10-K 1 tv488011_10k.htm 10-K

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

 

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

 

For the fiscal year ended December 31, 2017

 

OR

 

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

 

COMMISSION FILE NUMBER 000-50400

 

SELECT BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

NORTH CAROLINA 20-0218264
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

 

  700 W. Cumberland Street, Dunn, North Carolina 28334
(Address of Principal Executive Offices) (Zip Code)

 

Registrant’s Telephone number, including area code: (910) 892-7080

 

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

 

Title of each class   Name of each exchange on which registered
     
Common Stock, par value $1.00 per share   The NASDAQ Stock Market LLC

 

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 x 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 x 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.

x Yes ¨ No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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).  x 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 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, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ¨   Accelerated filer x
     
Non-accelerated filer ¨ (Do not check if a smaller reporting company)   Smaller reporting company ¨
     
    Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

¨ Yes x No

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter: $123,399,405.

 

Indicate the number of shares outstanding of each of the registrant’s classes of Common Stock as of the latest practicable date: 14,013,917 shares outstanding as of March 9, 2018.

 

Documents Incorporated by Reference:

Portions of the registrant’s Proxy Statement for its 2018 Annual Meeting of Shareholders are incorporated by reference into Part III hereof.

 

 

 

   

 

 

FORM 10-K CROSS-REFERENCE INDEX

 

form 10-k

Proxy

statement

 
       
part i      
Item 1 – Business 3    
Item 1A – Risk Factors 20    
Item 1B – Unresolved Staff Comments 34    
Item 2 – Properties 35    
Item 3 – Legal Proceedings 36    
Item 4 – Mine Safety Disclosures 36    
       
PART II      
       
Item 5 – Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 37    
Item 6 – Selected Financial Data 40    
Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 42    
Item 7A – Quantitative and Qualitative Disclosures About Market Risk 66    
Item 8 – Financial Statements and Supplementary Data 68    
Item 9 – Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 141    
Item 9A – Controls and Procedures 141    
Item 9B – Other Information 142    
       
PART III      
       
Item 10 – Directors, Executive Officers and Corporate Governance   143  
Item 11 – Executive Compensation   143  
Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   143  
Item 13 – Certain Relationships and Related Transactions, and Director Independence   144  
Item 14 – Principal Accounting Fees and Services   144  
       
PART IV      
       
Item 15 – Exhibits, Financial Statement Schedules 145    

 

 - 2 - 

 

 

Part I

 

Item 1 –Business

 

General

 

Select Bancorp, Inc. (the “Registrant” or the “Company”) (formerly New Century Bancorp, Inc.) was incorporated under the laws of the State of North Carolina on May 14, 2003, at the direction of the Board of Directors of Select Bank & Trust Company (formerly New Century Bank), for the purpose of serving as the bank holding company for Select Bank & Trust Company (“Select Bank” or the “Bank”) and became the holding company for the Bank on September 19, 2003. To become the Bank’s holding company, the Registrant received the approval of the Federal Reserve Board as well as Select Bank’s shareholders. Upon receiving such approval, each outstanding share of common stock of Select Bank was exchanged on a one-for-one basis for one share of common stock of the Registrant. On July 25, 2014, New Century Bancorp, Inc. and New Century Bank changed their names to Select Bancorp, Inc. and Select Bank & Trust Company, respectively. This was in conjunction with the merger with “Legacy” Select Bancorp, Inc. and Select Bank & Trust Company of Greenville, NC. On December 15, 2017, the Registrant acquired Premara Financial, Inc. (“Premara”) and its banking subsidiary Carolina Premier Bank (“Carolina Premier”) of Charlotte, North Carolina. Under the terms of that acquisition, Premara was merged with and into the Registrant, Carolina Premier was merged with and into the Bank, and shareholders of Premara received 1.0463 shares of the Registrant’s common stock or $12.65 in cash for each outstanding share of Premara common stock, with approximately 70% of such shares being exchanged for shares of the Registrant’s common stock and 30% being exchanged for cash.

 

The Registrant operates for the primary purpose of serving as the holding company for its subsidiary depository institution, Select Bank & Trust Company. The Registrant’s headquarters is located at 700 West Cumberland Street, Dunn, North Carolina 28334.

 

The Bank was incorporated on May 19, 2000 as a North Carolina-chartered commercial bank, opened for business on May 24, 2000, and is located at 700 West Cumberland Street, Dunn, North Carolina.

 

The Bank operates for the primary purpose of serving the banking needs of individuals and small to medium-sized businesses in its market area. The Bank offers a range of banking services including checking and savings accounts, commercial, consumer, mortgage and personal loans, and other associated financial services.

 

Primary Market Area

 

The Registrant’s market area consists of portions of central and eastern North Carolina which includes Alamance, Beaufort, Brunswick, Carteret, Cumberland, Harnett, Mecklenburg, New Hanover, Pasquotank, Pitt, Robeson, Sampson, Wake and Wayne counties and portions of northwestern South Carolina in Cherokee, Pickens and York counties. The Bank has branch offices in Dunn, Burlington, Charlotte, Clinton, Elizabeth City, Fayetteville, Goldsboro, Greenville, Leland, Lillington, Lumberton, Morehead City, Raleigh and Washington, North Carolina and Rock Hill, Blacksburg and Six Mile, South Carolina.  The Registrant’s market area has a population of over 3.8 million with an average household income of over $44,500.

 

 - 3 - 

 

  

Total deposits in the Registrant’s market area exceeded $228 billion at June 30, 2017.  The leading economic components of Alamance County, North Carolina, are healthcare and education with the largest employers being LabCorp, the public school system, the Alamance Regional Medical Center and Elon University. In Beaufort County, North Carolina, the top employers are the Beaufort County Schools, PCS Phosphate Company, Vidant Medical Center and other manufacturing facilities and public administration. Brunswick County North Carolina’s leading industries are education, public administration with the County of Brunswick, Progress Energy and a Food Lion distribution center. In Carteret County, North Carolina, it is public services that are leading economic factors as education, health services and public administration are the leading employers followed by major retailers including Wal-Mart, Food Lion and Big Rock Sports LLC, an outdoor sporting goods distributor. Cumberland County, North Carolina’s leading sector is the Department of Defense with extensions of the Army, Navy and Air Force located there, followed by Cape Fear Valley Health Systems, a Wal-Mart distribution Center, county and city administration and Goodyear Tire manufacturing facility. The U.S. Department of Veteran’s Affairs and Fayetteville Technical Community College also employ over 1,000 in Cumberland County. In Harnett County, North Carolina, top economic sectors are Harnett County Schools, along with a Food Lion distribution center, Campbell University, public administration, Betsy Johnson Memorial Hospital and a new Rooms To Go manufacturing and distribution center. In New Hanover County, North Carolina, education, health services and government officers are leaders in the economy. New Hanover Regional Medical Center, the school system and the University of North Carolina at Wilmington are the largest employers along with PPD Development, a pharmaceutical company. In Mecklenburg County, education, financial activities and health services are leading industries. The Charlotte-Mecklenburg Hospital and school systems are top employers along with Wells Fargo and Bank of America. Transportation is also a leading industry in Mecklenburg County with American Airlines as a top employer. In Pasquotank County, North Carolina, education, health services and the U.S. Department of Homeland Security through the U.S. Coast Guard base in Elizabeth City are top employers. Pitt County, North Carolina, has a mix of education and health services employers and still relies heavily on manufacturing with over 1,000 jobs attributable to NACCO Materials Handling Group as well as being home to East Carolina University and Vidant Medical Center. In Robeson County, North Carolina, leading sectors include education, health services, and manufacturing with Mountaire Farms of N.C. employing over 1,000.  Robeson County is also home to UNC Pembroke and the Campbell Soup Supply Company.  In Sampson County, North Carolina, leading sectors include education, manufacturing, agriculture and natural resources with top employers including Smithfield Foods, Prestage Farms and Hog Slat.  In Wake County, North Carolina, leading sectors include government, education, healthcare, and technology.  Wayne County North Carolina’s leading sectors are the federal government and military services, education and retail trade. In South Carolina’s Cherokee County, manufacturing, administrative and waste management are leading industries. Brown Packing Company, the Cherokee County School District and Ambassador Personnel are among the largest employers. In Pickens County, South Carolina, state government and education are leading the economy with both the state government offices and Clemson University among the largest employers. In York County, South Carolina, manufacturing, medical, retail and education are leading economic components as Kent Companies, a concrete contractor, York Hospital, the federal government and Wal-Mart are the top employers.

 

Competition

 

Commercial banking in the North Carolina and South Carolina markets in which the Bank operates is extremely competitive. The Registrant competes in its market areas with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of the Registrant’s competitors have broader geographic markets and higher lending limits than Registrant and are also able to provide more services and make greater use of advertising.  As of June 30, 2017, data provided by the FDIC Deposit Market Share Report indicated that, within the Registrant’s market area, there were 903 offices of insured depository institutions (38 in Alamance County, 14 in Beaufort County, 38 in Brunswick County, 26 in Carteret County, 60 in Cumberland County, 24 in Harnett County, 235 in Mecklenburg County, 12 in Pasquotank County, 45 in Pitt County, 30 in Robeson County, 14 in Sampson County, 252 in Wake County and 28 in Wayne County, all in North Carolina and 10 in Cherokee County, 30 in Pickens County and 47 in York County, South Carolina), including offices of the Bank.

 

The enactment of legislation authorizing interstate banking resulted in great increases in the size and financial resources of some of the Registrant’s competitors. In addition, larger out-of-state commercial banks have recently acquired a number of North Carolina and South Carolina banks and further heightened the competition among banks.

 

 - 4 - 

 

  

Despite the competition in its market areas, the Registrant believes that it has certain competitive advantages that distinguish it from its competition. The Registrant believes that its primary competitive advantages are its strong local identity and affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The Registrant offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The Registrant offers many personalized services and intends to attract customers by being responsive and sensitive to their individualized needs. The Registrant also relies on goodwill and referrals from shareholders and satisfied customers, as well as traditional marketing media to attract new customers. To enhance a positive image in the community, the Registrant supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations.

 

Employees

 

As of December 31, 2017, the Registrant employed 202 full time equivalent employees. None of the Registrant’s employees are covered by a collective bargaining agreement. The Registrant believes relations with its employees to be good.

 

Regulation

 

Regulation of the Bank

 

General. The Bank is a North Carolina chartered commercial bank and its deposit accounts are insured by the Deposit Insurance Fund (“DIF”) administered by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is subject to supervision, examination and regulation by the North Carolina Office of the Commissioner of Banks (“Commissioner”) and the FDIC and to North Carolina and federal statutory and regulatory provisions governing such matters as capital standards, dividends, mergers, subsidiary investments and establishment of branch offices. The Bank is required to file reports with the Commissioner and the FDIC concerning its activities and financial condition and is required to obtain regulatory approval prior to entering into certain transactions, including mergers with, or acquisitions of, other depository institutions.

 

As a federally insured depository institution, the Bank is subject to various regulations promulgated by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) or (“FRB”), including Regulation B (Equal Credit Opportunity), Regulation D (Reserve Requirements), Regulation E (Electronic Fund Transfers), Regulation O (Loans to Insiders), Regulation W (Transactions with Affiliates), Regulation Z (Truth in Lending), Regulation CC (Availability of Funds and Collection of Checks) and Regulation DD (Truth in Savings).

 

The system of regulation and supervision applicable to the Bank establishes a comprehensive framework for the operations of the Bank, and is intended primarily for the protection of the FDIC and the depositors of the Bank, rather than shareholders. Changes in the regulatory framework could have a material effect on the Bank that in turn, could have a material effect on the Registrant. This discussion does not purport to be a complete explanation of all such laws and regulations.

 

State Law. The Bank is subject to extensive supervision and regulation by the Commissioner. The Commissioner oversees state laws that set specific requirements for bank capital and deposits in, and loans and investments by, banks, including the amounts, types, and in some cases, rates. The Commissioner supervises and performs periodic examinations of North Carolina-chartered banks to assure compliance with state banking statutes and regulations, and the Bank is required to make regular reports to the Commissioner describing in detail its resources, assets, liabilities and financial condition. Among other things, the Commissioner regulates mergers and consolidations of state-chartered banks, the payment of dividends, loans to officers and directors, record keeping, types and amounts of loans and investments, and the establishment of branches.

 

 - 5 - 

 

  

North Carolina Banking Law Modernization Act. On October 1, 2012, as a result of the recommendations of the Joint Legislative Study Commission on the Modernization of North Carolina Banking Laws, legislation went into effect that comprehensively modernized North Carolina’s banking laws for the first time since the Great Depression. As a result of the legislation, Articles 1 through 10, 12, and 13 of Chapter 53 of the North Carolina General Statutes were repealed, and new Chapter 53C, entitled “Regulation of Banks,” became law. Major changes enacted by the law included: a comprehensive list of definitions enhancing the clarity and meaning of the various sections of North Carolina’s banking law, a broader reliance on the North Carolina Business Corporation Act, and incorporation of modern concepts of capital adequacy and regulatory supervision. In 2013, the North Carolina General Assembly made certain technical corrections and clarifications to Chapter 53C.

 

Dodd-Frank Wall Street Reform and Consumer Protection Act. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. This law significantly changed the bank regulatory structure and affected the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies. The Dodd-Frank Act required various federal agencies to adopt a broad range of rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies have significant discretion in drafting rules and regulations, pursuant to the Dodd-Frank Act. The Dodd-Frank Act included, among other things:

 

·the creation of a Financial Stability Oversight Council to identify emerging systemic risks posed by financial firms, activities and practices, and to improve cooperation between federal agencies;
·the creation of a Bureau of Consumer Financial Protection authorized to promulgate and enforce consumer protection regulations relating to financial products, which affects both banks and non-bank financial companies;
·the establishment of strengthened capital and prudential standards for banks and bank holding companies;
·enhanced regulation of financial markets, including derivatives and securitization markets;
·the elimination of certain trading activities by banks;
·a permanent increase of FDIC deposit insurance to $250,000 per depository category and an increase in the minimum deposit insurance fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits;
·amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations; and
·disclosure and other requirements relating to executive compensation and corporate governance.

 

The Dodd-Frank Act prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of three percent (3%) of Tier 1 capital in private equity and hedge funds (known as the “Volcker Rule”).

 

In 2017, both the House of Representatives and the Senate introduced legislation that would repeal or modify provisions of the Dodd-Frank Act and significantly impact financial services regulation. Although the bills vary in content, certain key aspects include revisions to rules related to mortgage loans, delayed implementation of rules related to the Home Mortgage Disclosure Act, and reform and simplifications of certain Volcker Rule requirements. We cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced, or how such changes may affect us.

 

 - 6 - 

 

  

2017 Executive Order. On February 3, 2017, the President of the United States issued an executive order identifying “core principles” for the administration’s financial services regulatory policy and directing the Secretary of the Treasury, in consultation with the heads of other financial regulatory agencies, to evaluate how the current regulatory framework promotes or inhibits the principles and what actions have been, and are being, taken to promote the principles. In response to the executive order, on June 12, 2017, October 6, 2017 and October 26, 2017, respectively, the U.S. Department of the Treasury issued the first three of four reports recommending a number of comprehensive changes in the current regulatory system for U.S. depository institutions, the U.S. capital markets and the U.S. asset management and insurance industries.

 

Deposit Insurance. The Bank’s deposits are insured up to limits set by the Deposit Insurance Fund (“DIF”) of the FDIC. The DIF was formed on March 31, 2006, upon the merger of the Bank Insurance Fund and the Savings Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act established a range of 1.15% to 1.50% within which the FDIC may set the Designated Reserve Ratio (the “reserve ratio” or “DRR”). The Dodd-Frank Act gave the FDIC greater discretion to manage the DIF, raised the minimum DIF reserve ratio to 1.35%, and removed the upper limit of 1.50%. In October 2010, the FDIC adopted a restoration plan to ensure that the DIF reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. The FDIC also proposed a comprehensive, long-range plan for management of the DIF. As part of this comprehensive plan, the FDIC has adopted a final rule to set the DRR at 2.0%.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was enacted and temporarily raised the standard minimum deposit insurance amount (the “SMDIA”) from $100,000 to $250,000 per depositor. On May 20, 2009, the Helping Families Save Their Homes Act extended the temporary increase in the SMDIA to $250,000 per depositor through December 31, 2013. On July 21, 2010, the Dodd-Frank Act permanently increased FDIC insurance coverage to $250,000 per depositor.

 

The FDIC imposes a risk-based deposit insurance premium assessment on member institutions in order to maintain the DIF. This assessment system was amended by the Reform Act and further amended by the Dodd-Frank Act. Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. In addition, in the case of those institutions in the lowest risk category, the FDIC further determines its assessment rate based on certain specified financial ratios or, if applicable, its long-term debt ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits. The Dodd-Frank Act changed the methodology for calculating deposit insurance assessments from the amount of an insured institution’s domestic deposits to its total assets minus tangible capital. On February 7, 2011, the FDIC issued a new regulation implementing these revisions to the assessment system. The regulation went into effect April 1, 2011.

