ITEM 1. BUSINESS
Unless the context indicates otherwise, all references in this Form 10-K to “Citizens,” the “Corporation,” “we,” or “our,” refer to Citizens Republic Bancorp, Inc. and its subsidiary. References to the “Holding Company” refer to Citizens Republic Bancorp, Inc. alone. Citizens’ common stock is traded on the NASDAQ (“NASDAQ”) Capital Market® under the symbol “CRBC.” Citizens’ principal executive offices are located at 328 South Saginaw Street, Flint, Michigan 48502, and the telephone number is (810) 766-7500. Citizens maintains an internet website at www.citizensbanking.com where the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available without charge, as soon as reasonably practicable after Citizens files each such report with, or furnishes it to, the U.S. Securities and Exchange Commission (the “SEC”), which are also available at the SEC’s website www.sec.gov. The information on Citizens’ website does not constitute a part of this report. Investors may also contact Investor Relations at the corporate address listed above to receive copies of these reports without charge.
GENERAL
Citizens Republic Bancorp, Inc. was incorporated in the State of Michigan in 1980 with roots dating back to 1871. Citizens is a diversified banking and financial services company that is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”). Citizens provides a full range of banking and financial services to individuals and businesses through its banking subsidiary, Citizens Bank (the “Bank”). These services include deposit products, loan products, and other consumer-oriented financial services such as safe deposit and night depository facilities, wealth management services and Automated Teller Machines (“ATMs”). Among the services designed specifically to meet the needs of businesses are various types of specialized financing, treasury management services, and transfer/collection facilities. Citizens is not dependent upon any single or limited number of customers, the loss of which would have a material adverse effect on Citizens. No material portion of the business is seasonal.
RECENT DEVELOPMENTS
On April 19, 2012, Citizens announced that, effective April 17, 2012, the Federal Reserve Bank of Chicago (FRBC) and the Michigan Office of Financial and Insurance Regulation (OFIR) terminated their written agreement with Citizens, and our subsidiary, Citizens Bank dated July 28, 2010.
The Written Agreement required the boards of directors of the Holding Company and the Bank to undertake various assessments and submit by specified dates in 2010 a number of plans acceptable to the FRBC and OFIR in connection with the following matters.
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Allowance for Loan and Lease Losses
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Compliance Committee
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Staffing Plans
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Credit Risk Management Practices
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Credit Administration
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Asset Improvement
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Capital Plan
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Liquidity Position Management
On September 13, 2012, Citizens and FirstMerit Corporation (“FirstMerit”) announced the signing of an agreement and plan of merger, dated as of September 12, 2012 under which FirstMerit would acquire Citizens in a stock-for-stock merger transaction (the “FirstMerit Merger”). Under the terms of the merger agreement, holders of Citizens common stock will receive 1.37 shares of FirstMerit common stock in exchange for each share of Citizens common stock.
Subject to receipt of requisite approvals, FirstMerit is also required to repay at closing Citizens’ approximately $355 million of TARP preferred stock, which includes $55 million of estimated deferred dividends, held by the U.S. Treasury. The merger has been unanimously approved by the Boards of Directors of both Citizens and FirstMerit and is subject to customary closing conditions, including receipt of regulatory approvals and approval by both companies’ shareholders. The transaction is expected to close in the second quarter of 2013.
On December 10, 2012, Citizens announced that it would resume interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities. Regularly scheduled quarterly interest payments were deferred in January 2010 although Citizens continued to accrue for the obligations. Payment on the variable rate junior subordinated debenture issued on June 26, 2003 due June 2033 (“2003 Debenture”) was made on December 26, 2012 for the 12 payments due or deferred plus interest and dividends on the associated trust preferred securities were made to holders of record on December 15, 2012. Payment on the 7.50% junior subordinated debentures issued on October 3, 2006 due September 2066 (the “2006 Debenture”) (NYSE: CTZ-PrA) along with dividends on the associated trust preferred securities will be made in March 2013. In the aggregate, Citizens’ accrued obligation for these deferred payments was approximately $12 million. Citizens intends to resume the regular quarterly interest payment schedule.
GEOGRAPHIC LOCATIONS
Citizens conducts operations through 219 offices and 248 ATM locations throughout Michigan, Wisconsin, and Ohio with 1,973 full-time equivalent employees as of December 31, 2012. In Michigan, the primary markets are concentrated in the Lower Peninsula, primarily in the Mid-Michigan and Southeast Michigan areas, with a small presence in the Upper Peninsula. In Wisconsin, the primary markets include the greater Green Bay Metropolitan area, the Fox Valley region which extends from Appleton to Oshkosh, suburban Milwaukee, and also rural markets in southern and northern Wisconsin. In Ohio, the primary market is the greater Cleveland area. All of Citizens’ assets are located in the United States.
PRINCIPAL SOURCES OF REVENUE
Citizens’ primary source of revenue is interest income. The table below shows the amount of total consolidated revenues resulting from interest and fees on loans, interest and dividends on investment securities, money market investments, FHLB and Federal Reserve stock, and noninterest income for each of the last three years:
Citizens’ revenue tends to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, and competitive conditions within the marketplace, as well as residential housing markets in the communities Citizens serves.
LINES OF BUSINESS
Citizens’ performance is monitored by an internal profitability measurement system that provides line of business results and key performance measures. Citizens operates along five major business lines: Regional Banking, Specialty Consumer, Specialty Commercial, Wealth Management, and Other. The Regional Banking, Specialty Consumer, and Specialty Commercial business lines are involved in lending activity. Lending involves credit risk which is controlled and monitored through active asset quality management, the use of lending standards, and thorough review of potential borrowers. Credit risk management is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the captions “Critical Accounting Policies,” “Loan Portfolio,” “Credit Risk Management,” “Nonperforming Assets,” “Allowance for Loan Losses,” and “Contractual Obligations and Off-Balance Sheet Arrangements” and under Notes 1, 3, 4, and 16 to the Consolidated Financial Statements.
Additional information regarding the business lines is incorporated herein by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Line of Business Results” and in Note 15 of the Consolidated Financial Statements.
COMPETITION
The financial services industry is highly competitive. Citizens Bank competes with other commercial banks, many of which are subsidiaries of other bank holding companies, for loans, deposits, trust accounts and other business on the basis of interest rates, fees, convenience and quality of service. Major competitors include commercial banks, community banks, savings associations and thrifts, finance companies, mortgage banking companies, brokerage firms, insurance companies, credit unions and other organizations.
Mergers between financial institutions and the expansion of financial institutions both within and outside of the primary Midwest banking markets have provided significant competitive pressure in those markets. In addition, the passage of Federal interstate banking legislation has expanded the banking market and heightened competitive forces. The effect of this legislation is further discussed under the caption “Supervision and Regulation.”
Many of Citizens’ offices are located in small cities and rural areas that have diverse economies and a mix of manufacturing, service, retail and agricultural businesses. In many of these localities, Citizens is the largest bank, which we believe is a competitive advantage. In other markets, Citizens’ competitors may enjoy a competitive advantage, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. On the lending side, competitors may be able to offer lower rates for loans, which could hamper Citizens’ ability to retain existing loans or attract new customers. On the deposit side, Citizens’ competitors may also offer higher interest rates, which could decrease Citizens’ ability to retain existing deposits or attract new deposits or require Citizens to increase its rates to attract deposits.
Other factors such as employee relations and environmental laws also impact Citizens’ competitiveness. Citizens maintains a favorable relationship with its employees and none of its employees are represented by a collective bargaining group.
SUPERVISION AND REGULATION
General
The banking industry is subject to extensive state and federal regulation which continues to undergo significant change. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on Citizens are impossible to determine with any certainty. A change in applicable laws or regulations, or a change in the way such
laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations and earnings of Citizens. Citizens expects that the financial services industry will remain heavily regulated and that additional laws or regulations may be adopted. The following discussion summarizes certain aspects of the banking laws and regulations that affect Citizens. To the extent that the following information describes statutory or regulatory provisions, it is qualified entirely by reference to the particular statutory or regulatory provision.
The Holding Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (“FRB”) and is subject to regulation under the Bank Holding Company Act. The Bank Holding Company Act requires the FRB’s prior approval of an acquisition of assets or of ownership or control of voting shares of any bank or bank holding company if the acquisition would give the holder more than 10% of the voting shares of that bank or bank holding company. It also imposes restrictions, summarized below, on the assets or voting shares of non-banking companies that Citizens may acquire.
Under FRB policy, and as codified by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), a bank holding company is expected to serve as a source of financial strength to each of its subsidiary banks and to stand prepared to commit resources to support each of them. There are no specific quantitative rules on a holding company’s potential liability. If the Bank were to encounter financial difficulty, the FRB could invoke the doctrine and require a capital contribution from the Holding Company. In addition, and as a separate legal matter, a holding company is required to guarantee the capital plan of an undercapitalized subsidiary bank. See “Capital Adequacy and Prompt Corrective Action” below.
Citizens Bank is a state-chartered bank and is therefore subject to supervision, regulation and examination by the state banking regulator of the state in which it is chartered, the Michigan Office of Financial and Insurance Regulation. Citizens Bank is also subject to supervision and examination by the FRB because it is a member of the Federal Reserve System and by the Federal Deposit Insurance Corporation (“FDIC”), because the FDIC insures its deposits to the extent provided by law.
Payment of Dividends
There are various statutory restrictions on the ability of the Bank to pay dividends or make other payments to the Holding Company. The Bank is subject to dividend limits under the laws of Michigan. In addition, the Bank is a member bank of the Federal Reserve System, subject to the dividend limits of the FRB. The FRB allows a member bank to make dividends or other capital distributions in an amount not exceeding the current calendar year’s net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior approval of the FRB. FRB policy provides that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears to be consistent with the holding company’s capital needs, asset quality and overall financial condition.
On April 17, 2008, Citizens’ Board of Directors voted to suspend the common stock quarterly dividend. On January 28, 2010, Citizens announced that it was suspending the dividend payments on its trust preferred securities and on its fixed-rate cumulative perpetual preferred stock, Series A (the “TARP Preferred Stock”) with liquidation value of $300 million to the U.S. Department of the Treasury (“Treasury”) as part of the Treasury’s Capital Purchase Program. During 2011, two directors were elected to the Holding Company’s Board of Directors pursuant to the terms of the TARP Preferred Stock due to the Holding Company’s failure to pay dividends on the TARP Preferred Stock for six quarterly dividend periods. In December 2012, after consultation, and agreement with its primary regulator, Citizens announced it will resume interest payments on the outstanding junior subordinated debentures relating to our two trust preferred securities.
The Holding Company is unable to pay common stock dividends or engage in common stock repurchases until the TARP Preferred Stock dividend payments and payments deferred under our trust preferred securities are no longer in arrears. The accrued and unpaid TARP Preferred Stock dividends are scheduled to be paid just prior to completion of the FirstMerit Merger. Refer to “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity Risk Management” for additional information.
Capital Adequacy and Prompt Corrective Action
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires federal regulators to take prompt corrective action against any undercapitalized institution. FDICIA establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Regulatory capital requirements for bank holding companies are evaluated using three capital measures: (i) risk-based capital expressed as a percentage of total risk-weighted assets, and (ii) Tier 1 risk-based capital expressed as a percentage of total risk-weighted assets, and (iii) leverage capital expressed as a percentage of total assets.
The following table presents the regulatory capital requirements for the five categories.
(1) Total Capital is comprised of Tier 1 Capital, a portion of the allowance for loan losses and qualifying subordinated debt. Tier 1 Capital is calculated as follows: total shareholders’ equity + trust preferred securities - goodwill - accumulated other comprehensive income (loss) - disallowed portion of deferred tax asset - other intangible assets.
(2) Tier 1 Capital to quarterly average assets.
If the FDIC determines that an institution is in unsafe or unsound condition or that the institution has not corrected a less than satisfactory rating received in its last examination for asset quality, management, earnings or liquidity, an institution may be treated as if it were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well capitalized cannot accept, renew or rollover brokered deposits except with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or rollover brokered deposits.
The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institution’s capital, the agencies’ corrective powers include, among other things:
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prohibiting the payment of principal and interest on subordinated debt;
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prohibiting the holding company from making distributions without prior regulatory approval;
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placing limits on asset growth and restrictions on activities;
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placing additional restrictions on transactions with affiliates;
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restricting the interest rate the institution may pay on deposits;
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prohibiting the institution from accepting deposits from correspondent banks; and
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in the most severe cases, appointing a conservator or receiver for the institution.
A banking institution that is in any of the three undercapitalized categories is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institution’s holding company guarantees the plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.
FDICIA also contains a variety of other provisions that may affect Citizens’ operations, including reporting requirements, regulatory standards for real estate lending, “truth in savings” provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.
At December 31, 2012 and 2011, Citizens’ regulatory capital ratios were above “well capitalized” standards. Information concerning capital adequacy guidelines for the Holding Company and Citizens Bank including their regulatory capital position at December 31, 2012 and maintenance of minimum average reserve balances by the Bank with the FRB is incorporated herein by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the captions “Capital Resources” and “Liquidity Risk Management” and Note 18 to the Consolidated Financial Statements.
FDIC Insurance Assessments
The FDIC calculates deposit insurance based on a risk-based system that places a bank in one of four risk categories, principally on the basis of its capital level and an evaluation of the bank’s risk to the relevant deposit insurance fund, and bases premiums on the probability of loss to the FDIC with respect to each individual bank. Under the Federal Deposit Insurance Act, depository institutions such as Citizens’ subsidiary bank may not pay interest on indebtedness, if such interest is required to be paid out of net profits, or distribute any of its capital assets while it remains in default on any assessment due to the FDIC.
The calculation of the FDIC assessment includes the Financing Corporation (“FICO”) assessment. FICO was established to finance the Federal Savings and Loan Insurance Corporation resolution fund. All FDIC insured banks are required to pay into this resolution fund through the Deposit Insurance Fund (“DIF”).
In mid 2011, the FDIC Board implemented a rule that changed the assessment base from domestic deposits to average assets minus average tangible equity, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund. The rule finalized a target size for the Deposit Insurance Fund at 2 percent of insured deposits. It also implemented a lower assessment rate schedule when the fund reaches 1.15 percent so that the average rate over time should be about 8.5 basis points of the assessment base and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent. The rule, in aggregate, increased the share of assessments paid by large institutions and created a scorecard-based assessment system for banks with more than $10 billion in assets. The scorecards include financial measures that the FDIC believes are predictive of long-term performance.
Interstate Banking
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal Act”), as amended, a bank holding company may acquire banks in states other than its home state, subject to any state requirement that the bank has been organized and operating for a minimum period of time (not to exceed five years) and the requirement that the bank holding company not control, prior to or following the proposed acquisition, more than 10% of the total amount of deposits of insured depository institutions nationwide or, unless the acquisition is the bank holding company’s initial entry into the state, more than 30% of such deposits in the state, or such lesser or greater amount set by the state. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states.
Transactions with Affiliates
Transactions between the Bank and its affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. The affiliates of the Bank include any entity controlled by Citizens. Generally, Sections 23A and 23B (i) limit the extent to which the subsidiary banks may engage in “covered transactions” with any one affiliate to an amount equal to 10% of Citizens’ capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of the bank’s capital stock and surplus, (ii) require that a bank’s extensions of credit to such affiliates be fully collateralized (with 100% to 130% collateral coverage, depending on the type of collateral), (iii) prohibit the bank from purchasing or
accepting as collateral from an affiliate any “low quality assets” (including nonperforming loans) and (iv) require that all “covered transactions” be on terms substantially the same, or at least as favorable, to the bank or its subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other types of similar transactions. The definition of “covered transactions” has been expanded by the Dodd-Frank Act and applicable regulations to include repurchase agreements with an affiliate, debt obligations issued as collateral for a loan or extension of credit, securities borrowing and lending transactions to the extent the transaction creates credit exposure to the Bank and derivative transactions. Additionally, covered transactions must now be secured at all times by collateral with a specified market value. Previously, a covered transaction only needed to be secured at the time of transaction with collateral of a specified market value.
Loans to Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal stockholders of banks. Under Section 22(h) of the Federal Reserve Act and its implementing regulations, loans to a director, an executive officer or a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one-borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed the bank’s unimpaired capital and unimpaired surplus. Section 22(h) and its implementing regulations also prohibit loans, above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. Section 22(h) generally requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons. Under the Dodd-Frank Act and applicable regulations, the types of extensions of credit covered by Section 22(h) have been expanded to include credit exposure to a person resulting from derivative transactions, repurchase agreements, reverse repurchase agreements, securities lending transactions and securities borrowing transactions.
Community Reinvestment Act
Under the Community Reinvestment Act (“CRA”) and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate income areas, consistent with safe and sound banking practice. Depository institutions are periodically examined for compliance with CRA and are periodically assigned ratings in this regard. Banking regulators consider a depository institution’s CRA rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiary.
Fair Lending and Consumer Laws
In addition to CRA, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that in some cases prospective borrowers experience unlawful discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against some depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act. These factors include evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of certain loans to customers.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 (the “GLBA”) covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA repealed sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well capitalized, well-managed and have at least a satisfactory CRA rating. Citizens has determined not to become certified as a financial holding company but may reconsider this determination in the future.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a non-discriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law. The federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA repealed the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a set of activities in which a bank may engage without being deemed a “dealer.” Additionally, the law makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA also contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to “opt out” of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the GLBA.
Anti-Money Laundering and the USA Patriot Act of 2001
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) is designed to deny terrorists and criminals the ability to obtain access to the United States’ financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The Patriot Act mandates that financial services companies implement policies and procedures with respect to additional measures designed to address the following matters: money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, and currency crimes.
The Patriot Act also substantially broadened existing anti-money laundering legislation, imposed new compliance and due diligence obligations, created new crimes and penalties, and compelled the production of documents located both inside and outside the United States. The Treasury has issued a number of regulations that apply some of these requirements to financial institutions such as Citizens Bank. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. Pursuant to the Patriot Act and the related regulations, Citizens has established anti-money laundering compliance and due diligence programs that include, among other things, the designation of a Bank Secrecy Act officer, employee training programs and an independent audit function to review and test the program.
EESA and Troubled Asset Relief Capital Purchase Program
In response to the financial crises affecting the financial markets and the banking system, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law and established the Troubled Asset Relief Program (“TARP”). On October 14, 2008, the Treasury announced the Capital Purchase Program (“CPP”) to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Under CPP, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of senior preferred stock and warrants which qualify as Tier 1 capital. On December 12, 2008, Citizens issued $300.0 million of TARP Preferred Stock and a warrant to purchase 1,757,813 shares of its common stock at $25.60 per share to the Treasury as part of this program. The TARP Preferred Stock pays a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The TARP Preferred Stock is callable after three years. Participating financial institutions were required to adopt the Treasury’s standard for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the CPP.
The Treasury has been given authority to promulgate regulations under the EESA. Any new regulations implemented by the Treasury under the EESA may be applied retroactively to recipients of TARP funding under the CPP. In addition, the U.S. government could pass new legislation which may have a similar effect in the future. In either case, any such new regulations or legislation may have the effect of imposing additional economic restrictions or obligations on Citizens under the TARP CPP, at least for as long as any of Citizens’ obligations under the CPP remain outstanding.
The Special Inspector General for the Troubled Asset Relief Program (“SIGTARP”) was established pursuant to Section 121 of the EESA, and has the duty among other things, to conduct, supervise, and coordinate audits and investigations of the purchase, management, and sale of assets by the Treasury under TARP and the CPP including the TARP Preferred Stock purchased from Citizens.
American Recovery and Reinvestment Act
The American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law on February 17, 2009. ARRA includes a wide variety of programs intended to stimulate the economy. In addition, ARRA imposes executive compensation and expenditure limits on all TARP CPP recipients, such as Citizens, and expands the class of employees to whom the limits and restrictions apply. ARRA also provides the opportunity for additional repayment flexibility for existing TARP CPP recipients. The Treasury published interim final rules to implement the compensation and corporate governance provisions of the ARRA that became effective in 2009.
Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain of Citizens’ most highly paid employees (except in the form of restricted stock subject to specified limitations and conditions), and requires each TARP recipient to comply with certain other executive compensation related requirements. These provisions modify the executive compensation provisions that were included in the EESA, and in most instances apply retroactively for so long as any obligation arising from financial assistance provided to the recipient under TARP remains outstanding. The ARRA guidelines generally supersede the executive compensation and corporate governance standards for TARP recipients set forth in the EESA.
In addition, the ARRA directs the Secretary of the Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP recipient to determine whether any such payments were excessive, inconsistent with the purposes of the ARRA or the TARP, or otherwise contrary to the public interest. If the Secretary determines that any such payments have been made by a TARP recipient, the Secretary will seek to negotiate with the TARP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP recipient) with respect to any such compensation or bonuses. The ARRA also permits the Secretary, subject to consultation with the appropriate federal banking agency, to allow a TARP recipient to repay any assistance previously provided to such TARP recipient under the TARP, without regard to whether the TARP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under the ARRA.
Dodd-Frank Wall Street Reform and Consumer Protection Act
On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act will likely result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates. Implementation of the Dodd-Frank Act will require many new rules to be made by various federal regulatory agencies over the next several years. Uncertainty remains until final rulemaking is complete as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact either on the financial services industry as a whole, or on Citizens’ business, results of operations, and financial condition. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits, and interchange fees could increase the costs associated with deposits and place limitations on certain revenues those deposits may generate.
Among other provisions affecting Citizens’ business, the Dodd-Frank Act:
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Changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible equity, eliminated the ceiling and the size of the Deposit Insurance Fund, and increased the floor applicable to the size of the DIF.
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Repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transactions and other accounts.
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Centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (“CFPB”), and giving it responsibility for implementing, examining and enforcing compliance with federal consumer protection laws.
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Provided that debit card interchange fees must be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. This provision is known as the Durbin Amendment. The Board of Governors of the Federal Reserve System (“Federal Reserve Board”) adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction if the issuer implements certain fraud-prevention standards.
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Authorized the Federal Reserve Board to adopt enhanced supervision standards for, among others, bank holding companies with total consolidated assets of $50 billion or more (often referred to as “systemically important financial institutions” or “SIFI”), and authorized the Federal Reserve Board to establish such standards either on its own or upon the recommendations of the Financial Stability Oversight Council (“FSOC”), a new systemic risk oversight body created by Dodd-Frank. In April 2012, the Federal Reserve Board and FSOC issued final rules and
interpretative guidance establishing enhanced prudential standards responsive to these provisions for (i) risk-based capital requirements and leverage limits, (ii) stress testing of capital, (iii) liquidity requirements, (iv) overall risk management requirements, (v) resolution plan and credit exposure reporting and (vi) concentration/credit exposure limits (the “SIFI Rules”). The SIFI Rules address a wide, diverse array of regulatory areas, each of which is highly complex. Most of the SIFI Rules will not apply to Citizens for so long as its total consolidated assets remain below $50 billion. Two aspects of the SIFI Rules - requirements for annual stress testing of capital under one base and two stress scenarios and certain corporate governance provisions requiring, among other things, that each bank holding company establish a risk committee of its board of directors and that such committee include a “risk expert” - apply to bank holding companies with total consolidated assets of $10 billion or more.
The implications of the Dodd-Frank Act for Citizens’ will depend to a large extent on the manner in which rules adopted pursuant to the Dodd-Frank Act are implemented by the primary U.S. financial regulatory agencies as well as potential changes in market practices and structures in response to the requirements of the Dodd-Frank Act. Citizens continues to analyze the impact of rules adopted under the Dodd-Frank Act. However, the full impact will not be known until the rules, and other regulatory initiatives that overlap with the rules are implemented and their combined impacts can be understood.
Basel III
The United States is a member of the Basel Committee on Banking Supervision (the “Basel Committee”), that provides a forum for regular international cooperation on banking supervisory matters. The Basel Committee develops guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Basel Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.
In December 2010, the Basel Committee released its new framework for strengthening international capital and liquidity regulation, now officially identified as “Basel III.” In June 2011, a revised version of this framework was released. Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity. The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. In November 2012, however, the US Federal Reserve, FDIC and Office of the Comptroller of the Currency announced that implementation of the capital requirements would be delayed indefinitely. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact Citizens’ operating results.
ECONOMIC FACTORS AND MONETARY POLICY
Citizens’ earnings and business are affected by the general economic and political conditions in the United States and abroad and by the monetary and fiscal policies of various federal regulatory authorities, including the Federal Reserve System. Citizens’ policy for addressing credit risk, the effect of the economy on credit risk in 2012, 2011, and 2010 and its potential effect on future periods is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the captions “Critical Accounting Policies,” “Loan Portfolio,” “Credit Risk Management,” “Nonperforming Assets,” and “Allowance for Loan Losses” and incorporated herein by reference. Through open market securities transactions, variations in the Federal Funds rate and the establishment of reserve requirements, the Board of Governors of the Federal Reserve System exerts considerable influence on interest rates and the supply of money and credit. Citizens strives to manage the effects of interest rates through its asset/liability management process but the effect of fluctuating economic conditions and federal regulatory policies on Citizens’ future profitability cannot be predicted with any certainty. The effect of the economy and changes in interest rates on Citizens’ net interest margin and net interest income in 2012, 2011, and 2010 and their potential effect on future periods is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Net Interest Income” and is incorporated herein by reference. Citizens’ sensitivity to changes in interest rates and the potential effect of changes in interest rates on net interest income is presented in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Risk” and incorporated herein by reference.
ENVIRONMENTAL MATTERS
Citizens’ primary exposure to environmental risk is through lending activities and trust services. In each instance, policies and procedures are in place to mitigate environmental risk exposures. With respect to lending activities, Citizens requires environmental site assessments at the time of loan origination to confirm collateral quality on commercial real estate parcels posing higher than normal potential for environmental impact, as determined by reference to present and past uses of the subject property and adjacent sites. Environmental assessments are also mandated prior to any foreclosure activity involving non-residential real estate collateral. In the case of trust services, Citizens utilizes various types of environmental transaction screening to identify actual and potential risks arising from any proposed holding of non-residential real estate for trust accounts. Consequently, Citizens does not anticipate any material effect on capital expenditures, earnings or the competitive position of Citizens or its subsidiary with regard to compliance with federal, state or local environmental protection laws or regulations. Additional information is provided in “Item 3. Legal Proceedings.”
ITEM 1A.
ITEM 1A. RISK FACTORS
Unless otherwise noted or the context indicates otherwise, all references in this Item to “we,” “us,” or “our,” refer to Citizens and its subsidiary. An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that we believe affect us are described below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are not aware of or focused on or currently deem immaterial may also impair business operations. This report is qualified in its entirety by these risk factors. If any of the following risks occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and shareholders could lose all or part of their investment.
Risks Related to Our Business
We face the risk that loan losses, including unanticipated loan losses due to changes in loan portfolios, fraud and economic factors, could exceed the allowance for loan losses and that additional increases in the allowance will be required. Additions to the allowance for loan losses would cause our operating results to decline and could have a negative impact on our capital and financial position.
Making loans is an essential element of our business, and there is a risk that customer loans will not be repaid. The risk of nonpayment is affected by a number of factors, including:
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the duration of the loan;
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credit risks of a particular borrower;
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changes in economic and industry conditions; and
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in the case of a collateralized loan, the potential inadequacy of the value of the collateral in the event of default, such as has resulted from the deterioration in commercial and residential real estate values.
We attempt to maintain an appropriate allowance for loan losses to provide for probable losses inherent in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors including, among others, the ongoing review and grading of the loan portfolio, consideration of past loan loss experience as well as that of the banking industry, trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, the size and diversity of individual credits, and other
qualitative and quantitative factors which could affect probable credit losses. We determine the amount of the allowance for loan losses by considering these factors and by using estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on our historical loss experience with additional qualitative factors for various issues, and estimates of necessary reserves for special situations that are unique to the measurement period such as anticipated problem loan resolution activities, along with consideration of current economic trends and conditions, all of which are susceptible to significant change and are inherently subjective. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly.
A significant portion of our loan portfolio is secured by commercial and residential real estate. These portfolios are comprised of borrowers primarily located in Michigan, Wisconsin, and Northern Ohio. While the overall economy continues to improve, the Michigan and Northern Ohio markets in particular were adversely affected by job losses, declines in real estate value, declines in home sale volumes, and declines in new home building during the recent recession. The credit performance of loans secured by commercial income producing properties were negatively affected by tenant losses and reduced rental rates, contributing to the decline in values associated with the income producing loan portfolio. We may suffer further losses in these segments if our efforts to limit losses through execution of prudent workout strategies are unsuccessful. Although we do not engage in subprime lending, the credit performance of the residential mortgage portfolio has been negatively impacted by borrowers’ loss of or reduction in, income.
Increased stress on borrowers’ cash flow due to job loss, reduced rental income, higher interest rates or other factors could lead to even higher payment delinquencies and defaults. Declines in real estate values could lead to higher loss severity. Although our most significant loan losses to date have been concentrated in our commercial real estate and residential mortgage loan portfolios, adverse economic conditions could negatively affect other portions of our loan portfolio.
There is no precise method of predicting loan losses, and therefore we always face the risk that charge-offs in future periods will exceed our allowance for loan losses or that additional increases in the allowance for loan losses will otherwise be required. Additions to the allowance for loan losses would cause operating results to decline in the period(s) in which such additions occur and could also have a material adverse impact on our capital and financial position.
Our core lending and other businesses have been adversely affected by the recent weakness in the national and regional economies in which we operate, particularly Michigan. Our ability to generate earnings and maintain regulatory capital ratios at acceptable levels at our Holding Company and the Bank depends substantially on developments in those economies. Also, our potential inability to comply with applicable laws, regulations and regulatory policies or standards due to the effects of these conditions on our results of operations and financial condition may result in heightened regulatory scrutiny and require us to take actions to protect depositors that are not in the best interests of our shareholders.
While the Michigan economy is showing improvement, economic growth has been slow. With historic weaknesses in the economy nationally and particularly in our primary markets, and the effect of this weakness on unemployment rates and the value of real estate collateralizing many of our loans, we have incurred substantial losses in previous years and our capital levels have been adversely affected. These effects have, in turn, hampered our ability to comply with various standards and policies of our various banking regulators which are intended primarily for the protection of depositors and the FDIC, not shareholders or holders of subordinated debt or trust preferred securities. Any failure to comply with laws, regulations, or regulatory policies or standards could also result in heightened regulatory scrutiny and in further sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to operate or expand our business, could require us to raise additional capital, sell assets or take other actions on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition, results of operations, and stock price.
Our business may be adversely affected by the highly regulated environment in which we operate. Changes in applicable laws, regulations, and regulatory practices at either the federal or state level may result in the imposition of additional costs or restrict our ability to operate our business in the manner most beneficial to our shareholders.
The banking industry is heavily regulated, and such regulations are intended primarily for the protection of depositors and the federal deposit insurance funds, not shareholders or holders of subordinated debt or trust preferred securities. As a bank holding company, the Holding Company is subject to regulation by the FRB.
Citizens Bank is subject to federal regulation primarily by the FRB and is also subject to regulation by the OFIR. These regulations affect lending practices, capital structure, investment practices, dividend policy and growth. Citizens Bank also engages in providing investment management and insurance brokerage services, which industries are also heavily regulated on both a state and federal level.
Various legislative and regulatory initiatives have been introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any impending regulations, would have on our financial condition and results of operations. A change in statutes, regulations or regulatory policies applicable to us could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things, any of which could have a material effect on our business.
The Dodd-Frank Act has and will continue to significantly change bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.
The new Bureau of Consumer Financial Protection, created pursuant to the Dodd-Frank Act, has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. Additionally, the Bureau of Consumer Financial Protection has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.
Proposals for further regulation of the financial services industry are continually being introduced in the Congress of the United States of America. The agencies regulating the financial services industry also periodically adopt changes to their regulations. It is possible that additional legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on our business.
In addition, changes in laws, regulations and regulatory practices affecting the financial services industry, such as those relating to the Dodd-Frank Act and Basel III, among others, could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a
cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
While we attempt to manage the risk from changes in market interest rates, interest rate risk management techniques are not exact. In addition, we may not be able to economically hedge our interest rate risk. A rapid or substantial increase or decrease in interest rates could adversely affect our net interest income and results of operations.
Our ability to generate net income depends primarily upon our net interest income. Net interest income is income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates and the levels of nonperforming loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of noninterest-bearing demand deposits and equity capital.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest earning assets, or vice versa. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce net interest income. We are unable to predict changes in market interest rates which are affected by many factors beyond our control including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, relationships between interest sensitive instruments and key driver rates, as well as balance sheet growth, client loan and deposit preferences and the timing of changes in these variables.
We attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. We continually review our interest rate risk position and modify our strategies based on projections to minimize the impact of future interest rate changes. We also use derivative financial instruments to modify our exposure to changes in interest rates. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect results of operations and financial performance.
The negative economic effects caused by terrorist attacks, cyber attacks, potential attacks and other destabilizing events would likely contribute to the deterioration of the quality of our loan portfolio and could reduce our customer base, our level of deposits, and demand for our financial products such as loans.
High inflation, natural disasters, acts of terrorism, cyber attacks, an escalation of hostilities or other international or domestic occurrences, and other factors could have a negative impact on the economy of the Upper Midwest regions in which we operate. An additional economic downturn in our markets would likely contribute to the deterioration of the quality of our loan portfolio by impacting the ability of our customers to repay loans, the value of the collateral securing loans, and may reduce the level of deposits in the Bank and the stability of our deposit funding sources. An additional economic downturn could also have a significant impact on the demand for our products and services. The cumulative effect of these matters on our results of operations and financial condition would likely be adverse and material.
If we are unable to continue to attract and retain core deposits, to obtain third party financing on favorable terms, or to have access to interbank or other liquidity sources (as a result of rating agency downgrades or other market factors), our cost of funds will increase, adversely affecting the ability to generate the funds necessary for lending operations, reducing net interest margin and negatively affecting results of operations.
The Bank derives liquidity through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. Additionally, the Bank has access to financial market borrowing sources on an unsecured, and a collateralized basis for both short-term and long-term purposes including, but not limited to, the Federal Reserve, Federal Home Loan Banks of which the Bank is a member, and other correspondent banks. If these funding sources are not sufficient or available, we may have to acquire funds through higher-cost sources.
Our credit ratings are important to our liquidity. Our credit rating was downgraded by various ratings services in the past. Any further reduction or anticipated reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger unfavorable contractual obligations.
Increased competition with other financial institutions or an adverse change in our relationship with a number of major customers could reduce our net interest margin and net income by decreasing the number and size of loans originated, the interest rates charged on these loans and the fees charged for services to customers.
The Bank faces substantial competition in originating commercial and consumer loans. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors have competitive advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of the loans that we originate and the interest rates we charge on these loans.
In attracting business and consumer deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates, which could decrease the deposits that we attract or require us to increase rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations which could increase our cost of funds.
We also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, credit unions, insurance companies and governmental organizations which may offer more favorable terms on deposits or investments. Some non-bank competitors are not subject to the same extensive regulations that govern banking operations. As a result, such non-bank competitors may have advantages over us in providing certain products and services. This competition may reduce or limit our margins on banking and non-banking services, reduce our market share and adversely affect our earnings and financial condition.
The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems.
Events such as significant adverse changes in the business climate, adverse action by a regulator, unanticipated changes in the competitive environment, and a decision to change our operations or dispose of an operating unit could have a negative effect on our goodwill or other intangible assets such that we may need to record an impairment charge, which could have a material adverse impact on our results of operations.
Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are assessed at least annually for impairment, or more frequently when impairment indicators are present. After evaluating goodwill and other intangible assets, we may determine that one or both are deemed to be impaired for accounting purposes. Deterioration in the outlook for credit quality, changes in the value of the loan or deposit portfolios, or increases in the discount rates could have a material impact on future goodwill impairment testing results. If we identify any impairment, it would be reflected as a charge to earnings in the period during which such impairment is identified and could have a material adverse effect on our results of operations.
If the FDIC raises the assessment rate charged to its insured financial institutions, our FDIC insurance premium may increase and this could have a negative effect on our expenses and results of operations.
Recent high levels of bank failures and temporary programs increasing deposit insurance limits dramatically increased resolution costs for the FDIC and depleted its deposit insurance fund. In order to maintain a strong funding position and restore reserve ratios for the deposit insurance fund, the FDIC increased assessment rates for all insured institutions in recent years. There can be no assurance that we will not be required to pay even higher FDIC insurance premiums than the recently increased levels, particularly if our assets increase to more than $10 billion, which may materially adversely affect our results of operations and financial condition.
We may not realize our deferred income tax assets and loss carryforwards.
The realization of our deferred income tax assets is dependent on generating future taxable income, executing tax planning strategies, and reversing existing taxable temporary differences. If a period of sustained losses were to occur, we may be required to recognize an allowance against all or part of our deferred tax asset, which would have a material adverse effect on our results of operations in the period in which such an allowance is recognized. In addition, under Section 382 of the Internal Revenue Code of 1986, as amended, if a change of ownership occurs with respect to a company with deferred income tax assets, that company’s use of the pre-change of ownership tax loss carryforwards as well as the ability to use certain unrealized built-in losses would be substantially limited. A change of ownership occurred under Section 382 as a result of the exchange offers of common stock for long-term debt in the third quarter of 2009. Generally, under Section 382, the yearly limitation on our ability to utilize such deductions will be equal to the product of the applicable long-term tax exempt rate and the sum of the values of our common stock and our TARP Preferred Stock immediately before the ownership change. Our ability to utilize deductions related to credit losses during the twelve-month period following such an ownership change would also be limited under Section 382, together with net operating loss carryforwards, to the extent that such deductions reflect a net loss that was “built-in” to our assets immediately prior to the ownership change.
Because the 2009 exchange offers triggered an ownership change, our ability to use the net operating loss carryforwards and certain built-in losses existing at the time of the deemed change in ownership to offset future income will be substantially limited. Therefore, we may suffer higher than anticipated tax expense, and consequently lower net income and cash flow, in future years. Moreover, any future change in ownership would further limit our ability to use our net operating loss carryforwards and certain built-in losses existing at the time of the future change in ownership.
Our stock price can be volatile.
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:
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Actual or anticipated negative variations in quarterly results of operations;
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Negative recommendations by securities analysts;
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Poor operating and stock price performance of other companies that investors deem comparable to us;
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News reports relating to negative trends, concerns and other issues in the financial services industry or the economy in general;
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Negative perceptions in the marketplace regarding us and/or our competitors;
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New technology used, or services offered, by competitors;
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Adverse changes in interest rates;
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Adverse changes in the real estate market;
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Negative economic news;
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Adverse changes in government regulations; and
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Geopolitical conditions such as acts or threats of terrorism or military conflicts.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause our stock price to decrease regardless of operating results.
An investment in our common stock is not an insured deposit.
Our common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you could lose some or all of your investment.
We may be adversely affected by the soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral we hold cannot be liquidated at prices sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our financial condition and results of operations.
In order to maintain and strengthen our capital base or to repay outstanding obligations, we may need to raise additional capital in transactions that may be highly dilutive to our common shareholders. If such capital becomes needed, our failure to raise additional capital could have serious consequences for our business.
