10-K 1 pbib20151231_10k.htm FORM 10-K pbib20151231_10k.htm Table Of Contents

 

 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 10-K 


 

(Mark One)

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

   
  For the Fiscal Year Ended December 31, 2015

 

OR

 

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

  For the transition period from              to             

 

 Commission file number: 001-33033  


PORTER BANCORP, INC.

(Exact name of registrant as specified in its charter)


 

Kentucky

61-1142247

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer Identification No.)

 

   

2500 Eastpoint Parkway, Louisville, Kentucky

40223

(Address of principal executive offices)

(Zip Code)

 

Registrant’s telephone number, including area code: (502) 499-4800

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

 

 

Title of each class

Name of each exchange on which registered

Common Stock, no par value

NASDAQ Capital Market

 

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

None

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

 

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

 

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

 

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

 

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

 

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

 

   Large accelerated filer  ☐    Accelerated filer  ☐    Non-accelerated filer  ☐    Smaller reporting company  ☒

 

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

 

The aggregate market value of the voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the close of business on June 30, 2015, was $15,625,021 based upon the last sales price reported for such date on the NASDAQ Capital Market.

 

 20,086,177 shares of Common Stock and 6,858,000 shares of Non-Voting Common Stock, no par value, were outstanding as of February 29, 2016.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held May 25, 2016 are incorporated by reference into Part III of this Form 10-K.

 



  

TABLE OF CONTENTS

 

     

 

 

 Page No.

PART I

 

1

Item 1.

Business

9

Item 1A.

Risk Factors

19

Item 1B.

Unresolved Staff Comments

19

Item 2.

Properties

19

Item 3.

Legal Proceedings

19

Item 4.

Mine Safety Disclosures

19

     

PART II

 

20

Item 5.

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

20

Item 6.

Selected Financial Data

22

Item 7.

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

23

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

54

Item 8.

Financial Statements and Supplementary Data

56

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

103

Item 9A.

Controls and Procedures

103

Item 9B.

Other Information

103

     

PART III

 

104

Item 10.

Directors, Executive Officers and Corporate Governance

104

Item 11.

Executive Compensation

104

Item 12.

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

104

Item 13.

Certain Relationships and Related Transactions, and Director Independence

104

Item 14.

Principal Accounting Fees and Services

104

     

PART IV

 

105

Item 15.

Exhibits and Financial Statement Schedules

105

     

 

Signatures

106

     

 

Index to Exhibits

107

 

  

PART I

 

Preliminary Note Concerning Forward-Looking Statements

 

This report contains statements about the future expectations, activities and events that constitute forward-looking statements. Forward-looking statements express our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

 

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we expressed or implied in any forward-looking statements. These risks and uncertainties can be difficult to predict and may be beyond our control. Factors that could contribute to differences in our results include, but are not limited to deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; changes in the interest rate environment, which may reduce our margins or impact the value of securities, loans, deposits and other financial instruments; changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments; general economic or business conditions, either nationally, regionally or locally in the communities we serve, may be worse than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; the results of regulatory examinations; any matter that would cause us to conclude that there was impairment of any asset, including intangible assets; the continued service of key management personnel; our ability to attract, motivate and retain qualified employees; factors that increase the competitive pressure among depository and other financial institutions, including product and pricing pressures; the ability of our competitors with greater financial resources to develop and introduce products and services that enable them to compete more successfully than us; inability to comply with regulatory capital requirements and to secure any required regulatory approvals for capital actions; legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry; and fiscal and governmental policies of the United States federal government.

 

Other risks are detailed in Item 1A. “Risk Factors” of this Form 10-K all of which are difficult to predict and many of which are beyond our control.

 

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include the assumptions or bases underlying the forward-looking statement. We have made our assumptions and bases in good faith and believe they are reasonable. We caution you however, that estimates based on such assumptions or bases frequently differ from actual results, and the differences can be material. The forward-looking statements included in this report speak only as of the date of the report. We do not intend to update these statements unless applicable laws require us to do so.

 

Item 1.

Business

 

Overview

 

Porter Bancorp, Inc. (the “Company”) is a bank holding company headquartered in Louisville, Kentucky. We operate the tenth largest bank domiciled in the Commonwealth of Kentucky based on total assets through our wholly owned subsidiary PBI Bank (the “Bank”). We operate 15 banking offices in twelve counties in Kentucky. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products. As of December 31, 2015, we had total assets of $948.7 million, total loans of $618.7 million, total deposits of $878.0 million and stockholders’ equity of $32.0 million.

 

Our Markets

 

We operate in markets that include the four largest cities in Kentucky – Louisville, Lexington, Bowling Green and Owensboro – and in other communities along the I-65 corridor.

 

 

Louisville/Jefferson, Bullitt and Henry Counties: Our headquarters are in Louisville, the largest city in Kentucky. We also have banking offices in Bullitt County, south of Louisville, and Henry County, east of Louisville. Our five banking offices in these counties also serve the contiguous counties of Spencer, Shelby and Oldham to the east and northeast of Louisville. The area’s major employers are diversified across many industries and include the air hub for United Parcel Service (“UPS”), two Ford assembly plants, General Electric’s Consumer and Industrial division, Humana, Norton Healthcare, Brown-Forman, YUM! Brands, Papa John’s Pizza, and Texas Roadhouse.

 

 

 

Lexington/Fayette County: Lexington, located in Fayette County, is the second largest city in Kentucky. Lexington is the financial, educational, retail, healthcare and cultural hub for Central and Eastern Kentucky. It is known worldwide for its horse farms and Keeneland Race Track, and proudly boasts of itself as “The Horse Capital of the World.” It is also the home of the University of Kentucky and Transylvania University. The area’s major employers include Toyota, Lexmark, IBM Global Services and Valvoline.

 

 

Southern Kentucky: This market includes Bowling Green, the third largest city in Kentucky, located about 60 miles north of Nashville, Tennessee. Bowling Green, located in Warren County, is the home of Western Kentucky University and is the economic hub of the area. This market also includes communities in the contiguous Barren County, including the city of Glasgow. Major employers in Barren and Warren Counties include GM’s Corvette plant, several other automotive facilities, and R.R. Donnelley’s regional printing facility.

 

 

Owensboro/Daviess County: Owensboro, located on the banks of the Ohio River, is Kentucky’s fourth largest city. The city is called a festival city, with over 20 annual community celebrations that attract visitors from around the world, including its world famous Bar-B-Q Festival which attracts over 80,000 visitors. It is an industrial, medical, retail and cultural hub for Western Kentucky and the area employers include Owensboro Medical System, Texas Gas, US Bank Home Mortgage and Toyotetsu.

 

 

South Central Kentucky: South of the Louisville metropolitan area, we have banking offices in Butler, Edmonson, Green, Hart, and Ohio Counties. This region includes stable community markets comprised primarily of agricultural and service-based businesses. Each of our banking offices in these markets has a stable customer and core deposit base.

 

Our Products and Services 

 

We meet our customers’ banking needs with a broad range of financial products and services. Our lending services include real estate, commercial, mortgage, agriculture, and consumer loans to small to medium-sized businesses, the owners and employees of those businesses, as well as other executives and professionals. We complement our lending operations with an array of retail and commercial deposit products. In addition, we offer our customers drive-through banking facilities, automatic teller machines, night depository, personalized checks, credit cards, debit cards, internet banking, mobile banking, treasury management services, remote deposit services, electronic funds transfers through ACH services, domestic and foreign wire transfers, cash management, vault services, along with loan and deposit sweep accounts.

 

Employees

 

At December 31, 2015, the Company had 244 full-time equivalent employees. Our employees are not subject to a collective bargaining agreement, and management considers the Company’s relationship with employees to be good.

 

Competition 

 

The banking business is highly competitive, and we experience competition from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices within our market area and beyond.

 

Supervision and Regulation

 

Consent Order and Written Agreement. On June 24, 2011, the Bank entered into a consent order (the “Consent Order”) with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The Bank agreed to obtain the written consent of both agencies before declaring or paying any future dividends. The Consent Order established benchmarks for the Bank to improve its asset quality, reduce its loan concentrations, and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%.

 

On September 21, 2011, we entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of St. Louis. The Company made formal commitments in the Written Agreement to use its financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without written approval, and to submit an acceptable plan to maintain sufficient capital.

 

 

The Consent Order with the FDIC and KDFI was subsequently revised in October 2012 and October 2015. In the most recent revision, the Bank continues to agree to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. The Bank also agrees that if it should be unable to reach the required capital levels, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise obtain a capital investment into the Bank sufficient to recapitalize the Bank. The Bank has not been directed by the FDIC to implement such a plan. The most recent Consent Order includes several of the substantive provisions of the prior Consent Orders, but omits previous provisions related to reducing loan concentrations, which the Bank has satisfied. It also requires the Bank to continue to adhere to the plans implemented in response to the prior Consent Orders.

 

We continue to work towards achieving capital ratio compliance. At December 31, 2015, the Bank’s Tier 1 leverage ratio was 6.08% and its total risk-based capital ratio was 10.58%, which are below the minimums of 9.0% and 12.0% required by the Consent Order.

 

Bank and Holding Company Laws, Rules and Regulations. The following is a summary description of the relevant laws, rules and regulations governing banks and bank holding companies. The descriptions of, and references to, the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

 

The Dodd-Frank Act. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was signed into law. The Dodd-Frank Act imposed new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions. Because the Dodd-Frank Act requires various federal agencies to adopt a broad range of regulations with significant discretion, certain of the details of the law and the effects it will have on the Company are not known at this time.

 

The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States. There are a number of reform provisions that significantly impact the ways in which banks and bank holding companies, including us, do business. For example, the Dodd-Frank Act changed the assessment base for federal deposit insurance premiums by modifying the assessment base calculation to be based on a depository institution’s consolidated assets less tangible capital instead of deposits, and permanently increased the standard maximum amount of deposit insurance per customer to $250,000. The Dodd-Frank Act also imposed more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred security issuances from counting as Tier I capital. The Dodd-Frank Act also repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. The Act codified and expanded the Federal Reserve’s source of strength doctrine, which requires that all bank holding companies serve as a source of financial strength for its subsidiary banks. Other provisions of the Dodd-Frank Act include, but are not limited to: (i) the creation of a new financial consumer protection agency that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer protection; (ii) enhanced regulation of financial markets, including derivatives and securitization markets; (iii) reform related to the regulation of credit rating agencies; (iv) the elimination of certain trading activities by banks; and (v) new disclosure and other requirements relating to executive compensation and corporate governance.

 

Many provisions of the Dodd-Frank Act require interpretation and rule-making by federal agencies. The Company monitors all relevant sections of the Dodd-Frank Act to ensure continued compliance with laws and regulations. While the ultimate effect of the Dodd-Frank Act on the Company is not fully known, the law is likely to result in greater compliance costs and higher fees paid to regulators, along with possible restrictions on the Company’s operations.

