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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(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, 2019

 

or

 

o    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934  

For the transition period from            to           

 

Commission file number 001-10897

 

Carolina Financial Corporation

(Exact name of registrant as specified in its charter)

 

Delaware   57-1039673
(State of Incorporation)   (I.R.S. Employer Identification No.)

 

288 Meeting Street, Charleston, South Carolina   29401
(Address of principal executive offices)   (Zip Code)

 

(843) 723-7700
(Issuer’s Telephone Number)

 

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

 

Title of Each Class Trading Symbol Name of each exchange on which registered
Common Stock, $0.01 par value per share CARO The Nasdaq Capital Market®

 

Securities registered under Section 12(g) of the Exchange Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes x  No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes o  No x

 

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 o

 

Indicate by check mark whether the registrant has submitted electronically, if any, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes x  No o

 

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

 

Large accelerated filer  x Accelerated filer  o
   

Non-accelerated filer  o

(Do not check if a smaller reporting company)

Smaller reporting company   o

 

Emerging growth company  o

 

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

o

 

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

Yes o  No x

 

The aggregate market value of the voting and nonvoting common equity held by non-affiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $738,763,981 as of the last business day of the registrant’s most recently completed second fiscal quarter.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

Class   Outstanding at February 19, 2020
Common Stock, $.01 par value per share   24,825,817 shares

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Some of the information required by Part I and Part III is incorporated by reference from the prospectus and joint proxy statement filed by United Bankshares, Inc. and the registrant on February 13, 2020 pursuant to Rule 424(b) under the Securities Act of 1933 and Rule 14a-6 under the Securities Exchange Act of 1934.

 

The information required by Part III will be incorporated by reference from either the registrant’s definitive proxy statement which involves the election of directors if such proxy statement is filed not later than 120 days after the end of the fiscal year covered by this report or as an amendment to this report filed not later than the end of such 120-day period.

 
 

TABLE OF CONTENTS

 

     
    Page
PART 1    
Item 1. Business 3
Item 1A. Risk Factors 27
Item 1B. Unresolved Staff Comments 42
Item 2. Properties 42
Item 3. Legal Proceedings 42
Item 4. Mine Safety Disclosures 42
     
PART II    
Item 5. Market for Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities 43
Item 6. Selected Financial Data 45
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 47
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 79
Item 8. Financial Statements and Supplementary Data 80
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 160
Item 9A. Controls and Procedures 160
Item 9B. Other Information 160
     
PART III      
Item 10. Directors, Executive Officers and Corporate Governance 161
Item 11. Executive Compensation 161
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 161
Item 13. Certain Relationships and Related Transactions, and Director Independence 161
Item 14. Principal Accounting Fees and Services 161
Item 15. Exhibits, Financial Statement Schedules 162
     
EXHIBIT INDEX 163
   
SIGNATURES 165

 
 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K, including information included or incorporated by reference, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the “Securities “Act”) and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described below under “Item 1A- Risk Factors” and the following:

 

  · our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;
  · examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets or otherwise impose restrictions or conditions on our operations, including, but not limited to, our ability to acquire or be acquired;
  · changes in economic conditions, either nationally or regionally and especially in our primary market areas, resulting in, among other things, a deterioration in credit quality;
  · changes in interest rates, or changes in regulatory environment resulting in a decline in our mortgage production and a decrease in the profitability of our mortgage banking operations;
  · greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;
  · greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;
  · changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the South Carolina, North Carolina and national real estate markets;
  · the rate of delinquencies and amount of loans charged-off;
  · the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
  · the rate of loan growth in recent or future years;
  · our ability to attract and retain key personnel;
  · our ability to retain our existing customers, including our deposit relationships;
  · significant increases in competitive pressure in the banking and financial services industries;
  · adverse changes in asset quality and resulting credit risk-related losses and expenses;
  · changes in the interest rate environment which could reduce anticipated or actual margins;
  · changes in political conditions or the legislative or regulatory environment, including, but not limited to, the Dodd-Frank Act and regulations adopted thereunder, changes in federal or state tax laws or interpretations thereof by taxing authorities and other governmental initiatives affecting the banking, mortgage banking, and financial service industries;
  · changes occurring in business conditions and inflation;
  · increased funding costs due to market illiquidity, increased competition for funding, or increased regulatory requirements with regard to funding;
  · discontinuation of a published LIBOR rate after 2021 and the impact to our assets and liabilities;
  · the impact of past and future hurricanes and other natural disasters on our loan portfolio and the economic prospects of our coastal markets;
  · our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, business and a negative impact on results of operations;
1
 
  · changes in deposit flows;
  · changes in technology;
  · changes in monetary and tax policies;
  · changes in accounting policies, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board ( “PCAOB”) and the Financial Accounting Standards Board  (“FASB”);
  · loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;
  · our expectations regarding our operating revenues, expenses, effective tax rates and other results of operations;
  · our anticipated capital expenditures and our estimates regarding our capital requirements;
  · our liquidity and working capital requirements;
  · competitive pressures among depository and other financial institutions;
  · the growth rates of the markets in which we compete;
  · our anticipated strategies for growth and sources of new operating revenues;
  · our current and future products, services, applications and functionality and plans to promote them;
  · anticipated trends and challenges in our business and in the markets in which we operate;
  · the evolution of technology affecting our products, services and markets;
  · our ability to retain and hire necessary employees and to staff our operations appropriately;
  · management compensation and the methodology for its determination;
  · our ability to compete in our industry and innovation by our competitors;
  · increased cybersecurity risk, including potential business disruptions or financial losses;
  · acquisition integration risks relating to companies we have acquired, including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related matters, and the inability to identify and successfully negotiate and complete additional combinations with potential merger or acquisition partners or to successfully integrate such businesses into the Company, including the ability to realize the benefits and cost savings from, and limit any unexpected liabilities associated with, any such business combinations;
  · our ability to stay abreast of new or modified laws and regulations that currently apply or become applicable to our business;
  · estimates and estimate methodologies used in preparing our consolidated financial statements and determining option exercise prices and stock-based compensation;
·the matters noted under the heading “Cautionary Statement Regarding Forward-Looking Statements” in the prospectus and joint proxy statement filed by United Bankshares, Inc. and us on February 13, 2020, which is incorporated herein by reference.

 

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of this report. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this report. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed in, or implied or projected by, the forward-looking statements.

2
 

PART I

Item 1.  Business

 

General Overview

 

Carolina Financial Corporation is a Delaware corporation that was organized in February 1997 to serve as a bank holding company. In 2017, it applied for, and received, financial holding company status from the Federal Reserve. The Company operates principally through its wholly-owned subsidiary, CresCom Bank, a South Carolina state-chartered bank. CresCom Bank operates Crescent Mortgage Company, Carolina Services Corporation of Charleston (“Carolina Services”), DTFS, Inc., CresCom Leasing, LLC and Western Carolina Holdings, LLC, as wholly-owned subsidiaries of CresCom Bank. Except where the context otherwise requires, the “Company”, “we”, “us” and “our” refer to Carolina Financial Corporation and its consolidated subsidiaries and the “Bank” refers to CresCom Bank.