We regularly perform a variety of analyses on our assets and the impact of credit losses on our capital base, including the preparation of stress case scenarios. Due to economic conditions in the markets in which we operate and the challenges posed to our business, including those described in other Risk Factors, we may determine, based on these analyses, that we need to raise additional Tier 1 common equity to maintain and strengthen our capital base as the effects of these events impact our business over the coming months and years. We may also determine to raise equity capital to repay outstanding obligations, with unfavorable interest or dividend rates. Any potential capital raising transaction could be highly dilutive to our common shareholders. The market price of our common stock could decline as a result of the dilutive effect of the capital raising transactions we may enter into, or the perception that such transactions could occur.
In connection with the issuance of the TARP Preferred stock, we also issued a warrant to Treasury to purchase approximately 1.8 million additional shares of our common stock at an initial per share exercise price of $25.60, subject to adjustment, which expires ten years from the issuance date. Even if we were to redeem the TARP Preferred Stock, we may not fully retire this warrant and, therefore, this warrant may be exercised, in whole or part, prior to its expiration date. Furthermore, the terms of the warrant provide that, if we issue common stock or securities convertible or exercisable into, or exchangeable for, common stock at a price that is less than 90% of the market price of such shares on the last trading day preceding the date of the agreement to sell such shares, the number and the per share price of common stock to be purchased pursuant to the warrant will be adjusted pursuant to its terms. As part of our potential capital raising efforts, we could issue securities convertible into or exercisable for our common stock, which may trigger the anti-dilution provisions of the warrant issued to the Treasury. If we issue such securities and they are subsequently exercised, converted into or exchanged for common stock such transactions would have a further dilutive effect on other holders of our common stock.
Also, if we determine that we need to raise additional capital, our capital raising efforts may not be successful, or we may be required to raise additional capital on terms that are unfavorable to us. A failure to maintain capital above “well capitalized” levels could require us to further reduce the size of our business and would likely have serious negative consequences for our business.
We have agreements with derivative counterparties that contain a provision where if we fail to maintain our status as a well capitalized or adequately capitalized institution, then the counterparty could terminate the derivative positions and we would be required to settle our obligations under the agreements. A default under these agreements could have a material adverse effect on our business, results of operations and financial condition.
Our Holding Company may not have sufficient resources to make capital contributions to the Bank if required by bank regulatory agencies, or if we might otherwise wish to do so, in order to maintain the Bank’s capital ratios at acceptable levels.
Our Holding Company is required by banking regulation to act as a “source of strength” to the Bank. If the Bank incurs losses and regulatory capital levels at the Bank decline, our Holding Company may be required by the bank regulatory agencies to contribute additional capital to the Bank. As of December 31, 2012, the Holding Company’s cash resources totaled $81.8 million. We may not have sufficient funds at our Holding Company level to make required capital contributions to the Bank if the Bank incurs losses.
As a bank holding company that conducts substantially all of our operations through our operating subsidiary, the ability of our Holding Company to pay dividends, repurchase our shares or to repay our indebtedness depends upon the results of operations of our subsidiary and its ability to pay dividends to our Holding Company. Dividends paid by the subsidiary are subject to limits imposed by federal and state law.
The Holding Company is a separate and distinct legal entity from our operating subsidiary, the Bank, and it receives substantially all of its revenue from dividends from the Bank and sales of our securities to investors. Dividends from the Bank are an important source of funds to pay dividends on common stock and interest and principal on debt. Various federal and state laws and regulations limit the amount of dividends that our subsidiary may pay to the Holding Company. Also, our Holding Company’s right to participate in a distribution of assets upon the Bank’s liquidation or reorganization is subject to the prior claims of the Bank’s creditors. If we are unable to pay dividends to our Holding Company, we may not be able to service debt, pay obligations or, should we have the ability to do so in the future, pay dividends on common stock.
The Holding Company’s interest and preferred dividend payment obligations are approximately $20 million annually. There can be no assurance that the Holding Company’s cash resources will be sufficient to fulfill its obligations.
We could face unanticipated environmental liabilities or costs related to real property owned or acquired through foreclosure. Compliance with federal, state and local environmental laws and regulations, including those related to investigation and clean-up of contaminated sites, could have a negative effect on expenses and results of operations.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on results of operations.
We are party to various lawsuits. Litigation is subject to many uncertainties such that the expenses and ultimate exposure with respect to many of these matters cannot be ascertained.
From time to time, customers, shareholders and others make claims and take legal action against us and our directors. Whether these claims and legal actions are legitimate or unfounded, if such claims and legal actions are not resolved in our favor they may result in significant financial liability to us (directly or as a result of our indemnification obligations), adversely affect the market’s perception of us and our products and services and impact customer demand for our products and services. Any financial liability or reputation damage could have a material adverse effect on our business, financial condition and results of operations.
The financial services industry is undergoing rapid technological changes. If we are unable to adequately invest in and implement new technology-driven products and services, we may not be able to compete effectively, or the cost to provide products and services may increase significantly.
The financial services industry is undergoing rapid technological changes with frequent introduction of new technology-driven products and services. In addition to providing better customer service, the effective use of technology increases efficiency and enables financial service institutions to reduce costs. Our future success will depend, in part, upon our ability to address customer needs by using technology to provide products and services to enhance customer convenience, as well as to create additional operational efficiencies. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services, which could reduce our ability to effectively compete and, in turn, have a material adverse effect on our financial condition and results of operations.
The products and services offered by the banking industry and customer expectations regarding them are subject to change. We attempt to respond to perceived customer needs and expectations by offering new products and services, which are often costly to develop and market initially. A lack of market acceptance of these products and services would have a negative effect on our financial condition and results of operations.
From time to time, we implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly
in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we may invest significant time and resources. We may not achieve initial timetables for the introduction and development of new lines of business and/or new products or services and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.
We may not be able to attract and retain skilled people. If we were to lose key employees, we may experience a disruption in our relationship with certain customers.
Our success depends, in large part, on our ability to attract and retain skilled people. Competition for the best people in most of our business activities can be intense, and we may not be able to hire sufficiently skilled people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.
Many of our key employees have extensive customer relationships. Loss of a key employee with such customer relationships may lead to the loss of customers if they were to follow that employee to a competitor. While we believe that our relationship with our key producers is good, we cannot guarantee that all of our key personnel will remain with us.
The Standard & Poor’s downgrade in the U.S. government’s sovereign credit rating, and in the credit ratings of instruments issued, insured or guaranteed by certain related institutions, agencies and instrumentalities, creates risks to our net income, capital levels, financial condition and liquidity and causes uncertainties in general economic conditions that may adversely impact us.
In August 2011, Standard & Poor’s downgraded the United States long-term debt ratings and downgraded the credit ratings of certain long-term debt instruments issued by Fannie Mae and Freddie Mac and other U.S. government agencies linked to long-term U.S. debt. Instruments of this nature are key assets on the balance sheets of financial institutions, including Citizens. These downgrades could adversely affect the market value of such instruments, and could adversely impact our ability to obtain funding that is collateralized by affected instruments, as well as affecting the pricing of that funding when it is available. In addition, these downgrades could materially affect financial markets and economic conditions, which may affect our net income, financial condition and liquidity and result in future changes in capital requirements or our investment portfolio in response to management’s assessment of the related risk weightings. We cannot predict if, when or how these changes to the credit ratings will affect economic conditions. As a result, it is possible that these changes could result in a significant adverse impact to us, and could affect other risks to which we are subject.
New accounting or tax pronouncements or interpretations may be issued by the accounting profession, regulators or other government bodies which could change existing accounting methods. Changes in accounting methods could negatively impact our results of operations and financial condition.
Current accounting and tax rules, standards, policies, and interpretations influence the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on us, such as the bankruptcy of major U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, and various taxing authorities, responding by adopting and/or proposing substantive revision to laws, regulations, rules, standards, policies, and interpretations.
New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. A change in accounting standards may adversely affect reported financial condition and results of operations.
Our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, our business and a negative impact on our results of operations.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems, whether due to severe weather, natural disasters, cyber attack, acts of war or terrorism, criminal activity or other factors, could result in failures or disruptions in general ledger, deposit, loan, customer relationship management, and other systems. While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our results of operations.
Our vendors could fail to fulfill their contractual obligations, resulting in a material interruption in, or disruption to, our business and a negative impact on our results of operations.
We have entered into subcontracts for the supply of current and future services, such as data processing, mortgage loan processing and servicing, and certain property management functions. These services must be available on a continuous and timely basis and be in compliance with any regulatory requirements. Failure to do so could substantially harm our business.
We often purchase services from vendors under agreements that typically can be terminated on a periodic basis. There can be no assurance, however, that vendors will be able to meet their obligations under these agreements or that we will be able to compel them to do so. Risks of relying on vendors include the following:
•
If an existing agreement expires or a certain service is discontinued by a vendor, then we may not be able to continue to offer our customers the same breadth of products and our operating results would likely suffer unless we are able to find an alternate supply of a similar service.
•
Agreements we may negotiate in the future may commit us to certain minimum spending obligations. It is possible we will not be able to create the market demand to meet such obligations.
•
If market demand for our products increases suddenly, our current vendors might not be able to fulfill our commercial needs, which would require us to seek new arrangements or new sources of supply, and may result in substantial delays in meeting market demand.
•
We may not be able to control or adequately monitor the quality of services we receive from our vendors. Poor quality services could damage our reputation with our customers.
Potential problems with vendors such as those discussed above could have a significant adverse effect on our business, lead to higher costs and damage our reputation with our customers and, in turn, have a material adverse effect on our financial condition and results of operations.
Our controls and procedures may fail or be circumvented which could have a material adverse effect on our business, results of operations and financial condition.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
Our articles of incorporation and bylaws as well as certain banking laws may have an anti-takeover effect.
Provisions of our articles of incorporation and bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire our Holding Company, even if doing so would be perceived to be beneficial to shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
Risks Relating to the FirstMerit Merger
We will be subject to contractual restrictions and business uncertainties while the FirstMerit merger is pending.
Our merger agreement with FirstMerit restricts us from operating our business other than in the ordinary course, and prohibits us from taking specified actions without FirstMerit’s consent until the merger occurs. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger. In addition, uncertainty about the effect of the FirstMerit merger on our staff members and clients may have an adverse effect on our business. We may have difficulty retaining staff members while the merger is pending, as certain staff members may experience uncertainty about their future roles with FirstMerit. In addition, the uncertainty caused by the pending merger could cause our clients and business associates to seek to change their existing business relationships with us. These uncertainties may impair our ability to attract, retain, and motivate key personnel and retain and grow our client base until we complete the merger.
The merger is subject to certain closing conditions that, if not satisfied or waived, will result in the merger not being completed. Failure to complete the merger with FirstMerit could negatively affect our business or cause our stock price to decline.
The merger is subject to customary conditions to closing, including the receipt of required regulatory approvals and approval of the Citizens and FirstMerit shareholders. If any condition to the merger is not satisfied or waived, to the extent permitted by law, including the absence of any materially burdensome condition in the regulatory approvals, the merger will not be completed. In addition, FirstMerit or Citizens may terminate the merger agreement under certain circumstances even if the merger is approved by their shareholders, including but not limited to, if the merger has not been completed on or before June 12, 2013. If we do not complete the merger, the market price of our common stock may decline to the extent that the current market price reflects a market assumption that the merger will be completed. In addition, we would not realize any of the expected benefits of having completed the merger. If the merger is not completed, additional risks could materialize, which could materially and adversely affect the business, financial results, financial condition and stock prices of FirstMerit or Citizens.
If the merger is not completed, we will have incurred substantial expenses without realizing the expected benefits of the merger.
We have incurred substantial expenses in connection with the negotiation and signing of the merger agreement, the receipt of regulatory and shareholder approvals and in anticipation of the completion of the merger. If the merger is not completed, we would have to recognize these expenses without realizing the expected benefits of the merger.
The merger is subject to the receipt of consents and approvals from governmental entities that may impose conditions that could have an adverse effect on the combined company following the merger.
Before the merger may be completed, various approvals or consents must be obtained from regulatory authorities. These regulatory authorities, including the Federal Reserve and the Comptroller of the Currency may impose conditions on the completion of the merger or require changes to the terms of the
merger. Such conditions or changes could have the effect of delaying completion of the merger, giving FirstMerit the right to terminate the merger agreement or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have an adverse effect on the combined company following the merger. The Comptroller of the Currency’s approval of the merger of FirstMerit Bank and Citizens Bank is a condition of the merger.
We cannot be sure of the market value of the merger consideration that our common shareholders will receive as a result of the announced merger with FirstMerit.
Upon completion of the merger, each share of our common stock will be converted into merger consideration consisting of 1.37 shares of FirstMerit common stock. The market value of the merger consideration will vary from the closing price of FirstMerit common stock on the date we announced the merger, on the date that the proxy statement/prospectus is mailed to our shareholders, on the date of the special meeting of our shareholders, on the date we complete the merger and thereafter. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in our respective businesses, operations and prospects, and regulatory situation of FirstMerit and Citizens. Many of these factors are beyond our control. Any change in the market price of FirstMerit common stock prior to completion of the merger will affect the market value of the merger consideration that our shareholders will receive upon completion of the merger, and there will be no adjustment to the merger consideration for changes in the market price of either shares of FirstMerit common stock or shares of our common stock. Accordingly, at the time of the special meeting, our shareholders will not know or be able to calculate the market value of the merger consideration they would receive upon completion of the merger.
Further, the businesses of FirstMerit and Citizens differ in important respects and, accordingly, the results of operations of the combined company and the market price of the combined company’s shares of common stock may be affected by factors different from those currently affecting the independent results of operations of FirstMerit and Citizens.
We may fail to realize all of the anticipated benefits of the merger.
The success of the merger will depend, in part, on FirstMerit’s ability to realize anticipated benefits and cost savings from combining the businesses of FirstMerit and Citizens and to combine the businesses of FirstMerit and Citizens in a manner that permits growth opportunities and cost savings to be realized without materially disrupting the existing customer relationships of Citizens nor decreasing revenues due to loss of customers. However, to realize these anticipated benefits and cost savings, FirstMerit must successfully combine the business of FirstMerit and Citizens. If the combined company is not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully or at all or may take longer to realize than expected.
Citizens has operated and, until the completion of the merger, will continue to operate, independently. It is possible that the integration process could result in the loss of key employees who may then receive severance benefits, the disruption of each company’s ongoing business or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the merger. The anticipated cost savings from the merger are largely expected to derive from the absorption by FirstMerit of many of our back-office and other duplicative administrative functions. Integration efforts between the two companies will also divert significant management attention and resources that will not be available for normal operations. An inability to successfully market FirstMerit’s products to Citizens’ customer base could cause the earnings of the combined company to be less than anticipated. An expected benefit from the merger is an expected increase in the revenues of the combined company from anticipated sales of FirstMerit’s wide variety of financial products, and from increased lending out of the combined company’s larger capital base and legal lending limits. An inability to successfully market FirstMerit’s products to our customer base could cause the earnings of the combined company to be less than anticipated. Integration matters and the transition to FirstMerit could have an adverse effect on Citizens and FirstMerit during the pre-merger transition period, and on FirstMerit for an undetermined period after consummation of the merger.
The merger agreement limits our ability to pursue an alternative acquisition proposal and requires us to pay a termination fee of $37.5 million under limited circumstances relating to alternative acquisition proposals.
The merger agreement prohibits FirstMerit and Citizens from soliciting, initiating or encouraging certain alternative acquisition proposals with any third party, subject to exceptions set forth in the merger agreement. The merger agreement also provides for the payment by FirstMerit or Citizens of a termination fee in the amount of $37.5 million in the event that the other party terminates the merger agreement for certain reasons. These provisions might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of Citizens from considering or proposing such an acquisition.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
Citizens’ executive offices are located at 328 South Saginaw Street, Flint, Michigan in the main office building of Citizens Bank, the bank subsidiary. The bank subsidiary operates through 219 offices. Of these, 60 are leased and the remainder are owned and not subject to any material liens. Rent expense on the leased properties totaled $6.1 million in 2012. The banking offices are located in various communities throughout the states of Michigan and Wisconsin, and in parts of Ohio, and are used by all of Citizens’ business segments. At certain Citizens Bank locations a portion of the office buildings are leased to tenants.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Citizens is party to a number of lawsuits incidental to its business. Although litigation is subject to many uncertainties and the ultimate exposure with respect to many of these matters cannot be ascertained, Citizens does not believe the ultimate outcome of these matters will have a material adverse effect on its financial condition or liquidity.
In the first quarter of 2012, putative class action litigation was filed against the Bank and the Corporation, in the United States District Court for the Eastern District of Michigan and in Genesee County Circuit Court in the State of Michigan, relating to the Bank’s practices in posting debit card transactions to customers’ deposit accounts. The class of plaintiffs, which purports to constitute substantially all of the Bank’s customers during the class period, alleges that the Bank improperly reordered debit card transactions from the highest amount to lowest amount before processing these transactions in order to generate unwarranted overdraft fees. Plaintiffs contend that the Bank should have processed such transactions in the chronological order they were authorized or from lowest to highest, and seek restitution for the fees they claim were wrongly charged as well as a declaratory judgment and attorney fees. The state court action was stayed, and the same lead plaintiff then filed suit in federal court. During the second quarter of 2012, the two federal cases were consolidated into one case pending in the United States District Court for the Eastern District of Michigan under the caption Jane Simpson, et al. v. Citizens Bank, U.S. District Court Case No. 2:12-cv-10267, while the state court action was dismissed. Citizens has filed a motion to dismiss the consolidated federal action, which motion is currently pending. This litigation is still in its early stages and there can be no assurance that the outcome will not be adverse to Citizens. However, based on the information currently known, Citizens does not believe the resolution of this litigation will have a material adverse effect on its results of operations, cash flows or financial condition.
Between September 17, 2012 and October 5, 2012, alleged shareholders of Citizens filed six purported class action lawsuit in the Circuit Court of Genesee County, Michigan, which have been consolidated as In re Citizens Republic Bancorp, Inc. Shareholder Litigation, Case No. 12-99027-CK (the “Lawsuit”). The consolidated complaint (the “Complaint”) names as defendants Citizens, each of the current members of Citizens’ board of directors and FirstMerit. It alleges that the director defendants breached their fiduciary duties by failing to obtain the best available price in connection with the merger, by not utilizing a proper process to evaluate the merger and by agreeing to protective devices that ensure that no entity other than FirstMerit will seek to acquire Citizens. The Complaint also alleges that FirstMerit and Citizens aided and abetted those alleged breaches of fiduciary duty. The Complaint seeks declaratory and injunctive relief to prevent the consummation of the merger, rescissory damages and other equitable relief. The defendants filed a motion to dismiss the Complaint.
On February 21, 2013, the plaintiffs and defendants entered into a memorandum of understanding (the “MOU”) setting forth their agreement in principle to settle the Lawsuit. While the defendants deny the allegations made in the Complaint, they have agreed to enter into the MOU to avoid the costs and disruptions of any further litigation and to permit the timely closing of the Merger. The MOU describes the terms that the parties have agreed to include in the final settlement agreement concerning the Complaint (the “Settlement Agreement”), subject to confirmatory discovery by the plaintiffs, and describes the actions that the parties will take or refrain from taking between the date of the MOU and the date that the Settlement Agreement is finally approved.
The MOU, among other things, provided that the Defendants would amend the joint proxy statement/prospectus filed on February 21, 2013, to include the supplemental disclosures contained in the MOU. The MOU also provides that the Settlement Agreement will include an injunction against proceedings in connection with the Complaint and any additional complaints concerning claims that will be covered by the Settlement Agreement. In addition, the MOU provides that the Settlement Agreement will include a release on behalf of the plaintiffs, along with other members of the class of Citizens’ shareholders certified for purposes of the Settlement Agreement, in favor of the defendants and their related parties from any claims that arose from or are related to the Merger. The Defendants have agreed to pay the plaintiffs’ attorneys’ fees and expenses as awarded by the court, subject to court approval of the Settlement Agreement and the consummation of the Merger.
We do not believe the costs associated with the Settlement Agreement or the MOU will have a material impact on Citizens’ financial condition, results of operations or liquidity.
From time to time, the Bank is notified by applicable environmental regulatory agencies, pursuant to state or federal environmental statutes or regulations, that they may be potentially responsible parties (“PRP”) for environmental contamination on or emanating from properties currently or formerly owned. Typically, exact costs of remediation of the contamination cannot be fully determined at the time of initial notification. While, as PRPs, the Bank is potentially liable for the costs of remediation, in most cases, a number of other PRPs have been identified as being jointly and severally liable for remediation costs. Additionally, in certain cases, statutory defenses to liability for remediation costs may be asserted based on the Bank’s status as a lending institution that acquired ownership of the contaminated property through foreclosure. Citizens is not presently aware of any environmental liabilities that pose a reasonable possibility of future material impact on its results of operations. It is Citizens’ policy to establish and accrue appropriate reserves for all such identified exposures during the accounting period in which a loss is deemed to be probable and the amount is determinable.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Holding Company’s common stock is traded on NASDAQ under the symbol “CRBC”. There were approximately 24,500 shareholders of the Holding Company’s common stock as of December 31, 2012, which includes record holders and individual participants in security position listings.
Information regarding the Holding Company’s high and low stock prices during each quarter of the last two fiscal years is set forth in the table below. The Holding Company is currently prohibited from paying cash dividends or repurchasing shares of common stock without the prior written consent of the U.S. Treasury and none have been paid during the last three years. Also, the Holding Company is unable to pay common stock dividends or engage in common stock repurchases until the TARP Preferred Stock dividend payments and payments deferred under our trust preferred securities are no longer in arrears. Restrictions on the Holding Company’s ability to pay dividends are described in “Item 1 Business - Supervision and Regulation” and such descriptions are incorporated herein by reference.
(1) Prices retroactively adjusted to reflect the 1-for-10 reverse stock split effective after the close of trading on July 1, 2011.
In addition, the information under the caption “Equity Compensation Plan Information” under Item 12 of this Report is incorporated herein by reference.
Stock Performance Graph
The following graph summarizes the annual percentage change in the cumulative total shareholder return of the Holding Company’s common stock for the last five years compared with the Keefe, Bruyette & Woods Regional Banking Index (Ticker: KRX) and the S&P 500 Index (Ticker: SPX). The graph assumes the investment in Citizens’ common stock and each index was $100 on December 31, 2007 and the reinvestment of all dividends. The returns shown are not necessarily indicative of future performance.
The information furnished under the heading “Stock Performance Graph” shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section, and such information shall not be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended.
Issuer Purchases of Equity Securities
(1) Shares repurchased in connection with taxes due from employees as a result of the vesting of certain restricted share awards in accordance with the related grant agreements. These repurchases were not part of the repurchase program approved in October 2003.
(2) In October 2003, the Board of Directors approved the repurchase of 300,000 shares of common stock from time to time in the market. There is no expiration date for the repurchase program. The repurchase of shares is generally prohibited, with certain exceptions, by the CPP Letter Agreement while Treasury continues to hold the related Series A Preferred Stock, by the terms of Citizens’ outstanding trust preferred securities, and is also subject to limitations that may be imposed by applicable securities laws and regulations and the rules of NASDAQ. The timing of the purchases and the number of shares to be bought at any one time also depend on market conditions and Citizens’ capital requirements. There can be no assurance that Citizens will repurchase the remaining shares authorized to be repurchased.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below is derived from Citizens’ audited consolidated financial statements and should be read in conjunction with its Consolidated Financial Statements for the years ended December 31, 2012, 2011, and 2010, and notes thereto and “Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following presents management’s discussion and analysis of Citizens’ financial condition and results of operations for each of the past three years and should be read in conjunction with the accompanying Consolidated Financial Statements and Notes. The discussion highlights the principal factors affecting earnings (loss) for the years 2012, 2011, and 2010 and the significant changes in balance sheet items from December 31, 2011 to December 31, 2012 and is intended to help the reader understand, from management’s perspective, the consolidated financial statements, notes to financial statements, and the accompanying tables, charts and financial statistics appearing elsewhere in this report. Where applicable, this discussion also reflects management’s insights regarding known events and trends that have or may reasonably be expected to have a material effect on Citizens’ operations and financial condition. All share and per share amounts have been adjusted to reflect the 1-for-10 reverse stock split that became effective July 1, 2011.
Forward-Looking Statements
Discussions and statements in this report that are not statements of historical fact, including without limitation statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “anticipate,” “estimate,” “project,” “intend,” and “plan,” and statements regarding Citizens’ future financial and operating results, plans, objectives, expectations and intentions, are forward-looking statements that involve risks and uncertainties, many of which are beyond Citizens’ control or are subject to change. No forward-looking statement is a guarantee of future performance and actual results could differ materially. Factors that could cause or contribute to such differences include, without limitation, risks and uncertainties detailed from time to time in Citizens’ filings with the SEC, including those listed in “Item 1A. Risk Factors” of this report.
Other factors not currently anticipated may also materially and adversely affect Citizens’ results of operations, cash flows, financial position, and prospects. There can be no assurance that future results will meet expectations. While Citizens believes that the forward-looking statements in this report are reasonable, the reader should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. Citizens does not undertake, and expressly disclaims any obligation to update or alter any statements, whether as a result of new information, future events or otherwise, except as may be required by applicable law.
OVERVIEW
Nature of Citizens’ Business
Citizens is a diversified banking and financial services company that provides a full range of banking, financial services and wealth management services to individuals and businesses through its subsidiary, Citizens Bank. Citizens conducts operations through 219 offices and 248 ATM locations throughout Michigan, Wisconsin, and Ohio. Citizens operates in five major business lines: Regional Banking, Specialty Consumer, Specialty Commercial, Wealth Management, and Other. Citizens’ performance is monitored by an internal profitability measurement system that provides line of business results as presented in “Line of Business Results” and Note 15 to the Consolidated Financial Statements, incorporated herein by reference.
Citizens’ primary source of revenue is net interest income, which is the difference between interest income on earning assets (such as loans and securities) and interest expense on liabilities (such as interest-bearing deposits and borrowings) used to fund those assets. Net interest income is affected by fluctuations in the amount and composition of earning assets and funding sources and in the yields earned and rates paid, respectively, on these assets and liabilities. Citizens’ measures the level of interest income relative to earning assets and interest bearing liabilities through two statistics-interest spread and net interest margin. The interest spread represents the difference between the taxable equivalent yields on earning assets and the rates paid for interest-bearing liabilities. The net interest margin is expressed as the percentage of taxable equivalent net interest income to average earning assets. Citizens’ sensitivity to changes in interest rates and the potential effect of changes in interest rates on net interest income is presented in more detail in “Interest Rate Risk”.
Proper management of the volume and composition of the Citizens’ earning assets and funding sources is essential for ensuring strong and consistent earnings performance, maintaining adequate liquidity and limiting exposure to risks caused by changing market conditions. Citizens’ investment securities portfolio is structured to provide a source of liquidity principally through the maturity of the securities held in the portfolio and to generate an income stream with relatively low levels of principal risk. Loans comprise the largest component of earning assets and are the highest yielding assets. Client deposits are the primary source of funding for earning assets while short-term debt and other managed sources of funds are utilized as market conditions and liquidity needs change.
Citizens monitors and manages its liquidity position so that funds will be available at a reasonable cost to meet client cash flow needs, while maintaining funds available for loan and investment opportunities as well as to service debt, invest in its subsidiary, finance business expansion, satisfy other operating requirements and take advantage of unforeseen opportunities. Citizens derives its liquidity through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. Citizens also has access to market borrowing sources for both short-term and long-term purposes.
Citizens’ other principal source of revenue is noninterest income, particularly fees and other revenue from financial services provided to customers. Citizens’ noninterest income includes service charges on deposit accounts, trust fees related to personal, institutional and employee benefit products and services, revenue related to loan products, including commercial loan fees and mortgage banking revenue, and fees for various other services, such as brokerage and investment services, ATM network use, and other financial services.
Performance Summary
An analysis of the major components of net income (loss) is presented below.
Three Year Summary of Net Income Components
(1) Amounts contained in “Other Income” on Consolidated Statement of Operations.
(2) Pre-tax pre-provision profit (non-GAAP) defined in “Use of Non-GAAP Financial Measures.”
Key factors behind the changes in results for 2012 compared with 2011 were:
•
The decrease in net interest income was primarily a result of a decrease of $317.3 million in average earning assets. Additionally, net interest margin dropped by two basis points to 3.56%. The decrease in average earning assets was primarily due to reductions in our loan portfolio, particularly in the commercial real estate business, as well as smaller decreases in the residential mortgage and direct consumer portfolios. These reductions were partially offset by substantial increases in the commercial and industrial and indirect portfolios, as well as investment securities. The decrease in net interest margin was primarily the result of the continued low interest rate environment, which has resulted in reduced yields on our earning assets. The negative effects on asset yields were almost fully offset by a more advantageous funding mix and reduced funding costs.
•
The decrease in the provision for loan losses in 2012 was primarily a result of the continuing improvement of the credit metrics within our business. During 2012, we experienced improvement in virtually every credit metric including delinquencies, non-performing assets, and charge offs.
•
Noninterest income dropped 3% compared to 2011 as clients changed their behavior relative to penalty fees and product choices. Additionally, we experienced a net loss in loans held for sale in 2012 while we recorded gains in 2011. The loss in 2012 was driven by a $2.7 million charge related to one commercial loan relationship in the loans held for sale portfolio.
•
The decrease in noninterest expense was the result of a reduction in credit related expenses including gains or losses on ORE, ORE expenses and other loan expense. These reductions were partially offset by increased employment and merger related costs.
•
The large increase in the income tax benefit was driven almost entirely by the elimination of our valuation allowance on the deferred tax asset.
•
Pre-tax pre-provision profit decreased approximately $10.0 million due largely to reduced net interest income discussed above.
SIGNIFICANT DEVELOPMENTS
Business Combination
On September 13, 2012, Citizens and FirstMerit Corporation (“FirstMerit”) announced the signing of a definitive agreement under which FirstMerit will acquire Citizens in a stock-for-stock merger transaction. Under the terms of the agreement, Citizens’ common shareholders will receive 1.37 shares of FirstMerit common stock in exchange for each share of Citizens’ common stock.
FirstMerit is also required to repay at closing Citizens’ approximately $355 million of TARP preferred stock, which includes $55 million of estimated deferred dividends, held by the U.S. Treasury. The merger has been unanimously approved by the Boards of Directors of both Citizens and FirstMerit and is subject to customary closing conditions, including receipt of regulatory approvals and approval by both companies’ shareholders. The transaction is expected to close in the second quarter of 2013.
Payments resumed on Trust Preferred Securities
On December 10, 2012, Citizens announced that it will resume interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities. Regularly scheduled quarterly interest payments were deferred in January 2010 although Citizens continued to accrue for the obligations. Payment on the variable rate junior subordinated debentures due June 2033 was made on December 26, 2012 for the 12 payments due or deferred plus interest and dividends on the associated trust preferred securities were made to holders of record on December 15, 2012. Payment on the 7.50% junior subordinated debentures due September 2066 (NYSE: CTZ-PrA) along with dividends on the associated trust preferred securities will be made in March 2013. In the aggregate, Citizens’ accrued obligation for these deferred payments as of December 31, 2012 was approximately $12 million. Citizens intends to resume the regular quarterly interest payment schedule.
Reversal of the Valuation Allowance on our Deferred Tax Asset
During 2012, Citizens recorded an income tax benefit of $273.0 million primarily the result of eliminating the valuation allowance against our deferred tax asset that had been established as of December 2008. Following Citizens’ quarterly review of the deferred tax asset at June 30, 2012, Citizens determined that the deferred tax asset valuation allowance was no longer necessary. As of December 31, 2012, the recorded balance of the net deferred tax asset was $272.9 million.
Termination of the Written Agreement with FRBC and OFIR
On July 28, 2010, Citizens and Citizens Bank entered into a written supervisory agreement with the FRBC and OFIR, their primary regulators. Effective April 17, 2012, the Federal Reserve Bank of Chicago and the Michigan Office of Financial and Insurance Regulation terminated the written agreement.
Reverse Stock Split
Citizens affected a 1-for-10 reverse stock split of its common stock effective after the close of trading on July 1, 2011. Citizens common stock began trading on a split adjusted basis on The NASDAQ Capital Market at the opening of trading on July 5, 2011.
Proportional adjustments were made to Citizens’ equity based plans as well as outstanding options, warrants and other securities entitling their holders to purchase or receive shares of Citizens common stock so that the reverse stock split did not materially affect any of the rights of holders of those securities.
Resolution of Problem Assets
In an effort to reduce overall problem asset levels, Citizens resolved $460.0 million of problem assets in the first quarter of 2011 and $466.2 million of problem assets in the fourth quarter of 2010 through a combination of bulk sales and individual workouts, recording a provision for loan losses of $88.7 million and $131.3 million and net charge-offs of $160.6 million and $159.3 million in the first quarter of 2011 and fourth quarter of 2010, respectively. These resolution efforts led to substantial decreases in the provision for loan losses in the second half of 2011, significantly reduced the outstanding amount of nonperforming loans and watchlist loans and improved the credit quality of our loan portfolio.
Discontinued Operations
On April 23, 2010, Citizens completed the sale of its wholly owned subsidiary, F&M Bank-Iowa (“F&M”) to Great Western Bank in exchange for $50.0 million in cash. The price represented approximately 25 times F&M’s average earnings and 1.10 times its tangible book value. The sale proceeds improved Citizens’ capital and liquidity positions in a manner that was non-dilutive to shareholders.
The financial condition and operating results for this subsidiary have been segregated from the financial condition and operating results of Citizens’ continuing operations throughout this report and, as such, are presented as a discontinued operation. While all prior periods have been revised retrospectively to align with this treatment, these changes do not affect Citizens’ reported consolidated financial condition or operating results for any of the prior periods.
Use of Non-GAAP Financial Measures
In addition to results presented in accordance with generally accepted accounting principles in the United States (“GAAP”), this report includes non-GAAP financial measures such as net interest margin, efficiency ratio, tangible equity to tangible assets ratio, tangible common equity to tangible assets ratio, Tier 1 common equity ratio and pre-tax pre-provision profit. Citizens believes these non-GAAP financial measures provide additional information that is useful to investors in understanding the underlying performance of Citizens, its business, and performance trends and, to a lesser degree, such measures may help facilitate performance comparisons with others in the banking industry. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. Readers should be aware of these limitations and should be cautious as to their use of such measures. To mitigate these limitations, Citizens has procedures in place to ensure that these measures are calculated using the appropriate GAAP or regulatory components in their entirety and to ensure that Citizens’ performance is properly reflected to facilitate consistent period-to-period comparisons. Although Citizens believes the non-GAAP financial measures disclosed in this report enhance investors’ understanding of its business and performance, these non-GAAP measures should not be considered in isolation, or as a substitute for GAAP basis financial measures.
Net Interest Margin and Efficiency Ratio (non-GAAP financial measures)
In accordance with industry standards, certain designated net interest income amounts are presented on a taxable equivalent basis, including the calculation of net interest margin and the efficiency ratio. Citizens believes the presentation of net interest margin on a taxable equivalent basis using a 35% effective tax rate allows comparability of net interest margin with industry peers by eliminating the effect of the differences in portfolios attributable to the proportion represented by both taxable and tax-exempt investments. See “Item 6 Selected Financial Data,” the Non-GAAP Reconciliation Table, and the Average Balances/Net Interest Income/Average Rates Table later in this report for additional information.
Tangible Equity, Tangible Common Equity and Tier 1 Common Equity Ratios (non-GAAP financial measures)
Citizens believes the exclusion of goodwill and other intangible assets to create “tangible assets” and “tangible equity” facilitates the comparison of results for ongoing business operations. Citizens’ management internally assesses the company’s performance based, in part, on these non-GAAP financial measures. The tangible common equity ratio and Tier 1 common equity ratio have become a
focus of some investors and management believes that these ratios may assist investors in analyzing Citizens’ capital position absent the effects of intangible assets and preferred stock. Because tangible common equity and Tier 1 common equity are not formally defined by GAAP or codified in the federal banking regulations, these measures are considered to be non-GAAP financial measures. Because analysts and banking regulators may assess Citizens’ capital adequacy using tangible common equity and Tier 1 common equity, Citizens believes that it is useful to provide investors the ability to assess its capital adequacy on the same basis. Tier 1 common equity is often expressed as a percentage of net risk-weighted assets. Under the risk-based capital framework, a bank’s balance sheet assets and credit equivalent amounts of off-balance sheet items are assigned to one of four broad risk categories. The aggregated dollar amount in each category is then multiplied by the risk weight assigned to that category. The resulting weighted values from each of the four categories are added together and this sum is the risk-weighted assets total that, as adjusted, comprises the denominator of certain risk-based capital ratios. Tier 1 capital is then divided by this denominator (net risk-weighted assets) to determine the Tier 1 capital ratio. Adjustments are made to Tier 1 capital to arrive at Tier 1 common equity as shown in the Non-GAAP Reconciliation Table below. The amounts disclosed as net risk-weighted assets are calculated consistent with banking regulatory requirements.
Pre-tax Pre-Provision Profit (non-GAAP financial measure)
Pre-tax pre-provision profit (“PTPP”), as defined by Citizens’ management represents total revenue (total net interest income and noninterest income) excluding any securities gains/losses, fair value adjustments on loans held for sale, interest rate swaps, and bank owned life insurance, less noninterest expense excluding any goodwill impairment charges, credit writedowns, fair value adjustments, merger-related expenses, and special assessments. While certain of these items are an integral part of Citizens’ banking operations, in each case, the excluded items are items that management believes are particularly impacted by economic stress or significant changes in the credit cycle and are therefore likely to make it more difficult to understand our underlying performance trends and the ability of our banking operations to generate revenue. Net interest income, noninterest income and noninterest expense are all calculated in accordance with GAAP and are presented in the Consolidated Statements of Operations. While noninterest income and noninterest expense are adjusted for the specific items listed above in the calculation of PTPP, these adjustments represent the excluded items in their entirety for each period presented to better facilitate period-to-period comparisons.
Viewed together with Citizens’ GAAP results, PTPP provides management, investors, and others with a useful metric to evaluate and better understand trends in Citizens’ period-to-period earnings power and ability to generate capital to cover credit losses, in each case exclusive of the effects of the current and recent economic stress and the credit cycle. As recent results for the banking industry demonstrate, loan charge-offs, related credit provision, and credit writedowns can vary significantly from period to period, making a measure that helps isolate the impact of credit costs on profitability all the more important to investors. The “Credit Quality” section of this report discusses the quality of Citizens’ loan portfolio and the impact on Citizens’ earnings as reflected in the provision for loan losses.
A portion of the compensation awarded to Citizens’ Named Executive Officers and certain other management employees for their performance in 2011 and 2012 is measured against a PTPP performance target as Citizens believes that PTPP is a key measurement that helps keep revenue generation as a focus for its business and a particularly valuable measure during challenging credit cycles. Based on 2011 full year results, the total cash compensation award linked to PTPP was $0.8 million. Additionally, during 2011, approximately 186,500 shares of restricted stock were granted which have a two-year vesting period based partially on PTPP results and partially on net income. Based on 2012 full year results, the total potential cash compensation award linked to PTPP is $1.6 million, payable in early 2013. The grants are designed so that a portion of the compensation is based on net income while the remainder does not depend on management’s performance with regard to managing loan losses, securities impairments, merger related expenses, and other asset impairments.
