10KSB 1 c68917e10ksb.txt FORM 10KSB FOR FISCAL YEAR END DECEMBER 31, 2001 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- FORM 10-KSB Mark One [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2001 - Commission File Number 33-1983; OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ___________ to ___________. SURETY CAPITAL CORPORATION (Exact name of Registrant as specified in its charter) Delaware 75-2065607 -------------------------------------------------------------------------------- (State of Incorporation) (IRS Employer Identification No.) 1501 Summit Avenue, Fort Worth, Texas 76102 -------------------------------------------------------------------------------- (Address of Principal Executive Offices) 817-335-5955 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X 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. Issuer's revenues for its most recent fiscal year $7,854,106 The aggregate market value of Common Stock held by nonaffiliates of the Registrant on April 16, 2002, based on the average of the bid and ask price for the Common Stock, was $2,745,394. For purposes of this computation, all officers, directors and 5% beneficial owners of the Registrant are deemed to be affiliates. Such determination should not be deemed an admission that such officers, directors or 5% beneficial owners are, in fact, affiliates of the Registrant. As of April 16, 2002, 7,994,852 shares of Common Stock were outstanding. Transitional Small Business Disclosure Format (check one). Yes No __X__ Documents Incorporated by Reference: None. -2- SPECIAL NOTE CONCERNING 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. -3- - 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 and the payment, which was due March 31, 2002. These risks and uncertainties should be considered in evaluating -4- 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. -5- PART I ITEM 1. BUSINESS. GENERAL Surety Capital Corporation (the "Company"), a corporation incorporated under the laws of the state of Delaware in 1985, is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). The Company owns all of the issued and outstanding shares of capital stock of Surety Bank, National Association (the "Bank"), Fort Worth, Texas, formerly Texas Bank, National Association and formerly Texas National Bank. The Bank has full service offices in Converse, Fort Worth, New Braunfels, San Antonio, Schertz, Universal City, and Whitesboro, Texas. The Company's and the Bank's principal executive offices are located at 1501 Summit Avenue, Fort Worth, Texas 76102, and its telephone number is 817-335-5955. THE COMPANY Surety Finance Company, the predecessor to the Company, commenced business in 1985 as a sole proprietorship. In December 1989, the Company acquired approximately 98% of the common stock of the Bank and subsequently increased its ownership to 100%. Prior to acquisition of the Bank, the Company operated as a casualty insurance premium financing ("IPF") company licensed by the State of Texas. Upon its acquisition by the Company, the Bank began making IPF loans, and the Company ceased writing new IPF business to allow the Bank to succeed to the existing business of the Company at that time. The Company conducts all its operations through the Bank. THE BANK The Bank was chartered as a national banking association in 1963. The Bank operates full service offices in Converse, Fort Worth, New Braunfels, San Antonio, Schertz, Universal City, and Whitesboro, Texas. The bank operates two mobile branches to serve Dallas, Tarrant, Bexar and Travis counties in Texas. The Bank provides retail and commercial banking services to its customers, including checking and savings accounts, time deposits, IRAs, money transfers, safe deposit facilities, commercial loans, real estate mortgage loans, consumer loans and night depository facilities. The Bank also specializes in IPF lending. At December 31, 2001 commercial loans, real estate loans, consumer loans and IPF loans represented 21.33%, 61.38%, 9.94% and 7.35% of the Company's total loan portfolio, respectively. Management believes that no material industry or group concentrations exist in the loan -6- portfolio. REGULATORY RELATIONS FORMAL AGREEMENT. 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 December 31, 2001 the Bank met the capital levels required by the Formal Agreement, with total risk-based capital of 14.86% of risk-weighted assets and Tier I leverage capital of 9.31% of adjusted total assets compared to the ratios required under the Formal Agreement of 14% and 7%, 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. 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 the 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 -7- 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. DEPENDENCE ON BANK The Company, as a holding company without significant assets other than its ownership of all the common stock of the Bank, is dependent upon dividends received from the Bank 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 (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"). Under the Formal Agreement, the Bank is currently precluded from declaring and paying any dividends without prior OCC approval. On November 9, 1999 the OCC approved a $262,000 reduction of the Bank's surplus, the proceeds of which were up streamed to the Company, which, together with a $60,000 capital contribution by certain officers and directors of the Company and a $139,000 federal income tax payment by the Bank to the Company, was sufficient to enable the Company to meet its September 30, 1999 interest obligations under the Notes and to pay certain other operating expenses. Additionally, on March 28, 2000 the OCC approved another reduction in the Bank's surplus in the amount of $500,000 that enabled the Company to meet debt service obligations under the Notes and pay for other operating expenses through March 31, 2000. There are no approvals by the OCC for future reductions in the Bank's surplus, payment of dividends or other upstream of capital by the Bank to the Company. The Company does not think the OCC will approve any such request until the Bank demonstrates continued profitability. In October 2000, certain current and former members of the Company's Board of Directors and an employee loaned the Company $260,000 to enable the Company to meet its cash obligations. The promissory notes evidencing the loans matured on January 2, 2002 and bear no interest from date of issuance until maturity. Additionally, the promissory notes are convertible into common -8- stock at a rate of one share of common stock per $0.36 of principal amount of the notes. Management is in the process of renegotiating those notes with the holders. A director also accepted a $38,000 non interest-bearing note, which matured December 31, 2001 and was paid at a 34% discount in January 2002, in exchange for professional fees due to the director's firm. During 2001, certain Board members loaned the Company $195,000 under the notes and purchased $351,900 of newly issued restricted stock to enable the Company to meet its cash obligations, including interest payments on the Notes. There are no future commitments by any officer or director to loan the Company funds or purchase the Company's stock. Accordingly, the Company has no source of funds to pay interest on the Notes or provide other working capital needs. 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. COMMERCIAL AND CONSUMER LENDING The Company provides general commercial lending services for corporate and other business clients as a part of the Company's efforts to serve the local communities in which it operates. Certain risks are involved in granting loans, primarily related to the borrowers' ability and willingness to repay the debt. Before the Company extends a new loan to a customer, these risks are assessed through a review of the borrower's past and current credit history, the collateral being used to secure the transaction, the borrower's general character and various other factors. Once the decision has been made to extend credit, a responsible credit officer monitors these factors throughout the life of the loan. The Company periodically commissions an independent loan review, which was last performed by the former Company's independent accounting firm. Any loan identified as a problem credit by management or during the loan review is assigned to the Company's "watch loan list," and is subject to ongoing monitoring to ensure appropriate action is taken when deterioration has occurred. Commercial, industrial and agricultural loans are primarily variable-rate and include operating lines of credit and term loans made to small businesses primarily based on their ability to repay the loan from the business's cash flow. Business assets such as equipment and inventory typically secure these loans. When the borrower is not an individual, the Company generally obtains the personal guarantee of the business owner. As compared to consumer lending, which includes loans secured by a single-family residence, personal installment loans and automobile loans, commercial lending entails significant additional risks. These loans typically involve larger loan balances and are generally dependent on the business's cash flow and, thus, may be subject to adverse conditions in the general economy or in a specific industry. Management reviews the borrower's cash flows when deciding whether to grant the credit to evaluate whether estimated future cash flows will be adequate to service principal and interest of the new obligation in addition to existing obligations. -9- Commercial real estate and farmland loans are primarily secured by borrower-occupied business real estate and are dependent on the ability of the related business to generate adequate cash flow to service the debt. Such loans primarily carry variable-interest rates. Commercial real estate loans are generally originated with a loan-to-value ratio of 80% or less. Management performs much the same analysis when deciding whether to grant a commercial real estate loan as a commercial loan. Residential real estate loans and home equity lines of credit carry primarily variable rates, although fixed-rate loans are originated, and are secured by the borrower's residence. Such loans are made based on the borrower's ability to make repayment from employment and other income. Management assesses the borrower's ability to repay the debt through review of credit history and ratings, verification of employment and other income, review of debt-to-income ratios and other measures of repayment ability. The Company generally makes these loans in amounts of 80% or less of the value of collateral. An appraisal is obtained from a qualified real estate appraiser for substantially all loans secured by real estate. Construction loans are secured by residential and business real estate, generally occupied by the borrower on completion. The Company's construction lending program is established in a manner to minimize risk of this type of lending by not making a significant amount of loans on speculative projects. While not contractually required to do so, the Company usually makes the permanent loan at the end of the construction phase. Construction loans also are generally made in amounts of 80% or less of the value of collateral. Consumer installment loans to individuals include loans secured by automobiles and other consumer assets. Consumer loans for the purchase of new automobiles generally do not exceed 80% of the sticker price of the car. Loans for used cars generally do not exceed average loan value as stipulated in a recent auto industry used car price guide. Overdraft protection loans are unsecured personal lines of credit to individuals of demonstrated good credit character with reasonably assured sources of income and satisfactory credit histories. Consumer loans generally involve more risk than residential mortgage loans because of the type and nature of collateral and, in certain types of consumer loans, the absence of collateral. Since these loans are generally repaid from ordinary income of an individual or family unit, repayment may be adversely affected by job loss, divorce, and ill health or by general decline in economic conditions. The Company assesses the borrower's ability to make repayment through a review of credit history, credit ratings, debt-to-income ratios and other measures of repayment ability. INSURANCE PREMIUM FINANCING The Company supplements its traditional community bank lending with its specialized niche-lending product of IPF. The Company funds this specialized lending activity by using relatively low cost core retail deposits -10- from its network of community banking offices. This gives the Company a pricing advantage over non-bank competitors. IPF lending involves the lending of funds to companies and individuals for the purpose of financing their purchase of property and casualty insurance. The Company markets this product through 318 independent insurance agents and maintains a loan portfolio supported by insurance policies underwritten by 177 insurance companies. The loans are relatively short term, generally with initial maturities of eight to ten months. The down payment and monthly installments on each loan are calculated so that in most cases the equity or value of the unearned premium in the policy exceeds the net balance due on the loan. If the borrower does not make the loan payments on time, the Company has the right, after notice to the borrower, to cancel the insurance policy and to receive the entire amount of the unearned premium from the insurance company writing the insurance. The unearned premium is then applied to the net loan balance. As a result of various accounting irregularities found by the Company during the course of an internal audit of the IPF division of the Bank conducted in 1999 and concluded in the first quarter of 2000, the Company recognized additional losses, including interest, of $2,611,000, (on a before tax basis) over prior years beginning in the first quarter of 1996 and extending through the fourth quarter of 1999. These losses were primarily the result of the diversion of refunds due certain insurance premium finance customers to the accounts of other customers. Errors resulting from the absence of appropriate accounting controls to a much lesser extent, also contributed to such losses. Upon finding the irregular transactions, the Company's management reported the irregularities to the Board of Directors and the OCC. On September 21, 1999 the Board of Directors and the OCC entered into an Amendment to the Formal Agreement pursuant to which the Bank was required to retain the services of a qualified and independent auditor of the Bank to review all IPF accounting transactions (from 1997 forward) relating to any overpayment of loan balances and/or refunds due to IPF customers and report to the Board of Directors and the OCC regarding the review. The Company engaged Thomas J. Kwentus C.P.A., an independent forensic accountant who later joined the Company's Board of Directors, to conduct an independent review of the IPF division covering the period from January 1, 1996 to December 31, 1999. Based on the findings of the review, the Company made refunds to affected borrowers totaling $2,523,000, of which $567,000 was interest. The Company and the Bank no longer employ the persons directly responsible for managing the IPF division during the period when the diversions occurred. There can be no assurance that additional regulatory actions involving the Company or the Bank will not be taken, or if taken, will not have a material adverse impact on the Company or the Bank. The Company is cooperating with regulatory and law enforcement agencies in their review of these matters. Additionally, the Company charged off $1.8 million in IPF loans, net of recoveries, in 1998 primarily related to IPF loans generated by the Bank's -11- southeastern United States IPF operation headquartered in Atlanta, Georgia. The Atlanta office has been closed and, with the exception of a few relationships, loan production from that market has been terminated. Management will continue to actively and aggressively attempt to collect the charged-off IPF loans. At December 31, 2001, IPF loans totaled $4.6 million, or 7.35% of the Bank's gross loans, compared to $5.9 million, or 9.97% of gross loans, at December 31, 2000. DISCONTINUED BUSINESS LINE -- MEDICAL CLAIMS FACTORING From 1990 through 1998 the Company was engaged in medical claims factoring, purchasing primarily insurance company claims from a variety of health care providers. In 1998 the Company realized net charge-offs of $3.5 million for medical claims receivables. Accordingly, the operations of the medical claims factoring division was discontinued; however, due to the existence of contractual commitments to nine customers and in order to enhance the collectibility of previously charged-off medical claims, the Company continued to factor new medical claims receivables on behalf of these customers in 1999. Management will continue to actively pursue the collection of the charged-off receivables. In 2000 and 1999, recoveries, net of charge offs, totaled $4,202 and $540,000. At this time, the Company cannot predict the likely amount of any additional recoveries. COMPETITION There is significant competition among banks and bank holding companies in the market served by the Company, and the Company believes that such competition among such banks and bank holding companies, many of which have far greater assets and financial resources than the Company, will continue to increase in the future. The Company also encounters intense competition in its commercial and consumer banking business from savings and loan associations, credit unions, factors, insurance companies, commercial and captive finance companies, and certain other types of financial institutions, many of which are larger in terms of capital, resources and personnel. The casualty IPF business of the Company is also very competitive. Large insurance companies offer their own financing plans, and other independent premium finance companies and other financial institutions offer IPF loans. The Company believes that such competition will continue and increase in the future. In addition, the manner in which and the means by which financial services are delivered to customers have changed significantly in the past and can be expected to continue to change in the future. It is not possible to predict the manner in which existing technology, and changes in existing technology, will affect the Company. Changes in technology are likely to require additional capital investments to remain competitive. Although the Company has invested in new technology in the past, there can be no assurance that the Company will have sufficient financial resources or access to the -12- proprietary technology, which might be necessary to remain competitive in the future. On November 12, 1999 the Gramm-Leach-Bliley Act (the "GLB Act") was enacted into law. The GLB Act makes sweeping changes in the financial services in which various types of financial institutions may engage. The Glass-Steagall Act, which had generally prevented banks from affiliating with securities and insurance firms, was repealed. A new "financial holding company," which owns only well capitalized and well managed depository institutions, will be permitted to engage in a variety of financial activities, including insurance and securities underwriting and agency activities. The GLB Act is not expected to have a material effect on the activities in which the Company and the Bank currently engage, except to the extent that competition with other types of financial institutions may increase as they engage in activities not permitted prior to enactment of the GLB Act. See "Gramm-Leach-Bliley Act of 1999" under "Item 1. Business - Supervision and Regulation: Regulation of the Company." EMPLOYEES As of December 31, 2001 the Bank had 78 full-time employees and 3 part-time employees. The Bank provides a number of benefits such as health, dental and life insurance for all, as well as education assistance for qualified employees. None of the Bank's employees are subject to a collective bargaining agreement, and the Bank believes that its employee relations are good. The Company has no employees not also employed by the Bank. SELECTED FINANCIAL DATA The following summary of consolidated financial data of the Company is derived from the financial statements of the Company as of and for the five years ended December 31, 2001. All financial information prior to 1999 has been restated to reflect previously unrecognized losses resulting from accounting irregularities in the Company's IPF division and certain other error corrections.
At December 31, ------------------------------------------------------------ (Dollars in thousands, except per share amounts) 2001 2000 1999(1) 1998(2) 1997 ------------------------------------------------------------ BALANCE SHEET DATA: Total assets $95,560 $93,180 $104,194 $174,605 $171,985 Cash and cash equivalents 14,403 11,023 9,751 34,052 28,461 Securities available for sale 10,598 13,071 12,480 24,887 29,305 Securities held to maturity -- -- -- -- -- Loans, net of unearned interest 62,263 59,502 67,207 98,994 98,621 Allowance for credit losses on loans 1,266 1,264 1,434 1,962 951 Medical claims factoring, net -- -- -- 505 3,073
-13- Total deposits 83,155 79,661 84,878 154,847 154,541 Long term debt 4,350 4,350 4,350 4,350 -- Shareholders' equity 6,975 7,678 11,323 11,716 15,206
Year Ended December 31, ---------------------------------------------------------------- 2001 2000 1999(1) 1998(2) 1997 ---------------------------------------------------------------- INCOME STATEMENT DATA: Interest income $ 6,996 $ 7,488 $ 9,912 $ 16,451 $ 15,420 Interest expense 3,225 3,372 4,104 7,101 5,750 ---------------------------------------------------------------- Net interest income 3,771 4,116 5,808 9,350 9,670 Provision for credit losses -- (35) 137 2,839 7,169 ---------------------------------------------------------------- Net interest income after provision for credit losses 3,771 4,151 5,671 6,511 2,501 Noninterest income 858 1,900 4,552 3,425 2,539 Noninterest expense 6,183 9,326 10,809 12,493 11,154 ---------------------------------------------------------------- Income (loss) before income taxes (1,554) (3,275) (586) (2,557) (6,114) Income tax expense (benefit) -- 839 (840) 913 (2,085) ---------------------------------------------------------------- Net income (loss) $ (1,554)) $ (4,114) $ 254 $ (3,470) $ (4,029) ================================================================ COMMON SHARE DATA: Net income (loss) - basic $ (0.23) $ (0.69) $ 0.04 $ (0.60) $ (0.70) Net income (loss) - diluted (0.23) (0.69) 0.04 (0.60) (0.70) Book value 0.87 1.30 1.92 2.03 2.64 Dividend pay-out ratio -- -- -- -- --
As of or for the Year Ended December 31, --------------------------------------------------------- 2001 2000 1999(1) 1998(2) 1997 --------------------------------------------------------- PERFORMANCE DATA Return (loss) on average total assets (1.64)% (4.20)% 0.19% (1.66)% (2.30)% Return (loss) on average shareholders' equity (20.72)% (38.02)% 2.28% (27.09)% (21.94)% Net interest spread(3) 3.93% 4.30% 4.28% 4.55% 5.39% Net interest margin(4) 4.60% 5.06% 4.98% 5.11% 6.11% Average shareholders' equity to average assets 7.92% 11.04% 8.11% 6.13% 10.50% Total loans to total deposits at year-end 74.88% 74.69% 79.18% 63.93% 63.82% ASSET QUALITY RATIOS Nonperforming assets to total assets 1.54% 2.41% 1.48% 1.16% 2.63% Nonperforming loans to total loans(5) 1.18% 2.15% 1.06% 1.82% 0.19% Net loan charge-offs to average loans(5) 0.00% 0.22% 1.61% 2.88% 1.01% Allowance for credit losses on loans to total loans(5) 2.03% 2.12% 2.12% 2.02% 0.94% Allowance for credit losses on loans to nonperforming 172.98% 98.53% 199.30% 108.16% 502.00% Loans(6)
-14- (1) On June 30, 1999 the Company sold two branches located in Waxahachie and Midlothian, Texas. (2) On April 1, 1998 the Company acquired 100% of the outstanding common stock of TexStar National Bank, Universal City, Texas. On October 16, 1998 the Company sold four branches located in Chester, Kennard, Lufkin and Wells, Texas. (3) Calculated as the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. (4) Calculated as net interest income divided by average interest-earning assets. (5) Exclusive of medical claims factoring. SUPERVISION AND REGULATION GENERAL The Company and the Bank are subject to the generally applicable state and federal laws governing businesses and employers. Special state and federal laws and regulations applicable only to financial institutions and their parent companies further regulate the Company and the Bank. Virtually all aspects of the Company's and the Bank's operations are subject to specific requirements or restrictions and general regulatory oversight, including laws regulating consumer finance transactions, such as the Truth in Lending Act, the Home Mortgage Disclosure Act and the Equal Credit Opportunity Act and laws regulating collections and confidentiality, such as the Fair Debt Collection Practices Act, the Fair Credit Reporting Act and the Right to Financial Privacy Act. The supervision and regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the Federal Deposit Insurance Corporation ("FDIC") and the banking system as a whole, and not for the protection of bank holding company stockholders or creditors. To the extent that the following discussion describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statute or regulation. Any change in applicable laws, regulations or policies of various regulatory authorities may have a material effect on the business, operations and prospects of the Company and the Bank. The Company is unable to predict the nature or the extent of the effects on its business or earnings that fiscal or monetary policies, economic control or new federal or state legislation may have in the future. REGULATION OF THE COMPANY The Company is a bank holding company registered under the BHC Act, and therefore is subject to regulation and supervision by the FRB. The Company is required to file reports with, and to furnish such other information -15- as the FRB may require pursuant to the BHC Act, and to subject itself to examination by the FRB. The BHC Act and other federal laws subject bank holding companies (except those that have become "financial holding companies," as described below) to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. Certain violations may also result in criminal penalties. MEMORANDUM OF UNDERSTANDING: On October 28, 1999 the Board of Directors of the Company entered into an MOU with 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. The Company has submitted each of the requested plans and procedures to the FRB. 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. 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 Company by the OCC. 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. REGULATORY RESTRICTIONS ON DIVIDENDS AND SOURCE OF STRENGTH: It is the policy of the FRB that 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. This supports the FRB's position that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB regulations or both. This doctrine has become known as the "source of strength" doctrine. As discussed below, a bank holding company in certain circumstances could be required to guarantee the capital plan of an undercapitalized banking subsidiary. Under the prompt corrective action provisions of the Federal Deposit Insurance Act, as amended ("FDIA"), any company which controls an undercapitalized bank can be required to guarantee compliance by the bank with a capital restoration plan. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution's -16- assets at the time it became undercapitalized or the amount necessary to cause the institution to become "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 FRB approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates. In the event of a bank holding company's bankruptcy under Chapter 11 of the United States Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor holding company to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for breach of such obligation will generally have priority over most unsecured claims. As of the date of this report the Company has neither the cash flow nor the financial flexibility to act as a source of strength for the Bank. ACQUISITIONS OF CONTROL: The BHC Act and the Change in Bank Control Act, together with regulations promulgated by the FRB, require that, depending on the particular circumstances, either FRB approval must be obtained or notice must be furnished to the FRB and not disapproved prior to any person or company acquiring "control" of a bank holding company, such as the Company, subject to certain exemptions for certain transactions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more but less than 25% of any class of voting securities and either the company has registered securities under Section 12 of the Securities Exchange Act of 1934, as amended, or no other person will own a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenge of the rebuttable control presumption. Control is rebuttably presumed not to exist if a company acquires less than 5% of any class of voting securities of a bank or a bank holding company. Bank holding companies (other than those that have become "financial holding companies," as described below) are required to obtain approval from the FRB prior to merging or consolidating with any other bank holding company, acquiring all or substantially all of the assets of any bank or acquiring ownership or control of shares of a bank or bank holding company if, after the acquisition, the bank holding company would directly or indirectly own or control 5% or more of the voting shares of such bank or bank holding company. In approving such bank acquisitions by bank holding companies, the FRB is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served and various competitive factors. -17- ACTIVITIES CLOSELY RELATED TO BANKING: The BHC Act prohibits a bank holding company (other than those that have become "financial holding companies," as described below) with certain limited exceptions, from acquiring a direct or indirect interest in or control of more than 5% of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiary banks, except that it may engage in and may own shares of companies engaged in certain activities found by the FRB to be so closely related to banking or managing and controlling banks as to be a proper incident thereto. Some of the activities that have been determined by regulation to be closely related to banking include operating a mortgage, finance, credit card, or factoring company; performing certain data processing operations; providing investment and financial advice; acting as an insurance agent for certain types of credit-related insurance; leasing personal property on a full-payout, non-operating basis; and providing certain stock brokerage and investment advisory services. In approving acquisitions by bank holding companies of companies engaged in banking related activities or the addition of activities, the FRB considers whether the acquisition or the additional activities can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh such possible adverse effects as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The FRB is also empowered to differentiate between activities commenced de novo and activities commenced through acquisition of a going concern. The BHC Act generally imposes certain limitations on transactions by and between banks that are members of the Federal Reserve System and other banks and non-bank companies in the same holding company structure, including limitations on extensions of credit (including guarantees of loans) by a bank to affiliates, investments in the stock or other securities of a bank holding company by its subsidiary bank, and the nature and amount of collateral that a bank may accept from any affiliate to secure loans extended to the affiliate. A bank holding company, as an affiliate of a bank, is also subject to these restrictions. ANTI-TYING RESTRICTIONS: Under the BHC Act and FRB regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. GRAMM-LEACH-BLILEY ACT OF 1999: The Gramm-Leach-Bliley Act of 1999 (the "GLB Act") eliminates many legal barriers between banks and bank holding companies, on the one hand, and securities firms, insurance companies and other financial services providers, on the other. Among other things, the GLB Act repealed certain Glass-Steagall Act restrictions on affiliations between banks and securities firms, and amended the BHC Act to permit bank holding companies that qualify as "financial holding companies" ("FHCs") to engage in activities, and acquire companies engaged in activities, that are (a) financial -18- in nature; (b) incidental to financial activities; or (c) complementary to financial activities if the FRB determines that they pose no substantial risk to the safety or soundness of depository institutions or the financial system in general. The GLB Act treats various lending, insurance underwriting, insurance company portfolio investment, financial advisory, securities underwriting, dealing and market making, and merchant banking activities as financial in nature for this purpose. The FRB, in consultation with the Secretary of the Treasury, may add to this list. The GLB Act not only permits bank holding companies to acquire securities and insurance firms, but also allows such firms to acquire banks and bank holding companies. A bank holding company may become an FHC only if (a) all of its depository institution subsidiaries are well capitalized, (b) all of its depository institution subsidiaries are well managed, and (c) the bank holding company has filed with the FRB a declaration that the company elects to be an FHC. In addition, a bank holding company generally may not commence any new activity or acquire any additional company as an FHC if any of its depository institution subsidiaries has received a rating of less than "satisfactory" in its most recent examination under the Community Reinvestment Act of 1977 ("CRA"). The GLB Act generally permits national banks to engage through special financial subsidiaries in the financial and other incidental activities authorized for FHCs by the GLB Act. However, such financial subsidiaries may not engage in insurance or annuity underwriting, insurance company portfolio investments, real estate investment and development or, at least for the first five years after the GLB Act's enactment, merchant banking. Also, the national bank in question and all its depository institution affiliates must be well capitalized, well managed and have satisfactory CRA ratings, and there are limits on such a bank's investments in such subsidiaries. With certain limited exceptions, a national bank's dealings with its financial subsidiaries are subject to Sections 23A and 23B of the Federal Reserve Act. The GLB Act also imposes new restrictions on financial institutions' transfer and use of nonpublic personal information about their customers. Among other things, it directs the federal banking agencies to develop new regulations for this purpose; gives customers the right to "opt out" of having their nonpublic personal information shared with nonaffiliated third parties; bars financial institutions from disclosing customer account numbers or other such access codes to nonaffiliated third parties for direct marketing purposes; and requires annual disclosure by financial institutions of their policies and procedures for protecting customers' nonpublic personal information. SAFE AND SOUND BANKING PRACTICES: Bank holding companies are not permitted to engage in unsafe or unsound banking practices. The FRB's Regulation Y, for example, generally requires a bank holding company to give the FRB prior notice of any redemption or repurchase of its own securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company's consolidated net worth. The FRB may oppose the transaction if -19- it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. Depending on the circumstances, the FRB could take the position that paying a dividend would constitute an unsafe or unsound banking practice. The FRB has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1,000,000 for each day the activity continues. SECURITIES AND EXCHANGE COMMISSION AGREEMENT. The Company is subject to reporting and other 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's 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 employs the persons directly responsible for managing the IPF division during the period when the diversions occurred and the Company no longer uses 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. REGULATION OF THE BANK The Bank is a national banking association and therefore is subject to regulation, supervision and examination by the OCC. The Bank is also a member of the FRB and the FDIC. Requirements and restrictions under the laws of the United States include a reserves requirement, restrictions on the -20- nature and the amount of loans which can be made, restrictions on the business activities in which a bank may engage, restrictions on the payment of dividends to shareholders, and minimum capital requirements. See "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources." Because the FRB regulates the bank holding company parent of the Bank, the FRB also has supervisory authority that directly affects the Bank. In addition, upon making certain determinations with respect to the condition of any insured national bank, such as the Bank, the FDIC may begin proceedings to terminate a bank's federal deposit insurance. FORMAL AGREEMENT WITH THE OCC: On November 19, 1998 the Board of Directors of the Bank entered into a Formal Agreement with 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 was also required to achieve certain additional capital levels by December 31, 1999. . The Bank initially was unable to achieve the capital requirements set forth in the Formal Agreement and after receiving an extension from the OCC , the Bank achieved the required level of capital upon completion of the sale of the Midlothian and Waxahachie branches on June 30, 1999 and has remained in compliance. At December 31, 2001 and 2000 the Bank met the capital levels required by the Formal Agreement with total risk-based capital of 14.86% and 15.99% of risk-weighted assets and Tier I leverage capital of 9.31% and 9.83% of adjusted total assets. Additionally, pursuant to the Formal Agreement, the Board of Directors was required to develop a three year capital plan program, a plan to enhance its management information systems, a three year strategic plan establishing objectives for the Bank's earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of non-performing assets, product line development and market segments which the Bank intends to promote or develop, together with strategies to achieve those objectives, a revised loan policy, and a loan classification policy, each for submission to, and approval by, the OCC. All of these recommended enhancements have been implemented. On September 21, 1999 the Board of Directors of the Bank entered into an amendment to the Formal Agreement (the "Amendment") with the OCC which required the Bank to retain the services of a qualified and independent auditor to review all IPF accounting transactions (from 1997 forward) relating to any overpayment of loan balances and/or refunds due to IPF customers and report to the Board of Directors and the OCC regarding the findings of the review. Under the Amendment the Bank was further required, within sixty days of receipt of the report, to submit an action plan to the OCC setting out the Bank's program for (1) making full reimbursement of any and all unpaid IPF refunds; (2) establishing internal controls and procedures to ensure that IPF accounts are handled in a way which is consistent with safe and sound banking practices; and (3) providing appropriate training to all bank employees who are, or will be, involved in IPF activities at the Bank. The Bank is in compliance with the requirements of the Amendment. -21- The OCC has extensive enforcement authority over the operations of all national banks, including the Bank. In the event the Company fails to comply with the Formal Agreement, the OCC may under certain circumstances assess civil monetary damages against the Bank and the Directors of the Bank, issue cease-and-desist or removal orders and initiate injunctive actions. Additionally, the OCC may impose a number of corrective measures on the Bank, including (1) the imposition of restrictions on certain activities involving asset growth, acquisitions, branch establishment, expansion into new lines of business, declaration and payment of dividends, and transactions with affiliates, (2) the imposition of certain additional mandated capital raising activities, and (3) as a last resort, the appointment of a receiver or conservator of the Bank. The Formal Agreement also prohibits the Board of Directors from declaring or paying any dividends unless the Bank (1) is in compliance with 12 U.S.C. Sections 56 and 60 (see "Restrictions on Distribution of Subsidiary Bank Dividends and Assets" under "Item 1. Business - Supervision and Regulation: Regulation of Bank"), its approved capital program provided for in the Formal Agreement, and the capital levels set forth in the Formal Agreement, as more fully described above, and (2) has obtained the prior written approval of the OCC. The Bank remains subject to the Formal Agreement and management does no know when or if the OCC will agree to terminate the Formal Agreement. RESTRICTIONS ON DISTRIBUTION OF SUBSIDIARY BANK DIVIDENDS AND ASSETS: The Company owns all the outstanding common stock of the Bank. As a holding company without significant assets other than its ownership of all the common stock of the Bank, the Company's ability to meet its cash obligations, including debt service on the $4,350,000 aggregate principal amount of the Notes is almost entirely dependent upon the payment of dividends by the Bank on its common stock. The declaration and payment of dividends by the Bank is subject to the discretion of the Board of Directors of the Bank and is restricted by the national banking laws and the regulations of the OCC, as well as by the Formal Agreement. Pursuant to 12 U.S.C. Section 56, a national bank may not pay dividends from its capital. All dividends must be paid out of undivided profits, subject to other applicable provisions of law. As of December 31, 2001 the Bank has negative undivided profits of $(6,611,043). Payment of dividends out of undivided profits is further limited by 12 U.S.C. Section 60(a), which prohibits a national bank from declaring a dividend on its shares of common stock until its surplus equals its common capital, unless there has been transferred to surplus not less than 1/10th of the national bank's net income of the preceding half year in the case of quarterly or semi-annual dividends or not less than 1/10th of the national bank's net income of the preceding two consecutive half year periods in the case of annual dividends. The payment of dividends by the Bank is also subject to the provisions of 12 U.S.C. Section 60(b), which provides that no dividend may be declared or paid without the prior approval of the OCC if the total of all dividends, including the proposed dividend, in any calendar year -22- exceeds the total of the Bank's net income for that year combined with its retained net income (or loss) of the preceding two years. The Bank incurred aggregated losses for fiscal years 2001 and 2000 in the amount of $4,018,716. Furthermore, under federal law, a bank cannot pay a dividend if after paying the dividend, the bank will be "undercapitalized." Moreover, the OCC may find a dividend payment that meets all of the foregoing statutory requirements to be an unsafe and unsound practice and on those grounds prohibit the dividend. Additionally, the Formal Agreement prohibits the Board of Directors of the Bank from declaring or paying any dividends unless the Bank (1) is in compliance with 12 U.S.C. Sections 56 and 60, its approved capital program provided for in the Formal Agreement, and the Tier I capital levels set forth in the Formal Agreement, and (2) has obtained the prior written approval of the OCC. See "Formal Agreement with the OCC" under "Item 1. Business - Supervision and Regulation: Regulation of the Bank." On November 9, 1999 the OCC approved a $262,000 reduction of the Bank's surplus, the proceeds of which were up streamed to the Company, which together with a $60,000 capital contribution by certain officers and directors of the Company and a $139,000 federal income tax payment by the Bank to the Company, was sufficient to enable the Company to meet its September 30, 1999 interest obligations under the Notes and to pay certain other operating expenses. On March 28, 2000 the OCC approved another reduction in the Bank's surplus in the amount of $500,000 that enabled the Bank to meet its debt service obligations under the Notes and to pay for other operating expenses through March 31, 2000. In October 2000, certain current and former members of the Company's Board of Directors and an employee loaned the company $260,000 and another Director agreed to accept a $38,000 promissory note for fees due. The notes do not bear interest and matured January 2, 2002, except for the note for fees due, which matured on December 31, 2001. $260,000 of the notes are convertible, at the option of the holder, into common shares of the Company at the rate of $0.36 per share. The Company believes note holders will either renew under similar terms or convert the notes into common stock. During 2001, certain Board members loaned the Company $195,000 under the notes and purchased $351,900 of newly issued restricted stock to enable the Company to meet its cash obligations, including interest payments on the Notes. There are no future commitments by any officer or director to loan the Company funds or purchase the Company's stock. Accordingly, the Company has no source of funds to pay interest on the Notes or provide other working capital needs. The Company is attempting to negotiate with Note Holders to accept non-interest bearing notes, warrants to purchase Company stock, and/or a modified conversion feature 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. Until the restrictions under the Formal Agreement are lifted and the Bank satisfies the other statutory and regulatory requirements with respect to the payment of dividends, the Bank is precluded from paying a dividend to the -23- Company, without prior OCC approval. Under these circumstances it is highly unlikely that the Company would be able to rely on alternative sources of capital, such as borrowings from financial institutions or issuances of equity securities and subordinated debt instruments. Therefore, the Company for the foreseeable future is dependent on the OCC's approval of future dividends by the Bank to the Company or continued loans from certain directors. The OCC may not approve dividends by the Bank to the Company, particularly if the Bank is unable to commence operating profitably in the near future. In the event the Company is unable to make the required interest payments, the Company will be in default under the Notes for failure to pay accrued interest thereon. The Indenture pursuant to which the Notes are issued does not provide for any right of acceleration of the payment of the Notes as a result of any failure of the Company to timely pay principal of and interest on the Notes, or to comply with the covenants contained in the Indenture; the holder of the Notes (or the Trustee on behalf of the holders of all the Notes affected) may, however, in lieu of accelerating the maturity of the Notes, seek to enforce payment of such interest, principal or premium, if any, and the performance of such covenants or agreements. Furthermore, the Notes may be accelerated in the event of the bankruptcy, insolvency or reorganization of the Company. The initiation of any such course of action by the holders of the Notes in the event of the failure of the Company to meet its debt servicing obligations under the Notes could have a significant adverse impact on the future operations of the Company. 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. Because the Company is a legal entity separate and distinct from its subsidiaries, its right to participate in the distribution of assets of any subsidiary upon the subsidiary's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its stockholders, including any depository institution holding company (such as the Company) or any stockholder or creditor thereof. LIMITATIONS ON INTEREST CHARGES: Federal and Texas state laws generally limit the amount of interest and fees that lenders, including the Bank, may charge regarding loans. The applicable law, and the applicable limits, may vary depending upon, among other things, the identity, nature and location of the lender, and the type of loan or collateral. In Texas, the maximum interest rate applicable to most loans changes with changes in the average auction rate for United States Treasury Bills, but does not decline below 18% or rise above 24% (except for certain loans in excess of $250,000 for which the maximum annual rate may not rise above 28%). However, the interest that may be charged on an IPF loan is regulated by the Texas -24- Department of Insurance and is governed by the Texas Consumer Loan Law. The Texas Consumer Loan Law provides that for regular transactions (loans payable in consecutive monthly installments of substantially equal amounts with the first installment due within one month and 15 days after the date of the loan), the maximum interest rate may not exceed the amount of add-on rate equal to $18 per $100 per year on the first $1,380 and $8 per $100 on amounts of $1,380 up to $11,500. These amounts are subject to adjustments as of July 1 of each year under the Texas adjustment of dollar amounts provisions. BRANCHING: National banks domiciled in Texas may establish a branch anywhere in Texas provided that the branch is approved in advance by the OCC, 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. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal"), subject to certain concentration limits and other requirements, (a) bank holding companies such as the Company are permitted to acquire banks and bank holding companies located in any state; (b) any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of the holding company, and (c) banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states, and establishing de novo branch offices in other states - provided that, in the case of any such purchase or de novo branch, the host state has adopted legislation "opting in" to those provisions of Riegle-Neal; and, provided that, in the case of a merger with a bank located in another state, neither of the two states involved has adopted legislation "opting out" of that provision of Riegle-Neal. On August 28, 1995 Texas enacted legislation opting out of interstate banking which was effective until September 1999. However, in the second quarter of 1998 the OCC approved a series of merger transactions requested by a non-Texas-based institution that ultimately resulted in the merger of its Texas-based bank into the non-Texas based institution. Although challenged in the courts, the final legal ruling allowed the merger to proceed. In addition, on May 13, 1998 the Texas Banking Commission began accepting applications filed by state banks to engage in interstate mergers and branching. CORRECTIVE MEASURES FOR CAPITAL DEFICIENCIES: FDIA requires the OCC to take "prompt corrective action" with respect to any national bank that does not meet specified minimum capital requirements. The applicable regulations establish five capital levels, ranging from "well-capitalized" to "critically undercapitalized," and require or permit the OCC to take supervisory action regarding any national bank that is not at least "adequately capitalized." Under these regulations, a national bank is considered "well capitalized" if it has a total risk-based capital ratio of 10% or greater, a Tier I risk-based capital ratio of 6% or greater, a leverage ratio of 5% or greater, and it is not subject to any order, written agreement or directive to meet and maintain a specific capital level for any capital measure. A national bank is considered "adequately capitalized" if it has a total risk-based capital ratio of -25- 8% or greater, a Tier I risk-based capital ratio of 4% or greater, and a leverage capital ratio of 4% or greater (3% or greater if the institution was rated a CAMEL 1 in its most recent report of examination and is not experiencing significant growth), and the institution does not meet the definition of an undercapitalized institution. A national bank is considered "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier I risk-based capital ratio that is less than 4%, or a leverage ratio that is less than 4% (or a leverage ratio that is less than 3% if the institution was rated CAMEL 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines). A "significantly undercapitalized" institution is one which has a total risk-based capital ratio that is less than 6%, a Tier I risk-based capital ratio that is less than 3%, or a leverage ratio that is less than 3%. A "critically undercapitalized" institution is one that has a ratio of tangible equity to total assets that is equal to or less than 2%. With certain exceptions, national banks will be prohibited from making capital distributions or paying management fees if the payment of such distributions or fees will cause them to become undercapitalized. Furthermore, undercapitalized national banks will be required to file capital restoration plans with the OCC. Undercapitalized national banks also will be subject to restrictions on growth, acquisitions, branching and engaging in new lines of business unless they have an approved capital plan that permits otherwise. The OCC may also, among other things, require an undercapitalized national bank to issue shares or obligations, which could be voting stock, to recapitalize the institution or, under certain circumstances, to divest itself of any subsidiary. The OCC is authorized to take various enforcement actions against any significantly undercapitalized national bank and any undercapitalized national bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the OCC. The powers include, among other things, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company which controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring a new election of directors and requiring the dismissal of directors and officers. As an institution's capital decreases, the OCC's enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The OCC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator. Based on its capital ratios as of December 31, 2001, and exclusive of the Formal Agreement, the Bank meets the requirements to be categorized as "well capitalized" under the applicable regulations. However, if the Bank were to become undercapitalized and these restrictions were to be imposed, the -26- restrictions, either individually or in the aggregate, could have a significant adverse effect on the operations of the Bank. CAPITAL ADEQUACY GUIDELINES: Capital management consists of providing equity to support both current and future operations. The Company is subject to capital adequacy requirements issued by the FRB and the Bank is subject to similar requirements imposed by the OCC. The various federal bank regulatory agencies, including the FRB and the OCC, have adopted risk-based capital requirements for assessing bank holding company and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profile among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The minimum standard for the ratio of Tier I capital to total risk-weighted assets is 4% and the ratio of total capital to risk-weighted assets (including certain off-balance sheet obligations, such as standby letters of credit) is 8%. At least half of the risk-based capital must consist of common equity, retained earnings, and qualifying perpetual preferred stock, less deductions for goodwill and various other intangibles ("Tier I capital"). The remainder may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock, and a limited amount of the general valuation allowance for loan losses ("Tier II capital"). The sum of Tier I capital and Tier II capital is "total risk-based capital." See "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations." The FRB (for the Company) and the OCC (for the Bank) have also adopted guidelines which supplement the risk-based capital guidelines with a minimum leverage ratio of Tier I capital to average total consolidated assets ("leverage ratio") of 3% for institutions with well diversified risk (including no undue interest rate exposure, excellent asset quality, high liquidity, good earnings), that are generally considered to be strong banking organizations (rated a CAMEL 1 under applicable federal guidelines), and that are not experiencing or anticipating significant growth. Other banking organizations are required to maintain a leverage ratio of at least 4% to 5%. These rules further provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels and comparable to peer group averages, without significant reliance on intangible assets. The FRB continues to consider a "tangible Tier I leverage ratio" in evaluating proposals for expanding activities by bank holding companies. The tangible Tier I leverage ratio is the ratio of a banking organization's Tier I capital (less deductions for -27- intangibles otherwise includable in Tier I capital) to total tangible assets. See "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources" for a discussion of the Company's and the Bank's Tier I and Tier II capital ratios. RESTRICTIONS OF TRANSACTIONS WITH AFFILIATES AND INSIDERS: Transactions between the Bank and its nonbanking affiliates, including the Company, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions and also requires certain levels of collateral for loans to such affiliated parties. It also limits the amount of advances to third parties that are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving nonaffiliated persons. The restrictions on loans to directors, executive officers, principal stockholders and their related interests (collectively referred to herein as "insiders") contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. 