S-1/A 1 d568616ds1a.htm S-1/A S-1/A
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As filed with the Securities and Exchange Commission on March 18, 2019

Registration No. 333-228446

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Pre-effective

Amendment No. 1

to

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

SILVERGATE CAPITAL CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Maryland   6022   33-0227337

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

 

 

4250 Executive Square

Suite 300

La Jolla, CA 92037

(858) 362-6300

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

Alan J. Lane

President and Chief Executive Officer

Silvergate Capital Corporation

4250 Executive Square

Suite 300

La Jolla, CA 92037

(858) 362-6300

(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent For Service)

 

 

Copies to:

 

Kevin M. Houlihan, Esq.

William H. Levay, Esq.

Mark R. Goldschmidt, Esq.

Holland & Knight LLP

800 17th Street, Suite 1100

Washington, D.C. 20006

(202) 955-3000

 

Michael Kaplan, Esq.

Derek Dostal, Esq.

Davis Polk & Wardwell LLP

450 Lexington Avenue

New York, NY 10017

(212) 450-4000

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ☐

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an 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.

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer      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 7(a)(2)(B) of the Securities Act.  ☒

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of each Class of

Security to be Registered

 

Proposed

Maximum

Aggregate

Offering Price(1)(2)

 

Amount of

Registration Fee(3)

Class A Common Stock, $0.01 par value per share

  $50,000,000   $6,060

 

 

(1) 

Includes shares of Class A Common Stock to be sold by the selling shareholders and shares of Class A Common Stock that may be purchased by the underwriters pursuant to their option to purchase additional shares in the offering.

(2) 

Estimated solely for purposes of calculating the registration fee in accordance with Rule 457(o) under the Securities Act of 1933. This amount represents the proposed maximum aggregate offering price of the securities registered hereunder to be sold by the Registrant.

(3) 

Previously paid.

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file an amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. Neither we nor the selling shareholders may sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion, dated March 18, 2019

PROSPECTUS

 

 

             Shares

 

LOGO

SILVERGATE CAPITAL CORPORATION

Class A Common Stock

 

 

This prospectus relates to the initial public offering of Silvergate Capital Corporation. We are offering              shares of our Class A Common Stock, or common stock. The selling shareholders identified in this prospectus are offering an additional              shares of our common stock. We will not receive any proceeds from sales of shares of our common stock by the selling shareholders.

Prior to this offering, there has been no established public market for our common stock. We currently estimate that the initial public offering price of our common stock will be between $            and $            per share. We have applied to list our common stock on the New York Stock Exchange under the symbol “SI .”

We are an “emerging growth company” as defined under the federal securities laws, and may take advantage of reduced public company reporting and relief from certain other requirements otherwise generally applicable to public companies. See “Implications of Being an Emerging Growth Company.”

Investing in our common stock involves a high degree of risk. See “Risk Factors” beginning on page 18.

 

     Per Share      Total  

Initial public offering price

   $                    $                

Underwriting discount(1)

   $        $    

Proceeds to us (before expenses)

   $        $    

Proceeds to the selling shareholders (before expenses)

   $        $    

 

(1) 

The underwriters will also be reimbursed for certain expenses incurred in this offering. See “Underwriting” for additional information.

We and the selling shareholders have granted the underwriters an option exercisable for 30 days after the date of this prospectus to purchase, from time to time, in whole or in part, up to an additional              shares of common stock from us and              shares of common stock from the selling shareholders at the public offering price less underwriting discounts and commissions.

Neither the Securities and Exchange Commission nor any other regulatory authority has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

The shares of our common stock that you purchase in this offering are not deposits, savings accounts or other obligations of our bank or nonbank subsidiaries and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency.

The underwriters expect to deliver shares of common stock to purchasers on or about                     , 2019, subject to customary closing conditions.

 

 

Joint Book-Running Managers

 

Barclays   Keefe, Bruyette & Woods
  A Stifel Company

Prospectus dated                     , 2019


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TABLE OF CONTENTS

 

PROSPECTUS SUMMARY

     1  

RISK FACTORS

     18  

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

     49  

USE OF PROCEEDS

     51  

DIVIDEND POLICY

     52  

CAPITALIZATION

     53  

DILUTION

     54  

SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA

     56  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     58  

BUSINESS

     87  

MANAGEMENT

     106  

EXECUTIVE COMPENSATION

     117  

PRINCIPAL AND SELLING SHAREHOLDERS

     125  

CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

     128  

DESCRIPTION OF CAPITAL STOCK

     132  

SHARES ELIGIBLE FOR FUTURE SALE

     137  

SUPERVISION AND REGULATION

     139  

CERTAIN MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES TO NON-U.S. HOLDERS OF COMMON STOCK

     155  

UNDERWRITING

     159  

LEGAL MATTERS

     167  

EXPERTS

     167  

WHERE YOU CAN FIND MORE INFORMATION

     167  

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1  

GLOSSARY

     A-1  


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ABOUT THIS PROSPECTUS

In this prospectus, unless we state otherwise or the context otherwise requires, references to “we,” “our,” “us,” “the Company” and “Silvergate” refer to Silvergate Capital Corporation and its wholly owned subsidiary, Silvergate Bank, which we sometimes refer to as “Silvergate Bank,” “the Bank” or “our Bank,” and references to “common stock” or “Class A Common Stock” refer to our Class A voting common stock. References to “Class B Common Stock” refer to our Class B non-voting common stock. For explanations of certain other terms used in this prospectus, please read “Glossary” beginning on page A-1.

This prospectus describes the specific details regarding this offering and the terms and conditions of our common stock being offered hereby and the risks of investing in our common stock. For additional information, please see the section entitled “Where You Can Find More Information.”

The information contained in this prospectus, or any free writing prospectus prepared by or on behalf of us or to which we have referred you, is accurate only as of its date, regardless of the time of delivery of this prospectus or of any sale of our common stock. Our assets, business, cash flows, condition (financial or otherwise), liquidity, prospects or results of operations may have changed since that date.

You should not interpret the contents of this prospectus, or any free writing prospectus prepared by or on behalf of us or to which we have referred you, to be legal, business, investment or tax advice. You should consult with your own advisors for that type of advice and consult with them about the legal, tax, business, financial and other issues that you should consider before investing in our common stock.

We, the selling shareholders and the underwriters have not authorized anyone to provide any information to you other than that contained in this prospectus or in any free writing prospectus prepared by or on behalf of us or to which we have referred you. We, the selling shareholders and the underwriters take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you.

No action is being taken in any jurisdiction outside the United States to permit a public offering of our securities or possession or distribution of this prospectus in that jurisdiction. Persons who come into possession of this prospectus in jurisdictions outside the United States are required to inform themselves about, and to observe, any restrictions as to the offering and the distribution of this prospectus applicable to those jurisdictions. We, the selling shareholders and the underwriters are not making an offer of these securities in any jurisdiction where such offer is not permitted.

“Silvergate Bank” and its logos and other trademarks referred to and included in this prospectus belong to us. Solely for convenience, we refer to our trademarks in this prospectus without the ® or the ™ or symbols, but such references are not intended to indicate that we will not fully assert under applicable law our trademark rights. Other service marks, trademarks and trade names referred to in this prospectus, if any, are the property of their respective owners, although for presentational convenience we may not use the ® or the ™ symbols to identify such trademarks.

Market and Industry Data

This prospectus includes government, industry and trade association data, forecasts and information that we have prepared based, in part, upon data, forecasts and information obtained from independent trade associations, industry publications and surveys, government agencies and other information available to us, which information may be specific to particular markets or geographic locations. Statements as to our market position are based on market data currently available to us. Industry publications and surveys and forecasts generally state that the information contained therein has been obtained from sources believed to be reliable. Although we believe these sources are reliable, we have not independently verified the information. Some data is also based on our good faith estimates, which are derived from management’s knowledge of the industry and independent sources. For example, while we believe we are the leading provider of innovative financial infrastructure solutions and services to participants in the digital currency industry, that belief has not been independently verified. That belief is based on management’s knowledge of the industry and is informed by independent sources. In addition,


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we exclude digital currency exchanges as providers of financial infrastructure solutions in making this statement. We believe our internal research is reliable, even though such research has not been verified by any independent sources. In this regard, we note that we estimated the addressable market for U.S. dollar deposits related to digital currencies by aggregating a number of industry estimates as of the most recent date available, June 30, 2018, including (i) the estimated amount of corporate and venture funding and other investments into the digital currency industry from January 1, 2013 through June 30, 2018, (ii) the estimated value of assets held by various digital currency funds, which includes traditional financial products that are exposed to the digital currency industry such as exchange traded notes, trusts and futures and (iii) the estimated value of certain other retail and institutional assets held through digital currency exchanges. While we are not aware of any misstatements regarding the industry data presented herein, our estimates involve risks and uncertainties and are subject to change based on various factors, including those discussed under the heading “Risk Factors” in this prospectus. Forward-looking information obtained from these sources is subject to the same qualifications and the additional uncertainties regarding the other forward-looking statements in this prospectus.

Implications of Being an Emerging Growth Company

As a company with less than $1.07 billion in total annual gross revenue during our last fiscal year, we qualify as an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements and is relieved of certain other significant requirements that are otherwise generally applicable to public companies. As an emerging growth company, we are:

 

   

permitted to present only two years of audited financial statements, in addition to any required interim financial statements, and only two years of related discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations;”

 

   

exempt from the requirement to obtain an attestation from our auditors on management’s assessment of our internal control over financial reporting under the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act;

 

   

permitted to provide less extensive disclosure about our executive compensation arrangements; and

 

   

not required to hold non-binding shareholder advisory votes on executive compensation or golden parachute arrangements.

We may take advantage of some or all of these provisions for up to five years or such earlier time as we cease to qualify as an emerging growth company, which will occur if we have more than $1.07 billion in total annual gross revenue, if we issue more than $1.0 billion of non-convertible debt in a three-year period, or if the market value of our common stock held by non-affiliates exceeds $700.0 million as of any June 30, in which case we would no longer be an emerging growth company as of the following December 31. We have taken advantage of certain reduced reporting obligations in this prospectus. Accordingly, the information contained herein or provided in the future may be different than the information you receive from other public companies in which you hold stock.

In addition to reduced disclosure and the other relief described above, the JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. However, we have elected not to take advantage of this extended transition period, which means that the financial statements included in this prospectus, as well as any financial statements that we file in the future, will be subject to all new or revised accounting standards generally applicable to public companies. Our election not to take advantage of the extended transition period is irrevocable.


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PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus. You should read the entire prospectus carefully before making an investment decision, including the information under the headings “Risk Factors,” “Cautionary Note Regarding Forward-Looking Statements,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and the historical consolidated financial statements and the related notes thereto appearing elsewhere in this prospectus.

Who We Are

Overview

Silvergate Capital Corporation is the holding company for our wholly-owned subsidiary, Silvergate Bank, which we believe is the leading provider of innovative financial infrastructure solutions and services to participants in the nascent and expanding digital currency industry. As a result of this leadership position, the majority of our funding comes from noninterest bearing deposits associated with clients in the digital currency industry. This unique source of funding is a distinctive advantage over most traditional financial institutions and allows us to generate revenue from a conservative portfolio of investments in cash, short term securities and certain types of loans that we believe generate attractive risk-adjusted returns. In addition, we believe that fee income may represent a valuable source of additional future revenue as we develop and deploy fee-based solutions in connection with our digital currency initiative.

Our History

Our leadership position in the digital currency industry has enabled us to establish a significant balance of noninterest bearing deposits from our digital currency customers. While the financial services provided by the Bank have historically included commercial banking, business lending, commercial and residential real estate lending and mortgage warehouse lending, all funded primarily by interest bearing deposits and borrowings, we began pursuing digital currency customers in 2013 and since that time, we believe we have effectively leveraged our traditional commercial bank platform to become the leader in the industry. We intend to continue focusing on our digital currency initiative as the core of our future strategy and direction. We believe we will further transition from a traditional asset based bank model focused on loan generation to a deposit based model focused on increasing noninterest bearing deposits. This emphasis on noninterest bearing deposits, primarily associated with our digital currency initiative, will likely result in a continued shift in our asset composition with a greater percentage consisting of liquid assets such as interest earning deposits in other banks and investment securities, and a corresponding decrease in the percentage of loans.

Digital Currency Initiative

We leverage our technology platform and our management team’s expertise in the digital currency industry to develop, implement and maintain critical financial infrastructure solutions and services for many of the largest U.S. digital currency exchanges and global investors. Our proprietary technology platform is a central element of the operations of our digital currency related customers, which enables us to grow with our existing customers and to attract new customers who can benefit from our innovative solutions and services. We believe that our management team’s vision and our advanced approach to compliance complement this technology platform and empower us to extend our leadership position in the industry by developing additional infrastructure solutions and services that will facilitate growth in our business.

We began exploring the digital currency industry in 2013 based on market dynamics which we believed were highly attractive:

 

   

Significant and Growing Industry: Digital currency presented a revolutionary model for executing financial transactions with substantial potential for growth.



 

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Infrastructure Needs: In order to become widely adopted, digital currency would need to rely on many traditional elements of financial services, including those services that support funds transfers, customer account controls and other security measures.

 

   

Regulatory Complexity as a Barrier to Entry: Providing infrastructure solutions and services to the digital currency industry would require specialized compliance capabilities and a management team with a deep understanding of both the digital currency and the financial services industries.

These insights have been proven correct and we believe they remain true today. In fact, we believe that the market opportunity for digital currencies, the need for infrastructure solutions and services and the regulatory complexity have all expanded significantly since 2013. Our ability to address these market dynamics over the past five years has provided us with a first-mover advantage within the digital currency industry that is the cornerstone of our leadership position today.

The digital currency market has grown dramatically since 2013, with the aggregate value of the five largest digital currencies increasing from approximately $10 billion at December 31, 2013 to approximately $103.4 billion as of March 7, 2019. We believe that the total addressable market for digital currency-related financial services infrastructure solutions and services is significant and that this market will grow as the market for digital currencies grows. We also believe that existing solutions do not adequately address the infrastructure needs of industry participants, and that services enabling industry participants to efficiently and reliably transfer and hold fiat U.S. dollar deposits are critical to the industry’s growth. We estimate that the addressable market for fiat currency deposits related to digital currencies alone is approximately $30 to $40 billion based on various industry sources as described under “Market and Industry Data.”

We develop scalable infrastructure technology solutions to address this broader industry opportunity. We designed our proprietary Silvergate Exchange Network, or SEN, as a network of digital currency exchanges and digital currency investors that enables the efficient movement of U.S. dollars between participating digital currency exchanges and investors 24 hours a day, 7 days a week, 365 days a year. In this respect, the SEN is a first-of-its-kind digital currency infrastructure solution. The SEN was developed and tested in 2017 with a limited number of Bank customers. The SEN was made available to all of the Bank’s digital currency related customers in early 2018. The core function of the SEN, enabled through the Bank’s business online banking data processing system, is to allow SEN participants to make transfers of U.S. dollars from their SEN account at the Bank to any other account they have at the Bank or to the Bank account of another SEN participant with which a counterparty relationship has been established, and to view funds transfers received from their SEN counterparties. Counterparty relationships between parties effecting digital currency transactions are established on the SEN to facilitate U.S. dollar transfers associated with those transactions. The Bank provides investors with the identity of select participating exchanges and mutually agreed counterparties are reflected as such during the Bank’s SEN enrollment process. SEN transfers occur on a virtually instant basis as compared to electronic funds transfers being sent outside of the Bank, such as wire transfers and ACH transactions, which can take from several hours to several days to complete. Our proprietary, cloud-based application programming interface, or API, combined with our online banking tools, allows customers to efficiently control their fiat currency, transact through the SEN and automate their interactions with our technology platform. Customers value this around-the-clock access to U.S. dollar transactions and further benefit from the SEN’s powerful network effects—as more users join the SEN, its importance to digital currency exchanges and investors increases dramatically. These compelling technology tools have enabled us to attract many of the digital currency industry’s largest market participants as customers.

Our solutions and services are built on our deep-rooted commitment and proprietary approach to regulatory compliance. When we began pursuing digital currency customers in 2013, many digital currency industry participants found it difficult to identify a reliable financial services partner due to the significant financial and human resources required to navigate the complex and underdeveloped regulatory regimes applicable to these



 

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digital currency customers. To address market demand, we took a deliberate approach to developing compliance policies, procedures and controls designed to specifically address the digital currency industry and to hiring capable personnel required to implement those controls, policies and procedures. Over the past five years we have further developed our proprietary compliance capabilities—which include ongoing monitoring of customer activities and evaluating a market participant’s ability to actively monitor the flow of funds of their own customers. We believe these capabilities are a distinct competitive advantage for us, and provide a meaningful barrier to entry against our potential competitors, as there is not currently a well-established and easily navigable regulatory roadmap for competitors to serve digital currency industry customers. For this reason, our long-term investment in developing and enhancing our highly specialized compliance capabilities will remain a strategic priority for us.

Our digital currency industry solutions and services are currently offered through our subsidiary, Silvergate Bank, a California-chartered commercial bank that is a member of the Federal Reserve System. The success of our digital currency initiative has enabled Silvergate Bank to rapidly grow noninterest bearing deposits from digital currency customers. Silvergate Bank deploys deposits from its digital currency customers, as well as deposits from its three branches in San Diego County, California, into interest earning deposits in other banks and investment securities, as well as into certain lending opportunities that provide attractive risk-adjusted returns. We deploy our deposits into lending opportunities across four categories: commercial real estate lending, mortgage warehouse lending, correspondent lending and commercial business lending. Silvergate Bank also generates fee revenue from transaction volume across its platform primarily from mortgage warehouse fee income, service fees related to off-balance sheet deposits and other deposit related fees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Year Ended December 31, 2018 compared to Year Ended December 31, 2017—Noninterest Income.”

Because of our focus on the digital currency industry in recent years and the unique value-add solutions and services we provide, we have achieved substantial improvements in our deposit base and significant growth in key operating metrics:

 

     At December 31,     % Increase
/(Decrease)
 
     2018     2017  
     (Dollars in thousands)        

Digital Currency Customers (#)

     542       244       122.1

Noninterest Bearing Deposits

   $ 1,581,813     $ 1,464,154       8.0
     Year Ended December 31,     % Increase
/(Decrease)
 
             2018                     2017          
     (Dollars in thousands)        

Cost of Deposits

     0.10     0.44     (77.3 )% 

Cost of Funds

     0.17     0.59     (71.2 )% 

Net Interest Income

   $ 69,623     $ 41,951       66.0

Noninterest Income

   $ 7,563     $ 3,448       119.3

Net Income

   $ 22,333     $ 7,643       192.2

Industry Background

Adoption and commercialization of digital currencies have significantly expanded since the creation of bitcoin in 2009. Digital currencies are recognized as a new asset class with the prospect to act as a store of value, a currency with the ability to facilitate financial transactions, and a worldwide medium of exchange, all in ways that differ meaningfully from traditional fiat currencies.



 

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Investor interest has grown substantially as the potential uses and advantages of digital currencies have become better understood. Although the digital currency market consists of many individual digital currencies, it is currently concentrated among the five largest digital currencies by market capitalization. As of March 7, 2019, the market value of the five largest digital currencies was $103.4 billion, equal to approximately 0.30% of the global money supply.

We believe that institutional acceptance of the digital currency asset class will continue to grow as capital flows into institutional investment vehicles and other digital currency-based business ventures. Currently, there are over 300 institutional investment funds with aggregate estimated assets under management of between approximately $7.5 billion to $10 billion. Over $8.3 billion has been invested in digital currency-related projects, excluding initial coin offering funding, since December 31, 2013. Approximately $1.3 billion in venture funding was raised in the digital currency and blockchain market in the 12 months ended June 30, 2018, which is the most recent date such information is available.

In response to the rapid growth in the industry and challenges faced by investors, we began developing technology solutions, including the SEN. While innovations, such as the SEN, have enabled increasing numbers of institutional investors to begin investing in digital currencies, many of the world’s largest investors remain unable to invest in the asset class due to the continuing limitations of existing infrastructure. We believe that additional industry innovation will address these infrastructure challenges, enabling increased and accelerated growth in the industry. Services such as a federally regulated digital currency custodian and digital currency borrowing facilities do not currently exist in a meaningful way, creating significant opportunities for us to facilitate growth in the industry and to extend our leadership position into other elements of digital currency infrastructure.

Digital Currency Customers

We have developed a diverse set of 542 established and emerging digital currency industry customers as of December 31, 2018. Our customer base has grown rapidly, as many customers proactively approach us due to our reputation as the leading provider of innovative financial infrastructure solutions and services to participants in the digital currency industry, which includes our unique technology solutions. As of December 31, 2018, we had 232 prospective digital currency customers in various stages of our customer onboarding process, which includes extensive regulatory compliance diligence and integrating of the customer’s technology stack for those digital currency customers interested in using our API.

Our customers include some of the largest U.S. exchanges and global investors in the digital currency industry. These market participants generally hold either or both of two distinct types of funds: (i) those funds that market participants use for digital currency investment activities, which we refer to as investor funds, and (ii) those funds that market participants use for business operations, which we refer to as operating funds.

Our customer ecosystem also includes software developers, digital currency miners, custodians and general industry participants that need our solutions and services. These customers comprised 26.2% of our digital currency customers as of December 31, 2018 and we believe this group presents future growth opportunities as the digital currency industry landscape continues to develop.

We constantly strive to grow our customer ecosystem. By expanding and deepening our customer relationships, we intend to reinforce and enhance our leadership position in the industry and to increase the value of the SEN to all participants. Our relationships with the leaders of the digital currency industry are particularly important because these participants continue to inform us of the industry’s needs and enable us to continue advancing our product development to provide relevant solutions and services for the industry’s most pressing challenges and greatest opportunities.



 

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Deepening our customer relationships through integration of our solutions with our customers’ processes and operating systems creates enhanced value and stronger, long-term relationships with them. For example, digital currency exchanges that integrate our API into their technology infrastructure can attribute incoming client funds, at scale, without human involvement and in virtually real-time, typically within a matter of seconds. This solution enhances our value proposition, creating even closer relationships with our customers.

To maintain our position in the industry, we must remain highly selective in our customer onboarding process to ensure the integrity of the platform. Many customers choose us as their solution provider at least in part because of our long-term commitment to the industry and their belief in our platform’s longevity. Customers respect our need for onboarding and our ongoing compliance processes, as they understand that all our digital currency customers must submit to initial and continued due diligence by us.

The following chart sets forth summary information regarding the types of market participants who are our primary customers (data as of December 31, 2018):

 

     Digital Currency Exchanges    Institutional Investors    Other Customers

Overview

   Exchanges through which digital currencies are bought and sold; includes over-the-counter, or OTC, trading desks    Hedge funds, venture capital funds, private equity funds, family offices and traditional asset managers, which are investing in digital currencies as an asset class    Companies developing new protocols, platforms and applications; mining operations; and providers of other services

Typical Uses

  

•  SEN to facilitate fiat transfers(1)

•  API to attribute fiat transfers(2)

•  Cash management

•  Deposit accounts to hold investor funds and operating funds

  

•  SEN to transfer fiat to digital currency exchanges and traditional bank accounts(1)

•  Cash management

•  Deposit accounts to hold investor funds

  

•  SEN to facilitate fiat transfers(1)

•  Cash management

•  Deposit accounts to hold operating funds

Noteworthy metrics

   Silvergate’s customers include the 5 largest U.S. domiciled digital currency exchanges(3)    Silvergate’s customers have transferred approximately $9 billion in fiat quarterly since January 1, 2018(4)    Silvergate’s customers have raised over $1 billion through private placements

Number of Customers

   37    363   

142

Total Deposits

   $618.5 million    $577.5 million    $273.9 million

Select Customers

   LOGO    LOGO    LOGO

 

(1) 

SEN transfers are funds transfers within the Bank’s deposit system from one SEN participant to another SEN participant.

(2) 

This refers to the attribution of funds received by a SEN API user within its own platform on a programmatic basis without manual human interaction, based on the user’s integration of the Bank’s API into the user’s own systems.



 

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(3) 

Based on data reflecting U.S. dollar 30 day trading volume as of January 9, 2019 from coinmarketcap.com.

(4) 

Consists of $8.3 billion of U.S. dollar transfers on the SEN for the year ended December 31, 2018 and $28.1 billion of non-SEN transfers of U.S. dollars, primarily consisting of wire transfers, during the year ended December 31, 2018.

Technology-Driven Solutions for Our Digital Currency Customers

We launched our digital currency initiative in response to unmet demand for U.S. dollar deposit accounts for many market participants. Our digital currency initiative solutions and services also address various infrastructure shortfalls for market participants, including liquidity and counterparty risk management as explained in more detail below. Currently, our digital currency initiative solutions and services are focused on the SEN, cash management solutions and other deposit account services:

Silvergate Exchange Network (SEN)—We believe that the SEN is an innovative, market leading solution and a key point of differentiation that increases in capability and value by generating a network effect as additional users join the platform. Since launching the SEN in early 2018, as of December 31, 2018, we already had approximately 70.4% of our eligible digital currency related customers as SEN participants. The SEN only transfers fiat U.S. dollars, is only available to commercial customers and is not enabled for customers who are individual investors. The SEN reduces industry friction and creates a compelling value proposition for market participants, whether they participate as a digital currency exchange, an investor or otherwise. SEN participants can efficiently move U.S. dollars 24 hours a day, 7 days a week, 365 days a year between their Bank accounts and other SEN participants’ Bank accounts, via our API or online banking system. Multiple steps are required to create, authorize and approve a SEN transfer, depending on the channel in which the SEN transfer is created (online banking system vs. API). Both channels follow a three step process by which the sender is authorized as a SEN participant, the receiver is validated as a SEN participant, and the transfer amount is confirmed to be available in the originating account. SEN transfers are push only and settle virtually instantly if all three conditions are met. No other transfer-of-value type transactions may be made on the SEN.

The ability to execute these types of transactions in virtually real-time is particularly valuable for digital currency investors and exchanges because digital currency trading occurs constantly on a global scale, with no regulated market hours. Consequently, the SEN enhances transaction execution speed, which meaningfully mitigates exposure to digital currency pricing fluctuations. In addition, SEN participants may spend a significant amount of time and resources developing customized applications that interface directly with our API in a manner that most effectively facilitates SEN participants’ business models. We believe that these dynamics not only strengthen our customer relationships, but also serve as an organic marketing tool. Additional market participants are driven to the SEN as our customers urge their counterparties in digital currency transactions to join the SEN to facilitate efficient, predictable and timely transaction execution.

The following example highlights the benefits that the SEN provides to its participants with respect to liquidity and counterparty risk. A digital currency institutional investor maintains a deposit account with Silvergate Bank. The institutional investor wishes to move U.S. dollars from participating Exchange A to participating Exchange B. The institutional investor can execute the transaction in virtually real-time, outside of traditional banking hours via the SEN, if the institutional investor, Exchange A and Exchange B each maintain a deposit account at Silvergate Bank.