Like all non-GAAP metrics, PTPP’s usefulness is inherently limited. Because Citizens’ calculation of PTPP may differ from the calculation of similar measures used by other bank holding companies, PTPP should be used to determine and evaluate period to period trends in Citizens’ performance and in
comparison to Citizens’ loan charge-offs, related credit provision, and credit writedowns, rather than in comparison to non-GAAP metrics used by other companies. In addition, investors should bear in mind that income tax expense (benefit), the provision for loan losses, and the other items excluded from revenues and expenses in the PTPP calculation are recurring and integral expenses to Citizens’ banking operations, and that these expenses will still accrue under GAAP, thereby reducing GAAP earnings and, ultimately, shareholders’ equity.
The following table displays the calculation for the past three years of these non-GAAP measures other than pre-tax pre-provision profit, the calculation of which is set forth in the “Performance Summary” section.
Non-GAAP Reconciliation
RESULTS OF OPERATIONS
NET INTEREST INCOME
An analysis of net interest income, interest spread and net interest margin with average balances and related interest rates is presented below.
(1) Interest income is shown on actual basis and does not include taxable equivalent adjustments.
(2) Average rates are presented on an annual basis and include taxable equivalent adjustments to interest income of $6.1 million, $7.5 million and $10.6 million for the years ended December 31, 2012, 2011 and 2010, respectively, based on a tax rate of 35%.
(3) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
(4) Nonaccrual loans are included in average balances for each applicable loan category.
(5) The interest spread and net interest margin are presented on a tax-equivalent basis.
(6) Because noninterest-bearing funding souces, demand deposits, other liabilities and shareholders’ equity also support earning assets, the net interest margin exceeds the interest spread.
2012 compared with 2011
The decrease in net interest margin was primarily the result of lower earning assets and the continued low interest rate environment, which resulted in a slightly reduced yield on our earning assets. The negative effects on asset yields were almost fully offset by a more advantageous funding mix and reduced funding costs. Average earning assets decreased $317.3 million. Additionally, net interest margin dropped by two basis points to 3.56%. The decrease in average earning assets was primarily due to reductions in our loan portfolio, particularly in the commercial real estate business, as well as smaller decreases in the residential mortgage and direct consumer portfolios. These reductions were partially offset by substantial increases in the commercial and industrial and indirect portfolios as well as investment securities.
2011 compared with 2010
The increase in net interest margin was primarily the result of declining deposit costs, reductions in high-cost funding, lower levels of nonperforming assets and a planned reduction in excess cash and money market investments, partially offset by lower investment securities yields. The decrease in net interest income was primarily the result of a decrease in average earning assets due to the effects of the accelerated problem asset resolution initiatives completed during the first half of 2011.
The table below shows changes in interest income, interest expense and net interest income due to volume and rate variances for major categories of earning assets and interest-bearing liabilities.
Analysis of Changes in Interest Income and Interest Expense
(1) Changes are based on actual interest income and do not reflect taxable equivalent adjustments.
(2) The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar amounts of the change in each.
2012 compared with 2011
The decrease in net interest income reflects rate and volume variances that are unfavorable in the aggregate. The unfavorable rate variance was primarily the result of the continued low interest rate environment, which has resulted in reduced yields on our earning assets. The negative effects on asset yields were partially offset by a more advantageous funding mix and reducing funding costs. The negative volume variance is the result of a lower level of average earning assets.
2011 compared with 2010
The decrease in net interest income reflects volume variances that were unfavorable in the aggregate and rate variances that were favorable in the aggregate. The unfavorable volume variance was primarily due to the reduction in the loan portfolios as a result of the accelerated problem asset resolution initiative, partially offset by an increase in the taxable investment securities portfolio and a decrease in time deposits and long term debt.
The favorable rate variance was primarily the result of borrowings repricing to lower rates as a result of lower market interest rates in 2011 and reduced deposit price competition, partially offset by lower reinvestment yields for investment securities and intensified price competition for commercial and industrial loans.
PROVISION FOR LOAN LOSSES
After determining what Citizens believes is an appropriate allowance for loan losses based on the inherent risk in the portfolio, the provision for loan losses is calculated each quarter as a result of the net effect of the quarterly change in the allowance for loan losses and the quarterly net charge-offs. The decreases in the provision for loan losses for 2012 compared with 2011 as well as 2011 to 2010 were primarily due to our focused efforts to improve asset quality, stabilized portfolio credit metrics and an overall decrease in loan balances. See “Critical Accounting Policies - Allowance for Loan Losses” and “Allowance for Loan Losses” for a discussion of the calculation of the allowance and the related methodology.
NONINTEREST INCOME
An analysis of the components of noninterest income is presented in the table below.
Noninterest Income
2012 compared with 2011
Noninterest income dropped 3.1% compared to 2011. We experienced a net loss on loans held for sale in 2012 while we recorded gains in 2011. The loss in 2012 was driven by a $2.7 million charge related to one commercial loan relationship in the category. Changes in the other noninterest items were largely offsetting. Service charges on deposit accounts were lower as clients changed their behavior relative to penalty fees and product choices. Mortgage and other loan income were down due to a decline in commercial letter of credit fees and derivative income, partially offset by increased mortgage origination volume. Brokerage and investment fees performed well due to increased focus to improve performance.
2011 compared with 2010
Noninterest income was essentially unchanged from last year, with gains on loans held for sale, offset by investment securities losses and lower other income. The gain on loans held for sale was offset by fewer writedowns to reflect fair value declines of the underlying collateral in 2011 compared to 2010. Citizens recorded net losses on investment securities compared to net gains in 2010 directly related to the sale of four CMOs during 2011 at a loss, and a gain on sale of securities in 2010 as part of Citizens’ capital strategy. The decline in other income reflects a decrease in interest rate swap income recognition and unrealized losses on deferred compensation plans.
NONINTEREST EXPENSE
An analysis of the components of noninterest expense is presented in the table below.
Noninterest Expense
2012 compared with 2011
The decrease in noninterest expense was the result of a substantial reduction in credit related expenses including reduced losses on ORE, ORE expenses and other loan expense. These expenses were lower in 2012 due to the continued improvement in our credit quality. These reductions were partially offset by increased salaries and benefits costs resulting from increased incentives due to better performance and a fuller staff compliment. The increase in professional services is related to our pending merger with FirstMerit.
2011 compared with 2010
The decrease in noninterest expense was the result of decreases in all noninterest expense categories, primarily lower other expenses, lower other loan expense, lower salaries and employee benefits, lower data processing services and lower professional services. The decline in other expenses was primarily related to reductions in FDIC insurance costs. Lower other loan expense was primarily the result of lower commercial and residential mortgage origination volume and foreclosure-related expenses. The decline in salaries and employee benefits, professional services and data processing services reflect the continued focus on improving efficiencies.
FDIC insurance premiums
In 2011, the FDIC implemented a rule that changed the assessment base from domestic deposits to average assets minus average tangible equity, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund. The rule finalized a target size for the DIF at 2 percent of insured deposits. It also implemented a lower assessment rate schedule when the fund reaches 1.15 percent so that the average rate over time should be about 8.5 basis points of the assessment base and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent. The rule, in aggregate, increased the share of assessments paid by large institutions and created a scorecard-based assessment system for banks with more than $10 billion in assets. The scorecards include financial measures that the FDIC believes are predictive of long-term performance. The new rule did not have a material effect on our results of operations and financial condition as assets were below $10 billion in 2012 and 2011.
FEDERAL AND STATE INCOME TAXES
Citizens recorded an income tax benefit of $273.0 million for 2012 compared with a tax benefit of $20.3 million for 2011 and a tax expense of $12.9 million in 2010. The tax benefit in 2012 was primarily the result of eliminating the valuation allowance against our deferred tax asset. The tax benefit in 2011 was primarily the result of recording a receivable due to the change in a tax election and changes in other components of income that are included in the calculation of the tax provision. The tax expense in 2010 was primarily the result of alternative minimum tax calculations.
In assessing whether or not some or all of our deferred tax assets are more likely than not to be realized in the future, we consider all available positive and negative evidence, including projected future taxable income, tax planning strategies and recent financial operations. Based on an evaluation of the then-available positive and negative evidence, Citizens determined it was appropriate to establish a full valuation allowance on our deferred tax asset as of December 31, 2008. At that time, and in subsequent quarters, negative evidence, including a recent cumulative history of operating losses, outweighed the positive evidence.
However, at June 30, 2012, the positive evidence outweighed the negative evidence and Citizens determined that a deferred tax asset valuation allowance was no longer necessary. The significant positive evidence in our analysis included: five consecutive quarters of profitability, termination of the written agreement with our primary regulators, improved capital levels, solid credit metrics, strong deposit mix, reduced regulatory risk, and a stabilizing economy.
The positive evidence continued through the remainder of 2012 including seven consecutive quarters of profitability, continued strong credit metrics, and other items noted above. As a result we continue to believe that the positive evidence outweighs the negative evidence and no valuation allowance is necessary at December 31, 2012.
During 2009, we incurred an ownership change within the meaning of Section 382 of the Internal Revenue Code. As a result, federal tax law places an annual limitation of approximately $17.7 million on the amount of certain loss carryforwards that may be used.
For further discussion of federal and state income taxes, see Note 13 to the Consolidated Financial Statements.
LINE OF BUSINESS RESULTS
Net income or loss by line of business is presented in the table below. A description of each business line, important financial performance data and the methodologies used to measure financial performance are presented in Note 15 to the Consolidated Financial Statements. Certain amounts have been revised retrospectively for discontinued operations.
2012 compared with 2011
Net income for Regional Banking increased primarily due to lower provision for loan losses, partially offset by lower net interest income and increased income tax expense. The decrease in the provision for loan losses reflected the results of our focused efforts to improve asset quality and stabilized portfolio credit metrics. The decrease in net interest income reflected the decline in loan balances. Income taxes increased due to the improvement in pre-tax earnings.
Specialty Consumer recorded net income in 2012, compared to a net loss in 2011 primarily due to lower provision for loan losses, which reflects the results of our focused efforts to improve asset quality, stabilized portfolio credit metrics as well as an overall decrease in loan balances.
Specialty Commercial recorded net income in 2012, compared to a net loss in 2011 primarily due to lower provision for loan losses and higher net interest income. The decrease in the provision for loan losses reflected the results of our focused efforts to improve asset quality and stabilized portfolio credit metrics. The increase in net interest income was directly related to an increase in commercial and industrial lending.
Net income for Wealth Management decreased primarily as a result of lower trust income due to a lower level of trust assets under administration.
Activities that are not directly attributable to one of the primary lines of business are included in the Other business line. Included in this category are the Holding Company; the shared services unit; Citizens’ treasury unit, including the securities portfolio, short-term borrowing and asset/liability management activities; inter-company eliminations; and the economic impact of certain assets, capital and support functions not specifically identifiable with the four primary lines of business. Net income for the Other line of business increased primarily as a result of lower income taxes as a result of the reversal of the deferred tax valuation allowance, partially offset by lower net interest income. Changes in income taxes reflect an allocation of 35% to all other lines of businesses in 2012 and 2011.
2011 compared with 2010
Regional Banking recorded net income in 2011, compared to a net loss in 2010 primarily due to lower provision for loan losses, partially offset by lower net interest income. The decrease in the provision for loan losses reflected the results of our focused efforts to improve asset quality and stabilized portfolio credit metrics as well as an overall decrease in loan balances. The decrease in net interest income reflected the decline in loan balances due to the resolution of problem assets.
Net losses for Specialty Consumer decreased primarily due to lower provision for loan losses and higher noninterest income due to credit writedowns in 2010 associated with the bulk sale of nonperforming residential mortgage loans.
Net losses for Specialty Commercial decreased primarily due to lower provision for loan losses and higher noninterest income, partially offset by lower net interest income. The decrease in the provision for loan losses reflected the results of our focused efforts to improve asset quality and stabilized portfolio credit metrics as well as an overall decrease in loan balances. The increase in noninterest income reflected fewer writedowns associated with loans held for sale. The decrease in net interest income reflected the decline in loan balances due to the resolution of problem assets.
Net income for Wealth Management increased primarily as a result of a decrease in noninterest expense relating to decreases in salaries and employee benefits expense and lower data processing expenses.
The Other line of business recorded net income for 2011, compared to a net loss in 2010 primarily as a result of higher net interest income, lower noninterest expense, lower discontinued operations and lower taxes. These improvements were partially offset by lower noninterest income. The increases in net interest income were primarily the result of the internal profitability methodology utilized at Citizens that insulates the other lines of business from interest-rate risk and assigns the risk to the asset/liability management function, which is a component of this segment. The decrease in noninterest expense was primarily the result of a decrease in FDIC insurance costs, as well as a continued focus on improving efficiencies. The 2010 loss on discontinued operations was directly related to the fair value adjustment related to the sale of F&M. The decrease in noninterest income was primarily the result of net gains on investment securities sales during 2010. Changes in income taxes reflect an allocation of 35% to all other lines of businesses in 2011 and 2010.
FINANCIAL CONDITION
TOTAL ASSETS
Total assets at December 31, 2012 were $9.6 billion, an increase of $123.8 million or 1.3% from December 31, 2011. The increase was due to the restoration of the deferred tax asset, and increases in investment securities, partially offset by a reduction in loan balances.
MONEY MARKET INVESTMENTS AND INVESTMENT SECURITIES
Objectives in managing the securities portfolio are driven by the dynamics of the balance sheet, including growth, maturity, management of interest rate risk and maximizing return. On October 6, 2008 the FRB announced that it would pay interest on required and excess reserve balances at rates close to the targeted federal funds rates. Citizens has chosen to utilize this program while adverse conditions exist in the credit markets. Securities are classified as available for sale or held to maturity and as of December 31, 2012, 58.1% of the securities in Citizens’ investment securities portfolio were classified as available for sale. A summary of investment securities balances is provided below.
Investment Securities
Citizens maintained the risk profile of its investment securities portfolio during 2012 by increasing holdings of GNMA or agency-issued mortgage-backed securities and decreasing holdings of municipal and whole-loan mortgage-backed securities.
In June 2011 and December 2010, Citizens transferred certain mortgage-backed securities from the available for sale to the held to maturity category in accordance with Topic 320 “Investments-Debt and Equity Securities.” Management determined that it had both the ability to hold these investments to maturity and the positive intent to do so. The securities transferred in June 2011 had a total amortized cost of $924.6 million and a fair value of $943.1 million. The securities transferred in December 2010 had a total amortized cost of $179.2 million and a fair value of $181.8 million. The unrealized gain of $18.5 million in June 2011 and $2.6 million in December 2010 will be amortized over the remaining life of the securities as an adjustment of the yield, offset against the amortization of the unrealized gain maintained in accumulated other comprehensive income.
The collateralized mortgage obligations (“CMO”) sector includes securities where the underlying collateral consists of agency issued or whole loan mortgages. At December 31, 2012, the whole loan CMOs had a market value of $58.9 million with gross unrealized losses of $0.6 million. Citizens performs a thorough
credit review on a quarterly basis on the underlying mortgage collateral as well as the supporting credit enhancement and structure. The results of the December 31, 2012 credit review demonstrated continued strength and no material degradation to the holdings. Additionally, Citizens determined there is no other-than-temporary impairment on any security in the investment portfolio at December 31, 2012.
Maturities and average yields of investment securities are presented in the table below.
Maturity Distribution of Investment Securities Portfolio (1)
(1) This table excludes stock holdings of the Federal Home Loan Bank and Federal Reserve.
(2) Yields are based on amortized cost and are purchase yields.
(3) Maturity distributions for collateralized mortgage obligations and mortgage-backed securities are based on estimated average lives.
(4) Average yields on tax-exempt obligations have been computed on a tax equivalent basis, based on a 35% federal tax rate.
As of December 31, 2012, the estimated aggregate fair value of the investment securities portfolio was $109.2 million above amortized cost, consisting of gross unrealized gains of $109.9 million and gross unrealized losses of $0.7 million. Except for obligations of the U.S. Government and its agencies, no holdings of securities of any single issuer exceeded 10% of consolidated shareholders’ equity at December 31, 2012 or 2011. A summary of estimated fair values and unrealized gains and losses for the major components of the investment securities portfolio is provided in Note 2 to the Consolidated Financial Statements. Citizens’ policies with respect to the classification of investments in debt and equity securities are discussed in Note 1 to the Consolidated Financial Statements. During 2012, money market deposits decreased to $186.3 million from $313.6 million as funds were invested in higher yielding assets.
LOAN PORTFOLIO
Citizens primarily extends credit within its local markets in Michigan, Wisconsin, and Ohio. Citizens generally lends to consumers and small to mid-sized businesses and, consistent with its emphasis on relationship banking, most of these credits represent core, multi-relationship customers who also maintain deposit relationships and utilize other banking services such as treasury management. The loan portfolio is diversified by borrower and industry, with no concentration within a single industry segment that exceeds 10% of total portfolio loans. Citizens has minimal loans to foreign debtors. Citizens seeks to limit its credit risk by reviewing the aggregate outstanding commitments and loans to particular borrowers and industries. Citizens obtains and monitors collateral based on the nature of the credit and the risk assessment of the customer. See “Underwriting” for a discussion of Citizens’ underwriting policies and practices.
Loan balances by category for the past five years and an analysis of the maturity and interest rate sensitivity of commercial and industrial, and commercial real estate loans at December 31, 2012 are presented below.
Portfolio Loans (1)
Portfolio Loan Maturities and Interest Rate Sensitivity
(1) Excludes mortgage loans held for sale
Increases in commercial and industrial, as well as indirect loans, in 2012 reflect our targeted lending efforts during the year. Decreases in the other categories of portfolio loans during 2012 reflect the paydowns as a result of normal client activity, and continuing efforts to improve the risk profile of Citizens.
Commercial and Industrial. The commercial and industrial loan portfolio includes a diverse group of loans to companies in a variety of businesses across many industries. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment purchases. While some short-term loans may be made on an unsecured basis, the large majority are secured by the assets being financed with collateral margins consistent with Citizens’ loan underwriting guidelines. Commercial and industrial loans are evaluated for adequacy of repayment sources at the time of approval and are regularly reviewed for any possible deterioration in the ability of the borrower to repay on agreed terms. Credit risk in commercial and industrial loans arises due to fluctuations in borrowers’ financial condition, deterioration in collateral values, and changes in market conditions.
Commercial Real Estate. The majority of this portfolio consists of commercial real estate intermediate-term loans to developers and owners of commercial real estate for single and multiple family residential as well as multi-unit commercial properties. These loans are viewed first as cash-flow loans and secondarily as loans secured by real estate.
Commercial real estate loans are subject to underwriting standards and processes specific to the risks embedded in each of the geographic markets served by Citizens, primarily Michigan and Ohio. Management monitors commercial real estate loans based on sustainable cash flow, collateral, geography, and risk rating criteria. As a general rule, Citizens avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. Management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied “investment” real estate loans. At December 31, 2012, approximately 43% of commercial real estate loans were secured by owner-occupied properties.
Citizens proactively manages the credit performance of loans secured by commercial income producing properties. The value of loans in this portfolio have been negatively affected by tenant losses and reduced rental rates. While market conditions have stabilized, Citizens may suffer losses in these segments if market conditions deteriorate or do not continue to improve and efforts to limit these losses through execution of prudent workout strategies are unsuccessful.
Residential Mortgage Loans. The residential mortgage loan category is predominately comprised of single family owner-occupied residential properties primarily located in Michigan and Ohio. Residential mortgage loans are evaluated based on credit scores, debt-to-income ratios and loan-to-collateral value ratios.
Residential Mortgage Loan Balances By Category
Residential Mortgage Loan Origination Volume
(1) All construction mortgages are retained by Citizens in the residential mortgage portfolio.
In June 2008, Citizens entered into a master sales agreement to sell its residential mortgage originations to a third-party servicer at a fixed rate with no recourse. Under this agreement, Citizens sells more than 95% of new mortgage origination, resulting in minimal new loans being retained in the residential mortgage portfolio. During 2012, a total of $3.4 million in originated residential mortgage loans were returned to our portfolios since these loans had characteristics (other than loan amount or new construction) that made them non-compliant with the underwriting standards of government-sponsored entities (“GSE”) Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) and Government National Mortgage Association (“GNMA”). These loans were underwritten with compensating factors such as mortgage insurance, maximum debt to income ratios, maximum loan-to-value ratios and minimum credit scores which Citizens believes offset the additional risks.
Prior to June 2008, when Citizens sold its residential mortgage originations to several secondary market participants, it made various standard representations and warranties. The specific representations and warranties made by Citizens depended on the nature of the transaction and the requirements of the buyer. In the event of a breach of the representations and warranties, Citizens may be required to either repurchase the mortgage loans (generally at unpaid principal balance plus accrued interest) with the identified defects or indemnify the investor. Citizens repurchased $6.2 million and $2.2 million in 2012 and 2011, respectively, of loans pursuant to such provisions. Citizens recorded $6.4 million and $4.3 million in 2012 and 2011, respectively, in Other Expense on the Consolidated Statements of Operations related to repurchasing or indemnifying such loans.
Citizens proactively manages the residential loan portfolio, and in 2011 we started to experience stability with declining levels of delinquencies and nonaccrual loans. While delinquency rates continued to stabilize and drop slightly in 2012, non-accrual loans increased largely due to our adoption of new regulatory guidance relating to clients who filed for bankruptcy and have not reaffirmed the obligation. While real estate values continue to slowly recover, the extended time frame associated with the sale of repossessed residential properties continues to stress this asset category.
Direct Consumer. The direct consumer loan category includes home equity loans and direct installment loans to individuals used to purchase boats, recreational vehicles, automobiles, and other personal items. Home equity loans consist of revolving lines of credit and fixed rate loans to consumers that are secured by residential real estate. Credit risks for these types of loans are influenced by general economic conditions, the financial strength of individual borrowers, and the value of the loan collateral. Credit risk in the direct consumer loan portfolio arises from the borrowers potentially being unable to repay the loan on agreed terms, or by a shortfall in the collateral value in relation to the outstanding loan balance in the event of default and subsequent liquidation of collateral.
Citizens originates consumer loans utilizing a credit scoring model to supplement the underwriting process. To monitor and manage consumer loan risk, policies and underwriting guidelines are developed and modified as market conditions require. This monitoring activity, coupled with relatively small loan amounts spread across many individual borrowers, reduces risk. Additionally, trend and outlook reports are reviewed by management on a regular basis.
Indirect Consumer. The indirect consumer loan category includes indirect installment loans used by customers to purchase boats and recreational vehicles. Credit risks for these types of loans are influenced by general economic conditions, the characteristics of individual borrowers, and the value of loan collateral. Additionally, credit risk may include the dealer’s ability to collect proper customer information, and adhere to appropriate lending guidelines, including but not limited to, evaluating collateral value, accurately capturing property identification numbers, and following related documentation guidelines. Credit risk in the indirect consumer loan portfolio arises from a borrower’s potential inability to repay their loan and by a potential shortfall in the collateral value in relation to the outstanding loan balance in the event of default and subsequent liquidation of collateral. Credit risk is generally controlled by reviewing the creditworthiness of the borrowers as well as taking appropriate collateral and guaranty positions.
LOANS HELD FOR SALE
Loans that Citizens has the intent and ability to sell are classified as held for sale and are carried at the lower of cost or fair value, net of estimated costs to sell. Commercial loans held for sale are comprised primarily of loans identified for sale that are recorded at the lower of carrying amount or fair value based on appraisals of the underlying collateral, which are also subject to management adjustments based on current market conditions and recent sales activity. Fair value may also be measured using the present value of expected future cash flows discounted at an appropriate interest rate. Residential mortgage loans held for sale are comprised of loans originated for sale in the ordinary course of business and selected nonperforming residential mortgage loans. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for similar loans. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral, net of estimated costs to sell, using market prices derived from indicative pricing models which utilize projected assumptions Citizens believes potential investors would make, broker price opinions or appraisals. Gains and losses on the sales of loans are determined using the specific identification method. Subsequent valuation adjustments to reflect current fair value, as well as gains and losses on disposal of these loans are charged to noninterest income as incurred.
Held for sale loans at December 31, 2012 totaled $10.7 million, a $0.3 million or 3% increase from December 31, 2011.
UNDERWRITING
Citizens’ Commercial Credit Policy and Underwriting Guidelines and Citizens’ Consumer Loan Credit Policy and Underwriting Guidelines (together, the “Underwriting Guidelines”) are written in a manner that is consistent with prudent banking practices and regulatory guidance applicable to each loan product. Citizens’ Underwriting Guidelines outline loan requirements and structuring parameters to determine the borrower’s financial capacity to repay under the terms of the loan and evaluate the collateral pledged to secure the loan and are designed to provide an adequate margin of safety for full collection of both principal and interest, within contractual terms. The Underwriting Guidelines provide the framework to determine that the borrower has the financial capacity to fully repay the loan, structurally mitigate credit risks, and monitor the loan’s credit performance over the term of the loan. Additionally, the Underwriting Guidelines are updated periodically in response to market and economic conditions and are reviewed by the Risk Management Committee of the Board as well as Citizens’ full Board of Directors.
The commercial Underwriting Guidelines outline product-and collateral-specific acceptable loan terms and conditions, including maximum loan to value ratios for real estate collateral, advance rates for non-real estate collateral, and debt service coverage. Acceptable credit management practices require that the borrower’s financial capacity to repay the loan be analyzed based on the most recent financial information as specified by the loan’s documented structure. It is Citizens’ general practice to obtain personal guarantees and underwrite the guarantor’s capacity to support the loan no less frequently than annually and more frequently if changes occur in the borrower’s capacity to repay or in general economic conditions that might affect the borrower. Citizens’ Underwriting Guidelines for non-owner occupied commercial real estate loans delineate maximum terms, amortizations and loan to value ratios as well as minimum equity investments and debt service coverage ratios based on property type. Generally, maximum loan terms are five years, maximum amortizations are 25 years, minimum equity requirements range from 10% to 25%, debt service coverage ratios range from 1.2 to 1.5 times and loan to value ratios range from 65% to 80%. Citizens’ Real Estate Appraisal and Environmental Policy specifies the Bank’s requirements for obtaining appraisals from licensed or certified appraisers to assess the value of the underlying collateral. New variable rate commercial loans are underwritten at fully indexed rates. Additionally, variable rate commercial loan underwriting includes stress tests of the borrower’s debt service capabilities with higher than existing interest rates and fluctuations in the underlying cash flows available for repayment.
The consumer Underwriting Guidelines outline product-and collateral-specific loan terms and conditions, including maximum debt ratios and advance rates based on the borrower’s credit score. Residential mortgage loans are evaluated based on credit scores, debt-to-income ratios, and loan to collateral value ratios. They are predominately originated in accordance with underwriting standards set forth by the government-sponsored entities FNMA, FHLMC and GNMA, which serve as the primary purchasers of loans sold in the secondary market by mortgage lenders. These underwriting standards generally require that the loans be collateralized by one-to-four family residential real estate. Automated underwriting engines deployed by a GSE are used to determine creditworthiness of the vast majority of borrowers. Maximum allowable loan-to-value (“LTV”)/combined loan-to-value (“CLTV”) on these loan products generally do not exceed 95% at origination. Citizens has not offered “no-doc/low doc” and “stated income/stated asset” loans since January 1, 2007 and does not have any of these loans in its residential mortgage portfolio. Sub-prime, initial teaser rate and negative amortization loans were originated on an exception basis prior to 2007 and have not been offered since January 1, 2007. At December 31, 2012 and 2011, the outstanding balance of these loans and the associated interest income was immaterial.
Direct consumer loans include home equity loans, and direct installment loans to individuals used to purchase boats, recreational vehicles, automobiles and other personal items. Underwriting guidelines for these loans are heavily influenced by statutory requirements, which include, but are not limited to, maximum loan-to-value ratios, credit scoring results, ability to service overall debt, and documentation requirements. Individual borrowers may be required to provide additional collateral or a satisfactory endorsement or guaranty from another person, depending on the creditworthiness of the borrower. Home equity loans consist of fully-indexed variable rate revolving lines of credit and fixed rate loans to consumers that are secured by residential real estate. Home equity loans are generally in a junior lien
position and are originated through Citizens’ branches with cumulative loan-to-value ratios generally at or less than 80% of appraised collateral value. As of December 31, 2012, Citizens’ home equity portfolio totaled $682.7 million, and had an average loan size of $35,851 with an average refreshed FICO score of 741. As of December 31, 2012, other direct installment loans totaled $161.5 million and had an average loan size of $19,497 with an average refreshed FICO score of 728.
Indirect consumer loans are originated through our centralized underwriting group that has established relationships with certain dealers which meet Citizens’ underwriting guidelines and adhere to prudent business practices. The dealers are evaluated on their creditworthiness and business practices with performance monitored on an annual basis. The dealers refer customers to the centralized underwriting group, which utilizes a credit scoring model to supplement the underwriting process, and then complete the loans utilizing Citizens’ loan documents. As of December 31, 2012, indirect consumer loans had an average loan size of $24,276 with an average refreshed FICO score of 742.
CREDIT RISK MANAGEMENT
Extending credit to businesses and consumers exposes Citizens to credit risk, which is the risk that the principal balance of a loan and any related interest will not be collected under the original underwriting terms due to the inability or unwillingness of the borrower to repay the loan. Citizens lending policies and underwriting guidelines, discussed above, are designed to maximize loan income within an acceptable level of risk. Credit risk is mitigated through a comprehensive system of internal controls, which includes adherence to conservative lending practices, underwriting guidelines, collateral monitoring, and oversight of financial performance. Credit risk associated with fluctuations in economic conditions is mitigated through portfolio diversification that limits exposure to any single industry or customer. Lending policies and guidelines are reviewed by credit administration and modified on an ongoing basis as conditions change and new credit products are offered. The commercial and industrial and commercial real estate credit administration policies include a two-tier loan rating system that incorporates probability of default and loss given default to estimate a borrower’s ability to repay and the strength of the collateral supporting their loan obligation. To strengthen and monitor loan structuring and collateral position, collateral field audits are regularly performed on those credits that have a significant reliance on accounts receivable and inventory. Additionally, a reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potentially problematic loans. Citizens monitors its loans in an effort to proactively identify, manage, and mitigate any potential credit quality issues and losses.
The quality of Citizens’ loan portfolio is impacted by numerous factors, including the economic environment in the markets in which Citizens operates. Citizens carefully monitors its loans in an effort to identify and mitigate any potential credit quality issues and losses in a proactive manner. Citizens performs quarterly reviews of the non-watchlist commercial credit portfolio. This process seeks to validate each reviewed credit’s risk rating, underwriting structure and exposure management under current and stressed economic scenarios while strengthening these relationships and improving communication with these clients.
Citizens maintains an independent loan review department that reviews the quality, trends, collectability and collateral margins within the loan portfolio. The loan review department validates the credit risk profile on a regular basis by sampling loans using criteria such as loan size, delinquency status, loan officer coverage and other factors. This process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel. Results of these reviews are presented to management and to the Risk Committee of the Board of Directors.
As part of the overall credit underwriting and review process, Citizens carefully monitors commercial and industrial and commercial real estate credits that are current in terms of principal and interest payments but may deteriorate in quality as economic conditions change. Commercial relationship officers monitor their clients’ financial condition and initiate changes in loan ratings based on their findings. Loans that have migrated within the loan rating system to a level that requires increased oversight, at management’s discretion, are considered ‘watchlist’ loans (generally consistent with the regulatory definition of special mention, substandard, and doubtful loans) and include loans that are in accruing or nonperforming status.
Citizens utilizes the watchlist process as a proactive credit risk management practice to help mitigate the migration of commercial loans to nonperforming status and potential loss. Once a loan is placed on the watchlist, it is reviewed quarterly by the appropriate credit and market officers to assess cash flows, collateral valuations, guarantor liquidity, and other pertinent trends. During these reviews, action plans are developed to address emerging problem loans or to implement specific actions for alternatives to strengthen the credit and/or for removing the loans from the portfolio. Additionally, loans viewed as substandard or doubtful are transferred to Citizens’ special loans or small business workout groups and are subjected to an even higher level of monitoring and workout activity.
The following table illustrates the commercial loans on the watchlist that, while still accruing interest, may be at risk due to general economic conditions or changes in borrower’s financial status.
Commercial Watchlist
Accruing loans only
The decreases in watchlist credits were primarily due to a reduction in the level of new inflows, and continued emphasis on improving the risk profile through resolutions.
The following table illustrates loans where the contractual payment is 30 to 89 days past due and interest is still accruing. While these loans are actively worked to bring them current, past due loan trends may be a leading indicator of potential future nonperforming loans and charge-offs.
Delinquency Rates By Loan Portfolio
30 to 89 days past due
The decreases in total delinquencies were primarily the result of continued emphasis on proactively managing and resolving delinquent commercial and consumer loans along with a more stable economic environment.
NONPERFORMING ASSETS
Loans are generally placed on nonaccrual status when there is substantial doubt regarding collection of principal or interest, in full, based on Citizens’ credit policies and practices or when principal or interest is past due in excess of 90 days. When a loan is placed on nonaccrual status, interest that is accrued but not collected is reversed and charged against income. Nonperforming assets are comprised of nonaccrual loans, loans past due over 90 days and still accruing interest, nonperforming loans held for sale, and other repossessed assets acquired. Although these assets have more than a normal risk of loss, they may not necessarily result in future losses. A five-year history of nonperforming assets is presented below. The nonperforming commercial loans in this table are also reviewed as part of the watchlist process.
Nonperforming Assets and Past Due Loans
(1) Refer to Note 4 for a summary of interest income foregone on nonaccrual and restructured loans, as of December 31, 2012.
(2) Other real estate assets acquired (“ORAA”) includes nonaccrual loans held for sale.
(3) Total assets exclude assets from discontinued operations.
Nonperforming assets decreased in 2012 from the previous year end due to reductions of new inflows to commercial nonperforming assets as well as continued efforts to reduce overall problem loans. Additionally, Citizens has selectively reduced the level of nonperforming loans held for sale and other repossessed assets through sales.
Some of the nonperforming loans included in the nonperforming asset table above are considered to be impaired. A loan is impaired when, based on current information and events, Citizens determines it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. In most instances, impairment is measured based on the fair value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. Citizens measures impairment on all nonaccrual commercial and industrial and commercial real estate loans for which it has established specific reserves. This policy does not apply to large groups of smaller balance homogeneous loans, such as smaller balance commercial loans, direct and indirect consumer loans and residential mortgage loans, which are collectively evaluated for impairment, except for those loans restructured under a troubled debt restructuring. Citizens maintains a valuation reserve for impaired loans as a part of the specific allocated allowance component of the allowance for loan losses. Cash collected on impaired nonaccrual loans is generally applied to outstanding principal.
Citizens recognizes that elevated levels of unemployment and depressed real estate values may result in many customers facing difficult financial situations. Distressed homeowners are identified and offered assistance. In order to avoid foreclosure, residential mortgage loans may be restructured for certain qualified borrowers who have the ability to make payments under the new terms of the loan. Citizens’
residential mortgage foreclosure abatement program includes several different options to modify contractual payments. Modified consumer and residential mortgage loans are considered troubled debt restructures (“TDRs”) when the debt restructure, for economic or legal reasons related to the borrower’s financial difficulties, results in a concession to the debtor that otherwise would not be considered by the bank. Citizens classifies TDRs as nonperforming loans unless the loan qualified for accruing status at the time of the restructure, or the loan has performed according to the new contractual terms for at least six months. To qualify for accruing status at the time of the restructure, the original loan must have been less than 90 days past due at the time of the restructure and the modification must not have resulted in impairment. As a result of 2012 guidance from the Office of the Comptroller of the Currency, approximately $4.0 million of residential mortgage and consumer loans were identified as TDRs because the borrower’s obligation to Citizens has been discharged in bankruptcy and the borrower has not reaffirmed the debt. These loans were reclassified as TDRs as of December 31, 2012 and consisted of $2.9 million residential mortgage loans and $1.1 million of consumer loans.
The recorded investment balance of TDRs approximated $29.1 million at December 31, 2012. TDRs of $21.0 million were on accrual status and $8.1 million of TDRs were on nonaccrual status at December 31, 2012. Of this total, $27.1 million were consumer and residential TDRs that carried a total specific reserve of $4.0 million. Of these TDRs, 37.7% involved only a reduction in interest rate, 36.8% involved both reduced interest rate and term extensions, 12.1% involved only term extensions and 13.4% were related to bankruptcies. See Note 4 to the Consolidated Financial Statements in this report for information on impaired loans.
ALLOWANCE FOR LOAN LOSSES
A summary of loan loss experience for the past five years appears below.
Summary of Loan Loss Experience
(1) Balances exclude mortgage loans held for sale.
Loan losses are charged against, and recoveries are credited to, the allowance for loan losses. The significant decrease in net charge-offs for 2012 compared with 2011 reflects the continued stability and steady improvement in credit metrics and economic trends.
The allowance for loan losses represents management’s estimate of an amount appropriate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date. To assess the appropriateness of the allowance for loan losses, management considers and evaluates such factors as changes in the size and character of the loan portfolio, changes in the levels of impaired or other nonperforming loans, the risk inherent in specific loans, concentrations of loans to specific borrowers or groups of borrowers, existing economic conditions, underlying collateral, and other qualitative and quantitative factors which could affect probable loan losses. The evaluation process is inherently subjective, as it requires estimates that may be susceptible to significant change and have the potential to affect net income materially. The methodology used for measuring the appropriateness of the allowance for loan losses relies on several key elements, which include specific allowances for identified impaired loans, a migration methodology based risk allocated allowance for the remainder of the portfolio and a general valuation allowance estimate. Management also considers overall portfolio indicators, including trends in historical charge-offs, a review of industry, geographic and portfolio performance, and other qualitative factors. During 2012 an independent validation of the process and methodology utilized to establish the allowance for loan losses was completed with no material findings or recommendations noted. Further discussion regarding the process for establishing the allowance for loan losses can be found in “Critical Accounting Policies” and Note 1 to the Consolidated Financial Statements.
The allowance for loan losses is comprised of three parts: specific allocated, risk allocated, and general valuation. Nonperforming loans are reviewed under the specific allocated reserve for impairment analysis. Loss expectations are established based on specific impairment by loan. The following table summarizes the allocation of the allowance for loan losses for specific allocated, risk allocated, and general valuation allowances by loan type and the proportion of total portfolio loans represented by each loan type.
Allocation of the Allowance for Loan Losses (1)
N/M - Not Meaningful
(1) The allocation of the allowance for loan losses in the above table is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or precision of the specific amounts. Citizens does not view the allowance for loan losses as being divisible among the various categories of loans. The entire allowance is available to absorb any future losses without regard to the category or categories in which the charged-off loans are classified.
(2) Related nonperforming loans (“NPL”) amounts in risk allocated allowances include loans 90+ days past due and still accruing but classified as nonperforming. NPLs now exclude troubled debt restructurings (TDRs) that are on an accrual status and performing in accordance with their modified terms.
(3) The portfolio balance of the loans with a specific allocated allowance is equal to the related NPL for said loans.
(4) Portfolio loans only include loan balances evaluated for risk allocated allowance.
Total Allowance for Loan Losses. The decrease in the total allowance as of December 31, 2012 compared to December 31, 2011 was primarily the result of the improved risk profile of all asset classes and improvement in both local and macro economic trends.
Based on current conditions and expectations, Citizens believes that the allowance for loan losses is appropriate to address the estimated loan losses inherent in the existing loan portfolio at December 31, 2012. After determining what Citizens believes is an appropriate allowance for loan losses based on the risk in the portfolio, the provision for loan losses is calculated as a result of the net effect of the change in the allowance for loan losses.
