10QSB 1 sryss.txt FORM 10-QSB SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 Mark One [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002, OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________ TO _____________. Commission file number 001-12818 SURETY CAPITAL CORPORATION (Exact name of small business issuer as specified in its charter) Delaware 75-2065607 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 1501 Summit Avenue, Fort Worth, Texas 76102 (Address of principal executive offices) 817-335-5955 (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days. Yes X No Common stock outstanding on May 13, 2002: 7,994,852 shares SURETY CAPITAL CORPORATION INDEX PART I - FINANCIAL INFORMATION Page No. Item 1 Financial Statements (Unaudited) Consolidated Balance Sheets 3 Consolidated Statements of Operations 4 Consolidated Statements of Comprehensive Income 5 Condensed Consolidated Statements of Changes in Shareholders' Equity 6 Condensed Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 14 PART II - OTHER INFORMATION Item 1 Legal Proceedings 20 Item 2 Changes in Securities and Use of Proceeds 20 Item 3 Defaults Upon Senior Securities 20 Item 4 Submission of Matters to a Vote of Security Holders 21 Item 5 Other Information 21 Item 6 Exhibits and Reports on Form 8-K 21 SURETY CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETS March 31, December 31, 2002 2001 Assets: (Unaudited) Cash and due from banks $ 3,767,429 $ 4,387,913 Federal funds sold 8,880,000 10,015,000 ---------- ---------- Total cash and cash equivalents 12,647,429 14,402,913 Interest-bearing time deposits in other financial institutions 27,958 27,771 Securities available for sale, at fair value 8,483,390 10,597,837 Securities to be held to maturity 2,500,00 -- Loans, net 63,718,639 60,996,714 Premises and equipment, net 5,264,194 5,310,166 Accrued interest receivable 487,860 439,190 Other real estate and repossessed assets 715,000 737,000 Goodwill, net 2,536,679 2,536,679 Other assets 656,453 512,161 ----------- ---------- Total assets $97,037,602 $95,560,431 ============ =========== Liabilities: Noninterest-bearing demand deposits $ 17,560,398 $15,936,327 Savings, NOW and money market accounts 28,901,082 28,196,609 Time deposits, $100,000 and over 12,752,020 14,392,822 Other time deposits 25,811,819 24,628,757 Total deposits 85,025,319 83,154,515 Convertible subordinated debt 4,350,000 4,350,000 Notes Payable 95,000 132,746 Accrued interest payable and other liabilities 1,044,749 948,478 ------------- ----------- Total liabilities 90,515,068 88,585,739 Shareholders' Equity: Preferred stock, $0.01 par value, 1,000,000 shares authorized, none issued Common stock, $0.01 par value, 20,000,000 shares authorized, 8,074,688 and 8,074,688 shares issued, respectively 80,747 80,747 Additional paid-in capital 17,803,491 17,803,491 Accumulated deficit (10,951,035) (10,522,414) Treasury stock, 79,836 shares at cost (375,443) (375,443) Accumulated other comprehensive income (loss) (35,226) (11,689) ---------- ---------- Total shareholders' equity 6,522,534 6,974,692 ---------- ---------- Total liabilities and shareholders' Equity $97,037,602 $95,560,431 =========== ========== SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended ------------------ March 31,2002 March 31,2001 Interest income: ------------- ------------- Loans, including fees $ 1,257,483 $ 1,408,976 Securities, all taxable 102,712 205,305 Federal funds sold and interest bearing deposits 38,677 101,143 --------- ----------- Total interest income 1,398,872 1,715,424 --------- ----------- Interest expense: Deposits 492,882 786,275 Notes payable 97,875 97,875 --------- ----------- Total interest expense 590,757 884,150 --------- ----------- Net interest income 808,115 831,274 Provision for credit losses -- -- --------- ----------- Net interest income after provision for credit losses 808,115 831,274 Noninterest income: Service charges on deposit accounts 168,918 158,897 Loan collection fees and late charges 28,422 52,391 Other income 55,924 30,859 ---------- ----------- Total noninterest income 253,264 242,147 Noninterest expense: Salaries and employee benefits 784,992 674,852 Occupancy and equipment 260,639 305,581 Other expenses 444,369 408,761 --------- ----------- Total noninterest expense 1,490,000 1,389,194 Net loss before income taxes (428,621) (315,773) Income tax (benefit) -- -- ---------- ------------ Net income (loss) $ (428,621) $ (315,773) ============ ============ Net income (loss) per share - Basic $ (0 .05) $ (0 .05) Net income (loss) per share - Diluted $ (0.05) $ (0.05) SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) Three Months Ended March 31,2002 March 31,2001 Net income (loss) $ (428,621) $ (315,773) Other comprehensive income (loss): Unrealized gain (loss) on available-for-sale securities arising during period (35,664) 263,456 Tax effect 12,127 (89,575) --------- --------- Total other comprehensive income (loss) (23,537) 173,881 --------- --------- Comprehensive income (loss) $ (452,158) $ (141,892) ============ ============== SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) Three Months Ended March 31, March 31, 2002 2001 Balance at beginning of period $ 6,974,692 $ 7,677,669 Issuance of Common Stock -- 40,000 Net income (loss) (428,621) (315,773) Change in fair value of securities available for sale, net of tax (23,537) 173,881 ------------- ------------- Balance at end of period $ 6,522,534 $ 7,575,777 ============= ============= SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Three Months Ended March 31, March 31, 2002 2001 Net cash from operating activities $ (358,464) $(224,078) ----------- ------------ Cash flows from investing activities: Net change in loans (2,721,925) 815,074 Securities available for sale: Purchases - Available for sale (2,350,000) (500,000) Purchases - to be held to maturity (2,500,000) -- Maturities, calls, and repayments 4,423,273 502,211 Premises and equipment