 

The FDIC has authority to increase deposit insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Registrant and the Bank. Management cannot predict what insurance assessment rates will be in the future.

 

Insurance of deposits may be terminated by the FDIC upon a finding that an insured institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management of the Bank is not aware of any practice, condition or violation that might lead to termination of its FDIC deposit insurance.

 

 - 7 - 

 

  

Capital Requirements. The federal banking regulators have adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit, and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 1,250% for certain assets with high credit risk, such as securitization exposures.

 

A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Common Equity Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. “Common Equity Tier 1,” or core capital, includes common equity, qualifying noncumulative perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less goodwill and other intangibles, subject to certain exceptions. “Additional Tier 1 Capital” includes noncumulative perpetual preferred stock, tier 1 minority interests, grandfathered Trust preferred securities, and Troubled Asset Relief Program instruments less applicable regulatory adjustments and deductions. “Tier 2,” or supplementary capital, includes among other things, limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan and lease losses, subject to certain limitations and less required deductions. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. Banks and bank holding companies subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 5% and a ratio of total capital to risk-weighted assets of at least 10% to meet well capitalized thresholds. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant.

 

The federal banking agencies have adopted regulations specifying that they will include, in their evaluations of a bank’s capital adequacy, an assessment of the bank’s interest rate risk exposure. The standards for measuring the adequacy and effectiveness of a banking organization’s interest rate risk management include a measurement of board of director and senior management oversight, and a determination of whether a banking organization’s procedures for comprehensive risk management are appropriate for the circumstances of the specific banking organization.

 

Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions, including limitations on its ability to pay dividends or expand with new branch offices or through acquisitions, the issuance by the applicable regulatory authority of a capital directive to increase capital and, in the case of depository institutions, the termination of deposit insurance by the FDIC, as well as the measures described under the “Federal Deposit Insurance Corporation Improvement Act of 1991” below, as applicable to undercapitalized institutions. In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the Registrant and its shareholders.

 

On July 2, 2013, the Federal Reserve approved a final rule that establishes an integrated regulatory capital framework that addresses shortcomings in certain capital requirements. The rule implements in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act.

 

 - 8 - 

 

  

The major provisions of the rule applicable to us are:

 

·The rule implements higher minimum capital requirements, includes a new common equity Tier1 capital requirement, and establishes criteria that instruments must meet in order to be considered Common Equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. These enhancements both improve the quality and increase the quantity of capital required to be held by banking organizations, better equipping the U.S. banking system to deal with adverse economic conditions. The minimum capital to risk-weighted assets (“RWA”) requirements under the rule are a common equity Tier 1 capital ratio of 4.5% and a Tier 1 capital ratio of 6.0%, which is an increase from 4.0%, and a total capital ratio that remains at 8.0%. The minimum leverage ratio (Tier 1 capital to total assets) is 4.0%. The rule maintains the general structure of the current prompt corrective action, or PCA, framework while incorporating these increased minimum requirements.

 

·The rule improves the quality of capital by implementing changes to the definition of capital. Among the most important changes are stricter eligibility criteria for regulatory capital instruments that would disallow the inclusion of instruments such as trust preferred securities in Tier 1 capital going forward, and new constraints on the inclusion of minority interests, mortgage-servicing assets (“MSAs”), deferred tax assets (“DTAs”), and certain investments in the capital of unconsolidated financial institutions. In addition, the rule requires that certain regulatory capital deductions be made from common equity Tier 1 capital.

 

·Under the rule, 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. This buffer is intended to help ensure that banking organizations conserve capital when it is most needed, allowing them to better weather periods of economic stress. The buffer is measured relative to RWA. A three-year phase-in of the capital conservation buffer requirements began on January 1, 2016. A banking organization with a buffer greater than 2.5% would not be subject to limits on capital distributions or discretionary bonus payments; however, a banking organization with a buffer of less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The rule also prohibits a banking organization from making distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. When the rule is fully phased in, the minimum capital requirements plus the capital conservation buffer will exceed the PCA well-capitalized thresholds.

 

·The rule also increases the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.

 

The Bank was required to comply with the new rule beginning on January 1, 2015. Compliance by the Registrant and the Bank with these capital requirements affects their respective operations by increasing the amount of capital required to conduct operations.

 

In October 2017, the federal banking agencies issued a notice of proposed rulemaking on simplifications to the final rules, a majority of which would apply solely to banking organizations that are not subject to the advanced approaches capital rule. Under the proposed rulemaking, non-advanced approaches banking organizations, such as the Registrant, would apply a simpler regulatory capital treatment for mortgage servicing assets (“MSAs”); certain deferred tax assets (“DTAs”) arising from temporary differences; investments in the capital of unconsolidated financial institutions; and capital issued by a consolidated subsidiary of a banking organization and held by third parties.

 

 - 9 - 

 

  

Specifically, the proposed rulemaking would eliminate: (i) the capital rule’s 10 percent common equity tier 1 capital deduction threshold that applies individually to MSAs, temporary difference DTAs, and significant investments in the capital of unconsolidated financial institutions in the form of common stock; (ii) the aggregate 15 percent common equity tier 1 capital deduction threshold that subsequently applies on a collective basis across such items; (iii) the 10 percent common equity tier 1 capital deduction threshold for non-significant investments in the capital of unconsolidated financial institutions; and (iv) the deduction treatment for significant investments in the capital of unconsolidated financial institutions not in the form of common stock. The capital rule would no longer have distinct treatments for significant and non-significant investments in the capital of unconsolidated financial institutions, but instead would require that non-advanced approaches banking organizations deduct from common equity tier 1 capital any amount of MSAs, temporary difference DTAs, and investments in the capital of unconsolidated financial institutions that individually exceeds 25 percent of common equity tier 1 capital. The proposed rulemaking also includes revisions to the treatment of certain acquisition, development, or construction exposures that are designed to address comments regarding the current definition of high volatility commercial real estate exposure under the capital rule’s standardized approach.

 

In November 2017, the federal banking agencies adopted a final rule to extend the regulatory capital treatment applicable during 2017 under the capital rules for certain items, including regulatory capital deductions, risk weights, and certain minority interest limitations. The relief provided under the final rule applies to banking organizations that are not subject to the capital rules’ advanced approaches, such as the Registrant. Specifically, the final rule extends the current regulatory capital treatment of mortgage servicing assets, deferred tax assets arising from temporary differences that could not be realized through net operating loss carrybacks, significant investments in the capital of unconsolidated financial institutions in the form of common stock, non-significant investments in the capital of unconsolidated financial institutions, significant investments in the capital of unconsolidated financial institutions that are not in the form of common stock, and common equity tier 1 minority interest, tier 1 minority interest, and total capital minority interest exceeding the capital rules’ minority interest limitations.

 

In December 2017, the Basel Committee on Banking Supervision published the last version of the Basel III accord, generally referred to as “Basel IV.” The Basel Committee stated that a key objective of the revisions incorporated into the framework is to reduce excessive variability of risk-weighted assets (“RWA”), which will be accomplished by enhancing the robustness and risk sensitivity of the standardized approaches for credit risk and operational risk, which will facilitate the comparability of banks’ capital ratios; constraining the use of internally modeled approaches; and complementing the risk-weighted capital ratio with a finalized leverage ratio and a revised and robust capital floor.  Leadership of the federal banking regulators, who are tasked with implementing Basel IV, supported the revisions. Although it is uncertain at this time, we anticipate some, if not all, of the Basel IV accord may be incorporated into the capital requirements framework applicable to the Registrant.

 

Prompt Corrective Action. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the federal banking regulators are required to take prompt corrective action if an insured depository institution fails to satisfy the minimum capital requirements discussed above, including a leverage limit, a risk-based capital requirement, and any other measure deemed appropriate by the federal banking regulators for measuring the capital adequacy of an insured depository institution. All institutions, regardless of their capital levels, are restricted from making any capital distribution or paying any management fees if the institution would thereafter fail to satisfy the minimum levels for any of its capital requirements. An institution that fails to meet the minimum level for any relevant capital measure (an “undercapitalized institution”) may be: (i) subject to increased monitoring by the appropriate federal banking regulator; (ii) required to submit an acceptable capital restoration plan within 45 days; (iii) subject to asset growth limits; and (iv) required to obtain prior regulatory approval for acquisitions, branching and new lines of business. The capital restoration plan must include a guarantee by the institution’s holding company that the institution will comply with the plan until it has been adequately capitalized on average for four consecutive quarters, under which the holding company would be liable up to the lesser of 5% of the institution’s total assets or the amount necessary to bring the institution into capital compliance as of the date it failed to comply with its capital restoration plan. A “significantly undercapitalized” institution, as well as any undercapitalized institution that does not submit an acceptable capital restoration plan, may be subject to regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on capital distributions by any bank holding company controlling the institution. Any company controlling the institution may also be required to divest the institution or the institution could be required to divest subsidiaries. The senior executive officers of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior regulatory approval and the institution is prohibited from making payments of principal or interest on its subordinated debt. In their discretion, the federal banking regulators may also impose the foregoing sanctions on an undercapitalized institution if the regulators determine that such actions are necessary to carry out the purposes of the prompt corrective action provisions. If an institution’s ratio of tangible capital to total assets falls below the “critical capital level” established by the appropriate federal banking regulator, the institution will be subject to conservatorship or receivership within specified time periods.

 

 - 10 - 

 

  

As discussed above, on July 2, 2013, the Federal Reserve Board, and on July 9, 2013, the FDIC, adopted a final rule that implements the Basel III changes to the international regulatory capital framework, referred to as the “Basel III Rules.” The Basel III Rules apply to both depository institutions and (subject to certain exceptions not applicable to the Registrant) their holding companies. Although parts of the Basel III Rules apply only to large, complex financial institutions, substantial portions of the Basel III Rules apply to the Registrant and the Bank. The Basel III Rules include requirements contemplated by the Dodd-Frank Act as well as certain standards initially adopted by the Basel Committee on Banking Supervision in December 2010.

 

The Basel III Rules include new risk-based and leverage capital ratio requirements which refine the definition of what constitutes “capital” for purposes of calculating those ratios. The minimum capital level requirements applicable to the Registrant and the Bank under the Basel III Rules are: (i) a common equity Tier 1 risk-based capital ratio of 4.5 percent; (ii) a Tier 1 risk-based capital ratio of 6 percent (increased from 4 percent); (iii) a total risk-based capital ratio of 8 percent (unchanged from prior rules); and (iv) a Tier 1 leverage ratio of 4 percent for all institutions. Common equity Tier 1 capital will consist of retained earnings and common stock instruments, subject to certain adjustments.

 

The Basel III Rules also established a “capital conservation buffer” of 2.5 percent above the new regulatory minimum risk-based capital requirements. The conservation buffer, when added to the capital requirements, result in the following minimum ratios: (i) a common equity Tier 1 risk-based capital ratio of 7.0 percent, (ii) a Tier 1 risk-based capital ratio of 8.5 percent, and (iii) a total risk-based capital ratio of 10.5 percent. The new capital conservation buffer requirement is being phased in beginning in January 2016 at 0.625 percent of risk-weighted assets with increases to that amount each year until full implementation in January 2019. An institution is subject to limitations on certain activities including payment of dividends, share repurchases and discretionary bonuses to executive officers if its capital level is below the buffer amount.

 

The Basel III Rules also revised the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Bank, if their capital levels do not meet certain thresholds. These revisions became effective on January 1, 2015. The prompt corrective action rules were modified to include a common equity Tier 1 capital component and to increase certain other capital requirements for the various thresholds. For example, under the prompt corrective action rules, insured depository institutions are required to meet the following capital levels in order to qualify as “well capitalized:” (i) a new common equity Tier 1 risk-based capital ratio of 6.5 percent; (ii) a Tier 1 risk-based capital ratio of 8 percent (increased from 6 percent); (iii) a total risk-based capital ratio of 10 percent (unchanged from prior rules); and (iv) a Tier 1 leverage ratio of 5 percent (unchanged from prior rules).

 

The Basel III Rules set forth certain changes in the methods of calculating certain risk-weighted assets, which in turn affect the calculation of risk based ratios. Under the Basel III Rules, higher or more sensitive risk weights would be assigned to various categories of assets, including certain credit facilities that finance the acquisition, development or construction of real property, certain exposures or credits that are 90 days past due or on nonaccrual, foreign exposures and certain corporate exposures. In addition, the Basel III Rules include (i) alternative standards of creditworthiness consistent with the Dodd-Frank Act; (ii) greater recognition of collateral and guarantees; and (iii) revised capital treatment for derivatives and repo-style transactions.

 

 - 11 - 

 

  

In addition, the final rule includes certain exemptions to address concerns about the regulatory burden on community banks. For example, banking organizations with less than $15 billion in consolidated assets as of December 31, 2009 are permitted to include in Tier 1 capital trust preferred securities and cumulative perpetual preferred stock issued and included in Tier 1 capital prior to May 19, 2010 on a permanent basis, without any phase out. The Bank has opted out of the requirement to include most accumulated other comprehensive income (“AOCI”) components in the calculation of CET1 capital and, in effect, retain the AOCI treatment under the prior capital rules and exclude accumulated other comprehensive income from capital.

 

Certain Basel III Rules became effective January 1, 2015. The conservation buffer will be phased in beginning in 2016 and will take full effect on January 1, 2019. Certain calculations under the Basel III Rules will also have phase-in periods.

 

Under the implementing regulations, the federal banking regulators, including the FDIC, generally measure an institution’s capital adequacy on the basis of its total risk-based capital ratio (the ratio of its total capital to risk-weighted assets), Tier 1 risk-based capital ratio (the ratio of its core capital to risk-weighted assets) and leverage ratio (the ratio of its core capital to adjusted total assets).

 

The following table shows the Bank’s actual capital ratios and the required capital ratios for the various prompt corrective action categories as of December 31, 2017.

 

                   Regulatory
         Adequately     Significantly  Minimum
   Actual   Well-capitalized  Capitalized  Undercapitalized  Undercapitalized  Requirement
Total risk-based capital ratio   11.38%  10.0% or more  8.0% or more  Less than 8.0%  Less than 6.0%  11.50% or more
Tier 1 risk-based capital ratio   10.56%  8.0% or more  6.0% or more  Less than 6.0%  Less than 4.0%  8.00% or more
Common equity Tier 1 risk-based capital ratio   10.56%  6.5% or more  4.5% or more  Less than 4.50%  Less than 3.0%  8.00% or more
Leverage ratio   12.08%  5.0% or more  4.0% or more *  Less than 4.0% *  Less than 3.0%  8.00% or more

 

 

* 3.0% if institution has the highest regulatory rating and meets certain other criteria.

 

A “critically undercapitalized” institution is defined as an institution that has a ratio of “tangible equity” to total assets of less than 2.0%. Tangible equity is defined as core capital plus cumulative perpetual preferred stock (and related surplus) less all intangibles other than qualifying supervisory goodwill and certain purchased mortgage servicing rights. The FDIC may reclassify a well-capitalized institution as adequately capitalized and may require an adequately capitalized or undercapitalized institution to comply with the supervisory actions applicable to institutions in the next lower capital category (but may not reclassify a significantly undercapitalized institution as critically undercapitalized) if the FDIC determines, after notice and an opportunity for a hearing, that the institution is in an unsafe or unsound condition or that the institution has received and not corrected a less-than-satisfactory rating for any CAMELS rating category. See Note M of the Notes to Consolidated Financial Statements included under Item 8 of this Annual Report on Form 10-K.

 

Safety and Soundness Guidelines. Under FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994 (the “CDRI Act”), each federal banking agency was required to establish safety and soundness standards for institutions under its authority. The interagency guidelines require depository institutions to maintain internal controls and information systems and internal audit systems that are appropriate for the size, nature and scope of the institution’s business. The guidelines also establish certain basic standards for the documentation of loans, credit underwriting, interest rate risk exposure, asset growth, and information security. The guidelines further provide that depository institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions. If the appropriate federal banking agency determines that a depository institution is not in compliance with the safety and soundness guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines. A depository institution must submit an acceptable compliance plan to its primary federal regulator within 30 days of receipt of a request for such a plan. Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions.

 

 - 12 - 

 

  

International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001. On October 26, 2001, the USA PATRIOT Act of 2001 was enacted. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money laundering measures affecting insured depository institutions, broker-dealers and other financial institutions. The Act requires U.S. financial institutions to adopt new policies and procedures to combat money laundering and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions.

 

Office of Foreign Assets Control Regulation. The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the U.S. Treasury’s Office of Foreign Assets Control (OFAC). The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure of a financial institution to comply with these sanctions could result in legal consequences for the institution.

 

Community Reinvestment Act. The Bank, like other financial institutions, is subject to the Community Reinvestment Act (“CRA”). The purpose of the CRA is to encourage financial institutions to help meet the credit needs of their entire communities, including the needs of low-and moderate-income neighborhoods.