In contrast, if the institutional investor seeks to move funds from Exchange A to Exchange B without the SEN, the transaction would likely need to occur during traditional banking hours and could take several days to clear. This delay in transaction execution could limit the institutional investor’s ability to take advantage of digital currency market movements or require the institutional investor to keep additional funds at each exchange to take advantage of other transaction opportunities, resulting in reduced capital efficiency, reduced liquidity and/or increased counterparty risk.



 

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The graphic below illustrates the various components of a transaction effected through the SEN as compared to a similar transaction effected through a traditional execution pathway. We expect customer adoption of the SEN to increase as network effects drive expanded utility. As reflected, transactions on the SEN process in virtually real time as opposed to legacy transactions that may take from several hours to several days. Legacy transactions are subject to a number of variables that impact timing such as the daily cut-off time for the Federal Reserve wire system as well as incomplete or inaccurate information or wire destinations (country or recipient) that may require further action to confirm or clear.

 

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Cash Management Solutions—Our cash management solutions enable our customers to send, receive and manage payments in a timely, efficient and scalable manner using the SEN, wire transfers and ACH transactions. To receive the full benefits of our cash management solutions, customers invest significant time and resources using their own development resources to build customized gateways that integrate our API and other solutions into their technology infrastructure. The Bank offers a full suite of corporate cash management solutions from deposit, reporting and reconciliation (remote deposit capture, online banking, mobile banking, file / reporting automation, API, check reconciliation), liquidity management (positive pay, ACH positive pay, off balance sheet deposit sweeps), and payment solutions (domestic and foreign wire transfers and ACH origination and receipt transactions). The Bank periodically expands its offerings in these areas to meet the needs of its customers.

Deposit Account Services—We are one of only a small group of institutions that currently open deposit accounts and provide ongoing services in a manner that is designed to be regulatory compliant for digital currency market participants. Our proprietary compliance procedures, developed over five years of serving the digital currency industry, are designed to enable us to prudently and efficiently establish deposit accounts for market participants. These deposit accounts do not consist of any digital currencies but may consist of investor funds or operating funds. Our deposit accounts offer a wide variety of features and security to market participants, including access to our cash management solutions, and other relevant business banking services.

The Company comprehensively investigates the customers it proposes to onboard according to the level it deems necessary and appropriate, based on whether the customer is an “administrator,” an “exchanger” or a “user” of virtual currencies, which terms are defined in March 2013 guidance by the U.S. Treasury Department, or the Treasury Department. Under applicable regulations, administrators and exchangers are required to register with the Treasury Department’s Financial Crimes Enforcement Network, or FinCEN, as a money service business and may also be subject to licensing as money transmitters under applicable state laws. The Company’s



 

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due diligence and onboarding processes include, at a minimum, detailed reviews of each customer’s ownership, management team, business activities and the geographies in which they operate. For customers such as exchanges which pose a higher degree of risk or have a higher degree of regulatory obligations, the Company’s processes are more extensive and incorporate reputational reviews, reviews of applicable licensing requirements, plans, and status, and reviews of customer policies and procedures regarding the BSA, consumer compliance, information security, Dodd-Frank Act prohibitions against unfair, deceptive or abusive acts or practices, as well as reviews of transaction monitoring systems and audit results. The differences in these processes results in a variation in the time necessary to complete the onboarding process, which can range from a matter of days to six to eight weeks.

All regulatory compliance-related responsibilities involving onboarded customers are addressed in the Company’s core banking system or through various additional manual diligence and compliance review processes. No funds transfer transactions occur on the SEN, which is simply the means by which internal account transfer transaction instructions are passed to the Bank’s core banking system through which they are executed. Since all SEN participants are required to be deposit customers of the Bank, the Bank satisfies its know your customer, or KYC, obligations at the time of the customer’s account opening. Transaction instructions are passed to the core banking system via the SEN, are executed on the core banking system, and are subsequently monitored through the Bank’s automated BSA systems.

Our Competitive Advantages in the Digital Currency Industry

We believe our first-mover advantage serving the digital currency industry has led to numerous strategic advantages, many of which are significant barriers to entry for potential competitors. We expect that these advantages will enable us to maintain our leadership position in the industry:

Digital Currency-Focused Strategy—We believe we are the leading provider of innovative financial infrastructure solutions and services for the digital currency industry. We are one of the only financial services providers in the United States catering to our target customer base. These market participants have been underserved by the legacy financial services community due to a lack of vision and regulatory complexity associated with the digital currency industry, which we have been able to overcome because of the in-depth industry knowledge and strategic foresight of our management team and our robust risk management and regulatory compliance framework. Our commitment to, and relationship with, participants in the digital currency industry is highlighted by the fact that digital currency related investors own approximately 13.1% of the issued and outstanding common stock of the Company, as of December 31, 2018, before giving effect to this offering. The focus and mission of our talented team is to address this unique market opportunity.

Customer Base—Our first-mover advantage and expertise in the industry has allowed us to attract 542 digital currency customers, many of whom are the digital currency industry’s most notable participants. These respected and recognizable customers bolster our reputation and enhance our ability to attract new customers. Our customer network also enables us to receive feedback on challenges that the industry currently faces and anticipates facing in the future. Through active dialogue with our customers, we stay at the forefront of industry trends, identify opportunities early and create solutions to address challenges. As an example, the SEN was developed as a result of conversations with our early customers about pain points in the industry. We currently penetrate a small percentage of the market opportunity, and we foresee significant growth if we can execute on our relationship-building strategy with market participants.

SEN Network Effects—We believe the SEN is unique in the industry and its power grows with each new SEN participant, thereby attracting more customers and creating higher levels of customer retention and transaction activity. The Bank provides investors with the identities of participating exchanges that have authorized the Bank to identify them to new or prospective SEN participants. Customer attraction to the SEN can



 

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come from our explaining its advantages to a prospective participant or from encouragement from a customer’s digital currency exchange counterparty for the customer to enroll in the SEN to expedite funds transfers. Customer demand for the SEN is driven by its availability, ease of use, and instant settlement functionality. SEN benefits are quickly understood from the customer’s perspective and provide value to both sides of a SEN transfer. The SEN’s functionality saves time and reduces costs and risks to its users, as we described above.

API Integration—Our proprietary, internally-developed, cloud-based API enables our customers to build direct access to the SEN and their deposit accounts into their technology infrastructure. Customers who use our API commit significant time and resources to integrate our API into their systems because of the increased functionality provided by our API connection. Once fully integrated, our API provides significant value for our customers via its direct interface to our core system. For example, our exchange customers using the API attribute client and counterparty funds programmatically and in virtually real time—a distinct advantage over traditional cash management systems which require human intervention to attribute such funds. Even if competitors were to develop competing solutions to our API and SEN, our customers would need to commit significant time, money and other resources to replace our solutions or adopt additional solutions.

While the Bank does not integrate into customer systems, the Bank provides tools for sophisticated customers to securely access and interact with their accounts’ functions over the Bank’s API. The movement toward application programming interfaces, or open banking, is an initiative that many U.S. banks have embraced. An application programming interface allows customers to automate manual processes, scale operations, or innovate on new product offerings by giving programmatic access to their account history, the ability to send payments, or the automated reconciliation of their accounts. It is the customer’s efforts to leverage these tools that may require significant time and resources on the customer’s part, depending on what the customer is trying to do. For instance, some of the Bank’s customers integrate the API with their systems within a day while other customers have created complex programs built on the API that were built over a period of months. Each customer’s use case and implementation is slightly different, but all are facilitated by the same basic APIs, documentation, developer portal, and Silvergate integration team. The SEN’s ability to permit a customer to make an internal transfer from their own account to another Silvergate customer’s account is one of the functionalities available through and supported by the Bank’s API. For the year ended December 31, 2018, 33% of SEN transfers were conducted through the API.

Robust Risk Management and Compliance Framework—We have invested heavily in our risk management and compliance infrastructure. We have attracted a talented, dedicated compliance team with substantial experience in regulated financial institutions, including developing, implementing and monitoring systems to detect and prevent financial crimes. Our risk management and compliance team has developed a strong risk management and compliance framework that leverages technology for onboarding and monitoring market participants. See “Supervision and Regulation.”

Culture of Innovation—We have a culture of innovation that is driven by our CEO, Alan Lane, whose career in the financial services and technology industries spans over 37 years. In 2013, Mr. Lane began focusing our management team’s attention on the potential long-term impact of digital currencies. Under Mr. Lane’s leadership, we have developed a broad team of digital currency, technology and financial services professionals. This team helps leverage our experience and significant customer base to enable us to identify and respond to opportunities to innovate and add value to our current and future customers. Our team collaborated in the design and implementation of the SEN and coordinated and oversaw the development and deployment of our API to enable us to seamlessly address the needs of our digital currency customers. We expect our culture of product innovation will enable us to continue identifying, building and deploying new customer solutions, both within our digital currency initiative and other potential future initiatives that may be related to new innovations in the financial services industry.



 

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Digital Currency Solutions and Services Drive Our Business Model

Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, which has driven the Bank’s funding costs to among the lowest in the U.S. banking industry. This has allowed us to generate attractive returns on lower risk assets through increased investments in interest earning deposits in other banks and securities, as well as funding limited loan growth. Our business model is described more fully below:

Prudently Leveraging Lower-Cost Core Deposit Base—Our lower-cost core deposit base is a key element of our financial success. We have increased our noninterest bearing deposits as a percentage of total deposits from 12.4% as of December 31, 2013 to 88.7% as of December 31, 2018, an increase that is largely attributable to our digital currency initiative. Our cost of total deposits was 0.10% and our cost of funds was 0.17% for the year ended December 31, 2018 as compared to 0.78% and 1.00%, respectively, for the year ended December 31, 2013. This funding base allows us to manage our interest earning assets conservatively and we have transitioned from primarily deploying our funding into loans to deploying funds into assets such as interest earning deposits in other banks and securities that generate attractive risk-adjusted returns. For example, loans held-for-investment, net have decreased as a percentage of our total assets from 56.0% at December 31, 2013 to 29.6% at December 31, 2018 while the aggregate amount of interest earning deposits in other banks and securities available-for-sale have increased from 9.4% of total assets to 51.3% over the same time period.

 

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(1) 

Represents noninterest bearing deposits as a percentage of total deposits as of December 31, 2018.

(2) 

Data represents median noninterest bearing deposits and average year to date cost of deposits for banks in the United States with total assets between $1.0 billion and $10.0 billion as of the most recent quarter reported.

We deploy our deposits into assets that generate attractive risk-adjusted returns. Our interest earning deposits in other banks and our securities portfolio have grown substantially as our noninterest bearing deposits attributable to our digital currency initiative have expanded.

We segment our deposits based on their potential volatility, which drives our choices regarding the assets we fund with such deposits. Deposits attributable to digital currency exchange customer funds and investor funds are assigned the highest potential volatility. These deposits amounted to $1.1 billion as of December 31, 2018, and we invest these funds primarily in interest earning deposits in other banks and adjustable rate securities available-for-sale.



 

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This strategy also provides significant asset sensitivity, as we expect yields on interest earning deposits in other banks as well as yields on our securities portfolio will rise with potential increases in short term interest rates, while our deposit funding costs will not rise to the same extent.

As of December 31, 2018, our interest earning deposits in other banks totaled $670.2 million. Our average yield on these deposits was 1.95% for the year ended December 31, 2018.

As of December 31, 2018, our portfolio of securities available-for-sale totaled $357.2 million, an increase of 86.2% from December 31, 2017. This portfolio is primarily composed of adjustable rate mortgage-backed securities, collateralized mortgage obligations and pools of government sponsored student loans. We view our available-for-sale securities as a conservatively managed portfolio which offers a source of additional interest income and provides liquidity management flexibility.

We have more flexibility in deciding how to deploy our deposits attributable to digital currency customer operating funds, which totaled $361.9 million as of December 31, 2018.

Conservative Lending and Niche Asset Growth—We also selectively deploy our funding into specialty lending businesses, including mortgage warehouse lending, commercial real estate lending, correspondent lending, and commercial business lending. We have developed underwriting expertise across these asset classes and believe that these loans offer attractive risk-adjusted returns.

We use a portion of our deposits attributable to digital currency exchange and investor funds as the funding source for our mortgage warehouse lending activities. We are comfortable with this strategy because of the short-term nature of our mortgage warehouse assets and because we can access funding at the Federal Home Loan Bank should we experience heightened volatility in the deposit balances related to these digital currency exchange and investor funds.

We use a portion of our deposits attributable to operating funds to make loans across our other lending businesses. A significant portion of our portfolio consists of loans on both owner-occupied and non-owner-occupied commercial real estate. The properties securing these loans are located primarily throughout our markets and are generally diverse in terms of type. Our commercial business lending provides loans to small- and medium-sized businesses in a wide variety of industries and segments, including wholesalers, manufacturers, municipalities, construction and business services companies. These loans are collateralized by inventory, equipment, real estate and other commercial assets, and may be supported by other credit enhancements such as personal guarantees.

 

 

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As of December 31, 2018 we had net loans (including loans held-for-sale) of $943.4 million compared to $513.3 million as of December 31, 2013. Our yield on loans was 5.52% for the year ended December 31, 2018 as compared to 4.84% for the year ended December 31, 2013.

Noninterest Income—For the year ended December 31, 2018, we had noninterest income of $7.6 million (10.9% of net interest income and a 119.3% increase from the same period in the prior year), and our ratio of noninterest income to average assets was 0.38%. Our noninterest income is primarily driven by service fees related to our digital currency customers, mortgage warehouse fee income and other fees. We anticipate an increase in our noninterest income as our customers grow and their needs develop further, and as we continue to develop and deploy fee-based solutions in connection with our digital currency initiative.

Our Growth Strategy

We intend to extend our leadership position in the digital currency industry by combining our management team’s industry vision with our strategic focus, market position, and technology platform to grow our existing business lines and develop additional market-leading product offerings. Our strategies to achieve these goals include:

Focus on High-Growth Customers—Our customers have experienced significant growth as the digital currency industry has rapidly expanded. We expect these customers to continue growing, generating additional deposit potential for us and new opportunities for innovation to address customer needs.

Broaden Our Digital Currency-Related Customer Base—Our customer growth has primarily been driven by market participants proactively approaching us and by high-quality referrals from existing customers who value our sophisticated and flexible approach to addressing their industry-specific challenges. As of December 31, 2018, we had 542 digital currency customers and 232 prospective customers in various stages of our onboarding process. As we further build out our technology and brand awareness, we expect to more deeply penetrate the universe of existing digital currency-related businesses in need of banking services. By further extending the breadth of our services, we believe we will generate an increasing number of high-quality referrals.

Monetization of the SEN as Platform Matures—The competitive advantage of operating on the SEN is crucial for exchanges and investors participating in the digital currency industry. We believe the SEN can grow to a critical mass of adoption and utilization across the digital currency industry. As we continue to enhance SEN functionality and the customer ecosystem related to the SEN, we believe the capabilities and value of the network will continue to increase, providing us with the opportunity to earn fees commensurate with the significant value we are providing to our customers.

Develop New Solutions and Services for Our Customers—We are developing additional products and services to address the digital currency industry’s largest opportunities. We believe we are well positioned to capitalize on these opportunities because of our technology platform and competitive advantages. Our product roadmap includes:

 

   

Stablecoin Transaction Flows and Collateral. We believe that the continuing adoption of stablecoins, as well as our deep relationships with many of the leading developers of stablecoins, presents a large opportunity for our business in several ways. Stablecoins that are backed by U.S. dollars in a one-to-one ratio to their digital representations and that are offered by regulated institutions who agree to third-party audits present what we currently believe to be the largest growth opportunity for deposits for us. At scale, many believe fiat-backed stablecoins will be the catalyst for widespread adoption of digital currencies as a medium of exchange, allowing consumers to purchase goods and services using digital currency without the friction that exists today within the global banking environment and the volatility that exists in the digital currency markets. Additionally, institutional investors are looking for more



 

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efficient ways to move capital between global exchanges that are not currently part of the SEN. The Company does not have any direct involvement with stablecoin pricing, transactions or exchanges.

We are already benefiting from our clients’ interest in stablecoins by holding fiat currency for our customers that may ultimately be exchanged for stablecoins. Fiat currency held for customers that may be used for exchanging into stablecoins is not treated any differently than other fiat currency held by the Bank’s depositors. We hold these funds on deposit similar to other investor funds held on an exchange. Secondly, in many cases, investors are moving fiat currency onto exchanges in order to buy stablecoins using the SEN, increasing the utility of the network and ultimately expanding the opportunity to earn fees commensurate with the value of our service. Finally, we believe the largest opportunity is to hold fiat currency in a deposit account as collateral for stablecoins and we are working closely with several leading stablecoin developers to hold their deposit collateral. In the aggregate, we believe these three opportunities represent substantial growth opportunities that could dramatically enhance our deposits and profitability.

 

   

Custodian Services—We have identified significant demand among institutional investors for regulated custodians to securely store digital currency on their behalf. Many institutional investors require qualified custodians to hold assets on their behalf, and we believe we are well-positioned to capture market share in this emerging space given our existing investor relationships, our leading brand and reputation, and our ownership of a federally regulated bank. We estimate that there are custodial services currently being sought with respect to several billions of dollars worth of digital currency-related assets, and that there are limited potential providers of these custodial services because traditional qualified custodians (e.g., banks, trust companies and broker-dealers) lack the infrastructure and expertise to custody digital currency. Our growth strategy contemplates the establishment of a qualified custodian entity as a Company subsidiary to address this market opportunity. This entity would seek to become a New York state licensed limited liability trust company through which digital currency custodial activities would be conducted. The State of New York was strategically chosen due to its established track record of granting trust charters for digital currency related companies. A full application for this new entity has been submitted and is under review. The Bank does not currently have custody of any digital currency assets, and is not currently planning on transferring digital currency assets across the SEN.

 

   

Expand Our International Customer Base—Due to the global nature of the digital currency industry and rapid adoption of digital currencies as an asset class, we believe we will have the opportunity to extend the reach of our franchise into international markets. As part of this opportunity, we expect to offer products and services to those markets, as well as to our U.S. customers wishing to access those markets, that will drive additional growth and strategic value in our business. For example, we work with correspondent banking partners, including a leading global investment bank to provide competitive foreign exchange alternatives to our clients.

 

   

Other Potential Fintech Opportunities—We carefully monitor events and emerging trends in the markets in which we operate to identify opportunities to further leverage our management team’s experience and technology-driven approach to developing additional fintech-related business opportunities to grow our deposits, earn additional fee income and generate attractive risk adjusted returns. These potential initiatives may include developing additional applications of our API architecture. We believe the API is an attractive platform to support business activities that involve frequent transfer transactions between parties, including, among others, escrow, property/cash exchanges, non-profit non-governmental organizations, marketplace firms such as marketplace lenders and other participants in the sharing economy, and dollar aggregators that facilitate micro investing and crowdfunding activities.



 

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Capitalize on our Unique Market Insights—Because of our management team’s vision and our status as a sought-after partner within the digital currency industry, we see potential opportunities that many legacy financial services providers as well as digital currency market participants may not be able to see in the near-term. We believe that this unique position within the market will enable us to continue developing next generation financial infrastructure solutions and services and extend our first-mover advantage. Capitalizing on these opportunities has the potential to significantly accelerate our growth beyond the drivers visible to most market participants today and help us grow our position as a leading provider of innovative financial services infrastructure solutions and services to the digital currency industry.

Recent Developments

On November 15, 2018, the Company and the Bank entered into a purchase and assumption agreement to sell the Bank’s business lending division and retail branch located in San Marcos, California to HomeStreet Bank. Under the purchase and assumption agreement, HomeStreet Bank has agreed to acquire approximately $123 million of business loans and assume approximately $124 million of deposits (both as of October 31, 2018). HomeStreet Bank has agreed to acquire the loans at par value, plus accrued interest, as of the closing date and will pay deposit premiums based on the deposit type and average deposit balances for the 30 day period up to and including the closing date. Changes in the amount of total deposits and the amount of deposits within each deposit classification may change the financial impact at closing. Furthermore, the amount of loans sold may increase or decrease before closing.

This transaction enables the Company to increase its focus on its digital currency initiative and its specialty lending competencies. Subject to customary closing conditions, including all necessary regulatory approvals, the transaction is expected to be completed in the first quarter of 2019.

Summary Risk Factors

Our business is subject to many substantial risks and uncertainties you should consider before deciding to invest in our common stock. These risks are discussed more fully in the section entitled “Risk Factors.” Some of these risks include the following:

 

   

risks related to our digital currency initiative, including risks that that the digital currency industry may not gain widespread adoption, that legal and regulatory uncertainty regarding the regulation of digital currencies and digital currency activities may inhibit the growth of the digital currency industry, that our low-cost funding strategy may not be sustainable, that our deposits may be adversely affected by price volatility and that our further development and/or implementation of our solutions and services may not successful;

 

   

risks related to cybersecurity and technology, including risks that our systems may fail or be breached, that we may not have sufficient resources to keep pace with rapid technological change in the financial services industry, that our technology may malfunction and that the third-party service providers we use may experience systems failures;

 

   

risks related to our traditional banking business, including risks that a sustained downturn of the economy in the United States or in California may adversely impact our business, that our competitors may lower their loan rates or underwriting standards, that our risk management practices or allowance for loan losses may not be sufficient and that fluctuations in interest rates and the monetary policies and regulations of the Board of Governors of the Federal Reserve System, or the Federal Reserve, may negatively impact our business; and

 

   

risks related to regulation, including risks that legislative and regulatory actions may increase our costs and negatively impact our business, that the capital requirements that the Bank and the Company are subject to



 

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may limit our activities and that our compliance with anti-money laundering laws may not be adequate to detect or prevent money laundering activities and could subject us to fines or regulatory actions.

Corporate Information

Our principal executive offices are located at 4250 Executive Square, Suite 300, La Jolla, CA 92037, and our telephone number at that address is (858) 362-6300. Our website address is www.silvergatebank.com. The information on, or accessible through, our website or any other website cited in this prospectus is not part of, or incorporated by reference into, this prospectus and should not be relied upon in determining whether to make an investment decision.



 

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The Offering

 

Class A Common Stock offered by us

                shares.

 

Class A Common Stock offered by the selling shareholders

                shares.

 

Underwriters’ option to purchase additional shares

We and the selling shareholders have granted the underwriters an option exercisable for 30 days after the date of this prospectus to purchase, from time to time, in whole or in part, up to an additional                  shares from us and                 shares from the selling shareholders at the public offering price less underwriting discounts and commissions.

 

Shares of Class A Common Stock to be outstanding after this offering

            shares of Class A Common Stock (or                 shares if the underwriters exercise in full their option to purchase additional shares of Class A Common Stock).

 

Shares of Class B Common Stock to be outstanding after this offering

            shares of Class B Common Stock.

 

Voting rights

Each holder of our Class A Common Stock is entitled to one vote for each share on all matters submitted to a vote of shareholders, except as otherwise required by law and subject to the rights and preferences of the holders of any outstanding shares of our preferred stock. Our Class B Common Stock is non-voting while held by the initial holder with certain limited exceptions. Each share of Class B Common Stock will automatically convert into a share of Class A Common Stock upon certain sales or transfers by the initial holder including to an unaffiliated third-party and in a widely dispersed public offering. See “Description of Capital Stock.”

 

Use of proceeds

Assuming an initial public offering price of $                  per share, which is the midpoint of the price range set forth on the cover page of this prospectus, we estimate that the net proceeds to us from the sale of our Class A Common Stock in this offering will be $                 million (or $                 million if the underwriters exercise in full their option to purchase additional shares of Class A Common Stock), after deducting the underwriting discount and estimated offering expenses payable by us. We intend to use the net proceeds to us from this offering to fund organic growth and for general corporate purposes, which could include repayment of long-term debt, future acquisitions and other growth initiatives. We will not receive any proceeds from the sale of shares of our Class A Common Stock by the selling shareholders. See “Use of Proceeds.”

 

Dividend policy

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paid any cash dividends on our capital stock since inception, and we currently have no plans to pay dividends for the foreseeable future. Our ability to pay dividends to our shareholders in the future will depend on regulatory restrictions, our liquidity and capital requirements, our earnings and financial condition, the general economic climate, contractual restrictions, our ability to service any equity or debt obligations senior to our Class A and Class B Common Stock and other factors deemed relevant by our board of directors. For additional information, see “Dividend Policy.”

 

Directed share program

At our request, the underwriters have reserved for sale, at the initial public offering price, up to 5% of the shares of our common stock offered in this offering for sale to certain of our directors, executive officers, employees and other related persons. We will offer these reserved shares of common stock to the extent permitted under applicable laws and regulations in the United States through a directed share program. Reserved shares of common stock purchased by our directors and executive officers will be subject to the lock-up provisions described in “Underwriting—Lock-Up Agreements.” We do not know if these persons will choose to purchase all or any portion of the reserved shares of common stock but the number of shares of our common stock available for sale to the public will be reduced to the extent these persons purchase the reserved shares. Any reserved shares of our common stock that are not so purchased will be offered by the underwriters to the public on the same terms as the other shares of our common stock offered by this prospectus. See “Underwriting—Directed Share Program.”

 

New York Stock Exchange Listing

We have applied to list our Class A Common Stock on the New York Stock Exchange under the trading symbol “ SI.”

 

Risk factors

Investing in our Class A Common Stock involves risks. See “Risk Factors” for a discussion of certain factors that you should carefully consider before deciding to invest in shares of our Class A Common Stock.

Except as otherwise indicated, references in this prospectus to the number of shares of Class A and Class B Common Stock outstanding after this offering are based upon 16,628,941 shares of Class A Common Stock and 1,189,548 shares of Class B Common Stock issued and outstanding as of December 31, 2018, respectively. Unless expressly indicated or the context otherwise requires, all information in this prospectus:

 

   

assumes no exercise by the underwriters of their option to purchase up to an additional              shares of Class A Common Stock;

 

   

assumes that the shares of Class A Common Stock sold in this offering are sold at $            per share, which is the midpoint of the price range set forth on the cover page of this prospectus;

 

   

does not attribute to any director, executive officer or principal shareholder any purchases of shares of our common stock in this offering, including through the directed share program described in “Underwriting—Directed Share Program;” and

 

   

excludes 816,616 shares of Class A Common Stock issuable upon exercise of stock options outstanding at December 31, 2018 at a weighted average exercise price of $5.54 per share.



 

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RISK FACTORS

Investing in our common stock involves a significant degree of risk. You should carefully consider the following risk factors, in addition to the other information contained elsewhere in this prospectus, including our consolidated financial statements and related notes, before deciding to invest in our common stock. Any of the following risks, as well as risks that we do not know of or that we currently deem immaterial, could have a material adverse effect on our business, financial condition, results of operations and future prospects. As a result, the trading price of our common stock could decline, and you could lose all or part of your investment.

Risks Related to the Digital Currency Industry

The characteristics of digital currency have been, and may in the future continue to be, exploited to facilitate illegal activity such as fraud, money laundering, tax evasion and ransomware scams; if any of our customers do so or are alleged to have done so, it could adversely affect us.