Specific Allocated Allowance. The specific allocated allowance is based on probable losses on specific commercial and industrial or commercial real estate loans as well as impairment on TDRs. The allowance allocated to nonperforming commercial real estate loans is typically based on the underlying collateral’s appraised value, updated at least annually, less management’s estimates of cost to sell. The allowance allocated to nonperforming commercial and industrial loans is typically based on collateral liquidation value estimates, frequently validated by third parties. Valuations are obtained more frequently if changes in the collateral or market conditions warrant. Deterioration in individual asset values, underlying commercial loans, evidenced by refreshed appraisals and liquidation valuations, is reflected in the specific allocated allowance for commercial nonperforming loans.
The fair value of nonperforming residential mortgage loans is based on the underlying collateral’s value obtained through appraisals, updated at least semi-annually, less management’s estimates of cost to sell. The allowance allocated to restructured residential loans is typically based on the present value of the expected future cash flows discounted at the loan’s effective interest rate.
The specific allocated allowance decreased both in amount and as a percentage of nonperforming loans from 2011, primarily as a result of the decline in loan portfolio balances identified and evaluated for specific reserves.
Risk Allocated Allowance. The risk allocated allowance is comprised of several loan pool valuation allowances developed utilizing migration modeling techniques and incorporating Probability of Default and Loss Given Default assumptions which are derived from Citizens historical loan portfolio experience. Additionally management evaluates qualitative risks such as changes in asset quality; the experience, ability and effectiveness of Citizens’ lending management; the composition and concentrations of credit; and macro and local economic trends, as well as other factors to determine if adjustments to the quantitative results are appropriate.
The decrease in risk allocated allowance from 2011 was primarily related to the improved risk profile as evidenced in our improving credit metrics, as well as a stabilizing economy. A decrease in the loan portfolio balances that are evaluated for this reserve also contributed to the reduction.
General Valuation Allowance. The general valuation allowance is established to provide for potential model imprecision and other risks not entirely captured within the Risk Allocated portion of the allowance. Management considers factors such as current economic and credit metric trends along with actions or activities that may result in outcomes that differ from those historically experienced, to develop an appropriate reserve level.
As discussed in “Critical Accounting Policies”, nonperforming commercial and industrial and commercial real estate loans are generally charged off to the extent principal due exceeds the fair value of the collateral less estimated cost to sell with the charge-off occurring when the loss is reasonably quantifiable, but not later than when the loan becomes 180 days past due. Nonperforming residential mortgage loans are generally charged off to the extent principal exceeds the current appraised value less estimated costs to sell when the loan becomes five payments past due. Nonperforming direct and indirect consumer loans (open and closed end) are generally charged off before the loan becomes 120 days past due.
GOODWILL
Goodwill at December 31, 2012 was $318.2 million, unchanged from December 31, 2011. Citizens elected to perform the qualitative assessment in 2012. No events (individually or in aggregate) have occurred since the annual goodwill impairment analysis that indicates a potential impairment of goodwill. Citizens will continue to perform evaluations on an interim basis if events or circumstances indicate that impairment may exist. There can be no assurance that such tests will not result in additional material impairment charges due to further developments in the banking industry or Citizens’ markets. For further discussion of the evaluation of goodwill, see Note 6 to the Consolidated Financial Statements.
DEPOSITS
The table below provides a year-to-year comparison of average deposit balances over the last three years. Average, rather than period-end, balances can be more meaningful in analyzing deposit funding sources because of inherent fluctuations that occur on a monthly basis within most deposit categories.
Average Deposits
Average time deposits declined due to the intentional non-renewal of high cost rate sensitive retail and brokered balances. Savings deposit balances remained relatively unchanged, as the shift in funding mix was offset by a reduction in brokered balances. The decrease in the average cost of the deposit portfolio resulted from the lower interest rate environment, partially offset by competitive deposit pricing pressures.
As of December 31, 2012, certificates of deposit of $100,000 or more accounted for approximately 7.1% of total deposits. The maturities of these deposits are summarized below.
Maturity of Time Certificates of Deposit of
$100,000 or more at December 31, 2012
Citizens gathers deposits from its markets and has used brokered deposits from time to time when cost effective. Time deposits greater than $100,000 decreased by $105.6 million at December 31, 2012 over the prior year-end primarily as a result of a planned reduction in brokered deposits and a shift in funding mix from customer time deposits to core deposits. Citizens will continue to evaluate the use of alternative funding sources such as brokered deposits to best meet its funding objectives. Citizens continues to promote relationship driven core deposit growth and stability through focused marketing efforts and competitive pricing strategies.
BORROWED FUNDS
Short-term borrowings consists of federal funds purchased, securities sold under agreements to repurchase, and other bank borrowings. The increase in short-term borrowings to $42.7 million at December 31, 2012 from $40.1 million at December 31, 2011 was primarily the result of an increase in short-term repurchase agreements. See Note 8 to the Consolidated Financial Statements for additional information on short-term borrowings.
Long-term debt consists of FHLB debt, subordinated notes, other promissory notes and other borrowed funds. Long-term debt totaled $850.9 million at December 31, 2012, compared with $854.2 million at December 31, 2011. FHLB debt decreased $3.4 million to $655.1 million at December 31, 2012, due to maturing advances not being replaced. Citizens restructured $350.0 million and $245.0 million in FHLB advances during 2012 and 2011, respectively which locked in lower term funding rates. The average interest rate on the 2012 restructured advances was reduced to 2.55% from 3.50% and the average remaining term was extended to 9.0 years from 3.2 years. The average interest rate on the 2011 restructured advances was reduced to 3.32% from 4.84% and the average remaining term was extended to 5.8 years from 3.3 years. As of December 31, 2012, other borrowed funds remained essentially unchanged from December 31, 2011. See Note 9 to the Consolidated Financial Statements for additional information.
CAPITAL RESOURCES
Citizens continues to maintain a strong capital position which supports current needs and provides a sound foundation to support lending in the communities in which we operate. Regulatory capital ratios for Citizens have remained above the “well capitalized” standards. Capital ratios are presented below.
Shareholders’ equity at December 31, 2012 totaled $1.4 billion, an increase of $351.0 million or 34.4% from December 31, 2011. Book value per common share at December 31, 2012 and 2011 was $26.62 and $18.24, respectively. Both increases are due almost entirely to the net income recorded in 2012 which was heavily impacted by the elimination of the deferred tax valuation allowance.
During 2012, the Holding Company did not purchase any shares of common stock pursuant to its share repurchase program and is not likely to do so for the foreseeable future. Information regarding the Citizens’ share repurchase program and current limitations on share repurchases is set forth under Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
Contractual Obligations
In the ordinary course of business, Citizens has entered into certain contractual arrangements that require future cash payments and may impact liquidity. These obligations include deposits, issuance of debt to fund operations, purchase obligations to acquire goods or services, and property leases. The table below summarizes contractual obligations and future required minimum payments as of December 31, 2012. Refer to Notes to the Consolidated Financial Statements for further discussion of these contractual obligations.
Contractual Obligations
(1) In the banking industry, interest-bearing obligations are principally utilized to fund interest-bearing assets. As such, interest charges on related contractual obligations were excluded from reported amounts as the potential cash outflows would have corresponding cash inflows from interest-bearing assets.
(2) This schedule excludes all carrying value adjustments, such as purchase accounting fair value adjustments, hedge accounting fair value adjustments, and unamortized premiums and discounts, that will not affect future cash payments associated with the maturity of this debt.
At December 31, 2012, Citizens’ liability for uncertain tax positions, including associated interest and penalties and net of related federal tax benefits, was $0.2 million. This liability represents an estimate of income taxes and other state taxes which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table.
Citizens has obligations not included in the above table under its retirement plans as described in Note 11 to the Consolidated Financial Statements. At December 31, 2012, the underfunded status of the cash balance pension plan for employees, the retirement health plan and the supplemental pension plans is recognized in the Consolidated Balance Sheet as an accrued liability. Citizens anticipates contributing $1.2 million in 2013 to the defined benefit pension plan as required under current funding regulations. Citizens anticipates making a contribution of $0.5 million to the nonqualified supplemental benefit plans during 2013. In addition, Citizens expects to pay $0.2 million in contributions to the postretirement healthcare benefit plan during 2013.
Off-Balance Sheet Arrangements
In the normal course of business, in order to meet the financing needs of customers and to manage exposure to interest rate risk, Citizens enters into various transactions, which, in accordance with U.S. generally accepted accounting principles, are not included in its Consolidated Balance Sheets. These transactions include commitments to extend credit, standby letters of credit, commercial letters of credit, forward commitments to sell mortgage loans, and interest rate swaps. These transactions involve, to varying degrees, elements of credit risk, market risk and liquidity risk in excess of the amount recognized in the Consolidated Balance Sheets, however, they do not represent unusual risks. Citizens minimizes its exposure to loss under these transactions by subjecting them to credit approval and monitoring procedures.
The following table presents the total notional amounts and expected maturity of off-balance sheet financial instruments outstanding at December 31, 2012 and the notional amounts outstanding at December 31, 2011.
Off-Balance Sheet Financial Instruments
Loan commitments are legally binding agreements to lend cash to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee.
Standby letters of credit are written conditional commitments issued by Citizens to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, Citizens would be required to fund the commitment. The maximum potential amount of future payments Citizens could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, Citizens would be entitled to seek recovery from the customer. Standby letters of credit at December 31, 2012 decreased from December 31, 2011 primarily as a result of the current economic climate and reduced customer demand. Commercial letters of credit are written conditional commitments issued by Citizens to guarantee the performance of a customer to a third party. These guarantees are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party.
The credit risk associated with commitments to extend credit and letters of credit is essentially the same as that involved with direct lending. Therefore, these agreements are subject to loan review and approval procedures and credit policies. Based upon management’s credit evaluation of the counter-party, collateral may be required as security for the agreement, including real estate, accounts receivable, inventories, and investment securities. The maximum credit risk associated with these instruments is equal to their contractual amounts, assuming that the counter-party defaults and the collateral proves to be worthless. The total contractual amounts of commitments to extend credit and letters of credit do not necessarily represent future cash requirements, since many of these agreements may expire without being drawn upon. Citizens’ commitments to extend credit and letters of credit are described in further detail in Note 16 to the Consolidated Financial Statements.
Refer to Notes 1 and 17 to the Consolidated Financial Statements for further discussion of derivative instruments.
Citizens has two active wholly owned trusts formed for the purpose of issuing securities which qualify as regulatory capital and are considered Variable Interest Entities (“VIEs”). Citizens is not the primary beneficiary, and consequently, the trusts are not consolidated in the consolidated financial statements. Each of the two active trusts issued trust preferred securities to investors in 2006 and 2003, with respect to which there remain $48.7 million and $25.8 million in aggregate liquidation amounts outstanding, respectively. The trust preferred securities held by these entities qualify as Tier 1 capital and are classified as “long-term debt” on the Consolidated Balance Sheets, with the associated interest expense recorded in “long-term debt” on the Consolidated Statements of Operations. The expected losses and residual returns of these entities are absorbed by the trust preferred stock holders, and consequently Citizens is not exposed to loss related to these VIEs. Refer to Note 9 to the Consolidated Financial Statements for further discussion.
At December 31, 2012, the unpaid principal balance of mortgage loans serviced for others was $237.3 million. These loans are not recorded on the Consolidated Financial Statements. Capitalized servicing rights relating to the serviced loans were $0.8 million at December 31, 2012.
Assets held in a fiduciary or agency capacity are not included in the Consolidated Financial Statements because they are not assets of Citizens. The total assets managed or administered by Citizens at December 31, 2012, in its fiduciary or agency capacity, were $2.1 billion.
LIQUIDITY RISK MANAGEMENT
Citizens monitors and manages its liquidity position so that funds will be available at a reasonable cost to meet financial commitments, to finance business expansion and to take advantage of unforeseen opportunities. Liquidity management involves projecting funding requirements and maintaining sufficient capacity to meet those needs and accommodate fluctuations in asset and liability levels due to changes in business operations or unanticipated events. Sources of liquidity include deposits and other customer-based funding, and wholesale market funding.
Citizens manages liquidity at two levels. The first level is at the Holding Company which owns the Bank. The second level is at the Bank. The management of liquidity at both levels is essential because the Holding Company and the Bank have different funding needs and sources, and are subject to certain regulatory guidelines and requirements. The Asset Liability Committee is responsible for establishing a liquidity policy, approving operating and contingency procedures, and monitoring liquidity on an ongoing basis. In order to maintain adequate liquidity through a wide range of potential operating environments and market conditions, Citizens conducts liquidity management and business activities in a manner designed to preserve and enhance funding stability, flexibility, and diversity of funding sources. Key components of this operating strategy include a strong focus on customer-based funding, maximizing secured borrowing capacity, maintaining relationships with wholesale market funding providers, and maintaining the ability to liquidate certain assets if conditions warrant.
Credit ratings by the nationally recognized statistical rating agencies are an important component of Citizens’ liquidity profile. Credit ratings could impact Citizens’ ability to issue debt securities and the cost to borrow money, and should not be viewed as an indication of future stock performance or a recommendation to buy, sell, or hold securities. Among other factors, the credit ratings are based on financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core deposits, and Citizens’ ability to access a broad array of wholesale funding sources. Adverse changes in these factors could result in a negative change in credit ratings and impact not only the ability to raise funds in the capital markets, but also the cost of these funds. Citizens’ credit ratings were downgraded throughout 2009 and 2010. In January of 2012, Fitch Ratings raised Citizens’ long-term issuer rating from CCC to B with a positive outlook. In February of 2012, Moody’s affirmed Citizens’ ratings and raised the long-term issuer rating outlook to stable. Following the September 13, 2012 announcement of the pending merger with FirstMerit, both Moody’s and Fitch raised Citizens’ rating outlook to watch positive. Ratings are subject to revision or withdrawal at any time and each rating should be evaluated independently of any other rating. The current credit ratings for the Holding Company and the Bank, the dates on which the ratings were last issued and the outlook watch status of the ratings are displayed in the following table. An explanation of these ratings may be obtained from the respective rating agency.
Credit Ratings
Ratings Watch Action Legend: (WP) Watch Positive, (WN) Watch Negative, (WU) Watch Uncertain, (WR) Watch Removed, (OP) Outlook Positive, (ON) Outlook Negative, (OS) Outlook Stable, (OD) Outlook Developing
The primary sources of liquidity for the Holding Company are dividends from and returns on investment in its subsidiary and existing cash resources. Banking regulations limit the amount of dividends a financial institution may declare to a parent company in any calendar year. The Bank is subject to dividend limits under the laws of the state in which it is chartered and to the banking regulations previously discussed. Federal and national chartered financial institutions are generally allowed to make dividends or other capital distributions in an amount not exceeding the current calendar year’s net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior regulatory approval. During 2012, the Bank paid dividends in the amount of $25.0 million to the Holding Company and did not pay any dividends in 2011 or 2010. The ability to borrow funds on both a short-term and long-term basis and to sell equity securities provides an additional source of liquidity for the Holding Company. The Holding Company’s current cash available for use totaled $81.8 million as of December 31, 2012. Citizens monitors the relationship between cash obligations and available cash resources, and believes that the Holding Company has sufficient liquidity to meet its currently anticipated short and long-term needs.
The primary source of liquidity for the Bank is customer deposits raised through the branch offices. Additional sources are wholesale borrowing, unencumbered or unpledged investment securities, access to secured borrowing at the Federal Reserve Bank of Chicago and the Federal Home Loan Bank of Indianapolis and contributions of capital from the Holding Company.
Citizens maintains a strong liquidity position, with substantial on-and off-balance sheet liquidity sources and a very stable funding base comprised of approximately 75% deposits, 9% long-term debt, 14% equity, and 2% short-term liabilities. Securities available for sale and money market investments can be sold for cash to provide additional liquidity, if necessary.
Since the first quarter of 2010, Citizens has deferred regularly scheduled quarterly interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities and suspended quarterly cash dividend payments on its fixed-rate cumulative perpetual preferred stock, TARP Preferred Stock, issued to and owned by the U.S Treasury as part of the Treasury’s Capital Purchase Program, in each case, as permitted by the underlying documentation. During the fourth quarter of 2012 Citizens began paying interest on the 2003 Debenture held by its Statutory Trust 1 including deferred interest and interest accrued on the deferred interest and Statutory Trust 1 made the related dividend payments to its associated trust preferred holders. During the first quarter of 2013 Citizens will begin paying interest on the 2006 Debenture held by its Citizens Funding Trust I including paying all previously deferred interest
and interest accrued on the deferred interest and Citizens Funding Trust 1 will pay the related dividend payments to its associated trust preferred holders. Citizens will resume paying dividends on both series of trust preferred securities on the normal quarterly payment dates going forward. Dividends for Citizens TARP Preferred Stock, including deferred dividends are expected to be paid as part of the completion of a merger with FirstMerit Corporation. The Holding Company is unable to pay common stock dividends or engage in common stock repurchases until the TARP Preferred Stock dividend payments and payments deferred under our trust preferred securities are no longer in arrears.
Effective April 17, 2012, the Federal Reserve Bank of Chicago and the Michigan Office of Financial and Insurance Regulation terminated their written agreement with Citizens and its subsidiary, Citizens Bank, dated July 28, 2010.
Citizens’ long-term debt to equity ratio was to 62.1% as of December 31, 2012 compared with 83.8% as of December 31, 2011. Changes in deposit obligations and short-term and long-term debt during the fourth quarter of 2012 are further discussed in the sections titled “Deposits” and “Borrowed Funds.” Citizens believes that it has sufficient liquidity to meet presently known short and long-term cash-flow requirements arising from ongoing business transactions.
INTEREST RATE RISK
Interest rate risk refers to the risk of loss arising from changes in market interest rates. The risk of loss can be assessed by examining the potential for adverse changes in fair values, cash flows, and future earnings resulting from changes in market interest rates. Interest rate risk on Citizens’ balance sheet consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity or repricing timing of asset and liability portfolios. Option risk arises from embedded options present in many financial instruments such as loan prepayment options, deposit early withdrawal options, and interest rate options. These options allow certain of Citizens’ customers and counterparties of the investment and wholesale funding portfolios the opportunity to benefit when market interest rates change, which typically results in higher costs or lower revenues for Citizens. Basis risk results when assets and liabilities reprice at the same time but based on different market rates or indices, which can change by different amounts, resulting in a narrowing of profit spread.
The asset/liability management process seeks to insulate net interest income from large fluctuations attributable to changes in market interest rates and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, Citizens’ interest rate sensitivity is monitored on an ongoing basis by its Asset Liability Committee, which oversees interest rate risk management and establishes risk measures, limits, and policy guidelines. A combination of complementary techniques is used to measure interest rate risk exposure, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships. These measures include static repricing gap analysis, simulation of earnings, and estimates of economic value of equity.
Static repricing gap analysis provides a measurement of reprice risk on Citizens’ balance sheet as of a point in time. This measurement is accomplished through stratification of Citizens’ rate sensitive assets and liabilities into repricing periods. The sums of assets and liabilities maturing or repricing in each of these periods are compared for mismatches within each time segment. Core deposits lacking contractual maturities or repricing frequencies are placed into repricing and maturity periods based upon historical experience. Repricing periods for assets include the effects of expected prepayments on cash flows.
Rate sensitive assets repricing within one year exceeded rate sensitive liabilities repricing within one year by $906.3 million or 9.5% of total assets as of December 31, 2012 compared with $843.0 million or 8.9% of total assets at December 31, 2011. These results incorporate the impact of off-balance sheet derivatives and reflect interest rates consistent with December 31, 2012 levels. Repricing gap analysis is limited in its ability to measure interest rate sensitivity, as embedded options can change the repricing characteristics of assets, liabilities, and off-balance sheet derivatives in different interest rate scenarios, thereby changing the repricing position from that outlined above. Further, basis risk is not captured by repricing gap analysis.
Citizens utilizes a net interest income simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model measures the impact to net interest income relative to a base case scenario of hypothetical changes in interest rates over the next 12 months. These simulations incorporate assumptions including prepayment speeds on various loan and investment assets, cash flows and maturities of financial instruments, market conditions, balance sheet growth and mix, pricing, client preferences, and Citizens’ financial capital plans. These assumptions are inherently uncertain and subject to fluctuation and revision in a dynamic environment and as a result the model cannot perfectly forecast net interest income nor exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude, and frequency of balance sheet component and interest rate changes, and differences in client behavior, market conditions and management strategies, among other factors.
Net interest income simulations were performed as of December 31, 2012 to evaluate the impact of market rate changes on net interest income over the subsequent 12 months assuming expected changes in balance sheet composition over that time period. If market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift of the yield curve) net interest income would be expected to increase by 0.2% and 1.6%, respectively, from what it would be if rates were to remain at December 31, 2012 levels. Net interest income simulation for 100 and 200 basis point parallel declines in market rates were not performed at December 31, 2012, as the results would not have been meaningful given the current levels of short-term market interest rates. These measurements represent similar exposure to rising interest rates at December 31, 2011. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, pricing spreads in relation to market rates, balance sheet growth, the mix of different types of assets and liabilities, and the timing of changes in these variables. Scenarios different from those outlined above, whether different by timing, level, or a combination of factors, could produce different results.
From time to time, derivative contracts are used to help manage or hedge exposure to interest rate risk and market value risk. Citizens enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Citizens’ derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash receipts and expected cash payments principally related to certain variable-rate loan assets and fixed-rate borrowings. Citizens has agreements with its derivative counterparties that contain a provision where if Citizens defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, then it could also be declared in default on its derivative obligations. Citizens also has agreements with certain of its derivative counterparties that contain a provision where if it fails to maintain its status as a well or adequately capitalized institution, then the counterparty could terminate the derivative positions and Citizens would be required to settle its obligations under the agreements. Citizens has agreements with certain of its derivative counterparties containing provisions that require its debt to maintain an investment grade credit rating from each of the major credit rating agencies. Although Citizens was not in compliance at December 31, 2012, the value required to be paid under these agreements at that date if the counterparties had exercised their rights to terminate was not material. Further discussion of derivative instruments is included in Note 17 to the Consolidated Financial Statements.
CRITICAL ACCOUNTING POLICIES
Citizens’ Consolidated Financial Statements are prepared in accordance with GAAP and follow general practices within the industry in which it operates. Application of these principles requires management to make estimates, assumptions, and complex judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes,
the financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, goodwill, fair value measurements, pension and postretirement benefits, and income taxes. Citizens believes that these estimates and the related policies discussed below are important to the portrayal of its financial condition and results of operations. Therefore, management considers them to be critical accounting policies and discusses them directly with the Audit Committee of the Board of Directors. Citizens’ significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements.
Allowance for Loan Losses
The allowance for loan losses represents Citizens’ estimate of probable losses inherent in the loan portfolio, the largest asset category on the consolidated balance sheet. Determining the amount of the allowance for loan losses is considered a critical accounting policy because it requires significant judgment and the evaluation of numerous factors including: loan migration and performance trends, historical and current trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, the size and diversity of individual large credits, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly.
Citizens’ allowance for loan loss methodology is based on GAAP and SEC guidance. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the performance of the loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. Refer to “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the caption “Allowance for Loan Losses” for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
Citizens’ allowance for loan losses consists of three elements: (i) specific allocated allowances based on probable losses on specific commercial or commercial real estate loans, restructured residential mortgage or consumer loans; (ii) risk allocated allowance which is comprised of several loan pool valuation allowances developed utilizing migration modeling techniques and incorporating Probability of Default (“PD”) and Loss Given Default (“LGD”) assumptions which are derived from Citizens historical loan portfolio experience, and may also include additional qualitative adjustments for risks determined by the judgment of management; and (iii) the general valuation allowance is based on existing regional and local economic trends, and other judgmental factors supported by qualitative documentation.
Specific allocated allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate it is probable that Citizens will be unable to collect all amounts due according to the contractual terms of the loan. The specific allocated allowance is based on probable losses on specific commercial and industrial or commercial real estate loans as well as impairment on TDRs. The allowance allocated to nonperforming commercial real estate loans is typically based on the underlying collateral’s appraised value, updated at least annually, less management’s estimates of cost to sell. The allowance allocated to nonperforming commercial and industrial loans is typically based on collateral liquidation value estimates, frequently validated by third parties. Valuations are obtained more frequently if changes in the collateral or market conditions warrant. Deterioration in individual asset values, underlying commercial loans, evidenced by refreshed appraisals and liquidation valuations, is reflected in the specific allocated allowance for commercial nonperforming loans. TDRs are evaluated for impairment under specific allocated reserve guidance.
Citizens’ risk allocated allowance, which is comprised of several loan pool valuation allowances, employs migration modeling techniques to estimate incurred losses in each portfolio segment. The analysis utilizes PD and LGD assumptions which are applied to risk ratings assigned to commercial loans and credit scores assigned to consumer loans to develop quantitative estimates of imbedded losses. Management also evaluates internal and external qualitative factors including: (i) the experience, ability and effectiveness of Citizens’ lending management and staff; (ii) the effectiveness of loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on the portfolio (ix) the impact of rising interest rates on the portfolio and (x) the impact of loan modification programs. Citizens evaluates the degree of risk that these components have on the quality of the loan portfolio on a quarterly basis and incorporates appropriate adjustments to quantitative estimates if necessary. Adjustments to quantitative model generated projections may also include estimates of inherent but undetected losses within the portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition, and the difficulty in identifying triggering events that correlate perfectly to subsequent default rates. The PD and LGD assumptions derived from the historical performance of the portfolio may not be representative of actual losses inherent in the portfolio that have not yet been realized.
The general valuation allowance is based on management’s estimate of other risks not entirely captured within the Risk Allocated portion of the allowance, such as the inherent imprecision in loan loss projection models, and is established through the consideration and evaluation of factors such as current economic and credit metric trends along with actions or activities that may result in outcomes that differ from those historically experienced.
Continuous credit monitoring processes and the analysis of loss components are the principal methods relied upon by management to ensure that changes in estimated credit loss levels are reflected in Citizens’ allowance for loan losses on a timely basis. Citizens utilizes regulatory guidance and its own experience in this analysis. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require additions to the allowance based on their judgment on information available to them at the time of their examination.
Actual loss ratios experienced in the future may vary from those projected. In the event that management overestimates future cash flows or underestimates losses on loan pools, we may be required to increase the allowance for loan losses through the provision for loan losses, which would have a negative impact on the results of operations in the period in which the increase occurred. Note 1 to the Consolidated Financial Statements describes the allowance for loan losses accounting policy, and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under the caption “Allowance for Loan Losses.”
Goodwill
Goodwill arises from business acquisitions and is initially measured as the excess of the cost of the acquired business over the sum of the amounts assigned to assets acquired less liabilities assumed. Citizens’ goodwill, which resides almost entirely in the Regional Banking reporting unit, is evaluated at least annually for impairment. Citizens performs this annual test on its major reporting units (which are equivalent to Citizens’ lines of business) as of October 1 of each year. Goodwill impairment analyses are performed on a more frequent basis if events or circumstances indicate that it is more likely than not that the fair values of the reporting units are below their respective carrying amounts. Such events could include a significant adverse change in legal factors or in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment, an unanticipated loss of key employees, a decision to change the operations or dispose of a reporting unit, cash or operating losses, significant revisions to forecasts, or a long-term negative outlook for the industry.
With the issuance of ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): “Testing Goodwill for Impairment” the FASB introduced an optional qualitative assessment for testing goodwill for impairment. Citizens adopted this ASU in the first quarter of 2012. The qualitative screen permits companies to qualitatively assess whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the qualitative screen suggests that the fair value may be less than its carrying amount, the company would have to perform the annual two-step test. If a company concludes otherwise, it has completed its goodwill impairment test and does not need to perform the two-step test.
In Step 1 of the test, Citizens estimates the fair value of the reporting units using discounted cash flow models derived from internal earnings forecasts. The primary assumptions used by Citizens include ten-year earnings forecasts, terminal values based on estimated future growth rates, and discount rates based on capital asset pricing models. A Step 1 analysis is prepared for each reporting unit, including those without goodwill, in order to analyze the implied control premium, which measures the difference between the combined estimated fair value of Citizens’ reporting units calculated in Step 1 and total market value. If the carrying amount of a reporting unit exceeds its estimated fair value, Step 2 is required for those reporting units that have goodwill to measure the amount of impairment, if any.
In Step 2 of the test, if necessary, Citizens estimates the fair value of a reporting unit’s assets and liabilities in the same manner as if a purchase of the reporting unit was taking place using exit pricing, which includes estimating the fair value of other implied intangibles. Any excess of this hypothetical purchase price over the fair value of the reporting unit’s net assets (excluding goodwill) represents the implied fair value of the goodwill. If the implied fair value of goodwill calculated in Step 2 is less than the carrying amount of goodwill, an impairment loss is charged to noninterest expense to reduce the carrying amount to the implied fair value. The write down cannot exceed the carrying amount and goodwill cannot be adjusted upward for any subsequent reversal of previously recognized goodwill write downs.
The recorded balance of goodwill has not changed during 2012 and 2011. Citizens elected to perform the qualitative assessment to determine whether it is more likely than not that the fair value of goodwill was below its carrying amount as of October 1, 2012. As a starting point, Citizens considered the results of the prior year quantitative (Step 1) impairment test conducted as of October 1, 2011. The results indicated that the estimated fair value of the goodwill exceeded its carrying value by approximately 15%. Citizens then considered several factors including, but not limited to, the anticipated purchase premium related to the pending merger with FirstMerit, macroeconomic conditions, industry and market considerations, and company financial performance of Citizens. Based on the positive evidence in the analysis, Citizens concluded that it is more likely than not that our fair value of goodwill exceeds its carrying value. Citizens performed a review of events or circumstances that would require an additional analysis as of December 31, 2012. Citizens determined that no events or circumstances existed which indicated the need for an additional impairment test.
Citizens’ management believes that the estimates and assumptions used in its goodwill impairment analyses are reasonable. Further deterioration in the outlook for credit quality, changes in the value of the loan or deposit portfolios, or increases in the discount rates could have a material impact on future goodwill impairment testing results. Due to the ongoing uncertainty regarding market conditions, which may negatively impact the performance of the Regional Banking line of business, Citizens will continue to monitor the goodwill impairment indicators and perform additional interim tests, if necessary. Since this evaluation process requires Citizens to make estimates and assumptions with regard to the fair value of its reporting units, actual values may differ significantly from these estimates. Such differences could result in future impairment of goodwill that would, in turn, negatively impact Citizens’ results of operations and the business segments where the goodwill is recorded. For more information on goodwill, see Note 6 to the Consolidated Financial Statements.
Fair Value Measurements
Fair value is defined as the exit price in the principal market (or, if lacking a principal market, the most advantageous market) in which Citizens would complete a transaction. Fair value is based on management’s best estimate of the assumptions market participants would use when pricing an asset or liability and a fair value hierarchy that prioritizes the information used to develop those assumptions. The
fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Citizens bases fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For assets and liabilities recorded at fair value, it is Citizens’ policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.
A number of valuation techniques are used to determine the fair value of assets and liabilities in Citizens’ financial statements. These include quoted market prices for securities, interest rate swap valuations based upon the modeling of termination values adjusted for credit spreads with counterparties and appraisals of real estate from independent licensed appraisers, among other valuation techniques. Fair value measurement for investment securities is based upon quoted prices for similar assets, if available, or matrix pricing models. Matrix pricing is a mathematical technique widely used in the banking industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. The securities in the investment portfolio are priced by independent providers. These providers utilize pricing models that vary by asset class and incorporate available trade, bid and other market information and for structured securities, cash flow and, when available, loan performance data. Because many fixed income securities do not trade on a daily basis, the pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. In addition, model processes to assess interest rate impact and develop prepayment scenarios are used. The impact of unobservable inputs and proprietary models are not material to the determination of fair values of these securities. In obtaining such valuation information from third parties, Citizens has evaluated their valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of an exit price in Citizens’ principal markets. Further, Citizens completes a comparison of the fair value estimates quarterly by validating the data received to date provided by a separate third party. In order to then evaluate reasonableness of the market data, Citizens also independently prices a sampling of securities using data from an independent source. Should Citizens find variances, the prices are then challenged and prices are adjusted accordingly. To date, there have been no significant findings or adjustments made by Citizens. Citizens’ principal markets for its securities portfolios are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets.
Fair value measurements for assets and liabilities where there exists limited or no observable market data are based primarily upon estimates which require significant judgment, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. The fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction and considers additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment will be recognized in the statement of operations. If an impairment is determined, it could limit the ability of Citizens Bank to pay dividends or make other payments to the Holding Company.
Pension and Postretirement Benefits
Pension liabilities are established and pension costs are charged to current operations based on actuarially determined present value calculations. The valuation of the pension obligation and net periodic pension expense is considered critical as it requires management to make estimates regarding the amount and timing of expected future cash outflows including assumptions about employee mortality, assumed return on cash balances, assumed discount rate used to determine the current benefit obligation, and the long-term rate of return expected on plan assets. The long-term rate of return expected on plan assets is finalized after considering long-term returns in the general market, long-term returns experienced by the assets in the plan, and projected plan expenses. The assets are invested in certain investment funds administered by a third party. Citizens reviews its pension plan assumptions on
an annual basis with an actuarial consultant to determine if the assumptions are reasonable and adjusts the assumptions to reflect changes in expectations. If Citizens were to determine that more conservative assumptions were necessary, costs would likely increase and have a negative impact on results of operations in the period in which the increase occurred.
The assumed future interest crediting rate on cash balance pension plan accounts was reduced from 4.50% for 2011 to 3.50% for 2012, which reflects the current rate environment, and will cause a slight decrease in pension expense for future periods. The determination of the discount rate used for calculating pension benefit and postretirement benefit obligations was based on a cash flow matching method. A spot yield curve for “A” rated finance bonds was converted to zero coupon equivalent bond rates. These zero coupon bond rates were matched to the actuarially determined benefit obligation annual cash flows. The resulting single discount rate was rounded to a 25 basis point increment. Based on this methodology, the discount rate used for the pension obligation was reduced to 3.50% at the end of 2012 from 4.50% and 5.00% at the end of 2011 and 2010, respectively. The discount rate used for the postretirement healthcare obligation as well as the supplemental pension benefit plans was reduced to 3.00% at the end of 2012 from 4.00% and 4.50% at the end of 2011 and 2010, respectively. Rates are set at the end of each year for use in determining the following year’s expense.
Citizens has recognized the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of its pension plan in the consolidated balance sheet, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income represents the net unrecognized actuarial losses and unrecognized prior service costs that will be subsequently recognized as net periodic pension cost pursuant to Citizens’ historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic pension cost. Note 11 to the Consolidated Financial Statements provides further discussion of the accounting for Citizens’ employee benefit plans and the estimates used in determining the actuarial present value of the benefit obligations and the net periodic pension expense.
Income Taxes
Income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. Deferred tax liabilities and assets are also established for the future tax consequences of events that have been recognized in Citizens’ financial statements or tax returns. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and deductions that can be carried forward (used) in future years. Citizens assesses whether a valuation allowance should be established against its deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. For example, a cumulative loss in recent years is significant verifiable negative evidence, however, it can be overcome with significant verifiable positive evidence, such as multiple recent consecutive quarters of profitability, improved standing with regulators and improved capital levels. As of December 31, 2012, Citizens had no valuation allowance against our deferred tax assets.
The valuation of current and deferred tax liabilities and assets is considered critical as it requires management to make estimates based on provisions of the enacted tax laws and other future events. The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. Citizens believes its tax assets and liabilities are properly recorded in the consolidated financial statements. For more information regarding income tax accounting, see Notes 1 and 13 to the Consolidated Financial Statements.
RECENT ACCOUNTING PRONOUNCEMENTS
Note 1 to the Consolidated Financial Statements discusses new accounting policies adopted by Citizens during 2012 and 2011 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects Citizens’ financial condition, results of operations or liquidity, the impact is discussed elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Risk.”
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Balance Sheets
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Operations
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Comprehensive Income
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements
Consolidated Statements of Changes in Shareholders’ Equity
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Cash Flows
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Citizens Republic Bancorp, Inc.
Notes To Consolidated Financial Statements
Unless the context indicates otherwise, all references in this Form 10-K to “Citizens” or the “Corporation,” refer to Citizens Republic Bancorp, Inc. and its subsidiary, Citizens Bank. References to the “Holding Company” refer to Citizens Republic Bancorp, Inc. alone. Citizens was incorporated in the State of Michigan in 1980, and is a diversified banking and financial services company that is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. Citizens provides a full range of banking and financial services to individuals and businesses through its subsidiary Citizens Bank. These services include deposit products, loan products, and other consumer-oriented financial services such as safe deposit and night depository facilities, wealth management services, and Automated Teller Machines (“ATMs”). Among the services designed specifically to meet the needs of businesses are various types of specialized financing, treasury management services, and transfer/collection facilities. Citizens is not dependent upon any single or limited number of customers, the loss of which would have a material adverse effect. No material portion of Citizens’ business is seasonal.
Note 1. Basis of Presentation and Accounting Policies
The accounting and reporting policies for Citizens conform to U.S. generally accepted accounting principles (“GAAP”). The following describes Citizens’ policies:
Basis of Financial Statement Presentation
The accompanying consolidated financial statements include the accounts of Citizens and its wholly owned subsidiary. All material intercompany transactions have been eliminated in consolidation.
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 date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, loans held for sale, other real estate owned, goodwill and core deposit intangible assets, fair value measurements, pension and postretirement benefits, derivative instruments and income taxes.
Citizens also determines whether it should consolidate other entities or account for them on the equity method of accounting depending on whether it has a controlling financial interest in an entity of less than 100% of the voting interest of that entity to determine if it is a Variable Interest Entity (“VIE”). A VIE is a corporation, partnership, trust or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. An entity that holds a variable interest in a VIE is required to consolidate the VIE if the entity is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns or both. VIE treatment is considered for entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make financial and operating decisions.
Citizens has two active wholly owned trusts formed for the purpose of issuing securities which qualify as regulatory capital and are considered VIEs. Citizens is not the primary beneficiary, and consequently, the trusts are not consolidated in the consolidated financial statements. Each of the two active trusts has issued separate offerings of trust preferred securities to investors in 2006 and 2003. The gross proceeds from the issuances were used to purchase junior subordinated deferrable interest debentures issued by Citizens, which is the sole asset of each trust. The trust preferred securities held by these entities qualify as Tier 1 capital and are classified as “long-term debt” on the Consolidated Balance Sheets, with the associated interest expense recorded in “long-term debt” on the Consolidated Statements of Operations.
The expected losses and residual returns of these entities are absorbed by the trust preferred stock holders, and consequently Citizens is not exposed to loss related to these VIEs.
On June 14, 2011, Citizens announced a 1-for-10 reverse stock split of Citizens common stock effective after the close of trading on July 1, 2011. Citizens common stock began trading on a split adjusted basis on The NASDAQ Capital Market at the opening of trading on July 5, 2011. All share and per share amounts herein reflect the 1-for-10 reverse stock split. Refer to Note 14 for additional disclosures.
