benefits programs, mutual funds, unit investment trusts, fixed and variable annuities, fixed and variable life insurance, long term care, and disability. The products and services are provided by TFA/WFG and the over 100 other financial institutions with which TFA/WFG has selling agreements. Through referral relationships, WFG is also able to provide estate planning documents, and business & personal property solutions.

Other Services

The Company provides other traditional commercial and consumer banking services, including cash management products for businesses, online banking, safe deposit services, debit and automated teller machine (“ATM”) cards, automated clearing house (“ACH”) transactions, cashier’s checks, notary services and others. The Company is a member of numerous ATM networks and utilizes an outside processor for the processing of these automated transactions. The Company has an agreement with MoneyPass, an ATM provider, which permits Company customers to use MoneyPass ATMs located throughout the country at no charge to the customer.

 

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Employees

At December 31, 2016, the Company employed 374 FTE employees with 61 FTE employees in the Puget Sound market, 75 FTE employees in the Portland market, and 79 FTE employees in the Eugene market as well as 159 FTE employees in administrative functions primarily located in Eugene, Oregon. None of these employees are represented by labor unions, and management believes that the Company’s relationship with its employees is good. The Company emphasizes a positive work environment for its employees, which is validated by recognition from independent third-parties.

During 2016, the Company was recognized for the seventeenth consecutive year by Oregon Business magazine as one of the 100 Best Companies to Work For in Oregon. Also, the Company was recognized by Seattle Business magazine as one of Washington’s “100 Best Companies to Work For.” The Portland Business Journal named the Company as one of Oregon’s most admired companies. This was the sixth time the Company was recognized as a top-ten company in the “Financial Services” classification. Additionally, Seattle Business magazine named the Company “Business of the Year,” in the small business category. The Company was recognized by Raymond James as one of the top performing community banks in the country with its prestigious Community Bankers Cup. The award recognizes the top 10 percent of community banks nationally, based on various profitability, operational efficiency and balance sheet metrics.

Management continually strives to retain and attract top talent as well as provide career development opportunities to enhance skill levels. A number of benefit programs are available to eligible employees, including group medical plans, paid sick leave, paid vacation, group life insurance, 401(k) plans, deferred compensation plans, and equity compensation plans.

Supervision and Regulation

General

The following discussion provides an overview of certain elements of the extensive bank regulatory framework applicable to the Company and the Bank. This regulatory framework is primarily designed for the protection of depositors and other customers of banks, the federal deposit insurance fund and the banking system as a whole, rather than specifically for the protection of shareholders or other investors in the securities of banking organizations in the United States. Due to the breadth and growth of this regulatory framework, our costs of compliance continue to increase in order to monitor and satisfy these requirements.

To the extent that this section describes statutory and regulatory provisions, it is qualified by reference to those provisions. These statutes and regulations, as well as related policies, are subject to change by Congress, state legislatures and federal and state regulators. Changes in statutes, regulations or regulatory policies applicable to us, including the interpretation or implementation thereof, could have a material adverse effect on our business and operations. In light of the financial crisis, which began in 2008 and 2009, numerous changes to the statutes, regulations or regulatory policies applicable to the Company and other banks generally have been made or proposed. The full extent to which these changes will impact our business is not yet known. However, our continued efforts to monitor and comply with new regulatory requirements add to the complexity and cost of our business.

Federal and State Bank Holding Company Regulation

General. The Company is a bank holding company under the Bank Holding Company Act of 1956, as amended (“BHCA”), and is therefore subject to regulation, supervision and examination by the Federal Reserve. In general, the BHCA limits the business of bank holding companies to owning or controlling banks and engaging in other activities closely related to banking. The Company must file reports with and provide to the Federal Reserve such additional information as it may require. Under the GLB Act, a bank holding company may apply to the Federal Reserve to become a financial holding company, and thereby engage (directly or through a subsidiary) in certain expanded activities deemed financial in nature, such as securities and insurance underwriting. The Company has not applied to the Federal Reserve to become a financial holding company and has no plans to do so.

Holding Company Bank Ownership. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve before (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5 percent of such shares; (ii) acquiring all or substantially all of the assets of another bank or bank holding company; or (iii) merging or consolidating with another bank holding company.

 

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Holding Company Control of Non-Banks. With some exceptions, the BHCA also prohibits a bank holding company from acquiring or retaining direct or indirect ownership or control of more than 5 percent of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities that, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks.

Transactions with Affiliates. Subsidiary banks of a bank holding company are subject to restrictions imposed by the Federal Reserve Act on extensions of credit to the holding company or its subsidiaries, on investments in their securities, and on the use of their securities as collateral for loans to any borrower. These restrictions prevent the Company from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in the Company are limited individually to 10 percent of the Bank’s capital stock and surplus and in the aggregate to 20 percent of the Bank’s capital stock and surplus. The Federal Reserve Act also provides that extensions of credit and other transactions between the Bank and the Company must be on terms and conditions, including credit standards, that are substantially the same or at least as favorable to the Bank as those prevailing at the time for comparable transactions involving other non-affiliated companies, or, in the absence of comparable transactions, on terms and conditions, including credit standards, that in good faith would be offered to, or would apply to, non-affiliated companies. These regulations and restrictions may limit the Company’s ability to obtain funds from the Bank for its cash needs, including funds for payment of dividends, interest, and operational expenses.

Tying Arrangements. The Company is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor its subsidiaries may condition an extension of credit to a customer on either (i) a requirement that the customer obtain additional services provided by us; or (ii) an agreement by the customer to refrain from obtaining other services from a competitor.

Support of Subsidiary Banks. Under Federal Reserve policy and the Dodd-Frank Act, the Company is required to act as a source of financial and managerial strength to the Bank. This means that the Company is required to commit, as necessary, resources to support the Bank. However, the contribution of additional capital to an under-capitalized subsidiary bank may be required at times when a bank holding company may not have the resources to provide such support. Any capital loans a bank holding company makes to its subsidiary banks are subordinate to deposits and to certain other indebtedness of those subsidiary banks.

State Law Restrictions. As an Oregon corporation, the Company is subject to certain limitations and restrictions under applicable Oregon corporate law. For example, state law restrictions and limitations in Oregon include indemnification of directors, distributions to shareholders, transactions involving directors, officers or interested shareholders, maintenance of books, records and minutes, and observance of certain corporate formalities.

Federal and State Regulation of Pacific Continental Bank

General. The Bank is an Oregon commercial bank operating in Oregon and Washington with deposits insured by the FDIC. As an Oregon state bank that is not a member of the Federal Reserve System, the Bank is subject to supervision and regulation by the Oregon Department of Consumer and Business Services (the “Oregon Department”) and the FDIC. These agencies have the authority to prohibit banks from engaging in what they believe constitute unsafe or unsound banking practices. Additionally, the Bank’s branches in Washington are subject to supervision and regulation by the Washington Department of Financial Institutions and must comply with applicable Washington laws regarding community reinvestment, consumer protection, fair lending, and intrastate branching.

Consumer Protection. The Bank is subject to a variety of federal and state consumer protection laws and regulations that govern its relationship with consumers, including laws and regulations that mandate certain disclosure requirements and regulate the manner in which we take deposits, make and collect loans, and provide other services. Failure to comply with these laws and regulations can subject the Bank to various penalties, including but not limited to, enforcement actions, injunctions, fines, civil liability, criminal penalties, punitive damages, and the loss of certain contractual rights.

Community Reinvestment. The Community Reinvestment Act of 1977 (“CRA”) requires that, in connection with examinations of financial institutions within their jurisdiction, the FDIC evaluate the record of the financial institution in meeting the credit needs of its local communities, including low- and moderate-income neighborhoods, consistent with the

 

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safe and sound operation of the institution. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and the CRA into account when regulating and supervising other activities, and in evaluating whether to approve applications for permission to engage in new activities or for acquisitions of other banks or companies or de novo branching. An unsatisfactory CRA rating may be the basis for denying the application. In the most current CRA examination report dated February 24, 2014, the Bank’s compliance with CRA was rated “Satisfactory”.

Insider Credit Transactions. Banks are also subject to certain restrictions imposed by the Federal Reserve Act and the regulations of the Federal Reserve on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are at least as stringent as those prevailing at the time for comparable transactions with persons not covered above and who are not employees; and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in the assessment of substantial civil monetary penalties, regulatory enforcement actions, and other regulatory sanctions.

Regulation of Management. Federal law (i) sets forth circumstances under which officers or directors of a bank may be removed by the institution’s federal supervisory agency; (ii) places restraints on lending by a bank to its executive officers, directors, principal shareholders and their related interests; and (iii) generally prohibits management personnel of a bank from serving as a director or in other management positions of another financial institution which assets exceed a specified amount or which has an office within a specified geographic area.

Safety and Soundness Standards. Certain non-capital safety and soundness standards are also imposed upon banks. These standards cover internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, such other operational and managerial standards as the agency determines to be appropriate, and standards for asset quality, earnings and stock valuation. An institution that fails to meet these standards may be subject to regulatory sanctions.

Customer Information Security. The federal bank regulatory agencies have adopted guidelines for safeguarding confidential, personal customer information. The guidelines require each financial institution to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. The Bank has adopted a customer information security program.

Privacy. The GLB Act requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to non-affiliated third parties. In general, the statute requires explanations to consumers on policies and procedures regarding the disclosure of such nonpublic personal information, and, except as otherwise required by law, prohibits disclosing such information except as provided in the banks’ policies and procedures. The Bank implemented a privacy policy, which provides that all of its existing and new customers will be notified of the Bank’s privacy policies. State laws and regulations designed to protect the privacy and security of customer information also apply to us.

Interstate Banking and Branching

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”), together with the Dodd-Frank Act, relaxed prior interstate branching restrictions under federal law by permitting, subject to regulatory approval, state and federally chartered commercial banks to establish branches in states where the laws permit banks chartered in such states to establish branches. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area. Federal banking agency regulations prohibit banks from using their interstate branches primarily for deposit production, and the federal banking agencies have implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition. The Dodd-Frank Act also authorized nationwide de novo branching by national and state banks and certain foreign banks operating in the U.S., which could also result in new entrants to the markets served by the Bank.

 

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Dividends

The principal source of the Company’s cash is from dividends received from the Bank, which are subject to government regulation and limitations. In addition, capital raises may provide another source of cash. Regulatory authorities may prohibit banks and bank holding companies from paying dividends in a manner that would constitute an unsafe or unsound banking practice or would reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. The Oregon Bank Act and the Federal Deposit Insurance Corporation Improvement Act of 1991 also limit a bank’s ability to pay cash dividends to its parent company. A bank may not pay cash dividends if that payment would reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. In addition, under the Oregon Bank Act, the amount of the dividend paid by the Bank may not be greater than net unreserved retained earnings, after first deducting, to the extent not already charged against earnings or reflected in a reserve, all bad debts, which are debts on which interest is unpaid and past due at least six months unless the debt is fully secured and in the process of collection; all other assets charged-off as required by Oregon bank regulators or a state or federal examiner; and all accrued expenses, interest and taxes of the Bank. The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve’s view that a bank holding company should pay cash dividends only to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition. Payment of cash dividends by the Company and the Bank will depend on sufficient earnings to support them and adherence to bank regulatory requirements.

Capital Adequacy

Regulatory Capital Rules. Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. The guidelines are “risk-based,” meaning that they are designed to make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies. The Federal Reserve Board and the other U.S. federal banking agencies have adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the current international regulatory capital accord (“Basel III”) of the Basel committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of banking supervisory authorities from major countries in the global financial system which formulates broad supervisory standards and guidelines relating to financial institutions for implementation on a country-by-country basis. These rules replace the U.S. federal banking agencies’ general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. Banks, such as Pacific Continental Bank, became subject to the new rules on January 1, 2015. The new rules generally establish more restrictive capital definitions, create additional categories and higher risk-weightings for certain asset classes and off-balance sheet exposures, higher leverage ratios and capital conservation buffers that will be added to the minimum capital requirements and must be met for banking organizations to avoid being subject to certain limitations on dividends and discretionary bonus payments to executive officers. The new rules also implement higher minimum capital requirements, include a new common equity Tier 1 capital requirement, and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.50%; (b) a Tier 1 capital ratio of 6.00% (which is an increase from 4.00%); (c) a total capital ratio of 8.00%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4.00%. While earlier proposals would have required that trust preferred securities be phased out of Tier 1 capital, the new rules exempt depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, such as the Company, from this requirement. These capital instruments, if issued prior to May 19, 2010, and currently in Tier 1 capital, are grandfathered in Tier 1 capital, subject to certain limits.

Under the new rules, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements (equal to 2.50% of total risk-weighted assets). The phase-in of the capital conservation buffer began on January 1, 2016, and will be completed by January 1, 2019. The new rules also provide for various adjustments and deductions to the definitions of regulatory capital that phase in from January 1, 2014 to December 31, 2017.

In January 2014, the Basel Committee issued an updated version of its leverage ratio and disclosure guidance (the “Basel III Leverage Ratio”). The Basel Committee guidance continues to set a minimum Basel III Leverage Ratio of 3%. In April 2016, the Basel Committee proposed, among other things, that for purposes of calculating the denominator of the leverage ratio, off-balance sheet exposures of banks to securitization transactions should be treated the same as such exposures are treated under the Basel Committee revisions to its securitization framework for risk-based capital. The Basel III Leverage Ratio will be subject to further calibration until 2017, with final implementation expected by January 2018. The Basel Committee is

 

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expected to collect data during this observation period to assess whether a minimum leverage ratio of 3% is appropriate over a full credit cycle and for various types of business models and to assess the impact of using either common equity Tier 1 capital or total regulatory capital as the numerator.

The implementation of these new rules could have an adverse impact on our financial position and future earnings due to the inclusion of Tier 1 capital as a core capital component and because of the heightened minimum capital requirements. These capital rules could restrict our ability to grow during favorable market conditions, or require us to raise additional capital and liquidity, generally increase our cost of doing business, and impose other restrictions on our operations. The application of more stringent capital requirements would, among other things, result in lower returns on invested capital and result in regulatory sanctions if we were unable to comply with these requirements. As a result, our business, results of operations, financial condition or prospects could be adversely affected. We expect that we will be able to satisfy the minimum capital requirements adopted by the Federal Reserve and the other U.S. banking agencies within the prescribed implementation timelines. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources” in this Form 10-K.

Prompt Corrective Action. Under the guidelines, a bank is assigned to one of five capital categories ranging from “well-capitalized” to “critically under-capitalized.” Institutions that are “under-capitalized” or lower are subject to certain mandatory supervisory corrective actions. At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. Failure to meet regulatory capital guidelines can result in a bank being required to raise additional capital. An “under-capitalized” bank must develop a capital restoration plan and its parent holding company must guarantee compliance with the plan subject to certain limits. During challenging economic times, the federal banking regulators have actively enforced these provisions.

At December 31, 2016, the Company and the Bank each exceeded the required risk-based capital ratios for classification as “well capitalized” as well as the required minimum leverage ratios for the Bank, and we believe we will meet the minimum capital ratios plus the fully phased-in conservation buffer as implemented. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources” in this Form 10-K.

Regulatory Oversight and Examination

The Federal Reserve conducts periodic inspections of bank holding companies, which are performed both onsite and offsite. The supervisory objectives of the inspection program are to ascertain whether the financial strength of the bank holding company is being maintained on an ongoing basis and to determine the effects or consequences of transactions between a holding company or its non-banking subsidiaries and its subsidiary banks. For holding companies under $10 billion in assets, such as the Company, the inspection type and frequency varies depending on asset size, complexity of the organization and the holding company’s rating at its last inspection.

The Federal Reserve also has extensive enforcement authority over all bank holding companies, such as the Company. Such enforcement powers include the power to assess civil money penalties against any bank holding company violating any provision of the BHCA or any regulation or order of the Federal Reserve Board under the BHCA and the power to order termination of activities or ownership of nonbank subsidiaries of the holding company if it determines that there is reasonable cause to believe that the activities or ownership of the non-bank subsidiaries constitutes a serious risk to the financial safety, soundness or stability of banks owned by the bank holding company. Knowing violations of the BHCA or regulations or orders of the Federal Reserve Board can also result in criminal penalties for the Company and any individuals participating in such conduct.

Banks are subject to periodic examinations by their primary regulators. Bank examinations have evolved from reliance on transaction testing in assessing a bank’s condition to a risk-focused approach. These examinations are extensive and cover the entire breadth of operations of the Bank. Generally, safety and soundness examinations occur on an 18-month cycle for banks under $500 million in total assets that are well-capitalized and without regulatory issues, and on a 12-month cycle otherwise. Examinations alternate between the federal and state bank regulatory agency and may occur on a combined schedule. The frequency of consumer compliance and CRA examinations is linked to the size of the institution and its compliance and CRA ratings at its most recent examinations. However, the examination authority of the FDIC allows it to examine supervised banks as frequently as deemed necessary based on the condition of the Bank or as a result of certain triggering events. Neither the Company nor the Bank is party to a formal or informal agreement with the FDIC, the Federal Reserve or the Oregon Department.

 

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Corporate Governance and Accounting

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the “Act”) addresses, among other things, corporate governance, auditing and accounting, enhanced and timely disclosure of corporate information, and penalties for non-compliance. Generally, the Act (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission (the “SEC”), (ii) imposes specific and enhanced corporate disclosure requirements, (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies, (iv) requires companies to adopt and disclose information about corporate governance practices, including whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert,” and (v) requires the SEC, based on certain enumerated factors, to regularly and systematically review corporate filings.

As a publicly reporting company, we are subject to the requirements of the Act and related rules and regulations issued by the SEC and NASDAQ. After enactment, we updated our policies and procedures to comply with the Act’s requirements and have found that such compliance, including compliance with Section 404 of the Act relating to internal control over financial reporting, has resulted in significant additional expense for the Company. We anticipate that we will continue to incur such additional expense in our ongoing compliance.

Anti-terrorism and Anti-Money Laundering

USA Patriot Act of 2001. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”), intended to combat terrorism, was renewed with certain amendments in 2006 . Certain provisions of the Patriot Act were made permanent and other sections were made subject to extended “sunset” provisions. The Patriot Act, in relevant part, (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports.

In recent years, the federal bank regulators have announced regulatory enforcement actions against a number of large bank holding companies and banks arising from deficiencies in processes, procedures and controls involving anti-money laundering measures and compliance with the economic sanctions that affect transactions with designated foreign countries, nationals and others as provided for in the regulations of the Office of Foreign Assets Control of the U.S. Treasury Department. These actions evidence an intensification of the U.S. government’s expectations for compliance with these regulatory regimes on the part of banks operating in the U.S., including the Bank, and may result in increased compliance costs and increased risks of regulatory sanctions.

Financial Services Modernization

The GLB Act, which became law in 1999, brought about significant changes to the laws affecting banks and bank holding companies. Generally, the GLB Act (i) repealed historical restrictions on preventing banks from affiliating with securities firms; (ii) provided a uniform framework for the activities of banks, savings institutions and their holding companies; (iii) broadened the activities that may be conducted by national banks and banking subsidiaries of bank holding companies; (iv) provided an enhanced framework for protecting the privacy of consumer information and requires notification to consumers of bank privacy policies; and (v) addressed a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. Bank holding companies that qualify and elect to become financial holding companies can engage in a wider variety of financial activities than permitted under previous law, particularly with respect to insurance and securities underwriting activities.

Deposit Insurance

The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits, and are subject to deposit insurance assessments designed to tie what banks pay for deposit insurance more closely to the risks they pose. Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole. As required by the Dodd-Frank Act, the FDIC adopted a comprehensive, long-range “restoration” plan for the deposit insurance fund to better ensure the adequacy of the fund’s reserves relative to total insured deposits in the U.S. The ultimate effect on our business of these legislative and regulatory developments relating to the deposit insurance fund cannot be predicted with any certainty. There can be no assurance that the FDIC will not impose special assessments or increase annual assessments in the future.

 

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The FDIC may terminate the deposit insurance of any insured depository institution if it determines that the institution has engaged in or is engaging in unsafe and unsound banking practices, is in an unsafe or unsound condition or has violated any applicable law, regulation or order or any condition imposed in writing by, or pursuant to, any written agreement with the FDIC. The termination of deposit insurance for the Bank could have a material adverse effect on our financial condition and results of operations due to the fact that the Bank’s liquidity position would likely be adversely affected by deposit withdrawal activity.

The Federal Deposit Insurance Act provides that, in the event of the liquidation or other resolution of an insured depository institution, the claims of its depositors (including claims by the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC as receiver would be afforded a priority over other general unsecured claims against such an institution. If an insured depository institution fails, insured and uninsured depositors along with the FDIC will be placed ahead of unsecured, non-deposit creditors, in order of priority of payment.

