ITEM 1. BUSINESS
General
Bank of the Carolinas Corporation (the “Company”) was formed in 2006 to serve as a holding company for Bank of the Carolinas (the “Bank”). The Company is registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and the bank holding company laws of North Carolina. The Company’s office is located at 135 Boxwood Village Drive, Mocksville, North Carolina 27028. The Company’s primary business activity consists of directing the activities of the Bank.
The Bank is incorporated under the laws of North Carolina and began operations on December 7, 1998 as a North Carolina chartered commercial bank. The Bank operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”). As a state chartered non-Federal Reserve member bank, the Bank is subject to examination and regulation by the FDIC and the North Carolina Commissioner of Banks (the “Commissioner”). The Bank is further subject to certain regulations of the Federal Reserve. The business and regulation of the Bank are also subject to legislative changes from time to time. See Item 1. Description of Business-Supervision and Regulation.
The Bank’s primary market area is in the Piedmont region of North Carolina where we are engaged in general commercial banking primarily in Davie, Randolph, Rowan, Cabarrus, Davidson, Forsyth and Stokes Counties. The Bank’s main office is located at 135 Boxwood Village Drive in Mocksville, North Carolina. Our main office in Mocksville and our Advance office are located in Davie County. Our other offices are located in Asheboro (Randolph County), Landis (Rowan County), Harrisburg and Concord (Cabarrus County), Lexington (Davidson County), King (Stokes County)1 and Winston-Salem (Forsyth County).
Services
Our operations are primarily retail oriented and directed toward individuals and small- and medium-sized businesses located in our banking market. The majority of our deposits and loans are derived from customers in our banking market, but we also make loans and have deposit relationships in areas surrounding our immediate banking market. We also occasionally solicit and accept wholesale deposits. We offer a variety of commercial and consumer banking services, but our principal activities are the taking of demand and time deposits and the making of consumer and commercial loans. To a lesser extent, we also generate income from other fee-based products and services that we provide.
The Bank’s primary source of revenue is interest and fee income from its lending activities. These lending activities consist principally of originating commercial operating and working capital loans, residential mortgage loans, home equity lines of credit, other consumer loans and loans secured by commercial real estate. Interest and dividend income from investment activities generally provide the second largest source of income to the Bank.
Deposits are the primary source of the Bank’s funds for lending and other investment purposes. The Bank attracts both short-term and long-term deposits from the general public by offering a variety of accounts and rates. The Bank offers statement savings accounts, negotiable order of withdrawal accounts, money market demand accounts, non-interest-bearing accounts and fixed interest rate certificates with varying maturities. The Bank also utilizes alternative sources of funds such as borrowings from the Federal Home Loan Bank (the “FHLB”) of Atlanta, Georgia and other commercial banks.
Subject to regulatory approval, we intend to permanently close the King office in the second quarter of 2013.
The Bank’s deposits are obtained primarily from its primary market area. The Bank uses traditional marketing methods to attract new customers and deposits including print media advertising and direct mailings. Deposit flows are greatly influenced by economic conditions, the general level of interest rates, competition and other factors.
Organization
The Bank is the sole banking subsidiary of the Company. A trust (Bank of the Carolinas Trust I) was formed as a subsidiary of the Company to facilitate the issuance of Trust Preferred Securities as a form of non-dilutive equity to supplement our capital.
The Bank formed an LLC (East Atlantic Properties, LLC) to manage our income producing assets transferred from our Other Real Estate Owned. BOTC, LLC, is a North Carolina limited liability company which serves as the trustee for the benefit of Bank of the Carolinas in connection with real estate deeds of trust. Both LLCs are consolidated into the Bank and are disregarded entities for tax purposes.
Lending Activities
General. We make a variety of types of consumer and commercial loans to individuals and small- and medium-sized businesses for various personal, business and agricultural purposes, including term and installment loans, commercial and equity lines of credit, and overdraft checking credit. For financial reporting purposes, our loan portfolio generally is divided into real estate loans (including home equity lines of credit), commercial loans, and consumer loans. We make credit card services available to our customers through a correspondent relationship. For an analysis of the components of our loan portfolio, see Table I. Analysis of Loan Portfolio in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Real Estate Secured Loans. Our real estate loan classifications include loans secured by real estate which are made to purchase, construct or improve residential or commercial real estate, for real estate development purposes, and for various other commercial and consumer purposes (whether or not those purposes are related to our real estate collateral).
Commercial real estate and construction loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In the case of commercial real estate loans, loan repayment may be dependent on the successful operation of income producing properties, a business, or a real estate project and, thus, may, to a greater extent than in the case of other loans, be subject to the risk of adverse conditions in the economy generally or in the real estate market in particular.
Construction loans involve special risks due to the fact that loan funds are advanced upon the security of houses or other improvements that are under construction and that are of uncertain value prior to the completion of construction. For that reason, it is more difficult to evaluate accurately the total loan funds required to complete a project and the related loan-to-value ratios. To minimize these risks, generally we limit loan amounts to 80% of the projected appraised value of our collateral upon completion of construction.
Many of our real estate loans, while secured by real estate, were made for purposes unrelated to the real estate collateral. That generally is reflective of our efforts to minimize credit risk by taking real estate as primary or additional collateral, whenever possible, without regard to loan purpose. All our real estate loans are secured by first or junior liens on real property, the majority of which is located in or near our banking market. However, we have made loans, and have purchased participations in some loans from other entities, which are secured by real property located outside our banking market.
Our real estate loans may be made at fixed or variable interest rates and, generally, with the exception of our long-term residential mortgage loans discussed below, have maturities that do not exceed five years. However, we also make real estate loans that have maturities of more than five years, or which are based on amortization schedules of as much as 30 years, but that generally will include contractual provisions which allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of no more than five to fifteen years.
In addition to residential real estate loans made for a variety of purposes, we offer long-term, residential mortgage loans that are funded by and closed in the name of third-party lenders. This arrangement permits us to offer this product in our banking market and enhance our fee-based income, but, by closing the loans in the names of the ultimate owners of those loans, we avoid the credit and interest rate risk associated with these long-term loans. However, on a limited basis, we also make residential mortgage loans that we retain in our own loan portfolio. Those loans typically are secured by first liens on the related residential property, are made at fixed and variable interest rates, and have maturities that do not exceed 15 years, although we have a small number of residential mortgage loans in our portfolio with 30-year maturities.