CresCom Bank provides a full range of commercial and retail banking financial services designed to meet the financial needs of our customers through its branch network in South Carolina and North Carolina. Crescent Mortgage Company, headquartered in Atlanta, Georgia, is primarily a correspondent/wholesale mortgage company approved to originate loans in 48 states partnering with community banks, credit unions and mortgage brokers. 

  

On March 18, 2017, the Company completed its acquisition of Greer Bancshares Incorporated (“Greer”), the holding company for Greer State Bank. The Company issued 1,789,523 shares of its common stock and paid $4.4 million in cash to Greer shareholders. In the transaction, the Company acquired $384.5 million in total assets, loans receivable of $194.6 million and deposits of $311.1 million. In addition, the Company assumed aggregate subordinated debt principal of $11.3 million, which at the date of acquisition had a fair value of $7.5 million.

 

On November 1, 2017, the Company completed its acquisition of First South Bancorp, Inc., the holding company for First South Bank (“First South”). In the transaction, the Company acquired $1.1 billion in total assets, loans receivable of $759.2 million and deposits of $952.6 million. The Company issued 4,822,540 shares of its common stock to First South shareholders. In addition, the Company assumed aggregate subordinated debt principal of $10.3 million, which at the date of acquisition had a fair value of $8.6 million.

 

On December 31, 2019, the Company completed its acquisition of Carolina Trust BancShares, Inc., the holding company for Carolina Trust Bank (“Carolina Trust”). In the transaction, the Company acquired $635.0 million of total assets, loans receivable of $481.0 million and deposits of $537.8 million. The Company issued 2,512,543 shares of its common stock to Carolina Trust shareholders. In addition, the Company assumed aggregated subordinated debt principal of $10.0 million, which at the date of acquisition had a fair value of $10.1 million.

 

As of December 31, 2019, the Company had total assets of $4.7 billion, loans receivable, net of $3.2 billion, total deposits of $3.4 billion, and total stockholders’ equity of $743.4 million.  

 

Our main office is located at 288 Meeting Street, Charleston, South Carolina 29401.

 

Pending Merger with and into United Bankshares, Inc.

 

On November 17, 2019, the Company announced the execution of an agreement and plan of merger by and between the Company and United Bankshares, Inc. (“United”), pursuant to which, subject to the terms and conditions set forth therein, the Company will merge with and into United, with United as the surviving corporation of the merger. The agreement provides that at the effective time of the merger, the Bank will merge with and into United Bank, a wholly-owned subsidiary of United Bank, with United Bank as the surviving entity. Pursuant to the merger agreement, each outstanding share of common stock of Carolina Financial will be converted into the right to receive 1.13 shares of United common stock, par value $2.50 per share, resulting in an aggregate transaction value of approximately $1.1 billion.

3
 

United’s and United Bank’s existing charters and bylaws will remain in place following the Merger and the Bank Merger.

 

Pursuant to the merger agreement, as of the effective time of the merger, each outstanding Company stock option, whether vested or unvested as of the date of the merger agreement, shall, at such option holder’s election, (i) vest and convert into an option to acquire United common stock adjusted based on the 1.13 exchange ratio, or (ii) be entitled to receive cash consideration equal to the difference between (a) the option’s exercise price and (b) the volume weighted average trading price over a specified period multiplied by the number of shares of Company common stock subject to such stock option. Also, at the effective time of the merger, each restricted stock grant, restricted stock unit grant or any other award of a share of Carolina Financial common stock subject to vesting, repurchase or other lapse restriction under a Company stock plan (other than a stock option) that is outstanding immediately prior to the effective time of the merger, will fully vest in accordance with the terms of the stock plan and at the election of the holder (i) convert into the right to receive shares of United common stock based on the 1.13 exchange ratio or (ii) convert into cash in an amount equal to the volume weighted average trading price of Company common stock over a specified period multiplied by the shares of Company common stock subject to the stock award. Consummation of the merger is subject to approval of the stockholders of United and Carolina Financial, the receipt of all required regulatory approvals, as well as other customary conditions.

 

The foregoing description of the merger agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the merger greement, a copy of which is filed as Exhibit 2.1 to this report and is incorporated herein by reference. The merger agreement has been attached as an exhibit to provide investors and security holders with information regarding its terms. It is not intended to provide any other financial information about the Company. The representations, warranties and covenants contained in the merger agreement were made only for purposes of that agreement and as of specific dates, are solely for the benefit of the parties to the merger greement, may be subject to limitations agreed upon by the parties, including being qualified by confidential disclosures made for the purposes of allocating contractual risk between the parties to the merger agreement instead of establishing these matters as facts, and may be subject to standards of materiality applicable to the parties that differ from those applicable to investors. Investors should not rely on the representations, warranties, or covenants or any description thereof as characterizations of the actual state of facts or condition of the Company. Moreover, information concerning the subject matter of the representations, warranties, and covenants may change after the date of the merger agreement, which subsequent information may or may not be fully reflected in public disclosures by the Company.

 

In connection with entering into the merger agreement, each of the directors of the Company have entered into a support agreement. The support agreements generally require that the stockholder party thereto vote all of his or her shares of the Company’s common stock in favor of the merger and, subject to specified exceptions, prohibit such stockholder from transferring his or her shares of Company common stock prior to the consummation of the merger. The support agreements will terminate upon the earlier of the consummation of the merger and the termination of the merger agreement in accordance with its terms. The foregoing description of the support agreements does not purport to be complete and is qualified in its entirety by reference to the form of support agreement included as Exhibit A to the merger agreement, which is filed as Exhibit 2.1 to this report and incorporated by reference herein.

 

United has filed a registration statement on Form S-4 with the SEC to register the shares of United’s common stock that will be issued to the Company’s stockholders in connection with the proposed merger. The definitive prospectus of United and joint proxy statement of United and the Company, filed on February 13, 2020 has been provided to the stockholders of each of United and the Company in connection with the proposed merger and is incorporated herein by reference. INVESTORS AND SECURITY HOLDERS ARE URGED TO READ THE REGISTRATION STATEMENT AND THE DEFINITIVE JOINT PROXY STATEMENT-PROSPECTUS (AND ANY OTHER DOCUMENTS FILED WITH THE SEC IN CONNECTION WITH THE PROPOSED MERGER OR INCORPORATED BY REFERENCE INTO THE JOINT PROXY STATEMENT-PROSPECTUS) BECAUSE SUCH DOCUMENTS CONTAIN IMPORTANT INFORMATION REGARDING THE PROPOSED MERGER. Investors and security holders may obtain free copies of these documents and other documents filed with the SEC on its website at www.sec.gov. Investors and security holders may also obtain free copies of the documents filed with the SEC by United on its website at www.ubsi-wv.com and by the Company on its website at www.haveanicebank.com.

 

This report does not constitute an offer to sell or the solicitation of an offer to buy any securities or a solicitation of any vote or approval. Before making any voting or investment decision, investors and security holders of United and the Company are urged to read carefully the entire registration statement and definitive joint proxy statement-prospectus, including any amendments thereto, because these documents contain important information about the proposed merger. Free copies of these documents may be obtained as described above.