If any insured depository institution becomes insolvent and the FDIC is appointed its conservator or receiver, the FDIC may, in most cases, disaffirm or repudiate any contract to which such institution is a party, if the FDIC determines that performance of the contract would be burdensome, and that disaffirmance or repudiation of the contract would promote the orderly administration of the institution’s affairs. In addition, the FDIC as conservator or receiver may enforce most contracts entered into by the institution notwithstanding any provision providing for termination, default, acceleration or exercise of rights upon or solely by reason of insolvency of the institution, appointment of a conservator or receiver for the institution, or exercise of rights or powers by a conservator or receiver for the institution.

Other Legislation

Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act , enacted in 2010, has resulted in sweeping changes to the U.S. financial system. Among other provisions, the Dodd-Frank Act (1) created the Consumer Financial Protection Bureau with broad powers to regulate consumer financial products such as credit cards and mortgages, (2) created the Financial Stability Oversight Council (comprised of the Secretary of the Treasury, heads of the federal bank regulatory agencies and the SEC, and certain other officials) to provide oversight of all risks created within the U.S. economy from the activities of financial services companies, (3) has led to new capital requirements from federal banking agencies, (4) placed new limits on electronic debit card interchange fees, and (5) required the SEC and national stock exchanges to adopt significant new corporate governance and executive compensation reforms. As discussed below, many of the law’s provisions have been implemented by rules and regulations of the federal banking agencies, but certain provisions of the law are yet to be implemented. As a result, the full scope and impact of the law on banking institutions generally and on our business and operations cannot be fully determined at this time. However, the Dodd-Frank Act is expected to have a significant impact on our business operations, including increasing the cost of doing business, as its provisions continue to take effect. Some of the provisions of the Dodd-Frank Act that may impact our business are summarized below.

Corporate Governance. The Dodd-Frank Act requires publicly traded companies to provide their shareholders with (1) a non-binding shareholder vote on executive compensation, (2) a non-binding shareholder vote on the frequency of such vote, (3) disclosure of “golden parachute” arrangements in connection with specified change in control transactions, and (4) a non-binding shareholder vote on golden parachute arrangements in connection with these change in control transactions. Except with respect to “smaller reporting companies” and participants in the Troubled Asset Relief Program (“TARP”), the new rules applied to proxy statements relating to annual meetings of shareholders held after January 20, 2011.

Prohibition Against Charter Conversions of Troubled Institutions. The Dodd-Frank Act generally prohibits a depository institution from converting from a state to federal charter, or vice versa, while subject to an enforcement action, unless the bank seeks prior approval from its regulator and complies with specified procedures to ensure compliance with the enforcement action.

Overdraft and Interchange Fees. The Federal Reserve has adopted amendments under its Regulation E that imposed new restrictions on banks’ abilities to charge overdraft services and fees. The rule prohibits financial institutions from charging fees for paying overdrafts on ATM and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. The opt-in provision established requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. Since a percentage of the Bank’s service charges on deposits are in the form of overdraft fees on point-of-sale transactions, this has had an adverse impact on our noninterest income.

 

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The Dodd-Frank Act, through a provision known as the Durbin Amendment, required the Federal Reserve to establish standards for interchange fees that are “reasonable and proportional” to the cost of processing the debit card transaction and imposes other requirements on card networks. Under the final rule, effective in October 2011, the maximum permissible interchange fee that a bank may receive is the sum of $0.21 per transaction and five basis points multiplied by the value of the transaction, with an additional upward adjustment of no more than $0.01 per transaction if a bank develops and implements policies and procedures reasonably designed to achieve fraud-prevention standards set by regulation. The Federal Reserve’s regulation on charges for overdraft services and interchange fees on debit card transactions reduces the fee revenues that banks receive from the business of processing debit card transactions. While the restrictions on interchange fees do not apply to banks that, together with their affiliates, have assets of less than $10 billion, the rule could affect the competitiveness of debit cards issued by smaller banks.

Consumer Financial Protection Bureau. The Dodd-Frank Act created a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”). The CFPB has broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws for banks and thrifts with greater than $10 billion in assets. Among the CFPB’s responsibilities are implementing and enforcing federal consumer financial protection laws, reviewing the business practices of financial services providers for legal compliance, monitoring the marketplace for transparency on behalf of consumers and receiving complaints and questions from consumers about consumer financial products and services. The Dodd-Frank Act added prohibitions on unfair, deceptive or abusive acts and practices to the scope of consumer protection regulations overseen and enforced by the CFPB. Institutions with less than $10 billion in assets, such as the Company, are subject to rules promulgated by the CFPB but will continue to be examined and supervised by their federal banking regulators for compliance purposes.

Repeal of Demand Deposit Interest Prohibition. The Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

Proposed Legislation

Proposed legislation that may affect the Company and the Bank is introduced in almost every legislative session, both federal and state. Certain of such legislation could dramatically affect the regulation of the banking industry and significantly change the competitive and operating environment in which we operate. We cannot predict if any such legislation will be adopted or, if it is adopted, how it would affect the business of the Bank or the Company. Past history has demonstrated that new legislation or changes to existing laws or regulations usually results in a greater compliance burden and therefore generally increases our cost of doing business.

Effects of Government Monetary Policy

Our earnings and growth are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government, particularly the Federal Reserve. The Federal Reserve implements national monetary policy for such purposes as curbing inflation and combating recession. Its open market operations in U.S. government securities, control of the discount rate applicable to borrowings from the Federal Reserve, and establishment of reserve requirements against certain deposits, influence the growth of bank loans, investments and deposits, and also affect interest rates charged on loans or paid on deposits. For the past several years, the banking industry has operated in an extremely low interest rate environment relative to historical averages, and the Federal Reserve has pursued highly accommodative monetary measures, including a very low federal funds rate and substantial purchases of long-term U.S. Treasury and agency securities, in an effort to facilitate growth in the U.S. economy and a reduction in levels of unemployment. In December 2016, the Federal Reserve raised the target range for the federal funds rate to  12 percent. The Federal Reserve indicated that the increase notwithstanding, the stance of monetary policy remains accommodative, thereby supporting a policy aimed at further strengthening in the labor market and a return to two percent inflation. The Federal Reserve further indicated that it expects economic conditions to evolve in a manner which will warrant only gradual further increases in the federal funds rate. The Federal Reserve also indicated that it intended to continue its policy of holding longer-term agency and Treasury securities at sizeable levels to help maintain accommodative financial conditions.

 

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Statistical Information

All dollar amounts in the following sections, except per common share data, are in thousands of dollars, except where otherwise indicated.

Selected Quarterly Information

The following chart contains data for the prior eight quarters.

 

YEAR

  2016     2015  

QUARTER

  Fourth     Third     Second     First     Fourth     Third     Second     First  
    (in thousands, except per share data)  

Interest income

  $ 27,044     $ 22,662     $ 20,284     $ 19,953     $ 19,877     $ 19,450     $ 18,840     $ 16,069  

Interest expense

    2,060       1,891       1,137       1,144       1,055       1,142       1,144       1,095  

Net interest income

    24,984       20,771       19,147       18,809       18,822       18,308       17,696       14,974  

Provision for loan loss

    1,875       1,380       1,950       245       520       625       550       —    

Noninterest income

    2,344       1,919       1,747       1,807       2,008       1,714       1,627       1,276  

Noninterest expense

    15,829       13,825       14,932       12,007       11,706       11,182       11,030       11,972  

Net income

    6,860       4,851       2,606       5,459       5,528       5,325       5,095       2,803  

PER COMMON

               

SHARE DATA

               

Earnings per share- (basic)

  $ 0.30     $ 0.24     $ 0.13     $ 0.29     $ 0.28     $ 0.27     $ 0.26     $ 0.16  

Earnings per share- (diluted)

  $ 0.30     $ 0.23     $ 0.13     $ 0.29     $ 0.28     $ 0.27     $ 0.26     $ 0.16  

Regular cash dividends

  $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.10     $ 0.10  

WEIGHTED AVERAGE SHARES OUTSTANDING

               

Basic

    22,606,539       20,511,392       19,697,314       19,607,106       19,598,484       19,591,666       19,562,363       18,232,076  

Diluted

    22,822,395       20,676,964       19,868,967       19,782,282       19,765,852       19,816,770       19,788,885       18,444,971  

 

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Investment Portfolio

The following chart contains information regarding the Company’s investment portfolio. All of the Company’s investment securities are accounted for as available-for-sale and are reported at estimated fair value. Temporary differences between estimated fair value and amortized cost, net of deferred taxes, are recorded as a separate component of shareholders’ equity. Credit-related other-than-temporary impairment is recognized against earnings as a realized loss in the period in which it is identified.

INVESTMENT PORTFOLIO

ESTIMATED FAIR VALUE

 

     December 31,  
     2016      2015      2014      2013      2012  
     (dollars in thousands)  

Obligations of U.S. government agencies

   $ 25,620      $ 44,623      $ 39,185      $ 30,847      $ 17,844  

Obligations of states and political subdivisions

     110,739        97,151        83,981        78,795        81,501  

Private label mortgage-backed securities

     1,937        2,789        3,816        5,314        8,600  

Mortgage-backed securities

     290,036        185,370        205,390        223,720        281,940  

SBA pools

     42,664        35,772        19,574        8,710        —    

Corporate securities

     —          893        —          —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 470,996      $ 366,598      $ 351,946      $ 347,386      $ 389,885  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The following chart presents the fair value of each investment category by maturity date and includes a weighted average yield for each period. Mortgage-backed and private label mortgage-backed securities have been classified based on their December 31, 2016, projected average lives.

SECURITIES AVAILABLE-FOR-SALE

 

     December 31, 2016  
     One Year
or Less
    After One
Year
Through
Five Years
    After Five
Years
Through
Ten Years
    After Ten
Years
 
     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield  
     (dollars in thousands)  

Obligations of U.S. government agencies

   $ —          —       $ 6,656        2.50   $ 18,964        2.36   $ —          —    

Obligations of states and political subdivisions

     951        3.97     62,712        2.99     47,076        2.32     —          —    

Private label mortgage-backed securities

     403        —         795        5.65     739        5.37     —          —    

Mortgage-backed securities

     4,088        2.64     166,949        2.50     102,271        2.44     16,728        2.80

SBA variable rate pools

     —          —         22,665        1.80     19,999        1.99     —          —    

Corporate securities

     —          —         —          —         —          —         —          —    
  

 

 

      

 

 

      

 

 

      

 

 

    

Total

   $ 5,442        3.04   $ 259,777        2.57   $ 189,049        2.40   $ 16,728        2.80
  

 

 

      

 

 

      

 

 

      

 

 

    

 

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Loan Portfolio

The following table contains period-end information related to the Company’s loan portfolio for each of the five years ended December 31.

LOAN PORTFOLIO

 

     December 31,  
     2016     2015     2014     2013     2012  
     (dollars in thousands)  

Commercial and other loans

   $ 639,716     $ 508,556     $ 408,011     $ 391,229     $ 326,716  

Real estate loans

     1,049,338       785,737       560,171       500,752       461,240  

Construction loans

     167,811       108,368       73,967       98,910       79,720  

Consumer loans

     2,922       3,351       3,862       3,878       3,581  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     1,859,787       1,406,012       1,046,011       994,769       871,257  

Deferred loan origination fees, net

     (2,020     (1,530     (990     (924     (841
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     1,857,767       1,404,482       1,045,021       993,845       870,416  

Allowance for loan losses

     (22,454     (17,301     (15,637     (15,917     (16,345
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   $ 1,835,313     $ 1,387,181     $ 1,029,384     $ 977,928     $ 854,071  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table presents loan portfolio information by loan category related to maturity and repricing sensitivity. Variable rate loans are fully floating and can adjust at any time. Adjustable rate loans are fixed for a certain time period, but will adjust at a point in the future, prior to maturity. Variable and adjustable rate loans are included in the time frame in which the interest rate on the loan could be first adjusted. At December 31, 2016, the Company had approximately $50,501 of variable rate loans at their floors and $510,842 of adjustable rate loans at their floors that are included in the analysis below. These loans are included in the category of their next available repricing date.

MATURITY AND REPRICING DATA FOR LOANS

 

     December 31, 2016  
     Commercial
and Other
     Real Estate      Construction      Consumer      Total  
     (dollars in thousands)  

Three months or less

   $ 157,313      $ 72,954      $ 92,561      $ 2,512      $ 325,340  

Over three months through 12 months

     8,291        96,088        37,426        23        141,828  

Over 1 year through 3 years

     47,399        278,316        8,505        137        334,357  

Over 3 years through 5 years

     76,931        350,397        4,345        118        431,791  

Over 5 years through 15 years

     349,782        245,043        24,974        132        619,931  

Thereafter

     —          6,540        —          —          6,540  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

   $ 639,716      $ 1,049,338      $ 167,811      $ 2,922      $ 1,859,787  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Loan Concentrations

At December 31, 2016, loans to dental professionals totaled $377,478 and represented approximately 20.30% of outstanding loans. Approximately 65% of the Company’s loans were secured by real estate at December 31, 2016.

Nonperforming Assets

The following table presents period-end nonperforming loans and assets for the years ended December 31, 2016, 2015, 2014, 2013 and 2012:

NONPERFORMING ASSETS

 

     December 31,  
     2016     2015     2014     2013     2012  
     (dollars in thousands)  

Nonaccrual loans

   $ 11,833     $ 5,509     $ 2,695     $ 5,343     $ 9,361  

90 or more days past due and still accruing

     —         —         —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming loans

     11,833       5,509       2,695       5,343       9,361  

Government guarantees

     (2,354     (2,790     (706     (735     (905
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net nonperforming loans

     9,479       2,719       1,989       4,608       8,456  

Other real estate owned

     12,068       11,747       13,374       16,355       17,972  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming assets

   $ 21,547     $ 14,466     $ 15,363     $ 20,963     $ 26,428  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Nonperforming assets as a percentage of total assets

     1.13     0.76     1.02     1.45     1.92

If interest on nonaccrual loans had been accrued, such income would have been approximately $375, $194, $100, $421 and $708, respectively, for the years ended December 31, 2016, 2015, 2014, 2013 and 2012.

 

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Table of Contents

Allowance for Loan Losses

The following chart presents information about the Company’s allowance for loan losses. Management and the Board of Directors evaluate the allowance monthly and consider the amount to be adequate to absorb possible loan losses.

ALLOWANCE FOR LOAN LOSSES

 

     December 31,  
     2016     2015     2014     2013     2012  
           (dollars in thousands)        

Balance at beginning of year

   $ 17,301     $ 15,637     $ 15,917     $ 16,345     $ 14,941  

Charges to the allowance

          

Commercial and other loans

     (716     (630     (610     (1,658     (1,401

Real estate loans

     —         (61     (58     (407     (1,190

Construction loans

     —         —         (155     —         (1,054

Consumer loans

     (9     (9     (12     (23     (19
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charges to the allowance

     (725     (700     (835     (2,088     (3,664

Recoveries against the allowance

          

Commercial and other loans

     207       562       348       982       1,917  

Real estate loans

     55       76       186       360       55  

Construction loans

     163       16       16       60       1,188  

Consumer loans

     3       15       5       8       8  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries against the allowance

     428       669       555       1,410       3,168  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Provisions

     5,450       1,695       —         250       1,900  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of the year

   $ 22,454     $ 17,301     $ 15,637     $ 15,917     $ 16,345  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge offs as a percentage of total average loans

     0.02     0.00     0.30     0.70     0.06

Allowance for loan losses as a percentage of gross loans

     1.21     1.23     1.49     1.60     1.88

The following table sets forth the allowance for loan losses allocated by loan type:

 

     December 31,  
     2016     2015     2014     2013     2012  
     (dollars in thousands)  
     Amount      Percent
of loans
in each
category
to total
loans
    Amount      Percent
of loans
in each
category
to total
loans
    Amount      Percent
of loans
in each
category
to total
loans
    Amount      Percent
of loans
in each
category
to total
loans
    Amount      Percent
of loans
in each
category
to total
loans
 

Commercial and other loans

   $ 8,614        34.39   $ 6,349        36.17   $ 5,733        39.00   $ 5,113        39.30   $ 3,846        37.50

Real estate loans

     10,872        56.43     8,297        55.88     7,494        53.50     7,668        50.40     9,456        53.00

Construction loans

     1,781        9.02     1,258        7.71     1,077        7.10     1,493        10.00     1,987        9.10

Consumer loans

     41        0.16     46        0.24     54        0.40     68        0.30     70        0.40

Unallocated

     1,146        N/A       1,351        N/A       1,279        N/A       1,575        N/A       986        N/A  
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Allowance for loan losses

   $ 22,454        100.00   $ 17,301        100.00   $ 15,637        100.00   $ 15,917        100.00   $ 16,345        100.00
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

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Table of Contents

During 2016 and 2015, the Company recorded loan losses provision of $5,450 and $1,695, respectively. At December 31, 2016, the Company’s recorded investment in impaired loans, net of government guarantees, was $10,567, with a specific allowance of $736 provided for in the ending allowance for loan losses. See Note 5 in the Notes to Consolidated Financial Statements in this Form 10-K for additional information regarding the Company’s allowance for loan losses.

While the Company saw improvement with regard to the overall credit quality of the loan portfolio in 2016, management cannot predict the level of the provision for loan losses, the level of the allowance for loan losses, or the level of nonperforming assets in future quarters as a result of continuing uncertain economic conditions. At December 31, 2016, and as shown above, the Company’s unallocated reserves were $1,146 or 5.10% of the total allowance for loan losses at year-end. Management believes that the allowance for loan losses at December 31, 2016, was adequate and that this level of unallocated reserves was prudent in light of the economic conditions and uncertainty that exists in the Northwest markets that the Company serves and the concentration in loans to dental professionals. See Note 6 in the Notes to Consolidated Financial Statements in this Form 10-K for additional information regarding the dental loan portfolio.

Deposits

Average balances and average rates paid by category of deposit are included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K. The chart below details period-end information related to the Company’s time deposits at December 31, 2016. The Company did not have any foreign deposits at December 31, 2016. Variable rate deposits are listed by first repricing opportunity.

TIME DEPOSITS

 

     December 31, 2016  
     Time of
$100 or
more
    Time of
less than
$100
    Total Time  
     (dollars in thousands)  

<3 Months

   $ 2,544     $ 49,003     $ 51,547  

3-6 Months

     2,197       12,452       14,649  

6-12 Months

     2,729       18,777       21,506  

>12 Months

     2,624       88,557       91,181  
  

 

 

   

 

 

   

 

 

 
   $ 10,094     $ 168,789     $ 178,883  
  

 

 

   

 

 

   

 

 

 

Percentage of time deposits to total deposits

     0.47     7.86     8.33

Borrowings

The Company uses short-term borrowings to fund fluctuations in deposits and loan demand. The Bank has access to both secured and unsecured overnight borrowing lines. The secured borrowing lines are collateralized by loans. At December 31, 2016, the Company had secured borrowing lines with the Federal Home Loan Bank of Des Moines (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). At December 31, 2016, the FHLB borrowing line was limited by the amount of collateral pledged, which limited total borrowings to $632,202. The borrowing line with the FRB is limited by the value of discounted collateral pledged, which at December 31, 2016, was $80,784. At December 31, 2016, the Company also had unsecured borrowing lines with various correspondent banks totaling $154,000. At December 31, 2016, the Company had no overnight borrowings outstanding on its unsecured borrowing lines. Borrowings include interest at the then stated rate. At December 31, 2016, there was $801,986 available on secured and unsecured borrowing lines with the FHLB, the FRB, and various correspondent banks.

 

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Table of Contents

SHORT-TERM BORROWINGS

 

     December 31,  
     2016     2015     2014  
     (dollars in thousands)  

Federal funds purchased, FHLB cash management advance, FRB, & short-term advances

      

Average interest rate

      

At year end

     0.70     0.34     0.48

For the year

     0.47     0.18     0.40

Average amount outstanding for the year

   $ 164,615     $ 129,665     $ 121,016  

Maximum amount outstanding at any month-end

   $ 183,500     $ 117,000     $ 168,500  

Amount outstanding at year-end

   $ 57,000     $ 47,000     $ 68,500  

In addition to the Company’s $57,000 in short-term borrowings outstanding at December, 31, 2016, the Company had $8,000 in long term FHLB borrowing, for a total of $65,000. The combined short and long-term borrowings had a weighted average interest rate of 1.01% and a remaining average maturity of approximately 1.87 years. More information on the Company’s long-term borrowings can be found in Note 13 in the Notes to Consolidated Financial Statements in this Form 10-K.

