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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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(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, 2002
[ ] 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 000-31825
HERITAGE FINANCIAL HOLDING CORPORATION
(Exact name of registrant specified in its charter)
Delaware 63-1259533
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1323 Stratford Road 35601
Decatur, Alabama (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (256) 355-9500
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Common Stock -- Par Value $0.01 Per Share
(Title of Class)
Indicate by a check mark whether 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, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by a check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X]
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates computed by reference to the price at which the common
equity was last sold, or the average bid and asked price of such common equity,
as of the last business day of the registrant's most recently completed second
fiscal quarter. Common Stock, par value $0.01 per share -- $42,141,554.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock as of March 24, 2003. Common Stock, par value $0.01 per
share -- 9,113,122 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the annual meeting of
stockholders on May 20, 2003 incorporated by reference into Part III.
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HERITAGE FINANCIAL HOLDING CORPORATION
2002 FORM 10-K ANNUAL REPORT
Table of Contents
PART I............................................................................................................1
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS.........................................................1
RISK FACTORS...................................................................................................2
ITEM 1. BUSINESS........................................................................................3
ITEM 2. PROPERTIES.....................................................................................14
ITEM 3. LEGAL PROCEEDINGS..............................................................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................14
PART II..........................................................................................................14
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS......................14
ITEM 6. SELECTED FINANCIAL DATA........................................................................17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..........18
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................40
ITEM 8. FINANCIAL STATEMENTS...........................................................................40
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...........83
PART III.........................................................................................................83
ITEM 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT;
EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS; AND CERTAIN RELATIONSHIPS
AND RELATED TRANSACTIONS........................................................................83
ITEM 14. CONTROLS AND PROCEDURES........................................................................84
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K...............................85
EXHIBIT 11 - STATEMENTS RE: COMPUTATION OF PER SHARE EARNINGS..........................................102
EXHIBIT 12 - STATEMENTS RE: COMPUTATION OF RATIOS......................................................103
EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT............................................................104
EXHIBIT 24 - POWER OF ATTORNEY.........................................................................105
EXHIBIT 99.1 - CERTIFICATION OF PRESIDENT AND CEO......................................................107
EXHIBIT 99.2- CERTIFICATION OF CHIEF FINANCIAL OFFICER.................................................108
PART I
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report and documents incorporated by reference herein, may
contain certain statements relating to our future results based on information
currently available. The presentations, and certain of the other disclosures in
this Annual Report, including any statements preceded by, followed by or which
include the words, "may," "could," "should," "will," "would," "believe,"
"expect," "anticipate," "estimate," "intend," "plan," "assume," or similar
expressions, constitute forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended. These forward looking
statements, implicitly and explicitly, include the assumptions underlying the
statements and other information with respect to our beliefs, plans, objectives,
goals, expectations, anticipations, estimates, intentions, financial condition,
results of operations, future performance and business, including our
expectations and estimates with respect to our revenues, expenses, return on
equity, return on assets, efficiency ratio, asset quality and other financial
data and capital and performance ratios.
Although we believe that the expectations reflected in our forward-looking
statements are reasonable, these statements involve risks and uncertainties
which are subject to change based on various important factors (some of which
are beyond our control). The following factors, among others, could cause our
financial performance to differ materially from our goals, plans, objectives,
intentions, expectations, and other forward-looking statements: (1) the extent
to which we are able to achieve and maintain certain capital ratios at the
Company and the Bank, as well as the effects of the inability or failure to
achieve such ratios; (2) the effects of certain operating restrictions on the
Company and the Bank, including, without limitation, the ability to declare or
pay dividends without prior regulatory approval; (3) the strength of the United
States economy in general and the strength of the regional and local economics
in which we conduct operations; (4) the effects of, and changes in, trade,
monetary and fiscal policies and laws, including interest rate policies of the
Board of Governors of the Federal Reserve System; (5) inflation, interest rate,
market and monetary fluctuations; (6) our timely development of new products and
services to a changing environment, including the features, pricing and quality
compared to the products and services of our competitors; (7) the willingness of
users to substitute competitors' products and services for our products and
services; (8) the impact of changes in financial services policies, laws and
regulations, including laws, regulations and policies concerning taxes, banking,
securities and insurance, and the application thereof by regulatory bodies; (9)
technological changes; (10) changes in consumer spending and savings habits;
(11) regulatory or judicial proceedings; and (12) the declaration of war and the
commencement of hostilities in Iraq and elsewhere. We also direct your attention
to the Risk Factors discussed immediately following this section under the
heading "Risk Factors."
If one or more of the factors affecting our forward-looking information and
statements proves incorrect, then our actual results, performance or
achievements could differ materially from those expressed in, or implied by
forward-looking information and statements contained in this Annual Report. We
do not intend to update or revise our forward-looking information and
statements, whether written or oral, to reflect any changes. All forward-looking
statements attributable to us are expressly qualified by these cautionary
statements.
1
RISK FACTORS
The Company and the Bank are Restricted from Certain Activities Including
Payment of Dividends to Stockholders.
During 2002, management of the Company identified significant operational
and asset quality deficiencies at the Bank. These deficiencies resulted in
material increases to the Bank's loan loss reserves, resulting in material
reductions in the capital levels of the Company and the Bank. As a result, the
Board of Directors and management of the Company and the Bank have identified
specific corrective steps and actions to address capital deficiencies, improve
asset quality, and enhance operational controls and procedures. The Bank,
without the prior written approval of its regulators, may not declare or pay any
cash dividends. In addition, the Bank has determined to hire and retain certain
personnel who have been given specific written authority by the Board of
Directors to implement sound lending, recordkeeping and accounting practices.
The Bank also has taken steps to develop an educational program for board
members and to create a written review of the Bank's staffing requirements. The
Board of Directors of the Company intends to cause management of the Company and
the Bank to take steps to attain and maintain a Tier 1 leverage ratio of 8
percent and to be "well-capitalized" as defined by the FDIC by March 31, 2003.
Should the Tier 1 leverage ratio fail to meet the specified Tier 1 leverage
ration of 8 percent or subsequently fall below such level, the Bank must notify
the regulatory authorities and take steps to increase capital sufficient to meet
the required ratios within 30 days.
If the quality of the Company's assets does not improve, or if there is
further deterioration in the Bank's loan portfolio, the Company and the Bank may
be required to take additional remedial action that may further restrict the
Company's and the Bank's operations in future periods.
The Company and the Bank Have Made Significant Changes to the Bank's Loan Loss
Reserves as a Result of Reviews of the Bank's Loan Portfolio, and The Bank May
Be Required to Further Increase the Allowance for Loan and Lease Losses.
During the course of a targeted, limited scope review of the loan portfolio
of the Company's wholly-owned subsidiary Heritage Bank, an Alabama state banking
corporation (the "Bank"), and a concurrent safety and soundness audit and
information systems examination conducted by regulatory authorities, management
identified certain assets in the Bank's loan portfolio that management believed
should be classified. Due to the erosion in asset quality identified by the
review, the Company increased its allowance for loan losses by $2,000,000 during
the quarterly period ended June 30, 2002. Additional review of the Bank's loan
portfolio subsequently identified additional asset quality problems, which
resulted in the Company increasing the allowance for loan losses net of charge
offs and recoveries by a total of $20,916,364 for the year ending December 31,
2002. As of December 31, 2002, the allowance for loan losses on the Company's
consolidated balance sheet totaled $26,990,594, compared to $6,074,230 at
December 31, 2001.
The fourth quarter provision for loan losses in the amount of $16,393,000
contributed to a quarterly loss of $9,829,000, and a loss for the year of
$14,413,000. The Board of Directors and management of the Company and of the
Bank engaged in discussions regarding the Bank's Tier 1 capital that ultimately
led to the Company entering into a Loan Agreement with First Tennessee Bank
National Association dated October 30, 2002, pursuant to which the Company was
able to borrow up to $7.5 million (the "First Tennessee Loan"). Immediately
following the execution of the Loan Agreement, the Company drew down $5 million
of the First Tennessee Loan and contributed said loan proceeds to the capital of
the Bank. Subsequently, on December 27, 2002, the Company drew down an
additional $1.5 million of the First Tennessee Loan and contributed said loan
proceeds to the capital of the Bank. Following the $5 million and $1.5 million
contributions, the Bank's Tier 1 leverage ratio increased to approximately 5.99
percent as of the year ending December 31, 2002.
Management has continued the credit review process, and this has resulted
in additional classification of assets following September 30, 2002. Additional
classification of assets may result in an additional increase in the Bank's
allowance for loan losses, and such increases could have a material adverse
effect on the Company's and the Bank's financial condition and results of
operations.
The Board of Directors of the Company intends to cause management of the
Company and the Bank to take steps to attain and maintain a Tier 1 leverage
ratio at the Bank of 8 percent by March 31, 2003. The Bank did not
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achieve a Tier 1 leverage ratio of 7.5 percent as of December 31, 2002, and
management believes the Bank may not achieve a Tier 1 leverage ratio of 8
percent if the Bank is unable to acquire additional capital. Failure to achieve
these capital ratios could subject the Bank and the Company to regulatory
enforcement actions or proceedings.
The Company Has Had a Significant Change in Operating Strategy and Management
Since March 12, 2002 and There Can Be No Assurance that the New Strategy or
Management Will Result in Improved Financial Condition or Net Income.
On March 12, 2002, Reginald D. Gilbert, President, Chief Executive Officer
and Director of the Company and the Bank, ended his relationship with the
Company and the Bank. Harold B. Jeffreys, a Director, has been serving as
Interim President and Chief Executive Officer of the Company until such time as
the Company hires a new President and Chief Executive Officer. In addition, on
April 9, 2002, the Board of Directors accepted the resignations from the Board
of Directors of three officers of the Bank who had been serving on the Board.