 

United, the Company and certain of their directors and executive officers may be deemed participants in the solicitation of proxies from the stockholders of each of United and the Company in connection with the proposed merger. Information regarding the directors and executive officers of United and the Company and other persons who may be deemed participants in the solicitation of the stockholders of United or of the Company in connection with the proposed merger is included in the definitive joint proxy statement-prospectus for each of United’s and the Company’s special meeting of stockholders, which has been filed by United and the Company with the SEC. Information about the directors and officers of United and their ownership of United common stock can also be found in United’s definitive proxy statement in connection with its 2018 annual meeting of stockholders, as filed with the SEC on March 29, 2019, and other documents subsequently filed by United with the SEC. Information about the directors and officers of the Company and their ownership of the Company’s common stock can also be found in this Annual Report on Form 10-K, and other documents subsequently filed by the Company with the SEC. Additional information regarding the interests of such participants is included in the definitive prospectus and joint proxy statement and other relevant documents regarding the proposed merger filed with the SEC.

4
 

Available Information

 

We provide our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act on our website at www.haveanicebank.com under the “Investor Relations” section. These filings are made accessible as soon as reasonably practicable after they have been filed electronically with the Securities and Exchange Commission (the “SEC”). These filings are also accessible on the SEC’s website at www.sec.gov. In addition, we make available under the Investor Relations section on our website the following, among other things, (i) Code of Ethics and Whistleblower Policy and (ii) the charters of the Audit, Corporate Governance and Nominating and Compensation and Benefits Committees of our board of directors. These materials are available to the general public on our website free of charge. Printed copies of these materials are also available free of charge to shareholders who request them in writing. Please address your request to: Investor Relations, Attn: William A. Gehman III, Carolina Financial Corporation, 288 Meeting Street, Charleston, South Carolina 29401. Statements of beneficial ownership of equity securities filed by directors, officers, and 10% or greater stockholders under Section 16 of the Exchange Act are also available through our website. The information on our website is not incorporated by reference into this report.

 

Our Market Area

 

Our primary market areas are the Coastal, Midlands, and Upstate regions of South Carolina, including the Charleston (Charleston, Dorchester and Berkeley Counties), Myrtle Beach (Horry and Georgetown Counties), Columbia (Richland and Lexington Counties), and the Upstate (Greenville and Spartanburg Counties) market areas. Our primary market areas in North Carolina include Wilmington (New Hanover County), Raleigh-Durham (Durham and Wake Counties), Charlotte-Concord-Gastonia (NC and SC) and the southeastern coastal region of North Carolina (Bladen, Brunswick, Columbus, Cumberland, Duplin and Robeson Counties).

 

The following table presents, for each of our above-described primary market and reflecting the pro-forma franchise with acquired Carolina Trust branches, the number of branches of CresCom Bank, the approximate amount of deposits in the market areas as of June 30, 2019 and the approximate deposit market share in the market area at June 30, 2019 (the latest date for which such data is available).

 

   Number of   Deposits   Market 
Market Name  Branches   (in millions)   Share 
Charleston   8   $708    4.1%
Myrtle Beach   8   $436    4.7%
Midlands South Carolina   3   $137    1.6%
Upstate South Carolina   5   $315    2.4%
Inland North Carolina   9   $320    4.6%
Coastal North Carolina   4   $145    6.4%
Wilmington   3   $53    0.6%
Charlotte   12   $519    3.6%
Raleigh/Durham   2   $68    0.1%
Eastern NC   19   $627    4.8%
                

Our markets in or near Charleston, South Carolina are heavily influenced by the diverse economic mix of the Charleston region. The region is home to the Port of Charleston, one of the busiest container ports along the Southeast and Gulf Coasts, as well as a number of national and international manufacturers, including Boeing South Carolina and Robert Bosch LLC. The region also benefits from a thriving tourism industry. In addition, a number of academic institutions are located within the region, including the Medical University of South Carolina, The Citadel, The College of Charleston, Charleston Southern University, Trident Technical College and The Charleston School of Law. Charleston also hosts military installations for the U.S. Navy, Marine Corps, U.S. Air Force, U.S. Army and U.S. Coast Guard. Data obtained through SNL Financial LC projects population growth in the Charleston-North Charleston MSA of 7.65% from 2020 to 2025.

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The Myrtle Beach area, also known as the Grand Strand, is a 60-mile stretch of beaches extending south from the South Carolina/North Carolina state line to Pawley’s Island and is consistently ranked as one of the top vacation destinations in the country. According to data published by the Myrtle Beach Area Chamber of Commerce, Myrtle Beach hosted an estimated over 19 million visitors in 2019 with the economy of the region dominated by the tourism and retail industries. The Myrtle Beach-Conway-North Myrtle Beach MSA is also home to Coastal Carolina University in Conway and Webster University in Myrtle Beach. Data obtained through SNL Financial LC projects population growth in the Myrtle Beach-Conway-North Myrtle Beach MSA of 9.2% from 2020 to 2025.

 

The Midlands market includes branches in the Columbia, South Carolina market. Columbia, the state capital of South Carolina, is located within Richland County in the center of the state between the Upstate region and the coastal cities of Charleston and Myrtle Beach. Columbia’s central location has contributed greatly to its commercial appeal and growth, and the city benefits from a diverse economy composed of advanced manufacturing, healthcare, technology, shared services, logistics, and energy. The largest employers in the Columbia market area include the U.S. Army’s Fort Jackson, the University of South Carolina, Prisma Health (formerly Palmetto Health Alliance), Blue Cross Blue Shield, and Lexington Medical Center. Data obtained through SNL Financial LC projects population growth in the Columbia MSA of 5.5% from 2020 to 2025.

 

The Upstate market includes banking locations in the Greenville-Spartanburg market area. Major industries in the Upstate include the automobile industry, which is concentrated primarily along the corridor between Greenville and Spartanburg around the BMW manufacturing facility in Greer, South Carolina. The Greenville Health System and Bon Secours St. Francis Health System represent the healthcare and pharmaceuticals industry in the area. The Upstate is also home to significant private sector and university-based research including research and development facilities for Michelin, Fuji and General Electric and research centers to support the automotive, life sciences, plastics and photonics industries. The Upstate also benefits from being an academic center and is home to collegiate and university education facilities such as Clemson University, Furman University, Presbyterian College, University of South Carolina-Upstate, Anderson University, Lander University, Bob Jones University, Wofford College and Converse College, among others. Data obtained through SNL Financial LC projects population growth in the Greenville-Anderson MSA of 6.1% from 2020 to 2025.

 

The Raleigh/Durham area is among the most visited of the United States. The largest research park in the United States is situated between Durham and Raleigh and is home to more than 250 companies including IBM, GlaxoSmithKline and Cisco Systems. The area is also home to university and research facilities of Duke University and the University of North Carolina – Chapel Hill. Data obtained through SNL Financial LC projects population growth in the Raleigh-Cary and Durham-Chapel Hill MSAs of 7.7% and 6.2%, respectively, from 2020 to 2025.

 

Our Wilmington and other markets in southeastern North Carolina are contiguous to South Carolina and the Grand Strand. Wilmington has a diversified economy and is a major resort area and a center for light manufacturing. The city also serves as the retail and medical center for the region. Companies in the Wilmington area produce fiber optic cables for the communications industry, aircraft engine parts, pharmaceuticals, nuclear fuel components and various textile products. According to data published by the Wilmington Chamber of Commerce, major employers in the area include General Electric, PPD, Inc., and Corning, Inc. The area also benefits from the presence of the University of North Carolina-Wilmington, which is also a major employer for the market. Data obtained through SNL Financial LC projects population growth in the Wilmington MSA of 7.1% from 2020 to 2025.