The Company’s other long-term borrowings consisted of two junior subordinated debentures. The first totals $8,248 was issued on November 28, 2005, and matures on January 7, 2036. The interest rate on the debentures was 6.27% until January 2012 after which it was converted to a floating rate of three-month LIBOR plus 135 basis points. In April 2013, the Company entered into a swap agreement with a third party, which fixed the rate on its $8,000 of trust preferred securities at 2.73% for seven years. The second was acquired September 6, 2016 following the acquisition of Foundation Bank. In third quarter 2016, the Company assumed ownership of Foundation Statutory Trust I, which had previously issued $6,000 in aggregate liquidation amount of trust preferred securities. The interest rate on these trust preferred securities is a floating rate of three-month LIBOR plus 173 basis points. The Company also acquired $6,148 of junior subordinated debentures (the “Foundation Debentures”) to the trust in exchange for ownership of all of the common security of the trust and the proceeds of the preferred securities sold by the trust. In accordance with current accounting guidance, the trust is not consolidated in the Company’s financial statements, but rather the Foundation Debentures are shown as a liability, and acquired at an acquisition date fair value of $3,013. The Company also recognized its $186 investment in the Foundation Statutory Trust I, which is recorded among “Other Assets” in its consolidated balance sheet at December 31, 2016 and 2015.

In June 2016, in a regional public offering the Company issued $35,000 in aggregate principal amount of fixed-to-floating rate subordinated debentures (the “Notes”). The Notes are callable at par after five years, have a stated maturity of June 30, 2026 and bear interest at a fixed annual rate of 5.875% per year, from and including June 27, 2016 but excluding June 30, 2021. From and including June 30, 2021 to the maturity date or early redemption date, the interest rate will reset quarterly to an annual interest rate equal to the then-current three-month LIBOR plus 471.5 basis points. The Notes are included in Tier 2 capital (with certain limitations applicable) under current regulatory guidelines and interpretations.

 

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Table of Contents
ITEM 1A Risk Factors

We are subject to numerous risks and uncertainties, including but not limited to, the following information:

Industry Factors

The continued challenges in the U.S. and our region’s economies could have a material adverse effect on our future results of operations or market price of our stock; there can be no assurance that U.S. governmental measures responding to these challenges will successfully address these circumstances; the U.S. government continues to face significant fiscal and budgetary challenges which, if not resolved, may further exacerbate U.S. economic conditions.

The national economy and the financial services sector in particular are still facing challenges. A large percentage of our loans are to businesses in western Washington and Oregon, markets facing many of the same challenges as the national economy, including elevated unemployment and weakness in commercial and residential real estate values. Although some economic indicators are improving both nationally and in the markets we serve, there remains uncertainty regarding the strength of the economic recovery. A continued slow economic recovery could result in the following consequences, any of which could have an adverse impact, which may be material, on our business, financial condition, results of operations and prospects, and could also cause the market price of our stock to decline:

 

    Economic conditions may not stabilize, increasing the likelihood of credit defaults by borrowers.

 

    Loan collateral values, especially as they relate to commercial and residential real estate, may decline, thereby increasing the severity of loss in the event of loan defaults.

 

    Demand for banking products and services may decline, including loan products and services for low cost and noninterest-bearing deposits.

 

    Changes and volatility in interest rates may negatively impact the yields on earning assets and the cost of interest-bearing liabilities.

Our earnings and growth are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government, particularly the Federal Reserve. Refer to “Supervision and Regulation” in Item 1 of Part I of this Form 10-K for discussion of certain of these measures. In response to the adverse financial and economic developments that have, in the past decade, impacted the U.S. and global economies and financial markets, and presented challenges for the banking and financial services industry and for our Company, various significant economic and monetary stimulus measures were implemented by the U.S. Congress. Also, the Federal Reserve has pursued a highly accommodative monetary policy aimed at keeping interest rates at historically low levels although the Federal Reserve has begun to taper down certain aspects of this policy and has recently raised short-term interest rates. See “— Fluctuating interest rates could adversely affect our profitability”. U.S. economic activity has shown improvement, but there can be no assurance that this progress will continue or will not reverse. If the U.S. economy were to deteriorate, or its recovery were to slow, this would present significant challenges for the U.S. banking and financial services industry and for our Company.

The challenges to the level of economic activity in the U.S., and, therefore, to the banking industry, have also been exacerbated at times in recent years by extensive political disagreements regarding the statutory debt limit on U.S. federal government obligations and measures to address the substantial federal deficits. These political disagreements led to the downgrade in the long-term sovereign credit rating on the U.S. to “AA+” from “AAA” although other credit rating agencies did not take such action. Certain compromises between the Republican Congress and the Obama Administration were eventually reached which alleviated to some degree the concerns about U.S. sovereign debt. However, there can be no assurance that the earlier political disagreements regarding the federal budget and the substantial federal deficits will not occur again in the future. Any such future disagreements, if not resolved, could result in further downgrades by the rating agencies with respect to the obligations of the U.S. federal government. Any such further downgrades could increase over time the U.S. federal government’s cost of borrowing which may worsen its fiscal challenges, as well as generating upward pressure on interest rates generally in the U.S. which could, in turn, have adverse consequences for borrowers and the level of business activity.

 

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Table of Contents

The outcome and impact of these developments cannot be predicted with any certainty, but could have further adverse consequences for the credit ratings of U.S. debt and also present additional challenges for the U.S. economy and for the U.S. banking industry in general and for our business prospects as well. Any of the foregoing developments could generate further uncertainties and challenges for the U.S. economy which, in turn, could adversely affect the prospects of the banking industry in the U.S. and our business.

Tightening of credit markets and liquidity risk could adversely affect our business, financial condition and results of operations.

A tightening of the credit markets or any inability to obtain adequate funds at an acceptable cost for continued loan growth could adversely affect our asset growth and liquidity position and, therefore, our earnings capability. In addition to core deposit growth, maturity of investment securities, and loan payments, the Company also relies on wholesale funding sources including unsecured borrowing lines with correspondent banks, secured borrowing lines with the Federal Home Loan Bank of Seattle and the Federal Reserve Bank of San Francisco, public time certificates of deposits, and out-of-area and brokered time certificates of deposit. Our ability to access these funding sources could be impaired by deterioration in our financial condition as well as factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations for the financial services industry or serious dislocation in the general credit markets. In the event such disruption should occur, our ability to access these funding sources could be adversely affected, both as to price and availability, which would limit, or potentially raise the cost of, the funds available to the Company.

The FDIC has increased insurance premiums to rebuild and maintain the federal deposit insurance fund and there may be additional future premium increases and special assessments which would adversely affect our results of operations.

The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits, and are subject to deposit insurance assessments designed to tie what banks pay for deposit insurance more closely to the risks they pose. Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole. As required by the Dodd-Frank Act, the FDIC adopted a comprehensive, long-range “restoration” plan for the deposit insurance fund to better ensure the adequacy of the fund’s reserves relative to total deposits in the U.S. See “Supervision and Regulation- Deposit Insurance” in this Form 10-K. The ultimate effect on our business of these legislative and regulatory developments relating to the deposit insurance fund cannot be predicted with any certainty.

Despite the FDIC’s actions to restore the deposit insurance fund, the fund may suffer additional losses in the future due to failures of insured institutions. There may be additional significant deposit insurance premium increases, special assessments or prepayments in order to restore the insurance fund’s reserve ratio. Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations.

In the past decade, levels of market volatility were unprecedented and we cannot predict whether they will return.

From time-to-time over the past decade, the capital and credit markets have experienced volatility and disruption at unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If similar levels of market disruption and volatility return, we could experience an adverse effect, which may be material, on our ability to access capital and funding and on our business, financial condition and results of operations.

We operate in a highly regulated environment and the effects of recent and pending federal legislation or of changes in, or supervisory enforcement of, banking or other laws and regulations could adversely affect us.

As discussed more fully in the section entitled “Supervision and Regulation” in this Form 10-K, we are subject to extensive regulation, supervision and examination by federal and state banking authorities. In addition, as a publicly traded company, we are subject to regulation by the SEC. Any change in applicable regulations or federal, state or local legislation could have a substantial impact on us and our operations. Additional legislation and regulations that could significantly affect our powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on our financial condition and results of operations. New legislation and regulations are likely to increase the overall costs of regulatory compliance and, in many ways, have increased, or may increase in the future, the cost of doing business and present other challenges to the financial services industry.

 

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Regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws or regulations by financial institutions and bank holding companies in the performance of their supervisory and enforcement duties. In recent years, these powers have been utilized more frequently due to the serious national, regional and local economic conditions we are facing. The exercise of regulatory authority may have a negative impact on our financial condition and results of operations.

Following the financial crisis, the Federal Reserve and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations. For additional information, see “Supervision and Regulation – Capital Adequacy” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources” in this Form 10-K.

The need to maintain more and higher quality capital under the banking agencies capital rules, as well as greater liquidity, could limit our business activities, including lending, and our ability to expand, either organically or through acquisitions. It could also result in the Company taking steps to increase its capital or being limited in its ability to pay dividends or otherwise return capital to its shareholders, or selling or refraining from acquiring assets. In addition, the regulatory liquidity standards could require the Company to increase its holdings of highly liquid short-term investments, thereby reducing our ability to invest in longer-term or less liquid assets even if more desirable from a balance sheet management perspective.

The capital rules of the U.S. federal banking agencies as well as the various other regulations referred to above, along with other regulations which may be adopted in the future, may also generally increase our cost of doing business or lead us to stop, reduce or modify our offerings of various products.

We cannot accurately predict the ultimate effects of recent legislation or the various governmental, regulatory, monetary and fiscal initiatives which have been and may be enacted on the financial markets, on the Company and on the Bank. The terms and costs of these activities, or the failure of these actions to help stabilize the financial markets, asset prices, market liquidity and a continuation or worsening of current financial market and economic conditions, could materially and adversely affect our business, financial condition, results of operations and the trading price of our common stock.

The Administration of newly-elected President Donald J. Trump has yet to promulgate detailed proposals with respect to the oversight and regulation of the financial services industry. There could be significant changes in existing laws and regulations relevant to the industry or the introduction of new laws and regulations. In addition, substantial reform of the federal corporate taxation system in the U.S., including a reduction in corporate and personal tax rates, has been mentioned by representatives of the new Administration as an important objective. While such reform could have positive effects on corporate profitability which could benefit the Company and its customers, there could be other potential adverse consequences for the economy and the business climate, such as a large increase in federal deficits and increasing interest rates generally, including for the federal government’s borrowing costs. The potential long-term impact of these possible developments remains uncertain.

Fluctuating interest rates could adversely affect our profitability.

As is the case with many banks, our profitability is dependent to a large extent upon our net interest income, which is the difference between the interest earned on loans, securities and other interest-earning assets and interest paid on deposits, borrowings, and other interest-bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect, and has in past years, impacted, our net interest margin, and, in turn, our profitability. This impact could result in a decrease in our interest income relative to interest expense. Increases in interest rates may also adversely impact the value of our securities investment portfolio. At December 31, 2016, our balance sheet was liability sensitive, and an increase in interest rates could cause our net interest margin and our net interest income to decline. For the past several years, the banking industry has operated in an extremely low interest rate environment relative to historical averages, and the Federal Reserve has pursued highly accommodative monetary policies (including a very low Federal funds rate and substantial purchases of long-term U.S. Treasury and agency securities) in an effort to facilitate growth in the U.S. economy and a reduction in levels of unemployment. This environment has placed downward pressure on the net interest margins of U.S. banks, including the Bank. In December 2016, the Federal Reserve raised the target range for the federal funds rate to  34 percent and indicated that the increase notwithstanding, the stance of monetary policy remains accommodative, thereby supporting a policy aimed at further strengthening in the labor market and a return to two percent inflation. The Federal Reserve further indicated that it expects economic conditions to evolve in a manner which will warrant only gradual further increases in the federal funds rate. The Federal Reserve also indicated that it intended to continue its policy of holding longer-

 

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term agency and Treasury securities at sizeable levels to help maintain accommodative financial conditions. The degree to which the Federal Reserve will continue its accommodative monetary policies, and the timing of any easing of those policies, will depend upon the Federal Reserve’s judgments regarding labor market conditions and the overall economic outlook, and are, therefore, subject to continuing uncertainty.

Company Factors

Our allowance for loan losses may not be adequate to cover actual loan losses, which could adversely affect our earnings.

We maintain an allowance for loan losses in an amount that we believe is adequate to provide for losses inherent in our loan portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, at any time there are loans included in the portfolio that may result in losses, but that have not yet been identified as potential problem loans. Through established credit practices, we attempt to identify deteriorating loans and adjust the loan loss reserve accordingly. However, because future events are uncertain, there may be loans that deteriorate in an accelerated time frame. As a result, future additions to the allowance at elevated levels may be necessary. Because the loan portfolio contains a number of commercial real estate loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers, such as have resulted due to the current, and potentially worsening, economic conditions. Additionally, federal banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operations.

Concentration in real estate loans and further deterioration in the real estate markets we serve could require material increases in our allowance for loan losses and adversely affect our financial condition and results of operations.

We have a high degree of concentration in loans secured by real estate (see Note 5 in the Notes to Consolidated Financial Statements included in this Form 10-K). Further deterioration in the local economies we serve could have a material adverse effect on our business, financial condition and results of operations due to a weakening of our borrowers’ ability to repay these loans, higher default rates, and a decline in the value of the collateral securing these loans. In light of the continuing effects of the economic downturn, real estate values have been adversely affected. As we have experienced, significant declines in real estate collateral can occur quite suddenly as new appraisals are performed in the normal course of monitoring the credit quality of the loan. Significant declines in the value of real estate collateral due to new appraisals can occur due to declines in the real estate market, changes in methodology applied by the appraiser, and/or using a different appraiser than was used for the prior appraisal. Our ability to recover on these loans by selling or disposing of the underlying real estate collateral is adversely impacted by declining real estate values which increases the likelihood we will suffer losses on defaulted loans secured by real estate beyond the amounts provided for in the allowance for loan losses. This, in turn, could require material increases in our allowance for loan losses and adversely affects our financial condition and results of operations, perhaps materially.

We have a significant concentration in loans to dental professionals, and loan concentrations within one industry may create additional risk.

Bank regulatory authorities and investors generally view significant loan concentrations within any particular industry as carrying higher inherent risk than a loan portfolio without any significant concentration in one industry. We have a significant concentration of loans to dental professionals which represented 20.30% in principal amount of our total loan portfolio at December 31, 2016 (see Note 5 in the Notes to Consolidated Financial Statements included in this Form 10-K). While we apply credit practices which we believe to be prudent to these loans as well as all the other loans in our portfolio, due to our concentration in dental lending, we are exposed to the general risks of industry concentration, which include adverse market factors impacting that industry alone or disproportionately to other industries. In addition, bank regulatory authorities may in the future require us to limit additional lending in the dental industry if they have concerns that our concentration in that industry creates significant risks, which in turn could limit our ability to pursue new loans in an area where we believe we currently have a competitive advantage.

 

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Nonperforming assets take significant time to resolve and adversely affect our results of operations and financial condition.

At December 31, 2016, our nonperforming loans (which include all nonaccrual loans, net of government guarantees) were 0.51% of the loan portfolio. At December 31, 2015, our nonperforming assets (which include foreclosed real estate) were 0.85% of total assets. Nonperforming loans and assets adversely affect our net income in various ways. Until economic and market conditions improve, we expect to continue to incur losses relating to nonperforming assets. We generally do not record interest income on nonperforming loans or other real estate owned, thereby adversely affecting our income and increasing our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, less estimated selling expenses, which may ultimately result in a loss. An increase in the level of nonperforming assets increases our risk profile and may impact the capital levels our regulators believe are appropriate in light of the ensuing risk profile. While we reduce problem assets through loan sales, workouts, and restructurings and otherwise, decreases in the value of the underlying collateral, or in these borrowers’ performance or financial condition, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition, perhaps materially. In addition, the resolution of nonperforming assets requires significant commitments of time from management and our directors which can be detrimental to the performance of their other responsibilities. Any significant future increase in nonperforming assets could have a material adverse effect on our business, financial condition and results of operations.

We may not have the ability to continue paying dividends on our common stock at current or historic levels.

On January 26, 2017, we announced a quarterly cash dividend of $0.11 per share, payable to shareholders on February 23, 2017. For the year ended December 31, 2016, the Company paid $0.44 per share in dividends and has historically declared dividends quarterly. Our ability to pay dividends on our common stock depends on a variety of factors. It is possible in the future that we may not be able to continue paying quarterly dividends commensurate with historic levels, if at all. As a holding company, a substantial portion of our cash flow typically comes from dividends our bank subsidiary pays to us. Cash dividends will depend on sufficient earnings to support them and adherence to bank regulatory requirements. If the Bank is not able to pay dividends to the Company, the Company may not be able to pay dividends on its common stock. Consequently, the inability to receive dividends from the Bank could adversely affect the Company’s financial condition, results of operations and prospects.

Changes in accounting standards could materially impact our financial statements.

From time to time, the Financial Accounting Standards Board (“FASB”) and the SEC change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements or new interpretations of existing standards emerge as standard industry practice. These changes can be very difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retrospectively, resulting in our restating prior period financial statements.

We may be required, in the future, to recognize impairment with respect to investment securities, including the FHLB stock we hold.

Our securities portfolio contains whole loan private mortgage-backed securities and municipal securities and currently includes securities with unrecognized losses. We may continue to observe volatility in the fair market value of these securities. We evaluate the securities portfolio for any other than temporary impairment (“OTTI”) each reporting period, as required by GAAP. Future evaluations of the securities portfolio could require us to recognize impairment charges. The credit quality of securities issued by certain municipalities has deteriorated in recent quarters. Although management does not believe the credit quality of the Company’s municipal securities has similarly deteriorated, such deterioration could occur in the future. For example, it is possible that government-sponsored programs to allow mortgages to be refinanced to lower rates could materially adversely impact the yield on our portfolio of mortgage-backed securities, since a significant portion of our investment portfolio is composed of such securities.

In addition, as a condition to membership in the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB. At December 31, 2016, we had stock in the FHLB totaling $5,423. The FHLB stock held by us is carried at cost and is subject to recoverability testing under applicable accounting standards. As of December 31, 2016, we did not recognize an impairment charge related to our FHLB stock holdings. Future negative changes to the financial condition of the FHLB could require us to recognize an impairment charge with respect to such holdings.

 

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If the goodwill we have recorded in connection with acquisitions becomes impaired, it could have an adverse impact on our reported earnings.

At December 31, 2016, we had $61,401 of goodwill on our balance sheet. In accordance with GAAP, our goodwill is not amortized but rather evaluated for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists. Such evaluation is based on a variety of qualitative and quantitative factors, including macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, and other relevant entity-specific events. The last impairment test was performed at December 31, 2016. At December 31, 2016, we did not recognize an impairment charge related to our goodwill. Future evaluations of goodwill may result in findings of impairment and write-downs, which would impact our operating results and could be material.

We face strong competition from financial services companies and other companies that offer financial services.

Our three major markets are in Oregon and Washington. The banking and financial services businesses in our market area are highly competitive, and increased competition may adversely impact the level of our loans and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. These competitors include national banks, foreign banks, regional banks and other community banks. We also face competition from many other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, our competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services. We have also seen an increase in competition relative to our national dental lending program. If we are unable to attract and retain banking customers, we may be unable to develop loan growth or maintain our current level of deposits, which could adversely affect our business, financial condition and results of operations.

A failure in our operational systems or infrastructure, or those of third-parties, could impair our liquidity, disrupt our businesses, result in the unauthorized disclosure of confidential information, damage our reputation and cause financial losses.

We are dependent on third-parties and their ability to process and monitor, on a daily basis, a large number of transactions, many of which are highly complex, across numerous and diverse markets. These transactions, as well as the information technology services we provide to clients, often must adhere to client-specific guidelines, as well as legal and regulatory standards. Due to the breadth of our client base and our geographical reach, developing and maintaining our operational systems and infrastructure is challenging, particularly as a result of rapidly evolving legal and regulatory requirements and technological shifts. Our financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, such as electrical, internet or telecommunications outages, a spike in transaction volume, a cybersecurity attack or other unforeseen catastrophic events, which may adversely affect our ability to process these transactions or provide services.

In addition, our operations rely on the secure processing, storage, transmission and reporting of personal, confidential and other sensitive information or data on our computer systems, networks and business applications. Although we take numerous protective measures to maintain the confidentiality, integrity and availability of our and our clients’ information across all geographic and product lines, and endeavor to modify these protective measures as circumstances warrant, the nature of the threats continues to evolve. As a result, our computer systems, software and networks may be vulnerable to breaches, unauthorized access, loss or destruction of data (including confidential client information), account takeovers, unavailability of service, computer viruses or other malicious code, cybersecurity attacks and other events that could have an adverse security impact and significant negative consequences to us. Despite the defensive measures we take to manage our internal technological and operational infrastructure, these threats may originate externally from third-parties, such as foreign governments, organized crime and other hackers, and outsource or infrastructure-support providers and application developers, or the threats may originate from within our organization. These events could result in litigation or financial losses that are either not insured against or not fully covered by insurance, regulatory consequences or reputational harm, any of which could harm our competitive position, operating results and financial condition. These types of incidents can remain undetected for extended periods of time, thereby increasing the associated risks. We may also be required to expend significant resources to modify our protective measures or to investigate and remediate vulnerabilities or exposures arising from cybersecurity risks.