Our home equity lines of credit include lines of credit that generally are used by borrowers for consumer purposes and are secured by first or junior liens on residential real property. Our commitment on each line is for a term of 15 years, and interest is charged at a variable rate. The terms of these lines of credit provide that borrowers either may pay accrued interest only, with the outstanding principal balances becoming due in full at the maturity of the lines, or they will make payments of principal and interest based on a 15-year amortization schedule.
Commercial Loans. Our commercial loan classification includes loans to individuals and small- and medium-sized businesses for working capital, equipment purchases, and various other business and agricultural purposes, but that classification excludes any such loan that is secured by real estate. These loans generally are secured by inventory, equipment or similar assets, but they also may be made on an unsecured basis. In addition to loans which are classified on our books as commercial loans, as described above, many of our loans included within the real estate loan classification were made for commercial purposes but are classified as real estate loans on our books because they are secured by first or junior liens on real estate. Commercial loans may be made at variable or fixed rates of interest. However, it is our policy that any loan which has a maturity or amortization schedule of longer than five years normally would be made at an interest rate that varies with our prime lending rate or would include contractual provisions which allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of no more than five years.
Commercial loans typically are made on the basis of the borrower’s ability to make repayment from business cash flow, and those loans typically are secured by business assets, such as accounts receivable, equipment and inventory. As a result, the ability of borrowers to repay commercial loans may be substantially dependent on the success of their businesses, and the collateral for commercial loans may depreciate over time and their values may not be as determinable relative to the time the loans were originated.
Consumer Loans. Our consumer loans consist primarily of loans for various consumer purposes, as well as the outstanding balances on non-real estate secured consumer revolving credit accounts. A majority of these loans are secured by liens on various personal assets of the borrowers, but they also may be made on an unsecured basis. Additionally, our real estate loans include loans secured by first or junior liens on real estate which were made for consumer purposes unrelated to the real estate collateral. Consumer loans generally are made at fixed interest rates and with maturities or amortization schedules which generally do not exceed five years. However, consumer-purpose loans secured by real estate (and, thus, classified as real estate loans as described above) may be made for terms of up to 30 years, but under terms which allow us to call the loan in full, or provide for a “balloon” payment, at the end of no more than five to fifteen years.
Consumer loans generally are secured by personal property and other personal assets of borrowers which often depreciate rapidly or are vulnerable to damage or loss. In cases where damage or depreciation reduces the value of our collateral below the unpaid balance of a defaulted loan, repossession may not result in repayment of the entire outstanding loan balance. The resulting deficiency often does not warrant further substantial collection efforts against the borrower. In connection with consumer lending in general, the success of our loan collection efforts are highly dependent on the continuing financial stability of our borrowers. Our collection capacity on consumer loans may be more likely to be adversely affected by a borrower’s job loss, illness, personal bankruptcy or other change in personal circumstances than is the case with other types of loans.
Loan Administration and Underwriting. Like most community banks, we make loans based to a great extent on our assessment of borrowers’ income, cash flow, net worth, character and ability to repay the loan. A principal risk associated with each loan category is the creditworthiness of our borrowers. Our loans may be viewed as involving a higher degree of credit risk than is typically the case with some other types of loans, such as long-term residential mortgage loans where greater emphasis is placed on assessed collateral values. To manage risk, we have adopted written loan policies and procedures. Our loan portfolio is administered under a defined process that includes guidelines for loan underwriting
standards, risk assessment, procedures for loan approvals, loan risk grading, ongoing identification and management of credit deterioration, and portfolio reviews to assess loss exposure. These reviews also are used to test our compliance with our credit policies and procedures in an ongoing fashion.
The underwriting standards that we employ for loans include an evaluation of various factors, including but not limited to a loan applicant’s income, cash flow, payment history on other debts and an assessment of ability to meet existing obligations including payments on any proposed loan. Though creditworthiness of the applicant is a primary consideration within the loan approval process, we take collateral (particularly real estate) whenever it is available. This is done without regard to loan purpose. In the case of secured loans, the underwriting process includes an analysis of the value of the proposed collateral. The analysis is conducted in relation to the proposed loan amount. Consideration is given to the value of the collateral, the degree to which the value is ascertainable with any certainty, the marketability of the collateral in the event of default, and the likelihood of depreciation in the collateral value.
Our Board of Directors has approved levels of lending authority for lending personnel based on our aggregate credit exposures to borrowers, along with the secured or unsecured status and the risk grade of a proposed loan. A loan that satisfies our loan policies and is within a lending officer’s assigned authority may be approved by that officer. Anything above that amount must be approved before funding by our Credit Administration management, the Loan Committee of the Board of Directors or our Board of Directors.
At the time a loan is proposed, the account officer assigns a risk grade to the loan based on various underwriting and other criteria. The grades assigned to loans generally indicate the level of ongoing review and attention that we will give to those loans to protect our position.
After funding, all loans are reviewed by our Loan Administration personnel for adequacy of documentation and compliance with regulatory requirements. Most loans (including the largest exposure loans) are reviewed for compliance with our underwriting criteria and to reassess the grades assigned to them by the account officers.
During the life of each loan, its grade is reviewed and validated. Modifications can and are made to reflect changes in circumstances and risk. Loans generally are placed in a non-accrual status if they become 90 days past due (unless, based on relevant circumstances, we believe that collateral is sufficient to justify continued accrual and the loan is in process of collection). Non-accrual status is also applied whenever we believe that collection has become doubtful. Loans are charged off when the collection of principal and interest has become doubtful and the loans no longer can be considered a sound collectible asset (or, in the case of unsecured loans, when they become 90 days past due).
Allowance for Loan Losses. Our Board of Directors’ Loan Committee reviews all substandard loans at least monthly, and our management meets regularly to review asset quality trends and to discuss loan policy issues. Based on these reviews and our current judgments about the credit quality of our loan portfolio and other relevant internal and external factors as well as historical charge off rates, we have established an allowance for loan losses. The appropriateness of the allowance is assessed by our management, reviewed by the Loan Committee each month, and reviewed by the Board of Directors quarterly. We make provisions to the allowance based on those assessments which are charged against our earnings.
