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EX-32 - EX-32 - FNCB Bancorp, Inc.a11-23234_1ex32.htm
EX-31.2 - EX-31.2 - FNCB Bancorp, Inc.a11-23234_1ex31d2.htm
EX-31.1 - EX-31.1 - FNCB Bancorp, Inc.a11-23234_1ex31d1.htm
EX-10.6 - EX-10.6 - FNCB Bancorp, Inc.a11-23234_1ex10d6.htm
EX-10.5 - EX-10.5 - FNCB Bancorp, Inc.a11-23234_1ex10d5.htm

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-K/A

Amendment No. 1

 

x

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

 

For the fiscal year ended December 31, 2009

 

OR

 

o

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

 

For the transition period from                      to                     

 

Commission File No. 000-53869

 

FIRST NATIONAL COMMUNITY BANCORP, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Pennsylvania

 

23-2900790

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

 

 

102 E. Drinker St., Dunmore, PA

 

18512

(Address of Principal Executive Offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code    (570) 346-7667

 

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

NONE

 

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

Common Stock, $1.25 par value

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No x

 

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

 

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

 

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

 

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

 

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

 

Large Accelerated Filer o

Accelerated Filer  x

 

 

Non-Accelerated Filer o

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

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

 

The aggregate market value of the voting and non-voting common stock of the registrant, held by non-affiliates was $102,938,176 at June 30, 2009.

 

APPLICABLE ONLY TO CORPORATE REGISTRANTS

 

State the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 16,441,319 shares of common stock as November 29, 2011.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Shareholders held on May 19, 2010 are incorporated by reference into Part III of this report.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

 

 

 

Page

 

 

 

Explanatory Note

 

3

 

 

 

 

PART I

 

 

 

 

 

 

 

Item 1.

Business

 

4

Item 1A.

Risk Factors

 

15

Item 1B.

Unresolved Staff Comments

 

21

Item 2.

Properties

 

21

Item 3.

Legal Proceedings

 

23

Item 4.

(Removed and Reserved)

 

23

 

 

 

 

PART II

 

 

 

 

 

 

 

Item 5.

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

 

23

Item 6.

Selected Financial Data

 

27

Item 7.

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

 

28

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

56

Item 8.

Financial Statements and Supplementary Data

 

60

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

107

Item 9A.

Controls and Procedures

 

107

Item 9B.

Other Information

 

113

 

 

 

 

PART III

 

 

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

 

113

Item 11.

Executive Compensation

 

113

Item 12.

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

 

113

Item 13.

Certain Relationships and Related Transactions, and Director Independence

 

113

Item 14.

Principal Accountant Fees and Services

 

113

 

 

 

 

PART IV

 

 

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

 

114

 

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FIRST NATIONAL COMMUNITY BANCORP, INC.

 

EXPLANATORY NOTE

 

This Amendment No. 1 (“Amendment”) on Form 10-K/A to the Annual Report on Form 10-K of First National Community Bancorp, Inc.  (the “Company”) for the year ended December 31, 2009, filed with the Securities and Exchange Commission (“SEC”) on March 16, 2010 (the “Original Report”) is being filed to revise and restate the Company’s consolidated financial statements for the annual period ended December 31, 2009 that were filed with the Original Report to correct certain information and to address the impact of such changes on other disclosures included in the Original Report.  The Company has previously advised that the financial statements for December 31, 2009 included in the Original Report should no longer be relied upon.

 

In particular, this Amendment:

 

·                  amends and restates in their entirety the consolidated financial statements of the Company, and the notes thereto, included in Item 8 hereof, to appropriately reflect (i) the accounting for and timing of charges related to other than temporary impairment of the collateralized debt obligations in the Company’s securities investment portfolio, (ii) the determination of the Company’s provision and allowance for loan and lease losses, (iii) the provision for off-balance sheet commitments, (iv) the accounting for deferred loan fees and costs, (v) the accounting for goodwill, (vi) the related effect on the Company’s deferred tax assets and valuation allowance and (vii) other miscellaneous accounting issues;

·                  amends and revises Management’s Discussion and Analysis of Financial Condition and Results of Operations to reflect the restated consolidated financial statements;

·                  revises the disclosures regarding, and management’s assessment of, the Company’s disclosure controls and procedures and internal control over financial reporting to reflect current management’s determination that material weaknesses in such controls existed at December 31, 2009;

·                  provides additional disclosure regarding non-performing assets, including those loans extended to insiders or affiliates thereof;

·                  revises and enhances the disclosures about the Company’s business lines and procedures, including providing information relating to the Company’s and Bank’s regulatory orders entered into after the date of the Original Report to provide context for the amendments included in this document;

·                  revises and enhances the disclosure of the risks relating to the Company’s business and operations; and

·                  revises and corrects disclosure in response to comments from the SEC.

 

Other than as noted above, the Company is not required to and has not updated any forward-looking statements previously included in the Original Report. The Company has made no attempt in this Amendment to modify or update the disclosures presented in the Original Report other than as noted above.  Other than as noted above, or reflected in this Explanatory Note, this Amendment does not reflect events occurring after the filing of the Original Report except to the extent information learned after the Original Report was filed relates to periods prior to December 31, 2009.  This Amendment is being filed in conjunction with amendments to the Company’s quarterly reports on Form 10-Q for the quarterly periods ended March 31, 2010 and June 30, 2010.  The Company plans to file shortly its annual report on Form 10-K for the year ended December 31, 2010 and its quarterly reports on Form 10-Q for the quarterly periods ended September 30, 2010, March 31, 2011, June 30, 2011 and September 30, 2011.  This Amendment should be read in conjunction with all such filings and all such filings should be read in their entirety.

 

As indicated above, the Company has restated its financial statements for the year ended December 31, 2009.  Unless otherwise indicated, the discussion in this Amendment gives effect to the restatement of the Company’s financial statements.

 

In the first half of 2011, the Company received document subpoenas from the SEC.  The information requested generally relates to disclosure and financial reporting by the Company and the restatement of the Company’s financial statements for the year ended December 31, 2009, and the quarters ended March 30, 2010 and June 30, 2010.  The Company is cooperating with the SEC in this matter.

 

Readers should review the risk factors described in other documents that the Company files or furnishes, from time to time, with the SEC, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K, Form 10-Q and other current reports filed or furnished on Form 8-K and any amendments to such reports.

 

For additional information regarding these matters, please refer to Item 1 — Business; Item 1A — Risk Factors; Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations; Item 7A -  Quantitative and Qualitative Disclosures about Market Risk discussion; and Item 8 — Financial Statements and Supplementary Data of this report.

 

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PART 1

 

Item 1.  Business

 

Unless the context otherwise requires, we use the terms “Company,” “we,” “us,” and “our” to refer to First National Community Bancorp, Inc. and its subsidiaries.  In certain circumstances, however, First National Community Bancorp, Inc. uses the term “Company” to refer to itself.

 

Overview

 

The Company

 

The Company is a Pennsylvania corporation, incorporated in 1997 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended.  The Company became an active bank holding company on July 1, 1998 when it acquired ownership of First National Community Bank (the “Bank”).   The Bank is a wholly-owned subsidiary of the Company.

 

The Company’s primary activity consists of owning and operating the Bank, which provides customary retail and commercial banking services to individuals and businesses.  The Bank provides practically all of the Company’s earnings as a result of its banking services.

 

The Bank

 

The Bank was established as a national banking association in 1910 as “The First National Bank of Dunmore.”  The Bank changed its name to “First National Community Bank” effective March 1, 1988.  The Bank’s operations are conducted from 21 offices located in Lackawanna, Luzerne, Wayne and Monroe Counties, Pennsylvania.

 

The Bank offers many traditional banking services to its customers, which are further detailed below.

 

As a result of criticism received from banking regulators in connection with their examination process during 2010, the Company took steps to remediate and improve its lending policies and its credit administration function.  The Company has also been advised by its regulators that it must increase its regulatory capital.

 

Retail Banking

 

The Bank provides many retail banking services and products to individuals and businesses including Image Checking and E-Statement.  Deposit products include various checking, savings and certificate of deposit products, as well as a variety of preferred products for higher balance customers.  The Bank also participates in the Certificate of Deposit Account Registry program, which allows customers to secure Federal Deposit Insurance Corporation (“FDIC”) insurance on balances in excess of the standard limitations.

 

The Bank also offers customers the convenience of 24-hour banking, seven days a week, through FNCB Online and its Bill Payment service via the internet and its automated teller machine (“ATM”) network.  The Bank has ATMs in all 21 branch offices and 10 other locations.

 

Telephone Banking (Account Link), Loan by Phone, and Mortgage Link services are available to customers.  These services provide consumers the ability to access account information, perform related account transfers, and apply for a loan through the use of a touch tone telephone.  The Bank offers overdraft Bounce Protection which provides consumers with an added level of protection against unanticipated cash flow emergencies and account reconciliation errors.

 

FNCB Business Online is a menu driven product that allows the Bank’s business customers direct access to their account information and the ability to perform internal and external transfers and process Direct Deposit payroll transactions for employees, 24 hours a day, 7 days a week, from their place of business.

 

Lending Activities

 

The Bank offers a full range of products to individuals and businesses generally within its market area.  The Bank offers a variety of loans, including commercial mortgages, commercial loans, residential mortgage loans, home equity loans and lines of credit, construction loans and consumer loans.

 

The Bank strives to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of an economic downturn or other negative influences.  Plans for mitigating inherent risks in managing loan assets include carefully enforcing loan policies and

 

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procedures, evaluating each borrower’s industry and business plan during the underwriting process, identifying and monitoring primary and alternative sources for repayment and obtaining collateral that is margined to minimize loss in the event of liquidation.

 

Guidance adopted by the federal banking regulators provides that banks having concentrations in construction, land development or commercial real estate loans are expected to maintain higher levels of risk management and, potentially, higher levels of capital. It is possible that the Bank may be required to maintain higher levels of capital than would otherwise be expected as a result of its levels of construction, development and commercial real estate loans, which may adversely affect shareholder returns, or require us to obtain additional capital sooner than the Company otherwise would.  Excluded from the scope of this guidance are loans secured by non-farm nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property.

 

Commercial Mortgage Loans

 

At December 31, 2009, commercial mortgage loans totaled $411.3 million or 43.8% of the Bank’s total loan portfolio.  Commercial mortgage loans represent the largest portion of the Bank’s total loan portfolio and loans in this portfolio generally have larger loan balances.

 

The commercial mortgage loan portfolio is secured by a broad range of real estate, including but not limited to multi-family residential properties, office complexes, shopping centers, hotels, warehouses, gas stations/ convenience markets, residential care facilities, nursing care facilities, restaurants and land subdivisions.  This category also includes various types of commercial construction financing.  The Bank’s commercial real estate portfolio consists of owner occupied properties and non-owner occupied properties and generally includes the personal guarantees of the principals.  Owner occupied properties of $160 million represents 38.9% of the commercial mortgage loan portfolio, construction/land acquisition loans of $94 million represents 22.8% of the commercial mortgage loan portfolio and non-owner occupied properties of $158 million represents 38.3% of the commercial mortgage loan portfolio.

 

The Bank offers various rates and terms for commercial mortgage loans secured by real estate.  The interest rates associated with these types of loans are primarily underwritten as adjustable rate loans that adjust every three or five years or floating rate loans that adjust to a spread over the National Prime Rate (“NPR”) index.  Loan pricing for most floating rate commercial mortgage loans generally has a minimum interest rate.  The terms for commercial real estate loans typically do not exceed 20 years.

 

Commercial mortgage loans are originated under a comprehensive lending policy.  In particular, these types of loans are subject to specific loan to value guidelines prior to the time of closing.  The policy limits for developed real estate loans are subject to a maximum loan-to-value ratio of 80%.  Loans for undeveloped real estate are subject to a loan-to-value ratio not to exceed 65%.  Construction loans are treated similarly to the developed real estate loans and are generally subject to an 80% loan to value ratio based upon an “as-completed” appraised value.

 

Commercial mortgage loans must also meet specific criteria that includes the capacity, capital, credit worthiness and cash flow of the borrower and the project being financed.  In order to make a decision on whether or not to make a commercial mortgage loan, the borrower(s) and guarantor(s) must provide the Bank with historical and current financial data.  The Bank performs a review of the cash flow analysis of the borrower(s), guarantor(s) and the project.  The Bank also considers the borrower’s expertise, credit history, net worth and the value of the underlying property.  The Bank generally requires that borrowers for loans secured by real estate have a debt service coverage ratio of at least 1.15 times.

 

Although the Bank believes its initial loan underwriting was sound, the Commercial Loan portfolio, and in particular, the commercial mortgage segment, was negatively impacted during 2009 as a result of the current recession.  Both our national and local economies experienced a prolonged severe economic downturn, with rising unemployment levels and an erosion in consumer confidence.  These factors contributed to a number of loan defaults.  Additionally, the softening of the real estate market resulted in a decline in the value of the real estate securing the loans in this portfolio.  In particular, loans for land development and subdivisions were substantially impacted and create greater risk of collectability than other types of commercial mortgage loans.

 

One-to-Four-Family Residential Mortgage Loans

 

The Bank offers fixed and variable rate one-to-four-family residential loans.  The interest rates for the variable rate loans are adjusted to a percentage above the one year treasury rate.  The Bank may sell loans and retain servicing when warranted by market conditions.  The Bank also offers a rate lock to customers which allows the borrowers to lock in their interest rate at the time of application as well as at time of commitment.  During 2009 and 2008, the volume of customers who exercised the option to lock the rate was minimal.  At December 31, 2009, one to four family residential mortgage loans totaled $142.1 million, or 15.1% of our total loan portfolio.

 

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Commercial Business Loans

 

The Bank offers commercial business loans to individuals and businesses located in our primary market area.  The commercial loan portfolio includes lines of credit, dealer floor plan lines, equipment loans, vehicle loans, improvement loans and term loans.   These loans are primarily secured by vehicles, machinery and equipment, inventory, accounts receivable, marketable securities, deposit accounts and real estate.  At December 31, 2009, commercial business loans totaled $220.8 million or 23.5% of the Bank’s total loan portfolio

 

The Bank offers various rates and terms for commercial loans.  These loans also generally require the personal guarantee of the principals.  Most lines of credit are primarily issued for one year time periods and are renewable annually thereafter at the discretion of the Bank.  Most other commercial loans range in terms from one year to seven years.

 

The interest rates associated with these types of loans are primarily underwritten as fixed rate loans based upon the term of the loan or floating rate loans that adjust to a spread over the NPR index.  Loan pricing for most floating rate commercial loans generally have a minimum interest rate floor.  The interest rate for most lines of credit is issued on a floating rate basis.  The rates generally range from the NPR index to 2% in excess of the NPR index.  Finally, loans secured by deposit accounts are primarily underwritten at a spread over the interest rate of the deposit instrument used as collateral for the loan.

 

Construction Loans

 

The Bank offers interim construction financing secured by residential property for the purpose of constructing one to four family homes.  The Bank also offers interim construction financing for the purpose of constructing residential developments and various commercial properties including shopping centers, office complexes and single purpose owner occupied structures.  The Bank’s construction program offers either short term interest only loans that require the borrower to pay interest only during the construction phase with a balloon payment of the principal outstanding at the end of the construction period and interest only during construction with a conversion to amortizing principal and interest when the construction is complete.

 

Construction loans generally yield a higher interest rate than residential mortgage loans but also carry more risk.  If a construction loan defaults, the Bank would have to take control of the property and, either find another contractor to complete the project which may be at a higher cost, or obtain title to the property, categorize it as Other Real Estate Owned (“OREO”) or seek to sell the property.

 

Home Equity and Lines of Credit Loans

 

The Bank offers home equity loans and lines of credit with a maximum combined loan-to-value ratio of 90% based on the appraised value of the property.  Home equity loans have fixed rates of interest and are for terms up to 15 years.  Equity lines of credit have adjustable interest rates and are based upon the prime interest rate.  The Bank holds a first or second mortgage position on the homes that secure its home equity loans and lines of credit.