 

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We also face the risk of operational disruption, failure, termination or capacity constraints of any of the third-parties that facilitate our business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an attack on, or breach of, our operational systems, data or infrastructure. In addition, as interconnectivity with our clients grows, we increasingly face the risk of operational failure with respect to our clients’ systems.

Other financial institutions have been the target of various denial-of-service or other cyberattacks as part of what appears to be a coordinated effort to disrupt the operations of financial institutions and potentially test their cybersecurity in advance of future and more advanced cyberattacks. These denial-of-service attacks require substantial resources to defend, and may affect customer satisfaction and behavior. In addition, there have been increasing efforts on the part of third parties to breach data security at financial institutions as well as the other types of companies, such as large retailers, or with respect to financial transactions, including through the use of social engineering schemes such as “phishing”. The ability of our customers to bank remotely, including online and through mobile devices, requires secure transmissions of confidential information and increase the risk of data security breaches which would expose us to financial claims by customers or others and which could adversely affect our reputation. Even if cyberattacks and similar tactics are not directed specifically at the Bank, such attacks on other large financial institutions could disrupt the overall functioning of the financial systems and undermine consumer confidence in banks generally, to the detriment of other financial institutions, including the Bank.

Under the applicable Federal regulatory guidance, financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. In addition, the financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyberattack involving destructive malware. A financial institution is also expected to develop appropriate processes that enable recovery of data and business operations and that address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyberattack. A financial institution which fails to observe the regulatory guidance could be subject to various regulatory sanctions, including financial sanctions.

The Federal bank regulators have also issued a cybersecurity assessment tool, the output of which can assist a financial institution’s senior management and board of directors in assessing the institution’s cybersecurity risk and preparedness. The first part of the assessment tool is the inherent risk profile, which aims to assist management in determining an institution’s level of cybersecurity risk. The second part of the assessment tool is cybersecurity maturity, which is designed to help management assess whether their controls provide the desired level of preparedness. The Federal bank regulators utilize the assessment tool as part of their examination process when evaluating financial institutions’ cybersecurity preparedness in information technology and safety and soundness examinations and inspections. Failure to effectively utilize this tool could result in regulatory criticism. Significant resources may be required to adequately implement the tool and address any assessment concerns regarding preparedness. Management conducted an initial cyber-security assessment using this tool and expects to perform additional periodic assessments to facilitate the identification and remediation of any concerns regarding our cyber-security preparedness.

To date we have not experienced any material losses relating to a cybersecurity incident or other information security breaches, but there can be no assurance that we will not suffer such losses or information security breaches in the future. If one or more of these events occurs, it could potentially jeopardize the confidential, proprietary and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, as well as our clients’ or other third-parties’, operations which could result in damage to our reputation, substantial costs, regulatory penalties and/or client dissatisfaction or loss. Potential costs of a cybersecurity incident may include, but would not be limited to, remediation costs, increased protection costs, lost revenue from the unauthorized use of proprietary information or the loss of current and/or future customers, and litigation.

We maintain an insurance policy which we believe provides sufficient coverage at a manageable expense for an institution of our size and scope with similar technological systems. However, we cannot assure that this policy would be sufficient to cover all financial losses, damages, penalties, including lost revenues, should we experience any one or more of our or a third-party’s systems failing or experiencing attack.

 

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Our business and financial results could be impacted materially by adverse results in legal or regulatory proceedings.

As is the case with other banking institutions, we are from time to time subject to claims and proceedings related to our present or previous operations. In addition, we may be the subject of governmental investigations and other forms of regulatory inquiry from time to time. The results of these legal proceedings and governmental investigations and inquiries could lead to significant monetary damages or penalties, restrictions on the way in which we conduct our business, or reputational harm, and could involve significant defense or other costs. Although we establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and that the amount of loss can be reasonably estimated, we do not have accruals for all legal proceedings where we face a risk of loss. In addition, amounts accrued may not represent the ultimate loss to us from the legal proceedings in question. Thus, our ultimate losses may be higher or lower, and possibly significantly so, than the amounts accrued for legal loss contingencies. To mitigate the cost of some of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage does not cover any civil money penalties or fines imposed by government authorities and may not cover all other claims that have been or might be brought against us, or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our business, prospects, results of operations and financial condition.

Risks associated with potential acquisitions and expansion activities or divestitures may disrupt our business and adversely affect our operating results.

We regularly evaluate potential acquisitions and expansion opportunities. We have in the past, and may in the future, seek to expand our business by acquiring other businesses which we believe will enhance our business. We cannot predict the frequency, size or timing of our acquisitions, as this will depend on the availability of prospective target opportunities at valuation levels we find attractive and the competition for such opportunities from other parties. There can be no assurance that our acquisitions will have the anticipated positive results, including results related to: the total cost of integration; the retention of key personnel; the time required to complete the integration; the amount of longer-term cost savings; continued growth; or the overall performance of the acquired company or combined entity. We also may encounter difficulties in obtaining required regulatory approvals and unexpected contingent liabilities can arise from the businesses we acquire or other business combinations we enter into. Further, the asset quality or other financial characteristics of a business or assets we may acquire may deteriorate after an acquisition agreement is signed or after an acquisition closes, which could result in impairment or other expenses and charges which would reduce our operating results. Integration of an acquired business can be complex and costly. If we are not able to integrate successfully past or future acquisitions, there is a risk that results of operations could be adversely affected. To the extent that we grow through acquisitions, there is a risk that we will not be able to adequately or profitably manage this growth. In addition, we may sell or restructure portions of our business. Any divestitures or restructuring may result in significant expenses and write-offs, which would have a material adverse effect on our business, results of operations and financial condition, and may involve additional risks, including difficulties in obtaining any required regulatory approvals, the diversion of management’s attention from other business concerns, the disruption of our business and the potential loss of key employees. We may not be successful in addressing these or any other significant risks encountered in connection with any acquisition or divestitures we might make.

We may issue additional capital in the future, which could dilute the holders of our outstanding common stock and may adversely affect the market price of our common stock.

From time to time, particularly in the current uncertain economic environment, we may consider alternatives for raising capital when opportunities present themselves, in order to further strengthen our capital and/or better position ourselves to take advantage of identified or potential opportunities that may arise in the future. Such alternatives may include issuance and sale of common or preferred stock, or borrowings by the Company, with proceeds contributed to the Bank. Any such capital raising alternatives could dilute the holders of our outstanding common stock and may adversely affect the market price of our common stock.

Anti-takeover provisions in our amended and restated articles of incorporation and bylaws and Oregon law could make a third-party acquisition of us difficult.

Our amended and restated articles of incorporation contain provisions that could make it more difficult for a third-party to acquire us (even if doing so would be beneficial to our shareholders) and for holders of our common stock to receive any related takeover premium for their common stock. We are also subject to certain provisions of Oregon law that could delay, deter or prevent a change in control of us. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

 

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ITEM 1B Unresolved Staff Comments

None

 

ITEM 2 Properties

The principal properties of the Company are comprised of the banking facilities owned by the Bank. At December 31, 2016 the Bank operated 15 full-service facilities and two loan production offices. The Bank owns a total of eight buildings and, with the exception of three of those buildings, owns the land on which these buildings are situated. Significant properties owned by the Bank are as follows:

 

1) Three-story building and land with approximately 35,000 square feet located on Olive Street in Eugene, Oregon.

 

2) Building with approximately 4,000 square feet located on West 11th Avenue in Eugene, Oregon. The building is on leased land.

 

3) Building and land with approximately 8,000 square feet located on High Street in Eugene, Oregon.

 

4) Three-story building and land with approximately 36,000 square feet located in Springfield, Oregon. The Company occupies approximately 5,500 square feet of the first floor and approximately 10,763 square feet on the second floor and leases, or is seeking to lease, the remaining space.

 

5) Building and land with approximately 4,000 square feet located in Beaverton, Oregon.

 

6) Building and land with approximately 2,000 square feet located in Junction City, Oregon.

 

7) Building and land with approximately 5,000 square feet located near the Convention Center in Portland, Oregon.

 

8) Building with approximately 7,000 square feet located at the Nyberg Shopping Center in Tualatin, Oregon. The building is on leased land.

The Bank leases facilities for branch offices in Eugene, Oregon, Portland, Oregon, Seattle, Washington, Bellevue, Washington, and Vancouver, Washington. The Company also leases facilities for a loan production office in Tacoma, Washington. In addition, the Company leases a portion of an adjoining building to the High Street office in Eugene, Oregon for administrative and training functions. Management considers all owned and leased facilities adequate for current use.

 

ITEM 3 Legal Proceedings

On August 23, 2013, a putative class action lawsuit (“Class Action”) was filed in the Circuit Court of the State of Oregon for the County of Multnomah on behalf of individuals who placed money with Berjac of Oregon and Berjac of Portland (collectively, “Berjac”). The Berjac entities merged and the surviving company, Berjac of Oregon, is currently in Chapter 7 bankruptcy. The Class Action complaint, which has been amended several times, currently asserts three claims against PCB, Fred “Jack” W. Holcomb, Holcomb Family Limited Partnership, Jones & Roth, P.C., and Umpqua Bank, as defendants. The lawsuit asserts that PCB is jointly and severally liable for materially aiding or participating in Berjac’s sales of securities in violation of the Oregon Securities Law. Claimants seek the return of the money placed with Berjac of Oregon and Berjac of Portland, plus interest, and costs and attorneys’ fees. The current version of the complaint seeks $100 million in damages from all defendants.

On August 28, 2015, the court-appointed bankruptcy trustee for Berjac of Oregon filed an adversary complaint (“Trustee’s Lawsuit”) in the U.S. Bankruptcy Court for the District of Oregon alleging that The Company, The Bank, Umpqua Bank, Century Bank and Summit Bank provided lines of credit that enabled continuation of the alleged Ponzi scheme operated by Berjac of Oregon and the two partners of the pre-existing Berjac general partnerships, Michael Holcomb and Gary Holcomb. The Company acquired Century Bank on February 1, 2013. The Trustee’s Lawsuit was transferred from the U.S. Bankruptcy Court to the U.S. District Court for the District of Oregon (Eugene Division).

In addition to seeking an award of punitive damages, the trustee is asserted fraudulent transfer law and unjust enrichment in an effort to recover payments made by Berjac to Century Bank and PCB. Among other claims for relief, the trustee is sought the disgorgement of monies advanced to the Holcomb Family Limited Partnership by Century Bank and returned to the estate by court order following the post-petition cash collateral hearing, and of monies received by PCB from the proceeds of the sale of stock held by the Holcomb Family Limited Partnership and securing one of the lines of credit previously held by Century Bank. The trustee also asserted a claim for alleged aiding and abetting of breaches of duties owed to Berjac. The complaint in the Trustee’s Lawsuit indicated the range of damages sought by the trustee which included, among other claims for relief, an award of punitive damages not to exceed $10 million, recovery of payments associated with allegedly fraudulent transfers totaling up to approximately $55.3 million, including up to $20.7 million from Century Bank and up to $7.7 million from PCB.

 

 

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On November 16, 2016, the U.S. District Court judge stayed all deadlines in the Trustee’s Lawsuit and all parties were ordered to participate in a judicial settlement conference. The judicial settlement conference sessions were held on February 18, 2016 and April 20, 2016. At the April 20, 2016, settlement conference, PCB reached a tentative settlement of the Class Action and the Trustee’s Lawsuit. Per the December 2, 2016 Trustee’s Motion and Notice of Intent to Settle and Compromise Adversary Proceeding (“Motion”), and subsequently ordered by District Court Judge Aiken on December 6, the settlement and compromise between PCB and the Trustee was to be deemed effective without further order within 23 days unless a written objection to the Trustee’s Motion was filed and served on the Trustee. No written objection was filed, and PCB is informed that no written objection was served on the Trustee. Accordingly, final approval of the settlement of the Trustee’s Action was effective December 29, 2016. The state Circuit Court gave final approval of the settlement of the Class Action at a hearing on January 6, 2017. The settlement is not expected to have a material adverse effect on PCC’s financial condition.

We may from time to time be involved in claims, proceedings and litigation arising from our business and property ownership. Based on currently available information, the Company does not expect that the results of such proceedings, including the above-described proceeding, in the aggregate, to have a material adverse effect on our financial condition.

 

ITEM 4 Mine Safety Disclosures

Not applicable.

PART II

 

ITEM 5 Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information and Shareholders

The Company’s common stock is traded on the NASDAQ Global Select Market under the symbol “PCBK”. At February 28, 2017, the Company had 22,665,881 shares of common stock outstanding held by approximately 3,181 beneficial shareholders.

The high, low and closing sales prices (based on daily closing price) for the last eight quarters are shown in the table below.

 

YEAR    2016      2015  
QUARTER    Fourth      Third      Second      First      Fourth      Third      Second      First  

Market value:

                       

High

   $ 22.05      $ 16.85      $ 17.02      $ 16.39      $ 16.11      $ 13.63      $ 13.95      $ 13.81  

Low

     16.50        14.48        15.03        13.78        13.10        12.63        12.74        12.64  

Close

     21.85        16.82        15.71        16.13        14.88        13.31        13.53        13.22  

Dividends

The Company has generally paid cash dividends on a quarterly basis. Cash dividends, when and if declared, are typically declared and announced simultaneously with the Company’s quarterly earnings releases in January, April, July, and October each year with dividends, if any, to be paid in February, May, August, and November. The Board of Directors considers the dividend amount quarterly and takes a broad perspective in its dividend deliberations, including a review of recent operating performance, capital levels, and concentrations of loans as a percentage of capital, as well as growth projections. The Board also considers dividend payout ratios, dividend yield, and other financial metrics in setting the quarterly dividend. Regulatory authorities may prohibit the Company from paying dividends in a manner that would constitute an unsafe or unsound banking practice or would reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. Current guidance from the Federal Reserve provides, among other things, that dividends per share generally should not exceed earnings per share, measured over the previous four fiscal quarters.

 

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YEAR    2016     2015  
QUARTER    Fourth     Third     Second     First     Fourth     Third     Second     First  

Cash dividend

   $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.11     $ 0.10     $ 0.10  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Dividend payout ratio

     36.67     47.83     84.62     37.93     39.29     40.74     38.46     62.50

Equity Compensation Plan Information

 

     Year Ended December 31, 2016  
     Number of shares to be
issued upon exercise of
outstanding options,
warrants and rights (2)
     Weighted-average exercise
price of outstanding options,
warrants and rights (2) (3)
     Number of shares remaining
available for future issuance
under equity compensation
plans (2)
 

Equity compensation plans approved by security holders(1)

     664,952      $ 13.92        408,474  

Equity compensation plans not approved by security holders

     —          —          —    
  

 

 

    

 

 

    

 

 

 

Total

     664,952      $ 13.92        408,474  
  

 

 

    

 

 

    

 

 

 

 

(1)  Under the Company’s respective equity compensation plans, the Company may grant incentive stock options and non-qualified stock options, restricted stock, restricted stock units and stock appreciation rights to its employees and directors; however, only employees may receive incentive stock options.
(2)  Amounts have been adjusted to reflect stock splits and stock dividends subsequent to initial issuance of instruments.
(3) Weighted average exercise price is based on equity grants which have an exercise price.

Share Repurchase Plan

On July 27, 2015, the Company adopted a repurchase plan providing for authority to purchase up to five percent of the Company’s outstanding shares. There were no shares repurchased under the plan during the twelve months ended December 31, 2016.

 

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Performance Graph

The information contained in the following chart entitled “Total Return Performance” is not considered to be “soliciting material,” or “filed,” or incorporated by reference in any past or future filing by the Company under the Securities Exchange Act of 1934 or the Securities Act of 1933 unless and only to the extent that the Company may specifically incorporate it by reference.

 

LOGO

 

     Period Ended  

Index

   12/31/11      12/31/12      12/31/13      12/31/14      12/31/15      12/31/16  

Pacific Continental Corporation

     100.00        113.77        197.85        184.82        200.12        302.06  

Russell 2000

     100.00        116.35        161.52        169.43        161.95        196.45  

SNL Bank $1B-$5B

     100.00        123.31        179.31        187.48        209.86        301.92  

The above graph and following table compares the total cumulative shareholder return on the Company’s Common Stock, based on reinvestment of all dividends, to the cumulative total returns of the Russell 2000 Index and SNL Securities $1 Billion to $5 Billion Bank Asset Size Index. The graph assumes $100 invested on December 31, 2011, in the Company’s Common Stock and each of the indices.

 

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ITEM 6 Selected Financial Data

Selected financial data for the past five years is shown in the table below.

(Dollars in thousands, except for per share data)

 

     For the year ended December 31,  
     2016     2015     2014     2013     2012  
     (in thousands, except per share data)  

Net interest income

   $ 83,711     $ 69,800     $ 57,448     $ 56,139     $ 50,076  

Provision for loan losses

     5,450       1,695       —         250       1,900  

Noninterest income

     7,817       6,625       4,995       5,826       5,741  

Noninterest expense

     56,593       45,890       37,729       40,732       35,105  

Income tax expense

     9,709       10,089       8,672       7,216       6,159  

Net income

     19,776       18,751       16,042       13,767       12,653  

Cash dividends

     8,983       8,041       12,308       13,050       5,588  

Per common share data

          

Net income:

          

Basic

   $ 0.96     $ 0.97     $ 0.90     $ 0.77     $ 0.70  

Diluted

     0.95       0.97       0.89       0.76       0.69  

Regular cash dividends

   $ 0.44     $ 0.42     $ 0.40     $ 0.36     $ 0.24  

Special cash dividends

     —         —         0.29       0.37       0.07  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total dividends

   $ 0.44     $ 0.42     $ 0.69     $ 0.73     $ 0.31  

Book value

   $ 12.11     $ 11.15     $ 10.39     $ 10.01     $ 10.28  

Tangible book value(1)

     8.99       8.94       9.07       8.69       9.05  

Market value, end of year

     21.85       14.88       14.18       15.94       9.73  

At year end

          

Assets

   $ 2,541,437     $ 1,909,478     $ 1,504,325     $ 1,449,726     $ 1,373,487  

Gross loans (2)

     1,857,767       1,404,482       1,045,021       993,845       870,416  

Allowance for loan losses

     (22,454     (17,301     (15,637     (15,917     (16,345

Available-for-sale securities

     470,996       366,598       351,946       347,386       389,885  

Core deposits (3)

     2,035,067       1,533,942       1,110,861       990,315       938,629  

Total deposits

     2,148,103       1,597,093       1,209,093       1,090,981       1,046,154  

Shareholders’ equity

     273,755       218,491       184,161       179,184       183,381  

Tangible equity (1)

     203,373       175,332       160,666       155,568       161,350  

Average for the year

          

Assets

   $ 2,159,411     $ 1,782,832     $ 1,477,060     $ 1,433,213     $ 1,317,094  

Earning assets

     2,006,472       1,653,898       1,372,407       1,323,281       1,214,719  

Gross loans (2)

     1,573,331       1,270,129       1,025,889       959,873       832,787  

Allowance for loan losses

     (18,999     (16,142     (15,707     (16,492     (16,132

Available-for-sale securities

     416,138       378,747       348,049       365,889       384,810  

Core deposits (3)

     1,705,556       1,406,168       1,031,140       967,592       877,256  

Total deposits

     1,794,194       1,475,815       1,132,428       1,074,166       972,854  

Interest-paying liabilities

     1,211,517       1,049,248       913,018       912,022       833,680  

Shareholders’ equity

     240,205       208,500       181,762       180,857       181,475  

Financial ratios

          

Return on average:

          

Assets

     0.92     1.05     1.09     0.96     0.96

Equity

     8.23     8.99     8.83     7.61     6.97

Tangible equity (1)

     10.50     11.14     10.14     8.75     7.94

Avg shareholders’ equity / avg assets

     11.12     11.69     12.31     12.62     13.78

Dividend payout ratio

     46.32     43.30     77.53     96.05     44.93

Regulatory Capital

          

Tier I capital (to leverage assets)

     9.01     9.93     11.33     11.49     12.33

Common equity tier I capital (to risk weighted assets)(4)

     9.52     10.97     NA       NA       NA  

Tier I capital (to risk weighted assets)

     10.08     11.47     14.48     14.90     16.90

Total capital (to risk weighted assets)

     12.69     12.58     15.73     16.15     18.15

 

(1)  Tangible book value per share and tangible equity exclude goodwill and core deposit intangibles related to acquisitions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” - “Results of Operations Overview” in this Form 10-K for a reconciliation of non-GAAP financial measures.
(2)  Outstanding loans include loans held for sale and net deferred fees.
(3)  Core deposits include all demand, interest checking, money market, savings and local non-public time deposits, including local non-public time deposits in excess of $100.
(4)  The Common equity Tier I capitl ratio was established under the Basel Committee’s final rules. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations”—“Capital Resources”, and “Business”— Supervision regarding the final Basel III rules.