For additional information regarding loss experience, our allowance for loan losses and problem assets, see Table II. Summary of Loan Loss Experience, Table III. Allocation of Allowance for Loan Losses, and Table V. Nonperforming Assets in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Deposit Activities
Our deposit products include business and individual checking accounts, savings accounts, NOW accounts, certificates of deposit and money market checking accounts. We monitor our competition in order to keep the rates paid on our deposits at a competitive level. However, under FDIC regulations and the terms of the regulatory consent order discussed under the heading “Supervision and Regulation” below, we may not currently solicit deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yield on insured deposits of comparable maturity in our market area or the market area where the deposits are being solicited. The majority of our deposits are
derived from within our banking market. However, we have historically solicited and accepted wholesale deposits as a way to supplement funding to support loan growth and provide added balance sheet liquidity. For additional analysis of deposit relationships, see Table VIII. Deposit Mix in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Investment Portfolio
On December 31, 2012, our investment portfolio consisted of U.S. government agency securities, state and municipal obligations, mortgage-backed securities issued by the Federal National Mortgage Association (“Fannie Mae”), the Government National Mortgage Association (“Ginnie Mae”), and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and corporate obligations. Our securities are classified as both “held to maturity” and “available for sale.” We analyze their performance monthly and carry the available for sale securities on our books at their fair market values while carrying the held to maturity securities at their amortized cost. For additional analysis of investment security balances by type and maturities and average yields by security type, see Table VI. Investment Securities and Table VII. Investment Securities in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. For additional information regarding appreciation and depreciation by security type, and information relating to Other Than Temporary Impairment, see Note 2. Investment Securities in our Notes to Consolidated Financial Statements under Item 8.
Competition
Commercial banking in North Carolina is highly competitive, due in large part to our state’s early adoption of statewide branching. Over the years, federal and state legislation (including the elimination of many of the restrictions on interstate banking) has heightened the competitive environment in which all financial institutions conduct their business, and the potential for competition among financial institutions of all types has increased significantly. We compete with approximately 30 commercial banks and institutions with offices in our banking market.
Interest rates, both on loans and deposits, and prices of fee-based services are significant competitive factors among financial institutions in general. Other important competitive factors include office location, office hours, the quality of customer service, community reputation, continuity of personnel and services, and, in the case of larger commercial customers, relative lending limits and the ability to offer sophisticated cash management and other commercial banking services. Many of our competitors have greater resources, broader geographic markets, more extensive branch networks, and higher lending limits than we do. They also can offer more products and services and can better afford and make more effective use of media advertising, support services and electronic technology than we can. In terms of assets, we are one of the smaller commercial banks in North Carolina, and there is no assurance that we will be or continue to be an effective competitor in our banking market. However, we believe that community banks can compete successfully by providing personalized service and making timely, local decisions, and that further consolidation in the banking industry is likely to create additional opportunities for community banks to capture deposits from affected customers who may become dissatisfied as their financial institutions grow larger. Additionally, we believe that the continued growth of our banking market affords an opportunity to capture new deposits from new residents.
Substantially all of our customers are individuals and small- and medium-sized businesses. We try to differentiate ourselves from our larger competitors with our focus on relationship banking, personalized service, direct customer contact, and our ability to make credit and other business decisions locally. We also depend on our reputation as a community bank in our banking market, our involvement in the communities we serve, the experience of our senior management team, and the quality of our associates. We believe that our focus allows us to be more responsive to our customers’ needs and more flexible in approving loans based on our personal knowledge of our customers.
Employees
On December 31, 2012, we had approximately 105 full-time equivalent employees (including our executive officers). We are not party to any collective bargaining agreement with our employees, and we consider our relations with our employees to be good.
Supervision and Regulation
Our business and operations are subject to extensive federal and state governmental regulation and supervision. The following is a summary of some of the basic statutes and regulations that apply to us, but it is not a complete discussion of all the laws that affect our business. In addition to these statutes and regulations, we are subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks and a written agreement with the Federal Reserve Bank of Richmond, as summarized below.
Consent Order with FDIC and North Carolina Commissioner of Banks. The Bank entered into a Stipulation to the Issuance of a Consent Order (the “Stipulation”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Office of the Commissioner of Banks (the “Commissioner”) and the FDIC and the Commissioner issued the related Consent Order (the “Order”), effective April 27, 2011. The description of the Stipulation and the Order set forth below is qualified in its entirety by reference to the Stipulation and the Order, copies of which are included as exhibits 10.14 and 10.15 to this Form 10-K, and incorporated herein by reference.
Management. The Order requires that the Bank have and retain qualified management, including a chief executive officer, senior lending officer, and chief operating officer with qualifications and experience commensurate with their assigned duties and responsibilities within 60 days from the effective date of the Order. Within 30 days of the effective date of the Order, the board of directors was required to retain a bank consultant to develop a written analysis and assessment of the Bank’s management needs. Following receipt of the consultant’s management report, the Bank was required to formulate a written management plan that incorporated the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a time frame for completing each action.
Capital Requirements. While the Order is in effect, the Bank must maintain a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%. If the Bank’s capital ratios are below these levels as of the date of any call report or regulatory examination, the Bank must, within 30 days from receipt of a written notice of capital deficiency from its regulators, present a plan to increase capital to meet the requirements of the Order.
Allowance for Loan and Lease Losses and Call Report. Upon issuance of the Order, the Bank was required to make a provision to replenish the allowance for loan and lease losses (“ALLL”). Within 30 days of the effective date of the Order, the Bank was required to review its call reports filed with its regulators on or after December 31, 2010, and amend those reports if necessary to accurately reflect the financial condition of the Bank. Within 60 days of the effective date of the Order, the Bank was required to submit a comprehensive policy for determining the adequacy of the ALLL.
Concentrations of Credit. Within 60 days of the issuance of the Order, the Bank was required to perform a risk segmentation analysis with respect to its concentrations of credit and develop a written plan for systematically reducing and monitoring the Bank’s commercial real estate and acquisition, construction, and development loans to an amount commensurate with the Bank’s business strategy, management expertise, size, and location.
Charge-Offs, Credits. The Order requires that the Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified “loss” and 50% of those assets classified “doubtful.” If an asset is classified “doubtful,” the Bank may alternatively charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment. The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, “loss” or “doubtful” and is uncollected. The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.” These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.
Asset Growth. While the Order is in effect, the Bank must notify its regulators at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition. The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from its regulators.
Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of its regulators. In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior regulatory approval.
Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area. An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.
Written Plans and Other Material Terms. Under the terms of the Order, the Bank was required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:
-
Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management
-
Plan to reduce assets of $500,000 or greater classified “doubtful” and “substandard”
-
Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions
-
Effective internal loan review and grading system
-
Policy for managing the Bank’s other real estate
-
Business/strategic plan covering the overall operation of the Bank
-
Plan and comprehensive budget for all categories of income and expense for the year 2011
-
Policy and procedures for managing interest rate risk
-
Assessment of the Bank’s information technology function
Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities. The Bank was also required to establish a board committee to monitor and coordinate compliance with the Order.
The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
Written Agreement with the Federal Reserve Bank of Richmond. The Company entered into a written agreement (the “Agreement”) with the Federal Reserve Bank of Richmond, on August 26, 2011. The description of the Agreement set forth below is qualified in its entirety by reference to the Agreement, a copy of which is included as exhibit 10.16 to this Form 10-K, and is incorporated herein by reference.
Source of Strength. The Agreement requires that the Company take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to its wholly-owned subsidiary, Bank of the Carolinas (the “Bank”), and ensure that the Bank complies with the requirements of the consent order entered into between the North Carolina Commissioner of Banks, the FDIC and the Bank.
Dividends, Distributions, and other Payments. The Agreement prohibits the Company’s payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation. It also prohibits the Company from directly or indirectly taking any dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank of Richmond.
Under the terms of the Agreement, the Company and the Bank may not make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.
Debt and Stock Redemption. The Agreement requires that the Company and any non-bank subsidiary of the Company not, directly or indirectly, incur, increase or guarantee any debt without the prior written approval of the Federal Reserve Bank. The Agreement also requires that the Company not, directly or indirectly, purchase or redeem any shares of its capital stock without the prior written approval of the Federal Reserve Bank of Richmond.
Capital Plan, Cash Flow Projections and Progress Reports. The Agreement requires that the Company file an acceptable capital plan and certain cash flow projections with the Federal Reserve Bank of Richmond. It also requires that the Company file a written progress report within 30 days after the end of each calendar quarter while the Agreement remains in effect.
The Order will remain in effect until modified or terminated by the Federal Reserve Bank of Richmond.
Regulation of Bank Holding Companies. Bank of the Carolinas Corporation is a North Carolina business corporation that operates as a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”). We are subject to supervision and examination by, and the regulations and reporting requirements of, the Federal Reserve Board (the “FRB”). Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in other activities the FRB determines are closely related and a proper incident to banking or managing or controlling banks.
Bank holding companies may elect to be regulated as “financial holding companies” if all their financial institution subsidiaries are and remain well capitalized and well managed as described in the FRB’s regulations and have a satisfactory record of compliance with the Community Reinvestment Act. In addition to the activities that are permissible for bank holding companies, financial holding companies are permitted to engage in additional activities that are determined by the FRB, in consultation with the Secretary of the Treasury, to be financial in nature or incidental to a financial activity, or that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions, or the financial system generally, as determined by the FRB. We are not a financial holding company.
The BHCA prohibits a bank holding company or financial holding company from acquiring direct or indirect control of more than 5.0% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without the prior approval of or, under specified circumstances, notice to, the FRB. Additionally, the BHCA generally prohibits banks or financial holding companies from acquiring ownership or control of more than 5.0% of the outstanding voting stock of any company that engages in an activity other than one that is permissible for the holding company. In approving an application to engage in a nonbanking activity, the FRB must consider whether that activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.
The law imposes a number of obligations and restrictions on a bank holding company and its insured bank subsidiaries designed to minimize potential losses to depositors and the FDIC insurance fund. For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee the bank’s compliance (subject to certain limits) with the terms of any capital restoration plan filed with its federal banking agency. A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances in which, absent that policy, it might not do so. Under the BHCA, the FRB may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the FRB determines that the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of a bank holding company. As described above, Bank of the Carolinas Corporation is currently party to a written agreement with the Federal Reserve Bank of Richmond.
Regulation of the Bank. The Bank is an FDIC-insured, North Carolina-chartered bank. Its deposits are insured under the FDIC’s Deposit Insurance Fund (“DIF”), and it is subject to supervision and examination by, and the regulations and reporting requirements of, the FDIC and the Commissioner. The FDIC and the Commissioner are its primary federal and state banking regulators. The Bank is not a member bank of the Federal Reserve System.
As a state insured bank, the Bank is prohibited from engaging as principal in any activity that is not permitted for national banks unless (1) the FDIC determines that the activity or investment would not pose a significant risk to the DIF,
and (2) the Bank is, and continues to be, in compliance with the capital standards that apply to it. The Bank also is prohibited from directly acquiring or retaining any equity investment of a type or in an amount that is not permitted for national banks.
The FDIC and the Commissioner regulate all areas of the Bank’s business, including its reserves, mergers, payment of dividends and other aspects of its operations. They conduct regular examinations of the Bank, and the Bank must furnish periodic reports to the FDIC and the Commissioner containing detailed financial and other information about its affairs. The FDIC and the Commissioner have broad powers to enforce laws and regulations that apply to the Bank and to require the Bank to correct conditions that affect its safety and soundness. Among others, these powers include issuing cease and desist orders, imposing civil penalties, and removing officers and directors, and their ability otherwise to intervene in the Bank’s operation if their examinations of the Bank, or the reports it files, reflect a need for them to do so. As described above, the Bank is currently subject to a Consent Order issued by the FDIC and the Commissioner.
The Bank’s business also is influenced by prevailing economic conditions and governmental policies, both foreign and domestic, and, though it is not a member bank of the Federal Reserve System, by the monetary and fiscal policies of the FRB. The FRB’s actions and policy directives determine to a significant degree the cost and availability of funds the Bank obtains from money market sources for lending and investing, and they also influence, directly and indirectly, the rates of interest the Bank pays on time and savings deposits and the rates it charges on commercial bank loans.