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. These loans cannot exceed the institution's total unimpaired capital and surplus, and the OCC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. EXAMINATIONS: The OCC periodically examines and evaluates national banks. Based upon such an evaluation, the OCC may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between the OCC-determined value and the book value of such assets. AUDIT REPORTS: Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution's holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting principles, management's certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial -28- management, must have access to outside counsel and must not include representatives of large customers. At present, these requirements do not apply to the Bank, since total assets are substantially below $500 million. BROKERED DEPOSIT RESTRICTIONS: Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the OCC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or roll over brokered deposits. DEPOSITOR PREFERENCE STATUTE: Federal legislation has been enacted providing that deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such institution, including federal funds and letters of credit, in the liquidation or other resolution of the institution by any receiver. CROSS-GUARANTEE PROVISIONS: The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee" provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution. DEPOSIT INSURANCE ASSESSMENTS: Deposits held by the Bank are insured by the Bank Insurance Fund ("BIF") of the FDIC. The FDIC assessment is calculated on the level of deposits held by the Bank. The BIF assessment rate is determined by the FDIC for categories of banks based upon the risk to the insurance fund. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The current range of BIF assessments are between zero and 27 cents per $100 in assessable deposits. The FDIC has also established a process for raising or lowering all rates for insured institutions semi-annually if conditions warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. The FDIC can make changes in the rate schedule outside the five-cent range above or below the current schedule only after a full rulemaking with opportunity for public comment. The FDIC also applies an assessment against BIF-assessable deposits to be paid to the Financing Corporation ("FICO") to assist in paying interest on FICO bonds, which financed the resolution of the thrift industry crisis. The FICO assessment is approximately 1.22 basis points, on an annual basis, on BIF-insured deposits. COMMUNITY REINVESTMENT ACT OF 1977 ("CRA"): Under the CRA, a bank's applicable regulatory authority (which is the OCC for the Bank) is required to assess the record of each financial institution which it regulates to determine if the institution meets the credit needs of its entire community, -29- including low- and moderate-income neighborhoods served by the institution, and to take that record into account in its evaluation of any application made by such institution for, among other things, approval of the acquisition or establishment of a branch or other deposit facility, an office relocation, a merger, or the acquisition of shares of capital stock of another financial institution. The regulatory authority prepares a written evaluation of an institution's record of meeting the credit needs of its entire community and assigns a rating. The Bank has undertaken significant actions to comply with the CRA, and received a "satisfactory" rating in its most recent review by federal regulators with respect to its compliance with the CRA. Both the United States Congress and the banking regulatory authorities have proposed substantial changes to the CRA and fair lending laws, rules and regulations, and there can be no certainty as to the effect, if any, that any such changes would have on the Bank. INSTABILITY OF REGULATORY STRUCTURE: Various legislation, including proposals to overhaul the bank regulatory system, expand the powers of banking institutions and bank holding companies and limit investments that a depository institution may make with insured funds, is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of the Company and the Bank in substantial and unpredictable ways. The Company cannot determine the ultimate effect that potential legislation, if enacted, or implementing regulations with respect thereto, would have upon the financial condition or results of operations of the Company or the Bank. EXPANDING ENFORCEMENT AUTHORITY: One of the major additional burdens imposed on the banking industry by FDICIA is the increased ability of banking regulators to monitor the activities of banks and their holding companies. In addition, the FRB, OCC and FDIC possess extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution that it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. FDICIA, FIRREA and other laws have expanded the agencies' authority in recent years, and the agencies have not yet fully tested the limits of their powers. EFFECT ON ECONOMIC ENVIRONMENT: The policies of regulatory authorities, including the monetary policy of the FRB, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the FRB to affect the money supply are open market operations in United States 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 and their use may affect interest rates charged on loan or paid for deposits. -30- FRB 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 the business and earnings of the Company and the Bank cannot be predicted. STATISTICAL DISCLOSURES The following schedules present, for the periods indicated, certain financial and statistical information of the Company as required under the Securities and Exchange Commission's Industry Guide 3, "Statistical Disclosures By Bank Holding Companies" for a specific reference as to the location of required disclosures included as a part of this Form 10-KSB as of and for the year ended December 31, 2001. I. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL A & B. Average Balance Sheet and Related Analysis of Net Interest Earnings This information is included under the heading "Yields Earned and Rates Paid" included in "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations." C. Interest Differential This information is included under the heading "Yields Earned and Rates Paid" included in "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations." II. SECURITIES PORTFOLIO A. The following is a schedule of the carrying values of securities available for sale and other securities at December 31:
2001 2000 1999 ---- ---- ---- U.S. Treasury notes $ -- $ -- $ -- U.S. government agencies 9,082,196 11,861,766 10,509,965 State and county municipals -- -- -- Mortgage-backed securities 748,737 448,368 476,173 Other securities 766,904 761,104 1,494,354 ----------- ----------- ----------- Total securities $10,597,837 $13,071,238 $12,480,492 =========== =========== ===========
B. The following is a schedule of maturities for each category of securities available for sale and the related weighted-average yield of such securities as of December 31, 2001 (Other securities, which consists primarily of stock holdings in the Independent Bankers Corporation, -31- the Federal Reserve Bank and the Federal Home Loan Bank are not considered in the calculation of total yield) :
Within 1 Year After 1 Year but After 5 Years but After 10 Years and Within 5 Years Within 10 Years Other Securities -------------------- -------------------- -------------------- -------------------- Amount Yield Amount Yield Amount Yield Amount Yield ------ ----- ------ ----- ------ ----- ------ ----- U.S. government agencies $ 198,796 1.72% $8,375,980 3.59% $ 507,420 5.47% $ -- -- % Mortgage-backed securities 182,110 3.90 -- -- 71,753 3.91 494,874 4.95 Other securities -- -- -- -- -- -- 766,904 -- ---------- ---------- ---------- ---------- Total $ 380,906 5.62 8,375,980 $3.59% $ 579,173 5.42 1,261,778 $4.95% ========== ========== ========== ==========
The weighted-average yields are calculated using fair market value of securities and are based on coupon rates for securities purchased at par value and on effective interest rates considering amortization or accretion if the securities were purchased at a premium or discount. Other securities include stock holdings in the Independent Bankers Financial Corporation, the Federal Reserve Bank and the Federal Home Loan Bank that bear no stated maturity or yield. C. Excluding holdings of obligations of U.S. government agencies, there were no investments in securities of any one issuer exceeding 10% of the Company's consolidated shareholders' equity at December 31, 2001. III. LOAN PORTFOLIO A. Types of Loans - Total year-end loans and medical claims receivables are comprised of the following classifications:
2001 2000 1999 1998 1997 ----------------------------------------------------------------------------------------- Loans: Insurance premium financing $ 4,588,151 $ 5,951,300 $ 20,639,094 $ 24,570,762 $ 40,361,185 Commercial loans 13,311,170 10,919,098 8,841,027 29,424,509 23,171,566 Consumer loans 6,202,544 5,511,651 5,678,584 3,867,119 10,632,451 Real estate loans 38,296,528 37,280,209 32,558,724 42,047,938 26,668,598 ------------- ------------- ------------- ------------- ------------- Total loans 62,398,393 59,662,258 67,717,429 99,910,328 100,833,800 Less: Unearned interest (135,216) (160,237) (510,834) (916,152) (2,212,391) Allowance for credit losses (1,266,463) (1,263,961) (1,434,041) (1,961,840) (950,809) ------------- ------------- ------------- ------------- ------------- Total loans, net $ 60,996,714 $ 58,238,060 $ 65,772,554 $ 97,032,336 $ 97,670,600 ============= ============= ============= ============= ============= Medical claims receivables: Medical claims receivables, $ -- $ -- $ -- $ 646,378 $ 7,381,040 net of unearned interest
-32- Less: Allowance for credit losses -- -- -- (141,184) (4,307,885) ------------- ------------- ------------- ------------- ------------- Total medical claims receivables, net $ -- $ -- $ -- $ 505,194 $ 3,073,155 ============= ============= ============= ============= =============
The following table details the percentage of loans in each category to total loans as of December 31:
2001 2000 1999 1998 1997 ------------------------------------------------------- Loans: Insurance premium financing 7.35% 9.97% 30.48% 24.59% 40.03% Commercial loans 21.33% 18.30% 13.06% 29.45% 22.98% Consumer loans 9.94% 9.24% 8.38% 3.87% 10.54% Real estate loans 61.38% 62.49% 48.08% 42.09% 26.45% ------ ------ ------ ------ ------ Total loans 100.00% 100.00% 100.00% 100.00% 100.00% ====== ====== ====== ====== ======
B. Maturities and Sensitivities of Loans to Changes in Interest Rates - The following is a schedule of maturities of loans based on contractual terms and assuming no amortization or prepayments, excluding residential real estate and home equity loans, insurance premium finance loans and consumer installment loans, as of December 31, 2001:
Within One One Year to After Five Total Year Five Years Years ----------- ----------- ----------- ----------- Fixed Rate: Commercial and commercial $ 758,663 $ 3,008,388 $ 511,971 $ 4,279,0224 real estate Real estate construction 972,841 -- -- 972,841 ----------- ----------- ----------- ----------- Total $ 1,731,503 $ 3,008,388 $ 511,971 $ 5,251,862 =========== =========== =========== =========== Variable Rate: Commercial and commercial $ 8,580,780 $ 3,632,394 $20,749,044 $32,962,218 real estate Real estate construction 2,710,639 -- -- 2,710,639 ----------- ----------- ----------- ----------- Total $11,291,420 $ 3,632,394 $20,749,044 $35,672,858 =========== =========== =========== ===========
C. Risk Elements -33- 1. Nonaccrual, Past Due and Restructured Loans - The following schedule summarizes nonaccrual, past due and restructured loans.
(a), (b) & (c) 2001 2000 1999 1998 1997 ---------------------------------------------------------------------- Nonaccrual loans $ 732,131 $1,282,785 $ 705,969 $1,398,800 $ 91,868 Loans 90 days or more past -- -- 13,557 414,969 97,537 due and still accruing ---------------------------------------------------------------------- Total nonperforming loans $ 732,131 $1,282,785 719,526 1,813,769 189,405 Medical claims receivables -- -- -- -- 4,183,064 aged beyond 120 days Other repossessed assets 737,000 960,155 825,245 205,877 158,271 ---------------------------------------------------------------------- Total nonperforming assets $1,469,131 $2,242,940 $1,544,771 $2,019,646 $4,530,740 ======================================================================
There were no loans, which are "troubled debt restructurings" as defined in Statement of Financial Accounting Standards No. 15 (exclusive of loans included in total nonperforming loans in the above table). The policy for placing loans on nonaccrual status is to cease accruing interest on loans when management believes that collection of interest is doubtful, which is when loans are past due as to principal and interest 90 days or more (120 days for IPF), except that in certain circumstances interest accruals are continued on loans deemed by management to be fully collectible. In such cases, loans are individually evaluated in order to determine whether to continue income recognition after 90 days beyond the due dates. When loans are placed on nonaccrual status, any accrued interest is charged against interest income. During 2001, $56 thousand -- would have been recorded on the above nonaccruing loans had such loans been accruing pursuant to contractual terms. During such period, no interest income was actually recorded on such loans. (d) Impaired Loans - Information regarding impaired loans at December 31 is as follows:
2001 2000 1999 1998 1997 ---------------------------------------------------------------------- Year-end loans with allowance $1,495,244 $1,941,947 $3,958,654 $3,640,069 $2,306,501 allocated Year-end loans with no 1,217,478 1,256,490 414,419 1,614,945 505,443 allowance allocated ---------------------------------------------------------------------- Total impaired loans $2,712,722 $3,198,437 $4,373,073 $5,255,014 $2,811,944 ====================================================================== Amount of the allowance allocated $ 263,020 $ 504,346 $ 645,899 $ 971,456 $ 331,174 ======================================================================
-34- Impaired loans are primarily comprised of commercial loans and installment loans, and are carried at present value of expected cash flows, discounted at the loan's effective interest rate or at fair value of collateral, if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans. Smaller-balance homogeneous loans are evaluated for impairment in total. Such loans include residential first mortgage and construction loans secured by one- to four-family residences, IPF, consumer and home equity loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of a borrower's operating results and financial condition indicates that the borrower's underlying cash flows are not adequate to meet its debt service requirements, the loan is evaluated for impairment. Impaired loans, or portions thereof, are charged off when deemed uncollectible. 2. Potential Problem Loans - At December 31, 2001 no loans were identified which management has serious doubts about the borrower's ability to comply with present loan repayment terms and which are not included in Item III.C.1., above. 3. Foreign Outstandings - There were no foreign outstandings during any period presented. 4. Loan Concentrations - At December 31, 2001 there were no concentrations of loans greater than 10% of total loans that are not otherwise disclosed as a category of loans in Item III.A. above. D. Other Interest-Bearing Assets - At December 31, 2001 there were no other interest-bearing assets required to be disclosed under Item III.C.1. or 2. above, if such assets were loans. -35- E. IV. SUMMARY OF LOAN LOSS EXPERIENCE A. The following schedule presents an analysis of the activity in the allowance for loan losses, average loan data and related ratios:
2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- Beginning balance $ 1,263,961 $ 1,434,041 $ 1,961,840 $ 950,809 $ 1,067,041 Charge-offs: Commercial loans (121,455) (78,628) (602,922) (555,230) (32,519) Consumer loans (58,838) (65,522) (254,334) (305,333) (332,889) Real estate loans -- (23,971) (249,848) (10,058) (38,046) Insurance premium finance (267,124) (592,213) (1,265,999) (3,146,848) (784,493) ------------- ------------- ------------- ------------- ------------- Total charge-offs (447,417) (760,334) (2,373,103) (4,017,469) (1,187,947) ------------- ------------- ------------- ------------- ------------- Recoveries: Commercial loans 62,875 90,386 24,202 83,515 6,258 Consumer loans 33,256 42,103 57,343 49,071 92,511 Real estate loans 5,126 46,704 27,992 15,191 40,455 Insurance premium finance 348,662 445,703 930,195 526,996 7,998 ------------- ------------- ------------- ------------- ------------- Total recoveries 449,919 624,896 1,039,732 674,773 147,222 ------------- ------------- ------------- ------------- ------------- Net (charge-offs) recoveries 2,502 (135,438) (1,333,371) (3,342,696) (1,040,725) Bank acquisition -- -- -- 820,625 -- Transfer from allowance for medical claims receivable losses -- -- 668,636 -- -- Provision for credit losses on loans -- (34,642) 136,936 3,533,102 924,493 ------------- ------------- ------------- ------------- ------------- Ending balance $ 1,266,463 $ 1,263,961 $ 1,434,041 $ 1,961,840 $ 950,809 ============= ============= ============= ============= ============= Average loans $ 61,465,810 $ 62,707,632 $ 82,725,870 $ 116,049,351 $ 103,321,220 ============= ============= ============= ============= ============= Ratio of net charge-offs to average loans --% 0.22% 1.61% 2.88% 1.01% ============= ============= ============= ============= =============
-36- The following schedule presents an analysis of the activity in the allowance for medical claims receivable losses, average receivable data and related ratios:
1999 1998 1997 ---- ---- ---- Beginning balance $ 141,184 $ 4,307,885 $ 217,734 Charge-offs (12,707) (4,428,530) (2,156,355) Recoveries 540,159 956,023 1,510 ----------- ----------- ----------- Net (charge-offs) recoveries 527,452 (3,472,507) (2,154,845) Provision for medical claims receivable losses -- (694,194) 6,244,996 Transfer to allowance for credit losses on loans (668,636) -- -- ----------- ----------- ----------- Ending balance $ -- $ 141,184 $ 4,307,885 =========== =========== =========== Period end medical claims receivables, net of unearned interest $ -- $ 646,378 $ 7,381,040 =========== =========== =========== Average medical claims receivables $ 206,432 $ 3,582,939 $ 9,044,262 =========== =========== =========== Ratio of net charge-offs (recoveries) to average medical claims receivables (255.50)% 96.92% 23.83% =========== =========== ===========
Medical claims receivable is no longer a part of the Company's product line and the balance in the allowance for medical claims receivables at December 31, 1999 was transferred to the allowance for loan losses. The allowance for loan and medical claims receivable losses balances and provisions charged to expense in the years presented above were determined by management based on periodic reviews of the loan and medical claims receivable portfolios, past loss experience, economic conditions and various other circumstances which are subject to change over time. In making this judgment, management reviewed selected large credits as well as impaired loans, other delinquent, nonaccrual and problem loans and loans to industries experiencing economic difficulties. The collectibility of these loans was evaluated after considering current operating results and financial position of the borrower, estimated market value of collateral, guarantees and the Company's collateral position versus other creditors. Judgments, which are necessarily subjective, as to probability of loss and amount of such loss were formed on these loans and medical claims receivables, as well as other loans, taken together. B. The following schedule is a breakdown of the year-end allowance for credit losses allocated by type of credit. A breakdown of the -37- percentage of loans in each category to total loans is included in Item III.A., above.
2001 2000 1999 1998 1997 ---------------------------------------------------------------------- Loans: Insurance premium financing $ 93,293 $ 115,464 $ 346,359 $ 644,456 $ 353,765 Commercial loans 480,346 386,314 352,833 450,724 152,117 Installment loans 22,020 132,017 187,370 351,246 234,798 Real estate loans 312,240 300,569 444,459 515,414 210,129 Unallocated 358,564 329,597 103,020 -- -- ---------- ---------- ---------- ---------- ---------- Total for allowance loan losses 1,266,463 1,263,961 1,434,041 1,961,840 950,809 Medical claims receivables -- -- 141,184 4,307,885 ---------- ---------- ---------- ---------- ---------- Total allowance for credit losses $1,266,463 $1,263,961 $1,434,041 $2,103,024 $5,258,694 ========== ========== ========== ========== ==========
Management believes any allocation of the allowance for credit losses into categories lends an appearance of precision that does not exist. The allowance is utilized as a single unallocated allowance available for all loans. The above allocation table should not be interpreted as an indication of the specific amounts or the relative proportion of future charges to the allowance. Such a table is merely a convenient device for assessing the adequacy of the allowance as a whole. The allocation table has been derived by applying a general allowance to the portfolio as a whole, in addition to specific allowance amounts for internally classified loans. In retrospect, the specific allocation in any particular category may prove excessive or inadequate and consequently may be reallocated in the future to reflect the then current condition. Accordingly, the entire allowance is available for any charge-offs that occur. V. DEPOSITS A. The following is a schedule of average deposit amounts and average rates paid on each category for the periods indicated:
Average Amount Outstanding Average Rate Paid During the Year During the Year ---------------------------------------------- ------------------------ 2001 2000 1999 2001 2000 1999 ------------ ------------ ------------ ---- ---- ---- Noninterest-bearing demand deposits $ 16,168,798 $ 17,111,610 $ 24,750,304 --% --% --% Interest-bearing demand deposits 22,295,204 18,421,938 29,419,592 2.77% 3.37% 2.38% Savings deposits 3,290,143 3,437,995 6,019,141 2.22% 2.50% 2.27% Time deposits 39,956,954 42,457,749 57,460,935 5.36% 5.35% 5.00% ------------ ------------ ------------ Total average deposits $ 81,711,099 $ 81,429,292 $117,649,972 3.47% 4.14% 3.15% ============ ============ ============
-38- B. Other categories - not applicable. C. Foreign deposits - not applicable. D. The following is a schedule of maturities of time deposits in amounts of $100,000 or more as of December 31, 2001: Three months or less $ 5,124,839 Over three through six months 3,362,114 Six through twelve months 4,094,395 Over twelve months 1,811,474 ------------ Total $ 14,392,822 ============
E. Time deposits greater than $100,000 issued by foreign offices - not applicable. VI. RETURN ON EQUITY AND ASSETS This information is included in "Item 1. Business - Selected Financial Data." VII. SHORT-TERM BORROWINGS This item is not required for the Company because average outstanding balances of short-term borrowings during the years ended December 31, 2001 and 2000 were less than 30% of shareholders' equity at such dates. ITEM 2. PROPERTIES. The following chart provides information about the Company's existing facilities.
BRANCH/OFFICE SQ. FT. LOCATION/OWNERSHIP Converse 3,750 9154 FM 78 Converse, Texas 78109 Owned Fort Worth 18,208 1501 Summit Avenue Fort Worth, Texas 76102 Owned
-39-
BRANCH/OFFICE SQ. FT. LOCATION/OWNERSHIP New Braunfels 1,250 1012 IH 35 South New Braunfels, Texas 78130 Land is Leased, Building and premises are owned. San Antonio 2,800 426 Wolfe San Antonio, Texas 78216 Owned Schertz 1,000 420 Schertz Parkway Schertz, Texas 78154 Leased Universal City 12,000 600 Pat Booker Road Universal City, Texas 78148 Owned Whitesboro 6,365 2500 Highway 82 East Whitesboro, Texas 76263 Owned
The Company considers its physical properties to be in good operating condition and suitable for the purposes for which they are being used. All the properties owned by the Company are unencumbered by any mortgage or security interest and are, in management's opinion, adequately insured. The Company operates its community banking business segment out of each facility, while the IPF business segment is operated out of the Fort Worth facility. ITEM 3. 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The following matters were submitted to a vote of security holders at the Company's annual meeting of shareholders held October 17, 2001. Shareholders approved an amendment of the Amended and Restated 1998 Incentive Stock Option Plan of Surety Capital Corporation to allow tax qualified incentive stock options to be issued to all of the Company's employees, at the discretion of the of the compensation committee. Previously, only officers and other "key employees" were eligible to receive options under the plan. 5,841,485 voted for, 462,111 voted against and 165,609 abstained. -40- Stockholders ratified the appointment of Weaver and Tidwell, L.L.P. as the Company's independent public accountants for the 2001 fiscal year. 4,843,885 voted for, 1,625,142 voted against and 178 abstained. Shareholders elected Richard N. Abrams, Charles M. Ireland, Garrett Morris, David F. Chappell, Thomas J. Kwentus, and Guy J. Butts to serve as members of the Company's Board of Directors for a one-year term. The results of the voting for the election of Director was as follows:
Name of Nominee For Against Abstain Richard N. Abrams 5,841,485 462,111 165,609 Charles M. Ireland 5,821,485 462,111 165,609 Garrett Morris 5,841,985 461,111 165,609 David F. Chappell 5,841,485 462,111 165,609 Thomas J. Kwentus 5,842,485 461,111 165,609 Guy J. Butts 5,841,985 461,111 165,609 Milton M. Bley 5,841,485 462,111 165,609
Shareholders defeated a stockholder proposal that "the officers of Surety Capital Corporation will enter into a contract or contracts for the best possible sale of all assets of the corporation and then the proceeds obtained from the sale will be used to pay off all debts and the remaining money will be distributed to all shareholders."1,050,790 voted for the proposal, 1,858,275 voted against the proposal, and 461,534 abstained. -41- ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. MARKET INFORMATION On October 25, 2001, the Company sold 932,964 shares of unregistered common stock for $932,000 or $0.27 per share. The Company did not use the services of any underwriter. The shares were sold at a 30% discount to reflect lack of liquidity associated with nonregistered shares. The Company relied on Regulation D of the Securities and Exchange Act of 1934, as amended, for exemption to registration as the recipients were officers, directors and other accredited investors. Funds were used to pay interest then due on the convertible subordinated notes. The following table sets forth, for the periods indicated, the high and low bid price per share of the Company's Common Stock as reported on the National Quotation Bureau for 2000 and 2001. The quotations provided reflect inter-dealer prices, without retail markup, markdown or commission and may not represent actual transactions.