Effective July 11, 2002, the Board of Directors hired Thomas E. Hemmings as
Chief Financial Officer of the Company. Mr. Hemmings has been charged with
taking steps to improve profitability for the Company and, more recently,
helping the Company to address its internal controls and procedures.
On October 23, 2002, the Board of Directors engaged Larry R. Mathews as
President and Chief Executive Officer of the Bank. The decision to retain Mr.
Mathews, given his experience in the areas of management, credit quality and
internal controls and procedures, is part of the Company's renewed focus on the
loan portfolio of the Bank and the overall credit quality of the Bank, as well
as the operating controls and procedures of the Bank. The Board of Directors
intends for Mr. Mathews to focus his initial efforts on improving asset quality
and loan administration, continuing the review and implementation of internal
controls and procedures and improving the Company's overall performance.
On October 25, 2002, the Board of Directors engaged Don Pruett as Executive
Vice President and Chief Lending Officer for the Bank. The Board of Directors
has given Mr. Pruett the authority and responsibility to implement sound lending
practices, credit underwriting standards, loan documentation and administration
practices. Mr. Pruett also has been given the overall responsibility for
improving the quality of the Bank's loan portfolio and maintaining the Bank's
asset quality in a manner that fully meets safe and sound banking practices
requirements and is in compliance with applicable laws and regulations.
On January 8, 2003, Heritage Bank employed Robert F. Harwell, Jr. and
Michael Hockman as President and Senior Lender, respectively, of the North
Alabama region. Mr. Harwell will have responsibility for both the Huntsville and
Decatur markets. Since 1996, he has been employed with a regional bank holding
company in Huntsville including the last eighteen months as President of their
North Alabama Division. Mr. Hockman served with the same regional bank holding
company prior to accepting his position with the Bank.
The Company and the Bank have continued to add experienced personnel to
assist in the review and oversight of important areas such as credit quality and
loan review. Despite these changes in management and the Board of Directors'
mandate to management to address the Bank's asset quality and lending
procedures, and to improve the Company's financial results, there can be no
assurance that the new management will be successful in improving the financial
condition or increasing the net income of the Company.
ITEM 1. BUSINESS
GENERAL
We are a Delaware-chartered bank holding company headquartered in Decatur,
Alabama. We offer a broad range of banking and related products and services in
ten locations in Northern Alabama through Heritage Bank, an Alabama banking
corporation and our principal subsidiary. We had assets of approximately $593
million, loans of approximately $524 million, deposits of approximately $526
million and stockholders' equity of approximately $24 million at December 31,
2002. Our principal executive offices are located at 1323 Stratford Road,
Decatur, Alabama 35601, and the telephone number is (256) 355-9500.
3
The Company's business is conducted primarily through the Bank. Although we
have no immediate plans to conduct any other business, the Company may engage
directly or indirectly in a number of activities which the Federal Reserve has
determined to be so closely related to banking or managing or controlling banks
as to be a proper incident thereto.
SUBSIDIARY BANK
At December 31, 2002, the Bank conducted business through 10 locations in
Morgan, Madison, Marshall and Jefferson counties, Alabama. We offer a wide range
of commercial and retail banking services, including savings and time deposit
accounts, personal and commercial loans and personal and commercial checking
accounts. We seek to provide superior service to our customers and to become a
vital component of each of the communities which we serve.
RECENT DEVELOPMENTS
As previously reported in the Form 10-Q filings of the Company for the
quarterly periods ended June 30, 2002 and September 30, 2002, a targeted,
limited scope review of the loan portfolio of the Bank by regulatory authorities
identified certain assets of the Bank that the regulatory authorities believed
should be classified. In connection with such review, the Company and the Bank
took steps to charge off or establish additional loan loss reserves for
specified assets and to adjust the Bank's levels of loan loss provisions.
The Board of Directors of the Company and the Bank have imposed certain
restriction on the operations of the Company and the Bank in order to address
asset quality concerns, operational controls and procedures, and capital
deficiencies. The Bank, without the prior written approval of its regulatory
authorities, may not declare or pay any cash dividends. In addition, the Bank
has undertaken to hire and retain qualified lending and operational personnel
with the specific written authority by the Board of Directors to implement sound
lending, recordkeeping and accounting practices. The Bank also has undertaken to
develop an educational program for board members and to create a written review
of the Bank's staffing requirements. Our management and staff are working toward
meeting all of these requirements and implementing policies which will make the
Company and the Bank stronger and more efficient.
The Board of Directors of the Bank has determined to improve and increase
the capital ratios of the Bank, which have declined as a result of the increase
in the Bank's loan loss reserves. The Board of Directors of the Company intends
to cause management of the Company and the Bank to take steps to attain and
maintain a Tier 1 leverage ratio of 8 percent and to be "well-capitalized" as
defined by the FDIC by March 31, 2003. Should the Tier 1 leverage ratio fail to
meet or exceed the specified ratio of 8 percent or subsequently fall below such
level, the Bank must notify the regulatory authorities and take steps to
increase capital sufficient to meet the required ratios within 30 days.
Management believes the Bank may fail to achieve a Tier 1 leverage ratio of 8
percent if the Bank is unable to acquire additional capital.
The management of the Company and the Bank has aggressively addressed asset
quality, loan and audit issues. The Bank has charged off the balance of any
assets classified Loss and one-half of those assets classified Doubtful in any
official report of examination by any of the regulatory authorities, and has
gone further by conducting additional reviews of the Bank's loan portfolio to
insure full knowledge of the Bank's asset quality issues. The Bank must reduce
the balance of assets classified Substandard or Doubtful in accordance with a
specific timetable, and may not extend additional credit to any borrower
obligated to the Bank on any extension of credit that has been charged off by
the Bank or classified Loss or Doubtful as long as such credit remains
uncollected. In addition, the Bank is obligated to review its existing written
loan policies and to adopt new internal loan review systems to address problems
with the Bank's loan portfolio.
SERVICES
We focus on commercial, consumer, residential mortgage and real estate
construction lending to customers in our local markets. Our retail loan products
include mortgage banking services, home equity lines of credit, consumer loans,
including automobile loans, and loans secured by certificates of deposit and
savings accounts. Our commercial loan products include working capital lines of
credit, term loans for both real estate and equipment, letters of credit and
Small Business Administration loans. We also offer a variety of deposit programs
to individuals
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and businesses and other organizations, including a variety of personal
checking, savings, money market and NOW accounts, as well as business checking
and saving accounts. In addition, we offer individual retirement accounts, safe
deposit and night depository facilities and additional services such as internet
banking and the sale of traveler's checks, money orders and cashier's checks.
MARKET AREAS
The Company conducts its banking activities in Morgan, Madison, Marshall
and Jefferson counties in Alabama and in the surrounding vicinities. Within
those areas, the Company has banking offices located in the cities of Decatur,
Huntsville, Madison, Birmingham and Trussville, Alabama.
LENDING ACTIVITIES
We offer a range of lending services, including real estate, consumer and
commercial loans, primarily to individuals and businesses and other
organizations that are located in or conduct a substantial portion of their
business in our market areas. Our total loans at December 31, 2002 were $523.9
million, or 89.1% of total earning assets. The interest rates we charge on loans
vary with the risk, maturity and amount of the loan and are subject to
competitive pressures, money market rates, availability of funds and government
regulations. We do not have any foreign loans.
LOAN PORTFOLIO
Real Estate Loans - Loans secured by real estate are a significant
component of our loan portfolio, constituting $371.7 million, or 71.0% of total
loans at December 31, 2002. Our primary type of real estate loan is
single-family first mortgage loans, construction loans and acquisition and
development loans, typically structured with fixed or adjustable interest rates,
based on market conditions. Fixed rate loans usually have terms of five years or
less, with payments through the date of maturity generally based on a 15 to 30
year amortization schedule. Adjustable rate loans generally have a term of 5 to
30 years. We typically charge an origination fee on these mortgage loans.
Our nonresidential mortgage loans include commercial, industrial and land
loans. The commercial real estate loans are typically used to provide financing
for retail establishments, offices and manufacturing facilities. We generally
require nonresidential mortgage loans to have an 80% loan-to-value ratio and
usually underwrite commercial loans on the basis of the borrower's cash flow and
ability to service the debt from earnings, more than on the basis of the value
of the collateral. Terms are typically five years and may have payments through
the date of maturity based on a 15 to 30 year amortization schedule.
Construction loans usually have a term of twelve months and generally require
personal guarantees.
Commercial, Financial and Agricultural Loans - At December 31, 2002, we had
general commercial, financial and agricultural loans of $132.2 million,
comprising 25.2% of the total loan portfolio. Commercial loans consist primarily
of operating loans made to manufacturers, wholesalers and retailers of goods,
service companies and other industries. We concentrate on making loans to small
and medium size companies. The primary repayment risk for commercial loans is
the failure of the borrower due to economic or financial factors. Although we
typically look to a commercial borrower's cash flow as the principal source of
repayment, many commercial loans are secured by inventory, equipment, accounts
receivable and other assets. These loans are typically made on terms up to five
years at fixed or variable rates and are secured by accounts receivable,
inventory or, in the case of equipment loans, the financed equipment. We attempt
to reduce our credit risk on commercial loans by limiting the loan to value
ratio to 65% on loans secured by accounts receivable or inventory and 75% on
equipment loans. Agricultural loans are comprised of loans to finance
agricultural production, loans to farmers and loans secured by farmland. We are
able to manage the risks inherent in these types of loans due to our small
number of agricultural loans.