Digital currencies and the digital currency industry are relatively new and, in many cases, lightly regulated or largely unregulated. Some types of digital currency have characteristics, such as the speed with which digital currency transactions can be conducted, the ability to conduct transactions without the involvement of regulated intermediaries, the ability to engage in transactions across multiple jurisdictions. the irreversible nature of certain digital currency transactions and encryption technology that anonymizes these transactions, that make digital currency particularly susceptible to use in illegal activity such as fraud, money laundering, tax evasion and ransomware scams. Two prominent examples of marketplaces that accepted digital currency payments for illegal activities include Silk Road, an online marketplace on the dark web that, among other things, facilitated the sale of illegal drugs and forged legal documents using digital currencies and AlphaBay, another darknet market that utilized digital currencies to hide the locations of its servers and identities of its users. Both of these marketplaces were investigated and closed by U.S. law enforcement authorities. U.S. regulators, including the Securities and Exchange Commission, or the SEC, Commodity Futures Trading Commission, or the CFTC, and Federal Trade Commission, or the FTC, as well as non-U.S. regulators, have taken legal action against persons alleged to be engaged in Ponzi schemes and other fraudulent schemes involving digital currencies. In addition, the Federal Bureau of Investigation has noted the increasing use of digital currency in various ransomware scams.

While we believe that our risk management and compliance framework, which includes thorough reviews we conduct as part of our due diligence process (either in connection with onboarding new customers or monitoring existing customers), is reasonably designed to detect any such illicit activities conducted by our potential or existing customers (or, in the case of digital currency exchanges, their customers), we cannot ensure that we will be able to detect any such illegal activity in all instances. Because the speed, irreversibility and anonymity of certain digital currency transactions make them more difficult to track, fraudulent transactions may be more likely to occur. We or our banking counterparties may be specifically targeted by individuals seeking to conduct fraudulent transfers, and it may be difficult or impossible for us to detect and avoid such transactions in certain circumstances. If one of our customers (or in the case of digital currency exchanges, their customers) were to engage in or be accused of engaging in illegal activities using digital currency, we could be subject to various fines and sanctions, including limitations on our activities, which could also cause reputational damage and adversely affect our business, financial condition and results of operations. For more information regarding the regulatory agencies and regulations to which we are subject, see “—Risks Related to Regulation”. Lastly, we may experience a reduction in our deposits if such an incident were to impact one of our customers, even if there was no wrongdoing on our part.

 

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Risks Related to Our Digital Currency Initiative

The majority of the Bank’s deposits are from businesses involved in the digital currency industry. As a result, we rely heavily on the success of the digital currency industry, the development and acceptance of which is subject to a variety of factors that are difficult to evaluate.

We have grown rapidly over the last year because of our initiative to provide traditional banking and other services to customers in the digital currency industry. We have created a unique, technology-led infrastructure platform, including the SEN and cash management solutions, to facilitate cash transactions for the Bank’s digital currency deposit customers. This platform has driven growth of a customer base that includes some of the largest and fastest growing companies within the digital currency industry, consisting primarily of digital currency exchanges, institutional investors and other industry participants. See “Prospectus Summary—Digital Currency Customers.” As of December 31, 2018, the Bank’s 10 largest depositors accounted for $843.6 million in deposits, or approximately 47.3% of the Bank’s total deposits, nine of whom are customers in the digital currency industry.

The businesses in which these customers engage involve digital currencies such as bitcoin, other technologies underlying digital currencies such as blockchain, and services associated with digital currencies and blockchain. The digital currency industry includes a diverse set of businesses that use digital currencies for different purposes and provide services to others who use digital currencies. This is a new and rapidly evolving industry, and the viability and future growth of the industry and adoption of digital currencies and the underlying technology is subject to a high degree of uncertainty, including based upon the adoption of the technology, regulation of the industry, and price volatility, among other factors. Because the sector is relatively new, your investment may be exposed to additional risks which are not yet known or quantifiable.

Bitcoin, the first widely used digital currency, and many other digital currencies were designed to function as a form of money. However, digital currencies have only recently become selectively accepted as a means of payment for goods and services and then only by some retail and commercial businesses. Use of digital currency by consumers as a form of payment is limited. Some digital currencies were built for uses other than as a substitute for fiat money. For example, the Ethereum network is intended to permit the development and use of smart contracts, which are programs that execute on a blockchain. The digital asset known as Ether was designed to facilitate transactions involving smart contracts on the Ethereum network. Many of these digital currencies are listed on digital currency exchanges and are traded and purchased as investments by a variety of market participants.

Other factors affecting the further development of the digital currency industry and our business include, but are not limited to:

 

   

the adoption and use of digital currencies, including adoption and use as a substitute for fiat currency or for other uses, which may be adversely impacted by continued price volatility;

 

   

government and quasi-government regulation of digital currencies, their use, and intermediaries and other businesses involved in digital currencies, noting in particular that the SEC has taken action against several cryptocurrency operators and has raised questions whether certain digital currency exchanges must be registered with the SEC to continue operating;

 

   

the use of digital currencies, or the perception of such use, to facilitate illegal activity such as fraud, money laundering, tax evasion and ransomware scams by our customers;

 

   

restrictions on or regulation of access to and operation of the digital currency exchanges or other platforms that facilitate trading in digital currencies;

 

   

heightened risks to digital currency businesses, such as digital currency exchanges, of hacking, malware attacks, and other cyber-security risks, which can lead to significant losses;

 

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developments in digital currency trading markets, including decreasing price volatility of digital currencies, resulting in narrowing spreads for digital currency trading and diminishing arbitrage opportunities across digital currency exchanges, or increased price volatility, which could negatively impact our customers and therefore our deposits, either of which in turn may reduce the benefits of the SEN and negatively impact our business;

 

   

changes in consumer demographics and public taste and preferences;

 

   

the maintenance and development of the software protocol of the digital currency networks;

 

   

the availability and popularity of other forms or methods of buying and selling goods and services, including new means of using fiat currencies;

 

   

the use of the networks supporting digital currencies for developing smart contracts and distributed applications;

 

   

general economic conditions and the regulatory environment relating to digital currencies; and

 

   

increased regulatory oversight of digital currencies and the costs associated with such regulatory oversight.

If any of these factors, or other factors, slows development of the digital currency industry, it could adversely affect our digital currency initiative and therefore have a material adverse effect on our business, financial condition and results of operation. For example, a decline in the digital currency industry that leads to a decline in deposit balances by our digital currency customers would negatively affect our sources of funding. In such circumstances, we may be forced to rely more heavily on other, potentially more expensive and less stable funding sources. Consequently, a decline in the growth of the digital currency industry could have a material adverse effect on our business, financial condition and results of operations.

We may not be able to implement aspects of our growth strategy, which may impact our position as the leading provider of innovative financial infrastructure solutions and services to participants in the digital currency industry and adversely affect our ability to maintain our recent growth and earnings trends.

We have grown rapidly over the last year, primarily through organic growth related to our digital currency initiative. We may not be able to execute on aspects of our growth strategy, which may impair our ability to sustain this rate of growth or prevent us from growing at all. More specifically, we may not be able to generate sufficient amounts of new loans and deposits within acceptable risk and expense tolerances or obtain the personnel or funding necessary for additional growth, which may therefore preclude us from developing products and services relating to stablecoin transaction flows and collateral, custodian services, international expansion of our customer base and other potential fintech opportunities, as described under “Business —Who We Are —Our Growth Strategy”. The process of developing new or improved solutions or services for digital currency industry participants is expensive, complex and involves uncertainties.

The success of new or improved solutions and services depends on several factors, including costs, timely completion, regulatory approvals, the introduction, reliability and stability of our solutions and services, differentiation of new or improved solutions and market acceptance. There can be no assurance that we will be successful in developing and marketing our digital currency initiative in a timely manner or at all, or that our new or improved solutions and services will adequately address market demands. Market acceptance and adoption of solutions and services within our digital currency initiative will depend on, among other things, the solutions and services demonstrating a real advantage over existing products and services, the success of our sales and marketing teams in creating awareness of our solutions and services, competitive pricing of such solutions and services, customer recognition of the value of our technology and the general willingness of potential customers to try new technologies. In particular, if we are unable to achieve sufficient market adoption of the SEN, our growth strategy may be adversely affected.

 

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Various factors, such as general economic conditions, conditions in the digital currency industry and competition with other financial institutions and infrastructure service providers, may impede or preclude the growth of our operations. Our business and the growth of our operations are dependent on, among other things, the continued success and growth of the SEN. If conditions in digital currency markets change such that certain trading strategies currently employed by our institutional investor customers become less profitable, the benefits of the SEN and the API may be diminished, resulting in a decrease in our deposit balance and adversely impacting our growth strategy. In addition, if a competitor were to launch an alternative to the SEN, we could lose noninterest bearing deposits and our business, financial condition, results of operations and growth strategy could be adversely impacted. Further, we may be unable to attract and retain experienced employees, which could adversely affect our growth.

The success of our strategy also depends on our ability to manage our growth effectively, which depends on many factors, including our ability to adapt our regulatory, compliance, credit, operational, technology and governance infrastructure to accommodate expanded operations, particularly as these relate to the digital currency industry. If we are successful in continuing our growth, we cannot assure you that further growth would offer the same levels of potential profitability, or that we would be successful in controlling costs and maintaining asset quality in the face of that growth. Accordingly, an inability to maintain growth, or an inability to effectively manage growth, could have a material adverse effect on our business, financial condition and results of operations. The further development and acceptance of digital currencies and blockchain technology are subject to a variety of factors that are difficult to evaluate, as discussed above. The slowing or stopping of the development or acceptance of digital currency networks and blockchain technology may adversely affect our ability to continue to grow and capitalize on our digital currency strategy.

The Bank has several large depositor relationships that are concentrated in the digital currency industry generally and among digital currency exchanges in particular, the loss of any of which could force us to fund our business through more expensive and less stable sources.

As of December 31, 2018, the Bank’s 10 largest depositors accounted for $843.6 million in deposits, or approximately 47.3% of the Bank’s total deposits, nine of whom are customers operating in the digital currency industry. Deposits from digital currency exchanges represent approximately 34.7% of the Bank’s overall deposits and are held by approximately 37 exchanges. Digital currency exchanges have discretion over which financial institution holds deposits on behalf of its customers. As a result, the Bank is exposed to high customer concentration with our exchange customers. A decision by the customers of an exchange to exit the exchange or a decision by an exchange to withdraw deposits or move deposits to our competitors could result in substantial changes in our deposit base. Exchanges present additional risks because they have been frequent targets and victims of fraud and cyber attacks and the failure or exit of one or more exchanges as customers could have a material adverse effect on our business, financial condition and results of operations.

In addition, withdrawals of deposits by any one of our largest depositors could force us to rely more heavily on borrowings and other sources of funding for our business and withdrawal demands, adversely affecting our net interest margin and results of operations. The Bank may also be forced, because of deposit withdrawals, to rely more heavily on other, potentially more expensive and less stable funding sources. Consequently, the occurrence of any of these events could have a material adverse effect on our business, financial condition and results of operations.

Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, which has driven the Bank’s funding costs to levels that may not be sustainable.

Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, and has allowed us to generate attractive returns on lower risk assets through increased investments in interest earning deposits in other banks and securities, as well as funding limited loan growth. We have increased our noninterest bearing deposits as a percentage of total deposits from 12.4% as of December 31, 2013 to 88.7%

 

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as of December 31, 2018, an increase that is largely attributable to our digital currency initiative. Our future growth may be adversely impacted if we are unable to retain and grow this strong, low-cost deposit base. There may be competitive pressures to pay higher interest rates on deposits to our digital currency customers, which could increase funding costs and compress net interest margins. Further, even if we are able to grow and maintain our noninterest bearing deposit base, our deposit balances may decrease if our digital currency customers are offered more attractive returns from our competitors. If our digital currency customers move funds out of deposits, we could lose a low cost source of funds, increasing our funding costs, reducing our net interest income and net interest margin, which could have a material adverse effect on our business, financial condition and results of operations.

The prices of digital currencies are extremely volatile. Fluctuations in the price of various digital currencies may cause uncertainty in the market and could negatively impact trading volumes of digital currencies and therefore the extent to which participants in the digital currency industry demand our services and solutions, which would adversely affect our business, financial condition and results of operations.

The value of digital currencies is based in part on market adoption and future expectations, which may or may not be realized. As a result, the prices of digital currencies are highly speculative. The prices of digital currencies have been subject to dramatic fluctuations to date. Several factors may affect price, including, but not limited to:

 

   

Global digital currency supply, including various alternative currencies which exist, and global digital currency demand, which can be influenced by the growth or decline of retail merchants’ and commercial businesses’ acceptance of digital currencies as payment for goods and services, the security of online digital currency exchanges and digital wallets that hold digital currencies, the perception that the use and holding of digital currencies is safe and secure and regulatory restrictions on their use;

 

   

Changes in the software, software requirements or hardware requirements underlying a blockchain network. For example, a fork occurs when there is a change to a digital currency’s underlying protocol, which creates new rules for the system. Forks in the future are likely to occur and there is no assurance that such a fork would not result in a sustained decline in the market price of digital currencies;

 

   

Changes in the rights, obligations, incentives, or rewards for the various participants in a blockchain network;

 

   

The maintenance and development of the software protocol of digital currencies;

 

   

Digital currency exchanges deposit and withdrawal policies and practices, liquidity on such exchanges and interruptions in service from or failures of such exchanges;

 

   

Regulatory measures, if any, that affect the use and value of crypto-assets;

 

   

Competition for and among various digital currencies that exist and market preferences and expectations with respect to adoption of individual currencies;

 

   

Actual or perceived manipulation of the markets for digital currencies;

 

   

Actual or perceived threats that digital currencies and related activities such as mining have adverse effects on the environment or are tied to illegal activities; and

 

   

Expectations with respect to the rate of inflation in the economy, monetary policies of governments, trade restrictions and currency devaluations and revaluations.

The digital currency market is volatile, and changes in the prices and/or trading volume of digital currencies may adversely impact our growth strategy and our business. In particular, the impact that changes in prices and/or trading volume of digital currencies have on our deposit balance from customers in the digital currency industry is unpredictable, as any reduction in deposits attributable to such changes may be amplified or mitigated by other developments, such as the onboarding of new customers, loss of existing customers and changes in our

 

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customers’ operational and trading strategies. For example, from December 31, 2017 to December 31, 2018 the price of bitcoin fell from $13,860.14 to $3,742.70, in line with the approximately 77.4% overall decrease in the market value of all digital currencies. Over this same period, the balance of our deposits from our customers in the digital currency industry increased $150.4 million, or approximately 11.4%, primarily due to approximately $837 million in net deposits from new accounts for customers in the digital currency industry, partially offset by decreases in deposit balances from existing digital currency customers. Although our overall deposit balance from customers in the digital currency industry increased from December 31, 2017 to December 31, 2018 despite the decrease in market value of digital currencies over the same period, there can be no assurance that a continued decrease in the value of digital currencies would not adversely impact the amount of such deposits in the future. In addition, volatility in the values of digital currencies caused by the factors described above or other factors may impact the demand for our services and therefore have a material adverse effect on our business, financial condition and results of operations.

Risks Related to Cybersecurity and Technology

System failure or cybersecurity breaches of our network security could subject us to increased operating costs as well as litigation and other potential losses.

Our computer systems and network infrastructure, including the SEN and API, could be vulnerable to hardware and cybersecurity issues. Our operations are dependent upon our ability to protect our computer equipment against damage from fire, power loss, telecommunications failure or a similar catastrophic event. We could also experience a breach by intentional or negligent conduct on the part of employees or other internal sources. Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations.

Our operations are also dependent upon our ability to protect our computer systems and network infrastructure, including the SEN, the API, and our other online banking systems, against damage from physical break-ins, cybersecurity breaches and other disruptive problems caused by the internet or other users. Such computer break-ins and other disruptions would jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability, damage our reputation and inhibit the use of our internet banking services by current and potential customers. We could also become the target of various cyberattacks as a result of our focus on the digital currency industry. We regularly add additional security measures to our computer systems and network infrastructure to mitigate the possibility of cybersecurity breaches, including firewalls and penetration testing. However, it is difficult or impossible to defend against every risk being posed by changing technologies as well as acts of cyber-crime. Increasing sophistication of cyber criminals and terrorists make keeping up with new threats difficult and could result in a system breach. Controls employed by our information technology department and cloud vendors could prove inadequate. A breach of our security that results in unauthorized access to our data could expose us to a disruption or challenges relating to our daily operations, as well as to data loss, litigation, damages, fines and penalties, significant increases in compliance costs and reputational damage, any of which could have a material adverse effect on our business, financial condition and results of operations.

We may not have the resources to keep pace with rapid technological changes in the industry or implement new technology effectively.

The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to serving customers better, the effective use of technology increases efficiency and enables financial institutions to reduce costs. As a result, to stay current with the industry, our business model may need to evolve as well. Our future success will depend, at least in part, upon 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 as we continue to grow and expand our products and service offerings. We may experience operational challenges as

 

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we implement these new technology enhancements or products, which could impair our ability to realize the anticipated benefits from such new technology or require us to incur significant costs to remedy any such challenges in a timely manner. From time to time, we may modify aspects of our business model relating to our product mix and service offerings. We cannot offer any assurance that these or any other modifications will be successful.

The technology relied upon by the Company, including the SEN, the API and our other on-line banking systems, may not function properly, which may have a material impact on the Company’s operations and financial conditions. There may be no alternatives available if such technology does not work as anticipated. The importance of the SEN, the API and our other on-line banking systems to the Company’s operations means that any problems in its functionality would have a material adverse effect on the Company’s operations. This technology may malfunction because of internal problems or because of cyberattacks or external security breaches. Any such technological problems would have a material adverse impact on the Company’s business model and growth strategy.

Many of our larger competitors have substantially greater resources to invest in technological improvements. Third parties upon which we rely for our technology needs may not be able to develop, on a cost-effective basis, systems that will enable us to keep pace with such developments. As a result, our larger competitors may be able to offer additional or superior products compared to those that we will be able to provide, which would put us at a competitive disadvantage. We may lose customers seeking new technology-driven products and services to the extent we are unable to provide such products and services. The ability to keep pace with technological change is important and the failure to do so could adversely affect our business, financial condition and results of operations.

Our operations could be interrupted if our third-party service providers experience operational or other systems difficulties, terminate their services or fail to comply with banking regulations.

We outsource some of our operational activities and accordingly depend on relationships with many third-party service providers. Specifically, we rely on third parties for certain services, including, but not limited to, core systems support, informational website hosting, internet services, online account opening and other processing services. Our business depends on the successful and uninterrupted functioning of our information technology and telecommunications systems and third-party service providers. The failure of these systems, a cybersecurity breach involving any of our third-party service providers or the termination or change in terms of a third-party software license or service agreement on which any of these systems is based could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. Replacing vendors or addressing other issues with our third-party service providers could entail significant delay, expense and disruption of service.

As a result, if these third-party service providers experience difficulties, are subject to cybersecurity breaches, or terminate their services, and we are unable to replace them with other service providers, particularly on a timely basis, our operations could be interrupted. If an interruption were to continue for a significant period, our business, financial condition and results of operations could be adversely affected. Even if we can replace third-party service providers, it may be at a higher cost to us, which could adversely affect our business, financial condition and results of operations.

In addition, the Bank’s primary federal regulator, the Federal Reserve, has issued guidance outlining the expectations for third-party service provider oversight and monitoring by financial institutions. The federal banking agencies, including the Federal Reserve, have also issued enforcement actions against financial institutions for failure in oversight of third-party providers and violations of federal banking law by such providers when performing services for financial institutions. Accordingly, our operations could be interrupted if any of our third-party service providers experience difficulties, are subject to cybersecurity breaches, terminate

 

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their services or fail to comply with banking regulations, which could adversely affect our business, financial condition and results of operations. In addition, our failure to adequately oversee the actions of our third-party service providers could result in regulatory actions against the Bank, which could adversely affect our business, financial condition and results of operations.

Risks Related to Our Traditional Banking Business

As a business operating in the financial services industry, our business and operations may be adversely affected in numerous and complex ways by weak economic conditions.

Our business and operations, which primarily consist of lending money to clients in the form of loans, borrowing money from clients in the form of deposits and investing in interest earning deposits in other banks and securities, are sensitive to general business and economic conditions in the United States. We solicit deposits throughout the United States and, while our primary lending market is the state of California, we purchase and originate loans throughout the United States. If the U.S. economy weakens, our growth and profitability from our lending, deposit and investment operations could be constrained. Uncertainty about the federal fiscal policymaking process, the medium- and long-term fiscal outlook of the federal government and future tax rates is a concern for businesses, consumers and investors in the United States. While there has been an improvement in the U.S. economy since the 2008 financial crisis as evidenced by a rebound in the housing market, lower unemployment and higher equity capital markets, economic growth has been uneven and opinions vary on the strength and direction of the economy. Uncertainties also have arisen regarding the potential for a reversal or renegotiation of international trade agreements, the effects of the legislation commonly known as Tax Cuts and Jobs Act of 2017, or the Tax Act, and the impact such actions and other policies the current administration may have on economic and market conditions.

Weak economic conditions are characterized by numerous factors, including deflation, fluctuations in debt and equity capital markets, a lack of liquidity and depressed prices in the secondary market for mortgage loans, increased delinquencies on mortgage, consumer and commercial loans, residential and commercial real estate price declines and lower levels of home sales and commercial activity. The current economic environment is characterized by lower interest rates than historically have been the case, which impacts our ability to generate attractive earnings through our loan and investment portfolios. These factors can individually or in the aggregate be detrimental to our business, and the interplay between these factors can be complex and unpredictable. Adverse economic conditions could have a material adverse effect on our business, financial condition and results of operations.

Our commercial banking clients and their operations are concentrated in Southern California and we are more sensitive than our more geographically diversified competitors to adverse changes in the local economy.

Unlike many of our larger competitors that maintain significant operations located outside our market area, a substantial portion of our commercial business clients are located and doing business in Southern California. Therefore, our success depends substantially upon the general economic conditions in this area, which we cannot predict with certainty. As a result, our operations and profitability may be more adversely affected by a local economic downturn in Southern California than those of larger, more geographically diverse competitors. A downturn in the local economy generally could make it more difficult for our borrowers to repay their loans and may lead to loan losses that are not offset by operations in other markets. For these reasons, any regional or local economic downturn that affects Southern California, or existing or prospective borrowers in Southern California, could have a material adverse effect on our business, financial condition and results of operations. To a significantly lesser extent, our Bank provides financing to clients who live or have companies or properties located outside our core Southern California markets, such as Arizona and Florida. In such cases, we would face similar local market risks in those communities for these clients.

 

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

We operate in the highly competitive financial services industry and face significant competition for customers from financial institutions located both within and beyond our principal markets. We compete with commercial banks, savings banks, credit unions, nonbank financial services companies and other financial institutions operating both within our market areas and nationally, and in respect of our digital currency initiative we also compete with other entities in the digital currency industry, including a limited number of other banks providing services to the digital currency industry and digital currency exchanges. In addition, as customer preferences and expectations continue to evolve, technology has lowered barriers to entry and made it possible for banks to expand their geographic reach by providing services over the internet and for nonbanks to offer products and services traditionally provided by banks, such as automatic payment systems. The banking industry is experiencing rapid changes in technology and, as a result, our future success will depend in part on our ability to address our customers’ needs by using technology. Customer loyalty can be influenced by a competitor’s new products, especially offerings that could provide cost savings or a higher return to the customer. Increased lending activity of competing banks following the 2008–2009 economic downturn has also led to increased competitive pressures on loan rates and terms for high quality credits. We may not be able to compete successfully with other financial institutions in our markets, and we may have to pay higher interest rates to attract deposits, accept lower yields to attract loans and pay higher wages for new employees, resulting in lower net interest margins and reduced profitability.

Many of our non-bank competitors are not subject to the same extensive regulations that govern our activities and may have greater flexibility in competing for business. The financial services industry could become even more competitive because of legislative, regulatory and technological changes and continued consolidation. In addition, some of our current commercial banking customers may seek alternative banking sources as they develop needs for credit facilities larger than we may be able to accommodate.

Our inability to compete successfully in the markets in which we operate could have a material adverse effect on our business, financial condition or results of operations.

We may not be able to measure and limit our credit risk adequately, which could lead to unexpected losses.

The business of lending is inherently risky, including risks that the principal of or interest on any loan will not be repaid in a timely manner or at all or that the value of any collateral supporting the loan will be insufficient to cover our outstanding exposure. These risks may be affected by the financial condition of the borrower, the strength of the borrower’s business sector and local, regional and national market and economic conditions. Many of our loans are made to small- to medium-sized businesses that may be less able to withstand competitive, economic and financial pressures than larger borrowers. Our risk management practices, such as monitoring the concentration of our loans within specific industries, and our credit approval practices may not adequately reduce credit risk. Further, our credit administration personnel, policies and procedures may not adequately adapt to changes in economic or any other conditions affecting customers and the quality of the loan portfolio. A failure to measure and limit the credit risk associated with our loan portfolio effectively could lead to unexpected losses and have a material adverse effect on our business, financial condition and results of operations.

Our allowance for loan losses may prove to be insufficient to absorb potential losses in our loan portfolio.

We maintain an allowance for loan losses that represents management’s judgment of probable losses and risks inherent in our loan portfolio. As of December 31, 2018, our allowance for loan losses totaled $6.7 million, which represents approximately 1.13% of our total gross loans held-for-investment. The level of the allowance reflects management’s continuing evaluation of general economic conditions, diversification and seasoning of the loan portfolio, historic loss experience, identified credit problems, delinquency levels and adequacy of

 

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collateral. The determination of the appropriate level of our allowance for loan losses is inherently highly subjective and requires management to make significant estimates of and assumptions regarding current credit risks, all of which may undergo material changes. Inaccurate management assumptions, deterioration of economic conditions affecting borrowers, new information regarding existing loans, identification or deterioration of additional problem loans, acquisition of problem loans and other factors (including third-party review and analysis), both within and outside of our control, may require us to increase our allowance for loan losses. In addition, our regulators, as an integral part of their periodic examination, review our methodology for calculating, and the adequacy of, our allowance for loan losses and may direct us to make additions to the allowance based on their judgments about information available to them at the time of their examination. Further, if actual charge-offs in future periods exceed the amounts allocated to our allowance for loan losses, we may need additional provisions for loan losses to restore the adequacy of our allowance for loan losses. Finally, the measure of our allowance for loan losses depends on the adoption and interpretation of accounting standards. The Financial Accounting Standards Board, or FASB, has recently issued a new credit impairment model, the Current Expected Credit Loss, or CECL, model, which will become applicable to us on January 1, 2020. The CECL model will require financial institutions to estimate and develop a provision for credit losses over the lifetime of the loan at origination, as opposed to reserving for probable incurred losses up to the balance sheet date. Under the CECL model, our estimate of credit losses over the life of the loan would be reflected in the statement of operations in the period of origination or acquisition of the loan, with changes in expected credit losses due to further credit deterioration or improvement reflected in the periods in which the expectation changes. Accordingly, the CECL model could require financial institutions like the Bank to increase their allowances for loan losses. Moreover, the CECL model may create more volatility in our level of 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.