-------------------------------------------------------------------------------- High Low -------------------------------------------------------------------------------- 2001 Fiscal Year First Quarter $0.65 $0.34 Second Quarter $0.52 $0.41 Third Quarter $0.58 $0.34 Fourth Quarter $0.58 $0.26 -------------------------------------------------------------------------------- 2000 Fiscal Year First Quarter --- --- Second Quarter $0.69 $0.13 Third Quarter $0.70 $0.38 Fourth Quarter $0.50 $0.26
As a result of the unavailability of current audited financial statements of the Company, on March 22, 2000, AMEX determined that the Company was not in compliance with its continued listing requirements. The Company's Common Stock is currently traded through the National Quotation Bureau (commonly known as "pink sheets") at any time that a broker agrees to make a market in the stock. STOCKHOLDERS -42- As of April 9, 2002, there were 414 record holders of the Company's Common Stock. DIVIDEND POLICY The Company has not previously paid any cash dividends. The Company currently intends to retain earnings to make the interest payment on the Notes and to pay its other operating expenses, rather than using earnings to pay dividends. The payment of any cash dividends by the Company in the future will depend to a large extent on the receipt of dividends from the Bank. The ability of the Bank to pay dividends is dependent upon the Bank's earnings and financial condition, the Bank's compliance with 12 U.S.C. Sections 56 and 60, and the Bank's fulfillment of certain requirements set forth in the Formal Agreement. See "Formal Agreement with the OCC" and "Restrictions on Distribution of Subsidiary Bank Dividends and Assets" under "Item 1. Business - Supervision and Regulation: Regulation of the Bank" for a discussion of regulatory constraints on the payment of dividends by national banks and bank holding companies generally. TRANSFER AGENT Securities Transfer Corporation 16910 Dallas Parkway, Suite 100 Dallas, Texas 75248 (972) 447-9890 ANNUAL AND OTHER REPORTS, STOCKHOLDER AND GENERAL INQUIRIES Surety Capital Corporation is required to file an annual report on Form 10-KSB for its fiscal year ended December 31, 2001 with the Securities and Exchange Commission. Copies of the Form 10-KSB annual report and the Company's quarterly reports may be obtained without charge by contacting: Ms. Mary Jo Davis Surety Capital Corporation 1501 Summit Avenue Fort Worth, Texas 76102 (817) 335-5955 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. INTRODUCTION In the following pages, management presents an analysis of the Company's financial condition and results of operations as of and for the year ended December 31, 2001, compared to 2000. This discussion is designed to provide stockholders with a more comprehensive review of the operating results and financial position than could be obtained from an examination of the -43- financial statements alone. This analysis should be read in conjunction with the financial statements and related footnotes included elsewhere in this report. ANALYSIS OF FINANCIAL CONDITION Total Assets. The Company's total assets totaled $95.6 million at December 31, 2001 compared to $93.2 million at December 31, 2000, an increase of $2.4 million, or 2.5%. The increase in assets was primarily the result of a $2.8 million growth in loan volumes. Loan growth was primarily funded by a $3.5 million increase in total deposits. Securities. Federal funds sold increased $1.2 million, or 13.5%, from $8.8 million at December 31, 2000 to $10.0 million at December 31, 2001. This increase in federal funds sold was primarily to temporarily invest funds available as a result of the decline in securities available for sale. Total securities available for sale were $10.6 million at December 31, 2001, a 18.9% decrease. The decline in investment securities is the result of issuing agencies calling higher interest coupon bonds and the Company's decision not to reinvest during a period of low yields. The Company invests primarily in U.S. Treasury notes, obligations of U.S. government agencies and corporations, municipal bonds, and mortgage-backed securities. Mortgage-backed securities include Federal Home Loan Mortgage Corporation and Government National Mortgage Association participation certificates. Other securities include stock holdings in the Independent Bankers Financial Corporation, the Federal Reserve Bank of Dallas and the Federal Home Loan Bank of Dallas. All of the Company's securities are classified as available for sale. Management classifies securities as available for sale to provide the Company with the flexibility to provide for liquidity needs or to move such funds into loans as demand warrants. The Company held no derivative securities or structured notes during any period presented. Loans. At December 31, 2001 the net unrealized loss on securities available for sale totaled $17,710 compared to a net unrealized loss of $289,619 at December 31, 2000. This is primarily because the market value of bonds generally rises during times of falling interest rates, which occurred through 2001. Net loans increase $2.8 million, or 4.7%, from $58.2 million at December 31, 2000 to $61.0 million at December 31, 2001. IPF loans decreased $1.4 million or 22.9% from $6.0 million at December 31, 2000 to $4.6 million at December 31, 2001. The decrease is due primarily to the loss of customers and employees responding to the negative publicity associated -44- with of the IPF refund diversion discussed earlier. Management is attempting to rebuild the division and is pursuing new business. A salesman was added to the division during 2001. The growth initiative was stymied by the September 11 terrorist attack on America as the Company provides a significant amount of premium financing to the trucking and transportation industry, which was adversely impacted. Commercial loans increased $2.4 million or 21.9% and real estate loans increased $1.1 million or 2.7%. While the Company is vigorously pursuing real estate and commercial loans to replace the loan decline at the IPF division and reinvest lower yielding Federal funds, it has not compromised its philosophy regarding pricing or underwriting standards for such loans during the year. Loan calling officers were added to four of the Company's San Antonio branches and two loan officers and a marketing officer were added to the Company's Fort Worth branch. The San Antonio loan officers joined the Company during the second and third quarters of 2001 while the Fort Worth personnel were recently recruited. The goal of the new calling officers is to solicit deposits and commercial loans. Total loans, net of unearned interest, as a percentage of total deposits increase slightly to 74.88% at December 31, 2001 compared to 74.69% at December 31, 2000. Other Assets. Net premises and equipment declined to $5.3 million at December 31, 2001 compared to $5.7 million at December 31, 2000, due primarily to $590,000 depreciation expense offset by $197,000 invested in new equipment . In 1999 the Bank purchased and remodeled an existing facility in downtown Fort Worth, Texas and relocated the main office operations from the former leased facility in Hurst, Texas. Additions to premises and equipment in connection with the new facility totaled $1.8 million. Other Real Estate Owned. Other real estate owned and repossessed assets totaled $737,000 at December 31, 2001 compared to $960,000 at December 31, 2000. The decline is due primarily to a $204,000 write-down in the carrying value of real estate represented by 212 lots in Wilson County acquired in settlement of loans during 1999. The Bank has listed its other real estate with area brokers but does not know how quickly the properties can be sold. Deposits. Deposits are attracted principally from within the Company's primary market area through the offering of a broad selection of deposit instruments, including checking accounts, money market accounts, regular savings accounts, term certificate accounts and individual retirement accounts. Interest rates paid, maturity terms, service fees and withdrawal penalties for the various types of accounts are established periodically by management based on the Company's liquidity requirements, growth goals and interest rates paid by competitors. The Company does not use brokers to attract deposits. Total deposits increased $3.5 million, or 4.4%, from $79.7 million at December 31, 2000 to $83.2 million at December 31, 2001. Noninterest-bearing deposits increased $1 million, or 6.5%, while savings, NOW and money market accounts increased $4.9 million, or 21.0%. Time deposits -45- $100,000 and over increased $43 thousand or 0.3% and other time deposits decreased $2.4 million, or 8.9%. The increase in deposits is due to the Company's addition of marketing staff during 2001 and may also be partly due to inflow of funds from customers switching money into liquid investments during a time of interest rate and stock market declines. The Company continues to lose certain deposits retained in connection with the sale of the Midlothian and Waxahachie branches in the second quarter of 1999. In order to obtain regulatory approval for the sale of the branches, the Company retained $8.5 million in time certificates of deposit and IRAs. Management believes that customers have elected not to renew these deposits as they have matured because the Company no longer has branch facilities in their market areas. At December 31, 2001, the Company's time deposits totaled $39.0 million, or 46.9% of total deposits compared to $41.4 million, or 52.0% of total deposits, at December 31, 2000. Substantially all of the Company's time deposits mature within five years. As of December 31, 2001, $33.1 million in time deposit were due to mature within one year. Based on past experience and the Company's prevailing pricing strategies, management believes a substantial percentage of such certificates will renew with the Company at maturity. If there is a significant deviation from historical experience, the Company's bank can utilize borrowings from the FHLB as an alternative to this source of funds, subject to regulatory approval under the Formal Agreement. Borrowings. Convertible subordinated debt totaled $4.4 million at December 31, 2001 and 2000. Convertible subordinated notes were issued on March 31, 1998 to provide funds to finance the acquisition of TexStar. 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. Details of these subordinated notes are discussed further in the notes to the consolidated financial statements. The Company was unable to pay the March 31, 2002 interest due under the notes. The Company is attempting to negotiate with Note Holders to accepts non-interest bearing notes, warrants for Company common stock, and/or modified conversion features in exchange for interest currently due and to be due over the next three years. Management does not know if it will be successful in these negotiations. Notes payable were $132,746 at December 31, 2001 compared to $297,746 last year. These notes represent loans from certain current and former members of the Board of Directors, which were made to enable the Company to pay interest on the convertible subordinated debt and other corporate expenses. These notes matured January 2, 2002 and do not bear interest. However, $95,000 these notes are convertible at the option of the note holder into shares of the Company's common stock at the rate of $0.36 per share and the note holders have indicated they will renew under similar terms. The remaining $37,746 was paid in January 2002. During 2001, the Company borrowed $195,000, repaid $40,000, and converted $320,000 to common stock. COMPARISON OF RESULTS OF OPERATIONS -46- NET INCOME. 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 realized a $1.6 million loss for 2001 compared to $4.1 million loss for 2000. Net loss per share was $0.23 for 2001 and $0.69 for 2000. Net loss as a percentage of average assets was 1.64% and 4.20% for 2001 and 2000 respectively. Net loss as a percentage of average shareholders' equity was 20.7% and 38.0% over the same two years. 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. 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. Declining interest rates had a negative effect on the Company's net interest income. The average yield on federal funds sold, which represented 9.8% of total average earning assets during 2001, declined 259 basis points. In addition, the yield on securities declined 57 basis points as issuers called higher yielding securities. The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions through adjustments to the discount rate. The discount rate is the interest rate at which member institutions can borrow funds from the Federal Reserve, if necessary. The discount rate at December 31, 2000 was 6.0%. Through a series of twelve rate reductions, the FRB steadily lowered the discount rate to 1.25% at December 31, 2001. Over the same period, the Company's prime interest rate, the rate offered on loans to borrowers with strong credit, adjusted in a similar pattern. At December 31, 2001, 2000, and 1999, the prime rate was 5.00%, 9.50% and 8.50%, respectively. The average yield on federal funds sold fell from 6.40% during the fourth quarter of 2000 to 1.82% during the fourth quarter of 2001. The yield fell in direct correlation with the FRB discount rate. As of December 31, 2001 and 2000 the Company was in a positive gap position, or asset sensitive. The "gap" is the difference between the repricing of interest-earning assets and interest-bearing liabilities within certain time periods. Accordingly, the Company's interest-bearing assets will generally -47- reprice more quickly than its interest-earning liabilities. Therefore, the Company's net interest margin is likely to increase in periods of rising interest rates in the market and decrease in periods of declining interest rates. The Company's asset sensitivity is due primarily to the decline in IPF loans and investment securities, which are typically fixed rate, to more asset rate sensitive federal funds sold, and commercial and commercial real estate loans. The Company's net interest margin decreased to 4.60% in 2001 from 5.06% in 2000. The average yield earned on interest-earning assets decreased 78 basis points while the average rate paid on interest bearing liabilities only declined 30 basis points. The disproportionate drop in yields earned compared to rates paid is due to primarily to the 259 basis point decline in the yield on federal funds sold and the 57 basis point decline in security yields. The yield on average loans fell 37 basis points due to a decline in IPF loans reinvested primarily in variable rate commercial loans. The average rate paid on interest-bearing liabilities was 4.61% in 2001 compared to 4.91% in 2000. The average interest rate spread deteriorated to 3.93% in 2001 compared to 4.30% in 2000. The ratio of average interest-earning assets to average interest-bearing liabilities was 117.2% in 2001 compared to 118.45% % in 2000 due primarily to a shift in the deposit composition from noninterest bearing demand deposits to interest bearing demand deposits. Net interest income decreased $346 thousand from $4.1 million in 2000 to $3.8 million in 2001. The decrease was due to decreases in the average net interest margin, net interest income presented as a return on average interest-earning assets, a shift from noninterest bearing demand deposits to interest bearing demand deposits partly offset by a $596 thousand increase in average earning assets. 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. To assist in identifying and managing potential loan losses, the Company contracts with an independent loan review service provider to evaluate individual credit -48- relationships as well as overall loan portfolio conditions. 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. The $449,000 of recoveries on loans previously charged off exceeded the $447,000 of loan charge-offs in 2001 resulting in a $2 thousand increase in the allowance for possible credit losses. Net loans charged off during 2000 were $135,000 or 0.22% of average loans. The IPF division recorded $82 thousand net loan recoveries during 2001 compared to net loan charge-offs in 2000 of $147,000. The Company did not record a provision for loan loss expense in 2001 and recognized a negative $35,000 provision for loan losses in 2000. The year-end balance in the allowance for loan losses totaled $1.3 million at December 31, 2001 and 2000 and represented 2.03% of total loans outstanding at December 31, 2001 compared to 2.12% at December 31, 2000. The Company will report $169 thousand of net loan charge offs during the first quarter of 2002, which includes $88,000 of loans on non-accrual status at December 31, 2001. While management's analysis of the adequacy of the allowance for loan losses remains adequate, the Company might have to record a provision for loan loss expense during 2002 if loan growth warrants an increase or if general economic conditions deteriorate. Nonperforming loans, defined as loans past due 90 days or more and loans for which the accrual of interest has been discontinued, totaled $732,000 at December 31, 2001 and $1.3 million at December 31, 2001. Nonperforming loans as a percentage of total loans totaled 1.18% and 2.15%, respectively. Management will attempt to increase IPF loans but does not anticipate significant changes in loan portfolio risk in the near future, and 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 $0.9 million in 2001 compared to $1.9 million in 2000, a $1 million decline. The 2000 amount includes $785,000 in other income recovered from fidelity bond claims related to losses incurred in prior periods. The $231 thousand decline in loan collection fees and late charges is primarily related to the decline in average IPF loans outstanding. NONINTEREST EXPENSE. Noninterest expense was $6.2 million for 2001 compared to $9.3 million for 2000. During 2000, the Bank recognized a 2.2 million impairment on long-lived assets loss. Salaries and employee benefit expenses declined $473 thousand due to a reduction in force during the second half of 2000. However, additional personnel were added in late 2001 and during the first quarter of 2002 to enhance the Company's calling efforts in the markets it serves and improve underwriting standards and general supervision. -49- The work force was reduced from 99 full time employees at December 31, 1999 to 62 at December 31, 2000 but rose to 78 at December 31, 2001. Other noninterest expense declined $306 thousand due primarily to a $217 thousand reduction in legal and professional fees and a $182 thousand in amortization of goodwill expense partly offset by a $83 thousand increase in director fees and a $204 impairment of other real estate loss. The decline in legal fees is primarily due to the fees paid in 2000 associated with the IPF review. The reduction in goodwill expense is due to a lower amount of goodwill subject to amortization after the $2.2 million impairment loss recognized in 2000. The 2001 expense represents the value of common stock awarded to directors. Note 11 of the notes to consolidated financial statements sets forth a table presenting in detail other noninterest expenses for each of the two years ended December 31, 2001. The $2.2 million impairment of long-lived asset expense in 2000 relates to the write down of goodwill associated with the San Antonio branches acquired in 1998 with the acquisition of TexStar. Non-compete agreements and employment contracts were not part of the purchase transaction. Several former TexStar officers and directors joined a competing bank in the San Antonio market and were able to solicit the business of their former customers in the area resulting in the loss of numerous commercial relationships to the competitor financial institution. The impairment loss recognizes the permanent decline in market value of goodwill recorded at the time of the TexStar Acquisition. The Company's efficiency ratio was 76.1% and 82.90% in 2001 and 2000, respectively. The efficiency ratio measures the percentage of total revenues, on a taxable equivalent basis excluding securities gains, fidelity bond recoveries, loss on impairment of long-lived assets and other nonrecurring gains, absorbed by non-interest expense. Expressed differently, for example, for every dollar of revenue the Company generated in 2001, the Company incurred $0.76 in overhead expenses. The Company's efficiency ratios for the comparable periods compare unfavorably to other financial institutions in the Company's peer group. However, management believes that this is due in large part because the Company operates more facilities and has a larger market area than other banks its size. 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 would compare more favorably with larger institutions. The efficiency ratio should improve if the additional staffing is successful in its growth initiatives. INCOME TAXES. The change in income tax expense/(benefit) is primarily attributable to the 100% valuation reserve on deferred tax assets realized in 2000. The provision for income taxes totaled $840,000 in 2000 and there was no benefit in 2001. The Company has incurred losses for income tax purposes in excess of recovery available by carry back to prior periods resulting in net operating losses that carry forward to future tax years. As of December 31, 2001 and 2000, management concluded a valuation allowance for the net deferred tax asset was necessary, as management could not predict -50- with any degree of certainty that the Company will realize the net deferred tax assets during the carry-forward period. Accordingly, a valuation reserve was recorded which had the effect of eliminating the tax benefit associated with losses recorded in 2001 and 2000 and reversing the accrued tax benefit in 2000 that was recorded in 1999. YIELDS EARNED AND RATES PAID The following table sets forth information relating to the Company's average balance sheet and reflects the average yield on interest-earning assets and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, for the periods presented. Average balances are derived from daily balances, which include nonaccruing loans in the loan portfolio. -51-
Year ended December 31, 2001 Year ended December 31, 2000 ------------------------------------ -------------------------------------- Average Interest Average Average Interest Average Balance Income/ Rate Balance Income/ Rate ------- Expense ---- ------- Expense ---- ------- ------- ASSETS Interest-earning assets: Interest-bearing deposits and federal funds sold $ 8,060,522 $ 302,749 3.76% $ 5,996,006 $ 380,437 6.35% Securities 12,408,300 748,163 12,636,332 834,602 6.03 6.60 Loans(1) 61,465,810 5,944,964 9.67 62,707,632 6,273,500 10.04 ---------- --------- ---------- --------- Total interest-earning assets 81,934,632 6,995,876 8.54 81,338,970 7,488,539 9.21 Noninterest-earning assets: Cash and due from banks 3,997,790 3,920,240 Premises and equipment 5,523,174 6,010,433 Accrued interest receivable 465,715 579,013 Other real estate owned 897,013 543,607 Other assets 3,260,172 6,937,546 Allowance for credit losses (1,341,873) (1,323,130) ----------- ----------- Total assets $ 94,736,623 $ 98,006,679 ============ ============ LIABILITIES Interest-bearing liabilities: Interest-bearing demand deposits $ 22,295,204 618,091 2.77 $ 18,421,938 620,816 3.37 Savings deposits 3,290,143 72,986 2.22 3,437,995 85,997 2.50 Time deposits 39,956,954 2,142,544 5.36 42,457,749 2,273,440 5.35 ---------- --------- ---------- --------- Total interest-bearing deposits 65,542,301 2,833,621 4.32 64,317,682 2,980,253 4.63 Other borrowed funds 4,350,000 391,500 9.00 4,350,000 391,500 9.00 --------- ------- --------- ------- Total interest-bearing liabilities 69,892,301 3,225,121 4.61 68,667,682 3,371,753 4.91 --------- --------- Noninterest-bearing liabilities Noninterest-bearing deposits 16,168,798 17,111,610 Other liabilities 1,172,325 1,406,428 --------- --------- Total liabilities 87,233,424 87,185,720 Shareholders' equity 7,503,199 10,820,959 --------- ---------- Total liabilities and equity $ 94,736,623 $ 98,006,679 ============ ============ Net interest income $3,770,755 $4,116,786 ========== ========== Net interest spread 3.93% 4.30% ===== ===== Net interest margin 4.60% 5.06% ===== =====
-52- (1) Calculated net of deferred loan fees and costs and unearned interest. The table below describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume (multiplied by prior year rate); (2) changes in rate (multiplied by prior year volume); and (3) total changes in rate and volume. The combined effects of changes in both volume and rate, that are not separately identified, have been allocated proportionately to the change due to volume and change due to rate:
2001 Compared to 2000 Increase/(Decrease) ------------------------------------- Change Change Total Due to Due to Change Volume Rate ------ ------ ---- Interest Income: Interest-bearing deposits and federal funds sold $ 106,529 $ (184,217) $ (77,688) Securities (14,836) (71,603) (86,439) Loans (122,501) (206,035) (328,536) --------- --------- --------- Total interest income (30,808) (461,855) (492,663) Interest Expense: Interest-bearing demand deposits 117,971 (120,696) (2,725) Savings deposits (3,583) (9,428) (13,011) Time deposits (134,091) 3,195 (130,896) --------- ----- --------- Total deposits (19,703) (126,929) (146,632) Other borrowed funds -- -- -- -- -- -- Total interest expense (19,703) (126,929) (146,632) -------- --------- --------- Net interest margin $(11,105) $(334,926) $(346,031) ========= ========== ==========
ASSET AND LIABILITY MANAGEMENT AND MARKET RISK The Company's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Interest rate risk is the risk that the Company's financial condition will be adversely affected due to movements in interest rates. The income of financial institutions is primarily derived from the excess of interest earned on interest-earning assets over the interest paid on interest-bearing liabilities. Accordingly, the Company places great importance on monitoring and controlling interest rate risk. -53- There are several methods employed by the Company to monitor and control interest rate risk. One such method is using a gap analysis. As discussed above in management's analysis of net interest income, the gap is defined as the repricing variance between rate sensitive assets and rate sensitive liabilities within certain periods. The repricing can occur due to changes in rates on variable rate products as well as maturities of interest-earning assets and interest-bearing liabilities. A high ratio of interest sensitive liabilities, generally referred to as a negative gap, tends to benefit net interest income during periods of falling interest rates as the average rate paid on interest-bearing liabilities declines faster than the average rate earned on interest-earning assets. The opposite holds true during periods of rising interest rates. The Company attempts to minimize the interest rate risk through management of the gap in order to achieve consistent return. The Company's asset and liability management policy is to maintain a gap position whereby the ratio of rate sensitive assets to rate sensitive liabilities is between 60.0% and 140.0% on a one-year time horizon. As of December 31, 2001 the Company was in a positive gap position so its assets will reprice more quickly than its liabilities. The continuous decline in interest rates during 2001 resulted in issuing agencies calling high yielding bonds carried in the Company's securities portfolio. The Company was not willing to reinvest in longer-term instruments during a period of low interest rates and instead invested in federal funds sold. This had the effect of making the Company more interest rate sensitive. One strategy used by the Company is to originate variable rate loans tied to market indices. Such loans reprice on an annual, quarterly, monthly or daily basis as the underlying market indices change. Currently, $45.6 million, or 67.4%, of the Company's loan portfolio reprices on a regular basis or matures within one year. The Company also invests excess funds in liquid federal funds that mature and reprice on a daily basis. Federal funds sold were $10.1 million at December 31, 2001 and represented 12.3% of total interest earning assets. The Company also maintains all of its securities in the available for sale portfolio to take advantage of interest rate swings and to maintain liquidity for loan funding and deposit withdrawals. In addition to the gap analysis, management measures the Company's interest rate risk by computing estimated changes in net interest income. The Company's senior management and the Board of Directors Asset/Liability review committee review the exposure to interest rates at least quarterly. Exposure to interest rate risk is measured with the use of an interest rate sensitivity analysis software to determine the impact of hypothetical changes in interest rates, while the gap analysis is used to determine the repricing characteristics of assets and liabilities. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. -54- As with any method of measuring interest rate risk, certain shortcomings are inherent. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Further, in the event of a change in interest rates, expected rates of prepayment on loans and mortgage-backed securities and early withdrawal levels from certificates of deposit would likely deviate significantly from those assumed in making risk calculations. 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 by the Company 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 Company also has the ability to borrow from the FHLB, subject to regulatory approval under the Formal Agreement. 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 increased $3.4 million, or 30.7%, from $11.0 million at December 31, 2000 to $14.4 million at December 31, 2001 due primarily to a $2.5 million decline in securities available for sale. Cash and cash equivalents includes federal funds sold, which increased $1.2 million. The continuous decline in interest rates during 2001 resulted in issuing agencies calling high yielding bonds carried in the Company's securities portfolio. The Management was not willing to reinvest in longer-term securities during a period of low interest rates and instead invested in federal funds sold. This had the effect of increasing cash and cash equivalents. Cash and cash equivalents represented 15.1% of total assets at December 31, 2001 compared to 11.8% of total assets at December 31, 2000. Subject to regulatory approval under the Formal Agreement with the OCC, the Company's bank subsidiary has the ability to borrow funds from the FHLB and has various federal fund sources from correspondent banks, should the bank need to supplement its future liquidity needs in order to meet deposit flows, loan demand or to fund investment opportunities. Management believes the bank's liquidity position is strong based on its high level of cash, cash -55- equivalents, core deposits, the stability of its other funding sources and the support provided by its capital base. As summarized in the Consolidated Statements of Cash Flows, the Company utilized $464 thousand of cash for its operating activities during 2001 compared to $1.4 million during 2000. $2.8 million was generated from the reduction in the investment portfolio during 2001 compared to $155 thousand in 2000. $2.8 million was invested in loan growth during 2001 compared to $6.7 million of cash generated during 2000 as a result of a declines in IPF loan portfolio. Deposit growth generated a $3.5 million increase in cash and equivalents during 2001 compared to $5.2 million used during 2000 to fund the reduction in deposits. On a stand-alone basis, the Company had $29,000 in cash on hand as of December 31, 2001. The liquidity of the Company has been adversely affected by its inability to receive dividends from the Bank, which are limited by banking statutes and regulations and the Formal Agreement, discussed below. The subordinated convertible notes are obligations of the Holding Company and not the Bank. The Company met its cash obligations under the notes and other corporate cash needs by borrowing funds from its directors and selling them stock. During 2001, the Company issued $195,000 of notes to directors and sold them $351,000 in stock. $320,000 of notes issued during 2000 and 2001 were converted to common stock. In addition, director fees were paid in the form of restricted stock, which will be issued in 2002. There are no guarantees from any director, officer, or other party to lend funds or purchase Company stock in the future. The Company cannot pay the interest due or meet its cash obligations during 2002 unless holders of the notes agree to negotiations initiated by the Company. The Company has not made the interest payment 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 common stock, and/or a modified conversion features in exchange for interest currently due and interest to be due over the next three years. Management does not know if it will be successful in these negotiations CAPITAL RESOURCES Total shareholders' equity decreased $703,000 primarily due to the $1.6 million net loss offset by the $179,000 decrease of the after-tax impact of unrealized losses on securities available for sale, issuance of $351,000 of common stock and conversion of $320,000 of notes payable to stock. The 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 institutions 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 -56- 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 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 adjusted total assets for the most recent quarter. As discussed above, the Bank is subject to more stringent capital requirements under the Formal Agreement. Under the Formal Agreement, the Bank was required to achieve, by March 31, 1999, a total risk-based capital ratio of at least 12% and a leverage ratio of at least 7.5%. As of December 31, 1999 the Bank was required to achieve a total risk-based capital ratio of at least 14%. At December 31, 1998 the Bank had total risk-based capital of 10.24% of risk weighted assets and Tier I leverage capital of 5.64% of adjusted total assets. The Bank failed to achieve the capital levels and the ratios required by the Formal Agreement by March 31, 1999. The Bank submitted a request to the OCC for an extension from March 31, 1999 to September 30, 1999 to meet the capital requirements of the Formal Agreement. The OCC granted the extension and 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 December 31, 2001 and 2000 the Bank met the capital levels required by the Formal Agreement, with total risk-based capital of 14.86 and 15.99%, respectively, of risk-weighted assets and Tier I leverage capital of 9.31% and 9.83%, respectively, of adjusted total assets. 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. -57-