 

 

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Table of Contents
ITEM 7 Management’s Discussion and Analysis of Financial Condition and Results of Operation

The following discussion is intended to provide a more comprehensive review of the Company’s operating results and financial condition than can be obtained from reading the Consolidated Financial Statements alone. The discussion should be read in conjunction with the audited financial statements and the notes included later in this Form 10-K. All dollar amounts, except per share data, are expressed in thousands of dollars.

HIGHLIGHTS

 

     2016     2015     % Change
2016 vs. 2015
    2014     % Change
2015 vs. 2014
 
     (in thousands, except per share data)  

Net income

   $ 19,776     $ 18,751       5.47   $ 16,042       16.89

Operating revenue (1)

     91,528       76,425       19.76     62,443       22.39

Earnings per share

          

Basic

   $ 0.96     $ 0.97       -1.03   $ 0.90       7.78

Diluted

   $ 0.95     $ 0.97       -2.06   $ 0.89       8.99

Assets, period-end

   $ 2,541,437     $ 1,909,478       33.10   $ 1,504,325       26.93

Gross loans, period-end (2)

     1,859,787       1,406,012       32.27     1,046,011       34.42

Core deposits, period-end (3)

     2,035,067       1,533,942       32.67     1,110,861       38.09

Deposits, period-end

     2,148,103       1,597,093       34.50     1,209,093       32.09

Return on average assets

     0.92     1.05       1.09  

Return on average equity

     8.23     8.99       8.83  

Return on average tangible equity (4)

     10.50     11.14       10.14  

Avg shareholders’ equity / avg assets

     11.12     11.69       12.31  

Dividend payout ratio

     46.32     43.30       77.53  

Net interest margin (5)

     4.29     4.32       4.27  

Efficiency ratio

     61.13     59.22       59.41  

 

(1)  Operating revenue is defined as net interest income plus noninterest income.
(2)  Excludes net deferred fees and allowance for loan losses.
(3)  Defined by the Company as demand, interest checking, money market, savings and local non-public time deposits, including local non-public time deposits in excess of $100.
(4)  Tangible equity excludes goodwill and core deposit intangibles related to acquisitions.
(5)  Presentation of net interest margin for all periods reported has been adjusted to a tax- equivalent basis using a 35% tax rate.

Merger

On January 9, 2017, Pacific Continental entered into a definitive agreement to merge with Columbia Banking System, Inc., headquartered in Tacoma, Washington. Upon completion of the merger, the combined company will operate under the Columbia Bank name and brand. The agreement was approved by the Board of Directors of each company. Closing of the transaction, which is expected to occur in mid-2017, is contingent on shareholder approval and receipt of necessary regulatory approvals, along with satisfaction of other customary closing conditions.

Results of Operations—Overview

The Company recorded net income of $19,776 for the year ended 2016, an improvement of $1,025 or 5.47% over the prior year. The results for 2016 and 2015 included $4,934 and $1,836, respectively, in merger-related expenses associated with the 2016 acquisition of Foundation Bank Bancorp, Inc. (“Foundation”) and the 2015 acquisition of Capital Pacific Bancorp. Improvement in 2016 net income over 2015 was due to increased revenues, specifically net interest income. A portion of the improvement in net interest income was offset by increased loan loss provision, higher noninterest expenses, primarily personnel expense, and merger-related expenses. The Company recorded $5,450 in provision for loan losses in 2016 compared to $1,695 in 2015. This increase was primarily due to a high level of growth in organic loans, however the bank did experience some small credit deterioration, related to a downgrade of one dental relationship.

 

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The Company recorded net income of $18,751 for the year ended 2015, an improvement of $2,709 or 16.89% over the prior year. The results for 2015 and 2014 included $1,836 and $470, respectively, in merger-related expenses associated with the acquisition of Capital Pacific Bancorp. Improvement in 2015 net income over 2014 was due to increased revenues, specifically net interest income. The increase in net interest income was attributable to an increase in organic loans and improvement in the yield on the securities portfolio. The Company made $1,695 in provision for loan losses in 2015 compared to no provision in 2014. This increase was primarily attributable to portfolio growth as the bank experienced a reduction in classified assets and nonperforming loans.

Year-end assets at December 31, 2016, were $2,541,437, up $631,959 or 33.10% from December 31, 2015, asset totals. Growth in assets was mainly due to an increase in outstanding gross loans of $453,775, which included $270,533 of loans acquired in the Foundation acquisition. Total assets also grew $27,223 due to the goodwill and core deposit intangible associated with the Foundation acquisition. The Company experienced a typical seasonal core deposit pattern in 2016 with deposit outflows occurring during the first half of the year followed by growth in core deposits during the second half of the year. Outstanding core deposits were $2,035,067 at December 31, 2016, up $501,125 or 32.67% over the prior year-end. A portion of this growth was related to the Foundation acquisition, with acquired core deposits totaling $396,509 at September 6, 2016. The remainder of the core deposit growth was due to new relationships or growth in existing relationships in the bank’s current markets. Growth in the Company’s demand deposits accounted for $290,308 of the increase in core deposits and was up 51.05% over December 31, 2015, outstanding demand deposits.

During 2016, the Company believes the following factors could impact our financial results, in addition to those described in “Risk Factors” and elsewhere in this Form 10-K:

 

    Changes and volatility in interest rates could negatively impact yields on earning assets and the cost of interest-bearing liabilities, thus negatively affecting the Company’s net interest margin and net interest income.

 

    Global economic weakness and a rise in short-term interest rates could lead to a slowdown of economic growth, thus negatively affecting loan demand, causing a decline in banking industry revenues.

 

    Increased market competition for quality loans could cause a reduction in loan yields.

 

    The ability to manage noninterest expense growth in light of regulatory compliance cost.

 

    The competition to attract and retain qualified and experienced bankers in our markets.

Reconciliation of non-GAAP financial information

Management utilizes certain non-GAAP financial measures to monitor the Company’s performance. While we believe the presentation of non-GAAP financial measures provides additional insight into our operating performance, readers of this report are urged to review the GAAP results as presented in Financial Statements and Supplementary Data in this Form 10-K.

The Company presents a computation of tangible equity and tangible assets along with tangible book value and return on average tangible equity. The Company defines tangible equity as total shareholders’ equity before goodwill and core deposit intangible assets. Tangible book value is calculated as tangible equity divided by total shares outstanding. Return on average tangible equity is calculated as net income divided by average tangible equity. We believe that tangible equity and certain tangible equity ratios are meaningful measures of capital adequacy which may be used when making period-to-period and company-to-company comparisons. Tangible equity and tangible equity ratios are considered to be non-GAAP financial measures and should be viewed in conjunction with total shareholders’ equity, book value and return on average equity.

 

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The following table presents a reconciliation of total shareholders’ equity to tangible equity.

 

     December 31,  
     2016     2015     2014  
     (in thousands, except per share data)  

Total shareholders’ equity

   $ 273,755     $ 218,491     $ 184,161  

Subtract:

      

Goodwill

     (61,401     (39,255     (22,881

Core deposit intangibles

     (8,981     (3,904     (614
  

 

 

   

 

 

   

 

 

 

Tangible shareholders’ equity (non-GAAP)

   $ 203,373     $ 175,332     $ 160,666  
  

 

 

   

 

 

   

 

 

 

Book value

   $ 12.11     $ 11.15     $ 10.39  

Tangible book value (non-GAAP)

   $ 8.99     $ 8.94     $ 9.07  
     December 31,  
     2016     2015     2014  

Average Total shareholders’ equity

   $ 241,721     $ 209,943     $ 181,762  

Subtract:

      

Average goodwill

     (46,304     (35,216     (22,881

Average core deposit intangibles

     (5,459     (3,467     (674
  

 

 

   

 

 

   

 

 

 

Average Tangible shareholders’ equity (non-GAAP)

   $ 189,958     $ 171,260     $ 158,207  
  

 

 

   

 

 

   

 

 

 

Return on average equity

     8.23     8.99     8.83

Return on average tangible equity (non-GAAP)

     10.50     11.14     10.14

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although we believe these non-GAAP financial measure are frequently used by stakeholders in the evaluation of a company, they have limitations as analytical tools, and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

SUMMARY OF CRITICAL ACCOUNTING POLICIES

We follow accounting standards set by the Financial Accounting Standards Board, commonly referred to as the “FASB.” The FASB sets generally accepted accounting principles (“GAAP”) that we follow to ensure we consistently report our financial condition, results of operations, and cash flows. References to GAAP issued by the FASB in this report are to the “FASB Accounting Standards Codification”, sometimes referred to as the “Codification,” or “ASC.” The FASB finalized the Codification effective for periods ending on or after September 15, 2009. Prior FASB Statements, Interpretations, Positions, EITF consensuses, and AICPA Statements of Position are no longer being issued by the FASB. The Codification does not change how the Company accounts for its transactions or the nature of related disclosures made. However, when referring to guidance issued by the FASB, the Company refers to topics in the ASC rather than the specific FASB statement. We have updated references to GAAP in this report to reflect the guidance in the Codification.

The SEC defines “critical accounting policies” as those that require the application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. Significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements in this Form 10-K. Management believes that the following policies and those disclosed in the Notes to Consolidated Financial Statements should be considered critical under the SEC definition:

Nonaccrual Loans

Accrual of interest is discontinued on contractually delinquent loans when management believes that, after considering economic and business conditions and collection efforts, the borrower’s financial condition is such that collection of principal or interest is doubtful. At a minimum, loans that are past due as to maturity or payment of principal or interest by 90 days or

 

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more are placed on nonaccrual status, unless such loans are well-secured and in the process of collection. Interest income is subsequently recognized only to the extent cash payments are received satisfying all delinquent principal and interest amounts, and the prospects for future payments in accordance with the loan agreement appear relatively certain. In accordance with GAAP, payments received on nonaccrual loans are applied to the principal balance and no interest income is recognized.

Allowance for Loan Losses and Reserve for Unfunded Commitments

The allowance for loan losses on outstanding loans is classified as a contra-asset account offsetting outstanding loans, and the allowance for unfunded commitments is classified as an “other” liability on the balance sheet. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balances of the allowance for loan losses for outstanding loans and unfunded commitments are maintained at an amount management believes will be adequate to absorb known and inherent losses in the loan portfolio and commitments to loan funds. The appropriate balance of the allowance for loan losses is determined by applying loss factors to the credit exposure from outstanding loans and unfunded loan commitments. Estimated loss factors are based on subjective measurements including management’s assessment of the internal risk classifications, changes in the nature of the loan portfolios, industry concentrations, and the impact of current local, regional, and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.

Troubled Debt Restructurings

In the normal course of business, the Company may modify the terms of certain loans, attempting to protect as much of its investment as possible. Management evaluates the circumstances surrounding each modification to determine whether it is a troubled debt restructuring (“TDR”). TDRs exist when 1) the restructuring constitutes a concession, and 2) the debtor is experiencing financial difficulties. Additional information regarding the Company’s troubled debt restructurings can be found in Note 5 of the Notes to Consolidated Financial Statements in this Form 10-K.

Goodwill and Intangible Assets

At December 31, 2016, the Company had a recorded balance of $61,401 in goodwill from the November 30, 2005, acquisition of Northwest Business Financial Corporation (“NWBF”), the February 1, 2013, acquisition of Century Bank, the March 6, 2016 acquisition of Capital Pacific Bank and the September 6, 2016 acquisition of Foundation Bank. In addition, at December 31, 2016, the Company had $8,981 of core deposit intangible assets resulting from the acquisition of Century Bank, Capital Pacific Bank and Foundation Bank. The Century Bank core deposit intangible was determined to have an expected life of seven years, and is being amortized over that period using the straight-line method. The Century Bank core deposit intangible will be fully amortized in January 2020. The Capital Pacific Bank core deposit intangible was determined to have an expected life of ten years, and is being amortized over that period using the straight-line method. The Capital Pacific Bank core deposit intangible will be fully amortized in February 2025. The Foundation Bank core deposit intangible was determined to have an expected life of ten years, and is being amortized over that period using the straight-line method, and will be fully amortized in August 2026. In accordance with GAAP, the Company does not amortize goodwill or other intangible assets with indefinite lives but instead periodically tests these assets for impairment. Management performs an impairment analysis of the intangible assets with indefinite lives at least annually, but more frequently if an impairment triggering event is deemed to have occurred. The last impairment test was performed at December 31, 2016, at which time no impairment was determined to exist.

Share-based Compensation

Consistent with the provisions of FASB ASC 718, Stock Compensation, a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation, we recognize expense for the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees’ requisite service period (generally the vesting period). The requisite service period may be subject to performance conditions. The fair value of each restricted stock unit is calculated using the stock closing price on the grant date with the expense recognized over the service period of the equity award. Additional information is included in Note 1 of the Notes to Consolidated Financial Statements in this Form 10-K.

 

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Fair Value Measurements

Generally accepted accounting principles define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820, Fair Value Measurements, establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources while unobservable inputs reflect our estimates about market data. In general, fair values determined by Level 1 inputs utilize quoted prices for identical assets or liabilities traded in active markets that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

Recent Accounting Pronouncements

Recent accounting pronouncements are discussed in Note 1 of the Notes to Consolidated Financial Statements in this Form 10-K. None of these pronouncements are expected to have a significant effect on the Company’s financial condition or results of operations.

RESULTS OF OPERATIONS

Net Interest Income

The largest component of the Company’s earnings is net interest income. Net interest income is the difference between interest income derived from earning assets, principally loans, and the interest expense associated with interest-bearing liabilities, principally deposits. The volume and mix of earning assets and funding sources, market rates of interest, demand for loans, and the availability of deposits affect net interest income.

The following two tables follow which analyze the changes in net interest income for the years 2016, 2015 and 2014. Table I, “Average Balance Analysis of Net Interest Income,” provides information with regard to average balances of assets and liabilities as well as associated dollar amounts of interest income and interest expense, relevant average yields or rates, and net interest income as a percent of average earning assets. Net interest income and the net interest margin for all periods reported have been adjusted to a tax-equivalent basis using a 35.00% tax rate. Table II, “Analysis of Changes in Interest Income and Interest Expense,” shows the increase (decrease) in the dollar amount of interest income and interest expense and the differences attributable to changes in either volume or rates.

 

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Table I

Average Balance Analysis of Net Interest Income

(dollars in thousands)

 

     Twelve Months Ended     Twelve Months Ended     Twelve Months Ended  
     December 31, 2016     December 31, 2015     December 31, 2014  
     Average
Balance
     Interest
Income or
(Expense)
    Average
Yields or
Rates
    Average
Balance
     Interest
Income or
(Expense)
    Average
Yields or
Rates
    Average
Balance
     Interest
Income or
(Expense)
    Average
Yields or
Rates
 

Interest-earning assets

                     

Federal funds sold and interest-bearing deposits

   $ 30,032      $ 154       0.51   $ 13,869      $ 34       0.25   $ 3,926      $ 10       0.25

Federal Home Loan Bank stock

     5,970        141       2.36     7,294        50       0.69     10,250        10       0.10

Securities available-for-sale:

                     

Taxable

     341,832        7,601       2.22     305,850        6,482       2.12     276,625        6,181       2.23

Tax-exempt (1)

     74,306        2,988       4.02     72,898        3,040       4.17     71,424        3,032       4.25

Loans, net of deferred fees and allowance (2)

                     

Taxable

     1,497,320        77,735       5.19     1,223,763        64,557       5.28     1,004,438        53,627       5.34

Tax-exempt (3)

     57,012        3,645       6.39     30,224        1,749       5.79     5,744        350       6.09
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

Total interest-earning assets

     2,006,472        92,264       4.60     1,653,898        75,912       4.59     1,372,407        63,210       4.61

Non earning assets

                     

Cash and due from banks

     27,974            22,536            18,506       

Premises and equipment

     19,167            17,822            18,324       

Goodwill & intangible assets

     51,842            40,183            23,556       

Interest receivable and other

     53,956            48,393            44,267       
  

 

 

        

 

 

        

 

 

      

Total nonearning assets

     152,939            128,934            104,653       
  

 

 

        

 

 

        

 

 

      

Total assets

   $ 2,159,411          $ 1,782,832          $ 1,477,060       
  

 

 

        

 

 

        

 

 

      

Interest-bearing liabilities

                     

Money market and NOW accounts

   $ 866,683      $ (2,281     -0.26   $ 747,918      $ (1,956     -0.26   $ 543,116      $ (1,491     -0.27

Savings deposits

     72,012        (157     -0.22     60,185        (74     -0.12     51,164        (67     -0.13

Time deposits—core

     65,724        (245     -0.37     79,798        (309     -0.39     60,685        (326     -0.54
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

Total interest-bearing core deposits (4)

     1,004,419        (2,683     -0.27     887,901        (2,339     -0.26     654,965        (1,884     -0.29

Non-core time deposits

     88,638        (1,164     -1.31     69,647        (975     -1.40     101,288        (1,368     -1.35

Interest-bearing repurchase agreements

     655        —         0.00     —          —         0.00     —          —         0.00

Federal funds and overnight funds purchased

     776        (8     -1.03     1,555        (11     -0.71     2,053        (14     -0.68

Federal Home Loan Bank borrowings

     90,313        (954     -1.06     81,897        (885     -1.08     146,464        (1,088     -0.74

Subordinated debentures

     17,506        (1,143     -6.53     —          —         0.00     —          —         0.00

Junior subordinated debenture

     9,210        (279     -3.03     8,248        (226     -2.74     8,248        (225     -2.73
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

Total interest-bearing wholesale funding

     207,098        (3,548     -1.71     161,347        (2,097     -1.30     258,053        (2,695     -1.04
  

 

 

    

 

 

     

 

 

    

 

 

     

 

 

    

 

 

   

Total interest-bearing liabilities

     1,211,517        (6,231     -0.51     1,049,248        (4,436     -0.42     913,018        (4,579     -0.50

Noninterest-bearing liabilities

                     

Demand deposits

     701,137            518,267            376,175       

Interest payable and other

     6,552            6,817            6,105       
  

 

 

        

 

 

        

 

 

      

Total noninterest liabilities

     707,689            525,084            382,280       
  

 

 

        

 

 

        

 

 

      

Total liabilities

     1,919,206            1,574,332            1,295,298       

Shareholders’ equity

     240,205            208,500            181,762       
  

 

 

        

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 2,159,411          $ 1,782,832          $ 1,477,060       
  

 

 

        

 

 

        

 

 

      

Net interest income

      $ 86,033          $ 71,476          $ 58,631    
     

 

 

        

 

 

        

 

 

   

Net interest margin (1)(3)

        4.29          4.32          4.27  
     

 

 

        

 

 

        

 

 

   

 

(1)  Tax-exempt securities income has been adjusted to a tax-equivalent basis at a 35% tax rate. The amount of such adjustment was an addition to recorded income of approximately $1,046, $1,064, and $1,061 for the twelve months ended December 31, 2016, 2015, and 2014, respectively. Net interest margin was positively impacted by 5, 6 and 8 basis points, respectively.
(2)  Interest income includes recognized loan origination fees of $1,091, $702, and $574 for the twelve months ended December 31, 2016, 2015, and 2014, respectively.
(3)  Tax-exempt loan income has been adjusted to a tax-equivalent basis at a 35% tax rate. The amount of such adjustment was an addition to recorded income of approximately $1,276, $612, and $122 for the twelve months ended December 31, 2016, 2015, and 2014, respectively. Net interest margin was positively impacted by 6, 4, and 1 basis points, respectively.
(4)  Defined by the Company as interest checking, money market, savings and local non-public time deposits, including local non-public time deposits in excess of $100.

 

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Table II

Analysis of Changes in Interest Income and Interest Expense

(dollars in thousands)

 

     2016 compared to 2015     2015 compared to 2014  
     Increase (decrease) due to     Increase (decrease) due to  
     Volume     Rate     Net     Volume     Rate     Net  

Interest earned on:

            

Federal funds sold and interest-bearing deposits

   $ 40     $ 80     $ 120     $ 25     $ (1   $ 24  

Federal Home Loan Bank stock

     (9     100       91       (3     43       40  

Securities available-for-sale:

            

Taxable

     763       356       1,119       653       (352     301  

Tax-exempt (1)

     59       (111     (52     63       (55     8  

Loans, net of deferred fees and allowance

            

Taxable

     14,431       (1,253     13,178       11,710       (780     10,930  

Tax-exempt (2)

     1,551       345       1,896       1,492       (93     1,399  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets

   $ 16,835     $ (483   $ 16,352     $ 13,940     $ (1,238   $ 12,702  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest paid on:

            

Money market and NOW accounts

   $ 311     $ 14     $ 325     $ 562     $ (97   $ 465  

Savings deposits

     15       68       83       12       (5     7  

Time deposits—core (3)

     (54     (10     (64     103       (120     (17
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing core deposits

     272       72       344       677       (222     455  

Non-core time deposits

     266       (77     189       (427     34       (393

Interest-bearing repurchase agreements

     —         —         —         —         —         —    

Federal funds and overnight funds purchased

     (6     3       (3     (3     —         (3

Federal Home Loan Bank borrowings

     91       (22     69       (480     277       (203

Subordinated debentures

     —         1,143       1,143       —         —         —    

Junior subordinated debenture

     26       27       53       —         1       1  

Total interest-bearing wholesale funding

     377       1,074       1,451       (910     312       (598
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

     649       1,146       1,795       (233     90       (143
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   $ 16,186     $ (1,629   $ 14,557     $ 14,173     $ (1,328   $ 12,845  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)  Tax-exempt securities income has been adjusted to a tax-equivalent basis at a 35% tax rate. The amount of such adjustment was an addition to recorded income of approximately $1,046, $1,064, and $1,061 for the twelve months ended December 31, 2016, 2015, and 2014, respectively. Net interest margin was positively impacted by 5, 6 and 8 basis points, respectively.
(2)  Tax-exempt loan income has been adjusted to a tax-equivalent basis at a 35% tax rate. The amount of such adjustment was an addition to recorded income of approximately $1,276, $612, and $122 for the twelve months ended December 31, 2016, 2015, and 2014, respectively. Net interest margin was positively impacted by 6, 4, and 1 basis points, respectively.
(3)  Defined by the Company as interest checking, money market, savings and local non-public time deposits, including local non-public time deposits in excess of $100.