On January 29, 2010 Citizens entered into a stock purchase agreement with Great Western Bank whereby Great Western Bank agreed to acquire all of the stock of Citizens’ wholly owned subsidiary, F&M Bank - Iowa (“F&M”). On April 23, 2010, Citizens completed the stock sale in exchange for $50.0 million in cash. Citizens has no continuing cash flow from F&M. As of the transaction sale date, the assets and liabilities of F&M were removed from Citizens’ consolidated balance sheet. The financial condition and operating results for this subsidiary have been segregated from the financial condition and operating results of Citizens’ continuing operations throughout this report and, as such, are presented as a discontinued operation.
Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. Generally, U.S. government and Federal agency securities are pledged as collateral under these financing arrangements and cannot be sold or re-pledged by the secured party. The fair value of collateral either received from or provided to a third party is continually monitored and additional collateral is obtained, or requested to be returned to Citizens as deemed appropriate.
In the first quarter of 2012, Citizens adopted new guidance (amended by ASU 2011-03) intended to improve the accounting for repurchase agreements by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets. The adoption of this amendment did not have a material impact on Citizens’ financial condition, results of operations or liquidity.
Investment Securities
At the time of purchase, securities are classified as held to maturity or available for sale. Investment securities classified as held to maturity, which management has the positive intent and ability to hold to maturity, are reported at amortized cost, and adjusted for amortization of premiums and accretion of discounts, using the effective yield method. The amortized cost of debt securities classified as held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts, or in the case of mortgage-related securities, over the estimated life of the security. Such amortization and accretion from the related security is included in interest income. Available for sale securities are reported at fair value with unrealized gains and losses, net of related deferred income taxes, included in shareholders’ equity as a separate component of other comprehensive income. The cost of securities sold is based on the specific identification method. An investment is considered impaired if its fair value is less than its amortized cost. When determining whether an impairment is other than temporary to debt securities, management asserts: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. Any security for which there has been an other-than-temporary impairment of value is written down to its estimated fair value through a charge to earnings for the amount representing the credit loss on the security and a charge recognized in other comprehensive income related to all other factors. Realized securities gains or losses and declines in value judged to be other-than-temporary representing credit losses are included in investment securities gains (losses) in the consolidated statements of operations.
Loans
Loans are reported at the principal amount outstanding, net of unearned income. Interest income is recognized on an accrual basis. Loan origination fees, certain direct and indirect costs, unamortized premiums and unearned discounts are deferred and amortized into interest income as an adjustment to the yield over the term of the loan. Loan commitment fees are generally deferred and amortized into fee income on a straight-line basis over the commitment period. Other credit-related fees, including letter and line of credit fees, are amortized into fee income on a straight-line basis over their contractual life.
Loans are placed on nonaccrual status when the collection of principal or interest is considered doubtful or payment of principal or interest is past due 90 days or more. When loans are placed on nonaccrual status, all interest previously accrued but unpaid is reversed against current year interest income. Loans are normally restored to accrual status if and when interest and principal payments are current and it is believed that the financial condition of the borrower has improved to the extent that future principal and interest payments will be met on a timely basis.
Nonperforming commercial and industrial and commercial real estate loans are generally charged off to the extent principal due exceeds the net realizable value of the collateral, with the charge-off occurring when the loss is reasonably quantifiable, but not later than when the loan becomes 180 days past due. Nonperforming residential mortgage loans are generally charged off to the extent principal exceeds the current appraised value less estimated costs to sell when the loan is five payments past due. Nonperforming direct and indirect consumer loans (open and closed end) are generally charged off before the loan becomes 120 days past due.
Allowance for Loan Losses
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, as well as trends in these items. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors beyond Citizens’ control, including the performance of its loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
Citizens’ allowance for loan losses consists of three elements: (i) specific allocated allowances based on probable losses on specific commercial or commercial real estate loans or restructured residential mortgage or consumer loans; (ii) risk allocated allowance which is comprised of several loan pool valuation allowances based on Citizens’ historical quantitative loan loss experience for similar loans with similar risk characteristics, including additional qualitative risks determined by the judgment of management; and (iii) general valuation allowances determined based on existing regional and local economic factors, including deterioration in commercial and residential real estate values, a macroeconomic adjustment factor used to calibrate for the current economic cycle the bank is experiencing, and other judgmental factors supported by qualitative and quantitative documentation such as the inherent imprecision of the loan loss projection models.
Commercial and industrial and commercial real estate loans exceeding certain fixed dollar amounts are evaluated for impairment on a loan-by-loan basis whereby an allowance is established as a component of the allowance for loan losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and the recorded investment in the loan exceeds its fair value. In most instances the fair value is measured based on the fair value of the collateral. Fair value may also be measured using the present value of expected future cash flows discounted at an appropriate interest rate.
In 2011, Citizens adopted new guidance which requires disclosures and clarifies existing disclosure requirements about an entity’s allowance for credit losses and credit quality of its financing receivables. In the third quarter of 2011, Citizens adopted new guidance that clarifies which loan modifications
constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties. The adoption of the new guidance did not have a material impact on Citizens’ financial condition, results of operations or liquidity; however, the adoption did have a significant impact on Citizens’ credit disclosures. Refer to Note 4 for additional disclosures.
Loans Held for Sale
Loans that Citizens has the intent and ability to sell are classified as held for sale and are carried at the lower of cost or fair value, net of estimated costs to sell. Commercial loans held for sale are comprised primarily of loans identified for sale that are recorded at the lower of carrying amount or fair value based on appraisals of the underlying collateral, which are also subject to management adjustments based on current market conditions and recent sales activity or the present value of expected future cash flows discounted at the loan’s effective interest rate. Residential mortgage loans held for sale are comprised of loans originated for sale in the ordinary course of business and selected nonperforming residential mortgage loans. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for similar loans. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral, net of estimated costs to sell, using market prices derived from indicative pricing models which utilize projected assumptions Citizens believes potential investors would make, broker price opinions or appraisals. Gains and losses on the sales of loans are determined using the specific identification method. Subsequent valuation adjustments to reflect current fair value, as well as gains and losses on disposal of these loans are charged to noninterest income as incurred. Citizens sells substantially all of its residential mortgage originations to PHH Mortgage Corporation (“PHH”) at a contractual price, generally within 14 days after closing.
Premises and Equipment
Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are computed principally on a straight-line basis and are charged to expense over the lesser of the estimated useful life of the assets or lease term. Useful lives range from three to twenty years for furniture, fixtures, and equipment and seven to forty years for buildings and improvements. Maintenance and repairs are charged to expense as incurred. Gains and losses on dispositions are charged to income as incurred.
Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, Citizens recognizes a loss for the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis.
Other Real Estate Owned
Other Real Estate Owned is comprised of commercial and residential real estate properties acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure. These properties are carried at the lower of cost or fair value at the time of acquisition, net of estimated costs to sell, based upon current appraised value adjusted for management’s best estimate of current market conditions. Losses arising from the initial acquisition of such properties are charged against the allowance for loan losses at the time of transfer. Subsequent valuation adjustments to reflect the lower of cost or fair value, as well as gains and losses on disposal of these properties are charged to noninterest expense as incurred.
Bank Owned Life Insurance
Bank Owned Life Insurance is recorded as an asset at the amount that could be realized under the insurance contracts as of the date of the consolidated balance sheets, commonly referred to as cash surrender value. The change in cash surrender value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contracts for the period. This change is recorded in noninterest income.
Goodwill and Core Deposit Intangible Assets
Goodwill represents the excess of the cost of an acquisition over the fair value of net identifiable tangible and intangible assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. Goodwill is tested at least annually for impairment and Citizens performs its annual impairment test as of October 1 each year. Evaluations are also performed on a more frequent basis if events or circumstances indicate that it is more likely than not that the fair values of the reporting units are below their respective carrying amounts. Such events could include a significant adverse change in legal factors or in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment, an unanticipated loss of key employees, a decision to change the operations or dispose of a reporting unit, cash or operating losses, significant revision to forecasts, or a long-term negative outlook for the industry.
In the first quarter of 2012, Citizens adopted new guidance (amended by ASU 2011-08) that allows an optional qualitative assessment for testing goodwill. The qualitative screen permits Citizens to qualitatively assess whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If that is not the case, Citizens would have to perform the annual two-step test. If Citizens concludes otherwise, it has completed its goodwill impairment test and does not need to perform the two-step test. In 2012, Citizens utilized the qualitative assessment for the annual goodwill impairment test.
Impairment of goodwill is evaluated by reporting unit, which is equivalent to Citizens’ lines of business. In Step 1 of the analysis, Citizens estimates the fair value of the reporting units using discounted cash flow models derived from internal earnings forecasts. The primary assumptions used by Citizens include ten-year earnings forecasts, terminal values based on estimated future growth rates, and discount rates based on capital asset pricing models. A Step 1 analysis is prepared for each reporting unit, including those without goodwill, in order to analyze the implied control premium, which measures the difference between the combined fair value of Citizens’ reporting units calculated in Step 1 and Citizens’ total market value. If the carrying amount of a reporting unit exceeds its estimated fair value, the second step (Step 2) of the goodwill impairment test is required for those reporting units that have goodwill to measure the amount of impairment, if any. In Step 2 of the test, Citizens estimates the fair value of a reporting unit’s assets and liabilities in the same manner as if a purchase of the reporting unit was taking place using exit pricing, which includes estimating the fair value of other implied intangibles. Any excess of this hypothetical purchase price over the fair value of the reporting unit’s net assets (excluding goodwill) represents the implied fair value of goodwill. If the implied fair value of goodwill calculated in Step 2 is less than the carrying amount of goodwill, an impairment loss is charged to noninterest expense to reduce the carrying amount to the implied fair value. The writedown cannot exceed the carrying amount and goodwill cannot be adjusted upward for any subsequent reversal of previously recognized goodwill writedowns.
During the first quarter of 2011, new guidance was issued that modified Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples, which require that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The adoption of ASU 2010-28 did not have a material impact on Citizens’ financial condition, results of operations or liquidity.
Core deposit intangible assets represent the present value of the cost savings obtained from funding associated with the purchase of core deposits through an acquisition. Core deposit intangible assets are valued using a discounted cost savings approach. All of Citizens’ core deposit intangible assets have finite lives, are amortized on an accelerated basis corresponding with the anticipated lives of the underlying deposits over varying periods not exceeding 10 years, and are subject to impairment testing.
In the third quarter of 2012, Citizens adopted new guidance (amended by ASU 2012-02) intended to reduce the complexity of performing an impairment test for indefinite-lived intangible assets by simplifying how Citizens tests those assets for impairment and improve consistency in impairment testing guidance among long-lived asset categories. The adoption of ASU 2012-02 did not have a material impact on Citizens’ financial condition, results of operations or liquidity.
Pension and Postretirement Benefits
Citizens has recognized the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of its pension plan in the consolidated balance sheets, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income represents the net unrecognized actuarial losses and unrecognized prior service costs that will be subsequently recognized as net periodic pension cost pursuant to Citizens’ accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic pension cost.
Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is based on management’s best estimate of the assumptions market participants would use when pricing an asset or liability and a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. For assets and liabilities recorded at fair value, it is Citizens’ policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.
Fair value measurements for assets and liabilities where there are limited or no observable market data are based primarily upon estimates which require significant judgment, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. The fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction and considers additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. Citizens discloses in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the balance sheet.
In 2011, Citizens adopted new guidance which includes new disclosures about purchases, sales, issuances, and settlements in the roll-forward of activity in Level 3 fair value measurements. In the first quarter of 2012, Citizens adopted new guidance (amended by ASU 2011-04) that requires new disclosures and clarifies existing concepts about fair value measurement. The adoption of this guidance did not have a material impact on Citizens’ financial condition, results of operations or liquidity. See Note 10 to the Consolidated Financial Statements for more information on fair value measurements.
Derivative Instruments
Citizens enters into derivative transactions from time to time to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. Under the guidelines of ASC Topic 815, all derivative instruments are required to be carried at fair value on the balance sheet. Topic 815 also provides special hedge accounting provisions. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under Topic 815. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
Fair value hedges designated as hedging instruments are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the asset or liability on the balance sheet with corresponding offsets recorded in the statement of operations. The adjustment to the hedged asset or liability is included in the basis of the item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the interest income or expense recorded on the hedged asset or liability.
Cash flow hedges designated as hedging instruments are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in other comprehensive income within shareholders’ equity, net of tax. Amounts are reclassified from other comprehensive income to the statement of operations in the period or periods the hedged forecasted transaction affects earnings.
Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in noninterest income.
Citizens enters into various derivative agreements with customers desiring protection from possible adverse future fluctuations in interest rates. As an intermediary, Citizens generally maintains a portfolio of matched offsetting derivative agreements. These contracts are marked to market through earnings.
In 2010, Citizens adopted new guidance that clarifies the type of embedded credit derivatives that are exempt from embedded derivative bifurcation requirements. The adoption had no impact on Citizens’ financial condition, results of operations or liquidity. For more information on derivative financial instruments and hedge accounting, see Note 17 to the Consolidated Financial Statements.
Income Taxes
Amounts provided for income tax expense or benefit are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable or receivable under tax laws. Deferred income taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent on utilizing taxable income in prior carryback years, generating future taxable income, executing tax planning strategies, and reversing existing taxable temporary differences. Currently, the ultimate realization of deferred tax assets is primarily dependent on the generation of future taxable income during the periods in which those temporary differences become deductible.
Citizens utilizes a two-step approach for evaluating tax positions. Recognition (Step 1) occurs when an enterprise concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination. Measurement (Step 2) is only addressed if the result of Step 1 is that the position is more likely than not to be sustained. Under Step 2, the tax benefit is measured as the largest amount of benefit, determined on a cumulative probability basis, which is more likely than not to be realized on ultimate settlement.
Citizens files a consolidated federal income tax return and various Holding Company and subsidiary state income tax returns. When income and expenses are recognized in different periods for tax purposes, applicable deferred taxes are provided in the Consolidated Financial Statements. Citizens recognizes interest and penalties accrued relative to unrecognized tax benefits in their respective federal or state income tax accounts.
Stock-Based Compensation
The compensation cost for share-based awards is recognized in salaries and employee benefits based on the fair value at the date of grant and is recognized on a straight-line basis over the requisite service period of the awards. The requisite service period is presumed to be the stated vesting period or the estimated time that will be required to satisfy any performance conditions. Restricted shares are included in outstanding stock totals, and are entitled to receive dividends and have voting rights. Restricted stock units have no voting or dividend rights but have dividend equivalent rights entitling them to additional shares at the time the units are settled for common stock. Forfeited and expired options and forfeited shares of restricted stock become available for future grants. Refer to Note 12 for additional disclosures.
Net Income per Common Share
Basic net income or loss per common share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding in each period. Diluted net income per common share shows the dilutive effect of additional common shares issuable upon the assumed exercise of stock options granted under Citizens’ stock option plans, using the treasury stock method, and restricted stock awards granted but not yet vested. Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are included in the computation of earnings per share pursuant to the two-class method.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents are considered to include cash and due from banks, interest-bearing deposits in other financial institutions, federal funds sold and securities purchased under agreements to resell.
Subsequent Events
The Company evaluated subsequent events through the date its Financial Statements were issued.
Reclassifications
Certain amounts have been reclassified to conform to the current year presentation. There was no impact on net income and shareholders’ equity as the result of these reclassifications.
Accounting Standard Update (“ASU”)
Pending Accounting Pronouncements
FASB ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”
The amendments in this ASU seek to improve the reporting of reclassifications out of accumulated other comprehensive income (AOCI) by requiring an entity to report the effect of significant reclassifications out of AOCI either on the respective line items in net income or cross-reference to other disclosures required under GAAP that provide additional detail about these amounts. ASU 2013-02 is effective for Citizens in the first quarter of 2013 and should be applied prospectively for reporting periods. Early adoption is permitted. Citizens does not expect the adoption of the amendments to have a material impact on Citizens’ financial condition, results of operations or liquidity.
FASB ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities”
The amendments in this ASU affect entities that have derivatives accounted for in accordance with Topic 815-Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and
reverse repurchase agreements, and securities borrowing and securities lending transactions. Entities with other types of financial assets and financial liabilities subject to a master netting arrangement or similar agreement are no longer subject to the disclosure requirements in ASU 2011-11. ASU 2013-01 is effective for Citizens in the first quarter of 2013 and should be applied retrospectively for all comparative periods presented. Citizens does not expect the adoption of the amendments to have a material impact on Citizens’ financial condition, results of operations or liquidity.
FASB ASU 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities”
The amendments in this ASU allow existing GAAP guidance for balance sheet offsetting, including industry-specific guidance. However, new disclosures are required to enable users of financial statements to understand significant quantitative differences in balance sheets prepared under GAAP and International Financial Reporting Standards (“IFRS”) related to the offsetting of financial instruments. ASU 2011-11 is effective for Citizens in the first quarter of 2013, and should be applied retrospectively for all prior periods presented. Citizens does not expect the adoption of the amendments to have a material impact on Citizens’ financial condition, results of operations or liquidity.
Note 2. Investment Securities
The amortized cost, estimated fair value and gross unrealized gains and losses of investment securities follow.
(1) Amortized cost includes adjustments for the unamortized portion of unrealized gains on securities transferred from available for sale.
Securities with amortized cost of $535.6 million at December 31, 2012, and $665.8 million at December 31, 2011 were pledged to secure public deposits, repurchase agreements and other liabilities. Except for obligations of the U.S. Government and its agencies, no holdings of securities of any single issuer exceeded 10% of consolidated shareholders equity at December 31, 2012 or 2011.
In June 2011 and December 2010, Citizens transferred certain mortgage-backed securities from the available for sale to the held to maturity category in accordance with Topic 320 “Investments-Debt and Equity Securities.” Management determined that it had both the ability to hold these investments to maturity and the positive intent to do so. The securities transferred in June 2011 had a total amortized cost of $924.6 million and a fair value of $943.1 million. The securities transferred in December 2010 had a total amortized cost of $179.2 million and a fair value of $181.8 million. The unrealized gain of $18.5 million in June 2011 and $2.6 million in December 2010 will be amortized over the remaining life of the securities as an adjustment of the yield, offset against the amortization of the unrealized gain maintained in accumulated other comprehensive income.
The amortized cost and estimated fair value of debt securities by maturity at December 31, 2012 are shown below.
A total of 18 securities had unrealized losses at December 31, 2012 compared with 45 securities at December 31, 2011. These securities, with unrealized losses aggregated by investment category and length of time in a continuous unrealized loss position, are as follows:
Citizens performs a review of securities with unrealized losses at each reporting period. Citizens assesses each holding to determine whether and when a security will recover in value, whether it intends to sell the security and whether it is more likely than not that Citizens will be required to sell the security before the value is recovered. In assessing the recovery of value, the key factors reviewed include the length of time and the extent the fair value has been less than the carrying cost, adverse conditions, if any, specifically related to the security, industry or geographic area, historical and implied volatility of the fair value of the security, credit quality factors affecting the issuer or the underlying collateral, payment structure of the security, historical payment history of the security, changes to the credit rating of the security, recoveries or declines in value subsequent to the balance sheet date or any other relevant factors. Evaluations are performed on a more frequent basis as the degree to which fair value is below carrying cost or the length of time that the fair value has been continuously below carrying cost, increases. As of December 31, 2012, Citizens has concluded that all issuers have the ability to pay contractual cash flows. The unrealized losses displayed in the above table are believed to be temporary and thus no impairment loss has been realized in the statements of operations. Citizens has not decided to sell securities with unrealized losses nor does Citizens believe it will be required to sell securities before the value is recovered, but may change its intent in response to significant, unanticipated changes in policies, regulations, statutory legislation or other criteria.
The collateralized mortgage obligations (“CMO”) sector includes securities where the underlying collateral consists of agency issued or whole loan mortgages. At December 31, 2012, the whole loan CMOs had a market value of $58.9 million with gross unrealized losses of $0.6 million. Citizens performs a thorough credit review on a quarterly basis for the underlying mortgage collateral as well as the supporting credit enhancement and structure. The results of the December 31, 2012 credit review demonstrated continued strength and no material degradation in the holdings.
Citizens has determined there is no other-than-temporary impairment at December 31, 2012.
For the year ended December 31, 2012, as part of its capital strategy, Citizens sold $2.5 million of available for sale securities and recorded no gain or loss.
Note 3. Loans
Citizens has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Citizens seeks to control its credit risk by reviewing its aggregate outstanding commitments and loans to particular borrowers, industries, and geographic areas. Collateral is secured based on the nature of the credit and management’s credit assessment of the customer. Total portfolio loans outstanding are recorded net of unearned income, unamortized premiums and discounts, deferred loan fees and costs, and fair value adjustments. Citizens does not have a concentration in any single industry segment that exceeds 10% of total loans.
The quality of Citizens loan portfolios is assessed as a function of net loan losses, levels of nonperforming loans and delinquencies, and credit quality ratings. These credit quality ratings are an important part of the overall credit risk management process and evaluation of the allowance for loan losses (see Note 4 - Allowance for Loan Losses).
Past Due Loans, Nonaccrual Loans and Nonperforming Assets. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are generally placed on nonaccrual status when there is substantial doubt regarding collection of principal or interest, in full, based on Citizens’ credit policies and practices or when principal or interest is past due in excess of 90 days. When a loan is placed on nonaccrual status, interest that is accrued but not collected is reversed and charged against income. Cash collected on nonaccrual loans is generally applied to outstanding principal. Loans are normally restored to accrual status if and when interest and principal payments are current, it is believed that the financial condition of the borrower has improved to the extent that future principal and interest payments will be met on a timely basis, and the borrower has maintained the loan in a current status for a period of not less than six months. Nonperforming assets are comprised of nonaccrual loans, loans past due over 90 days and still accruing interest, nonperforming loans held for sale, and other repossessed assets acquired.
A summary of nonperforming assets by class of loans follows:
The following tables provide a summary of loans by class, including the delinquency status of those loans that continue to accrue interest and those loans that are nonaccrual.
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
Credit Quality Indicators. Citizens categorizes commercial loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Citizens analyzes commercial loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $0.5 million and non-homogeneous loans, such as commercial and industrial and commercial real estate loans. Credit quality indicators are reviewed and updated as applicable on an ongoing basis in accordance with Citizens’ credit policy. Citizens uses the following definitions for risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation for full value, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Commercial loans considered doubtful are evaluated for impairment as part of the specific allocated allowance.
Loans not meeting the criteria above are considered to be pass rated loans. Commercial loans by risk category of class follow.
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
For residential and consumer loans, Citizens evaluates credit quality based on the aging status of the loan and by payment activity. Performing loans are considered to have a lower risk of loss and are on accruing status. Nonperforming loans are comprised of nonaccrual loans and loans past due over 90 days and still accruing interest. The following table presents the recorded investment in residential and consumer loans based on payment activity.
Loans Held for Sale. Loans held for sale are comprised of commercial real estate and residential mortgage loans. Loans held for sale were $10.7 million at December 31, 2012, compared to $10.4 million at December 31, 2011. During 2012, $24.0 million in portfolio loans and $5.2 million in repurchased loans were transferred to held for sale. Also during 2012, $16.0 million of loans held for sale were sold, and there were $11.3 million of repayments on the held for sale portfolio.
Note 4. Allowance for Loan Losses
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The methodology used for measuring the appropriateness of the allowance for loan losses relies on several key elements, which include specific allowances for identified impaired loans, a risk-allocated allowance for the remainder of the portfolio and a general valuation allowance estimate.
The activity within the allowance for loan losses is presented below.
A summary of the allowance for loan losses, segregated by portfolio segment follows:
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
(1) Amounts contained in “Commercial and industrial” on Consolidated Balance Sheets.
Impaired loans. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
Citizens recognized $2.6 million of interest income on nonperforming loans for years ended December 31, 2012. Had nonperforming loans performed in accordance with their original contract terms, Citizens would have recognized additional interest income of approximately $3.2 million for the year ended December 31, 2012. There were no significant commitments outstanding to lend additional funds to clients whose loans were classified as restructured at December 31, 2012 or December 31, 2011.
A summary of information regarding loans individually reviewed for impairment, segregated by class are set forth in the following table.
Troubled Debt Restructurings. A modified loan is considered a Troubled Debt Restructuring (“TDR”) when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made that would not otherwise be considered for a borrower with similar credit characteristics. While commercial loan modifications vary depending on circumstances, the most common types of modifications for residential and consumer loans include below market rate reductions and/or maturity extensions, and generally do not include forgiveness of principal balances. Modified terms are dependent upon the financial position and needs of the individual borrower. Citizens does not employ modification programs for temporary or trial periods, all modifications are permanent. The modified loan does not revert back to its original terms, even if the modified loan agreement is violated.
Citizens classifies TDRs as nonaccruing loans unless the loan qualified for accruing status at the time of the restructure, or the loan has performed according to the new contractual terms for at least six months. To qualify for accruing status at the time of the restructure, the original loan must have been less than 90 days past due at the time of the restructure and the modification must not have resulted in an impairment loss. At December 31, 2012 the majority of Citizens’ TDRs are on accrual status and are reported as impaired. TDR classifications may be removed if the borrower demonstrates compliance with the modified terms and the restructuring agreement specifies a market rate of interest equal to that which would be provided to a borrower with similar credit at the time of restructuring. Otherwise, the loans remain classified as TDRs. As a result of guidance from the Office of the Comptroller of the Currency (“OCC”), approximately $4.0 million of residential mortgage and consumer loans were identified as TDRs whereby the borrower’s obligation to Citizens has been discharged in bankruptcy and the borrower has not reaffirmed the debt. These loans were reclassified as TDRs as of December 31, 2012 and consisted of $2.9 million of residential mortgage loans and $1.1 million of consumer loans.
The recorded investment balance of TDRs approximated $29.1 million at December 31, 2012. TDRs of $21.0 million were on accrual status and $8.1 million of TDRs were on nonaccrual status at December 31, 2012. TDRs are evaluated separately in Citizens’ allowance for loan loss methodology based on the expected cash flows for loans in this status. At December 31, 2012, the allowance for loan losses included specific reserves of $4.0 million related to TDRs, which included $3.3 million related to mortgage TDRs and $0.7 million related to direct consumer TDRs, compared to $2.9 million of specific reserves related to TDRs at December 31, 2011, which included $2.8 million related to mortgage TDRs and $0.1 million related to direct consumer TDRs. Citizens charged off $4.1 million and $6.1 million for the years ended December 31, 2012 and December 31, 2011, respectively, for the portion of TDRs deemed to be uncollectible.
The following table provides information on loans modified during each year noted as a TDR.
The following table provides information on how loans were modified as a TDR.
(1) Other includes covenant modification, forebearance, loans discharged in bankruptcy and not reaffirmed, and other concessions or combination of concessions that do not consist of interest rate adjustments and/or maturity extensions.
A TDR loan is considered to have a payment default when one or more payments is over 90 days past due. At December 31, 2012 and 2011, respectively, there were 26 loans of approximately $1.6 million and two loans of approximately $0.4 million modified as TDRs that were in payment default.
Note 5. Premises and Equipment
A summary of premises and equipment follows:
Certain branch facilities and equipment are leased under various operating contracts. Total rental expense, including expenses related to these operating leases, was $6.1 million in 2012 and $6.0 million in both 2011 and 2010. Future minimum rental commitments under non-cancelable operating leases are as follows.
Note 6. Goodwill and Core Deposit Intangible Assets
A summary of goodwill allocated to the lines of business follows:
The recorded balance of goodwill has not changed during 2012 and 2011. In 2012, Citizens elected to perform the qualitative assessment to determine whether it is more likely than not that the fair value of the reporting unit was below its carrying amount as of October 1, 2012. Based on the positive evidence in the analysis, Citizens concluded that it is more likely than not that fair value exceeds its carrying value. Furthermore, no goodwill impairment exists on the consolidated level as the allocated goodwill resides only in these two reporting units. No events (individually or in aggregate) have occurred since the annual goodwill impairment analysis that indicates a potential impairment of goodwill
A summary of core deposit intangibles follows:
The following presents the estimated future amortization expense of core deposit intangible assets.
All of Citizens’ core deposit intangible assets have finite lives and are amortized on an accelerated basis corresponding with the anticipated lives of the underlying deposits over varying periods not exceeding 10 years. The weighted average amortization period for core deposit intangible assets is 1.8 years.
Note 7. Deposits
Overdrafts on demand accounts are classified as loans, rather than deposits, on the face of the balance sheet and totaled $3.0 million and $7.2 million at December 31, 2012 and 2011, respectively. Time deposits over $100,000 totaled $510.4 million at December 31, 2012, compared with $616.0 million at December 31, 2011. The scheduled maturities for time deposits at December 31, 2012 were as follows.
Note 8. Short-Term Borrowings
Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase and other short-term borrowings. Federal funds purchased are overnight borrowings from other financial institutions. Securities sold under agreements to repurchase are secured transactions done principally with investment banks. Maturities of securities sold under agreements to repurchase are generally 90 days or less.
Information relating to federal funds purchased and securities sold under agreements to repurchase follows.
Note 9. Long-Term Debt
A summary of long-term debt follows.
On January 27, 2003, Citizens issued $125.0 million of 5.75% subordinated notes, maturing February 1, 2013. Issuance costs were capitalized and are included in the long-term debt total on the balance sheet. The issuance costs were amortized over ten years as a component of interest expense.
On June 26, 2003, Citizens issued $25.8 million of floating rate, 30-year trust preferred securities through an unconsolidated special purpose trust to unrelated institutional investors. The gross proceeds from issuance were used to purchase a floating rate junior subordinated deferrable interest debenture (“2003 Debenture”) issued by Citizens, which is the sole asset of the trust. The 2003 Debenture matures in thirty years and bears interest at an annual rate equal to the three-month LIBOR plus 3.10%, payable quarterly beginning in September 2003. Interest is adjusted on a quarterly basis not to exceed 11.75%. The 2003 Debenture is an unsecured obligation of Citizens and is junior in right of payment to all future senior indebtedness of Citizens. Citizens has guaranteed that interest payments on the 2003 Debenture made to the trust will be distributed by the trust to the holders of the trust preferred securities. The trust preferred securities of the special purpose trust are callable at par and must be redeemed in thirty years after issuance. The issuance costs were amortized to the call date over five years as a component of interest expense, as Citizens believed this was the most probable life of these securities. Under the risk-based capital guidelines, the trust preferred securities currently qualify as Tier 1 capital.
On October 3, 2006, Citizens Funding Trust I (“2006 Trust”) completed an offering of $150.0 million aggregate liquidation amount of enhanced trust preferred securities. The gross proceeds from issuance were used to purchase a junior subordinated deferrable interest debenture issued by Citizens, which is the sole asset of the 2006 Trust (the “2006 Debenture”). The 2006 Debenture ranks junior to Citizens’ outstanding debt, including the other outstanding junior subordinated debentures. The enhanced trust preferred securities are listed on the New York Stock Exchange (NYSE symbol CTZ-PrA). Distributions on the securities, which represent undivided beneficial interests in the assets of the 2006 Trust, accrue from the original issue date and are payable quarterly in arrears at an annual rate of 7.50%, beginning December 15, 2006. The securities became callable on September 15, 2011 and mature on September 15, 2066. Issuance costs of $5.1 million were capitalized and are amortized through the long-term debt total on the Consolidated Balance Sheets. The issuance costs were amortized to the call date over five years as a component of interest expense. The proceeds were used to finance the cash portion of the consideration paid in Citizens’ merger with Republic Bancorp and for general corporate purposes.
On January 28, 2010 Citizens announced that it was suspending the dividend payments on its trust preferred securities. In December 2012, Citizens announced the resumption of payments on these securities beginning in December 2012, as to the 2003 Debenture, and in March 2013 as to the 2006 Debenture. Citizens accrues for these obligations in other liabilities on the Consolidated Balance Sheets and as of December 31, 2012, the total amount of the arrearage is $12.4 million.
As of December 31, 2012, advances from the FHLB are at fixed rates ranging from 2.16% to 6.93% and mature from 2016 through 2022. Citizens restructured $350.0 million and $245.0 million in FHLB advances during 2012 and 2011, respectively. These restructures resulted in the locking in of lower term funding rates. The average interest rate on the 2012 restructured advances was reduced to 2.55% from 3.50% and the average remaining term was extended to 9.0 years from 3.2 years. The average interest rate on the 2011 restructured advances was reduced to 3.32% from 4.84% and the average remaining term was extended to 5.8 years from 3.3 years. FHLB advances totaling $5.0 million may be put back to Citizens at the option of the FHLB. Advances totaling $462.0 million are non-convertible and subject to neither put nor call options. Citizens’ advances from the FHLB were collateralized at December 31, 2012 with $2.0 billion of residential and commercial loans secured by real estate and securities held for pledging. At December 31, 2012, Citizens had $185.0 million of variable rate advances from the FHLB outstanding. The advances are indexed to one month LIBOR with an average interest rate of 3.25% and an average remaining term to maturity of 5.0 years.
As of December 31, 2012, $103.4 million of long-term repurchase agreements with interest rates up to 4.69%, maturing between August 2015 and May 2016 were outstanding. Long-term repurchase agreements are classified under Other borrowed funds.
The par value of long-term debt is scheduled to mature as shown in the table below. This schedule excludes all carrying value adjustments, such as purchase accounting fair value adjustments, hedge accounting fair value adjustments, and unamortized premiums and discounts, that will not affect future cash payments associated with the maturity of this debt.
Note 10. Fair Values of Assets and Liabilities
Fair value estimates are intended to represent the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Given that there is no active market for many of Citizens’ financial instruments, Citizens has made estimates using discounted cash flow or other valuation techniques. Inputs to these valuation methods are subjective in nature, involve uncertainties, and require significant judgment and therefore cannot be determined with precision. Accordingly, the derived fair value estimates presented herein are not necessarily indicative of the amounts Citizens could realize in a current market exchange.
The fair value estimates are based on existing on and off balance sheet financial instruments and do not attempt to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. For example, Citizens has a substantial trust department that contributes net fee income annually. The trust department is not considered a financial instrument and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include Citizens’ brokerage network, net deferred tax assets (and any related valuation reserves), and premises and equipment. In addition, tax ramifications related to the recognition of unrealized gains and losses such as those within the investment securities portfolio can have a significant effect on estimated fair values and have not been considered in the estimates. For these reasons, the aggregate fair value should not be considered an indication of Citizens’ value.
Citizens groups assets and liabilities which are recorded at fair value into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. An asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). A brief description of each level follows.
Level 1 - Valuation is based upon quoted prices for identical instruments in active markets.
Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Valuation techniques include the use of discounted cash flow models and similar techniques.
The carrying amount, estimated fair value, and placement in the fair value hierarchy of Citizens’ financial instruments that are not measured at fair value in their entirety on a recurring basis follow.
The carrying amount approximates fair value for cash, money market investments, and accrued interest. The methods and assumptions used to estimate the fair value of other financial instruments, regardless of whether the instrument is carried at fair value or not, are set forth below. There were no significant changes in the valuation methods used to estimate fair value during the year ended December 31, 2012.
Securities Available for Sale. Fair value measurement is based upon quoted prices for similar assets, if available, or matrix pricing models. Matrix pricing is a mathematical technique widely used in the financial industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. The securities in the available for sale portfolio are priced by independent providers. These providers utilize pricing models that vary by asset class and incorporate available trade, bid and other market information and for structured securities, cash flow and, when available, loan performance data. Because many fixed income securities do not trade on a daily basis, the pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. In addition, Citizens uses model processes to assess interest rate impact and develop prepayment scenarios. The impact of unobservable inputs and proprietary models are not material to the determination of fair values of these securities. In obtaining such valuation information from third parties, Citizens has evaluated their valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of the price at which a transaction would take place in current markets. Further, Citizens completes a comparison of the fair value estimates quarterly by validating the data received to date provided by a separate third party. In order to then evaluate reasonableness of the market data, Citizens also independently prices a sampling of securities using data from an independent source. Should Citizens find variances, the prices are then challenged and prices are adjusted accordingly. To date, there have been no significant findings or adjustments made by Citizens. Citizens’ principal markets for its securities portfolios are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets.
Recurring Level 3 securities include auction rate securities issued by student-loan authorities and a taxable municipal Qualified Zone Academy Bond (“QZAB”). Due to the nature of the auction rate securities and the lack of a secondary market with active fair value indicators, Citizens used an income approach based on a discounted cash flow model utilizing significant unobservable inputs (Level 3) in the valuation process to estimate the transaction price between market participants for each group of securities as of the valuation date. The significant assumptions made in this modeling process included the liquidity and credit premiums, and fail rate formulas utilizing assumed interest payments. Due to the current illiquid market for QZAB bonds, Citizens relies on models containing significant unobservable market-based inputs to determine the fair value of these bonds. The primary unobservable pricing input was the assumption made regarding the ability of market participants to utilize the tax credits associated with this type of instrument.
Securities Held to Maturity. The estimated fair value of securities classified as held to maturity are based upon quoted prices for similar assets, if available, or matrix pricing models. This process is essentially the same as the valuation methodologies and price verification functions used for securities available for sale.
FHLB and Federal Reserve Stock. The carrying amount of FHLB and Federal Reserve stock is used to approximate the fair value of these investments. These securities are not readily marketable, are recorded at cost (par value), and are evaluated for impairment based on the ultimate recoverability of the par value. Citizens considers positive and negative evidence, including the profitability and asset quality of the issuer, dividend payment history and recent redemption experience, when determining the ultimate recoverability of the par value. Citizens believes its investments in FHLB and Federal Reserve stock are ultimately recoverable at par.
Net Portfolio Loans. The fair value of loans and loan commitments is estimated based on discounted cash flows using exit-value rates at December 31, 2012 and December 31, 2011, weighted for varying maturity dates. The cash flows take into consideration current portfolio interest rates and repricing characteristics as well as assumptions relating to prepayment speeds. The discount rates take into
consideration the current market interest rate environment, a credit risk component based on the credit characteristics of each loan portfolio, and a liquidity premium reflecting the liquidity or illiquidity of the market. If an entry-value rate was used to estimate fair value of loans and loan commitments, the disclosed fair value would have been higher for the periods presented.
Deposits. The estimated fair value of demand deposits (e.g., noninterest and interest bearing demand, savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for certificates of deposit are based on the discounted value of contractual cash flows at current interest rates. The estimated fair value of deposits does not take into account the value of Citizens’ long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, and not considered financial instruments.
Short-Term Borrowings. The carrying amounts of federal funds purchased, securities sold under agreement to repurchase and other short-term borrowings approximate their fair values because they frequently reprice to a market rate.
Long-Term Debt. The fair value is estimated using observable market prices and by discounting future cash flows using current interest rates for similar financial instruments.
Derivative Instruments. Substantially all derivative instruments held or issued by Citizens are traded in over-the-counter markets where quoted market prices are not readily available. Derivative instruments are priced by independent providers using observable market assumptions with adjustments based on widely accepted valuation techniques. For those derivatives, Citizens measures fair value with models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk (credit valuation adjustments). Citizens assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions, and determined that the credit valuation adjustments were not significant to the overall valuation of its derivatives.
Deferred Compensation Assets. Citizens has a portfolio of mutual fund investments classified as trading securities which hedge the deferred compensation liabilities for various employees, former employees and directors. These investments are traded on active exchanges with valuations obtained from readily available pricing sources for market transactions involving identical assets. Additionally, Citizens invests in a Guaranteed Income Fund which is supported by a group annuity insurance contract issued by Prudential Retirement Insurance and Annuity Company. The investment is recorded at contract value and, based on the nature of the fund, generally approximates fair value. The Guaranteed Income Fund has no maturity date and is secured only by Prudential’s general account. Therefore, the Guaranteed Income Fund is recorded as recurring Level 3.