Minimum Requirements To Be Well Formal Capitalized Agreement at For Capital Under Prompt Actual Year-End Capital Ratios December 31, Adequacy Action 2001 2000 2000 Purposes Requirement ------------------------------ ------------ ----------- ------------ Leverage Ratio: Tier I capital to average assets Consolidated 4.98% 5.17% -- 4.00% 5.00% Bank 9.31% 9.83% 7.00% 4.00% 5.00% Risk-Based Capital Ratios: Tier I capital to risk-weighted assets Consolidated 6.92% 7.76% -- 4.00% 6.00% Bank 13.6% 14.75% 6.00% 4.00% 6.00% Total capital to risk-weighted assets Consolidated 11.64% 12.88% -- 8.00% 10.00% Bank 14.86% 15.99% 14.00% 8.00% 10.00%
As of December 31, 2001 the Company and the Bank met the level of capital required to be categorized as well capitalized under prompt corrective action regulations. Management is not aware of any conditions, other than continued operating losses, subsequent to December 31, 2001 that would change the Company's or the Bank's capital category. The 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 loans from its Directors or employees in order to meet its cash obligations, including debt service on the Notes. Under the Formal Agreement the Bank is currently precluded from declaring and paying any dividends without prior OCC approval. On November 9, 1999 the OCC approved a $262,000 reduction of the Bank's surplus, the proceeds of which were upstreamed to the Company, which, together with a $60,000 capital contribution by certain officers and directors of the Company and a $139,000 federal income tax payment by the Bank to the Company, was sufficient to enable the Company to meet its September 30, 1999 interest obligations under the Notes and to pay certain other operating expenses. Additionally, on March 28, 2000 the OCC approved another reduction in the Bank's surplus in the amount of $500,000 that enabled the Company to meet debt service obligations under the Notes and pay for other operating expenses through March 31, 2000. The OCC will not approve future reductions in the Bank's surplus until the Bank is unable to commence operating profitably in the near future. The Bank remains subject to the Formal Agreement and management does no know when or if the OCC will agree to terminate the Formal Agreement. In 2000, certain current and former members of the Company's Board of Directors and an employee loaned the Company $260,000 and another director accepted a promissory note in exchange for professional fees due to the director's firm, which was settled at a discount in January, 2002. The notes do not bear interest and matured January 2, 2002. $260,000 of the notes are convertible, at the option of the note holder, into shares of common stock at the rate of $0.36 per share. Management is in the process of renegotiating those notes with the holders. During 2001 the Company issued $195,000 of -58- notes to directors and sold them $351,000 in stock. $320,000 of notes issued during 2000 and 2001 was converted to common stock and $40,000 of the notes were paid off. In addition, director fees were paid in the form of restricted stock, which will be issued in 2002. Advances under the notes were evidenced by non-interest bearing notes convertible into the Company's common stock at the lower of $0.36 per share or 75% of the average bid price during the ten day period prior to any advance. There are no commitments from the directors to provide operating capital or from regulatory authorities allowing the bank to declare dividends in the near future. The Company has no other sources of liquidity. RECENT ACCOUNTING PRONOUNCEMENTS During the second and third quarters of 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," SFAS No142 "Goodwill and Other Intangible Assets," SFAS No 143, "Accounting for Asset Retirement Obligations" and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," 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. SFAS No 141 requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method of accounting, and prohibits the use of the pooling of interests method for such transactions. It also requires identified intangible assets acquired in a business combination to be recognized as an asset apart from goodwill if they meet certain criteria. SFAS No. 143, which addresses the diversity in practice for recognizing asset retirement obligations, is effective for fiscal years beginning after June 15, 2002. SFAS No. 144, addresses financial accounting and reporting for the impairment or disposal of long-lived assets and resolves accounting and implementation issues related to previous pronouncements. The Company does not expect that the pronouncement will have a material effect on the Company's financial position or results of operation. IMPACT OF INFLATION AND CHANGING PRICES -59- The consolidated financial statements and notes included herein have been prepared in accordance with generally accepted accounting principles ("GAAP"). Presently GAAP requires the Company to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on the operations of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates have a more significant effect on the performance of a financial institution than do the effects of changes in the general rate of inflation and changes in prices. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Interest rates are highly sensitive to many factors that are beyond the control of the Company, including the influence of domestic and foreign economic conditions and the monetary and fiscal policies of the United States government and federal agencies, particularly the FRB. The FRB implements national monetary policy such as seeking to curb inflation and combat recession by its open market operations in United States government securities, control of the discount rate applicable to borrowing by banks, and establishment of reserve requirements against bank deposits. The actions of the FRB in these areas influence the growth of bank loans, investments and deposits, and affect the interest rates charged on loans and paid on deposits. The nature, timing and impact of any future changes in federal monetary and fiscal policies on the Company and its results of operations are not predictable. ITEM 7. FINANCIAL STATEMENTS. The financial statements and supplementary data required to be included pursuant to Item 7 are set forth on the "F" pages immediately following the exhibit index and are incorporated herein by reference. ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The change in accountants to Weaver and Tidwell, LLP was reported on form 8-K filed on October 26, 2001. On October 19, 2001, the Company engaged Weaver and Tidwell, LLP, of Fort Worth, Texas as the independent accounting firm to audit the consolidated financial statements of the Company, for the fiscal year ended December 31, 2001. During the Company's fiscal years ended December 31, 2000 and 1999 and the subsequent period prior to engaging weaver and Tidwell, LLP, the Company (or anyone on its behalf) did not consult Weaver and Tidwell, LLP regarding: (i) either the application of accounting principles to a specified transaction, either completed or proposed; or the type of audit opinion that might be rendered on the Company's financial statements; and as such no written report was provided to the -60- Company and no oral advice was provided that the new accountant concluded was an important factor considered by the Company in reaching a decision as to any accounting, auditing or financial reporting issue, or (ii) any matter that was either the subject of disagreement or a reportable event. PART III ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The bylaws of the Company provide that the Board shall consist of such number of directors as shall be determined by resolution of the Board. By a resolution adopted by the Board on May 1, 2000, the number of directors comprising the Board was set at eight (8) and currently consists of six members. Each member of the Board of Directors is elected for a one-year term to serve until his or her successor is elected and qualified. Each executive officer is appointed by the Board of Directors to serve until the first meeting of directors after the next annual meeting of stockholders. The following table sets forth certain information relating to the directors and executive officers of the Company as of March 31, 2002:
NAME AGE POSITION Richard N. Abrams 60 Chairman of the Board, Chief Executive Officer and Director Charles M. Ireland 54 Director and President David F. Chappell 58 Director Thomas J Kwentus 51 Director Guy J. Butts 30 Director and President Whitesboro branch Jim Finley Director Mary Jo Davis 49 Vice President and Chief Financial Officer
The business experience of each of these directors and executive officers during the past five years is set forth below: RICHARD N. ABRAMS has served as a director of the Company since May 2000 and was named Chairman of the Board of Directors and Chief Executive Officer in March 2001. He has served as Chairman of the Board and Chief Executive Officer of Funeral Financial Systems, Ltd. (a factor to the funeral industry) since August 1985, and of Executive Offices, Ltd. (a shared office building) since October 1986. Mr. Abrams has also served as Chairman -61- of the Board of Funeraleasing, Ltd. (a leasing company for the funeral industry) since December 1998. Mr. Abrams is a certified public accountant. Mr. Abrams has served as a director of the Bank since March 2000. CHARLES M. IRELAND has served as a director of the Company since August 1999 and served as Chairman of the Board and Chief Executive Officer of the Company from September 1999 until March 2001, when he became President. Mr. Ireland has also served as President of the Bank since July 1999, and has served as a director of the Bank since August 1999. He was previously employed by Landmark Bank from August 1997 to July 1999, most recently as Senior Vice President/Senior Lender in its Denison, Texas banking facility. From December 1985 to July 1997 Mr. Ireland served as a Senior Vice President of NationsBank, Texas N.A. MARY JO DAVIS has served as Vice President and Chief Financial Officer of the Company and the Bank since March 2002, as Vice President and Controller of the Company and the Bank since June 2000 and from September 1999 was Assistant Comptroller of the bank. From January 1996 to August 1999, she was a financial analyst with Ratheon Corporation. Ms. Davis is a certified public accountant. DAVID CHAPPELL has served as a director of the Bank and Company since 2001. He is an attorney and a partner with Chappell, Hill & Lowrance, and L.L.P. in Fort Worth, Texas. THOMAS J. KWENTUS has served as a director of the Bank and Company since 2001. He is a certified public accountant and owns his own private practice in Fort Worth, Texas. GUY J. BUTTS has served as President of the Whitesboro Bank Center of Surety Bank since 2001 and as a director of the Bank and Company since 2001. Prior to joining the bank, Mr. Butts was with First National Bank of Durant and the American Bank of Texas. JIM FINLEY has served as a director of the Bank and Company since January 2002. He is a certified public accountant and principal with Finley Resources, Fort Worth, Texas. Mr. Finley owns interests in producing oil wells and manages commercial buildings. He serves on the board of directors of OEC Compression, Corp., a publicly traded provider of natural gas compression services. No family relationships exist among the executive officers and directors of the Company. Other than Mr. Finley, no director presently holds any other directorships in companies with a class of securities registered pursuant to Section 12 of the Securities Exchange Act of 1934 or subject to the requirements of Section 15 of that act. COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT -62- Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors, executive officers and holders of more than ten percent (10%) of the Common Stock to file with the SEC initial reports of ownership and reports of changes in ownership of the Common Stock. Such persons are required by SEC regulations to furnish the Company with copies of all Section 16(a) reports they file with the SEC. The Company's management is currently reviewing the compliance of its officers, directors and 10% stockholders with their Section 16 reporting obligations. While management believes that no person has incurred any short-swing liability under Section 16, management believes that no Section 16 reports were filed in 2001. ITEM 10. EXECUTIVE COMPENSATION. SUMMARY OF CASH AND CERTAIN OTHER COMPENSATION The following table provides certain summary information concerning compensation paid or accrued by the Company and the Bank to or on behalf of the Company's Chairman of the Board and Chief Executive Officer. There were no other executive officers that earned over $100,000 in 2000. SUMMARY COMPENSATION TABLE ANNUAL COMPENSATION
NAME AND YEAR SALARY($)(1) BONUS($) ALL OTHER PRINCIPAL POSITION COMPENSATION ($) Richard N. Abrams, Chairman and Chief 2001 --- $61,872(2) $4,760(3) Executive Officer(4) Charles M. Ireland 2001 $113,249 $--- $--- Chairman of the Board until March, 2001 and 2000 $105,500 $--- $--- Chief Executive Officer President of the 1999 $44,250 $--- $--- Company; President and Chief Executive Officer of the Bank (5)
---------- (1) Includes salary and directors' fees paid by the Bank, before any salary reduction for contributions to the Bank's Savings Plan under Section 401(k) of the Internal Revenue Code of 1986, as amended (the "Code") and the value of car allowance. -63- (2) Represents the discounted value of 400,000 shares of restricted Company common stock awarded to Mr. Abrams for services provided to the Company. The stock is not registered. (3) Represents the discounted value of 20,000 shares of restricted, unregistered Company common stock for Board of Director and Committee meeting attendance. No value is included for the value of lodging provided to Mr. Abrams while in Texas. (4) Mr. Abrams became Chief Executive Officer in March, 2001. The Company was not required to report Mr. Abrams' compensation in prior years and, therefore, the Company is only reporting his compensation for 2001. (5) Mr. Ireland served as Chief Executive Officer of the Company from September 1999 to March 2001.In March 2001, Mr. Ireland was named President and no longer serves as Chief Executive Officer or the Chairman of the Board. STOCK OPTION PLANS OPTION GRANTS. No stock options were granted in fiscal year 2001 to Mr. Ireland. OPTION EXERCISES AND HOLDINGS. The following table provides information with respect to the named executive officers concerning the exercise of incentive stock options during the last fiscal year and unexercised incentive stock options held as of the end of the last fiscal year under the Stock Option Plans: AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION VALUES
Value of Number of Unexercised Unexercised In-the-Money Options at Options at FY-End (#) FY-End ($) Shares Value ----------------------------------- Acquired Realized Exercisable/ Exercisable/ Name on Exercise (#) ($)(1) Unexercisable Unexercisable(2) -------------------------------------------------------------------------------------------- Richard N. Abrams --- $--- 2,000/--- $2,000/$--- Charles M. Ireland --- $--- 66,667 / 33,333 $0 / $0
---------- (1) No incentive stock options were exercised in 2001 by the named executive officers. -64- COMPENSATION OF DIRECTORS The Company's and the Bank's Board of Directors consist of the same members and both organizations hold meetings on the same dates. In 2001, the Bank discontinued payment of cash director fees and does not plan to pay director cash fees in the near future. The Company awarded each non-employee director 2,000 shares of restricted stock for each board of director meeting attended and 1,000 shares for each committee meeting attended plus additional shares as approved by the compensation committee. During 2001, a total of 50,000 shares were awarded for attendance at board of director meetings and a total of 31,000 shares were awarded for attendance at committee meetings. In addition, 500,000 shares were issued based on the recommendation of the compensation committee. In addition, Mr. Chappell was awarded 120,000 restricted shares, Mr. Bley was awarded 100,000 restricted shares, Mr. Kwentus was awarded 45,000 restricted shares, Mr. Finley was awarded 20,000 restricted shares and Mr. Morris was awarded 10,000 restricted shares. These awards were based extraordinary efforts by the recipients as determined by the Compensation Committee composed of Mr. Bley and Mr. Chappell. In 2002, the Company will continue the same practice of awarding shares for board of director and committee meetings as practiced in 2001. The Company has adopted the 1996 Stock Option Plan for Directors (the "1996 Directors Plan") and the 1997 Non-Qualified Stock Option Plan for Non-Employee Directors (the "1997 Directors Plan"). Under the 1996 and 1997 Directors Plans, an aggregate of 250,000 shares of Common Stock of the Company were set aside for issuance pursuant to the exercise of options granted thereunder, of which 178,000 shares are subject to outstanding options and 56,000 shares remain available for grant. The 1996 Directors Plan is a formula plan pursuant to which annual options are automatically granted to directors of the Company who are not employees of the Company or the Bank at fair market value. All options under the 1996 Directors Plan are non-qualified stock options, and vest one year following the date of grant. On the first business day of each calendar year, each non-employee director is automatically granted an option to purchase 2,000 shares of Common Stock of the Company at 100% of fair market value on the grant date. In 2001, each non-employee director of the Company received an option to purchase 2,000 shares of Common Stock of the Company at an exercise price of - per share. The 1997 Directors Plan provided for the one time grant of 25,000 non-qualified stock options to directors of the Company who were not employees of the Company or the Bank at fair market value. In 1997, each non-employee director of the Company received an option to purchase 25,000 shares of Common Stock of the Company at exercise prices ranging from $4.18 to $5.375 per share. These options vest over five years. Currently, 140,000 options remain outstanding pursuant to the 1997 Director's Plan. The Company adopted the 2000 Non-Qualified Stock Option Plan for Advisory Directors. Under the provisions of the plan, 100,000 shares were allocated for non-qualified stock options to advisory directors. Grantees are -65- awarded 10-year options to acquire shares at the market price on the date the option is granted. The options vest and become fully exercisable based on a vesting schedule as determined by the Compensation Committee of the Board of Directors on the date of grant. On November 6, 2000, grantees were awarded options to acquire 28,000 shares of common stock of the Company at $0.55 per share, which vest and become fully exercisable one year from the date of grant. EMPLOYMENT AGREEMENT The Company and the Bank have entered into an employment agreement with Charles M. Ireland. Pursuant to the agreement, in the event that Mr. Ireland's employment is terminated by the Company or the Bank, for any reason other than for "cause," as defined in the agreement, or if Mr. Ireland terminates his employment for "good reason," as defined in the agreement, then Mr. Ireland will receive a lump sum cash payment equal to his annual base salary. In the event Mr. Ireland terminates his employment for any reason other than for a "good reason," and within two months thereafter either has not accepted employment with another company or has accepted employment at another company at an annual salary less than his annual salary with the Company and the Bank, then Mr. Ireland will be entitled to receive a lump sum cash payment equal to one-sixth of his annual base salary. STOCK OPTION PLANS. The Board has adopted the 1988, 1995 and 1998 Incentive Stock Option Plans of Surety Capital Corporation and the 1997 Non-Qualified Stock Option Plan for Officers and Key Employees of Surety Capital Corporation (the "Stock Option Plans") for officers and/or key employees of the Company. The 1988, 1995 and 1998 Stock Option Plans have been approved by the stockholders of the Company. The purpose of the Stock Option Plans is to attract and retain capable employees and provide an incentive to such employees to remain in the employ of the Company. Options for the purchase of Common Stock under the Stock Option Plans may be granted to officers or key employees selected from time to time by the Stock Option Committee of the Board. The exercise price for any options granted pursuant to the Stock Option Plans must be at least equal to the fair market value of the Common Stock on the date the options are granted. Under the Stock Option Plans an aggregate of 1,200,000 shares of Common Stock of the Company were set aside for issuance pursuant to the exercise of options granted thereunder, of which 733,333 shares are subject to outstanding options and 308,825 shares remain available for grant. To exercise the options, grantees must pay the exercise price in cash or Common Stock, or any combination of cash and Common Stock. Options granted under the 1988, 1995 and 1998 Stock Option Plans are incentive stock options and options granted under the 1997 Stock Option Plan are non-qualified stock options. The Stock Option Plans contain certain "change in control" provisions designed to attract and retain valued employees of the Company and to ensure that such employees' performance is not undermined by the possibility, threat or occurrence of a change in control. The 1988 and 1995 Plans provide that in -66- the event of a change in control of the Company (in the form of a dissolution or liquidation of the Company or a merger or consolidation in which the Company is not the surviving corporation) any options granted under the plans become fully exercisable, notwithstanding any vesting schedule relating to such options to the contrary. The 1997 and 1998 Plans provide for the acceleration of any applicable vesting schedule upon a "change in control," which definition not only includes the dissolution or liquidation of the Company or a merger or consolidation in which the Company is not the surviving corporation, but also the acquisition by a person or group of 20% or more of the combined voting power of the Company's capital stock or under certain circumstances a change in the constitution of the Board. The plan was amended in 2001 to allow for the award of options to all employees. POST RETIREMENT SERVICES AGREEMENT. The Company and the Bank are parties to a post retirement services agreement with C. Jack Bean in recognition of his activities as a founder of the Company and of his long tenure as the principal executive officer of the Company and the Bank. Under the agreement, the Company must provide Mr. Bean payments, payable in annual, monthly or bi-monthly installments, and totaling $53,825 per year. Additionally, the Company must provide or reimburse Mr. Bean for the cost of health, accident and medical insurance coverage that is equivalent to the coverage provided to those persons serving from time to time as the senior executive officers of the Company. The Company's obligation under the agreement terminates at the earlier of death or when Mr. Bean reaches 85 years of age. All amounts payable under the agreement are accelerated and become due immediately upon a change in control (as defined in the agreement). The Company may terminate the agreement for cause (as defined in the agreement) or upon disability of the former Chairman. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. BY MANAGEMENT The following table shows beneficial ownership of shares of Common Stock of the Company by all current directors and executive officers of the Company named in "Item 10. Executive Compensation" individually, and together with all current executive officers of the Company as a group, as of March 26, 2001: -67-
-------------------------------------------------------------------------------- Name of Individual Amount and Percent or Number of Nature of of Class (2) Persons In Group Beneficial Ownership (1) -------------------------------------------------------------------------------- Richard N. Abrams 1,489,069(3) 16.36% Charles M. Ireland 66,667(4) * David F. Chappell 318,906(5) 3.50% Thomas J. Kwentus 62,554(6) * Guy J. Butts 0 - Jim Finley 286,185(7) 3.14% Mary Jo Davis 0 -- All directors and 2,223,381 24.425% executive officers as a group (7 persons)
---------- * Less than 1% of all the issued and outstanding shares of Common Stock. (1) Based on information furnished by persons named and, except as otherwise indicated below, each person has sole voting and dispositive power with respect to all shares of Common Stock owned by such person. (2) Based on 9,103,405 shares of Common Stock, which includes 7,994,852 shares of Common Stock issued and outstanding at April 16,2002, and shares convertible or exercisable within sixty (60) days which are deemed outstanding for a specific stockholder pursuant to Rule 13d-3(d)(1) under the Securities Exchange Act of 1934. Shares convertible or exercisable within thirty days consist of , 68,667 shares currently exercisable under employee and director option plans, 776,000 shares awarded during 2001 but not yet issued to existing and prior directors, and 236,886 convertible under terms of director notes,. (3) Includes 208,332 shares of Common Stock which are convertible from notes, 420,000 shares awarded as compensation and director fees during 2001 but not yet issued, and 2,000 shares which Mr. Abrams has the right to acquire within sixty (60) days from the date hereof. Also includes 11,250 shares owned by Funeral Financial Services, Inc., a company under the control of Mr. Abrams and 37,037 shares over which Mr. Abrams has joint voting power with his spouse. (4) Includes 66,667 shares of Common Stock that Mr. Ireland has the right to acquire within sixty (60) days from the date hereof. -68- (5) Includes Include 27,777 shares of Common Stock that are convertible from notes and 139,000 shares of Common Stock awarded as director and committee fees during 2001 but not yet issued. (6) Includes 57,000 shares of Common Stock awarded as director and committee fees during 2001 but not yet issued.. (7) Includes 31,000 shares of Common Stock awarded as director and committee fees during 2001 but not yet issued. (8) Includes 263,886shares of Common Stock, which the directors and executive officers have a right to acquire within sixty (60) days from the date hereof pursuant to options or convertible notes. 5.0% STOCKHOLDERS The following table sets forth certain information with respect to stockholders of the Company who were known to be beneficial owners of more than five percent (5%) of the issued and outstanding shares of the Common Stock of the Company as of April 16, 2002, except for Richard N. Abrams, whose ownership interest is disclosed in the preceding table.