Powers of the FDIC in Connection with the Insolvency of an Insured Depository Institution. Under the Federal Deposit Insurance Act (the “FDIA”), if any insured depository institution becomes insolvent and the FDIC is appointed as its conservator or receiver, the FDIC may disaffirm or repudiate any contract or lease to which the institution is a party which it determines to be burdensome, and the disaffirmance or repudiation of which is determined to promote the orderly administration of the institution’s affairs. The disaffirmance or repudiation of any of our obligations would result in a claim of the holder of that obligation against the conservatorship or receivership. The amount paid on that claim would depend upon, among other factors, the amount of conservatorship or receivership assets available for the payment of unsecured claims and the priority of the claim relative to the priority of other unsecured creditors and depositors.
In its resolution of the problems of an insured depository institution in default or in danger of default, the FDIC generally is required to satisfy its obligations to insured depositors at the least possible cost to the deposit insurance fund. In addition, the FDIC may not take any action that would have the effect of increasing the losses to the deposit insurance fund by protecting depositors for more than the insured portion of deposits or creditors other than depositors. The FDIA authorizes the FDIC to settle all uninsured and unsecured claims in the insolvency of an insured bank by making a final settlement payment after the declaration of insolvency as full payment and disposition of the FDIC’s obligations to claimants. The rate of the final settlement payments will be a percentage rate determined by the FDIC reflecting an average of the FDIC’s receivership recovery experience.
North Carolina Banking Law Modernization Act. On October 1, 2012, as a result of the recommendations of the Joint Legislative Study Commission on the Modernization of North Carolina Banking Laws, legislation went into effect that comprehensively modernizes North Carolina’s banking laws for the first time since the Great Depression. As a result of the legislation, Articles 1 through 10, 12, and 13 of Chapter 53 of the North Carolina General Statutes were repealed, and new Chapter 53C, entitled “Regulation of Banks,” became law. Major changes enacted by the law include: a comprehensive list of definitions enhancing the clarity and meaning of the various sections of North Carolina’s banking law, a broader reliance on the North Carolina Business Corporations Act, and incorporation of modern concepts of capital adequacy and regulatory supervision. On March 4, 2013, a bill was filed for consideration by the North Carolina General Assembly to make certain technical corrections and clarifications to Chapter 53C.
Dodd-Frank Wall Street Reform and Consumer Protection Act. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. This law has significantly changed the current bank regulatory structure and is affecting 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 have significant discretion in drafting 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 years. The Dodd-Frank Act included, among other things:
•
the creation of a Financial Stability Oversight Council to identify emerging systemic risks posed by financial firms, activities and practices, and to improve cooperation between federal agencies;
•
the creation of a Bureau of Consumer Financial Protection authorized to promulgate and enforce consumer protection regulations relating to financial products, which would affect both banks and non-bank financial companies;
•
the establishment of strengthened capital and prudential standards for banks and bank holding companies;
•
enhanced regulation of financial markets, including derivatives and securitization markets;
•
the elimination of certain trading activities by banks;
•
a permanent increase of FDIC deposit insurance to $250,000 per deposit category and an increase in the minimum deposit insurance fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits;
•
amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations; and
•
new disclosure and other requirements relating to executive compensation and corporate governance.
The Dodd-Frank Act prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of three percent (3%) of tier 1 capital in private equity and hedge funds (known as the “Volcker Rule”). The Federal Reserve released a final rule in early 2011 which requires a “banking entity,” a term that is defined to include bank holding companies like the Company, to bring its proprietary trading activities and investments into compliance with the Dodd-Frank Act restrictions no later than two years after the earlier of: (1) July 21, 2012, or (2) 12 months after the date on which interagency final rules are adopted. Pursuant to the compliance date final rule, banking entities are permitted to request an extension of this timeframe from the Federal Reserve. In late 2011, the federal banking agencies released for comment proposed regulations implementing the Volcker Rule. The public comment period closed in early 2012. The proposed rules are highly complex and many aspects of their application remain uncertain. Due to the complexity of the new rules, the challenges of agency coordination, and the volume of public comments received, implementation of the Volcker Rule has been delayed. We do not currently anticipate that the Volcker Rule will have a material effect on our operations. However, until a final rule is adopted, the precise impact of the Volcker Rule on the Company cannot be determined.
A number of other provisions of the Dodd-Frank Act remain to be implemented through the rulemaking process at various regulatory agencies. We are unable to predict the extent to which the Dodd-Frank Act or the forthcoming rules and regulations will impact our business. However, we believe that certain aspects of the legislation, including, without limitation, the additional cost of higher deposit insurance coverage and the costs of compliance with disclosure and reporting requirements and examinations could have a significant impact on our business, financial condition, and results of operations. Additionally, we cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced, or how such changes may affect us.
Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act enacted in 1999 (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act permitted bank holding companies to become “financial holding companies” and, in general (1) expanded opportunities to affiliate with securities firms and insurance companies; (2) overrode certain state laws that would prohibit certain banking and insurance affiliations; (3) expanded the activities in which banks and bank holding companies may participate; (4) required that banks and bank holding companies engage in some activities only through affiliates owned or managed in accordance with certain requirements; and (5) reorganized responsibility among various federal regulators for oversight of certain securities activities conducted by banks and bank holding companies. The GLB Act expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, while this expanded authority permits financial institutions to engage in additional activities, it also presents smaller institutions with challenges as larger competitors continue to expand their services and products into areas that are not feasible for smaller, community-oriented financial institutions. We are not a financial holding company.
Payment of Dividends. Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis.
However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders and pay our own obligations is dividends we receive from the Bank. For that reason, our ability to pay dividends effectively is subject to the same limitations that apply to the Bank. There are statutory and regulatory limitations on the Bank’s payment of dividends to us.
As described above, the terms of the consent order issued by the Bank’s regulators prohibit the Bank from declaring or paying dividends without the prior written approval of its regulators. The Company is also prohibited from declaring or paying dividends without prior regulatory approval under the terms of its written agreement with the Federal Reserve.
Our sale of Series A Preferred Stock to the U.S. Treasury during April 2009 under the TARP Capital Purchase Program resulted in additional restrictions on our ability to pay dividends on our common stock and to repurchase shares of our common stock. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. We began deferring dividend payments on our Series A Preferred Stock in February 2011. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase outstanding shares of our common stock, unless the Series A Preferred Stock has been redeemed in full or the U.S. Treasury has transferred all of the Series A Preferred Stock to third parties.
Under North Carolina banking law, the Bank’s Board of Directors may declare dividends so long as they do not reduce the Bank’s capital below its applicable required capital. As described above, the Bank is currently restricted from paying dividends under the terms of the Consent Order with the FDIC and the Commissioner.
