UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the Quarterly Period Ended March 31, 2016

 

OR

 

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

 

For the Transition Period from ____________to____________

 

Commission File Number 000-26995

 

HCSB FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

South Carolina	57-1079444
(State or other jurisdiction	(I.R.S. Employer
of incorporation)	Identification No.)

 

5201 Broad Street
Loris, South Carolina 29569
(Address of principal executive
offices, including zip code)

 

(843) 756-6333
(Registrant’s telephone number, including area code)

 

 

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 x No o

 

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

	Large accelerated filer o	Accelerated filer o
	Non-accelerated o (do not check if a smaller reporting company)	Smaller reporting company x

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 363,314,783 shares of common stock, par value $.01 per share, were issued and outstanding as of May 9, 2016.

Index

 

		Page No.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets – March 31, 2016 and December 31, 2015		3
Condensed Consolidated Statements of Operations - Three months ended March 31, 2016 and 2015		4
Condensed Consolidated Statements of Comprehensive Income (Loss) – Three months ended March 31, 2016 and 2015		5
Condensed Consolidated Statements of Changes in Shareholders’ Equity - Three months ended March 31, 2016 and 2015		6
Condensed Consolidated Statements of Cash Flows – Three months ended March 31, 2016 and 2015		7
Notes to Unaudited Condensed Consolidated Financial Statements		8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		52
Item 3. Quantitative and Qualitative Disclosures about Market Risk		65
Item 4. Controls and Procedures		65
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		66
Item 1A. Risk Factors		68
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		68
Item 3. Defaults Upon Senior Securities		68
Item 4. Mine Safety Disclosures		68
Item 5. Other Information		68
Item 6. Exhibits		68
SIGNATURES		69

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Item 1. Financial Statements

  

CONDENSED CONSOLIDATED BALANCE SHEETS

 

		March 31,				December 31,
		2016				2015
(Dollars in thousands except share amounts)		(unaudited)				(audited)
Assets:
Cash and cash equivalents:
Cash and due from banks		$	41,652			$	22,137
Securities available-for-sale			83,205				89,701
Nonmarketable equity securities			1,276				1,330
Total investment securities			84,481				91,031
Loans receivable			199,635				209,367
Less allowance for loan losses			(3,719	)			(4,601	)
Loans, net			195,916				204,766
Premises and equipment, net			15,758				15,917
Accrued interest receivable			1,516				1,745
Cash value of life insurance			11,400				11,319
Other real estate owned			11,270				13,624
Other assets			1,370				884
Total assets		$	363,363			$	361,423
Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Noninterest-bearing transaction accounts		$	40,227			$	40,182
Interest-bearing transaction accounts			44,485				40,478
Money market savings accounts			66,835				65,806
Other savings accounts			11,293				10,394
Time deposits $250 and over			3,741				3,735
Other time deposits			168,880				170,236
Total deposits			335,461				330,831
Repurchase agreements			1,248				1,716
Advances from the Federal Home Loan Bank			17,000				17,000
Subordinated debentures			11,023				11,021
Junior subordinated debentures			6,118				6,117
Accrued interest payable			6,333				5,958
Other liabilities			828				1,030
Total liabilities			378,011				373,673
Commitments and contingencies
Shareholders’ Equity
Preferred stock, $0.01 par value; 5,000,000 shares authorized;12,895 shares issued and outstanding			12,895				12,895
Common stock, $0.01 par value, 500,000,000 shares authorized; 3,846,340 shares issued and outstanding			38				38
Capital surplus			30,220				30,220
Common stock warrant			1,012				1,012
Retained deficit			(58,090	)			(54,807	)
Accumulated other comprehensive loss			(723	)			(1,608	)
Total shareholders’ deficit			(14,648	)			(12,250	)
Total liabilities and shareholders’ deficit		$	363,363			$	361,423

 

The accompanying notes are an integral part of the consolidated financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

 

		Three months ended March 31,
(Dollars in thousands except share amounts)		2016				2015
Interest income:
Loans, including fees		$	2,483			$	2,833
Investment securities:
Taxable			461				485
Nonmarketable equity securities			14				14
Other interest income			31				16
Total			2,989				3,348
Interest expense:
Deposits			523				648
Borrowings			523				497
Total			1,046				1,145
Net interest income			1,943				2,203
Provision for loan losses			1,424				—
Net interest income after provision for loan losses			519				2,203
Noninterest income:
Service charges on deposit accounts			161				183
Gains on sales of securities available-for-sale			17				134
Gains on sales of mortgage loans			—				62
Other fees and commissions			72				97
Brokerage commissions			9				15
Income from cash value of life insurance			110				107
Net loss on sale of assets			—				(6	)
Other operating income			47				111
Total			416				703
Noninterest expenses:
Salaries and employee benefits			1,286				1,423
Net occupancy expense			275				295
Furniture and equipment expense			224				253
FDIC insurance premiums			309				362
Net cost (profit) of operations of other real estate owned			1,564				(282	)
Other operating expenses			560				626
Total			4,218				2,677
(Loss) income before income taxes			(3,283	)			229
Income tax expense			—				27
Net (loss) income		$	(3,283	)		$	202
Preferred dividends			(398	)			(297	)
Net loss available to common shareholders		$	(3,681	)		$	(95	)
Net loss per common share
Basic		$	(0.96	)		$	(0.02	)
Diluted		$	(0.96	)		$	(0.02	)
Weighted average common shares outstanding
Basic and diluted			3,846,340				3,816,340

 

The accompanying notes are an integral part of the consolidated financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited)

 

		Three months ended March 31,
(Dollars in thousands)		2016				2015
Net (loss) income		$	(3,283	)		$	202
Other comprehensive income:
Unrealized gains on securities available-for-sale:
Net unrealized holding gains arising during the period			902				708
Reclassification to realized gains			(17	)			(134	)
Other comprehensive income			885				574
Comprehensive (loss) income		$	(2,398	)		$	776

The accompanying notes are an integral part of the consolidated financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

 

Three months ended March 31, 2016 and 2015

(unaudited)

 

																														Accumulated
																														Other
										Common																				Compre-
		Common Stock								Stock				Preferred Stock								Capital				Retained				hensive
		Shares				Amount				Warrant				Shares				Amount				Surplus				Deficit				Loss				Total
(Dollars in thousands except share data)
Balance, December 31, 2014			3,816,340			$	38			$	1,012				12,895			$	12,895			$	30,214			$	(54,561	)		$	(845	)		$	(11,247	)
Net income			—				—				—				—				—				—				202				—				202
Other comprehensive income			—				—				—				—				—				—				—				574				574
Balance, March 31, 2015			3,816,340			$	38			$	1,012				12,895			$	12,895			$	30,214			$	(54,359	)		$	(271	)		$	(10,471	)
Balance, December 31, 2015			3,846,340			$	38			$	1,012				12,895			$	12,895			$	30,220			$	(54,807	)		$	(1,608	)		$	(12,250	)
Net loss			—				—				—				—				—				—				(3,283	)			—				(3,283	)
Other comprehensive income			—				—				—				—				—				—				—				885				885
Balance, March 31, 2016			3,846,340			$	38			$	1,012				12,895			$	12,895			$	30,220			$	(58,090	)		$	(723	)		$	(14,648	)

 

The accompanying notes are an integral part of the consolidated financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

		Three months ended March 31,
(Dollars in thousands)		2016				2015
Cash flows from operating activities:
Net (loss) income		$	(3,283	)		$	202
Adjustments to reconcile net (loss) income to net cash (used) provided by operating activities:
Depreciation and amortization			170				186
Amortization of debt issuance costs			3				3
Provision for loan losses			1,424				—
Amortization less accretion on investments			13				65
Net gains on sales of securities available-for-sale			(17	)			(134	)
Gains on sales of other real estate owned			(15	)			(523	)
(Write-ups) write-downs of other real estate owned			1,369				(3	)
Decrease in accrued interest receivable			229				79
Increase in accrued interest payable			375				399
(Increase) decrease in other assets			(486	)			1,428
Income (net of mortality cost) on cash value of life insurance			(81	)			(79	)
Decrease in other liabilities			(202	)			(288	)
Net cash (used) provided by operating activities			(501	)			1,335
Cash flows from investing activities:
Purchases of securities available-for-sale			(7,558	)			—
Maturities, calls and principal paydowns of securities available-for-sale			10,790				4,164
Proceeds from sales of securities available-for-sale			4,153				6,412
Redemptions of nonmarketable equity securities			54				12
Decrease in loans to customers			6,947				3,221
Purchases of premises and equipment, net			(11	)			—
Proceeds from sale of other real estate owned			1,479				3,257
Net cash provided by investing activities			15,854				17,066
Cash flows from financing activities:
Net increase in demand deposits and savings			5,980				11,661
Net decrease in time deposits			(1,350	)			(8,396	)
Net decrease in repurchase agreements			(468	)			(622	)
Net cash provided by financing activities			4,162				2,643
Net increase in cash and cash equivalents			19,515				21,044
Cash and cash equivalents, beginning of period			22,137				28,527
Cash and cash equivalents, end of period		$	41,652			$	49,571
Cash paid during the period for:
Income taxes		$	—			$	—
Interest		$	671			$	746
Noncash investing and financing activities:
Transfers of loans to other real estate owned		$	479			$	1,790
Transfers of premises and equipment to assets held for sale		$	—			$	3,927
Unrealized gains on investments		$	885			$	574

The accompanying notes are an integral part of the consolidated financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS

 

Organization and Significant Accounting Policies

  

Basis of Presentation and Consolidation - The accompanying consolidated financial statements include the accounts of HCSB Financial Corporation (the “Company”) which was incorporated on June 10, 1999 to serve as a bank holding company for its wholly owned subsidiary, Horry County State Bank (the “Bank”). The Bank was incorporated on December 18, 1987, and opened for operations on January 4, 1988. The principal business activity of the Company is to provide commercial banking services in Horry County, South Carolina, and in Columbus and Brunswick Counties, North Carolina. The Bank is a state-chartered bank, and its deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”). HCSB Financial Trust I (the “Trust”) is a special purpose subsidiary organized for the sole purpose of issuing trust preferred securities. The operations of the Trust have not been consolidated in these financial statements.

 

The accompanying consolidated financial statements have been prepared in accordance with the requirements for interim financial statements and, accordingly, they are condensed and omit disclosures, which would substantially duplicate those contained in the most recent annual report to shareholders. The financial statements as of March 31, 2016 and for the interim periods ended March 31, 2016 and 2015 are unaudited and, in our opinion, include all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation. Operating results for the three-month period ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. The financial information as of December 31, 2015 has been derived from the audited financial statements as of that date. For further information, refer to the financial statements and the notes included in HCSB Financial Corporation’s 2015 Annual Report on Form 10-K which was filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2016, as amended on Form 10-K/A which was filed with the SEC on April 1, 2016.

 

Management’s Estimates - In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and income and expenses for the period. Actual results could differ significantly from those estimates.

 

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, including valuation allowances for impaired loans, and the carrying amount of real estate acquired in connection with foreclosures or in satisfaction of loans. Management must also make estimates in determining the estimated useful lives and methods for depreciating premises and equipment.

 

While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowance may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowances for losses on loans and foreclosed real estate. Such agencies may require the Company to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowances for losses on loans and foreclosed real estate may change materially in the near term.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

Investment Securities - Investment securities available-for-sale owned by the Company are carried at amortized cost and adjusted to their estimated fair value for reporting purposes. The unrealized gain or loss is recorded in shareholders’ equity net of any deferred tax effects. Management does not actively trade securities classified as available-for-sale, but intends to hold these securities for an indefinite period of time and may sell them prior to maturity to achieve certain objectives. Reductions in fair value considered by management to be other than temporary are reported as a realized loss and a reduction in the cost basis in the security. The adjusted cost basis of securities available-for-sale is determined by specific identification and is used in computing the realized gain or loss from a sales transaction.

 

Nonmarketable Equity Securities - Nonmarketable equity securities include the Company’s investments in the stock of the Federal Home Loan Bank (the “FHLB”). The FHLB stock is carried at cost because the stock has no quoted market value and no ready market exists. Investment in FHLB stock is a condition of borrowing from the FHLB, and the stock is pledged to collateralize the borrowings. Dividends received on FHLB stock are included as a separate component in interest income.

 

Loans Receivable - Loans receivable are stated at their unpaid principal balance less any charge-offs. Interest income on loans is computed based upon the unpaid principal balance. Interest income is recorded in the period earned.

 

The accrual of interest income is generally discontinued when a loan becomes contractually 90 days past due as to principal or interest. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral exceeds the principal balance and accrued interest.

 

Loan origination and commitment fees and certain direct loan origination costs (principally salaries and employee benefits) are deferred and amortized to income over the contractual life of the related loans or commitments, adjusted for prepayments, using the straight-line method.

 

Loans are impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans are subject to these criteria except for smaller balance homogeneous loans that are collectively evaluated for impairment and loans measured at fair value or at the lower of cost or fair value. The Company considers its consumer installment portfolio and home equity lines as such exceptions. Therefore, loans within the real estate and commercial loan portfolios are reviewed individually.

 

Impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent. When management determines that a loan is impaired, the difference between the Company’s investment in the related loan and the present value of the expected future cash flows, or the fair value of the collateral, is charged off with a corresponding entry to the allowance for loan losses or a specific reserve is set aside within the allowance for loan losses. The accrual of interest is discontinued on an impaired loan when management determines the borrower may be unable to meet payments as they become due.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

Concentrations of Credit Risk - Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans receivable, investment securities, federal funds sold and amounts due from banks.

 

The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily throughout Horry County in South Carolina and Columbus and Brunswick counties of North Carolina. The Company’s loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. However, the loan portfolio does include a concentration in loans secured by residential and commercial real estate and commercial and industrial non-real estate loans. These loans are especially susceptible to being adversely effected by unfavorable economic conditions. The recent downturn in general economic conditions has resulted in an increase in loan delinquencies, defaults and foreclosures, and these trends may continue, especially in the Myrtle Beach area. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure, and there is a risk that this trend will continue. The commercial real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values in our market areas continue to decline, it is also more likely that we would be required to increase our allowance for loan losses.

 

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries and geographic regions, management monitors exposure to credit risk from concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.), and loans with high loan-to-value ratios. Management has determined that there is no concentration of credit risk associated with its lending policies or practices. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Company to unusual credit risk.

 

The Company’s investment portfolio consists principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in its investment portfolio. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.

 

Allowance for Loan Losses – The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Management’s judgments about the adequacy of the allowance are based on numerous assumptions about current events, which management believes to be reasonable, but which may or may not prove to be accurate. Thus, there can be no assurance that loan losses in future periods will not exceed the current allowance amount or that future increases in the allowance will not be required. No assurance can be given that management’s ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the allowance, thus adversely affecting the operating results of the Company.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

The allowance is subject to examination by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require the Company to adjust its allowance based on information available to them at the time of their examination.

 

The methodology used to determine the reserve for unfunded lending commitments, which is included in other liabilities, is inherently similar to that used to determine the allowance for loan losses adjusted for factors specific to binding commitments, including the probability of funding and historical loss ratio.