 

The federal banking agencies have implemented an evaluation system that rates an institution based on its asset size and actual performance in meeting community credit needs. Under these regulations, the institution is first evaluated and rated under two categories: a lending test and a community development test. For each of these tests, the institution is given a rating of either “outstanding,” “high satisfactory,” “low satisfactory,” “needs to improve,” or “substantial non-compliance.” A set of criteria for each rating has been developed and is included in the regulation. If an institution disagrees with a particular rating, the institution has the burden of rebutting the presumption by clearly establishing that the quantitative measures do not accurately present its actual performance, or that demographics, competitive conditions or economic or legal limitations peculiar to its service area should be considered. The ratings received under the three tests will be used to determine the overall composite CRA rating. The composite ratings currently given are: “outstanding,” “satisfactory,” “needs to improve” or “substantial non-compliance.”

 

The Bank’s CRA rating would be a factor to be considered by the FRB and the FDIC in considering applications submitted by the Bank to acquire branches or to acquire or combine with other financial institutions and take other actions and, if such rating was less than “satisfactory,” could result in the denial of such applications. During the Bank’s last compliance examination, the Bank received a satisfactory rating with respect to CRA compliance.

 

 - 13 - 

 

  

Federal Home Loan Bank System. The FHLB System consists of 12 district FHLBs subject to supervision and regulation by the Federal Housing Finance Agency (“FHFA”). The FHLBs provide a central credit facility primarily for member institutions. As a member of the FHLB of Atlanta, the Bank is required to acquire and hold shares of capital stock in the FHLB of Atlanta. The Bank was in compliance with this requirement with investment in FHLB of Atlanta stock of $2.5 million at December 31, 2017. The FHLB of Atlanta serves as a reserve or central bank for its member institutions within its assigned district. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It offers advances to members in accordance with policies and procedures established by the FHFA and the Board of Directors of the FHLB of Atlanta. Long-term advances may only be made for the purpose of providing funds for residential housing finance, small businesses, small farms and small agribusinesses.

 

Reserves. Pursuant to regulations of the FRB, the Bank must maintain average daily reserves equal to 3% on transaction accounts of $15.2 million up to $110.2 million, plus 10% on the remainder. This percentage is subject to adjustment by the FRB. Because required reserves must be maintained in the form of vault cash or in a noninterest bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets. As of December 31, 2017, the Bank met its reserve requirements.

 

The Bank is also subject to the reserve requirements of North Carolina commercial banks. North Carolina law requires state nonmember banks to maintain, at all times, a reserve fund in an amount set by the Commissioner.

 

Liquidity Requirements. FDIC policy requires that banks maintain an average daily balance of liquid assets (cash, certain time deposits, mortgage-backed securities, loans available for sale and specified United States government, state, or federal agency obligations) in an amount which it deems adequate to protect the safety and soundness of the Bank. The FDIC currently has no specific level which it requires. The Bank maintains its liquidity position under policy guidelines based on liquid assets in relationship to deposits and short-term borrowings. Based on its policy calculation guidelines, the Bank’s calculated liquidity ratio was 11.34% of total deposits and short-term borrowings at December 31, 2017, which management believes is adequate.

 

Dividend Restrictions. Under FDIC regulations, the Bank is prohibited from making any capital distributions if after making the distribution, the Bank would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less than 4.0%. The FDIC and the Commissioner have the power to further restrict the payment of dividends by the Bank.

 

Limits on Loans to One Borrower. The Bank generally is subject to both FDIC regulations and North Carolina law regarding loans to any one borrower, including related entities. Under applicable law, with certain limited exceptions, loans and extensions of credit by a state chartered nonmember bank to a person outstanding at one time and not fully secured by collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 15% of the unimpaired capital of the Bank. In addition, the Bank has an internal policy that loans and extensions of credit fully secured by readily marketable collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 10% of the unimpaired capital fund of the Bank. Under the internal policy, the Bank’s loans to one borrower were limited to $10.5 million at December 31, 2017.

 

Transactions with Related Parties. Transactions between the Bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of the Bank is any company or entity which controls, is controlled by or is under common control with the Bank. In a holding company context, the parent holding company of a bank (such as the Registrant) and any companies which are controlled by such parent holding company are affiliates of the bank. Generally, Sections 23A and 23B (i) limit the extent to which an institution or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.

 

 - 14 - 

 

  

Loans to Directors, Executive Officers and Principal Stockholders. The Bank is subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the applicable regulations thereunder (“Regulation O”) on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, executive officer and to a greater than 10% stockholder of a state nonmember bank and certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and related interests, the institution’s loans-to-one-borrower limit and all loans to such persons may not exceed the institution’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and greater than 10% stockholders of a depository institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the institution with any “interested” director not participating in the voting. Regulation O prescribes the loan amount (which includes all other outstanding loans to such person) as to which such prior board of directors approval is required as being the greater of $25,000 or 5% of capital and surplus (or any loans aggregating $500,000 or more). Further, Section 22(h) requires that loans to directors, executive officers and principal stockholders generally be made on terms substantially the same as offered in comparable transactions to other persons. Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or directors.

 

The Bank is also subject to the additional requirements and restrictions of Regulation O on loans to executive officers. Section 22(g) of the Federal Reserve Act requires approval by the board of directors of a depository institution for such extensions of credit and imposes reporting requirements for and additional restrictions on the type, amount and terms of credits to such officers. In addition, Section 106 of the Bank Holding Company Act of 1956, as amended (“BHCA”) prohibits extensions of credit to executive officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.

 

The Volcker Rule. Under provisions of the Dodd-Frank Act referred to as the “Volcker Rule,” certain limitations are placed on the ability of bank holding companies and their affiliates to engage in sponsoring, investing in and transacting with certain investment funds, including hedge funds and private equity funds. The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities. The Volcker Rule, which became fully effective in July 2015, has not had a material impact on the Bank or the Registrant.

 

In 2017, both the House of Representatives and the Senate introduced legislation that would repeal or modify provisions of the Dodd-Frank Act and significantly impact financial services regulation. Although the bills vary in content, certain key aspects include revisions to, and simplifications of, certain Volcker Rule requirements.

 

Restrictions on Certain Activities. State chartered nonmember banks with deposits insured by the FDIC are generally prohibited from engaging in equity investments that are not permissible for a national bank. The foregoing limitation, however, does not prohibit FDIC-insured state banks from acquiring or retaining an equity investment in a subsidiary in which the bank is a majority owner. State chartered banks are also prohibited from engaging as a principal in any type of activity that is not permissible for a national bank and, subject to certain exceptions, subsidiaries of state chartered FDIC-insured banks may not engage as a principal in any type of activity that is not permissible for a subsidiary of a national bank, unless in either case, the FDIC determines that the activity would pose no significant risk to the DIF and the bank is, and continues to be, in compliance with applicable capital standards.

 

The Registrant cannot predict what legislation might be enacted or what regulations might be adopted in the future, or if enacted or adopted, the effect thereof on the Bank’s operations.

 

 - 15 - 

 

  

Regulation of the Registrant

 

Federal Regulation. The Registrant is a registered bank holding company subject to examination, regulation and periodic reporting under the Bank Holding Company Act of 1956, as administered by the Federal Reserve Board. The Federal Reserve Board has adopted capital adequacy guidelines for bank holding companies on a consolidated basis.

 

The status of the Registrant as a registered bank holding company under the Bank Holding Company Act does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.

 

The Registrant is required to obtain the prior approval of the Federal Reserve Board to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior Federal Reserve Board approval is required for the Registrant to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than five percent of any class of voting shares of such bank or bank holding company.

 

In addition, in certain such cases, an application to, and the prior approval of, the North Carolina Commissioner of Banks may also be required.

 

The Registrant is required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Registrant’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not required for a bank holding company that would be treated as “well-capitalized” and “well-managed” under applicable regulations of the Federal Reserve Board, that has received a composite “1” or “2” rating at its most recent bank holding company inspection by the Federal Reserve Board, and that is not the subject of any unresolved supervisory issues.

 

In addition, a bank holding company is prohibited generally from engaging in, or acquiring five percent or more of any class of voting securities of any company engaged in, non-banking activities. One of the principal exceptions to this prohibition is for activities found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the Federal Reserve Board has determined by regulation to be so closely related to banking as to be a proper incident thereto are:

 

- making or servicing loans;

- performing certain data processing services;

- providing discount brokerage services;

- acting as fiduciary, investment or financial advisor;

- leasing personal or real property;

- making investments in corporations or projects designed primarily to promote community welfare; and

- acquiring a savings and loan association.

 

In evaluating a written notice of such an acquisition, the Federal Reserve Board will consider various factors, including among others the financial and managerial resources of the notifying bank holding company and the relative public benefits and adverse effects which may be expected to result from the performance of the activity by an affiliate of such company. The Federal Reserve Board may apply different standards to activities proposed to be commenced de novo and activities commenced by acquisition, in whole or in part, of a going concern. The required notice period may be extended by the Federal Reserve Board under certain circumstances, including a notice for acquisition of a company engaged in activities not previously approved by regulation of the Federal Reserve Board. If such a proposed acquisition is not disapproved or subjected to conditions by the Federal Reserve Board within the applicable notice period, it is deemed approved by the Federal Reserve Board.

 

 - 16 - 

 

  

However, with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which became effective on March 11, 2000, the types of activities in which a bank holding company may engage were significantly expanded. Subject to various limitations, the Modernization Act generally permits a bank holding company to elect to become a “financial holding company.” A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are “financial in nature.” Among the activities that are deemed “financial in nature” are, in addition to traditional lending activities, securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, certain merchant banking activities and activities that the Federal Reserve Board considers to be closely related to banking.

 

A bank holding company may become a financial holding company under the Modernization Act if each of its subsidiary banks is “well-capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve Board that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. The Registrant has not yet elected to become a financial holding company.

 

Under the Gramm-Leach-Bliley Act, the Federal Reserve Board serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies generally will be regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators and insurance activities by insurance regulators. The Gramm-Leach-Bliley Act also imposes additional restrictions and heightened data privacy and disclosure requirements regarding non-public information collected by financial institutions.

 

Capital Requirements. The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish additional banks or non-bank businesses.

 

The Federal Reserve Board’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies:

 

-leverage capital requirement expressed as a percentage of adjusted total assets;
-common equity Tier 1 expressed as a percentage of total risk-weighted assets;
-risk-based requirement expressed as a percentage of total risk-weighted assets; and
-Tier 1 leverage requirement expressed as a percentage of adjusted total assets.

 

The leverage capital requirement consists of a minimum ratio of total capital to total assets of 4.0%, with an expressed expectation that banking organizations generally should operate above such minimum level. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8.0%, of which at least one-half must be Tier 1 capital (which consists principally of shareholders’ equity). The Tier 1 leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3.0% for the most highly-rated companies, with minimum requirements of 4.0% to 5.0% for all others.

 

 - 17 - 

 

  

The risk-based and leverage standards presently used by the Federal Reserve Board are minimum requirements, and higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets), well above the minimum levels.

 

Source of Strength for Subsidiaries. Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

 

Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, the Registrant’s ability to pay cash dividends depends upon the cash dividends the Registrant receives from the Bank. At present, the Registrant’s only source of income is dividends paid by the Bank and interest earned on any investment securities the Registrant holds. The Registrant must pay all of its operating expenses from funds it receives from the Bank. Therefore, shareholders may receive dividends from the Registrant only to the extent that funds are available after payment of our operating expenses and the board decides to declare a dividend. In addition, the Federal Reserve Board generally prohibits bank holding companies from paying dividends except out of operating earnings where the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition.

 

The FDIC Improvement Act requires the federal bank regulatory agencies biennially to review risk-based capital standards to ensure that they adequately address interest rate risk, concentration of credit risk and risks from non-traditional activities and, since adoption of the Riegle Community Development and Regulatory Improvement Act of 1994, to do so taking into account the size and activities of depository institutions and the avoidance of undue reporting burdens. In 1995, the agencies adopted regulations requiring as part of the assessment of an institution’s capital adequacy the consideration of (a) identified concentrations of credit risks, (b) the exposure of the institution to a decline in the value of its capital due to changes in interest rates and (c) the application of revised conversion factors and netting rules on the institution’s potential future exposure from derivative transactions.

 

In addition, the agencies in September 1996 adopted amendments to their respective risk-based capital standards to require banks and bank holding companies having significant exposure to market risk arising from, among other things, trading of debt instruments, (1) to measure that risk using an internal value-at-risk model conforming to the parameters established in the agencies’ standards and (2) to maintain a commensurate amount of additional capital to reflect such risk. The new rules were adopted effective January 1, 1997, with compliance mandatory from and after January 1, 1998.

 

Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default.

 

Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions imposed by the Federal Reserve Act on any extension of credit to, or purchase of assets from, or letter of credit on behalf of, the bank holding company or its subsidiaries, and on the investment in or acceptance of stocks or securities of such holding company or its subsidiaries as collateral for loans. In addition, provisions of the Federal Reserve Act and Federal Reserve Board regulations limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank, the Registrant, any subsidiary of the Registrant and related interests of such persons. Moreover, subsidiaries of bank holding companies are prohibited from engaging in certain tying arrangements (with the holding company or any of its subsidiaries) in connection with any extension of credit, lease or sale of property or furnishing of services.

 

 - 18 - 

 

  

Any loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and to certain other indebtedness of the subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to a priority of payment. This priority would also apply to guarantees of capital plans under the FDIC Improvement Act.

 

Incentive Compensation Policies and Restrictions. In July 2010, the federal banking agencies issued guidance which applies to all banking organizations supervised by the agencies. Pursuant to the guidance, to be consistent with safety and soundness principles, a banking organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance risk and reward; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive compensation.

 

In addition, in March 2011, the federal banking agencies, along with the Federal Housing Finance Agency, and the Securities and Exchange Commission, released a proposed rule intended to ensure that regulated financial institutions design their incentive compensation arrangements to account for risk. Specifically, the proposed rule would require compensation practices of the Registrant and the Bank to be consistent with the following principles: (1) compensation arrangements appropriately balance risk and financial reward; (2) such arrangements are compatible with effective controls and risk management; and (3) such arrangements are supported by strong corporate governance. In addition, financial institutions with $1 billion or more in assets would be required to have policies and procedures to ensure compliance with the rule and would be required to submit annual reports to their primary federal regulator. In May 2016, the federal bank regulatory agencies replaced the regulations proposed in 2011 with a new proposal. The comment period has closed and a final rule has not yet been published.

 

Tax Cuts and Jobs Act of 2017. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) was signed into law. The Tax Act includes a number of provisions that impact the Registrant, including the following:

 

·Tax Rate. The Tax Act replaces the graduated corporate tax rates applicable under prior law, which imposed a maximum tax rate of 35%, with a reduced 21% flat tax rate. Although the reduced tax rate generally should be favorable to the Registrant by resulting in increased earnings and capital, it decreased the value of our existing deferred tax assets by approximately $2.6 million as of December 31, 2017.

 

·Employee Compensation. A “publicly held corporation” is not permitted to deduct compensation in excess of $1 million per year paid to certain employees. The Tax Act eliminates certain exceptions to the $1 million limit applicable under prior to law related to performance-based compensation, such as equity grants and cash bonuses that are paid only on the attainment of performance goals.

 

·Business Asset Expensing. The Tax Act allows taxpayers immediately to expense the entire cost (instead of only 50%, as under prior law) of certain depreciable tangible property and real property improvements acquired and placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain property). This 100% “bonus” depreciation is phased out proportionately for property placed in service on or after January 1, 2023 and before January 1, 2027 (with an additional year for certain property).

 

·Interest Expense. The Tax Act limits a taxpayer’s annual deduction of business interest expense to the sum of (i) business interest income and (ii) 30% of “adjusted taxable income,” defined as a business’s taxable income without taking into account business interest income or expense, net operating losses, and, for 2018 through 2021, depreciation, amortization and depletion.

 

 - 19 - 

 

  

Future Legislation

 

The Registrant cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on the Registrant’s operations.

 

Item 1A – RISK FACTORS

 

An investment in the Registrant’s common stock involves certain risks. The following discussion highlights the risks that management believes are material for the Registrant, but does not necessarily include all the risks that we may face. Additional risks and uncertainties that are not currently known or that management does not currently deem material could also have a material adverse impact on our business, results of our operations and financial condition. You should carefully consider the risk factors and uncertainties described below and elsewhere in this Report in evaluating an investment in the Registrant’s common stock.

 

Risks Related to Our Business

 

We may experience unexpected credit losses in connection with the loans we make, which could have a material adverse effect on our capital, financial condition, and results of operations.