 

Porter Bancorp. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). As such, we must file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to operational guidelines established by the Federal Reserve Board. We are subject to the Bank Holding Company Act and other federal laws on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

 

 

Acquisitions. A bank holding company must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock or all or substantially all of the assets of a bank, merging or consolidating with any other bank holding company and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities. Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then may only do so if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

 

Permissible Activities. A bank holding company is generally permitted under the Bank Holding Company Act to engage in or acquire direct or indirect control of more than 5% of the voting shares of any bank, bank holding company or company engaged in any activity that the Federal Reserve Board determines to be so closely related to banking as to be a proper incident to the business of banking.

 

Under current federal law, a bank holding company may elect to become a financial holding company, which enables the holding company to conduct activities that are “financial in nature,” incidental to financial activity, or complementary to financial activity that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Activities that are “financial in nature” include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. We have not filed an election to become a financial holding company.

 

Capital Adequacy Requirements. Both the Company and the Bank are required to comply with capital adequacy guidelines. Guidelines are established by the Federal Reserve Board for the Company and the FDIC for the Bank. Both the Federal Reserve Board and the FDIC have substantially similar risk based and leverage ratio guidelines for banking organizations, which are intended to ensure that banking organizations have adequate capital related to the risk levels of assets and off-balance sheet instruments. The capital adequacy guidelines are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. The Bank is subject to a Consent Order with its primary regulators and therefore cannot be considered well-capitalized. The Consent Order calls for a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0%. PBI Bank’s Tier 1 leverage ratio and total-risk based capital ratios were 6.08% and 10.58%, respectively at December 31, 2015.

 

In July 2013, the Federal Reserve Board and the FDIC approved final rules that substantially amended the regulatory risk-based capital rules applicable to the Company and Bank. The final rules implement the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and changes required by the Dodd-Frank Act. The final rules implementing the Basel III regulatory capital reforms became effective for the Company and Bank on January 1, 2015, and include new minimum risk-based capital and leverage ratios.  These rules refine the definition of what constitutes “capital” for purposes of calculating the capital ratios.

  

The Basel III minimum capital level requirements applicable to bank holding companies and banks subject to the rules are  a common equity Tier 1 capital ratio of 4.5%, a Tier 1 risk-based capital ratio of 6%, a total risk-based capital ratio of 8%, and a Tier 1 leverage ratio of 4% for all institutions. The rules also establish a “capital conservation buffer” of 2.5%, to be phased in over three years, above the regulatory minimum risk-based capital ratios. Once the capital conservation buffer is fully phased in, the minimum ratios area common equity Tier 1 risk-based capital ratio of 7.0%, a Tier 1 risk-based capital ratio of 8.5%, and a total risk-based capital ratio of 10.5%.

  

The phase-in of the capital conservation buffer requirement begins in January 2016 at 0.625% of risk-weighted assets and will increase each year until fully implemented in January 2019. An institution is subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if capital levels fall below minimum levels plus the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

 

Under these new rules, Tier 1 capital generally consists of common stock (plus related surplus) and retained earnings, limited amounts of minority interest in the form of additional Tier 1 capital instruments, and non-cumulative preferred stock and related surplus, subject to certain eligibility standards, less goodwill and other specified intangible assets and other regulatory deductions. Tier 2 capital may consist of subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the allowance for loan losses. Proceeds of trust preferred securities are excluded from Tier 1 capital unless issued before 2010 by an institution with less than $15 billion of assets. Total capital is the sum of Tier 1 and Tier 2 capital.

 

Prompt Corrective Action. Pursuant to the Federal Deposit Insurance Act (“FDIA”), the FDIC must take prompt corrective action to resolve the problems of undercapitalized institutions. FDIC regulations define the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A bank is “undercapitalized” if it fails to meet any one of the ratios required to be adequately capitalized. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The degree of regulatory scrutiny increases and the permissible activities of a bank decrease, as the bank moves downward through the capital categories. Depending on a bank’s level of capital, the FDIC’s corrective powers include:

 

 

 

 

requiring a capital restoration plan;

 

 

placing limits on asset growth and restriction on activities;

 

 

requiring the bank to issue additional voting or other capital stock or to be acquired;

 

 

placing restrictions on transactions with affiliates;

 

 

restricting the interest rate the bank may pay on deposits;

 

 

ordering a new election of the bank’s board of directors;

 

 

requiring that certain senior executive officers or directors be dismissed;

 

 

prohibiting the bank from accepting deposits from correspondent banks;

 

 

requiring the bank to divest certain subsidiaries;

 

 

prohibiting the payment of principal or interest on subordinated debt; and

 

 

ultimately, appointing a receiver for the bank.

 

If an institution is required to submit a capital restoration plan, the institution’s holding company must guarantee the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

 

Dividends. Under Federal Reserve Board policy, bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not declare a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

 

The Company is a legal entity separate and distinct from the Bank. Historically, the majority of our revenue has been from dividends paid to us by the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and hearing, that the institution cease such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), an insured institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings. A bank holding company may still declare and pay a dividend if it does not have current operating earnings if the bank holding company expects profits for the entire year and the bank holding company obtains the prior consent of the Federal Reserve. The Company and the Bank must obtain the prior written consent of each of their primary regulators prior to declaring or paying any future dividends.

 

 

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KDFI must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or in the corporation becoming unable to pay its debts as they come due. The Bank did not pay any dividends in 2015 or 2014.

 

With respect to the payment of dividends, Porter Bancorp’s issued and outstanding Series E and Series F Preferred Shares rank senior to its common shares and non-voting common shares.

 

Source of Financial Strength. Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Federal Reserve’s “Source of Financial Strength” policy was codified in the Dodd-Frank Act.

 

PBI Bank. The Bank, a Kentucky chartered commercial bank, is subject to regular bank examinations and other supervision and regulation by both the FDIC and the KDFI. Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky banking corporation to engage in any banking activity which could be engaged in by a national bank operating in any state; a state bank, a thrift or savings bank operating in any other state; or a federal chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

 

Capital Requirements. Please see capital adequacy requirements discussion above. As previously discussed, PBI Bank has agreed with its primary regulators to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a Tier 1 leverage ratio of 9%. As of December 31, 2015, the Bank’s ratio of total capital to total risk-weighted assets was 10.58% and its Tier I leverage ratio was 6.08%, both under the ratios required by the Consent Order.

 

Deposit Insurance Assessments. The deposits of the Bank are insured by the Deposit Insurance Fund (“DIF”) of the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance premium assessments of the DIF. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits.

 

The Dodd-Frank Act imposed additional assessments and costs with respect to deposits. Under the Dodd-Frank Act, the FDIC imposes deposit insurance assessments based on total assets rather than total deposits. Pursuant to the Dodd-Frank Act, the FDIC revised the deposit insurance assessment system and implemented a revised assessment rate process with the goal of differentiating insured depository institutions who pose greater risk to the DIF.

 

Safety and Soundness Standards.    The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to these matters. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. See “Prompt Corrective Actions” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

 

 

Branching. Kentucky law permits Kentucky chartered banks to establish a banking office in any county in Kentucky. A Kentucky bank may also establish a banking office outside of Kentucky. Well capitalized Kentucky banks that have been in operation at least three years and satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a banking office in Kentucky without the approval of the KDFI upon notice to the KDFI and any other state bank with its main office located in the county where the new banking office will be located. Branching by all other banks requires the approval of the KDFI, which must ascertain and determine that the public convenience and advantage will be served and promoted and that there is reasonable probability of the successful operation of the banking office. The transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

 

Section 613 of the Dodd-Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power may increase competition within the markets in which the Company and the Bank operate.

 

Insider Credit Transactions. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions and their subsidiaries. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests, which may not exceed the institution’s total unimpaired capital and surplus.

 

Consumer Protection Laws. The Bank is subject to federal consumer protection statues and regulations promulgated under those laws, including, but not limited to, the:

 

 

Truth-In-Lending Act and Regulation Z, governing disclosures of credit terms to consumer borrowers;

 

Home Mortgage Disclosure Act and Regulation C, requiring financial institutions to provide certain information about home mortgage and refinanced loans;

 

Real Estate Settlement Procedures Act (“RESPA”), requiring lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibiting certain abusive practices;

 

Secure and Fair Enforcement for Mortgage Licensing Act (“S.A.F.E. Act”), requiring residential loan originators who are employees of financial institutions to meet registration requirements;

 

Fair Credit Reporting Act and Regulation V, governing the provision of consumer information to credit reporting agencies and the use of consumer information;

 

Equal Credit Opportunity Act and Regulation B, prohibiting discrimination on the basis of race, religion or other prohibited factors in the extension of credit;

 

Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

Truth in Savings Act and Regulation DD, which requires disclosure of deposit terms to consumers;

 

Regulation CC, which relates to the availability of deposit funds to consumers;

 

Right to Financial Privacy Act, which imposes a duty to maintain the confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

 

Electronic Funds Transfer Act, governing automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services;

 

Automated Overdraft Payment Regulations and Regulation E, requiring financial institutions to provide customer notices, monitor overdraft payment programs, and prohibiting financial institutions from charging consumer fees for paying overdrafts on automated teller machine and one time debit card transactions unless a consumer consents, or opts in to the service for those types of transactions.

 

The Dodd-Frank Act created a new, independent federal agency called the Consumer Financial Protection Bureau, which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB, but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB.

 

 

The Dodd-Frank Act also permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.

 

Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 15% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by certain readily marketable collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.

 

Volcker Rule. On December 10, 2013, the final Volcker Rule under the Dodd-Frank Act was approved and implemented by the Federal Reserve Board, the FDIC, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission. The Volcker Rule attempts to reduce risk and banking system instability by restricting U.S. banks from investing in or engaging in proprietary trading and speculation and imposing a strict framework to justify exemptions for underwriting, market-making and hedging activities. U.S. banks will be restricted from investing in funds with collateral comprised of less than 100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk. We do not believe the Volcker Rule will have a significant effect on the Bank’s operations.

 

Privacy. Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

 

Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new banking office or to relocate an office.

 

Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities. In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

 

USA Patriot Act. The USA Patriot Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism. This includes standards for verifying customer identification at account opening, as well as rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. It grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

 

Effect on Economic Environment. The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and bank subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits. Their use may affect interest rates charged on loans or paid for deposits.

 

 

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings and those of our subsidiaries cannot be predicted.