In addition to the restrictions described above, other state and federal statutory and regulatory restrictions apply to the Bank’s payment of cash dividends. As an insured depository institution, federal law prohibits the Bank from making any capital distributions, including the payment of a cash dividend if it is “undercapitalized” (as that term is defined in the FDIA) or after making the distribution, would become undercapitalized. The Bank was considered “undercapitalized” at December 31, 2011. If the FDIC believes that we are engaged in, or about to engage in, an unsafe or unsound practice, the FDIC may require, after notice and hearing, that we cease and desist from that practice. The FDIC has indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. The FDIC has issued policy statements that provide that insured banks generally should pay dividends only from their current operating earnings, and, under the FDIA, no dividend may be paid by an insured bank while it is in default on any assessment due the FDIC. The Bank’s payment of dividends also could be affected or limited by other factors, such as events or circumstances which lead the FDIC to require (as further described below) that it maintain capital in excess of regulatory guidelines.
In the future, our ability to declare and pay cash dividends will be subject to our Board of Directors’ evaluation of our operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations.
Federal Capital Adequacy Regulations. We and the Bank are required to comply with the FRB’s and FDIC’s capital adequacy standards for bank holding companies and insured banks. The FRB and FDIC have issued risk-based capital and leverage capital guidelines for measuring capital adequacy, and all applicable capital standards must be satisfied for us or the Bank to be considered in compliance with regulatory capital requirements.
Under the FDIC’s risk-based capital measure, the minimum ratio (“Total Capital Ratio”) of the Bank’s total capital (“Total Capital”) to its risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit) is 8.0%. At least half of Total Capital must be composed of “Tier 1 Capital.” Tier 1 Capital includes common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and various other intangible assets. The remainder of Total Capital may consist of “Tier 2 Capital” which includes certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves. A bank or bank holding company that does not satisfy minimum capital requirements may be required to adopt and implement a plan acceptable to its federal banking regulator to achieve an adequate level of capital.
Under the leverage capital measure, the minimum ratio (“Leverage Capital Ratio”) of Tier 1 Capital to average assets, less goodwill and various other intangible assets, generally is 3.0% for entities that meet specified criteria, including having the highest regulatory rating. All other entities generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum. The FDIC’s guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets, and a bank’s “Tangible Leverage Ratio” (determined by deducting all intangible assets) and other indicators of a bank’s capital strength also are taken into consideration by banking regulators in evaluating proposals for expansion or new activities.
As described above, the Bank is subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks. The consent order requires that the Bank maintain capital levels in excess of normal statutory minimums, including a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%.
The FRB and FDIC also consider interest rate risk (arising when the interest rate sensitivity of the Bank’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of the Bank’s capital adequacy. Banks with excessive interest rate risk exposure are required to hold additional amounts of capital against their exposure to losses resulting from that risk. The regulators also require banks to incorporate market risk components into their risk-based capital. Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.
Our capital categories are determined solely for the purpose of applying the “prompt corrective action” rules described below and they are not necessarily an accurate representation of our overall financial condition or prospects for other purposes. A failure to meet the capital guidelines could subject us to a variety of enforcement actions under those rules, including the issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on the taking of brokered deposits, and other restrictions on our business. As described below, the FDIC also can impose other substantial restrictions on banks that fail to meet applicable capital requirements.
In June 2012, the federal bank regulatory agencies jointly issued three proposed rules that would revise the general risk-based capital rules to incorporate certain revisions by the Basel Committee on Banking Supervision to the Basel capital framework (Basel III). While the regulatory agencies had initially proposed an effective date of January 1, 2013 for the new rules, the agencies have since confirmed that the implementation will be delayed as a result of the many industry participants, including community banks, that expressed concern over the impact of the proposed rules. When and if the proposed rules become effective, they would, among other things: revise the definition of regulatory capital components and related calculations, add a new common equity Tier 1 capital ratio, and increase the minimum Tier 1 Capital Ratio requirement from 4% to 6% percent. If the proposed rules are implemented as written, the amount of capital that the Bank would be required to hold would likely increase.
Regulatory Guidance on “CRE” Lending Concentrations. During 2006, the FDIC and other federal banking regulators issued guidance for sound risk management for financial institutions whose loan portfolios are deemed to have significant concentrations in commercial real estate (“CRE”). In 2008, the FDIC and other federal banking regulators issued further guidance on applying these principles in the current real estate lending environment, and they noted particular concern about construction and development loans. The banking regulators have indicated that this guidance does not set strict limitations on the amount or percentage of CRE within any given loan portfolio, and that they also will examine risk indicators in banks which have amounts or percentages of CRE below the thresholds. However, if a bank’s CRE exceeds these thresholds or if other risk indicators are present, the FDIC and other federal banking regulators may require additional reporting and analysis to document management’s evaluation of the potential additional risks of such concentration and the impact of any mitigating factors. The 2008 supplementary guidance stated that banks with significant CRE concentrations should maintain or implement processes to: (1) increase and maintain strong capital levels; (2) ensure that their loan loss allowances are appropriately strong; (3) closely manage their CRE and construction and development loan portfolios; (4) maintain updated financial and analytical information about borrowers and guarantors; and (5) bolster their workout infrastructure for problem loans. It is possible that regulatory constraints associated with this guidance could increase the costs of monitoring and managing this component of our loan portfolio.
Prompt Corrective Action. Federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Under this system, the FDIC has established five capital categories (“well capitalized,”
“adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”) and is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories. The severity of any such actions taken will depend upon the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.
Under the FDIC’s prompt corrective action rules, a bank that (1) has a Total Capital Ratio of 10.0% or greater, a Tier 1 Capital Ratio of 6.0% or greater, and a Leverage Ratio of 5.0% or greater, and (2) is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC, is considered to be “well capitalized.” A bank with a Total Capital Ratio of 8.0% or greater, a Tier 1 Capital Ratio of 4.0% or greater, and a Leverage Ratio of 4.0% or greater, is considered to be “adequately capitalized.” A bank that has a Total Capital Ratio of less than 8.0%, a Tier 1 Capital Ratio of less than 4.0%, or a Leverage Ratio of less than 4.0%, is considered to be “undercapitalized.” A bank that has a Total Capital Ratio of less than 6.0%, a Tier 1 Capital Ratio of less than 3.0%, or a Leverage Ratio of less than 3.0%, is considered to be “significantly undercapitalized,” and a bank that has a tangible equity capital to assets ratio equal to or less than 2.0% is deemed to be “critically undercapitalized.” For purposes of these rules, the term “tangible equity” includes core capital elements counted as Tier 1 Capital for purposes of the risk-based capital standards, plus the amount of outstanding cumulative perpetual preferred stock (including related surplus), minus all intangible assets (with various exceptions). A bank may be considered to be in a capitalization category lower than indicated by its actual capital position if it receives an unsatisfactory examination rating.