 

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Core Margin, non-GAAP

To better understand the Bank’s results of operations we have provided the following non-GAAP financial metric, which removes nonrecurring interest income and accretion income relating to the Bank’s acquired loan portfolio fair value discounts to provide a “core net interest margin.” While management believes the presentation of this non-GAAP financial measure provides additional insight into our operating performance, readers of this report are urged to review the GAAP results as presented in the Financial Statements and Supplementary Data in this Form 10-K.

Reconciliation of Adjusted Net Interest Income to Net Interest Income

 

     December 31,  
     2016     2015     2014  
     (in thousands, except per share data)  

Tax equivalent net interest income (1)

   $ 86,033     $ 71,476     $ 58,631  

Subtract

      

Century Bank accretion

     125       341       527  

Capital Pacific Bank accretion

     1,090       1,950       —    

Foundation Bank accretion

     2,471       —         —    

Interest recoveries on nonaccrual loans

     —         —         100  

Prepayment penalties on loans

     737       133       187  

Prepayment penalties on brokered deposits

     (61     (54     —    
  

 

 

   

 

 

   

 

 

 

Adjusted net interest income (non-GAAP)

   $ 81,671     $ 69,106     $ 57,817  
  

 

 

   

 

 

   

 

 

 

Average earning assets

   $ 2,006,472     $ 1,653,898     $ 1,372,407  

Net interest margin

     4.29     4.32     4.27

Core net interest margin (non-GAAP)

     4.07     4.18     4.21

 

(1)  Tax-exempt income has been adjusted to a tax-equivalent basis at a 35% tax rate. The amount of such adjustment was an addition to recorded income of $2,322, $1,676 and $1,183 for the twelve months ended December 31, 2016, 2015, and 2014, respectively.

Nonrecurring items outlined above added 22 and 14 basis points to the 2016 and 2015 net interest margins, respectively. When comparing non-GAAP core net interest margin, we saw a decrease of 11 basis points from 4.18% in 2015 to 4.07% in 2016.

2016 Compared to 2015

The net interest margin for the year 2016 was 4.29%, representing a decrease of 3 basis points from the 4.32% net interest margin reported for 2015. The decrease was primarily attributable to a decrease in the yield on earning assets in addition to an increase in the cost of wholesale deposits.

The yield on taxable loans dropped 8 basis points from 2015 to 2016, which is after the inclusion of $1,952 in nonrecurring interest income, primarily attributable to accretion on the acquired loan portfolios. Without the inclusion of the nonrecurring interest income, the yield on our taxable loan portfolio would have been 5.06%, which represented a reduction of 21 basis points from the prior year. Accretion income relating to the acquired portfolios is recognized in interest income using the interest method for amortizing loans, and on a straight-line basis for lines of credit. It is typical for accretion income to be higher toward the beginning of an acquired portfolio’s life and begin to reduce as loans pay off, refinance, or balances reduce due to standard amortization. At December 31, 2016, the acquired loan portfolios had a remaining balance of $11,297 related to the purchased fair value discount for credit and interest rate. In addition to a decrease in the taxable portion of the loan portfolio, we saw an increase in the yield on tax exempt loans. The increase was primarily attributable to the Company’s involvement with the Oregon SNAP bond program financing, which in many cases has fixed rate financing for a ten year period. This extended maturity led to an increase in the yield on the tax exempt portfolio.

 

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During 2016 the cost of interest-bearing core deposits increased by 1 basis point, which was primarily attributable to the increased cost of the Foundation acquired deposits. Typically, following an acquisition the Bank will grant temporary rate variances to allow bankers time to determine which variances, if any need to remain. In addition, the Bank saw an increase in the cost of wholesale funding of 0.41%. The increase was attributable to the cost of the subordinated debenture, which was issued at the end of June 2016, in conjunction with the planned acquisition of Foundation Bank and the acquisition of Foundation Bank’s junior subordinated debenture.

The year ended December 31, 2016, rate/volume analysis in Table II shows that interest income including loan fees increased by $16,351 over 2015. Higher volume, primarily higher loan volume, resulted in an increase of $16,834 in interest income in 2016, which was partially offset by a $483 decline in interest income due to lower rates on loans. The reduction in income due to lower rates would have been greater if the Bank did not recognize accretion income of $3,686, as a result of the three prior acquisitions. The rate/volume analysis shows that interest expense for the year 2016 increased by $1,798. An increase in the interest paid on wholesale funding of $1,454 was primarily attributable to interest expense on the subordinated debenture, which was entered into in June 216. Overall, changes in the volume mix increased interest expense by $649 in 2016, while higher rates on interest-bearing liabilities increased interest expense by $1,146.

2015 Compared to 2014

The net interest margin for the year 2015 was 4.32%, representing an increase of 5 basis points from the 4.27% net interest margin reported for 2014. Table I shows earning asset yields declined by 3 basis points from 4.61% in 2014 to 4.59% in 2015, which was more than offset by the decrease in the cost of interest bearing liabilities from 0.50% in 2014 to 0.42% in 2015.

The yield on taxable loans dropped 6 basis points from 2014 to 2015, which is after the inclusion of $2,424 in nonrecurring interest income, primarily attributable to accretion on the acquired loan portfolios. Without the inclusion of the nonrecurring interest income, the yield on our taxable loan portfolio would have been 5.08%, which represents a reduction of 26 basis points from the prior year.

The 2015 net interest margin benefitted from a decline in the cost of interest-bearing liabilities. The cost of interest-bearing core deposits declined by 3 basis points, which was partially offset by an increase in the cost of interest-bearing wholesale funding of 26 basis points. The Bank saw an increase in demand deposits of $142,092 over the prior year, which helped to reduce the average balance of wholesale funding by $96,706 from $258,053 in 2014 to $161,347 in 2015. Therefore, even though the cost of wholesale funding increased during the period, the impact of that increase was minimal as only 15.38% of interest bearing liabilities relate to non-core funding.

 

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Table of Contents

Provision for Loan Losses

Management provides for possible loan losses by maintaining an allowance. The level of the allowance is determined based upon judgments regarding the size and nature of the loan portfolio, historical loss experience, the financial condition of borrowers, the level of nonperforming loans, and current general economic conditions. Additions to the allowance are charged to expense. Loans are charged against the allowance when management believes the collection of principal is unlikely.

The Company made $5,450 in provision for loan losses in 2016, compared to $1,695 in 2015. The increase in the 2016 provision was due to loan growth, and some credit deterioration associated with a few customer relationships. The Bank’s organic loan portfolio grew by $183,242 during 2016, which is excluding the $270,533 of loans acquired in the Foundation Bank acquisition, which are purchased net of their credit and interest fair value adjustments and only included in our provision to the extent their reserve exceeds the remaining credit related fair value discount. Of the $5,450 in 2016 provision for loan losses, $783 was allocated to the acquired portfolios. Net loan charge offs for the year 2016 were $297 compared to $31 in 2015.

 

     December 31,  
     2016     2015     2014  

Substandard contingent liabilities

   $ 1,026     $ 726     $ 562  

Impaired loans (less government guarantees)

     18,074       8,451       6,032  

Substandard loans (less government guarantees)

     24,821       23,834       22,451  

Classified securities

     1,338       1,517       1,879  

Other real estate owned

     12,068       11,747       13,374  
  

 

 

   

 

 

   

 

 

 

Classified Assets

   $ 57,327     $ 46,275     $ 44,298  
  

 

 

   

 

 

   

 

 

 

Tier 1 Capital

   $ 221,346     $ 183,600     $ 164,864  

Allowance for Loan Losses

     22,454       17,301       15,637  
  

 

 

   

 

 

   

 

 

 
   $ 243,800     $ 200,901     $ 180,501  
  

 

 

   

 

 

   

 

 

 

Classified Asset Ratio

     23.51     23.03     24.54

When comparing December 31, 2016 to December 31, 2015, the Bank saw an increase in classified assets of $13,029, which translated into a classified asset ratio increase of 0.48%. This increase primarily related to the acquisition of Foundation Bank, which added approximately $20,256 in classified assets at the close of the acquisition. The Bank’s organic loan portfolio continued to see resolutions of classified assets. When excluding the acquired substandard loans the Bank’s organic substandard loans decreased by $9,204. This trend is indicative of past years where the classified asset totals are temporarily raised following an acquisition, but through resolution efforts by the Bank’s special assets group totals begin to lower following the acquisition.

 

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Table of Contents

Nonperforming Assets

At December 31, 2016, the Company had $21,547 in nonperforming assets, net of government guarantees, or 0.85% of total assets, compared to $14,466 or 0.76% of total assets at December 31, 2015. The schedule below provides a more detailed breakdown of nonperforming assets by loan type:

NONPERFORMING ASSETS

 

     December 31,  
     2016     2015  

Nonaccrual loans

    

Real estate secured loans:

    

Permanent loans:

    

Multi-family residential

   $ —       $ —    

Residential 1-4 family

     1,294       733  

Owner-occupied commercial

     1,605       2,369  

Nonowner-occupied commercial

     3,374       790  
  

 

 

   

 

 

 

Total permanent real estate loans

     6,273       3,892  

Construction loans:

    

Multi-family residential

     —         —    

Residential 1-4 family

     —         53  

Commercial real estate

     —         —    

Commercial bare land and acquisition & development

     —         —    

Residential bare land and acquisition & development

     —         —    
  

 

 

   

 

 

 

Total real estate construction loans

     —         53  
  

 

 

   

 

 

 

Total real estate loans

     6,273       3,945  

Commercial loans

     5,560       1,564  

Consumer loans

     —         —    
  

 

 

   

 

 

 

Total nonaccrual loans

     11,833       5,509  

90 days past due and accruing interest

     —         —    
  

 

 

   

 

 

 

Total nonperforming loans

     11,833       5,509  

Nonperforming loans guaranteed by government

     (2,354     (2,790
  

 

 

   

 

 

 

Net nonperforming loans

     9,479       2,719  

Other real estate owned

     12,068       11,747  
  

 

 

   

 

 

 

Total nonperforming assets, net of guaranteed loans

   $ 21,547     $ 14,466  
  

 

 

   

 

 

 

Net nonperforming loans to net outstanding loans

     0.51     0.19

Net nonperforming assets to total assets

     0.85     0.76

Nonperforming assets at December 31, 2016, consisted of $9,479 of nonaccrual loans (net of $2,354 in government guarantees) and $12,068 of other real estate owned. Total nonperforming assets at December 31, 2016, were up $7,081 from nonperforming assets at December 31, 2015, as the Company acquired nonperforming assets in the Foundation Bank acquisition. At December 31, 2016, dental nonperforming assets totaled $2,067, up $1,554 from the $513 reported at December 31, 2015. The increase in dental nonperforming assets is primarily attributable to one large relationship, which was placed on nonaccrual during the third quarter of 2016. This relationship is being monitored and reviewed by the Bank’s special assets group and will continue to be evaluated for potential impairment.

 

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Other real estate owned at December 31, 2016, consisted of seven properties, including two properties valued at $1,103 acquired through the Foundation Bank acquisition. Two properties, a commercial land development loan, which contains two separate parcels, a commercial real estate property, and a residential vacation home valued at $9,839, $960 and $1,013 respectively, made up 97.88% of total other real estate owned at December 31, 2016. Subsequent to the end of the year the Company closed a sale of one of its OREO properties, which was valued at $1,013, generating a gain on sale of $3. In addition, the Company is currently under contract for the sale of one of the two parcels of the large commercial real estate property. Timing or completion of the sale cannot currently be determined, however closing is anticipated prior to the end of 2017. While the Company is actively marketing all properties, the location and type of these properties make them susceptible to possible valuation write-downs as new appraisals become available.

The allowance for loan losses at December 31, 2016, was $22,454 (1.21% of gross outstanding loans) compared to $17,301 (1.23% of loans) and $15,637 (1.49% of loans) at the years ended 2015 and 2014, respectively. The reduction in the allowance for loan losses to total loans ratio was primarily due to loans acquired in the Foundation Bank and the Capital Pacific Bank acquisitions, which were booked net of fair value adjustments, including the fair value adjustment for credit and potential losses. At December 31, 2016, the Company had also reserved $548 for possible losses on unfunded loan commitments, which was classified in other liabilities. The 2016 ending allowance included $736 in specific allowance for $12,568 in impaired loans. At December 31, 2015, the Company had $8,800 in impaired loans with a specific allowance of $175 assigned.

The dental allowance for loan losses at December 31, 2016, was $4,713 or 1.25% of dental loans. This is a decrease from the dental allowance of $4,022 or 1.18% of dental loans at December 31, 2015. The increase is primarily attributable to a specific reserve associated with one dental relationship. Historically, the allowance for dental loans was lower than the Bank’s non-dental loans due to a historically low loss experience in the portfolio. For additional information on the dental portfolio statistics, please see Note 6 of the Consolidated Financial Statement in this Form 10-K.

While the Company saw some positive credit trends in 2016, with the exception of the classified assets acquired from Foundation Bank, management cannot predict with certainty the level of the provision for loan losses, the level of the allowance for loans losses, nor the level of nonperforming assets in future quarters. At December 31, 2016, and as shown in this Form 10-K under Note 5 of the Notes to Consolidated Financial Statements, the Company had unallocated reserves of $1,146, representing 5.10% of the total allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2016, is adequate and this level of unallocated reserves was prudent in light of the economic conditions that exist in the Northwest markets the Company serves and the increased growth experienced in the portfolio during the last three quarters of 2016.

Noninterest Income

Noninterest income is derived from sources other than fees and interest on earning assets. The Company’s primary sources of noninterest income are service charge fees on deposit accounts, merchant bankcard activity, and business credit card interchange fees. Below is a summary of noninterest income for 2016, 2015 and 2014.

 

     Years Ended                 Year Ended              
     December 31,                 December 31,              
     2016     2015     change $     change %     2014     change $     change %  

Service charges on deposit accounts

   $ 2,876     $ 2,644     $ 232       8.77   $ 2,134     $ 510       23.90

Bankcard Income

     1,214       1,029       185       17.98     951       78       8.20

Bank-owned life insurance income

     702       592       110       18.58     473       119       25.16

Net gain (loss) on sale of investment securities

     373       672       (299     -44.49     (34     706       -2076.47

Impairment losses on investment securities (OTTI)

     (21     (22     1       -4.55     —         (22     NA  

Other noninterest income

     2,673       1,710       963       56.32     1,471       239       16.25
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   
   $ 7,817     $ 6,625     $ 1,192       17.99   $ 4,995     $ 1,630       32.63
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

2016 Compared to 2015

Noninterest income for the year 2016 was up $1,192 or 17.99% from the same period last year. The increase in noninterest income in 2016 when compared to the prior year was due to 1) increased service charge revenue from the full year impact of the Capital Pacific acquisition, and the additional service charge earned from the Foundation Bank acquisition, 2) increased bankcard income through our Vantiv partnership and 3) increase in other income. The other income category increase was due to many factors, including $327 gain on the early liquidation of a cash flow hedge tied to FHLB borrowing, which was terminated during the fourth quarter. The Bank also booked $157 in other income tied to legal and collection expense incurred by Capital Pacific Bank, prior to the acquisition, which was reimbursed to the Bank. In addition, we experienced a $124

 

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increase in business credit card interchange, primarily tied to increased client usage. In 2016, the Bank changed its business MasterCard product and began offering rewards, which increased users use of the card and interchange revenue.

2015 Compared to 2014

Noninterest income for the year 2015 was up $1,630 or 32.63% from the same period last year. The increase in noninterest income in 2015 when compared to the prior year was due to gains on sales in the securities portfolio, an increase in service charge and increased earnings on bank owned life insurance. During 2015, the Bank sold $52,119 of securities generating a net gain of $672. The security sales were primarily related to a repositioning of the portfolio, which resulted in a gain. The increase in service charges on deposit accounts is partially attributable to an increase in outstanding deposits through the acquisition of Capital Pacific Bank in March 2015 and an increase in account analysis fees effective April 1, 2015. The increase in BOLI earnings related to the BOLI policies acquired through the Capital Pacific Bank acquisition, not an increase in the overall BOLI yield. When comparing 2014 and 2015, the yield on BOLI declined from 2.89% at December 31, 2014, to 2.75% at December 31, 2015, which was reflective of a decrease in the asset yields associated with the policies. The tax equivalent yield on the BOLI policies for the periods ended December 31, 2015 and 2014 were 4.23% and 4.45%, respectively.

Noninterest Expense

Noninterest expense represents all expenses other than the provision for loan losses and interest costs associated with deposits and other interest-bearing liabilities. It incorporates personnel, premises and equipment, data processing and other operating expenses. Below is a summary of noninterest income for 2016, 2015 and 2014.

 

     Years Ended                  Year Ended               
     December 31,                  December 31,               
     2016     2015      change $     change %     2014      change $     change %  

Salaries and employee benefits

   $ 31,873     $ 27,501      $ 4,372       15.90   $ 23,555      $ 3,946       16.75

Property and equipment

     4,742       4,347        395       9.09     3,735        612       16.39

Data processing

     3,709       3,259        450       13.81     2,720        539       19.82

Business development

     2,049       1,640        409       24.94     1,531        109       7.12

Legal and professional services

     3,297       1,924        1,373       71.36     1,252        672       53.67

FDIC insurance assessment

     1,089       1,051        38       3.62     868        183       21.08

Merger-related expense

     4,934       1,836        3,098       168.74     470        1,366       290.64

Other real estate expense

     (36     346        (382     -110.40     449        (103     -22.94

Other noninterest expense

     4,936       3,986        950       23.83     3,149        837       26.58
  

 

 

   

 

 

    

 

 

     

 

 

    

 

 

   
   $ 56,593     $ 45,890      $ 10,703       23.32   $ 37,729      $ 8,161       21.63
  

 

 

   

 

 

    

 

 

     

 

 

    

 

 

   

2016 Compared to 2015

During 2016 the Bank experienced a significant increase in noninterest expense, in every category, with the exception of other real estate income/expense. The largest area of increase related to salaries and benefits, which was up $4,372 or 15.90% over 2015. The increase was attributable to the full year impact of the 19 FTEs retained through the Capital Pacific acquisition, who were only included in 2015 from the close date of March 6, 2015 through year end. The acquisition of Foundation Bank’s 33 employees were also included in the 2016 salaries and benefits totals from the acquisition close on September 6, 2016, through year end. The Bank also incurred $150 of stock based compensation expense associated with liability based stock awards tied to the Company’s stock price. As the stock price increased significantly during the year, it was necessary to increase the liability. Apart from employee related expenses the Bank saw an increase in legal and professional expenses associated with increased legal expense related to pending litigation and continued legal expense related to the expansion of the Bank’s national dental footprint. The Bank also saw an increase in merger-related expense of $3,098 due to the full cost of the Foundation Bank acquisition being incurred in 2016, compared to a portion of the expenses associated with Capital Pacific Bank posting in 2015.

2015 Compared to 2014

For the year 2015, noninterest expense was up $8,161 or 21.63% from the prior year. When merger expenses relating to the acquisition of Capital Pacific Bank of $1,836 recorded in 2016, and $470 recorded in 2014, are excluded from noninterest expense, the 2016 expense was up $6,795 or 18.24% over 2015. The largest noninterest expense fluctuation was related to salary and benefits expense, which increased $3,946 or 16.75% over the prior year. Of the overall increase in salaries and benefits, $2,606 is attributable to increases in base salary expense associated with 34 FTE positions added during 2016,

 

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including 19 employees retained after the Capital Pacific Bank acquisition. The Bank also saw an increase in legal and professional services expense of $672 over the prior year, which was due in part, to a legal recovery booked during 2015 of $300. The Bank also saw an increase in property and equipment of $612, primarily attributable to the addition of the Capital Pacific Bank’s Fox Tower location to the Company’s office network.