 

As a lender, we face the risk that our borrowers will not repay their loans and guarantors or other related parties will also fail to perform in accordance with the loan terms. A borrower’s failure to repay us is usually preceded by missed monthly payments. In some instances, however, a borrower may declare bankruptcy prior to missing payments, and, following a borrower filing bankruptcy, a lender’s recovery of the credit extended is often limited. Since many of our loans are secured by collateral, we may attempt to seize the collateral if and when a borrower defaults on a loan. However, the value of the collateral might not equal the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our borrower. The resolution of nonperforming assets, including the initiation of foreclosure proceedings, requires significant commitments of time from management, which can be detrimental to the performance of their other responsibilities, and which expose us to additional legal costs. Elevated levels of loan delinquencies and bankruptcies in our market areas, generally, and among our borrowers specifically, can be precursors of future charge-offs and may require us to increase our allowance for loan losses. Higher charge-off rates, delays in the foreclosure process or in obtaining judgments against defaulting borrowers or an increase in our allowance for loan losses may negatively impact our overall financial performance, may increase our cost of funds, and could materially adversely affect our business, results of operations and financial condition.

 

Our allowance for loan losses may be insufficient and significant loan losses could require us to increase our allowance for loan losses through a charge to earnings.

 

To account for the risk that our borrowers will not repay their loans, we maintain an allowance for loan losses, which is a reserve established through a charge to earnings. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality and trends; present economic, political, and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates and assumptions regarding current credit risks and future trends, all of which may undergo material changes. We might underestimate the loan losses inherent in our loan portfolio and have loan losses in excess of the amount recorded in our allowance for loan losses. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside our control, may require an increase in the allowance for loan losses. There may be a significant increase in the number of borrowers who are unable or unwilling to repay their loans, resulting in our charging off more loans and increasing our allowance. Furthermore, when real estate values decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans with high combined loan-to-value ratios. Downturns in the national economy and the local economies of the areas in which our loans are concentrated could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss provisions in future periods. If charge-offs in future periods exceed the allowance for probable loan losses; we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations.

 

 - 20 - 

 

  

In addition, our determination as to the amount of our allowance for loan losses is subject to review by our primary regulators, the FDIC and the Commissioner, as part of their examination process, which may result in the establishment of an additional allowance based upon the judgment of either of these regulators after a review of the information available at the time of their examination. Our allowance for loan losses amounted to $8.8 million and $8.4 million, or 0.90% and 1.24% of total loans outstanding and 127% and 89% of nonperforming loans, at December 31, 2017 and 2016, respectively. See Item 7 of Part II, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Note E to our consolidated financial statements presented under Item 8 of Part II of this Form 10-K, for further discussion related to our process for determining the appropriate level of the allowance for probable loan losses.

 

An increase in our nonperforming assets will negatively affect our earnings.

 

Our nonperforming assets adversely affect our net income in various ways. We do not record interest income on non-accrual loans or other real estate owned. We must reserve for probable losses, which is established through a current period charge to the provision for loan losses, and, from time to time as appropriate, write down the value of properties in our other real estate owned portfolio to reflect changing market values. Additionally, there are legal fees associated with the resolution of problem assets as well as carrying costs such as taxes, insurance and maintenance related to our other real estate owned. Further, the resolution of nonperforming assets requires the active involvement of management, which can distract them from other responsibilities. Finally, if our estimate for the recorded allowance for loan losses proves to be incorrect and our allowance is inadequate, we will have to increase the allowance accordingly, which would decrease our net income and may have a material adverse effect on our financial condition and results of operations.

 

The geographic concentration of our loan portfolio and lending activities makes us vulnerable to a downturn in the local economy.

 

Nearly all of our loans are secured by real estate or made to businesses in our market area, which includes portions of central and eastern North Carolina and northwestern South Carolina. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Declines in these markets’ economic conditions may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations. Adverse conditions in the local economy such as inflation, unemployment, recession or other factors beyond our control could impact the ability of our borrowers to repay their loans, which could impact our financial condition and results of operations.

 

A decline in local economic conditions could adversely affect the values of real property used as collateral for our loans. Consequently, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse. At December 31, 2017, approximately 83.5% of the Bank’s loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If the value of real estate in our market area were to decline materially, a significant portion of our loan portfolio could become under collateralized and/or cause us to realize a loss in the event of a foreclosure. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

 

 - 21 - 

 

  

A significant portion of our loan portfolio consists of loans for commercial real estate and construction, which carry greater historical credit risk than residential mortgage loans.

 

We originate commercial real estate loans and commercial and industrial loans, most often secured by commercial properties and construction loans primarily within our market area. These loans tend to involve larger loan balances to a single borrower or groups of related borrowers, more complex underlying collateral, and are most susceptible to a risk of loss during a downturn in the business cycle. These loans also have historically had greater credit risk than residential real estate other loans for the following reasons:

 

·Commercial Real Estate Loans. Repayment is dependent on income being generated in amounts sufficient to cover operating expenses and debt service. These loans also involve greater risk because they are generally not fully amortizing over a loan period, but rather have a balloon payment due at maturity. A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property. As of December 31, 2017, commercial real estate loans were approximately 41.0% of the Bank’s total loan portfolio.

 

·Commercial and Industrial Loans. Repayment is generally dependent upon the successful operation of the borrower’s business. In addition, the collateral securing the loans may depreciate over time, be difficult to appraise, be more difficult to liquidate than residential real estate, or fluctuate in value based on the success of the business. As of December 31, 2017, commercial and industrial loans were approximately 10.8% of the Bank’s total loan portfolio.

 

·Construction Loans. Repayment is dependent on completion of the project and the subsequent financing of the completed project as a commercial real estate or residential real estate loan, and in some instances on the rent or sale of the underlying project. The risk of loss is largely dependent on our initial estimate of whether the property’s value at completion equals or exceeds the cost of property construction and the availability of take-out financing. During the construction phase, a number of factors can result in delays or cost overruns. If our estimate is inaccurate or if actual construction costs exceed estimates, the value of the property securing our loan may be insufficient to ensure full repayment when completed through a permanent loan, sale of the property, or by seizure of collateral. As of December 31, 2017, construction loans were approximately 18.1% of the Bank’s total loan portfolio.

 

Our commercial real estate loans include both owner and non-owner occupied properties. Non-owner occupied properties expose us to a greater risk of non-payment and loss than loans secured by owner-occupied properties because repayment of such loans depends primarily on the tenant’s continuing ability to pay rent to the property owner, who is our borrower, or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream, or other events beyond the borrower’s control. In addition, the physical condition of non-owner-occupied properties is often below that of owner-occupied properties due to lax property maintenance standards, which has a negative impact on the value of the collateral properties. Furthermore, some of our non-owner-occupied borrowers have more than one loan outstanding with us, which may expose us to a greater risk of loss compared to residential and commercial borrowers with only one loan.

 

 - 22 - 

 

  

We are exposed to risks in connection with residential mortgage loans.

 

We originate fixed and adjustable rate loans secured by one-to-four family residential real estate. As of December 31, 2017, we had $156.9 million in residential mortgage loans, which comprised 15.97% of our total loan portfolio. The residential loans in our loan portfolio are sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. Residential loans with high combined loan-to-value ratios generally are more sensitive and may experience a higher incidence of default and severity of losses. In addition, if the borrowers sell their homes, the borrowers may be unable to repay their loans in full from the sale proceeds. As a result, these loans may experience higher rates of delinquencies, defaults and losses, which could in turn adversely affect our financial condition and results of operations.

 

We depend on the accuracy and completeness of information about clients and counterparties.

 

In deciding whether to extend credit or enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, we may assume that a customer’s audited financial statements conform to accounting principles generally accepted in the United States of America (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our earnings are significantly affected by our ability to properly originate, underwrite and service loans. Our financial condition and results of operations could be negatively impacted to the extent we incorrectly assess the creditworthiness of our borrowers, fail to detect or respond to deterioration in asset quality in a timely manner, or rely on financial statements that do not comply with GAAP or are materially misleading.

 

We may be forced to foreclose on the collateral property securing our loans and own the underlying real estate, which may subject us to the increased costs associated with the ownership of real property.

 

We originate loans secured by real estate and from time to time are forced to foreclose on the collateral property to protect our investment and may thereafter own and operate such property, which exposes us to the inherent risks of real property ownership. The amount that we, as a lender, may realize after a default is dependent upon factors outside of our control, including, but not limited to:

 

·general or local economic conditions;
·environmental cleanup liability;
·neighborhood values;
·interest rates;
·real estate tax rates;
·operating expenses of the mortgaged properties;
·supply of and demand for rental units or properties;
·ability to obtain and maintain adequate occupancy of the properties;
·zoning laws;
·governmental rules, regulations and fiscal policies; and
·natural or other disasters.

 

Certain expenditures associated with the ownership of real estate, principally real estate taxes and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the rental income earned from such property, and we may have to advance funds in order to protect our investment or we may be required to dispose of the real property at a loss. This may result in reduced net income, which may have a material adverse effect on our financial condition and results of operations.

 

 - 23 - 

 

  

Our expansion strategy may expose us to additional risks related to our acquisition of other financial institutions.

 

Our acquisition of other financial institutions, such as the recent merger with Carolina Premier Bank, or parts of other institutions, such as with branch acquisitions, involves a number of risks, including the risk that:

 

·we may incur substantial costs in identifying and evaluating potential acquisitions and merger partners, or in evaluating new markets, hiring experienced, local managers, and opening new offices;
·our estimates and judgments used to evaluate credit, operations, management and market risks relating to target institutions may not be accurate;
·the institutions we acquire may have distressed assets and there can be no assurance that we will be able to realize the value we predict from those assets or that we will make sufficient provisions or have sufficient capital for future losses;
·we may be required to take write-downs or write-offs, restructuring and impairment, or other charges related to the institutions we acquire that could have a significant negative effect on our financial condition and results of operations;
·there may be substantial lag-time between completing an acquisition and generating sufficient assets and deposits to support costs of the expansion;
·our management’s attention in negotiating a transaction and integrating the operations and personnel of the combining businesses may be diverted from our existing business and we may not be able to successfully integrate such operations and personnel;
·we may enter new markets where we lack local experience or that introduce new risks to our operations, or that otherwise result in adverse effects on our results of operations;
·we may introduce new products and services we are not equipped to manage or that introduce new risks to our operations, or that otherwise result in adverse effects on our results of operations;
·we may incur intangible assets in connection with an acquisition, or the intangible assets we incur may become impaired, which could result in adverse short-term effects on our results of operations;
·we may assume liabilities in connection with an acquisition, including unrecorded liabilities that are not discovered at the time of the transaction, and the repayment of those liabilities may have an adverse effect on our results of operations, financial condition and stock price; or
·we may lose key employees and customers that were part of the reason we pursued an acquisition.

 

We cannot assure you that we will be able to successfully integrate any banks or banking offices that we acquire into our operations or retain the customers that we acquire in any acquisition. If any of these risks occur in connection with our expansion efforts, it may have a material and adverse effect on our results of operations and financial condition.

 

We may be subject to environmental liability associated with our lending activities.

 

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

 

 - 24 - 

 

  

Changes in interest rates affect our profitability and the value of our interest-earning assets.

 

The Bank derives its income primarily from the difference or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowed funds and other interest-bearing liabilities. In general, the larger the spread, the more the Bank earns. When market rates of interest change, the interest the Bank receives on its assets and the interest the Bank pays on its liabilities will fluctuate. Changes in market interest rates could adversely affect our interest rate spread and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our interest rate spread to expand or contract. Our liabilities are shorter in duration than our assets, so they will adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs generally will rise faster than the yield we earn on our assets, causing our interest rate spread to contract until the yield catches up. Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—will also reduce our interest rate spread. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities are shorter in duration than our assets, when the yield curve flattens or even inverts, we will experience pressure on our interest rate spread as our cost of funds increases relative to the yield we can earn on our assets. In addition, our mortgage banking income is sensitive to changes in interest rates. During periods of rising and relatively higher interest rates, mortgage originations for purchased homes can decline considerably and refinanced mortgage activity can severely decrease. During periods of falling and relatively lower interest rates, the opposite effects can occur.

 

Changes in market interest rates could reduce the value of the Bank’s financial assets. Fixed-rate investments, mortgage-backed and related securities and mortgage loans generally decrease in value as interest rates rise. In addition, interest rates affect how much money the Bank lends. For example, when interest rates rise, the cost of borrowing increases and the loan originations tend to decrease.

 

Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Open Market Committee of the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect our ability to originate loans and obtain deposits. Rates have been historically low for a long period of time and at this point, should rates rise steadily, we will be operating in an environment different from that in which we have been operating for the last decade. This change could pressure our margins if we are unable to adjust our business practices. If the Bank is unsuccessful in managing the effects of changes in interest rates, the financial condition and results of operations could suffer. Any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on our business, financial condition and results of operations.

 

We are subject to extensive regulation that could restrict our activities, have an adverse impact on our operations, and impose financial requirements or limitations on the conduct of our business.

 

We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various regulatory agencies. The Company is subject to Federal Reserve Board regulation, and the Bank is subject to extensive regulation, supervision, and examination by the FDIC and the Commissioner. In addition, as a member of the FHLB of Atlanta, the Bank must comply with applicable regulations of the Federal Housing Finance Board and the FHLB. The Bank’s activities are also regulated under consumer protection laws applicable to our lending, deposit, and other activities. A claim against us under these laws could have a material adverse effect on our results of operations.

 

 - 25 - 

 

  

Regulation by these agencies is intended primarily for the protection of our depositors and the deposit insurance fund and not for the benefit of our shareholders. Federal and state regulators have the ability to impose substantial sanctions, restrictions, and requirements on us if they identify violations of laws with which we must comply or weaknesses or failures with respect to general standards of safety and soundness. Such enforcement may be formal or informal and can include directors’ resolutions, memoranda of understanding, written supervisory agreements, cease-and-desist orders, civil money penalties and termination of deposit insurance and bank closures. Enforcement actions may be taken regardless of the capital levels of the institutions, and regardless of prior examination findings. Any of these consequences could damage our reputation, restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.

 

Changes in laws and regulations and the cost of regulatory compliance with new laws and regulations may adversely affect our operations.

 

Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes and is one example of how legislative changes can greatly impact our business. Changes to statutes, regulations or regulatory policies or supervisory guidance, including changes in interpretation or implementation of statutes, regulations, policies or supervisory guidance, could affect us in substantial and unpredictable ways, including, among other things, subjecting us to increased capital requirements, liquidity and risk management requirements, creating additional costs, limiting the types of financial services and products we may offer and/or increasing the ability of non-banks to offer competing financial services and products. While we cannot predict the extent to which additional legislation will be enacted or the extent we will become subject to increased regulatory scrutiny by any of these regulatory agencies, any regulatory changes or scrutiny could increase or decrease the cost of doing business, limit or expand our permissible activities, or affect the competitive balance among banks, credit unions, savings and loan associations, and other institutions.

 

We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

 

The federal Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs, conduct enhanced customer due diligence, and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the U.S. Treasury Department to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by the U.S. Treasury’s Office of Foreign Assets Control. Federal and state bank regulators also focus on compliance with the Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient or the policies, procedures and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to proceed with certain aspects of our business plan, including our acquisition plans, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.

 

 - 26 - 

 

  

Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business. 

 

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations. It is our policy not to make predatory loans and to determine borrowers’ ability to repay in accordance with regulatory standards, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and impact the cost and pricing of loans that we make.

 

We are subject to federal and state fair lending laws, and failure to comply with these laws could lead to material penalties.

 

Federal and state fair lending laws and regulations, such as the Equal Credit Opportunity Act and the Fair Housing Act, impose nondiscriminatory lending requirements on financial institutions. The Department of Justice, CFPB and other federal and state agencies are responsible for enforcing these laws and regulations. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. A successful challenge to our performance under the fair lending laws and regulations could adversely impact our rating under the Community Reinvestment Act and result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on merger and acquisition activity and restrictions on expansion activity, which could negatively impact our reputation, business, financial condition and results of operations.

 

The Federal Reserve Board may require us to commit capital resources to support the Bank.

 

The Federal Reserve Board requires a bank holding company to act as a source of financial and managerial strength to a subsidiary bank and to commit resources to support such subsidiary bank. Under the “source of strength” doctrine, the Federal Reserve Board may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. In addition, the Dodd-Frank Act directs the federal bank regulators to require that all companies that directly or indirectly control an insured depository institution serve as a source of strength for the institution. Under these requirements, in the future, we could be required to provide financial assistance to our Bank if the Bank experiences financial distress.

 

A capital injection may be required at times when we do not have the resources to provide it, and therefore we may be required to borrow the funds. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of its note obligations. Thus, any borrowing that must be done by the holding company in order to make the required capital injection becomes more difficult and expensive and will adversely impact the holding company’s cash flows, financial condition, results of operations and prospects.

 

 - 27 - 

 

  

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results. As a result, current and potential shareholders could lose confidence in our financial reporting, which would harm our business and the trading price of our securities.

 

If we identify material weaknesses in our internal control over financial reporting or are otherwise required to restate our financial statements, we could be required to implement expensive and time-consuming remedial measures and could lose investor confidence in the accuracy and completeness of our financial reports. We may also face regulatory enforcement or other actions, including the potential delisting of our securities from NASDAQ. This could have a material adverse effect on our business, financial condition and results of operations, and could subject us to litigation.