 

Consumer Loans

 

Consumer loans include both secured and unsecured installment loans, personal lines of credit and overdraft protection loans.  The Bank is also in the business of underwriting indirect auto loans which are originated through various auto dealers in northeastern Pennsylvania and dealer floor plan loans. The Bank also offers VISA personal credit cards, although it does not underwrite these VISA personal credit cards and assumes no credit risk.

 

Loan Originations, Sales, Purchases and Participations

 

Loan originations generally are from the Bank’s market area, however, from time to time, the Bank participates in loans originated by other banks that supplement its loan portfolio.  As of December 31, 2009, the Bank participated in approximately 26 loans with a total outstanding balance of $18.5 million and exposure of $59.6 million. Over the past six years, the Bank participated in seven commercial real estate loans with a financial institution headquartered in Minneapolis, Minnesota, and the majority of those participations related to loans for projects located outside of the Company’s general market area.  As of December 31, 2009, the Company had outstanding participations in four out-of-area loans secured by commercial real estate located in Florida and one in western Pennsylvania. The Bank is not usually the lead lender in these participations but underwrites these loans using the same criteria it uses for market loans it originates.  The Bank does not service the loans in these purchased participations and is subject to the policies and practices of the lead lender with regard to monitoring delinquencies, pursuing collections and instituting foreclosure proceedings.

 

Asset Management

 

Asset management services are available at the Bank. Customers are able to access alternative products such as mutual funds, annuities, stocks and bonds directly for purchase from an outside provider.

 

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Deposit Activities

 

In general, deposits, borrowings and loan repayments are the major sources of our funds for lending and other investment purposes.  The Bank grows its deposits within our market area primarily by offering a wide selection of deposit accounts.  Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors.  In determining the terms of our deposit accounts, the Bank considers the interest rates offered by the competition, the interest rates available on borrowings, its liquidity needs and customer preferences.  The Bank generally reviews its deposit mix and deposit pricing weekly.  The Bank’s deposit pricing strategy generally has been to remain competitive in its market area, and to offer special rates in order to attract deposits of a specific type or term to satisfy the Bank’s asset and liability requirements.

 

Competition

 

The Bank faces substantial competition in originating loans and in attracting deposits.  The competition comes principally from other banks, savings institutions, credit unions, mortgage banking companies and, with respect to deposits, institutions offering investment alternatives, including money market funds.  As a result of consolidation in the banking industry, some of the Bank’s competitors and their respective affiliates may enjoy advantages such as greater financial resources, a wider geographic presence, a wider array of services, or more favorable pricing alternatives and lower origination and operating costs.

 

Supervision and Regulation

 

General

 

The Company is subject to the Securities Exchange Act of 1934 (“1934 Act”) and must file quarterly and annual reports with the SEC regarding its business operations and comply with SEC rules.  As a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”), the Company is subject to supervision and regulation by the Board of Governors of the Federal Reserve System, and its activities and those of its bank subsidiary are limited to the business of banking and activities closely related or incidental to banking.  Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board (“FRB”).  The FRB has issued regulations under the BHCA that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the FRB, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to the Bank subsidiary during periods of financial stress or adversity.  The BHCA prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock or substantially all of the assets of any bank, or merging or consolidating with another bank holding company, without prior approval of the FRB.  The BHCA also prohibits the Company from acquiring 5% or more of the outstanding shares of any class of voting stock of any company engaged in a non-banking business unless such business is determined by the FRB, by regulation or by order, to be so “closely related to banking” as to be a “proper incident” thereto.

 

Banking is a highly regulated industry.  Consequently, the growth and earnings performance of the Bank and Company may be affected not only by management decisions and general and local economic conditions but also by the regulation of the Bank by the Office of the Comptroller of the Currency (“OCC”) (and, to some extent, the FDIC and Federal Reserve Bank of Philadelphia) and by the regulation of the Company by the Federal Reserve Bank of Philadelphia, under a variety of federal and state laws, regulations, and policies.  These statutes, regulations, and policies, and the interpretation and application of them by regulatory agencies, have a significant impact on the Company’s business, and cannot always be determined with complete accuracy.  The effect of any changes in these statutes, regulations, and policies, and the interpretation and application of them by regulatory agencies, can be significant and cannot be predicted.

 

The primary objectives of the bank regulatory system are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy and not to benefit shareholders.  Congress has created several regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry.  The system of supervision and regulation applicable to the Company and the Bank is intended primarily for the protection of the FDIC’s deposit insurance fund, the Bank’s depositors, and the public, rather than shareholders and creditors. The following summarizes some of the relevant laws, rules and regulations governing banks and bank holding companies, but does not represent a complete or thorough summary of all applicable laws and regulations applicable to banks and bank holding companies.  The descriptions are qualified in their entirety by reference to the specific statutes and regulations summarized.

 

Supervisory Actions

 

Subsequent to December 31, 2009 and to the filing of the Original Report, the Company and Bank entered into regulatory agreements with their respective federal regulators.  Set forth below is a summary description of the material terms of the regulatory agreements.  While the Company and the Bank have made significant efforts to comply with each of the provisions of the Order and the Agreement, as of the date of the filing of this Amendment, neither the Bank nor the Company is yet in compliance with all of the

 

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requirements, and no assurance can be given that they will be able to satisfy all of such requirements.

 

OCC Consent Order. The Bank, pursuant to a Stipulation and Consent to the Issuance of a Consent Order (the “Order”) dated September 1, 2010 without admitting or denying any wrongdoing, consented and agreed to the issuance of an Order by the OCC, the Bank’s primary regulator.  The Order requires the Bank to undertake certain actions within designated timeframes, and to operate in compliance with the provisions thereof during its term.  The Order is based on the results of an examination of the Bank as of March 31, 2009.  Since the examination, management has engaged in discussions with the OCC and has taken steps to improve the condition, policies and procedures of the Bank.  Compliance with the Order is to be monitored by a committee (the “Committee”) of at least three directors, none of whom is an employee or controlling shareholder of the Bank or its affiliates or a family member of any such person. The Committee is required to submit written progress reports on a monthly basis and the Agreement requires the Bank to make periodic reports and filings with the OCC. The members of the Committee are John P. Moses, Joseph Coccia, Joseph J. Gentile and Thomas J. Melone. The material provisions of the Order are as follows:

 

(i) By October 31, 2010, the Board of Directors of the Bank (the “Board”) is required to adopt and implement a three-year strategic plan which must be submitted to the OCC for review and prior determination of no supervisory objection; the strategic plan must establish objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in the volume of nonperforming assets, product line development, and market segments that the Bank intends to promote or develop, and is to include strategies to achieve those objectives; if the strategic plan involves the sale or merger of the Bank, it must address the timeline and steps to be followed to provide for a definitive agreement within 90 days after the receipt of a determination of no supervisory objection;

 

(ii) by October 31, 2010, the Board is required to adopt and implement a three year capital plan, which must be submitted to the OCC for review and prior determination of no supervisory objection;

 

(iii) by November 30, 2010, the Bank is required to achieve and thereafter maintain a total risk-based capital equal to at least 13% of risk-weighted assets and a Tier 1 capital equal to at least 9% of adjusted total assets;

 

(iv) the Bank may not pay any dividend or capital distribution unless it is in compliance with the higher capital requirements required by the Order, the Capital Plan, applicable legal requirements and, then only after receiving a determination of no supervisory objection from the OCC;

 

(v) by November 15, 2010, the Committee must review the Board and the Board’s committee structure; by November 30, 2010, the Board must prepare or cause to be prepared an assessment of the capabilities of the Bank’s executive officers to perform their past and current duties, including those required to respond to the most recent examination report, and to perform annual performance appraisals of each officer;

 

(vi) by October 31, 2010, the Board must adopt, implement and thereafter ensure compliance with a comprehensive conflict of interest policy applicable to the Bank’s and the Company’s directors, executive officers, principal shareholders and their affiliates and such person’s immediate family members and their related interests, employees, and by November 30, 2010, conduct a review of existing relationships with such persons to identify those, if any, not in compliance with the policy; and review all subsequent proposed transactions with such persons or modifications of transactions;

 

(vii) by October 31, 2010, the Board must develop, implement and ensure adherence to policies and procedures for Bank Secrecy Act (“BSA”) compliance; and account opening and monitoring procedures compliance;

 

(viii) by October 31, 2010, the Board must ensure the BSA audit function is supported by an adequately staffed department or third party firm; adopt, implement and ensure compliance with an independent BSA audit; and assess the capabilities of the BSA officer and supporting staff to perform present and anticipated duties;

 

(ix) by October 31, 2010, the Board is required to adopt, implement and ensure adherence to a written credit policy, including specified features, to improve the Bank’s loan portfolio management;

 

(x) the Board is required to take certain actions to resolve certain credit and collateral exceptions;

 

(xi) by October 31, 2010, the Board is required to establish an effective, independent and ongoing loan review system to review, at least quarterly, the Bank’s loan and lease portfolios to assure the timely identification and categorization of problem credits; by October 31, 2010, to adopt and adhere to a program for the maintenance of an adequate allowance for loan and lease losses (“ALLL”), and to review the adequacy of the Bank’s ALLL at least quarterly;

 

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(xii) by October 31, 2010, the Board must adopt and the Bank implement and adhere to a program to protect the Bank’s interest in criticized assets; and the Bank may only extend additional credit (including renewals) to a borrower whose loans are criticized under specified circumstances;

 

(xiii) by October 31, 2010, the Board must adopt and ensure adherence to action plans for each piece of other real estate owned;

 

(xiv) by November 30, 2010, the Board is required to develop, implement and ensure adherence to a policy for effective monitoring and management of concentrations of credit;

 

(xv) by October 31, 2010, the Board must revise and implement the Bank’s other than temporary impairment policy;

 

(xvi) by October 31, 2010, the Board must take action to maintain adequate sources of stable funding and liquidity and a contingency funding plan; by October 31, 2010, the Board is required to adopt, implement and ensure compliance with an independent, internal audit program; and

 

(xvii) take actions to correct cited violations of law; and adopt procedures to prevent future violations and address compliance management.

 

Federal Reserve Agreement. On November 24, 2010, the Company entered into a written Agreement (the “Agreement”) with the Federal Reserve Bank of Philadelphia (the “Reserve Bank”). The Agreement requires the Company to undertake certain actions within designated timeframes, and to operate in compliance with the provisions thereof during its term. The material provisions of the Agreement include the following:

 

(i) the Company’s Board must take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with its Consent Order entered into with the OCC;

 

(ii) the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Federal Reserve Board;

 

(iii) the Company may not take dividends or other payments representing a reduction of the Bank’s capital without the prior written approval of the Reserve Bank;

 

(iv) the Company and its nonbank subsidiary may not make any payment of interest, principal or other amounts on the Company’s subordinated debentures or trust preferred securities without the prior written approval of the Reserve Bank and the Director;

 

(v) the Company may not make any payment of interest, principal or other amounts on debt owed to insiders of the Company without the prior written approval of the Reserve Bank and Director;

 

(vi) the Company and its nonbank subsidiary may not incur, increase or guarantee any debt without the prior written approval of the Reserve Bank;

 

(vii) the Company may not purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank;

 

(viii) the Company must submit to the Reserve Bank, by January 23, 2011, an acceptable written plan to maintain sufficient capital at the Company on a consolidated basis.  Thereafter, the Company must notify the Reserve Bank within 45 days of the end of any quarter in which the Company’s capital ratios fall below the approved capital plan’s minimum ratios, and submit an acceptable written plan to increase the Company’s capital ratios above the capital plan’s minimums;

 

(ix) the Company must immediately take all actions necessary to ensure that: (1) each regulatory report accurately reflects the Company’s condition on the date for which it is filed and all material transactions between the Company and its subsidiaries; (2) each such report is prepared in accordance with its instructions; and (3) all records indicating how the report was prepared are maintained for supervisory review;

 

(x) the Company must submit to the Reserve Bank, by January 23, 2011, acceptable written procedures to strengthen and maintain internal controls to ensure all required regulatory reports and notices filed with the Board of Governors are accurate and filed in accordance with the instructions for preparation;

 

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(xi) the Company must submit to the Reserve Bank, by January 8, 2011, a cash flow projection for 2011, reflecting the Company’s planned sources and uses of cash, and submit a cash flow projection for each subsequent calendar year at least one month prior to the beginning of such year;

 

(xii) the Company must comply with: (1) the notice provisions of Section 32 of the FDI Act and Subpart H of Regulation Y in appointing any new director or senior executive officer or changing the duties of any senior executive officer; and (2) the restrictions on indemnification and severance payments of Section 18(k) of the FDI Act and Part 359 of the FDIC’s regulations; and

 

(xiii) the Board must submit written progress reports within 30 days of the end of each calendar quarter.

 

Since entering into the Order and the Agreement, the Company has incurred expenses in an effort to comply with the terms of these agreements.  In particular, the Company has incurred expenses in connection with developing and implementing policies and procedures and hiring additional personnel as required by the Order and the Agreement.  During 2009, 2010 and the first nine months of 2011, the Company incurred approximately $114 thousand, $1.4 million and $851 thousand, respectively, of expenses related to entering into and complying with these regulatory agreements, consisting primarily of professional and consulting fees.  In addition, the Order and the Agreement place restrictions on the Company’s ability to borrow funds and to pay interest and dividends to its security holders.  In the future, the Company expects to continue to experience increased costs related to compliance with these regulatory agreements, primarily as a result of increased head count and also expects to face certain restrictions on its operations for as long as it continues to operate under the Order and the Agreement.  The Company expects, however, that future compliance expenses will decrease significantly from the 2010 and 2011 levels, because the majority of the expenses incurred to date are related to development and implementation of processes and policies that, once those policies and processes are finalized and implemented, are not expected to recur.

 

The Order and the Agreement have not and are not expected to have an impact on the Company’s ability to attract and maintain deposits or the Company’s cost of funds. In order to meet the increased capital requirements imposed under the Order and the Agreement, however, unless the Company is able to raise additional capital, the Company could be limited in the aggregate amount of loans it can have outstanding, which may constrain loan growth. While it is not anticipated that the Order and the Agreement will have an immediate impact on the Company’s net interest margin, the overall cost of compliance with the Order and the Agreement will continue to impact profitability at least through the end of 2012.

 

The Company

 

The Company is a bank holding company registered with, and subject to regulation by, the Reserve Bank and the FRB.  The BHCA and other federal laws subject bank holding companies to 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 and unsafe and unsound banking practices.

 

The BHCA requires approval of the FRB for, among other things, the acquisition by a proposed bank holding company of control of more than five percent (5%) of the voting shares, or substantially all the assets, of any bank or the merger or consolidation by a bank holding company with another bank holding company.  The BHCA also generally permits the acquisition by a bank holding company of control or substantially all the assets of any bank located in a state other than the home state of the bank holding company, except where the bank has not been in existence for the minimum period of time required by state law; but if the bank is at least 5 years old, the FRB may approve the acquisition.

 

With certain limited exceptions, a bank holding company is prohibited from acquiring control of any voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or furnishing services to or performing service for its authorized subsidiaries.  A bank holding company may, however, engage in, or acquire an interest in, a company that engages in activities that the FRB has determined by order or regulation to be so closely related to banking or managing or controlling banks as to be properly incident thereto.  In making such a determination, the FRB is required to consider whether the performance of such activities can reasonably be expected to produce benefits to the public, such as convenience, increased competition or gains in efficiency, which outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.  The FRB is also empowered to differentiate between activities commenced de novo and activities commenced by the acquisition, in whole or in part, of a going concern.  Some of the activities that the FRB has determined by regulation to be closely related to banking include making or servicing loans, performing certain data processing services, acting as a fiduciary or investment or financial advisor, and making investments in corporations or projects designed primarily to promote community welfare.

 

Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower.  Further, a holding company and any subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit.  A subsidiary bank may not extend credit, lease or sell property, or furnish any services, or fix or vary the consideration for any of the foregoing on the condition that: (i) the customer obtain or provide some additional credit, property or services from or to such bank other than a loan, discount, deposit or trust service; (ii) the customer obtain or provide some additional credit, property or service from or to the bank holding company or any other subsidiary of the bank holding company; or (iii) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to assure the soundness of credit extended.