expenditures (81,426) (19,948) ------------ ---------- Net cash from investing activities (3,230,078) 797,337 ------------ ---------- Cash flows from financing activities: Increase (decrease) in notes payable (37,746) 20,000 Net change in deposits 1,870,804 219,129 ----------- --------- Net cash from financing activities 1,833,058 239,129 ----------- --------- Net change in cash and cash equivalents (1,755,484) 812,388 Cash and cash equivalents at beginning of period 14,402,913 11,023,209 ----------- --------- Cash and cash equivalents at end of period $12,647,429 $11,835,597 =========== =========== Supplemental disclosures: Cash paid for interest $ 540,238 $ 917,999 Cash paid (refunds received) for federal income taxes -- -- Significant non-cash transactions: Transfers of repossessed collateral to other real estate andrepossessed assets -- 15,389 Additions to loans to facilitate sale of other real estate -- -- Conversion of notes payable to common stock -- 40,000 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies The accompanying consolidated financial statements include the accounts of Surety CapitalCorporation (the "Holding Company") and its wholly-owned subsidiary, Surety Bank, National Association (the "Bank"), together, with the Holding Company, referred to as the "Company". All significant intercompany accounts and transactions have been eliminated in consolidation. These interim financial statements are unaudited and reflect all adjustments that, in the opinion of management, are necessary to present fairly the financial position of the Company at March 31, 2002, and its results of operations and cash flows for the periods presented. All such adjustments are normal and recurring in nature. The accompanying financial statements have been prepared in accordance with the instructions of Form 10-QSB and, therefore, do not purport to contain all necessary financial disclosures required by generally accepted accounting principles that might otherwise be necessary in the circumstances, and should be read in conjunction with financial statements, and notes thereto, of the Company for the year ended December 31, 2001, included in its annual report on Form 10-KSB for the fiscal year ended December 31, 2001 (the "2001 Form10-KSB").Please refer to the accounting policies of the Company described in the notes to financial statements contained in the 2001 Form 10-KSB. The Company has consistently followed these policies in preparing this Form 10-QSB. Some items in prior financial statements have been reclassified to conform to the current presentation. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 142 effective January, 2002. SFAS No. 142 applies to all goodwill and identified intangible assets acquired in a business combination. Under the new standard, all goodwill, including that acquired before the initial application of the standard, and indefinite-lived intangible assets will not be amortized but will be tested for impairment at least annually. Identified finite-lived intangible assets will be amortized over their useful lives and reviewed for impairment when circumstances warrant. Within six months of initial application of the new standard, a transitional impairment test must be performed on all goodwill. Any ultimate impairment loss recognized must be reported as a change in accounting principle. In addition to the transitional impairment test, the required annual impairment test must be performed in the year of adoption of the standard. The new standard is required to be applied prospectively. As required, the Company adopted SFAS No. 142 on January 1, 2002, and estimates that the elimination of goodwill amortization will reduce noninterest expense by approximately $262,000 for 2002. Included in other operating expense for the first quarter of 2001 is $ 66,000 Goodwill amortization expense. 2. Earnings Per Share Earnings per share is computed in accordance with SFAS No. 128, which requires dual presentation of basic and diluted earnings per share ("EPS") for entities with complex capital structures. Basic EPS is based on net income divided by the weighted-average number of shares outstanding during the period. Diluted EPS includes the dilutive effect of stock options granted using the treasury stock method. Earnings per common share are computed by dividing net income by the weighted-average number of shares outstanding for the year. The weighted-average number of common shares outstanding for basic and diluted earnings per share computations was as follows: Three Months Ended March 31, March 31, 2002 2001 --------- ---------- Weighted-average shares outstanding-Basic 8,074,688 5,976,716 Effect of stock options -- -- --------- ---------- Weighted-average shares outstanding-Diluted 8,074,688 5,976,716 ========= ========= The Company reported a net loss for the three-month periods ended March 31, 2002 and 2001. Accordingly, the dilutive effect of stock options is not considered in the net loss per share calculations for these periods. 3. Securities Securities available for sale consisted of the following: Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains ( Losses) Value March 31, 2002: ---------- ---------- ----------- ----------- U.S. Treasury notes $ 199,747 $ -- $ ( 87) $ 199,660 U.S. government agencies 6,895,650 -- (50,301) 6,845,349 Mortgage-backed securities 674,463 2,615 (5,601) 671,477 Other securities 766,904 -- -- 766,904 --------- ----- ---------- --------- Total $ 8,536,764 $ 2,615 $ (55,989) $ 8,483,390 ============= ===== ========== ========= December 31, 2001: U.S. government agencies $9,100,582 $ 4,389 $ (22,775) $ 9,082,196 Mortgage-backed securities 748,061 4,457 (3,781) 748,737 Other securities 766,904 -- -- 766,904 ---------- ----- ----------- ---------- Total $10,615,547 $ 8,846 $( 26,556) $ 10,597,837 =========== ===== ============ =========== In addition, the Company held U.S. government agencies at March 31, 2002 of $2,500,000 with