 

Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially impact our financial statements.

 

We are also subject to the accounting rules and regulations of the Securities and Exchange Commission (the “SEC”) and the Financial Accounting Standards Board (the “FASB”). From time to time the SEC and the FASB, update accounting principles generally accepted in the United States that govern the preparation of our financial statements and may also require extraordinary efforts or additional costs to implement. Any of these rules or regulations may be modified or changed from time to time, and we cannot be assured that such modifications or changes will not adversely affect us. These changes can be hard 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 retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing our financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, we may experience unexpected material adverse consequences that could negatively affect our business, results of operations and financial condition.

 

The FASB has recently issued an accounting standard update that will result in a significant change in how we recognize credit losses and may have a material impact on our financial condition or results of operations.

 

In June 2016, the FASB issued an accounting standard update, “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss (“CECL”) model. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected over the contractual life of the financial instrument. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to materially increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.

 

The new CECL standard will become effective for us on January 1, 2020. We are currently evaluating the impact the CECL model will have on our accounting, but we expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations.

 

 - 28 - 

 

  

We may be required to raise additional capital in the future, including to comply with increased minimum capital thresholds established by our regulators as part of their implementation of Basel III, but that capital may not be available when it is needed and could be dilutive to our existing shareholders, which could adversely affect our financial condition and results of operations.

 

In July 2013, the Federal Reserve, FDIC and Office of the Comptroller of the Currency approved final rules that established an integrated regulatory capital framework that addressed perceived shortcomings in certain capital requirements. The rules implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. Compliance by the Registrant and the Bank with these capital requirements affects our business by increasing the amount of capital required to conduct operations. In order to support the operations at the Bank, we may need to raise capital in the future. Our ability to raise capital will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we may be unable to raise capital on terms acceptable to us if at all. If we cannot raise capital when needed, our ability to operate or further expand our operations could be materially impaired. In addition, if we decide to raise equity capital under such conditions, the interests of our shareholders could be diluted.

 

We may need additional access to capital, which we may be unable to obtain on attractive terms or at all.

 

We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments, for future growth, to fund losses or additional provision for loan losses in the future, or to strengthen our capital ratios. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our stock price could be negatively affected. In addition, if we decide to raise additional equity capital, our current shareholders’ interests could be diluted.

 

Liquidity is essential to our business.

 

The primary sources of our Bank’s funds are client deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters, and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to clients on alternative investments and general economic conditions.

 

Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands, particularly if we continue to grow and experience increasing loan demand. We may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate, which could have a material adverse effect on our earnings and financial condition.

 

 - 29 - 

 

  

Increases in FDIC insurance premiums may adversely affect our net income and profitability.

 

The last economic recession caused a high level of bank failures, which dramatically increased FDIC resolution costs and led to a significant reduction in the balance of the Deposit Insurance Fund. As a result, the FDIC significantly increased the initial base assessment rates paid by financial institutions for deposit insurance. We are generally unable to control the amount of premiums that the Bank is required to pay for FDIC insurance. If there are bank or financial institution failures that exceed the FDIC’s expectations, the Bank may be required to pay higher FDIC premiums than those currently in force. Any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings and financial condition.

 

We rely on other companies to provide key components of our business infrastructure.

 

Third-party vendors provide key components of our business infrastructure such as internet connections, network access, core application processing, and operational software. While we have selected these third-party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Any such failures could damage our reputation, which could negatively affect our operating results. Replacing these third-party vendors could also entail significant delay and expense.

 

Security breaches and other information system disruptions, such as cyber-attacks, could compromise our information and expose us to liability, which would cause our business and reputation to suffer.

 

The banking industry has experienced increasing efforts on the part of third parties, including through cyber-attacks, to breach data security at financial institutions or with respect to financial transactions. There have been several recent instances involving financial services and consumer-based companies reporting the unauthorized disclosure of client or customer information or the destruction or theft of corporate data. In addition, because the techniques used to cause such security breaches change frequently, often are not recognized until launched against a target and may originate from less regulated and remote areas around the world, we may be unable to proactively address these techniques or to implement adequate preventative measures. The ability of our customers to bank remotely, including online and through mobile devices, requires secure transmission of confidential information and increases the risk of data security breaches.

 

In the ordinary course of our business, we collect and store sensitive data, including our proprietary business information and that of our customers, and personally identifiable information of our customers and employees, on our networks. The secure processing, maintenance and transmission of this information is critical to our operations. Despite our security measures, our information technology and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. Any failure, interruption, or breach in security or operational integrity of these systems could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, and regulatory penalties, disrupt our operations and the services we provide to customers, damage our reputation, and cause a loss of confidence in our products and services, which could adversely affect our financial condition, revenues and competitive position.

 

 - 30 - 

 

  

Failure to keep pace with technological change could adversely affect our business.

 

The banking industry undergoes frequent technological changes with introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in continuous technological improvements than we do. We may not be able to quickly deploy these new products and services or be successful in marketing these products and services to our customers. Additionally, the implementation of changes and maintenance to current systems may cause service interruptions, transaction processing errors and system conversion delays. Failure to successfully keep pace with technological change affecting the banking industry while avoiding interruptions, errors and delays could have a material adverse effect on our business, financial condition or results of operations.

 

We generally outsource a portion of the operational and technological modifications and improvements we make to third parties, and they may experience errors or disruptions that could adversely impact us and over which we may have limited control. In addition, these third parties could also be the source of an attack on, or breach of, our operational systems, data or infrastructure. We also face risk from the integration of new infrastructure platforms and/or new third-party providers of such platforms into our existing businesses.

 

We may not be able to realize the remaining benefit of our deferred tax assets.

 

As of December 31, 2017 and 2016, we had a net deferred tax asset of $4.5 million and $3.2 million, respectively. A deferred tax asset is reduced by a valuation allowance if, based on the weight of the evidence available, it is more likely than not that some portion or all of the total deferred tax asset will not be realized. In assessing the future ability of the Company to realize the deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company will continue to monitor its deferred tax assets closely to evaluate whether we will be able to realize the full benefit of our net deferred tax asset or whether there is any need for a valuation allowance. Significant negative trends in credit quality, losses from operations, or other factors could impact the realization of the deferred tax asset in the future. If we are unable to realize the full benefit of the deferred tax assets, it could negatively impact our results of operations.

 

If our goodwill becomes impaired, we may be required to record a significant charge to earnings.

 

We have goodwill recorded on our balance sheet as an asset with a carrying value as of December 31, 2017 of $24.9 million. Under GAAP, goodwill is required to be tested for impairment at least annually and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The test for goodwill impairment involves comparing the fair value of a company’s reporting units to their respective carrying values. The Bank is our only reporting unit. The price of our common stock is one of several factors available for estimating the fair value of our reporting units. Although the price of our common stock is currently trading above book value, it has traded below book value in the past and may do so again in the future. Subject to the results of other valuation techniques, if this situation were to return and persist, it could indicate that a portion of our goodwill is impaired. Accordingly, for this reason or other reasons that indicate that the goodwill at any of our reporting units is impaired, we may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill is determined, which could have a negative impact on our results of operations.

 

We may not be able to effectively compete with larger financial institutions for business.

 

Commercial banking in North Carolina and South Carolina is extremely competitive. The Bank competes with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of these competitors have broader geographic markets, higher lending limits, more services, and more media advertising. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition.

 

 - 31 - 

 

  

Consumers may decide not to use banks to complete their financial transactions.

 

Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that historically would have been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as peer-to-peer payments, paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits resulting in reduced liquidity and loss of income generated from those deposits. Additionally, our customer base of consumers and small businesses has increasing non-bank options for credit. Now that credit is available through the Internet, competition for small balance loans is expected to increase. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

 

We may not be able to attract and retain skilled people and the lack of sufficient talent could adversely impact our operations.

 

Our success depends in part on our ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small- to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. Consequently the loss of one or more members of our executive management team may have a material adverse effect on our operations.

 

Hurricanes or other adverse weather events could disrupt our operations, which could have an adverse effect on our business or results of operations.

 

North Carolina’s coastal region and inland areas of eastern North Carolina are affected, from time to time, by adverse weather events, particularly hurricanes. We cannot predict whether, or to what extent, damage caused by future hurricanes or other weather events will affect our operations. Weather events could cause a disruption in our day-to-day business activities and could have a material adverse effect on our business, results of operations and financial condition.

 

Our business reputation is important and any damage to it could have a material adverse effect on our business.

 

Our reputation is very important to sustain our business, as we rely on our relationships with our current, former and potential customers and shareholders, and the industries that we serve. Any damage to our reputation, whether arising from legal, regulatory, supervisory or enforcement actions, matters affecting our financial reporting or compliance with SEC and exchange listing requirements, negative publicity, the conduct of our business or otherwise could have a material adverse effect on our business, results of operations and financial condition.

 

Risks Related to an Investment in Our Common Stock

 

The relatively low trading volume in our common stock may adversely affect your ability to resell shares at prices that you find attractive or at all.

 

Our common stock is listed for quotation on the Nasdaq Global Market under the ticker symbol “SLCT”. The average daily trading volume for our common stock is less than that of larger financial institutions. Due to its relatively low trading volume, sales of our common stock may place significant downward pressure on the market price of our common stock. Furthermore, it may be difficult for holders to resell their shares at prices they find attractive, or at all.

 

 - 32 - 

 

  

The market price of our common stock may be volatile and subject to fluctuations in response to numerous factors, including, but not limited to, the factors discussed in other risk factors and the following:

 

·actual or anticipated fluctuation in our operating results;
·changes in interest rates;
·changes in the legal or regulatory environment in which we operate;
·press releases, announcements or publicity relating to us or our competitors or relating to trends in our industry;
·changes in expectations as to our future financial performance, including financial estimates or recommendations by securities analysts and investors;
·future sales of our common stock;
·changes in economic conditions in our market, general conditions in the U.S. economy, financial markets or the banking industry; and
·other developments affecting our competitors or us.

 

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent a shareholder from selling common stock at or above the current market price. These factors may also adversely affect our ability to raise capital in the open market if needed. In addition, we cannot say with any certainty that a more active and liquid trading market for its common stock will develop.

 

Additional issuances of common stock or securities convertible into common stock may dilute holders of our common stock.

 

We may, in the future, determine that it is advisable, or we may encounter circumstances where it is determined that it is necessary, to issue additional shares of common stock, securities convertible into, exchangeable for or that represent an interest in common stock, or common stock-equivalent securities to fund strategic initiatives or other business needs or to build additional capital. Our board of directors is authorized to cause us to issue additional shares of common stock from time to time for adequate consideration without any additional action on the part of our shareholders in some cases. The market price of our common stock could decline as a result of other offerings, as well as other sales of a large block of common stock or the perception that such sales could occur.

 

Offerings of debt, which would rank senior to our common stock upon liquidation, may adversely affect the market price of our common stock.

 

We may attempt to increase our capital resources or, if regulatory capital ratios fall below the required minimums, we could be forced to raise additional capital by making additional offerings of debt or equity securities, senior or subordinated notes, preferred stock and common stock. Upon liquidation, holders of our debt securities and lenders with respect to other borrowings will receive distributions of available assets prior to the holders of our common stock.

 

Anti-takeover provisions could adversely affect our shareholders.

 

In some cases, shareholders would receive a premium for their shares if we were acquired by another company. However, state and federal law and our articles of incorporation and bylaws make it difficult for anyone to acquire us without approval of our board of directors. For example, our articles of incorporation require a supermajority vote of two-thirds of our outstanding common stock in order to effect a sale or merger of the Company in certain circumstances. Consequently, a takeover attempt may prove difficult, and shareholders may not realize the highest possible price for their securities.

 

 - 33 - 

 

  

An investment in our common stock is not an insured deposit and may lose value.

 

Shares of our common stock are not savings accounts, deposits or other obligations of any depository institution and are not insured or guaranteed by the FDIC or any other governmental agency or instrumentality, any other deposit insurance fund or by any other public or private entity. An investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section. As a result, if you acquire shares of our common stock, you may lose some or all of your investment.

 

Item 1B – UNRESOLVED STAFF COMMENTS

 

None.

 

 - 34 - 

 

 

Item 2 - Properties

 

The following table sets forth the location of the main office, branch offices, and operation centers of the Registrant’s subsidiary depository institution, Select Bank & Trust Company, as well as certain information relating to these offices.

 

Office Location  Year
Opened
  Approximate
Square Footage
   Owned or Leased
           
Select Bank & Trust Main Office  2001   12,600   Owned
700 West Cumberland Street           
Dunn, NC  28334           
            
Blacksburg Office  2017   2,898   Owned
203 W Cherokee Street           
Blacksburg, SC  29702           
            
Burlington Office  2015   5,056   Owned
3158 South Church Street           
Burlington, NC  27217           
            
Charlotte Office  2017   15,191   Leased
13024 Ballantyne Corporate Place           
Charlotte, NC  28277           
            
Clinton Office  2008   3,100   Owned
111 Northeast Boulevard           
Clinton, NC  28328           
            
Elizabeth City Office  2014   3,229   Owned
416 Hughes Boulevard           
Elizabeth City, NC  27909           
            
Fayetteville Office  2004   10,000   Owned
2818 Raeford Road           
Fayetteville, NC 28303           
            
Goldsboro Office  2005   6,300   Owned
431 North Spence Avenue           
Goldsboro, NC  27534           
            
Greenville Charles Blvd Office  2014   6,860   Owned
3600 Charles Blvd.           
Greenville, NC  27858           
            
Leland Office  2015   3,731   Owned
1101 New Pointe Boulevard           
Leland, NC  28451           
            
Lillington Office  2007   4,500   Owned
818 McKinney Parkway           
Lillington, NC  27546           
            
Lumberton Office  2006   3,500   Owned
4400 Fayetteville Road           
Lumberton, NC 28358           
            
Morehead City Office  2015   3,731   Leased
168 N.C. 24           
Morehead City, NC 28577           
            
Raleigh Office  2016   6,538   Leased
4505 Falls of Neuse Road, Suite #100           
Raleigh, NC 27609           
            
Rock Hill Office  2017   2,030   Leased
201 Oakland Avenue           
Rock Hill, SC  29730           
            
Six Mile Office  2017   700   Leased
115 N Main Street           
Six Mile, SC  29682           
            
Washington Office  2014   1,126   Leased
155 North Market Street, Suite 103           
Washington, NC  27889           
            
Wilmington Office  2017   8,500   Leased
1001 Military Cutoff Road, Suite 100           
Wilmington, NC  28405           
            
Operations Center  2010   7,500   Owned
861 Tilghman Drive           
Dunn, NC 28335           
            
Operations Center - Annex  2010   5,000   Owned
863 Tilghman Drive           
Dunn, NC 28335           

 

 - 35 - 

 

 

Item 3 - Legal Proceedings

 

In the ordinary course of operations, the Registrant and the Bank are at times involved in legal proceedings. In the opinion of management, as of December 31, 2017 there are no material pending legal proceedings to which the Registrant, or any of its subsidiaries, is a party, or of which any of their property is the subject.

 

Item 4 – mine safety disclosureS

 

Not applicable.

 

 - 36 - 

 

 

Part II

 

Item 5 - Market for registrant’s Common Equity, Related Stockholder Matters and ISSUER PURCHASES OF EQUITY SECURITIES

 

The Registrant’s common stock is quoted on the NASDAQ Global Market under the trading symbol “SLCT.” Raymond James & Associates, Inc., Automated Trading Desk Financial Services, B-Trade Services, Citadel Securities, Domestic Securities, Hill Thompson Magid & Company, Hudson Securities, J. P. Morgan Securities, Janney Montgomery Scott, LLC, Knight Capital Americas, L.P., Monroe Financial Partners, UBS Securities, Sandler O’Neill & Partners, L.P., and Scott & Stringfellow provide bid and ask quotes for our common stock. At March 9, 2018, there were 14,013,917 shares of common stock issued and outstanding, which were held by 1,149 shareholders of record.

 

   Sales Prices 
   High   Low 
2017          
First Quarter  $11.22   $9.71 
Second Quarter   12.25    10.91 
Third Quarter   12.70    11.25 
Fourth Quarter   12.64    11.55 
           
2016          
First Quarter  $8.18   $7.70 
Second Quarter   8.25    8.00 
Third Quarter   8.72    7.89 
Fourth Quarter   10.48    8.02 

 

The Registrant did not declare or pay common stock cash dividends during 2017 and 2016, and it is not currently anticipated that cash dividends will be declared and paid to common shareholders at any time in the foreseeable future.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

See Item 12 of this report for disclosure regarding securities authorized for issuance under equity compensation plans required by Item 201(d) of Regulation S-K.

 

 - 37 - 

 

 

Performance Graph

 

Select Bancorp, Inc.