Impaired Loans. A loan is considered to be impaired when it is probable that all of the principal and interest due under the original underwriting terms of the loan may not be collected. Impairment is typically measured based on the fair value of the underlying collateral. The fair value of the underlying collateral is determined, where possible, using market prices derived from appraisals, which are considered to be Level 2. Since certain assumptions and unobservable inputs related to loss severity are currently being used, impaired loans are recorded as Level 3 in the fair value hierarchy. Citizens measures impairment on all nonaccrual commercial and industrial and commercial real estate loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses. Citizens measures impairment on all residential mortgage loans over five payments past due.
Loans Held for Sale. Residential mortgage loans held for sale are comprised of loans originated for sale in the ordinary course of business and selected nonperforming residential mortgage loans. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for similar loans and are classified as nonrecurring Level 2. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral, net of estimated costs to sell, using market prices derived from indicative pricing models which utilize projected assumptions about loss severity Citizens believes potential investors would make or appraisals and are classified as nonrecurring Level 3.
Commercial loans held for sale are comprised primarily of loans identified for sale that are recorded at the lower of carrying amount or fair value based on appraisals of the underlying collateral, which are also subject to management adjustments for loss severity based on current market conditions and recent sales activity. Citizens records commercial loans held for sale as nonrecurring Level 3.
Other Real Estate. Other real estate (“ORE”) is comprised of commercial and residential real estate acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure. Commercial properties and former branch locations are carried at fair value at the time of acquisition based on the fair value of the underlying real property, net of estimated costs to sell and are subsequently monitored for lower of carrying value or fair value adjustments. This is determined using market prices derived from appraisals, which are considered to be Level 2. However, certain assumptions and unobservable inputs related to loss severity are currently being used by appraisers and management, therefore, qualifying the assets as Level 3 in the fair value hierarchy. Residential real estate is recorded at the fair value of the underlying real property, net of estimated costs to sell, using market prices derived from indicative pricing models which utilize projected assumptions Citizens believes potential investors would make or appraisals and are classified as nonrecurring Level 3. Losses arising from the initial acquisition of such properties are charged against the allowance for loan losses at the time of transfer. Subsequent valuation adjustments to reflect fair value, as well as gains and losses on disposal of these properties, are charged to noninterest expense as incurred. Citizens records ORE properties as nonrecurring Level 3.
Repossessed Assets. Repossessed assets consist of consumer assets acquired to satisfy the consumer’s outstanding delinquent debt. These assets consist of automobiles, boats, recreational vehicles and other personal items. These assets are carried at fair value, net of estimated costs to sell, based on internally developed procedures. Citizens records repossessed assets as nonrecurring Level 3.
Some of the assets and liabilities discussed above are measured on a recurring basis while others are measured on a nonrecurring basis, with the determination based upon applicable existing accounting pronouncements. For example, investment securities available for sale, derivative instruments, and deferred compensation assets are recorded at fair value on a recurring basis. Other assets, such as loans held for sale, impaired loans, other real estate, and repossessed assets are recorded at fair value on a nonrecurring basis. Goodwill and core deposit intangibles are measured for impairment on a nonrecurring basis and are written down when the value of the individual asset has declined.
The following table presents the balances of assets and liabilities that were measured at fair value on a recurring basis.
There were no significant transfers between levels within the fair value hierarchy nor were there any issuances during the 12 month period ended December 31, 2012. The following table presents the reconciliation of Level 3 assets held by Citizens.
(1) Net realized gains and losses recorded in earnings include discount accretions.
The following table includes assets measured at fair value on a nonrecurring basis that have had a fair value adjustment.
The following table represents quantitative information about Level 3 fair value measurements.
(1) Carrying value approximates fair value.
(2) Contract value approximates fair value.
The significant unobservable inputs used in the fair value measurement of Citizens’ recurring Level 3 securities are the liquidity and credit premiums and fail rate formula. A change in these inputs to a different amount would not result in a material change in fair value.
Note 11. Employee Benefit Plans
Pension and Postretirement Benefits. Citizens maintains a cash balance defined benefit pension plan. Pension retirement benefits are based on the employees’ length of service and salary levels. Under the defined benefit plan, employees are eligible for early retirement at age 55 with at least 3 years of service. It is Citizens’ policy to fund pension costs in an amount sufficient to meet or exceed the minimum funding requirements of applicable laws and regulations, plus such additional amounts as Citizens deems appropriate up to the level allowed by federal tax regulations. Actuarially determined pension costs are charged to current operations. Effective December 31, 2006, Citizens’ defined benefit pension plan was “frozen,” preserving prior earned benefits but discontinuing the accrual of further benefits. Citizens also maintains nonqualified supplemental benefit plans for certain former key employees. These plans are provided for by charges to earnings sufficient to meet the projected benefit obligation under applicable accounting standards. Benefits under the nonqualified supplemental plans are based primarily on years of service, age and compensation before retirement. The defined pension benefits provided under these plans are unfunded and any payments to plan participants are made by Citizens. Citizens’ postretirement benefit plan provides postretirement health and dental care to full-time employees who retired with eligibility for coverage based on historical plan terms. Current employees are not eligible to participate in the bank-subsidized retiree health and dental plan.
The estimated portion of balances included in accumulated other comprehensive income that have not been recognized prior to December 31 are presented below.
The amounts in accumulated other comprehensive income expected to be recognized as components of net periodic benefit costs during 2013 are amortization of prior service credits and net losses of $0.9 million and $3.4 million, respectively.
The net actuarial gain or loss and prior service cost recognized in accumulated other comprehensive income are presented below.
An actuarial measurement date of December 31 was utilized in the following table to determine the projected benefit obligations, fair value of plan assets, and accumulated benefit obligation.
The change in projected benefit obligation for the Defined Benefit Pension Plan, is related to a decrease in the discount rate, partially offset by a small demographic gain and a decrease in the cash balance interest crediting rate. At December 31, 2012, the underfunded status of the Cash Balance Pension Plan for employees, the Supplemental Pension Plans, and the Retirement Health Plan is recognized in the consolidated balance sheet as an accrued liability. No plan assets are expected to be returned to Citizens during the year ending December 31, 2013.
Effective December 31, 2011, Citizens recognized the impact of a plan amendment based upon the implementation of a new Medicare Supplemental program for the postretirement plan participants. Additionally, this change resulted in the recognition of a curtailment benefit due to the elimination of a subsidy for a portion of the plan participants.
The components of net periodic benefit cost charged to operations each year for all plans follow.
The assumptions used in determining the actuarial present value of the benefit obligations and the net periodic pension expense follow.
The projected benefit payments for the employee benefit plans over the next ten years follow.
The projected payments were calculated using the same assumptions as those used to calculate the benefit obligations listed above.
Investment Policy and Strategy. Management’s investment policy and strategy for managing defined benefit plan assets is described as growth with income. Management analyzes the potential risks and rewards associated with the asset allocation strategies on a quarterly basis. Implementation of the strategies includes regular rebalancing to the target asset allocation. The target asset allocation mix remained at 60% equities and 40% fixed income debt securities and cash equivalents during 2012. The long-term rate of return expected on plan assets is finalized after considering long-term returns in the general market, long-term returns experienced by the assets in the plan, and projected plan expenses.
The plans’ target asset allocation and the actual asset allocation at December 31, 2012 are presented below.
The pension plan assets for which Citizens determines fair value include a short-term pooled money fund, equity, and fixed income securities, all of which fall into Level 2 in the fair value hierarchy at December 31, 2012. Citizens’ pension plan assets are invested solely in pooled separate account funds, which are managed by Prudential. The net asset values (NAV) are based on the value of the underlying assets owned by the fund, minus its liabilities, and then divided by the number of units outstanding. The NAV’s unit price of the pooled separate accounts is not quoted on any market; however, the unit price is based on the underlying investments which are traded in an active market and are priced by independent providers. Citizens has evaluated their valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of an exit price in Citizens’ principal markets. Further, Citizens has developed an internal, independent price verification function that performs testing on valuations received from third parties. There are no significant restrictions on Citizens’ ability to sell any of the investments in the pension plan.
The estimated fair values of Citizens’ pension plan assets follows.
Citizens contributed $2.7 million in 2012 and anticipates contributing $1.2 million in 2013 as required under current funding regulations. Citizens anticipates making a contribution of $0.5 million to the nonqualified supplemental benefit plans during 2013. In addition, Citizens expects to pay $0.2 million in contributions to the postretirement healthcare benefit plan during 2013.
Prior service pension costs for the Citizens’ Cash Balance Pension plan are amortized on a straight-line basis over average remaining service period of employees expected to receive benefits under the plan. The annual amortization for the Postretirement Benefits Plans is calculated based on the average remaining lifetime of current retired participants. For the postretirement health care benefit plan, Citizens assumed an 8.8% annual health care cost trend rate for 2012, which grades down to the ultimate trend of 5.0% by 2032. This assumption can have a significant effect on the amounts reported. A one-percentage-point change in assumed health care trend rates would have the following effects:
Defined Contribution Retirement and 401(k) Plans. Substantially all employees are eligible to contribute a portion of their pre-tax salary to a defined contribution 401(k) savings plan. Citizens suspended the 401(k) matching funds and annual discretionary contributions during the third quarter of 2009. The Board of Directors approved the reinstatement of the 401(k) matching funds effective January 1, 2012. Contributions to the 401(k) savings plan are now matched 50% on the first 2% of salary deferred and 25% on the next 6% deferred. Under the elective contribution feature, Citizens contributed $1.8 million in 2012.
Note 12. Stock-Based Compensation
Citizens has a stock-based compensation plan authorizing the granting of incentive and nonqualified stock options, restricted stock awards, restricted stock units, and performance awards to employees and non-employee directors. A plan amendment and restatement was approved by shareholders on May 4, 2010 that increased the number of shares reserved under the plan to 2,400,000, removed the 200,000 share sublimit for grants other than stock options and made various other changes. At December 31, 2012, Citizens had 950,248 shares of common stock reserved for future issuance under the current plan.
Under the provisions of the grants made pursuant to the Stock Compensation Plan in 2012 and 2011, stock awards were divided between performance-based stock and time-based stock. The performance-based stock was measured against annual metrics over a two year period. The time-based stock will vest three years after the grant date. Once vested, these shares will remain nontransferable until the Holding Company has redeemed all or a portion of the Troubled Asset Relief Program (“TARP”) Preferred Stock issued to Treasury pursuant to the Capital Purchase Program. A prorated portion of the vested shares become transferable upon redemption of the TARP Preferred Stock based on a predefined schedule established by the Treasury.
The compensation cost for share-based awards is recognized over the requisite service period of the award. The requisite service period is presumed to be the stated vesting period or the estimated time that will be required to satisfy any performance conditions. Restricted shares are included in outstanding stock totals, and are entitled to receive dividends and have voting rights. Restricted stock units have no voting or dividend rights but have dividend equivalent rights entitling them to additional shares at the time the units are settled for common stock. There have been no options granted since 2006 and no recognized costs associated with stock options since 2009. Forfeited and expired options and forfeited shares of restricted stock become available for future grants.
The following table sets forth the total stock-based compensation expense resulting from stock options and restricted stock awards included in the Consolidated Statements of Operations.
New shares are issued when stock options are exercised. There were no stock options exercised during the years ended December 31, 2012, 2011, and 2010. Citizens presents excess tax benefits from the exercise of stock options, if any, as financing cash inflows and as operating cash outflows on the Consolidated Statements of Cash Flows.
The following table summarizes stock option activity.
There were no stock options vested during 2012 and 2011. The fair value of options vested during 2010 was less than $0.1 million.
As of December 31, 2012, $5.7 million of total unrecognized compensation cost related to restricted stock is expected to be recognized over a weighted average period of 1.6 years.
The following table summarizes restricted stock activity.
(1) Includes 75,814 vested shares under restriction prohibiting sale until conditions are met, including two years from grant date and certain TARP payments are made.
The total fair value of restricted stock vested during 2012 was $1.4 million and $0.3 million for 2011 and 2010.
Note 13. Income Taxes
Significant components of income taxes from continuing operations are as follows.
Generally, the calculation for the income tax provision (benefit) does not consider the tax effects of changes in OCI, which is a component of shareholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a pre-tax loss from continuing operations and income in other components of the financial statements. In such a case, pre-tax income from other categories (such as changes in OCI) is included in the calculation of the continuing operations tax provision. For 2011, this resulted in an increase to the income tax benefit of $7.7 million.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Citizens’ deferred tax assets and liabilities as of December 31, 2012 and 2011 follow.
At December 31, 2012, the carrying values of certain loss carryforwards include a cumulative reduction of $39.1 million to reflect their estimated realizability at year end. This adjustment was required due to limitations imposed by Section 382 of the Internal Revenue Code as further discussed below.
At December 31, 2012, taking into account the above noted reduction, Citizens had gross federal loss carryforwards of $618.0 million that expire in 2028 through 2032, gross state loss carryforwards of $81.8 million that expire in 2014 through 2027, and $13.6 million of federal alternative minimum tax credits with an indefinite life. The gross loss carryforward contains $0.2 million that relates to unrealized excess benefits on stock-based compensation for which a tax benefit will be recorded to shareholders’ equity when utilized.
In assessing whether or not some or all of our deferred tax assets are more likely than not to be realized in the future, we consider all available positive and negative evidence, including projected future taxable income, tax planning strategies and recent financial operations. Based on an evaluation of the then-available positive and negative evidence, Citizens determined it was appropriate to establish a full valuation allowance on our deferred tax asset as of December 31, 2008. At that time, and in subsequent quarters, negative evidence, including a recent cumulative history of operating losses, outweighed the positive evidence.
However, at June 30, 2012, the positive evidence outweighed the negative evidence and Citizens determined that a deferred tax asset valuation allowance was no longer necessary. The significant positive evidence in our analysis included: five consecutive quarters of profitability, termination of the written agreement with our primary regulators, improved capital levels, solid credit metrics, strong deposit mix, reduced regulatory risk, and a stabilizing economy.
At December 31, 2012, the positive evidence above including, now, seven consecutive quarters of profitability, continues to exist and outweigh the negative evidence. Therefore, management has determined that no valuation allowance is necessary at December 31, 2012.
The deferred tax assets continue to be analyzed quarterly for changes affecting realizability and the valuation allowance may be adjusted in future periods accordingly. The ultimate realization of these deferred tax assets is primarily dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Changes in existing tax laws could also affect actual tax results and the valuation of deferred tax assets over time. The accounting for deferred taxes is based on an estimate of future results. Differences between anticipated and actual outcomes of these future tax consequences could have an impact on Citizens’ consolidated results of operations or financial position.
During 2009, Citizens incurred an ownership change within the meaning of Section 382 of the Internal Revenue Code. As a result, federal tax law places an annual limitation of approximately $17.7 million on the amount of certain loss carryforwards that may be used.
Citizens’ effective tax rate differs from the statutory federal tax rate. The following is a summary of such differences:
In December 2010, Citizens filed a request with the Internal Revenue Service (“IRS”) to change its tax accounting method related to bad debts. The IRS approved the request in June 2011, which allowed Citizens to change its current method of recording tax bad debts from the book conformity method to a new specific charge-off method.
A reconciliation of the beginning and ending amount of unrecognized tax benefits follows.
The entire amount of unrecognized tax benefits would affect Citizens’ effective tax rate if recognized. It is Citizens’ policy to recognize interest and penalties accrued relative to unrecognized tax benefits in its respective federal or state income tax accounts. Accrued interest was $0.1 million as of December 31, 2012 and 2011. Citizens accrued no interest in 2012 and recognized $0.1 million benefit of interest in 2011. Citizens does not believe it is reasonably possible that unrecognized tax benefits will significantly change within the next 12 months.
During 2010, Citizens settled its 2006 through 2008 federal examinations and recognized a tax benefit of $0.5 million.
Citizens and its subsidiary file U.S. federal income tax returns, as well as various returns in the states where its banking offices are located. The following tax years remain subject to examination as of December 31, 2012.
Note 14. Shareholders’ Equity and Earnings Per Common Share
On June 14, 2011, Citizens announced a 1-for-10 reverse stock split of Citizens common stock effective after the close of trading on July 1, 2011. Citizens common stock began trading on a split adjusted basis on The NASDAQ Capital Market at the opening of trading on July 5, 2011. All share and per share amounts reflect the 1-for-10 reverse stock split.
In connection with the reverse stock split, stockholders received one new share of common stock in exchange for every ten shares held at the effective time. The reverse stock split reduced the number of shares of outstanding common stock from approximately 397.8 million to 39.8 million. The number of authorized shares of common stock was reduced from 1.05 billion to 105.0 million. Proportional adjustments were made to Citizens’ outstanding options, warrants and other securities entitling their holders to purchase or receive shares of Citizens common stock so that the reverse stock split did not materially affect any of the rights of holders of those securities. The number of shares available under Citizens’ equity-based plans was also proportionately reduced.
During the first quarter of 2010, Citizens suspended quarterly cash dividend payments on its fixed-rate cumulative perpetual preferred stock, TARP Preferred Stock, issued to and owned by the U.S. Department of the Treasury as part of the Treasury’s Capital Purchase Program. Citizens has both the intent and ability in the future to pay these dividends and therefore accrues for this obligation. Citizens is currently in arrears in the amount of $48.5 million and $31.5 million with the dividend payments on the TARP Preferred Stock as of December 31, 2012 and 2011, respectively.
On December 12, 2008, Citizens issued 300,000 shares of TARP Preferred Stock to the Treasury as part of the Treasury’s Capital Purchase Program. In addition, Citizens issued a ten-year warrant to the Treasury to purchase up to 1,757,813 shares of Citizens’ common stock, no par value at an exercise price of $25.60 per share. The aggregate proceeds from the transaction were $300.0 million. The TARP Preferred Stock has no par value, carries a liquidation price of $1,000 per share, and pays cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Citizens may redeem the preferred stock at the liquidation price plus accrued and unpaid dividends. Citizens is accreting the book value of the preferred stock issued under the TARP using the effective interest method up to the par value of $300 million. The preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The preferred shares qualify as Tier 1 capital. The warrant is immediately exercisable, qualifies as Tier 1 capital and expires in December 2018.
Earnings per common share is computed using the two-class method. Basic earnings per common share is computed by dividing net income allocated to common shareholders by the weighted average number of common shares outstanding, excluding outstanding participating securities. Participating securities include restricted stock awards because holders of these awards have the right to receive non-forfeitable dividends at the same rate as holders of common stock and have voting rights. Diluted earnings per common share is computed based on the weighted average number of common shares outstanding including the dilutive effect of stock-based compensation. Potential common stock that would be generated from restrictions lapsing on unvested shares as well as additional shares issued through the exercise of stock options and warrant were anti-dilutive and therefore excluded from the computation of dilutive earnings per share.
A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations follows.
Stock Repurchase Program: Citizens purchased shares under a board approved stock repurchase program initiated in October 2003. This program authorizes Citizens to repurchase up to 300,000 shares. 124,115 shares remain available for repurchase under the program. There were no shares purchased under this plan in 2010, 2011, or 2012. Shares deemed purchased in connection with the exercise of certain employee stock options and the vesting of certain share awards were not part of the repurchase program. In 2012 and 2011, Citizens purchased 26,707 and 1,684 shares, respectively, primarily in connection with taxes due from employees as a result of the vesting of certain share awards.
The components of accumulated other comprehensive income (loss), net of tax, are presented below.
Note 15. Lines of Business
The financial performance of Citizens is monitored by an internal profitability measurement system, which provides line of business results and key performance measures. The profitability measurement system is based on internal management methodologies designed to produce consistent results and reflect the underlying economics of the businesses. The development and application of these methodologies is a dynamic process. Accordingly, these measurement tools and assumptions may be revised periodically to reflect methodology, product, and/or management organizational changes. Further, these policies measure financial results that support the strategic objectives and internal organizational structure of Citizens. Consequently, the information presented is not necessarily comparable with similar information for other institutions.
A description of each business line, selected financial performance and the methodologies used to measure financial performance are presented below.
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Regional Banking -Regional Banking provides a wide range of lending, depository, and other related financial services to both individual consumers and businesses. The products and services offered to consumer clients include: direct loans, home equity loans and lines of credit, checking, savings and money market accounts, certificates of deposit, and fixed and variable annuities, as well as private banking services for affluent clients. Citizens partners with outside providers to offer consumer clients the availability of nationwide ATM, debit, and credit card networks as well as mortgage origination services. The transaction-based income and expense associated with these services are included in Regional Banking. The products and services offered to commercial and industrial clients include: term loans, revolving credit arrangements, inventory and accounts receivable financing, commercial mortgages, letters of credit, and small business loans. Noncredit services for commercial clients include deposit accounts, treasury management, corporate cash management, international banking services, advice and assistance in the placement of securities, and financial planning. Brokerage and insurance delivers retail mutual funds, other securities, variable and fixed annuities, personal disability and life insurance products and discounted brokerage services.
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Specialty Consumer- Specialty Consumer includes the indirect consumer and the residential mortgage portfolios. The indirect lending team partners with dealerships mostly across the Midwest and adjacent states to provide primarily marine and recreational vehicle loans to consumers. As nearly all of new mortgage volume is originated through the Regional Banking delivery channel and sold into the secondary market, the residential mortgage loan portfolio residing in Specialty Consumer consists primarily of historical loan production as well as the minimal new production that is retained.
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Specialty Commercial-Specialty Commercial provides a full range of lending, depository, and related financial services to commercial real estate developers, owners of multi-unit commercial properties, and middle-market companies. Products and services offered include commercial mortgages, term loans, revolving credit arrangements, letters of credit, inventory and accounts receivable financing, and leveraged cash flow lending. Noncredit services for these customers include deposit accounts, treasury management, corporate cash management, international banking services, advice and assistance in the placement of securities, and financial planning.
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Wealth Management-Wealth Management offers a broad array of asset management, financial planning, estate settlement and trust administration, credit and deposit products and services. Retirement plan services focus on investment management and fiduciary activities with special emphasis on 401(k) plans.
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Other- The Other line of business includes activities that are not directly attributable to one of the primary business lines. Included in this category are the Holding Company; shared services unit; Citizens’ treasury unit, including the securities portfolio, short-term borrowing and asset/liability management activities; inter-company eliminations; and the economic impact of certain assets, capital and support functions not specifically identifiable with the four primary lines of business.
The accounting policies of the individual business units are the same as those of Citizens described in Note 1 to the Consolidated Financial Statements. Funds transfer pricing is used in the determination of net interest income by assigning a cost for funds used or credit for funds provided to assets and liabilities within each business unit. Assets and liabilities are match-funded based on their maturity, prepayment and/or repricing characteristics. As a result, the Regional Banking, Specialty Consumer, Specialty Commercial, and Wealth Management units are largely insulated from changes in interest rates. Changes in net interest income due to changes in interest rates are reported in Citizens’ treasury unit. The provision for loan losses is allocated based upon the actual net charge-offs of each respective line of business, adjusted for loan growth and changes in risk profile. Noninterest income and expenses directly attributable to a line of business are assigned to that business. Expenses for centrally provided services are allocated to the business lines as follows: product processing and technology expenditures are allocated based on standard unit costs applied to actual volume measurements; corporate overhead is allocated based on the ratio of either a line of business’ aggregate balance sheet accounts or FTE resources as a percentage of applicable business lines. There are no significant intersegmental revenues. Selected segment information is included in the following table.
Note 16. Commitments, Contingent Liabilities and Guarantees
Commitments. The Consolidated Financial Statements do not reflect various loan commitments (unfunded loans and unused lines of credit) and letters of credit originated in the normal course of business. Loan commitments are made to accommodate the financial needs of clients. Generally, new loan commitments do not extend beyond 90 days and unused lines of credit are reviewed at least annually. Letters of credit guarantee future payment of client financial obligations to third parties. They are normally issued for services provided or to facilitate the shipment of goods, and generally expire within one year. Both arrangements have essentially the same level of credit risk as that associated with extending loans to clients and are subject to Citizens’ normal credit policies. Inasmuch as these arrangements generally have fixed expiration dates or other termination clauses, most expire unfunded and do not necessarily represent future liquidity requirements. Collateral is obtained based on management’s assessment of the client and may include receivables, inventories, real property and equipment.
Amounts available to clients under loan commitments and letters of credit follow.
At December 31, 2012 and December 31, 2011, a liability of $1.9 million was recorded for probable losses on commitments to extend credit. In accordance with applicable accounting standards related to guarantees, Citizens defers fees collected in connection with the issuance of standby letters of credit. The fees are then recognized in income proportionately over the life of the standby letter of credit agreement.
Contingent Liabilities and Guarantees: Citizens and its subsidiary are parties to litigation arising in the ordinary course of business. Management believes that the aggregate liability, if any, resulting from these proceedings would not have a material effect on Citizens’ consolidated financial position or results of operations. Citizens has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements.
Prior to June 2008, when Citizens sold its residential mortgage originations to several secondary market participants, it made various standard representations and warranties. The specific representations and warranties made by Citizens depended on the nature of the transaction and the requirements of the buyer. In the event of a breach of the representations and warranties, Citizens may be required to either repurchase the mortgage loans (generally at unpaid principal balance plus accrued interest) with the identified defects or indemnify the investor. During both 2012 and 2011, Citizens repurchased $6.2 million and $2.2 million of loans, respectively, pursuant to such provisions. Citizens recorded $6.4 million and $4.3 million in 2012 and 2011, respectively, in Other Expense on the Consolidated Statements of Operations related to repurchasing or indemnifying such loans.
Purchase Obligations: Citizens has entered into contracts for the supply of current and future services incurred in the ordinary course of business, such as data processing and certain property management functions. Citizens often purchases services from vendors under agreements that typically can be terminated on a periodic basis.
Change in Control Agreements: Citizens has change in control agreements with certain executive officers. Under these agreements, each covered person could receive, upon the effectiveness of a change in control, up to two times (or in the case of the CEO, three times) (i) his or her base compensation plus (ii) up to two times (or in the case of the CEO, three times) the average of the annual bonuses paid to the executive in the last three years. Additionally, subject to certain conditions, each covered person’s medical and dental insurance benefits will continue for up to eighteen months after the termination and all long-term incentive awards will immediately vest. The provisions of the Emergency Economic Stabilization Act (“EESA”) and American Recovery and Reinvestment Act of 2009 (“ARRA”), and Treasury regulations promulgated thereunder, limit Citizens’ ability to make payments under these agreements while the preferred stock issued to Treasury remains outstanding.
Note 17. Derivatives and Hedging Activities
Risk Management Objective of Using Derivatives
Citizens is exposed to certain risks arising from both its business operations and economic conditions. Citizens manages economic risks, including interest rate, liquidity, and credit risk, primarily through the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, Citizens enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Citizens’ derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash receipts and cash payments principally related to certain variable-rate loan assets and fixed and floating rate liabilities. When entering into an interest rate swap, Citizens and a counterparty agree to exchange cash flows based on a specified notional amount multiplied by an interest rate. Typically Citizens will pay a fixed rate and receive a floating rate (or vice versa), though paying one floating rate and receiving another is possible. In all cases the underlying notional amount is not exchanged. When Citizens purchases an interest rate cap, it receives variable-rate amounts from a counterparty if a specific interest rate index rises above the strike rate on the contract in exchange for an upfront premium.
Fair Values of Derivative Instruments on the Consolidated Balance Sheets
The table below presents the fair value of Citizens’ derivative financial instruments as well as their classification on the Consolidated Balance Sheets.
Cash Flow Hedges of Interest Rate Risk
Citizens’ objectives in using cash flow hedges is to add stability to net interest income through managing its income exposure to changes in market interest rates. To accomplish this objective, Citizens uses interest rate caps and swaps as part of its interest rate risk management strategy. Citizens had twelve interest rate caps and swaps with an aggregate notional amount of $385.0 million at December 31, 2012 and December 31, 2011 that were designated as cash flow hedges of interest rate risk.
The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The net unrealized loss in accumulated other comprehensive income related to the effective portion of the changes of the fair value of derivatives was $11.2 million and $3.6 million at December 31, 2012 and December 31, 2011, respectively. During 2012 and 2011, such derivatives were used to hedge the variable cash inflows and outflows associated with existing pools of prime and LIBOR-based loan assets and liabilities. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. No hedge ineffectiveness was recognized during 2012 and 2011.
Amounts reported in accumulated other comprehensive income related to derivatives are reclassified to interest income as interest payments are received on Citizens’ variable-rate assets. During the years ended December 31, 2012 and 2011, Citizens accelerated the reclassification of unrealized gains in accumulated other comprehensive income of less than $0.1 million and $0.7 million, respectively, to earnings as a result of the hedged forecasted transactions becoming probable not to occur. During the next twelve months, Citizens estimates that $2.7 million will be reclassified as an increase to interest expense and there will be no reclassification to interest income.
The following tables summarize the impact of cash flow hedges on the Consolidated Financial Statements.
Fair Value Hedges of Interest Rate Risk
Citizens is exposed to changes in the fair value of certain of its fixed-rate assets and liabilities due to changes in market interest rates. Citizens utilizes derivatives designated as fair value hedges to mitigate this market value risk. As of December 31, 2012 and 2011, Citizens does not have any transactions designated as fair value hedges.
For derivatives that are designated and qualify as fair value hedges, the gain or loss on the derivative as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in earnings. Citizens includes the gain or loss on the hedged items in the same line item in the Statement of Operations as the offsetting loss or gain on the related derivatives. During the year ended December 31, 2012, Citizens did not recognize any gains in interest expense related to hedge ineffectiveness. Citizens recognized gains of $0.7 million in interest expense related to hedge ineffectiveness for the year ended December 31, 2011. Citizens recognized no net reduction to interest expense during the year ended December 31, 2012. Citizens recognized a net reduction to interest expense of $0.9 million for the year ended December 31, 2011, which includes net settlements on the derivatives and any amortization adjustment in the basis of the hedged items. In addition, during the years ended December 31, 2012 and 2011, Citizens recognized a net reduction to interest expense of $0.6 million and $0.8 million, respectively, related to the amortization adjustment of the basis in the hedged items that were in a hedging relationship with hedges that were terminated.
The following table summarizes the impact of fair value hedges on the Consolidated Financial Statements.
Derivatives Not Designated as Hedges
Citizens does not use derivatives for trading or speculative purposes and does not use credit derivatives for any purpose. Derivatives not designated as hedges are used to manage Citizens’ exposure to interest rate movements and other identified risks but do not satisfy the conditions for hedge accounting. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings. Additionally, Citizens holds interest rate derivatives, including interest rate swaps and option products, resulting from a service Citizens provides to certain clients. Citizens executes interest rate derivatives with commercial banking clients to facilitate their respective risk management strategies.
Those derivatives are simultaneously hedged by offsetting derivatives that Citizens executes with a third party, such that Citizens minimizes its net risk exposure resulting from such transactions. As of December 31, 2012 and 2011, Citizens had 134 derivative transactions with an aggregate notional amount of $523.4 million and 156 derivative transactions with an aggregate notional amount of $527.4 million, respectively, related to this program.
The following table summarizes the impact of derivatives not designated as hedges on the Consolidated Financial Statements.
Credit-Risk Related Contingent Features
Citizens has agreements with its derivative counterparties that contain a provision where if Citizens defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, then it could also be declared in default on its derivative obligations. Citizens also has agreements with certain of its derivative counterparties that contain a provision where if it fails to maintain its status as a well or adequately capitalized institution, then the counterparty could terminate the derivative positions and Citizens would be required to settle its obligations under the agreements.
As of December 31, 2012, the fair value of derivatives in a net liability position with all counterparties, which includes accrued interest, but excludes any adjustment for nonperformance risk related to these agreements was $19.8 million. As of December 31, 2012, Citizens had minimum collateral posting with its derivative counterparties and assigned collateral of $28.6 million. If credit risk related contingent features underlying these agreements had been triggered as of December 31, 2012, Citizens would not have been required to pledge additional collateral.
In addition, if Citizens’ credit rating is reduced below investment grade, then a termination event is deemed to have occurred with one of its counterparties and the counterparty has the right to terminate all affected transactions under the related agreement. Citizens has breached these provisions with respect to a Moody’s rating below investment grade at August 6, 2009 and may be required to settle its obligations under the agreement at the termination value. Citizens may be required to pay additional amounts due in excess of amounts previously posted as collateral. As of December 31, 2012, the termination value approximated $5.2 million.
Citizens does not offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against recognized fair value amounts of derivatives executed with the same counterparty under a master netting agreement. Citizens has the right to reclaim collateral assigned of $28.6 million.
Note 18. Regulatory Matters
Citizens Bank is required to maintain a combination of cash on hand and non-interest-bearing deposits with the Federal Reserve Bank (“FRB”) to meet regulatory reserve requirements. These reserve balances vary depending upon the level of client deposits. During 2012 and 2011, the average reserve balances were $72.9 million and $37.0 million, respectively.
Citizens Bank is also subject to statutory limitations on extensions of credit to members of the affiliate group. Generally, extensions of credit are limited to 10% to any one affiliate and 20% in aggregate to all affiliates of a subsidiary bank’s capital and surplus (net assets) as defined.
The principal source of cash flows for the Holding Company is dividends from the Bank. The Bank is a state chartered financial institution. Banking regulations limit the amount of dividends the Bank may declare to the Holding Company in any calendar year. The Bank’s dividends may not exceed the retained net profit, as defined, of that year plus the retained net profit of the preceding two years, unless prior regulatory approval is obtained.
During 2010, in consultation with the Federal Reserve Bank of Chicago as required by regulatory policy, Citizens decided to defer regularly scheduled quarterly interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities and to suspend quarterly cash dividend payments on its TARP Preferred Stock issued to Treasury under its Capital Purchase Program. During the fourth quarter of 2012 Citizens began paying interest on the 2003 Debenture held by its Statutory Trust I including deferred interest and interest accrued on the deferred interest. During the first quarter of 2013 Citizens will begin paying interest on it’s the 2006 Debenture held by its Citizens Funding Trust I including paying all previously deferred interest and interest accrued on the deferred interest. Citizens will resume paying on the normal quarterly payment dates going forward. Dividends for Citizens TARP Preferred Stock, including deferred dividends are expected to be paid as part of the completion of a merger with FirstMerit Corporation.
The Bank is 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 direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification 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 Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined). As of December 31, 2012, the Bank met all applicable capital adequacy requirements.
As of December 31, 2012, the Bank’s and the Holding Company’s capital ratios exceeded well capitalized levels under the regulatory framework for prompt corrective action. The table below sets forth the Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios for the Holding Company and the Bank. There are no conditions or events since December 31, 2012 that management believes would cause Citizens to fall below the well capitalized level.
(1) Total Capital is comprised of Tier 1 Capital, a portion of the allowance for loan losses and qualifying subordinated debt. Tier 1 Capital is calculated as follows: total shareholders’ equity + trust preferred securities-goodwill-accumulated other comprehensive income (loss)-disallowed portion of deferred tax asset-other intangible assets.
(2) Tier 1 Capital to quarterly average assets.
Note 19. Citizens Republic Bancorp (Parent Only) Statements
Balance Sheets
Citizens Republic Bancorp (Parent Only)
Statements of Operations
Citizens Republic Bancorp (Parent Only)
Statements of Cash Flows
Citizens Republic Bancorp (Parent Only)
Note 20. Business Combination
On September 13, 2012, Citizens and FirstMerit Corporation (“FirstMerit”) announced the signing of an agreement and plan of merger, dated as of September 12, 2012 under which FirstMerit will acquire Citizens in a stock-for-stock merger transaction. Under the terms of the merger agreement, holders of Citizens’ common stock will receive a fixed 1.37 shares of FirstMerit common stock in exchange for each share of Citizens’ common stock.
Subject to receipt of requisite approvals, FirstMerit also expects to repay Citizens’ approximately $355 million of TARP preferred stock, which includes $55 million of estimated deferred dividends, held by the U.S. Treasury at closing. The merger has been unanimously approved by the Boards of Directors of both Citizens and FirstMerit and is subject to customary closing conditions, including receipt of regulatory approvals and approval by both companies’ shareholders. In 2012, Citizens recorded $5.0 million of merger-related expenses in professional services. The transaction is expected to close in the second quarter of 2013.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and the Shareholders of Citizens Republic Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Citizens Republic Bancorp, Inc. as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Citizens Republic Bancorp, Inc. at December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Citizens Republic Bancorp, Inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Detroit, Michigan
February 28, 2013
Schedule SELECTED QUARTERLY INFORMATION (unaudited)
The table below sets forth selected quarterly financial information for each calendar quarter during 2012 and 2011.
Selected Quarterly Information
(1) Decreases in Provision for loan losses in all quarters of 2012 was primarily a result of the continuing improvement of the credit metrics. Decreases in Provision for loan losses and Noninterest expense in the second, third, and fourth quarters of 2011 reflect the completion of our accelerated problem asset resolution efforts.
(2) Noninterest income includes a fair-value adjustment on loans held for sale of $1.7 million and $0.9 million in the fourth and first quarters of 2012, respectively.
(3) Noninterest expense includes fair-value adjustments on other real estate (“ORE”) of $0.9 million in the third quarter of 2012 and $1.1 million, $1.2 million, $1.4 million, and $9.1 million in the fourth, third, second and first quarters of 2011, respectively.
(4) Net income (loss) includes merger-related expenses of $4.4 million and an income tax benefit of $276.8 million in the third and second quarters of 2012, respectively. The tax benefit for the second quarter of 2012 was primarily a result from the elimination of the valuation allowance against the deferred tax asset.
(5) Number of shares and per share data were adjusted to reflect the 1-for-10 reverse stock split effective 7/1/11 and include participating shares which are restricted stock units and restricted shares.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rule 13a-15 of the Securities Exchange Act of 1934, that are designed to cause the material information required to be disclosed by Citizens in the reports it files or submits under the Securities Exchange Act of 1934 to be recorded, processed, summarized, and reported to the extent applicable within the time periods required by the Securities and Exchange Commission’s rules and forms. In designing and evaluating the disclosure controls and procedures, management recognized that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been detected.
As of the end of the period covered by this report, Citizens performed an evaluation under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective at the reasonable assurance level.
Report on Management’s Assessment of Internal Control over Financial Reporting
The management of Citizens Republic Bancorp, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined under applicable Securities and Exchange Commission rules as a process designed under the supervision of the Corporation’s Chief Executive Officer and Chief Financial Officer and effected by the Corporation’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The Corporation’s internal control over financial reporting includes those policies and procedures that:
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Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation;
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Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of management and the directors of the Corporation; and
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Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As of December 31, 2012, management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of the Corporation’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, management determined that the Corporation’s internal control over financial reporting was effective as of December 31, 2012.
Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Corporation included in this Annual Report on Form 10-K, has issued a report on the Corporation’s internal control over financial reporting as of December 31, 2012. The report, which expresses an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2012, is included in this Item under the heading “Report of Independent Registered Public Accounting Firm on Effectiveness of Internal Control Over Financial Reporting.”
/s/ Lisa T. McNeely
/s/ Cathleen H. Nash
Lisa T. McNeely
Cathleen H. Nash
Executive Vice President and Chief Financial Officer
President and Chief Executive Officer
Changes in Internal Control over Financial Reporting
No changes were made to Citizens’ internal control over financial reporting (as defined in Rule 13a-15 under the Securities Exchange Act of 1934) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.