Our commercial real estate loan portfolio exposes us to credit risks that may be greater than the risks related to other types of loans.

As of December 31, 2018, approximately $309.7 million, or 51.9%, of our total gross loans held-for-investment were commercial real estate loans (including owner-occupied commercial real estate loans). Further, as of December 31, 2018, our commercial real estate loans (excluding owner-occupied commercial real estate loans) totaled 160.5% of our total risk-based capital. These loans typically involve repayment that depends upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service. The availability of such income for repayment may be adversely affected by changes in the economy or local market conditions. These loans expose a lender to the risk of liquidating the collateral securing these loans in times when there may be significant fluctuation of commercial real estate values. Additionally, commercial real estate loans generally involve relatively large balances to single borrowers or related groups of borrowers. Unexpected deterioration in the credit quality of our commercial real estate loan portfolio could require us to increase our allowance for loan losses, which would reduce our profitability and could have a material adverse effect on our business, financial condition and results of operations.

Because a significant portion of our loan portfolio held-for-investment is comprised of real estate loans, negative changes in the economy affecting real estate values and liquidity could impair the value of collateral securing our real estate loans and result in loan and other losses.

As of December 31, 2018, approximately $546.7 million, or 91.6%, of our total gross loans held-for-investment were loans with real estate as a primary or secondary component of collateral. The market value of real estate can fluctuate significantly in a short period of time. As a result, adverse developments affecting real estate values and the liquidity of real estate in our primary markets could increase the credit risk associated with our loan portfolio, and could result in losses that adversely affect our credit quality, financial condition and results of operations. Negative changes in the economy affecting real estate values and liquidity in our market areas could significantly impair the value of property pledged as collateral on loans and affect our ability to sell the collateral upon foreclosure without a loss or additional losses. Collateral may have to be sold for less than the

 

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outstanding balance of the loan, which could result in losses on such loans. Such declines and losses would have a material adverse effect on our business, financial condition and results of operations. If real estate values decline, it is also more likely that we would be required to increase our allowance for loan losses, which could adversely affect our business, financial condition and results of operations.

Appraisals and other valuation techniques we use in evaluating and monitoring loans secured by real property, other real estate owned and repossessed personal property may not accurately describe the net value of the asset.

In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made and, as real estate values may change significantly in relatively short periods of time (especially in periods of heightened economic uncertainty), this estimate may not accurately describe the net value of the real property collateral after the loan is made. As a result, we may not be able to realize the full amount of any remaining indebtedness when we foreclose on and sell the relevant property. In addition, we rely on appraisals and other valuation techniques to establish the value of our other real estate owned, or OREO, and personal property that we acquire through foreclosure proceedings and to determine certain loan impairments. If any of these valuations are inaccurate, our combined and consolidated financial statements may not reflect the correct value of our OREO, and our allowance for loan losses may not reflect accurate loan impairments. This could have a material adverse effect on our business, financial condition or results of operations.

In the case of defaults on loans secured by real estate, we may be forced to foreclose on the collateral, subjecting us to the costs and potential risks associated with the ownership of the real property, or consumer protection initiatives or changes in state or federal law that may substantially raise the cost of foreclosure or prevent us from foreclosing at all.

Since we originate loans secured by real estate, we may have to foreclose on the collateral property to protect our investment and may thereafter own and operate such property for some period, in which case we would be exposed to the risks inherent in the ownership of real estate. As of December 31, 2018, we held approximately $31,000 in OREO that is currently marketed for sale. The amount that we, as a mortgagee, may realize after a default depends on factors outside of our control, including, but not limited to, general or local economic conditions, environmental cleanup liabilities, assessments, interest rates, real estate tax rates, operating expenses of the mortgaged properties, our ability to obtain and maintain adequate occupancy of the properties, zoning laws, governmental and regulatory rules, and natural disasters. Our inability to manage the amount of costs or size of the risks associated with the ownership of real estate, or write-downs in the value of other real estate owned, could have a material adverse effect on our business, financial condition and results of operations.

Additionally, consumer protection initiatives or changes in state or federal law may substantially increase the time and expense associated with the foreclosure process or prevent us from foreclosing at all. Some states in recent years have either considered or adopted foreclosure reform laws that make it substantially more difficult and expensive for lenders to foreclose on properties in default. If new state or federal laws or regulations are ultimately enacted that significantly raise the cost of foreclosure or raise outright barriers, such laws could have a material adverse effect on our business, financial condition and results of operation.

We are subject to claims and litigation pertaining to intellectual property.

Banking and other financial services companies, such as our Company, rely on technology companies to provide information technology products and services necessary to support their day-to-day operations. Technology companies frequently pursue litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. Competitors of our vendors, or other individuals or companies, may from time to time claim to hold intellectual property sold to us by our vendors. Such claims may increase in the future

 

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as the financial services sector becomes more reliant on information technology vendors. The plaintiffs in these actions frequently seek injunctions and substantial damages.

Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, we may have to engage in protracted litigation. Such litigation is often expensive, time-consuming, disruptive to our operations and distracting to management. If we are found to infringe one or more patents or other intellectual property rights, we may be required to pay substantial damages or royalties to a third party. In certain cases, we may consider entering into licensing agreements for disputed intellectual property, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase our operating expenses. If legal matters related to intellectual property claims were resolved against us or settled, we could be required to make payments in amounts that could have a material adverse effect on our business, financial condition and results of operations.

Third parties may assert intellectual property claims relating to the holding and transfer of digital assets and their source code. Regardless of the merit of any intellectual property or other legal action, any threatened action that reduces confidence in long-term viability or the ability of end-users to hold and transfer the currency may adversely affect an investment in digital currencies. Additionally, a meritorious intellectual property claim could prevent investors and other end-users from accessing, holding or transferring their digital currency, which could force the liquidation of holdings of such digital currency (if liquidation is possible). As a result, intellectual property claims against large digital currency participants could adversely affect the business and operations of digital currency exchanges as well as our own.

We may not be able to protect our intellectual property rights, and may become involved in lawsuits to protect or enforce our intellectual property, which could be expensive, time consuming and unsuccessful.

Competitors may violate our intellectual property rights. To counter infringement or unauthorized use, litigation may be necessary to enforce or defend our intellectual property rights, to protect our trade secrets and/or to determine the validity and scope of our own intellectual property rights or the proprietary rights of others. Such litigation can be expensive and time consuming, which could divert management resources and harm our business and financial results. Potential competitors may have the ability to dedicate greater resources to litigate intellectual property rights than we can. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.

We may be subject to environmental liabilities relating to the real properties we own and the foreclosure on real estate assets securing loans in our loan portfolio.

In conducting our business, we may foreclose on and take title to real estate or otherwise be deemed to be in control of property that serves as collateral on loans we make. As a result, we could be subject to environmental liabilities with respect to those properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties relating to environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.

The cost of removal or abatement may substantially exceed the value of the affected properties or the loans secured by those properties, we may not have adequate remedies against the prior owners or other responsible parties and we may not be able to resell the affected properties either before or after completion of any such removal or abatement procedures. If material environmental problems are discovered before foreclosure, we generally will not foreclose on the related collateral or will transfer ownership of the loan to a subsidiary. It

 

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should be noted, however, that the transfer of the property or loans to a subsidiary may not protect us from environmental liability. Furthermore, despite these actions on our part, the value of the property as collateral will generally be substantially reduced or we may elect not to foreclose on the property and, as a result, we may suffer a loss upon collection of the loan. Any significant environmental liabilities could have a material adverse effect on our business, financial condition and results of operations.

Our mortgage warehouse division may not continue to provide us with significant noninterest income and interest income.

A portion of our lending involves the funding of single family residential mortgage loans originated by third party mortgage bankers. Mortgage warehouse fee income has fluctuated with mortgage warehouse activity and such income amounted to $1.5 million and $1.7 million for the years ended December 31, 2018 and 2017, respectively. The residential mortgage business is highly competitive and highly susceptible to changes in market interest rates, consumer confidence levels, employment statistics, the capacity and willingness of secondary market purchasers to acquire and hold or securitize loans, and other factors beyond our control. Additionally, in many respects, the traditional mortgage origination business is relationship-based, and dependent on mortgage banker relationships. The loss one or more mortgage banker relationships could have the effect of reducing the level or rate of growth of our mortgage warehouse activity. Because of these factors, we cannot be certain that we will be able to maintain or increase the volume or percentage of revenue or net income produced by the mortgage warehouse business.

Our mortgage warehouse lending business may expose us to increased lending and other risks.

Risks associated with our mortgage warehouse loans include risks relating to the mortgage bankers to which we provide funding, including the risk of intentional misrepresentation or fraud; changes in the market value of mortgage loans originated by the mortgage banker, the sale of which is the expected source of repayment of the warehouse funding we provide, due to changes in interest rates during the time in warehouse; and originations of mortgage loans that are unsalable or impaired, which could lead to decreased collateral value and the failure of a prospective purchaser of the mortgage loan to ultimately purchase the loan from the mortgage banker. Any one or a combination of these events may adversely affect our loan portfolio and may result in increased delinquencies, loan losses and increased future provision levels, which, in turn, could adversely affect our business, financial condition and results of operations.

Our concentration of large loans to a limited number of borrowers may increase our credit risk.

As of December 31, 2018, our 10 largest borrowing relationships accounted for approximately 33.3% of our total gross loans held-for-investment. Along with other risks inherent in these loans, such as the deterioration of the underlying businesses or property securing these loans, this high concentration of borrowers presents a risk to our lending operations. If any one of these borrowers becomes unable to repay its loan obligations because of economic or market conditions, or personal circumstances, such as divorce or death, our nonaccrual loans and our allowance for loan and lease losses could increase significantly, which could have a material adverse effect on our assets, business, financial condition and results of operations.

A lack of liquidity could impair our ability to fund operations and adversely impact our business, financial condition and results of operations.

Liquidity is essential to our business. We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities, respectively, to ensure that we have adequate liquidity to fund our operations. An inability to raise funds through deposits, borrowings, sales of our investment securities, sales of loans or other sources could have a substantial negative effect on our liquidity and our ability to continue our growth strategy.

 

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Our most important source of funds is deposits. As of December 31, 2018, approximately $1.6 billion, or 88.7%, of our total deposits were noninterest bearing demand accounts. These deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control, such as a loss of confidence by customers in us or the banking sector generally, customer perceptions of our financial health and general reputation, any of which could result in significant outflows of deposits within short periods of time increasing our funding costs and reducing our net interest income and net income. Substantially all of these noninterest bearing demand accounts are deposits from our customers in the digital currency industry.

Additional liquidity is provided by our ability to borrow from the Federal Home Loan Bank of San Francisco, or the FHLB, and the Federal Reserve Bank of San Francisco, or the FRB. We also may borrow funds from third-party lenders, such as other financial institutions. Our access to funding sources in amounts adequate to finance or capitalize our activities, or on terms that are acceptable to us, could be impaired by factors that affect us directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. Our access to funding sources could also be affected by one or more adverse regulatory actions against us.

Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could, in turn, have a material adverse effect on our business, financial condition and results of operations.

By engaging in derivative transactions, we are exposed to additional credit and market risk.

By engaging in derivative transactions, we are exposed to counterparty credit and market risk. If the counterparty fails to perform, credit risk exists to the extent of the fair value gain in the derivative. Market risk exists to the extent that interest rates change in ways that are significantly different from what was modeled when we entered into the derivative transaction. The existence of credit and market risk associated with our derivative instruments could adversely affect our mortgage banking revenue and, therefore, could have a material adverse effect on our business, financial condition and results of operations.

We are dependent on the use of data and modeling in our management’s decision-making, and faulty data or modeling approaches could negatively impact our decision-making ability or possibly subject us to regulatory scrutiny in the future.

The use of statistical and quantitative models and other quantitative analyses is necessary for bank decision-making, and the employment of such analyses is becoming increasingly widespread in our operations.

Liquidity stress testing, interest rate sensitivity analysis and the identification of possible violations of anti-money laundering regulations are all examples of areas in which we are dependent on models and the data that underlies them. The use of statistical and quantitative models is also becoming more prevalent in regulatory compliance. While we are not currently subject to annual Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, stress testing and the Comprehensive Capital Analysis and Review submissions, we believe that model-derived testing may become more extensively implemented by regulators in the future.

We anticipate data-based modeling will penetrate further into bank decision-making, particularly risk management efforts, as the capacities developed to meet rigorous stress testing requirements are able to be employed more widely and in differing applications. While we believe these quantitative techniques and approaches improve our decision-making, they also create the possibility that faulty data or flawed quantitative approaches could negatively impact our decision-making ability or, if we become subject to regulatory stress-testing in the future, adverse regulatory scrutiny. Secondarily, because of the complexity inherent in these approaches, misunderstanding or misuse of their outputs could similarly result in suboptimal decision-making.

 

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We are subject to interest rate risk as fluctuations in interest rates may adversely affect our earnings.

Most of our banking assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, our earnings are significantly dependent on our net interest income, the principal component of our earnings, which is the difference between interest earned by us from our interest earning assets, such as loans and investment securities, and interest paid by us on our interest bearing liabilities, such as deposits and borrowings. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest bearing liabilities will be more sensitive to changes in market interest rates than our interest earning assets, or vice versa. In either case, if market interest rates should move contrary to our position, this gap will negatively impact our earnings. The impact on earnings is more adverse when the slope of the yield curve flattens; that is, when short-term interest rates increase more than long-term interest rates or when long-term interest rates decrease more than short-term interest rates. Many factors impact interest rates, including governmental monetary policies, inflation, recession, changes in unemployment, the money supply, international economic weakness and disorder and instability in domestic and foreign financial markets. In addition, the Federal Reserve has stated its intention to end its quantitative easing program and has begun to reduce the size of its balance sheet by selling securities, which might also affect interest rates. As of December 31, 2018, approximately 88.2% of our interest earning assets and approximately 85.3% of our interest bearing liabilities had a variable interest rate.

Interest rate increases often result in larger payment requirements for our borrowers, which increases the potential for default and could result in a decrease in the demand for loans. At the same time, the marketability of the property securing a loan may be adversely affected by any reduced demand resulting from higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as borrowers refinance their loans at lower rates. In addition, in a low interest rate environment, loan customers often pursue long-term fixed rate borrowings, which could adversely affect our earnings and net interest margin if rates later increase. Changes in interest rates also can affect the value of loans, securities and other assets. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on loans may lead to an increase in nonperforming assets and a reduction of income recognized, which could have a material adverse effect on our results of operations and cash flows. Further, when we place a loan on nonaccrual status, we reverse any accrued but unpaid interest receivable, which decreases interest income. At the same time, we continue to incur costs to fund the loan, which is reflected as interest expense, without any interest income to offset the associated funding expense. Thus, an increase in the amount of nonperforming assets could have a material adverse impact on net interest income. If short-term interest rates remain at their historically low levels for a prolonged period and assuming longer-term interest rates fall further, we could experience net interest margin compression as our interest earning assets would continue to reprice downward while our interest bearing liability rates could fail to decline in tandem. Such an occurrence would reduce our net interest income and could have a material adverse effect on our business, financial condition and results of operations.

The potential cessation of LIBOR and the uncertainty over possible replacements for LIBOR may adversely affect our business.

On July 27, 2017, the Chief Executive of the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it intends to stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. The announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. It is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. The potential cessation of LIBOR quotes in 2021 and the uncertainty over possible replacement rates for LIBOR creates substantial risks to the banking industry, including us.

At this time, no consensus exists as to what rate or rates may become accepted alternatives to LIBOR and it is impossible to predict the cost of transitioning to or the effect of any such alternatives on the value of LIBOR-based securities or the outstanding loans with interest rates based on LIBOR that we have made to borrowers,

 

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including certain of the Company’s floating rate subordinated debentures, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally. If a published LIBOR rate is unavailable after 2021, the interest rates on our subordinated debentures, which are currently based on the LIBOR rate, will be determined as set forth in the accompanying offering documents, and the value of such securities may be adversely affected. Uncertainty as to the nature of alternative reference rates and as to potential changes or other reforms to LIBOR could also cause confusion that could disrupt the capital and credit markets more broadly. Currently, the manner and impact of this transition and related developments, as well as the effect of an alternative reference rate on our future and legacy funding costs, loan and investment securities portfolios, asset-liability management and business, is uncertain.

Any future failure to maintain effective internal control over financial reporting could impair the reliability of our financial statements, which in turn could harm our business, impair investor confidence in the accuracy and completeness of our financial reports and our access to the capital markets and cause the price of our common stock to decline and subject us to regulatory penalties.

If we fail to maintain effective internal control over financial reporting, we may not be able to report our financial results accurately and in a timely manner, in which case our business may be harmed, investors may lose confidence in the accuracy and completeness of our financial reports, we could be subject to regulatory penalties and the price of our common stock may decline.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting and for evaluating and reporting on that system of internal control. Our internal control over financial reporting consists of a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, or GAAP. As a public company, we will be required to comply with the Sarbanes-Oxley Act and other rules that govern public companies. We will be required to certify our compliance with Section 404 of the Sarbanes-Oxley Act beginning with our second annual report on Form 10-K, which will require us to furnish annually a report by management on the effectiveness of our internal control over financial reporting. In addition, our independent registered public accounting firm may be required to report on the effectiveness of our internal control over financial reporting beginning as of that second annual report on Form 10-K.

The accuracy of our financial statements and related disclosures could be affected if the judgments, assumptions or estimates used in our critical accounting policies are inaccurate.

The preparation of financial statements and related disclosures in conformity with GAAP requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are included in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this prospectus, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider critical because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events or regulatory views concerning such analysis differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures, in each case resulting in our need to revise or restate prior period financial statements, cause damage to our reputation and the price of our common stock and adversely affect our business, financial condition and results of operations.

There could be material changes to our financial statements and disclosures if there are changes in accounting standards or regulatory interpretations of existing standards

From time to time the FASB or the SEC may change the financial accounting and reporting standards that govern the preparation of our financial statements. Such changes may result in us being subject to new or

 

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changing accounting and reporting standards. In addition, the bodies that interpret the accounting standards (such as banking regulators or outside auditors) may change their interpretations or positions on how new or existing standards should be applied. These changes may be beyond our control, 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 retrospectively, or apply an existing standard differently and retrospectively, in each case resulting in our needing to revise or restate prior period financial statements, which could materially change our financial statements and related disclosures, cause damage to our reputation and the price of our common stock, and adversely affect our business, financial condition and results of operations.

We could recognize losses on investment securities held in our securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.

We invest a percentage of our total assets (17.8% as of December 31, 2018) in investment securities with the primary objectives of providing a source of liquidity, providing an appropriate return on funds invested, managing interest rate risk and meeting pledging requirements. As of December 31, 2018, the fair value of our available-for-sale investment securities portfolio was $357.2 million, which included gross unrealized losses of $2.8 million and gross unrealized gains of $0.3 million. Factors beyond our control can significantly and adversely influence the fair value of securities in our portfolio. For example, fixed-rate securities are generally subject to decreases in market value when interest rates rise. Additional factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual borrowers with respect to the underlying securities and instability in the credit markets. Any of the foregoing factors could cause other-than-temporary impairment in future periods and result in realized losses. The process for determining whether impairment is other-than-temporary usually requires difficult, subjective judgments about the future financial performance of the issuer and any collateral underlying the security to assess the probability of receiving all contractual principal and interest payments on the security. Because of changing economic and market conditions affecting interest rates, the financial condition of issuers of the securities and the performance of the underlying collateral, we may recognize realized and/or unrealized losses in future periods, which could have a material adverse effect on our business, financial condition and results of operations.

We are subject to certain operational risks, including, but not limited to, customer, employee or third-party fraud and data processing system failures and errors.

Employee errors and employee or customer misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence.

We maintain a system of internal controls to mitigate operational risks, including data processing system failures and errors and customer or employee fraud, as well as insurance coverage designed to protect us from material losses associated with these risks, including losses resulting from any associated business interruption. If our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could adversely affect our business, financial condition and results of operations.

In addition, we rely heavily upon information supplied by third parties, including the information contained in credit applications, property appraisals, title information and employment and income documentation, in deciding which loans we will originate, as well as the terms of those loans. If any of the information upon which we rely is misrepresented, either fraudulently or inadvertently, and the misrepresentation is not detected prior to loan funding, the value of the loan may be significantly lower than expected, or we may fund a loan that we would not have funded or on terms that do not comply with our general underwriting standards. Whether a misrepresentation is made by the applicant or another third party, we generally bear the risk of loss associated

 

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with the misrepresentation. A loan subject to a material misrepresentation is typically unsellable or subject to repurchase if it is sold prior to detection of the misrepresentation. The sources of the misrepresentations are often difficult to locate, and it is often difficult to recover any of the resulting monetary losses we may suffer, which could adversely affect our business, financial condition and results of operations.

We rely heavily on our executive management team and other key employees, and we could be adversely affected by the unexpected loss of their services.

We are led by an experienced core management team with substantial experience in the markets that we serve, and our operating strategy focuses on providing products and services through long-term relationship managers and ensuring that our largest clients have relationships with our senior management team. Accordingly, our success depends in large part on the performance of these key personnel, as well as on our ability to attract, motivate and retain highly qualified senior and middle management. Competition for employees is intense and the process of locating key personnel with the combination of skills and attributes required to execute our business plan may be lengthy. If any of our executive officers, other key personnel or directors leaves us or our Bank, our financial condition and results of operations may suffer because of his or her skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified personnel to replace him or her.

Negative public opinion regarding the Company or failure to maintain our reputation in the communities we serve could adversely affect our business and prevent us from growing our business.

As a community bank and service provider to the digital currency industry, our Bank’s reputation within the communities we serve is critical to our success. We believe we have built strong personal and professional relationships with our customers and are active members of the communities we serve. As such, we strive to enhance our reputation by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve and delivering superior service to our customers. If our reputation is negatively affected by the actions of our employees or otherwise, including because of a successful cyberattack against us or other unauthorized release or loss of customer information, we may be less successful in attracting new talent and customers or may lose existing customers, and our business, financial condition and results of operations could be adversely affected. In addition, if the reputation of the digital currency industry as a whole is harmed, including due to events such as cybersecurity breaches, scams perpetrated by bad actors or other unforeseen developments as a result of the evolving regulatory landscape of the digital currency industry, our reputation may be negatively affected due to our connection with the digital currency industry, which could adversely affect our business, financial condition and results of operations. Our exposure to and interactions with the digital currency industry put us at a higher risk of media attention and scrutiny. Further, negative public opinion can expose us to litigation and regulatory action and delay and impede our efforts to implement our expansion strategy, which could further adversely affect our business, financial condition and results of operations.

We may not be able to raise the additional capital needed, in absolute terms or on terms acceptable to us, to fund our growth in the future if we continue to grow at our current pace.

After giving effect to this offering, we believe that we will have sufficient capital to meet our capital needs for our immediate growth plans. However, we will continue to need capital to support our longer-term growth plans. If capital is not available on favorable terms when we need it, we will have to either issue common stock or other securities on less than desirable terms or reduce our rate of growth until market conditions become more favorable. Either of such events could have a material adverse effect on our business, financial condition and results of operations.

 

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Risks Related to Regulation

There is substantial legal and regulatory uncertainty regarding the regulation of digital currencies and digital currency activities. This uncertainty or adverse regulatory changes may inhibit the growth of the digital currency industry, including our customers, and therefore have a material adverse effect on the digital currency initiative.

The U.S. Congress, U.S. state legislatures, and a number of U.S. federal and state regulators and law enforcement agencies, including FinCEN, U.S. federal banking regulators, SEC, CFTC, the Financial Industry Regulatory Authority, or FINRA, the Consumer Financial Protection Bureau, or CFPB, the Department of Justice, the Department of Homeland Security, the Federal Trade Commission, the Federal Bureau of Investigation, the Internal Revenue Service, or the IRS, and state banking regulators, state financial services regulators, and states attorney generals, have been examining the operations of digital currency networks, exchanges, and digital currency businesses, with particular focus on the extent to which digital currencies can be used for illegal activities, including but not limited to laundering the proceeds of illegal activities, funding criminal or terrorist enterprises, engaging in fraudulent activities (see “—Risks Related to the Digital Currency Industry”), as well as whether and the extent to which digital currency businesses should be subject to existing or new regulation, including those applicable to banks, securities intermediaries, derivatives intermediaries, or money transmitters.

For example, FinCEN requires firms engaged in the business of administration, exchange, or transmission of a virtual currency to register with FinCEN under its money services business licensing regime. The New York DFS has established a licensing regime for businesses involved in virtual currency business activity in or involving New York, commonly known as BitLicense regime. The SEC and CFTC have each issued formal and informal guidance on the applicability of securities and derivatives regulations to digital currencies and digital currency activities. The SEC has suggested that, depending on the circumstances, an initial coin offering, or ICO, may constitute securities offerings subject to the provisions of the Securities Act of 1933, as amended, or the Securities Act, and the Securities Exchange Act of 1934, as amended, or the Exchange Act, and that some ICOs in the past have been illegal, which could, in turn, result in regulatory actions or other scrutiny against our customers or us. The SEC has also stated that venues that permit trading of tokens that are deemed securities are required to either register as national securities exchanges under Section 6 of the Exchange Act or obtain an exemption. If any of our digital currency customers are subject to regulatory actions relating to illegal securities offerings or are required to register as a national securities exchange under the Exchange Act, we may experience a substantial loss of deposits and our business may be materially adversely affected.

Many state and federal agencies have also issued consumer advisories regarding the risks posed to users and investors in digital currencies. U.S. federal and state legislatures, regulators and law enforcement agencies continue to develop views and approaches to a wide variety of digital currencies and activities involved in digital currencies and it is likely that, as the legal and regulatory landscape develops, additional regulatory requirements could apply to digital currency businesses, including our digital currency customers and us. U.S. state and federal, and foreign regulators and legislatures have taken legal actions against digital currency businesses or adopted restrictions in response to adverse publicity arising from hacks, consumer harm, criminal activity, or other activities related to digital currencies. Ongoing and future regulatory actions may alter, perhaps to a materially adverse extent, the nature of the digital currency industry or the ability of our customers to continue to operate. This may significantly impede the viability or growth of our existing funding sources based on deposits from digital currency business as well as our digital currency initiative. In addition, we may become subject to additional regulatory scrutiny as a result of certain aspects of our growth strategy, including our plans to develop custodian services and to expand our international customer base.

Digital currencies and digital currency related activities also currently face an uncertain regulatory landscape in many foreign jurisdictions such as the European Union, China, the United Kingdom, Australia, Japan, Russia, Israel, Poland, India, Hong Kong, Canada and Singapore. Various foreign jurisdictions may adopt laws regulations or directives that affect digital currencies. Such laws, regulations or directives may conflict with those of the United States and may negatively impact the acceptance of digital currencies by users, merchants and service providers

 

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outside the United States and may therefore impede the growth or sustainability of the digital currency industry in these jurisdictions as well as in the United States and elsewhere, or otherwise negatively affect the digital currency industry or our customers, which may adversely affect our digital currency initiative and could therefore result in a material adverse effect on our business, financial condition, results of operations and growth prospects.