 

 

   Period Ending 
Index  12/31/12   12/31/13   12/31/14   12/31/15   12/31/16   12/31/17 
Select Bancorp, Inc.   100.00    119.13    131.61    144.46    175.89    225.71 
Russell 2000 Index   100.00    138.82    145.62    139.19    168.85    193.58 
SNL Southeast Bank Index   100.00    135.52    152.63    150.24    199.45    246.72 

 

Source: S&P Global Market Intelligence

© 2017

 

 - 38 - 

 

 

 

Issuer Purchases of Equity Securities

 

The following table sets forth information regarding the Registrant’s repurchases of its common stock. There were no share repurchases during the fourth quarter of the fiscal year covered by this annual report.

 

Period  Total number
of shares
purchased
   Average
price paid
per share
   Total number of shares
purchased as part of
publicly announced
plans or programs(1)
   Maximum number of
shares that may yet
be purchased under
the plans or
programs(1)
 
                 
October 2017
Beginning Date: 10/1
Ending Date: 10/31
      $        581,518 
                     
November 2017
Beginning Date: 11/1
Ending Date: 11/30
               581,518 
                     
December 2017
Beginning Date: 12/1
Ending Date: 12/31
               581,518 

 

(1) On August 31, 2016, the Registrant announced that its board of directors had authorized a repurchase plan under which the Registrant may repurchase up 581,518 shares of its common stock through open market purchases or privately negotiated transactions. The Registrant’s purchase plan has no time limit.

 

 - 39 - 

 

 

ITEM 6 – SELECTED FINANCIAL DATA

 

   At or for the year ended December 31, 
   2017   2016   2015   2014   2013 
   (dollars in thousands, except per share data) 
     
Operating Data:                         
Total interest income  $39,617   $34,709   $33,341   $26,104   $22,903 
Total interest expense   5,106    3,733    3,542    4,519    5,258 
Net interest income   34,511    30,976    29,799    21,585    17,645 
Provision (Recovery) for loan losses   1,367    1,516    890    (194)   (325)
Net interest income after provision (recovery) for loan losses   33,144    29,460    28,909    21,779    17,970 
Total non-interest income   3,072    3,222    3,292    2,675    2,629 
Merger related expenses   2,166    -    378    1,941    428 
Other non-interest expense   25,153    22,281    21,852    18,719    15,427 
Income before income taxes   8,897    10,401    9,971    3,794    4,744 
Provision for income taxes   5,712    3,647    3,418    1,437    1,803 
Net Income   3,185    6,754    6,553    2,357    2,941 
Dividends on Preferred Stock   -    4    77    38    - 
Net income available to common shareholders  $3,185   $6,750   $6,476   $2,319   $2,941 
                          
Per Share Data:                         
Earnings per share - basic  $0.27   $0.58   $0.56   $0.26   $0.43 
Earnings per share - diluted   0.27    0.58    0.56    0.26    0.43 
Market Price                         
High   12.70    10.48    8.47    10.78    7.42 
Low   9.71    7.70    6.62    6.25    5.43 
Close   12.64    9.85    8.09    7.37    6.67 
Book value   9.72    8.95    8.38    8.59    8.09 
Tangible book value   7.72    8.29    7.67    7.82    8.07 
                          
Selected Year-End Balance Sheet Data:                         
Loans, gross of allowance  $982,626   $677,195   $617,398   $552,038   $346,500 
Allowance for loan losses   8,835    8,411    7,021    6,844    7,054 
Other interest-earning assets   89,531    93,093    134,368    138,198    138,406 
Goodwill   24,904    6,931    6,931    6,931    - 
Core deposit intangible   3,101    810    1,241    1,625    182 
Total assets   1,194,135    846,640    817,015    766,121    525,646 
Deposits   995,044    679,661    651,161    618,902    448,458 
Borrowings   47,651    60,129    58,376    46,324    18,677 
Shareholders’ equity   136,115    104,273    104,702    97,685    56,004 
                          
Selected Average Balances:                         
Total assets  $898,943   $829,315   $765,274   $631,905   $555,354 
Loans, gross of allowance   732,089    639,412    578,759    430,571    354,871 
Total interest-earning assets   813,773    744,024    686,663    565,264    511,597 
Goodwill   7,719    6,931    9,931    2,946    - 
Core deposit intangible   640    1,020    1,330    884    237 
Deposits   738,310    665,764    607,214    523,954    470,526 
Total interest-bearing liabilities   787,073    723,111    659,676    554,405    413,419 
Shareholders’ equity   108,709    102,110    102,068    73,660    55,701 
                          
Selected Performance Ratios:                         
Return on average assets   0.35%   0.81%   0.86%   0.37%   0.53%
Return on average equity   2.93%   6.61%   6.42%   3.12%   5.28%
Net interest margin (4)   4.14%   4.06%   4.34%   3.88%   3.46%
Net interest spread (4)   4.09%   4.04%   4.18%   3.60%   3.22%
Efficiency ratio (1)   72.69%   65.15%   67.18%   77.16%   78.20%
                          
Asset Quality Ratios:                         
Nonperforming loans to period-end loans (2)   0.71%   1.02%   1.41%   2.15%   4.58%
Allowance for loan losses to period-end loans (3) 0.90%   1.24%   1.14%   1.24%   2.04%     
Net loan charge-offs (recoveries) to average loans   0.13%   0.02%   0.12%   (0.03)%   0.15%

 

 - 40 - 

 

 

   At or for the year ended December 31, 
   2017   2016   2015   2014   2013 
   (dollars in thousands, except per share data) 
                     
Capital Ratios:                         
Total risk-based capital   11.86%   15.12%   16.01%   17.70%   19.26%
Tier 1 risk-based capital   11.04%   14.03%   15.04%   16.56%   18.00%
Common equity Tier 1 Capital   9.94%   12.48%   12.33%   -    - 
Leverage ratio   12.64%   12.99%   13.81%   13.10%   12.62%
Tangible equity to assets   9.05%   11.40%   10.88%   11.65%   10.62%
Equity to assets ratio   11.40%   12.57%   13.68%   15.46%   10.65%
                          
Other Data:                         
Number of banking offices   18    13    14    14    8 
Number of full time equivalent employees   202    150    153    154    97 

 

(1)Efficiency ratio is calculated as non-interest expenses divided by the sum of net interest income and non-interest income.
(2)Nonperforming loans consist of non-accrual loans and restructured loans.
(3)Allowance for loan losses to period-end loans ratio excludes loans held for sale.
(4)Fully taxable equivalent basis.

 

 - 41 - 

 

 

Item 7 - ManageMent’s Discussion and Analysis of Financial Condition and Results of OperationS

 

The following presents management’s discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes contained elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors, many of which are beyond our control. The following discussion is intended to assist in understanding the financial condition and results of operations of Select Bancorp, Inc. Because Select Bancorp, Inc. has no material operations and conducts no business on its own other than owning its consolidated subsidiary, Select Bank & Trust Company, and its unconsolidated subsidiary, New Century Statutory Trust I, the discussion contained in this Management's Discussion and Analysis concerns primarily the business of the bank subsidiary. However, for ease of reading and because the financial statements are presented on a consolidated basis, Select Bancorp, Inc. and Select Bank & Trust are collectively referred to herein as the Company unless otherwise noted.

 

DESCRIPTION OF BUSINESS

 

The Company is a commercial bank holding company that was incorporated on May 14, 2003 and has one wholly-owned banking subsidiary, Select Bank & Trust Company (referred to as the “Bank”), which became a subsidiary of the Company as part of a holding company reorganization. In September 2004, the Company formed New Century Statutory Trust I, which issued trust preferred securities to provide additional capital for general corporate purposes, including the expansion of the Bank. New Century Statutory Trust I is not a consolidated subsidiary of the Company. The Company’s only business activity is the ownership of the Bank. Accordingly, this discussion focuses primarily on the financial condition and operating results of the Bank.

 

The Bank’s lending activities are oriented to the consumer/retail customer as well as to the small-to-medium sized businesses located in central and eastern North Carolina in addition to northwest South Carolina. The Bank offers the standard complement of commercial, consumer, and mortgage lending products, as well as the ability to structure products to fit specialized needs. The deposit services offered by the Bank include small business and personal checking, savings accounts and certificates of deposit. The Bank concentrates on customer relationships in building its customer deposit base and competes aggressively in the area of transaction accounts.

 

FINANCIAL CONDITION

DECEMBER 31, 2017 AND 2016

 

Overview

 

Total assets at December 31, 2017 were $1.2 billion, which represents an increase of $347.5 million or 41.0% from December 31, 2016. Interest earning assets at December 31, 2017 totaled $1.1 billion and consisted of $973.8 million in net loans, $63.8 million in investment securities, and $46.1 million in overnight investments and interest-bearing deposits in other banks. Total deposits and shareholders’ equity at December 31, 2017 were $995.0 million and $136.1 million, respectively.

 

On December 15, 2017 the Company acquired Premara Financial, Inc. through the merger of Premara with and into the Company. Immediately following the parent merger, Premara’s wholly owned subsidiary, Carolina Premier Bank, was merged with and into Select Bank. As a result of the mergers, the Company acquired a branch in Charlotte, North Carolina and branches in Rock Hill, Blacksburg and Six Mile, South Carolina. The Company also added additional assets of $278.8 million, net loans of $198.4 million and $226.3 million in deposits through the acquisition. The Company now operates 18 full-service offices in two states, having also added a full-service branch in Wilmington, North Carolina during 2017 and a branch in Raleigh, North Carolina during 2016.

 

 - 42 - 

 

 

Investment Securities

 

Investment securities increased to $63.8 million at December 31, 2017 from $62.3 million at December 31, 2016. The Company’s investment portfolio at December 31, 2017, which consisted of U.S. government sponsored entities agency securities (GSE’s), mortgage-backed securities, corporate bonds and bank-qualified municipal securities, aggregated $63.8 million with a weighted average taxable equivalent yield of 2.88%. The Company also holds an investment of $2.5 million in Federal Home Loan Bank Stock with a weighted average yield of 5.86%. The investment portfolio increased $1.5 million in 2017 as a result of $4.3 million of maturities and $6.0 million prepayments, $22.0 million in disposals, offset by $34.4 million in purchases of which $32.8 million were from the Premara merger and a decrease of $42,000 in the market value of securities available for sale and net accretion of investment discounts.

 

The following table summarizes the securities portfolio by major classification as of December 31, 2017:

 

Securities Portfolio Composition

(dollars in thousands)

 

           Tax 
   Amortized   Fair   Equivalent 
   Cost   Value   Yield 
             
U. S. government agency securities - GSE’s:               
Due within one year  $324   $327    2.66%
Due after one but within five years   9,636    9,718    2.49%
Due after five but within ten years   3,155    3,189    2.75%
Due after ten years   126    130    3.91%
    13,241    13,364    2.57%
Mortgage-backed securities:               
Due within one year   -    -    -% 
Due after one but within five years   27,667    27,774    2.47%
Due after five but within ten years   1,904    1,910    2.83%
Due after ten years   -    -    -% 
    29,571    29,684    2.48%
Corporate bonds:               
Due within one year   -    -    -% 
Due after one but within five years   593    607    8.57%
Due after five but within ten years   1,265    1,281    4.76%
Due after ten years   -    -    -% 
    1,858    1,888    5.56%
                
State and local governments:               
Due within one year   651    653    3.05%
Due after one but within five years   7,522    7,600    2.91%
Due after five but within ten years   1,499    1,510    3.30%
Due after ten years   8,911    9,075    3.94%
    18,583    18,838    3.40%
Total securities available for sale:               
Due within one year   975    980    2.43%
Due after one but within five years   45,418    45,699    2.61%
Due after five but within ten years   7,823    7,890    3.45%
Due after ten years   9,037    9,205    3.86%
                
   $63,253   $63,774    2.88%

 

 - 43 - 

 

 

Loans Receivable

 

The loan portfolio at December 31, 2017 totaled $982.6 million, which was a $305.5 million, or 45.1%, increase from December 31, 2016. At December 31, 2017, the portfolio was composed of $867.5 million in real estate loans, $106.2 million in commercial and industrial loans, and $10.2 million in loans to individuals. Also included in loans outstanding is $1.3 million in net deferred loan fees. The increase in loans outstanding during 2017 was due primarily to loan growth and the acquisition of Carolina Premier, which acquisition accounted for $198.4 million of net loans at December 31, 2017.

 

The following table describes the Company’s loan portfolio composition by category at the dates indicated:

 

   At December 31, 
   2017   2016   2015   2014   2013 
       % of       % of       % of       % of       % of 
       Total       Total       Total       Total       Total 
   Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans 
   (dollars in thousands) 
Real estate loans:                                                  
1-to-4 family residential  $156,901    16.0%  $97,978    14.5%  $87,955    14.2%  $90,903    16.5%  $35,006    10.1%
Commercial real estate   403,100    41.0%   281,723    41.6%   259,259    42.0%   233,630    42.3%   169,176    48.9%
Multi-family residential   76,983    7.8%   56,119    8.3%   40,738    6.6%   42,224    7.6%   19,739    5.7%
Construction   177,933    18.1%   100,911    14.9%   107,688    17.4%   83,593    15.1%   53,325    15.3%
Home equity lines of credit   52,606    5.3%   41,158    6.1%   42,002    6.8%   38,093    6.9%   31,863    9.2%
Total real estate loans   867,523    88.2%   577,889    85.4%   537,642    87.0%   488,443    88.4%   309,109    89.2%
Other loans:                                                  
Commercial and industrial   106,164    10.8%   90,678    13.4%   73,491    11.9%   58,217    10.6%   29,166    8.4%
Loans to individuals & overdrafts   10,244    1.1%   9,827    1.4%   7,255    1.2%   6,017    1.1%   8,775    2.5%
Total other loans   116,408    11.9%   100,505    14.8%   80,746    13.1%   64,234    11.7%   37,941    10.9%
Less:                                                  
Deferred loan origination (fees) cost, net   (1,305)   (0.1)%   (1,199)   (0.2)%   (990)   (0.1)%   (639)   (0.1)%   (550)   (0.1)%
Total loans   982,626    100.0%   677,195    100%   617,398    100.0%   552,038    100.0%   346,500    100.0%
Allowance for loan losses   (8,835)        (8,411)        (7,021)        (6,844)        (7,054)     
Total loans,  net  $973,791        $668,784        $610,377        $545,194        $339,446      

 

The majority of the Company’s loan portfolio is comprised of real estate loans. This category, which includes both commercial and consumer loan balances, increased from 85.4% of the loan portfolio at December 31, 2016 to 88.2% at December 31, 2017. There was a $121.4 million increase in commercial real estate loans, a $59.0 million increase in 1-to-4 family residential loans, a $11.4 million increase in HELOC loans, a $77.0 million increase in construction loans, and a $20.9 million increase in multi-family residential loans.

 

Management monitors trends in the loan portfolio that may indicate more than normal risk. A discussion of certain risk factors follows. Some loans or groups of loans may contain one or more of these individual loan risk factors. Therefore, an accumulation of the amounts or percentages of the individual loan risk factors may not necessarily be an indication of the cumulative risk in the total loan portfolio.

 

 - 44 - 

 

 

Acquisition, Development and Construction Loans

 

The Company originates construction loans for the purpose of acquisition, development, and construction of both residential and commercial properties (“ADC” loans).

 

Acquisition, Development and Construction Loans

As of December 31, 2017

(dollars in thousands)

 

   Construction   Land and Land
Development
   Total 
Total ADC loans  $149,856   $28,077   $177,933 
                
Average Loan Size  $262   $265      
                
Percentage of total loans   15.25%   2.86%   18.11%
                
Non-accrual loans  $384   $-   $384 

 

Management closely monitors the ADC portfolio as to collateral value, funding based on project completeness, and the performance of similar loans in the Company’s market area.

 

Included in ADC loans and residential real estate loans as of December 31, 2017 were certain loans that exceeded regulatory loan to value (“LTV”) guidelines. As of that date, the Company had $24.6 million in non-1-to-4 family residential loans that exceeded the regulatory LTV limits and $13.8 million of 1-to-4 family residential loans that exceeded the regulatory LTV limits. The banking regulators recognize that it may be appropriate in individual cases to originate or purchase loans with LTV ratios in excess of regulatory limits based on the support provided by other credit factors. The Bank has established a review and approval procedure for such loans. Under applicable guidance, the total amount of all loans in excess of regulatory LTV limits should not exceed 100% of total capital. The total amount of these loans represented 31.2% of total risk-based capital as of December 31, 2017, which is less than the 100% maximum specified in regulatory guidance. These loans may present more than ordinary risk to the Company if the real estate market softens for both market activity and collateral valuations. Similar information with respect to the Company’s ADC portfolio at December 31, 2016 is set forth below:

 

Acquisition, Development and Construction Loans

As of December 31, 2016

(dollars in thousands)

 

   Construction   Land and Land
Development
   Total 
Total ADC loans  $76,037   $24,874   $100,911 
                
Average Loan Size  $166   $350      
                
Percentage of total loans   11.23%   3.67%   14.90%
                
Non-accrual loans  $151   $-   $151 

 

Included in ADC loans and residential real estate loans as of December 31, 2016 were certain loans that exceeded regulatory loan to value (“LTV”) guidelines. As of that date, the Company had $21.7 million in non-1-to-4 family residential loans that exceeded the regulatory LTV limits and $4.8 million of 1-to-4 family residential loans that exceeded the regulatory LTV limits. The total amount of these loans represented 23.6% of total risk-based capital as of December 31, 2016, which is less than the 100% maximum specified in regulatory guidance.