A bank that becomes “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” is required to submit an acceptable capital restoration plan to the FDIC. An “undercapitalized” bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing new branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC. Also, the FDIC may treat an “undercapitalized” bank as being “significantly undercapitalized” if it determines that those actions are necessary to carry out the purpose of the law.
The following table lists our and the Bank’s capital ratios at December 31, 2012. As described above, the Bank is subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks. The consent order requires that the Bank maintain capital levels in excess of normal statutory minimums, including a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%.
North Carolina Capital Requirements and Regulatory Action. Under North Carolina banking law, a bank’s “required capital” is equal to at least the amount required for the bank to be considered “adequately capitalized” under the federal regulatory capital standards described above. “Inadequate capital” is defined as an amount of capital equal to at least 75% but less than 100% of required capital. “Insufficient capital” is defined as an amount of capital less than 75% of required capital.
The Commissioner is empowered to take regulatory action if a bank’s capital falls below the required capital level. If the Commissioner determines that a bank has “inadequate capital” or “insufficient capital,” the Commissioner may order the bank to take corrective action. If the Commissioner determines that that a bank has insufficient capital and is conducting business in an unsafe or unsound manner or in a fashion that threatens the financial integrity of the bank, the Commissioner may serve a notice of charges and show-cause order on the bank and, if after a hearing, he determines that
supervisory control of the bank is necessary to protect the bank’s customers, creditors, or the general public, the Commissioner may take supervisory control of the bank. The Commissioner may also take custody of the books and records of a bank and appoint a receiver if the bank’s capital is impaired such that the likely realizable value of the bank’s assets is insufficient to pay and satisfy the claims of its depositors and creditors.
U.S. Treasury’s Troubled Asset Relief Program (TARP) Capital Purchase Program. On April 17, 2009, we issued Series A Preferred Stock in the amount of $ 13.179 million and a warrant to purchase 475,204 shares of our common stock to the U.S. Treasury as a participant in the TARP Capital Purchase Program. The Series A Preferred Stock qualifies as Tier 1 capital for purposes of regulatory capital requirements and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. We began deferring dividend payments on our Series A Preferred Stock in February 2011. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase outstanding shares of our common stock, unless we have redeemed all of this preferred stock or the U.S. Treasury has transferred all of this preferred stock to a third party. In addition, until the U.S. Treasury ceases to own our securities sold under the TARP Capital Purchase Program, the compensation arrangements for our senior executive officers must comply in all respects with the U.S. Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009, and the rules and regulations thereunder.
Reserve Requirements. Under the FRB’s regulations, all FDIC-insured depository institutions must maintain average daily reserves against their transaction accounts. No reserves are required to be maintained on the first $11.5 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $11.5 million and $59.5 million, and reserves equal to 10.0% must be maintained on aggregate balances in excess of $59.5 million. The FRB may adjust these percentages from time to time. Because the Bank’s reserves are required to be maintained in the form of vault cash or in an account at a Federal Reserve Bank or with a qualified correspondent bank, one effect of the reserve requirement is to reduce the amount of our assets that are available for lending and other investment activities.
Deposit Insurance. The Bank’s deposits are insured up to limits set by the Deposit Insurance Fund (the “DIF”) of the FDIC. The DIF was formed on March 31, 2006, upon the merger of the Bank Insurance Fund and the Savings Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act established a range of 1.15% to 1.50% within which the FDIC may set the Designated Reserve Ratio (the “reserve ratio”). The Dodd-Frank Act gave the FDIC greater discretion to manage the DIF, raised the minimum DIF reserve ratio to 1.35%, and removed the upper limit of 1.50%. In 2010, the FDIC adopted a restoration plan to ensure that the DIF reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. The FDIC also proposed a comprehensive, long-range plan for management of the DIF. As part of this comprehensive plan, the FDIC has adopted a final rule to set the reserve ratio at 2.0%.
In 2010, the Dodd-Frank Act permanently increased FDIC insurance coverage to $250,000 per deposit category.
The FDIC imposes a risk-based deposit insurance premium assessment on member institutions in order to maintain the DIF. This assessment system was amended by the Reform Act and further amended by the Dodd-Frank Act. Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. In addition, in the case of those institutions in the lowest risk category, the FDIC further determines its assessment rate based on certain specified financial ratios or, if applicable, its long-term debt ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits. The Dodd-Frank Act changed the methodology for calculating deposit insurance assessments from the amount of an insured institution’s domestic deposits to its total assets minus tangible capital. In 2011, the FDIC issued a new regulation implementing these revisions to the assessment system.
In 2008, the FDIC announced the Temporary Liquidity Guarantee Program (the “TLGP”) to strengthen confidence and encourage liquidity in the banking system. The TLGP consists of two components: a temporary guarantee of newly-issued senior unsecured debt named the Debt Guarantee Program, and a temporary unlimited guarantee of funds in
noninterest-bearing transaction accounts at FDIC insured institutions named the Transaction Account Guarantee Program (“TAG”). All newly-issued senior unsecured debt will be charged an annual assessment of up to 100 basis points (depending on term) multiplied by the amount of debt issued and calculated through the date of that debt or June 30, 2012, whichever is earlier. The Bank elected to opt out of the Debt Guarantee Program and elected to participate in the TAG Program. In 2009, the FDIC adopted a final rule extending the TAG portion of the TLGP for six months through June 30, 2010 and it was extended again through December 31, 2010. The Bank elected to continue to participate in the TAG Program through December 31, 2010. In 2010, the Dodd-Frank Act extended unlimited FDIC insurance coverage to noninterest-bearing transaction deposit accounts through December 31, 2012. As of January 1, 2013, funds in noninterest-bearing accounts (including Interest on Lawyers’ Trust Accounts, or IOLTA, accounts) were no longer eligible for unlimited deposit insurance coverage. Deposits held in these accounts are now aggregated with any interest-bearing deposits the owner may hold in the same ownership category, and the combined total is insured up to $250,000.