 

Premises, Furniture and Equipment - Premises, furniture and equipment are stated at cost less accumulated depreciation. The provision for depreciation is computed by the straight-line method. Rates of depreciation are generally based on the following estimated useful lives: buildings - 40 years; furniture and equipment - three to ten years. The cost of assets sold or otherwise disposed of and the related accumulated depreciation is eliminated from the accounts, and the resulting gains or losses are reflected in the income statement.

 

Maintenance and repairs are charged to current expense as incurred, and the costs of major renewals and improvements are capitalized.

 

Other Real Estate Owned - Other real estate owned (“OREO”) includes real estate acquired through foreclosure. OREO is initially recorded at appraised value, less estimated costs to sell.

 

Any write-downs at the dates of acquisition are charged to the allowance for loan losses. Subsequent write-downs are charged to a reserve for OREO losses. Expenses to maintain such assets, subsequent write-downs, and gains and losses on disposal are included in net cost (profit) of operations of other real estate owned on the statement of operations.

 

Income and Expense Recognition - The accrual method of accounting is used for all significant categories of income and expense. Immaterial amounts of insurance commissions and other miscellaneous fees are reported when received.

 

Income Taxes – The Company files a consolidated federal income tax return and separate company state income tax returns. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The Company accounts for income taxes based on two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period and includes income tax expense related to uncertain tax positions, if any.

 

Deferred income taxes are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is based on the tax impacts of the differences between the book and tax bases of assets and liabilities and recognizes enacted changes in tax rates and laws in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized subject to the Company’s judgment that realization is more likely than not. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize. The tax position is measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement. Interest and penalties, if any, are recognized as a component of income tax expense.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

The Company reviews the deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years, projections of future operating results, cumulative tax losses over the past three years, tax loss deductibility limitations, and available tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, a valuation allowance against the deferred tax asset must be established with a corresponding charge to income tax expense. The deferred tax assets and valuation allowance are evaluated each quarter, and a portion of the valuation allowance may be reversed in future periods. The determination of how much of the valuation allowance that may be reversed and the timing is based on future results of operation and the amount and timing of actual loan charge-offs and asset write-downs. At March 31, 2016 and December 31, 2015, the Company’s deferred tax asset was offset in its entirety by a valuation allowance.

 

The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain income tax positions have been recorded.

 

The 2016 private placement transaction discussed throughout this document has been structured to avoid being deemed a change in ownership under the IRS rules and the Company is continuing to work with its legal and accounting advisors to evaluate methods to preserve its deferred tax assets.

 

Net Income (Loss) Per Common Share - Basic income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed based on net income divided by the weighted average number of common and potential common shares. The computation of diluted net loss per share does not include potential common shares as their effect would be anti-dilutive. The only potential common share equivalents are related to the CPP Warrant.

 

Comprehensive Income - Accounting principles generally require recognized income, expenses, gains, and losses to be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income and are also presented in a separate statement of comprehensive income. Accumulated other comprehensive income for the Company consists entirely of unrealized holding gains and losses on available for sale securities.

 

Statements of Cash Flows - For purposes of reporting cash flows, the Company considers certain highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash equivalents include amounts due from banks, federal funds sold, and interest-bearing deposits with other banks.

 

Off-Balance Sheet Financial Instruments - In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit and letters of credit. These financial instruments are recorded in the financial statements when they become payable by the customer.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

Recently Issued Accounting Pronouncements – The following is a summary of recent authoritative pronouncements.

 

In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

 

In January 2015, the FASB issued guidance to eliminate from U.S. GAAP the concept of an extraordinary item, which is an event or transaction that is both (1) unusual in nature and (2) infrequently occurring. Under the new guidance, an entity will no longer (1) segregate an extraordinary item from the results of ordinary operations; (2) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; or (3) disclose income taxes and earnings-per-share data applicable to an extraordinary item. The amendments were effective for the Company on January 1, 2016. The Company will apply the guidance prospectively. The amendments had no effect on the financial statements.

 

In February 2015, the FASB issued guidance which amends the consolidation requirements and significantly changes the consolidation analysis required under U.S. GAAP. Although the amendments are expected to result in the deconsolidation of many entities, the Company will need to reevaluate all its previous consolidation conclusions. The amendments were effective for the Company on January 1, 2016 and did not have a material effect on the financial statements.

 

In April 2015, the FASB issued guidance which changes the presentation of debt issuance costs. The amendments were effective for the Company on January 1, 2016. As a result, all debt issuance costs have been reclassified to offset related debt.

 

In June 2015, the FASB issued amendments to clarify the Accounting Standards Codification (“ASC”), correct unintended application of guidance, and make minor improvements to the ASC that are not expected to have a significant effect on current accounting practice or create a significant administrative cost to most entities. The amendments were effective upon issuance (June 12, 2015) for amendments that do not have transition guidance. Amendments that are subject to transition guidance were effective for the Company on January 1, 2016. The amendments had no effect on the financial statements.

 

In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

 

In August 2015, the FASB issued amendments to the Interest topic of the ASC to clarify the SEC staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements. The amendments were effective upon issuance. The Company does not expect these amendments to have a material effect on its financial statements.

 

In February 2016, the FASB amended the Leases topic of the ASC to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

In March 2016, the FASB amended the Revenue from Contracts with Customers topic of the ASC to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.

 

In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them to apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. The amendments will be effective for the Company for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company does not expect these amendments to have a material effect on its financial statements.

 

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

 

Risks and Uncertainties - In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on a different basis, than its interest-earning assets. Credit risk is the risk of default on the Company’s loan portfolio that results from a borrower’s inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company.

 

The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions from the regulators’ judgments based on information available to them at the time of their examination.

 

Prior to the repurchase of the Series T preferred stock and the cancellation of the CPP Warrant by the U.S. Treasury, the Company was subject to certain regulations due to our participation in the CPP. Pursuant to the terms of the CPP Purchase Agreement between the Company and the U.S. Treasury, we adopted certain standards for executive compensation and corporate governance for the period during which the Treasury holds the equity issued pursuant to the CPP Purchase Agreement, including the common stock which may be issued pursuant to the CPP Warrant. These standards generally applied to our named executive officers and included: (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) requiring clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) a prohibition on making golden parachute payments to senior executives; (4) a prohibition on providing tax gross-up provisions; and (5) an agreement not to deduct for tax purposes executive compensation in excess of $500 thousand for each senior executive. With the repurchase of the Series T preferred stock and the cancellation of the CPP Warrant on April 11, 2016 following the closing of the 2016 private placement, these standards no longer apply to the Company.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

In February 2005, the Bank purchased a $500 thousand 15-year renewable and convertible term life insurance policy through Banner Life Insurance Company on the life of James R. Clarkson, President and CEO. The Bank is both the owner and the beneficiary of this key person policy. The purpose of securing this policy was to provide the Bank with financial protection in the event of the unexpected death of Mr. Clarkson and better enable the Bank to attract a qualified replacement for Mr. Clarkson in such a situation. The Bank anticipates transferring this policy to Mr. Clarkson upon his retirement, and he will assume payment obligations relating thereto.

 

Reclassifications - Certain captions and amounts for prior periods have been reclassified to conform to the March 31, 2016 presentation. These reclassifications had no effect on net income (loss) or shareholders’ deficit as previously reported.

 

Recent Developments - On April 11, 2016, the Company completed a private placement of 359,468,443 shares of common stock at $0.10 per share and 905,315.57 shares of a new series of convertible perpetual preferred stock, Series A (the “Series A preferred stock”), at $10.00 per share for aggregate cash proceeds of approximately $45.0 million (the “2016 private placement”). Net proceeds from the 2016 private placement, after deducting commissions and expenses, were approximately $41.5 million, of which $38.0 million was contributed to the Bank as a capital contribution to support its operations and increase its capital ratios to meet the higher minimum capital ratios required under the terms of the Bank’s Consent Order (the “Consent Order”) with the FDIC and the South Carolina Board of Financial Institutions (the “State Board”). Net proceeds from the 2016 private placement were also used to repurchase the Company’s outstanding Series T preferred stock (as defined below), trust preferred securities, and subordinated promissory notes, as described below.

 

On July 31, 2010, the Company completed a private placement of subordinated promissory notes that totaled $12.1 million. The notes bore interest at a rate equal to the current Prime Rate in effect, as published by the Wall Street Journal, plus 3%; provided, that the interest rate would not be less than 8% per annum or more than 12% per annum. Beginning in October 2011, the Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the subordinated promissory notes, and as a result, the Company had deferred interest payments in the amount of approximately $5.2 million as of March 31, 2016. Effective as of September 16, 2015,the Company, the Bank, and certain other defendants entered into a class action settlement agreement in potential settlement of the putative class action lawsuit initiated by three holders of the Company’s subordinated promissory notes, on behalf of themselves and as representatives of a class of similarly situated purchasers of the Company’s subordinated promissory notes, with respect to alleged wrongful conduct associated with purchases of the subordinated promissory notes, including fraud, violation of state securities statutes, and negligence. On March 2, 2016, the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry entered a final order of approval approving the class action settlement agreement. Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the class action settlement agreement, the Company established a settlement fund of approximately $2.4 million, which represented 20% of the principal of subordinated promissory notes issued by the Company. The settlement fund will be used to redeem the subordinated promissory notes held by class members. Also on April 11, 2016, the Company settled, pursuant to previously executed binding settlement agreements, with all subordinated promissory note holders who opted out of the class action settlement. These settlements, including the class action settlement, constituted the full satisfaction of the principal and interest owed on, and required the immediate dismissal of all pending litigation related to, the respective subordinated promissory notes. In each case, the Company and the Bank also obtained a full and complete release of all claims asserted or that could have been asserted with respect to the subordinated promissory notes. Refer to Note 8 to our Financial Statements for additional information on the subordinated promissory notes.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

On March 6, 2009, as part of the Troubled Asset Relief Program (the “TARP”) Capital Purchase Program (the “CPP”) established by the U.S. Department of the Treasury (the “U.S. Treasury”) under the Emergency Economic Stabilization Act of 2009, the Company issued and sold to the U.S. Treasury (i) 12,895 shares of fixed rate cumulative perpetual preferred stock, Series T, having a liquidation preference of $1,000 per share (the “Series T preferred stock”), and (ii) a ten-year warrant to purchase up to 91,714 shares of its common stock at an initial exercise price of $21.09 per share (the “CPP Warrant”), for an aggregate purchase price of $12.9 million in cash. Beginning in February 2011, the Federal Reserve Bank of Richmond required the Company to defer dividend payments on the Series T preferred stock, and as a result, the Company had deferred dividend payments due on the Series T preferred stock totaling $5.1 million as of March 31, 2016. On February 29, 2016, the Company entered into a securities purchase agreement with the U.S. Treasury, pursuant to which the Company agreed to repurchase all 12,895 shares of the Series T preferred stock for $129 thousand, plus reimbursement of attorneys’ fees and other expenses incurred by the U.S Treasury not to exceed $25 thousand. Under the terms of the securities purchase agreement, the U.S. Treasury also agreed to waive any and all unpaid dividends on the Series T preferred stock and to cancel the CPP Warrant. Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the securities purchase agreement, the Company repurchased all 12,895 shares of the Series T preferred stock from the U.S. Treasury for $129 thousand and the U.S. Treasury canceled the CPP Warrant. Refer to Note 9 to our Financial Statements for additional information on the Series T preferred stock.

 

On December 21, 2004, the Trust issued and sold a total of 6,000 trust preferred securities, with $1,000 liquidation amount per capital security and a maturity of December 31, 2034, to institutional buyers in a pooled trust preferred issue. The Company received from the Trust the $6.0 million proceeds from the issuance of the securities and the $186 thousand initial proceeds from the capital investment in the Trust and, accordingly, has shown the funds due to the trust as a $6.2 million junior subordinated debenture. Beginning in February 2011, the Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the trust preferred securities, and as a result, the Company had deferred interest payments in the amount of approximately $953 thousand as of March 31, 2016. The Company was permitted to defer these interest payments for up to 20 consecutive quarterly periods, or until March 15, 2016, at which point all of the deferred interest, including interest accrued on such deferred interest, would become due and payable. On February 29, 2016, the Company entered into a securities purchase agreement with Alesco Preferred Funding VI LTD (“Alesco”), pursuant to which the Company agreed to repurchase the trust preferred securities for $600 thousand, plus reimbursement of attorneys’ fees and other expenses incurred by Alesco not to exceed $25 thousand. Alesco also agreed to forgive any and all unpaid interest on the trust preferred securities. On March 16, 2016, the Company received a notice of default from The Bank of New York Mellon Trust Company, N.A., in its capacity as trustee, relating to the trust preferred securities. Immediately following the closing of the 2016 private placement on April 11, 2016, pursuant to the terms of the securities purchase agreement, the Company repurchased all of the trust preferred securities from Alesco for $600 thousand. Refer to Note 7 to our Financial Statements for additional information on the trust preferred securities.

 

In aggregate, after taking into account the discounted repurchase or redemption prices for the Series T preferred stock, the trust preferred securities and the subordinated promissory notes, each as described above, as well as the forgiveness of accrued and deferred interest, legal fees, amounts paid in settlement of litigation, income taxes, and other expenses incurred in connection with these transactions, the Company recognized a gain, net of income taxes, of approximately $31.3 million on these transactions on a pro forma basis as of March 31, 2016. This gain has not been reflected in the accompanying financial statements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 1 – ORGANIZATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENT DEVELOPMENTS - continued

 

Also on April 11, 2016, the boards of directors of the Company and the Bank appointed Jan H. Hollar as the chief executive officer and a director of the Company and the Bank. James C. Clarkson, who had served as the president and chief executive officer of the Company and the Bank since the formation of the Bank in 1987 and the formation of the Company in 1999, stepped down as president and chief executive officer and as a director of the Company on such date but agreed to stay on with the Company and the Bank as an employee on a temporary basis in order to assist with transition matters.

 

On August 7, 2015, the Bank consummated its previously disclosed sale of its Socastee, Windy Hill, and Carolina Forest branches, which included deposits of $34.2 million and $5.7 million in loans, to Sandhills Bank, North Myrtle Beach, South Carolina. The transaction included a deposit premium of 2.5% resulting in a net gain of $736 thousand to the Bank, after $167 thousand in expenses related to data processing and sales analysis. The sale consisted of the following (in thousands):

 

Assets
Cash		$	23,933
Loans receivable			5,728
Premises and equipment			3,877
Reduction to assets			33,538
Liabilities
Transaction and savings deposits			20,866
Time deposits			13,370
Accrued interest payable			8
Other accrued liabilities			30
Reduction to liabilities			34,274
Net gain on sale of branches		$	736

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS

  

Consent Order with the Federal Deposit Insurance Corporation and South Carolina Board of Financial Institutions

 

On February 10, 2011, the Bank entered into the Consent Order with the FDIC and the State Board. 