-------------------------------------------------------------------------------- Name and Address Amount and Nature Percent of Beneficial Owner of Beneficial of Class(2) Ownership(1) -------------------------------------------------------------------------------- Carlson Capital, L.P. (3) 519,300 5.70% 301 Commerce Street, Suite 3300 Fort Worth, Texas 76102 Pine Capital Management, Incorporated (4) 509,546 5.60% 353 Sacramento Street, 10th Floor San Francisco, California 94111 Rodney Abrams (5) 1,034,314 11.36% 141 West Jackson Suite 1310 A Chicago, Illinois, 60604 Cullen W. Turner (6) 471,377 5.18% 2501 Norwood Drive Hurst, Texas 76054
---------- (1) Based on information furnished by the entities named and, except as otherwise indicated below, each entity has sole voting and dispositive power with respect to all shares of Common Stock owned by such entity. (2) Based on 9,103,405 shares of Common Stock, which includes 7,994,852 shares of Common Stock issued and outstanding at April 16,2002, -69- and shares convertible or exercisable within sixty (60) days, which are deemed outstanding for a specific stockholder pursuant to Rule 13d-3(d)(1) under the Securities Exchange Act of 1934 (3) As reported on a Schedule 13D/A filed on April 26, 1999 with the SEC. (4) As reported on a Schedule 13G/A filed on January 18, 2002. Pine Capital Management, Incorporated has shared dispositive power with its clients, none of which own over five percent (5%) of the issued and outstanding shares of the Company, and no voting power with respect to these shares (5) As reported on a Schedule 13G filed on March 31, 2001, as adjusted by 459,259 issued October 25, 2001 under the conversion features of a note. (6) As reported on a Schedule 13D filed on January 31, 2001. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Certificate of Incorporation of the Company limits the liability of directors to the full extent permitted by Delaware law. The Certificate of Incorporation also provides that the Company will indemnify directors and officers to the full extent provided by Delaware law. On January 18, 2000 the Company and the Bank entered into indemnification agreements with all members of the Board of Directors and one executive officer. The agreements provide that in consideration of each indemnitee's service as an officer or director after the date of the agreement, the Company or the Bank will hold harmless and indemnify the indemnitee to the full extent authorized or permitted by law if he or she is made a party to or a participant in certain proceedings by reason of his or her service as director, officer, employee or agent or fiduciary of the Company or the Bank or of any other corporation, partnership, joint venture, trust, employee benefit plan or other enterprise which such person is or was serving at the express written request of the Company or the Bank, as further specified in the agreements. The only person still covered by the agreement is Charles Ireland. The Company plans to enter into a similar indemnification agreement with current members of the Board of Directors. From time to time, the Bank makes loans to officers, directors and principal stockholders (and their affiliates) of the Company or the Bank. All loans to such persons are made in the ordinary course of business; are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons; and do not involve more than the normal risk of collectibility or present other unfavorable features. -70- During 2001 the Company paid $127,000 for legal services to Chappell, Hill & Lowrance, L.L.P. in Fort Worth, Texas, a law firm in which David Chappell is a partner. Mr. Chappell is a director of the Company. Mr. Chappell also loaned the company funds under the non interest bearing notes discussed below. During 2001 the Company issued $195,000 of notes to directors and sold them $351,000 in stock. $320,000 of notes issued during 2000 and 2001 were converted to common stock. In 2000, certain current and former members of the Company's Board of Directors and an employee loaned the Company $260,000 and another director accepted a promissory note in exchange for professional fees due to the director's firm. The notes do not bear interest and matured January 2, 2002. $260,000 of the notes are convertible, at the option of the note holder, into shares of common stock at the rate of $0.36 per share Notes issued during 2001 are convertible into the Company's common stock at the lower of $.36 per share or 75% of the average bid price during the ten day period prior to any advance. ITEM 13. EXHIBITS AND REPORTS OF FORM 8-K (a) EXHIBITS. The Exhibit Index, located directly after the signature pages, is incorporated herein by reference. (b) REPORTS ON FORM 8-K. The Company filed a form 8-k on October 26, 2001, reporting a change in the registrant's certifying accountant. -71- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SURETY CAPITAL CORPORATION Date: April 16, 2002 By: /s/ Richard N. Abrams -------------------------------------- Richard N. Abrams, Chief Executive Officer By: /s/ Mary Jo Davis -------------------------------------- Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated on this 16th day of April, 2001.
Signature Capacity --------- -------- /s/ Richard N. Abrams Chairman of the Board, Chief Executive Officer and ---------------------------------- Director (Principal Executive Officer) Richard N. Abrams /s/ Charles M. Ireland President and Director ---------------------------------- Charles M. Ireland /s/ David F. Chappell Director ---------------------------------- David F. Chappell /s/ Thomas J. Kwentus Director ---------------------------------- Thomas J Kwentus /s/ Guy J. Butts Director ---------------------------------- Guy J. Butts
-72- /s/ Jim Finely Director ---------------------------------- Jim Finley
-73- INDEX TO EXHIBITS
-------------------------------------------------------------------------------------------------------------------------- Incorporated Herein by Filed Exhibit No. Description Reference To Herewith -------------------------------------------------------------------------------------------------------------------------- 3.01 Certificate of Incorporation, as Filed with the Company's Form 10-K dated December amended 31, 1993 and incorporated by reference herein. 3.02 Form of Common Stock certificate Filed with the Company's Form 10-K dated December (specimen) 31, 1993 and incorporated by reference herein. 3.03 Restated Bylaws of the Company Filed with the Company's Form 10-K dated December 31, 1994 and incorporated by reference herein. 4.01 Indenture dated as of March 31, 1998 Filed with the Company's Form 10-Q for the between the Company and Harris Trust quarter ended March 31, 1998 and incorporated by and Savings Bank, Chicago, Illinois, reference herein. as trustee 4.02 Form of Notes (included in Exhibit Filed with the Company's Form 10-Q for the 4.02) quarter ended March 31, 1998 and incorporated by reference herein. 4.03 Form of Note Purchase Agreements Filed with the Company's Registration Statement dated March 31, 1998 No. 333-57601 on Form S-3 and incorporated by reference herein. 10.01 Surety Capital Corporation 1988 Filed with the Company's Form 10-K dated December Incentive Stock Option Plan 31, 1991 and incorporated by reference herein. 10.02 Surety Capital Corporation 1995 Filed with the Company's Form 10-K dated December Incentive Stock Option Plan 31, 1994 and incorporated by reference herein. 10.03 Surety Capital Corporation Amended Filed with the Company's Form 10-K dated December and Restated Stock Option Plan for 31, 1996 and incorporated by reference herein. Directors, and Form of Stock Option Agreement
10.04 Surety Capital Corporation 1997 Filed with the Company's Form 10-K dated December Non-Qualified Stock Option Plan for 31, 1997 and incorporated by reference herein. Officers and Key Employees, and Form of Stock Option Agreement 10.05 Surety Capital Corporation 1997 Filed with the Company's Form 10-K dated December Non-Qualified Stock Option Plan for 31, 1997 and incorporated by reference herein. Non-Employee Directors, and Form of Stock Option Agreement 10.06 Amended and Restated Post Retirement Filed with the Company's Form 10-K dated December Services Agreement Between Surety 31, 1998 and incorporated by reference herein. Capital Corporation, Surety Bank, National Association and C. Jack Bean, dated November 1, 1998 10.07 Surety Capital Corporation Amended Filed with the Company's Proxy Statement for the and Restated 1998 Incentive Stock Annual Meeting of Stockholders held on May 21, Option Plan 1998 and incorporated by reference herein. 10.08 Earnest Money Contract between Curtis Filed with the Company's Form 10-K dated December F. Nooner, Norman S. Moize, and 31, 1999 and incorporated by reference herein. Waldron Property Company No. Two, L.P., as seller, and Surety Bank, National Association, as purchaser, dated April 29, 1999, and First Amendment to Earnest Money Contract, dated June 25, 1999 10.09 Form of Redeemable Convertible Filed with the Company's Form 10-K dated December Promissory Note between Surety 31, 1999 and incorporated by reference herein. Capital Corporation and C. Jack Bean, Charles M. Ireland, Margaret E. Holland, Aaron M. Siegel, Garrett Morris, Cullen W. Turner, William B. Byrd, Michael L. Milam and Lloyd W. Butts, and related Warrant, dated October 29, 1999
10.10 Form of Indemnification Agreement Filed with the Company's Form 10-K dated December between Surety Capital Corporation 31, 1999 and incorporated by reference herein. and William B. Byrd, Lloyd W. Butts, Charles M. Ireland, Margaret E. Holland, Michael L. Milam, Garrett Morris, Cullen W. Turner and John D. Blackmon, dated January 18, 2000 10.11 Form of Indemnification Agreement Filed with the Company's Form 10-K dated December between Surety Bank, National 31, 1999 and incorporated by reference herein. Association and William B. Byrd, Lloyd W. Butts, Charles M. Ireland, Margaret E. Holland, Michael L. Milam, Garrett Morris, Cullen W. Turner and John D. Blackmon, dated January 18, 2000 10.12 Employment Agreement between Surety Filed with the Company's Form 10-K dated December Capital Corporation, Surety Bank, 31, 2001 and incorporated by reference herein. National Association and Charles M. Ireland, dated January 14, 2001 10.13 Form of Redeemable Convertible Filed with the Company's Form 10-K dated December Promissory Note between Surety 31, 2001 and incorporated by reference herein. Capital Corporation and various directors and an employee, dated October 2, 2000 16.01 Letter from PricewaterhouseCoopers Filed with the Company's Form 8-K/A (Amendment LLP to the Securities and Exchange No. 1) dated June 3, 1999 and incorporated by Commission dated June 11, 1999 reference herein. 21.01 Subsidiaries of the Registrant X 23.01 Consent of Weaver and Tidwell, L.L.P. X
SURETY CAPITAL CORPORATION FINANCIAL REPORT DECEMBER 31, 2001 C O N T E N T S
Page INDEPENDENT AUDITOR'S REPORT............................................. F-1 INDEPENDENT AUDITOR'S REPORT............................................. F-2 FINANCIAL STATEMENTS Consolidated Balance Sheets........................................... F-3 Consolidated Statements of Operations................................. F-4 Consolidated Statements of Comprehensive Loss......................... F-5 Consolidated Statements of Shareholders' Equity....................... F-6 Consolidated Statements of Cash Flows................................. F-7 Notes to Consolidated Financial Statements............................ F-9
INDEPENDENT AUDITOR'S REPORT To the Board of Directors and shareholders of Surety Capital Corporation Fort Worth, Texas We have audited the accompanying consolidated balance sheet of Surety Capital Corporation as of December 31, 2001, and the related consolidated statements of operations, comprehensive loss, shareholders' equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with U. S. generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Surety Capital Corporation as of December 31, 2001, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with U. S. generally accepted accounting principles. /s/ Weaver and Tidwell, L.L.P. WEAVER AND TIDWELL, L.L.P. Fort Worth, Texas March 26, 2002 REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors and Shareholders Surety Capital Corporation Fort Worth, Texas We have audited the accompanying consolidated balance sheets of Surety Capital Corporation as of December 31, 2000 and 1999, and the related consolidated statements of operations, comprehensive loss, shareholders' equity, and cash flows for years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Surety Capital Corporation as of December 31, 2000 and 1999, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles. /s/ Fisk & Robinson, P.C. Fisk & Robinson, P.C. Dallas, Texas March 2, 2001, except as to Note 21, for which the date is April 2, 2001 SURETY CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2001 AND 2000
2001 2000 ------------ ------------ ASSETS Cash and due from banks $ 4,387,913 $ 2,198,209 Federal funds sold 10,015,000 8,825,000 Total cash and cash equivalents 14,402,913 11,023,209 Interest bearing time deposits in other financial institutions 27,771 26,548 Securities available for sale, at fair value 10,597,837 13,071,238 Loans, net 60,996,714 58,238,060 Premises and equipment, net 5,310,166 5,703,372 Accrued interest receivable 439,190 621,178 Deferred tax assets, net of valuation allowance 6,022 98,471 Other real estate and repossessed assets 737,000 960,155 Goodwill, net 2,536,679 2,799,019 Other assets 506,139 639,057 TOTAL ASSETS $ 95,560,431 $ 93,180,307 ------------ ------------
2001 2000 ------------ ------------ LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES Noninterest bearing demand deposits $ 15,936,327 $ 14,961,725 Savings, NOW and money market accounts 28,196,609 23,303,934 Time deposits, $100,000 and over 14,392,822 14,350,316 Other time deposits 24,628,757 27,044,793 ------------ ------------ Total deposits 83,154,515 79,660,768 Convertible subordinated debt 4,350,000 4,350,000 Notes payable 132,746 297,746 Accrued interest payable and other liabilities 948,478 1,194,124 ------------ ------------ Total liabilities 88,585,739 85,502,638 ------------ ------------ COMMITMENTS AND CONTINGENCIES -- -- SHAREHOLDERS' EQUITY Preferred stock, $.01 par value; 1,000,000 shares authorized; none issued at December 31, 2001 and 2000 -- -- Common stock, $0.01 par value; 20,000,000 shares authorized; 8,074,688 and 5,975,071 shares issued and outstanding at December 31, 2001 and 2000, respectively 80,747 59,751 Additional paid-in capital 17,803,491 17,152,587 Accumulated deficit (10,522,414) (8,968,077) Treasury stock, 79,836 shares at cost (375,443) (375,443) Accumulated other comprehensive loss (11,689) (191,149) ------------ ------------ Total shareholders' equity 6,974,692 7,677,669 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 95,560,431 $ 93,180,307 ============ ============
F-3 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2001 AND 2000
2001 2000 ------------ ------------ INTEREST INCOME Loans, including fees $ 5,944,964 $ 6,273,500 Securities, taxable 748,163 834,602 Federal funds sold and interest bearing deposits 302,749 380,437 ------------ ------------ Total interest income 6,995,876 7,488,539 INTEREST EXPENSE Deposits 2,833,621 2,980,253 Notes payable 391,500 391,500 ------------ ------------ Total interest expense 3,225,121 3,371,753 ------------ ------------ Net interest income 3,770,755 4,116,786 Provision for credit losses on loans -- (34,642) ------------ ------------ Net interest income after provision for credit losses 3,770,755 4,151,428 NON-INTEREST INCOME Service charges on deposit accounts 642,728 648,734 Loan collection fees and late charges 149,545 380,423 Other income 65,957 870,869 ------------ ------------ Total non-interest income 858,230 1,900,026 NON-INTEREST EXPENSE Salaries and employee benefits 2,694,132 3,167,392 Occupancy and equipment 1,225,706 1,394,261 Impairment of long-lived assets -- 2,194,407 Other expenses 2,263,484 2,569,900 ------------ ------------ Total non-interest expense 6,183,322 9,325,960 ------------ ------------ Loss before income taxes (1,554,337) (3,274,506) Income tax expense -- 839,609 ------------ ------------ Net loss $ (1,554,337) $ (4,114,115) ============ ============ Net loss per share - basic and diluted $ (0.23) $ (0.69) ============ ============
F-4 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS YEARS ENDED DECEMBER 31, 2001 AND 2000
2001 2000 ------------ ------------ NET LOSS $ (1,554,337) $ (4,114,115) OTHER COMPREHENSIVE INCOME Unrealized gain on securities available for sale 271,909 710,324 Tax effect (92,449) (241,510) ------------ ------------ Total other comprehensive income 179,460 468,814 ------------ ------------ COMPREHENSIVE LOSS $ (1,374,877) $ (3,645,301) ============ ============
F-5 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2001 AND 2000
Accumulated Common Stock Other --------------------- Additional Stock Comprehensive Par Paid-in Accumulated Rights Treasury Income Shares Value Capital Deficit Issuable Stock (Loss) Total ----------------------------------------------------------------------------------------------------- BALANCE, December 31, 1999 5,975,071 $59,751 $17,152,587 $ (4,911,864) $ 57,902 $(375,443) $(659,963) $11,322,970 Expiration of stock purchase rights -- -- -- 57,902 (57,902) -- -- -- Net loss -- -- -- (4,114,115) -- -- (4,114,115) Change in fair value of securities available for sale, net of tax of $241,510 -- -- -- -- -- -- 468,814 468,814 ----------------------------------------------------------------------------------------------------- BALANCE, December 31, 2000 5,975,071 59,751 17,152,587 (8,968,077) -- (375,443) (191,149) 7,677,669 Sale of common stock 1,210,738 12,107 339,793 -- -- -- -- 351,900 Conversion of notes payable to common stock 888,879 8,889 311,111 -- -- -- -- 320,000 Change in fair value of securities available for sale, net of tax of $92,449 -- -- -- -- -- -- 179,460 179,460 Net loss -- -- -- (1,554,337) -- -- -- (1,554,337) ----------------------------------------------------------------------------------------------------- BALANCE, December 31, 2001 8,074,688 80,747 17,803,491 (10,522,414) -- (375,443) (11,689) 6,974,692 =====================================================================================================
F-6 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2001 AND 2000
2001 2000 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (1,554,337) $ (4,114,115) Adjustments to reconcile net loss to net cash used in operating activities Provision for credit losses -- (34,642) Provision for other real estate owned 204,000 -- Impairment of long-lived assets -- 2,194,407 Depreciation 590,103 665,120 Amortization, net of accretion (47,694) -- Amortization of intangible assets and debt acquisition costs 303,931 438,920 FHLB stock dividends (5,800) (42,300) Net gain on sale or disposal of assets (4,669) (39,642) Deferred income taxes -- 839,609 Changes in assets and liabilities Accrued interest receivable 181,988 (106,725) Other assets 114,151 1,285,911 Accrued interest payable and other liabilities (245,646) (2,448,722) ------------ ------------ Net cash used in operating activities (463,973) (1,362,179) CASH FLOWS FROM INVESTING ACTIVITIES Net change in loans (2,758,654) 6,686,270 Securities available for sale Purchases (9,809,848) (1,600,000) Maturities and repayments 12,608,652 1,754,634 Purchase of interest-bearing time deposits (1,223) (1,548) Premises and equipment expenditures (196,897) (74,873) Proceeds from sales of premises and equipment -- 1,683 Proceeds from sales of other real estate 1,000 787,598 ------------ ------------ Net cash provided by (used in) investing activities (156,970) 7,553,764
F-7 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2001 AND 2000
2001 2000 ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 3,493,747 (5,217,350) Sale of common stock 351,900 -- Payments on debt (40,000) -- Proceeds from issuance of debt, net of issuance costs 195,000 297,746 ------------ ------------ Net cash provided by (used in) financing activities 4,000,647 (4,919,604) ------------ ------------ Net change in cash and cash equivalents 3,379,704 1,271,981 CASH AND CASH EQUIVALENTS, beginning of year 11,023,209 9,751,228 ------------ ------------ CASH AND CASH EQUIVALENTS, end of year $ 14,402,913 $ 11,023,209 ============ ============ SUPPLEMENTAL DISCLOSURES Cash paid for interest $ 3,306,485 $ 3,349,437 ============ ============ Cash refund received for federal income taxes $ -- $ 1,298,285 ============ ============ Significant non-cash transactions Transfers of repossessed collateral to other real estate and repossessed collateral $ -- $ 882,866 ============ ============ Conversion of debt to common stock $ 320,000 $ -- ============ ============