Consumer Loans - At December 31, 2002, loans to individuals for personal
expenditures totaled $19.9 million, comprising some 3.8% of our loan portfolio.
These consumer loans include loans to purchase automobiles, recreational
vehicles, mobile homes, appliances and boats, and the Bank continues to hold a
small amount of credit card loans. Consumer loans are underwritten based on the
borrower's income, current debt, credit history and collateral. Terms generally
range from four to five years on automobile loans and one to three years on
other consumer loans.
5
CREDIT PROCEDURES AND REVIEW
The regulatory authorities found significant weaknesses with our loan
policy, including our loan approval process, credit analysis, loan review and
other key lending support functions. As part of our response to these issues, we
have revised the Bank's loan policy to address areas the regulatory authorities
found to be inadequate, and have hired additional personnel to upgrade our
compliance in these areas.
Loan Approval - We attempt to minimize loan losses through various means
and use generally recognized underwriting criteria. In particular, on larger
credits, we generally rely on the cash flow of a debtor as the source of
repayment and secondarily on the value of the underlying collateral. In
addition, we attempt to utilize shorter loan terms in order to reduce the risk
of a decline in the value of such collateral. We have reduced the unsecured
lending authority of our officers and have reduced the overdraft authority of
our officers in order to address certain loan portfolio issues.
We address repayment risks by adhering to internal credit policies and
procedures that include officer and customer lending limits, a multi-layered
loan approval process for larger loans, periodic documentation examination and
follow-up procedures for any exceptions to credit policies. The point in our
loan approval process at which a loan is approved depends on the size of the
borrower's credit relationship with the Bank. We require approval by the Board
of Directors of the Bank for new advances of credit to any borrowers with loans
classified Substandard and prohibit the advance of additional credit to any
borrower with loans classified Doubtful or Loss.
Loan Review - The Bank has a loan review process designed to promote early
identification of credit quality problems. All lending officers are charged with
the responsibility of reviewing all past due loans in their respective
portfolios. Lending officers establish a watch list of loans to be reviewed by
management and the Board of Directors. Lending officers also conduct a regular
centralized internal review which tests compliance with loan policy and
documentation for all loans over $250,000 and a sampling of smaller loans.
The entire loan portfolio undergoes close scrutiny to maintain its quality
and diversity and to assure proper documentation. This policy also requires that
each loan have an agreed upon repayment schedule and gives individual lending
officers the responsibility of obtaining, and analyzing current credit
information. Maximum loan to value ratios and terms are established in the
policy for the various types of loans. The criteria outlined in the Bank's loan
policy follows guidelines provided by banking regulators. Through the Bank's
credit policy and credit review procedures, management believes that it is able
to identify areas of concern in the loan portfolio and to take corrective action
when necessary.
DEPOSITS
Core deposits are our principal source of funds, constituting approximately
71.4% of our total deposits as of December 31, 2002. Core deposits consist of
demand deposits, interest-bearing transaction accounts, savings deposits and
certificates of deposit (excluding certificates of deposits and other time
deposits over $100,000). Transaction accounts include checking, money market and
NOW accounts that provide the Bank with a source of fee income and
cross-marketing opportunities, as well as a low-cost source of funds. Time and
savings accounts also provide a relatively stable and low-cost source of
funding. The largest source of funds for the Bank is certificates of deposit.
Certificates of deposit in excess of $100,000 are held primarily by customers
outside of our market areas.
Deposit rates are reviewed weekly by senior management. We believe our
rates are competitive with those offered by competing institutions in our market
areas; however, we focus on customer service, not high rates, to attract and
retain deposits.
COMPETITION
The banking industry in Alabama is highly competitive, and our
profitability depends principally on our ability to compete in our market areas.
The area is dominated by a number of major banks and bank holding companies
which have substantially greater resources, and numerous offices and affiliates
operating over wide geographic areas. We encounter strong competition both in
making loans and attracting deposits. Competition among financial institutions
is based upon interest rates offered on deposit accounts, interest rates charged
on loans and other credit and service charges. Customers also consider the
quality and scope of the services rendered, the
6
convenience of banking facilities and, in the case of loans to commercial
borrowers, relative lending limits, and may also consider the fact that other
banks offer different services. Many of the large regional banks against which
we compete have significantly greater lending limits and may offer additional
products; however, we believe we have been able to compete effectively with
other financial institutions, regardless of their size, by emphasizing customer
service and by providing a wide array of services. In addition, most of our
non-bank competitors are not subject to the same extensive federal regulations
that govern bank holding companies and federally insured banks. See "Supervision
and Regulation." Competition may further intensify if additional financial
services companies enter markets in which we conduct business.
EMPLOYEES
As of December 31, 2002, the Company employed approximately 133 individuals
of which approximately 124 were full-time employees.
SUPERVISION AND REGULATION
The Company, as a bank holding company under the Bank Holding Company Act
of 1956, as amended ("BHCA"), is subject to the supervision, examination and
reporting requirements of the Federal Reserve Board and the BHCA. The BHCA and
other federal laws subject bank holding companies to particular restrictions on
the types of activities in which they may engage and to a range of supervisory
requirements and activities, including regulatory enforcement actions for
violations of laws and regulations. The Company is required to file with the
Federal Reserve periodic reports and such other information as the Federal
Reserve may request. The Federal Reserve conducts examinations of the Company,
and also may examine its subsidiaries. The State of Alabama does not regulate
bank holding companies.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"),
which made substantial revisions to the statutory restrictions separating
banking activities from certain other financial activities. Under the GLBA, bank
holding companies that are "well-capitalized" and "well-managed" and whose
subsidiary banks have satisfactory or better ratings under the Community
Reinvestment Act of 1977, as amended (the "CRA"), and meet certain other
conditions can elect to become "financial holding companies." Financial holding
companies and their subsidiaries are permitted to acquire or engage in
previously impermissible activities, such as insurance underwriting, travel
agency activities, broad insurance agency activities, merchant banking, and
other activities that the Federal Reserve determines to be financial in nature
or complimentary to financial activities. In addition, under the merchant
banking authority added by the GLBA and Federal Reserve regulations, financial
holding companies are authorized to invest in companies that engage in
activities that are not financial in nature, as long as the financial holding
company makes its investment with the intention of limiting the terms of its
investment, does not manage the company on a day-to-day basis, and the investee
company does not cross-market with any of the financial holding company's
controlled depository institutions. Financial holding companies continue to be
subject to the overall oversight and supervision of the Federal Reserve. While
the Company has not elected to become a financial holding company, and may not
do so at the present time, it may elect to do so in the future.
The supervision and regulation of bank holding companies and their
subsidiaries are intended primarily for the protection of depositors, the
deposit insurance funds of the Federal Deposit Insurance Corporation (the
"FDIC") and the banking system as a whole, not for the protection of bank
holding company stockholders or creditors. The banking agencies have broad
enforcement power over bank holding companies and banks, including the power to
impose substantial fines and other penalties for violation of laws and
regulations. The following description summarizes some of the laws to which we
are subject. References herein to applicable statutes and regulations are brief
summaries thereof, do not purport to be complete and are qualified in their
entirety by reference to such statutes and regulations.
The Bank is subject to regulation, supervision and examination by the
Federal Reserve, the Federal Deposit Insurance Corporation ("FDIC") and the
Alabama Banking Department. As a member of the FDIC, the Bank's deposits are
insured to the maximum extent provided by law.
Regulatory Restrictions on Dividends - The payment of dividends to the
Company by the Bank is subject to certain restrictions imposed by state and
federal banking laws, regulations and authorities. The Federal Reserve Board
requires that bank holding companies should pay cash dividends on common stock
only out of income
7
available over the past year and only if prospective earnings retention is
consistent with the bank holding company's expected future needs and financial
condition. This policy provides that bank holding companies should not maintain
a level of cash dividends that undermines the bank holding company's ability to
serve as a source of strength for its banking subsidiaries. The prior approval
of the Federal Reserve is required if the total of all dividends declared by the
state member bank in any calendar year will exceed the sum of such bank's net
profits for the year and its retained net profits for the preceding two calendar
years, less any required transfers to surplus. Federal law also prohibits any
state member bank from paying dividends that would be greater than such bank's
undivided profits after deducting statutory bad debt reserves in excess of such
bank's allowance for loan losses. The Bank is currently prohibited from paying a
cash dividend to the Company without seeking prior written approval from federal
banking authorities.
Under Alabama law, a bank may not pay a dividend in excess of 90% of its
net earnings until the bank's surplus is equal to at least 20% of its capital.
The Bank is also required by Alabama law to obtain the prior approval of the
Superintendent of the State Banking Department of Alabama for its payment of
dividends if the total of all dividends declared by the Bank in any calendar
year will exceed the total of (1) the Bank's net earnings (as defined by
statute) for that year, plus (2) its retained net earnings for the preceding two
years, less any required transfers to surplus. No dividends may be paid from the
Bank's surplus without the prior written approval of the Superintendent. The
Bank is currently prohibited from paying dividends to the Company without the
prior approval of the Superintendent of the State Banking Department.
In addition, federal bank regulatory authorities have authority to prohibit
the payment of dividends by bank holding companies if their actions constitute
unsafe or unsound practices. The Federal Reserve Board has issued a policy
statement on the payment of cash dividends by bank holding companies, which
expresses the Federal Reserve Board's view that a bank holding company
experiencing earnings weaknesses should not pay cash dividends that exceed its
net income or that could only be funded in ways that weaken the bank holding
company's financial health, such as by borrowing. Our ability and the Bank's
ability to pay dividends in the future is currently, and could be further,
influenced by bank regulatory policies and capital guidelines.