 

The Consent Order conveys specific actions needed to address the Bank’s current financial condition, primarily related to capital planning, liquidity/funds management, policy and planning issues, management oversight, loan concentrations and classifications, and non-performing loans. A summary of the requirements of the Consent Order and the Bank’s status on complying with the Consent Order is as follows:

 

Requirements of the Consent Order	Bank’s Compliance Status
Achieve and maintain, by July 10, 2011, Total Risk Based capital at least equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% of total assets.	The Bank did not meet the capital ratios as specified in the Consent Order and, as a result, submitted a revised capital restoration plan to the FDIC on July 15, 2011. The revised capital restoration plan was determined by the FDIC to be insufficient and, as a result, we submitted a further revised capital restoration plan to the FDIC on September 30, 2011. We received the FDIC’s non-objection to the further revised capital restoration plan on December 6, 2011.   Following the closing of the 2016 private placement on April 11, 2016, the Company contributed $38.0 million to the Bank as a capital contribution. As a result, the Bank had Total Risk Based capital equal to 21.2% of risk-weighted assets and Tier 1 capital equal to 19.9% of risk-weighted assets as of April 12, 2016. Accordingly, we believe that the Bank is now in compliance with this provision of the Consent Order.
Submit, by April 11, 2011, a written capital plan to the supervisory authorities.	We believe we have complied with this provision of the Consent Order.
Establish, by March 12, 2011, a plan to monitor compliance with the Consent Order, which shall be monitored by the Bank’s Directors’ Committee.	We believe we have complied with this provision of the Consent Order. The Directors’ Committee meets monthly and each meeting includes reviews and discussions of all areas required in the Consent Order.
Develop, by May 11, 2011, a written analysis and assessment of the Bank’s management and staffing needs.	We believe we have complied with this provision of the Consent Order. In 2011, the Bank engaged an independent third party to perform an assessment of the Bank’s staffing needs to ensure the Bank has an appropriate organizational structure with qualified management in place. The Board of Directors has reviewed all recommendations regarding the Bank’s organizational structure.
Notify the supervisory authorities in writing of the resignation or termination of any of the Bank’s directors or senior executive officers.	We believe we have complied with this provision of the Consent Order.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS - continued

 

Eliminate, by March 12, 2011, by charge-off or collection, all assets or portions of assets classified “Loss” and 50% of those assets classified “Doubtful.”	We believe we have complied with this provision of the Consent Order.
Review and update, by April 11, 2011, its policy to ensure the adequacy of the Bank’s allowance for loan and lease losses, which must provide for a review of the Bank’s allowance for loan and lease losses at least once each calendar quarter.	We believe we have complied with this provision of the Consent Order.
Submit, by April 11, 2011, a written plan to the supervisory authorities to reduce classified assets, which shall include, among other things, a reduction of the Bank’s risk exposure in relationships with assets in excess of $750,000 which are criticized as “Substandard” or “Doubtful”.  In accordance with the approved plan, reduce assets classified in the June 30, 2010 Report of Examination by 65% by August 11, 2012 and by 75% by February 9, 2013.	We believe we have complied with this provision of the Consent Order. The written plan was submitted and approved and assets classified in the June 30, 2010 Report of Examination have been reduced by 82.03% as of March 31, 2016.
Revise, by April 11, 2011, its policies and procedures for managing the Bank’s Adversely Classified Other Real Estate Owned.	We believe we have complied with this provision of the Consent Order.
Not extend any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been charged-off or classified, in whole or in part, “Loss” or “Doubtful” and is uncollected. In addition, the Bank may not extend any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been criticized, in whole or in part, “Substandard” and is uncollected, unless the Bank’s board of directors determines that failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.	We believe we have complied with this provision of the Consent Order.  In the second quarter of 2010, the Bank engaged the services of an independent firm to perform an extensive review of the Bank’s credit portfolio and help management implement a more comprehensive lending and collection policy and more enhanced loan review.  An independent review of the Bank’s credit portfolio was most recently completed in the first quarter of 2016.
Perform, by April 11, 2011, a risk segmentation analysis with respect to the Bank’s Concentrations of Credit and develop a written plan to systematically reduce any segment of the portfolio that is an undue concentration of credit.	We believe we have complied with this provision of the Consent Order.
Review, by April 11, 2011 and annually thereafter, the Bank’s loan policies and procedures for adequacy and, based upon this review, make all appropriate revisions to the policies and procedures necessary to enhance the Bank’s lending functions and ensure their implementation.	We believe we have complied with this provision of the Consent Order.  As noted above, the Bank engaged the services of an independent firm to perform an extensive review of the Bank’s credit portfolio and help management implement a more comprehensive lending and collection policy and more enhanced loan review.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS – continued

 

Adopt, by May 11, 2011, an effective internal loan review and grading system to provide for the periodic review of the Bank’s loan portfolio in order to identify and categorize the Bank’s loans, and other extensions of credit which are carried on the Bank’s books as loans, on the basis of credit quality.	We believe we have complied with this provision of the Consent Order.  As noted above, the Bank engaged the services of an independent firm to perform an extensive review of the Bank’s credit portfolio and help management implement a more comprehensive lending and collection policy and more enhanced loan review.
Review and update, by May 11, 2011, its written profit plan to ensure the Bank has a realistic, comprehensive budget for all categories of income and expense, which must address, at minimum, goals and strategies for improving and sustaining the earnings of the Bank, the major areas in and means by which the Bank will seek to improve the Bank’s operating performance, realistic and comprehensive budgets, a budget review process to monitor income and expenses of the Bank to compare actual results with budgetary projections, assess that operating assumptions that form the basis for budget projections and adequately support major projected income and expense components of the plan, and coordination of the Bank’s loan, investment, and operating policies and budget and profit planning with the funds management policy.	We believe we have complied with this provision of the Consent Order.  The Bank engaged an independent third party to assist management with a strategic plan to help restructure its balance sheet, increase capital ratios, return to profitability and maintain adequate liquidity.
Review and update, by May 11, 2011, its written plan addressing liquidity, contingent funding, and asset liability management.	We believe we have complied with this provision of the Consent Order.  In 2011, the Bank engaged an independent third party to assist management in its development of a strategic plan that achieves all requirements of the Consent Order.  The strategic plan reflects the Bank’s plans to restructure its balance sheet, increase capital ratios, return to profitability, and maintain adequate liquidity.  The Board of Directors has reviewed and adopted the Bank’s strategic plan.
Eliminate, by March 12, 2011, all violations of law and regulation or contraventions of policy set forth in the FDIC’s safety and soundness examination of the Bank in November 2009.	We believe we have complied with this provision of the Consent Order.
Not accept, renew, or rollover any brokered deposits unless it is in compliance with the requirements of 12 C.F.R. § 337.6(b).	We believe we have complied with this provision of the Consent Order. Since entering into the Consent Order, the Bank has not accepted, renewed, or rolled-over any brokered deposits.
Limit asset growth to 5% per annum.	We believe we have complied with this provision of the Consent Order.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

 

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS – continued

  

Not declare or pay any dividends or bonuses or make any distributions of interest, principal, or other sums on subordinated debentures without the prior approval of the supervisory authorities.	We believe we have complied with this provision of the Consent Order.
The Bank shall comply with the restrictions on the effective yields on deposits as described in 12 C.F.R. § 337.6.	We believe we have complied with this provision of the Consent Order.
Furnish, by March 12, 2011 and within 30 days of the end of each quarter thereafter, written progress reports to the supervisory authorities detailing the form and manner of any actions taken to secure compliance with the Consent Order.	We believe we have complied with this provision of the Consent Order, and we have submitted the required progress reports to the supervisory authorities.
Submit, by March 12, 2011, a written plan to the supervisory authorities for eliminating its reliance on brokered deposits.	We believe we have complied with this provision of the Consent Order.
Adopt, by April 11, 2011, an employee compensation plan after undertaking an independent review of compensation paid to all of the Bank’s senior executive officers.	We believe we have complied with this provision of the Consent Order.
Prepare and submit, by May 11, 2011, its written strategic plan to the supervisory authorities.	We believe we have complied with this provision of the Consent Order. In 2011, the Bank engaged an independent third party to assist management in its development of a strategic plan that achieves all requirements of the Consent Order. The Board of Directors has reviewed and adopted the Bank’s strategic plan.

 

Following the closing of the 2016 private placement, we believe that we are currently in substantial compliance with the Consent Order. Nevertheless, the determination of the Bank’s compliance will be made by the FDIC and the State Board, and we do not expect to be released from the Consent Order until completion of a full examination cycle. There can be no assurances that this will happen or that the Consent Order will be lifted in a timely manner. Until the Consent Order is lifted, we will be subject to limits on our growth and on hiring additional personnel, among other restrictions. In addition, the supervisory authorities may amend the Consent Order based on the results of their ongoing examinations.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited CONDENSED Consolidated Financial Statements

  

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS – continued

 

Written Agreement

 

On May 9, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond.  The Written Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank.

 

The Written Agreement contains provisions similar to those in the Bank’s Consent Order. Specifically, pursuant to the Written Agreement, the Company agreed, among other things, to seek the prior written approval of the Federal Reserve Bank of Richmond before undertaking any of the following activities:

 

●

declaring or paying any dividends,

 

●

directly or indirectly taking dividends or any other form of payment representing a reduction in capital from the Bank,

 

●

making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities,

 

●

directly or indirectly, incurring, increasing or guarantying any debt, and

 

●

directly or indirectly, purchasing or redeeming any shares of its stock.

 

The Company also agreed to comply with certain notice provisions set forth in the Federal Deposit Insurance Act and regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position.  The Company is also required to comply with certain restrictions on indemnification and severance payments pursuant to the Federal Deposit Insurance Act and FDIC regulations.

 

We believe we are currently in substantial compliance with the Written Agreement.

 

On August 18, 2014, the Federal Reserve Bank of Richmond informed the Company that it is required to repay two notes in the amount of $1.8 million to the Bank as soon as the Company has the funds available to do so for repayment of loans deemed made from the Bank to the Company. The Bank is a general unsecured creditor of the Company with respect to these loans. The Company made this payment to the Bank shortly following the closing of the private placement on April 11, 2016.

 

Other Considerations

 

The effects of the current economic environment are being felt across many industries, with financial services and residential real estate being particularly hard hit. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, has seen a decline in the value of the collateral securing its portfolio as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. However, since 2012, the Bank’s nonperforming assets have begun to stabilize. The Bank’s nonperforming assets at March 31, 2016 were $17.4 million compared to $22.4 million at December 31, 2015. As a percentage of total assets, nonperforming assets were 4.78% and 6.19% as of March 31, 2016 and December 31, 2015, respectively. As a percentage of total loans, nonperforming loans were 3.06% and 4.18% as of March 31, 2016 and December 31, 2015, respectively.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 2 – REGULATORY MATTERS AND OTHER CONSIDERATIONS – continued

 

The Company and the Bank operate in a highly regulated industry and must plan for the liquidity needs of each entity separately. A variety of sources of liquidity have historically been available to the Bank to meet its short-term and long-term funding needs. Although a number of these sources have been limited following execution of the Consent Order, management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during 2016 in an effort to ensure that the sources available are sufficient to meet the Bank’s projected liquidity needs for this period.

 

Prior to the most recent economic downturn, the Company, if needed, would have relied on dividends from the Bank as its primary source of liquidity. The Company is a legal entity separate and distinct from the Bank. However, various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends. In addition, the terms of the Consent Order further limit the Bank’s ability to pay dividends to the Company to satisfy its funding needs.

 

Management believes the Bank’s liquidity sources are adequate to meet its needs for at least the next 12 months.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 3 - INVESTMENT SECURITIES

  

Securities available-for-sale consisted of the following:

		Amortized				Gross Unrealized								Estimated
(Dollars in thousands)		Cost				Gains				Losses				Fair Value
March 31, 2016
Government-sponsored enterprises		$	30,175			$	162			$	(46	)		$	30,291
Mortgage-backed securities			52,537				206				(1,087	)			51,656
State and political subdivisions			1,216				42				—				1,258
Total		$	83,928			$	410			$	(1,133	)		$	83,205
December 31, 2015
Government-sponsored enterprises		$	36,720			$	—			$	(688	)		$	36,032
Mortgage-backed securities			53,368				54				(977	)			52,445
State and political subdivisions			1,221				5				(2	)			1,224
Total		$	91,309			$	59			$	(1,667	)		$	89,701

 

The following is a summary of maturities of securities available-for-sale as of March 31, 2016. The amortized cost and estimated fair values are based on the contractual maturity dates. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty.

 

March 31, 2016 (in thousands)		Amortized Cost Due
		Due				After One				After Five
		Within				Through				Through				After Ten								Market
		One Year				Five Years				Ten Years				Years				Total				Value
Investment securities
Government-sponsored enterprises		$	—			$	360			$	5,024			$	24,791			$	30,175			$	30,291
Mortgage-backed securities			—				—				5,244				47,293				52,537				51,656
State and political subdivisions			—				—				616				600				1,216				1,258
Total		$	—			$	360			$	10,884			$	72,684			$	83,928			$	83,205

 

The following table shows gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position, at:

 

		March 31, 2016
		Less than twelve months								Twelve months or more								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
(Dollars in thousands)		Value				Losses				Value				Losses				Value				Losses
Government-sponsored enterprises		$	2,328			$	(21	)		$	6,623			$	(25)			$	8,951			$	(46	)
Mortgage-backed securities			14,286				(276	)			19,654				(811	)			33,940				(1,087	)
Total		$	16,614			$	(297	)		$	26,277			$	(836)			$	42,891			$	(1,133	)

 

 

		December 31, 2015
		Less than twelve months								Twelve months or more								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
(Dollars in thousands)		Value				Losses				Value				Losses				Value				Losses
Government-sponsored enterprises		$	31,490			$	(558	)		$	4,543			$	(130	)		$	36,033			$	(688	)
Mortgage-backed securities			28,024				(354	)			17,008				(623	)			45,032				(977	)
State and political subdivisions			617				(2	)			—				—				617				(2	)
Total		$	60,131			$	(914	)		$	21,551			$	(753	)		$	81,682			$	(1,667	)

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 3 - INVESTMENT SECURITIES - continued

 

Management evaluates its investment portfolio periodically to identify any impairment that is other than temporary. At both March 31, 2016 and December 31, 2015, the Company had three government-sponsored enterprise securities and sixteen mortgage-backed securities that have been in an unrealized loss position for more than twelve months. Management believes these losses are temporary and are a result of the current interest rate environment. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost.

 

At March 31, 2016 and December 31, 2015, investment securities with a book value of $40.4 million and $36.7 million, respectively, and a market value of $40.2 million and $36.1 million, respectively, were pledged to secure deposits.