Legislative and regulatory actions taken now or in the future may increase our costs and impact our business, governance structure, financial condition or results of operations.

Economic conditions that contributed to the financial crisis in 2008, particularly in the financial markets, resulted in government regulatory agencies and political bodies placing increased focus and scrutiny on the financial services industry. The Dodd-Frank Act, which was enacted in 2010 as a response to the financial crisis, significantly changed the regulation of financial institutions and the financial services industry. The Dodd-Frank Act and the regulations thereunder have affected both large and small financial institutions. The Dodd-Frank Act, among other things, imposed new capital requirements on bank holding companies; changed the base for FDIC insurance assessments to a bank’s average consolidated total assets minus average tangible equity, rather than upon its deposit base; raised the standard deposit insurance limit to $250,000; and expanded the FDIC’s authority to raise insurance premiums. The Dodd-Frank Act established the CFPB as an independent entity within the Federal Reserve, which has broad rulemaking authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans and credit cards, and contains provisions on mortgage-related matters, such as steering incentives, determinations as to a borrower’s ability to repay and prepayment penalties. Compliance with the Dodd-Frank Act and its implementing regulations has and may continue to result in additional operating and compliance costs that could have a material adverse effect on our business, financial condition, results of operations and growth prospects.

On May 24, 2018, President Trump signed into law the “Economic Growth, Regulatory Relief and Consumer Protection Act,” or the Regulatory Relief Act, which amends parts of the Dodd-Frank Act, as well as other laws that involve regulation of the financial industry. While the Regulatory Relief Act keeps in place fundamental aspects of the Dodd-Frank Act’s regulatory framework, it does make regulatory changes that are favorable to depository institutions with assets under $10 billion, such as the Bank, and to bank holding companies, or BHCs, with total consolidated assets of less than $10 billion, such as the Company, and also makes changes to consumer mortgage and credit reporting regulations and to the authorities of the agencies that regulate the financial industry. These and other changes are more fully discussed under “Supervision and Regulation—The Regulatory Relief Act.” Certain provisions of the Regulatory Relief Act favorable to the Company and the Bank require the federal banking agencies to either promulgate regulations or amend existing regulations, and it may take some time for these agencies to implement the necessary regulations or amendments.

Federal and state regulatory agencies frequently adopt changes to their regulations or change the way existing regulations are applied. Regulatory or legislative changes to laws applicable to the financial industry, if enacted or adopted, may impact the profitability of our business activities, require more oversight or change certain of our business practices, including the ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads and could expose us to additional costs, including increased compliance costs. These changes also may require us to invest significant management attention and resources to make any necessary changes to operations to comply and could have a material adverse effect on our business, financial condition and results of operations.

Changes in tax laws and regulations, or changes in the interpretation of existing tax laws and regulations, may have a material adverse effect on our business, financial condition, results of operations and growth prospects.

We operate in an environment that imposes income taxes on our operations at both the federal and state levels to varying degrees. We engage in certain strategies to minimize the impact of these taxes. Consequently, any change in tax laws or regulations, or new interpretation of existing laws or regulations, could significantly alter the effectiveness of these strategies.

 

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The net deferred tax asset reported on our statement of financial condition generally represents the tax benefit of future deductions from taxable income for items that have already been recognized for financial reporting purposes. The bulk of these deferred tax assets consists of deferred loan loss deductions. The net deferred tax asset is measured by applying currently-enacted income tax rates to the accounting period during which the tax benefit is expected to be realized. As of December 31, 2018, our net deferred tax asset was $3.3 million.

In December 2017, the Tax Act was signed into law. The act includes numerous changes to existing U.S. federal income tax law, including a reduction in the federal corporate income tax rate from 35% to 21%, which took effect January 1, 2018. The reduction in the federal corporate income tax rate resulted in an impairment of our net deferred tax asset based on our reevaluation of the future tax benefit of these deferrals using the lower tax rate. We recorded this impairment as an additional tax provision of $1.2 million in the fourth quarter of 2017.

Because of the Dodd-Frank Act and related rulemaking, the Bank and the Company are subject to more stringent capital requirements.

In July 2013, the U.S. federal banking authorities approved the implementation of regulatory capital reforms of the Basel Committee on Banking Supervision, which is referred to as Basel III, and issued rules effecting certain changes required by the Dodd-Frank Act. Basel III is applicable to all U.S. banks that are subject to minimum capital requirements as well as to bank and saving and loan holding companies other than those subject to the Federal Reserve’s Small Bank Holding Company Policy Statement. The Small Bank Holding Company Policy Statement currently applies to certain holding companies with consolidated assets of less than $1.0 billion that do not have a material amount of SEC-registered debt or equity securities outstanding. Although the Regulatory Relief Act directs the Federal Reserve to increase the asset threshold for the Small Bank Holding Company Policy Statement from $1.0 billion to $3.0 billion, this change would not affect the Company, since it would not be eligible for the Small Bank Holding Company Policy Statement upon the issuance of the equity securities that are the subject of this registration statement.

Relative to the capital requirements that predated it, Basel III increased most of the required minimum regulatory capital ratios and introduced a new common equity Tier 1 capital ratio and the concept of a capital conservation buffer. Basel III also narrowed the definition of capital by establishing additional criteria that capital instruments must meet to be considered additional Tier 1 and Tier 2 capital. The Basel III capital rules became effective as applied to the Bank on January 1, 2015 and to the Company on January 1, 2018 with a phase-in period that generally extends through January 1, 2019 for many of the changes. See “Supervision and Regulation—Capital Adequacy Guidelines.”

Certain ratios calculated under the Basel III rules are sensitive to changes in total deposits, including the minimum leverage ratio that is discussed further under “Supervision and Regulation—Capital Adequacy Guidelines.” Due to the potential volatility of deposits related to our Digital Currency Initiative, we may be at increased risk of a sudden adverse change in these ratios.

The failure to meet applicable regulatory capital requirements could result in one or more of our regulators placing limitations or conditions on our activities, including our growth initiatives, or restricting the commencement of new activities, and could affect customer and investor confidence, our costs of funds and FDIC insurance costs, our ability to pay dividends on our common stock, our ability to make acquisitions, and our business, results of operations and financial condition.

Federal banking agencies periodically conduct examinations of our business, including our compliance with laws and regulations, and our failure to comply with any supervisory actions to which we are or become subject based on such examinations could adversely affect us.

As part of the bank regulatory process, the Federal Reserve and the California Department of Business Oversight, Division of Financial Institutions, or the DBO, periodically conduct examinations of our business,

 

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including compliance with laws and regulations. If, based on an examination, one of these federal banking agencies were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, asset sensitivity, risk management or other aspects of any of our operations have become unsatisfactory, or that the Company, the Bank or their respective management were in violation of any law or regulation, it may take such remedial actions as it deems appropriate. These actions include the power to enjoin unsafe or unsound practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital levels, to restrict our growth, to assess civil monetary penalties against us, the Bank or their respective officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate the Bank’s deposit insurance. If we become subject to such regulatory actions, our business, financial condition, results of operations and reputation could be adversely affected.

Our regulators may limit current or planned activities related to the digital currency industry.

The digital currency industry is relatively new and is subject to significant risks. The digital currency initiative involves customers and activities with which regulators, including our primary banking regulators the Federal Reserve and DBO, may be less familiar and which they may consider higher risk than those involving more established industries. While we have consulted, and will continue to consult with, our regulators regarding our activities involving digital currency industry customers and the digital currency initiative, in the future a regulator may determine to limit or restrict one or more of these activities. Such actions could have a material adverse effect on our business, financial condition, or results of operations.

Financial institutions, such as the Bank, face risks of noncompliance and enforcement actions related to the Bank Secrecy Act and other anti-money laundering statutes and regulations (in particular, as such statutes and regulations relate to the digital currency industry).

The Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, FinCEN and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. To administer the Bank Secrecy Act, FinCEN 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 the IRS. There is also increased scrutiny of compliance with the sanctions programs and rules administered and enforced by the Treasury Department’s Office of Foreign Assets Control.

Our compliance with the anti-money laundering laws is in part dependent on our ability to adequately screen and monitor our customers for their compliance with these laws. Customers associated with our digital currency initiative may represent an increased compliance risk given the prevalence of money laundering activities using digital currencies. We have developed enhanced procedures to screen and monitor these customers, which include, but are not limited to, system monitoring rules tailored to digital currency activities, a system of “red flags” specific to various customer types and activities, the development of and investment in proprietary technology tools to supplement our third-party transaction monitoring system, customer risk scoring with risk factors specific to the digital-currency industry, and the use of various blockchain monitoring tools. We believe these enhanced procedures adequately screen and monitor our customers associated with the digital currency initiative for their compliance with anti-money laundering laws; however, given the rapid developments in digital currency markets and technologies, there can be no assurance that these enhanced procedures will be adequate to detect or prevent money laundering activity. If regulators determine that our enhanced procedures are insufficient to address the financial crimes risks posed by digital currencies, the digital currency initiative may be adversely affected, which could have a material adverse effect on our business, financial condition and results of operations.

 

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To comply with regulations, guidelines and examination procedures in this area, we have dedicated significant resources to our anti-money laundering program. If our policies, procedures and systems are deemed deficient, we could be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the inability to obtain regulatory approvals to proceed with certain aspects of our business plans, including acquisitions and de novo branching.

We are subject to anticorruption laws, including the U.S. Foreign Corrupt Practices Act, or FCPA, and we may be subject to other anti-corruption laws, as well as anti-money laundering and sanctions laws and other laws governing our operations, to the extent our business expands to non-U.S. jurisdictions. If we fail to comply with these laws, we could be subject to civil or criminal penalties, other remedial measures, and legal expenses, which could adversely affect our business, financial condition and results of operations.

We continue to pursue deposit sourcing opportunities outside of the United States. We are currently subject to anti-corruption laws, including the FCPA. The FCPA and other applicable anti-corruption laws generally prohibit us, our employees and intermediaries from bribing, being bribed or making other prohibited payments to government officials or other persons to obtain or retain business or gain other business advantages. We may also participate in collaborations and relationships with third parties whose actions could potentially subject us to liability under the FCPA or other jurisdictions’ anti-corruption laws. There is no assurance that we will be completely effective in ensuring our compliance with all applicable anti-corruption laws, including the FCPA. If we are not in compliance with the FCPA or other anti-corruption laws, we may be subject to criminal and civil penalties, disgorgement and other sanctions and remedial measures, and legal expenses, which could have an adverse impact on our business, financial condition and results of operations. Similarly, any investigation of any potential violations of the FCPA or other anti-corruption laws by authorities in the United States or other jurisdictions where we conduct business could also have an adverse impact on our reputation, business, financial condition and results of operations.

We are subject to numerous laws and regulations, designed to protect consumers, including the Community Reinvestment Act and fair lending laws, and failure to comply with these laws or regulations could lead to a wide variety of sanctions.

The Community Reinvestment Act, or CRA, directs all insured depository institutions to help meet the credit needs of the local communities in which they are located, including low- and moderate-income neighborhoods. Each institution is examined periodically by its primary federal regulator, which assesses the institution’s performance. The Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. The CFPB, the U.S. Department of Justice and other federal agencies are responsible for enforcing these laws and regulations. The CFPB was created under the Dodd-Frank Act to centralize responsibility for consumer financial protection with broad rulemaking authority to administer and carry out the purposes and objectives of federal consumer financial laws with respect to all financial institutions that offer financial products and services to consumers. The CFPB is also authorized to prescribe rules applicable to any covered person or service provider, identifying and prohibiting acts or practices that are “unfair, deceptive, or abusive” in any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product, or service. The ongoing broad rulemaking powers of the CFPB have potential to have a significant impact on the operations of financial institutions offering consumer financial products or services. The CFPB has indicated that it may propose new rules on overdrafts and other consumer financial products or services, which could have a material adverse effect on our business, financial condition and results of operations if any such rules limit our ability to provide such financial products or services.

A successful regulatory challenge to an institution’s performance under the CRA, fair lending or consumer lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions activity, restrictions on expansion, and

 

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restrictions on entering new business lines. Private parties may also challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have a material adverse effect on our business, financial condition and results of operations.

Increases in FDIC insurance premiums could adversely affect our earnings and results of operations.

The deposits of our Bank are insured by the FDIC up to legal limits and, accordingly, subject it to the payment of FDIC deposit insurance assessments as determined according to the calculation described in “Supervision and Regulation—Deposit Insurance.” To maintain a strong funding position and restore the reserve ratios of the DIF following the financial crisis, the FDIC increased deposit insurance assessment rates and charged special assessments to all FDIC-insured financial institutions. Further increases in assessment rates or special assessments may occur in the future, especially if there are significant additional financial institution failures. Any future special assessments, increases in assessment rates or required prepayments in FDIC insurance premiums could reduce our profitability or limit our ability to pursue certain business opportunities, which could have a material adverse effect on our business, financial condition and results of operations.

The Federal Reserve may require us to commit capital resources to support the Bank at a time when our resources are limited, which may require us to borrow funds or raise capital on unfavorable terms.

The Federal Reserve requires a BHC to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. Under the “source of strength” doctrine that was codified by the Dodd-Frank Act, the Federal Reserve may require a BHC to make capital injections into a troubled subsidiary bank at times when the BHC may not be inclined to do so and may charge the BHC with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. Accordingly, we could be required to provide financial assistance to the Bank if it experiences financial distress.

A capital injection may be required at a time when our resources are limited, and we may be required to borrow the funds or raise capital to make the required capital injection. Any loan by a BHC to its subsidiary bank is subordinate in right of repayment to payments to depositors and certain other creditors of such subsidiary bank. In the event of a BHC’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 any note obligations. Thus, any borrowing by a BHC for making a capital injection to a subsidiary bank often becomes more difficult and expensive relative to other corporate borrowings. Borrowing funds or raising capital on unfavorable terms for such a capital injection may have a material adverse effect on our business, financial condition and results of operations.

We are exposed to a various types of credit risk due to interconnectivity in the financial services industry and could be adversely affected by the insolvency of other financial institutions.

Financial services institutions are interrelated based on trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when our collateral cannot be foreclosed upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due. Any such losses could adversely affect our business, financial condition and results of operations.

 

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Monetary policies and regulations of the Federal Reserve could adversely affect our business, financial condition and results of operations.

In addition to being affected by general economic conditions, our earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to influence the U.S. money supply and credit conditions. Among the traditional methods that have been used to achieve this objective are open market operations in U.S. government securities, changes in the discount rate for bank borrowings, expanded access to funds for non-banks and changes in reserve requirements against bank deposits. More recently, the Federal Reserve has, as a response to the financial crisis, significantly increased the size of its balance sheet by buying securities and has paid interest on excess reserves held by banks at the Federal Reserve. Both the traditional and more recent methods are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, interest rates on loans and securities, and rates paid for deposits.

The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The monetary policies of the Federal Reserve are influenced by various factors, including inflation, unemployment, and short-term and long-term changes in the international trade balance and in the fiscal policies of the U.S. government. Following a prolonged period in which the federal funds rate was stable or decreasing, the Federal Reserve has begun to increase this benchmark rate. In addition, the Federal Reserve Board has stated its intention to end its quantitative easing program and has begun to reduce the size of its balance sheet by selling securities. Future monetary policies, including whether the Federal Reserve will continue to increase the federal funds rate and whether or at what pace it will continue to reduce the size of its balance sheet, cannot be predicted, and although we cannot determine the effects of such policies on us now, such policies could adversely affect our business, financial condition and results of operations.

Risks Related to an Investment in Our Common Stock

There is currently no established public market for our common stock. An active, liquid market for our common stock may not develop or be sustained upon completion of this offering, which may impair your ability to sell your shares.

Our common stock is not currently traded on an established public trading market. We have applied to list our common stock on the New York Stock Exchange, but an active, liquid trading market for our common stock may not develop or be sustained following this offering. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace and independent decisions of willing buyers and sellers of our common stock, over which we have no control. Without an active, liquid trading market for our common stock, shareholders may not be able to sell their shares at the volume, prices and times desired. Moreover, the lack of an established market could materially and adversely affect the value of our common stock. The market price of our common stock could decline significantly due to actual or anticipated issuances or sales of our common stock in the future.

The market price of our common stock may be subject to substantial fluctuations, which may make it difficult for you to sell your shares at the volume, prices and times desired.

The market price of our common stock may be highly volatile, which may make it difficult for you to resell your shares at the volume, prices and times desired. There are many factors that may affect the market price and trading volume of our common stock, including, without limitation, the risks discussed elsewhere in this “Risk Factors” section and:

 

   

actual or anticipated fluctuations in our operating results, financial condition or asset quality;

 

   

changes in general economic or business conditions;

 

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changes in digital currency industry conditions;

 

   

the effects of, and changes in, trade, monetary and fiscal policies, including the interest rate policies of the Federal Reserve;

 

   

publication of research reports about us, our competitors or the financial services industry generally, or changes in, or failure to meet, securities analysts’ estimates of our financial and operating performance, or lack of research reports by industry analysts or ceasing of coverage;

 

   

operating and stock price performance of companies that investors deem comparable to us;

 

   

additional or anticipated sales of our common stock or other securities by us or our existing shareholders;

 

   

additions or departures of key personnel;

 

   

perceptions in the marketplace regarding our competitors or us;

 

   

significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving our competitors or us;

 

   

other economic, competitive, governmental, regulatory or technological factors affecting our operations, pricing, products and services; and

 

   

other news, announcements or disclosures (whether by us or others) related to us, our competitors, our core markets or the financial services industry.

The stock market and the market for financial institution stocks has experienced substantial fluctuations in recent years, which in many cases have been unrelated to the operating performance and prospects of particular companies. In addition, significant fluctuations in the trading volume in our common stock may cause significant price variations to occur. Increased market volatility may materially and adversely affect the market price of our common stock, which could make it difficult to sell your shares at the volume, prices and times desired.

The market price of our common stock could decline significantly due to actual or anticipated issuances or sales of our common stock in the future.

Actual or anticipated issuances or sales of substantial amounts of our common stock following this offering could cause the market price of our common stock to decline significantly and make it more difficult for us to sell equity or equity-related securities in the future at a time and on terms that we deem appropriate. The issuance of any shares of our common stock in the future also would, and equity-related securities could, dilute the percentage ownership interest held by shareholders prior to such issuance. Our Articles of Incorporation, as amended, or Articles, authorize us to issue up to 125,000,000 shares of our Class A Common Stock,              of which will be outstanding following the completion of this offering (or              shares if the underwriters exercise in full their option to purchase additional shares) and 25,000,000 shares of Class B Common Stock,              of which will be outstanding following the completion of this offering. All              of the shares of common stock sold in this offering (or              shares if the underwriters exercise in full their option to purchase additional shares) will be freely tradable, except that any shares purchased by our “affiliates” (as that term is defined in Rule 144 under the Securities Act) may be resold only in compliance with the limitations described under “Shares Eligible for Future Sale.” The remaining outstanding shares of our common stock will be deemed to be “restricted securities” as that term is defined in Rule 144, and may be resold in the United States only if they are registered for resale under the Securities Act or an exemption, such as Rule 144, is available. We also intend to file a registration statement on Form S-8 under the Securities Act to register an aggregate of              shares of common stock issued or reserved for issuance under our equity incentive plans.

We may issue these shares without any action or approval by our shareholders and issued shares (including upon exercise of outstanding options) will be available for sale into the public market, subject to the restrictions described above, if applicable, for affiliate holders.

 

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Further, in connection with this offering, we, our executive officers and directors, the selling shareholders and each of our other equity and option holders who beneficially own at least         % of our outstanding common stock on a fully diluted basis have generally agreed not to sell or otherwise transfer our or their shares of common stock for a period of 180 days after the completion of this offering. These lock-up agreements are subject to certain limited exceptions. For additional information, see “Underwriting—Lock-Up Agreements.” The underwriters do not have any present intention or arrangement to release any shares of our common stock subject to lock-up agreements prior to the expiration of the 180-day lock-up period. In addition, after this offering, approximately             shares of our common stock will not be subject to lock-up agreements. The resale of such shares could cause the market price of our stock to drop significantly, and concerns that those sales may occur could cause the trading price of our common stock to decrease or to be lower than it should be.

In addition, we may issue shares of our Class A and/or Class B Common Stock or other securities from time to time as consideration for future acquisitions and investments and pursuant to compensation and incentive plans. If any such acquisition or investment is significant, the number of shares of our Class A and Class B Common Stock, or the number or aggregate principal amount, of other securities that we may issue may be substantial. After expiration of the lock-up period described above, we may also grant registration rights covering those shares of our Class A and Class B Common Stock or other securities in connection with any such acquisitions and investments.

We cannot predict the size of future issuances of our common stock or the effect, if any, that future issuances and sales of our common stock will have on the market price of our common stock. Sales of substantial amounts of our common stock (including shares of our common stock issued in connection with an acquisition or under a compensation or incentive plan), or the perception that such sales could occur, may adversely affect prevailing market prices for our common stock and could impair our ability to raise capital through future sales of our securities.

While our growth strategy is focused on the digital currency industry, investors should not expect that the value of our common stock to be correlated with the value of digital currencies. Investing in our common stock is not a proxy for gaining exposure to digital currencies.

While our growth strategy is focused on the digital currency industry and the majority of the Bank’s deposits are from digital currency-related activities, investors should not expect that investing in our common stock is a proxy for gaining exposure to digital currencies. The impact of fluctuations in prices and/or trading volume of digital currencies on our deposit balance from customers in the digital currency industry and, by extension, our profitability, is unpredictable, and the price of our common stock may not be correlated to the prices of digital currencies.

Though not a proxy for gaining exposure to digital currencies, market participants may view our common stock as such, which could in turn attract investors seeking to buy or sell short our common stock in order to gain such exposure, therefore increasing the price volatility of our common stock. There may also be a heightened level of speculation in our common stock as a result of our exposure to the digital currency industry. For more information regarding the volatility of digital currencies, see “—Risks Related to Our Digital Currency Initiative—The prices of digital currencies are extremely volatile. Fluctuations in the price of various digital currencies may cause uncertainty in the market and could negatively impact trading volumes of digital currencies and therefore the extent to which participants in the digital currency industry demand our services and solutions, which would adversely affect our business, financial condition and results of operations.”

The obligations associated with being a public company will require significant resources and management attention, which will increase our costs of operations and may divert focus from our business operations.

As a public company, we will face increased legal, accounting, administrative and other costs and expenses that we have not incurred as a private company, particularly after we no longer qualify as an emerging growth

 

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company. After the completion of this offering, we will be subject to the reporting requirements of the Exchange Act which requires that we file annual, quarterly and current reports with respect to our business and financial condition and proxy and other information statements, and the rules and regulations implemented by the SEC, the Sarbanes-Oxley Act, the Dodd-Frank Act, the Public Company Accounting Oversight Board, or the PCAOB, and the New York Stock Exchange, each of which imposes additional reporting and other obligations on public companies. As a public company, compliance with these reporting requirements and other SEC and the New York Stock Exchange rules will make certain operating activities more time-consuming, and we will also incur significant new legal, accounting, insurance and other expenses. Furthermore, the need to establish the corporate infrastructure demanded of a public company may divert management’s attention from implementing our operating strategy, which could prevent us from successfully implementing our strategic initiatives and improving our results of operations. We have made, and will continue to make, changes to our internal control over, and procedures relating to, financial reporting and accounting systems to meet our reporting obligations as a public company. However, we cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements. We anticipate that these costs will materially increase our general and administrative expenses and such increases will reduce our profitability.

Investors in this offering will experience immediate dilution.

The initial public offering price is expected to be higher than the tangible book value per share of our common stock immediately following this offering. Therefore, if you purchase shares in this offering, you will experience immediate dilution in tangible book value per share in relation to the price that you paid for your shares. We expect the dilution because of this offering to be $             per share, based on an assumed initial public offering price of $             per share (the midpoint of the price range set forth on the cover page of this prospectus) and our as adjusted tangible book value of $             per share as of December 31, 2018. Accordingly, if we were liquidated at our as adjusted tangible book value, you would not receive the full amount of your investment. See “Dilution.”

Securities analysts may not initiate or continue coverage on us.

The trading market for our common stock will depend, in part, on the research and reports that securities analysts publish about us, our business and our industry. We do not have any control over these securities analysts, and they may choose not to cover us. If one or more of these securities analysts cease to cover us or fail to publish regular reports on us, we could lose visibility in the financial markets, which could cause the price or trading volume of our common stock to decline. If we are covered by securities analysts and are the subject of an unfavorable report, the price of our common stock may decline.

Our management and board of directors have significant control over our business.

As of December 31, 2018, our directors, our named executive officers and their respective family members and affiliated entities beneficially owned an aggregate of             shares, or approximately     % of our issued and outstanding Class A Common Stock. Following the completion of this offering, our directors, our named executive officers and their respective family members and affiliated entities will beneficially own approximately     % of our outstanding Class A Common Stock (or     % if the underwriters exercise in full their option to purchase additional shares), excluding any shares that any such persons may purchase through the directed share program described in “Underwriting—Directed Share Program.” Consequently, our management and board of directors may be able to significantly affect the outcome of the election of directors and the potential outcome of other matters submitted to a vote of our shareholders, such as mergers, the sale of substantially all our assets and other extraordinary corporate matters. The interests of these insiders could conflict with the interests of our other shareholders, including you.

 

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We have broad discretion in the use of the net proceeds to us from this offering, and our use of these proceeds may not yield a favorable return on your investment.

We intend to use the net proceeds to us from this offering to fund organic growth and for general corporate purposes, which could include repayment of our long-term debt, future acquisitions and other growth initiatives. We have not specifically allocated the amount of net proceeds to us that will be used for these purposes and our management will have broad discretion over how these proceeds are used and could spend these proceeds in ways with which you may not agree. In addition, we may not use the net proceeds to us from this offering effectively or in a manner that increases our market value or enhances our profitability. We have not established a timetable for the effective deployment of the net proceeds to us, and we cannot predict how long it will take to deploy these proceeds. Investing the net proceeds to us in securities until we can deploy these proceeds will provide lower yields than we generally earn on loans, which may have a material adverse effect on our profitability. Although we may, from time to time in the ordinary course of business, evaluate potential acquisition opportunities that we believe provide attractive risk-adjusted returns, we do not have any immediate plans, arrangements or understandings relating to any acquisitions, nor are we engaged in negotiations with any potential acquisition targets.

The holders of our existing debt obligations, as well as debt obligations that may be outstanding in the future, will have priority over our common stock with respect to payment in the event of liquidation, dissolution or winding up and with respect to the payment of interest.

In the event of any liquidation, dissolution or winding up of the Company, our common stock would rank below all claims of debt holders against us. As of December 31, 2018, we had outstanding $15.8 million in aggregate principal amount of subordinated debentures issued to statutory trusts that, in turn, issued $15.5 million of trust preferred securities. Payments of the principal and interest on the trust preferred securities are conditionally guaranteed by us. In addition, at December 31, 2018, the Company had a term loan from a commercial bank with an outstanding principal balance of $4.9 million. Our debt obligations are senior to our shares of common stock. As a result, we must make payments on our debt obligations before any dividends can be paid on our common stock. In the event of our bankruptcy, dissolution or liquidation, the holders of our debt obligations must be satisfied before any distributions can be made to the holders of our common stock. To the extent that we issue additional debt obligations, the additional debt obligations will be of equal rank with, or senior to, our existing debt obligations and senior to our shares of common stock.