Source of Strength - Under Federal Reserve Board policy, a bank holding
company is expected to act as a source of financial strength for its bank
subsidiary and commit resources to its support. This support may be required by
the Federal Reserve Board at times when, absent this policy, additional
investments in a troubled bank may not otherwise be warranted. A bank holding
company, in certain circumstances, could be required to guarantee the capital
plan of an undercapitalized banking subsidiary. In addition, any capital loans
by a bank holding company to any of its depository institution subsidiaries
likely will be unsecured and subordinate in right of payment to deposits and to
certain other indebtedness of the banks.
Under the Federal Deposit Insurance Act ("FDIA"), an FDIC-insured
depository institution can be held liable for any loss incurred by, or
reasonably expected to be incurred by, the FDIC in connection with (1) the
default of a common controlled FDIC-insured depository institution or (2) any
assistance provided by the FDIC to any commonly controlled FDIC-insured
depository institution "in danger of default." "Default" is defined generally as
the appointment of a conservator or receiver, and "in danger of default" is
defined generally as the existence of certain conditions indicating that a
default is likely to occur in the absence of regulatory assistance. 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 FDIC-insured depository institution.
Common controlled FDIC-insured depository institutions are liable to the FDIC
for any losses incurred in connection with the failure of a commonly controlled
institution.
Safe and Sound Banking Practices - Bank holding companies are not permitted
to engage in unsafe or unsound banking practices. The Federal Reserve Board has
broad authority to prohibit activities of bank holding companies and their
non-banking subsidiaries which represent unsafe or unsound banking practices or
which constitute violations of laws or regulations, and can assess civil money
penalties for certain activities conducted on a knowing or reckless basis, if
those activities caused a substantial loss to a depository institution. The
penalties can be as high as $1,000,000 for each day the activity continues.
The Federal Reserve adopted the Federal Financial Institutions Examination
Council's ("FFIEC") updated rating system which assigns each financial
institution a confidential composite "CAMELS" rating based on an
8
evaluation and rating of six essential components of an institution's financial
condition and operations including capital adequacy, asset quality, management,
earnings, liquidity and sensitivity to market risk. For most institutions, the
FEIEC has indicated that market risk is rated based upon, but not limited to, an
assessment of the sensitivity of the financial institution's earnings or the
economic value of its capital to adverse changes in interest rates, foreign
exchange rates, commodity prices, or equity prices; management's ability to
identify, measure, monitor and control exposure to market risk; and the nature
and complexity of interest rate risk exposure arising from nontrading positions.
Capital Adequacy Requirements - We are required to comply with the capital
adequacy standards established by the Federal Reserve Board, and the Bank is
subject to additional requirements of the FDIC and the Alabama Banking
Department. The Federal Reserve Board has adopted two basic measures of capital
adequacy for bank holding companies: a risk-based measure and leverage measure.
All applicable capital standards must be satisfied for a bank holding company to
be in compliance.
The risk-based capital standards are designed to make regulatory
requirements more sensitive to differences in risk profiles among banks and bank
holding companies, to account for off-balance-sheet exposure, and to minimize
disincentives for holding liquid capital assets. Assets and off-balance-sheet
items are assigned to broad risk categories, each with appropriate weights. The
resulting capital ratios represent capital as a percentage of total
risk-weighted assets and off-balance-sheet items.
The minimum guidelines for the ratio ("Total Risk-Based Capital Ratio") of
total capital ("Total Capital") to risked-weighted assets (including certain
off-balance sheet items, such as standby letters of credit) is 8%. At least half
of Total Capital must be comprised of common stock, minority interests in the
equity accounts of consolidated subsidiaries, noncumulative perpetual preferred
stock, and a limited amount of cumulative perpetual preferred stock, less
goodwill and other intangible assets ("Tier 1 Capital"). The remainder may
consist of subordinated debt, other preferred stock, and a limited amount of
loan loss reserves ("Tier 2 Capital").
In addition, the Federal Reserve Board has established minimum leverage
ratio guidelines for bank holding companies and state member banks. These
guidelines provide for a minimum ratio (the "Leverage Ratio") of Tier 1 Capital
to average assets, less goodwill and certain other intangible assets, of 3% for
bank holding companies that meet certain specified criteria, including having
the highest regulatory rating. All other bank holding companies generally are
required to maintain a Leverage Ratio of at least 3%, plus an additional cushion
of 1% - 2%, if the institution has less than the highest regulatory rating. The
guidelines also provide that bank holding companies experiencing internal growth
or making acquisitions will be expected to maintain strong capital positions
substantially above the minimum supervisory levels without significant reliance
on intangible assets. Furthermore, the Federal Reserve Board has indicated that
it will consider a tangible Tier 1 Capital Leverage Ratio (deducting all
intangibles) and other indicia of capital strength in evaluating proposals for
expansion or new activities.
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"), among other things, requires the federal banking agencies to take
"prompt corrective action" regarding depository institutions that do not meet
minimum capital requirements. FDICIA establishes five capital tiers: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," and "critically undercapitalized." A bank's capital tier will
depend upon how its capital levels compare to various relevant capital measures
and certain other factors, as established by regulations.
All of the federal banking agencies have adopted regulations establishing
relevant capital measures and relevant capital levels. The relevant capital
measures are the Total Capital ratio, Tier 1 capital ratio, and the leverage
ratio. Under the regulations, a state member bank will be (i) well capitalized
if it has a Total Capital ratio of 10% or greater, a Tier 1 capital ratio of 6%
or greater, a Tier 1 leverage ratio of 5% or greater and is not subject to any
written agreement, order, capital directive or prompt corrective action
directive by a federal bank regulatory agency to meet and maintain a specific
capital level for any capital measure, (ii) adequately capitalized if it has a
Total Capital ratio of 8% or greater, a Tier 1 capital ratio of 4% or greater,
and a leverage ratio of 4% or greater (3% in certain circumstances), (iii)
undercapitalized if it has a Total Capital ratio of less than 8%, a Tier 1
capital ratio of less than 4% (3% in certain circumstances), and a leverage
ratio of less than 4%, (iv) significantly undercapitalized if it has a Total
Capital ratio of less than 6%, a Tier 1 capital ratio of less than 3% and a
leverage ratio of less than 3% or (v) critically undercapitalized if its
tangible equity is equal to or less than 2% of average quarterly tangible
assets.
9
As of December 31, 2002, the consolidated capital ratios of the Company and
the Bank were as follows:
Regulatory
Minimum Company Bank
Tier 1 leverage ratio 3.0-5.0% 4.94% 5.99%
Tier 1 Risk-based capital ratio 4% 6.09% 7.68%
Total Risk-based capital ratio 8% 7.81% 8.98%
As of December 31, 2002, both the Company and the Bank were "adequately
capitalized."
Acquisitions by Bank Holding Companies - The BHCA requires every bank
holding company to obtain prior approval of the Federal Reserve Board before it
(1) may acquire all or substantially all of the assets of any bank; (2) may
acquire direct or indirect ownership or control of any voting shares of any
bank, if after such acquisition it would own or control, directly or indirectly,
more than 5% of the voting shares of such bank; or (3) may merge or consolidate
with any other bank holding company. In approving bank acquisitions by bank
holding companies, the Federal Reserve Board is required to consider the
financial and managerial resources and future prospects of the bank holding
company and the banks concerned, the convenience and needs of the communities to
be served and various other factors.
The BHCA further provides that the Federal Reserve Board may not approve
any transaction that would result in a monopoly or would be in furtherance of
any combination or conspiracy to monopolize or attempt to monopolize the
business of banking in any section of the United States, or the effect of which
may be substantially to lessen competition or to tend to create a monopoly in
any section of the country, or that in any other manner would be in restraint of
trade, unless the anti-competitive effects of the proposed transaction are
clearly outweighed by the public interest in meeting the convenience and needs
of the communities to be served. The Federal Reserve Board is required to
consider the financial and managerial resources and future prospects of the bank
holding companies and banks concerned, including capital adequacy, and the
convenience of the community to be served including the parties' performance
under the Community Reinvestment Act.
Control Acquisitions - The Change in Bank Control Act prohibits a person or
group of persons from acquiring "control" of a bank holding company unless the
Federal Reserve Board has been notified and has not objected to the transaction.
Under a rebuttable presumption established by the Federal Reserve Board, the
acquisition of 10% or more of a class of voting stock of a bank holding company
with a class of securities registered under Section 12 of the Exchange Act,
would, under the circumstances set forth in the presumption, constitute
acquisition of control of that bank holding company.
In addition, under the BHCA, any company is required to obtain the prior
approval of the Federal Reserve Board before acquiring 25% (and bank holding
companies are required to obtain prior approval from the Federal Reserve Board
before acquiring 5%) or more of the outstanding common stock of a bank holding
company, or otherwise obtain control or a "controlling influence" over the bank
holding company.
Branching - The BHCA, as amended by the interstate banking provisions of
the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
"Interstate Banking Act") repealed prior statutory restrictions on interstate
banking, such that a bank holding company may acquire a bank located in any
other state, and any bank holding company located outside Alabama may lawfully
acquire any Alabama-based bank regardless of state law to the contrary, in
either case subject to certain deposit-percentage, aging requirements and other
restrictions. In addition, the Interstate Banking Act generally provided that
after June 1, 1997, national state-chartered banks may branch interstate through
acquisition of banks in other states. The State of Alabama has laws relating
specifically to acquisition of banks, bank holding companies and other types of
financial institutions in each state, by financial institutions that are based
in, and not based in, those states. Alabama law has set five years as the
minimum age of banks which may be acquired.