 

The Charlotte-Concord-Gastonia (NC and SC) market includes branches acquired in the Carolina Trust acquisition that closed on December 31, 2019. The acquisition of Carolina Trust expanded the Company’s footprint to the Charlotte-Concord-Gastonia, NC-SC MSA with 11 banking locations and a loan production office, which complemented the Company’s de novo branch in the Charlotte market. Charlotte is one of the 25 largest cities in the U.S. and is the largest city in North Carolina. Charlotte is home to more than 10 Fortune 1000 companies including Bank of America, Wells Fargo, Belk, Shutterfly, Duke Energy, Lance and Nucor. Data obtained through SNL Financial LC projects population growth in the Charlotte-Concord-Gastonia MSA of 7.0% from 2020 to 2025.

 

Our markets have experienced steady economic and population growth over the past 10 years, and we expect that the areas, as well as the business and tourism industries needed to support it, will continue to grow.

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Competition

 

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

 

We compete with these institutions both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well-established, larger financial institutions, such as Bank of America, Wells Fargo, PNC and Truist.  These institutions offer some services, including extensive and established branch networks, that we do not provide.  In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks.

 

Lending Activities

 

General. We emphasize a range of lending services, including commercial and residential real estate mortgage loans, real estate construction loans, commercial and industrial loans, commercial leases, and consumer loans. Our customers are generally individuals and small to medium-sized businesses and professional firms that are located in or conduct a substantial portion of their business in our market areas. We have focused our lending activities primarily on the professional market, including small business to medium-sized owners and commercial real estate developers.

 

Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer lending limits, with approval processes for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds the maximum senior officer’s lending authority, the loan request will be considered by the management loan committee, or MLC, which is comprised of five members, all of whom are part of the senior management team of the Bank. The MLC meets weekly to approve loans with total loan commitment relationships generally exceeding $2.5 million. The loan authority of the MLC is equal to two-thirds of the legal lending limit of the Bank which is equivalent to the in-house loan limit. Total credit exposure above the in-house limit requires approval by the majority of the board of directors. We do not make any loans to any director, executive officer of the Bank, or the related interests of each, unless the loan is approved by the full Board of Directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.

 

Our lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. This legal lending limit will increase or decrease as the Bank’s level of capital increases or decreases. Based upon the capitalization of the Bank at December 31, 2019, the maximum amount we could lend to one borrower was $89.6 million. However, our internal lending limit without board of director approval at December 31, 2019 was $59.7 million. The board of directors will adjust the internal lending limit as deemed necessary to continue to mitigate risk and serve the Bank’s clients. We are able to sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.

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 The following is a description of the risk characteristics of the material loan portfolio segments:

 

Residential Mortgage Loans and Home Equity Loans. We generally originate and hold short-term and long-term first mortgages and traditional second mortgage residential real estate loans. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%. Loans over 80% LTV generally require private mortgage insurance. We offer fixed and adjustable rate residential real estate loans with terms of up to 30 years. We also offer a variety of lot loan options to consumers to purchase the lot on which they intend to build their home. The options available depend on whether the borrower intends to begin building within 12 months of the lot purchase or at an undetermined future date. We also offer traditional home equity loans and lines of credit. Our underwriting criteria for, and the risks associated with, home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity loans typically have terms of 10 years or less.

 

Commercial Real Estate. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, generally does not exceed 80%. We also generally require that a borrower’s cash flow exceed 120% of monthly debt service obligations. In order to ensure secondary sources of payment and liquidity to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.

 

Real Estate Construction and Development Loans. We offer fixed and adjustable rate residential and commercial construction loan financing to builders and developers and to consumers who wish to build their own home. The term of construction and development loans generally is limited to 18 months, although payments may be structured on a longer amortization basis. Most loans will mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the subsequent sale of the property. We attempt to reduce risk associated with construction and development loans by obtaining personal guarantees and by keeping the maximum loan-to-value ratio at or below 65%-80% of the lesser of cost or appraised value, depending on the project type. Generally, we do not have interest reserves built into loan commitments but require periodic cash payments for interest from the borrower’s cash flow.

 

Commercial Loans. We make loans for commercial purposes in various lines of businesses, including the manufacturing industry, service industry, and professional service areas. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate.

 

Equipment loans typically will be made for a term of 10 years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 75% of cost. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.

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The Company’s primary markets are generally concentrated in real estate lending. However, in order to diversify our lending portfolio, the Company purchases nationally syndicated commercial and industrial loans. These loans typically have terms of seven years and are generally tied to a floating rate index such as LIBOR or prime. To effectively manage this line of business, the Company has an experienced senior lending executive who leads a team with relevant experience to manage this area of this segment of the loan portfolio. In addition, the Company engaged a consulting firm that specializes in syndicated loans to assist in monitoring performance analytics. Syndicated loans are grouped within commercial business loans.

 

The Bank originates leases, primarily on equipment utilized for business purposes with terms that generally range from 12 to 60 months and include options to purchase the leased equipment at the end of the lease. Most leases provide 100% of the cost of the equipment and are secured by the leased equipment. The Company requires the leased equipment to be insured and that we be listed as a loss payee and named as an additional insured on the insurance policy. We manage credit risk associated with our lease financing loan class based upon the dollar amount of the lease and the level of credit risk. We follow a formal review process that entails analysis of the following factors: equipment value/residual value, exposure levels, jurisdiction risk, industry risk, guarantor requirements, and regulatory compliance. As of December 31, 2019 and December 31, 2018, there were approximately $16.8 million and $23.1 million in lease receivables outstanding. Lease receivables are grouped within commercial business loans. 

 

Consumer Loans. We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit. Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral. Consumer rates are both fixed and variable, with negotiable terms. Our installment loans typically amortize over periods up to 72 months. Although we typically require monthly payments of interest and a portion of the principal on our loan products, we will offer consumer loans with a single maturity date when a specific source of repayment is available. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.

 

Mortgage Operations

 

Mortgage Activities and Servicing. Our correspondent/wholesale mortgage banking operations are conducted through our mortgage origination subsidiary, Crescent Mortgage Company. Mortgage activities involve the purchase of mortgage loans and table funded originations for the purpose of generating gains on sales of loans and fee income on the origination of loans and is included in mortgage banking income in the accompanying consolidated statements of operations. While the Company originates residential one-to-four family loans that are held in its loan portfolio, the majority of new loans are generally sold pursuant to third-party market guidelines through Crescent Mortgage Company. Generally, residential mortgage loans are sold and, depending on the pricing in the marketplace, servicing rights are either sold or retained. The level of loan sale activity and its contribution to the Company’s profitability depends on maintaining a sufficient volume of loan originations and margin. Changes in the level of interest rates and the local economy affect the volume of loans originated by the Company and the amount of loan sales and loan fees earned.