We may issue shares of preferred stock in the future, which could make it difficult for another company to acquire us or could otherwise adversely affect holders of our common stock, which could depress the price of our common stock.

Our Articles authorize us to issue up to 10,000,000 shares of one or more series of preferred stock. Our board of directors will have the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our shareholders. Our preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock. The potential issuance of preferred stock may delay or prevent a change in control of us, discouraging bids for our common stock at a premium over the market price, and materially adversely affect the market price and the voting and other rights of the holders of our common stock.

We are an emerging growth company, and the reduced regulatory and reporting requirements applicable to emerging growth companies may make our common stock less attractive to investors.

We are an emerging growth company, as defined in the JOBS Act. For as long as we continue to be an emerging growth company we may take advantage of reduced regulatory and reporting requirements that are otherwise generally applicable to public companies. These include, without limitation, not being required to

 

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comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced financial reporting requirements, reduced disclosure obligations regarding executive compensation and exemptions from the requirements of holding non-binding shareholder advisory votes on executive compensation or golden parachute payments. The JOBS Act also permits an emerging growth company such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. However, we have irrevocably opted out of this provision, and we will comply with new or revised accounting standards to the same extent that compliance is required for non-emerging growth companies.

We may take advantage of some or all of these provisions for up to five years or such earlier time as we cease to qualify as an emerging growth company, which will occur if we have more than $1.07 billion in total annual gross revenue, if we issue more than $1.0 billion of non-convertible debt in a three-year period, or if the market value of our common stock held by non-affiliates exceeds $700.0 million as of any June 30 before that time, in which case we would no longer be an emerging growth company as of the following December 31. Investors may find our common stock less attractive because we intend to rely on certain of these exemptions, which may result in a less active trading market and increased volatility in our stock price.

We are dependent upon the Bank for cash flow, and the Bank’s ability to make cash distributions is restricted.

Our primary asset is Silvergate Bank. We depend upon the Bank for cash distributions (through dividends on the Bank’s common stock) that we use to pay our operating expenses and satisfy our obligations (including our junior subordinated debentures). Federal and state statutes, regulations and policies restrict the Bank’s ability to make cash distributions to us. Further, the Federal Reserve and the DBO can restrict the Bank’s payment of dividends by supervisory action. If the Bank is unable to pay dividends to us, we may not be able to satisfy our obligations or, if applicable, pay dividends on our common stock. See “Supervision and Regulation—Dividends.”

Our future ability to pay dividends is subject to restrictions.

Holders of our common stock are only entitled to receive dividends when, as and if declared by our board of directors out of funds legally available for dividends. We have not paid any cash dividends on our Class A and Class B Common Stock since inception and we currently have no plans to pay cash dividends in the foreseeable future. Any declaration and payment of dividends on our Class A and Class B Common Stock in the future will depend on regulatory restrictions, our earnings and financial condition, our liquidity and capital requirements, the general economic climate, contractual restrictions, our ability to service any equity or debt obligations senior to our Class A and Class B Common Stock and other factors deemed relevant by our board of directors. Furthermore, consistent with our strategic plans, growth initiatives, capital availability, projected liquidity needs and other factors, we have made, and will continue to make, capital management decisions and policies that could adversely affect the amount of dividends, if any, paid to our common shareholders. See “Dividend Policy.”

The Federal Reserve has indicated that bank holding companies should carefully review their dividend policy in relation to the organization’s overall asset quality, current and prospective earnings and level, composition and quality of capital. The guidance provides that we inform and consult with the Federal Reserve prior to declaring and paying a dividend that exceeds earnings for the period for which the dividend is being paid or that could result in an adverse change to our capital structure, including interest on the senior promissory note, the subordinated debt obligations, the subordinated debentures underlying our trust preferred securities and our other debt obligations. If regularly scheduled payments on our outstanding junior subordinated debentures, held by our unconsolidated subsidiary trusts, are not made or are deferred, or dividends on any preferred stock we may issue are not paid, we will be prohibited from paying dividends on our Class A and Class B Common Stock.

 

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Provisions in our governing documents and Maryland law may have an anti-takeover effect, and there are substitutional regulatory limitations on changes of control of bank holding companies.

Our corporate organizational documents and provisions of federal and state law to which we are subject contain certain provisions that could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition that you may favor or an attempted replacement of our board of directors or management.

Our Articles and our Bylaws may have an anti-takeover effect and may delay, discourage or prevent an attempted acquisition or change of control or a replacement of our board of directors or management. Our governing documents and Maryland law include provisions that:

 

   

empower our board of directors, without shareholder approval, to issue our preferred stock, the terms of which, including voting power, are to be set by our board of directors;

 

   

divide our board of directors into three classes serving staggered three-year terms;

 

   

provide that directors may be removed from office (i) without cause but only upon an 80% vote of shareholders and (ii) for cause but only upon a majority shareholder vote;

 

   

eliminate cumulative voting in elections of directors;

 

   

permit our board of directors to alter, amend or repeal our Bylaws or to adopt new bylaws;

 

   

permit our board of directors to increase or decrease the number of authorized shares of our Class A and Class B Common Stock and preferred stock;

 

   

require the request of holders of at least 20% of the outstanding shares of our capital stock entitled to vote at a meeting to call a special shareholders’ meeting;

 

   

require shareholders that wish to bring business before annual or special meetings of shareholders, or to nominate candidates for election as directors at our annual meeting of shareholders, to provide timely notice of their intent in writing; and

 

   

enable our board of directors to increase, between annual meetings, the number of persons serving as directors and to fill the vacancies created by such increase by a majority vote of the directors present at a meeting of directors.

In addition, certain provisions of Maryland law may delay, discourage or prevent an attempted acquisition or change in control. Furthermore, banking laws impose notice, approval, and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution or its holding company. These laws include the Bank Holding Company Act of 1956, as amended, or the BHC Act, and the Change in Bank Control Act, or the CBCA. These laws could delay or prevent an acquisition.

An investment in our common stock is not an insured deposit and is subject to risk of loss.

Any shares of our common stock you purchase in this offering will not be savings accounts, deposits or other obligations of any of the Bank or any of our other subsidiaries and will not be insured or guaranteed by the FDIC or any other government agency. Your investment will be subject to investment risk, and you must be able to afford the loss of your entire investment.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements, including in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “project,” “projection,” “forecast,” “goal,” “target,” “would,” “aim” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry and management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. The inclusion of these forward-looking statements should not be regarded as a representation by us, the selling shareholders, the underwriters or any other person that such expectations, estimates and projections will be achieved. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although we believe that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements.

There are or will be important factors that could cause our actual results to differ materially from those indicated in these forward-looking statements, including, but not limited to, the following:

 

   

the success of the digital currency industry, the development and acceptance of which is subject to a high degree of uncertainty, as well as the continued evolution of the regulation of this industry and uncertainty of adoption of digital currencies;

 

   

the success of the digital currency initiative and our ability to implement aspects of our growth strategy;

 

   

the concentration of our depositor relationships in the digital currency industry generally and among digital currency exchanges in particular;

 

   

our ability to grow or sustain our low-cost funding strategy related to the digital currency initiative;

 

   

system failure or cybersecurity breaches of our network security;

 

   

our ability to keep pace with rapid technological changes in the industry or implement new technology effectively;

 

   

our reliance on third-party service providers for core systems support, informational website hosting, internet services, online account opening and other processing services;

 

   

economic conditions (including interest rate environment, government economic and monetary policies, the strength of global financial markets and inflation and deflation) that impact the financial services industry and/or our business;

 

   

increased competition in the financial services industry, particularly from regional and national institutions;

 

   

credit risks, including risks related to the significance of commercial real estate loans in our portfolio, our ability to manage our credit risk effectively and the potential deterioration of the business and economic conditions in our primary market areas;

 

   

risks associated with our residential mortgage warehouse business;

 

   

results of examinations of us by our regulators, including the possibility that our regulators may, among other things, require us to increase our allowance for loan losses or to write-down assets;

 

   

changes in the value of collateral securing our loans;

 

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our ability to protect our intellectual property and the risks we face with respect to claims and litigation initiated against us;

 

   

interest rate risk associated with our business, including sensitivity of our interest earning assets and interest bearing liabilities to interest rates, and the impact to our earnings from changes in interest rates;

 

   

our dependence on our management team and changes in management composition;

 

   

the effectiveness of our internal control over financial reporting and our ability to remediate any future material weakness in our internal control over financial reporting.

 

   

the sufficiency of our capital, including sources of capital and the extent to which we may be required to raise additional capital to meet our goals;

 

   

potential exposure to fraud, negligence, computer theft and cyber-crime and other disruptions in our computer systems relating to our development and use of new technology platforms;

 

   

the adequacy of our risk management framework;

 

   

our involvement from time to time in legal proceedings, examinations and remedial actions by regulators;

 

   

changes in the laws, rules, regulations, interpretations or policies relating to financial institution, accounting, tax, trade, monetary and fiscal matters;

 

   

the financial soundness of other financial institutions;

 

   

further government intervention in the U.S. financial system;

 

   

natural disasters and adverse weather, acts of terrorism, an outbreak of hostilities or other international or domestic calamities, and other matters beyond our control; and

 

   

other factors that are discussed in the section entitled “Risk Factors.”

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this prospectus, including those discussed in the section entitled “Risk Factors.” If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from our forward looking statements. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date of this prospectus, and we do not undertake any obligation to publicly update or review any forward-looking statement, whether because of new information, future developments or otherwise, except as required by law. New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence. In addition, we cannot assess the impact of each risk and uncertainty on our business or the extent to which any risk or uncertainty, or combination of risks and uncertainties, may cause actual results to differ materially from those contained in any forward-looking statements.

 

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USE OF PROCEEDS

Assuming an initial public offering price of $              per share, which is the midpoint of the price range set forth on the cover page of this prospectus, we estimate that the net proceeds to us from the sale of our common stock in this offering will be $              million (or $              million if the underwriters exercise in full their option to purchase additional shares), after deducting the underwriting discount and estimated offering expenses payable by us. Each $1.00 increase or decrease in the assumed initial public offering price would increase or decrease (as applicable) the net proceeds to us from this offering by approximately $              million (or approximately $              million if the underwriters elect to exercise in full their option to purchase additional shares), in each case, assuming the number of shares we sell, as set forth on the cover page of this prospectus, remains the same, after deducting the underwriting discount and estimated offering expenses payable by us.

We intend to use the net proceeds to us from this offering to fund organic growth and for general corporate purposes, which could include repayment of long-term debt, future acquisitions and other growth initiatives. We do not have any current plans, arrangements or understandings to make any material acquisitions. Our management will retain broad discretion to allocate the net proceeds of this offering. The precise amounts and timing of our use of the proceeds will depend upon market conditions, among other factors. Proceeds held by us will be invested in short-term investments until needed for the uses described above.

We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders.

 

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DIVIDEND POLICY

Holders of our Class A and Class B Common Stock are only entitled to receive dividends when, as and if declared by our board of directors out of funds legally available for dividends. We have not paid any cash dividends on our Class A and Class B Common Stock since inception, and we currently have no plans to pay dividends for the foreseeable future. As a Maryland corporation, we are only permitted to pay dividends out of net earnings.

Because we are a bank holding company and do not engage directly in business activities of a material nature, our ability to pay dividends to our shareholders depends, in large part, upon our receipt of dividends from the Bank, which is also subject to numerous limitations on the payment of dividends under California banking laws, regulations and policies. See “Supervision and Regulation—Dividends.”

Our ability to pay dividends to our shareholders in the future will depend on regulatory restrictions, our liquidity and capital requirements, our earnings and financial condition, the general economic climate, contractual restrictions, our ability to service any equity or debt obligations senior to our Class A and Class B Common Stock and other factors deemed relevant by our board of directors.

 

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CAPITALIZATION

The following table shows our capitalization, including regulatory capital ratios for the Company on a consolidated basis and for the Bank, as of December 31, 2018:

 

   

on an actual basis; and

 

   

on an as adjusted basis to give effect to the issuance and sale by us of                  shares of common stock in this offering and our receipt of the net proceeds therefrom (assuming the underwriters do not exercise their option to purchase additional shares) at an assumed initial public offering price of $                per share, which is the midpoint of the price range set forth on the cover page of this prospectus, after deducting the underwriting discount and estimated offering expenses payable by us.

The following table excludes the impact of the proposed sale of the Bank’s business lending division and the retail branch pursuant to a purchase and assumption agreement entered into on November 15, 2018 described under “Prospectus Summary—Recent Developments.” You should read the following table in conjunction with the sections titled “Selected Historical Consolidated Financial and Other Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

     As of December 31, 2018  
         Actual             As adjusted(1)      
     (In thousands, except per share data)  

Cash and cash equivalents

   $ 674,420     $                
  

 

 

   

 

 

 

Long-term debt:

    

Notes payable

   $ 4,857     $    

Subordinated debentures, net

     15,802    
  

 

 

   

 

 

 

Total long-term debt

     20,659    

Shareholders’ equity:

    

Preferred stock, $0.01 par value per share, 10,000 shares authorized, no shares issued or outstanding at December 31, 2018 and as adjusted

     —      

Class A common stock, $0.01 par value per share, 125,000 shares authorized, 16,629 shares outstanding at December 31, 2018 and                  shares outstanding as adjusted

     166    

Class B non-voting common stock, $0.01 par value per share, 25,000 shares authorized, 1,190 shares outstanding at December 31, 2018 and                  shares outstanding as adjusted

     12    

Additional paid-in capital

     125,665    

Retained earnings

     67,464    

Accumulated other comprehensive loss

     (2,061  
  

 

 

   

 

 

 

Total shareholders’ equity

     191,246    
  

 

 

   

 

 

 

Total capitalization

   $ 211,905     $    
  

 

 

   

 

 

 

Company capital ratios:

    

Tier 1 leverage to average assets

     9.00  

Common equity tier 1 capital to risk-weighted assets

     23.10  

Tier 1 capital to risk-weighted assets

     24.96  

Total capital to risk-weighted assets

     25.77  

Total shareholders’ equity to total assets

     9.54  

Per Share:

    

Book value per share

   $ 10.73     $    

 

(1)

A $1.00 increase (decrease) in the assumed initial public offering price of $                 per share would increase (decrease) our as adjusted total shareholders’ equity and total capitalization by approximately $                 million, assuming no change to the number of shares of common stock being offered hereby as set forth on the cover page of this prospectus, and after deducting the underwriting discount and estimated offering expenses payable by us.

 

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DILUTION

If you invest in our common stock in this offering, your ownership interest will be diluted to the extent the initial public offering price per share of our common stock exceeds the as adjusted tangible book value per share of our common stock immediately following this offering. As of December 31, 2018, the tangible book value of our common stock was approximately $                million, or $                per share of common stock based on                  shares of our common stock issued and outstanding. Tangible book value per share represents total shareholders’ equity, less intangible assets, divided by total shares of common stock outstanding. At December 31, 2018, we did not have any intangible assets and, as a result, there was no difference between our book value per share and tangible book value per share at such date.

After giving effect to the sale of                  shares of our common stock in this offering (assuming the underwriters do not exercise their option to purchase additional shares) at an assumed initial public offering price of $            per share, which is the midpoint of the price range set forth on the cover page of this prospectus, and deducting the underwriting discount and estimated offering expenses payable by us, the as adjusted tangible book value of our common stock at December 31, 2018 would have been approximately $            million, or $            per share. Therefore, under those assumptions, this offering will result in an immediate increase of $            in the tangible book value per share of our common stock of existing shareholders and an immediate dilution of $            in the tangible book value per share of our common stock to investors purchasing shares of common stock in this offering, or approximately     % of the assumed initial public offering price of $            per share.

The following table illustrates the calculation of the amount of dilution per share that a new investor in our common stock in this offering will incur given the assumptions above:

 

Assumed initial public offering price

   $                

Tangible book value per share of common stock at December 31, 2018

  

Increase in tangible book value per share of common stock attributable to new investors

  
  

 

 

 

As adjusted tangible book value per share of common stock after this offering

  
  

 

 

 

Dilution per share of common stock to new investors in this offering

   $    
  

 

 

 

If the underwriters exercise in full their option to purchase additional shares, our as adjusted tangible book value per share of common stock after giving effect to this offering would be approximately $        , and the dilution in as adjusted tangible book value per share of common stock to new investors in this offering would be approximately $        .

A $1.00 increase (decrease) in the assumed initial public offering price of $        per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our tangible book value by $        million, or $        per share, and the dilution to new investors would increase (decrease) by $        per share, assuming no change to the number of shares of common stock being offered hereby as set forth on the cover page of this prospectus, and after deducting the underwriting discount and estimated offering expenses payable by us.

 

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The following table illustrates the differences between the number of shares of common stock purchased from us, the total consideration paid and the average price per share paid by existing shareholders and new investors purchasing shares of our common stock in this offering based on an assumed initial public offering price of $          per share, which is the midpoint of the price range set forth on the cover page of this prospectus, and before deducting the underwriting discount and estimated offering expenses payable by us as of December 31, 2018 on an as adjusted basis.

 

     Shares Purchased     Total Consideration
(Dollars in thousands)
    Average Price  
     Number      Percent     Amount      Percent     Per Share  

Shareholders as of December 31, 2018

                                        $                                     $                

New investors in this offering

            
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total

                   $                         $    

Assuming no shares of common stock are sold to existing shareholders in this offering, sales of shares of our common stock by the selling shareholders in this offering will reduce the number of shares of common stock held by existing shareholders to                 , or approximately     % of the total shares of our Class A and Class B Common Stock outstanding after this offering, and will increase the number of shares held by new investors to                 , or approximately     % of the total shares of our Class A and Class B Common Stock outstanding after this offering.

If the underwriters exercise in full their option to purchase additional shares, the percentage of shares of our common stock held by existing shareholders will decrease to approximately     % of the total number of shares of our Class A and Class B Common Stock outstanding after this offering, and the number of shares held by new investors will increase to                 , or approximately     % of the total shares of our Class A and Class B Common Stock outstanding after this offering.

The table and the two immediately preceding paragraphs above exclude 816,616 shares of our common stock issuable upon the exercise of stock options outstanding at December 31, 2018 at a weighted average exercise price of $5.54 per share.

To the extent that any of the foregoing are exercised, investors participating in the offering will experience further dilution.

 

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SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA

You should read the following selected historical consolidated financial and other data in conjunction with our consolidated financial statements and related notes and the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Capitalization” included elsewhere in this prospectus. The following tables set forth selected historical consolidated financial and other data as of and for the years ended December 31, 2018, 2017, 2016, 2015 and 2014. Selected financial data as of and for the years ended December 31, 2018 and 2017 have been derived from our audited financial statements included elsewhere in this prospectus. We have derived the selected financial data as of and for the years ended December 31, 2016, 2015 and 2014 from our audited financial statements not included in this prospectus. Our historical results are not necessarily indicative of any future period. The performance ratios and asset quality and capital ratios are unaudited and derived from our audited financial statements and other financial information as of and for the periods presented. Average balances have been calculated using daily averages.

The following selected historical consolidated financial and other data excludes the impact of the proposed sale of the Bank’s business lending division and retail branch pursuant to a purchase and assumption agreement entered into on November 15, 2018 described under “Prospectus Summary—Recent Developments.”

 

     Year Ended December 31,  
      2018     2017     2016     2015     2014  
     (In thousands, except per share data)  

Statement of Operations Data:

          

Total interest income

   $ 72,752     $ 48,306     $ 41,541     $ 36,728     $ 28,538  

Total interest expense

     3,129       6,355       7,729       5,947       5,522  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income before provision for loan losses

     69,623       41,951       33,812       30,781       23,016  

(Reversal of) provision for loan losses

     (1,527     262       1,136       1,906       1,067  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan losses

     71,150       41,689       32,676       28,875       21,949  

Total noninterest income

     7,563       3,448       3,308       4,797       5,629  

Total noninterest expense

     48,314       30,706       24,214       21,525       20,124  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     30,399       14,431       11,770       12,147       7,454  

Income tax expense(1)

     8,066       6,788       4,735       4,737       2,909  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     22,333       7,643       7,035       7,410       4,545  

Dividends on preferred stock

     —         —         13       159       159  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income available to common shareholders

   $ 22,333     $ 7,643     $ 7,022     $ 7,251     $ 4,386  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected Performance Ratios:

          

Return on average assets (ROAA)

     1.11     0.66     0.76     0.82     0.61

Return on average equity (ROAE)

     13.47     10.80     10.45     10.63     7.18

Return on average common equity (ROACE)

     13.47     10.80     10.55     11.93     8.18

Net interest margin(2)

     3.49     3.68     3.68     3.52     3.25

Noninterest income / average assets

     0.38     0.30     0.36     0.54     0.78

Noninterest expense / average assets

     2.41     2.67     2.60     2.44     2.80

Efficiency ratio(3)

     62.59     67.64     65.23     60.50     70.25

Loan yield(4)

     5.52     5.20     4.92     4.44     4.31

Per Share Data:

          

Common stock shares issued and outstanding at end of period

     17,818       9,224       9,224       9,728       9,712  

Basic weighted average shares outstanding

     16,543       9,224       9,705       9,762       9,544  

Diluted weighted average shares outstanding

     17,023       9,618       10,039       10,067       9,775  

Basic earnings per share

   $ 1.35     $ 0.83     $ 0.72     $ 0.74     $ 0.46  

Diluted earnings per share

   $ 1.31     $ 0.79     $ 0.70     $ 0.72     $ 0.45  

Book value per share

   $ 10.73     $ 8.00     $ 7.13     $ 7.24     $ 5.76  

 

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      December 31,  
      2018     2017     2016     2015     2014  
     (Dollars in thousands)  

Statement of Financial Condition Data:

          

Interest earning deposits in other banks

   $ 670,243     $ 793,717     $ 31,055     $ 45,182     $ 37,188  

Securities

     357,251       191,921       89,455       47,226       44,839  

Loans held-for-investment, net

     592,781       689,303       669,136       637,510       623,435  

Loans held-for-sale

     350,636       190,392       166,986       169,190       107,068  

Total assets

     2,004,318       1,891,948       981,068       951,854       868,952  

Total deposits

     1,783,005       1,775,146       767,862       633,533       544,244  

FHLB advances

     —         15,000       115,000       199,000       210,000  

Total liabilities

     1,813,072       1,818,148       915,261       881,461       805,469  

Total shareholders’ equity

     191,246       73,800       65,807       70,393       63,483  

Nonperforming Assets:

          

Nonperforming loans

   $ 8,303     $ 4,510     $ 5,126     $ 4,020     $ 4,800  

Troubled debt restructurings

   $ 514     $ 592     $ 944     $ 2,356     $ 2,105  

Other real estate owned, net

   $ 31     $ 2,308     $ 562     $ 1,292     $ —    

Nonperforming assets

   $ 8,334     $ 6,818     $ 5,688     $ 5,312     $ 4,800  

Asset Quality Ratios:

          

Nonperforming assets / assets

     0.42     0.36     0.58     0.56     0.55

Nonperforming loans / loans(5)

     1.39     0.65     0.76     0.63     0.77

Nonperforming assets / loans(5) + other real estate owned

     1.40     0.98     0.84     0.82     0.77

Net charge-offs (recoveries) to average loans(5)

     (0.01 )%      0.02     0.00     (0.01 )%      0.01

Allowance for loan losses to total loans(5)

     1.13     1.17     1.19     1.07     0.80

Allowance for loan losses to nonperforming loans

    
80.97

    181.04     156.93     171.64     103.25

Bank Capital Ratios:

          

Tier 1 leverage ratio

     8.51     6.33     9.03     9.40     9.45

Common equity tier 1 capital

     23.68     13.11     13.06     12.96     N/A  

Tier 1 risk-based capital

     23.68     13.11     13.06     12.96     13.83

Total risk-based capital ratio

     24.50     14.29     14.31     14.04     14.75

Common equity to total assets

     9.77     4.89     8.71     8.80     8.74

 

(1)

The year ended December 31, 2017 included a $1.2 million increase in income tax expense related to the revaluation of our deferred tax assets resulting from the reduction in the corporate income tax rate as a result of the Tax Act.

(2)

Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period.

(3)

Efficiency ratio is calculated by dividing noninterest expenses by net interest income plus noninterest income.

(4)

Includes nonaccrual loans and loans 90 days and more past due.

(5)

Loans exclude loans held-for-sale at each of the dates presented.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes thereto and other financial information included elsewhere in this prospectus. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from our expectations. Factors that could cause such differences are discussed in the sections entitled “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.” We assume no obligation to update any of these forward-looking statements except to the extent required by law.

The following discussion pertains to our historical results, on a consolidated basis. However, because we conduct all our material business operations through our wholly owned subsidiary, Silvergate Bank, the discussion and analysis relates to activities primarily conducted at the subsidiary level.

All dollar amounts in the tables in this section are in thousands of dollars, except per share data or where otherwise specifically noted.

Overview

The Company is a Maryland corporation that is the parent company of Silvergate Bank. The Company’s assets consist primarily of its investment in the Bank and its primary activities are conducted through the Bank. The Company became a registered bank holding company that is subject to supervision by the Federal Reserve. The Bank is subject to supervision by the DBO and, as a Federal Reserve member bank since 2012, the Federal Reserve. The Bank’s deposits are insured up to legal limits by the FDIC.

The Bank provides financial services that include commercial banking, business lending, commercial and residential real estate lending, and mortgage warehouse lending. Our client base is diverse and consists of business and individual clients in California and other states and includes digital currency-related customers in the United States and internationally. Following the Bank’s conversion to a commercial bank we began introducing an expanded array of relationship-oriented business products and services, which in the past four years has been augmented by our digital currency initiative. While our commercial real estate lending activities are concentrated in California, we have a broader, nationwide focus on deposit and cash management services for digital currency-related businesses, as well as mortgage warehouse and correspondent residential lending. Our goal is to establish profitable long-term banking relationships.

Two major developments affecting our financial condition and results of operations since December 31, 2016 have been the substantial growth in our deposits and the change in their mix and the recent significant increase in our capital position, as described below.

From December 31, 2016 to December 31, 2018, our total deposits grew from $767.9 million to $1.8 billion, a 132.2% increase. More importantly, over the same period our noninterest bearing deposits grew from $166.5 million to $1.6 billion, representing more than an eight-fold increase. At December 31, 2018, noninterest bearing deposits represented 88.7% of our total deposits, compared to 21.7% of total deposits at December 31, 2016. These changes in total deposits and noninterest bearing deposits are predominantly a result of our digital currency initiative that originated in 2013, with deposits related to this initiative growing from $45.8 million (90.4% noninterest bearing) at December 31, 2016, to $1.5 billion (97.3% noninterest bearing) at December 31, 2018. This growth in primarily noninterest bearing deposits enabled us to meaningfully increase our interest earning assets and decrease our borrowings and higher cost time deposits, all of which contributed to a significant increase in net interest income and net income.