Restrictions on Transactions With Affiliates and Insiders - The Company is
a legal entity separate and distinct from the Bank. Transactions between the
Bank and its affiliates, including the Company, are subject to Sections
10
23A and 23B of the Federal Reserve Act. Section 23A defines "covered
transactions," which include extensions of credit, and limits a bank's covered
transactions with any affiliate to 10% of such bank's capital and surplus. All
covered and exempt transactions between a bank and its affiliates must be on
terms and conditions consistent with safe and sound banking practices, and banks
and their subsidiaries are prohibited from purchasing low-quality assets from
the bank's affiliates. Finally, Section 23A requires that all of a bank's
extensions of credit to an affiliate be appropriately secured by acceptable
collateral, generally United States government or agency securities. Section 23B
of the Federal Reserve Act generally requires that certain transactions between
a bank and its respective affiliates be on terms substantially the same, or at
least as favorable to such bank, as those prevailing at the time for comparable
transactions with or involving other nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal
stockholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and Regulation O apply to all
insured institutions and their subsidiaries and bank holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on all
loans to insiders and their related interests. These loans cannot exceed the
institution's total unimpaired capital and surplus, and the FDIC may determine
that a lesser amount is appropriate. Insiders are subject to enforcement actions
for knowingly accepting loans in violation of applicable restrictions. State
banking laws also have similar provisions.
FDIC Insurance Assessments - Each financial institution is assigned to one
of three capital groups - well capitalized, adequately capitalized or
undercapitalized - and further assigned to one of three subgroups within a
capital group, on the basis of supervisory evaluations by the institution's
primary federal and, if applicable, state regulators and other information
relevant to the institution's financial condition and the risk posed to the
applicable insurance fund. The actual assessment rate applicable to a particular
bank will, therefore, depend in part upon the risk assessment classification so
assigned to the bank by the FDIC.
Under the FDIA, insurance of deposits may be terminated by the FDIC upon a
finding that the institution has engaged in unsafe and unsound practices, is in
an unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, rule, order, or condition imposed by the FDIC.
Community Reinvestment Act - The Company and the Bank are subject to the
Community Reinvestment Act ("CRA"). The CRA and the regulations issued
thereunder are intended to encourage banks to help meet the credit needs of
their service area, including low and moderate income neighborhoods, consistent
with the safe and sound operations of the banks. The CRA does not establish
specific lending requirements or programs for financial institutions, nor does
it limit an institution's discretion to develop the types of products and
services that it believes are best suited to its particular community,
consistent with the CRA. The CRA requires a bank's primary federal regulator, in
connection with its examination of the institution, to assess the institution's
record of assessing and meeting the credit needs of the community served by that
institution, including low- and moderate-income neighborhoods. These regulatory
assessments are utilized by the Federal Reserve when considering applications to
establish branches, merger applications and applications to acquire the assets
and assume the liabilities of another bank. The Financial Institutions Reform,
Recovery and Enforcement Act of 1989 ("FIRREA") requires federal banking
agencies to make public a rating of a bank's performance under the CRA. In the
case of a bank holding company, the CRA performance record of the banks involved
in the transaction are reviewed by federal banking agencies in connection with
the filing of an application to acquire ownership or control of shares or assets
of a bank or thrift or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction. The Bank
has received a satisfactory CRA rating from federal banking agencies.
Current CRA Regulations rate banks based on their actual performance in
meeting community credit needs. CRA performance is evaluated by the Federal
Reserve, the Bank's primary federal regulator, using a lending test, or
investment test, and a service test. The Federal Reserve also will consider: (i)
demographic data about the community; (ii) the bank's capacity and constraints;
(iii) the bank's product offerings and business strategy; and (iv) data on the
prior performance of the bank and similarly-situated lenders. As a result of the
GLBA, CRA agreements with private parties must be disclosed and annual CRA
reports must be made to a bank's primary federal regulator. A bank holding
company will not be permitted to become a financial holding company and no new
activities authorized under GLBA may be commenced by a holding company or by a
bank financial subsidiary if any of its bank subsidiaries received less than a
"satisfactory" CRA rating in its latest CRA examination.
11
Consumer Laws and Regulations - In addition to the laws and regulations
discussed herein, the Bank is also subject to certain consumer laws and
regulations that are designed to protect consumers in transactions with banks.
While the list set forth herein is not exhaustive, these laws and regulations
include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds
Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity
Act and the Fair Housing Act, among others. These laws and regulations mandate
certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits, making loans to or
engaging in other types of transactions with such customers.
LEGISLATIVE AND REGULATORY CHANGES
Various bills are routinely introduced in the United States Congress and
the Alabama legislature with respect to the regulation of financial
institutions. Certain of these proposals, if adopted, could significantly change
the regulation of banks and the financial services industry. We cannot predict
whether any of these proposals will be adopted or, if adopted, how these
proposals would affect us.
EFFECT ON ECONOMIC ENVIRONMENT
The policies of regulatory authorities, especially the monetary policy of
the Federal Reserve Board, have a significant effect on the operating results of
bank holding companies and their subsidiaries. Among the means available to the
Federal Reserve Board to affect the money supply are open market operations in
U.S. Government securities, changes in the discount rate on member bank
borrowings and changes in reserve requirements against member bank deposits.
These means are used in varying combinations to influence overall growth and
distribution of bank loans, investments and deposits, and their use may affect
interest rates charged on loans or paid for deposits.
Federal Reserve Board monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on our business and earnings cannot be predicted.
12
STATISTICAL DISCLOSURE
Statistical and other information regarding the following items are set forth in
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations" in the pages indicated below. Page(s)
Loan Portfolio...............................................................................................20
Selected Loan Maturity and Interest Rate Sensitivity.........................................................21
Securities Portfolio.........................................................................................21
Securities Portfolio Maturity Schedule.......................................................................22
Maturities of Large Time Deposits............................................................................23
Maturities of Long-Term Debt.................................................................................24
Return on Equity and Assets..................................................................................25
Capital Adequacy Ratios......................................................................................25
Interest Rate Sensitivity Analysis...........................................................................27
Average Balances, Interest Income/Expense and Yields/Rates...................................................29
Rate/Volume Variance Analysis................................................................................30
Summary of Loan Loss Experience..............................................................................32
Allocation of Loan Loss Reserve..............................................................................33
Nonperforming Assets.........................................................................................34
Noninterest Income...........................................................................................34
Noninterest Expenses.........................................................................................35
Interest Rate Risk...........................................................................................36
13
ITEM 2. PROPERTIES
Our headquarters are located at 1323 Stratford Road, Decatur, Morgan
County, Alabama. We operate eight banking offices throughout Northern Alabama.
We own two and lease six of these offices. Rental expense on the leased
properties totaled approximately $635,667 in 2002.
ITEM 3. LEGAL PROCEEDINGS
The Bank has received demand letters from two former directors, officers
and employees of the Bank. The Bank terminated such officers in November 2002
for cause, as such term is defined by their respective employment contracts. One
officer has claimed monetary compensation, stock options and attorneys' fees,
while the second officer has claimed monetary compensation, as well as stock
options and payment of country club dues for two years following the date of his
termination. The Bank maintains that it terminated each of these officers for
"cause" and that it is under no obligation to pay them any additional
compensation. On March 14, 2003, one of these officers filed a lawsuit against
the Bank in the Circuit Court for Morgan County, Alabama, alleging breach of
contract and demanding certain payments and benefits allegedly due under his
employment agreement. The Bank intends to vigorously defend this and any other
action brought against the Bank by either of the officers, and does not believe
that the final outcome will have a material impact on the Bank or the Company.
While we may from time-to-time be a party to various legal proceedings
arising from the ordinary course of business, we believe that there are
currently no other proceedings threatened or pending against us at this time
that will, individually or in the aggregate, materially or adversely affect our
business, financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders of the Company during
the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company is not listed on any exchange and there is no organized trading
market for the shares of its common stock. When shares are traded, they are
traded in privately negotiated transactions. Therefore, no reliable information
is available as to trades of the Company's common stock, or as to the prices at
which such common stock has traded.
Management has reviewed the limited information available to the Company as
to the ranges at which shares of the Company's common stock has been sold. The
following table sets forth, on a per share basis for the periods indicated, the
high and low sale prices of the Company's common stock.
Fiscal 2002 Fiscal 2001
----------------------- -----------------------
High Low High Low
--------- --------- ---------- ---------
First Quarter $ 12.50 $ 8.00 $ 13.00 $ 12.50
Second Quarter $ 12.00 $ 10.00 $ 13.00 $ 12.00
Third Quarter $ 10.50 $ 9.50 $ 13.00 $ 12.00
Fourth Quarter $ 9.50 $ 9.50 $ 12.50 $ 8.00
As of December 31, 2002, the Company had approximately 1,116 stockholders
of record.
Holders of our common stock are entitled to receive dividends when, as and
if declared by our board of directors. We have never paid dividends on our
common stock. We conduct our principal business through our subsidiaries,
primarily the Bank. We derive cash available to pay dividends primarily, if not
entirely, from
14
dividends paid by our subsidiaries. There are certain restrictions that limit
the Bank's ability to pay dividends to us and on our ability to pay dividends.
In addition, the Bank is currently prohibited from paying dividends to the
Company without the prior approval of the Superintendent of the State Banking
Department. Our ability to pay dividends to our stockholders will depend on our
earnings and financial condition, liquidity and capital requirements, the
general economic and regulatory climate, our ability to service any equity or
debt obligations senior to our common stock and other factors deemed relevant by
our board of directors. We currently intend to retain any future earnings to
fund the development and growth of our business. Therefore, we do not at the
present time anticipate paying any cash dividends on our common stock in the
foreseeable future.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information as of December 31, 2002 regarding
compensation plans (including individual compensation arrangements) under which
common stock of the Company is authorized for issuance.