 

Proceeds from sales of available-for-sale securities were $4.2 million and $6.4 million for the three-month periods ended March 31, 2016 and 2015, respectively. Gross realized gains and losses on sales of available-for-sale securities for the periods ended were as follows:

 

(Dollars in thousands)

 

		Three months ended March 31,
		2016				2015
Gross realized gains		$	17			$	134
Gross realized losses			—				—
Net gain		$	17			$	134

 

NOTE 4 – LOAN PORTFOLIO

 

Loans consisted of the following:

 

		March 31,				December 31,
(Dollars in thousands)		2016				2015
Residential		$	72,603			$	75,081
Commercial Real Estate			92,461				101,291
Commercial			29,842				27,881
Consumer			4,729				5,114
Total gross loans		$	199,635			$	209,367

Provision and Allowance for Loan Losses

 

An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

In evaluating the adequacy of the Company’s loan loss reserves, management identifies loans believed to be impaired. Impaired loans are those not likely to be repaid as to principal and interest in accordance with the terms of the loan agreement. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, or liquidation value and discounted cash flows. Reserves are maintained for each loan in which the principal balance of the loan exceeds the fair value of the collateral or the net present value of cash flows. In addition to the specific allowance for individually reviewed loans, a general allowance for potential loan losses is established based on management’s review of the composition of the loan portfolio with the purpose of identifying any concentrations of risk, and an analysis of historical loan charge-offs and recoveries. The final component of the allowance for loan losses incorporates management’s evaluation of current economic conditions and other risk factors which may impact the inherent losses in the loan portfolio. These evaluations are highly subjective and require that a great degree of judgmental assumptions be made by management. This component of the allowance for loan losses includes additional estimated reserves for internal factors such as changes in lending staff, loan policy and underwriting guidelines, and loan seasoning and quality, and external factors such as national and local economic trends and conditions.

 

The following table details the activity within our allowance for loan losses as of and for the periods ended March 31, 2016 and 2015 and as of and for the year ended December 31, 2015, by portfolio segment:

 

March 31, 2016
(Dollars in thousands)
						Commercial
		Commercial				Real Estate				Consumer				Residential				Total
Allowance for loan losses:
Beginning balance		$	952			$	2,543			$	80			$	1,026			$	4,601
Charge-offs			(18	)			(2,322	)			(6	)			(33	)			(2,379	)
Recoveries			34				14				7				18				73
Provision			(439	)			1,750				29				84				1,424
Ending balance		$	529			$	1,985			$	110			$	1,095			$	3,719
Ending balances:
Individually evaluated for impairment		$	95			$	518			$	10			$	617			$	1,240
Collectively evaluated for impairment		$	434			$	1,467			$	100			$	478			$	2,479
Loans receivable:
Ending balance, total		$	29,842			$	92,461			$	4,729			$	72,603			$	199,635
Ending balances:
Individually evaluated for impairment		$	2,466			$	19,121			$	118			$	9,248			$	30,953
Collectively evaluated for impairment		$	27,376			$	73,340			$	4,611			$	63,355			$	168,682

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

March 31, 2015
(Dollars in thousands)
						Commercial
		Commercial				Real Estate				Consumer				Residential				Total
Allowance for loan losses:
Beginning balance		$	597			$	3,591			$	185			$	1,414			$	5,787
Charge-offs			(436	)			(99	)			(45	)			(194	)			(774	)
Recoveries			142				175				5				54				376
Provision			538				(776	)			65				173				—
Ending balance		$	841			$	2,891			$	210			$	1,447			$	5,389
Ending balances:
Individually evaluated for impairment		$	149			$	777			$	9			$	735			$	1,670
Collectively evaluated for impairment		$	692			$	2,114			$	201			$	712			$	3,719
Loans receivable:
Ending balance, total		$	32,179			$	111,015			$	5,905			$	80,737			$	229,836
Ending balances:
Individually evaluated for impairment		$	3,098			$	25,098			$	122			$	10,623			$	38,941
Collectively evaluated for impairment		$	29,081			$	85,917			$	5,783			$	70,114			$	190,895

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

December 31, 2015
(Dollars in thousands)
						Commercial
		Commercial				Real Estate				Consumer				Residential				Total
Allowance for loan losses:
Beginning balance		$	597			$	3,591			$	185			$	1,414			$	5,787
Charge-offs			(539	)			(1,212	)			(81	)			(501	)			(2,333	)
Recoveries			200				727				37				183				1,147
Provision			694				(563	)			(61	)			(70	)			—
Ending balance		$	952			$	2,543			$	80			$	1,026			$	4,601
Ending balances:
Individually evaluated for impairment		$	137			$	396			$	10			$	560			$	1,103
Collectively evaluated for impairment		$	815			$	2,147			$	70			$	466			$	3,498
Loans receivable:
Ending balance, total		$	27,881			$	101,291			$	5,114			$	75,081			$	209,367
Ending balances:
Individually evaluated for impairment		$	2,727			$	21,582			$	134			$	9,418			$	33,861
Collectively evaluated for impairment		$	25,154			$	79,709			$	4,980			$	65,663			$	175,506

 

Loan Performance and Asset Quality

 

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

  

The following chart summarizes delinquencies and nonaccruals, by portfolio class, as of March 31, 2016 and December 31, 2015.

 

March 31, 2016
(Dollars in thousands)
		30-59 Days				60-89 Days				90+ Days				Total								Total Loans				Non-
		Past Due				Past Due				Past Due				Past Due				Current				Receivable				accrual
Commercial		$	405			$	250			$	124			$	779			$	29,063			$	29,842			$	291
Commercial real estate:
Construction			134				12				66				212				24,522				24,734				476
Other			1,075				362				3,462				4,899				62,828				67,727				4,145
Real Estate:
Residential			2,686				51				704				3,441				69,162				72,603				1,202
Consumer:
Other			147				6				—				153				4,004				4,157				—
Revolving credit			1				1				—				2				570				572				1
Total		$	4,448			$	682			$	4,356			$	9,486			$	190,149			$	199,635			$	6,115
December 31, 2015
(Dollars in thousands)
		30-59 Days				60-89 Days				90+ Days				Total								Total Loans				Non-
		Past Due				Past Due				Past Due				Past Due				Current				Receivable				accrual
Commercial		$	321			$	110			$	1			$	432			$	27,449			$	27,881			$	139
Commercial real estate:
Construction			25				—				3,186				3,211				27,321				30,532				3,384
Other			973				—				3,046				4,019				66,740				70,759				3,895
Real Estate:
Residential			2,887				142				948				3,977				71,104				75,081				1,314
Consumer:
Other			108				18				10				136				4,395				4,531				10
Revolving credit			4				—				—				4				579				583				—
Total		$	4,318			$	270			$	7,191			$	11,779			$	197,588			$	209,367			$	8,742

 

There were no loans outstanding 90 days or more and still accruing interest at March 31, 2016 or December 31, 2015.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

The following table summarizes management’s internal credit risk grades, by portfolio class, as of March 31, 2016 and December 31, 2015.

 

March 31, 2016
(Dollars in thousands)
						Commercial
		Commercial				Real Estate				Consumer				Residential				Total
Grade 1 - Minimal		$	1,200			$	—			$	351			$	—			$	1,551
Grade 2 – Modest			938				111				35				270				1,354
Grade 3 – Average			2,467				5,420				191				4,907				12,985
Grade 4 – Satisfactory			12,605				50,332				3,528				48,560				115,025
Grade 5 – Watch			10,034				14,504				351				7,451				32,340
Grade 6 – Special Mention			519				1,840				137				1,501				3,997
Grade 7 – Substandard			2,079				20,254				136				9,914				32,383
Grade 8 – Doubtful			—				—				—				—				—
Grade 9 – Loss			—				—				—				—				—
Total loans receivable		$	29,842			$	92,461			$	4,729			$	72,603			$	199,635
December 31, 2015
(Dollars in thousands)
						Commercial
		Commercial				Real Estate				Consumer				Residential				Total
Grade 1 - Minimal		$	975			$	—			$	434			$	—			$	1,409
Grade 2 – Modest			561				1,024				37				277				1,899
Grade 3 – Average			4,934				5,620				218				4,716				15,488
Grade 4 – Satisfactory			14,693				58,549				4,031				53,187				130,460
Grade 5 – Watch			2,445				9,654				152				2,988				15,239
Grade 6 – Special Mention			992				6,321				98				3,544				10,955
Grade 7 – Substandard			3,281				20,123				144				10,369				33,917
Grade 8 – Doubtful			—				—				—				—				—
Grade 9 – Loss			—				—				—				—				—
Total loans receivable		$	27,881			$	101,291			$	5,114			$	75,081			$	209,367

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

Loans graded one through four are considered “pass” credits. As of March 31, 2016, $130.9 million, or 65.6% of the loan portfolio had a credit grade of “minimal,” “modest,” “average” or “satisfactory.” For loans to qualify for these grades, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

 

Loans with a credit grade of “watch” and “special mention” are not considered classified; however, they are categorized as a watch list credit and are considered potential problem loans. This classification is utilized by us when there is an initial concern about the financial health of a borrower. These loans are designated as such in order to be monitored more closely than other credits in the portfolio. Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of March 31, 2016, loans with a credit grade of “watch” and “special mention” totaled $36.3 million. Watch list loans are considered potential problem loans and are monitored as they may develop into problem loans in the future.

 

Loans graded “substandard” or greater are considered classified credits. At March 31, 2016 classified loans totaled $32.4 million, with $30.2 million being collateralized by real estate. Classified credits are evaluated for impairment on a quarterly basis. This includes $27.6 million in troubled debt restructurings (“TDRs”), of which $22.9 million were performing.

 

The Bank identifies impaired loans through its normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs), an impairment is recognized by establishing or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve, if any.

 

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impaired consumer and residential loans are identified for impairment disclosures, however, it is policy to individually evaluate for impairment all loans with a credit grade of “substandard” or greater that have an outstanding balance of $50 thousand or greater, and all loans with a credit grade of “special mention” that have outstanding principal balance of $100 thousand or greater.

 

Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral or based on the net present value of cash flows. For loans valued based on collateral, market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At March 31, 2016, the recorded investment in impaired loans was $31.0 million, compared to $33.9 million at December 31, 2015.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to UNAUDITED Condensed Consolidated Financial Statements

 

NOTE 4 – LOAN PORTFOLIO – continued

 

The following chart details our impaired loans, which includes TDRs totaling $27.6 million and $29.1 million, by category as of March 31, 2016 and December 31, 2015, respectively:

 

March 31, 2016
(Dollars in thousands)						Unpaid								Average				Interest
		Recorded				Principal				Related				Recorded				Income
		Investment				Balance				Allowance				Investment				Recognized
With no related allowance recorded:
Commercial		$	1,248			$	1,522			$	—			$	1,348			$	15
Commercial real estate			14,631				18,434				—				15,226				131
Residential			4,480				4,804				—				4,722				53
Consumer			55				55				—				57				1
Total:		$	20,414			$	24,815			$	—			$	21,353			$	200
With an allowance recorded:
Commercial			1,218				1,218				95				1,242				11
Commercial real estate			4,490				4,490				518				4,517				44
Residential			4,768				4,808				617				4,780				52
Consumer			63				63				10				65				1
Total:		$	10,539			$	10,579			$	1,240			$	10,604			$	108
Total:
Commercial			2,466				2,740				95				2,590				26
Commercial real estate			19,121				22,924				518				19,743				175
Residential			9,248				9,612				617				9,502				105
Consumer			118				118				10				122				2
Total:		$	30,953			$	35,394			$	1,240			$	31,957			$	308
December 31, 2015
(Dollars in thousands)						Unpaid								Average				Interest
		Recorded				Principal				Related				Recorded				Income
		Investment				Balance				Allowance				Investment				Recognized
With no related allowance recorded:
Commercial		$	1,070			$	1,339			$	—			$	1,319			$	72
Commercial real estate			17,180				22,037				—				18,989				722
Residential			4,016				4,338				—				4,936				137
Consumer			68				68				—				84				7
Total:		$	22,334			$	27,782			$	—			$	25,328			$	938
With an allowance recorded:
Commercial			1,657				1,657				137				1,729				79
Commercial real estate			4,402				4,402				396				4,461				207
Residential			5,402				5,443				560				5,445				215
Consumer			66				66				10				66				3
Total:		$	11,527			$	11,568			$	1,103			$	11,701			$	504
Total:
Commercial			2,727				2,996				137				3,048				151
Commercial real estate			21,582				26,439				396				23,450				929
Residential			9,418				9,781				560				10,381				352
Consumer			134				134				10				150				10
Total:		$	33,861			$	39,350			$	1,103			$	37,029			$	1,442

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. We only restructure loans for borrowers in financial difficulty that have designed a viable business plan to fully pay off all obligations, including outstanding debt, interest and fees, either by generating additional income from the business or through liquidation of assets. Generally, these loans are restructured to provide the borrower additional time to execute upon their plans.

 

With respect to restructured loans, we grant concessions by (1) reduction of the stated interest rate for the remaining original life of the debt, or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. We do not generally grant concessions through forgiveness of principal or accrued interest. Restructured loans where a concession has been granted through extension of the maturity date generally include extension of payments in an interest only period, extension of payments with capitalized interest and extension of payments through a forbearance agreement. These extended payment terms are also combined with a reduction of the stated interest rate in certain cases.

 

Success in restructuring loans has been mixed but it has proven to be a useful tool in certain situations to protect collateral values and allow certain borrowers additional time to execute upon defined business plans. In situations where a TDR is unsuccessful and the borrower is unable to follow through with terms of the restructured agreement, the loan is placed on nonaccrual status and continues to be written down to the underlying collateral value.

 

Our policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual going forward. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on nonaccrual status.

 

We will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured note terms. If, after previously being classified as a TDR, a loan is restructured a second time, then that loan is automatically placed on nonaccrual status. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms before that loan can be placed back on accrual status. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. We believe that all of our modified loans meet the definition of a TDR.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited Condensed Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

The following is a summary of information pertaining to our TDRs:

 

		March 31,				December 31,
(Dollars in thousands)		2016				2015
Nonperforming TDRs		$	4,668			$	5,449
Performing TDRs:
Commercial			1,977				2,565
Commercial real estate			13,835				13,883
Residential			6,998				7,059
Consumer			100				106
Total performing TDRs			22,910				23,613
Total TDRs		$	27,578			$	29,062

 

The following tables summarize how loans that were considered TDRs were modified during the periods indicated:

 

For the Three Months ended March 31, 2016
(Dollars in thousands)

 

		TDRs identified during the period												TDRs identified in the last twelve months that subsequently defaulted(1)
						Pre-				Post								Pre-				Post-
						modification				modification								modification				modification
		Number				outstanding				outstanding				Number				outstanding				outstanding
		of				recorded				recorded				of				recorded				recorded
		contracts				investment				investment				contracts				investment				investment
Commercial			2			$	137			$	137				1			$	106			$	25
Residential			2				135				135				3				413				373
Total			4			$	272			$	272				4			$	519			$	398

 

(1)

Loans past due 90 days or more are considered to be in default.

 

During the quarter ended March 31, 2016, four loans were modified that were considered to be TDRs. Term concessions were granted for all four loans and payment deferrals were also granted for one of the loans.

 

For the Three Months ended March 31, 2015
(Dollars in thousands)

 

		TDRs identified during the period												TDRs identified in the last twelve months that subsequently defaulted(1)
						Pre-				Post								Pre-				Post-
						modification				modification								modification				modification
		Number				outstanding				outstanding				Number				outstanding				outstanding
		of				recorded				recorded				of				recorded				recorded
		contracts				investment				investment				contracts				investment				investment
Commercial			1			$	63			$	63				1			$	30			$	30
Commercial real estate			1				172				172				—				—				—
Residential			2				89				89				1				296				296
Total			4			$	324			$	324				2			$	326			$	326

 

(1)

Loans past due 90 days or more are considered to be in default.