 

Loan Servicing. We retain the rights to service a portion of the loans we sell on the third-party market, as part of our mortgage banking activities, for which we receive service fee income. In addition, at certain times we may purchase rights to service from third parties. These rights are known as mortgage servicing rights, or MSRs, where the owner of the MSR acts on behalf of the mortgage loan owner and has the contractual right to receive a stream of cash flows in exchange for performing specified mortgage servicing functions. These duties typically include, but are not limited to, performing loan administration, collection, and default activities, including the collection and remittance of loan payments, responding to customer inquiries, accounting for principal and interest, holding custodial (impound) funds for the payment of property taxes and insurance premiums, counseling delinquent mortgagors, modifying loans and supervising foreclosures and property dispositions. We subservice the duties and responsibilities obligated to the owner of the MSR to a third party provider for which we pay a fee.

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Deposit Products

  

We provide a range of deposit services, including noninterest-bearing demand accounts, interest-bearing demand and savings accounts, money market accounts and time deposits. These accounts generally pay interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Deposits continue to be our primary funding source. At December 31, 2019, deposits totaled $3.4 billion, an increase from deposits of $2.7 billion at December 31, 2018. Excluding the impact of deposits acquired from Carolina Trust, deposits increased $152.4 million since December 31, 2018. The increase in deposits since December 31, 2018 relates to continued efforts to fund our balance sheet growth with core deposits through business development.

 

Emerging Growth Company

 

On December 31, 2018, our status as an “emerging growth company”, as defined in the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), terminated because the market value of our common stock held by non-affiliates exceeded $700 million on June 30, 2018.  As an “emerging growth company,” we took advantage of some reduced disclosure and other requirements that were otherwise applicable generally to public companies.  With the filing of the 2018 Form 10-K, we began providing the information required from “large accelerated filers” as defined in Rule 12b-2 under the Exchange Act in periodic reports required under the Exchange Act. As a result, the information that we provided to our stockholders prior to the 2018 Form 10-K may be different from the information provided by other public reporting companies. 

 

Employees

 

As of February 20, 2020, we had 880 total employees, including 836 full-time employees. 

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SUPERVISION AND REGULATION

 

Both the Company and the Bank are subject to extensive state and federal banking laws and regulations that impose restrictions on and provide for general regulatory oversight of their operations.  These laws and regulations generally are intended to protect consumers and depositors and not stockholders.  The following summary is qualified by reference to the statutory and regulatory provisions discussed.  Changes in applicable laws or regulations may have a material effect on our business and prospects.  Our operations may be affected by legislative changes and the policies of various regulatory authorities.  We cannot predict the effect that fiscal or monetary policies, economic control or new federal or state legislation may have on our business and earnings in the future.

 

The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of those laws and regulations on our operations.  It is intended only to briefly summarize some material provisions.

 

Recent Legislative and Regulatory Initiatives

 

Banking statutes, regulations and policies are continually under review by Congress, state legislatures and federal and state regulatory agencies. In addition to laws and regulations, state and federal bank regulatory agencies may issue policy statements, interpretive letters and similar written guidance applicable to the Company and its subsidiaries. Any change in the statutes, regulations and regulatory policies applicable to us, including changes in their interpretation or implementation, could have a material effect on our business and organization.

 

Both the scope of the laws and regulations and the intensity of supervision to which we are subject have increased in recent years in response to the financial crisis, as well as other factors such as technological and market changes. Regulatory enforcement and fines have also increased across the banking and financial services sector. Many of these changes have occurred as a result of the Dodd-Frank Act and its implementing regulations, most of which are now in place. The Company expects that its business will remain subject to extensive regulation and supervision.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed into law in 2010 (the “Dodd-Frank Act”), among other things, changes the oversight and supervision of financial institutions, includes new minimum capital requirements, creates a new federal agency to regulate consumer financial products and services and implements changes to corporate governance and compensation practices. The Dodd-Frank Act is focused in large part on the financial services industry, and contains a number of provisions that will affect us, including:

 

Minimum Leverage and Risk-Based Capital Requirements. Under the Dodd-Frank Act, the Federal banking agencies are required to establish minimum leverage and risk-based capital requirements on a consolidated basis for all insured depository institutions and bank holding companies, which can be no less than the currently applicable leverage and risk-based capital requirements for depository institutions. As a result, the Bank will be subject to at least the same capital requirements and must include the same components in regulatory capital.

 

Deposit Insurance Modifications. The Dodd-Frank Act modified the FDIC’s assessment base upon which deposit insurance premiums are calculated. The new assessment base equals our average total consolidated assets minus the sum of our average tangible equity during the assessment period. The Dodd-Frank Act also permanently raised the standard maximum insurance amount to $250,000.

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Creation of New Governmental Authorities. The Dodd-Frank Act created various new governmental authorities such as the Financial Stability Oversight Council and the Consumer Financial Protection Bureau (the “CFPB”), an independent regulatory authority housed within the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The CFPB has broad authority to regulate the offering and provision of consumer financial products. The CFPB officially came into being on July 21, 2011, and rulemaking authority for a range of consumer financial protection laws (such as the Truth in Lending Act, the Electronic Funds Transfer Act and the Real Estate Settlement Procedures Act, among others) transferred from the Federal Reserve and other federal regulators to the CFPB on that date. The Dodd-Frank Act gives the CFPB authority to supervise and examine depository institutions with more than $10 billion in assets for compliance with these federal consumer laws. The authority to supervise and examine depository institutions with $10 billion or less in assets for compliance with federal consumer laws will remain largely with those institutions’ primary regulators. However, the CFPB may participate in examinations of these smaller institutions on a “sampling basis” and may refer potential enforcement actions against such institutions to their primary regulators. The CFPB also has supervisory and examination authority over certain nonbank institutions that offer consumer financial products. The Dodd-Frank Act identifies a number of covered nonbank institutions, and also authorizes the CFPB to identify additional institutions that will be subject to its jurisdiction. Accordingly, the CFPB may participate in examinations of the Bank, which currently has assets of less than $10 billion, and could supervise and examine our other direct or indirect subsidiaries that offer consumer financial products or services. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the CFPB, and state attorneys general are permitted to enforce consumer protection rules adopted by the CFPB against certain institutions.

 

The Dodd-Frank Act also authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay. Under the Dodd-Frank Act, financial institutions may not make a residential mortgage loan unless they make a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure but provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” On January 10, 2013, the CFPB published final rules to, among other things, specify the types of income and assets that may be considered in the ability-to-repay determination, the permissible sources for verification, and the required methods of calculating the loan’s monthly payments. Since then the CFPB made certain modifications to these rules. The rules extend the requirement that creditors verify and document a borrower’s “income and assets” to include all “information” that creditors rely on in determining repayment ability. The rules also provide further examples of third-party documents that may be relied on for such verification, such as government records and check-cashing or funds-transfer service receipts. The rules took effect January 10, 2014. The rules also define “qualified mortgages,” imposing both underwriting standards - for example, a borrower’s debt-to-income ratio may not exceed 43% - and limits on the terms of their loans. Points and fees are subject to a relatively stringent cap, and the terms include a wide array of payments that may be made in the course of closing a loan. Certain loans, including interest-only loans and negative amortization loans, cannot be qualified mortgages.