 

Recently Enacted and Future Legislation. From time to time various laws, regulations and governmental programs affecting financial institutions and the financial industry are introduced in Congress or otherwise promulgated by regulatory agencies. Such measures may change the environment in which the Company and its subsidiaries operate in substantial and unpredictable ways. The nature and extent of future legislative, regulatory or other changes affecting financial institutions are unpredictable at this time.  Future legislation, policies and the effects thereof might have a significant influence on overall growth and distribution of loans, investments and deposits. They also may affect interest rates charged on loans or paid on time and savings deposits. New legislation and policies 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.

 

Available Information

 

We file periodic reports with the SEC including our annual report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K and proxy statements. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Our SEC reports are accessible at no cost on our web site at http://www.pbibank.com, under the Investors Relations section, once they have been electronically filed with the SEC. A shareholder may also request a copy of our Annual Report on Form 10-K free of charge upon written request to: Chief Financial Officer, Porter Bancorp, Inc., 2500 Eastpoint Parkway, Louisville, Kentucky 40223.

 

Item 1A. Risk Factors

 

An investment in our common stock involves a number of risks. Realization of any of the risks described below could have a material adverse effect on our business, financial condition, results of operations, cash flow and/or future prospects.

 

We are subject to a Consent Order with the FDIC and the KDFI and a Written Agreement with the Federal Reserve that restrict the conduct of our operations and may have a material adverse effect on our business.

 

Our Consent Order with the FDIC and the KDFI requires the Bank to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. If it should be unable to reach the required capital levels, and if directed in writing by the FDIC, the Bank has agreed to develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution or otherwise obtain a capital investment into the Bank sufficient to recapitalize the Bank. The Bank has not been directed by the FDIC to implement such a plan. The Consent Order requires the Bank to obtain the written consent of both agencies before declaring or paying any future dividends to the Company. The most recent Consent Order requires the Bank to continue to adhere to the plans implemented in response to prior Consent Orders, but omits previous provisions related to reducing loan concentrations, which the Bank has satisfied.

 

We continue to work towards achieving capital ratio compliance. At December 31, 2015, the Bank’s Tier 1 leverage ratio was 6.08% and its total risk-based capital ratio was 10.58%, which are below the minimums of 9.0% and 12.0% required by the Bank’s Consent Order.

 

In a Written Agreement with the Federal Reserve Bank of St. Louis, the Company made formal commitments in the agreement to use its financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without written approval, and to submit an acceptable plan to maintain sufficient capital.

 

Bank regulatory agencies can exercise discretion when an institution does not meet minimum regulatory capital levels and the other terms of a consent order.  The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business. Compliance with our Consent Order also increases our operating expense, and adversely affects our financial performance.

 

 

We have made commitments to the banking regulators to raise additional capital. Our inability to increase our capital to the levels required by our bank regulatory agreements could have a material adverse effect on our business.

  

We incurred a net loss of $3.2 million and $11.2 million in 2015 and 2014, respectively. Losses, non-performing loan costs, expenses for other real estate owned (“OREO”), and asset impairments have reduced our capital below the levels we agreed to maintain with our banking regulators. While we believe we have recognized the probable losses in our portfolio, further credit deterioration could result in additional losses and a reduction in capital levels.

 

In its Consent Order with the FDIC and the KDFI, the Bank has agreed to maintain a ratio of total capital to total risk-weighted assets of at least 12.0% and a ratio of Tier 1 capital to average assets of 9.0%. As of December 31, 2015, the Bank’s ratio of total capital to total risk-weighted assets was 10.58% and its ratio of Tier 1 capital to average assets was 6.08%, both below the ratios required by the consent order.

 

We have agreed to restore our capital ratios to levels that comply with our regulatory agreements. We have implemented several initiatives to increase our regulatory capital and reduce our non-performing assets and continue to evaluate other specific initiatives to attain these objectives, such as selling assets and raising capital by selling stock.

 

Our ability to raise additional capital will depend on, among other things, conditions in the capital markets (which are outside of our control) and our financial performance, including the management of our revenue, expenses, levels of average assets, credit quality, levels of OREO, and contingent liability risks. We may not have access to capital on acceptable terms or at all. Our inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our businesses, financial condition, and results of operations. In addition, if we are unable to comply with our regulatory capital requirements, it could result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

 

Regulatory restrictions have prevented us from paying interest on the junior subordinated debentures that relate to our trust preferred securities since the fourth quarter of 2011. If we cannot pay accrued and unpaid interest on these securities for more than twenty consecutive quarters, we will be in default.

 

Effective with the fourth quarter of 2011, we began deferring interest payments on the junior subordinated debentures relating to our trust preferred securities. Deferring interest payments on the junior subordinated debentures resulted in a deferral of distributions on our trust preferred securities.

 

If we defer distributions on our trust preferred securities for 20 consecutive quarters, we must pay all deferred distributions in full or we will be in default. Our deferral period expires in the third quarter of 2016. Deferred distributions on our trust preferred securities, which totaled $2.5 million as of December 31, 2015, are cumulative, and unpaid distributions accrue and compound on each subsequent payment date. If as a result of a default we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities will be entitled to receive the liquidation amounts to which they are entitled, including all accrued and unpaid distributions, before any distribution can be made to our shareholders. In addition, the holders of our Series E and Series F Preferred Shares will be entitled to receive liquidation distributions totaling more than $10.5 million before any distribution can be made to the holders of our common shares.

 

As a bank holding company, we depend on dividends and distributions paid to us by our banking subsidiary.

 

The Company is a legal entity separate and distinct from the Bank and our other subsidiaries. Our principal source of cash flow, from which we would fund any dividends paid to our shareholders, has historically been dividends the Company receives from the Bank. Regulations of the FDIC and the KDFI govern the ability of the Bank to pay dividends and other distributions to us, and regulations of the Federal Reserve govern our ability to pay dividends or make other distributions to our shareholders. In its consent order with the FDIC and the KDFI, the Bank agreed not to pay dividends to us without the prior consent of those regulators. Liquid assets were $1.0 million at December 31, 2015. Since the Bank is unlikely to be in a position to pay dividends to the Company until the Consent Order is satisfied and the Bank returns to profitability, cash inflows for the Company are limited to common stock or debt issuances. As of December 31, 2015, we could issue approximately 5 million common shares while still preserving the value of our NOLs under Section 382 of the Internal Revenue Code. Ongoing operating expenses of the Company are forecasted at approximately $1.0 million for 2016. See the “Item 1. Business” “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities – Dividends.”

 

 

We are effectively precluded from paying any dividends for the foreseeable future.

  

Our agreement with the holders of our trust preferred securities provides that we cannot pay dividends until we pay all deferred distributions in full and resume paying quarterly distributions. We have also agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends. As a practical matter, we cannot pay dividends until the Consent Order is satisfied and we return to profitability. In addition, the dividend preferences of our Series E and Series F Preferred Shares entitle our preferred shareholders to receive an annual, noncumulative 2% dividend before we can pay a dividend on our non-voting common shares and voting common shares.

 

Our holding company debt could make it difficult to raise capital.

 

At December 31, 2015, we had an aggregate obligation of $23.5 million relating to the principal and accrued unpaid interest on our four issues of junior subordinated debentures, which has resulted in a deferral of distributions on our trust preferred securities. Although we are permitted to defer payments on these securities for up to five years (and we commenced doing so in 2011), the deferred interest payments continue to accrue until paid in full. Our deferral period expires in the third quarter of 2016.

 

Our holding company debt could make it difficult to recapitalize or enter into a business combination transaction because any investor or purchaser would effectively assume the outstanding liability on the debt in addition to the amount of funds such investors or purchaser would need to provide in order to recapitalize the Bank and the Company.

 

We are defendants in various legal proceedings.

 

The Company and the Bank are involved in judicial proceedings and regulatory investigations concerning matters arising from our business activities. Although we believe we have a meritorious defense in all significant litigation pending against us, we cannot assure you as to the ultimate outcome. Litigation is subject to inherent uncertainties and unfavorable rulings could occur.  We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain.  Accruals are not made in cases where liability is not probable or the amount cannot be reasonably estimated.  We provide disclosure of matters where we believe liability is reasonably possible and which may be material to our consolidated financial statements.  If we do not prevail, the ultimate outcome of litigation matter could have a material adverse effect on our financial condition, results of operations, or cash flows. For more information about ongoing legal proceedings, see “Note 24 – Contingencies” of the Notes to Consolidated Financial Statements.

 

The Bank previously has served as trustee for Employee Stock Ownership Plans (“ESOP”) which engaged in transactions that under review are the subject of litigation initiated by the U. S. Department of Labor (“DOL”), subjecting us to certain financial risks.

 

From 2007 until the first quarter of 2013, the Bank served as trustee for certain ESOPs that purchased the stock of companies from prior owners in purchase transactions.  Stock purchase transactions by ESOPs are subject to regular and routine reviews by the DOL for compliance with ERISA. Failure to fulfill our fiduciary duties under ERISA with respect to any such plan would subject us to certain financial risks such as claims for damages as well as fines and penalties assessable under ERISA. The Bank has been a defendant in legal proceedings initiated by the DOL with respect to two stock purchase transactions by ESOPs for which the Bank served as trustee. One such matter has been settled, and the parties have agreed to settle the second matter subject to final documentation. A ruling in any future litigation that the Bank failed to fulfill its fiduciary duties under ERISA with respect to an ESOP, including stock purchases by the ESOP, would subject us to claims for damages as well as fines and penalties assessable under ERISA. See “Note 24 – Contingencies” of the Notes to Consolidated Financial Statements.

 

Investigations into and heightened scrutiny of our operations could result in additional costs and damage our reputation.

 

In October 2014, the Department of Justice (“DOJ”) initiated an investigation concerning possible violations of federal laws, including, among other things, possible violations related to false bank entries, bank fraud and securities fraud. The investigation concerns allegations that Bank personnel engaged in practices intended to delay or avoid disclosure of the Bank’s asset quality at the time of and following the United States Treasury’s purchase of preferred shares from the Company in November 2008.  We are cooperating with the investigation.  To date, DOJ has made no determination whether to pursue any action in the matter. Heightened scrutiny of the operations of the Company and the Bank by federal and state officials may subject us to governmental or regulatory inquiries, investigations, actions, penalties and fines, which could adversely affect our reputation and result in costs to us in excess of current reserves and management’s estimate of the aggregate range of possible loss for litigation matters.

 

 

Our business may be adversely affected by conditions in the financial markets and by economic conditions generally.

 

Weakness in business and economic conditions generally or specifically in our markets may have one or more of the following adverse effects on our business:

 

 

A decrease in the demand for loans and other products and services offered by us;

 

A decrease in the value of collateral securing our loans;

 

An impairment of certain intangible assets, such as core deposit intangibles; and

 

An increase in the number of customers who become delinquent, file for protection under bankruptcy laws or default on their loans.