 

The Gramm Leach-Bliley Act of 1999 (the “GLB Act”) allows a bank holding company or other company to certify status as a financial holding company, which allows such company to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker, underwriting, dealing in or making markets in securities, and engaging in merchant banking under certain restrictions.  It also authorizes the FRB to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.

 

The Bank

 

The Bank, as a national bank, is a member of the Federal Reserve System and its accounts are insured up to the maximum legal limit by the Deposit Insurance Fund of the FDIC.  The Bank is subject to regulation, supervision and regular examination by the OCC.  The regulations of these agencies and the FDIC govern most aspects of the Bank’s business, including required reserves against deposits, loans, investments, mergers and acquisitions, borrowing, dividends and location and number of branch offices.  State laws may also apply

 

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to the Bank to the extent that federal law does not preempt the state law.  The laws and regulations governing the Bank generally have been promulgated to protect depositors and the Deposit Insurance Fund, and not for the purpose of protecting shareholders.

 

Competition among commercial banks, savings and loan associations, and credit unions has increased following enactment of legislation that greatly expanded the ability of banks and bank holding companies to engage in interstate banking or acquisition activities.  As a result of federal and state legislation, banks in the Company’s market are permitted, subject to limited restrictions, to acquire or merge with a bank in other jurisdictions, and are now permitted to branch de novo anywhere in Pennsylvania. The GLB Act allows a wider array of companies to own banks, which could result in companies with resources substantially in excess of the Bank’s resources entering into competition with the Bank.

 

Banking is a business that depends on interest rate differentials.  In general, the differences between the interest paid by a bank on its deposits and its other borrowings and the interest received by a bank on loans extended to its customers and securities held in its investment portfolio constitute the major portion of a bank’s earnings. Thus, the earnings and growth of the Bank are subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly, as it relates to monetary policy, the Federal Reserve, which regulates the supply of money through various means including open market dealings in United States government securities.  The nature and timing of changes in such policies and their impact on the Bank cannot be predicted.

 

Branching and Interstate Banking.  National banks are required by federal law to adhere to branching laws applicable to state banks in the states in which they are located.  Pennsylvania statutes currently authorize state banks to establish branch offices throughout the Commonwealth with prior regulatory approval.  Consequently, national banks located in Pennsylvania may also establish branch offices throughout Pennsylvania.

 

Federal law also authorizes the OCC to approve interstate branching de novo by national banks in states that specifically allow for such branching.  Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions.  Pennsylvania law permits banks chartered in Pennsylvania to branch in other states without limitation, but only permits out of state banks to branch in Pennsylvania if the home state of the out of state bank permits Pennsylvania banks to establish de novo branches.  Subsequent to December 31, 2009, federal law was changed to permit any state or federally chartered bank to branch in any state, with minimal exceptions.

 

The federal banking agencies are authorized to approve an interstate bank merger transaction without regard to whether such transaction is prohibited by the law of any state, with certain exceptions.

 

USA Patriot Act and Bank Secrecy Act (“BSA”).  Under the BSA, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and that the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act, commonly referred to as the “USA Patriot Act” or the “Patriot Act,” financial institutions are subject to prohibitions against specified financial transactions and account relationships, as well as enhanced due diligence standards intended to detect, and prevent, the use of the United States financial system for money laundering and terrorist financing activities. The Patriot Act requires financial institutions, including banks, to establish anti-money laundering programs, including employee training and independent audit requirements, meet minimum standards specified by the act, follow minimum standards for customer identification and maintenance of customer identification records, and regularly compare customer lists against lists of suspected terrorists, terrorist organizations and money launderers. The costs or other effects of the compliance burdens imposed by the Patriot Act or future anti-terrorist, homeland security or anti-money laundering legislation or regulation cannot be predicted with certainty.  The OCC has required the Bank to strengthen its internal policies and procedures with respect to BSA compliance, and the Bank continues to develop and implement policies designed to satisfy this requirement.

 

Capital Adequacy Guidelines.  The FRB and OCC have adopted risk based capital adequacy guidelines pursuant to which they assess the adequacy of capital in examining and supervising banks and bank holding companies and in analyzing bank regulatory applications.  Risk-based capital requirements determine the adequacy of capital based on the risk inherent in various classes of assets and off-balance sheet items.

 

National banks are expected to meet a minimum ratio of total qualifying capital (the sum of core capital (Tier 1) and supplementary capital (Tier 2)) to risk weighted assets of 8%.  At least half of this amount (4%) should be in the form of core capital.  Tier 1 Capital generally consists of the sum of common shareholders’ equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stock which may be included as Tier 1 Capital), less goodwill, without adjustment for changes in the market value of securities classified as “available for sale” in accordance with Accounting Standards Codification (“ASC”) Topic 320, Investments-Debt and Equity Securities.  Tier 2 Capital consists of the following: hybrid capital instruments; perpetual preferred stock

 

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that is not otherwise eligible to be included as Tier 1 Capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general ALLL.  Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no risk-based capital) for assets such as cash, to 100% for the bulk of assets which are typically held by a bank, including certain multi-family residential and commercial real estate loans, commercial business loans and consumer loans.  Residential first mortgage loans on one to four family residential real estate and certain seasoned multi-family residential real estate loans, which are not 90 days or more past-due or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans.  Off-balance sheet items also are adjusted to take into account certain risk characteristics.

 

In addition to the risk-based capital requirements, the OCC has established a minimum 3.0% leverage capital ratio (Tier 1 Capital to total adjusted assets) requirement for the most highly-rated banks, with an additional cushion of at least 100 to 200 basis points for all other banks, which effectively increases the minimum leverage capital ratio for such other banks to 4.0% - 5.0% or more.  The highest-rated banks are those that are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, those which are considered a strong banking organization.  A bank having less than the minimum leverage capital ratio requirement is required, within 60 days of the date as of which it fails to comply with such requirement, to submit a reasonable plan describing the means and timing by which the bank will achieve its minimum leverage capital ratio requirement.  A bank which fails to file such plan is deemed to be operating in an unsafe and unsound manner, and could subject the bank to a cease-and-desist order. Any insured depository institution with a leverage capital ratio that is less than 2.0% is deemed to be operating in an unsafe or unsound condition pursuant to Section 8(a) of the Federal Deposit Insurance Act (the “FDIA”) and is subject to potential termination of deposit insurance.  However, such an institution will not be subject to an enforcement proceeding solely on account of its capital ratios, if it has entered into and is in compliance with a written agreement to increase its leverage capital ratio and to take such other action as may be necessary for the institution to be operated in a safe and sound manner.  The capital regulations also provide, among other things, for the issuance of a capital directive, which is a final order issued to a bank that fails to maintain minimum capital or to restore its capital to the minimum capital requirement within a specified time period.  Such a directive is enforceable in the same manner as a final cease-and-desist order.

 

The Bank’s total capital ratio at December 31, 2009 and 2008 was 10.20% and 11.17%, respectively.  The Tier I capital to risk weighted assets at December 31, 2009 and 2008 was 8.94% and 10.36%, respectively.  The Tier I capital to average assets at December 31, 2009 and 2008 was 7.28% and 8.95%, respectively.  Under the Order, the Bank is required to achieve a total capital ratio of 13% and a Tier I capital to average assets ratio of 9% by November 30, 2010.  As of November 30, 2011, the Bank had not achieved these ratios.  On January 27, 2011, the Company announced that its Board of Directors retained Sandler O’Neill + Partners, L.P. as its financial adviser to assist the company in evaluating possible capital and strategic alternatives.

 

The Company’s total capital ratio at December 31, 2009 and 2008 was 10.54% and 11.18%, respectively.  The Tier I capital to risk weighted assets at December 31, 2009 and 2008 was 7.28% and 10.37%, respectively.  The Tier I capital to average assets at December 31, 2009 and 2008 was 5.94% and 8.99%, respectively.

 

Prompt Corrective Action.  Under Section 38 of the FDIA, each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates.  The federal banking agencies have promulgated substantially similar regulations to implement the system of prompt corrective action established by Section 38 of the FDIA.  Under the regulations, a bank will be deemed to be: (i) “well capitalized” if it has a Total Risk Based Capital Ratio of 10.0% or more, a Tier 1 risk based capital ratio of 6.0% or more, a leverage capital ratio of 5.0% or more and is not subject to any written capital order or directive; (ii) “adequately capitalized” if it has a total risk based capital ratio of 8.0% or more, a Tier 1 risk based capital ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of “well capitalized;” (iii) “undercapitalized” if it has a total risk based capital ratio that is less than 8.0%, a Tier 1 risk based capital ratio that is less than 4.0% or a leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) “significantly undercapitalized” if it has a total risk based capital ratio that is less than 6.0%, a Tier 1 risk based capital ratio that is less than 3.0% or a leverage capital ratio that is less than 3.0%; and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

 

An institution generally must file a written capital restoration plan which meets specified requirements with an appropriate federal banking agency within 45 days of the date the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized.  A federal banking agency must provide the institution with written notice of approval or disapproval within 60 days after receiving a capital restoration plan, subject to extensions by the applicable agency.

 

An institution which is required to submit a capital restoration plan must concurrently submit a performance guaranty by each company that controls the institution.  Such guaranty will be limited to the lesser of (i) an amount equal to 5.0% of the institution’s total assets at the time the institution was notified or deemed to have notice that it was undercapitalized or (ii) the amount necessary at such time to restore the relevant capital measures of the institution to the levels required for the institution to be classified as adequately capitalized.  Such a guaranty will expire after the federal banking agency notifies the institution that it has remained adequately capitalized for each of four consecutive calendar quarters.  An institution which fails to submit a written capital restoration plan within the requisite period,

 

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including any required performance guaranty, or fails in any material respect to implement a capital restoration plan, will be subject to the restrictions in Section 38 of the FDIA which are applicable to significantly undercapitalized institutions.

 

A “critically undercapitalized institution” is to be placed in conservatorship or receivership within 90 days unless the FDIC formally determines that forbearance from such action would better protect the deposit insurance fund. Unless the FDIC or other appropriate federal banking regulatory agency makes specific further findings and certifies that the institution is viable and is not expected to fail, an institution that remains critically undercapitalized on average during the fourth calendar quarter after the date it becomes critically undercapitalized must be placed in receivership. The general rule is that the FDIC will be appointed as receiver within 90 days after a bank becomes critically undercapitalized unless extremely good cause is shown and an extension is agreed to by the federal regulators.  In general, good cause is defined as capital which has been raised and is imminently available for infusion into the bank except for certain technical requirements which may delay the infusion for a period of time beyond the 90 day time period.

 

Immediately upon becoming undercapitalized, an institution becomes subject to the provisions of Section 38 of the FDIA, which (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution’s assets; and (v) require prior approval of certain expansion proposals.  The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the Deposit Insurance Fund, subject in certain cases to specified procedures.  These discretionary supervisory actions include: requiring the institution to raise additional capital; restricting transactions with affiliates; requiring divestiture of the institution or the sale of the institution to a willing purchaser; and any other supervisory action that the agency deems appropriate.  These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.

 

Additionally, under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed for an institution where:  (i) an institution’s obligations exceed its assets; (ii) there is substantial dissipation of the institution’s assets or earnings as a result of any violation of law or any unsafe or unsound practice;  (iii) the institution is in an unsafe or unsound condition;  (iv) there is a willful violation of a cease-and-desist order;  (v) the institution is unable to pay its obligations in the ordinary course of business;  (vi) losses or threatened losses deplete all or substantially all of an institution’s capital, and there is no reasonable prospect of becoming “adequately capitalized” without assistance;  (vii) there is any violation of law or unsafe or unsound practice or condition that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the institution’s condition, or otherwise seriously prejudice the interests of depositors or the insurance fund;  (viii) an institution ceases to be insured;  (ix) the institution is undercapitalized and has no reasonable prospect that it will become adequately capitalized, fails to become adequately capitalized when required to do so, or fails to submit or materially implement a capital restoration plan; or (x) the institution is critically undercapitalized or otherwise has substantially insufficient capital.

 

Regulatory Enforcement Authority.  Federal banking law grants substantial enforcement powers to federal banking regulators.  This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties.  In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices.  Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.

 

The Bank and its “institution-affiliated parties,” including its management, employees, agents, independent contractors, consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs, are subject to potential civil and criminal penalties for violations of law, regulations or written orders of a governmental agency.  In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.  Possible enforcement actions include the termination of deposit insurance and cease-and-desist orders.  Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss.  A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate.

 

Under provisions of the federal securities laws, a determination by a court or regulatory agency that certain violations have occurred at a company or its affiliates can result in fines, restitution, a limitation of permitted activities, disqualification to continue to conduct certain activities and an inability to rely on certain favorable exemptions.  Certain types of infractions and violations can also affect a public company in its timing and ability to expeditiously issue new securities into the capital markets.

 

The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss allowances for regulatory purposes.

 

As a result of the volatility and instability in the financial system during 2008 and 2009, Congress, the bank regulatory authorities and other government agencies have called for or proposed additional regulation and restrictions on the activities, practices and operations of

 

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banks and their holding companies.  While many of these proposals relate to institutions that have accepted investments from, or sold troubled assets to, the Department of the Treasury or other government agencies, or otherwise participate in government programs intended to promote financial stabilization, Congress and the federal banking agencies have broad authority to require all banks and holding companies to adhere to more rigorous or costly operating procedures, corporate governance procedures, or to engage in activities or practices which they might not otherwise elect.  Any such requirement could adversely affect the Company’s business and results of operations.  The Company did not accept an investment by the Treasury Department in its preferred stock or warrants to purchase common stock, and except for the temporary increases in deposit insurance for customer accounts, has not participated in any of the programs adopted by the Treasury Department, FDIC or Federal Reserve.

 

FDIC Insurance Premiums.  The FDIC maintains a risk-based assessment system for determining deposit insurance premiums. Four risk categories (I-IV), each subject to different premium rates, are established based upon an institution’s status as well capitalized, adequately capitalized or undercapitalized, and the institution’s supervisory rating.  During 2008, all insured depository institutions paid deposit insurance premiums ranging between 5 and 7 basis points on an institution’s assessment base for institution’s in risk category I (well capitalized institutions perceived as posing the least risk to the insurance fund), and 10, 28 and 40 basis points for institutions in risk categories II, III and IV.  The levels of rates are subject to periodic adjustment by the FDIC.  Depository institutions will also pay premiums for the increased coverage provided by the FDIC.

 

Commencing in 2009, the premium rates increased by 7 basis points in each category for the first quarter of 2009.  For the second quarter of 2009 and beyond, the FDIC established further changes in rates, and introduced three adjustments that can be made to an institution’s initial base assessment rate: (1) a potential decrease for long-term unsecured debt, including senior and subordinated debt and, for small institutions, a portion of Tier 1 capital; (2) a potential increase for secured liabilities above a threshold amount; and (3) for non-Risk Category I institutions, a potential increase for brokered deposits above a threshold amount.  The schedule for base assessment rates and potential adjustments is set forth in the following table.  Moreover, if the statutory cap on the level of the Deposit Insurance Fund, is increased or eliminated, there may be continuing premium obligations even after the fund is recapitalized.

 

 

 

Risk
Category I

 

Risk
Category II

 

Risk
Category III

 

Risk
Category IV

 

Initial Base Assessment Rate

 

12 – 16

 

22

 

32

 

45

 

Unsecured Debt Adjustment (added)

 

(5) to 0

 

(5) to 0

 

(5) to 0

 

(5) to 0

 

Secured Liability Adjustment (added)

 

0 to 8

 

0 to 11

 

0 to 16

 

0 to 22.5

 

Brokered Deposit Adjustment (added)

 

N/A

 

0 to 10

 

0 to 10

 

0 to 10

 

Total Base Assessment Rate

 

7 to 24.0

 

17 to 43.0

 

27 to 58.0

 

40 to 77.5

 

 

The FDIC also imposed a special insurance assessment of 5 basis points implemented for each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009, but no more than 10 basis points times the institution’s assessment base for the second quarter of 2009, which was collected on September 30, 2009.  Additional special assessments may be imposed by the FDIC in the future.  During 2009, the Bank was in risk category I and its total base assessment rate was 15.45%.