 

Executive Compensation and Corporate Governance Requirements. The Dodd-Frank Act requires public companies to include, at least once every three years, a separate non-binding “say on pay” vote in their proxy statement by which stockholders may vote on the compensation of the company’s named executive officers. In addition, if such companies are involved in a merger, acquisition, or consolidation, or if they propose to sell or dispose of all or substantially all of their assets, stockholders have a right to an advisory vote on any golden parachute arrangements in connection with such transaction (frequently referred to as “say-on-golden parachute” vote). Other provisions of the Dodd-Frank Act may impact our corporate governance. For instance, the Dodd-Frank Act requires the SEC to adopt rules:

 

  · prohibiting the listing of any equity security of a company that does not have an independent compensation committee; and
  · requiring all exchange-traded companies to adopt claw-back policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.

 

The Dodd-Frank Act also authorizes the SEC to issue rules allowing stockholders to include their own nominations for directors in a company’s proxy solicitation materials. Many provisions of the Dodd-Frank Act require the adoption of additional rules to implement the changes. In addition, the Dodd-Frank Act mandates multiple studies that could result in additional legislative action. Governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

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Regulatory Capital Requirements

 

Regulatory capital rules released by the federal bank regulatory agencies in July 2013 and fully-phased in as of January 1, 2019, referred to as Basel III, impose higher minimum capital requirements for bank holding companies and banks. The Basel III rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies with more than $1 billion in total consolidated assets. We collectively refer to these organizations herein as “covered” banking organizations. In certain respects, the rules impose more stringent requirements on “advanced approaches” banking organizations—those organizations with $250 billion or more in total consolidated assets, $10 billion or more in total foreign exposures, or that have opted in to the Basel II capital regime.

 

Specifically, we are required to maintain the following minimum capital levels:

 

  · a Common Equity Tier 1 (“CET1”) risk-based capital ratio of 4.5%;
  · a Tier 1 risk-based capital ratio of 6%;
  · a total risk-based capital ratio of 8%; and
  · a leverage ratio of 4%.

 

Under Basel III, Tier 1 capital is redefined to include two components: CET1 capital and additional Tier 1 capital. The new and highest form of capital, CET1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital is primarily comprised of non-cumulative perpetual preferred stock, Tier 1 minority interests and grandfathered trust preferred securities. The rules permit bank holding companies with less than $15 billion in total consolidated assets to continue to include trust preferred securities and cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not in CET1 capital, subject to certain restrictions. Tier 2 capital generally includes the allowance for loan losses up to 1.25% of risk-weighted assets, qualifying preferred stock, subordinated debt and qualifying Tier 2 minority interests, less any deductions in Tier 2 instruments of an unconsolidated financial institution. Cumulative perpetual preferred stock is included only in Tier 2 capital. Accumulated other comprehensive income (“AOCI”) is presumptively included in CET1 capital and often would operate to reduce this category of capital. The rules provided for a one-time opportunity at the end of the first quarter of 2015 for covered banking organization to opt-out of much of this treatment of AOCI. We made this opt-out election and, as a result, will retain the pre-existing treatment for AOCI.

 

In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three measurements (CET1 capital, Tier 1 capital and total capital). The capital conservation buffer was phased in incrementally over time, becoming fully effective on January 1, 2019, and consists of an additional amount of common equity equal to 2.5% of risk-based assets.

 

On December 21, 2018, the federal banking agencies issued a joint final rule to revise their regulatory capital rules to (i) address the upcoming implementation of a new credit impairment model, the Current Expected Credit Loss, or CECL model, and accounting standard under GAAP; (ii) provide an optional three-year phase-in period for the day-one adverse regulatory capital effects that banking organizations are expected to experience upon adopting CECL; and (iii) reduce the use of CECL in stress tests beginning with the 2020 capital planning and stress testing cycle for certain banking organizations that are subject to stress testing. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first quarter of 2020, the first reporting period in which the new standard is effective.

 

In November 2019, the federal banking regulators published final rules implementing a simplified measure of capital adequacy for certain banking organizations that have less than $10 billion in total consolidated assets. Under the final rules, which went into effect on January 1, 2020, depository institutions and depository institution holding companies that have less than $10 billion in total consolidated assets and meet other qualifying criteria, including a leverage ratio of greater than 8%, off-balance-sheet exposures of 25% or less of total consolidated assets and trading assets plus trading liabilities of 5% or less of total consolidated assets, are deemed “qualifying community banking organizations” and are eligible to opt into the “community bank leverage ratio framework.” A qualifying community banking organization that elects to use the community bank leverage ratio framework and that maintains a leverage ratio of greater than 9% is considered to have satisfied the generally applicable risk-based and leverage capital requirements under the Basel III rules and, if applicable, is considered to have met the “well capitalized” ratio requirements for purposes of its primary federal regulator’s prompt corrective action rules, discussed below. The final rules include a two-quarter grace period during which a qualifying community banking organization that temporarily fails to meet any of the qualifying criteria, including the greater-than-9% leverage ratio requirement, is generally still deemed “well capitalized” so long as the banking organization maintains a leverage capital ratio greater than 8%. A banking organization that fails to maintain a leverage capital ratio greater than 8% is not permitted to use the grace period and must comply with the generally applicable requirements under the Basel III rules and file the appropriate regulatory reports. We do not have any immediate plans to elect to use the community bank leverage ratio framework but may make such an election in the future.

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Volcker Rule

 

Section 619 of the Dodd-Frank Act, known as the “Volcker Rule,” prohibits any bank, bank holding company, or affiliate (referred to collectively as “banking entities”) from engaging in two types of activities: “proprietary trading” and the ownership or sponsorship of private equity or hedge funds that are referred to as “covered funds.” Proprietary trading includes the purchase or sale of principal of any security, derivative, commodity future, or option on any such instrument for the purpose of benefitting from short-term price movements or realizing short-term profits. In December 2013, our primary federal regulators, the Federal Reserve and the FDIC, together with other federal banking agencies and the SEC and the Commodity Futures Trading Commission, finalized a regulation to implement the Volcker Rule.

 

Exceptions apply, however. Trading in U.S. Treasuries, obligations or other instruments issued by a government sponsored enterprise, state or municipal obligations, or obligations of the FDIC is permitted. A banking entity also may trade for the purpose of managing its liquidity, provided that it has a bona fide liquidity management plan. Trading activities as agent, broker or custodian; through a deferred compensation or pension plan; as trustee or fiduciary on behalf of customers; in order to satisfy a debt previously contracted; or in repurchase and securities lending agreements are permitted. Additionally, the Volcker Rule permits banking entities to engage in trading that takes the form of risk-mitigating hedging activities.

 

The covered funds that a banking entity may not sponsor or hold an ownership interest in are, with certain exceptions, funds that are exempt from registration under the Investment Company Act of 1940 because they either have 100 or fewer investors or are owned exclusively by “qualified investors” (generally, high net worth individuals or entities). Wholly-owned subsidiaries, joint ventures and acquisition vehicles, foreign pension or retirement funds, insurance company separate accounts (including bank-owned life insurance), public welfare investment funds, and entities formed by the FDIC for the purpose of disposing of assets are not covered funds, and a bank may invest in them. Most securitizations also are not treated as covered funds.