a value of $2,481,298 purchased with the intention to hold to maturity. There were no holdings of securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of shareholders' equity at December 31, 2001 or March 31, 2002. Mortgage-backed securities are backed by pools of mortgages that are insured or guaranteed by the Federal Home Loan Mortgage Corporation and the Government National Mortgage Corporation. Other securities include stock holdings in Independent Bankers Financial Corporation, the Federal Reserve Bank and the Federal Home Loan Bank ("FHLB"). The amortized cost and estimated fair value of securities available for sale at March 31, 2002 by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mortgage-backed securities and other securities are shown separately since they are not due at a single maturity date. Amortized Cost Estimated Fair Value ------------- ------------------ Due within one year $ 199,747 $ 199,660 Due after one year through five years 6,392,719 6,343,474 Due after five years through ten years 502,931 501,875 Mortgage-backed securities 674,463 671,477 Other securities 766,904 766,904 ------------- ------------- Total securities available for sale $ 8,536,764 $ 8,483,390 ============= ============= There were no sales of securities available for sale during the three-month periods ended March 31, 2002 or March 31, 2001. 4. Loans Loans consisted of the following: March 31, December 31, 2002 2001 --------- ------------- Real estate loans $ 39,463,546 $ 38,296,528 Insurance premium financing 6,646,794 4,588,151 Commercial loans 12,912,946 13,311,170 Consumer loans 6,004,620 6,202,544 -------------- ------------- Total gross loans 65,027,906 62,398,393 Unearned interest (207,247) (135,216) Allowance for credit losses (1,102,020) (1,266,463) --------------- -------------- Loans, net $ 63,718,639 $ 60,996,714 =============== ============== Activity in the allowance for credit losses on loans was as follows: Three Months Ended March 31 March 31, 2002 2001 --------- --------- Beginning balance $ 1,266,463 $ 1,263,961 Provision for credit losses -- -- Charge-off (236,535) (92,092) Recoveries 72,092 110,637 ------------- ------------- Ending balance $ 1,102,020 $ 1,282,506 ============= ============= Impaired loans were as follows: March 31, December 31, 2002 2001 ------------ ------------ Impaired loans with allowance allocated $ 1,669,035 $ 1,495,244 Impaired loans with no allowance allocated 1,838,313 1,217,478 ------------ ----------- Total impaired loans $ 3,507,348 $ 2,712,722 ============ =========== Amount of the allowance allocated $ 221,979 $ 263,020 ============ =========== Nonperforming loans were as follows: March 31, December 31, 2002 2001 ------------ ------------ Loans past due over 90 days still on accrual $ 1,362,216 $ -- Nonaccrual loans 1,636,598 732,131 ------------- ------------ Total nonperforming loans $ 2,998,814 $ 732,131 ============= ============ 5. Convertible Subordinated Debt and Notes Payable On March 31, 1998, the Company issued $4,350,000 in 9% Convertible Subordinated Notes Due 2008 (the "Notes"), pursuant to an indenture between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (the "Trustee"). The Notes are general unsecured obligations of the Company. The terms of the Notes are such that they qualify as Tier II capital under the Federal Reserve Board's regulatory capital guidelines applicable to bank holding companies. The Notes bear interest at a rate of 9% per annum until maturity. Interest on the Notes is payable semi-annually on March 31 and September 30 of each year. No principal payments are due until maturity on March 31, 2008. The Company did not pay the interest due March 31, 2002. The Company is attempting to negotiate with Note Holders and has offered them non-interest bearing notes, warrants to purchase Company stock, and/or modified conversion features in exchange for interest to be due over the next three years. The Company does not know if it will be successful in these negotiations. The amount of the principal and any accrued and unpaid interest on the Notes is subordinated in right of payment to the prior payment in full of all senior indebtedness of the Company, including the Bank's deposits. Upon the occurrence of certain events involving the bankruptcy, insolvency, reorganization, receivership or similar proceedings of the Company, either the Trustee or the holders of not less than 25% in aggregate principal amount of the outstanding Notes may declare the principal of the Notes, together with any accrued and unpaid interest, to be immediately due and payable. The Notes do not otherwise provide for any right of acceleration of the payment of principal thereof. Other notes payable of $95,000 at March 31, 2002 and $132,746 at December 31, 2001 represent funds borrowed from current and former members of the Company's Board of Directors to provide the Company funds to meet its cash obligations. $37,746, which represents amounts to a former director's law firm for services provided, was paid in January 2002. The remaining promissory notes matured December 31, 2001. The notes bear no interest from the date of issuance until maturity and will be converted into common stock at a rate of one share of common stock per $0.2167 of principal amount of the notes. 6. Financial Instruments With Off-Balance-Sheet Risk and Concentration of Credit Risk Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued in the normal course of business to meet the financing needs of customers. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met. These agreements usually have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being used, the total commitments do not necessarily represent future cash requirements. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. Financial instruments with off-balance sheet risk at March 31, 2002 and December 31, 2001 included unfunded loan commitments of $3,861,223 and $4,897,000 and letters of credit of $288,991 and $450,000. Federal funds sold totaled $8,880,000 and $10,015,000 at March 31, 2002 and December 31, 2001. These funds represent uncollateralized loans, in varying amounts, to other commercial banks with which the Company has correspondent relationships. The Company maintains deposits with other financial institutions in amounts that exceed federal deposit insurance coverage. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risks on cash and cash equivalents. The Company has geographic concentrations of credit in its principal market areas of Bexar, Comal, Grayson, and Tarrant Counties, Texas. Additionally, the Company has a significant concentration of credit, based upon like collateral. Insurance Premium Finance ("IPF") loans, secured by the residual value of unearned insurance premiums, comprised $6,647,000 or 10.3%, and $4,715,000, or 7.6%, of gross loans at March 31, 2002 and December 31, 2001. 7. Other Noninterest Expense Other noninterest expense consisted of the following: Three Months Ended March 31, March 31, 2001 2002 ---------- ----------- Professional services $ 93,510 $ 94,949 Postage 31,661 39,112 Telephone 34,219 39,855 Office supplies 20,180 13,864 Amortization of intangibles and debt issuance costs 10,398 75,984 Insurance 37,463 31,152 FDIC and OCC assessments 25,090 9,460 Other 191,848 104,385 --------- --------- Total other noninterest expense $ 444,369 $ 408,761 ========= ========= Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion focuses on the consolidated financial condition of the Company at March 31, 2002 compared to December 31, 2001, and the consolidated results of operations for the three-month periods ended March 31, 2002 compared to the same period in 2001. The purpose of this discussion is to provide the reader with a more thorough understanding of the consolidated financial statements. This discussion should be read in conjunction with the consolidated financial statements and related footnotes. Forward-Looking Statements This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have material adverse effects on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following: The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets. The economic impact of the terrorist attacks that occurred on September 11th, as well as any future threats and attacks, and the response of the United States to any such threats and attacks. The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters. The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company's assets) and the policies of the Board of Governors of the Federal Reserve System. The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector. The inability of the Company to obtain new customers and to retain existing customers. The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers. The ability of the Company to develop and maintain secure and reliable electronic systems. The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner. Consumer spending and saving habits which may change in a manner that affects the Company's business adversely. Business combinations and the integration of acquired businesses that may be more difficult or expensive than expected. The costs, effects and outcomes of existing or future litigation. Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. The ability of the Company to manage the risks associated with the foregoing as well as its inability to meet its interest obligations under the subordinated convertible notes, an interest payment of $97,875 that was due March 31, 2002 and which remains unpaid. These risks and uncertainties should be considered in evaluating forward- looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission. Regulatory Relations Formal Agreement with the OCC. On November 19, 1998 the Board of Directors of the Bank entered into a formal written agreement (the "Formal Agreement") with the Office of the Comptroller of the Currency (the "OCC") pursuant to which the Bank was required to achieve certain capital levels and adopt and implement certain plans, policies and strategies by March 31, 1999. The Bank initially was unable to achieve the capital requirements set forth in the Formal Agreement and after receiving an extension to from the OCC the Bank achieved the required levels of capital upon completion of the sale of the Midlothian and Waxahachie branches on June 30, 1999, and has remained in compliance since that time. At March 31, 2002 the Bank met the capital levels required by the Formal Agreement, with total risk-based capital of 14.07% of risk-weighted assets and Tier I leverage capital of 9.01% of adjusted total assets compared to the ratios required under the Formal Agreement of 14.0% and 7.0%, respectively. The Company remains subject to the Formal Agreement and management does not know when or if the OCC will agree to terminate the Formal Agreement. .. Memorandum of Understanding with the Federal Reserve Board. On October 28, 1999 the Board of Directors of the Company entered into a Memorandum of Understanding (the "MOU") with the Board of Governors of the Federal Reserve System (the "FRB"). Under the MOU, the Company is not permitted to declare or pay any corporate dividends or incur any additional debt without the prior approval of the FRB. Also, the Company was required to develop and submit to the FRB a written three-year capital plan, a plan to service the Company's existing debt without incurring any additional debt, and written procedures designed to strengthen and maintain the Company's internal records and controls to ensure that future regulatory reports are filed in a timely and accurate manner. Finally, the Company is mandated under the MOU to comply fully with all formal and informal supervisory actions that have been or may be imposed on the Bank by the OCC. The Company has complied with the requirements of the MOU. However, the Company has not yet met its interest payment obligation