 

During the quarter ended March 31, 2015, four loans were modified that were considered to be TDRs. Term concessions were granted for all four loans and payment deferrals were also granted for three of the loans.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 4 - LOAN PORTFOLIO - continued

 

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charged-off. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

 

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The fair value of standby letters of credit is insignificant.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter-party.

 

Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties. The following table summarizes the Company’s off-balance sheet financial instruments whose contract amounts represent credit risk:

 

		March 31,				December 31,
(Dollars in thousands)		2016				2015
Commitments to extend credit		$	30,512			$	21,318
Standby letters of credit			253				257

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 5 – OTHER REAL ESTATE OWNED

 

Transactions in OREO for the periods ended March 31, 2016 and December 31, 2015:

 

		March 31,				December 31,
(Dollars in thousands)		2016				2015
Balance, beginning of period		$	13,624			$	19,501
Additions			479				4,058
Sales			(1,464	)			(9,709	)
Write-downs			(1,369	)			(226	)
Balance, end of period		$	11,270			$	13,624

 

NOTE 6 - ADVANCES FROM THE FEDERAL HOME LOAN BANK

 

Advances from the FHLB consisted of the following at March 31, 2016:

 

(Dollars in thousands)		Advance		Advance				Advance		Maturing
		Type		Amount				Rate		On
		Convertible Advance		$	2,000			3.60%		9/4/18
		Convertible Advance			5,000			3.45%		9/10/18
		Convertible Advance			5,000			2.95%		9/18/18
		Fixed Rate			5,000			3.86%		8/20/19
				$	17,000

 

As of March 31, 2016 we had advances totaling $17.0 million with various interest rates and maturity dates. Interest on all advances is at a fixed rate and payable quarterly. Convertible advances are callable by the FHLB on their respective call dates. The Company has the option to either repay any advance that has been called or to refinance the advance as a convertible advance.

 

At March 31, 2016, the Company had pledged as collateral for FHLB advances approximately $3.5 million of one-to-four family first mortgage loans, $1.3 million of commercial real estate loans, $4.4 million in home equity lines of credit, and $16.3 million of agency and private issue mortgage-backed securities. The Company has an investment in FHLB stock of $1.1 million. The Company has $7.2 million in excess borrowing capacity with the FHLB that is available if liquidity needs should arise. As a result of negative financial performance indicators, there is also a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated, although to date the Bank has not been denied advances from the FHLB or had to pledge additional collateral for its borrowings.

 

As of March 31, 2016, scheduled principal reductions include $12.0 million in 2018 and $5.0 million in 2019.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 7 – JUNIOR SUBORDINATED DEBENTURES

 

On December 21, 2004, the Trust issued $6.0 million floating rate trust preferred securities with a maturity of December 31, 2034. In accordance with current accounting standards, the Trust has not been consolidated in these financial statements. The Company received from the Trust the $6.0 million proceeds from the issuance of the securities and the $186 thousand initial proceeds from the capital investment in the Trust and, accordingly, has shown the funds due to the Trust as a $6.2 million junior subordinated debenture offset by debt issuance costs of $68 thousand and $69 thousand at March 31, 2016 and December 31, 2015, respectively. The current regulatory rules allow certain amounts of junior subordinated debentures to be included in the calculation of regulatory capital.

 

The Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the trust preferred securities beginning February 2011 and as a result, the Company had deferred interest payments in the amount of approximately $953 thousand due and payable at March 31, 2016.

 

As described in Note 1 to our financial statements, on February 29, 2016, the Company entered into a securities purchase agreement with Alesco for the repurchase of all the trust preferred securities for an aggregate cash payment of $600 thousand plus reimbursement of attorneys’ fees and other expenses incurred by Alesco not to exceed $25 thousand. Alesco also agreed to forgive any and all unpaid interest on the trust preferred securities.

 

On March 16, 2016, the Company received a notice of default from The Bank of New York Mellon Trust Company, N.A., in its capacity as trustee, relating to the trust preferred securities. The notice of default relates specifically to the Indenture dated December 21, 2004, by and among the Company and The Bank of New York Mellon Trust Company, N.A., successor-in-interest to JP Morgan Chase Bank, National Association, under which the Company issued the trust preferred securities. As permitted by the Indenture, the Company previously exercised its right to defer interest payments on the trust preferred securities for 20 consecutive quarterly payment periods. The Company’s right to defer such interest payments expired on March 15, 2016, at which time all deferred payments of interest became due and payable. The Company did not pay such deferred interest at the end of the permitted deferral period, constituting an event of default under the Indenture, and therefore pursuant to the Indenture, the trustee provided this notice of default. However, under the Indenture, the principal amount of the trust preferred securities, together with any premium and unpaid accrued interest, would only become due upon such an event of default if the trustee or Alesco declared such amounts due and payable by written notice to the Company.

 

On April 11, 2016, immediately following the closing of the 2016 private placement, the Company repurchased all of the outstanding trust preferred securities for $600 thousand, plus reimbursement of approximately $17 thousand in third party legal expenses. The redemption gain realized on this settlement was approximately $6.3 million.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 8 - SUBORDINATED DEBENTURES

 

On July 31, 2010, the Company completed a private placement of subordinated promissory notes that totaled $12.1 million. The notes bore interest at a rate equal to the current Prime Rate in effect, as published by the Wall Street Journal, plus 3%; provided, that the rate of interest shall not be less than 8% per annum or more than 12% per annum. The notes are offset by $39 thousand and $41 thousand of debt issuance costs at March 31, 2016 and December 31, 2015, respectively. The subordinated notes were structured to fully count as Tier 2 regulatory capital on a consolidated basis.

 

The Federal Reserve Bank of Richmond prohibited the Company from paying interest due on the subordinated notes beginning October 2011 and, as a result, the Company had deferred interest payments in the amount of approximately $5.2 million as of March 31, 2016.

 

During 2013, $1.0 million of the subordinated notes were canceled by the holder as part of a settlement of litigation between the holder, the Bank, and the Company. The Company was obligated to contribute capital in this amount to the Bank when it was able to do so and did so immediately following the closing of the 2016 private placement. The forgiveness of this debt was recognized in 2013 as noninterest income in the consolidated statements of operations.

 

Effective as of September 16, 2015, the Company, the Bank, and certain other defendants entered into a class action settlement agreement in potential settlement of the putative class action lawsuit initiated by three holders of the Company’s subordinated promissory notes, on behalf of themselves and as representatives of a class of similarly situated purchasers of the Company’s subordinated promissory notes, with respect to alleged wrongful conduct associated with purchases of the subordinated promissory notes, including fraud, violation of state securities statutes, and negligence. On March 2, 2016, the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry entered a final order of approval approving the class action settlement agreement.

 

On April 11, 2016, immediately following the closing of the 2016 private placement, the Company established a settlement fund of approximately $2.4 million, which represented 20% of the principal of subordinated promissory notes issued by the Company. The proceeds of the fund will be used to redeem the subordinated promissory notes held by class members. Also on April 11, 2016, the Company settled, pursuant to previously executed binding settlement agreements, with the subordinated promissory note holders who opted out of the class action settlement. These settlements, including the class action settlement, constituted the full satisfaction of the principal and interest owed on, and required the immediate dismissal of all pending litigation related to, the respective subordinated promissory notes. In each case, the Company and the Bank also obtained a full and complete release of all claims asserted or that could have been asserted with respect to the subordinated promissory notes. The redemption gain realized on this settlement was approximately $13.2 million.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS

 

Preferred Stock – In March 2009, in connection with the CPP, the Company issued to the U.S. Treasury 12,895 shares of the Company’s Series T preferred stock. The Series T preferred stock had a dividend rate of 5% for the first five years and 9% thereafter, and had a call feature after three years.

 

In connection with the sale of the Series T preferred stock, the Company also issued to the U.S. Treasury the CPP Warrant to purchase up to 91,714 shares of the Company’s common stock at an initial exercise price of $21.09 per share.

 

The Series T preferred stock and the CPP Warrant were sold to the U.S. Treasury for an aggregate purchase price of $12.9 million in cash. The purchase price was allocated between the Series T preferred stock and the CPP Warrant based upon the relative fair values of each to arrive at the amounts recorded by the Company. This resulted in the Series T preferred stock being issued at a discount which was being amortized on a level yield basis as a charge to retained earnings over an assumed life of five years.

 

As required under the CPP, dividend payments on and repurchases of the Company’s common stock were subject to certain restrictions. For as long as the Series T preferred stock was outstanding, no dividends could be declared or paid on the Company’s common stock until all accrued and unpaid dividends on the Series T preferred stock were fully paid. In addition, the U.S. Treasury’s consent was required for any increase in dividends on common stock before the third anniversary of issuance of the Series T preferred stock and for any repurchase of any common stock except for repurchases of common shares in connection with benefit plans.

 

Beginning in February 2011, the Federal Reserve Bank of Richmond required the Company to defer dividend payments on the 12,895 shares of the Series T preferred stock. Therefore, for each quarterly period beginning in February 2011, the Company notified the U.S. Treasury of its deferral of quarterly dividend payments on the Series T preferred stock. The amount of each of the Company’s quarterly interest payments was approximately $161 thousand through March 2014 and then increased to $290 thousand. As of March 31, 2016, the Company had $5.1 million of deferred dividend payments due on the Series T preferred stock.

 

As described in Note 1 to our financial statements, on April 11, 2016, immediately following the closing of the 2016 private placement, the Company repurchased all 12,895 shares of the outstanding Series T preferred stock from the U.S. Treasury for $129 thousand. The U.S. Treasury also canceled the CPP Warrant. The redemption gain realized on this settlement was approximately $13.8 million.

 

Restrictions on Dividends - Under the terms of the Written Agreement, the Company is currently prohibited from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank of Richmond. In addition, because the Company is a legal entity separate and distinct from the Bank and has little direct income itself, the Company relies on dividends paid to it by the Bank in order to pay dividends on its common stock. As a South Carolina state bank, the Bank may only pay dividends out of its net profits, after deducting expenses, including losses and bad debts. Under the Federal Deposit Insurance Corporation Act (“FDICIA”), the Bank may not pay a dividend if, after paying the dividend, the Bank would be undercapitalized. As of March 31, 2016, the Bank was classified as “significantly undercapitalized,” and therefore it is prohibited under FDICIA from paying dividends until it increases its capital levels. Following the closing of the 2016 private placement on April 11, 2016, the Company contributed $38.0 million to the Bank as a capital contribution. However, under the terms of the Consent Order, the Bank is further prohibited from declaring a dividend on its shares of common stock unless it receives approval from the FDIC and State Board.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

 

Regulatory Capital - The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

 

In July 2013, the federal bank regulatory agencies issued a final rule that has revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The final rule applies to all depository institutions, such as the Bank, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies, which we refer to below as “covered” banking organizations. Bank holding companies with less than $500 million in total consolidated assets, such as the Company, are not subject to the final rule. Effective March 31, 2015, the Bank was required to implement the new Basel III capital standards (subject to the phase in for certain parts of the new rules).

 

The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets (“CET1”) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to the risk weights for certain assets and off-balance sheet exposures. Finally, CET1 includes accumulated other comprehensive income (which includes all unrealized gains and losses on available-for-sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

 

To be considered “well-capitalized,” a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, a bank must maintain a minimum Tier 1 leverage ratio of at least 6%. Pursuant to the terms of the Consent Order with the FDIC and the State Board, the Bank must achieve and maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. Regardless of the Bank’s capital ratios, it is unable to be classified as “well-capitalized” while it is operating under the Consent Order with the FDIC.

 

At March 31, 2016, the Company was categorized as “critically undercapitalized” and the Bank was categorized as “significantly undercapitalized.” Our losses over the past few years have adversely impacted our capital. However, following the closing of the 2016 private placement on April 11, 2016, we believe that we are currently in substantial compliance with all of the terms of the Consent Order including the capital requirements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 9 - SHAREHOLDERS’ EQUITY AND CAPITAL REQUIREMENTS - continued

 

The following table summarizes the capital ratios and the regulatory minimum requirements for the Company and the Bank.

 

																		Minimum
																		To Be Well
										Minimum								Capitalized Under
										Capital								Prompt Corrective
		Actual								Requirement								Action Provisions
(Dollars in thousands)		Amount				Ratio				Amount				Ratio				Amount				Ratio
March 31, 2016
The Company
Total Capital (to Risk-Weighted Assets)		$	(13,925	)			(5.97	)%		$	18,671				8.00	%			N/A				N/A
Tier 1 Capital (to Risk-Weighted Assets)		$	(13,925	)			(5.97	)%		$	9,336				4.00	%			N/A				N/A
Tier 1 Capital (to Average Assets)		$	(13,925	)			(3.86	)%		$	14,438				4.00	%			N/A				N/A
The Bank
Total Capital (to Risk-Weighted Assets)		$	12,200				5.17	%		$	18,896				8.00	%		$	23,620				10.00	%
Tier 1 Capital (to Risk-Weighted Assets)		$	9,238				3.91	%		$	14,172				6.00	%			(1	)			(1	)
Tier 1 Capital (to Average Assets)		$	9,238				2.56	%		$	14,426				4.00	%		$	28,852				8.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		$	9,238				3.91	%		$	10,629				4.50	%			N/A				N/A
December 31, 2015
The Company
Total Capital (to Risk-Weighted Assets)		$	(10,642	)			(4.15	)%		$	20,537				8.00	%			N/A				N/A
Tier 1 Capital (to Risk-Weighted Assets)		$	(10,642	)			(4.15	)%		$	10,269				4.00	%			N/A				N/A
Tier 1 Capital (to Average Assets)		$	(10,642	)			(2.87	)%		$	14,831				4.00	%			N/A				N/A
The Bank
Total Capital (to Risk-Weighted Assets)		$	15,402				5.92	%		$	20,802				8.00	%		$	26,002				10.00	%
Tier 1 Capital (to Risk-Weighted Assets)		$	12,135				4.67	%		$	15,601				6.00	%			(1	)			(1	)
Tier 1 Capital (to Average Assets)		$	12,135				3.28	%		$	14,819				4.00	%		$	29,639				8.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		$	12,135				4.67	%		$	11,701				4.50	%			N/A				N/A

 

(1)

Minimum capital amounts and ratios presented as of March 31, 2016 and December 31, 2015, are amounts to be well-capitalized under the various regulatory capital requirements administered by the FDIC. On February 10, 2011, the Bank became subject to a regulatory Consent Order with the FDIC. Minimum capital amounts and ratios presented for the Bank as of March 31, 2016 and December 31, 2015, are the minimum levels set forth in the Consent Order. No minimum Tier 1 capital to risk-weighted assets ratio was specified in the Consent Order. Regardless of the Bank’s capital ratios, it is unable to be classified as “well-capitalized” while it is operating under the Consent Order with the FDIC.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 10 – INCOME (LOSS) PER SHARE

 

(Dollars in thousands, except		Three Months ended March 31,
per share amounts)		2016				2015
Basic loss per common share:
Net loss available to common shareholders		$	(3,681	)		$	(95	)
Weighted average common shares outstanding - basic			3,846,340				3,816,340
Basic loss per common share		$	(0.96	)		$	(0.02	)
Diluted loss per common share:
Net loss available to common shareholders		$	(3,681	)		$	(95	)
Weighted average common shares outstanding - basic			3,846,340				3,816,340
Incremental shares			—				—
Weighted average common shares outstanding - diluted			3,846,340				3,816,340
Diluted loss per common share		$	(0.96	)		$	(0.02	)

 

For the three month periods ended March 31, 2016 and 2015, there were 91,714 common stock equivalents outstanding which were not included in the diluted calculation because the effect would have been anti-dilutive.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE

 

Fair Value Hierarchy

 

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

 

Fair value estimates are made at a specific point in time based on relevant market and other information about the financial instruments. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on current economic conditions, risk characteristics of various financial instruments, and such other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

 

Accounting principles establish a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:

 

Level 1	Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries and money market funds.
Level 2	Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, mortgage-backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes certain derivative contracts and impaired loans.
Level 3	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, retained residual interests in securitizations, residential mortgage servicing rights, and highly-structured or long-term derivative contracts.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

Financial Instruments

 

The following methods and assumptions were used to estimate the fair value of significant financial instruments:

 

Cash and Cash Equivalents - The carrying amount is a reasonable estimate of fair value.