F-8 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL INFORMATION AND BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of Surety Capital Corporation (the Holding Company) and its wholly-owned subsidiary, Surety Bank, NA (the Bank), together referred to as the Company. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company is principally engaged in traditional community banking activities provided through its seven branches located in north Texas and south central Texas. Community banking activities include the Company's commercial and retail lending, deposit gathering and investment, and liquidity management activities. In addition to its community banking services, the Company offers insurance premium financing. Insurance premium finance (IPF) lending involves the lending of funds to companies and individuals for the purpose of financing its purchase of property and casualty insurance. The 2001 consolidated financial statements were prepared assuming the Company will continue as a going concern. Although the Company has suffered significant losses in its core business operations in all periods presented and is now operating under a written formal agreement with the OCC and a memorandum of understanding with the Federal Reserve Board (see Note 14), management believes the Company will be able to return to profitability. Management's plans to improve the Company's profitability include increasing marketing efforts, introducing new deposit products, emphasizing loan growth, and reducing non-interest expense. Management also believes the Company is in compliance with all of the requirements of the regulatory agreements. While the Bank's liquidity position appears sufficient to meet its cash needs for the year ending December 31, 2002, the Holding Company is primarily dependent upon dividends received from the Bank to meet its cash obligations, including interest payments on its convertible subordinated debt. Since the Bank is currently precluded from paying dividends without prior OCC approval, certain Holding Company Directors and shareholders have made loans to the Holding Company in order to fund interest payments on its convertible subordinated debt. In February 2002, the Holding Company notified the holders of its convertible subordinated debt that these certain Directors and shareholders will no longer make loans to the Holding Company to fund future interest payments and that the Holding Company will not have funds to make future interest payments until the Bank obtains relief from restrictions prohibiting the Bank from paying dividends to the Holding Company. As explained in Note 18, the Holding Company has offered the convertible subordinated debt holders certain options as alternatives to interest payments. Management believes that the proposed restructuring of the Holding Company's convertible subordinated debt will allow the Holding Company to meet its cash obligations for the year ending December 31, 2002, however, it cannot be assured. USE OF ESTIMATES The preparation of financial statements in conformity with U. S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets F-9 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED USE OF ESTIMATES - CONTINUED and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH FLOW REPORTING Cash and cash equivalents include cash, deposits with other financial institutions that have an original maturity under 90 days, and federal funds sold. Net cash flows are reported for loan and deposit transactions, and short-term borrowings. SECURITIES Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income. Trading securities are carried at fair value, with changes in unrealized holding gains and losses included in income. Management determines the appropriate classification of securities at the time of purchase. Other securities, such as stock in the Federal Reserve Bank and the Federal Home Loan Bank, are carried at cost. The Company had no securities classified as held to maturity or trading at December 31, 2001 and 2000. Interest income includes amortization of purchase premiums and discounts. Gains and losses on sales are based on the amortized cost of the security sold using specific identification. Securities are written down to fair value when a decline in fair value is not temporary. LOANS Loans are reported at the principal balance outstanding net of unearned interest, deferred loan fees and costs, and the allowance for credit losses. Interest income is reported on the level-yield interest method and includes amortization of net deferred loans fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically, when the loan is impaired or payments are past due over 90 days (120 days for insurance premium financing). Payments received on such loans are reported as principal reductions. F-10 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses is a valuation allowance for probable credit losses, increased by the provision for credit losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past credit loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific credits, but the entire allowance is available for any credit that, in management's judgment, should be charged-off. A loan is considered impaired when full payment of principal and interest under the loan terms is not expected. Impairment is evaluated in total for smaller balance loans of similar nature such as residential mortgage, consumer and insurance premium financial loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. PREMISES AND EQUIPMENT Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated using the straight-line method based on the estimated useful lives of the assets. OTHER REAL ESTATE AND REPOSSESSED ASSETS Assets acquired through or instead of loan foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed. GOODWILL Net assets acquired in purchase transactions are recorded at their fair value at the date of acquisition. Goodwill, the excess of the purchase price over the fair value of net assets acquired, is amortized on a straight-line basis, generally over a 15 year period. See the section titled "New Accounting Pronouncements" for new goodwill accounting requirements. LONG-TERM ASSETS Premises and equipment, goodwill and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at discounted amounts. F-11 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED INCOME TAXES Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the expected amount to be realized. ADVERTISING Advertising costs are expensed as incurred. STOCK COMPENSATION Employee compensation expense under stock option plans is reported if options are granted below market price at grant date. Pro forma disclosures of net income and earnings per share are shown using the fair value method of SFAS. No. 123 "Accounting for Stock Based Compensation" to measure expense for options granted after 1994, using an option pricing model to estimate fair value. FAIR VALUES OF FINANCIAL INSTRUMENTS Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on- and off-balance sheet financial instruments do not include the value of anticipated future business or the value of assets and liabilities not considered financial instruments. LOSS CONTINGENCIES Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements. DIVIDEND RESTRICTION Banking regulations require the maintenance of certain capital and net income levels that may limit the amount of dividends that may be paid. Regulatory capital requirements are more fully disclosed in a separate note. F-12 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED RESTRICTIONS ON CASH The Company is required to have certain levels of cash on hand or on deposit with the Federal Reserve Bank to meet regulatory reserve and clearing requirements. Deposits with the Federal Reserve Bank do not earn interest. Additionally, the Company had time deposits with other financial institutions totaling $27,771 and $26,548 at year end 2001 and 2000, respectively, pledged as security to its merchant card clearing agent. 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 only if the effect on earnings per share is dilutive. Earnings per common share is 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 were as follows:
2001 2000 --------- --------- Weighted-average shares outstanding - 6,679,815 5,975,071 basic effect of stock options -- -- --------- --------- Weighted-average share outstanding - diluted 6,679,815 5,975,071 ========= =========
The Company reported a net loss in 2001 and 2000. Accordingly, the dilutive effect of stock options and convertible debt is not considered in the net loss per share calculations for these years. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) is reported for all periods. Comprehensive income (loss) includes both net income (loss) and other comprehensive income (loss), which includes the change in unrealized gains and losses on securities available for sale. INDUSTRY SEGMENTS Internal financial information is primarily reported and aggregated in two lines of business consisting of community banking and insurance premium financing. F-13 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED NEW ACCOUNTING PRONOUNCEMENTS Goodwill, relating to past acquisitions, was amortized by the straight-line method over 15 years during 2001 and 2000. In June 2001, Statement of Financial Accounting Standards No. 141, "Business Combinations" (SFAS No. 141) and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142) were issued. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives not be amortized, but rather be tested at least annually for impairment. SFAS No. 142, is effective January 1, 2002 for calendar year companies. As required by SFAS No. 142, the Company will discontinue the amortization of goodwill with a net carrying value of $2,536,679 at January 1, 2002 and annual amortization of approximately $262,000 that resulted from business combinations prior to the adoption of SFAS No. 141. However, the Company continues to evaluate the additional effect, if any, that adoption of SFAS No. 142 will have on the Company's consolidated financial statements. RECLASSIFICATIONS Some items in prior financial statements have been reclassified to conform to the current presentation. These reclassifications have no effect on the net loss. NOTE 2. SECURITIES At December 31, securities available for sale consisted of the following:
Gross Gross Estimated Amortized Unrealized Unrealized Fair 2001 Cost Gains (Losses) Value ----------- ---------- ---------- ----------- U. S. government agencies and corporations $ 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 ----------- ---------- ---------- ----------- $10,615,547 $ 8,846 $ (26,556) $10,597,837 =========== ========== ========== ===========
F-14 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2. SECURITIES - CONTINUED
Gross Gross Estimated Amortized Unrealized Unrealized Fair 2000 Cost Gains (Losses) Value ----------- ---------- ---------- ----------- U. S. government agencies and corporations $12,150,224 $ 4,925 $ (293,383) $11,861,766 Mortgage-backed securities 449,529 578 (1,739) 448,368 Other securities 761,104 -- -- 761,104 ----------- ---------- ---------- ----------- $13,360,857 $ 5,503 $ (295,122) $13,071,238 =========== ========== ========== ===========
Mortgage-backed securities are backed by pools of mortgages that are insured or guaranteed by the Federal Home Loan Mortgage Corporation (FHLMC) and the Government National Mortgage Corporation (GNMA). Other securities include stock holdings in Independent Bankers Financial Corporation, the Federal Reserve Bank and the Federal Home Loan Bank. The amortized cost and estimated fair value of securities at year end 2001 and 2000, 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.
2001 2000 ------------------------- ------------------------- Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value ----------- ----------- ----------- ----------- Due within one year $ 198,797 $ 198,796 $ 196,179 $ 196,066 Due after one year through five years 8,398,754 8,375,980 2,992,834 2,953,045 Due after five years through ten years 503,031 507,420 8,961,211 8,712,655 Mortgage-backed securities 748,061 748,737 449,529 448,368 Other securities 766,904 766,904 761,104 761,104 ----------- ----------- ----------- ----------- Total Securities $10,615,547 $10,597,837 $13,360,857 $13,071,238 =========== =========== =========== ===========
At year end 2001, 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 year end 2001 and 2000, securities with a carrying amount of $9,320,000 and $8,685,000, respectively, were pledged as collateral for public deposits, as required or permitted by law. F-15 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. LOANS At December 31, loans were as follows:
2001 2000 ------------ ------------ Real estate loans $ 38,296,528 $ 37,280,209 Insurance premium financing 4,588,151 5,951,300 Commercial loans 13,311,170 10,919,098 Consumer loans 6,202,544 5,511,651 ------------ ------------ Total gross loans 62,398,393 59,662,258 Unearned interest (135,216) (160,237) Allowance for credit losses on loans (1,266,463) (1,263,961) ------------ ------------ Loans, net $ 60,996,714 $ 58,238,060 ============ ============
At December 31, 2001 and 2000, there were loans totaling $367,000 and $34,400, respectively, outstanding to directors, executive officers or principal shareholders of the Company, including their immediate families or companies in which they are principal owners. Loans with fixed rates were approximately $27,823,000 and $29,235,000 at December 31, 2001 and 2000, respectively. Activity in the allowance for credit losses on loans for 2001 and 2000 was as follows:
2001 2000 ------------ ------------ Balance at beginning of year $ 1,263,961 $ 1,434,041 Provision for credit losses on loans -- (34,642) Loans charged off (447,417) (760,334) Recoveries 449,919 624,896 ------------ ------------ Balance at end of year $ 1,266,463 $ 1,263,961 ============ ============
Impaired loans were as follows:
2001 2000 ------------ ------------ Year end loans with allowance allocated $ 1,495,244 $ 1,941,947 Year end loans with no allowance allocated 1,217,478 1,256,490 ------------ ------------ Impaired loans $ 2,712,722 $ 3,198,437 ============ ============ Amount of the allowance allocated $ 263,020 $ 504,346 ============ ============
F-16 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. LOANS - CONTINUED
2001 2000 ------------ ------------ Average impaired loans during the year $ 2,901,600 $ 3,785,755 ============ ============ Interest income recognized during impairment - all cash basis $ 186,165 $ 292,316 ============ ============ Loans past due over 90 days still on accrual $ -- $ -- Non-accrual loans 732,131 1,282,785 ------------ ------------ Total non-performing loans $ 732,131 $ 1,282,785 ============ ============
NOTE 4. PREMISES AND EQUIPMENT Premises and equipment at December 31, are summarized as follows:
Estimated Useful Lives 2001 2000 ------------ ----------- ----------- Buildings 5 - 40 years $ 3,720,387 $ 3,703,275 Furniture, fixtures and computers 3 - 10 years 3,682,180 4,096,167 Automobiles 3 - 5 years 51,317 20,894 Leasehold improvements 3 - 5 years 31,232 31,232 ----------- ----------- 7,485,116 7,851,568 Less accumulated depreciation (3,320,989) (3,294,235) Land 1,146,039 1,146,039 ----------- ----------- Premises and equipment, net $ 5,310,166 $ 5,703,372 =========== ===========
Rent expense totaled $99,000 and $65,000 for 2001 and 2000, respectively. Rent commitments under noncancelable operating leases were as follows at December 31, 2001, before considering renewal options that generally are present.
Year Amount ---- ------------ 2002 $ 28,560 2003 28,560 2004 28,560 2005 28,560 2006 9,520 ------------ $ 123,760 ============
F-17 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5. DEPOSITS At December 31, 2001, the scheduled maturities of time deposits were as follows:
Year Amount ---- ------------ 2002 $ 33,075,379 2003 3,789,536 2004 480,268 2005 1,253,821 2006 371,387 Thereafter 51,188
NOTE 6. CONVERTIBLE SUBORDINATED DEBT AND NOTES PAYABLE On March 31, 1998, the Company issued $4,350,000 in 9% Convertible Subordinated Notes Due 2008 (Notes), pursuant to an indenture between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (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 amount of the principal and any accrued and unpaid interest on the Notes are 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. Each holder of Notes has the right at any time prior to maturity of the Notes, unless previously redeemed, at the holder's option, to convert such Notes, or any portion thereof which is an integral multiple of $10,000, into shares of Common Stock of the Company, at the conversion price of $6 per share, subject to certain antidilutive adjustments (Conversion Price). The Notes are not subject to mandatory redemption or sinking fund provision. The Notes are redeemable for cash at the option of the Company on at least 30 but not more than 60 days notice, in whole or in part, at any time after the date of issuance and on or before March 31, 2002, at the redemption prices set forth in the table below, plus accrued interest to the date of redemption, if the closing sales price of the Company's common stock shall be F-18 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6. CONVERTIBLE SUBORDINATED DEBT AND NOTES PAYABLE - CONTINUED at least 130% of the Conversion Price then in effect for a period of 20 consecutive trading days in the principal market in which the common stock is then traded. At any time after March 31, 2002 and prior to maturity, the Notes are redeemable for cash at the option of the Company, on at least 30 but not more than 60 days notice, in whole or in part, at the redemption prices set forth in the table below, plus accrued interest to the date of redemption.
If Redeemed During Percentage of If Redeemed During Percentage of 12 Months Ended Principal 12 Months Ended Principal March 31, Amount March 31, Amount ------------------ ------------- ------------------ ------------- 2002 106% 2006 102% 2003 105% 2007 101% 2004 104% 2008 100% 2005 103%
In October and November 2000, certain current and former members of the Company's Board of Directors and one employee loaned the Company $297,746 to enable the Company to meet its cash obligations. $75,000 and $37,746 of the promissory notes evidencing the loans advanced in 2000 mature on January 2, 2002 and December 31, 2001, respectively and bear no interest from the date of issuance until maturity. The note maturing December 31, 2001 was subsequently paid in January 2002. During 2001, an additional $195,000 was loaned to the Company. These notes mature between January 2 and April 2, 2002, and bear no interest from the date of issuance until maturity. Additionally, $95,000 of the $132,746 promissory notes outstanding at December 31, 2001 are convertible into common stock at the rate of one share of common stock per $0.36 of principal amount of the notes. During 2001, $320,000 of the promissory notes were converted into common stock at the above rate. In February 2002, the Company notified the holders of its convertible subordinated debt that it will not have funds to make future interest payments and offered the holders certain options as alternatives to interest payments. See Note 18. NOTE 7. STOCK OPTIONS A summary of the Company's stock option plan is as follows: 1988 INCENTIVE STOCK OPTION PLAN: Under the provisions of the plan 100,000 shares, as restated to reflect a 1 for 10 reverse stock split effected on June 14, 1993, were allocated for incentive stock options to be granted to officers and/or key employees. Grantees are awarded 5-year options to acquire shares at the market price on the date the option is granted. The options are fully vested and exercisable as of the date of the grant. All options must be granted within 10 years of the plan adoption date. As of December 31, 2001, there were no options outstanding or available for grant under the plan. F-19 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7. STOCK OPTIONS - CONTINUED 1995 INCENTIVE STOCK OPTION PLAN: Under the provisions of the plan 100,000 shares were allocated for incentive stock options to be granted to officers and/or key employees. Grantees are awarded 10-year options to acquire shares at the market price on the date the option is granted. The options vest and become exercisable based on a vesting schedule determined by the Compensation Committee of the Board of Directors on the date of grant. As of December 31, 2001, there were 0 options outstanding, and 77,158 options available for grant under the plan. All options must be granted within 10 years of the plan adoption date. 1996 STOCK OPTION PLAN FOR DIRECTORS: Under the provisions of the plan 100,000 shares were allocated for non-qualified stock options to be granted to directors. The plan is a formula plan pursuant to which annual options are automatically granted to directors of the Company, who are not employees of the Company or the Bank, at fair market value. On the first calendar business day of each year, each non-employee director is automatically granted 10-year options to purchase 2,000 shares of Common Stock of the Company at the market price on the grant date. The options fully vest and become exercisable after the first anniversary of the grant date. As of December 31, 2001, there were 32,000 options outstanding, all of which were exercisable, and 62,000 options available for grant under the plan. 1997 NON-QUALIFIED STOCK OPTION PLAN FOR OFFICERS AND KEY EMPLOYEES: Under the provisions of the plan 500,000 shares were allocated for non-qualified stock options to be granted to officers and/or key employees. On January 2, 1997, grantees were awarded 10-year options to acquire 500,000 shares at the market price on that date. No additional options may be granted under the plan. The options fully vest and become exercisable in five equal installments commencing on December 31, 1997, and annually thereafter. As of December 31, 2001, there were 475,000 options outstanding of which all were exercisable. 1997 NON-QUALIFIED STOCK OPTION PLAN FOR NON-EMPLOYEE DIRECTORS: Under the provisions of the plan 150,000 shares were allocated for non-qualified stock options to be granted to directors. In 1997, grantees were awarded 10-year options to acquire 150,000 shares at the market price on the date the options were granted. The options vest and become exercisable based on a vesting schedule as determined by the Stock Option Committee of the Board of Directors on the date of grant. As of December 31, 2001, there were 140,000 options outstanding, all of which were exercisable, and no options were available for grant under the plan. 2000 NON-QUALIFIED STOCK OPTION PLAN FOR ADVISORY DIRECTORS: Under the provisions of the Plan 100,000 shares were allocated for non-qualified stock options to be granted to advisory directors. Grantees are awarded 10-year options to acquire shares at the market price on the date the option is granted. The options vest and become fully exercisable based on a vesting schedule as determined by the Stock Option Committee of the Board of Directors on the date of grant. As of December 31, 2001, there were 103,000 options outstanding, all of which were exercisable, and there are no options available for grant under the plan. F-20 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7. STOCK OPTIONS - CONTINUED 2001 AMENDED AND RESTATED 1998 INCENTIVE STOCK OPTION PLAN: Under the provisions of the plan, 500,000 shares were allocated for incentive stock options to be granted to officers and/or key employees. Grantees are awarded 10-year options to acquire shares at the market price on the date the option is granted. The options vest and become exercisable based on a vesting schedule as determined by the Stock Option Committee of the Board of Directors on the date of grant. As of December 31, 2001, there were 350,369 options outstanding, 73,333 of which were exercisable, and 139,631 were options available for grant under the plan. All options must be granted within 10 years of the plan adoption date. The following is a summary of activity in the Company's stock option plans:
2001 2000 ----------------------- ----------------------- Number of Weighted Number of Weighted Shares Average Shares Average Underlying Exercise Underlying Exercise Options Prices Options Prices ---------- ---------- ---------- ---------- Outstanding at beginning of the year 939,333 $ 3.24 1,165,000 $ 2.96 Granted 315,369 0.50 38,000 0.60 Exercised -- 0.00 -- -- Expired or forfeited (154,333) 1.26 (263,667) 1.59 ---------- ---------- Outstanding at end of year 1,100,369 2.78 939,333 3.24 ========== ========== Exercisable at end of year 823,333 3.51 628,114 3.79 Available for grant at end of year 278,789 436,825 Weighted-average remaining contractual life of options outstanding at end of year 6.52 years 6.04 years
The following table summarizes information about stock options outstanding at December 31, 2001:
Options Outstanding Options Exercisable ------------------------------------ ---------------------- Weighted Average Weighted Weighted Remaining Average Average Range of Number Contractual Exercise Number Exercise Exercise Prices Outstanding Life Price Exercisable Price --------------- ----------- ----------- -------- ----------- -------- $0.00 to $1.99 461,369 8.52 $ 0.67 184,333 $ 0.80 4.00 to 5.99 623,000 5.03 4.23 623,000 4.23 6.00 to 6.94 16,000 6.51 6.94 16,000 6.94 ----------- ----------- $0.50 to $6.94 1,100,369 6.52 2.78 823,333 3.51 =========== ===========
F-21 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7. STOCK OPTIONS - CONTINUED The weighted-average value per share of options granted during 2001 and 2000 was $0.27 and $0.49, respectively. The fair value of options granted was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: dividend yield of 0% for both years; expected volatility of 101.77% for 2001 and 97.58% for 2000; risk-free interest rate of 4.38% for 2001 and 6.92% for 2000; and an expected life of 4 to 8 years and 5 years for 2001 and 2000, respectively. SFAS No. 123, Accounting for Stock Based Compensation, requires pro forma disclosures for companies not adopting its fair value accounting method for stock-based employee compensation. The Company accounts for all stock options in accordance with Accounting Principles Board (APB) Option No. 23, Accounting for Stock Issued to Employees. Accordingly, the following pro forma information presents net loss and net loss per share for 2001 and 2000 had the Standard's fair value method been used to measure compensation cost for stock option plans. No compensation expense related to stock options was actually recognized for stock options accounted for under APB 25.