 

Adverse conditions in the general business environment have had an adverse effect on our business in the past. Although the general business environment has improved, we cannot predict how long such improvement can be sustained. In addition, the improvement of certain economic indicators, such as real estate asset values, rents, and unemployment, may vary between geographic markets and may continue to lag behind improvement in the overall economy. These economic indicators typically affect the real estate and financial services industries, in which we have a significant number of customers, more significantly than other economic sectors. Furthermore, we have a substantial lending business that depends upon the ability of borrowers to make debt service payments on loans. Should economic conditions worsen, our business, financial condition or results of operations could be adversely affected.

 

A large percentage of our loans are collateralized by real estate, and prolonged weakness in the real estate market may result in losses and adversely affect our profitability.

 

Approximately 80.1% of our loan portfolio as of December 31, 2015, was comprised of commercial and residential loans collateralized by real estate. Adverse economic conditions could decrease demand for real estate and depress real estate values in our markets. Persistent weakness in the real estate market could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline further, it will become more likely that we would be required to increase our allowance for loan losses. If during a period of depressed real estate values, we were required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

 

We offer real estate construction and development loans, which carry a higher degree of risk than other real estate loans. Weakness in the residential construction and commercial development real estate markets has in the past increased the non-performing assets in our loan portfolio and our provision for loan loss expense. These impacts have had, and could have in the future, a material adverse effect on our capital, financial condition and results of operations.

 

Approximately 5.4% of our loan portfolio as of December 31, 2015 consisted of real estate construction and development loans, up slightly from 5.3% at December 31, 2014 and down from 6.1% at December 2013. These loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the sale of the property. If we are forced to foreclose on a project prior to its completion, we may not be able to recover the entire unpaid portion of the loan or we may be required to fund additional money to complete the project, or hold the property for an indeterminate period of time. Any of these outcomes may result in losses and adversely affect our profitability and financial condition.

 

Residential construction and commercial development real estate activity in our markets were affected by challenging economic conditions following the financial crisis of 2008. Weakness in these sectors could lead to additional valuation adjustments to our loan portfolios and real estate owned as we continue to reassess the fair value of our non-performing assets, the loss severity of loans in default and the fair value of real estate owned. We also may realize additional losses in connection with our disposition of non-performing assets. A weak real estate market could further reduce demand for residential housing, which, in turn, could adversely affect real estate development and construction activities. Consequently, the longer challenging economic conditions persist, the more likely they are to adversely affect the ability of residential real estate development borrowers to repay these loans and the value of property used as collateral for such loans. These economic conditions and market factors have negatively affected some of our larger loans in the past, causing our total net-charge offs to increase and requiring us to significantly increase our allowance for loan losses. Any further increase in our non-performing assets and related increases in our provision for loan loss expense could negatively affect our business and could have a material adverse effect on our capital, financial condition and results of operations.

 

 

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

 

We maintain an allowance for loan losses at a level we believe is adequate to absorb probable incurred losses in our loan portfolio based on historical loan loss experience, economic and environmental factors, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual future loan losses, which would adversely affect our operating results. Our estimates are subjective, and their accuracy depends on the outcome of future events. Changes in economic, operating, and other conditions that are generally beyond our control could cause actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize additional loan charge-offs when their judgment has differed from ours. Any of these events could have a material negative impact on our operating results.

 

Our levels of classified loans and non-performing assets may increase in the foreseeable future if economic conditions cause more borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, may decline, making us less likely to realize a full recovery if a borrower defaults on a loan. Any additional increases in the level of our non-performing assets, loan charge-offs or provision for loan losses, or our inability to realize the estimated net value of underlying collateral in the event of a loan default, could negatively affect our business, financial condition, results of operations and the trading price of our securities.

 

If we experience greater credit losses than anticipated, our operating results would be adversely affected.

 

As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse effect on our operating results. Our credit risk with respect to our real estate and construction loan portfolio will relate principally to the creditworthiness of borrowers and the value of the real estate serving as security for the repayment of loans. Our credit risk with respect to our commercial and consumer loan portfolio will relate principally to the general creditworthiness of businesses and individuals within our local markets.

 

We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for estimated loss losses based on a number of factors. We believe that our allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, our allowance for loan losses may not be sufficient to cover our actual loan losses. We may have to increase our allowance in the future in response to the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for loan losses cannot be determined at this time and may vary from the amounts of past provisions.

 

We continue to hold and acquire OREO properties, which could increase operating expenses and result in future losses to the Company.

 

During recent years, we have acquired a significant amount of real estate as a result of foreclosure or by deed in lieu of foreclosure that is listed on our balance sheet as other real estate owned (“OREO”). An increase in our OREO portfolio increases the expenses incurred to manage and dispose of these properties, which sometimes includes funding construction required to facilitate sale. We expect that our operating results in 2016 will continue to be adversely affected by expenses associated with OREO, including insurance and taxes, completion and repair costs, as well as by the funding costs associated with OREO assets.

 

Properties in our OREO portfolio are recorded at the lower of the recorded investment in the loans for which the properties previously served as collateral or “fair value,” which represents the estimated sales price of the properties on the date acquired less estimated selling costs. Generally, in determining “fair value” an orderly disposition of the property is assumed, except where a different disposition strategy is expected. Significant judgment is required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current may change during periods of market volatility.

 

Any decreases in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our statement of operations. We evaluate OREO property values periodically and write down the carrying value of the properties if and when the results of our analysis require it.

 

 

In response to market conditions and other economic factors, we may utilize alternative sale strategies other than orderly disposition as part of our OREO disposition strategy, such as auctions or bulk sales. In this event, as a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from such sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of our OREO properties. In addition, our disposition of OREO through alternative sales strategies could impact the fair value of comparable OREO properties remaining in our portfolio.

 

Our profitability depends significantly on local economic conditions.

 

Because most of our business activities are conducted in central Kentucky and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business and employment activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy weakens, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by the economic downturn or a localized natural disaster. Events that adversely affect business activity and real estate values in Central Kentucky have had and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

 

Our small to medium-sized business portfolio may have fewer resources to weather a downturn in the economy.

 

Our portfolio includes loans to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small or medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn may have a more pronounced negative impact on our target market, causing us to incur substantial credit losses that could materially harm our operating results.

 

Our profitability is vulnerable to fluctuations in interest rates.

 

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic or international economic or political conditions. Factors beyond our control, such as inflation, recession, unemployment and money supply may also affect interest rates. If, as a result of decreasing interest rates, our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

 

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing. Fixed rate investment securities are subject to fair value declines as interest rates rise. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

 

If we cannot obtain adequate funding, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Company.

 

Our liquidity policies and limits are established by the Board of Directors of the Bank, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits and the percentage of assets funded with non-core or wholesale funding. The ALCO regularly monitors the overall liquidity position of the Bank and the Company to ensure that various alternative strategies exist to meet unanticipated events that could affect liquidity. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies do not work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. The ALCO follows established board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, and Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets. We are currently prohibited from accepting brokered deposits. We are also subject to FDIC interest rate restrictions for deposits. As such, we are permitted to offer up to the “national rate” plus 75 basis points as published weekly by the FDIC.

 

 

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common shares in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.

 

We may need to raise additional capital in the future by selling capital stock. Future sales or other dilution of our equity may adversely affect the market price of our common shares.

 

We are not restricted from issuing additional common shares, including securities that are convertible into or exchangeable for, or that represent the right to receive, common shares. The issuance of additional shares of common shares or the issuance of convertible securities would dilute the ownership interest of our existing common shareholders. The market price of our common shares could decline as a result of such an offering as well as other sales of a large block of shares of our common shares or similar securities in the market after such an offering, or the perception that such sales could occur. Our common shares have traded from time-to-time at a price below our book value per share. Accordingly, a sale of common shares at or below our book value would be dilutive to current shareholders.

 

We may not be able to realize the value of our tax losses and deductions.

 

Due to our losses, we have a net operating loss carry-forward of $38.1 million, credit carry-forwards of $900,000, and other net deferred tax assets of $13.1 million. In order to realize the benefit of these tax losses, credits and deductions, we will need to generate substantial taxable income in future periods. We established a 100% valuation allowance for all deferred tax assets in 2011. Should the Company issue a sufficient number of new shares to raise additional capital, a change in control could be triggered, as defined by Section 382 of the Internal Revenue Code, which could negatively impact or limit the ability to utilize our net operating loss carry-forwards, credit loss carry-forwards, and other net deferred tax assets.

 

Higher FDIC deposit insurance premiums and assessments could significantly increase our non-interest expense.

 

Our deposits are insured by the FDIC up to legal limits and, accordingly, we are subject to FDIC deposit insurance premiums and assessments. Pursuant to the Dodd-Frank Act, the FDIC amended its regulations regarding assessment for federal deposit insurance to base such assessments on the average total consolidated assets of the insured institution during the assessment period, less the average tangible equity of the institution during the assessment period.

 

The FDIC has also proposed a rule tying assessment rates of FDIC-insured institutions to the institution’s employee compensation programs. The exact nature and cumulative effect of these recent changes are not yet known, but they are expected to increase the amount of premiums we must pay for FDIC insurance. Any such increase may adversely affect our business, financial condition or results of operations.

 

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

 

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from other commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds, and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, savings and loan associations, mortgage banking firms, and consumer finance companies. In addition, competition for business in the Louisville and Lexington metropolitan area has grown in recent years as changes in banking law have allowed several banks to enter the market by establishing new branches.

 

Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

 

 

offer higher interest rates on deposits and lower interest rates on loans than we can;

 

offer a broader range of services than we do;

 

maintain more branch locations than we do; and

 

mount extensive promotional and advertising campaigns.

 

 

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

 

We depend on our senior management team, and the unexpected loss of one or more of our senior executives could impair our relationship with customers and adversely affect our business and financial results.

 

Our future success significantly depends on the continued services and performance of our key management personnel. Our future performance will depend on our ability to motivate and retain these and other key officers. The Dodd-Frank Act, and the policies of bank regulatory agencies have placed restrictions on our executive compensation practices. Such restrictions and standards may further impact our Company’s ability to compete for talent with other businesses and financial institutions that are not subject to the same limitations as we are. The loss of the services of members of our senior management or other key officers or our inability to attract additional qualified personnel as needed could materially harm our business.

 

Our reported financial results depend on management’s selection of accounting methods and certain assumptions and estimates.

 

Our accounting policies and assumptions are fundamental to our reported financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner in which to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in our reporting materially different results than would have been reported under a different alternative.

 

Certain accounting policies are critical to presenting our reported financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include the allowance for loan losses, valuation of OREO, valuation of securities, valuation of stock based compensation and valuation of deferred income taxes. Because of the uncertainty of estimates involved in these matters, we may be required, among other things, to significantly increase the allowance for credit losses, sustain credit losses that are significantly higher than the reserve provided, recognize significant impairment on our OREO, or permanently impair deferred tax assets.