 

As issued on December 10, 2013, the regulation treated collateralized debt obligations backed by trust preferred securities as covered funds and accordingly subject to divestiture. In an interim final rule issued on January 14, 2014, the agencies exempted collateralized debt obligations, or CDOs, issued before May 19, 2010, that were backed by trust preferred securities issued before the same date by a bank with total consolidated assets of less than $15 billion or by a mutual holding company, and that the bank holding the CDO interest had purchased before December 10, 2013, from the Volcker Rule prohibition. This exemption does not extend to CDOs backed by trust-preferred securities issued by an insurance company.

 

Tax Cuts and Jobs Act

 

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

 

  · Tax Rate. The Tax Act replaces the graduated corporate tax rates applicable under prior law, which imposed a maximum tax rate of 35%, with a reduced 21% flat tax rate. Although the reduced tax rate generally should be favorable to us by resulting in increased earnings and capital, it will decrease the value of our existing deferred tax assets. Generally accepted accounting principles (“GAAP”) require that the impact of the provisions of the Tax Act be accounted for in the period of enactment. Accordingly, the Company’s net income for the year ended December 31, 2017 was reduced by approximately $239,000, primarily due to a lower valuation of deferred income taxes. See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operation – Results of Operations – Income Tax Expense.

 

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

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

 

  · Interest Expense. The Tax Act limits a taxpayer’s annual deduction of business interest expense to the sum of (i) business interest income and (ii) 30% of “adjusted taxable income,” defined as a business’s taxable income without taking into account business interest income or expense, net operating losses, and, for 2018 through 2021, depreciation, amortization and depletion. Because we generate significant amounts of net interest income, we do not expect to be impacted by this limitation.

 

Proposed Legislation and Regulatory Action

 

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.

 

On May 24, 2018, President Trump signed into law the “Economic Growth, Regulatory Relief and Consumer Protection Act” (the “Regulatory Relief Act”), which amends parts of the Dodd-Frank Act, as well as other laws that involve regulation of the financial industry. While the Regulatory Relief Act keeps in place fundamental aspects of the Dodd-Frank Act’s regulatory framework, it does change the regulatory framework for depository institutions with assets under $10 billion, such as the Bank, and for large depository institutions with assets over $50 billion. The legislation includes a number of provisions which are favorable to bank holding companies with total consolidated assets of less than $10 billion, such as the Company, and also makes changes to consumer mortgage and credit reporting regulations and to the authorities of the agencies that regulate the financial industry. A number of the provisions included in the Regulatory Relief Act require the federal banking agencies to either promulgate regulations or amend existing regulations, and it will likely take some time for these agencies to implement the necessary changes.

 

The following is a brief summary of select provisions of the Regulatory Relief Act.

 

  · Modified Process for Designating Systemically Important Financial Institutions. The Regulatory Relief Act changes which bank holding companies will be designated as a systemically important financial institution (“SIFI”). Prior to passage of the Regulatory Relief Act, all bank holding companies with assets exceeding $50 billion were automatically designated as SIFIs and were subject to the enhanced prudential standards (“EPS”) of the Dodd-Frank Act, which required these bank holding companies to undergo special stress tests, develop resolution plans, and maintain certain levels of liquidity and financial capacity to absorb losses. The Regulatory Relief Act raised the $50 billion SIFI threshold to $250 billion, but staggered the application of this change for certain institutions, based on size. Upon enactment, bank holding companies with total consolidated assets of less than $100 billion are no longer subject to the EPS of the Dodd-Frank Act. Bank holding companies with total consolidated assets of more than $100 billion but less than $250 billion will no longer be subject to such requirements, beginning 18 months after the date of enactment. Because the Regulatory Relief Act does not amend the regulations that the federal banking agencies have promulgated to implement the EPS, it will likely take some time for these agencies to amend their regulations to account for the new thresholds included in the Regulatory Relief Act.

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Many of the changes in the Regulatory Relief Act amend provisions of Dodd-Frank Act that apply at the bank holding company level, but not to subsidiary national banks or other insured depository institutions. The Office of the Comptroller of the Currency, or the OCC, and the FDIC have adopted their own counterparts to some EPS for the bank subsidiaries that they regulate, including recovery and resolution planning. The OCC and the FDIC will need to address whether they intend to take similar measures under their regulations and guidance to align asset thresholds with what is reflected in the Regulatory Relief Act.

 

  · Provisions that are Favorable to Regional Banks. There are a number of provisions in the Regulatory Relief Act that will have a favorable impact on community banks such as the Bank. These are briefly referenced below.

 

  o Elimination of Company-Run Stress Tests. The Regulatory Relief Act exempts all banking organizations with less than $250 billion in total consolidated assets from the current requirement to conduct company-run stress tests.

 

  o Increase in Asset Threshold for Requirement to Establish a Risk Committee. The Regulatory Relief Act raises the asset threshold for the requirement that a publicly-traded bank holding company establish a risk committee from $10 billion to $50 billion or more in total consolidated assets.

 

  o Short Form Call Reports. The Regulatory Relief Act requires the federal banking agencies to promulgate regulations allowing an insured depository institution with less than $5 billion in total consolidated assets (and that satisfies such other criteria as determined to be appropriate by the agencies) to submit a short-form call report for its first and third quarters of a calendar year.

 

  · Consumer Protection Enhancements. The Regulatory Relief Act includes various provisions to address consumer protection challenges facing the credit reporting industry and borrowers in certain credit markets, specifically markets including active duty service members, veterans, and student loan borrowers. The Regulatory Relief Act subjects credit reporting agencies to additional requirements, including requirements to generally provide fraud alerts for consumer files for at least one year and to allow consumers to place security freezes on their credit reports. The Regulatory Relief Act also allows consumers to request that information related to a default on a qualified private student loan be removed from a credit report if the borrower satisfies the requirements of a loan rehabilitation program offered by a private lender. The Regulatory Relief Act prohibits lenders from declaring automatic default in the case of death or bankruptcy of the co-signer of a student loan and requires lenders to release cosigners from obligations related to a student loan in the event of the death of the student borrower. In addition, credit reporting agencies will be required to exclude certain medical debt from veterans’ credit reports.

 

Carolina Financial Corporation

 

The Company owns 100% of the outstanding capital stock of the Bank, and therefore is required to be and is registered as a bank holding company under the federal Bank Holding Company Act of 1956 (the “BHCA”). As a result, the Company is primarily subject to the supervision, examination and reporting requirements of the Federal Reserve under the BHCA and its regulations promulgated thereunder. Moreover, as a bank holding company of a bank located in South Carolina, the Company also is subject to the South Carolina Banking and Branching Efficiency Act.

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Permitted Activities. Under the BHCA, a bank holding company is generally permitted to engage in, or acquire direct or indirect control of more than 5% of the voting shares of any company engaged in the following activities:

 

  · banking or managing or controlling banks;
  · furnishing services to or performing services for our subsidiaries; and
  · any activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

 

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

 

  · factoring accounts receivable;
  · making, acquiring, brokering or servicing loans and usual related activities;
  · leasing personal or real property;
  · operating a non-bank depository institution, such as a savings association;
  · trust company functions;
  · financial and investment advisory activities;
  · conducting discount securities brokerage activities;
  · underwriting and dealing in government obligations and money market instruments;
  · providing specified management consulting and counseling activities;
  · performing selected data processing services and support services;
  · acting as agent or broker in selling credit life insurance and other types of insurance in connection with credit transactions; and
  · performing selected insurance underwriting activities.