BALANCE SHEET

Securities Available-for-Sale

At December 31, 2016, the balance of securities available-for-sale was $470,996, up $104,398 over December 31, 2016. The increase in the securities portfolio during 2016 was primarily due to the acquisition of Foundation Bank, which added approximately $89,000 to the securities total. At December 31, 2016, the portfolio had an unrealized pre-tax loss of $3,886 compared to an unrealized pre-tax gain of $4,341, at December 31, 2016. The decline in the unrealized gain or market value of the securities portfolio during 2016 was due to an increase in the short term interest rates and the market widening of spreads in virtually all investment products. The average life and duration of the portfolio at December 31, 2016, was 4.9 years and 4.4 years respectively, up from 4.1 years and 3.7 years, respectively, at December 31, 2015. At December 31, 2016, securities with an estimated fair value of $28,836 were pledged as collateral for public deposits in Oregon and Washington and for repurchase agreements.

The Company continued to structure the portfolio to provide consistent cash flow and reduce the market value volatility of the portfolio in a rising rate environment in light of the Company’s current liability sensitive position. The portfolio is structured to generate sufficient cash flow to allow reinvestment at higher rates should interest rates move up or to fund loan growth in future periods. In a stable rate environment, approximately $51,730 in cash flow is anticipated over the next twelve months. Going forward, purchases will be dependent upon core deposit growth, loan growth, and the Company’s interest rate risk position.

At December 31, 2016, $1,937, or 0.41% of the total securities portfolio was composed of private-label mortgage-backed securities. During 2016, management booked $21 in other than temporary impairment on this portion of the portfolio. In total, the private label mortgage backed portfolio had a cumulative balance of $270 in other than temporary impairments at December 31, 2016.

In management’s opinion, the remaining securities in the portfolio in an unrealized loss position are considered only temporarily impaired. The Company has no intent, nor is it more likely than not that it will be required, to sell its impaired securities before their recovery. The impairment is due to changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities, and not due to concerns regarding the underlying credit of the issuers or the underlying collateral. The decline in value of these securities resulted from current economic conditions. Although yields on these securities may be below market rates during the period, management does not currently anticipate the need to book any other-than-temporary impairment.

Loans

At December 31, 2016, outstanding gross loans were $1,859,787, up $453,775 over outstanding loans at December 31, 2015. A summary of outstanding loans by market, including national health care loans, for the years ended December 31, 2016, and December 31, 2015, follows:

 

     December 31,      2016 vs. 2015  
     2016      2015      $ Increase      % Increase  

Eugene market gross loans, period-end

   $ 442,556      $ 379,048      $ 63,508        16.75

Portland market gross loans, period-end

     747,037        667,995        79,042        11.83

Puget Sound market gross loans, period-end

     405,843        142,104        263,739        185.60

National health care gross loans, period end

     264,351        216,865        47,486        21.90
  

 

 

    

 

 

    

 

 

    

Total gross loans, period-end

   $ 1,859,787      $ 1,406,012      $ 453,775        32.27
  

 

 

    

 

 

    

 

 

    

During 2016, all of the Company’s markets showed growth in outstanding loans over the prior year. Loan growth was strongest in the Puget Sound market, due to the acquisition of Foundation Bank, which added $270,533 to outstanding gross loans and another $183,242 in organic loan growth during 2016. Growth in the Eugene market was primarily concentrated in construction lending, with advances on large owner-occupied construction projects occurring during 2016. Growth in national healthcare loans accounted for $47,486 of the organic loan growth recorded during 2016. At December 31, 2016, the

 

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Company had national healthcare loans in 44 states. The Company defines national healthcare loans as loans to healthcare professionals, primarily dentists located outside of the Company’s primary market area. The Company’s defined market area is within the States of Oregon and Washington west of the Cascade Mountain Range. This area is serviced by branch locations in Eugene, Oregon; Portland, Oregon; and Seattle, Washington. National health care loans, loans east of the Cascade Mountain Range and outside Oregon and Washington, are maintained and serviced by personnel located in the Portland market.

Outstanding loans to dental professionals, which are comprised of both local and national loans, at December 31, 2016, totaled $377,478 or 20.30% of the loan portfolio. Gross dental loans were up $37,316 over December 31, 2015, however the dental concentration decreased from the prior period due to growth in non-dental loans. Growth in national loans of $32,865 was partially offset by a $4,451 contraction in the local market dental loans. The more seasoned local dental loan portfolio experienced higher prepayment speeds due to competitive refinancing pricing offered. In addition, given the credit quality of dental loans in general, the Company encountered very competitive pricing in the national market. At December 31, 2016, $5,641 or 1.49% of the outstanding dental loans were supported by government guarantees. Loans to dental professionals include loans for such purposes as starting up a practice, acquisition of a practice, equipment financing, owner-occupied facilities, and working capital. National dental loans are limited to acquisition financing and owner-occupied facilities. Additional data on the Company’s dental loan portfolio and the credit quality of this portfolio can be found in Note 6 of the Notes to Consolidated Financial Statements in this report. Additional information regarding loan concentrations is included in Part II, Item 1A “Risk Factors” of this report under the heading “We have a significant concentration in loans to dental professionals, and loan concentrations within one industry may create additional risk.”

Detailed credit quality data on the entire loan portfolio can be found in Note 5 and Note 6 of the Notes to Consolidated Financial Statements in this report.

Goodwill

At December 31, 2016, the Company had a recorded balance of $61,401 in goodwill from the November 30, 2005, acquisition of NWB Financial Corporation and its wholly owned subsidiary, Northwest Business Bank (“NWBF”), the February 1, 2013, acquisition of Century Bank, the March 6, 2015, acquisition of Capital Pacific Bank and the September 6, 2016 acquisition of Foundation Bank. In accordance with GAAP, the Company does not amortize goodwill or other intangible assets with indefinite lives, but instead periodically tests these assets for impairment. Management performed an impairment analysis at December 31, 2016, based on the reporting unit level and determined there was no impairment of the goodwill at the time of the analysis.

Deferred Tax Assets

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. At December 31, 2016, the Company had a net deferred tax asset of $12,722. This includes the addition of the deferred tax assets of Foundation Bank, which included a large Federal net operating loss. The Company worked with outside accountants to conduct an IRC 382 analysis on loss and credit carryforwards. As a result of this analysis, the Bank has determined it is currently forecasted to utilize all of Foundation’s NOL carryforward by 2020, however there is an annual limitation due to prior Foundation Bank ownership changes. Deferred tax assets acquired from Foundation Bank have been adjusted for the effective rate differential between the Company and Foundation Bank. Any adjustment to the acquired deferred tax asset has affected the goodwill associated with the acquisition. Deferred tax assets are reviewed for recoverability and valuation allowances are provided, when necessary, to reduce deferred tax assets to the amounts expected to be realized. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefit, or that future deductibility is uncertain. In light of the Company’s performance, management anticipates that the deferred tax assets will be fully utilized to offset future income taxes and that no valuation allowance is required. Additional disclosures regarding the components of the net deferred tax asset are included in Note 16 of the Notes to Consolidated Financial Statements in this Form 10-K.

Deposits

Outstanding deposits at December 31, 2016, were $2,148,103, an increase of $551,010 over outstanding deposits of $1,597,093 at December 31, 2015. Core deposits, which are defined by the Company as demand, interest checking, money market, savings, and local non-public time deposits, including local non-public time deposits in excess of $100, were

 

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$2,035,067, up $501,125 or 32.67% over outstanding core deposits of $1,533,942 at December 31, 2015. At December 31, 2016, and 2015, core deposits represented 94.74% and 96.05%, respectively, of total deposits. Year-to-date December 31, 2016, average core deposits, a measurement that removes daily volatility, were $1,705,556, an increase of $229,388 or 21.29% over average core deposits of $1,406,168 for the year 2015.

A summary of outstanding deposits by market for the years 2016 and 2015 follows:

 

                   2016 vs. 2015  
     December 31,      $ Increase      % Increase  
     2016      2015      (Decrease)      (Decrease)  

Eugene market core deposits, period-end

   $ 815,674      $ 787,521      $ 28,153        3.57

Portland market core deposits, period-end

     630,806        552,283        78,523        14.22

Puget Sound market core deposits, period-end

     588,587        194,138        394,449        203.18
  

 

 

    

 

 

    

 

 

    

Total core deposits, period-end

     2,035,067        1,533,942        501,125        32.67

Public and brokered deposits, period-end

     113,036        63,151        49,885        78.99
  

 

 

    

 

 

    

 

 

    

Total deposits, period-end

   $ 2,148,103      $ 1,597,093      $ 551,010        34.50
  

 

 

    

 

 

    

 

 

    

All three of the Company’s primary markets showed an increase in core deposits during 2016. The Puget Sound market saw the largest growth, which included $396,509 in core deposits acquired through the Foundation Bank acquisition. All markets successfully acquired new deposit relationships and deepened deposit relationships with existing clients, however overall growth was tempered by the loss of a few large deposit clients. Mergers and acquisitions occurring in our market were the primary driver of deposits, as two large businesses sold, and deposits left the bank as a result of an out-of-state buyer. Because of its strategic focus on business banking and banking for nonprofits, the Company attracts a number of large depositors that account for a relatively significant portion of the core deposit base. Large depositor balances are subject to significant daily volatility. At December 31, 2016, large depositors, generally defined as relationships with $2,000 or more in deposits, accounted for $989,118 of the Company’s total core deposit base and represented 48.60% of outstanding core deposits, compared to $684,519 or 44.62% of outstanding core deposits at December 31, 2015. For more information on the Company’s large depositors and management of these relationships, see the “Liquidity and Cash Flows” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K. Additional information on deposits may also be found in Note 10 of the Notes to Consolidated Financial Statements in this
Form 10-K.

Public and Brokered Deposits

The Company uses public and brokered deposits to provide short-term and long-term funding sources. The Company defines short-term as having a contractual maturity of less than one year. The Company uses brokered deposits to help mitigate interest rate risk in a rising rate environment. A portion of the long-term brokered deposits have a call feature, which provides the Company the option to redeem the deposits on a quarterly basis, allowing the Company to refinance long-term funding at lower rates should market rates fall. Below is a schedule detailing public and brokered deposits by type, including weighted average rate and weighted average maturity.

 

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Non-Core Deposit Summary

 

     December 31, 2016      December 31, 2015  
     Balance      Weighted
average
rate
    Weighted
average
maturity
     Balance      Weighted
average
rate
    Weighted
average
maturity
 
     (dollars in thousands)      (dollars in thousands)  

<3 Months

   $ 30,149        0.84     53 days      $ 30,000        0.37     55 days  

3-6 Months

     290        0.27     106 days        300        0.36     108 days  

6-12 Months

     3,181        0.91     300 days        235        0.40     331 days  

>12 Months

     79,416        1.28     3.22 years        32,616        1.94     5.37 years  
  

 

 

         

 

 

      
   $ 113,036           $ 63,151       
  

 

 

         

 

 

      

During 2016, the Company saw an increase in usage of non-core funding, primarily related to additional brokered deposits. The expansion was tied to loan growth but also assisted in lengthening the Bank’s liabilities to help mitigate interest rate risk.

 

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Borrowings

The Company has both secured and unsecured borrowing lines with the Federal Home Loan Bank, Federal Reserve Bank and various correspondent banks. The Federal Reserve and correspondent borrowings are generally short-term, with a maturity of less than 30 days. The FHLB borrowings can be either short-term or long-term in nature with interest rates payable at then stated rates. See Notes 11 and 12 of the Notes to Consolidated Financial Statements in Item 8 of this report for additional information on borrowings.

 

     SHORT-TERM BORROWINGS  
     December 31,  
     2016     2015     2014  
     (dollars in thousands)  

Federal funds purchased, FHLB cash management advance, FRB, & short-term advances

      

Average interest rate

      

At year end

     0.70     0.34     0.48

For the year

     0.47     0.18     0.40

Average amount outstanding for the year

   $ 164,615     $ 129,665     $ 121,016  

Maximum amount outstanding at any month-end

   $ 183,500     $ 117,000     $ 168,500  

Amount outstanding at year-end

   $ 57,000     $ 47,000     $ 68,500  

Subordinated Debentures

In June 2016, the Company issued $35,000 in aggregate principal amount of fixed-to-floating rate subordinated debentures (the “Notes”) in a public offering. The Notes are callable at par after five years, have a stated maturity of September 30, 2026 and bear interest at a fixed annual rate of 5.875% per year, from and including June 27, 2016, but excluding September 30, 2021. From and including September 30, 2021 to the maturity date or early redemption date, the interest rate will reset quarterly to an annual interest rate equal to the then-current three-month LIBOR plus 471.5 basis points. Included in the proceeds from the debenture were various expenses including underwriting discount and commission, legal expenses, accounting expenses and various filing and trustee expenses. The total of the issuance cost was $951 and will be amortized over the life of the debt as an increase to interest expense. As of December 31, 2016, the subordinated debenture had a net book balance, including unamortized issuance cost of $34,096.

Junior Subordinated Debentures

The Company had $8,248 in junior subordinated debentures outstanding at December 31, 2016, which were issued in conjunction with the 2005 acquisition of NWBF. The junior subordinated debentures had an interest rate of 6.27% that was fixed through January 2011. In January 2011, the rate on the junior subordinated debentures changed to three-month LIBOR plus 135 basis points. On April 22, 2013, the Bank entered into a cash flow hedge on $8,000 of the trust preferred payment, swapping the variable interest rate for a fixed rate of 2.73% for a seven-year period. At December 31, 2016, the fair value of the interest rate swap on the Company’s subordinated debentures was $91, compared to $82 at December 31, 2015. At December 31, 2016, the $8,000 of the junior subordinated debentures qualified as Tier 1 capital under regulatory capital guidelines.

Following the acquisition of Foundation Bank in third quarter 2016, the Company assumed ownership of Foundation Statutory Trust I, which had previously issued $6,000 in aggregate liquidation amount of trust preferred securities. The interest rate on the these trust preferred securities is a floating rate of three-month LIBOR plus 173 basis points. The Company also acquired $6,148 of junior subordinated debentures (the “Foundation Debentures”) to the trust in exchange for ownership of all of the common security of the trust and the proceeds of the preferred securities sold by the trust. In accordance with current accounting guidance, the trust is not consolidated in the Company’s financial statements, but rather the Foundation Debentures are shown as a liability, and acquired at an acquisition date fair value of $3,013. The Company also recognized its $186 investment in the trust, which is recorded among “Other Assets” in its consolidated balance sheet at December 31, 2016.

 

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In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was signed into law which, among other things, limits the ability of certain bank holding companies to treat trust preferred security debt issuances, such as the Company’s junior subordinated debentures, as Tier 1 capital. Under final rules, recently adopted by the Federal Reserve and the other U.S. federal banking agencies, our trust preferred securities will remain as Tier 1 capital since total assets of the Company are less than $15 billion. Additional information regarding these final capital rules is included in in Part I, Item 1 “Business – Supervision and Regulation” and Part I, Item 1A “Risk Factors” of the report under the heading “We operate in a highly regulated environment and the effects of recent and pending federal legislation or of changes in, or supervisory enforcement of, banking or other laws and regulations could adversely affect us.”

Additional information regarding the terms of the cash flow hedge is included in Note 15 of the Notes to Consolidated Financial Statements in Item 8 of this report.

CAPITAL RESOURCES

Capital is the shareholders’ investment in the Company. Capital grows through the retention of earnings and the issuance of new stock or other equity securities whether through stock offerings or through the exercise of equity awards. Capital formation allows the Company to grow assets and provides flexibility in times of adversity. Shareholders’ equity at December 31, 2016, was $273,755, up $55,264 from December 31, 2015. The increase in shareholders’ equity was primarily due to the issuance of 2,853,362 shares of Company stock valued at $47,794 in conjunction with the acquisition of Foundation Bank during the third quarter 2016, combined with retention of a portion of income earned during 2016.

On July 27, 2016, the Company’s Board of Directors authorized the repurchase of up to 5.00% of the Company’s outstanding shares, or 892,500 shares, with the purchases to take place over a 12-month period. During 2016, the Company did not repurchase any shares as the strike price was below the current share value. Throughout 2016, the Company has used a combination of regular dividends, special dividends, and share repurchases to maintain capital levels comparable with year-end December 31, 2011, capital levels. For additional details regarding the changes in equity, review the Consolidated Statements of Changes in Shareholders’ Equity in Item 8 of this report.

The Federal Reserve and the FDIC have in place guidelines for risk-based capital requirements applicable to U.S. bank holding companies and banks. In July 2013, the Federal Reserve Board and the other U.S. federal banking agencies have adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the Basel Committee’s current international regulatory capital accord (Basel III). These rules were effective January 1, 2016 and replaced the federal banking agencies’ general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. The final rules establish more restrictive capital definitions, create additional categories and higher risk-weightings for certain asset classes and off-balance sheet exposures, higher leverage ratios and capital conservation buffers that will be added to the minimum capital requirements and must be met for banking organizations to avoid being subject to certain limitations on dividends and discretionary bonus payments to executive officers. The rules also implement higher minimum capital requirements, include a common equity Tier 1 capital requirement, and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.50%; (b) a Tier 1 capital ratio of 6.00% (which is an increase from 4.00%); (c) a total capital ratio of 8.00%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4.00%. The new rules permit depository institution holding companies with less than $15 billion in total consolidated assets as of December 31, 2009, such as the Company, to include trust preferred securities in Tier 1 capital. Under the rules, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements (equal to 2.50% of total risk-weighted assets). The phase-in of the capital conservation buffer will begin January 1, 2016, and be completed by January 1, 2019. The new rules also provide for various adjustments and deductions to the definitions of regulatory capital that will phase in from January 1, 2015 to December 31, 2017. The rules made it optional for banks and bank holding companies to include accumulated other comprehensive income in their calculations of Tier 1 capital. The Company’s accumulated other comprehensive income consists primarily of the unrealized gain or loss on the securities portfolio as a result of marking securities available-for-sale to market. The Company opted to exclude accumulated other comprehensive income from its calculation of Tier 1 capital. Overall, the rules did not materially impact the Company’s reported capital ratios. The Company will continue to evaluate the impact of the rules as they are phased in over the next few years.

 

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For additional information regarding the Company’s regulatory capital levels, see Note 24 in Notes to Consolidated Financial Statements in Item 8 of this report.

The Company’s common equity Tier 1 capital ratio, Tier 1 risk based capital ratio, total risk based capital ratio, and Tier 1 leverage capital ratio were 12.69%, 10.08%, 9.52% and 9.01%, respectively, at December 31, 2016, with all capital ratios for the Company above the minimum regulatory “well capitalized” designations.

The Company has regularly paid cash dividends on a quarterly basis, typically in February, May, August and November of each year. The Board of Directors considers the dividend amount quarterly and takes a broad perspective in its dividend deliberations including a review of recent operating performance, capital levels, and concentrations of loans as a percentage of capital, and growth projections. The Board also considers dividend payout ratios, dividend yield, and other financial metrics in setting the quarterly dividend. There can be no assurance that dividends will be paid in the future.

During 2016, the Company paid regular dividends totaling $0.44. The fourth quarter dividend represents a dividend payout of 36.67% of net income. Subsequent to the end of the year, on January 26, 2017, the Board of Directors approved a regular quarterly cash dividend to $0.11 per share payable to shareholders on February 23, 2017.

OFF-BALANCE SHEET ARRANGEMENTS AND COMMITMENTS

In the normal course of business, the Company commits to extensions of credit and issues letters of credit. The Company uses the same credit policies in making commitments to lend funds and conditional obligations as it does for other credit products. In the event of nonperformance by the customer, the Company’s exposure to credit loss is represented by the contractual amount of the instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established by the contract. Since some commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. At December 31, 2016, the Company had $352,361 in commitments to extend credit, up $63,205 from $289,156 reported at December 31, 2015.

Letters of credit written are conditional commitments issued by the Company to guarantee performance of a customer to a third-party. The credit risk involved is essentially the same as that involved in extending loan facilities to customers. At December 31, 2016, the Company had $987 in letters of credit and financial guarantees written.