 

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, we may suffer losses from operational risk in the future.

 

Management maintains internal operational controls, and we have invested in technology to help us process large volumes of transactions. However, we may not be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

 

We process large volumes of transactions on a daily basis and are exposed to numerous types of operational risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

 

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

 

 

Our information systems may experience an interruption or security breach.

 

Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a large financial institution, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume, electrical or telecommunications outages, natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics, events arising from local or larger scale political or social matters, including terrorist acts, and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical infrastructure or operating systems that support our businesses and customers.

 

Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. In addition, to access our products and services, our customers may use personal smartphones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches. These events could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our customers’ confidential, proprietary and other information or that of our customers, or otherwise disrupt the business operations of ourselves, our customers or other third parties.

 

Third parties with which we do business or that facilitate our business activities, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, we can give no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats and the prevalence of Internet and mobile banking. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our business, results of operations or financial condition.

 

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.

 

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, as described under “Item 1 – Business-Supervision and Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, and not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.

 

Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks, and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations, and policies or to maintain our capital requirements could affect our ability to pay dividends on common shares, our ability to grow through the development of new offices, make acquisitions, and remain independent. These limitations may prevent us from successfully implementing our growth and operating strategies.

 

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Consumer Financial Protection Bureau, the SEC, the Public Company Accounting Oversight Board and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

 

 

Changes in banking laws could have a material adverse effect on us.

 

We are subject to changes in federal and state laws as well as changes in banking and credit regulations, and governmental economic and monetary policies. We cannot predict whether any of these changes could adversely and materially affect us. The current regulatory environment for financial institutions entails significant potential increases in compliance requirements and associated costs. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on our activities that could have a material adverse effect on our business and profitability.

 

Recent legislation regarding the financial services industry may have a significant adverse effect on our operations. 

 

The Dodd-Frank Act was signed into law on July 21, 2010. The Dodd-Frank Act has had a significant impact the U.S. financial system, including among other things:

 

 

new requirements on banking, derivative and investment activities, including the repeal of the prohibition on the payment of interest on business demand accounts, and debit card interchange fee requirements;

 

the creation of the Consumer Financial Protection Bureau with supervisory authority, including the power to conduct examinations and take enforcement actions with respect to financial institutions with assets of $10 billion or more and implement regulations that will affect all financial institutions;

 

provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended; and

 

a provision that would require bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for holding companies with less than $15 billion in assets as of December 31, 2009.

 

Many provisions in the Dodd-Frank Act remain subject to regulatory rule-making, implementation, and interpretation, the effects of which are not yet known. As a result, it is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because the implementation of many concepts is left to regulatory agencies. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators. The CFPB has begun the rule-making process but it is not known at this time when all rules will be finalized and implemented.

 

The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions, as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition. 

 

 

Item 1B.

Unresolved Staff Comments

 

Not applicable.

 

Item 2.

Properties

 

The Bank operates 15 banking offices located in Kentucky. The following table shows the location, square footage and ownership of each property. We believe that each of these locations is adequately insured. Support operations are located in our main office in Louisville and in Glasgow.

 

Markets

 

Square Footage

 

Owned/Leased

Louisville/Jefferson, Bullitt and Henry Counties

           

Main Office: 2500 Eastpoint Parkway, Louisville

    30,000  

Owned

 

Eminence Office: 645 Elm Street, Eminence

    1,500  

Owned

 

Hillview Office: 11998 Preston Highway, Hillview

    3,500  

Owned

 

Pleasureville Office: 5440 Castle Highway, Pleasureville

    10,000  

Owned

 

Conestoga Office: 155 Conestoga Parkway, Shepherdsville

    3,900  

Owned

 
             

Lexington/Fayette County

           

Lexington Office: 2424 Harrodsburg Road, Suite 100, Lexington

    8,500  

Leased

 
             

South Central Kentucky

           

Brownsville Office: 113 East Main, Brownsville

    8,500  

Owned

 

Greensburg Office: 202-04 North Main Street, Greensburg

    11,000  

Owned

 

Horse Cave Office: 210 East Main Street, Horse Cave

    5,000  

Owned

 

Morgantown Office: 112 West Logan Street, Morgantown

    7,500  

Owned

 

Munfordville Office: 949 South Dixie Highway, Munfordville

    9,000  

Owned

 

Beaver Dam Office: 1300 North Main Street, Beaver Dam

    3,200  

Owned

 
             

Owensboro/Daviess County

           

Owensboro Office: 1819 Frederica Street, Owensboro

    3,000  

Owned

 
             

Southern Kentucky

           

Campbell Lane Office: 751 Campbell Lane, Bowling Green

    7,500  

Owned

 

Glasgow Office: 1006 West Main Street, Glasgow

    12,000  

Owned

 
             

Other Properties

           

Office Building: 701 Columbia Avenue, Glasgow

    19,000  

Owned

 

 

 

Item 3.

Legal Proceedings

We are defendants in various legal proceedings. Litigation is subject to inherent uncertainties and unfavorable outcomes could occur. See Note 24, “Contingencies” in the Notes to our consolidated financial statements for detail regarding ongoing legal proceedings and other matters.

 

Item 4.

Mine Safety Disclosures

 

Not applicable.

 

 

PART II

 

Item 5.

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

 

Market Information

 

Our common shares are traded on the NASDAQ Capital Market under the ticker symbol “PBIB”. The following table presents the high and low market closing prices for our common shares reported on the NASDAQ Capital Market for the periods indicated.

 

 

   

2015

 
   

Market Value

         

Quarter Ended

 

High

   

Low

   

Dividend

 

Fourth Quarter

  $ 1.76     $ 1.38     $ 0.00  

Third Quarter

    1.75       1.39       0.00  

Second Quarter

    1.86       0.90       0.00  

First Quarter

    0.96       0.46       0.00  

 

   

2014

 
   

Market Value

         

Quarter Ended

 

High

   

Low

   

Dividend

 

Fourth Quarter

  $ 1.03     $ 0.48     $ 0.00  

Third Quarter

    1.08       0.95       0.00  

Second Quarter

    1.18       0.90       0.00  

First Quarter

    1.24       0.94       0.00  

 

 

As of January 31, 2016, we had approximately 1,564 shareholders, including 349 shareholders of record and approximately 1,215 beneficial owners whose shares are held in “street” name by securities broker-dealers or other nominees.

 

  

 

 

 

Dividends 

 

We will not be able to pay dividends on our common shares until the Consent Order is satisfied and we return to profitability. We historically paid quarterly cash dividends on our common shares until we suspended dividend payments in October 2011. As a bank holding company, our ability to declare and pay dividends depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. We have agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends.

 

Our principal source of revenue with which to pay dividends on our common shares is the dividends that the Bank may declare and pay to us out of funds legally available for payment of dividends. Currently, the Bank must obtain the prior written consent of its primary regulators prior to declaring or paying any dividends. In addition to this current restriction, various laws applicable to the Bank also limit its payment of dividends to us. A Kentucky chartered bank may declare a dividend of an amount of the bank’s net profits as the board deems appropriate. The approval of the KDFI is required if the total of all dividends declared by the bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt.

 

Effective with the fourth quarter of 2011, we began deferring interest payments on the junior subordinated notes relating to our trust preferred securities. Deferring interest payments on the junior subordinated notes resulted in the deferral of distributions on our trust preferred securities. If we defer interest payments on our trust preferred securities for 20 consecutive quarters, we must pay all deferred interest or we will be in default. Our deferral period expires in the third quarter of 2016.

 

We will not be able to pay cash dividends on our common shares until we have paid all deferred distributions on our trust preferred securities. Deferred distributions on our trust preferred securities are cumulative, and distributions accrue and compound on each subsequent payment date. If we become subject to any liquidation, dissolution or winding up of affairs, holders of the trust preferred securities and then holders of the Preferred Shares will be entitled to receive the liquidation amounts to which they are entitled including the amount of any accrued and unpaid distributions and dividends, before any distribution can be made to the holders of our Common Shares or Preferred Shares. Our Series E and Series F Preferred Shares have priority over our common shares and non-voting common shares with respect to any payment of dividends.

 

Purchase of Equity Securities by Issuer

 

During the fourth quarter of 2015, the Company did not repurchase any of its common shares, which is its only registered class of equity securities.

 

 

Item 6.

Selected Financial Data

 

The following table summarizes our selected historical consolidated financial data from 2011 to 2015. You should read this information in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”

 

Selected Consolidated Financial Data 

 

   

As of and for the Years Ended December 31,

 

(Dollars in thousands except per share data)

 

2015

   

2014

   

2013

   

2012

   

2011

 

Income Statement Data:

                                       

Interest income

  $ 36,574     $ 39,513     $ 43,228     $ 57,729     $ 73,554  

Interest expense

    7,023       9,795       11,143       15,774       22,039  

Net interest income

    29,551       29,718       32,085       41,955       51,515  

Provision for loan losses

    (4,500

)

    7,100       700       40,250       62,600  

Non-interest income

    7,695       4,079       5,919       9,590       7,833  

Non-interest expense

    44,959       39,435       38,890       44,292       104,273  

Loss before income taxes

    (3,213

)

    (12,738

)

    (1,586

)

    (32,997

)

    (107,525

)

Income tax benefit

          (1,583

)

          (65

)

    (218

)

Net loss

    (3,213

)

    (11,155

)

    (1,586

)

    (32,932

)

    (107,307

)

Less:

                                       

Dividends and accretion on preferred stock

          2,362       2,079       1,929       1,927  

Effect of exchange of preferred stock for common stock

          (36,104

)

                 

Earnings (loss) allocated to participating securities

    (336

)

    3,159       (267

)

    (1,429

)

    (4,080

)

Net income (loss) attributable to common

  $ (2,877

)

  $ 19,428     $ (3,398

)

  $ (33,432

)

  $ (105,154

)

                                         

Common Share Data:

                                       

Basic earnings (loss) per common share

  $ (0.12

)

  $ 1.59     $ (0.29

)

  $ (2.85

)

  $ (8.98

)

Diluted earnings (loss) per common share

    (0.12

)

    1.59       (0.29

)

    (2.85

)

    (8.98

)

Cash dividends declared per common share

    0.00       0.00       0.00       0.00       0.02  

Book value per common share (1)

    1.09       1.67       (0.18

)

    0.74       3.74  

Tangible book value per common share (1)

    1.07       1.61       (0.29

)

    0.58       3.54  
                                         

Balance Sheet Data (at period end):

                                       

Total assets

  $ 948,722     $ 1,017,989     $ 1,076,121     $ 1,162,631     $ 1,455,424  

Debt obligations:

                                       

FHLB advances

    3,081       15,752       4,492       5,604       7,116  

Junior subordinated debentures

    21,000       25,000       25,000       25,000       25,000  

Subordinated capital note

    4,050       4,950       5,850       6,975       7,650  
                                         

Average Balance Data:

                                       

Average assets

  $ 984,419     $ 1,049,232     $ 1,098,400     $ 1,341,565     $ 1,659,959  

Average loans

    635,948       662,442       788,176       1,033,320       1,243,474  

Average deposits

    907,785       961,671       1,004,052       1,217,083       1,434,462  

Average FHLB advances

    3,473       4,473       4,990       6,325       15,315  

Average junior subordinated debentures

    23,981       25,000       25,000       25,000       25,000  

Average subordinated capital note

    4,608       5,508       6,404       7,309       8,208  

Average stockholders’ equity

    33,083       33,881       42,631       75,679       159,434  

 


(1)

After shareholder approval on February 25, 2015, the mandatorily convertible Series B Preferred Shares converted into 4,053,600 common shares and the mandatorily convertible Series D Preferred Shares converted into 6,458,000 non-voting common shares. 