 

Securities Available-for-Sale - Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

 

Nonmarketable Equity Securities - The carrying amount is a reasonable estimate of fair value since no ready market exists for these securities.

 

Loans Receivable - For certain categories of loans, such as variable rate loans which are repriced frequently and have no significant change in credit risk, fair values are based on the carrying amounts. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to the borrowers with similar credit ratings and for the same remaining maturities.

 

Deposits - The fair value of demand deposits, savings, and money market accounts is the amount payable on demand at the reporting date. The fair values of certificates of deposit are estimated using a discounted cash flow calculation that applies current interest rates to a schedule of aggregated expected maturities.

 

Repurchase Agreements – The carrying value of these instruments is a reasonable estimate of fair value.

 

Advances from the Federal Home Loan Bank - For the portion of borrowings immediately callable, fair value is based on the carrying amount. The fair value of the portion maturing at a later date is estimated using a discounted cash flow calculation that applies the interest rate of the immediately callable portion to the portion maturing at the future date.

 

Subordinated Debentures - The Company was unable to determine the fair value of these debentures as of December 31, 2015. Fair value of the debentures as of March 31, 2016, was estimated based on the settlement agreement which settled immediately following the closing of the 2016 private placement.

 

Junior Subordinated Debentures - The Company was unable to determine the fair value of these debentures as of December 31, 2015. Fair value of the debentures as of March 31, 2016, was estimated based on the securities purchase agreement which settled immediately following the closing of the 2016 private placement.

 

Off-Balance Sheet Financial Instruments - The contractual amount is a reasonable estimate of fair value for the instruments because commitments to extend credit and standby letters of credit are issued on a short-term or floating rate basis and include no unusual credit risks.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

The carrying values and estimated fair values of the Company’s financial instruments were as follows:

 

March 31, 2016										Fair Value Measurements
(Dollars in thousands)										Quoted				Significant
										market				other				Significant
										price in				observable				unobservable
		Carrying				Estimated				active markets				inputs				inputs
		Amount				Fair Value				(Level 1)				(Level 2)				(Level 3)
Financial Assets:
Cash and cash equivalents		$	41,652			$	41,652			$	41,652			$	—			$	—
Securities available-for-sale			83,205				83,205				—				83,205				—
Nonmarketable equity securities			1,276				1,276				—				—				1,276
Loans, net			195,916				196,839				—				—				196,839
Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts			162,840				162,840				162,840				—				—
Certificates of deposit			172,621				172,864				—				172,864				—
Repurchase agreements			1,248				1,248				—				1,248				—
Advances from the Federal Home Loan Bank			17,000				17,988				—				17,988				—
Subordinated debentures			11,023				3,082				3,082				—				—
Junior subordinated debentures			6,118				617				617				—				—
		Notional				Estimated
		Amount				Fair Value
Off-Balance Sheet Financial Instruments:
Commitments to extend credit		$	30,512				n/a
Standby letters of credit			253				n/a

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

December 31, 2015										Fair Value Measurements
(Dollars in thousands)										Quoted				Significant
										market				other				Significant
										price in				observable				unobservable
		Carrying				Estimated				active markets				inputs				inputs
		Amount				Fair Value				(Level 1)				(Level 2)				(Level 3)
Financial Assets:
Cash and cash equivalents		$	22,137			$	22,137			$	22,137			$	—			$	—
Securities available-for-sale			89,701				89,701				—				89,701				—
Nonmarketable equity securities			1,330				1,330				—				—				1,330
Loans, net			204,766				204,975				—				—				204,975
Financial Liabilities:
Demand deposit, interest-bearing transaction, and savings accounts			156,860				156,860				156,860				—				—
Certificates of deposit			173,971				174,964				—				174,964				—
Repurchase agreements			1,716				1,716				—				1,716				—
Advances from the Federal Home Loan Bank			17,000				17,108				—				17,108				—
Subordinated debentures			11,021				*				—				—				—
Junior subordinated debentures			6,117				*				—				—				—
		Notional				Estimated
		Amount				Fair Value
Off-Balance Sheet Financial Instruments:
Commitments to extend credit		$	21,318				n/a
Standby letters of credit			257				n/a

 

*

The Company is unable to determine this value.

 

Fair Value Measurements

 

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

 

Securities Available-for-Sale - Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets. All available-for-sale investment security fair values were based on quoted market prices and therefore classified as Level 2 for the periods presented.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

Loans - The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt and discounted cash flows. Those impaired loans not requiring a specific allowance represents loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. The fair value of Impaired Loans is generally based on judgment and therefore classified as nonrecurring Level 3.

 

Other Real Estate Owned - OREO is adjusted to fair value upon transfer of the loans to OREO. Real estate acquired in settlement of loans is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional allowances, which are charges to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. The fair value of OREO is generally based on judgment and therefore is classified as nonrecurring Level 3.

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

 

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis as of and for the periods ended March 31, 2016 and December 31, 2015, by level within the fair value hierarchy.

 

						Quoted prices in				Significant
						active markets				Other				Significant
						for identical				Observable				Unobservable
(Dollars in thousands)						assets				Inputs				Inputs
		Total				(Level 1)				(Level 2)				(Level 3)
March 31, 2016
Assets:
Government sponsored enterprises		$	30,291			$	—			$	30,291			$	—
Mortgage-backed securities			51,656				—				51,656				—
Obligations of state and local governments			1,258				—				1,258				—
Total		$	83,205			$	—			$	83,205			$	—
December 31, 2015
Assets:
Government sponsored enterprises		$	36,032			$	—			$	36,032			$	—
Mortgage-backed securities			52,445				—				52,445				—
Obligations of state and local governments			1,224				—				1,224				—
Total		$	89,701			$	—			$	89,701			$	—

 

The Company has no liabilities measured at fair value on a recurring basis.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following tables present the assets and liabilities carried on the balance sheet by caption and by level within the valuation hierarchy described above for which a nonrecurring change in fair value has been recorded.

 

						Quoted prices in				Significant
						active markets				Other				Significant
(Dollars in thousands)						for identical				Observable				Unobservable
						assets				Inputs				Inputs
		Total				(Level 1)				(Level 2)				(Level 3)
March 31, 2016
Assets:
Impaired loans, net of valuation allowance		$	29,713			$	—			$	—			$	29,713
Other real estate owned			11,270				—				—				11,270
Total		$	40,983			$	—			$	—			$	40,983
December 31, 2015
Assets:
Impaired loans, net of valuation allowance		$	32,758			$	—			$	—			$	32,758
Other real estate owned			13,624				—				—				13,624
Total		$	46,382			$	—			$	—			$	46,382

 

The Company has no liabilities measured at fair value on a nonrecurring basis.

 

Level 3 Valuation Methodologies

 

The fair value of impaired loans is estimated using one of several methods, including collateral value and discounted cash flows and, in rare cases, the market value of the note. Those impaired loans not requiring an allowance represent loans for which the net present value of the expected cash flows or fair value of the collateral less costs to sell exceed the recorded investments in such loans. When the fair value of the collateral is based on an executed sales contract with an independent third party, the Company records the impaired loan as nonrecurring Level 1. If the collateral is based on another observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or the Company determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans can be evaluated for impairment using the present value of expected future cash flows discounted at the loan’s effective interest rate. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

Foreclosed real estate is carried at fair value less estimated selling costs. Fair value is generally based upon current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for selling costs. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the asset as nonrecurring Level 2. However, the Company also considers other factors or recent developments which could result in adjustments to the collateral value estimates indicated in the appraisals such as changes in absorption rates or market conditions from the time of valuation. In situations where management adjustments are significant to the fair value measurements in its entirety, such measurements are classified as Level 3 within the valuation hierarchy.

 

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at March 31, 2016. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

 

(Dollars in thousands)

March 31,

Valuation

Unobservable

Range

2016

Techniques

Inputs

(Weighted Avg)

Impaired loans:

Commercial

$

2,371

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-55.00

%

Flows

Independent quotes

(4.63

%)

Commercial real estate

18,603

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-46.67

%

Flows

Independent quotes

(8.98

%)

Residential

8,631

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(8.47

%)

Consumer

108

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(3.33

%)

Other real estate owned

11,270

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(10.00

%)

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Notes to unaudited CONDENSED Consolidated Financial Statements

 

NOTE 11 - FAIR VALUE - continued

 

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2015. Management believes the weighted average range of adjustments to be appropriate. As discussed previously, depressed real estate values in the areas we serve may cause larger adjustments from time to time.

 

(Dollars in thousands)

December 31,

Valuation

Unobservable

Range

2015

Techniques

Inputs

(Weighted Avg)

Impaired loans:

Commercial

$

2,590

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(8.77

%)

Commercial real estate

21,186

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-32.33

%

Flows

Independent quotes

(10.23

%)

Residential

8,858

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(9.90

%)

Consumer

124

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(10.00

%)

Other real estate owned

13,624

Appraised Value/

Appraisals and/or sales

Discounted Cash

of comparable properties/

0.00%-10.00

%

Flows

Independent quotes

(10.00

%)

 

NOTE 12 - COMMITMENTS AND CONTINGENCIES

 

In the ordinary course of business, the Company may, from time to time, become a party to legal claims and disputes. At March 31, 2016, the Company is party to several court actions and investigations as discussed in detail in “Legal Proceedings” under Part II, Item 1 of this Form 10-Q.

 

The Company and the Bank have engaged legal counsel and intend to vigorously defend themselves in all actions. Except as otherwise noted herein, the ultimate outcomes of all referenced actions are unknown at this time and reasonably possible losses cannot be estimated. Any costs incurred by the Company associated with legal defense, government sanctions, or settlement or other litigation awards could have a material adverse effect on its financial condition due to the Company’s lack of consistent earnings.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

NOTE 13 – SUBSEQUENT EVENTS

 

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Nonrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and the following subsequent events occurred requiring accrual or disclosure that are not otherwise disclosed herein.

 

As described in Note 1 to our financial statements, on April 11, 2016, the Company completed the 2016 private placement in which it issued 359,468,443 shares of common stock at $0.10 per share and 905,315.57 shares of Series A preferred stock at $10.00 per share for aggregate cash proceeds of approximately $45.0 million. Net proceeds from the 2016 private placement, after deducting commissions and expenses, were approximately $41.5 million, of which $38.0 million was contributed to the Bank as a capital contribution to support its operations and increase its capital ratios to meet the higher minimum capital ratios required under the terms of the Bank’s Consent Order and approximately $3.1 million was used to repurchase the Company’s outstanding Series T preferred stock, trust preferred securities, and subordinated promissory notes.

 

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

 

INTRODUCTION

 

The following discussion describes our results of operations for the three months ended March 31, 2016 as compared to the three months ended March 31, 2015 and also analyzes our financial condition as of March 31, 2016 as compared to December 31, 2015. The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the SEC.

 

OVERVIEW

 

For the three months ended March 31, 2016, the Company had a net loss of $3.3 million compared to net income of $202 thousand for the three months ended March 31, 2015. The change was primarily the result of write-downs on OREO of $1.4 million and a $1.4 million provision for loan losses recognized in the first quarter of 2016.

 

Total assets at March 31, 2016 were $363.4 million, an increase of $2.0 million from $361.4 million at December 31, 2015. Cash and cash equivalents increased $19.5 million from December 31, 2015 to March 31, 2016. Deposit growth of $4.6 million, proceeds from sales and calls of available-for-sale securities that were not reinvested, and loan repayments increased cash and cash equivalents during the three months ended March 31, 2016.

 

RESULTS OF OPERATIONS

 

Results of Operations for the Three Months ended March 31, 2016 and 2015

 

The Company experienced a decrease of $359 thousand in total interest income for the three months ended March 31, 2016. Interest, including fees, on our loan portfolio decreased $350 thousand, or 12.4%, for the three months ended March 31, 2016 compared to the three months ended March 31, 2015, primarily related to decreased loan volume. Declines in rates and deposit volume resulted in a decrease to total interest expense of $99 thousand, or 8.7%, for the three-month period in 2016 compared to the three-month period in 2015. Net interest income decreased $260 thousand for the three months ended March 31, 2016 compared to the three months ended March 31, 2015.

 

The provision for loan losses is charged to earnings based upon management’s evaluation of specific loans in its portfolio and general economic conditions and trends in the marketplace. Please refer to the section “Loan Portfolio” for a discussion of management’s evaluation of the adequacy of the allowance for loan losses. A provision for loan losses of $1.4 million was recognized for the first quarter of 2016. No provision was considered necessary for the three-month period ended March 31, 2015.

 

Noninterest income decreased $287 thousand or 40.8% for the three months ended March 31, 2016 as compared to the three months ended March 31, 2015 as a result of lower gains realized on sales of securities available-for-sale and mortgage loans and reduced other income.

 

Noninterest expense increased from $2.7 million for the three months ended March 31, 2015 to $4.2 million for the three months ended March 31, 2016 due to increased costs of operations of OREO. The Company recognized a net expense of $1.6 million of net costs of operations of OREO for the three months of 2016 which mostly consisted of write-downs recognized on OREO during the period. The Company recognized net gains from sales of OREO properties of $523 thousand for the three months ended March 31, 2015, which offset OREO expenses resulting in a net profit of $282 thousand for the prior period.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

FINANCIAL CONDITION

 

Investment Portfolio

 

Management classifies investment securities as either held-to-maturity or available-for-sale based on our intentions and the Company’s ability to hold them until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held-to-maturity and carried at amortized cost. All other securities are designated as available-for-sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. As of March 31, 2016 and December 31, 2015, all securities were classified as available-for-sale.

 

The portfolio of available-for-sale securities decreased $6.5 million, or 7.2%, from $89.7 million at December 31, 2015 to $83.2 million at March 31, 2016. Our securities portfolio consisted primarily of high quality mortgage securities, government agency bonds, and high quality municipal bonds.

 

The following tables summarize the carrying value of investment securities as of the indicated dates and the contractual maturities and weighted-average yields of those securities at March 31, 2016.