on the $4.350 million subordinated convertible debt, which was due March 31, 2002. Management does not know when or if the FRB will agree to terminate the MOU or what action the FRB may take if the Company falls out of compliance. Securities and Exchange Commission Agreement. The Company is subject to reporting requirements of the Securities and Exchange Act of 1934, as amended. The Securities and Exchange Commission ("SEC") investigated the Company and others with respect to various accounting irregularities found by the Company in its IPF division during an internal audit of the division conducted in 1999 and the first quarter of 2000. Upon finding the irregularities, the Company reported them to the SEC, the OCC as well as certain legal authorities. The Company fully cooperated with the SEC as well as bank regulatory agencies involved in investigating the irregularities. In February 2002, the SEC issued a finding that the Company violated certain sections of the Securities and Exchange Act of 1934. In March 2002, the Company entered into settlement with the SEC. In connection with the settlement, the Company acknowledged certain reporting and internal control deficiencies and agreed to cease and desist from the stipulated violations in the future. The SEC acknowledged the efforts and cooperation of the Company's current Board of Directors and management and recognized that none of the current members of the Board of Directors or senior management were associated with or employed by the Company during the periods investigated. The Company and the Bank no longer employ the persons directly responsible for managing the IPF division during the period when the diversions occurred and the Company no longer uses the services of the accounting firm auditing the Company at that time. None of the current members of the Company or Bank's Board of Directors served in those capacities during the period when the violations of the Securities and Exchange Act of 1934 occurred. Analysis of Financial Condition The Company's assets totaled $97.0 million at March 31, 2002, representing a 1.5% increase compared to $95.6 million at December 31, 2001. The increase in assets was primarily the result of loan growth in the Company's IPF and Fort Worth lending divisions. Total securities (including securities to be held to maturity) increased 3.6% and were $11.0 million at March 31, 2002. The increase from December 31, 2001 was due to a reinvestment of federal funds primarily to meet pledging requirements of public funds deposits. Net unrealized losses were $53,000 at March 31, 2002 compared to $21,000 at December 31, 2001. No impairment loss related to these securities has been recognized, as believes the decline in the fair value is temporary. Net loans increased $2.7 million, or 4.5%, from $61.0 million at December 31, 2001 to $63.7 million at March 31, 2002. IPF loans increased $2.1 million, or 45%, from December 31, 2001. Real estate loans increased $1.2 million, or 3.0%. Commercial loans decreased $0.4 million, or 3.0%, due primarily to the Company's decision not to renew certain loans in the San Antonio region. Loans, net of unearned interest, as a percentage of total deposits were 76.2% at March 31, 2002 compared to 74.9% at December 31, 2001. Other assets increased $144,000 from December 31, 2001 due primarily to an increase in prepaid insurance and other prepaid expenses. Total deposits were $85.0 million at March 31, 2002, an $1.9 million increase, or 2.3%, from December 31, 2001. Noninterest-bearing demand deposits increased $1.6 million to $17.6 million and represented 20.7% of total deposits at March 31, 2002 compared to $15.9 million, or 19.1% of total deposits, at December 31, 2001. Savings, NOW and money market accounts increased $704,000 while time deposits declined $458,000. The shift in deposit categories is due to normal customer cash-usage patterns. Time deposits made up 45.4% of the deposit portfolio at March 31, 2002 compared to 46.9% at December 31, 2001. Substantially all of the Company's time deposits mature in less than five years and are obtained from customers in the Company's trade market. The Company does not purchase brokered deposits. Based on past experience and the Company's prevailing pricing strategies, management believes a substantial percentage of such deposits will renew with the Company at maturity.If there is a significant deviation from historical experience, the Company can utilize borrowings from the FHLB as an alternative to this source of funds, subject to regulatory approval under the Formal Agreement. Convertible subordinated debt totaled $4.4 million at March 31, 2002 and December 31, 2001. Convertible subordinated notes were issued on March 31, 1998 to provide funds to finance the acquisition of TexStar National Bank. The notes bear interest at a rate of 9% per annum until maturity. No principal payments are due until maturity on March 31, 2008, while interest on the notes is payable semi-annually. The Company did not pay the interest due March 31, 2002. The Company is attempting to negotiate with Note Holders and has offered them non-interest bearing notes, warrants to purchase Company stock, and/or modified conversion features in exchange for interest to be due over the next three years. The Company does not know if it will be successful in these negotiations. There are also notes payable representing funds borrowed from directors and officers under noninterest bearing, convertible notes. The notes in the principal amount of $95,000 remained outstanding on March 31, 2002 and will be converted into common stock at $0.2167 per share. Notes payable declined $38,000 from December 31, 2001 due to repayments. Comparison of Results of Operations Net Income. General economic conditions, the monetary and fiscal policies of federal agencies and the regulatory policies of agencies that regulate financial institutions affect the operating results of the