 

 

Item 7.

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

 

Management’s discussion and analysis of financial condition and results of operations analyzes the consolidated financial condition and results of operations of Porter Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, PBI Bank (the “Bank”). The Company is a Louisville, Kentucky-based bank holding company which operates banking offices in twelve counties through its wholly owned subsidiary, the Bank. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products.

 

Historically, we have focused on commercial and commercial real estate lending, both in markets where we have banking offices and other growing markets in our region. Commercial, commercial real estate and real estate construction loans accounted for 54.4% of our total loan portfolio as of December 31, 2015, and 55.5% as of December 31, 2014. Commercial lending generally produces higher yields than residential lending, but involves greater risk and requires more rigorous underwriting standards and credit quality monitoring.

 

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other schedules presented elsewhere in the report.

 

 

Overview

 

For the year ended December 31, 2015, we reported a net loss of $3.2 million compared with net loss of $11.2 million for the year ended December 31, 2014 and a net loss of $1.6 million for the year ended December 31, 2013. After deductions for dividends and accretion on preferred stock, allocating losses to participating securities, and the effect of the exchange of preferred stock for common stock, net loss attributable to common shareholders was $2.9 million for the year ended December 31, 2015, compared with net income attributable to common shareholders of $19.4 million for the year ended December 31, 2014, and a net loss attributable to common shareholders of $3.4 million for the year ended December 31, 2013. Basic and diluted loss per common share were ($0.12) for the year ended December 31, 2015, compared with net income per common share of $1.59 for 2014, and a net loss of ($0.29) for 2013.

 

Our financial performance in 2015 continued to be negatively impacted by the Bank’s elevated level of non-performing assets. Despite substantial improvement during 2015, asset quality remediation, increasing capital, and lowering the risk profile of the Company remain our major objectives for 2016.

 

Non-performing loans were 2.28% of total loans and non-performing assets were 3.51% of total assets, at December 31, 2015 compared to 7.57% and 9.19%, respectively, at December 31, 2014. We remain diligent in the management of our loan portfolio and are striving to continue improving credit quality by working throughout our markets to balance selective new customer acquisition, customer service for our existing clients and prudent risk management.

 

The following significant items are of note for the year ended December 31, 2015:

 

 

We recorded negative provision for loan losses expense of $4.5 million in 2015, compared to a provision for loan losses expense of $7.1 million for 2014, because of declining historical loss rates, improvements in asset quality, and management’s assessment of risk in the loan portfolio. Net loan charge-offs were $2.8 million for 2015, compared to $15.9 million for 2014 and $29.3 million for 2013. See additional discussion below regarding improving trends in non-performing loans, past due loans, and loan risk categories during the period, factors which led to the negative provision expense.


 

Non-performing loans decreased $33.2 million to $14.1 million at December 31, 2015, compared with $47.3 million at December 31, 2014. The decrease in non-performing loans was primarily due to $27.6 million in paydowns, $5.5 million in transfers to OREO, and $5.1 million in charge-offs.

 

 

Loans past due 30-59 days decreased from $4.0 million at December 31, 2014 to $3.1 million at December 31, 2015, and loans past due 60-89 days decreased from $980,000 at December 31, 2014 to $241,000 at December 31, 2015. Total loans past due and nonaccrual loans decreased to $17.5 million at December 31, 2015 from $52.3 million at December 31, 2014.

 

 

All loan risk categories (other than pass loans) have decreased since December 31, 2014. Pass loans represent 83.6% of the portfolio at December 31, 2015, compared to 73.8% at December 31, 2014 and 52.1% at December 31, 2013. During 2015, the pass category increased approximately $56.4 million, the watch category declined approximately $4.8 million, the special mention category declined approximately $2.8 million, and the substandard category declined approximately $55.1 million. The $55.1 million decrease in loans classified as substandard was primarily driven by $39.8 million in principal payments received, $5.5 million in migration to OREO, $14.0 million in loans upgraded from substandard, and $5.8 million in charge-offs, offset by $10.1 million in loans moved to substandard during 2015.

 

 

 

Foreclosed properties were $19.2 million at December 31, 2015, compared with $46.2 million at December 31, 2014.  During the year ended December 31, 2015, the Company acquired $5.5 million and sold $22.6 million of OREO. We incurred OREO losses totaling $9.9 million during the year ended December 31, 2015, reflecting fair value write-downs for reductions in listing prices for certain properties, updated appraisals, and certain properties liquidated through auctions, and $74,000 in net loss on sales of OREO. OREO expense may be elevated in future periods as we work to sell these properties, given the current size of the OREO portfolio.

 

 

Our non-performing assets decreased to $33.3 million or 3.51% of total assets at December 31, 2015, compared with $93.5 million or 9.19% of total assets at December 31, 2014. In addition, accruing troubled debt restructurings declined to $17.4 million at December 31, 2015 from $22.0 million at December 31, 2014.

 

 

Net interest margin increased 18 basis points to 3.27% for the year ended 2015 compared with 3.09% in the year ended December 31, 2014. The increase in margin between periods was primarily due to a decrease in the cost of interest bearing liabilities from 1.11% in 2014 to 0.85% in 2015. The decrease in cost of interest bearing liabilities was primarily driven by the continued repricing of certificates of deposit at lower rates. Average loans decreased 4.0% to $635.9 million in 2015 compared with $662.4 million in 2014.  

 

 

Non-interest income increased $3.6 million in 2015 to $7.7 million compared with $4.1 million for the year ended December 31, 2014 driven primarily by gains on the sales of securities totaling $1.8 million, compared to $92,000 for 2014, as well as an increase in OREO rental income of $1.1 million between the two periods. The increase in OREO income is the result of several larger properties with tenants being transferred to OREO in the second quarter of 2014. Non-interest income also increased due to an $883,000 gain on extinguishment of debt.


 

Non-interest expense increased $5.5 million in 2015 to $45.0 million compared with $39.4 million for 2014, due to an increase in OREO expenses of $6.5 million primarily related to fair value write-downs for 2015, and an increase in professional fees of $1.2 million related to legal fees and litigation expenses, offset by a decrease in loan collection expenses of $1.9 million.

 

 

Deposits decreased $48.8 million or 5.3% to $878.0 million at December 31, 2015 compared with $926.8 million at December 31, 2014. Certificate of deposit balances decreased $74.9 million during 2015 to $499.8 million at December 31, 2015, from $574.7 million at December 31, 2014. Demand deposits increased $5.1 million or 4.5% during 2015 to $120.0 million compared with $114.9 million at December 31, 2014.

 

 

On February 25, 2015, we completed the final step in the retirement of our Preferred Shares originally issued to the U.S. Treasury when shareholders approved the conversion of all mandatorily convertible Series B Preferred Shares into 4,053,600 common shares and the conversion of all mandatorily convertible Series D Preferred Shares into 6,458,000 non-voting common shares. The conversion reduced preferred stockholders’ equity by $5.8 million and increased common stockholders’ equity by the same amount. A total of 26,947,533 common shares and non-voting common shares were issued and outstanding at December 31, 2015.

 

 

In 2015, the Company took measures to preserve the value of its net operating loss carryforwards (“NOLs”) and other deferred tax assets under Section 382 of the Internal Revenue Code. On June 24, 2015, the Board of Directors adopted a tax benefits preservation plan intended to reduce the likelihood of an “ownership change” occurring as a result of purchases and sales of the Company's common stock. The tax benefits preservation plan is more fully described in Note 9 – “Income Taxes”. On September 23, 2015, the Company’s shareholders approved an amendment to its articles of incorporation designed to block transfers of common shares that could result in an ownership change. At December 31, 2015, the Company’s net deferred tax asset totaled $52.1 million and was subject to a full valuation allowance.

 

 

On September 30, 2015, we completed a common equity for debt exchange with the holders of $4.0 million of the capital securities issued by one of the Company’s subsidiary trusts. Accrued and unpaid interest on the trust securities totaled of approximately $330,000. In exchange for the $4.3 million debt and interest liability, the Company issued 800,000 common shares and 400,000 non-voting common shares, for a total of 1.2 million shares. In the transaction, a wholly owned subsidiary of the Company acquired one-third of the trust securities directly from an unrelated third party in exchange for the issuance of 400,000 common shares resulting in an $883,000 gain on extinguishment of debt. The subsidiary also acquired two-thirds of the Trust Securities having a book value of $2.9 million from related parties in exchange for the issuance of 400,000 common shares and 400,000 non-voting common shares, which was recorded as a capital transaction in accordance with the applicable accounting rules. Deferred distributions on the remaining $21.0 million of our trust preferred securities outstanding totaled $2.5 million as of December 31, 2015. The common equity for debt exchange is more fully described in Note 12 – “Junior Subordinated Debentures”.

 

 

These items are discussed in further detail throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” Section.

 

Going Concern Considerations and Future Plans

 

Our consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business for the foreseeable future. However, the events and circumstances described in this section and in Note 2 – “Going Concern Considerations and Future Plans” create substantial doubt about the Company’s ability to continue as a going concern.

 

For the year ended December 31, 2015, we reported a net loss of $3.2 million compared with net loss of $11.2 million for the year ended December 31, 2014 and a net loss of $1.6 million for the year ended December 31, 2013. After deductions for dividends and accretion on Preferred Shares, allocating losses to participating securities, and the effect of the exchange of Preferred Shares for common stock, net loss attributable to common shareholders was $2.9 million for the year ended December 31, 2015, compared with net income attributable to common shareholders of $19.4 million for the year ended December 31, 2014, and a net loss attributable to common shareholders of $3.4 million for the year ended December 31, 2013.