  

March 31, 2016 (in thousands)		Amortized Cost Due
		Due				After One				After Five
		Within				Through				Through				After Ten								Market
		One Year				Five Years				Ten Years				Years				Total				Value
Investment securities
Government-sponsored enterprises		$	—			$	360			$	5,024			$	24,791			$	30,175			$	30,291
Mortgage-backed securities			—				—				5,244				47,293				52,537				51,656
State and political subdivisions			—				—				616				600				1,216				1,258
Total		$	—			$	360			$	10,884			$	72,684			$	83,928			$	83,205
Weighted average yields
Government-sponsored enterprises			—	%			1.81	%			2.50	%			2.66	%
Mortgage-backed securities			—	%			—	%			1.89	%			1.97	%
State and political subdivisions			—	%			—	%			2.57	%			4.14	%
Total			—	%			1.81	%			2.21	%			2.22	%			2.22	%

 

		Book				Market
December 31, 2015 (in thousands)		Value				Value
Investment securities
Government-sponsored enterprises		$	36,720			$	36,032
Mortgage-backed securities			53,368				52,445
States and political subdivisions			1,221				1,224
Total		$	91,309			$	89,701

 

Loan Portfolio

 

The Company experienced a decline in its loan portfolio of $9.7 million during the three months ended March 31, 2016. The following table sets forth the composition of the loan portfolio by category as of March 31, 2016 and December 31, 2015.

 

		March 31,				December 31,
		2016				2015
(Dollars in thousands)
Real estate:
Commercial construction and land development		$	24,734			$	30,532
Other commercial real estate			67,727				70,759
Residential construction			2,129				2,342
Other residential			70,474				72,739
Commercial and industrial			29,842				27,881
Consumer			4,729				5,114
		$	199,635			$	209,367

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Loan Portfolio - continued

 

The primary component of our loan portfolio is loans collateralized by real estate, which made up approximately 82.7% of our loan portfolio at March 31, 2016. These loans are secured generally by first or second mortgages on residential, agricultural or commercial property. Commercial loans and consumer loans account for 14.9% and 2.4% of the loan portfolio, respectively.

 

Risk Elements

 

The downturn in general economic conditions has resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio. The declining real estate market has had a significant impact on the performance of our loans secured by real estate. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure. Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, in our current market the value of the collateral has deteriorated in value during the time the credit has been extended. There is a risk that this trend will continue, which could result in additional losses of earnings and increases in our provision for loan losses and loans charged-off.

 

Past due payments are often one of the first indicators of a problem loan. We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due. We determine past due and delinquency status based on the contractual terms of the note. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees.

 

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. If the borrower is able to bring the account current and establish a pattern of keeping the loan current for a specified time period, the loan is then placed back on regular accrual status.

 

For loans to be in excess of 90 days delinquent and still accruing interest, the borrowers must be either remitting payments although not able to get current, liquidation on loans deemed to be well secured must be near completion, or the Company must have a reason to believe that correction of the delinquency status by the borrower is near. The amount of both nonaccrual loans and loans past due 90 days or more were considered in computing the allowance for loan losses.

 

Nonperforming loans include nonaccrual loans and loans past due 90 days or more and still accruing interest. Nonperforming assets include nonperforming loans plus other real estate that we own as a result of loan foreclosures.

 

Nonperforming loans were $6.1 million or 3.1% of total loans at March 31, 2016 compared to nonperforming loans at December 31, 2015 of $8.7 million or 4.2% of total loans.

 

At March 31, 2016, nonperforming assets were $17.4 million compared to $22.4 million at December 31, 2015. As a percentage of total assets, nonperforming assets were 4.8% and 6.2% as of March 31, 2016 and December 31, 2015, respectively.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Loan Portfolio - continued

 

The following table summarizes nonperforming assets:

 

		March 31,				December 31,
Nonperforming Assets		2016				2015
(Dollars in thousands)
Nonaccrual loans		$	6,115			$	8,742
Loans past due 90 days or more and still accruing interest			—				—
Total nonperforming loans			6,115				8,742
Other real estate owned			11,270				13,624
Total nonperforming assets		$	17,385			$	22,366
Nonperforming assets to total assets			4.78	%			6.19	%
Nonperforming loans to total loans			3.06	%			4.18	%

 

We identify impaired loans through our normal internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs), an impairment is recognized by establishing or adjusting an existing allocation of the allowance, or by recording a partial charge-off of the loan to its fair value. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve, if any.

 

Impaired loans are valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral, less any selling costs, or based on the net present value of cash flows. For loans valued based on collateral, market values were obtained using independent appraisals, updated every 18 to 24 months, in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. At March 31, 2016, the recorded investment in impaired loans was $31.0 million, compared to $33.9 million at December 31, 2015.

 

TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.

 

At March 31, 2016 and December 31, 2015, the principal balance of TDRs totaled $27.6 million and $29.1 million, respectively. At March 31, 2016, $22.9 million of these restructured loans were performing as expected under the new terms and $4.7 million were considered to be nonperforming and evaluated for reserves on the basis of the fair value of the collateral. At December 31, 2015, $23.6 million of these restructured loans were performing as expected and $5.5 million were considered to be nonperforming. A TDR can be removed from nonperforming status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Loan Portfolio - continued

  

A rollforward of TDRs for the three months ended March 31, 2016 and for the year ended December 31, 2015 is presented below:

 

		March 31,				December 31,
TDRs		2016				2015
(Dollars in thousands)
Balance, beginning of period		$	29,062			$	33,166
New TDRs and advances			279				1,393
Repayments			(1,041	)			(2,688	)
Charged-off and foreclosed TDRs			(722	)			(2,809	)
Balance, end of period		$	27,578			$	29,062

 

Provision and Allowance for Loan Losses

 

We have established an allowance for loan losses through a provision for loan losses charged to expense on our statements of operations. The allowance represents an amount which management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. We do not allocate specific percentages of our allowance for loan losses to the various categories of loans but evaluate the adequacy on an overall portfolio basis utilizing several factors. The primary factor considered is the credit risk grading system, which is applied to each loan. The amount of both nonaccrual loans and loans past due 90 days or more is also considered. The historical loan loss experience, the size of our lending portfolio, changes in the lending policies and procedures, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, peer group comparisons, and current and anticipated economic conditions are also considered in determining the provision for loan losses. The amount of the allowance is adjusted periodically based on changing circumstances. Recognized losses are charged to the allowance for loan losses, while subsequent recoveries are added to the allowance.

  

We regularly monitor past due and classified loans. However, it should be noted that no assurances can be made that future charges to the allowance for loan losses or provisions for loan losses may not be significant to a particular accounting period. Our judgment as to the adequacy of the allowance is based upon a number of assumptions about future events which we believe to be reasonable, but which may or may not prove to be accurate. Because of the inherent uncertainty of assumptions made during the evaluation process, there can be no assurance that loan losses in future periods will not exceed the allowance for loan losses or that additional allocations will not be required. Our losses will undoubtedly vary from our estimates, and there is a possibility that charge-offs in future periods will exceed the allowance for loan losses as estimated at any point in time.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

At March 31, 2016, the allowance for loan losses was $3.7 million or 1.86% of total loans compared to $4.6 million or 2.20% of total loans as of December 31, 2015. Loan charge-offs of $2.4 million were recognized in the first quarter of 2016 compared to $774 thousand in the first quarter of 2015. A significant portion of charge-offs in 2016 consisted of one relationship. Due to the charge-offs in the first quarter of 2016, the Company recognized a provision for loan losses of $1.4 million. No such provisions was considered necessary for the first three months of 2015. Reserves specifically set aside for impaired loans of $1.2 million and $1.1 million were included in the allowance as of March 31, 2016 and December 31, 2015, respectively. Management believes the allowance is adequate. The following table summarizes the activity related to our allowance for loan losses.

  

Summary of Loan Loss Experience		Three				Three
		months				months				Year
		ended				ended				ended
(Dollars in thousands)		March 31,				March 31,				December  31,
		2016				2015				2015
Total loans outstanding at end of period		$	199,635			$	229,836			$	209,367
Allowance for loan losses, beginning of period		$	4,601			$	5,787			$	5,787
Charge offs:
Real estate			(2,355	)			(293	)			(1,713	)
Commercial			(18	)			(436	)			(539	)
Consumer			(6	)			(45	)			(81	)
Total charge-offs			(2,379	)			(774	)			(2,333	)
Recoveries of loans previously charged off			73				376				1,147
Net charge-offs			(2,306	)			(398	)			(1,186	)
Provision charged to operations			1,424				—				—
Allowance for loan losses at end of period		$	3,719			$	5,389			$	4,601
Ratios:
Allowance for loan losses to loans at end of period			1.86	%			2.34	%			2.20	%
Net charge-offs to allowance for loan losses			62.01	%			7.39	%			25.78	%
Net charge-offs to provisions for loan losses			161.94	%			n/a				n/a

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Advances from the Federal Home Loan Bank

 

The following table summarizes the Company’s FHLB borrowings for the three months ended March 31, 2016 and for the year ended December 31, 2015.

 

		Maximum								Weighted
		Outstanding								Average				Period
		at any				Average				Interest				End
(Dollars in thousands)		Month End				Balance				Rate				Balance
March 31, 2016
Advances from Federal Home Loan Bank		$	17,000			$	17,000				3.44	%		$	17,000
December 31, 2015
Advances from Federal Home Loan Bank		$	17,000			$	17,000				3.44	%		$	17,000

 

Advances from the FHLB are collateralized by one-to-four family residential mortgage loans, certain commercial real estate loans, certain securities in the Bank’s investment portfolio and the Company’s investment in FHLB stock. Although we expect to continue using FHLB advances as a secondary funding source, core deposits will continue to be our primary funding source. As a result of negative financial performance indicators, there is a risk that the Bank’s ability to borrow from the FHLB could be curtailed or eliminated. Although to date the Bank has not been denied advances from the FHLB, the Bank has had its collateral maintenance requirements altered to reflect the increase in our credit risk. Thus, we can make no assurances that this funding source will continue to be available to us.

 

Capital Resources

 

Total shareholders’ deficit increased from a deficit of $12.3 million at December 31, 2015 to a deficit of $14.6 million at March 31, 2016. The Company recognized a net loss of $3.3 million for the quarter which was offset by lower unrealized losses on our available-for-sale securities, which are included in accumulated other comprehensive loss.

 

On April 11, 2016, the Company completed a private placement of 359,468,443 shares of common stock at $0.10 per share and 905,315.57 shares of Series A preferred stock at $10.00 per share for aggregate cash proceeds of approximately $45.0 million. Net proceeds from the 2016 private placement, after deducting commissions and expenses, were approximately $41.5 million of which $38.0 million was contributed to the Bank as a capital contribution to support its operations and increase its capital ratios to meet the higher minimum capital ratios required under the terms of the Bank’s Consent Order.

 

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Tier 1 and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. Tier 2 capital consists of the allowance for loan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital. The Company and the Bank are also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Capital Resources – continued

  

In July 2013, the federal bank regulatory agencies issued a final rule that has revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions, such as the Bank, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies, which we refer to below as “covered” banking organizations. Bank holding companies with less than $500 million in total consolidated assets, such as the Company, are not subject to the final rule. Effective March 31, 2015, the Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules).

 

The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets (“CET1”) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to the risk weights for certain assets and off-balance sheet exposures. Finally, CET1 includes accumulated other comprehensive income (which includes all unrealized gains and losses on available-for-sale debt and equity securities), subject to a transition period and a one-time opt-out election. The Bank elected to opt-out of this provision. As such, accumulated comprehensive income is not included in the Bank’s Tier 1 capital.

 

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “well-capitalized” under these requirements, a bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 8%, and a leverage ratio of at least 5%. To be considered “adequately capitalized” under these capital guidelines, a bank must maintain a minimum total risk-based capital of 8%, with at least 6% being Tier 1 capital. In addition, a bank must maintain a minimum Tier 1 leverage ratio of at least 4%.

 

Pursuant to the terms of the Consent Order with the FDIC and the State Board, the Bank must achieve and maintain Tier 1 capital at least equal to 8% and total risk-based capital at least equal to 10%. Regardless of the Bank’s capital ratios, it is unable to be classified as “well-capitalized” while it is operating under the Consent Order with the FDIC. For a more detailed description of the capital amounts required to be obtained in order for the Bank to be considered well-capitalized, see Note 9 to our Financial Statements.

 

If a bank is not well capitalized, it cannot accept brokered deposits without prior FDIC approval. In addition, a bank that is not well capitalized cannot offer an effective yield in excess of 75 basis points over interest paid on deposits of comparable size and maturity in such institution’s normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the Bank’s normal market area. Moreover, the FDIC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be categorized as undercapitalized. Undercapitalized institutions are subject to growth limitations (an undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDIC determines that the proposed action will further the purpose of prompt corrective action) and are required to submit a capital restoration plan. The agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of an amount equal to 5.0% of the depository institution’s total assets at the time it became categorized as undercapitalized or the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is categorized as significantly undercapitalized.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Significantly undercapitalized categorized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become categorized as adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

 

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause a bank to become undercapitalized, it could not pay a management fee or dividend to the bank holding company.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Capital Resources – continued

 

The following table summarizes the capital amounts and ratios of the Company and the Bank at March 31, 2016 and December 31, 2015.

 

		March 31,				December 31,
		2016				2015
(Dollars in thousands)
The Company
Tier 1 capital		$	(13,925	)		$	(10,642	)
Tier 2 capital			—				—
Total qualifying capital		$	(13,925	)		$	(10,642	)
Risk-adjusted total assets (including off-balance sheet exposures)		$	233,388			$	256,713
Tier 1 risk-based capital ratio			(5.97	)%			(4.15	)%
Total risk-based capital ratio			(5.97	)%			(4.15	)%
Tier 1 leverage ratio			(3.86	)%			(2.87	)%
The Bank
Common equity Tier 1 capital		$	9,238				12,135
Tier 1 capital		$	9,238			$	12,135
Tier 2 capital			2,962				3,267
Total qualifying capital		$	12,200			$	15,402
Risk-adjusted total assets (including off-balance sheet exposures)		$	236,204			$	260,024
Common equity Tier 1 capital ratio			3.91	%			4.67	%
Tier 1 risk-based capital ratio			3.91	%			4.67	%
Total risk-based capital ratio			5.17	%			5.92	%
Tier 1 leverage ratio			2.56	%			3.28	%

 

At March 31, 2016, the Company was categorized as “critically undercapitalized” and the Bank was categorized as “significantly undercapitalized.” Our losses over the past few years have adversely impacted our capital. In addition, the Consent Order requires us to achieve and maintain Total Risk Based capital at least equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% of total assets. Following the closing of the private placement on April 11, 2016, we believe that we are currently in substantial compliance with all of the terms of the Consent Order including the capital requirements.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Capital Resources – continued

  

In addition, as required by the Federal Reserve Bank of Richmond, beginning in March 2011, we began exercising our right to defer all quarterly distributions on our trust preferred securities. All of the deferred interest, including interest accrued on such deferred interest, was due and payable at the end of the applicable deferral period, which was on March 15, 2016. On April 11, 2016, immediately following the closing of the private placement, we repurchased all of our outstanding floating rate trust preferred securities.

  

The Company does not anticipate paying dividends for the foreseeable future, and all future dividends will be dependent on the Company’s financial condition, results of operations, and cash flows, as well as capital regulations and dividend restrictions from the Federal Reserve Bank of Richmond, the FDIC, and the State Board.