 

Additionally, the Bank has elected to participate in the FDIC program whereby noninterest-bearing transaction account deposits will be insured without limitation through at least December 31, 2010.  Until December 31, 2009, the Bank was required to pay an additional premium to the FDIC of 10 basis points on the amount of balances in noninterest-bearing transaction accounts that exceed the existing deposit insurance limit of $250,000. During 2010, the fee will be 15 to 25 basis points, depending on its risk category.

 

Dividend Restrictions

 

The Company is a legal entity separate and distinct from the Bank.  The Company’s revenues (on a parent company only basis) result almost entirely from dividends paid by its subsidiary, the Bank, to the Company.  The right of the Company, and consequently the right of creditors and shareholders of the Company, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors) except to the extent that claims of the Company, in its capacity as a creditor, may be recognized.  Additionally, the ability of the Bank to pay dividends to the Company is subject to various regulatory restrictions. As of the date of the filing of this Amendment, the Order prohibits the Bank from paying dividends to the Company and the Agreement further prohibits the Company from taking dividend payments from the Bank.

 

Federal and state laws regulate the payment of dividends by the Company.  Federal banking regulators have the authority to prohibit banks and bank holding companies from paying a dividend if the regulators deem such payment to be an unsafe or unsound practice.  Currently the Agreement with the Federal Reserve Bank prohibits the Company from paying dividends without prior approval from the Reserve Bank.

 

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Employees

 

As of December 31, 2009, the Company employed 326 persons, including 55 part-time employees.

 

Available Information

 

The Company files reports, proxy and information statements and other information electronically with the SEC. You may read and copy any materials that the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information may be obtained on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The SEC’s website site address is http://www.sec.gov.  The Company’s web site address is http://www.fncb.com. Through its website, the Company makes available free of charge this Amendment No. 1 to the annual report on Form 10-K/A, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the 1934 Act as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC. Further, the Company will provide electronic or paper copies of the Company’s filings free of charge upon request.  A copy of the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2009 may be obtained without charge from our website at www.fncb.com or via email at fncb@fncb.com.  Information may also be obtained via written request to First National Community Bancorp, Inc. Attention:  Chief Financial Officer, 102 East Drinker Street, Dunmore, PA 18512.

 

Item 1A.  Risk Factors.

 

We may not be able to successfully compete with others for business.

 

The Company competes for loans, deposits and investment dollars with numerous regional and national banks and other community banking institutions, online divisions of banks located in other markets as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, mortgage brokers, and private lenders. Many competitors have substantially greater resources than the Company does, and operate under less stringent regulatory environments. The differences in available resources and applicable regulations may make it harder for the Company to compete profitably, reduce the rates that it can earn on loans and investments, increase the rates it must offer on deposits and other funds, and adversely affect its overall financial condition and earnings.

 

The current economic environment poses significant challenges for us and could adversely affect our financial condition and results of operations.

 

The Company is operating in a challenging and uncertain economic environment. Financial institutions continue to be affected by sharp declines in the real estate market and constrained financial markets. Dramatic declines in the housing market over the past years, with falling home prices and high levels of foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions. Continued declines in real estate values, home sales volumes, and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition and results of operations. A worsening of these conditions would likely exacerbate the adverse effects on us and others in the financial institutions industry. For example, our non-performing assets increased by $11.4 million in 2009 and represented 58.9% of shareholders’ equity as of December 31, 2009.  Further deterioration in economic conditions in our markets could drive losses beyond that which is provided for in our ALLL, which would necessitate further increases in the Company’s provision for loan and lease losses, which, in turn, would reduce the Company’s earnings and capital. The Company may also face the following risks in connection with the economic environment:

 

·                  economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of our loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on our business;

·                  market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities;

·                  the methodologies the Company used to establish the ALLL have proven to be inadequate and although the Company has revised its methodologies, they still rely on complex judgments, including forecasts of economic conditions, which are inherently uncertain.

·                  continued turmoil in the market, and loss of confidence in the banking system, could require the Bank to pay higher interest rates to obtain deposits to meet the needs of its depositors and borrowers, resulting in reduced margin and net interest income.  If conditions worsen, it is possible that banks such as the Bank may be unable to meet the needs of their depositors and borrowers, which could, in the worst case, result in the Bank being placed into receivership; and

 

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·                  compliance with increased regulation of the banking industry may increase our costs, limit our ability to pursue business opportunities, and divert management efforts.

 

If these conditions or similar ones continue to exist or worsen, the Company could experience continuing or increased adverse effects on its financial condition.

 

We have identified material weaknesses in our internal controls.

 

Management has concluded that our disclosure controls and procedures and internal control over financial reporting were not effective as of December 31, 2009.  We have also received an adverse opinion from our independent registered public accounting firm with respect to the material weaknesses in our internal controls over financial reporting.  A description of the material weaknesses in our internal controls over financial reporting is included in Part II, Item 9A — Controls and Procedures in this report.

 

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

 

We detected the following material weaknesses:

 

·                  Control deficiencies were found to exist in our accounting and financial reporting function in connection with our identification of material errors in (i) the accounting for and timing of charges related to other-than-temporary impairment (“OTTI”) of certain collateralized debt obligations in our securities investment portfolio, (ii) the determination of our provision and allowance for loan and lease losses and the timing of charge-offs, (iii) the provision for off-balance sheet commitments, (iv) the accounting for deferred loan fees and costs, (v) the accounting for goodwill, and (vi) the related effect on the income tax benefit, deferred tax asset and valuation allowance.  The errors identified have resulted in the restatement of our financial statements for the year ended December 31, 2009 and subsequent periods.

·                  Systemic control deficiencies were identified in our processes, procedures and safeguards for information systems security.  In particular, users of the Company’s computer sub-systems may have had inappropriate access and system privileges that allowed them to view information and/or perform functions that are not appropriate to their job functions. Such access may have led to transactions being recorded improperly or may have permitted unauthorized transactions to occur. However, the Company is not aware of any transactions that were improperly undertaken as a result of this material weakness and therefore does not believe that such material weakness had any material impact on the Company’s financial statements.

 

We are, and intend to continue, taking appropriate and reasonable steps to make the necessary improvements to remediate these deficiencies. We cannot be certain that our remediation efforts will ensure that our management designs, implements and maintains adequate controls over our financial processes and reporting in the future or will be sufficient to address and eliminate the material weakness identified. Our inability to remedy the identified material weaknesses or any additional deficiencies or material weaknesses that may be identified in the future could, among other things, have a material adverse effect on our business, results of operations and financial condition, as well as impair our ability to meet our quarterly, annual and other reporting requirements under the 1934 Act, as amended, in a timely manner, and require us to incur additional costs and to divert management resources.

 

Additionally, any further ineffective internal controls over financial reporting could result in additional restatements in the future, further increase regulatory scrutiny and could cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading value of our securities and our ability to raise capital.

 

Changes in interest rates could reduce our income, cash flows and asset values.

 

The Company’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the FRB. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Company receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Company’s ability to originate loans and obtain deposits, (ii) the fair value of the Company’s financial assets and liabilities, and (iii) the average duration of the Company’s mortgage-backed securities portfolio.

 

If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company’s interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely

 

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affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.  Any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Company’s financial condition and results of operations.

 

The Company is subject to lending risk.

 

As of December 31, 2009, approximately 43.8% of the Company’s loan portfolio consisted of commercial real estate loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because the Company’s loan portfolio contains a significant number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans.  Non-performing loans totaled $26.0 million, or 2.8% of total gross loans, as of December 31, 2009, and $23.4 million, or 2.4% of total gross loans, as of December 31, 2008.  A further increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.  The lending activities in which the Bank engages carry the risk that the borrowers will be unable to perform on their obligations.  As such, general economic conditions, nationally and in our primary market area, will have a significant impact on our results of operations.  To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Bank in full, in a timely manner, resulting in decreased earnings or losses to the Bank.  To the extent that loans are secured by real estate, adverse conditions in the real estate market may reduce the ability of the borrower to generate the necessary cash flow for repayment of the loan, and reduce our ability to collect the full amount of the loan upon a default.  To the extent that the Bank makes fixed rate loans, general increases in interest rates will tend to reduce our spread as the interest rates the Company must pay for deposits increase while interest income is flat.  Economic conditions and interest rates may also adversely affect the value of property pledged as security for loans.

 

Our concentrations of loans, including those to insiders and related parties, may create a greater risk of loan defaults and losses.

 

A substantial portion of our loans are secured by real estate in the Northeastern Pennsylvania market, and substantially all of our loans are to borrowers in that area. The Company also has a significant amount of real estate construction loans and land related loans for residential and commercial developments. At December 31, 2009, $553.3 million or 58.9% of our gross loans were secured by real estate, primarily commercial real estate.  Management has taken steps to mitigate the Company’s commercial real estate concentration risk by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis. Of these loans, $ 98.4 million, or 17.8% were construction and land development loans.  Construction and land development loans have the highest risk of uncollectability.  An additional $220.8 million, or 23.5% of portfolio loans, were commercial and industrial loans which are not secured by real estate. Historically, these categories of loans generally have had a higher risk of default than other types of loans, such as single family residential mortgage loans. The repayments of these loans often depends on the successful operation of a business or the sale or development of the underlying property and as a result, are more likely to be adversely affected by adverse conditions in the real estate market or the economy in general. While the Company believes that our loan portfolio is well diversified in terms of borrowers and industries, these concentrations expose the Company to the risk that adverse developments in the real estate market, or in the general economic conditions in the Company’s general market area, could increase the levels of nonperforming loans and charge-offs, and reduce loan demand. In that event, the Company would likely experience lower earnings or losses.  Additionally, if, for any reason, economic conditions in our market area deteriorate, or there is significant volatility or weakness in the economy or any significant sector of the area’s economy, the Company’s ability to develop our business relationships may be diminished, the quality and collectability of our loans may be adversely affected, the value of collateral may decline and loan demand may be reduced.

 

Commercial real estate, commercial and construction loans tend to have larger balances than single family mortgages loans and other consumer loans.  Because the loan portfolio contains a significant number of commercial and commercial real estate and construction loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming assets. An increase in nonperforming loans could result in: a loss of earnings from these loans, an increase in the provision for loan losses, or an increase in loan charge-offs, which could have an adverse impact on our results of operations and financial condition.

 

Outstanding loans and line of credit balances to directors, officers and their related parties totaled $105.7 million as of December 31, 2009.  Of those, loans in the amount of $4.2 million were not performing in accordance with the terms of the loan agreements.  These loans were guaranteed by two individuals who resigned from the Company’s Board of Directors during 2009.  Also, as of December 31, 2009, additional loans in the amount of $14.1 were categorized as criticized loans within the Bank’s risk rating system, meaning they are considered to present a higher risk of collection than other loans.  (Please refer to Note 14 — Related Party Transactions to our consolidated financial statements included in Item 8 of this report for more detail.)

 

Further, guidance adopted by the federal banking regulators provides that banks having concentrations in construction, land development or commercial real estate loans (other than loans for majority owner occupied properties) are expected to maintain higher

 

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levels of risk management and, potentially, higher levels of capital. Additionally, the Company is subject to the Order and the Agreement, which require the Company and the Bank to achieve and maintain increased levels of capitalization. It is possible that the Company may be required to maintain higher levels of capital than we would otherwise be expected to maintain as a result of its levels of construction, development and commercial real estate loans, which may require us to obtain additional capital sooner than the Company would otherwise seek it, which may reduce shareholder returns.

 

The Company will need to raise additional capital in the future, but that capital may not be available when it is needed and on terms favorable to current shareholders.

 

Laws, regulations and banking regulators require the Company and Bank to maintain adequate levels of capital to support their operations.  In addition, capital levels are also determined by the Company’s management and board of directors based on capital levels that they believe are necessary to support the Company’s business operations.  Also, pursuant to the Order and the Agreement, the Company and the Bank are required to maintain increased capital levels in compliance with the Company’s revised capital plan.  The Company is evaluating its present and future capital requirements and needs and is also analyzing capital raising alternatives and options.  Even if the Company succeeds in meeting the current regulatory capital requirements, the Company may need to raise additional capital in the near future to support possible loan losses during future periods or to meet future regulatory capital requirements.

 

The Board of Directors may determine from time to time that the Company needs to raise additional capital by issuing additional common shares or other securities. The Company is not restricted from issuing additional common shares, including securities that are convertible into or exchangeable for, or that represent the right to receive, common shares. Because the Company’s decision to issue securities in any future offering will depend on market conditions and other factors beyond its control, the Company cannot predict or estimate the amount, timing or nature of any future offerings, or the prices at which such offerings may be affected. Such offerings will likely be dilutive to common shareholders from ownership, earnings and book value perspectives.  New investors also may have rights, preferences and privileges that are senior to, and that adversely affect, our then current common shareholders.  Additionally, if the Company raises additional capital by making additional offerings of debt or preferred equity securities, upon liquidation, holders of the Company’s debt securities and shares of preferred shares, and lenders with respect to other borrowings, will receive distributions of the Company’s available assets prior to the holders of the Company’s common shares. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of the Company’s common shares, or both. Holders of the Company’s common shares are not entitled to preemptive rights or other protections against dilution.

 

The Company cannot assure that additional capital will be available on acceptable terms or at all.  Any occurrence that may limit the Company’s access to the capital markets may adversely affect the Company’s capital costs and its ability to raise capital and, in turn, its liquidity.  Moreover, if the Company needs to raise capital, it may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors.  An inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our business, financial condition and results of operations.

 

As of the date of this report, we are not currently able to pay dividends on the common shares, or repurchase common shares.

 

The Company conducts its principal business operations through the Bank, and the cash that it uses to pay dividends is derived from dividends paid to the Company by the Bank, therefore its ability to pay dividends is dependent on the performance of the Bank and on the Bank’s capital requirements.  The Bank’s ability to pay dividends to the Company and the Company’s ability to pay dividends to its shareholders are also limited by certain legal and regulatory restrictions.  In particular, pursuant to the supervisory agreements that the Company and the Bank have entered into with their regulators, the Company and the Bank are prohibited from declaring or paying any dividends and the Company is also prohibited from taking dividends or other payments representing a reduction of the Bank’s capital without prior regulatory approval.

 

If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.

 

The Company reviews its investment securities portfolio at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of the Company’s investment securities has declined below its carrying value, the Company is required to assess whether the decline is other than temporary. If the Company concludes that the decline is other than temporary, it is required to write down the value of that security through a charge to earnings.  As of December 31, 2009, the Company’s investment portfolio included seven pooled trust preferred collateralized debt obligation (“PreTSLs”) with an amortized cost of $16.3 million and an estimated fair value of $3.8 million.  Changes in the expected cash flows of these securities and/or prolonged price declines may result in additional impairment of these securities that is other than temporary in future periods, which would require a charge to earnings to write down theses securities to their fair value. Due to the complexity of the calculations and assumptions used in determining whether an asset, such as pooled trust preferred securities, is impaired, the impairment disclosed may not accurately reflect the actual impairment in the future.  In addition, to the extent that the value of any of our investment

 

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securities is sensitive to fluctuations in interest rates, any increase in interest rates may result in a decline in the value of such investment securities.

 

As of December 31, 2009, the Company’s investment portfolio included eight private label collateralized mortgage obligations, PLCMOs, with an amortized cost of $10.7 million and an estimated fair value of $8.2 million. Changes in the expected cash flows of these securities and/ or prolonged price declines may result in additional impairment of these securities that is other than temporary in future periods, which would require a charge to earnings to write down these securities to their fair value. Due to the complexity of the calculations and assumptions used in determining whether an asset, such as PLCMOs, is impaired, the impairment disclosed may not accurately reflect the actual impairment in the future. In addition, to the extent that the value of any of our investment securities is sensitive to fluctuations in interest rates, any increase in interest rates may result in a decline in the value of such investment securities.