 

 - 45 - 

 

 

Business Sector Concentrations

 

Loan concentrations in certain business sectors impacted by lower than normal retail sales, higher unemployment, higher vacancy rates, and weakened real estate market values may also pose additional risk to the Company’s capital position. The Company has established an internal commercial real estate guideline of 40% of Risk-Based Capital for any single product type.

 

At December 31, 2017, the Company exceeded the 40% guideline in five product types. The 1-to-4 Family Residential Rental category represented 52% of Risk-Based Capital or $64.4 million, Real Estate Commercial Construction represented 51% of Risk-Based Capital or $62.3 million, Real Estate Construction Spec & Presold represented 42% or $51.6 million, Office Building category represented 56% or $68.8 million, and the Multi-family Residential category represented 61% of Risk-Based Capital or $74.6 million. All other commercial real estate product types were under the 40% threshold. These product types exceeded established guidelines as a result of loans acquired in the merger with Carolina Premier and recent loan growth.

 

At December 31, 2016, the Company exceeded the 40% guideline in two product types. The 1-to-4 Family Residential Rental category represented 66% of Risk-Based Capital or $74.2 million and the Multi-family Residential category represented 49% of Risk-Based Capital or $54.5 million at December 31, 2016. All other commercial real estate product types were under the 40% threshold.

 

Geographic Concentrations

 

Certain risks exist arising from the geographic location of specific types of higher than normal risk real estate loans. Below is a table showing geographic concentrations for ADC and home equity lines of credit (“HELOC”) loans at December 31, 2017.

 

   ADC Loans   Percent   HELOC   Percent 
   (dollars in thousands) 
     
Harnett County  $5,076    2.85%  $5,365    10.20%
Alamance County   1,727    0.97%   1,075    2.04%
Beaufort County   147    0.08%   1,649    3.13%
Brunswick County   8,509    4.78%   1,696    3.22%
Carteret County   3,279    1.84%   2,795    5.31%
Craven County   923    0.52%   578    1.10%
Cherokee County   -    -%    59    0.11%
Cumberland County   23,105    12.99%   4,196    7.98%
Mecklenburg County   10,826    6.08%   3,249    6.18%
New Hanover County   19,445    10.93%   2,136    4.06%
Pasquotank County   1,115    0.63%   1,730    3.29%
Pickens County   -    -%    72    0.14%
Pitt County   17,421    9.79%   6,727    12.79%
Robeson County   837    0.47%   3,606    6.86%
Sampson County   26    0.01%   1,694    3.22%
Wake County   25,785    14.49%   1,281    2.43%
Wayne County   10,475    5.89%   4,185    7.96%
Wilson County   85    0.05%   71    0.13%
York County   408    0.23%   1,454    2.76%
All other locations   48,744    27.40%   8,988    17.09%
                     
Total  $177,933    100.00%  $52,606    100.00%

 

 - 46 - 

 

 

Below is a table showing geographic concentrations for ADC and HELOC loans at December 31, 2016.

 

   ADC Loans   Percent   HELOC   Percent 
   (dollars in thousands) 
                 
Harnett County $ 4,505   4.46%  $5,817    14.13%     
Alamance County   1,169    1.16%   1,065    2.59%
Beaufort County   182    0.18%   1,026    2.49%
Brunswick County   4,506    4.47%   1,899    4.61%
Carteret County   585    0.58%   2,350    5.71%
Cumberland County   22,610    22.40%   5,278    12.82%
Pasquotank County   947    0.94%   1,258    3.06%
Pitt County   13,697    13.57%   5,151    12.52%
Robeson County   803    0.80%   3,709    9.01%
Sampson County   71    0.07%   1,574    3.83%
Wake County   15,689    15.55%   1,536    3.73%
Wayne County   9,734    9.65%   4,281    10.40%
All other locations   26,413    26.17%   6,214    15.10%
                     
Total  $100,911    100.00%  $41,158    100.00%

 

Interest Only Payments

 

Another risk factor that exists in the total loan portfolio pertains to loans with interest only payment terms. At December 31, 2017, the Company had $291.8 million in loans that had terms permitting interest only payments. This represented 29.70% of the total loan portfolio. At December 31, 2016, the Company had $161.5 million in loans that had terms permitting interest only payments. This represented 23.85% of the total loan portfolio. In light of the risk inherent with interest only loans, it is customary and general industry practice that loans in the ADC portfolio are interest only payments during the acquisition, development, and construction phases of such projects but then convert to amortizing term loans with scheduled payments of principal and interest.

 

Large Dollar Concentrations

 

Concentrations of high dollar loans or large customer relationships may pose additional risk in the total loan portfolio. The Company’s ten largest loans or lines of credit concentrations totaled $66.7 million or 6.8% of total loans at December 31, 2017 compared to $62.9 million or 9.3% of total loans at December 31, 2016. The Company’s ten largest customer loan relationship concentrations totaled $90.0 million, or 9.2% of total loans, at December 31, 2017 compared to $80.9 million, or 11.9% of total loans at December 31, 2016. Deterioration or loss in any one or more of these high dollar loan or customer concentrations could have a material adverse impact on the capital position of the Company and on our results of operations.

 

 - 47 - 

 

 

Maturities and Sensitivities of Loans to Interest Rates

 

The following table presents the maturity distribution of the Company’s loans at December 31, 2017. The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the prime rate:

 

   At December 31, 2017 
       Due after one         
   Due within   year but within   Due after     
   one year   five years   five years   Total 
   (dollars in thousands) 
Fixed rate loans:                    
1-to-4 family residential  $12,954   $83,495   $28,564   $125,013 
Commercial real estate   42,618    239,719    63,656    345,993 
Multi-family residential   8,499    48,100    4,889    61,488 
Construction   3,617    40,803    12,906    57,326 
Home equity lines of credit   -    137    136    273 
Commercial and industrial   7,350    52,732    8,700    68,782 
Loans to individuals & overdrafts   1,905    3,358    1,833    7,096 
Total at fixed rates   76,943    468,344    120,684    665,971 
                     
Variable rate loans:                    
1-to-4 family residential   6,725    10,357    14,035    31,117 
Commercial real estate   8,745    35,891    11,943    56,579 
Multi-family residential   983    11,710    2,802    15,495 
Construction   105,968    12,853    1,402    120,223 
Home equity lines of credit   3,042    16,095    32,867    52,004 
Commercial and industrial   23,450    5,915    7,921    37,286 
Loans to individuals & overdrafts   1,810    617    714    3,141 
Total at variable rates   150,723    93,438    71,684    315,845 
                     
Subtotal   227,666    561,782    192,368    981,816 
                     
Non-accrual loans   799    803    513    2,115 
                     
Gross loans  $228,465   $562,585   $192,881   $983,931 
                     
Deferred loan origination (fees) costs, net                  (1,305)
                     
Total loans                 $982,626 

 

The Company may renew loans at maturity when requested by a customer whose financial strength appears to support such renewal or when such renewal appears to be in the Company’s best interest. In such instances, the Company generally requires payment of accrued interest and may require a principal reduction or modify other terms of the loan at the time of renewal.

 

Past Due Loans and Nonperforming Assets

 

At December 31, 2017, the Company had $6.2 million in loans that were 30 days or more past due. This represented 0.63% of gross loans outstanding on that date. This is an increase from December 31, 2016 when there were $3.0 million in loans that were past due 30 days or more, or 0.44% of gross loans outstanding. Non-accrual loans decreased to $2.1 million at December 31, 2017 from $5.8 million at December 31, 2016. As of December 31, 2017, the Company had thirty-six loans totaling $5.8 million that were considered to be troubled debt restructurings, of which twenty-two loans totaling $4.9 million were still accruing interest. As of December 31, 2016, the Company had thirty-seven loans totaling $6.0 million that were considered to be troubled debt restructurings, of which twenty-three loans totaling $3.6 million were still accruing interest. There were eleven loans in the aggregate amount of $1.5 million greater than 90 days past due and still accruing interest at December 31, 2017 and there were three loans in the amount of $529,000 greater than 90 days past due and still accruing interest at December 31, 2016. Tables included in Note E of the Notes to Consolidated Financial Statements included under Item 8 of this report present an age analysis of past due loans, including acquired credit-impaired loans, or PCI Loans, segregated by class of loans as of December 31, 2017.

 

 - 48 - 

 

 

The table below sets forth, for the periods indicated, information about the Company’s non-accrual loans, loans past due 90 days or more and still accruing interest, total non-performing loans (non-accrual loans plus restructured loans), and total non-performing assets.

 

   As December 31, 
   2017   2016   2015   2014   2013 
   (dollars in thousands) 
                     
Non-accrual loans  $2,115   $5,805   $6,635   $6,938   $9,319 
Restructured loans   4,863    3,625    2,077    4,938    6,537 
Total non-performing loans   6,978    9,430    8,712    11,876    15,856 
Foreclosed real estate   1,258    599    1,401    1,585    2,008 
Total non-performing assets  $8,236   $10,029   $10,113   $13,461   $17,864 
                          
Accruing loans past due 90 days or more  $1,476   $529   $142   $2,230   $- 
Allowance for loan losses  $8,835   $8,411   $7,021   $6,844   $7,054 
                          
Non-performing loans to period end loans   0.71%   1.39%   1.41%   2.15%   4.58%
Non-performing loans and accruing loans past due 90 days or more to period end loans   0.86%   1.47%   1.43%   2.56%   4.58%
Allowance for loan losses to period end loans   0.90%   1.24%   1.14%   1.24%   2.04%
Allowance for loan losses to non-performing loans   127%   89%   81%   58%   44%
Allowance for loan losses to non-performing assets   107%   84%   69%   51%   39%
Allowance for loan losses to non-performing assets and accruing loans past due 90 days or more   91%   80%   68%   44%   39%
Non-performing assets to total assets   0.69%   1.18%   1.24%   1.76%   3.40%
Non-performing assets and accruing loans past due 90 days or more to total assets   0.81%   1.25%   1.26%   2.05%   3.40%

 

In addition to the above, the Company had $4.9 million in loans that were considered to be impaired for reasons other than their past due, accrual or restructured status. In total, there were $8.0 million in loans that were considered to be impaired at December 31, 2017, which is a $3.0 million decrease from the $11.0 million that was impaired at December 31, 2016. Impaired loans have been evaluated by management in accordance with Accounting Standards Codification (“ASC”) 310 and $61,000 has been included in the allowance for loan losses as of December 31, 2017 for these loans. All troubled debt restructurings and other non-performing loans are included within impaired loans as of December 31, 2017.

 

 - 49 - 

 

 

Allowance for Loan Losses

 

The allowance for loan losses is a reserve established through provisions for loan losses charged to expense and represents management’s best estimate of probable loan losses that will be incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated losses and risk inherent in the loan portfolio. The Company’s allowance for loan loss methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of reserves is designed to account for changes in credit quality as they occur. The provision for loan losses reflects loan quality trends, including the levels of and trends related to past due loans and economic conditions at the local and national levels. It also considers the quality and risk characteristics of the Company’s loan origination and servicing policies and practices. Individual reserves are calculated according to ASC 310-10-35 against loans evaluated individually and deemed to most likely be impaired. Impaired loans include all loans in non-accrual status, all troubled debt restructures, all substandard loans that are deemed to be collateral dependent, and other loans that management determines require reserves.

 

The following table presents the Company’s allowance for loan losses by loan type as well as each loan type as a percentage of total loans at December 31 for the years indicated.

 

   At December 31, 
       % of       % of       % of       % of       % of 
       Total       Total       Total       Total       Total 
   2017   loans   2016   loans   2015   loans   2014   loans   2013   loans 
   (dollars in thousands) 
                                         
1-to-4 family residential  $1,058    11.98%  $846    10.05%  $605    14.25%  $628    16.47%  $826    10.10%
Commercial real estate   3,370    38.15%   3,448    41.12%   3,005    41.99%   2,938    42.32%   4,599    48.82%
Multi-family residential   791    8.95%   628    7.48%   393    6.60%   279    7.65%   74    5.70%
Construction   1,955    22.13%   1,301    15.47%   1,386    17.44%   1,103    15.14%   565    15.39%
Home equity lines of credit   549    6.21%   623    7.42%   573    6.80%   985    6.90%   680    9.20%
Commercial and industrial   807    9.13%   1,248    14.84%   922    11.90%   726    10.55%   245    8.42%
Loans to individuals & overdrafts   305    3.60%   317    3.76%   137    1.18%   185    1.09%   65    2.53%
Deferred loan origination (fees) cost, net        (0.15)%   -    (0.14)%   -    (0.16)%   -    (0.12)%   -    (0.16)%
                                                   
Total allocated   8,835    100.00%   8,411    100.00%   7,021    100.00%   6,844    100.00%   7,054    100.00%
Unallocated   -         -         -         -         -      
Total  $8,835        $8,411        $7,021        $6,844        $7,054      

 

The allowance for loan losses as a percentage of gross loans outstanding decreased by 0.34% during 2017 to 0.90% of gross loans at December 31, 2017 primarily due to the accounting impact of the purchase of Premara which doesn’t allow for their ALLL to be carried over. The change in the allowance during 2017 resulted from net charge-offs of $1.0 million and a provision of $1.4 million. General reserves totaled $8.8 million or 0.90% of gross loans outstanding as of December 31, 2017, as compared to year-end 2016 when they totaled $8.4 million or 1.22% of loans outstanding. At December 31, 2017, specific reserves on impaired loans constituted $61,000 or 0.01% of gross loans outstanding compared to $117,000 or 0.02% of loans outstanding as of December 31, 2016. The loans that were acquired from Premara are included in the gross loan number used in the calculations above. The acquired loans are accounted for under ASC 310-20 and ASC 310-30 which results in initial credit marks for the inherent loss risk for those loans being established as part of the initial fair value mark and is not included in the Allowance for Loan Losses. Total acquired loans represent $273.0 million of the gross loan total at December 31, 2017 of which $23.3 million are purchased credit impaired loans.

 

 - 50 - 

 

 

The following table presents information regarding changes in the allowance for loan losses in detail for the years indicated:

 

   As of December 31, 
   2017   2016   2015   2014   2013 
   (dollars in thousands) 
Allowance for loan losses at beginning of year  $8,411   $7,021   $6,844   $7,054   $7,897 
Provision (recovery) for loan losses   1,367    1,516    890    (194)   (325)
    9,778    8,537    7,734    6,860    7,572 
Loans charged off:                         
Commercial and industrial   (73)   (182)   (141)   (63)   (135)
Construction   (17)   (2)   (79)   (4)   (28)
Commercial real estate   (914)   (189)   (663)   (150)   (384)
Multi-family residential   (-)    (-)    (5)   -    - 
Home equity lines of credit   (179)   (205)   (115)   (327)   (316)
1-to-4 family residential   (22)   (7)   (70)   (26)   (325)
Loans to individuals & overdrafts   (101)   (90)   (54)   (98)   (135)
Total charge-offs   (1,306)   (675)   (1,127)   (668)   (1,323)
                          
Recoveries of loans previously charged off:                         
Commercial and industrial   211    22    48    32    137 
Construction   29    22    29    63    25 
Multi-family residential   2    -    106    -    - 
Commercial real estate   16    151    84    364    96 
Home equity lines of credit   25    35    21    78    81 
1-to-4 family residential   46    299    102    92    398 
Loans to individuals & overdrafts   34    20    24    23    68 
Total recoveries   363    549    414    652    805 
                          
Net recoveries (charge-offs)   (943)   (126)   (713)   (16)   (518)
                          
Allowance for loan losses at end of year  $8,835   $8,411   $7,021   $6,844   $7,054 
                          
Ratios:                         
Net charge-offs (recoveries) as a percent of average loans   0.13%   0.02%   0.12%   0.00%   0.15%
Allowance for loan losses as a percent of loans at end of year   0.90%   1.24%   1.14%   1.24%   2.04%

 

While the Company believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making determinations regarding the allowance.