EQUITY COMPENSATION PLAN INFORMATION
Number of securities
remaining available for
Number of Securities to be Weighted-average exercise future issuance under
issued upon exercise of price of outstanding equity compensation plans
outstanding options, options, warrants and (excluding securities
warrants and rights rights reflected in column (a))
Plan Category (a) (b) (c)
- ------------------------------- ---------------------------- ---------------------------- ----------------------------
Equity Compensation
Plans Approved by
Security Holders 3,239,016 3.75 --
Equity Compensation
Plans not Approved by
Security Holders -- -- --
Total 3,239,016 3.75
See Note 13 to the Consolidated Financial Statements for information regarding
the material features of the above plans. Each of the above plans provides that
the number of shares with respect to which options may be granted, and the
number of shares of Company Common Stock subject to an outstanding option, shall
be proportionately adjusted in the event of a subdivision or consolidation of
shares or the payment of a stock dividend on Company Common Stock, and the
purchase price per share of outstanding options shall be proportionately
revised.
15
MANAGEMENT'S STATEMENT ON
RESPONSIBILITY FOR FINANCIAL REPORTING
HERITAGE FINANCIAL HOLDING CORPORATION
The management of Heritage Financial Holding Corporation is responsible for
the content and integrity of the consolidated financial statements and all other
financial information included in this annual report. Management believes that
the financial statements have been prepared in conformity with generally
accepted accounting principles applied on a consistent basis to reflect, in all
material respects, the substance of events and transactions that should be
included, and that the other financial information in the annual report is
consistent with those financial statements. The financial statements necessarily
include amounts that are based on management's best estimates and judgments.
Management maintains and depends upon Heritage Financial Holding
Corporation's accounting systems and related systems of internal controls. The
internal control systems are designed to ensure that transactions are properly
authorized and recorded in the Company's financial record and to safeguard the
Company's assets from material loss or misuse. The Company maintains an internal
audit staff which monitors compliance with the Company's systems of internal
controls and reports to management and to the audit committee of the board of
directors.
The audit committee of the board of directors, composed solely of outside
directors, has responsibility for recommending to the board of directors the
appointment of the independent auditors for Heritage Financial Holding
Corporation. The committee meets periodically with the internal auditors and the
independent auditors to review the scope and findings of their respective
audits. The internal auditors, independent auditors and management each have
full and free access to meet privately as well as together with the committee to
discuss internal controls, accounting, auditing, or other financial reporting
matters.
The consolidated financial statements of Heritage Financial Holding
Corporation have been audited by Schauer, Taylor, Cox, Vise, Morgan, and Fowler,
P.C., independent auditors, who were engaged to express an opinion as to the
fairness of presentation of such financial statements.
/s/ Thomas E. Hemmings /s/ Harold B. Jeffreys
- --------------------------- ---------------------------
Thomas E. Hemmings Harold B. Jeffreys
Chief Financial Officer Interim President and
Chief Executive Officer
16
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data and ratios for the
Company and should be read in conjunction with our consolidated financial
statements including the related notes and "Management's Discussion and Analysis
of Financial Condition and Results of Operations." See "Item 8. Heritage
Financial Holding Corporation and Subsidiaries Financial Statements."
Years ended December 31,
---------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ---------- ----------- ----------
(Dollars in thousands except per share data)
Earnings Summary:
Interest income..................................$ 41,939 $ 44,253 $ 35,660 $ 17,248 $ 9,383
Interest expense................................. 21,742 28,594 22,018 9,874 5,399
Net interest income.............................. 20,197 15,659 13,642 7,374 3,984
Provision for loan losses........................ 29,469 3,602 3,389 1,808 828
Net interest income (loss) after
provision for loan losses...................... (9,272) 12,057 10,253 5,566 3,156
Noninterest income............................... 2,275 1,556 1,039 642 397
Noninterest expense.............................. 15,303 10,023 8,113 4,952 2,937
Income (loss) before income taxes................ (22,300) 3,590 3,179 1,256 616
Income taxes..................................... (7,887) 1,224 991 395 197
Net income (loss)................................ (14,413) 2,366 2,188 861 419
Per Common Share Data:
(Retroactively adjusted for effects of stock splits)
Net income (loss) - basic........................$ (1.65) $ 0.28 $ 0.26 $ 0.12 $ 0.07
Net income (loss) - diluted...................... (1.40) 0.23 0.22 0.11 0.07
Cash dividends declared per common share......... 0.00 0.00 0.00 0.00 0.00
Selected Average Balances:
Total assets.....................................$ 617,255 $ 559,921 $ 401,615 $ 213,101 $ 114,834
Total loans...................................... 544,079 489,897 333,340 172,418 83,217
Securities....................................... 39,961 26,662 23,183 19,405 15,786
Earning assets................................... 605,723 546,517 389,795 204,643 109,675
Deposits......................................... 544,598 496,283 348,819 180,072 94,796
Stockholders' equity............................. 35,296 34,178 29,910 19,062 11,606
Shares outstanding (thousands) (split adjusted).. 8,717 8,485 8,317 7,226 5,616
Selected Period-End Balances:
Total assets.....................................$ 592,942 $ 568,291 $ 471,458 $ 297,952 $ 167,378
Total loans...................................... 523,850 505,381 422,135 244,620 116,723
Securities....................................... 36,762 25,894 26,846 19,969 21,723
Earnings assets.................................. 587,734 550,865 458,478 287,307 155,068
Deposits......................................... 525,631 504,310 421,244 249,032 137,001
Stockholders' equity............................. 23,703 36,124 33,499 21,920 19,009
Shares outstanding (thousands) (split adjusted).. 8,821 8,515 8,476 7,581 7,192
Selected Ratios:
Return on average equity......................... (4.08)% 6.92% 7.32% 4.52% 3.61%
Return on average assets......................... (2.34) 0.42 0.54 0.40 0.36
Net interest margin (taxable equivalent)......... 3.35 2.88 3.52 3.63 3.65
Allowance for loan losses to loans............... 5.15 1.20 1.20 1.24 1.20
Net charge-offs to average loans................. 1.57 0.53 0.41 0.10 0.15
Average equity to average assets................. 5.72 6.10 7.45 8.95 10.11
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
The following is a narrative discussion and analysis of significant changes
in our results of operations and financial condition. This discussion should be
read in conjunction with the consolidated financial statements and selected
financial data included elsewhere in this Annual Report.
Our principal subsidiary is Heritage Bank, a financial institution
organized and existing under the laws of Alabama and headquartered in Decatur,
Alabama. The Bank operates ten offices throughout Northern Alabama. The Company
also has another wholly-owned subsidiary, Heritage Financial Statutory Trust I
("Heritage Trust"), a Connecticut statutory trust. Heritage Trust is a
consolidated special purpose entity formed solely to issue cumulative trust
preferred securities.
The Company was established in the year 2000 in order to facilitate a
reorganization and merger of the Company and the Bank into a bank holding
company structure. The reorganization was effective on August 31, 2000.
RECENT DEVELOPMENTS
As previously reported in the Form 10-Q filings of the Company for the
quarterly periods ended June 30, 2002 and September 30, 2002, a targeted,
limited scope review of the loan portfolio of the Bank by regulatory authorities
identified certain assets of the Bank that the regulatory authorities believed
should be classified. In connection with such review, the Company and the Bank
took steps to charge off or establish additional loan loss reserves for
specified assets and to adjust the Bank's levels of loan loss provisions.
The regulatory authorities charged with overseeing the Bank's operations
have outlined certain corrective actions to be taken by the Bank to address
concerns identified by the regulatory authorities. The Bank has agreed that it
will not declare or pay any cash dividends without seeking the prior approval of
the regulatory authorities. In addition, the Bank agreed to hire and retain
certain personnel who would be given specific written authority by the Board of
Directors to implement sound lending, recordkeeping and accounting practices.
The Bank is developing an educational program for board members and has created
a written review of the Bank's staffing requirements. Both the Board education
program and the written review of staffing requirements are required to be
submitted to the regulatory authorities for their review and comment.
The Bank also agreed to meet certain capital ratios. By December 31, 2002,
management of the Company and the Bank agreed to take steps to increase the
Bank's Tier 1 leverage ratio to 7.5 percent and to be "well-capitalized" as
defined by the FDIC. The Bank's Tier 1 leverage ratio must be no less than 8
percent by March 31, 2003, and the Bank must maintain a ratio of at least 8
percent until a reduction is approved by the regulatory authorities. The Bank
did not achieve a Tier 1 leverage ratio of 7.5 percent as of December 31, 2002,
and we believe the Bank may not achieve a Tier 1 leverage ratio of 8 percent if
the Bank is unable to acquire additional capital. Should the Tier 1 leverage
ratio fall below the minimum specified levels, the Bank must notify the
regulatory authorities and take steps to increase capital sufficient to meet the
required ratios within 30 days.
Management of the Company and the Bank are focused on addressing asset
quality, loan and audit issues. The Bank has charged off the balance of any
assets classified Loss and one-half of those assets classified Doubtful in any
official report of examination by any of the regulatory authorities. The Bank
has also reduced the balance of assets classified Substandard or Doubtful, and
has refused to extend additional credit to any borrower obligated to the Bank on
any extension of credit that has been charged off by the Bank or classified Loss
or Doubtful as long as such credit remains uncollected. In addition, the Bank
has commenced a review of its existing written loan policies and has adopted new
internal loan review systems to address problems with the Bank's loan portfolio.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a
18
description of the accounting policies applied by the Company which are deemed
"critical." In determining which accounting policies are "critical" in nature,
the Company has identified the policies that require significant judgment or
involve complex estimates. The application of these policies has a significant
impact on the Company's financial statements. Financial results could differ
significantly if different judgments or estimates are applied.