2001 2000 ------------ ------------ Net income (loss) As reported $ (1,554,337) $ (4,114,115) Pro forma (1,862,584) (4,247,497) Net income (loss) per share As reported Basic (0.23) (0.69) Diluted (0.23) (0.69) Pro forma Basic (0.28) (0.71) Diluted (0.28) (0.71)
The effects of applying SFAS 123 in this pro forma disclosure are not indicative of future amounts. The pro forma may increase in the future if more options are granted. NOTE 8. EMPLOYEE BENEFIT PLANS The Company offers a 401(k) profit sharing plan for the benefit of all full-time employees, age 21 or older. Participants may contribute up to 22.5% of their gross compensation, subject to statutory limits. The Company matches those contributions at a percentage to be determined by management. The Company may also provide an additional discretionary percentage. Employee contributions are vested at all times and the Company's contributions vest at the end of three years of service. The contribution expense included in salaries and employee benefits was $14,000 and $17,000 for 2001 and 2000, respectively. F-22 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8. EMPLOYEE BENEFIT PLANS - CONTINUED The Company provides certain post-retirement benefits to a former Chairman and officer. Under the agreement, the Company must provide the former Chairman payments, payable in annual, monthly or bi-monthly installments, totaling $53,825 per year. Additionally, the Company must provide or reimburse the former Chairman for the cost of health, accident and medical insurance coverage that is equivalent to the coverage provided to those persons serving from time to time as the senior executive officers of the Company. The Company's obligation under the agreement terminates at the earlier of death or when the former Chairman reaches 85 years of age. All amounts payable under the agreement are accelerated and become due immediately upon a change in control (as defined in the agreement). The Company may terminate the agreement for cause (as defined in the agreement) or upon disability of the former Chairman. The accrual for benefit obligation which represents the estimated discounted present value of the Company's future payment obligation totals $320,000 and $374,000 at December 31, 2001 and 2000, respectively. NOTE 9. COMMON STOCK RIGHTS AGREEMENTS Pursuant to the Rights Agreement dated June 17, 1997, between the Company and Securities Transfer Corporation, as rights agent, the Company declared a dividend of one common stock purchase right (Right) for each outstanding share of common stock, $0.01 par value of the Company (Common Stock Purchase plan) to stockholders of record at the close of business on June 6, 1997. The Rights expired during 2000. NOTE 10. 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 of 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. The total amounts of financial instruments with off-balance-sheet risk at December 31, 2001 and 2000 were unfunded loan commitments of $4,897,000 and $5,940,000 and letters of credit of $450,000 and $150,000, respectively. F-23 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK - CONTINUED Federal funds sold total $10,015,000 and $8,825,000 at December 31, 2001 and 2000, respectively. 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 FDIC 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 trade 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 loans, secured by the residual value of unearned insurance premiums, comprise $4,715,000 or 7.6% and $5,951,000 or 9.97% of gross loans at December 31, 2001 and 2000. NOTE 11. OTHER NON-INTEREST EXPENSE AND IMPAIRMENT OF LONG-LIVED ASSETS Other non-interest expense consisted of the following:
2001 2000 ------------ ------------ Advertising $ 58,904 $ 62,046 Amortization of intangibles and debt issuance costs 303,931 486,072 Directors fees 123,606 40,950 Impairment of other real estate 204,000 -- Insurance 131,954 137,356 Office supplies 84,271 113,477 Operational losses 29,697 81,484 Other 520,560 571,966 Postage 156,433 172,010 Professional services 493,695 710,763 Telephone 156,433 193,776 ------------ ------------ Total other non-interest expense $ 2,263,484 $ 2,569,900 ============ ============
Professional services expense includes legal fees to a firm in which a former director of the Company holds an interest in the amount of $13,000 and $177,000 in 2001 and 2000, respectively. In addition, legal fees paid to a firm in which a current director of the Company holds an interest totaling approximately $127,000 is included in professional services expense in 2001. F-24 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11. OTHER NON-INTEREST EXPENSE AND IMPAIRMENT OF LONG-LIVED ASSETS - CONTINUED The $2,194,407 impairment of long-lived assets for the year ended December 31, 2000 consists of a write-down in the carrying value of goodwill and other intangibles relating to the Company's San Antonio area branches. The amount of the write-down was determined by use of a third party appraisal performed as of December 31, 2000. NOTE 12. FEDERAL INCOME TAXES Year end deferred tax assets and liabilities consist of the following:
2001 2000 ------------ ------------ Deferred tax liabilities Depreciation and amortization $ (1,034,649) $ (1,014,284) Deferred loan costs (22,532) (44,703) Allowance for credit losses (15,695) -- Other (6,725) (40,074) ------------ ------------ Gross deferred tax liability (1,079,601) (1,099,061) Deferred tax assets Allowance for credit losses -- 41,329 Alternative minimum tax loss carryforward 239,997 239,997 Deferred compensation 108,867 127,168 Net operating loss carryforwards 2,496,629 2,077,434 Net unrealized loss on securities available for sale 6,022 98,471 Other 24,710 21,153 Other real estate losses 106,397 37,037 ------------ ------------ Gross deferred tax asset 2,982,622 2,642,589 ------------ ------------ Net deferred tax asset 1,903,021 1,543,528 Less valuation allowance for net deferred tax asset (1,896,999) (1,445,057) ------------ ------------ Total net deferred tax asset $ 6,022 $ 98,471 ============ ============
The realization of the net deferred tax asset is contingent upon the Company generating sufficient future taxable income during the carryforward period. Management has provided a 100% valuation allowance for its net deferred tax asset due to the uncertainty of realization during the carryforward period. The change in the valuation allowance was $451,942 and $1,445,057 for the years ended December 31, 2001 and 2000, respectively. F-25 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12. FEDERAL INCOME TAXES - CONTINUED The provision (benefit) for federal income taxes consists of the following:
2001 2000 ------------ ------------ Current $ -- $ -- Deferred Federal (451,942) (605,448) Valuation allowance 451,942 1,445,057 ------------ ------------ Provision (benefit) for federal income tax expense charged to results of operations -- 839,609 Tax effect of change in unrealized gain on securities available for sale 92,449 241,510 ------------ ------------ Comprehensive provision (benefit) for federal income taxes $ 92,449 $ 1,081,119 ============ ============
The effective tax rate on net loss before income taxes differs from the U. S. statutory tax rate as follows:
2001 2000 ------------ ------------ U. S. statutory rate 34.0% 34.0% Valuation allowance (28.4) (31.9) Goodwill (5.6) (27.3) Other -- (0.4) ------------ ------------ Effective tax rate 0.0% (25.6)% ============ ============
As of year end 2001 for income tax reporting purposes, the Company has a current net pretax operating loss carryforward of approximately $7,343,000 which expires from years beginning 2002 through 2021. The Company has an additional loss carryforward of approximately $104,000 for income tax reporting purposes, which expires, if not used, in 2003. The utilization of this additional net operating loss carryforward is limited by Section 382 of the Internal Revenue Code to approximately $15,000 annually until its expiration. The Tax Reform Act of 1986 imposed substantial restrictions on the utilization of net operating losses and tax credits in the event of an "ownership change" of a corporation. Accordingly, the Company's ability to utilize net operating loss carryforwards may be limited as a result of such an "ownership change" as defined in the Internal Revenue Code. The Company also has an alternative minimum tax credit carryover of $240,000 which can be used to offset regular tax in future periods. F-26 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13. COMMITMENTS AND CONTINGENCIES FEDERAL HOME LOAN BANK ADVANCES: As a member of the Federal Home Loan Bank (FHLB) system, the Bank has the ability to obtain borrowings up to a maximum total of 50% of its total assets subject to the level of qualified, pledgable 1-4 family residential real estate loans and FHLB stock owned. As discussed in a separate note, under a formal agreement with the OCC, the Bank is prohibited from incurring additional debt without prior approval. The advances are collateralized by a blanket pledge of the Bank's residential mortgage loan portfolio and FHLB stock. No FHLB advances were outstanding as of December 31, 2001 or 2000. LITIGATION: The Company is a party to various claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material effect on the Company's financial condition or results of operations. NOTE 14. REGULATORY MATTERS Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The Bank is a national banking association and, therefore, is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). The Bank is also a member of the Federal Reserve Banking System (FRB) and the Federal Deposit Insurance Corporation (FDIC). Because the FRB regulates the bank holding company parent of the Bank, the FRB also has supervisory authority that directly affects the Bank. In addition, upon making certain determinations with respect to the condition of any insured national bank, such as the Bank, the FDIC may begin proceedings to terminate a bank's federal deposit insurance. On November 19, 1998, the Board of Directors of the Bank entered into a Formal Agreement with 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 was also required to achieve certain additional capital levels by December 31, 1999. Under the Formal Agreement, by March 31, 1999, the Bank was required to achieve total risk-based capital of at least 12% of risk-weighted assets and Tier I leverage capital of at least 7.5% of average assets. By December 31, 1999, the Bank was required to achieve and maintain total risk-based capital of at least 14% of risk-weighted assets. The Bank failed to achieve the capital requirements set forth in the Formal Agreement by March 31, 1999, and submitted a request for an extension to September 30, 1999. The OCC granted the extension and the Bank achieved the required level of capital upon completion of the sales of the Midlothian and Waxahachie branches on June 30, 1999. F-27 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14. REGULATORY MATTERS - CONTINUED The Formal Agreement establishes higher capital requirements than those applicable under prompt corrective action regulations for an "adequately" and "well capitalized" bank. The following table sets forth Consolidated and Bank Only actual capital levels in addition to the capital requirements under the Formal Agreement and prompt corrective action regulations.
Minimum Requirements To Be Well Requirements Capitalized Actual Under Formal For Under Prompt Year-end Agreement at Capital Corrective Capital Ratios December 31, Adequacy Action 2001 2000 2000 Purposes Regulations ------ ------ ------------ -------- ------------ Leverage Ratio Tier I capital to average assets Consolidated 4.98% 5.17% 4.00% 5.00% Bank 9.31% 9.83% 7.00% 4.00% 5.00% Risk-Based Capital Ratios Tier I capital to risk- weighted assets Consolidated 6.92% 7.76% 4.00% 6.00% Bank 13.60% 14.75% 6.00% 4.00% 6.00% Total capital to risk- weighted assets Consolidated 11.64% 12.88% 8.00% 10.00% Bank 14.86% 15.99% 14.00% 8.00% 10.00%
Year end Consolidated and Bank Only actual capital amounts were as follows:
Consolidated Bank Only --------------------------- --------------------------- 2001 2000 2001 2000 ------------ ------------ ------------ ------------ Tier I capital $ 4,580,000 $ 5,070,000 $ 8,965,000 $ 9,587,000 Tier II capital 3,123,000 3,346,000 827,000 807,000 ------------ ------------ ------------ ------------ Total capital $ 7,703,000 $ 8,416,000 $ 9,794,000 $ 10,394,000 ============ ============ ============ ============ Risk-weighted assets $ 66,191,000 $ 65,330,000 $ 65,906,000 $ 65,012,000 ============ ============ ============ ============ Adjusted average assets $ 91,929,000 $ 98,006,000 $ 96,244,000 $ 97,540,000 ============ ============ ============ ============
As of year end 2001 and 2000, the Company and Bank met the level of capital required to be categorized as well capitalized under prompt corrective action regulations. Management is not aware of any conditions subsequent to December 31, 2001 that would change the Company's or the Bank's capital category. F-28 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14. REGULATORY MATTERS - CONTINUED Additionally, pursuant to the Formal Agreement, the Board of Directors was required to develop a three year capital plan program, a plan to enhance its management information systems, a three year strategic plan establishing objectives for the Bank's earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of non-performing assets, product line development and market segments which the Bank intends to promote or develop, together with strategies to achieve those objectives, a revised loan policy, and a loan classification policy, each for submission to, and approval by, the OCC. All of these recommended enhancements have been implemented. The Formal Agreement also prohibits the Board of Directors from declaring or paying any dividends unless the Bank (i) is in compliance with 12 U.S.C. Section 56 and 60, its approved capital program provided for in the Formal Agreement, and the capital levels set forth in the Formal Agreement, as more fully described above, and (ii) has obtained the prior written approval of the OCC. The Holding Company does not have material working capital needs separate from those of the Bank, other than the payment of interest on its convertible subordinated debt and the repayment of the notes payable (Note 9). The Bank is currently precluded from declaring and paying any dividends to the Holding Company under the Formal Agreement. The provisions of the subordinated debt do not allow holders to force an interest payment. On November 9, 1999, the OCC approved a $262,000 reduction of the Bank's surplus, the proceeds of which were upstreamed to the Holding Company which, together with a $60,000 capital contribution by certain officers and directors of the Holding Company and a $139,000 federal income tax payment by the Bank to the Holding Company, was sufficient to enable the Holding Company to meet its September 30, 1999 interest obligations under the Notes and to pay certain other operating expenses. Additionally, on March 28, 2000, the OCC approved another reduction in the Bank's surplus in the amount of $500,000 that enabled the Holding Company to meet debt service obligations under the Notes and pay for other operating expenses through March 31, 2000. Certain current and former members of the Company's Board of Directors and one employee have made loans to the Company to enable it to meet its cash needs (See Note 9). On October 28, 1999, the Holding Company entered into a Memorandum of Understanding (MOU) with 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 Holding Company was required to develop and submit to the FRB a written three year capital plan, a plan to service the Holding Company's existing debt without incurring any additional debt, and written procedures designed to strengthen and maintain the Holding Company's internal records and controls to ensure that future regulatory reports are filed in a timely and accurate manner. The Holding Company has submitted each of the requested plans and procedures to the FRB. Finally, the Holding 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. F-29 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value approximates carrying value for financial instruments except those described below: SECURITIES: Fair values for securities are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar instruments. LOANS: The fair value of fixed-rate loans and variable-rate loans which reprice on an infrequent basis is estimated by discounting future cash flows using the current interest rates at which similar loans with similar terms would be made to borrowers of similar credit quality. DEPOSITS: The fair value of deposit liabilities with defined maturities is estimated by discounting future cash flows using the interest rates currently offered for deposits of similar remaining maturities. LONG-TERM DEBT: The fair value of the Company's notes payable and subordinated debt is not readily determinable. The Company has estimated the value of the notes payable at face value of the subordinated debt at par plus the premium the Company would be required to pay if the notes were retired at year end. OFF-BALANCE SHEET INSTRUMENTS: The fair values of these items are not material and are, therefore, not included on the following schedule. The estimated year end fair values of financial instruments were as follows:
2001 2000 --------------------------- --------------------------- Carrying Estimated Carrying Estimated Value Fair Value Value Fair Value ------------ ------------ ------------ ------------ Financial assets Cash and cash equivalents $ 14,402,913 $ 14,403,000 $ 11,023,209 $ 11,023,000 Interest-bearing time deposits 27,771 28,000 26,548 27,000 Securities available for sale 10,597,837 10,598,000 13,071,238 13,071,000 Loans, net 60,996,714 65,606,000 58,238,060 58,205,000 Accrued interest receivable 439,190 439,000 621,178 621,000 Cash surrender value of life insurance 87,886 90,000 89,651 90,000 Financial liabilities Noninterest-bearing deposits (15,936,327) (15,936,000) (14,961,725) (14,962,000) Interest-bearing deposit (67,218,188) (67,902,000) (64,699,043) (64,966,000) Long-term debt (4,482,746) (4,787,246) (4,647,746) (4,952,000) Accrued interest payable (222,905) (223,000) (402,143) (402,000)
F-30 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 16. BUSINESS SEGMENTS The accounting policies of the segments are the same as those described above in Note 1. The Company evaluates segment performance based on net interest income and profit or loss from operations.
Insurance Community Premium 2001 Banking Financing Total ----------- ----------- ----------- Net interest income $ 3,144,893 $ 625,862 $ 3,770,755 Provision for credit losses -- -- -- Noninterest income 708,013 150,217 858,230 Noninterest expense 5,454,572 728,750 6,183,322 Net income (loss) (1,601,666) 47,329 (1,554,337) Loans, gross 57,812,013 4,586,379 62,398,392 Total assets 91,389,908 4,170,523 95,560,431 2000 Net interest income $ 2,781,736 $ 1,335,050 $ 4,116,786 Provision for credit losses (70,000) 35,358 (34,642) Noninterest income 1,518,353 381,673 1,900,026 Noninterest expense 8,511,566 814,394 9,325,960 Net income (loss) (4,686,316) 572,201 (4,114,115) Loans, gross 53,710,958 5,951,300 59,662,258 Total assets 87,565,260 5,615,047 93,180,307
NOTE 17. PARENT COMPANY CONDENSED FINANCIAL STATEMENTS The following are condensed parent company financial statements: Condensed Balance Sheets December 31, 2001 and 2000
2001 2000 ------------ ------------ Assets Cash and cash equivalents $ 29,249 $ 16,961 Investment in subsidiary 11,489,790 12,195,422 Other assets 280,066 321,657 ------------ ------------ Total assets $ 11,799,105 $ 12,534,040 ============ ============ Liabilities Convertible subordinated debt $ 4,350,000 $ 4,350,000 Notes payable 132,746 297,746 Accrued interest payable 97,875 97,875 Other liabilities 243,792 110,750 ------------ ------------ 4,824,413 4,856,371
F-31 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17. PARENT COMPANY CONDENSED FINANCIAL STATEMENTS - CONTINUED Condensed Balance Sheets December 31, 2001 and 2000 (continued)
2001 2000 ------------ ------------ Shareholder's equity Common stock 80,747 59,751 Additional paid-in capital 17,803,491 17,152,587 Accumulated deficit (10,522,414) (8,968,077) Treasury stock (375,443) (375,443) Accumulated other comprehensive loss (11,689) (191,149) ------------ ------------ Total shareholders' equity 6,974,692 7,677,669 ------------ ------------ Total liabilities and shareholders' equity $ 11,799,105 $ 12,534,040 ============ ============
Condensed Statements of Operations and Comprehensive Loss Years Ended December 31, 2001 and 2000
2001 2000 ------------ ------------ Operating income $ -- $ -- Operating expenses Interest expense 391,500 391,500 Other expenses 277,745 205,873 ------------ ------------ Total operating expenses 669,245 597,373 Loss before income taxes and equity in undistributed net income (equity in net loss) of subsidiary (669,245) (597,373) Income tax expense (benefit) -- 383,118 ------------ ------------ Loss before equity in net loss and distributions in excess of net loss of subsidiary (669,245) (980,491) Equity in net loss (885,092) (3,133,624) ------------ ------------ Net loss (1,554,337) (4,114,115) Other comprehensive income - net change in unrealized holding gain on securities available for sale, net of tax 179,460 468,814 ------------ ------------ Comprehensive loss $ (1,385,877) $ (3,645,301) ============ ============
F-32 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 17. PARENT COMPANY CONDENSED FINANCIAL STATEMENTS - CONTINUED Condensed Statements of Cash Flows Years Ended December 31, 2001 and 2000
2001 2000 ------------ ------------ Cash flows from operating activities Net loss $ (1,554,337) $ (4,114,115) Adjustments to reconcile net loss to net cash from operating activities Amortization of debt issuance costs 41,590 41,590 Equity in net loss (equity in undistributed earnings) of subsidiary 885,092 3,133,624 Net change in other assets and other liabilities 133,043 653,368 ------------ ------------ Net cash used in operating activities (494,612) (285,533) Cash flows from investing activities -- -- ------------ ------------ Net cash used in investing activities -- -- Cash flows from financing activities Sale of common stock 351,900 -- Proceeds from debt, net of issuance costs 195,000 297,746 Payment on debt (40,000) -- ------------ ------------ Net cash provided by financing activities 506,900 297,746 ------------ ------------ Net change in cash and cash equivalents 12,288 12,213 Beginning cash and cash equivalents 16,961 4,748 ------------ ------------ Ending cash and cash equivalents $ 29,249 $ 16,961 ============ ============
NOTE 18. SUBSEQUENT EVENTS In February 2002, the Company notified the holders of its convertible subordinated debt that the Company will not have funds available to make future interest payments on the convertible subordinated debt until the Bank obtains relief from restrictions prohibiting it from paying dividends. As alternatives in the place of interest payments, the Company offered the note holders the following options: OPTION 1: Amend the terms of the conversion feature to reduce the conversion price to $0.75 per share for 25% of the note amount in consideration of the forgiveness of all interest for a three year period. F-33 SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18. SUBSEQUENT EVENTS - CONTINUED OPTION 2: Issue a new note in the principal amount equal to three years of interest payments. The principal amount of the new note would bear interest and would be due in 2008. OPTION 3: Issue five year warrants to the note holders entitling them to acquire, in aggregate, 600,000 shares of Surety Capital common stock at $1.50 exercise price. In addition, in March 2002, the Company submitted an Offer of Settlement to the Securities and Exchange Commission whereby Surety Capital consents to the entry of an Order by the Commission which orders that Surety Capital cease and desist from committing or causing any violation, and any future violation, of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 there under. F-34