Company. Interest rates on competing investments and general market rates of interest influence the Company's cost of funds. Lending activities are influenced by the demand for various types of loans, which in turn is affected by the interest rates at which such loans are made, general economic conditions and the availability of funds for lending activities. The Company's net income is primarily dependent upon its net interest income, which is the difference between interest income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Provisions for credit losses, service charges, gains on the sale of assets and other income, noninterest expense and income taxes also affect net income. The Company experienced a $429,000 net loss for the three months ended March 31, 2002 compared to $316,000 net loss for the same period in 2001. Net loss per share was $0.05 per share for both three months periods. The Company did not reflect any tax benefit with the losses because the Company cannot be certain that it will receive a future income tax benefit. The loss is due primarily to declining net interest marginand increases in salary, occupancy, and other non-interest expenses. Salary expenses will show slight increases future quarters when compared to the first quarter of 2002. Net Interest Income. Net interest income is the largest component of the Company's income and is affected by the interest rate environment and the volume and composition of interest-earning assets and interest-bearing liabilities. For the first quarter 2002, net interest income decreased $23,000 or 2.8%, compared to the same period last year. The decline is due primarily to the reversal of interest accrued on a $1 million loan that was placed on non-accrual effective March 31,2002. By placing the loan on non-accrual, the Company reversed $53,000 of interest income, nearly half of which was accrued to income during 2001. The Company's net interest margin was 3.89% for the first quarter of 2002 compared to 4.26% during the same period last year. The decrease in average net interest margin was primarily due to a declining interest rate environment that reduced yields on earning assets at a greater rate than interest bearing liabilities and a shift in portfolio mix from investment securities to federal funds sold. These negative events were partly offset by a $5 million (6.5%) increase in the volume of average earning assets. The weighted-average yield on interest-earning assets was 6.74% versus 8.79% last year. The Company had $9.7 million of its average interest-earning assets invested in lower-yielding federal funds sold during the first quarter of 2002 representing 11.6% of total earning assets versus 9.1% of total earning assets last year. The growth of federal funds sold was funded by a decline in the volume of investment securities. Average investment securities declined from 16.4% of total earning assets during the first quarter of 2001 to 13.2% during the first quarter of 2002. During 2001, numerous high yielding bonds were called by the issuing agencies. The Company chose to invest a portion of the proceeds in federal funds to provide liquidity for loan growth. Called securities were replaced with lower yielding securities. The average yield on investment securities was 3.75% during the first quarter of 2002 compared to 6.44% during the first quarter of 2001. The yield on federal funds sold dropped 414 basis points. Average loan balances increased $4.3 million or 7.2% due primarily to a $2 million growth in average IPF loans and commercial loans in the Fort Worth region. The average yield on total average loans fell from 9.68% to 8.05%. The Company remains asset sensitive, whereby its interest-bearing assets will generally reprice more quickly than its interest-bearing liabilities. Therefore, the Company's net interest margin will generally increase in periods of rising market interest rates and will decrease in periods of declining market interest rates. However, in a rising interest rate environment, the Company may need to increase rates to attract and retain deposits. The average balance of non-interest bearing deposits was $16.8 million and $15.1 million during the first quarter of 2002 and 2001, respectively. Allowance and Provision for Credit Losses. The Company maintains an allowance for credit losses in an amount that, in management's judgment, is adequate to absorb reasonably foreseeable losses inherent in the loan portfolio. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors, including the performance of the Company's loan portfolio, the economy, changes in real estate values and interest rates and the view of the regulatory authorities toward loan classifications. The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level that is considered adequate to absorb losses inherent in the loan portfolio. The amount of the provision is based on management's review of the loan portfolio and consideration of such factors as historical loss experience, general prevailing economic conditions, changes in the size and composition of the loan portfolio and specific borrower considerations, including the ability of the borrower to repay the loan and the estimated value of the underlying collateral. All lending activity contains risks of loan losses and the Company recognizes these credit risks as a necessary element of its business activity. One of the primary objectives of the loan review function is to make recommendations to management as to both specific loss reserves and overall portfolio loss reserves. Loan charge offs, net of recoveries, was $164,000 for the first quarter of 2002 while loan recoveries exceeded loan charge-offs by $18,000 during the first quarter of 2001. The allowance for credit losses at March 31, 2002 was $1.1 million or 1.7% of period end loans versus $1.3 million or 2.18% of loans at March 31, 2001. Nonperforming loans, defined as loans past due 90 days or more and loans for which the