 

A bank holding company that meets specified conditions, including that its depository institutions subsidiaries are “well capitalized” and “well managed,” can opt to become a “financial holding company.” On June 20, 2017, an election submitted by the Company to become a financial holding company was declared effective by the Federal Reserve Bank of Richmond. As a financial holding company, we are now permitted to engage in a broader array of activities that are financial in nature or incidental or complimentary to financial activities, including insurance underwriting, sales and brokerage activities, providing financial and investment advisory services, underwriting services and limited merchant banking activities.

 

The Federal Reserve has the authority to order a bank holding company or its subsidiaries to terminate any of these activities or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that the bank holding company’s continued ownership, activity or control constitutes a serious risk to the financial safety, soundness or stability of it or any of its bank subsidiaries.

 

Change in Control. Two statutes, the BHCA and the Change in Bank Control Act (the “CBCA”), together with regulations promulgated under them, require some form of regulatory review before any company may acquire “control” of a bank or a bank holding company. Under the BHCA, control is deemed to exist if a company acquires 25% or more of any class of voting securities of a bank holding company; controls the election of a majority of the members of the board of directors; or exercises a controlling influence over the management or policies of a bank or bank holding company. In guidance issued in 2008, the Federal Reserve has stated that it would not expect control to exist if a person acquires, in aggregate, less than 33% of the total equity of a bank or bank holding company (voting and nonvoting equity), provided such person’s ownership does not include 15% or more of any class of voting securities. Prior Federal Reserve approval is necessary before an entity acquires sufficient control to become a bank holding company. Natural persons, certain non-business trusts, and other entities are not treated as companies (or bank holding companies), and their acquisitions are not subject to review under the BHCA. State laws generally, including South Carolina law, require state approval before an acquirer may become the holding company of a state bank.

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Under the CBCA, a person or company is required to file a notice with the Federal Reserve if it will, as a result of the transaction, own or control 10% or more of any class of voting securities or direct the management or policies of a bank or bank holding company and either if the bank or bank holding company has registered securities or if the acquirer would be the largest holder of that class of voting securities after the acquisition. For a change in control at the holding company level, both the Federal Reserve and the subsidiary bank’s primary federal regulator must approve the change in control; at the bank level, only the bank’s primary federal regulator is involved. Transactions subject to the BHCA are exempt from CBCA requirements. For state banks, state laws, including that of South Carolina, typically require approval by the state bank regulator as well.

 

Source of Strength. There are a number of obligations and restrictions imposed by law and regulatory policy on bank holding companies with regard to their depository institution subsidiaries that are designed to minimize potential loss to depositors and to the FDIC insurance funds in the event that the depository institution becomes in danger of defaulting under its obligations to repay deposits. In accordance with Federal Reserve policy, the Company is required to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances in which it might not otherwise do so. Under the Federal Deposit Insurance Corporate Improvement Act of 1991, or FDICIA, to avoid receivership of its insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” within the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.

 

Under the BHCA, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary, other than a non-bank subsidiary of a bank, upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of a bank holding company. Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or non-bank subsidiaries if the agency determines that divestiture may aid the depository institution’s financial condition.

 

In addition, the “cross guarantee” provisions of the Federal Deposit Insurance Act, (“FDIA”), require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company, but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

 

The FDIA also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general or unsecured senior liability, subordinated liability, general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of the Bank.

 

Further, any capital loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level would be assumed by the bankruptcy trustee and entitled to priority payment.

 

Capital Requirements. The Federal Reserve imposes certain capital requirements on the bank holding company under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are essentially the same as those that apply to the Bank and are described below under “CresCom Bank.” Subject to our capital requirements and certain other restrictions, we are able to borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company. We are also able to raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

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Dividends. Since the Company is a bank holding company, its ability to declare and pay dividends is dependent on certain federal and state regulatory considerations, including the guidelines of the Federal Reserve. The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the Federal Reserve’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Further, under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.

 

In addition, since the Company is a legal entity separate and distinct from the Bank and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of the Bank to pay dividends to it, which is also subject to regulatory restrictions as described below in “CresCom Bank – Dividends.”

 

South Carolina State Regulation. As a South Carolina bank holding company under the South Carolina Banking and Branching Efficiency Act, we are subject to limitations on sale or merger and to regulation by the South Carolina Board of Financial Institutions (the “SCBFI”). We are not required to obtain the approval of the SCBFI prior to acquiring the capital stock of a national bank, but we must notify them at least 15 days prior to doing so. We must obtain approval from the SCBFI prior to engaging in the acquisition of branches, a South Carolina state chartered bank, or another South Carolina bank holding company.

 

CresCom Bank

 

The Bank’s primary federal regulator is the FDIC. In addition, the Bank is regulated and examined by the SCBFI. Deposits in the Bank are insured by the FDIC up to a maximum amount of $250,000 per depositor, per ownership category, pursuant to the provisions of the Dodd-Frank Act.

 

The SCBFI and the FDIC regulate or monitor virtually all areas of the Bank’s operations, including:

 

  · security devices and procedures;
  · adequacy of capitalization and loss reserves;
  · loans;
  · investments;
  · borrowings;
  · deposits;
  · mergers;
  · issuances of securities;
  · payment of dividends;
  · interest rates payable on deposits;
  · interest rates or fees chargeable on loans;
  · establishment of branches;
  · corporate reorganizations;
  · maintenance of books and records; and
  · adequacy of staff training to carry on safe lending and deposit gathering practices.

 

These agencies, and the federal and state laws applicable to the Bank’s operations, extensively regulate various aspects of our banking business, including among other things, permissible types and amounts of loans, investments, and other activities, capital adequacy, branching, interest rates on loans and deposits, maintenance of reserves and the safety and soundness of our banking practices. See additional discussion related to Basel III above.

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All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:

 

  · internal controls;
  · information systems and audit systems;
  · loan documentation;
  · credit underwriting;
  · interest rate risk exposure; and
  · asset quality.

 

Prompt Corrective Action. As an insured depository institution, the Bank is required to comply with the capital requirements promulgated under the Federal Deposit Insurance Act and the prompt corrective action regulations thereunder, which set forth five capital categories, each with specific regulatory consequences. Under these regulations, the categories are:

 

  · Well Capitalized — The institution exceeds the required minimum level for each relevant capital measure.  A well capitalized institution (i) has a total risk-based capital ratio of 10% or greater, (ii) has a Tier 1 risk-based capital ratio of 8% or greater, (iii) has a CET 1 risk-based capital ratio of 6.5% or greater, (iv) has a leverage ratio of 5% or greater, and (v) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.
  · Adequately Capitalized — The institution meets the required minimum level for each relevant capital measure.  No capital distribution may be made that would result in the institution becoming undercapitalized.  An adequately capitalized institution (i) has a total risk-based capital ratio of 8% or greater, (ii) has a Tier 1 risk-based capital ratio of 6% or greater, (iii) has a CET 1 risk-based capital ratio of 4.5% or greater, and (iv) has a leverage ratio of 4% or greater.
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