 

ACCOUNTING AND FINANCIAL REPORTING ISSUES

  

We have adopted various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to the consolidated financial statements for the year ended December 31, 2015, as filed on our Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by us which have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates which could have a material impact on our carrying values of assets and liabilities and our results of operations.

 

We believe the allowance for loan losses is a critical accounting policy that requires significant judgment and estimates used in preparation of our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a description of our processes and methodology for determining our allowance for loan losses.

 

The determination of the value of OREO is also considered a critical accounting policy as management must use significant judgment and estimates when considering the reasonableness of the value.

  

The income tax provision is also an accounting policy that requires judgment as the Company seeks strategies to minimize the tax effect of implementing their business strategies. The Company’s tax returns are subject to examination by both federal and state authorities. Such examinations may result in assessment of additional taxes, interest and penalties. As a result, the ultimate outcome, and the corresponding financial statement impact, can be difficult to predict with accuracy.

  

Fair value determination and other-than-temporary impairment is subject to management’s evaluation to determine if it is probable that all amounts due according to contractual terms will be collected to determine if any other-than-temporary impairment exists. The process of evaluating other-than-temporary impairment is inherently judgmental, involving the weighing of positive and negative factors and evidence that may be objective or subjective.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

LIQUIDITY

  

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of additional liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and federal funds sold are the Company’s primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment securities portfolio is the Company’s principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits are the Company’s primary source of funds for credit activities. Although not historically used as principal sources of liquidity, federal funds purchased from correspondent banks and advances from the FHLB are other options available to management. Management believes that the Company’s liquidity sources will enable it to successfully meet its long-term operating needs.

 

As of March 31, 2016, the Company had no available lines of credit; however, the Bank’s greatest source of liquidity resides in its unpledged securities portfolio. The book and market values of unpledged securities available-for-sale totaled $43.6 million and $43.0 million, respectively, at March 31, 2016. This source of liquidity may be adversely impacted by changing market conditions, reduced access to borrowing lines, or increased collateral pledge requirements imposed by lenders. The Bank has implemented a plan to address these risks and strengthen its liquidity position. To accomplish the goals of this liquidity plan, the Bank will maintain cash liquidity at a minimum of 4% of total outstanding deposits and borrowings. In addition to cash liquidity, the Bank will also maintain a minimum of 15% off balance sheet liquidity. These objectives have been established by extensive contingency funding stress testing and analytics that indicate these target minimum levels of liquidity to be appropriate and prudent.

 

Comprehensive weekly and quarterly liquidity analyses serve management as vital decision-making tools by providing summaries of anticipated changes in loans, investments, core deposits, and wholesale funds. These internal funding reports provide management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan and securities paydowns and maturities. These liquidity analyses act as a cash forecasting tool and are subject to certain assumptions based on past market and customer trends. Through consideration of the information provided in these reports, management is better able to effectively monitor the Bank’s liquidity position.

  

To better manage our liquidity position, management also stress tests our liquidity position on a semi-annual basis under two scenarios: short-term crisis and a longer-term crisis. In the short term crisis, we would be cut off from our normal funding along with the market in general. In this scenario, the Bank would replenish our funding through the most likely sources of funding that would exist in the order of price efficiency. In the longer term crisis, we may be cut off from several of our normal sources of funding as our Bank’s financial situation deteriorated. In such a case, we would utilize our unpledged securities to raise funds in the reverse repurchase market or borrow from the FHLB. On a quarterly basis, management monitors the market value of our securities portfolio to ensure its ability to be pledged if liquidity needs should arise.

 

We believe our liquidity sources are adequate to meet our needs for at least the next 12 months.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

IMPACT OF OFF-BALANCE SHEET INSTRUMENTS

  

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. Commitments to extend credit are legally binding agreements to lend to a customer at predetermined interest rates as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the instrument is represented by the contractual notional amount of the instrument. Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued to guarantee a customer’s performance to a third party and have essentially the same credit risk as other lending facilities. Standby letters of credit often expire without being used. Management believes that through various sources of liquidity, the Company has the necessary resources to meet obligations arising from these financial instruments.

 

The Company uses the same credit underwriting procedures for commitments to extend credit and standby letters of credit as for on-balance-sheet instruments. The credit worthiness of each borrower is evaluated and the amount of collateral, if deemed necessary, is based on the credit evaluation. Collateral held for commitments to extend credit and standby letters of credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties, as well as liquid assets such as time deposit accounts, brokerage accounts, and cash value of life insurance.

  

The Company is not involved in off-balance sheet contractual relationships, other than those disclosed in this report, which it believes could result in liquidity needs or other commitments or that could significantly impact earnings.

 

As of March 31, 2016, commitments to extend credit totaled $30.5 million and standby letters of credit totaled $253 thousand.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

  

Not applicable.

  

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

  

Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2016, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. However, immediately following the closing of the 2016 private placement on April 11, 2016, as previously announced, James R. Clarkson retired as President and Chief Executive Officer of the Company. Jan H. Hollar was appointed as Chief Executive Officer at that same time and accordingly has reviewed, signed, and provided the applicable certifications for this Form 10-Q as the principal executive officer.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

PART II - OTHER INFORMATION

  

Item 1. Legal Proceedings

 

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. As of the date of this report, except as noted below we do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

 

For the below matters, the Company and the Bank have engaged legal counsel and intend to vigorously defend themselves. Given the Company’s current troubled financial condition, any costs incurred by the Company associated with legal defense, government sanctions, or settlement or other litigation awards could have a material adverse effect on its financial condition due to the Company’s lack of consistent earnings.

 

●

On April 26, 2012, Samuel C. Thomas, Jr. and Pamela A. Thomas filed a lawsuit in the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry, Case No. 2012-CP-26-3295. The complaint names as defendants the Company, the Bank and current and former employees, officers and members of the Board of Directors of the Company and the Bank. The complaint alleges that the plaintiffs were misled into investing $2 million in the Company’s subordinated promissory notes, that the Bank breached its promise to loan the plaintiffs up to 90% of the amount that the plaintiffs would invest in the subordinated notes offering, and that the defendants made false representations about the financial condition of the Bank and Company. The complaint seeks actual damages, consequential damages, punitive damages, pre-judgment and post-judgment interest, penalties as mandated by statute, set-off against other obligations of the plaintiffs due to the Company and the Bank, attorney’s fees and costs. The Court granted defendants’ motions to stay the litigation and compel arbitration, which proceedings were held in March 2015. At the conclusion of the arbitration proceedings, 17 of the initial 20 individual defendants had been dismissed through summary judgment or directed verdict motions. By order dated May 15, 2015, the arbitration panel ruled in favor of the remaining defendants and denied any recovery to plaintiffs. Plaintiffs have filed a “notice of appeal” with the state court and that action is still pending. The ultimate outcome is unknown at this time and a reasonably possible loss cannot be estimated. Plaintiffs also asserted counterclaims relating to the issuance of the subordinated debt notes as a defense to a separate lawsuit brought by the Bank against them for failure to repay a loan by the Bank. The Company and the Bank have entered into a confidential settlement agreement with plaintiffs and stipulations of dismissal with prejudice have been entered in both cases, thereby ending all litigation with Mr. Thomas.

 

●

On July 19, 2012, Robert Shelley, in his individual capacity and on behalf of a proposed class of other similarly situated persons, filed a lawsuit against the Company and the Bank in the Court of Common Pleas for the Fifteenth Judicial Circuit, State of South Carolina, County of Horry, Case No. 2012-CP-26-5546. The complaint alleges that the plaintiff and other similarly situated persons were contacted by employees of the Bank, that those employees solicited a sale of Bank stock, and that the Bank employees did not disclose material information about the Bank’s financial condition prior to their respective purchases of stock. The complaint seeks the certification of a class action to include all purchasers of Bank stock solicited between July 1, 2009 and December 31, 2011. The plaintiff has asserted violations of the South Carolina Uniform Securities Act, negligence and civil conspiracy, and seeks actual, punitive and treble damages and attorneys’ fees and costs. The Company and the Bank made a motion for summary judgment in March 2014, which the court granted on April 8, 2014. Robert Shelley subsequently filed a motion to reconsider, which was denied. Mr. Shelly subsequently filed a notice of appeal with the South Carolina Court of Appeals. Both parties have completed their briefing and it is expected this matter will be heard in the second quarter of 2016 by the South Carolina Court of Appeals. The ultimate outcome is unknown at this time and a reasonably possible loss cannot be estimated.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Item 1. Legal Proceedings - continued

 

●

On or about October 4, 2012, the United States Attorney for the District of South Carolina served the Company and the Bank with a subpoena requesting the production of documents related to the Company’s offering and sale of subordinated debt notes. The Company and the Bank have provided all documents and information requested by the government to date. By letter dated December 28, 2015, the office of the United States Attorney advised the Company and Bank that it was declining to prosecute and was closing its file. After this investigation was concluded, the office of SIGTARP, which had been working with the United States Attorney for South Carolina, notified the Company and the Bank that it would be requesting some additional documents needed for review. On March 1, 2016, the office of SIGTARP issued a subpoena for certain documents to the Company and Bank. The Company and Bank fully and timely responded to this subpoena, and there are no outstanding requests for documents or information at this time. The ultimate outcome is unknown at this time and a reasonably possible loss cannot be estimated.

 

●

On or about November 7, 2012, the South Carolina Attorney General served the Company and the Bank with a subpoena requesting the production of documents related to: names of certain officers, directors, shareholders, employees, and agents, as well as meetings of the Board of Directors or shareholders of the Company and/or the Bank; the Company’s offering and sale of subordinated debt notes; and the offering and/or sale of Company stock and related filings. The Company and the Bank have provided all documents and information requested by the Attorney General to date and believes that the investigation has been concluded, although the ultimate outcome is unknown at this time and a reasonably possible loss cannot be estimated.

 

●

Plaintiff Jan W. Snyder purchased $25,000 in subordinated debt notes in or around March 2010. After making three semi-annual interest payments, the Company was precluded from making further payments by the Federal Reserve Bank of Richmond. On January 14, 2014, Mr. Snyder, on his behalf and as a representative of a class of similarly situated purchasers of subordinated debt notes, sued the Company, the Bank, and several current and former officers, directors and employees in the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry (Case No. 2014-CP-26-0204). An amended complaint was then filed by Mr. Snyder and two other subordinated debt purchasers, Acey Livingston and Mark Josephs. The plaintiffs are seeking an unspecified amount of damages resulting from wrongful conduct associated with purchases of the subordinated debt notes, including fraud, violation of state securities statutes, and negligence. All outside director defendants have been voluntarily dismissed from the lawsuit and the remaining defendants filed timely motions to dismiss, which are still pending. Before the motions were heard, the parties agreed to terms of a proposed settlement that would resolve all claims asserted by the plaintiffs and the proposed class of subordinated debt holders. By final order dated March 2, 2016, the court finally approved the proposed settlement of claims. The Company will establish a settlement fund of approximately $2.4 million, which represents 20% of the principal of subordinated debt notes issued by the Company, and class members will be entitled to receive 20% of their notes, which will be paid from the settlement fund. In exchange, class members will grant the defendants a full and complete release of all claims that were asserted or could have been asserted in the lawsuit. The Company will also separately pay the approved attorneys’ fees, costs, and expenses of class counsel up to an aggregate of $250,000. Once the time for an appeal of the final order expired with no action taken, the parties began complying with the settlement terms and the dismissal of the case became effective. The parties are continuing to process the class claims and once all settlement obligations are completed, this matter will be fully completed.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

Item 1. Legal Proceedings – continued

 

●

Plaintiff Mozingo + Wallace Architects, LLC, was a depositor with the Bank. An employee named Debor Guear was charged with being responsible for Mozingo + Wallace’s finances, including the receipt and review of account statements, payment of invoices, and reconciling all financial accounts. In 2013, another bank advised Mozingo + Wallace that it had been receiving an unusually high number of checks issued by Mozingo + Wallace to Ms. Guear’s account. Mozingo + Wallace obtained records of its account at the Bank and alleges that Ms. Guear had been making unauthorized transactions from its account. On September 25, 2013, Mozingo + Wallace sued the Company and the Bank in the Court of Common Pleas for the Fifteenth Judicial District, State of South Carolina, County of Horry, Case No. 2013-CP-26-6494, alleging that the Bank improperly allowed Ms. Guear to control and access account statements and seeking damages in an unspecified amount. The plaintiff recently dismissed the case without prejudice and re-filed a new action on or about March 27, 2015, naming the Bank and Company, as well as the plaintiff’s former outside bookkeeper. Discovery is ongoing and the Bank’s motion for summary judgment was granted in part and denied in part after a hearing before the court. The parties will soon submit a proposed scheduling order, which will establish deadlines for the completion of discovery, filing of any final dispositive motions, and trial, if necessary. The ultimate outcome is unknown at this time and a reasonably possible loss cannot be estimated.

 

Item 1A. Risk Factors

 

There have been no material changes to the risk factors disclosed in Item 1A. of Part I in our Annual Report on Form 10-K for the year ended December 31, 2015.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None

 

Item 3. Defaults Upon Senior Securities

 

None

  

Item 4. Mine Safety Disclosures

 

Not applicable

 

Item 5. Other Information

 

None

  

Item 6. Exhibits

  

The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Index to Exhibits attached hereto and are incorporated herein by reference.

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Date:	May 12, 2016	By:	/s/ JAN H. HOLLAR
			Jan H. Hollar
			Chief Executive Officer
			(Principal Executive Officer)
Date:	May 12, 2016	By:	/s/ EDWARD L. LOEHR, JR.
			Edward L. Loehr, Jr.
			Chief Financial Officer
			(Principal Financial and Accounting Officer)

HCSB FINANCIAL CORPORATION AND SUBSIDIARY

 

EXHIBIT INDEX

 

Exhibit Number		Description
10.1		Securities Purchase Agreement, dated as of February 29, 2016, between the Company and the United States Department of the Treasury (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on March 3, 2016).
10.2		Securities Purchase Agreement, dated as of February 29, 2016, between the Company and Alesco Preferred Funding VI LTD (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on March 3, 2016).
10.3		Employment Agreement, dated as of February 29, 2016, between the Company, the Bank, and Jan H. Hollar (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed on March 3, 2016).
10.4		Consulting and Noncompete Agreement, dated as of February 29, 2016, between the Company, the Bank, and James R. Clarkson ((incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed on March 3, 2016).
10.5		Form of Stock Purchase Agreement, dated as of March 2, 2016, between the Company and Investors (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K/A filed on March 9, 2016).
31.1		Rule 13a-14(a) Certification of Principal Executive Officer.
31.2		Rule 13a-14(a) Certification of the Principal Financial Officer.
32		Section 1350 Certifications.
101		The following materials from the Quarterly Report on Form 10-Q of HCSB Financial Corporation for the quarter ended March 31, 2016, formatted in eXtensible Business Reporting Language (XBRL): (i) Condensed Consolidated Balance Sheets, (ii) Condensed Consolidated Statements of Operations, (iii) Condensed Consolidated Statements of Comprehensive Income, (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity, (v) Condensed Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Condensed Consolidated Financial Statements.