 

 - 51 - 

 

 

The table below presents information detailing the allowance for loan losses for originated and purchased credit impaired acquired loans:

 

Analysis of Allowance for Credit Losses

(dollars in thousands)

 

   Beginning   Charge           Ending 
   Balance   Offs   Recoveries   Provision   Balance 
Year ended December 31, 2017                         
Total loans                         
Commercial and Industrial  $1,248   $73   $211   $(579)  $807 
Construction   1,301    17    29    642    1,955 
Commercial real estate   3,448    914    16    820    3,370 
Multi-family residential   628    -    2    161    791 
Home Equity Lines of credit   623    179    25    80    549 
1-to-4 family residential   846    22    46    188    1,058 
Loans to individuals & overdrafts   317    101    34    55    305 
Total  $8,411   $1,306   $363   $1,367   $8,835 
                          
PCI loans                         
Commercial and Industrial  $37   $-   $-   $28   $65 
Construction   -    -    -    -    - 
Commercial real estate   -    -    -    66    66 
Multi-family residential   -    -    -    -    - 
Home Equity Lines of credit   12    -    -    (12)   - 
1-to-4 family residential   -    -    -    -    - 
Loans to individuals & overdrafts   -    -    -    -    - 
Total  $49   $-   $-   $82   $131 
                          
Loans – excluding PCI                         
Commercial and Industrial  $1,211   $73   $211   $(607)  $742 
Construction   1,301    17    29    642    1,955 
Commercial real estate   3,448    914    16    754    3,304 
Multi-family residential   628    -    2    161    791 
Home Equity Lines of credit   611    179    25    92    549 
1-to-4 family residential   846    22    46    188    1,058 
Loans to individuals & overdrafts   317    101    34    55    305 
Total  $8,362   $1,306   $363   $1,285   $8,704 

 

Determining the fair value of PCI loans at acquisition required the Company to estimate cash flows expected to result from those loans and to discount those cash flows at appropriate rates of interest. For such loans, the excess of cash flows expected to be collected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans and is called the accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and is called the nonaccretable difference. In accordance with GAAP, there was no carry-over of previously established allowance for credit losses from the acquired company.

 

Management believes the level of the allowance for loan losses as of December 31, 2017 is appropriate in light of the risk inherent within the Company’s loan portfolio.

 

Other Assets

 

At December 31, 2017, non-earning assets totaled $78.4 million, an increase of $61.5 million from $52.1 million at December 31, 2016. Non-earning assets at December 31, 2017 consisted of: cash and due from banks of $16.6 million, premises and equipment totaling $18.3 million, foreclosed real estate totaling $1.3 million, accrued interest receivable of $4.0 million, goodwill of $24.9 million and other assets totaling $13.3 million, including net deferred taxes of $4.5 million.

 

 - 52 - 

 

 

The Company has an investment in bank owned life insurance of $28.4 million, which increased $5.7 million from the Premara merger plus $575,000 due to earnings since December 31, 2016. The increase in BOLI in 2016 was from earnings. Since the income on this investment is included in non-interest income, the asset is not included in the Company’s calculation of earning assets.

 

Deposits

 

Total deposits at December 31, 2017 were $995.0 million and consisted of $227.1 million in non-interest-bearing demand deposits, $250.9 million in money market and NOW accounts, $69.5 million in savings accounts, and $447.6 million in time deposits. Total deposits increased by $315.4 million from $679.7 million as of December 31, 2016. Non-interest-bearing demand deposits increased by $63.5 million from $163.6 million as of December 31, 2016. MMDA and NOW accounts increased by $76.7 million from $174.2 million as of December 31, 2016. Savings accounts increased by $31.1 million from $38.4 million as of December 31, 2016. Time deposits increased by $144.2 million during 2017. The deposit growth of $315.4 million in 2017 was primarily due to the Carolina Premier acquisition which represented $226.3 million plus organic generation of $89.1 million and in 2016 the increase was due to organic deposit growth of $28.5 million.

 

The following table shows historical information regarding the average balances outstanding and average interest rates for each major category of deposits:

 

   For the Period Ended December 31, 
   2017   2016   2015   2014   2013 
   Average   Average   Average   Average   Average   Average   Average   Average   Average   Average 
   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate 
   (dollars in thousands) 
Savings, NOW and money market deposits  $220,249    0.25%  $209,769    0.19%  $205,792    0.19%  $170,183    0.19%  $147,800    0.23%
Time deposits > $100,000   258,141    1.09%   204,120    0.82%   158,704    0.85%   137,911    1.52%   122,166    2.13%
Other time deposits   94,420    1.03%   91,573    1.08%   104,388    1.19%   112,990    1.50%   117,564    1.61%
Total interest-bearing deposits   572,810    0.76%   505,462    0.60%   468,884    0.64%   421,084    0.98%   387,530    1.25%
                                                   
Noninterest-bearing deposits   173,608    -    160,302    -    138,330    -    102,870    -    82,996    - 
                                                   
Total deposits  $746,418    0.58%  $665,764    0.46%  $607,214    0.49%  $523,954    0.79%  $470,526    1.02%

 

Short-Term and Long-Term Debt

 

As of December 31, 2017, the Company had $28.3 million in short-term debt which consisted of FHLB advances, and $19.4 million in long-term debt, which included $12.4 million in junior subordinated debentures issued to New Century Statutory Trust I in connection with the Company’s 2004 issuance of trust preferred securities. The Company acquired $29.0 million in FHLB advances with the December 2017 acquisition of Carolina Premier Bank. However, we were still able to reduce oustanding short-term and long-term debt by $12.5 million compared to the prior year end as a result of increased deposits and the liquidation of investment securities.

 

Shareholders’ Equity

 

Total shareholders’ equity at December 31, 2017 was $136.1 million, an increase of $31.8 million from $104.3 million as of December 31, 2016. Changes in shareholders’ equity included $3.2 million in net income, $115,000 in stock based compensation, proceeds of $166,000 from stock option exercises, and other comprehensive income of $40,000 related to the increase in the unrealized gain in the Company’s available for sale investment security portfolio. In addition, the December 15, 2017 merger with Premara resulted in a $28.3 million increase in shareholders’ equity.

 

 - 53 - 

 

 

RESULTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2017 AND 2016

 

Overview

 

During 2017, the Company had net income of $3.2 million compared to net income of $6.8 million for 2016. Both basic and diluted net income per share for the year ended December 31, 2017 were $0.27, compared with basic and diluted net income per share of $0.58 for 2016.

 

Embedded in the Company's net income numbers for the year ended December 31, 2017, are net after tax merger expenses of $1.4 million, related to the acquisition of Carolina Premier. In addition, due to the Tax Act that was signed into law on December 22, 2017, the Company was required to calculate a "tax re-measurement" for the associated rate change for its deferred taxes. This tax re-calculation resulted in an increase of approximately $2.5 million of income tax expense for the year, which directly impacted the Company's reported GAAP results.

 

Net Interest Income

 

Like most financial institutions, the primary component of earnings for the Company is net interest income. Net interest income is the difference between interest income, principally from loans and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by the average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by the levels of non-interest bearing liabilities and capital.

 

Net interest income increased by $3.5 million to $34.5 million for the year ended December 31, 2017. The Company’s total interest income was impacted by an increase in interest earning assets and a slow rising interest rate environment in 2017. Average total interest-earning assets were $835.6 million in 2017 compared with $744.0 million in 2016. The yield on those assets increased by 7 basis points from 4.70% in 2016 to 4.77% in 2017 primarily because of increasing investment yields of 31 basis points. Meanwhile, average interest-bearing liabilities increased by $59.9 million from $622.7 million for the year ended December 31, 2016 to $562.8 million for the year ended December 31, 2017. Cost of these funds increased by 16 basis points in 2017 to 0.82% from 0.66% in 2016 which was primarily due to an increase of 25 basis points on larger time deposits and 38 basis points on borrowings. In 2017, the Company’s net interest margin was 4.16% and net interest spread was 3.95%. In 2016, net interest margin was 4.20% and net interest spread was 4.04%.

 

Provision for Loan Losses

 

The allowance for loan losses is a reserve established through provisions for loan losses charged to income and represents management’s best estimate of probable loan losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated losses and risk inherent in the loan portfolio. The Company’s allowance for loan loss methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of reserves is designed to account for changes in credit quality as they occur. The provision for loan losses reflects loan quality trends, including the levels of and trends related to past due loans and economic conditions at the local and national levels. It also considers the quality and risk characteristics of the Company’s loan origination and servicing policies and practices.

 

 - 54 - 

 

 

The Company recorded a $1.4 million provision for loan losses in 2017 compared to a provision of $1.5 million recorded in 2016. The decrease in provision was due to improving asset quality and was offset by loan growth. For more information on changes in the allowance for loan losses, refer to Note E of the notes to the consolidated financial statements in the section titled Allowance for Loan Losses.

 

Non-Interest Income

 

Non-interest income for the year ended December 31, 2017 was $3.1 million down $150,000 from $3.2 million from 2016. Contributing to the decrease were a decrease in deposit service charges of $67,000 due to lower overdraft fee income, a decrease in gain on sale of securities of $21,000 and a decrease in other non-interest income of $62,000 primarily due to debit cards and pin replacements.

 

Non-Interest Expenses

 

Non-interest expenses increased by $5.0 million or 22.6% to $27.3 million for the year ended December 31, 2017, from $22.3 million for the same period in 2016. The following are highlights of the significant changes in non-interest expenses from 2016 to 2017.

 

·Personnel expenses increased $1.8 million to $15.6 million primarily due to cost of living increases and the Bank’s branch expansion plus starting a mortgage department.
·Occupancy and equipment expenses decreased $112,000 to $2.2 million primarily due to lease maturities and reductions in repairs and maintenance.
·Information systems increased $187,000 to $2.3 million from $2.1 million in 2016 due largely to the increase in security related applications.
·Professional fees increased to $1.2 million in 2017 from $977,000 in 2016, a 21.0% increase due to legal fees and consulting fees.
·No merger /acquisition related expenses were recognized in 2016 compared to $2.2 million in 2017.
·Other operating expense increased primarily due to increased franchise taxes, dues and subscriptions, and other sundry expenses by $447,000 or 14.0%.

 

Provision for Income Taxes

 

The Company’s effective tax rate in 2017 was 64.2%, compared to 35.1% in 2016. Included in the effective tax rate for 2017 is the effect of the tax law legislation change enacted December 22, 2017. The tax law change required a re-measurement of the deferred taxes of the Company that resulted in a corresponding increase in income tax expense of $2.6 million. It is anticipated that the effective rate for 2018 will be approximately 23.4% to 23.6%. For further discussion pertaining to the Company’s tax position, refer to Note L of the consolidated financial statements.

 

 - 55 - 

 

 

 

RESULTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

 

Overview

 

During 2016, the Company had net income of $6.8 million compared to net income of $6.6 million for 2015. Both basic and diluted net income per share for the year ended December 31, 2016 were $0.58, compared with basic and diluted net income per share of $0.56 for 2015.

 

Net Interest Income

 

Net interest income increased by $1.2 million to $31.0 million for the year ended December 31, 2016. The Company’s total interest income was impacted by an increase in interest earning assets and a slow rising interest rate environment in 2016. Average total interest-earning assets were $744.0 million in 2016 compared with $686.7 million in 2015. The yield on those assets decreased by 20 basis points from 4.90% in 2015 to 4.70% in 2016 primarily because of declining loan yields of 23 basis points. Meanwhile, average interest-bearing liabilities increased by $41.5 million from $521.3 million for the year ended December 31, 2015 to $562.8 million for the year ended December 31, 2016. Cost of these funds decreased by 2 basis points in 2016 to 0.66% from 0.68% in 2015 which was primarily due to lower average time deposits of 11 basis points. In 2016, the Company’s net interest margin was 4.20% and net interest spread was 4.04%. In 2015, net interest margin was 4.39% and net interest spread was 4.22%.

 

Provision for Loan Losses

 

The Company recorded a $1.5 million provision for loan losses in 2016 compared to a provision of $890,000 recorded in 2015 as a result of loan recoveries. The increase in provision was due to loan growth, offset by lower net charge offs. For more information on changes in the allowance for loan losses, refer to Note E of the notes to consolidated financial statements in the section titled Allowance for Loan Losses.

 

Non-Interest Income

 

Non-interest income for the year ended December 31, 2016 was $3.2 million, down from $3.3 million from 2015. Contributing to the decrease were a decrease in deposit service charges of $90,000 due to lower overdraft fee income, a decrease in gain on sale of securities of $310,000 and an increase in other non-interest income of $330,000 primarily due to debit cards and pin replacements.

 

Non-Interest Expenses

 

Non-interest expenses increased by $51,000 or 0.2% to $22.3 million for the year ended December 31, 2016, from $22.2 million for the same period in 2015. The following are highlights of the significant changes in non-interest expenses from 2015 to 2016.

 

·Personnel expenses increased $531,000 to $12.7 million primarily due to cost of living increases and the 2015 branch acquisitions.
·Occupancy and equipment expenses increased $72,000 to $2.3 million primarily due to repairs and maintenance.
·Information systems increased $128,000 to $2.1 million from $1.9 million in 2015 due largely to the increase in security related applications.
·Professional fees decreased to $977,000 in 2016 from $1.2 million in 2015, a 19.8% decrease due to a reduction in legal fees and consulting fees.
·No merger /acquisition related expenses were recognized in 2016 compared to $378,000 in 2015.
·Other operating expense increased primarily due to increased advertising and marketing expenses and other sundry expenses by $162,000 or 5.3%.

 

Provision for Income Taxes

 

The Company’s effective tax rate in 2016 was 35.1%, compared to 34.3% in 2015. For further discussion pertaining to the Company’s tax position, refer to Note L of the notes to consolidated financial statements.

 

 - 56 - 

 

 

NET INTEREST INCOME

 

The following table sets forth, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Non-accrual loans have been included in determining average loans.

 

    For the Years Ended December 31,  
    2017     2016     2015  
    (dollars in thousands)  
    Average           Average     Average           Average     Average           Average  
    balance     Interest     rate     balance     Interest     rate     balance     Interest     rate  
Interest-earning assets:                                                                        
Loans, gross of allowance   $ 732,289     $ 37,853       5.17 %   $ 631,791     $ 33,062       5.23 %   $ 578,759     $ 31,576       5.46 %
Investment securities     59,082       1,523       2.58 %     72,244       1,638       2.27 %     91,790       2,027       2.21 %
Other interest-earning assets     44,204       480       1.09 %     39,989       257       0.64 %     16,114       71       0.44 %
Total interest-earning assets     835,575       39,856       4.77 %     744,024       34,957       4.70 %     686,663       33,674       4.90 %
                                                                         
Other assets     75,269                       85,288                       78,611                  
                                                                         
Total assets   $ 910,844                     $ 829,312                     $ 765,274                  
                                                                         
Interest-bearing liabilities:                                                                        
Deposits:                                                                        
Savings, NOW and money market   $ 220,249       547       0.25 %   $ 209,769       390       0.19 %   $ 205,792       393       0.19 %
Time deposits over $100,000     258,141       2,811       1.09 %     204,120       1,678       0.82 %     158,704       1,356       0.85 %
Other time deposits     94,420       968       1.03 %     91,573       986       1.08 %     104,388       1,242       1.19 %
Borrowings     49,891       780       1.56 %     57,348       679       1.18 %     52,462       551       1.05 %
                                                                         
Total interest-bearing liabilities     622,701       5,106       0.82 %     562,810       3,733       0.66 %     521,346       3,542       0.68 %
                                                                         
Non-interest-bearing deposits     173,608                       160,302                       138,330                  
Other liabilities     4,712                       4,090                       3,530                  
Shareholders' equity     109,823                       102,110                       102,068                  
                                                                         
Total liabilities and shareholders' equity   $ 910,844                     $ 829,312                     $ 765,274                  
                                                                         
Net interest income/interest rate spread (taxable-equivalent basis)           $ 34,750       3.95 %           $ 31,224       4.04 %           $ 30,132       4.22 %
                                                                         
Net interest margin (taxable-equivalent basis)                     4.16 %                     4.20 %                     4.39 %
                                                                         
Ratio of interest-earning assets to interest-bearing liabilities     134.19 %                     132.20 %                     131.71 %                
                                                                         
Reported net interest income                                                                        
Net interest income/net interest margin (taxable-equivalent basis)           $ 34,750       4.00 %           $ 31,224       4.00 %           $ 30,132       4.36 %
Less:                                                                        
taxable-equivalent adjustment             239                       248                       333          
                                                                         
Net Interest Income           $ 34,511                     $ 30,976                     $ 29,799          

  

 - 57 - 

 

 

RATE/VOLUME ANALYSIS

 

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

 

   Year Ended   Year Ended   Year Ended 
   December 31, 2017 vs. 2016   December 31, 2016 vs. 2015   December 31, 2015 vs. 2014 
   Increase (Decrease) Due to   Increase (Decrease) Due to   Increase (Decrease) Due to 
   Volume   Rate   Total   Volume   Rate   Total   Volume   Rate   Total 
   (dollars in thousands) 
Interest income:                                             
Loans  $5,227   $(436)  $4,791   $2,834   $(1,348)  $1,486   $8,641   $(1,212)  $7,429 
Investment securities   (318)   208    (110)   (437)   43    (394)   12    (234)   (222)
Other interest-earning assets   36    187    223    129    57    186    (141)   55    (86)
                                              
Total interest income (taxable-equivalent basis)   4,945    (41)   4,904    2,562    (1,248)   1,278    8,512    (1,391)   7,121 
                                              
Interest expense:                                             
Deposits:                                             
Savings, NOW and money market   23    134    157    7    (10)   (3)   68    (1)   67 
Time deposits over $100,000   516&nbs