On February 23, 2018, we completed the largest capital raise in our history, a private placement which raised $107.9 million of common equity, net of transaction expenses, $60.0 million of which was contributed as

 

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equity capital to our Bank subsidiary during the first quarter of 2018. Immediately after the sale of common stock, the Company purchased $11.4 million of common stock from an existing shareholder, resulting in a net increase in shareholders’ equity of $96.5 million. Our equity capital growth during the first quarter of 2018 supported increases in all Company and Bank capital ratios at December 31, 2018, as compared to December 31, 2017, most notably Tier I leverage ratio increased from 6.15% to 9.00% for the Company and from 6.33% to 8.51% for the Bank, and total risk-based capital ratio increased from 13.88% to 25.77% for the Company and from 14.29% to 24.50% for the Bank.

Principal Factors Affecting Our Results of Operations

Net Income. Net income is calculated by taking interest and noninterest income and subtracting our costs to do business, such as interest, salaries, taxes and other operational expenses. We evaluate our net income based on measures that include net interest margin, return on average assets and return on average equity.

Net Interest Income. Net interest income represents interest income, less interest expense. We generate interest income from interest, dividends and fees received on interest earning assets, including loans, interest earning deposits in other banks and investment securities we own. We incur interest expense from interest paid on interest bearing liabilities, including interest bearing deposits, borrowings and other forms of indebtedness. Net interest income typically is the most significant contributor to our net income. To evaluate net interest income, we measure and monitor: (i) yields on our loans, interest earning deposits in other banks and other interest earning assets; (ii) the costs of our deposits and other funding sources; (iii) our net interest spread; and (iv) our net interest margin. Net interest spread is the difference between rates earned on interest earning assets and rates paid on interest bearing liabilities. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Because noninterest bearing sources of funds, such as noninterest bearing deposits and shareholders’ equity, also fund interest earning assets, net interest margin includes the benefit of these noninterest bearing sources.

Since we maintain high levels of liquidity for our customers who operate in the digital currency industry, the extent to which we can generate net interest income on our deposits is limited by the fact that a significant proportion of our deposits are related to our digital currency initiative. See “Prospectus Summary—Overview.” Our diminished ability to generate interest income on our deposits in turn impacts our net interest margin. This impact is largely mitigated because currently deposits related to our digital currency initiative are generally noninterest bearing.

The success of our digital currency initiative has enabled the Bank to rapidly grow deposits from digital currency customers. The Bank deploys its customer deposits into interest earning deposits in other banks and securities, as well as into specialized lending opportunities that provide attractive risk-adjusted returns.

Changes in market interest rates and interest we earn on interest earning assets or pay on interest bearing liabilities, as well as the volume and types of our interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, usually have the largest impact on periodic changes in our net interest spread, net interest margin and net interest income. We measure net interest income before and after our provision for loan losses.

Provision for Loan Losses. Provision for loan losses is the amount of expense that, based on our management’s judgment, is required to maintain our allowance for loan losses at an adequate level to absorb probable losses inherent in our loan portfolio at the applicable balance sheet date and that, in our management’s judgment, is appropriate under relevant accounting guidance. Determination of the allowance for loan losses is complex and involves a high degree of judgment and subjectivity. For a description of the factors considered by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”

 

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Noninterest Income. Noninterest income consists of, among other things: (i) mortgage warehouse fee income; (ii) service fees related to off-balance sheet deposits; (iii) deposit related fees; (iv) gain on sale of loans; and (v) other noninterest income. Service fees related to off-balance sheet deposits are fees earned for off-balance sheet deposit placements, primarily for our digital currency customers. The placements are facilitated under agreements we have entered into with customers and nationally recognized third party service providers that, in accordance with customer instructions, allow us to sweep customer funds into deposit accounts at other insured depository institutions. In connection with such sweeps and placements, the Bank earns noninterest income based on the difference between the gross interest earned on such deposit placements and the net interest the Bank agreed to pay on such swept funds (if any). Deposit related fees include analyzed checking fees, account maintenance fees, insufficient funds fees, overdraft fees, stop payment fees, domestic and foreign wire transfer fees and card processing fee income.

Noninterest income has increased as the Bank has expanded deposit services to include cash sweep and analysis services to support customer demand. The Bank has also increased noninterest income related to foreign and domestic wire transactions which is a result of our digital currency initiative.

Noninterest Expense. Noninterest expense includes, among other things: (i) salaries and employee benefits; (ii) occupancy and equipment expense; (iii) communications and data processing fees (iv) professional services fees; (v) federal deposit insurance; (vi) correspondent bank charges; and (vii) other general and administrative expenses.

Salaries and employee benefits include compensation, employee benefits and tax expenses for our personnel. Occupancy and equipment expense includes depreciation expense, lease expense on our leased properties and other occupancy-related expenses. Equipment expense includes expenses related to our furniture, fixtures, equipment and software. Data processing fees include expenses paid to our third-party data processing system provider and other data service providers. Communications expense includes costs for telephone and internet. Professional fees include legal, accounting, consulting and other outsourcing arrangements. Federal deposit insurance expense relates to FDIC assessments based on the level of our deposits. Correspondent bank charges include wire transfer fees, transaction fees and service charges related to transactions settled with correspondent relationships. Other general and administrative expenses include expenses associated with travel, meals, advertising, promotions, sponsorships, training, supplies and postage. Noninterest expenses generally increase as we grow our business.

Noninterest expenses have increased as we have grown organically and as we have expanded and modernized our operational infrastructure and implemented our plan to build an efficient, technology-driven banking operation with significant capacity for growth. Significant increases in full-time equivalent employees have occurred in our operational and compliance division to support the continued deposit growth due to our digital currency initiative. In addition, we have expanded our information technology and security division to support enhancements in our technology infrastructure. Our professional services fees have increased as a result of our initiative to ensure we are operating efficiently and effectively while leveraging new and existing technology.

Factors Affecting Comparability of Financial Results

Following the completion of this offering, we expect to incur additional costs associated with operating as a public company. We expect that these costs will include additional personnel, legal, consulting, regulatory, insurance, accounting, investor relations and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, as well as rules adopted by the SEC, the Federal Reserve and national securities exchanges, requires public companies to implement specified corporate governance practices that are currently inapplicable to us as a private company. These additional rules and regulations will increase our legal, regulatory and financial compliance costs and will make some activities more time-consuming and costly.

 

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Financial Condition

The primary factors we use to evaluate and manage our financial condition include asset quality, capital and liquidity.

Asset Quality. We manage the diversification and quality of our assets based on factors that include the level, distribution, severity and trend of problem, classified, delinquent, nonaccrual, nonperforming and restructured assets, the adequacy of our allowance for loan losses, the diversification and quality of our loan and investment portfolios, the extent of counterparty risks, credit risk concentrations and other factors.

Capital. Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. During the first quarter of 2015, the Bank adopted the new Basel III regulatory capital framework as approved by federal banking agencies. The adoption of this new framework modified the calculation of the various capital ratios of the Bank, added a new ratio, common equity Tier 1, and revised the adequately and well capitalized thresholds of the Bank. In addition, Basel III established a new capital conservation buffer of 2.5% of risk-weighted assets, which is phased-in over a four-year period beginning January 1, 2016. The Bank’s capital ratios at December 31, 2018 exceeded all current well capitalized regulatory requirements.

We manage capital based upon factors that include: (i) the level and quality of capital and our overall financial condition; (ii) the trend and volume of problem assets; (iii) the adequacy of reserves; (iv) the level and quality of earnings; (v) the risk exposures in our balance sheet; (vi) the levels of Tier 1 and total capital; (vii) the Tier 1 risk-based capital ratio, the total risk-based capital ratio, the Tier 1 leverage ratio, and the common equity Tier 1 capital ratio; (viii) the state of local and national economic conditions; and (ix) other factors including our asset growth rate, as well as certain liquidity ratios.

Liquidity. We manage liquidity based on factors that include the amount of core deposits as a percentage of total deposits, the level of diversification of our funding sources, the allocation and amount of our deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets to be readily converted into cash without undue loss, the amount of cash, interest earning deposits in other banks and liquid securities we hold, the re-pricing characteristics and maturities of our assets when compared to the re-pricing characteristics of our liabilities and other factors.

We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. See “Risk Factors—Risks Related to Our Traditional Banking Business—A lack of liquidity could impair our ability to fund operations and adversely impact our business, financial condition and results of operations.” As a result, the Bank deploys its customer deposits into interest earning deposits in other banks and securities, as well as into specialized lending opportunities.

 

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Results of Operations

Year Ended December 31, 2018 compared to the Year Ended December 31, 2017

Net Income

The following table sets forth the principal components of net income for the periods indicated.

 

     Year Ended December 31,  
     2018     2017      $ Increase/
(Decrease)
    % Increase/
(Decrease)
 
     (Dollars in thousands)  

Interest income

   $ 72,752     $ 48,306      $ 24,446       50.6

Interest expense

     3,129       6,355        (3,226     (50.8 )% 
  

 

 

   

 

 

    

 

 

   

Net interest income

     69,623       41,951        27,672       66.0

(Reversal of) provision for loan losses

     (1,527     262        (1,789     (682.8 )% 
  

 

 

   

 

 

    

 

 

   

Net interest income after provision

     71,150       41,689        29,461       70.7

Noninterest income

     7,563       3,448        4,115       119.3

Noninterest expense

     48,314       30,706        17,608       57.3
  

 

 

   

 

 

    

 

 

   

Net income before income taxes

     30,399       14,431        15,968       110.7

Income tax expense

     8,066       6,788        1,278       18.8
  

 

 

   

 

 

    

 

 

   

Net income

   $ 22,333     $ 7,643      $ 14,690       192.2
  

 

 

   

 

 

    

 

 

   

Net income for the year ended December 31, 2018 was $22.3 million, an increase of $14.7 million or 192.2% from net income of $7.6 million for the year ended December 31, 2017. The increase was primarily due to an increase of $27.7 million or 66.0% in net interest income, partially offset by a $17.6 million or 57.3% increase in noninterest expense, all as described below.

Net Interest Income and Net Interest Margin Analysis

We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans, interest earning deposits in other banks and securities, and the interest expense incurred on interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing liabilities.

Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and types of interest earning assets, interest bearing and noninterest bearing liabilities and shareholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Southern California region, developments affecting the real estate, technology, hospitality, tourism and financial services sectors within our target markets and throughout the Southern California region, the volume and availability of residential loan pools and non-qualified residential loans and mortgage banker relationships. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings.

 

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The following tables show the average outstanding balance of each principal category of our assets, liabilities and shareholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and cost are calculated by dividing income or expense by the average daily balances of the associated assets or liabilities for the same period.

AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS

 

    Year Ended December 31,  
    2018     2017  
    Average
Outstanding
Balance
    Interest
Income/
Expense
    Average
Yield/
Rate
    Average
Outstanding
Balance
    Interest
Income/
Expense
     Average
Yield/
Rate
 
    (Dollars in thousands)  

Assets

            

Interest earning assets:

            

Interest earning deposits in other banks

  $ 851,283     $ 16,606       1.95   $ 203,029     $ 2,678        1.32

Securities

    263,903       7,332       2.78     106,730       2,274        2.13

Loans(1)(2)

    871,271       48,100       5.52     822,748       42,806        5.20

Other

    9,284       714       7.69     7,781       548        7.04
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total interest earning assets

    1,995,741       72,752       3.65     1,140,288       48,306        4.24
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest earning assets

    13,112           9,473       
 

 

 

       

 

 

      

Total assets

  $ 2,008,853         $ 1,149,761       
 

 

 

       

 

 

      

Liabilities and Shareholders’ Equity

            

Interest bearing liabilities:

            

Interest bearing deposits

  $ 258,583     $ 1,787       0.69   $ 482,091     $ 4,361        0.90

FHLB advances and other borrowings

    7,825       427       5.46     73,013       1,215        1.66

Subordinated debentures

    15,794       915       5.79     15,780       779        4.94
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total interest bearing liabilities

    282,202       3,129       1.11     570,884       6,355        1.11
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest bearing liabilities:

            

Noninterest bearing deposits

    1,554,852           503,480       

Other liabilities

    5,979           4,596       

Shareholders’ equity

    165,820           70,801       
 

 

 

       

 

 

      

Total liabilities and shareholders’ equity

  $ 2,008,853         $ 1,149,761       
 

 

 

       

 

 

      

Net interest spread(3)

        2.54          3.13
     

 

 

        

 

 

 

Net interest income

    $ 69,623         $ 41,951     
   

 

 

       

 

 

    

Net interest margin(4)

        3.49          3.68
     

 

 

        

 

 

 

 

(1)

Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period.

(2)

Interest income includes amortization of deferred loan fees, net of deferred loan costs.

(3)

Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities.

(4)

Net interest margin is a ratio calculated as annualized net interest income divided by average interest earning assets for the same period.

 

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Information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate.

ANALYSIS OF CHANGES IN NET INTEREST INCOME

 

     For the Year Ended
December 31, 2018 Compared to 2017
 
             Change Due To                 Interest    
    Variance    
 
         Volume             Rate      
     (Dollars in thousands)  

Interest Income:

      

Interest earning deposits in other banks

   $ 12,112     $ 1,816     $ 13,928  

Securities

     4,185       873       5,058  

Loans

     2,617       2,677       5,294  

Other

     118       48       166  
  

 

 

   

 

 

   

 

 

 

Total interest income

   $ 19,032     $ 5,414     $ 24,446  
  

 

 

   

 

 

   

 

 

 

Interest Expense:

      

Interest bearing deposits

   $ (1,766   $ (808   $ (2,574

FHLB advances and other borrowings

     (1,781     993       (788

Subordinated debentures

     2       134       136  
  

 

 

   

 

 

   

 

 

 

Total interest expense

     (3,545     319       (3,226
  

 

 

   

 

 

   

 

 

 

Net interest income

   $ 22,577     $ 5,095     $ 27,672  
  

 

 

   

 

 

   

 

 

 

Net interest income increased $27.7 million to $69.6 million for the year ended December 31, 2018 compared to $42.0 million for the year ended December 31, 2017, due to an increase of $24.4 million in interest income and a decrease of $3.2 million in interest expense. Interest earning assets and interest bearing liabilities, as well as the average rate paid on deposits were significantly impacted by the Company’s digital currency initiative and the corresponding change in the Company’s interest earning assets and interest bearing liabilities. Average total interest earning assets increased $855.5 million from $1.1 billion for the year ended December 31, 2017 to $2.0 billion for the year ended December 31, 2018. This increase was due to the inflow of noninterest bearing deposits related to our digital currency initiative which were invested primarily in interest earning deposits and securities. The average balance of interest earning deposits and securities increased from $203.0 million and $106.7 million, respectively, for the year ended December 31, 2017 to $851.3 million and $263.9 million, respectively, for the year ended December 31, 2018. The average annualized yield on total interest earning assets decreased from 4.24% for the year ended December 31, 2017 to 3.65% for the year ended December 31, 2018 as the funds from the inflow of noninterest bearing deposits were invested primarily in lower yielding and more liquid assets.

Average interest bearing liabilities decreased $288.7 million or 50.6% for the year ended December 31, 2018 as compared to 2017 primarily due to a decrease in interest bearing deposits between periods. The Company was able to replace these interest bearing deposits as a funding source due to the significant inflow of noninterest bearing deposits. The average balance of noninterest bearing deposits increased from $503.5 million for the year ended December 31, 2017 to $1.6 billion for the year ended December 31, 2018. As of December 31, 2018, noninterest bearing deposits amounted to $1.6 billion or 88.7% of total deposits.

 

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For the year ended December 31, 2018, the net interest spread was 2.54% and the net interest margin was 3.49% compared to 3.13% and 3.68%, respectively, for the comparable period in 2017. The decreases in the year ended December 31, 2018 were due primarily to the investment of funds from noninterest bearing deposits in lower yielding assets, as described above.

Provision for Loan Losses

The provision for loan losses is a charge to income to bring our allowance for loan losses to a level deemed appropriate by management. For a description of the factors considered by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses” and “—Critical Accounting Policies—Allowance for Loan Losses.”

We recorded a negative provision for loan losses of $1.5 million compared to a provision for loan losses $0.3 million for the year ended December 31, 2018 and 2017, respectively. The decrease of $1.8 million was primarily due to reclassifying $125.2 million in loans held-for-investment as loans held-for-sale in the fourth quarter of 2018, in connection with the Company’s November 2018 agreement to sell the Bank’s business lending division. The allowance for loan losses to total gross loans held-for-investment was 1.13% at December 31, 2018 compared to 1.17% at December 31, 2017.

Noninterest Income

The following table presents, for the periods indicated, the major categories of noninterest income:

NONINTEREST INCOME

 

     Year Ended December 31,  
     2018      2017      $ Increase/
(Decrease)
    % Increase/
(Decrease)
 
     (Dollars in thousands)  

Noninterest income:

          

Mortgage warehouse fee income

   $ 1,505      $ 1,732      $ (227     (13.1 )% 

Service fees related to off-balance sheet deposits

     2,422        223        2,199       986.1

Deposit related fees

     2,435        702        1,733       246.9

Gain on sale of loans

     711        459        252       54.9

Other income

     490        332        158       47.6
  

 

 

    

 

 

    

 

 

   

Total noninterest income

   $ 7,563      $ 3,448      $ 4,115       119.3
  

 

 

    

 

 

    

 

 

   

Noninterest income for the year ended December 31, 2018 was $7.6 million, an increase of $4.1 million or 119.3% compared to noninterest income of $3.4 million for the year ended December 31, 2017. This increase was primarily due to a $2.2 million increase in service fees related to off-balance sheet deposits due to increased off-balance sheet deposit placements primarily for our digital currency customers. Our off-balance sheet deposit placements are facilitated under agreements we have entered into with customers and nationally recognized third party service providers that, in accordance with customer instructions, allow us to sweep customer funds into deposit accounts at other insured depository institutions. In connection with such sweeps and placements, the Bank earns noninterest income based on the difference between the gross interest earned on such deposit placements and the net interest the Bank pays on such swept funds. The increase was also due to a $1.7 million increase in deposit related fees such as analyzed checking fees and wire transfer fees associated with our digital currency initiative. During the year ended December 31, 2018, the Bank sold $51.2 million of non-qualified single family residential loans for a gain of $0.6 million. An additional $0.1 million gain was recognized as a result of a $1.1 million commercial real estate loan sale.

 

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Noninterest Expense

The following table presents, for the periods indicated, the major categories of noninterest expense:

NONINTEREST EXPENSE

 

     Year Ended December 31,  
     2018      2017      $ Increase/
(Decrease)
     % Increase/
(Decrease)
 
     (Dollars in thousands)  

Noninterest expense:

           

Salaries and employee benefits

   $ 29,898      $ 20,168      $ 9,730        48.2

Occupancy and equipment

     3,091        2,397        694        29.0

Communications and data processing

     3,088        1,920        1,168        60.8

Professional services

     6,050        1,556        4,494        288.8

Federal deposit insurance

     1,230        683        547        80.1

Correspondent bank charges

     1,163        1,100        63        5.7

Other loan expense

     419        270        149        55.2

Other real estate owned expense

     27        22        5        22.7

Other general and administrative

     3,348        2,590        758        29.3
  

 

 

    

 

 

    

 

 

    

Total noninterest expense

   $ 48,314      $ 30,706      $ 17,608        57.3
  

 

 

    

 

 

    

 

 

    

Noninterest expense increased $17.6 million or 57.3% for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increases in salaries and employee benefits and professional services. To a lesser extent, the increase in noninterest expense for the year ended December 31, 2018 was due to increases in occupancy and equipment, communications and data processing, federal deposit insurance fees, correspondent bank charges and other general and administrative expenses. The increase of $9.7 million or 48.2% in salaries and employee benefits was due to increased staffing related to the growth of the Bank. The Bank’s full-time equivalent employees grew from 161 at December 31, 2017 to 211 at December 31, 2018 with significant increases in the Bank’s digital currency, compliance and administration divisions to support the growth of the organization. The increase of $4.5 million or 288.8% in professional services fees was primarily related to consulting, recruiting, and audit services. Consulting fees increased during the period as a result of numerous Bank initiatives designed to support infrastructure growth including technology improvements and enhanced internal control processes. As the Company continues to expand its technology solutions to compete in the digital currency market, these costs are expected to remain at current levels. Recruiting expenses increased as a direct result of the Bank’s growth in staff. Audit services increased as the Company prepared for complying with enhanced audit standards. Occupancy and equipment increased $0.7 million or 29.0% primarily due to expansion of the corporate headquarters to support our growth in headcount. Communications and data processing increased $1.2 million or 60.8% primarily due to updating our IT infrastructure and expansion projects to support our digital currency initiative. The increase of $0.5 million or 80.1% in federal deposit insurance payments was due to the significant increase in deposits compared to the prior period. Correspondent bank charges increased $0.1 million or 5.7% primarily due to wire transfers and bank charges. Correspondent bank charges grew as a result of increased wire expenses and other bank charges paid to our third-party processors as a direct result of the increased activity related to our digital currency customers. While the volume of transactions supporting these charges is expected to grow in conjunction with the growth of our digital currency customers, the Bank is exploring technology solutions that will ideally mitigate some of these costs. Other general and administrative expense increased $0.8 million or 29.3% primarily due to marketing, travel and other expenses as we increased staff and expanded the operations of the Bank.

 

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Income Tax Expense

The amount of income tax expense we incur is influenced by the amounts of our pre-tax income, and other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, such as the Tax Act, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Income tax expense was $8.1 million for the year ended December 31, 2018 compared to $6.8 million for the year ended December 31, 2017. The increase was primarily related to increased pre-tax income and was partially offset by the decrease in our effective tax rate. Our effective tax rates for the year ended December 31, 2018 and 2017 were 26.5% and 47.0%, respectively. The decrease in the effective tax rate was primarily related to the change in the statutory federal rate enacted by the Tax Act.

Financial Condition

As of December 31, 2018, our total assets increased to $2.0 billion compared to $1.9 billion as of December 31, 2017. Shareholders’ equity increased $117.4 million, or 159.1%, to $191.2 million at December 31, 2018. The increase in shareholders’ equity was due to net proceeds of $107.9 million from the sale of common stock in the first quarter of 2018. Immediately after the sale of common stock, the Company purchased $11.4 million of common stock from an existing shareholder, resulting in a net increase in shareholders’ equity of $96.5 million. In addition, net income for the year ended December 31, 2018 amounted to $22.3 million, increasing retained earnings.

Deposits

Deposits are the major source of funding for the Company. We offer a variety of deposit products including interest and noninterest bearing demand accounts, money market and savings accounts and certificates of deposit, all of which we market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers and our business banking officers. Deposits remained flat at $1.8 billion at December 31, 2018 compared to December 31, 2017.

Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, which has driven the Bank’s funding costs to among the lowest in the U.S. banking industry. This has allowed us to generate attractive returns on lower risk assets through increased investments in interest earning deposits in other banks and securities, as well as funding limited loan growth.

We segment our deposits based on their potential volatility, which drives our choices regarding the assets we fund with such deposits. Deposits attributable to digital currency exchange and investor funds have the highest potential volatility. See “Risk Factors—Risks Related to Our Digital Currency Initiative Our digital currency initiative has contributed significantly to an increase in our noninterest bearing deposits, which has driven the Bank’s funding costs to levels that may not be sustainable.” We invest these funds primarily in interest earning deposits in other banks and adjustable rate securities available-for-sale.

The Company has increased noninterest bearing deposits as a percentage of total deposits from 12.4% as of December 31, 2013 to 88.7% as of December 31, 2018, an increase that is largely attributable to the success of the digital currency initiative. This funding base has substantially reduced the Company’s cost of funds and allowed the Company to focus on retaining lower cost deposits. Our cost of total deposits and our cost of funds was 0.10% and 0.17%, respectively, for the year ended December 31, 2018 as compared to 0.78% and 1.00%, respectively, for the year ended December 31, 2013.

 

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The following table presents the average balances and average rates paid on deposits for the periods indicated:

COMPOSITION OF DEPOSITS

 

     Year Ended December 31,  
     2018     2017     2016  
     Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
    Average
Balance
     Average
Rate
 
     (Dollars in thousands)  

Noninterest bearing demand accounts

   $ 1,554,852        —       $ 503,480        —       $ 126,002        —    

Interest bearing accounts:

               

Interest bearing demand accounts

     53,627        0.14     27,117        0.16     16,683        0.35

Money market and savings accounts

     146,055        0.59     277,615        0.67     295,349        0.75

Certificates of deposit

     58,901        1.45     177,359        1.37     271,512        1.19
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total interest bearing deposits

     258,583        0.69     482,091        0.90     583,544        0.94
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total deposits

   $ 1,813,435        0.10   $ 985,571        0.44   $ 709,546        0.77
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

The following table presents the maturities of our certificates of deposit as of December 31, 2018:

MATURITIES OF CERTIFICATES OF DEPOSIT

 

     Three
Months
or Less
     Over
Three
Through
Six
Months
     Over Six
Through
Twelve
Months
     Over
Twelve
Months
     Total  
     (Dollars in thousands)  

$100,000 or more

   $ 6,255      $ 11,060      $ 7,264      $ 1,813      $ 26,392  

Less than $100,000

     1,687        2,592        2,114        618        7,011  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 7,942      $ 13,652      $ 9,378      $ 2,431      $ 33,403  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Interest Earning Deposits in Other Banks

Interest earning deposits in other banks decreased from $793.7 million at December 31, 2017 to $670.2 million at December 31, 2018 due to lower balances with the FRB and purchases of securities.

Securities

We use our securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements.

Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. For the years presented, substantially all securities were classified as available-for-sale.

Our securities portfolio has grown substantially as our noninterest bearing deposits attributable to our digital currency initiative have expanded. Our securities available-for-sale increased $165.4 million, or 86.2%, from

 

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$191.8 million at December 31, 2017 to $357.2 million at December 31, 2018. To supplement interest income earned on our loan portfolio, we invest in high quality mortgage-backed securities, collateralized mortgage obligations and asset backed securities.

The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2018 and the amortized cost and carrying value of those securities as of the indicated dates.