 

The Company recognized total OTTI charges of $20.6 million on its PreTSL and PLCMO securities for 2009 primarily as a result of market developments, some of which became evident through a subsequent events analyses after December 31, 2009 and a revision to our methodology to use more severe assumptions.

 

Changes in the value of goodwill and intangible assets could reduce our earnings.

 

The Company is required by U.S. generally accepted accounting principles (“GAAP”) to test goodwill and other intangible assets for impairment at least annually.  Testing for impairment of goodwill and intangible assets involves the identification of reporting units and the estimation of fair values.  The estimation of fair values involves a high degree of judgment and subjectivity in the assumptions used.  If our assumptions prove to be incorrect, the asset value of goodwill and intangible assets may be affected and would have a negative impact on the Company’s financial condition and results of operations.

 

Based on the results of its evaluation, the Company recorded an $8.1 million goodwill impairment charge during December 31, 2009, which resulted in no goodwill remaining on its balance sheet as of the end of the year.  Significant negative industry and economic trends, including the lack of recovery in the market price of the Company’s common shares and reduced estimates of future cash flows contributed to the impairment of goodwill. The Company’s valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and to rely on projections of future operating performance.

 

The Company operates in competitive environments and projections of future operating results and cash flows may vary significantly from actual results.

 

Our financial condition and results of operation would be adversely affected if our ALLL is not sufficient to absorb actual losses or if we are required to increase our allowance.

 

The lending activities in which the Bank engages carry the risk that the borrowers will be unable to perform on their obligations, and that the collateral securing the payment of their obligations may be insufficient to assure repayment. The Company may experience significant credit losses, which could have a material adverse effect on its operating results. The Company makes various assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of its loans. In determining the amount of the ALLL, the Company reviews its loans and its loss and delinquency experience, and the Company evaluates economic conditions. If its assumptions prove to be incorrect, its ALLL may not cover inherent losses in its loan portfolio at the date of its financial statements. Material additions to the Company’s allowance would materially decrease its net income. At December 31, 2009, its ALLL totaled $22.5 million, representing 2.4% of its total loans.

 

Although the Company believes it has underwriting standards to manage normal lending risks, it is difficult to assess the future performance of its loan portfolio due to the current economic environment and the state of the real estate market.  The assessment of future performance of the loan portfolio is inherently uncertain.  The Company can give you no assurance that its non-performing loans will not increase or that its non-performing or delinquent loans will not adversely affect its future performance.

 

In addition, federal regulators periodically review the Company’s ALLL and may require us to increase the ALLL or recognize further loan charge-offs. In 2009, as a result of regulatory review, the Company revised its ALLL methodology and the ALLL increased. Any increase in its ALLL or loan charge-offs as required by these regulatory agencies could have a material adverse effect on the Company’s results of operations and financial condition.

 

The need to account for assets at market prices may adversely affect our results of operations.

 

The Company reports certain assets, including investments and securities, at fair value. Generally, for assets that are reported at fair value the Company uses quoted market prices, third-party valuations or valuation models that utilize market data inputs to estimate

 

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fair value.  Because the Company carries these assets on its books at their fair value, losses may be incurred even if the asset in question presents minimal credit risk.  Given the continued disruption in the capital markets, the Company may be required to recognize OTTI in future periods with respect to securities in its portfolio.  The amount and timing of any impairment recognized will depend on the severity and duration of the decline in fair value of the securities and the Company’s estimation of the anticipated recovery period.

 

Our profitability depends significantly on economic conditions in the Commonwealth of Pennsylvania specifically in Lackawanna, Luzerne, Wayne and Monroe counties.

 

The Company’s success depends primarily on the general economic conditions of the Commonwealth of Pennsylvania and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Lackawanna, Luzerne, Wayne and Monroe County markets. The local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company’s financial condition and results of operations.

 

We rely on our management and other key personnel and the loss of any of them and the increased turnover of management may adversely affect our operations.

 

During the first quarter of 2010 the Company’s President and Principal Executive Officer (“CEO”) and Principal Financial Officer resigned.  In September 2010, the Company hired a new Chief Financial Officer and the search for a permanent CEO is continuing.  While we hope to recruit a new President and CEO as soon as possible, we do not know how long the process will take or when it will be concluded and the vacancy in this position is a violation of the Order. In addition, since August 2010, the Company has hired a new Chief Credit Officer, a new Chief Risk Officer, a new Internal Audit Manager as well as numerous additional personnel.  Further, until the Company finds a permanent President and CEO and integrates new personnel, it may be unable to successfully manage and grow the business, financial condition and profitability may suffer.  The Company believes each member of the senior management team is important to the Company’s success and the unexpected loss of any of these persons could impair our day-to-day operations as well as its strategic direction.

 

The Company’s success depends, in large part, on its ability to attract and retain key people.  Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or retain them.  The unexpected loss of services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.  The Company does not currently have employment agreements or non-competition agreements with any of its senior officers.

 

We are subject to claims and litigation pertaining to fiduciary responsibility.

 

From time to time, customers make claims and take legal action pertaining to the Company’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services as well as impact customer demand for those products and services.  Moreover, as a result of the restatement of its financial statements and revisions to many of its policies made for the year ended December 31, 2009, the Company may be at increased risk for such litigation. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.

 

The price of our common shares may fluctuate significantly, which may make it difficult for investors to resell shares of common shares at a time or prices they find attractive.

 

Our stock price may fluctuate significantly as a result of a variety of factors, many of which are beyond our control. These factors include, in addition to those described above:

 

·                  actual or anticipated quarterly fluctuations in our operating results and financial condition;

·                  changes in financial estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to us or other financial institutions;

·                  speculation in the press or investment community generally or relating to our reputation or the financial services industry;

 

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·                  strategic actions by us or our competitors, such as acquisitions, restructurings, dispositions or financings;

·                  fluctuations in the stock price and operating results of our competitors;

·                  future sales of our equity or equity-related securities;

·                  proposed or adopted regulatory changes or developments;

·                  anticipated or pending investigations, proceedings, or litigation that involve or affect us;

·                  domestic and international economic factors unrelated to our performance; and

·                  general market conditions and, in particular, developments related to market conditions for the financial services industry.

 

In addition, in recent years, the stock market in general has experienced extreme price and volume fluctuations.  This volatility has had a significant effect on the market price of securities issued by many companies, including for reasons unrelated to their operating performance. These broad market fluctuations may adversely affect our share price, notwithstanding our operating results. The Company expects that the market price of its common shares will continue to fluctuate and there can be no assurances about the levels of the market prices for our common shares.

 

An active public market for our common stock does not currently exist. As a result, shareholders may not be able to quickly and easily sell their common shares.

 

The Company’s common shares traded, through December 17, 2010, in the over the counter bulletin board market, and currently trades through the OTC Markets Group, Inc. During the year ended December 31, 2009, an average of 3,169 shares traded on a daily basis.  There can be no assurance that an active and liquid market for the Company’s common shares will develop, or if one develops that it can be maintained. The absence of an active trading market may make it difficult to subsequently sell the Company’s common shares at the prevailing price, particularly in large quantities.  See further discussion in Item 5.

 

We are subject to extensive government regulation and supervision and possible regulatory enforcement actions and may experience higher costs and lower shareholder returns.

 

The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. The Company and Bank are regulated and supervised by the OCC and the FRB. The burden imposed by federal regulations puts banks at a competitive disadvantage compared to less regulated competitors such as finance companies, mortgage banking companies and leasing companies. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including with respect to the imposition of restrictions on the operation of a bank or a bank holding company, the imposition of significant fines, the ability to delay or deny merger or other regulatory applications, the classification of assets by a bank, and the adequacy of a bank’s allowance for loan losses, among other matters. The Company and the Bank are subject to the requirements of the Order and the Agreement, and any failure to comply with, or any change in, such regulation and supervision, or change in regulation or enforcement by such authorities, whether in the form of policy, regulations, legislation, rules, orders, enforcement actions, or decisions, could have a material impact on the Company, our subsidiary banks and other affiliates, and our operations. Federal economic and monetary policy may also affect our ability to attract deposits and other funding sources, make loans and investments, and achieve satisfactory interest spreads.  Any failure to comply with such regulation or supervision could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations.

 

Item 1B.  Unresolved Staff Comments.

 

There are no unresolved written comments that were received from the SEC staff 180 days or more before the end of our 2009 fiscal year relating to our periodic or current reports filed under the 1934 Act.

 

Item 2.  Properties.

 

The Company currently conducts business from its main office located at 102 East Drinker Street, Dunmore, Pennsylvania, 18512 and from its additional 21 branches located throughout Lackawanna, Luzerne, Wayne and Monroe counties.  At December 31, 2009, aggregate net book value of premises and equipment was $20.7 million.  With the exception of potential remodeling of certain facilities to provide for the efficient use of work space and/or to maintain an appropriate appearance, each property is considered reasonably adequate for current and anticipated needs.

 

Property

 

Location

 

Ownership

 

Type of Use

1

 

102 East Drinker Street

 

 

 

 

 

 

Dunmore, PA

 

Own

 

Main Office

 

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2

 

419-421 Spruce Street

 

 

 

 

 

 

Scranton, PA

 

Own

 

Scranton Branch

 

 

 

 

 

 

 

3

 

934 Main Street

 

 

 

 

 

 

Dickson City, PA

 

Own

 

Dickson City Branch

 

 

 

 

 

 

 

4

 

1743 North Keyser Avenue

 

 

 

 

 

 

Scranton, PA

 

Lease

 

Keyser Village Branch

 

 

 

 

 

 

 

5

 

23 West Market Street

 

 

 

 

 

 

Wilkes-Barre, PA

 

Lease

 

Wilkes-Barre Branch

 

 

 

 

 

 

 

6

 

1700 North Township Blvd.

 

 

 

 

 

 

Pittston, PA

 

Lease

 

Pittston Plaza Branch

 

 

 

 

 

 

 

7

 

754 Wyoming Avenue

 

 

 

 

 

 

Kingston, PA

 

Lease

 

Kingston Branch

 

 

 

 

 

 

 

8

 

1625 Wyoming Avenue

 

 

 

 

 

 

Exeter, PA

 

Lease

 

Exeter Branch

 

 

 

 

 

 

 

9

 

Route 502 & 435

 

 

 

 

 

 

Daleville, PA

 

Lease

 

Daleville Branch

 

 

 

 

 

 

 

10

 

27 North River Road

 

 

 

 

 

 

Plains, PA

 

Lease

 

Plains Branch

 

 

 

 

 

 

 

11

 

169 North Memorial Highway

 

 

 

 

 

 

Shavertown, PA

 

Lease

 

Back Mountain Branch

 

 

 

 

 

 

 

12

 

269 East Grove Street

 

 

 

 

 

 

Clarks Green, PA

 

Own

 

Clarks Green Branch

 

 

 

 

 

 

 

13

 

734 Sans Souci Parkway

 

 

 

 

 

 

Hanover Township, PA

 

Lease

 

Hanover Township Branch

 

 

 

 

 

 

 

14

 

194 South Market Street

 

 

 

 

 

 

Nanticoke, PA

 

Own

 

Nanticoke Branch

 

 

 

 

 

 

 

15

 

330-352 West Broad Street

 

 

 

 

 

 

Hazleton, PA

 

Own

 

Hazleton Branch

 

 

 

 

 

 

 

16

 

3 Old Boston Road

 

 

 

 

 

 

Pittston, PA

 

Lease

 

Route 315 Branch

 

 

 

 

 

 

 

17

 

1001 Main Street

 

 

 

 

 

 

Honesdale, PA

 

Own

 

Honesdale Branch

 

 

 

 

 

 

 

18

 

301 McConnell Street

 

 

 

 

 

 

Stroudsburg, PA

 

Own

 

Stroudsburg Branch

 

 

 

 

 

 

 

19

 

1127 Texas Palmyra Highway

 

 

 

 

 

 

Honesdale, PA

 

Lease

 

Honesdale Route 6 Branch

 

 

 

 

 

 

 

20

 

5120 Milford Road

 

 

 

 

 

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Table of Contents

 

 

 

East Stroudsburg, PA

 

Own

 

Marshalls Creek Branch

 

 

 

 

 

 

 

21

 

200 South Blakely Street

 

 

 

 

 

 

Dunmore, PA

 

Lease

 

Administrative Center

 

 

 

 

 

 

 

22

 

107-109 South Blakely Street

 

 

 

 

 

 

Dunmore, PA

 

Own

 

Parking Lot

 

 

 

 

 

 

 

23

 

114-116 South Blakely Street

 

 

 

 

 

 

Dunmore, PA

 

Own

 

Parking Lot

 

 

 

 

 

 

 

24

 

1708 Tripp Avenue

 

 

 

 

 

 

Dunmore, PA

 

Own

 

Parking Lot

 

 

 

 

 

 

 

25

 

119-123 South Blakely Street

 

 

 

 

 

 

Dunmore, PA

 

Own

 

Parking Lot

 

 

 

 

 

 

 

26

 

Rt. 940

 

 

 

 

 

 

Blakeslee, PA

 

Own

 

Land

 

 

 

 

 

 

 

27

 

Route 611

 

 

 

 

 

 

Paradise Township, PA

 

Own

 

Land

 

 

 

 

 

 

 

28

 

Main Street

 

 

 

 

 

 

Taylor, PA

 

Own

 

Land

 

 

 

 

 

 

 

29

 

Milford Road

 

 

 

 

 

 

East Stroudsburg, PA

 

Own

 

Land

 

 

 

 

 

 

 

30

 

1219 Wheeler Avenue

 

 

 

 

 

 

Dunmore, PA

 

Lease

 

Wheeler Ave. Branch

 

 

 

 

 

 

 

31

 

280 Mundy Street

 

 

 

 

 

 

Wilkes-Barre, PA

 

Own

 

Future bank offices

 

Item 3.                                   Legal Proceedings.

 

Periodically, there have been various claims and lawsuits against the Company, such as claims to enforce liens, condemnation proceedings on properties in which the Company holds security interests, claims involving the making and servicing of real property loans and other issues incident to its business.  The Company is not a party to any pending legal proceedings that the Company believes would have a material adverse effect on its financial condition, results of operations or cash flows.

 

Item 4.                                   (Removed and Reserved.)

 

PART II

 

Item 5.                                   Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.

 

Market Prices of Stock and Dividends Paid

 

The Company’s common shares are not actively traded. The principal market area for the Company’s shares is northeastern Pennsylvania, although shares are held by residents of other states across the country.  In the fourth quarter of 2010, the Company was notified by the Financial Industry Regulatory Authority (“FINRA”) that the Company’s common shares would cease to be eligible for continued quotation on the Over the Counter (“OTC”) Bulletin Board after December 17, 2010.  This determination was based on the

 

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Company’s delay in filing its quarterly report on Form 10-Q for the third quarter of 2010.  The Company’s common shares are currently quoted on the OTC Markets Group, Inc. (formerly referred to as the “Pink Sheets”) under the symbol “FNCB”.  The Company intends to petition FINRA to return to full quotation status on the OTC Bulletin Board after completing the restatement process for fiscal year 2009 and the first and second quarters of 2010 and filing its September 30, 2010, March 31, 2011 and June 30, 2011 Forms 10-Q and the December 31, 2010 Form 10-K and becoming current with its 1934 Act reporting requirements.  Quarterly market highs and lows and dividends paid for each of the past two years are presented below.  These prices represent actual transactions.

 

 

 

MARKET PRICE

 

 

 

 

 

HIGH

 

LOW

 

DIVIDENDS PAID PER

 

QUARTER

 

2009

 

SHARE

 

First

 

$

11.90

 

$

7.55

 

$

.11

 

Second

 

13.00

 

8.70

 

.02

 

Third

 

9.25

 

5.50

 

.02

 

Fourth

 

6.85

 

4.90

 

.02

 

 

 

 

 

 

 

$

0.17

 

 

QUARTER

 

2008

 

 

 

First

 

$

18.96

 

$

12.98

 

$

.11

 

Second

 

16.47

 

13.48

 

.11

 

Third

 

15.25

 

11.87

 

.11

 

Fourth

 

13.48

 

9.56

 

.13

 

 

 

 

 

 

 

$

0.46

 

 

Holders

 

As of March 12, 2010, there were 1,648 holders of record of the Company’s common shares.