Report of Independent Registered Public Accounting Firm on Effectiveness of Internal
Control Over Financial Reporting
To the Board of Directors and the Shareholders of Citizens Republic Bancorp, Inc.
We have audited Citizens Republic Bancorp, Inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Citizens Republic Bancorp, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report on Management’s Assessment of Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Citizens Republic Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2012 consolidated financial statements of Citizens Republic Bancorp, Inc. and our report dated February 28, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Detroit, Michigan
February 28, 2013
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
Part III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
The name and age of each director, his or her business experience, and the year each became a director, according to information furnished by such directors, are set forth below. Each is a director of the Corporation and its subsidiary, Citizens Bank.
In September 2011, the U.S. Treasury, pursuant to the terms of Citizens’ TARP Preferred Stock, elected two directors to our board of directors as quarterly dividends had not been paid for more than six quarters. The Treasury has a right to elect such directors until all accrued and unpaid dividends have been paid. Ms. Champion and Mr. Fenimore, Jr. are the nominees elected to the board by Treasury. They will hold office until the next annual meeting and until their successors are elected and qualified, or until all dividends payable on all outstanding shares of the TARP Preferred Stock have been declared and paid in full.
Lizabeth A. Ardisana, 61, has served on our board since 2004. Ms. Ardisana has been the Chief Executive Officer and owner of ASG Renaissance, a technical and communications firm since 1994. Ms. Ardisana has extensive management and marketing experience as the founder of her own business. With her demonstrated leadership skills, business expertise and entrepreneurial spirit, Ms. Ardisana provides valuable management and financial insight to the board.
George J. Butvilas, 67, has served on our board since 2006. He has been the President and Chief Executive Officer of Quincy Hill Advisors, LLC, a financial services industry consulting firm, from 2007 to the present. He has served as Chairman of the Michigan Technological University Foundation since 1996. He also served as Vice Chairman of Republic Bancorp Inc. from 1999 to 2006. In his 35 years of service in the banking industry, Mr. Butvilas has served as Chief Executive Officer of D&N Financial Corporation, a publicly traded bank holding company, for 9 years, and as a chief operating officer, commercial banker, community banker and director. Mr. Butvilas brings strong financial and risk management expertise to the board and as Chairman of the risk management committee because of his extensive expertise in the banking and financial services industry, as well as institutional knowledge regarding the Republic portion of our business.
Madeleine L. Champion, 67, has served on our board since 2011. Ms. Champion is an international trade consultant for financial and non-financial institutions. She has more than 25 years of senior management experience in the banking industry and has served as President of the Bankers’ Association for Finance and Trade. Ms. Champion was Managing Director/Senior Vice President of international banking for JPMorgan Chase Bank, N.A. from 2004 through 2008 and Managing Director of emerging markets/international financial institutions for Banc One Capital Markets, Inc. from 2001 to 2004. She has also served as Senior Vice President, international financial institutions for Bank One from 1998 to 2001 and as Senior Vice President and head of global marketing and financial institutions for Bank One from 1997 to 1998. Ms. Champion has also held senior management positions for international banking operations for CoreStates Bank and Fidelity Bank from 1982 through 1997. Ms. Champion is also a director of Fresh Del Monte Produce, Inc. where she has served as an independent director since 2009.
Robert S. Cubbin, 55, has served on our board since 2008. Mr. Cubbin has been the President and Chief Executive Officer of Meadowbrook Insurance Group, Inc., a publicly traded risk management organization, specializing in specialty risk management solutions for agents, professional and trade associations, and small to medium-sized insureds, since May 2002 and has been a director since 1995. From February 1999 to May 2002, Mr. Cubbin served as the President and Chief Operating Officer of
Meadowbrook Insurance Group, Inc. Mr. Cubbin joined Meadowbrook Insurance Group, Inc. in 1987 as Vice President and General Counsel. Mr. Cubbin’s public company background and his extensive skills and experience pertaining to risk, capital, and financial management enable him to assist the board in assessing risk and developing capital planning strategies, which are particularly relevant in today’s financial services industry and is an “audit committee financial expert” as defined by applicable Commission rules.
William M. Fenimore, Jr., 69, has served on our board since 2011. Mr. Fenimore has more than 30 years of experience in the banking industry. His career included various senior management responsibilities with CoreStates Financial Corporation and its predecessor, where he worked for nearly 30 years. In 1994, he joined Meridian Bank where he served until 1996 as its group Executive Vice President, Chief Technology, and Strategic Planning Officer. He served from 1996 until 1999 as the Chief Executive Officer of Integrion Financial Network, an enterprise established by various large financial institutions to build and operate a common internet technology infrastructure to serve the e-commerce needs of financial services companies. From 2000 through 2003, Mr. Fenimore was President of Fenimore and Associates, a consulting company providing services in the areas of strategic positioning, organizational and financial structuring and strategic technology planning and operational management. In 2003, he became a managing partner at BridgeLink LLC, a Switzerland based firm providing capital raising and related advisory services to companies in the United States and Europe, where he served until 2011.
Gary J. Hurand, 66, has served on our board since 2006. Mr. Hurand has been the President of Dawn Donut Systems, Inc., a property development management company since 1988. Mr. Hurand, a successful business owner in the Michigan commercial real estate market, brings an entrepreneurial vision and valuable business and leadership skills to the board. Mr. Hurand also has public company board experience as a trustee of BRT Realty Trust for 20 years and as a director at Republic Bancorp Inc. for 16 years. With this background, Mr. Hurand provides the board with valuable insights regarding the current economic environment in Michigan.
Benjamin W. Laird, 63, has served on our board since 2001. Mr. Laird has been Of Counsel to the law firm of Godfrey & Kahn, S.C. since January 2008. He had been an attorney at Godfrey & Kahn, S.C. since 1985. Mr. Laird has also been a co-partner in Schoen-Laird Development, LLC, a real estate investment company since 1999. Mr. Laird has over 30 years of experience as an attorney practicing general business law representing large and small companies, including banks. Mr. Laird also has a long history of service on the board of directors of a paper converting machine company and various public and private financial institutions, which, together with his law practice, has given him valuable experience in corporate governance and oversight matters. As a Wisconsin resident and member of its business community, Mr. Laird provides a unique point of view with regard to our business in Wisconsin.
Stephen J. Lazaroff, 59, has served as a director on our board since 1997. Mr. Lazaroff has been the President of Diversified Precision Products, Inc., a special cutting tool manufacturer serving the automotive and hydraulic fittings industry, for 20 years. Mr. Lazaroff brings strong leadership management abilities to the board. His professional experience as a small business owner and manager allows him to provide the board with a solid understanding of business opportunities and customer views. He also has significant financial and operational expertise, which gives him unique oversight capabilities.
Cathleen H. Nash, 50, has served on our board since 2009. Ms. Nash has served as our President and Chief Executive Officer since February 2009 and was formerly our Executive Vice President responsible for regional banking from August 2007 to February 2009, and Executive Vice President and Head of Consumer Banking from July 2006 to August 2007. She was the director of Branch Banking at SunTrust Corporation from September 2003 to June 2006. Ms. Nash, as our current President and Chief Executive Officer, brings to the board extensive knowledge regarding the financial services industry and the current operational, economic and regulatory environment in which we operate, allowing her to provide critical insight into operational requirements and strategic planning. In that position, she is also able to promote the flow of information between the board and management and provide management’s perspective on issues facing the board.
Kendall B. Williams, 60, has served on our board since 1992. Mr. Williams is an attorney and counselor with The Williams Firm, P.C., which was established in 1997. Mr. Williams has over 35 years of experience as an attorney specializing in employment and labor law, general civil litigation, corporate law and municipal law. This expertise allows him to bring a unique and informed point of view with regard to management and human resources issues to the board. Furthermore, Mr. Williams’ legal experience allows him to make valuable contributions with regard to risk management and corporate governance issues.
James L. Wolohan, 61, has served on our board since 1997 and as the Chairman of our board since 2009. Mr. Wolohan has been President of Wolohan Investments, LLC, a financial investment company since January 2008. He served as Chairman of Wolohan Capital Strategies, a real estate and financial investment company from April 2006 to December 2007. Mr. Wolohan was formerly the President and Chief Executive Officer of Wolohan Lumber Co., a retailer of lumber, building materials and home improvement products from June 1987 to March 2006 and also served as Chairman of its board of directors for nine years. Wolohan Lumber was a public company until November 2003. Mr. Wolohan’s experience with Wolohan Lumber Co. has provided him with valuable financial and management expertise, as well as leadership abilities that are valuable to the board. Because of these skills and his ability to communicate and encourage discussion, Mr. Wolohan served as our lead independent director for four years and, beginning in May 2009, as our Chairman. He also brings strong accounting and financial skills to our audit committee and board.
The audit committee is comprised of the following directors: Robert S. Cubbin, chairman; Madeleine L. Champion, Gary J. Hurand, Benjamin W. Laird and James L. Wolohan. Our board of directors has determined that each of the members of the committee is “independent,” as defined in the applicable NASDAQ and Commission rules for audit committee members. Our board of directors has also determined that Mr. Cubbin is an “audit committee financial expert” as defined by applicable Commission rules and that each of the audit committee members satisfies all other qualifications for audit committee members set forth in the applicable NASDAQ rules.
Code of Ethics
We have a code of ethics that applies to all of our employees and directors. The code of ethics, as currently in effect (together with any amendments that may be adopted from time to time), is posted on the Corporate Governance page of the Investor Relations Section of our website at www.citizensbanking.com. In the future, to the extent any waiver is granted with respect to the code of ethics that requires disclosure under applicable Commission rules, we intend to post the waiver on the website at the address specified above.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Under the securities laws of the United States, our directors, executive officers and any persons holding more than 10% of the common stock, whom we refer to collectively as our reporting persons, are required to report their ownership of the common stock and any changes in that ownership to the Commission. Specific due dates for these reports have been established and pursuant to applicable rules, we are required to report any failure to file by these due dates. Based on certifications received from our reporting persons and on copies of the reports that they have filed with the Commission, all required reports of reporting persons have been timely filed with the Commission since the beginning of 2012.
Executive Officers
The following information is provided for those officers currently designated as executive officers by our board of directors.
(1) Ace Holding Company, LLC and Ace Mortgage Funding, LLC filed a petition under Chapter 7 of the federal bankruptcy laws on November 5, 2008.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Compensation Discussion And Analysis
Key Highlights of 2012 Executive Compensation Decisions
In 2012, the Compensation Committee, and the board of directors made the following decisions with regard to executive compensation paid to the Named Executive Officers, or NEOs, listed in the Summary Compensation Table:
•
Did not increase the cash portion of base salaries for our Chief Executive Officer and Chief Credit Officer as such salaries were deemed to be market competitive;
•
Increased the cash portion of base salaries for our other NEOs to keep pace with competitive market pay levels;
•
Continued our practice of paying a portion of base salary in shares of our common stock for certain of our NEOs and increased the CEO’s stock salary in light of competitive market practice for other CPP banks;
•
Made long-term equity grants that comply with the CPP-related limitations and included an additional performance requirements to provide further incentive to improve our profitability;
•
Did not pay short-term incentive awards to our NEOs because of the CPP-related limitations; and
•
Determined that our executive compensation programs do not encourage our NEOs to take excessive and unnecessary risks that threaten the value of the Corporation.
Overview of Compensation Philosophy and Program
Our compensation philosophy is to provide a competitive total compensation program that enables us to attract, motivate and retain the talent needed during this challenging economic cycle. Our philosophy is supported by a program that motivates our executives to achieve strategic goals prudently and within acceptable risk tolerances while driving financial performance and generating long-term, sustainable shareholder value. While we remain committed to our philosophy, our ability to offer a traditional competitive total compensation program and reward financial performance results that drive shareholder value is limited because of our participation in the CPP. Despite the CPP-related restrictions, we continue to seek ways to reinforce our philosophy, and as a result placed additional performance restrictions on a portion of our long-term incentive grants and paid a portion of base salaries for certain NEOs in the form of common stock. The effect of our participation in the CPP on our executive compensation program is discussed in more detail in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Capital Purchase Program” below. Our compensation philosophy is based primarily on the following objectives:
•
Pay executives for performance that is reflective of Citizens’ financial results and individual performance;
•
Align total compensation opportunity with shareholder interests;
•
Design a total compensation opportunity that is competitive and will attract, motivate and retain talent; and
•
Ensure appropriate risk mitigation measures are integrated into compensation programs and practices.
Our executive compensation objectives are achieved primarily through four elements:
•
Base salary;
•
Annual short-term, cash incentive awards (currently prohibited due to CPP-related limitations);
•
Long-term, typically equity-based awards; and
•
Employee and retirement benefits.
In making compensation decisions, the Compensation Committee considers each element of our compensation program individually and in relation to the total compensation of each executive officer. We believe that a significant portion of executive compensation should be in the form of performance-based long-term incentive grants. We believe this pay mix emphasizes both a short-term and a long-term perspective that is directly tied to shareholder value. The performance-based portion of compensation recognizes the significance of our executive officers’ contributions towards our overall financial performance.
Decisions about compensation of our executive officers are made by the Compensation Committee, all of the members of which are “independent” as defined under applicable NASDAQ rules or by the board of directors at the recommendation of the Compensation Committee. To help with its decision making each year, the Compensation Committee generally hires its own independent compensation consultant, who reports directly to the Compensation Committee. In 2012, the Compensation Committee retained Pearl Meyer and Partners as its independent compensation consultant. In light of the overwhelming shareholder support for our executive compensation practices expressed at last year’s annual meeting through the advisory vote on executive compensation, the Compensation Committee generally maintained our existing compensation program and philosophy in 2012.
The Compensation Committee, based on the recommendation of Pearl Meyer approved a peer group that was used for purposes of 2012 compensation decisions. The key considerations for peer group selection were industry, asset size, and region, in particular public commercial banks with assets from approximately half to two times our size. The result is a peer group of 24 banks, with Citizens positioned at approximately the median. Banks in the peer group include:
• Associated Banc-Corp
• Chemical Financial Corporation
• Commerce Bancshares, Inc.
• Community Bank Systems, Inc.
• F.N.B. Corporation
• First Commonwealth Financial Corporation
• First Financial Bancorp
• First Midwest Bancorp, Inc.
• FirstMerit Corporation
• Flagstar Bancorp, Inc.
• Fulton Financial Corporation
• MB Financial, Inc.
• National Penn Bancshares, Inc.
• NBT Bancorp, Inc.
• Old National Bancorp
• Park National Corporation
• PrivateBancorp, Inc.
• Signature Bank
• Susquehanna Bancshares, Inc.
• TCF Financial Corporation
• UMB Financial Corporation
• United Bankshares, Inc.
• WesBanco, Inc.
• Wintrust Financial Corporation
The Compensation Committee used this publicly reported compensation data from this peer group, and supplemented it with competitive market data prepared by Pearl Meyer that included broader financial industry surveys and data using similarly sized banks, for comparable executive roles. While the Compensation Committee relied primarily on the peer group data, the compensation survey data was also used as a secondary market reference. The Compensation Committee used this market data as reference for pay program decisions and to provide perspective for developing competitive compensation opportunities, to examine the appropriateness of executive pay levels and practices, to assess the pay and performance relationship for executives, to review practices and trends as they relate to executive compensation programs, and to make decisions on individual executive direct compensation opportunity levels.
We target our total direct compensation opportunities (which includes base salary, short-term incentive awards, and long-term incentive grants) for our executive officers to be at or around the market median. The Compensation Committee believes compensation opportunities at the market median provides competitive compensation to attract and retain our executive officers. The Compensation Committee may target total compensation above or below the market median for individual executives based upon individual roles, responsibilities, experience, contribution or other factors, but did not do so in 2012. We believe actual total direct compensation for each of our NEOs in 2012 was at or below the market median, due in part to compensation restrictions associated with our participation in the CPP.
Individual Performance Assessments
Each year, our chief executive officer reviews the performance of the other executive officers and assigns a performance rating to each executive officer based on the financial performance of the line of business, the unique contributions made to us and our need for the executive’s expertise. Additionally, executives are evaluated on core competencies that are used to evaluate all of our staff members. Our chief executive officer reviews the performance ratings with the chair of the board of directors, who attends Compensation Committee meetings. Our chief executive officer then makes recommendations regarding the total compensation for the executive officers to the Compensation Committee. Following a discussion of our chief executive officer’s recommendations and a review of the competitive market data, the Compensation Committee either approves the recommendations or adjusts total compensation as appropriate in its subjective judgment.
Ms. Nash’s performance as the chief executive officer is evaluated each year by the board of directors. The chair of the board of directors and the chair of the Compensation Committee solicit feedback regarding Ms. Nash’s performance from subordinates and meet with each of the other directors to evaluate Ms. Nash’s performance, based on the same core competencies and other factors on which our other executives are evaluated, as well as our financial performance. Ms. Nash also provides to the chair of the board of directors and the chair of the Compensation Committee a self-assessment of her performance. The chair of the board of directors and the chair of the Compensation Committee then prepare a performance review and summary to review with the board of directors. In making total compensation decisions regarding Ms. Nash, the Compensation Committee reviews the performance evaluation information, Ms. Nash’s self-assessment, the subordinate review, the recommendation of the chair of the board and the chair of the Compensation Committee, the peer group data and the competitive market data, and makes a recommendation for total compensation to our board of directors. After reviewing the information listed above in light of the Compensation Committee’s recommendation, the board of directors makes the final determination with regard to Ms. Nash’s total compensation.
Base Salary
We pay base salary as a fixed form of compensation to recognize our executive officers’ roles and individual performance. In order to attract and retain high performing executive officers, we believe our base salaries must be competitive with base salaries paid by our competitors, and appropriately reflect each executive’s experience, performance and contribution. As a result, we typically use the previously discussed market data along with the results of annual performance evaluations to determine base salary levels.
2012 Base Salary Determinations
Our continued participation in the CPP limits our ability to provide incentive-based compensation, thereby placing greater need and focus on ensuring base salaries provide fair and competitive pay. The Compensation Committee and the board of directors believe that base salary increases in the form of Stock Salary further align our executives’ interests with those of our shareholders, as a portion of their compensation would be directly tied to an increase or decrease in the price of our stock.
As a result of the process described in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Individual Performance Assessment,” and for the reasons indicated above, the Compensation Committee and our board of directors renewed the Stock Salary grants in April 2012. Ms. McNeely, Mr. Widawski, and Ms. Klawinski received the same amount of Stock Salary as previous years. In light of the competitive market data and market practice for other CPP banks, the board of directors, at the recommendation of the Compensation Committee, increased the Stock Salary grant to Ms. Nash. Mr. Green was not previously granted Stock Salary and so was not part of the renewal in April 2012. Stock Salary will continue until the one year anniversary of the grant date unless the Compensation Committee determines to discontinue payment of Stock Salary.
Stock Salary is paid as part of each bi-weekly pay period for one year, with the number of shares determined by dividing the dollar amount of salary to be paid in stock for that pay period, net of applicable withholdings and deductions, by the reported closing price per share on the NASDAQ Capital Market on the pay date for such period. Unlike the Stock Salary grants made in 2010 and 2011, the Compensation Committee determined that the shares issued as Stock Salary pursuant to the 2012 grant, in conformity with CPP-related requirements and evolving market practice for other CPP banks, would be fully earned upon issuance and not forfeitable and not have an additional two-year transfer restriction.
Additionally, the Compensation Committee determined, based on the recommendation of Ms. Nash and taking into consideration competitive market data, that base salary increases in the form of cash were appropriate for Ms. McNeely, Ms. Klawinski, and Mr. Green in order to recognize their individual performance and maintain their salaries at competitive levels. Mr. Widawski did not receive an increase in his base salary because his base salary is somewhat higher than the median indicated by the competitive market data for his position, which the Compensation Committee believes is appropriate due to the importance of his role in managing our credit challenges during this economic cycle. With the aforementioned increases, Ms. McNeely’s, Ms. Klawinski’s and Mr. Green’s salaries approximate the median indicated by the competitive market data for their positions.
The board of directors, at the recommendation of the Compensation Committee, determined that there would be no increase in the cash portion of Ms. Nash’s base salary after considering the increase in Stock Salary and competitive market data for her position.
The table below sets forth the effect of the base salary determinations in 2012.
Salaries for the NEOs are reflected in the salary column of the “Summary Compensation Table.”
Management Incentive Plan
Our Management Incentive Plan, or MIP, compensates executives, in cash, for the achievement of predetermined individual and corporate performance goals.
In view of our performance during the last several years and consistent with compensation limitations applicable to CPP participants, our NEOs and our next ten most highly compensated employees have not participated in the MIP. Despite our improved financial performance, our NEOs did not participate in the MIP in 2012 due to the CPP-related restrictions.
Cash Component of the 2009 Award
In January 2009, the Compensation Committee approved long-term incentive awards to our NEOs (except for Ms. McNeely and Mr. Green who were not executive officers at the time), which consisted of a cash component that would vest and be paid in three annual installments each January 29th beginning in 2010 as long as the Named Executive Officer remains employed with us. The table below shows the cash component of the award that was granted to our NEOs in 2009 and the final annual installment paid in 2012.
Long-Term Incentive Compensation
2012 Long-Term Incentive Grants
We believe long-term equity based compensation encourages a long-term focus with regard to our financial success, aligns our executives’ interests with those of our shareholders by linking a portion of executive compensation directly to the changes in stock price, and helps support sound risk management
practices as discussed in further detail in Item 11 “Executive Compensation - Compensation and Human Resources Committee Report” included below. Long-term equity awards are typically granted in the first part of the calendar year and are made under our Stock Compensation Plan.
With respect to grants of equity based compensation, as long as the preferred shares issued to Treasury under the CPP remain outstanding, we are limited in the amount of long-term restricted stock that may be paid to our NEOs and certain of our other most highly compensated employees. Long-term restricted stock grants cannot exceed one-third of the recipient’s total annual compensation, must have a minimum two-year vesting requirement, and will not become fully transferable while the TARP Preferred shares remain outstanding.
In April 2012, the Compensation Committee and the board of directors approved long-term incentive grants in the form of restricted stock and restricted stock units for our NEOs. In addition to the CPP-related restrictions noted above, forty percent of the long-term incentive grant made is subject to a pre-tax income performance condition designed to motivate our executives to focus on our profitability. To further encourage retention, the remaining sixty percent of the grant will vest in one installment three years after the grant date, rather than the two years required by the CPP-related compensation limits. The Compensation Committee and board of directors determined to make the long-term equity grants to the NEOs consistent with the maximum amount permitted under the CPP-related restrictions to maximize the motivational effect of the grants in view of the uniformly positive individual performance assessments and the additional performance-based conditions being imposed on a portion of the grants, and to keep pace, to the extent practical, with peer group compensation opportunity. The 2012 long-term equity grants made to our NEOs are listed in the table below.
The performance-based portion of the grant is subject to achieving the pre-tax income target for fiscal years 2012 and 2013 combined.
Pre-Tax Income is determined by subtracting provision expense and noninterest expense from net interest income and then adding noninterest income. The pre-tax income target for 2012 and 2013 is $125,700,000. The target performance goals for both years are based on our internal budget goals and are reasonably attainable if we sustain our current performance throughout 2013.
The Compensation Committee determined that with Citizens’ return to continued profitability, Pre-Tax Income more accurately reflected an emphasis on revenue generation and profitability rather than Pre-Tax Pre-Provision Profit, which had been used as the basis for incentive awards during the past few years. PTPP is a performance measure used in times of major economic stress to better understand underlying performance trends and to focus effort on our underlying performance trends and the ability of our banking operations to generate revenue. As the most recent stressed economic cycle has significantly abated and the Company has returned to profitability, the Compensation Committee changed to a performance measure that is more appropriate to the current environment and would emphasize our focus on profitable revenue generation.
The payout threshold begins upon our attainment of 90% of the pre-tax income target. The maximum payout will be capped if our performance is equal to or greater than 140% of the pre-tax income target. The grants will be paid on a pro-rata basis if the pre-tax income target is between the threshold and the maximum. To the extent applicable, CPP-related restrictions may limit the number of restricted shares or restricted stock units the NEOs would receive. The table below shows how the grants would be earned at varying levels of performance.
All of the NEOs, except for Ms. Nash, received restricted stock units which are granted to those who are retirement eligible, because of the more favorable tax treatment. The NEOs awarded restricted stock units will receive a pro-rata portion of any unvested restricted stock units upon retirement, while Ms. Nash would forfeit any unvested restricted stock upon retirement. Each restricted stock unit will be settled for one share of our common stock at the time the applicable restrictions lapse, with a portion of these shares withheld to satisfy income and employment tax withholding requirements. Holders of restricted stock units will have no voting or dividend rights prior to settlement of the units for shares of stock. Holders of restricted shares, however, will have voting and dividend rights with respect to those shares from the date of grant except to the extent such restricted shares are forfeited. If the merger with FirstMerit is completed, all of the foregoing awards will become immediately vested. The terms regarding acceleration and forfeiture of these grants are described in more detail in Item 11 “Executive Compensation - Other Potential Post-Employment Payments - Stock Compensation Plan.”
Vesting of 2011 Long-Term Incentive Grant
In May 2011, the Compensation Committee approved long-term incentive grants of restricted stock and restricted stock units subject to PTPP and net income performance targets. Those performance targets were met in 2011 and 2012. The table below shows the number of restricted share or restricted stock units that will vest on May 18, 2013 or earlier upon completion of the merger with FirstMerit.
Vesting of 2010 Long-Term Incentive Grant
In May 2010, the Compensation Committee approved long-term incentive grants of restricted stock or stock units which would vest on May 4, 2013, the third anniversary of the grant date. The table below shows the number of restricted shares or restricted stock units that would vest on May 4, 2013 or earlier upon completion of the merger with FirstMerit.
On May 14, 2010, Ms. McNeely and Mr. Green received additional grants in light of their increased responsibilities. Those grants will vest on May 14, 2013 or earlier upon the completion of the merger with FirstMerit. Mr. Green will receive an additional 3,043 restricted stock units and Ms. McNeely will receive an additional 1,087 restricted shares. Ms. McNeely also received an additional grant of 8,310 restricted shares on August 4, 2010 as part of her appointment as chief financial officer and such shares will vest on August 4, 2013 or earlier upon the completion of the merger with FirstMerit.
Retirement and Other Benefits
Qualified Plan
We maintain the Citizens Republic Bancorp Amended and Restated Cash Balance Pension Plan for Employees, or the Qualified Plan, which provides funded, tax-qualified retirement benefits up to the limits on compensation permitted under the Internal Revenue Code. The Qualified Plan is a cash balance pension plan that was frozen effective December 31, 2006. The accrual of future benefits under the Qualified Plan, other than the accrual of interest, has ceased so that pay and service after December 31, 2006 will not increase benefits payable under this plan although post-2006 service will count towards vesting requirements for benefits already accrued.
Benefits payable under the Qualified Plan are paid in the form of a lump sum or an equivalent annuity immediately following retirement and the attainment of age 55 with 3 years of service or prior to age 55 with at least 10 years of service. All of our NEOs earned an interest credit benefit under the Qualified Plan in 2012. As of the end of 2012, all of our NEOs have earned a vested interest in the Qualified Plan (completed at least 3 years of credited service). The present value of accumulated benefits under the Qualified Plan for each Named Executive Officer is disclosed in the “Pension Benefits” table and the change in those benefits during 2012 is disclosed in the “Summary Compensation Table.”
401(k) Plan
All of our NEOs participated in our 401(k) plan in 2012. Prior to August 2009, we matched up to 4% of eligible compensation per year. In 2009, the Compensation Committee, pursuant to a recommendation by Ms. Nash, eliminated the 401(k) matching benefit based in part on our corporate performance during the year and in an effort to accelerate our financial performance toward profitability. At the recommendation of Ms. Nash, the Compensation Committee determined to reinstate matching contributions of up to 2.5% of eligible compensation per year beginning January 1, 2012.
The terms of the 401(k) plan permit the Compensation Committee to make a discretionary contribution to the 401(k) plan on behalf of each eligible employee, regardless of participation in the 401(k) plan. The Compensation Committee and the board determined, however, that there would be no contribution for 2012 in an effort to continue maintaining our profitability.
Deferred Compensation Plan
Ms. Nash, Ms. Klawinski and Mr. Green participate in our Deferred Compensation Plan for Executives, or Deferred Compensation Plan. Under our Deferred Compensation Plan, we may make matching contributions in the form of our common stock, not to exceed 30% in value of the participant’s own contribution. The Compensation Committee has the discretion to determine whether to make matching contributions but to date has not made any matching contributions under the Deferred Compensation Plan.
Executive Perquisites and Benefits
We do not provide our NEOs with executive perquisites of benefits other than what is available to our staff members in general.
In compliance with the CPP, the Compensation Committee adopted an excessive or luxury expenditures policy, which prohibits excessive or luxury expenditures of our funds on entertainment or events, office or facility renovation, aviation or other transportation services, or other similar items, activities, or events, if such expenditures are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the operation of our business. The policy is accessible on the Corporate Governance page of the Investor Relations section of our website at www.citizensbanking.com.
Employment Agreements
In connection with Ms. Nash’s appointment as our president and chief executive officer in 2009, we entered into a letter agreement with Ms. Nash. The Compensation Committee proposed the initial terms based on market and peer group data and taking into account Ms. Nash’s relevant experience. The Compensation Committee negotiated the final terms of the letter agreement with Ms. Nash, which are designed to be competitive and motivate Ms. Nash to focus on our long-term growth and profitability. This agreement is described in more detail in Item 11 “Executive Compensation - Other Potential Post-Employment Payments - Nash Letter Agreement.”
Employment Termination Severance Benefits
We provide our NEOs with severance benefits upon termination of employment in connection with a change in control of Citizens and in certain other circumstances as deemed appropriate by the Compensation Committee. Each of our NEOs is entitled to benefits upon termination in connection with a change in control pursuant to our Amended and Restated Change in Control Agreement, or Change in Control Agreement. The Compensation Committee believes it is important to provide this protection in order to ensure our NEOs will remain engaged and committed to us during an acquisition of the Corporation or other transition in management. Each Change in Control Agreement provides for severance benefits in a lump sum payment equal to two times (or in the case of Ms. Nash three times) the Named Executive Officer’s annual base salary immediately prior to the change in control plus two times (three times in the case of Ms. Nash) the average of the annual bonuses paid to the Named Executive Officer in the last three full calendar years of employment under our MIP.
In addition, we may negotiate severance benefits with other individual executives upon termination in other circumstances when the Compensation Committee deems appropriate. Ms. Nash’s letter agreement provides that she will be entitled to two years of base salary plus outplacement services if her employment is terminated by the Corporation without cause that is not in connection with a change in control. These benefits and arrangements are described in detail in Item 11 “Executive Compensation - Other Potential Post-Employment Payments.”
Due to our participation in the CPP, as long as the TARP Preferred shares remain outstanding, we are generally not permitted to pay amounts to our NEOs and our next five highest paid employees for a change in control of the Corporation or their departure from the Corporation for any reason other than death or disability, except payments for services performed or benefits accrued and payments pursuant to qualified retirement plans or that are required by applicable law.
Based on questions raised by management in late 2011, the Compensation Committee in early 2012 conducted a thorough review of the terms of the existing Change in Control Agreements with the assistance of its consultant, Pearl Meyer. Based on that review, the Compensation Committee determined (i) that the after tax net payment to certain executives under the Change in Control Agreements was not comparable to the terms of agreements in place at similarly situated financial institutions not subject to CPP-related compensation restrictions, and (ii) to update the Change in Control Agreements accordingly as soon as practicable after the TARP Preferred stock was repurchased and when applicable Treasury regulations would allow. The Compensation Committee believed that it was important to maintain change in control agreements similar to those of other comparable financial institutions not subject to CPP-related compensation restrictions to the extent permitted under applicable Treasury regulations to retain management and preserve the value of Citizens’ franchise. In light of discussions concerning a potential strategic combination, and the Compensation Committee’s desire to incent Citizens’ management to stay through a transition period in the event of a strategic transaction, the Compensation Committee in the summer of 2012 determined to prepare a template change in control agreement for this purpose. The template agreement was finalized following discussions between representatives of the boards of Citizens and FirstMerit and will be executed by FirstMerit with the NEOs after completion of the merger and its purchase of the TARP Preferred shares from Treasury. For a summary of the material differences from the Change in Control Agreements now in effect, see Item 11 “Executive Compensation-Change in Control Agreements.”
Capital Purchase Program
As long as the TARP Preferred shares remain outstanding, we are subject to various restrictions on our ability to compensate our senior executives, including the NEOs, imposed by the Emergency Economic Stabilization Act of 2008, or EESA, the American Recovery and Reinvestment Act, or ARRA, and the Treasury regulations issued thereunder. These restrictions on executive compensation significantly affect our executive compensation program, and include, among others:
•
A prohibition on paying or accruing any bonuses, retention awards, or incentive compensation to our NEOs and the next 10 most highly compensated employees, other than (i) restricted shares with a minimum two-year vesting period, which are not transferable except to the extent the CPP assistance has been repaid, which have a value on the grant date that is no greater than one-third of the executive’s annual compensation, and which are subject to such other conditions as the Special Master may determine; and (ii) bonus payments pursuant to pre-existing, legally binding employment contracts executed on or before February 11, 2009 and not determined invalid by the Special Master;
•
A prohibition on paying any golden parachute payments (defined as any payment for departure for any reason except for payment for services performed or benefits accrued, and any payment due to a change in control) to our NEOs and the next five most highly compensated employees;
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A requirement to seek the return of any bonus, retention award, or incentive compensation paid to our NEOs and any of the next 20 most highly compensated employees based on financial statements or performance metrics later determined to have been materially inaccurate;
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A requirement to ask our shareholders to vote on a non-binding advisory resolution each year to approve the compensation of our NEOs;
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A prohibition on tax gross-ups for our NEOs and the next 20 most highly compensated employees;
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A requirement to establish a Corporation-wide policy on excessive or luxury expenditures;
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A requirement to disclose to the Treasury any perquisites in excess of $25,000 paid or provided to our NEOs or the next 10 most highly compensated employees;
•
A requirement that our Compensation Committee review on a semi-annual basis employee compensation plans to limit any features that would encourage our NEOs to take “unnecessary and excessive risks,” identify and eliminate any provisions in such plans that encourage the manipulation of reported earnings to enhance employee compensation and certify each year in the annual meeting proxy statement that it has done so; and
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A requirement that our chief executive officer and our chief financial officer provide a written certification as an exhibit to our Annual Report on Form 10-K of compliance with these compensation standards.
The TARP Preferred shares will be repurchased as part of our merger with FirstMerit and we will no longer be subject to CPP limitations on compensation.
Section 162(m) Compliance
Section 162(m) of the Internal Revenue Code of 1986, or the Code, restricts the ability of publicly traded companies such as ours to deduct executive compensation paid to each of our NEOs in excess of $1,000,000 in annual compensation. In years when the preferred shares issued to Treasury under the CPP are not outstanding, certain performance-based compensation is deductible, if it complies with various conditions described in Section 162(m). The Stock Compensation Plan and its predecessor plans contain provisions intended to allow certain performance-based pay to be deductible. However, while our CPP obligations are outstanding, the $1,000,000 annual federal compensation deduction is reduced to $500,000 and the performance-based compensation exemption is not applicable.
Our compensation program will result in payments from time to time that are subject to these restrictions on deductibility, but we do not believe the effect of these restrictions on us is currently material. While the Compensation Committee generally attempts to maximize tax deductibility of all compensation it believes that it may be appropriate to exceed the limitation on deductibility to ensure that executive officers are compensated in a manner that is consistent with our best interests, the best interests of our shareholders and our executive compensation philosophy and objectives, and we reserve the authority to approve non-deductible compensation in appropriate circumstances.
Stock Ownership Guidelines
Since September 2002, we have maintained common stock ownership guidelines for our executive officers. We believe that it is important for executive officers to own our common stock to ensure that their financial interests are directly aligned with those of our shareholders.
Under our stock ownership guidelines, the chief executive officer is required to hold 100,000 shares of our stock, and is provided a period of three years to attain such ownership level. The other NEOs whose base salaries are $250,000 or more are required to hold at least 30,000 shares of our common stock, and those NEOs whose base salaries are less than $250,000 are required to hold at least 10,000 shares of our common stock. The NEOs have five years from their date of appointment to attain such ownership.
Shares owned through our 401(k) plan, by the officer’s spouse or other family members, by controlled trusts, as Stock Salary, and unvested shares of restricted stock and restricted stock units, in addition to shares owned outright are included in the officer’s ownership for purposes of this guideline. The corporate governance and nominating committee is responsible for monitoring compliance with these guidelines and receives periodic updates from management with regard to progress towards complying with the guidelines. The table below shows the stock ownership of our NEOs as of February 15, 2013.
Executive Compensation Clawback Policy
Our general pay-for-performance philosophy means that we will not reward executive officers for performance if we discover that the applicable performance was due to the officer’s fraud or other misconduct. To implement this principle, our board of directors has adopted an Executive Compensation Clawback Policy to allow us in certain circumstances to recover bonus and incentive compensation paid to an executive officer. Under this policy, if the board subsequently determines that, as a result of the executive’s misconduct, we are required to materially restate all or a significant portion of our financial statements for the period for which the compensation was paid, we have the right to require that the executive officer reimburse us for the amount of any related bonus or incentive compensation received, forfeit any vested options or restricted stock, or cancel any related unvested restricted or deferred equity awards granted on the basis of having met or exceeded performance goals if, according to the restated financial statements, such goals were not in fact met or exceeded. In deciding whether to pursue the remedies provided in the policy, the board may consider all relevant facts, including whether the misconduct by the executive officer that caused or partially caused the need for the restatement was negligent, intentional, or gross misconduct. In addition to the remedies provided in this policy, we may dismiss or pursue other legal remedies against the executive officer.
In addition, to comply with the Treasury’s requirements with respect to the CPP, we are required to make cash or equity incentive compensation paid to NEOs and certain other highly compensated employees subject to recovery or “clawback” if the payments are based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria. Section 304 of the Sarbanes-Oxley Act of 2002 also contains a requirement that the chief executive officer and the chief financial officer forfeit any bonus, incentive-based compensation or equity-based compensation received and any profits from sales of our securities during the twelve month period following an accounting restatement due to our material non-compliance, as a result of misconduct, with any financial reporting requirement under the securities laws.
Compensation And Human Resources Committee Report
In accordance with its written charter adopted by the board of directors, the Compensation Committee determines and implements compensation and benefit systems for our executive officers and other employees.
The Compensation Committee certifies that:
(1) It has reviewed with the senior risk officers the NEOs’ compensation plans and has made all reasonable efforts to ensure that these plans do not encourage NEOs to take unnecessary and excessive risks that threaten the value of the Corporation;
(2) It has reviewed with the senior risk officers the employee compensation plans and has made all reasonable efforts to limit any unnecessary risks these plans pose to the Corporation; and
(3) It has reviewed the employee compensation plans to eliminate any features of these plans that would encourage the manipulation of reported earnings of the Corporation to enhance the compensation of any employee.