SECURITIES

 

    One Year or Less     More Than One
Year Through
Five Years
    More Than Five
Years Through
10 Years
    More Than
10 Years
    Total  
     Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Fair
Value
    Weighted
Average
Yield
 

December 31, 2018

  (Dollars in thousands)  

Securities Available-for-Sale:

                     

Mortgage-backed securities:

                     

Residential

  $ 53       4.69   $ —         —       $ —         —       $ 879       4.37   $ 932     $ 957       4.39

Commercial real estate

    —         —         —         —         —         —         19,141       4.32     19,141       19,061       4.32

Collateralized mortgage obligations

    —         —         15,769       1.85     8,048       1.77     55,735       3.05     79,552       77,936       2.69

Asset backed securities

    —         —         —         —         —         —         260,050       3.21     260,050       259,224       3.21

Securities Held-to-Maturity:

                     

Collateralized mortgage obligations

    —         —         —         —         —         —         73       2.61     73       72       2.61
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Securities

  $ 53       4.69   $ 15,769       1.85   $ 8,048       1.77   $ 335,878       3.25   $ 359,748     $ 357,250       3.16
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

    December 31, 2018     December 31, 2017     December 31, 2016  
    Total     Total     Total  
    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
 
    (Dollars in thousands)  

Securities Available-for-Sale:

           

Mortgage-backed securities:

           

Residential

  $ 932     $ 957     $ 1,075     $ 1,114     $ 1,269     $ 1,319  

Commercial real estate

    19,141       19,061       24,549       24,550       —         —    

Collateralized mortgage obligations

    79,552       77,936       85,043       84,038       89,008       87,731  

Asset backed securities

    260,050       259,224       82,191       82,100       —         —    

Securities Held-to-Maturity:

           

Collateralized mortgage obligations

    73       72       119       119       405       410  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Securities

  $ 359,748     $ 357,250     $ 192,977     $ 191,921     $ 90,682     $ 89,460  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Loan Portfolio

Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate and mortgage warehouse loans, as well as commercial and industrial loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, multi-family loans and commercial and industrial loans provide us with higher risk-adjusted returns, relatively shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our commercial real estate, multi-family real estate, construction and commercial and industrial lending activities are principally directed to our market area of Southern California. Our one-to-four family residential loans and warehouse loans are sourced throughout the United States. The decrease in our commercial and industrial loans was primarily a result of our planned sale of business loans and a retail location to HomeStreet Bank. As of December 31, 2018 these loans were classified on our balance sheet as loans held for sale.

The following table summarizes our loan portfolio by loan segment as of the dates indicated:

COMPOSITION OF LOAN PORTFOLIO

 

    As of December 31,  
    2018     2017     2016     2015     2014  
     Amount       Percent      Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  
    (Dollars in thousands)  

Real estate:

                   

One-to-four family

  $ 190,885       32.0   $ 219,855       31.6   $ 220,784       32.7   $ 231,107       35.9   $ 193,561       31.1

Multi-family

    40,584       6.8     23,958       3.4     26,344       3.9     30,421       4.7     33,287       5.3

Commercial

    309,655       51.9     346,227       49.8     284,547       42.1     211,303       32.9     175,932       28.3

Construction

    3,847       0.6     5,171       0.7     39,529       5.9     43,761       6.8     18,514       3.0

Commercial and industrial

    8,586       1.4     50,852       7.3     40,816       6.0     25,768       4.0     5,609       0.9

Consumer and other

    150       0.0     1,262       0.2     1,321       0.2     2,355       0.4     2,534       0.4

Reverse mortgage

    1,742       0.3     2,524       0.4     4,534       0.7     157       0.1     109,713       17.6

Mortgage warehouse

    41,586       7.0     45,718       6.6     57,525       8.5     98,035       15.2     83,703       13.4
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total gross loans held-for-
investment

    597,035       100.0     695,567       100.0     675,400       100.0     642,907       100.0     622,853       100.0

Deferred fees, net

    2,469         1,901         1,780         1,503         5,538    

Total loans held-for-investment

    599,504         697,468         677,180         644,410         628,391    

Allowance for loan losses

    (6,723       (8,165       (8,044       (6,900       (4,956  
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Total net loans

  $ 592,781       $ 689,303       $ 669,136       $ 637,510       $ 623,435    
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Loans held-for-sale

  $ 350,636       $ 190,392       $ 166,986       $ 169,190       $ 107,068    
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

 

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The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2018:

LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES

 

     As of December 31, 2018  
     Due in One Year
or Less
     Due in One to
Five Years
     Due After
Five Years
     Total  
     (Dollars in thousands)  

Real estate:

           

One-to-four family

   $ 71      $ 344      $ 190,470      $ 190,885  

Multi-family

     5        9,501        31,078        40,584  

Commercial

     23,491        144,156        142,008        309,655  

Construction

     3,847        —          —          3,847  

Commercial and industrial

     1,666        6,920        —          8,586  

Consumer and other

     150        —          —          150  

Reverse mortgage

     —          —          1,742        1,742  

Mortgage warehouse

     41,586        —          —          41,586  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total gross loans held-for-investment

   $ 70,816      $ 160,921      $ 365,298      $ 597,035  
  

 

 

    

 

 

    

 

 

    

 

 

 

Amounts with fixed rates

   $ 39,027      $ 114,270      $ 64,501      $ 217,798  
  

 

 

    

 

 

    

 

 

    

 

 

 

Amounts with floating rates

   $ 31,789      $ 46,651      $ 300,797      $ 379,237  
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonperforming Assets

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether such loans are actually past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments received exceed principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection.

We believe our disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our bankers, and we also monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

Nonperforming loans increased to $8.3 million, or 1.39% of total loans, at December 31, 2018 compared to $4.5 million, or 0.65% of total loans, at December 31, 2017. The increase in nonperforming loans during the year ended December 31, 2018 was primarily due to a loan relationship consisting of three commercial and industrial loans in an aggregate amount of $4.5 million; these three loans are cross defaulted and collateralized by either, or a combination of, real estate, accounts receivable, assignments of rents, and personal guarantees. The Bank and the borrowers and guarantors entered into a repayment agreement effective October 2, 2018. The Company has performed an impairment and collateral analysis on the loans associated with this relationship and does not expect to incur any

 

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losses at this time. In the fourth quarter of 2018, the commercial and industrial loans were reduced by approximately $0.9 million due to loan principal repayments.

Other real estate owned decreased to $31,000 as of December 31, 2018 compared to $2.3 million as of December 31, 2017, due to sales during the period.

Total nonperforming assets were $8.3 million and $6.8 million at December 31, 2018 and 2017, respectively, or 0.42% and 0.36%, respectively, of total assets.

The following table presents information regarding nonperforming assets at the dates indicated:

NONPERFORMING ASSETS

 

     As of December 31,  
     2018     2017     2016     2015     2014  
     (Dollars in thousands)  

Nonaccrual loans

          

Real Estate:

          

One-to-four family

   $ 3,062     $ 2,652     $ 2,500     $ 1,911     $ 2,049  

Commercial

     422       —         —         1,776       1,968  

Commercial and industrial

     3,596       —         177       176       377  

Reverse mortgage

     1,223       1,858       2,250       157       406  

Accruing loans 90 or more days past due

     —         —         199       —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total gross nonperforming loans

     8,303       4,510       5,126       4,020       4,800  

Other real estate owned, net

     31       2,308       562       1,292       —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming assets

   $ 8,334     $ 6,818     $ 5,688     $ 5,312     $ 4,800  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Restructured loans-nonaccrual

   $ 301     $ 424     $ 903     $ 1,993     $ 1,212  

Restructured loans-accruing

   $ 213     $ 168     $ 41     $ 363     $ 893  

Ratio of nonperforming loans to total loans(1)

     1.39     0.65     0.76     0.63     0.77

Ratio of nonperforming assets to total assets

     0.42     0.36     0.58     0.56     0.55

 

(1)

Total loans exclude loans held-for-sale at each of the dates presented.

Loans Grading

From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. We review the ratings on credits regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). The Bank uses the following definitions for watch list risk ratings:

 

   

Pass. Loans in all classes that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.

 

   

Special Mention. A special mention loan has potential weaknesses deserving of management’s close attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date.

 

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Substandard. A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if deficiencies are not corrected.

 

   

Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable.

 

   

Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss.

The following table presents the loan balances by segment as well as risk rating. No assets were classified as loss during the periods presented.

LOAN CLASSIFICATION

 

     Pass      Special
Mention
     Substandard      Doubtful      Total  
     (Dollars in thousands)  

December 31, 2018

              

Real estate loans:

              

One-to-four family

   $ 187,823      $ —        $ 3,062      $ —        $ 190,885  

Multi-family

     40,584        —          —          —          40,584  

Commercial

     309,233        —          422        —          309,655  

Construction

     3,847        —          —          —          3,847  

Commercial and industrial

     4,630        360        3,596        —          8,586  

Consumer and other

     150        —          —          —          150  

Reverse mortgage

     214        305        1,223        —          1,742  

Mortgage warehouse

     41,586        —          —          —          41,586  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total gross loans held-for-investment

   $ 588,067      $ 665      $ 8,303      $ —        $ 597,035  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2017

              

Real estate loans:

              

One-to-four family

   $ 217,203      $ —        $ 2,652      $ —        $ 219,855  

Multi-family

     23,958        —          —          —          23,958  

Commercial

     342,391        1,889        1,947        —          346,227  

Construction

     5,171        —          —          —          5,171  

Commercial and industrial

     50,136        716        —          —          50,852  

Consumer and other

     1,262        —          —          —          1,262  

Reverse mortgage

     156        510        1,858        —          2,524  

Mortgage warehouse

     45,718        —          —          —          45,718  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total gross loans held-for-investment

   $ 685,995      $ 3,115      $ 6,457      $ —        $ 695,567  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loan Reviews and Problem Loan Management.

Our credit administration staff conducts meetings at least eight times a year to review asset quality and loan delinquencies. The Bank’s Lending and Collection Policy requires that we perform annual reviews of every loan of $250,000 or more not rated special mention or adversely classified. Individual loan reviews encompass a loan’s payment status and history, current and projected paying capacity of the borrower and/or guarantor(s), current condition and estimated value of any collateral, sufficiency of credit and collateral documentation, and compliance with Bank and regulatory lending standards. Loan reviewers assign an overall loan risk rating from one of the Bank’s loan rating categories and prepare a written report summarizing the review, with any work papers related to the review retained.

 

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Once a loan is identified as a problem loan or a loan requiring a workout, the Bank makes an evaluation and develops a plan for handling the loan. In developing such a plan, management reviews all relevant information from the loan file and any loan review reports. We have a conversation with the borrower and update current and projected financial information (including borrower global cash flows when possible) and collateral valuation estimates. Following analysis of all available relevant information, management adopts an action plan from the following alternatives: (a) continuation of loan collection efforts on their existing terms, (b) a restructure of the loan’s terms, (c) a sale of the loan, (d) a charge off or partial charge off, (e) foreclosure on pledged collateral, or (f) acceptance of a deed in lieu of foreclosure.

Impaired Loans and TDRs. Impaired loans also include certain loans that have been modified as troubled debt restructurings, or TDRs. As of December 31, 2018 the Company held seven loans amounting to $0.5 million, which were TDRs, compared to nine loans amounting to $0.6 million at December 31, 2017.

A loan is identified as a TDR when a borrower is experiencing financial difficulties and, for economic or legal reasons related to these difficulties, the Company grants a concession to the borrower in the restructuring that it would not otherwise consider. The Company has granted a concession when, as a result of the restructuring, it does not expect to collect all amounts due or within the time periods originally due under the original contract, including one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a temporary forbearance with regard to the payment of principal or interest. All troubled debt restructurings are reviewed for potential impairment. Generally, a nonaccrual loan that is restructured remains on nonaccrual status for a minimum period of six months to demonstrate that the borrower can perform under the restructured terms. If the borrower’s performance under the new terms is not reasonably assured, the loan remains classified as a nonaccrual loan. Loans classified as TDRs are reported as impaired loans.

Allowance for Loan Losses

We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. See “Critical Accounting Policies—Allowance for Loan Losses.”

In reviewing our loan portfolio, we consider risk elements attributable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include:

 

   

for residential mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt-to-income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral;

 

   

for commercial and multi-family mortgage loans, the debt service coverage ratio, operating results of the owner in the case of owner-occupied properties, the loan-to-value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;

 

   

for construction loans, the perceived feasibility of the project including the ability to sell improvements constructed for resale, the quality and nature of contracts for presale, if any, experience and ability of the builder, loan-to-cost ratio and loan-to-value ratio;

 

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for commercial and industrial loans, the debt service coverage ratio (income from the business exceeding operating expenses compared to loan repayment requirements), the operating results of the commercial or professional enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; and

 

   

for mortgage warehouse loans held-for-investment, despite our negligible loss history, we provide a loss allowance factor subject to quarterly adjustment. Mortgage warehouse loans held-for-sale are not subject to any loan loss allowance.

The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated:

ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES

 

    For the Years Ended December 31,  
    2018     2017     2016     2015     2014  
    (Dollars in thousands)  

Total gross loans outstanding (end of period)

  $ 597,035     $ 695,567     $ 675,400     $ 642,907     $ 622,853  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average gross loans outstanding

  $ 687,257     $ 673,922     $ 649,234     $ 617,603     $ 491,294  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses at beginning of period

  $ 8,165     $ 8,044     $ 6,900     $ 4,956     $ 3,927  

Charge-offs:

         

Real estate:

         

One-to-four family

    6       53       —         38       44  

Commercial and industrial

    —         83       6       18       12  

Reverse mortgage

    —         —         5       —         —    

Mortgage warehouse

    —         76       —         —         —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

    6       212       11       56       56  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries:

         

Real estate:

         

One-to-four family

    (10     (49     —         (18     (3

Multi-family

    —         —         —         (76     (15

Commercial and industrial

    (80     (6     —         —         —    

Reverse mortgage

    (1     (1     (19     —         —    

Mortgage warehouse

    —         (15     —         —         —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

    (91     (71     (19     (94     (18
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs (recoveries)

    (85     141       (8     (38     38  

(Reversal of) provision for loan losses

    (1,527     262       1,136       1,906       1,067  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses at period end

  $ 6,723     $ 8,165     $ 8,044     $ 6,900     $ 4,956  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses to period end loans

    1.13     1.17     1.19     1.07     0.80
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs (recoveries) to average loans

    (0.01 )%      0.02     0.00     (0.01 )%      0.01
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Our allowance for loan losses at December 31, 2018 and 2017 was $6.7 million and $8.2 million, respectively, or 1.13% and 1.17% of loans for each respective period-end. We had $6,000 in charge-offs for the year ended December 31, 2018 and recoveries of $0.1 million compared to charge-offs of $0.2 million and $0.1 million recoveries for the year ended December 31, 2017.

Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio.

 

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The following table shows the allocation of the allowance for loan losses among loan categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category.

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

 

    As of December 31,  
    2018     2017     2016     2015     2014  
    Amount     Percent (1)     Amount     Percent (1)     Amount     Percent (1)     Amount     Percent (1)     Amount     Percent (1)  
    (Dollars in thousands)  

Real estate:

                   

One-to-four family

  $ 1,848       0.31   $ 1,991       0.29   $ 2,046       0.30   $ 1,994       0.31     1,451       0.23

Multi-family

    483       0.08     226       0.03     271       0.04     351       0.05     433       0.07

Commercial

    3,854       0.65     4,711       0.68     3,624       0.54     2,486       0.39     1,675       0.27

Construction

    98       0.02     140       0.02     1,082       0.16     1,193       0.19     511       0.08

Commercial and industrial

    156       0.03     677       0.10     612       0.09     499       0.08     144       0.03

Consumer and other

    1       0.00     18       0.00     18       0.00     18       0.00     16       0.00

Reverse mortgage

    54       0.01     41       0.00     75       0.01     16       0.00     429       0.07

Mortgage warehouse

    229       0.04     361       0.05     316       0.05     343       0.05     297       0.05
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for loan losses

  $ 6,723       1.13   $ 8,165       1.17   $ 8,044       1.19   $ 6,900       1.07     4,956       0.80
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

Loan category as a percentage of total gross loans.

Borrowings

We primarily utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below.

FHLB Advances. The FHLB allows us to borrow up to 35% of the Bank’s assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2018, approximately $625.3 million in real estate loans were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2018, we had $472.3 million in available borrowing capacity from the FHLB. Our use of FHLB advances has been significantly reduced due to the inflow of noninterest bearing deposits. At December 31, 2018, we did not have any FHLB advances. The following table sets forth certain information on our FHLB borrowings during the periods presented:

FHLB ADVANCES

 

     Year Ended December 31,  
     2018     2017     2016  
     (Dollars in thousands)  

Amount outstanding at period-end

   $ —       $ 15,000     $ 115,000  

Weighted average interest rate at period-end

     —         1.37     0.54

Maximum month-end balance during the period

   $ 15,000     $ 165,000     $ 192,000  

Average balance outstanding during the period

   $ 1,274     $ 65,452     $ 111,216  

Weighted average interest rate during the period

     1.49     1.17     0.60

Federal Reserve Bank of San Francisco. The FRB has an available borrower in custody arrangement that allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $10.7 million as of December 31, 2018. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2018.

 

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Other borrowings. The Company has also issued subordinated debentures and obtained a term loan. At December 31, 2018, these other borrowings amounted to $20.7 million.

A trust formed by the Company issued $12.5 million of floating rate trust preferred securities in July 2001 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at six-month LIBOR plus 375 basis points, which adjusts every six months in January and July of each year. Interest is payable semiannually. At December 31, 2018, the interest rate for the Company’s next scheduled payment was 6.28%, based on six-month LIBOR of 2.53%. On any January 25 or July 25 the Company may redeem the 2001 subordinated debentures at 100% of principal amount plus accrued interest. The 2001 subordinated debentures mature on July 25, 2031.

A second trust formed by the Company issued $3.0 million of trust preferred securities in January 2005 as part of a pooled offering of such securities. The Company issued subordinated debentures to the trust in exchange for its proceeds from the offering. The debentures and related accrued interest represent substantially all the assets of the trust. The subordinated debentures bear interest at three-month LIBOR plus 185 basis points, which adjusts every three months. Interest is payable quarterly. At December 31, 2018, the interest rate for the Company’s next scheduled payment was 4.64%, based on three-month LIBOR of 2.79%. On the 15th day of any March, June, September, or December, the Company may redeem the 2005 subordinated debentures at 100% of principal amount plus accrued interest. The 2005 subordinated debentures mature on March 15, 2035.

The Company also retained a 3% minority interest in each of these trusts which is included in subordinated debentures. The balance of the equity in the trusts is comprised of mandatorily redeemable preferred securities. The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations. The Company has the right to defer interest payments on the subordinated debentures from time to time for a period not to exceed five years.

On January 29, 2016, the Company obtained a term loan from a commercial bank with a single principal advance of $8.0 million due to mature on January 29, 2021. Loan interest and principal is payable quarterly commencing April 2016 and accrues interest at an annual rate equal to 2.60% plus the greater of zero percent and the one-month LIBOR rate. As of December 31, 2018, the one-month LIBOR rate was 2.375%. The proceeds were used to redeem preferred stock and can be prepaid at any time. The outstanding principal at December 31, 2018 was $4.9 million. Annual principal payments on outstanding borrowings are $1.1 million for years 2019 to 2020 and $2.6 million in 2021.

The Company also has available lines of credit of $32.0 million with other correspondent banks at December 31, 2018.

Liquidity and Capital Resources

Liquidity

Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operation, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management.

 

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We maintain high levels of liquidity for our customers who operate in the digital currency industry, as these deposits are subject to potentially dramatic fluctuations due to certain factors that may be outside of our control. See “Risk Factors—Risks Related to Our Traditional Banking Business—A lack of liquidity could impair our ability to fund operations and adversely impact our business, financial condition and results of operations.” As a result, our investment portfolio is comprised primarily of mortgage-backed securities backed by government-sponsored entities, collateralized mortgage obligations and asset-backed securities.

Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process.

The movement of funds on our balance sheet among different SEN deposit customers does not reduce the Bank’s deposits and thus does not present liquidity issues or require any borrowing by the Company or the Bank. In addition, to the extent that SEN participants fully withdraw funds from the Bank, no material liquidity issues or borrowing needs would be presented since the majority of SEN deposit funds are held in cash or other short duration liquid assets.

We expect funds to be available from basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include borrowings from the FHLB, other lines of credit and, if necessary, brokered certificates of deposit. We did not have any borrowings outstanding with the FRB at December 31, 2018 or December 31, 2017 and our borrowing capacity is limited only by eligible collateral. As of December 31, 2018, we had $472.3 million of available borrowing capacity from the FHLB, $10.7 million of available borrowing capacity from the FRB and available lines of credit of $32.0 million with other correspondent banks. Cash and cash equivalents at December 31, 2018 were $674.4 million. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary.

Capital Resources

Shareholders’ equity increased $117.4 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase in shareholders’ equity was due to net proceeds of $107.9 million from the sale of common stock in the first quarter of 2018. Immediately after the sale of common stock, the Company purchased $11.4 million of common stock from an existing shareholder, resulting in a net increase in shareholders’ equity of $96.5 million. In addition, net income resulted in an increase to retained earnings of $22.3 million.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative

 

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measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1,250%. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion, which we refer to below as “covered” banking organizations. The Company and the Bank were required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules) as of January 1, 2015 and January 1, 2018, respectively. The Company and the Bank made a one-time, permanent election to opt out of the inclusion of Accumulated Other Comprehensive Income, or AOCI, requirements on March 31, 2015 and with this election actual regulatory capital ratios reflect all applicable fully phased in Basel III requirements.

As of December 31, 2018, the Company and the Bank were in compliance with all applicable regulatory capital requirements to which they were subject, and the Bank was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth to remain in compliance with all regulatory capital standards applicable to us. See “Supervision and Regulation—Capital Adequacy Guidelines” for additional discussion regarding the regulatory capital requirements applicable to the Company and the Bank.

The following table presents the regulatory capital ratios for the Company and the Bank as of the dates indicated:

 

    Actual     Minimum capital
adequacy
    To be well
capitalized
 
     Amount     Ratio     Amount     Ratio     Amount     Ratio  

December 31, 2018

  (Dollars in thousands)  

The Company

 

Tier 1 leverage ratio (to average assets)

  $ 208,807       9.00   $ 92,812       4.00     N/A       N/A  

Common equity tier 1 capital ratio (to risk-weighted assets)

    193,307       23.10     37,650       4.50     N/A       N/A  

Tier 1 capital (to risk-weighted assets)

    208,807       24.96     50,200       6.00     N/A       N/A  

Total capital ratio (to risk-weighted assets)

    215,638       25.77     66,933       8.00     N/A       N/A  

The Bank

           

Tier 1 leverage ratio (to average assets)

    197,175       8.51     92,637       4.00     115,796       5.00

Common equity tier 1 capital ratio (to risk-weighted assets)

    197,175       23.68     37,472       4.50     54,127       6.50

Tier 1 capital (to risk-weighted assets)

    197,175       23.68     49,963       6.00     66,618       8.00

Total capital ratio (to risk-weighted assets)

    204,006       24.50     66,618       8.00     83,272       10.00

 

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    Actual     Minimum capital
adequacy
    To be well
capitalized
 
     Amount     Ratio     Amount     Ratio     Amount     Ratio  

December 31, 2017

  (Dollars in thousands)  

The Company

           

Tier 1 leverage ratio (to average assets)

  $ 90,507       6.15   $ 58,866       4.00     N/A       N/A  

Common equity tier 1 capital ratio (to risk-weighted assets)

    75,007       10.54     32,024       4.50     N/A       N/A  

Tier 1 capital (to risk-weighted assets)

    90,507       12.72     42,692       6.00     N/A       N/A  

Total capital ratio (to risk-weighted assets)

    98,817       13.88     56,955       8.00     N/A       N/A  

The Bank

           

Tier 1 leverage ratio (to average assets)

    93,030       6.33     58,787       4.00     73,483       5.00

Common equity tier 1 capital ratio (to risk-weighted assets)

    93,030       13.11     31,932       4.50     46,125       6.50

Tier 1 capital (to risk-weighted assets)

    93,030       13.11     42,577       6.00     56,769       8.00

Total capital ratio (to risk-weighted assets)

    101,340       14.29     56,733       8.00     70,917       10.00

Contractual Obligations

We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2018.

CONTRACTUAL OBLIGATIONS

 

     Due in 1
Year or Less
     Due After 1
Through
3 Years
     Due After 3
Through
5 Years
     Due After
5 Years
     Total  

As of December 31, 2018

   (Dollars in thousands)  

Certificates of Deposit $100,000 or more

   $ 24,579      $ 1,507      $ 306      $ —        $ 26,392  

Certificates of Deposit less than $100,000

     6,393        518        100        —          7,011  

Operating leases

     1,598        3,129        1,748        14        6,489  

Subordinated debt

     —          —          —          15,802        15,802  

Notes payable

     1,143        3,714        —          —          4,857  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 33,713      $ 8,868      $ 2,154      $ 15,816      $ 60,551  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Off-Balance Sheet Items

In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated statements of financial condition. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk exceeding the amounts recognized in our consolidated statements of financial condition. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however, we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated statements of financial condition.

Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements.

 

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CREDIT EXTENSION COMMITMENTS

 

     As of December 31,  
     2018      2017      2016  
     (Dollars in thousands)  

Unfunded lines of credit

   $ 71,398      $ 58,180      $ 72,171  

Letters of credit

     10        278        100  
  

 

 

    

 

 

    

 

 

 

Total credit extension commitments

   $ 71,408      $ 58,458      $ 72,271  
  

 

 

    

 

 

    

 

 

 

Unfunded lines of credit represent unused credit facilities to our current borrowers that represent no change in credit risk that exist in our portfolio. Lines of credit generally have variable interest rates. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the client from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants like those contained in loan agreements and our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers.

We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these letters of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used.

Commitments to extend credit are agreements to lend funds to a customer, if there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer.

Interest Rate Sensitivity and Market Risk

As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We manage our sensitivity position within our established guidelines.

Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those that have a short term to maturity. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.

We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options or financial future contracts for the purpose of reducing interest rate risk. We hedge the interest rate risks of our subordinated

 

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debentures by utilizing interest rate caps. Based on the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.

Our exposure to interest rate risk is managed by the Bank’s Asset/Liability Management Committee, or ALCO, in accordance with policies approved by our board of directors. The committee formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the committee considers the impact on earnings and capital on the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The committee meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the committee reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity. Management employs methodologies to manage interest rate risk, which include an analysis of relationships between interest earning assets and interest bearing liabilities and an interest rate shock simulation model.

The following table indicates that, for periods less than one year, rate-sensitive assets exceeded rate-sensitive liabilities, resulting in an asset-sensitive position. For a bank with an asset-sensitive position, or positive gap, rising interest rates would generally be expected to have a positive effect on net interest income, and falling interest rates would generally be expected to have the opposite effect.

INTEREST SENSITIVITY GAP

 

    Within One
Month
    After One
Month
Through
Three
Months
    After Three
Through
Twelve
Months
    Within One
Year
    Greater
Than One
Year or
Non
-Sensitive
    Total  

December 31, 2018

  (Dollars in thousands)  

Assets

           

Interest earning assets

           

Loans(1)

  $ 329,205     $ 19,570     $ 77,536     $ 426,311     $ 523,829     $ 950,140  

Securities(2)

    311,891       2,423       16,943       331,257       35,654       366,911  

Interest earning deposits in other banks

    664,315       —         —         664,315       5,928       670,243  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total earning assets

  $ 1,305,411     $ 21,993     $ 94,479     $ 1,421,883     $ 565,411     $ 1,987,294  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities

           

Interest bearing liabilities

           

Interest bearing deposits

  $ 123,175     $ —       $ —       $ 123,175     $ —       $ 123,175  

Certificates of deposit

    2,332       4,583       20,739       27,654       2,082       29,736