 

Despite substantial reductions in non-performing assets during the year, our financial performance in 2015 continued to be negatively impacted by the Bank’s elevated level of non-performing assets. Non-performing loans were 2.28% of total loans and non-performing assets were 3.51% of total assets, at December 31, 2015 compared to 7.57% and 9.19%, respectively, at December 31, 2014. See “Analysis of Financial Condition,” below.

 

Beginning with the fourth quarter of 2011, we have deferred paying interest on the junior subordinated debentures held by our trust subsidiaries, requiring our trust subsidiaries to defer distributions on our trust preferred securities held by investors. If we defer distributions on our trust preferred securities for 20 consecutive quarters, we must pay all deferred distributions in full or we will be in default. Our deferral period expires at the end of the third quarter of 2016. Deferred distributions on our trust preferred securities, which totaled $2.5 million as of December 31, 2015, are cumulative, and unpaid distributions accrue and compound on each subsequent payment date. If as a result of a default we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities will be entitled to receive the liquidation amounts to which they are entitled, including all accrued and unpaid distributions, before any distribution can be made to our shareholders. In addition, the holders of our Series E and Series F preferred stock will be entitled to receive liquidation distributions totaling $10.5 million before any distribution can be made to the holders of our common shares.

 

We continue to be involved in various legal proceedings. We dispute the material factual allegations made against us, and after conferring with our legal advisors, we believe we have meritorious grounds on which to prevail. If we do not prevail, the ultimate outcome of any one of these matters could have a material adverse effect on our financial condition, results of operations, or cash flows. These matters are more fully described in Note 24 – “Contingencies”.

 

As described in “Item 1 – Business” above, our Consent Order with the FDIC and KDFI requires the Bank to maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk based capital ratio of 12%. As of December 31, 2015, the Bank’s Tier 1 leverage ratio and total risk based capital ratio were 6.08% and 10.58%, respectively, both less than the minimum capital ratios required by the Consent Order. If the Bank should be unable to reach the required capital levels, and if directed in writing by the FDIC, the Consent Order requires the Bank to develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution or otherwise obtain a capital investment into the Bank sufficient to recapitalize the Bank. The Bank has not been directed by the FDIC to implement such a plan.

 

In order to meet the 9.0% Tier 1 leverage ratio and 12.0% total risk based capital ratio requirements of the Consent Order, the Board of Directors and management are continuing to evaluate and implement strategies to achieve the following objectives:

 

 

Increasing capital through the limited issuance of common stock to new and existing shareholders.

 

 

Continuing to operate the Company and Bank in a safe and sound manner.  We have reduced our lending concentrations and the size of our balance sheet while continuing to remediate non-performing loans.

 

 

Executing on the sale of OREO and reinvestment in quality income producing assets.

 

 

 

Continuing to improve our internal processes and procedures, distribution of labor, and work-flow to ensure we have adequately and appropriately deployed resources in an efficient manner in the current environment.

 

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. Based on individual circumstances, the agencies may issue mandatory directives, impose monetary penalties, initiate changes in management, or take more serious adverse actions such as directing a bank to seek a buyer or taking a bank into receivership.

 

The Consent Order requires the Bank to obtain the written consent of both agencies before declaring or paying any future dividends to the Company, which are its principal source of revenue. Since the Bank is unlikely to be in a position to pay dividends to the Company until the Consent Order is satisfied and the Bank returns to profitability, cash inflows for the Company are limited to the issuance of new debt or the issuance of capital securities. As of December 31, 2015, we could issue approximately 5 million common shares while still preserving the value of our NOLs under Section 382 of the Internal Revenue Code. The Company’s liquid assets were $1.0 million at December 31, 2015. Ongoing operating expenses of the Company are forecast at approximately $1.0 million for the next twelve months.

 

Our consolidated financial statements do not include any adjustments that may result should the Company be unable to continue as a going concern.

 

Application of Critical Accounting Policies

 

Our accounting and reporting policies comply with GAAP and conform to general practices within the banking industry. We believe that of our significant accounting policies, the following may involve a higher degree of management assumptions and judgments that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

 

Allowance for Loan Losses – The Bank maintains an allowance for loan losses believed to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. The Board of Directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We evaluate the adequacy of the allowance using, among other things, historical loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral and current economic conditions and trends. The allowance may be allocated for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually evaluated and measured for impairment. The general component is based on historical loss experience adjusted for qualitative environmental factors. We develop allowance estimates based on actual loss experience adjusted for current economic conditions and trends. Allowance estimates are a prudent measurement of the risk in the loan portfolio which we apply to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from those assumptions used by management in making its determination, we may be required to materially increase our allowance for loan losses and provision for loan losses, which could adversely affect our results.

 

Other Real Estate Owned – OREO is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure.  It is classified as real estate owned until such time as it is sold.  When property is acquired as a result of foreclosure or by deed in lieu of foreclosure, it is recorded at its fair market value less cost to sell.  Any write-down of the property at the time of acquisition is charged to the allowance for loan losses.  Costs incurred in order to perfect the lien prior to foreclosure may be capitalized if the fair value less the cost to sell exceeds the balance of the loan at the time of transfer to OREO. Examples of eligible costs to be capitalized are payments of delinquent property taxes to clear tax liens or payments to contractors and subcontractors to clear mechanics’ liens. Fair value of OREO is determined on an individual property basis. To determine the fair value of OREO for smaller dollar single family homes, we consult with internal real estate sales staff and external realtors, investors, and appraisers.  If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are taken. For larger dollar residential and commercial real estate properties, we obtain a new appraisal of the subject property or have staff from our special assets group or in our centralized appraisal department evaluate the latest in-file appraisal in connection with the transfer to other real estate owned.  We typically obtain updated appraisals within five quarters of the anniversary date of ownership unless a sale is imminent. Subsequent reductions in fair value are recorded as non-interest expense when a new appraisal indicates a decline in value or in cases where a listing price is lowered below the appraised amount. 

 

Stock-based Compensation – Compensation cost is recognized for restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. The market price of the Company’s common shares at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

 

 

Valuation of Deferred Tax Asset – We evaluate deferred tax assets for impairment on a quarterly basis. We established a 100% deferred tax valuation allowance in December 2011 based upon the analysis of our past performance and our expected future performance. When evaluating our deferred tax assets for realizability during 2015 and 2014, we concluded that a full valuation allowance was still necessary at December 31, 2015 and 2014, due to the additional losses incurred during those years. A return to profitability would enable us to reduce the valuation allowance and thereby offset income tax expense that would otherwise be recognized. Examinations of our income tax returns or changes in tax law may impact our deferred tax assets and liabilities as well as our provision for income taxes.

 

Contingencies – We are defendants in various legal proceedings. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain.

 

Results of Operations 

 

The following table summarizes components of income and expense and the change in those components for 2015 compared with 2014:

 

 

   

For the

Years Ended December 31,

   

Change from Prior Period

 
   

2015

   

2014

   

Amount

   

Percent

 
   

(dollars in thousands)

 

Gross interest income

  $ 36,574     $ 39,513     $ (2,939

)

    (7.4

)%

Gross interest expense

    7,023       9,795       (2,772

)

    (28.3

)

Net interest income

    29,551       29,718       (167

)

    (0.6

)

Provision (negative provision) for loan losses

    (4,500

)

    7,100       (11,600

)

    (163.4

)

Non-interest income

    5,929       3,987       1,942       48.7  

Gains on sale of securities, net

    1,766       92       1,674       1819.6  

Non-interest expense

    44,959       39,435       5,524       14.0  

Net loss before taxes

    (3,213

)

    (12,738

)

    9,525       (74.8

)

Income tax benefit

          (1,583

)

    1,583       (100.0

)

Net loss

    (3,213

)

    (11,155

)

    7,942       (71.2

)

Dividends and accretion on preferred stock

          (2,362

)

    2,362       (100.0

)

Effect of exchange of preferred stock for common stock

          36,104       (36,104

)

    (100.0

)

Losses (earnings) attributable to participating securities

    336       (3,159

)

    3,495       (110.6

)

Net income (loss) attributable to common shareholders

    (2,877

)

    19,428       (22,305

)

    (114.8

)

 

Net loss of $3.2 million for the year ended December 31, 2015 decreased by $7.9 million from a net loss of $11.2 million for 2014. A negative provision expense of $4.5 million was recorded for 2015 due to significant improvements in asset quality and management’s assessment of risk within the portfolio as compared to $7.1 million in provision for loan losses expense for 2014. Non-interest income improved $1.9 million during 2015 due to an increase in OREO rental income of $1.1 million and an $883,000 gain on extinguishment of junior subordinated debt. Non-interest expense increased $5.5 million during 2015 due to increased OREO expense of $6.5 million, offset by a reduction in loan collection expense of $1.9 million.

 

A tax benefit was recognized in 2014 due to gains in other comprehensive income that are presented in current operations. The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of stockholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and there is income in other components of the financial statements. In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations. The tax benefit recorded in 2014 was entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards. No tax benefit was recorded during the 2015.

 

Net loss attributable to common shareholders was $2.9 million for the year ended December 31, 2015, as compared to net income attributable to common shareholders of $19.4 million for 2014. This decrease was primarily attributable to the $36.1 million effect of the exchange of preferred shares for common shares recorded during 2014.

 

 

The following table summarizes components of income and expense and the change in those components for 2014 compared with 2013:

 

   

For the

Years Ended December 31,

   

Change from Prior Period

 
   

2014

   

2013

   

Amount

   

Percent

 
   

(dollars in thousands)

 

Gross interest income

  $ 39,513     $ 43,228     $ (3,715

)

    (8.6

)%

Gross interest expense

    9,795       11,143       (1,348

)

    (12.1

)

Net interest income

    29,718       32,085       (2,367

)

    (7.4

)

Provision for loan losses

    7,100       700       6,400       914.3  

Non-interest income

    3,987       5,196       (1,209

)

    (23.3

)

Gains on sale of securities, net

    92       723       (631

)

    (87.3

)

Non-interest expense

    39,435       38,890       545       1.4  

Net loss before taxes

    (12,738

)

    (1,586

)

    (11,152

)

    703.2  

Income tax benefit

    (1,583

)

          (1,583

)

     

Net loss

    (11,155

)

    (1,586

)

    (9,569

)

    603.3  

Dividends and accretion on preferred stock

    (2,362

)

    (2,079

)

    (283

)

    13.6  

Effect of exchange of preferred stock for common stock

    36,104             36,104       100.0  

Losses (earnings) attributable to participating securities

    (3,159

)

    267       (3,426

)

    (1283.1

)

Net income (loss) attributable to common shareholders

    19,428       (3,398

)

    22,826       (671.7

)

 

Net loss of $11.2 million for the year ended December 31, 2014 increased by $9.6 million from net loss of $1.6 million for 2013. This was primarily due to a $2.4 million decrease in net interest income driven by lower average earning assets, an increase of $6.4 million in provision for loan losses expense, and reductions in non-interest income from our exit of trust services in 2013 and lower gains on the sale of securities. Net income attributable to common shareholders of $19.4 million for the year ended December 31, 2014, improved $22.8 million from net loss to common shareholders of $3.4 million for 2013. This increase was primarily attributable to the $36.1 million effect of the exchange of preferred shares for common shares.