accrual of interest has been discontinued, totaled $3 million at March 31, 2002, a significant increase from the $1.6 million at March 31, 2001 and $732,000 at December 31, 2001. Nonperforming loans as a percentage of total loans totaled 4.7%, 1.2% and 1.2%, respectively, at such dates. Effective March 31, 2002, the Company placed $1 million loan on nonaccrual status. An apartment complex in San Antonio secures the loan. The loan originated with an 80% loan-to-appraised-value ratio. The borrower represents that a sale of the project will take place during the second quarter. The Company did not record a provision for credit loss expense in either the first quarter of 2002 or 2001 because management believes the allowance is sufficient to cover losses inherent in the existing loan portfolio. Management will continue to monitor the appropriate factors when considering future levels of provisions and the allowance for loan losses. While management believes that it uses the best information available to determine the allowance for estimated loan losses, unforeseen market conditions could result in adjustments to the allowance for estimated loan losses and net earnings could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. Noninterest Income. Noninterest income totaled $253,000 in the first quarter of 2002, compared to $242,000 in the first quarter of 2001. Service charges on deposit accounts was the largest category of noninterest income and rose $10,000 or 6.2% over the first quarter of 2002 due primarily to an increase in deposit accounts. Loan collection fees and late charge income declined $24,000 due primarily to a reduction in real estate loan origination fee income. Other noninterest income rose $25,000 over the first quarter of 2001 due primarily to $19,000 increase in the cash surrender value of a key man life insurance policy. Noninterest Expense. Noninterest expense totaled $1.5 million for the three month periods ended March 31, 2002, representing a $101,000 increase, or 7.6%, from the same period in 2001 due primarily to higher personnel cost. Salaries and employee benefits expense for the first quarter of 2002 represents an increase of $110,000 or 16.3% compared to the first quarter of 2001. During 2001, the Company hired branch presidents as for all its branches to enhance the marketing efforts and related support staff. In addition, two commercial loan officers and a marketing officer were added to the Fort Worth division, a senior commercial loan officer was hired at the Whitesboro branch and a salesman was added to the IPF division. Amortization of intangibles and debt issuance cost was $10,000 during the first quarter of 2001 versus $76,000 last year. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 142. SFAS No. 142 applies to all goodwill and identified intangible assets acquired in a business combination. Under the new standard, all goodwill, including that acquired before the initial application of the standard, and indefinite-lived intangible assets will not be amortized but will be tested for impairment at least annually. The Company's efficiency ratio was 90.1% for the three-month period ended March 31, 2002 compared to 71.0% for the comparable period of 2001. The efficiency ratio measures the percentage of total revenues, on a taxable equivalent basis excluding securities gains and other nonrecurring gains, absorbed by non-interest expense. Expressed differently, for example, for every dollar of revenue the Company generated in the first quarter of 2002, the Company incurred $0.90 in overhead expenses. The Company's efficiency ratios compare unfavorably to other financial institutions in the Company's peer group. The Company operates seven full service branches. Management believes that it has established an infrastructure which will allow it to grow with only modest increases in overhead expenses, and that its efficiency ratio will improve. Income Taxes. The Company recorded no income tax benefits during 2002 or 2001. Liquidity Liquidity is the ability of the Company to fund customers' needs for borrowing and deposit withdrawals. The purpose of liquidity management is to assure sufficient cash flow to meet all of the financial commitments and to capitalize on opportunities for business expansion. This ability depends on the institution's financial strength, asset quality and types of deposit and investment instruments offered to its customers. The Company's principal sources of funds are deposits, loan and securities repayments, maturities of securities, sales of securities available for sale and other funds provided by operations. The Bank has a $5,000,000 line of credit with an unrelated bank under which it can borrow federal funds. The Bank also has the ability to borrow from the FHLB, subject to regulatory approval under the Formal Agreement. Finally, the Bank can sell performing loans through participation agreements to other financial institutions. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan and mortgage-backed security prepayments are more influenced by interest rates, general economic conditions and competition. The Company maintains investments in liquid assets based upon management's assessment of (1) need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets and (4) objectives of the asset/liability management program. Cash and cash equivalents represented 13.0% of total assets at March 31, 2002 compared to 15.1% of total assets at December 31, 2001 and 12.7% of total assets at March 31, 2001 Subject to regulatory approval under the Formal Agreement, the Company has the ability to borrow funds from the FHLB and has various federal fund sources from correspondent banks, should the Company need to supplement its future liquidity needs in order to meet deposit flows, loan demand or to fund investment opportunities. Management believes the Company's liquidity position is strong based on its high level of cash, cash equivalents, core