Allowance for Loan Losses
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of the
adequacy of the allowance for loan losses is based on a formal analysis which
assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, level of
nonperforming loans, loan concentrations, and review of certain individual
loans. Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management's ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the bank's allowances for loan
losses. Such agencies may require the bank to recognize additions to the
allowance for loan losses based on their judgments.
SUMMARY
Our net loss for 2002 was ($14,413,000), a 709.2% decrease from 2001 which
was $2,366,000. Net income for the year 2001 represented a 8.2% increase from
2000 net income of $2,188,000. Our basic earnings (loss) per common share for
2002, 2001 and 2000 were $(1.65), $0.28 and $0.26, respectively. Pretax loss for
2002 decreased $25,890,000 or 721.2% from 2001 and pretax income for 2001
increased $411,000 or 12.9% from 2000.
The decrease in net income for 2002 is primarily attributable to an
increase in provision for loan losses, and retirement costs associated with the
retirement of the Company's former CEO.
EARNING ASSETS
Our total assets were $592,942,000 at December 31, 2002, an increase of
$24,651,000, or 4.3% from $568,291,000 as of December 31, 2001. The increase in
total assets primarily related to an increase in securities available for sale
of $10,868,000 and other assets, primarily deferred tax assets, of $9,169,000.
The increase in total assets was funded primarily by an increase in deposits.
Our average earning assets were approximately $605,723,000 in 2002,
representing an increase of $59,206,000 or 10.8% over 2001 Average earning
assets in the year 2001 were approximately $546,517,000, representing an
increase of $156,722,000 or 40.2% over the 2000 amount of $389,795,000.
Management considers many criteria in managing assets, including
creditworthiness, diversification and structural characteristics, maturity and
interest rate sensitivity. The following table sets forth the Bank's
interest-earning assets by category at December 31, in each of the last three
years.
Years Ended December 31,
----------------------------------------------
2002 2001 2000
------------- ------------- --------------
(In thousands)
Interest-bearing deposits with banks............................. $ 98 $ 326 $ 817
Securities....................................................... 36,762 25,894 26,846
Federal funds sold............................................... 14,681 6,716 8,680
Mortgage loans held-for-sale..................................... 12,343 12,548 --
Loans:
Real estate................................................... 371,714 344,749 296,025
Commercial and other.......................................... 152,136 160,632 126,110
------------- ------------- --------------
Total loans................................................. 523,850 505,381 422,135
------------- ------------- --------------
Interest-earning assets ......................................... $ 587,734 $ 550,865 $ 458,478
============= ============= ==============
19
LOAN PORTFOLIO
Loans are the largest category of interest-earning assets and typically
provide higher yields than other types of interest-earning assets. Loans involve
inherent risk and liquidity risks which management attempts to control and
mitigate. Our average loans increased $54,182,000 or 11.1% from year-end 2002 to
2001. The increase in loans was a result of strong loan demand. Loan growth for
2002 was funded primarily through deposits. The most significant loan increase
came from real estate mortgage loans which increased approximately $36,832,000
or 13.4% over the 2001 year-end amount.
Our average loans increased $156,557,000 or 47.0% from year-end 2000 to
2001. The increase in loans was a result of continued loan demand. Loan growth
for the year 2001 was funded primarily through deposits. The most significant
loan increase came from commercial, financial and agricultural loans which
increased by $32,951,000 or 31.3% over 2000.
The Loan Portfolio table presents the classifications of loans by major
category at December 31, 2002, and for each of the preceding four years.
Loan Portfolio
December 31,
-------------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
------------------ ------------------ ------------------ ------------------ -----------------
Percent Percent Percent Percent Percent
Amount of Total Amount of Total Amount of Total Amount of Total Amount of Total
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
(Dollars in Thousands)
Commercial,
financial and
agricultural............... $132,237 25.24% $138,344 26.71% $105,393 24.97% $66,144 27.04% $45,105 38.64%
Real estate - construction.. 60,206 11.49 70,073 13.53 90,603 21.46 49,432 20.21 12,583 10.78
Real estate - mortgage....... 311,508 59.47 274,676 55.46 205,422 48.66 112,643 46.05 45,320 38.83
Consumer..................... 19,899 3.80 22,288 4.30 20,717 4.91 16,410 6.70 13,658 11.70
Other........................ -- 0.00 -- 0.00 -- 0.00 -- 0.00 57 0.05
-------- -------- -------- -------- -------- -------- -------- -------- -------- --------
.............................. 523,850 100.00% 505,381 100.00% 422,135 100.00% 244,629 100.00% 116,723 100.00%
======== ======== ======== ======== ========
Allowance for loan losses.... (26,991) (6,074) (5,065) (3,036) (1,402)
Unearned income.............. -- -- -- (9) --
-------- -------- -------- -------- --------
Net loans.................... $496,859 $499,307 $417,070 $241,584 $115,321
======== ======== ======== ======== ========
20
The following table sets forth maturities of selected categories of the
loan portfolio and the related sensitivity to interest rate changes.
SELECTED LOAN MATURITY AND INTEREST RATE SENSITIVITY
Rate Structure for Loans
Maturity Maturing Over One Year
------------------------------------------------------ -----------------------------
Over One
One Year Over Predetermined Floating or
Year or Through Five Interest Adjustable
Less Five Years Years Total Rate Rate
----------- ----------- ----------- ----------- ------------- ------------
(Amounts in thousands)
Commercial, financial
and agricultural........ $ 71,571 $ 51,850 $ 8,816 $ 132,237 $ 45,839 $ 14,827
Real estate - construction. 45,032 12,735 2,439 60,206 6,009 9,165
----------- ----------- ----------- ----------- ------------- ------------
Total................. $ 116,603 $ 64,585 $ 11,255 $ 192,443 $ 51,848 $ 23,992
=========== =========== =========== =========== ============= ============
SECURITIES PORTFOLIO
Our securities portfolio increased by $10,868,000 or 42.0% from the year
2001 to 2002. The balance in the securities portfolio increased as a result of
deposit growth in 2002. Our securities portfolio decreased by $952,000 or 3.6%
from 2000 to 2001 as a result of strong loan demand in 2001.
We maintain an investment strategy of seeking portfolio yields within
acceptable risk levels, as well as providing liquidity. The Bank maintains one
classification of securities: "Available-for-Sale." The classification of
securities as Available-for-Sale is consistent with our investment philosophy of
maintaining flexibility to manage the portfolio. The Available-for-Sale
securities are carried at fair market value and represent all of our securities
at year-end 2002 and 2001. At year-ends 2002 and 2001, unrealized losses in the
Available-for-Sale portfolio amounted to $94,509 and $94,581, respectively.
At year-ends 2002 and 2001, obligations of the United States Government or
its agencies and obligations of states and political subdivisions represented
approximately 63.1% and 73.0%, respectively, of our securities portfolio.
The following table presents the carrying amounts of our securities
portfolio at December 31, in each of the last three years.
Securities Portfolio
December 31,
----------------------------------------------
2002 2001 2000
------------- ------------- --------------
(In thousands)
Available-for-Sale
U.S. government and agencies................................. $ -- $ 15,697 $ 18,450
Mortgage-backed securities................................... 23,208 617 1,020
Asset-backed securities...................................... -- 4,474 1,986
State and municipal.......................................... 1,330 2,590 2,300
Corporate debt securities.................................... 10,588 1,190 1,244
Equity securities............................................ 1,636 1,326 1,846
------------- ------------- --------------
Total...................................................... $ 36,762 $ 25,894 $ 26,846
============= ============= ==============
21
The maturities and weighted average yields of the investments in the 2002
portfolio of securities are presented below.
SECURITY PORTFOLIO MATURITY SCHEDULE
Maturing
--------------------------------------------------------------------------------------
Within After One But After Five But After
One Year Within Five Years Within Ten Years Ten Years
-------------------- -------------------- -------------------- --------------------
Amount Yield Amount Yield Amount Yield Amount Yield
-------- -------- -------- -------- -------- -------- --------- -------
(Amounts in thousands)
Securities Available-for-Sale
(amortized cost)
Mortgage-backed securities.... $ 32 -- $ 2,517 3.63% $ 9,371 4.35% 10,912 4.38%
State and municipal (1)....... -- -- -- -- -- -- 1,294 5.27
Corporate debt securities..... -- -- 2,433 3.99 -- -- 8,472 6.86
Equity securities............. -- -- -- -- -- -- 1,636 7.74
-------- -------- -------- ---------
$ 32 -- $ 4,950 3.81 $ 9,371 4.35 $ 22,314 5.62
======== ======== ======== =========
(1) The weighted average yields are calculated on the basis of the cost and
effective yield weighted for the scheduled maturity of each security. The
weighted average yields on tax-exempt obligations have been computed on a
fully taxable equivalent basis using a tax rate of 34%. The taxable
equivalent adjustment represents the annual amounts of income from
tax-exempt obligations multiplied by 152%.
We did not hold any securities of which the aggregate value on December 31,
2002, 2001 and 2000 exceeded ten percent of stockholders' equity at that date.
(Securities which are payable from and secured by the same source of revenue or
taxing authority are considered to be securities of a single issuer. Securities
of the U.S. Government and U.S. Government agencies and corporations are not
included.)