 

Net Interest Income – Our net interest income was $29.6 million for the year ended December 31, 2015, a decrease of $167,000, or 0.6%, compared with $29.7 million for the same period in 2014. Net interest spread and margin were 3.18% and 3.27%, respectively, for 2015, compared with 2.98% and 3.09%, respectively, for 2014. Average nonaccrual loans were $29.0 million and $63.1 million in 2015 and 2014, respectively. The decrease in net interest income was primarily the result of lower average earning assets coupled with lower rates on those assets. In addition, net interest income and net interest margin were adversely affected by $1.7 million and $3.3 million of interest lost on nonaccrual loans during 2015 and 2014, respectively.

 

Our average interest-earning assets were $917.5 million for 2015, compared with $979.2 million for 2014, a 6.3% decrease, primarily attributable to lower average loans, investment securities and interest bearing deposits with financial institutions. Average loans were $635.9 million for 2015, compared with $662.4 million for 2014, a 4.0% decrease. Average investment securities were $194.6 million for 2015, compared with $220.5 million for 2014, an 11.7% decrease. Average interest bearing deposits with financial institutions were $78.9 million in 2015, compared with $87.0 million in 2014, a 9.3% decrease. Our total interest income decreased 7.4% to $36.6 million for 2015, compared with $39.5 million for 2014.

 

Our average interest-bearing liabilities decreased by 6.6% to $826.9 million for 2015, compared with $885.8 million for 2014. Our total interest expense decreased by 28.3% to $7.0 million for 2015, compared with $9.8 million during 2014, due primarily to lower interest rates paid on and lower volume of certificates of deposit. Our average volume of certificates of deposit decreased 11.8% to $557.4 million for 2015, compared with $632.0 million for 2014. The average interest rate paid on certificates of deposit decreased to 0.96% for 2015, compared with 1.29% for 2014, as the result of continued re-pricing of certificates of deposit at maturity to lower interest rates. Our average volume of NOW and money market deposit accounts increased 11.9% to $21.5 million for 2015, compared with $179.7 million for 2014. The average interest rate paid on NOW and money market deposit accounts increased to 0.38% for 2015, compared with 0.36% for 2014. 

 

Our net interest income was $29.7 million for the year ended December 31, 2014, a decrease of $2.4 million, or 7.4%, compared with $32.1 million for the same period in 2013. Net interest spread and margin were 2.98% and 3.09%, respectively, for 2014, compared with 2.97% and 3.10%, respectively, for 2013. Average nonaccrual loans were $63.1 million and $107.3 million in 2014 and 2013, respectively. The decrease in net interest income was primarily the result of lower average earning assets coupled with lower rates on those assets. In addition, net interest income and net interest margin were adversely affected by $3.3 million and $5.6 million of interest lost on nonaccrual loans during 2014 and 2013, respectively.

 

 

Our average interest-earning assets were $979.2 million for 2014, compared with $1.05 billion for 2013, a 6.8% decrease, primarily attributable to lower average loans and partially offset by higher average investment securities and interest bearing deposits with financial institutions. Average loans were $662.4 million for 2014, compared with $788.2 million for 2013, a 16.0% decrease. Average interest bearing deposits with financial institutions were $87.0 million in 2014, compared with $65.1 million in 2013, a 33.7% increase. Average investment securities were $220.5 million for 2014, compared with $184.2 million for 2013, a 19.7% increase. Our total interest income decreased 8.6% to $39.5 million for 2014, compared with $43.2 million for 2013.

 

Our average interest-bearing liabilities decreased by 5.5% to $885.8 million for 2014, compared with $937.4 million for 2013. Our total interest expense decreased by 12.1% to $9.8 million for 2014, compared with $11.1 million during 2013, due primarily to lower interest rates paid on and lower volume of certificates of deposit. Our average volume of certificates of deposit decreased 10.2% to $632.0 million for 2014, compared with $704.0 million for 2013. The average interest rate paid on certificates of deposit decreased to 1.29% for 2014, compared with 1.35% for 2013, as the result of continued re-pricing of certificates of deposit at maturity to lower interest rates. Our average volume of NOW and money market deposit accounts increased 16.1% to $179.7 million for 2014, compared with $154.8 million for 2013. The average interest rate paid on NOW and money market deposit accounts increased to 0.36% for 2014, compared with 0.35% for 2013.

 

 

Average Balance Sheets

 

The following table sets forth the average daily balances, the interest earned or paid on such amounts, and the weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities for the periods indicated. Dividing income or expense by the average daily balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.

 

 

   

For the Years Ended December 31,

 
   

2015

   

2014

 
   

Average

Balance

   

Interest

Earned/Paid

   

Average

Yield/Cost

   

Average

Balance

   

Interest

Earned/Paid

   

Average

Yield/Cost

 
   

(dollars in thousands)

 

ASSETS

                                               

Interest-earning assets:

                                               

Loans receivables (1)(2)

                                               

Real estate

  $ 516,605     $ 25,423       4.92

%

  $ 562,829     $ 27,654       4.91

%

Commercial

    78,993       3,475       4.40       60,419       3,002       4.97  

Consumer

    10,432       856       8.21       12,786       1,087       8.50  

Agriculture

    29,395       1,470       5.00       25,806       1,321       5.12  

Other

    523       27       5.16       602       26       4.32  

U.S. Treasury and agencies

    31,269       684       2.19       32,459       755       2.33  

Mortgage-backed securities

    107,277       2,420       2.26       114,103       2,780       2.44  

State and political subdivision securities (3)

    25,354       764       4.64       30,428       936       4.73  

State and political subdivision securities

    24,059       774       3.22       24,873       757       3.04  

Corporate bonds

    6,116       155       2.53       18,041       607       3.36  

FHLB stock

    7,323       293       4.00       7,760       337       4.34  

Other debt securities

    544       43       7.90       572       46       8.04  

Other equity securities

                      21              

Federal funds sold

    752       1       0.13       1,502       2       0.13  

Interest-bearing deposits in other financial institutions

    78,904       189       0.24       86,986       203       0.23  

Total interest-earning assets

    917,546       36,574       4.03

%

    979,187       39,513       4.09

%

Less: Allowance for loan losses

    (17,154

)

                    (25,390

)

               

Non-interest-earning assets

    84,027                       95,435                  

Total assets

  $ 984,419                     $ 1,049,232                  
                                                 

LIABILITIES AND STOCKHOLDERS’ EQUITY

                                               

Interest-bearing liabilities

                                               

Certificates of deposit and other time deposits

  $ 557,441     $ 5,329       0.96

%

  $ 632,020     $ 8,125       1.29

%

NOW and money market deposits

    201,164       756       0.38       179,698       653       0.36  

Savings accounts

    35,604       75       0.21       36,803       89       0.24  

Federal funds purchased and repurchase agreements

    587       1       0.17       2,255       3       0.13  

FHLB advances

    3,473       95       2.74       4,473       124       2.77  

Junior subordinated debentures

    28,589       767       2.68       30,508       801       2.63  

Total interest-bearing liabilities

    826,858       7,023       0.85

%

    885,757       9,795       1.11

%

Non-interest-bearing liabilities

                                               

Non-interest-bearing deposits

    113,576                       113,150                  

Other liabilities

    10,902                       16,444                  

Total liabilities

    951,336                       1,015,351                  

Stockholders’ equity

    33,083                       33,881                  

Total liabilities and stockholders’equity

  $ 984,419                     $ 1,049,232                  
                                                 

Net interest income

          $ 29,551                     $ 29,718          
                                                 

Net interest spread

                    3.18

%

                    2.98

%

                                                 

Net interest margin

                    3.27

%

                    3.09

%

                                                 

Ratio of average interest-earning assets to average interest-bearing liabilities

                    110.97

%

                    110.55

%

 

 


(1)

Includes loan fees in both interest income and the calculation of yield on loans.

(2)

Calculations include non-accruing loans of $29.0 million and $63.1 million in average loan amounts outstanding.

(3)

Taxable equivalent yields are calculated assuming a 35% federal income tax rate.

 

 

   

For the Years Ended December 31,

 
   

2014

   

2013

 
   

Average

Balance

   

Interest

Earned/Paid

   

Average

Yield/Cost

   

Average

Balance

   

Interest

Earned/Paid

   

Average

Yield/Cost

 
   

(dollars in thousands)

 

ASSETS

                                               

Interest-earning assets:

                                               

Loans receivables (1)(2)

                                               

Real estate

  $ 562,829     $ 27,654       4.91

%

  $ 696,785     $ 32,591       4.68

%

Commercial

    60,419       3,002       4.97       50,990       2,772       5.44  

Consumer

    12,786       1,087       8.50       16,982       1,402       8.26  

Agriculture

    25,806       1,321       5.12       22,639       1,229       5.43  

Other

    602       26       4.32       780       21       2.69  

U.S. Treasury and agencies

    32,459       755       2.33       23,685       546       2.31  

Mortgage-backed securities

    114,103       2,780       2.44       83,160       1,552       1.87  

State and political subdivision securities (3)

    30,428       936       4.73       30,292       933       4.74  

State and political subdivision securities

    24,873       757       3.04       24,861       787       3.17  

Corporate bonds

    18,041       607       3.36       20,864       745       3.57  

FHLB stock

    7,760       337       4.34       10,072       421       4.18  

Other debt securities

    572       46       8.04       572       46       8.04  

Other equity securities

    21                   744       30       4.03  

Federal funds sold

    1,502       2       0.13       2,640       3       0.11  

Interest-bearing deposits in other financial institutions

    86,986       203       0.23       65,076       150       0.23  

Total interest-earning assets

    979,187       39,513       4.09

%

    1,050,142       43,228       4.16

%

Less: Allowance for loan losses

    (25,390

)

                    (40,343

)

               

Non-interest-earning assets

    95,435                       88,601                  

Total assets

  $ 1,049,232                     $ 1,098,400                  
                                                 

LIABILITIES AND STOCKHOLDERS’ EQUITY

                                               

Interest-bearing liabilities

                                               

Certificates of deposit and other time deposits

  $ 632,020     $ 8,125       1.29

%

  $ 703,982     $ 9,482       1.35

%

NOW and money market deposits

    179,698       653       0.36