 

Dividend Calendar

 

Dividends on the Company’s common shares, if approved by the Board of Directors, are customarily paid on or about March 15, June 15, September 15 and December 15.  Record dates for dividends are customarily on or about March 1, June 1, September 1, and December 1.  As of February 26, 2010, the Company has suspended paying dividends indefinitely and, as a result of the Order and the Agreement will not resume paying dividends without prior permission from the OCC and the Reserve Bank.

 

Equity Compensation Plan

 

Information regarding the Company’s compensation plans under which equity securities of the registrant are authorized for issuance as of December 31, 2009 is set forth below:

 

The following table summarizes our equity compensation plan information as of December 31, 2009.  Information is included for both equity compensation plans approved by First National Community Bancorp, Inc. shareholders and equity compensation plans not approved by First National Community Bancorp, Inc. shareholders.

 

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Table of Contents

 

Plan Category

 

Number of shares to be issued
upon exercise of outstanding
options, warrants and rights

(1) (2)

 

Weighted-average exercise
price of outstanding options,
warrants and rights

(1) (2)

 

Number of shares available for future
issuance under equity compensation
plans (excluding securities reflected in
column (a))

(2)

 

 

 

(a)

 

(b)

 

(c)

 

Equity compensation plans approved by First National Community Bancorp, Inc. shareholders

 

366,248

 

$

12.18

 

868,235

 

Equity compensation plans not approved by First National Community Bancorp, Inc. shareholders

 

0

 

0

 

0

 

Totals

 

366,248

 

$

12.18

 

868,235

 

 


(1)  The number of shares to be issued upon exercise of outstanding options and the weighted average exercise price includes any options which will become exercisable within sixty (60) days after December 31, 2009.

 

(2)  The Company’s equity compensation plans include the 2000 Independent Directors Stock Option Plan and the 2000 Employee Stock Incentive Plan which were approved by shareholders on May 16, 2001.  All share and per share information has been restated to reflect the retroactive effect of the 25% stock dividend paid December 27, 2007.

 

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Table of Contents

 

Performance Graph

 

The following graph compares the cumulative total shareholder return (i.e. price change, reinvestment of cash dividends and stock dividends received) on our common shares against the cumulative total return of the NASDAQ Stock Market (U.S. Companies) Index and the SNL Bank Index.  The stock performance graph assumes that $100 was invested on December 31, 2004.  The graph further assumes the reinvestment of dividends into additional shares of the same class of equity securities at the frequency with which dividends are paid on such securities during the relevant fiscal year.  The yearly points marked on the horizontal axis correspond to December 31 of that year.  The Company calculates each of the referenced indices in the same manner.  All are market-capitalization-weighted indices, so companies judged by the market to be more important (i.e. more valuable) count for more in all indices.

 

 

Total Return Performance

 

 

 

December 31,

 

Index

 

2004

 

2005

 

2006

 

2007

 

2008

 

2009

 

First National Community Bancorp, Inc.

 

100.00

 

108.57

 

131.46

 

110.20

 

65.16

 

36.87

 

NASDAQ Composite Index

 

100.00

 

101.37

 

111.03

 

121.92

 

72.49

 

104.31

 

SNL $1B-$5B Bank Index

 

100.00

 

98.29

 

113.74

 

82.85

 

68.72

 

49.26

 

 


(*)                                 Source:  SNL Financial LC, Charlottesville, VA © 2009.  SNL Securities is a research and publishing firm specializing in the collection and dissemination of data on the banking, thrift and financial services industries.

 

Assumes a $100 investment on December 31, 2004 and reinvestment of all dividends.  The graph above is not indicative of future price performance.

 

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Table of Contents

 

Purchase of Equity Securities by the Issuer or Affiliates Purchasers

 

None.

 

Item 6.  Selected Financial Data.

 

The selected consolidated financial and other data and management’s discussion and analysis of financial condition and results of operations set forth below and in Item 7 hereof is derived in part from, and should be read in conjunction with, the consolidated financial statements and notes thereto contained elsewhere herein.  The Company restated its financial statements for the year ended December 31, 2009.  Please see Note 3 to the consolidated financial statements included in Item 8 hereof.  Certain reclassifications have been made to prior years’ consolidated financial statements to conform to the current year’s presentation.  Those reclassifications did not impact net income.

 

FIRST NATIONAL COMMUNITY BANCORP, INC. AND SUBSIDIARIES

SELECTED FINANCIAL DATA

(In thousands, except per share data)

 

 

 

For the Years Ended December 31,

 

 

 

2009
(as restated)

 

2008

 

2007

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

1,366,332

 

$

1,313,759

 

$

1,297,553

 

$

1,186,327

 

$

1,009,254

 

Interest-bearing balances with financial institutions

 

0

 

0

 

0

 

0

 

2,178

 

Securities, available-for-sale

 

252,946

 

245,900

 

295,727

 

268,794

 

236,662

 

Securities, held-to-maturity

 

1,899

 

1,808

 

1,722

 

1,639

 

1,561

 

Net loans

 

917,516

 

956,674

 

897,665

 

829,121

 

707,248

 

Total deposits

 

1,071,608

 

952,892

 

945,517

 

920,973

 

750,666

 

Long-Term Debt

 

155,240

 

202,243

 

135,942

 

147,489

 

126,942

 

Shareholders’ equity

 

63,084

 

100,342

 

107,142

 

96,862

 

84,419

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

64,398

 

73,451

 

81,886

 

68,668

 

53,307

 

Interest expense

 

25,196

 

33,242

 

42,572

 

33,186

 

22,357

 

Net interest income before provision for loan and lease losses

 

39,202

 

40,209

 

39,314

 

35,482

 

30,950

 

Provision for loan and lease losses

 

42,089

 

1,804

 

2,200

 

2,080

 

1,860

 

Other income (loss)

 

(11,851

)

7,812

 

6,345

 

4,897

 

3,904

 

Other expenses

 

38,172

 

26,530

 

23,797

 

20,773

 

18,943

 

Income (loss) before income taxes

 

(52,910

)

19,687

 

19,662

 

17,526

 

14,051

 

Provision (credit) for income taxes

 

(8,594

)

4,604

 

4,966

 

4,017

 

2,826

 

Net income (loss)

 

(44,316

)

15,083

 

14,696

 

13,509

 

11,225

 

Cash dividends paid

 

2,738

 

7,294

 

6,614

 

5,776

 

4,513

 

 

 

 

 

 

 

 

 

 

 

 

 

Per share data (1):

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

(2.74

)

$

0.95

 

$

0.94

 

$

0.88

 

$

0.74

 

Earnings per share- diluted

 

$

(2.74

)

$

0.95

 

$

0.93

 

$

0.87

 

$

0.73

 

Cash dividends (2)

 

$

0.17

 

$

0.46

 

$

0.42

 

$

0.38

 

$

0.30

 

Book value

 

$

3.87

 

$

5.59

 

$

6.25

 

$

6.80

 

$

6.25

 

Weighted average number of shares outstanding—basic

 

16,169,777

 

15,862,335

 

15,601,377

 

15,352,406

 

15,125,382

 

Weighted average number of shares outstanding-diluted

 

16,169,777

 

15,946,149

 

15,786,028

 

15,498,746

 

15,318,419

 

Average equity to average assets

 

6.89

%

8.12

%

8.23

%

8.25

%

8.43

%

 


(1)          All per common share amounts reflect a 25% common stock dividend issued December 27, 2007 and a 10% stock dividend issued March 31, 2006.

(2)          Cash dividends per share have been adjusted to reflect the 25% stock dividend paid December 7, 2007 and the 10% stock dividend paid March 31, 2006.

 

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Table of Contents

 

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s discussion and analysis represents an overview of the financial condition and results of operations and should be read in conjunction with our consolidated financial statements and notes thereto included in Item 8 of this report and Risk Factors detailed in Item 1A of Part I of this report.

 

We are in the business of providing customary retail and commercial banking services to individuals and businesses.  Our core market is northeastern Pennsylvania.

 

FORWARD-LOOKING STATEMENTS

 

The Company may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the SEC (including this Amendment and the exhibits hereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

 

These forward-looking statements include statements with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company’s control).  The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements.  The following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements: the strength of the United States economy in general and the strength of the local economies in the Company’s markets; 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; inflation, interest rate, market and monetary fluctuations; the timely development of and acceptance of new products and services; the impact of the Company’s ability to comply with its regulatory agreements and orders; the effectiveness of the Company’s revised system of internal controls; the ability of the Company to attract additional capital investment; the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking, securities and insurance); technological changes; acquisitions; changes in consumer spending and saving habits; the nature, extent, and timing of governmental actions and reforms, and the success of the Company at managing the risks involved in the foregoing.

 

The Company cautions that the foregoing list of important factors is not exclusive.  Readers are also cautioned not to place undue reliance on any forward-looking statements, which reflect management’s analysis only as of the date of this report, even if subsequently made available by the Company on its website or otherwise.  The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company to reflect events or circumstances occurring after the date of this report.

 

CRITICAL ACCOUNTING POLICIES

 

In preparing the consolidated financial statements, management has made estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated statements of condition and results of operations for the periods indicated.  Actual results could differ significantly from those estimates.

 

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of its financial condition and results of operations.  The Company’s significant accounting policies are presented in Note 2 to the consolidated financial statements.  Management has identified the policies on the Allowance for Loan and Lease Losses (“ALLL”), securities valuation, goodwill and other intangible assets and income taxes to be critical as management is required to make subjective and/or complex judgments about matters that are inherently uncertain and could be most subject to revision as new information becomes available.

 

The judgments used by management in applying the critical accounting policies discussed below may be affected by a further and prolonged deterioration in the economic environment, which may result in changes to future financial results. Specifically, subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the ALLL in future periods, and the inability to collect on outstanding loans could result in increased loan losses. In addition, the valuation of certain securities in the Company’s investment portfolio could be negatively impacted by illiquidity or dislocation in marketplaces resulting in significantly depressed market prices thus leading to further impairment losses.

 

In connection with regulatory reviews of the Company’s operations, financial statements and SEC filings, the Company determined that certain of its accounting and reporting policies did not conform to U.S. GAAP and were not being applied properly or should otherwise be revised.  During 2009 and as reflected in this Amendment, the Company made the following changes to its accounting and reporting policies:

 

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Table of Contents

 

·                  In its preparation of the financial statements included in the Original Report, the Company did not properly formulate and evaluate its ALLL as a result of the timing of charge-offs and the recognition of TDRs.  In determining the ALLL included in the Original Report, the Company increased the specific reserve component of the ALLL when it determined a loan had impairment rather than timely recognizing the loss and reducing the reserve.  As reflected in this Amendment, the Company changed its ALLL policy to timely recognize charge-offs in the appropriate accounting period.  As revised, when a loan is determined to be impaired and collection of the entire amount of the loan is unlikely, the loan is charged off or charged down to the fair market value of the collateral, thus reducing the carrying value of the loan and the ALLL.  The change in policy led to an increase in the provision for loan and lease losses in the Original Report of $32.0 million to a provision of $42.1 million in this Amendment.  Additionally, the general reserve component of the ALLL, previously based on one aggregated pool of unimpaired loans, was increased after assigning these loans to one of three pools of “Pass”, “Special Mention” or “Accruing and Substandard” and applying historical loss factors and varied qualitative factor basis point allocations based on the risk profile in each pool to determine the appropriate reserve related to those loans.  The general reserve component of the ALLL also increased because of higher historical loss experience resulting from the increased loan charge-offs of impaired loans.

 

As a result of the change in ALLL policy reflected herein, the ALLL, which was $22.5 million in the Original Report and was comprised of a specific reserve of $12.4 million and a general reserve of $10.1 million, was restated to reduce the ALLL by charging off an additional $10.2 million in loans and recording an additional provision for loan and lease losses of $10.1 million. The change reallocated the reserve by reducing the specific reserves by $8.4 million, from $12.4 million to $4.0 million.  Included in the $4.0 million specific reserve allocation is $2.0 million in reserve for TDR impairments which were not previously identified by the Company.  The addition of the risk pools, along with higher historical loss experience as a result of increased charge-offs, resulted in the general reserves increasing by $8.4 million, from $10.1 to $18.5 million.  As a result the restated ALLL was $22.5 million.

 

·                  In connection with determining the appropriate ALLL, the Company also revised its loan impairment measurement process.  In the Original Report, the Company employed a policy of impairing or charging off impaired collateral-dependent loans upon receipt of a certified appraisal of the collateral and only used alternative valuation sources for the purposes of writing down loans if the receipt of a certified appraisal was significantly delayed, the timing of receipt was uncertain and an alternative methodology could be derived that produced logical results such as an available appraisal for a similar property in a similar location.  As a result of input received from the Company’s regulators, the Company revised its valuation policy to record downward adjustments on impaired collateral-dependent loans based on a variety of valuation sources, including, but not limited to, certified appraisals, broker price opinions, letters of intent and executed sale agreements.

 

Additional loan charge-offs reflected in this report resulted from the change in policy to timely recognize charge-offs in the appropriate accounting period.  As a result of this change in policy, this report reflects an additional $10.2 million of loan charge-offs from the amount of charge-offs reflected in the Original Report.

 

The Company also determined that it had calculated its provision for off-balance sheet commitments incorrectly in the Original Report.  The reserve for off-balance sheet commitments was previously calculated using all commitments and assumed these commitments would be fully funded.  This methodology was revised to provide a reserve on letters of credit and construction commitments. The Company also performs individual analyses on the aforementioned commitments to borrowers considered to be impaired. As a result, the Company reduced the related liability by $1.0 million.

 

·                  The Company also revised its policy for determining and calculating the value of the pooled trust preferred collateralized debt obligations securities (“PreTSLs”) in its securities portfolio and the amount of related credit impairment to employ more severe assumptions. In changing the methodology, the Company adopted a policy that is more consistent with those used by other market participants and that uses the same approach to value all of the PreTSLs in the Company’s portfolio. In the Original Report, the Company had assumed that 50% of issuers who had deferred payments would recover, including by paying previously deferred amounts, within two years of deferral. However, as reflected in this Amendment, the Company changed its policy to cause to be produced cash flow models for each security that assumes all deferring issuers default immediately, with no recovery assumed. The Company did not change its policy with respect to defaulted securities: credit impairment in the Original Report and in this Amendment both reflect the assumption that defaulted issuers default immediately with no recovery. As reflected in the Original Report, the Company had not determined whether factors, other than existing deferrals or defaults, indicated that an impairment loss had been incurred with respect to performing issuers, but rather, it had assumed a 0.375% default rate for all securities and relied on market data provided by a third party. As reflected in this Amendment, we changed our policy to evaluate each bank issuer based upon its financial trends, such as earnings, net interest margin, operating efficiency, liquidity, capital position, level of non-performing loans to total loans, apparent sufficiency of loan loss reserves, Texas ratio and whether the issuer received TARP monies. Based on this analysis of historical experience and assumptions of future events for each bank issuer, we developed annual expected default rates specific to each bank issuer rather than using the same expected default rate of 0.375% for each issuer. Furthermore, we had previously relied on two outside service providers, including a third party who sold us the PreTSLs included in its securities portfolio to provide us with fair values for our

 

29



Table of Contents

 

PreTSLs.However, under our revised methodology, fair value was calculated by a third party valuation service unaffiliated with the PreTSLs based on our estimates of future cash flows and the assumption that an investor would require a 15% return on investment for PreTSL XIX and PreTSL XXVI and a 20% return on investment for the remaining PreTSLs to be willing to purchase the cash flows. This change in methodology resulted in an additional impairment charge to earnings of $8.7 million.

 

The Company recognized additional other than temporary impairment (“OTTI”) charges of $4.9 million on PreTSL securities the issuers of which defaulted or deferred payments between the first quarter of 2010 and the date of this Amendment, after the Company reviewed its subsequent events analysis and determined that these events reflected issuer credit impairments that existed as of the fourth quarter of 2009. Also, as a result of its subsequent events analysis, the Company recognized additional OTTI of $800 thousand in the fourth quarter of 2009 on its PLCMOs.