DEPOSITS AND BORROWED FUNDS
Our average deposits rose $48,315,000 or 9.7% from the year 2001 to 2002.
Total deposits increased $21,321,000 or 4.2% from 2001 to 2002. The largest area
of growth in 2002 was in interest bearing demand accounts, which increased
$7,417,000 or 13.8%. From 2001 to 2002, other time deposits of more than
$100,000 increased $4,990,000 or 3.5%. Savings deposits increased $3,582,000 or
7.4%, and time deposits of less than $100,000 increased $4,616,000 or 1.9%. From
year-end 2001 to year-end 2002, total non-interest bearing deposits increased
$716,000 or 3.4%. Deposit growth has been generated primarily outside of our
local markets.
Our average deposits rose $147,464,000 or 42.3% from 2000 to 2001. Total
deposits increased $83,066,000 or 19.7% from 2000 to 2001. The largest area of
growth in 2001 was in other time deposits of less than $100,000, which increased
$33,227,000 or 16.1%. From 2000 to 2001, other time deposits of more than
$100,000 increased $7,126,000 or 5.3%, savings deposits increased $13,501,000 or
38.9%, and interest bearing demand accounts increased $19,570,000 or 57.2%. From
year-end 2000 to year-end 2001, total non-interest bearing deposits increased
$9,642,000 or 82.7%. Deposit growth has been generated primarily in our local
markets.
22
The following table sets forth our deposit structure at December 31, of
each of the last three years.
December 31,
----------------------------------------------
2002 2001 2000
------------- ------------- --------------
(In thousands)
Noninterest-bearing deposits:
Individuals, partnerships and corporations.................... $ 22,012 $ 21,296 $ 11,374
U.S. Government and states and political subdivisions......... -- -- --
Certified and official checks................................. -- -- 280
------------- ------------- --------------
Total noninterest-bearing deposits.......................... 22,012 21,296 11,654
------------- ------------- --------------
Interest-bearing deposits:
Interest-bearing demand accounts.............................. 61,193 53,776 34,206
Saving accounts............................................... 51,769 48,187 34,686
Certificates of deposit, less than $100,000................... 244,447 239,831 206,604
Certificates of deposit, more than $100,000................... 146,210 141,220 134,094
------------- ------------- --------------
Total interest-bearing deposits............................. 503,619 483,014 409,590
------------- ------------- --------------
Total deposits.............................................. $ 525,631 504,310 $ 421,244
============= ============= ==============
The following table presents a breakdown by category of the average amount
of deposits and the average rate paid on deposits for the periods indicated:
Years Ended December 31,
------------------------------------------------------------------------
2002 2001 2000
--------------------- ---------------------- -----------------------
Amount Rate Amount Rate Amount Rate
---------- --------- ---------- --------- ----------- ---------
(Dollars in thousands)
Noninterest-bearing deposits............. $ 21,832 .00% $ 16,975 0.00% $ 13,116 0.00%
Interest-bearing demand deposits......... 50,622 1.61 39,299 3.10 28,895 3.74
Savings deposits......................... 64,773 1.92 43,079 3.17 28,664 5.16
Time deposits............................ 407,370 4.33 396,930 6.09 278,144 6.58
---------- --------- ---------- --------- ------------ ---------
Total deposits........................ $ 544,597 3.62% $ 496,283 5.39% $ 348,819 5.98%
========== ========== ============
At December 31, 2002, time deposits greater than $100,000 aggregated
approximately $146,209,000. The following table indicates, as of December 31,
2002, the dollar amount of $100,000 or more by the time remaining until maturity
(in thousands):
MATURITIES OF LARGE TIME DEPOSITS
(In thousands)
Three months or less........................................................... $ 19,951
Over three through six months.................................................. 35,112
Over six through twelve months................................................. 45,821
Over twelve months............................................................. 45,325
-------------
Total........................................................................ $ 146,209
=============
Borrowed funds of $39,650,000 as of December 31, 2002, consist of long-term
Federal Home Loan Bank advances, an advance from a pooled trust preferred
private placement for subordinated debentures and a short-term borrowing from a
commercial bank. We had $13,500,000 in available lines to purchase Federal
Funds, on an unsecured basis, from commercial banks. At December 31, 2002, 2001
and 2000, we had no funds advanced against these lines. We are also approved to
borrow up to $65,223,000 under various short-term and long-term programs offered
by the Federal Home Loan Bank of Atlanta. These borrowings are secured under a
blanket lien agreement on certain qualifying mortgage instruments in loan and
investment security portfolios. The unused portion of these available funds
amounted to $42,223,000 at year-end 2002 and $46,000,000 at year-end 2001.
23
The following table sets forth the expected debt service for the next five
years based on interest rates and repayment provisions as of December 31, 2002.
MATURITIES OF LONG-TERM DEBT
(In thousands)
2003 2004 2005 2006 2007
--------- --------- --------- --------- ---------
Interest on indebtedness......................... $ 1,986 $ 1,986 $ 1,986 $ 1,986 $ 1,986
Repayment of principal........................... -- -- -- -- --
--------- --------- --------- --------- ---------
$ 1,986 $ 1,986 $ 1,986 $ 1,986 $ 1,986
========= ========= ========= ========= =========
CAPITAL RESOURCES
Stockholders' equity decreased $12,421,000 or 34.4% to $23,703,000 as of
December 31, 2002. The decrease in stockholders' equity was primarily
attributable to the net loss for the year. Stockholders' equity increased
$2,625,000 or 7.8% to $36,124,000 as of December 31, 2001. Stockholders' equity
increased $11,579,000 or 52.8% to $33,499,000 as of December 31, 2000. The
increases in stockholders' equity in 2001 and 2000 were attributable to net
income and the issuance of stock through exempt offerings, employee stock
purchase plan purchases and the exercise of stock options.
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage
Trust"), a Connecticut statutory trust established by the Company, received
$10,000,000 in proceeds in exchange for $10,000,000 principal amount of Heritage
Trust's 10.20% cumulative trust preferred securities (the "preferred
securities") in a pooled trust preferred private placement. The proceeds of that
transaction were then used by Heritage Trust to purchase an equal amount of our
10.20% subordinated debentures (the "subordinated debentures").
Under the terms of the indenture, we may elect to defer payments of
interest for up to ten semiannual payment periods. For the duration of such
deferral period, we are restricted from paying dividends to shareholders or
paying debt that is junior to the debentures.
We have fully and unconditionally guaranteed all obligations of Heritage
Trust on a subordinated basis with respect to the preferred securities. We
account for the Heritage Trust preferred securities as a minority interest.
Subject to certain limitations, the preferred securities qualify as Tier 1
capital and are presented in the Consolidated Statements of Financial Condition
as "Guaranteed preferred beneficial interests in the Company's subordinated
debentures." The sole asset of Heritage Trust is the subordinated debentures
issued by us. Both the preferred securities of Heritage Trust and our
subordinated debentures each have 30-year lives. However, both the Company and
Heritage Trust have a call option of ten years, subject to regulatory approval,
or earlier, depending upon certain changes in tax or investment company laws, or
regulatory capital requirements.
A strong capital position, which is vital to our continued profitability,
also promotes depositor and investor confidence and provides a solid foundation
for the future growth of the organization. The objective of management is to
maintain a level of capitalization that is sufficient to take advantage of
profitable growth opportunities while meeting regulatory requirements. This is
achieved by improving profitability through effectively allocating resources to
more profitable businesses, improving asset quality, strengthening service
quality, and streamlining costs. The primary measures used by management to
monitor the results of these efforts are the ratios of return on average assets,
return on average common equity and average equity to average assets.
24
The table below summarizes these and other key ratios for us for each of
the last three years.
RETURN ON EQUITY AND ASSETS
2002 2001 2000
----------- ----------- -----------
Return on average assets........................................... (2.34)% 0.42% 0.54%
Return on average common equity.................................... (4.08) 6.92 7.32
Dividend payout ratio.............................................. 0.00 0.00 0.00
Average common shareholders' equity to average
assets ratio.................................................... 5.72 6.10 7.45
In addition, banks and bank holding companies are required to maintain
capital to support, on a risk-adjusted basis, certain off-balance sheet
activities such as loan commitments. The Federal Reserve Board has adopted
capital guidelines governing the activities of bank holding companies. These
guidelines require the maintenance of an amount of capital based on
risk-adjusted assets so that categories of assets with potentially higher credit
risk will require more capital than assets with lower risk.
The capital guidelines classify capital into two tiers, referred to as Tier
1 and Tier 2. Under risk-based capital requirements, Total Capital consists of
Tier 1 capital which is generally common stockholders' equity less goodwill and
Tier 2 capital which is primarily a portion of the allowance for loan losses and
certain qualifying debt instruments. In determining risk-based capital
requirements, assets are assigned risk-weights of 0% to 100%, depending
primarily on the regulatory assigned levels of credit risk associated with such
assets. Off-balance sheet items are considered in the calculation of
risk-adjusted assets through conversion factors established by the regulators.
The framework for calculating risk-based capital requires banks and bank holding
companies to meet the regulatory minimums of 4% Tier 1 and 8% total risk-based
capital. In 1990 regulators added a leverage computation to the capital
requirements, comparing Tier 1 capital to total average assets less goodwill.
The table below illustrates our regulatory capital ratios under federal
guidelines at December 31, 2002, 2001 and 2000:
CAPITAL ADEQUACY RATIOS
Statutory Years ended December 31,
----------------------------------------
Minimum 2002 2001 2000
------------ ----------- ----------- -----------
(Amounts in thousands)
Tier 1 Capital $ 30,749 $ 46,180 $ 33,658
Tier 2 Capital 8,687 6,074 5,065