deposits, the stability of its other funding sources and the support provided by its capital base. The Company, as a holding company, is without significant assets other than its ownership of all the common stock of the Bank and is entirely dependent upon dividends received from the Bank or borrowings from its officers and directors in order to meet its cash obligations, including debt service on the $4,350,000 aggregate principal amount of 9% Convertible Subordinated Notes due 2008 , issued under an indenture dated as of March 31, 1998 between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (the "Indenture"). Under the Formal Agreement the Bank is currently precluded from declaring and paying any dividends without prior OCC approval. During 2001, the Company met its obligations by selling stock or borrowing funds from members of its board of directors. However, there are no commitments by any of the board of director members to lend additional funds. Accordingly, the Company does not have the financial means to service the interest payments on the Notes and did not pay the interest obligation due March 31, 2002. The Company is attempting to negotiate with Note holders and has offered them non-interest bearing notes, warrants to purchase Company stock, and/or modified conversion features in exchange for interest to be due over the next three years. The Company does not know if it will be successful in these negotiations. Capital Resources Total shareholders' equity was $6.5 million at March 31, 2002, representing a $442,000 decrease from December 31, 2001 or 6.3% The Holding Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Bank regulators monitor capital adequacy very closely and consider it an important factor in ensuring the safety of depositors' accounts. As a result, bank regulators have established standard risk- based capital ratios that measure the amount of an institution's capital in relation to the degree of risk contained in the balance sheet, as well as off-balance sheet exposure. Federal law requires each federal banking regulatory agency to take prompt corrective action to resolve problems of insured depository institutions including, but not limited to, those that fall below one or more prescribed capital ratios. According to the regulations, institutions whose Tier 1 and total capital ratios meet or exceed 6.0% and 10.0% of risk-weighted assets, respectively, are considered "well capitalized." Institutions whose Tier 1 and total capital ratios meet or exceed 4.0% and 8.0% of risk-weighted assets, respectively, are considered "adequately capitalized." Tier 1 capital is shareholders' equity excluding the unrealized gain or loss on securities classified as available for sale and intangible assets. Tier 2 capital, or total capital, includes Tier 1 capital plus the allowance for loan losses not to exceed 1.25% of risk-weighted assets. Risk-weighted assets are the Company's total assets after such assets are assessed for risk and assigned a weighting factor based on their inherent risk. In addition to the risk-weighted ratios, all institutions are required to maintain Tier 1 leverage ratios of at least 5.0% to be considered "well capitalized" and 4.0% to be considered "adequately capitalized." The leverage ratio is defined as Tier 1 capital divided by average adjusted assets for the most recent quarter. As discussed above, the Bank is subject to more stringent capital requirements under the Formal Agreement. The table below sets forth consolidated and Bank-only actual capital levels in addition to the capital requirements under the Formal Agreement and prompt corrective action regulations. Requirement To Be Well Actual Period-End Capitalized Capital Ratios Required For Capital Under Prompt March 31, Dec. 31, Under Formal Adequacy Action 2002 2001 Agreement Purposes Requirements Leverage Ratios: Tier I capital to average assets Consolidated 4.17% 4.98% -- 4.00% 5.00% Bank 9.01% 9.31% 7.00% 5.00% 5.00% Risk-Based CapitalRatios: Tier I Capital to risk-weighted assets Consolidated 5.93% 6.92% -- 4.00% 6.00% Bank 13.82% 13.60% 6.00% 4.00% 6.00% Total capital to risk-weighted assets Consolidated 10.14% 11.64% -- 8.00% 10.00% Bank 14.07% 14.86% 14.00% 8.00% 10.00% PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company is a defendant in various legal proceedings arising in connection with its ordinary course of business. In the opinion of management, the financial position of the Company will not be materially affected by the final outcome of these legal proceedings. Item 2. Changes in Securities and Use of Proceeds Not applicable. Item 3. Defaults Upon Senior Securities Although no default has been declared, the Company did not pay interest that was due March 31, 2002 on $4,350,000 aggregate principal amount of 9% Convertible Subordinated Notes due 2008 (the "Notes"), issued under an indenture dated as of March 31, 1998 between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (the "Indenture"). Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Item 5. Other Information Not applicable. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 11 Statement Regarding the Computation of Earnings Per Share. - Reference is hereby made to the Consolidated Statements of Operations on page 4 and Note 2 to the Consolidated Financial Statements on page 9 hereof. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended March 31, 2002. SIGNATURES In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: MAY 14, 2002 SURETY CAPITAL CORPORATION By: Richard N. Abrams, Chief Executive Officer and Director (Principal Executive Officer) By: Mary Jo Davis, Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) INDEX TO EXHIBITS Exhibit Number DESCRIPTION PAGE NUMBER II Statement Regarding the Reference is hereby Computation of Earnings made to the Per Share Consolidated Statements of operations on page 4 and Note 2 to the Consolidated Financial Statements on page 9 hereof 22 8