 

·                  In the Original Report, the Company accounted for loan fees and costs inconsistently across loan types.  The Company engaged a third party to review its methodology, assist in the calculation of the actual deferred fees and costs and the applicable amortization period and to provide a consistent approach.  This analysis has been incorporated into the Company’s methodology.  This change in methodology resulted in an additional deferral of $497 thousand.

 

Allowance for Loan and Lease Losses

 

The ALLL represents management’s estimate of probable loan losses inherent in the loan portfolio.  Determining the amount of the ALLL is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on qualitative factors and historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. Various banking regulators, as an integral part of their examination of the Company, also review the ALLL.  Such regulators may require, based on their judgments about information available to them at the time of their examination, that certain loan balances be charged off or require that adjustments be made to the ALLL.  Additionally, the ALLL is determined, in part, by the composition and size of the loan portfolio.

 

As previously noted, the Company changed its policy for determining the ALLL effective for 2009.  The allowance consists of specific and general components.  The specific component relates to loans that are classified as impaired.  For such loans an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan.  The general component covers loans that are performing as agreed and is based on historical loss experience adjusted by qualitative factors.  The general reserve component of the ALLL, previously based on one aggregated pool of unimpaired loans, was increased after assigning these loans to one of three pools of “Pass”, “Special Mention” or “Accruing and Substandard” and applying historical loss factors and varied qualitative factor basis point allocations based on the risk profile in each pool to determine the appropriate reserve related to those loans.  The general reserve component of the ALLL also increased because of higher historical loss experience resulting from the increased loan charge-offs of impaired loans.

 

Securities Valuation

 

Management utilizes various inputs to determine the fair value of its investment portfolio. To the extent they exist, unadjusted quoted market prices in active markets (level 1) or quoted prices on similar assets or models using inputs that are observable, either directly or indirectly (level 2) are utilized to determine the fair value of each investment in the portfolio. In the absence of observable inputs or if markets are illiquid, valuation techniques would be used to determine fair value of any investments that require inputs that are both unobservable and significant to the fair value measurement (level 3).  For level 3 inputs, valuation techniques are based on various assumptions, including, but not limited to cash flows, discount rates, rate of return, adjustments for nonperformance and liquidity, and liquidation values. A significant degree of judgment is involved in valuing investments using level 3 inputs.  The use of different assumptions could have a positive or negative effect on consolidated financial condition or results of operations.  See Note 5 of the consolidated financial statements included in Item 8 hereof for more details on our securities valuation techniques.

 

Management must periodically evaluate if unrealized losses (as determined based on the securities valuation methodologies discussed above) on individual securities classified as held to maturity or available for sale in the investment portfolio are considered to be OTTI. The analysis of OTTI requires the use of various assumptions, including, but not limited to, the length of time an investment’s book value is greater than fair value, the severity of the investment’s decline, any credit deterioration of the investment, whether management intends to sell the security, and whether it is more likely than not that the Company will be required to sell the security prior to recovery of its amortized cost basis. As a result of our adoption of new authoritative guidance under Accounting Standards Codification (“ASC”) Topic 320, “Investments—Debt and Equity Securities” on June 30, 2009, debt investment securities deemed to be OTTI are written down by the impairment related to the estimated credit loss and the non-credit related impairment is recognized in other comprehensive income. Prior to the adoption of the new authoritative guidance and unchanged for equity securities, if the decline in value of an investment was deemed to be other-than-temporary, the investment was written down to fair value and a non-cash impairment charge was recognized in the period of such evaluation.  The Company recognized OTTI charges on securities of $20.6 million, $0, and $ 0 in 2009, 2008, and 2007, respectively, within the net OTTI losses on securities on the consolidated statements of operations. For 2009, the OTTI charges relate mainly to estimated credit losses on pooled trust preferred securities. See - “Securities” section below and Note 18 Fair Value Measurements to the consolidated financial statements for additional analysis of our OTTI charges.

 

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Table of Contents

 

Goodwill and Intangible Assets

 

The Company records all assets, liabilities, and non-controlling interests in the acquiree in purchase acquisitions, including goodwill and other intangible assets, at fair value as of the acquisition date, and expenses all acquisition related costs as incurred as required by ASC Topic 805, “Business Combination.” Goodwill is not amortized but is subject to annual tests for impairment or more often if events or circumstances indicate it may be impaired. Other intangible assets are amortized over their estimated useful lives and are subject to impairment tests if events or circumstances indicate a possible inability to realize the carrying amount. The initial recording of goodwill and other intangible assets requires subjective judgments concerning estimates of the fair value of the acquired assets.

 

On an annual basis, the Company evaluates whether circumstances are present that would indicate potential impairment of its goodwill. These circumstances include the trading value of the Company’s common shares relative to its book value, adverse changes in the business or legal climate, actions by regulators, or loss of key personnel.  When the Company determines that these or other circumstances are present, the Company tests the carrying value of goodwill for impairment at an interim date.

 

The goodwill impairment test is performed in two phases. The first step compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value, an additional procedure must be performed.

 

In the second step, the Company calculates the implied value of goodwill by simulating a business combination for each reporting unit. This step subtracts the estimated fair value of net assets in the reporting unit from the step one estimated fair value to determine the implied value of goodwill. If the implied value of goodwill exceeds the carrying value of goodwill allocated to the reporting unit, goodwill is not impaired, but if the implied value of goodwill is less than the carrying value of the goodwill allocated to the reporting unit, a goodwill impairment charge for the difference is recognized in the consolidated statement of operations with a corresponding reduction to goodwill on the consolidated balance sheet.

 

In performing its evaluation of goodwill impairment, the Company makes significant judgments, particularly with respect to estimating the fair value of each reporting unit and if the second step test is required, estimating the fair value of net assets. The Company utilizes a third-party specialist who assists with valuation techniques to evaluate each reporting unit and estimate a fair value as though it were an acquirer. The estimates utilize historical data, cash flows, and market and industry data. Industry and market data is used to develop material assumptions such as transaction multiples, required rates of return, control premiums, transaction costs and synergies of a transaction, and capitalization.

 

The step two test resulted in $8.1 million of impairment, which eliminated goodwill as of December 31, 2009.  Our 2009 net income was also reduced by $8.1 million as a result of the impairment.

 

Intangible assets which are subject to amortization include core deposit intangible assets related to the Bank’s Honesdale branch acquisition during November 2006 and $2.6 million of mortgage servicing rights related to loans originated by the Bank and sold in the secondary market where servicing rights have been retained.  These assets subject to amortization are reviewed by management at least annually for potential impairment and whenever events or circumstances indicate that carrying amounts may not be recoverable.

 

Fair value may be determined using: market prices, comparison to similar assets, market multiples, discounted cash flow analyses and other determinants. Estimated cash flows may extend far into the future and, by their nature, are difficult to determine over an extended timeframe. Factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures and technology, and changes in discount rates, terminal values and specific industry or market sector conditions.

 

Income Taxes

 

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact our consolidated financial condition or results of operations.

 

We record income tax expense based on the amount of tax currently payable or receivable and the change in deferred tax assets and liabilities.  Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial and tax reporting purposes.  We conduct quarterly assessments of all available evidence to determine the amount of deferred tax assets that are more-likely-than-not to be realized.  The available evidence used in connection with these assessments includes taxable income in current and prior periods, cumulative losses in prior periods, projected future taxable income, potential tax-planning strategies, and projected future reversals of deferred tax items.  These assessments involve a certain degree of subjectivity which may change significantly depending on the related circumstances.

 

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In connection with determining our income tax provision, the Company considers maintaining liabilities for uncertain tax positions and tax strategies that management believes contain an element of uncertainty. Periodically, the Company evaluates each of our tax positions and strategies to determine whether the liability for uncertain tax benefits continues to be appropriate. Notes 2 and 13 to the consolidated financial statements include additional discussion on the accounting for income taxes.

 

New Authoritative Accounting Guidance

 

On July 1, 2009, the ASC became the FASB’s officially recognized source of authoritative U.S. GAAP applicable to all public and non-public non-governmental entities, superseding all existing FASB, American Institute of Certified Public Accountants (“AICPA”), Emerging Issues Task Force (“EITF”) and related literature. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative guidance for SEC registrants. All other accounting literature is considered non-authoritative.  The issuance of the ASC affects the way companies refer to U.S. GAAP in financial statements and other disclosures. See Note 2 of the consolidated financial statements for a description of recent accounting pronouncements including the dates of adoption and the effect on the results of operations and financial condition.

 

SUMMARY OF PERFORMANCE

 

The Company reported a net loss of $44.3 million in 2009 compared to $15.1 million in net income for fiscal year 2008.  Basic earnings/(loss) per share decreased from the $0.95 per share reported in 2008 to $(2.74) in 2009.

 

The deterioration in general economic conditions and declining real estate values severely impacted borrowers’ ability to make scheduled payments on their loans, resulting in the Company recording $42.1 million of provision for loan and lease losses to state the ALLL at the amount the Company believes is adequate to absorb probable loan losses. Other key items contributing to the 2009 results included OTTI losses incurred on investment securities totaling $20.6 million, a goodwill impairment charge of $8.1 million, a $5.4 million increase in operating expenses which includes a $2.1 million increase in FDIC insurance premiums and a $1.3 million increase in the expenses of other real estate owned.

 

The Company’s return on assets for the years ended December 31, 2009 and 2008 was (3.29)%, and 1.17%, respectively while the return on average equity was (47.78)% and 14.35%, respectively.

 

Goodwill Impairment

 

In connection with the purchase of the Honesdale branch during 2006, the Company acquired intangible assets of $9.8 million.  Of that amount, $1.7 million results from core deposit premium subject to periodic amortization over the useful life of 10 years.  Goodwill of $8.1 million, which is not subject to amortization, arose in connection with the acquisition.  In response to the significant loss reported by the Company in 2009 and the reduction in the market capitalization of the Company’s common shares, the Company’s goodwill was evaluated for impairment as of December 31, 2009.  The analysis included a combination of a market approach based analysis of comparable transactions, change of control premium to peer market price approach, a discounted cash flow analysis of the potential dividends of the company and the assessment of the fair value of the Company’s balance sheet as of the measurement date. As a result of the analysis, the $8.1 million was charged off as of December 31, 2009.

 

The following table displays the changes in the carrying amount of goodwill during the period (in thousands):

 

 

 

Goodwill

 

Accumulated
Impairment

 

Balance as of January1, 2009

 

$

8,134

 

$

 

 

 

 

 

 

 

Impairment write-off

 

(8,134

)

(8,134

)

Balance as of December 31, 2009

 

$

 

$

(8,134

)

 

Net Interest Income

 

Net interest income consists of interest income and fees on interest-earning assets less interest expense on deposits and borrowed funds.  It represents the largest component of the Company’s operating income and as such is the primary determinant of profitability. The net interest margin on a fully tax equivalent basis is calculated by dividing tax equivalent net interest income by average interest earning assets and is a key measurement used in the banking industry to measure income from earning assets. The net interest margin was 3.44 % for the year ended December 31, 2009, a decrease of 15 basis points compared to the same period in 2008.  This decrease in net interest margin was due to a 17% increase in non-earning assets.  Rate spread, the difference between the average yield on

 

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interest earning assets and the average cost of interest bearing liabilities shown on a fully tax equivalent basis was 3.28% for 2009, a decrease of 2 basis points versus 2008.  Management was able to maintain the rate spread by altering the balance and mix of interest earning assets and interest bearing liabilities to offset the changes in their corresponding interest yields and costs. However, the Company cannot guarantee that these actions and other asset/liability management strategies will prevent future declines in rate spread, net interest margin or net interest income.

 

Net interest income on a tax equivalent basis, decreased $374 thousand to $43.1 million for 2009 compared with $43.5 million for 2008. During 2009, an 87 basis point decline in interest rates paid on average interest bearing liabilities and higher loan balances positively impacted our net interest income, but were offset by a 112 basis point decline in the yield on average loans and investments and higher average interest bearing liabilities as compared to 2008. After reducing the Federal Funds rate throughout 2008, the Federal Reserve kept interest rates stable during 2009 leaving the Federal Funds rate at an historic low of 25 basis points. Because the Company’s floating rate loans are largely indexed to the national prime rate they reset lower as the prime rate followed the Federal Funds rate lower in 2008. Many of these loans are now at their floors and will remain there until the prime rate moves up enough for their rates to move above their floors. In addition, most of the time deposits in the Company’s funding portfolio matured and renewed at lower market rates in 2009.

 

Average loans totaling $938.3 million for the year ended December 31, 2009 increased $11.5 million or 1.25% in 2009 compared to the same period for 2008 primarily due to organic loan growth of $35.3 million in installment indirect auto loans, partly offset by a net decrease of $21.2 million in commercial loans. Interest income on a tax equivalent basis for loans decreased $7.4 million due to an 86 basis point decrease in average loan yield as loan rates reset lower and new business was originated at lower market rates compared with the same period in 2008, despite an increase of $612 thousand due to loan volumes. Average investment securities totaling $275.4 million declined $7.1 million or 2.5 percent in 2009 compared to the same period in 2008. Interest income on a tax equivalent basis for investment securities decreased $1.2 million primarily due to reinvestment of pay downs and maturities into more liquid lower yielding securities and the loss of dividends on stock in the Federal Home Loan Bank of Pittsburgh. Average federal funds sold increased $38.1 million as the Company increased its holdings of liquid assets.  Interest income on federal funds sold increased $86 thousand as the increase in volume more than offset the 142 basis point decline in yield earned.

 

The interest income that would have been earned on nonaccrual and restructured loans outstanding at December 31, 2009, 2008 and 2007 in accordance with their original terms approximated $4.1 million, $1.1 million and $227 thousand, respectively.  Interest income on impaired loans of $1 thousand, $166 thousand and $0 was recognized for cash payments received in 2009, 2008 and 2007, respectively.

 

Average interest bearing liabilities totaled $1.2 billion for the year ended December 31, 2009 an increase of $67.2 million or 6.2% during 2009 compared to the same period in 2008 primarily due to increases in interest bearing demand deposits of $24.1 million or 8.3%, increases in time deposits over $100 thousand of $76.1 million or 41.7% and savings deposits increases of $6.8 million or 9.1%.  These increases were partly offset by a decrease in other time deposits of $37.6 million or 12.1%. The cost of interest-bearing demand deposits, savings deposits, time deposits over $100 thousand, and other time deposits decreased 21, 20, 167, and 87 basis points respectively, from the same period in 2008. Average borrowed funds and other interest-bearing liabilities totaled $235.6 million for the year ended December 31, 2009 a decrease of $2.1 million or 1% compared to 2008.

 

In 2008, tax-equivalent net interest income improved $1.3 million, or 3.2%, when compared to the prior year.  Growth of the balance sheet, effective asset-liability management strategies and the positive impact due to re-pricing all contributed to earnings improvement.

 

Average loans outstanding increased $39.4 million, or 4.4% in 2008 compared to 2007.  The average yield earned on the loan portfolio decreased one hundred twenty one basis points as a result of the Federal Reserve monetary policy which reduced the prime interest rate by 4% to help a struggling economy.  This strategy had a significant impact on our variable rate loans, resulting in an $8.2 million decrease in income earned on total loans.  Commercial loans were most severely impacted by the lower interest rate environment due to the high volume of variable rate credits.  Interest income decreased $9.1 million on this group of loans in spite of a $23.8 million increase in average loans outstanding.  Included in this total is over $16 million of commercial loan balances which were transferred to nonaccrual status during 2008, and this transfer combined with balances previously placed in this non-earning category, resulted in a $1.2 million loss of earnings on those assets.  Retail loans outstanding grew $15.7 million on average due primarily to a $9.8 million increase in average indirect auto loans.  Earnings on retail loans improved $946 thousand when compared to 2007.