The Company has certain other financial commitments. These future financial commitments at December 31, 2016, are outlined below:

 

            Less than
One Year
     1-3 Years      3-5 Years      More than
5 Years
 
     Total              

Junior subordinated debentures

   $ 11,311      $ —        $ —        $ —        $ 11,311  

Subordinated debentures

     34,096        —          —          —          34,096  

FHLB borrowings

     65,000        60,000        3,000        —          2,000  

Time deposits

     178,883        87,701        53,689        25,128        12,365  

Operating lease obligations

     11,002        1,755        3,190        1,978        4,079  

Deferred compensation agreements

     742        34        —          —          708  

Employment contracts

     840        840        —          —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 301,874      $ 150,330      $ 59,879      $ 27,106      $ 64,559  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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LIQUIDITY AND CASH FLOWS

Liquidity is the term used to define the Company’s ability to meet its financial commitments. The Company maintains sufficient liquidity to ensure funds are available for both lending needs and the withdrawal of deposit funds. The Company derives liquidity through core deposit growth, maturity of investment securities, and loan payments. Core deposits include demand, interest checking, money market, savings, and local time deposits, including local nonpublic time deposits in excess of $100. Additional liquidity and funding sources are provided through the sale of loans, sales of securities, access to national CD markets, and both secured and unsecured borrowings. The Company uses a number of measurements to monitor its liquidity position on a daily, weekly, and monthly basis, which includes its ability to meet both short-term and long-term obligations, and requires the Company to maintain a certain amount of liquidity on the asset side of its balance sheet. The Company also prepares projections of its liquidity position. In addition, the Company prepares a Liquidity Contingency Plan at least semi-annually that is strategic in nature and forward-looking to test the ability of the Company to fund a liquidity shortfall arising from various escalating events. The Liquidity Contingency Plan is presented and reviewed by the Company’s Asset and Liability Committee.

Core deposits at December 31, 2016, were $2,035,067 and represented 94.74% of total deposits. Core deposits at December 31, 2016, were up $501,125 over December 31, 2015. The acquisition of Foundation Bank during the third quarter 2016 accounted for approximately $397,000 of deposit growth during 2016, while organic growth accounted for the remaining increase in total deposits.

The Company experienced an increase in outstanding loans of $453,775 during 2016, which included organic growth and loans acquired in the Foundation Bank acquisition. Organic loan growth was funded primarily by growth in core deposits, but a portion was funded by growth in brokered deposits. It is anticipated that core deposit growth and cash flows from the securities portfolio will provide a significant portion of the funding during 2017, as loans are expected to continue to increase. The securities portfolio represented 18.53% of total assets at December 31, 2016. At December 31, 2016, $29,256 of the securities portfolio was pledged to support public deposits and repurchase agreements, leaving $441,740 of the securities portfolio unencumbered and available-for-sale. In addition, at December 31, 2016, the Company had $25,477 of government guaranteed loans that could be sold in the secondary market to support the Company’s liquidity position.

Due to its strategic focus, the Company has been successful in developing deposit relationships with several large clients, which are generally defined as deposit relationships of $2,000 or more, which are closely monitored by management and Company officers. The loss of any such deposit relationship or other large deposit relationships could cause an adverse effect on short-term liquidity. The Company uses a 10-point risk-rating system to evaluate each of its large depositors in order to assist management in its daily monitoring of the volatility of this portion of its core deposit base. The risk-rating system attempts to determine the stability of the deposits of each large depositor, evaluating, among other things, the length of time the depositor has been with the Company and the likelihood of loss of individual large depositor relationships. Risk ratings on large depositors are reviewed at least quarterly and adjusted if necessary. Company management and officers maintain close relationships and hold regular meetings with its large depositors to assist in management of these relationships. The Company generally expects to maintain these relationships, believes it has sufficient sources of liquidity to mitigate the loss of one or more of these clients and regularly tests its ability to mitigate the loss of multiple large depositor relationships in its Liquidity Contingency Plan. The Company had five deposit relationships rated a 10, the highest risk, with outstanding deposit balances of approximately $95,000 as of December 31, 2016. The Company currently maintains sufficient short-term liquidity to cover any potential volatility in these relationships and is working on a longer term funding strategy in the event these deposits need to be replaced in the future. However, there can be no assurance that this deposit relationship or any of our other large depositor relationships will be maintained or that the loss of one or more of these clients will not adversely affect the Company’s liquidity.

At December 31, 2016, the Company had secured borrowing lines with the FHLB and the FRB, along with unsecured borrowing lines with various correspondent banks, totaling $866,986. The Company’s secured lines with the FHLB and FRB were limited by the amount of collateral pledged. At December 31, 2016, the Company had pledged $632,202 in discounted collateral value in commercial real estate loans, first and second lien single-family residential loans, and multi-family loans, to the FHLB. Additionally, certain commercial loans with a discounted value of $80,784 were pledged to the FRB under the Company’s Borrower-In-Custody program. The Company’s unsecured correspondent bank lines totaled $154,000. At December 31, 2016, the Company had $65,000 in borrowings outstanding from the FHLB, no borrowings outstanding with the FRB, and no funds outstanding on its overnight correspondent bank lines, leaving a total of $801,986 available on its secured and unsecured borrowing lines as of such date.

 

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As disclosed in the Consolidated Statements of Cash Flows in the Consolidated Financial Statements in this Form 10-K, net cash provided by operating activities was $31,513 for the year 2016. The difference between cash provided by operating activities and net income largely consisted of depreciation and amortization of $6,986. Net cash of $169,899 was used in investing activities for the year 2016, consisting principally of net loan originations of $184,498 and securities purchases of $179,174, which was offset by proceeds from maturities of investment securities of $150,669. Cash provided by financing activities was $168,824 for the year 2016, primarily due to an increase in deposits of $154,502. See the Consolidated Statements of Cash Flows in this form 10-K for further information.

INFLATION

Substantially all of the assets and liabilities of the Company are monetary. Therefore, inflation has a less significant impact on the Company than does fluctuation in market interest rates. Inflation can lead to accelerated growth in noninterest expenses, which could impact net earnings. During the last several years, inflation, as measured by the Consumer Price Index, did not change significantly. The effects of inflation have not had a material impact on the Company.

 

ITEM 7A Quantitative and Qualitative Disclosures About Market Risk

The Company’s results of operations are largely dependent upon its ability to manage market risks. Changes in interest rates can have a significant effect on the Company’s financial condition and results of operations. Although permitted by its funds management policy, the Company does not presently use derivatives, such as forward and futures contracts, options or interest rate swaps, to manage interest rate risk. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities.

Interest rate risk generally arises when the maturity or repricing structure of the Company’s assets and liabilities differ significantly. Asset and liability management, which among other things addresses such risk, is the process of developing, testing and implementing strategies that seek to maximize net interest income while maintaining sufficient liquidity. This process includes monitoring contractual maturity and prepayment expectations together with expected repricing of assets and liabilities under different interest rate scenarios. Generally, the Company seeks a structure that insulates net interest income from large deviations attributable to changes in market rates.

Interest rate risk is managed through the monitoring of the Company’s balance sheet by utilizing two key measurement tools; 1) Economic Value of Equity (EVE), and 2) Net Interest Income (NII). Economic Value of Equity is a measurement of net present value of assets less liabilities. Net interest income is a measurement of interest income less interest expense over a specified time horizon (usually 12, 24 and/or 36 months). Both measurements incorporate instantaneous parallel rate shocks of -100, +100, +200, +300, and +400 basis points. Key assumptions are applied to the analysis covering asset prepayments, liability decays and betas, and repricing characteristics. Other interest rate risk analysis includes stress-testing, back-testing, and forecast. Stress-testing the model provides a measurement of worst-case analysis and a degree of tolerance to the base model. Back-testing analysis provides a degree of validity of the base model as compared to actual results. Forecast provides management the what-if scenarios with predetermined balance and rate growth assumptions. In addition, forecasting takes into account growth in loans and deposits and management strategies that could be employed to maximize the net interest margin and net interest income.

The Company has recently outsourced its quarterly interest rate risk analysis to a third party vendor- Pacific Coast Bankers Bank. Pacific Coast Bankers Bank’s process and modeling software uses key internal assumptions for beta, decay, and prepayment speeds, as well as established policy limits, in order to determine the effect changes in interest rates have on Economic Value of Equity and Net Interest Income. Economic Value of Equity provides a long-term risk profile while Net Interest Income provides a short-term risk profile of the balance sheet. Although certain assets and liabilities may have similar repricing characteristics, they may not react correspondingly to changes in market interest rates. In the event of a change in interest rates, prepayment of loans and early withdrawal of time deposits would likely deviate from those previously assumed. Increases in market rates may also affect the ability of certain borrowers to make scheduled principal payments.

The models attempt to account for such limitations by imposing weights on the differences between repricing assets and repricing liabilities within each time segment. These weights are based on the ratio between the amount of rate change of each category of asset or liability and the amount of change in the federal funds rate. Certain non-maturing liabilities, such as checking accounts and money market deposit accounts, are allocated among the various repricing time segments to meet local competitive conditions and management’s strategies.

 

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At December 31, 2016, the Company was slightly asset sensitive to neutral, meaning that in a rising rate environment, the net interest margin and net interest income would be positively impacted. The Company’s interest rate risk position was primarily due to the frequency of loan repricing due to amortization and maturities, liquidity within the investment portfolio, and the concentration of low cost deposits.

There are numerous critical assumptions in the modeling of interest rate sensitivity, including the deposit decay rate (the rate at which non-maturing deposits run off over time) and the beta factor (the projected change in rates paid on non-maturing deposits for every 100 basis point increase or decrease in market interest rates). Critical assumptions are based on historical behaviors and current market conditions. Due to the critical nature of these assumptions on the overall calculated interest rate risk position, actual results and changes in net interest income and the net interest margin in the event of an increase or decrease of market interest rates may be materially different from projections.

The following table shows the estimated impact on Net Interest Income at one, two, and three year time horizons and Economic Value of Equity with instantaneous parallel rate shocks of -100, +100, +200, +300, and +400 basis points. Due to the various assumptions used for this modeling and potential balance sheet strategies management may implement to mitigate interest rate risk, no assurance can be given that projections will reflect actual results.

Interest Rate Shock Analysis

Net Interest Income and Economic Value of Equity Measurement

($ in thousands)

 

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Table of Contents
     1st Year Net Interest Income  

Interest

Rate Shocks

   $ Estimated
Value
     $ Change
From Base
     % Change
From Base
 

400

     100,629        520        0.52

300

     100,606        497        0.50

200

     100,483        374        0.37

100

     100,290        181        0.18

Base

     100,109        -        -  

-100

     96,854        (3,255      -3.25
     2nd Year Net Interest Income  

Interest

Rate Shocks

   $ Estimated
Value
     $ Change
From Base
     % Change
From Base
 

400

     113,074        14,164        14.32

300

     109,738        10,828        10.95

200

     106,273        7,363        7.44

100

     102,701        3,791        3.83

Base

     98,910        -        -  

-100

     91,401        (7,509      -7.59
     3rd Year Net Interest Income  

Interest

Rate Shocks

   $ Estimated
Value
     $ Change
From Base
     % Change
From Base
 

400

     124,281        25,785        26.18

300

     118,031        19,535        19.83

200

     111,686        13,190        13.39

100

     105,219        6,723        6.83

Base

     98,496        -        -  

-100

     88,295        (10,201      -10.36
     Economic Value of Equity  

Interest

Rate Shocks

   $ Estimated
Value
     $ Change
From Base
     % Change
From Base
 

400

     521,778        3,288        0.63

300

     522,948        4,458        0.86

200

     523,913        5,423        1.05

100

     521,491        3,001        0.58

Base

     518,490        -        -  

-100

     491,539        (26,951      -5.20

 

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ITEM 8 Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Pacific Continental Corporation and Subsidiary

We have audited the accompanying consolidated balance sheets of Pacific Continental Corporation and Subsidiary (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. We also have audited the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control -Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, 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 Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statements presentation. 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 audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

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.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Continental Corporation and Subsidiary as of December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with generally accepted accounting principles in the United States of America. Also in our opinion, Pacific Continental Corporation and Subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016 based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

/s/ Moss Adams LLP

Portland, Oregon

March 13, 2017

 

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Pacific Continental Corporation and Subsidiary

Consolidated Balance Sheets

(In thousands, except share amounts)

 

     December 31,  
     2016     2015  

ASSETS

    

Cash and due from banks

   $ 30,154     $ 23,819  

Interest-bearing deposits with banks

     36,959       12,856  
  

 

 

   

 

 

 

Total cash and cash equivalents

     67,113       36,675  

Securities available-for-sale

     470,996       366,598  

Loans, net of deferred fees

     1,857,767       1,404,482  

Allowance for loan losses

     (22,454     (17,301
  

 

 

   

 

 

 

Net loans

     1,835,313       1,387,181  

Interest receivable

     7,107       5,721  

Federal Home Loan Bank stock

     5,423       5,208  

Property and equipment, net of accumulated depreciation

     20,208       18,014  

Goodwill and intangible assets

     70,382       43,159  

Deferred tax asset

     12,722       5,670  

Other real estate owned

     12,068       11,747  

Bank-owned life insurance

     35,165       22,884  

Other assets

     4,940       6,621  
  

 

 

   

 

 

 

Total assets

   $ 2,541,437     $ 1,909,478  
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Deposits

    

Noninterest-bearing demand

   $ 858,996     $ 568,688  

Savings and interest-bearing checking

     1,110,224       889,802  

Core time deposits

     65,847       75,452  
  

 

 

   

 

 

 

Total core deposits

     2,035,067       1,533,942  

Other time deposits

     113,036       63,151  
  

 

 

   

 

 

 

Total deposits

     2,148,103       1,597,093  

Securities sold under agreements to repurchase

     1,966       71  

Federal Home Loan Bank borrowings

     65,000       77,500  

Subordinated debentures

     34,096       —    

Junior subordinated debentures

     11,311       8,248  

Accrued interest and other payables

     7,206       8,075  
  

 

 

   

 

 

 

Total liabilities

     2,267,682       1,690,987  
  

 

 

   

 

 

 

Commitments and contingencies (Note 22)

    

Shareholders’ equity

    

Common stock, no par value, shares authorized: 50,000,000; shares issued and outstanding: 22,611,535 at December 31, 2016 and 19,604,182 at December 31, 2015

     205,584       156,099  

Retained earnings

     70,486       59,693  

Accumulated other comprehensive income

     (2,315     2,699  
  

 

 

   

 

 

 
     273,755       218,491  
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 2,541,437     $ 1,909,478  
  

 

 

   

 

 

 

See accompanying notes.

 

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Table of Contents

Pacific Continental Corporation and Subsidiary

Consolidated Statements of Operations

(In thousands, except per share amounts)

 

     Years Ended December 31,  
     2016     2015     2014  

Interest and dividend income

      

Loans

   $ 80,104     $ 65,694     $ 53,855  

Taxable securities

     7,743       6,532       6,191  

Tax-exempt securities

     1,942       1,976       1,971  

Federal funds sold & interest-bearing deposits with banks

     154       34       10  
  

 

 

   

 

 

   

 

 

 
     89,943       74,236       62,027  
  

 

 

   

 

 

   

 

 

 

Interest expense

      

Deposits

     3,848       3,314       3,252  

Federal Home Loan Bank & Federal Reserve borrowings

     954       885       1,088  

Subordinated debentures

     1,143       —         —    

Junior subordinated debentures

     279       226       225  

Federal funds purchased

     8       11       14  
  

 

 

   

 

 

   

 

 

 
     6,232       4,436       4,579  
  

 

 

   

 

 

   

 

 

 

Net interest income

     83,711       69,800       57,448  

Provision for loan losses

     5,450       1,695       —    
  

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan losses

     78,261       68,105       57,448  
  

 

 

   

 

 

   

 

 

 

Noninterest income

      

Service charges on deposit accounts

     2,876       2,644       2,134  

Bankcard income

     1,214       1,029       951  

Bank-owned life insurance income

     702       592       473  

Net gain (loss) on sale of investment securities

     373       672       (34

Impairment losses on investment securities (OTTI)

     (21     (22     —    

Other noninterest income

     2,673       1,710       1,471  
  

 

 

   

 

 

   

 

 

 
     7,817       6,625       4,995  
  

 

 

   

 

 

   

 

 

 

Noninterest expense

      

Salaries and employee benefits

     31,873       27,501       23,555  

Property and equipment

     4,742       4,347       3,735  

Data processing

     3,709       3,259       2,720  

Legal and professional services

     3,297       1,924       1,252  

Business development

     2,049       1,640       1,531  

FDIC insurance assessment

     1,089       1,051       868  

Merger related expense

     4,934       1,836       470  

Other real estate (income) expense

     (36     346       449  

Other noninterest expense

     4,936       3,986       3,149  
  

 

 

   

 

 

   

 

 

 
     56,593       45,890       37,729  
  

 

 

   

 

 

   

 

 

 

Income before income tax provision

     29,485       28,840       24,714  

Income tax provision

     9,709       10,089       8,672  
  

 

 

   

 

 

   

 

 

 

Net income

   $ 19,776     $ 18,751     $ 16,042  
  

 

 

   

 

 

   

 

 

 

Earnings per share

      

Basic

   $ 0.96     $ 0.97     $ 0.90  
  

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.95     $ 0.97     $ 0.89  
  

 

 

   

 

 

   

 

 

 

See accompanying notes.

 

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Pacific Continental Corporation and Subsidiary

Consolidated Statements of Comprehensive Income

(In thousands)

 

     Years Ended December 31,  
     2016     2015     2014  

Net income

   $ 19,776     $ 18,751     $ 16,042  

Other comprehensive (loss) income:

      

Available-for-sale securities:

      

Unrealized (loss) gain arising during the year

     (7,877     (1,064     6,266  

Reclassification adjustment for (gains) losses realized in net income

     (373     (672     34  

Other than temporary impairment

     21       22       —    

Income tax benefit (expense)

     3,210       668       (2,457

Derivative instrument—cash flow hedge

      

Unrealized gain (loss) arising during the year

     336       (94     (230

Reclassification adjustment for gains realized in net income

     (327     —         —    

Income tax (expense) benefit

     (4     37       90  
  

 

 

   

 

 

   

 

 

 

Total other comprehensive (loss) income, net of tax

     (5,014     (1,103     3,703  
  

 

 

   

 

 

   

 

 

 

Total comprehensive income

   $ 14,762     $ 17,648     $ 19,745  
  

 

 

   

 

 

   

 

 

 

See accompanying notes.

 

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Pacific Continental Corporation and Subsidiary

Consolidated Statements of Changes in Shareholders’ Equity

(In thousands, except share amounts)

 

     Number of
Shares
    Common
Stock
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (loss)
    Total  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2013

     17,891,687     $ 133,835     $ 45,250     $ 99     $ 179,184  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

         16,042         16,042  

Other comprehensive loss, net of tax

           3,703       3,703  
        

 

 

   

 

 

 

Comprehensive income

             19,745  
          

 

 

 

Stock issuance and related tax benefit

     93,069       203           203  

Stock repurchase

     (267,080     (3,600         (3,600

Share-based compensation expense

       1,454           1,454  

Vested employee RSUs and SARs surrendered to cover tax consequences

       (517         (517

Cash dividends ($0.69 per share)

         (12,308       (12,308
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2014

     17,717,676     $ 131,375     $ 48,984     $ 3,802     $ 184,161  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

         18,751         18,751  

Other comprehensive income, net of tax

           (1,103     (1,103
        

 

 

   

 

 

 

Comprehensive income

             17,648  
          

 

 

 

Stock issuance and related tax benefit

     108,404       95           95  

Stock issued through acquisition

     1,778,102       23,578           23,578  

Share-based compensation expense

       1,700           1,700  

Vested employee RSUs and SARs surrendered to cover tax consequences

       (649         (649

Cash dividends ($0.42 per share)

         (8,042       (8,042
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2015

     19,604,182     $ 156,099     $ 59,693     $ 2,699     $ 218,491  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

         19,776         19,776  

Other comprehensive loss, net of tax

           (5,014     (5,014
        

 

 

   

 

 

 

Comprehensive income

             14,762  
          

 

 

 

Stock issuance and related tax benefit

     153,991       734           734  

Stock issued through acquisition

     2,853,362       47,794           47,794  

Share-based compensation expense

       1,853           1,853  

Vested employee RSUs and SARs surrendered to cover tax consequences

       (896         (896

Cash dividends ($0.44 per share)

         (8,983       (8,983
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2016

     22,611,535     $ 205,584     $ 70,486     $ (2,315   $ 273,755  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes.

 

65


Table of Contents

Pacific Continental Corporation and Subsidiary

Consolidated Statements of Cash Flows

(In thousands)

 

     Years Ended December 31,  
     2016     2015     2014  

Cash flows from operating activities:

      

Net income

   $ 19,776     $ 18,751     $ 16,042  

Adjustments to reconcile net income to net cash from operating activities:

      

Depreciation and amortization, net of accretion

     6,985       7,138       6,834  

Valuation adjustment on foreclosed assets

     162       129       82  

(Gain) loss on sale of other real estate owned

     (410     2       (7

Provision for loan losses

     5,450       1,695       —    

Deferred income tax provision

     (694     1,153       2,766  

BOLI income

     (702     (592     (473

Share-based compensation

     2,003       1,650       1,528  

Excess tax benefit of stock options exercised

     (43     (9     (14

Other than temporary impairment on investment securities

     21       22       —    

(Gain) loss on sale of investment securities

     (373     (672     34  

Change in:

      

(Increase) decrease in interest receivable

     (452     (401