Risk Review and Assessment Process
As required by ARRA and the Treasury regulations promulgated thereunder, our compensation plans will be reviewed every six months by our Compensation Committee. Our senior risk officer will approve the certification of the plans by considering whether any compensation plans might promote unnecessary risk taking and threaten the value of the financial institution and encourage manipulation of reported earnings, specifically including the following:
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If there is an appropriate balance between fixed and variable pay;
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If the maximum annual payouts are reasonable; and
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If the financial metrics are fair and balanced.
Upon his certification of the plans, the senior risk officer presented the findings to the Compensation Committee. Based on a review of the above factors, the senior risk officer has determined that our compensation plans do not promote or encourage excessive or unnecessary risk taking or encourage the manipulation of reported earnings and his report and conclusion has obtained the consensus and approval of the Compensation Committee.
Below is a list of the Named Executive Officer compensation plans and other employee compensation plans reviewed by the Compensation Committee along with a discussion of the reasons why the compensation plans do not promote or encourage excessive or unnecessary risk taking or encourage the manipulation of reported earnings.
Named Executive Officer Compensation Plans
Plan Name
Reason for Conclusion
Base Salary
Named Executive Officer salaries are fixed amounts determined based upon individual performance and peer group market data and are not based on the performance of the Corporation. While a portion of certain Named Executive Officer salaries is paid in Stock Salary, such amount of Stock Salary received is a fixed dollar amount paid and valued at the end of each pay period. Therefore, our NEOs are not encouraged to take unnecessary or excessive risks that threaten the Corporation’s value or manipulate reported earnings to enhance the compensation of any employee.
2009 Long-Term Incentive Awards
The structure of the awards includes a three-year measurement period that rewards improvement in years two and three over results in the prior year, and the goals have been set on a “pass/fail” basis without a sliding scale that might encourage additional risk taking to increase the size of the incentive. The number of restricted shares to be vested upon satisfaction of the performance goals is also fixed, and the Compensation Committee has no discretion to increase the amounts paid out. In addition, the payout is relatively modest and restricted shares will only have significant value if the market value of the common shares rises significantly, which we believe is not as likely to occur if the Corporation takes unnecessary or excessive risk. The awards made to executives are subject to our Executive Compensation Clawback Policy, reducing the risk that reported earnings might be manipulated. The cash portion of the long-term incentive grants are time-based rather than performance-based and therefore do not encourage unnecessary or excessive risk taking or manipulation of reported earnings.
2010 Long-Term Incentive Grants
The structure of the grant includes a two-year measurement period that rewards attaining certain goals in each year, and the goals have been set on a “pass/fail” basis without a sliding scale that might encourage additional risk taking to increase the size of the incentive. The number of restricted shares or restricted stock units to be vested upon satisfaction of the performance goals is also fixed, and the Compensation Committee has no discretion to increase the amounts paid out. In addition, the payout is relatively modest and restricted shares will only have significant value if the market value of the common shares rises significantly, which we believe is not as likely to occur if the Corporation takes unnecessary or excessive risk. The grants made to executives are subject to our Executive Compensation Clawback Policy, reducing the risk that reported earnings might be manipulated. One-half of the long-term incentive grants are time-based rather than performance-based and therefore do not encourage unnecessary or excessive risk taking or manipulation of reported earnings.
2011 Long-Term Incentive Grants
Forty percent of the grant is performance-based, so that payout is based on attaining cumulative targets over a two-year period. Although the payouts for the performance-based award are on a sliding scale, payouts are capped to discourage excessive risk taking. Also, to the extent applicable, certain executives may be limited in the number of shares earned due to CPP-related limitations. The threshold for payout is 90% of the targets. The grant meets the requirements of the limitations imposed by participating in the CPP. In addition, the payout is relatively modest and restricted shares will only have significant value if the market value of the common shares rises significantly, which we believe is not as likely to occur if the Corporation takes unnecessary or excessive risk. The awards made to executives are subject to our Executive Compensation Clawback Policy, reducing the risk that reported earnings might be manipulated. The remaining sixty percent of the 2011 long-term incentive grants are time-based rather than performance-based and therefore do not encourage unnecessary or excessive risk taking or manipulation of reported earnings.
2012 Long-Term Incentive Grants
Forty percent of the grant is performance-based, so that payout is based on attaining cumulative targets over a two-year period. Although the payouts for the performance-based award are on a sliding scale, payouts are capped to discourage excessive risk taking. Also, to the extent applicable, certain executives may be limited in the number of shares earned due to CPP-related limitations. The threshold for payout is 90% of the targets. The grant meets the requirements of the limitations imposed by participating in the CPP. In addition, the payout is relatively modest and restricted shares will only have significant value if the market value of the common shares rises significantly, which we believe is not as likely to occur if the Corporation takes unnecessary or excessive risk. The awards made to executives are subject to our Executive Compensation Clawback Policy, reducing the risk that reported earnings might be manipulated. The remaining sixty percent of the 2012 long-term incentive grants are time-based rather than performance-based and therefore do not encourage unnecessary or excessive risk taking or manipulation of reported earnings.
Qualified Plan
401(k) Plan
Deferred Compensation Plan
Change in Control Agreements
Country Club Dues and Fees
Severance Pay Plan
Employment Agreements
Benefits paid pursuant to these programs are generally unrelated to the performance of the Corporation and therefore do not encourage unnecessary or excessive risk taking or the manipulation of reported earnings to enhance the compensation of any employee by our NEOs or other employees.
Other Employee Compensation Plans
Plan Name
Reason for Conclusion
MIP
The MIP provides for incentive-based compensation for certain employees who are not NEOs based on the Corporation’s pre-tax pre-provision profits and its pre-tax ROA. The portion of the award based on PTPP, a key value driver for our business, is capped, discouraging excessive risk taking. PTPP, while a non-GAAP financial measure, is derived from our audited net income figures, and is subject to our stringent internal financial controls mitigating the risk of manipulation. In each case, the amount of the award may be adjusted down based on individual performance, which also reduces the likelihood of excessive risk taking or manipulation. The awards made to executive officers are subject to our Executive Compensation Clawback Policy, reducing the risk that reported earnings might be manipulated.
Core Banking Incentive Plans
Corporate Banking Incentive Plans
Credit Incentive Plans
Wealth Management Incentive Plans
These plans provide for incentive-based compensation to be paid to employees who are not NEOs based on multiple identified factors that drive the portion of our business in which they are engaged. Most of these factors are operational and not directly related to our earnings, and therefore have a low risk of encouraging manipulation of our earnings. Substantially all of the performance factors are inherently structured so that unnecessary or excessive risk taking is either discouraged by the other factors in the mix and operational
policies and procedures we have in place, or is irrelevant to the goal. The use of multiple performance measures diversifies the risk associated with a single performance measure. Awards are also subject to downgrade if certain credit metrics are not satisfied, further reducing the likelihood of excessive risk taking relating to lending. Individual performance is measured against the performance measures of the plan and is reviewed monthly at accountability meetings with supervisors and managers. Any unnecessary or excessive risk taking or manipulation of earnings is subject to corrective disciplinary action.
Reward and Recognition Program
Fraud Busters Program
Business Owner Banking Certificate
Program
These programs are generally unrelated to the performance of the Corporation and therefore, do not encourage unnecessary or excessive risk taking or the manipulation of reported earnings to enhance the compensation of any employee by our employees.
The Compensation Committee has reviewed and discussed with management the “Compensation Discussion and Analysis” section of this Annual Report on Form 10-K, or CD&A, for the year ended December 31, 2012. Based on such review and discussion, the Compensation Committee recommended to the board of directors that the CD&A be included in this Annual Report on Form 10-K for the year ended December 31, 2012.
By the Compensation Committee of the Board of Directors:
Lizabeth A. Ardisana, Chairperson
Robert S. Cubbin
William M. Fenimore, Jr.
Stephen J. Lazaroff
James L. Wolohan
Summary Compensation Table
The following table provides compensation information for the last three fiscal years for our chief executive officer, chief financial officer and the three other most highly paid executive officers who were serving as such at December 31, 2012. We refer to these individuals in this Form 10-K as our Named Executive Officers or NEOs. The material terms of plans and agreements pursuant to which certain items set forth below were paid are discussed elsewhere in this Item 11.
(1) A portion of the amounts shown in this column reflects the Stock Salary grants made in May 2010, May 2011 and April 2012 as shown in the table below. The number of shares shown in the table below reflect the shares issued net of tax withholding. The terms of these grants are described in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Base Salary.”
(2) The amounts set forth in this column reflect installments of the cash component of the 2009 long-term incentive award. The cash component of the January 2009 long-term incentive award is paid in three annual installments each January 29th beginning in 2010 if the Named Executive Officer remains employed with us.
(3) Stock awards consist of restricted shares of common stock and restricted stock units. The amounts shown represent the grant date fair value of each award calculated in accordance with FASB ASC Topic 718, excluding the effect of estimated forfeitures. The 2010, 2011 and 2012 awards vest when certain performance-based and time-based restrictions are satisfied. The value reported for the awards is the grant date fair value assuming the probable outcome of such conditions as of the grant date. In determining the grant date fair value, we have used the closing price of our stock as of the close of the market on the grant date and have assumed that all performance conditions will also be met.
(4) The amounts shown for all NEOs reflect changes in pension values.
(5) The amounts in this column for 2012 reflect 401(k) matching contributions only. The amounts in this column for 2010 reflect reimbursement of country club dues and fees only.
(6)
Ms. McNeely was appointed as chief financial officer on August 4, 2010.
(7)
Mr. Green was appointed as director of corporate banking and executive officer of Citizens on November 28, 2011.
Grants of Plan-Based Awards
The following table shows the estimated future payout under the grants made in 2012 pursuant to the Stock Compensation Plan.
(1) To the extent applicable, CPP-related restrictions may limit the ability of our NEOs to receive the maximum amount of shares listed in this column.
(2) The grants in this row are the performance-based portion of the 2012 long-term incentive grants described in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Long-Term Incentive Compensation - 2012 Long-Term Incentive Grants” and will not be earned until 2014 and then only if the performance conditions are met, or immediately upon a change in control.
(3) The grants in this row are the time-based portion of the 2012 long-term incentive grants described in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Long-Term Incentive Compensation - 2012 Long-Term Incentive Grants” and will not vest until 2015, or immediately upon a change in control.
(4) The grants in this row reflect the shares of Stock Salary received in 2012 from the May 18, 2011 grant (net of withholding). Although these shares are fully earned when paid they are not transferable until the earliest to occur of May 18, 2013 or the death, disability retirement or termination of employment where severance benefits are paid. See Item 11 “Executive Compensation - Compensation Discussion and Analysis - Base Salary - 2012 Base Salary Determinations.”
(5) The grants in this row reflect the shares of Stock Salary received in 2012 from the April 25, 2012 grant (net of withholding). These shares are fully earned when paid. The amounts exclude an unknown number of shares relating to the remaining portion of the April 2012 Stock Salary grant which are to be valued and paid in 2013 based on market prices prevailing on the respective pay dates. See Item 11 “Executive Compensation - Compensation Discussion and Analysis - Base Salary - 2012 Base Salary Determinations.”
The Stock Compensation Plan, or Stock Plan, under which all equity based awards to NEOs have been made, permits the Compensation Committee to make grants of stock options, stock appreciation rights, restricted stock, restricted stock units and various types of performance-based rights to acquire cash, common shares, other property or a combination thereof to directors and employees of the Corporation. See Item 11 “Executive Compensation - Other Potential Post-Employment Payments - Stock Compensation Plan” for a summary of certain provisions of the Stock Plan relating to termination and change in control.
Outstanding Equity Awards at Year-End
The following table shows all outstanding equity awards held by our NEOs as of December 31, 2012. Market value is based on the closing price of our common stock of $18.97 on December 31, 2012, as reported on the NASDAQ Capital MarketSM.
(1) The restricted shares in this column reflect the Stock Salary issued to Ms. Nash, Ms. Klawinski, Ms. McNeely and Mr. Widawski as part of the May 2011 grant and the time-based portion of the 2010, 2011, and 2012 long-term incentive awards granted to NEOs.
The shares received as Stock Salary in 2011, though earned and no longer forfeitable upon issuance, do not become transferable until the earliest to occur of the second anniversary of the grant date, or the death, disability, retirement or termination of employment that would result in benefits being payable under our severance plan. Also, all transfer restrictions will lapse upon a change of control. Those NEOs receiving Stock Salary have voting and dividend rights with respect to the restricted stock so granted prior to the lapse of the transfer restrictions.
The restrictions as to the time-based portion of the 2010, 2011, and 2012 long-term incentive grants will lapse on the third anniversary of the grant date, May 4, 2013, May 18, 2014 and April 30, 2015, respectively, if the Named Executive Officer remains employed by us. If a Named Executive Officer resigns or is terminated for cause, then any unvested restricted stock or restricted stock units will be
forfeited. If a Named Executive Officer retires and has received restricted stock units, then the Named Executive Officer will receive a pro-rata portion of any vested restricted stock units, while a Named Executive Officer who retires and has received restricted stock will forfeit any unvested restricted stock. However, if the Named Executive Officer terminates employment due to death, disability, the Named Executive Officer’s position is eliminated or the Named Executive Officer is terminated without cause, then the Named Executive Officer will receive a pro-rata portion of the restricted shares or restricted stock units that have vested as of the date employment terminates. In the event of a change in control, the provisions of our amended and restated change in control agreements would apply and the restricted stock or restricted stock units would be fully vested, subject to limitations imposed by applicable law at the time. Each restricted stock unit will be settled for one share of our common stock at the time the applicable restrictions lapse, with a portion of these shares withheld to satisfy income and employment tax withholding requirements. Holders of restricted stock units will have no voting or dividend rights prior to settlement of the units for shares of stock. Holders of restricted shares, however, will have voting and dividend rights with respect to those shares from the date of grant except to the extent such restricted shares are forfeited.
The restricted shares reflected in this column are scheduled to become vested and/or transferable as follows:
(2) These shares represent the number of restricted shares or restricted stock units of the performance-based portion of the long-term grants made in May 2011 and April 2012.
A portion of the May 2011 long-term incentive grants is subject to certain performance-based conditions. On May 18, 2013, the restrictions as to the performance-based portion of the award will lapse if the NEO remains employed by us, but only to the extent we have satisfied the PTPP performance condition for fiscal years 2011 and 2012 combined and/or the total net income performance condition for fiscal years 2011 and 2012 combined. Both performance conditions have been met. The restricted shares or restricted stock units meeting the performance-based conditions may not be transferred until the later of May 18, 2013 or the date on which the restricted shares or restricted stock units are no longer subject to the limitations placed on us by our participation in the CPP.
A portion of the April 2012 long-term incentive grant is subject to certain performance-based conditions. On April 30, 2014, the restrictions as to the performance-based portion of the award will lapse if the NEO remains employed by us, but only to the extent we satisfy the pre-tax income performance condition for fiscal years 2012 and 2013 combined. The restricted shares or restricted stock units meeting the performance based condition may not be transferred until the later of April 30, 2014 or the date on which the restricted shares or restricted stock units are no longer subject to limitations placed on us by our participation in the CPP.
With regard to the performance-based portion of the 2011 and 2012 long-term incentive grants, if the Named Executive Officer resigns or is terminated for cause, then any unvested restricted stock or restricted stock units will be forfeited. However, if the Named Executive Officer terminates employment
due to death, disability, retirement, or if the Named Executive Officer’s position is eliminated or terminated without cause, then the Named Executive Officer will receive a pro-rata portion of any unvested restricted shares or restricted stock units if the performance targets have been met. For example, if a Named Executive Officer had retired on June 30, 2012 and the performance targets for the 2011 long-term incentive award were met, then the executive officer would receive three-quarters of the restricted shares the officer would have received if the officer had remained employed. In the event of a change in control, the provisions of our amended and restated change in control agreements would apply and the restricted stock or restricted stock units would be fully vested, subject to limitations imposed by applicable law at the time. Each restricted stock unit will be settled for one share of our common stock at the time the applicable restrictions lapse, with a portion of these shares withheld to satisfy income and employment tax withholding requirements. Holders of restricted stock units will have no voting or dividend rights prior to settlement of the units for shares of stock. Holders of restricted shares, however, will have voting and dividend rights with respect to those shares from the date of grant except to the extent such restricted shares are forfeited.
Options Exercised and Stock Vested
The following table shows all stock awards vested and the value realized upon vesting, by NEOs during 2012. None of the NEOs exercised options during 2012.
(1) The table does not show the earned and no longer forfeitable restricted shares granted in 2012 as part of the 2011 Stock Salary grant to Ms. Nash, Ms. McNeely, Mr. Widawski and Ms. Klawinski because, even though the shares are fully earned upon grant, the transfer restrictions do not lapse on those shares until 2013. The restricted shares of our common stock received in 2012 as Stock Salary were as follows: Ms. Nash - 3,043, Ms. McNeely -1,878, Mr. Widawski - 916, and Ms. Klawinski - 621. The terms of the Stock Salary grants are described in more detail under “Outstanding Equity Awards at Year End” table.
(2) The value realized equals the market value of our common stock on the date that the transfer restrictions lapsed as reported on the NASDAQ Capital MarketSM, multiplied by the number of shares for which the transfer restrictions lapsed.
Non-Qualified Deferred Compensation
We offer executive officers and selected key employees the right to participate in our non-qualified Deferred Compensation Plan. Under the provisions of the plan, the participants may elect to defer up to 50% of their annual base salary and up to 100% of any cash incentive compensation. No executive contributions or matching contributions were made in 2012. The investment options generally available under the Deferred Compensation Plan are the same as those available under the Corporation’s 401(k) plan. As a general rule, amounts deferred and investment returns are required to be distributed no earlier than upon the participant’s termination of employment and shall be made in a single lump sum payment or, if the participant has made an irrevocable election at the time of enrollment, in equal annual installments over the period specified by the participant, not to exceed ten years. The following table shows certain information for NEOs under the Corporation’s non-qualified Deferred Compensation Plan.
(1) Executive contributions are reflected as compensation in the appropriate columns of the “Summary Compensation Table,” but earnings and losses on contributions are not reflected in the “Summary Compensation Table” because earnings are not above-market or preferential.
Pension Benefits
The table shows each Named Executive Officer’s number of years of service, present value of accumulated benefit and payments during the year ended December 31, 2012 under each of the plans, which are described in Item 11 “Executive Compensation - Compensation Discussion and Analysis - Retirement Benefits.”
(1) The Present Value of Accumulated Benefit is the lump sum value as of December 31, 2012 of the annual pension benefit payable for the Named Executive Officer’s life that was earned as of December 31, 2012. These lump sum values are equal to the accumulated cash balance as of December 31, 2012.
Other Potential Post-Employment Payments
We have entered into certain plans and agreements that require us to provide compensation to NEOs in the event of a termination of employment. Post-employment payments are provided for under the letter agreement with Ms. Nash, the Stock Plan, Change in Control Agreements, and retirement plans. These are described below.
As long as the TARP Preferred remain outstanding, there are limits on the ability to pay termination related or “golden parachute” payments. These limits are described in more detail under “Executive Compensation - Compensation Discussion and Analysis” section in this Item 11.
Nash Letter Agreement
On January 22, 2009, we entered into an agreement with Ms. Nash, our president and chief executive officer. The letter agreement provides that Ms. Nash is employed on an at-will basis and will receive the following:
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An annual base salary of $600,000;
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Annual incentive awards under the Management Incentive Plan to the extent that such awards are granted to the executive officers and subject to any restrictions on our ability to pay incentive compensation as long as the TARP Preferred remain outstanding; and
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A long-term award in 2009 under our Stock Compensation Plan equal to $300,000 in cash and 10,000 shares of restricted stock, with performance-based vesting terms as described under “Executive Compensation - Compensation Discussion and Analysis.”
Her annual salary, incentive compensation and long-term compensation is reviewed annually by the Compensation Committee and approved by the board of directors. Ms. Nash is eligible for other employee benefits and perquisites to the same extent provided to other executive officers. If her employment is terminated without cause other than in connection with a change in control, she will be entitled to two years of salary continuance, plus outplacement services. If her employment terminates due to death or disability, she will be eligible for the same benefits provided to other executive officers. Ms. Nash has agreed to non-compete and non-solicitation covenants expiring two years after her termination of employment, as well as confidentiality and non-disparagement covenants.
Stock Compensation Plan
The Stock Plan permits the Compensation Committee to make grants of stock options, stock appreciation rights, restricted stock, restricted stock units and various types of performance-based rights to acquire cash, common shares, other property or a combination thereof to directors and employees of the Corporation. The Stock Plan provides the following terms with respect to termination of employment or services of a participant holding an option or stock appreciation right, unless otherwise provided in the related grant agreement:
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If termination occurs for any reason prior to vesting, the right to exercise the option or stock appreciation right terminates and all rights cease;
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If termination occurs for any reason other than cause, death or disability after vesting, then the participant has the right to exercise the option or stock appreciation right to the extent it was exercisable upon termination until the earlier of three months after termination or the expiration of the option or stock appreciation right;
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If termination is due to the participant’s death or disability, then the participant or his or her estate may exercise the option or stock appreciation right to the extent it was exercisable upon termination until the earlier of the one year anniversary of employment termination or the expiration of the option or stock appreciation right;
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If termination is for cause, any unexercised portion of an outstanding option or stock appreciation right (whether or not then vested or exercisable), will immediately terminate and be forfeited as of the date of the cause determination.
The Compensation Committee may, in its discretion, accelerate the participant’s right to exercise an option or stock appreciation right or extend the exercise term, subject to any other limitations in the Stock Plan.
For other awards, the Stock Plan provides that, unless otherwise provided in the related grant agreement, if a participant’s employment or services are terminated for any reason prior to vesting other than death or disability or, in the case of most types of awards, retirement, restricted stock, restricted stock units, performance awards and incentive awards are generally forfeited. If termination is due to death or disability or, in the case of most types of awards, retirement, restricted stock, restricted stock units, performance awards and incentive awards will vest upon termination unless the grant agreement provides otherwise. The Compensation Committee may also waive restrictions in its sole discretion, except with respect to certain performance-based awards intended to qualify for an exemption from the Code Section 162(m) limit on deductibility, restrictions may only be waived in the event of termination due to death, disability or a change in control.
Awards under the Stock Plan are generally subject to special provisions upon the occurrence of a change in control of the Corporation. Under the Stock Plan, the Compensation Committee may provide in a grant agreement or otherwise that upon a change in control transaction (i) all outstanding options or stock appreciation rights immediately become fully vested and exercisable; (ii) any restriction period on any common shares or restricted stock units immediately lapses and the shares become freely transferable subject to any applicable federal or state securities laws; (iii) all performance goals are deemed to have been satisfied and any restrictions on any performance award or incentive award immediately lapse and the awards become immediately payable (either in full or pro-rata based on the portion of the applicable performance period completed); and (iv) awards may be treated in any other way as determined by the Compensation Committee. The Compensation Committee may also determine that upon a change in control, any outstanding option or stock appreciation right be canceled in exchange for payment in cash, stock or other property for each vested share in an amount equal to the excess of the fair market value of the consideration to be paid in the change in control transaction over the exercise price. The Compensation Committee, in its discretion, may provide in a participant’s agreement with respect to an option, stock appreciation right, restricted stock or restricted stock unit award, performance award or incentive award payable in shares that such awards will not be accelerated in the event of a change in control in which the successor company assumes the award.
The term “change in control” has the same definition as in our Change in Control Agreements which is defined below. To the extent any payment subject to Code Section 409A is payable on a change in control, an event will not be considered a change in control with respect to such payment unless it satisfies certain other conditions under Code Section 409A.
The 2011 and 2012 long-term incentive grant agreements provide that with regard to the performance-based portion of the award, if the Named Executive Officer resigns or is terminated for cause, then any unvested restricted stock or restricted stock units will be forfeited. However, if the Named Executive Officer terminates employment due to death, disability, retirement, or if the Named Executive Officer’s position is eliminated or terminated without cause, then the Named Executive Officer will receive a pro-rata portion of any unvested restricted shares or restricted stock units if the performance targets are ultimately met. With regard to the time-based portion of the 2010, 2011 and 2012 long-term incentive grants, if a Named Executive Officer resigns or is terminated for cause, then any unvested restricted stock or restricted stock units will be forfeited. If a Named Executive Officer holding restricted stock units retires, then the holder will receive a pro-rata portion of any unvested restricted stock units. A Named Executive Officer holding restricted stock who retires will forfeit any unvested restricted stock. If a Named Executive Officer’s employment is terminated due to death, disability, elimination of the Named Executive Officer’s position or is terminated without cause, then the Named Executive Officer will receive a pro-rata portion of the restricted shares or restricted stock units that have not yet vested as of the date employment terminates. In the event of a change in control, the restricted stock or restricted stock units would be fully vested, subject to limitations imposed by applicable law at the time.
Change in Control Agreements
We have Change in Control Agreements with each of our NEOs. The agreements provide severance benefits if there is a change in control of the Corporation and each Named Executive Officer’s employment with us is actually or constructively terminated at any time within three months prior to or on the date of such change in control, or within twenty-four months after a change in control. A “change in control” is defined as:
(i) the acquisition by any person or group of 20% or more of the outstanding common stock in a transaction which has not been approved by a majority of the board of directors;
(ii) a liquidation or dissolution of the Corporation;
(iii) a sale of substantially all of the assets of the Corporation;
(iv) a merger, consolidation or combination in which our shareholders immediately before such a transaction do not continue to control more than 65% of the voting power of the resulting entity; or
(v) under certain circumstances, a change in a majority of the members of the board of directors within a two-year period.
Our NEOs’ employment will have been constructively terminated following a change in control if:
(i) there is a significant reduction in the scope of the executive’s authority or in the extent of such executive’s powers, functions, duties or responsibilities;
(ii) there is a reduction in the executive’s rate of compensation;
(iii) fringe benefits are not provided to the executive on a basis commensurate with other executives; or
(iv) there are changes in our executive’s responsibilities, which would require moving such executive’s job outside of lower Michigan.
Each Change in Control Agreement provides for severance benefits of a lump sum payment equal to two times (three times in the case of Ms. Nash) the executive’s annual base salary immediately prior to the change in control (or if higher, the annual base salary on the date the executive’s employment is terminated) plus two times (three times in the case of Ms. Nash) the average of the annual bonuses paid to the executive in the last three full calendar years of employment under our MIP or such comparable plan in which the executive may have participated rather than the highest annual bonus paid to the executive in the last three calendar years.
In addition, the Change in Control Agreements provide our executives:
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Continued coverage under the medical, dental and life insurance benefit plans for eighteen months after termination, provided the executive does not enter into other employment providing comparable benefits;
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Transfer of any club memberships;
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Accelerated vesting of all stock options and restricted stock awards; and
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Payment of up to $20,000 for outplacement services.
In addition to the standard confidentiality requirements, our executives may not, for a period of two years following termination of employment, accept employment, consult for or otherwise assist any other financial institution, which conducts business from a location within fifty (50) miles of any of our locations.
Due to our participation in the CPP, as long as the TARP Preferred shares remain outstanding, we are generally not permitted to pay amounts to our NEOs and certain other employees for a change in control of the Corporation despite the contractual obligations in our Change in Control Agreements.
Pursuant to the terms of the merger agreement with FirstMerit, after the closing of the merger and FirstMerit’s purchase of the TARP Preferred stock, FirstMerit is obligated under the merger agreement to execute new change in control agreements with each of the former Citizens NEOs that replace the Change in Control Agreements currently in effect. The new change in control agreements are substantially similar to the Change in Control Agreements. The material differences include the following.
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Each of the new agreements acknowledges that a change in control has occurred as a result of the merger and; therefore, the benefits contemplated by the agreement would be triggered if the executive experiences a separation from service with FirstMerit or one of its subsidiaries as a result of an involuntary termination or a constructive dismissal within 24 months after the effective time of the merger.
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In the event of a qualifying separation from service, an executive would receive a lump sum severance payment fixed in amount based on the payment formula in the existing agreements assuming Citizens was not subject to TARP.
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In the event of a qualifying separation from service, an executive would also receive a lump sum payment in an amount equal to the cost, on a net after-tax basis, of continuing the medical, dental and vision insurance benefits for the executive and eligible dependents for 12 or 18 months of COBRA coverage, as applicable.
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In order to receive benefits under the agreement, an executive would be required to execute an agreement releasing FirstMerit from any claims he or she might have against FirstMerit, Citizens and their respective affiliates.
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Amounts payable to the executive may be subject to cutback unless, after the executive pays all of the applicable taxes, including any excise taxes in connection with Section 280G of the Code, the net after-tax amount the executive would receive is greater than the amount the executive would have received on a net after-tax basis after having the applicable portion of the executive’s payments cut back. The executives will not be reimbursed for any taxes payable by them in connection with the severance payments.
Retirement Plans
In the event of a termination due to retirement, our NEOs will receive benefits under our retirement plan. The retirement plan is described in detail in “Executive Compensation - Compensation Discussion and Analysis - Retirement Benefits” of Item 11.
Potential Post-Employment Payments Table
The table below represents the lump sum maximum amount each Named Executive Officer would have been eligible to receive upon a change in control or if their employment was terminated under one of the various scenarios described below as of December 31, 2012.
As noted above, we are currently not permitted to pay amounts to our NEOs for departure from the Corporation for any reason other than death or disability.
(1) The amounts shown in this column reflect the value of restricted shares or restricted stock units with respect to which transferability restrictions would have lapsed if a change in control had occurred on December 31, 2012.
(2) The amounts in this column reflect the pro-rata value of the restricted shares or restricted stock units with respect to which transferability restrictions would have lapsed had the NEOs terminated employment because of death or disability on December 31, 2012.
Compensation of Directors
In 2012, our non-employee directors were compensated as follows:
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Annual retainer: $20,000.
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Meeting fee for board and committee meetings: $1,500 if attended in person, $750 if attended by telephone.
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Non-Executive Chairman: additional $40,000 annual retainer.
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Chairperson of the audit committee: additional $10,000 annual retainer.
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Chairperson of the compensation and human resources committee and the risk management committee: additional $7,500 annual retainer.
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Chairperson of the corporate governance and nominating committee: additional $5,000 annual retainer.
Directors may participate in our directors deferred compensation plan, which allows directors to elect to defer up to 100% of their retainer, meeting and committee fees. The investment options available under the directors deferred compensation plan are the same as those available under our 401(k) plan. As a general rule, amounts deferred and investment returns are required to be distributed no earlier than upon the director’s termination of all directorships with us and our subsidiary. No additional compensation or above market earnings are paid pursuant to this plan. Non-employee directors do not receive perquisites or other personal benefits for their service as a director. Directors who are also our employees do not receive any additional compensation for their service as a director.
The following table provides information regarding compensation that was paid to the individuals who served as our directors during 2012, other than Ms. Nash. As a Named Executive Officer, Ms. Nash’s compensation is included in Item 11 “Summary Compensation Table”.
(1) In April, 2012, Ms. Champion received her $20,000 retainer fee in the form of 1,185 shares of our common stock. The number of shares was based on the closing price per share on the NASDAQ Capital Market on April 30, 2012, the date of the grant and such shares were fully vested upon grant.
Prior to 2008, as part of our standard non-employee director compensation arrangement, we made awards to our directors either in the form of restricted common shares or stock options. The table below sets forth for each director the number of options held as of December 31, 2012. All prior grants of restricted stock held by the directors have vested.
Compensation Committee Interlocks and Insider Participation
There were no interlock relationships involving members of the Compensation Committee in 2012, nor were there any transactions involving Citizens in which any member of the Compensation Committee or any member of their immediate family had a direct or indirect material interest. The members of the Compensation Committee are Lizabeth A. Ardisana, Robert S. Cubbin, William M. Fenimore, Jr., Stephen J. Lazaroff and James L. Wolohan.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Certain Beneficial Owners
The table below includes all of our shareholders that we know to beneficially own more than five percent of our common stock as of December 31, 2012, unless otherwise indicated.
(1) The information furnished for AQR Capital Management, LLC is based upon information contained in the Schedule 13G filed with the Securities and Exchange Commission on February 14, 2013.
(2) The information furnished for BlackRock, Inc. is based upon information contained in the Schedule 13G filed with the Securities and Exchange Commission on January 30, 2013.
(3) The information furnished for The Vanguard Group is based upon information contained in the Schedule 13G filed with the Securities and Exchange Commission on February 12, 2013.
The Department of the Treasury, United States Department of the Treasury, 1500 Pennsylvania Avenue, NW, Washington D.C. 20220, holds all of the outstanding 300,000 shares of the TARP Preferred stock.
Management
The following table reflects the beneficial ownership of our common stock as of February 15, 2013 by:
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Each current director;
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Each executive officer named in the “Executive Compensation - Summary Compensation Table,” whom we refer to as our NEOs; and
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Our current directors and all executive officers as a group.
The information in the table has been obtained from these individuals and is reported in accordance with the applicable rules of the Securities and Exchange Commission, or Commission. Under these rules, a person is deemed to beneficially own stock if they have or share the power to vote or dispose of the stock or have the right to acquire the power to vote or dispose of the stock within the next 60 days. As a result, the amounts shown in the table do not necessarily reflect stock ownership for any purpose other than compliance with the Commission’s reporting requirements.
* Represents holdings of less than one percent.
(1) The following table shows the number of shares included in the column that (1) may be acquired upon exercise of options which are exercisable or become exercisable on or before April 17, 2013, (2) are unvested restricted shares that vest on or before April 17, 2013, (3) are unvested restricted stock units that vest on or before April 17, 2013 or (4) are pledged by the owner as security. Vesting provisions for the restricted shares are described in the “Executive Compensation - Outstanding Equity Awards at Year-End” table in Item 11.
The shares shown for Mr. Green, Ms. Klawinski, Ms. McNeely, and Mr. Widawski do not include 21,616, 11,558, 14,374, and 44,845 restricted stock units, respectively, that have not yet vested and will not vest within the next 60 days.
(2) The shares shown for Mr. Wolohan do not include 3,169 shares held by the Wolohan Family Foundation, of which Mr. Wolohan is a director, or 2,150 shares held in trusts for Mr. Wolohan’s nieces and nephews of which Mr. Wolohan is a trustee. Mr. Wolohan disclaims beneficial ownership of such shares.
Equity Compensation Plan Information
Citizens has a stock-based compensation plan authorizing the granting of incentive and nonqualified stock options, restricted stock awards, restricted stock units, and performance awards to employees and non-employee directors up to a maximum of 2.4 million shares. At December 31, 2012, Citizens had 950,248 shares of common stock reserved for future issuance under the current plan.
In conjunction with the Republic merger in 2006, Citizens assumed Republic’s active stock-option plans which had previously been approved by Republic’s shareholders. Citizens has not made any awards under the assumed plans and treats these plans as if they are terminated as to future grants.
The following table sets forth, with respect to all of the stock-based compensation plans, (a) the number of shares of common stock to be issued upon the exercise of outstanding options, (b) the weighted average exercise price of outstanding options, and (c) the number of shares remaining available for future issuance, as of December 31, 2012.
At December 31, 2012
(1) Options for 53 Citizens common shares with a weighted-average exercise price of $227.33 per share were outstanding under the assumed Republic plans as of December 31, 2012 and are included in the table.
Proposed Change in Control
On September 13, 2012, FirstMerit Corporation and Citizens Republic Bancorp, Inc. announced a strategic business combination in which Citizens will merge with and into FirstMerit pursuant to an Agreement and Plan of Merger, dated as of September 12, 2012, by and between FirstMerit and Citizens. Under the terms of the merger agreement, holders of Citizens common stock will have a right to receive 1.37 shares of FirstMerit common stock for each share of Citizens common stock held immediately prior to the merger. The merger is subject to customary closing conditions, including the receipt of approval of bank regulators and the shareholders of Citizens and FirstMerit.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
During 2012, our banking subsidiary had, and expects to have in the future, banking transactions, in the ordinary course of business, with directors, officers and their associates. These transactions were made on substantially the same terms, including interest rate charges and collateral requirements, as comparable transactions are made with unrelated parties prevailing at the time of such transactions and did not involve more than the normal risk of collectability or present other unfavorable features. All credit transactions involving directors and executive officers are reviewed and, when required, approved by the board of directors. None of these loans is currently disclosed as non-accrual, past due, restructured or as a potential problem in this Annual Report on Form 10-K.
We maintain a written policy requiring the pre-approval by the board of directors of all lending transactions between us and executive officers and directors in compliance with Federal Reserve Regulation O. Although we do not have a written policy with regard to the approval of other transactions between us and our executive officers and directors, any such transactions constituting a perceived conflict of interest under our code of ethics or applicable law, or that would require disclosure in our annual meeting proxy statement, are generally discouraged. To the extent any such transaction were proposed, those individuals would report any such transaction to the chief executive officer, the general counsel or the chairman of the board and if a decision were made to proceed, the transaction would be submitted for approval to the board and to a committee of independent directors in accordance with our code of ethics, applicable law and applicable NASDAQ Marketplace Rules.
Our board of directors has determined that, except for Ms. Nash, all of our directors, including all the committee members, are “independent directors” as defined in NASDAQ Marketplace Rule 5605.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
In 2012, Ernst & Young LLP, or E&Y, performed audit and audit related services for us, which included examination of our consolidated financial statements, and consultation with us and our subsidiary on accounting and reporting matters.
Audit Fees. E&Y billed us a total of $1,246,990 and $1,071,295 during 2012 and 2011, respectively, for professional services in connection with the audit of our annual financial statements and the review of the quarterly financial statements during each such year. The amounts shown for 2012 and 2011 include fees relating to the audit of our internal controls over financial reporting.
Audit Related Fees. In 2012 and 2011, E&Y billed us a total of $42,000 and $55,000, respectively for assurance and related services that were related to the performance of the audit and review of the financial statements, including audits of our benefit plans.
Tax Fees. In 2012 and 2011, E&Y billed us a total of $44,120 and $22,320, respectively for tax compliance, tax advice and tax planning services.
All Other Fees. In 2012 and 2011, E&Y billed us a total of $1,995 each year for other services rendered during 2012 and 2011. These fees related primarily to E&Y’s online accounting research tool.
Our audit committee charter provides that the audit committee of the board of directors shall approve in advance all audit services and permissible non-audit services provided by our independent auditors. The audit committee preapproved all of the services performed by E&Y in 2012.
The audit committee does not consider the provision of the services described above by E&Y to be incompatible with the maintenance of E&Y’s independence.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) 1. Financial Statements:
The following Consolidated Financial Statements of Citizens and Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements are incorporated by reference under Item 8 “Financial Statements and Supplementary Data” of this document:
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Selected Quarterly Information
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
2. Financial Statement Schedules:
All schedules are omitted-see Item 15(c) below.
3. Exhibits:
The exhibits listed on the “Exhibit Index” of this report are filed herewith and are incorporated herein by reference.
(b) Exhibits:
The exhibits listed on the “Exhibit Index” of this report are filed herewith and are incorporated herein by reference. At the request of any shareholder, Citizens will furnish any exhibit upon the payment of a fee of $0.10 per page to cover the costs of furnishing the exhibit.
(c) Financial Statement Schedules
All financial statement schedules normally required by regulation S-X are omitted since they are either not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURES (continued)
EXHIBIT INDEX
The following exhibits are filed as part of this report, or were previously filed and are incorporated herein by reference to the filing indicated. Exhibits not required for this report have been omitted. Citizens’ Commission file number is 001-33063.
EXHIBIT INDEX (continued)
EXHIBIT INDEX (continued)
EXHIBIT INDEX (continued)
* Current management contracts or compensatory plans or arrangements.
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