 

Average securities decreased $3.4 million in 2008 as liquidity was utilized to fund loan growth.  Investment in higher yielding mortgage-back securities and tax- free municipal bonds led to a fourteen basis point improvement in the yield earned which resulted in an additional $206 thousand of interest income over the prior year.  Money market balances were limited to $717 thousand on average as funds were utilized in higher earning assets.  Earnings on this category of assets decreased $16 thousand in 2008 due to the lower interest rate environment.

 

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Table of Contents

 

Average interest-bearing deposit balances decreased $17.5 million in 2008 due to certificate of deposit maturities that were not replaced.  Interest-bearing demand deposits decreased $3.9 million during the year due to activity in large commercial accounts and municipal relationships while average savings deposits increased $2.9 million.  Average time deposits decreased $16.5 million as many customers withdrew funds as interest rates paid on certificates of deposit decreased.  The average cost of interest-bearing deposits decreased 1.10% from the 2007 rate which helped to offset the earnings lost on assets.  Average borrowed funds outstanding increased $60.1 million in 2008 to offset the deposits lost, and the average rate paid on these borrowings was ninety eight basis points lower than the rate paid in 2007.

 

Overall, an increase in interest-earning assets combined with a fourteen basis point increase in the spread earned resulted in the $1.3 million increase in tax-equivalent net interest income.  The net interest margin remained stable at 3.59%.  Investment leveraging transactions continued to add to the profitability of the company in 2008, contributing almost $1.4 million to pre-tax earnings, but the average spread earned on the transactions was 1.69% which negatively impacted the net interest margin.

 

The following table reflects the components of net interest income for each of the three years ended December 31, 2009, 2008 and 2007:

 

Analysis of Average Assets, Liabilities and Shareholders’ Equity and Net Interest Income on a Tax-Equivalent Basis

(in thousands) (1)

 

 

 

December 31, 2009

 

 

 

 

 

 

 

(as restated)

 

December 31, 2008

 

December 31, 2007

 

 

 

 

 

Interest

 

 Average

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Average

 

Income/

 

Interest

 

Average

 

Income/

 

Interest

 

Average

 

Income/

 

Interest

 

 

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earning Assets:(2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial loans-taxable

 

$

640,241

 

$

33,945

 

5.30

%

$

664,333

 

$

42,523

 

6.40

%

$

650,679

 

$

52,276

 

8.03

%

Commercial loans-tax free

 

51,206

 

3,520

 

6.87

%

48,325

 

3,494

 

7.23

%

38,229

 

2,874

 

7.52

%

Mortgage loans

 

34,369

 

2,576

 

7.50

%

36,890

 

2,619

 

7.10

%

34,695

 

2,352

 

6.78

%

Installment loans

 

212,501

 

12,494

 

5.88

%

177,228

 

11,253

 

6.35

%

163,729

 

10,574

 

6.46

%

Total Loans(1)(2)

 

938,317

 

52,535

 

5.60

%

926,776

 

59,889

 

6.46

%

887,332

 

68,076

 

7.67

%

Securities-taxable

 

161,094

 

7,759

 

4.82

%

194,162

 

11,020

 

5.68

%

211,139

 

11,446

 

5.42

%

Securities-tax free

 

114,298

 

7,883

 

6.90

%

88,376

 

5,774

 

6.53

%

74,817

 

5,142

 

6.87

%

Total Securities(1)(3)

 

275,392

 

15,642

 

5.68

%

282,538

 

16,794

 

5.94

%

285,956

 

16,588

 

5.80

%

Interest-bearing deposits with banks

 

0

 

0

 

0.00

%

0

 

0

 

0.00

%

0

 

0

 

0.00

%

Federal funds sold

 

38,863

 

98

 

0.25

%

717

 

12

 

1.67

%

544

 

28

 

5.15

%

Total Money Market Assets

 

38,863

 

98

 

0.25

%

717

 

12

 

1.67

%

544

 

28

 

5.15

%

Total Earning Assets

 

1,252,572

 

68,275

 

5.45

%

1,210,031

 

76,695

 

6.34

%

1,173,832

 

84,692

 

7.22

%

Non-earning assets

 

106,360

 

 

 

 

 

90,921

 

 

 

 

 

81,529

 

 

 

 

 

Allowance for loan and lease losses

 

(12,770

)

 

 

 

 

(6,861

)

 

 

 

 

(8,357

)

 

 

 

 

Total Assets

 

$

1,346,162

 

 

 

 

 

$

1,294,091

 

 

 

 

 

$

1,247,004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-Bearing Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing demand deposits

 

$

312,285

 

$

3,725

 

1.19

%

$

288,226

 

$

4,025

 

1.40

%

$

292,134

 

$

8,064

 

2.76

%

Savings deposits

 

81,149

 

589

 

0.73

%

74,349

 

692

 

0.93

%

71,444

 

868

 

1.21

%

Time deposits over $100,000

 

258,275

 

5,097

 

1.97

%

182,205

 

6,633

 

3.64

%

193,834

 

9,271

 

4.78

%

Other time deposits

 

272,001

 

8,010

 

2.94

%

309,585

 

12,240

 

3.95

%

314,469

 

15,413

 

4.90

%

Total Interest-Bearing Deposits

 

923,710

 

17,421

 

1.89

%

854,365

 

23,590

 

2.76

%

871,881

 

33,616

 

3.86

%

Interest-bearing liabilities

 

235,559

 

7,775

 

3.30

%

237,631

 

9,652

 

4.06

%

177,537

 

8,956

 

5.04

%

Total Interest-Bearing Liabilities

 

1,159,269

 

25,196

 

2.17

%

1,091,996

 

33,242

 

3.04

%

1,049,418

 

42,572

 

4.06

%

Demand deposits

 

81,081

 

 

 

 

 

81,772

 

 

 

 

 

80,515

 

 

 

 

 

Other liabilities

 

13,070

 

 

 

 

 

15,194

 

 

 

 

 

14,429

 

 

 

 

 

Shareholders’ equity

 

92,742

 

 

 

 

 

105,129

 

 

 

 

 

102,642

 

 

 

 

 

Total Liabilities and

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

$

1,346,162

 

 

 

 

 

$

1,294,091

 

 

 

 

 

$

1,247,004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Interest Income/Interest Rate Spread (4)

 

 

 

$

43,079

 

3.28

%

 

 

$

43,453

 

3.30

%

 

 

$

42,120

 

3.16

%

Net Interest Margin (5)

 

 

 

 

 

3.44

%

 

 

 

 

3.59

%

 

 

 

 

3.59

%

 

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Table of Contents

 


(1) Interest income is presented on a tax equivalent basis using a 34% tax rate for 2009 and a 35% tax rate for 2008 and 2007.

(2) Loans are stated net of unearned income and exclude non-performing loans.

(3) The yield for securities that are classified as available for sale is based on the average historical amortized cost.

(4) Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.

(5) Net interest income as a percentage of total average interest earning assets.

 

Rate Volume Analysis

 

The most significant impact on net income between periods is derived from the interaction of changes in the volume and rates earned or paid on interest-earning assets and interest-bearing liabilities.  The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods.  Components of interest income and interest expense are presented on a tax-equivalent basis using the statutory federal income tax rate of 34% for 2009 and a 35% tax rate for 2008 and 2007.

 

The following table shows the effect of changes in volume and interest rates on net interest income.  The variance in interest income or expense due to the combination of rate and volume has been allocated proportionately.

 

Rate/Volume Variance Report(1)

(in thousands-taxable equivalent basis)

 

 

 

2009 vs. 2008

 

2008 vs. 2007

 

 

 

 

 

Increase (Decrease)

 

 

 

Increase (Decrease)

 

 

 

Total
Change

 

Due to
Volume

 

Due to Rate

 

Total
Change

 

Due to
Volume

 

Due to Rate

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial loans-taxable

 

$

(8,578

)

$

(1,538

)

$

(7,040

)

$

(9,753

)

$

1,807

 

$

(11,560

)

Commercial loans-tax free

 

26

 

152

 

(126

)

620

 

771

 

(151

)

Mortgage loans

 

(43

)

(179

)

136

 

267

 

147

 

120

 

Installment loans

 

1,241

 

2,177

 

(936

)

679

 

847

 

(168

)

Total Loans

 

(7,354

)

612

 

(7,966

)

(8,187

)

3,572

 

(11,759

)

Securities-taxable

 

(3,261

)

(1,695

)

(1,566

)

(426

)

(1,245

)

819

 

Securities-tax free

 

2,109

 

1,694

 

415

 

632

 

932

 

(300

)

Total Securities

 

(1,152

)

(1

)

(1,151

)

206

 

(313

)

519

 

Interest-bearing deposits with banks

 

0

 

0

 

0

 

0

 

0

 

0

 

Federal funds sold

 

86

 

638

 

(552

)

(16

)

9

 

(25

)

Total Money Market Assets

 

86

 

638

 

(552

)

(16

)

9

 

(25

)

Total Interest Income

 

(8,420

)

1,249

 

(9,669

)

(7,997

)

3,268

 

(11,265

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing demand deposits

 

(300

)

335

 

(635

)

(4,039

)

(130

)

(3,909

)

Savings deposits

 

(103

)

63

 

(166

)

(176

)

29

 

(205

)

Time deposits over $100,000

 

(1,536

)

2,769

 

(4,305

)

(2,638

)

(600

)

(2,038

)

Other time deposits

 

(4,229

)

(1,436

)

(2,793

)

(3,174

)

(192

)

(2,982

)

Total Interest-Bearing Deposits

 

(6,168

)

1,731

 

(7,899

)

(10,027

)

(893

)

(9,134

)

Borrowed funds and other interest-bearing liabilities

 

(1,878

)

(84

)

(1,794

)

697

 

3,002

 

(2,305

)

Total Interest Expense

 

(8,046

)

1,647

 

(9,693

)

(9,330

)

2,109

 

(11,439

)

Net Interest Income

 

$

(374

)

$

(398

)

$

24

 

$

1,333

 

$

1,159

 

$

174

 

 

35



Table of Contents

 


(1)  Changes in interest income and interest expense attributable to changes in both volume and rate have been allocated proportionately to changes due to volume and changes due to rate.

 

During 2009, tax-equivalent net interest income decreased $374 thousand over the prior year total.  The re-pricing of interest sensitive assets and liabilities combined with growth at current market levels generated a positive variance due to rate in the amount of $24 thousand.

 

Interest income recognized on loans decreased $7.4 million in 2009.  The $11.5 million increase in average loans outstanding led to a $612 thousand increase in interest income, but earnings lost due to transferring loans to nonaccrual status led to a negative variance.

 

Investment securities interest income during 2009 decreased $1.2 million when compared to 2008 due primarily to a 0.30% decrease in the yield earned and the addition of lower yielding securities. Earnings from money market assets were $86 thousand higher than the prior year as deposit growth increased balances significantly.

 

Deposit growth resulted in a $1.7 million increase in interest expense in 2009, however declining interest rates led to a $7.9 million reduction of interest expense.  The $6.2 million decrease in the cost of deposits combined with a $1.9 million decrease in the cost of borrowings resulted in an $8.0 million reduction in total interest expense which offset the $8.4 million decrease in interest income for the year.

 

During 2008, tax-equivalent net interest income increased $1.3 million over the 2007 total.  Balance sheet growth was profitable as evidenced by the $1.2 million of improvement related to volume.  The repricing of interest sensitive assets and liabilities combined with growth at current market levels contributed to a positive variance due to rate in the amount of $174 thousand.

 

Interest income recognized on loans decreased $8.2 million in 2008 compared to 2007.  The $39 million increase in average loans outstanding led to a $3.6 million increase in interest income, but re-pricing resulting from Federal Reserve interest rate cuts contributed to the $11.8 million decrease due to rate.  Included in the negative variance due to rate is the $1.2 million of lost earnings on nonaccrual loans.  Investment securities added $200 thousand more interest income in 2008 compared to 2007 in spite of lower balances due to the repositioning of the securities portfolio into higher earning assets.  Earnings from money market assets were $16 thousand less than the prior year as funds were utilized in higher earning asset categories.

 

Deposits runoff resulted in an $893 thousand decrease in interest expense in 2008 compared to 2007, while declining interest rates led to an additional $9.1 million reduction of interest expense.  The $10 million decrease in the cost of deposits combined with a $700 thousand increase in the cost of borrowings due to increased balances resulted in a $9.3 million reduction in total interest expense which more than offset the $8.0 million decrease in interest income and resulted in the $1.3 million improvement in net interest income recorded for the year.

 

Provision for Loan and Lease Losses

 

Management closely monitors the loan portfolio and the adequacy of the ALLL considering underlying borrower financial performance and collateral values and increasing credit risks.  Future material adjustments may be necessary to the provision for loan and lease losses and the ALLL if economic conditions or loan performance differ substantially from the assumptions management used in making its evaluation of the ALLL.  The provision for loan and lease losses is an expense charged against net interest income to provide for estimated losses attributable to uncollectible loans and is based on management’s analysis of the adequacy of the ALLL.  The provision for loan and lease losses was $42.1 million in 2009 as compared to $1.8 million in 2008.  The increase was primarily related to increased charge offs due to the decline in the real estate market and the prolonged deterioration in the economy as well as our change in policy for determining the ALLL, including an enhanced loan impairment measurement process and historical loss analysis, described in more detail under “-Critical Accounting Policies” and “Financial Condition - Allowance for Loan and Lease Losses. “

 

36


 


Table of Contents

 

Other Income (Loss)

 

 

 

2009
(as restated)

 

2008

 

2007

 

 

 

 

 

(in thousands)

 

 

 

Service charges

 

$

2,863

 

$

3,118

 

$

2,840

 

Net gain on the sale of securities

 

890

 

1,156

 

721

 

Other-than-temporary-impairment loss on securities

 

(20,649

)

 

 

Net gain on the sale of loans

 

1,481

 

414

 

310

 

Net gain on the sale of other real estate

 

309

 

520

 

 

Net gain on the sale of other assets

 

 

3

 

26

 

Other

 

3,255

 

2,601

 

2,448

 

Total Other Income (Loss)

 

$

(11,851

)

$

7,812

 

$

6,345

 

 

During 2009, total other income (loss) decreased $19.7 million from the 2008 total primarily due to the recognition of OTTI charges on investment securities, in the amount of $20.6 million.  Gains from the sale of loans increased $1.1 million over 2008 as residential mortgages were sold to Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) or Federal Home Loan Bank (“FHLB”) in the secondary mortgage market.

 

The credit loss component of an OTTI write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income, provided that the Company does not intend to sell, or that it is more likely than not that the Company will not be required to sell, the underlying debt security.

 

During 2009, the Company recorded a $20.6 million OTTI charge on debt securities.  The charge includes $18.4 million in credit related OTTI on seven pooled trust preferred collateralized debt obligations and $2.2 million on eight private label mortgage-backed securities. All of the securities for which OTTI was recorded were classified as available-for-sale.  Additionally, $15 million in noncredit related OTTI was recorded in other comprehensive income on the fifteen securities which were classified as impaired.

 

During 2008, total other income increased $1.5 million, or 23.1%, over 2007.  Service charges improved $278 thousand, or 9.8%, due to a $293 thousand increase in overdraft privilege fees.  Income generated from the sale of assets increased $1.0 million compared to 2007.  Securities were sold to reposition the portfolio for future benefits and residential mortgages were sold to reduce the Company’s exposure to interest rate risk.  Additionally, a $520 thousand gain was recognized from the sale of several properties which were previously classified as OREO.  Other fee income also increased $153 thousand, or 6.3%, due to increased fees recognized on asset management services and Bank Owned Life Insurance.

 

Other Expenses

 

 

 

2009
(as restated)

 

2008

 

2007

 

 

 

 

 

(in thousands)

 

 

 

Salary expense

 

$

9,960

 

$

10,469

 

$

9,628

 

Employee benefit expense

 

2,195

 

2,276

 

2,289

 

Occupancy expense

 

2,218

 

2,349

 

2,116

 

Equipment expense

 

1,828

 

1,811

 

1,577

 

Advertising expense

 

713

 

988

 

890

 

Data processing expense

 

1,928

 

1,610

 

1,682

 

Goodwill Impairment

 

8,134

 

 

 

FDIC assessment