During 2009, the FDIC took several measures aimed at replenishing the DIF. On May 22, 2009, the FDIC imposed a 5 basis point special assessment on each insured institution’s assets minus Tier 1 capital as of June 30, 2009. On November 17, 2009, the FDIC voted to require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, as well as all of 2010, 2011, and 2012. For purposes of determining the prepayment, the FDIC used an institution’s assessment rate in effect on September 30, 2009.
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC upon a finding that an insured institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Community Reinvestment. Under the Community Reinvestment Act (the “CRA”), an insured institution has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of various applications by those banks. All banks are required to publicly disclose their CRA performance ratings. The Bank received a “Satisfactory” rating in its last CRA examination during August 2012.
Interstate Banking and Branching. The BHCA, as amended by the interstate banking provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Law”), permits adequately capitalized and managed bank holding companies to acquire control of the assets of banks in any state. Acquisitions are subject to antitrust provisions that cap at 10.0% the portion of the total deposits of insured depository institutions in the United States that a single bank holding company may control, and generally cap at 30.0% the portion of the total deposits of insured depository institutions in a state that a single bank holding company may control. Under certain circumstances, states have the authority to increase or decrease the 30.0% cap, and states may set minimum age requirements of up to five years on target banks within their borders.
The Dodd-Frank Act allows national and state banks to establish branches in any state if that state would permit the establishment of the branch by a state bank chartered in that state.
Restrictions on Transactions with Affiliates. The Bank is subject to the provisions of Sections 23A and 23B of the Federal Reserve Act which restrict a bank’s ability to enter into certain types of transactions with its “affiliates,” including its parent holding company or any subsidiaries of its parent company. Section 23A places limits on the amount of:
•
a bank’s loans or extensions of credit to, or investment in, its affiliates;
•
assets a bank may purchase from affiliates, except for real and personal property exempted by the FRB;
•
the amount of loans or extensions of credit by a bank to third parties which are collateralized by the securities or obligations of the bank’s affiliates; and
•
a bank’s guarantee, acceptance or letter of credit issued on behalf of one of its affiliates.
Transactions of the type described above are limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank also must comply with other provisions designed to avoid the taking of low-quality assets from an affiliate.
Among other things, Section 23B prohibits a bank or its subsidiaries generally from engaging in transactions with its affiliates unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.
Federal law also places restrictions on our ability to extend credit to our executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.
USA Patriot Act of 2001. The USA Patriot Act of 2001 is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification when accounts are opened, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 is sweeping federal legislation that addressed accounting, corporate governance and disclosure issues. The Act applies to all public companies and imposed significant new requirements for public company governance and disclosure requirements.
In general, the Sarbanes-Oxley Act mandated important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It established new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process, and it created a new regulatory body to oversee auditors of public companies. It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created new criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.
The economic and operational effects of the Sarbanes-Oxley Act on public companies, including us, have been and will continue to be significant in terms of the time, resources and costs associated with compliance. Because the Act, for the most part, applies equally to larger and smaller public companies, we have been and will continue to be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.
Federal Banking Agency Guidance on Executive Compensation. In 2010, the federal banking agencies issued guidance which applies to all banking organizations supervised by the agencies. Pursuant to the guidance, to be consistent with safety and soundness principles, a banking organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance risk and reward; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive compensation.
In addition, in 2011, the federal banking agencies, along with the Federal Housing Finance Agency, and the Securities and Exchange Commission, released a proposed rule intended to ensure that regulated financial institutions design their incentive compensation arrangements to account for risk. Specifically, the proposed rule would require
compensation practices of the Registrant to be consistent with the following principles: (1) compensation arrangements appropriately balance risk and financial reward; (2) such arrangements are compatible with effective controls and risk management; and (3) such arrangements are supported by strong corporate governance. In addition, financial institutions with $1 billion or more in assets would be required to have policies and procedures to ensure compliance with the rule and would be required to submit annual reports to their primary federal regulator. The comment period has closed and a final rule has not yet been published.
Statistical Data
Certain statistical data regarding our loans, deposits, investment securities and business is included in the information provided in Part II of this Report under the caption Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 1A.
Item 1A. Risk Factors.
Smaller reporting companies such as the Company are not required to provide the information required by this item.
Item 1B.
Item 1B. Unresolved Staff Comments.
Smaller reporting companies such as the Company are not required to provide the information required by this item.
Item 2.
Item 2. Properties.
As of December 31, 2012, we owned the facilities housing six of our banking offices, and we leased the facilities housing our remaining four offices. In addition, we own an operations center which houses the deposit operations, information technology and loan administration departments of the Bank. Each of our banking offices is in good condition and fully equipped for our purposes. On December 31, 2012, our investment in premises and equipment (cost less accumulated depreciation) was approximately $11.8 million.
On February 8, 2013, we permanently closed our branch office in Cleveland, North Carolina. The lease associated with this property was terminated effective February 28, 2013.
Subject to regulatory approval, we intend to permanently close our branch office in King, North Carolina, in the second quarter of 2013. The lease associated with this property is scheduled to expire on November 30, 2014. The Bank intends to negotiate with the landlord to obtain an early termination of this lease, however, there can be no assurance that any such negotiations will be successful.
Item 3.
Item 3. Legal Proceedings.
There are no material pending legal proceedings to which the Company or the Bank is a party, or of which any of their property is the subject other than routine litigation that is incidental to their business.
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.
Market for Registrant’s Common Stock; Dividends. Until March 5, 2012, our common stock was listed for trading on the Nasdaq Global Market. During the period from January 1, 2012, to March 5, 2012, the high and low sales prices for our common stock on the Nasdaq Global Market were $0.50 and $0.20, respectively. Trading of our common stock on the Nasdaq Global Market was suspended at the opening of business on March 5, 2012, due to the Company’s noncompliance with Nasdaq Listing Rule 5450(b)(1)(C), which requires that companies listed on the Nasdaq Global Market maintain a market value of publicly held shares of at least $5,000,000. Following the trading suspension from Nasdaq, our common stock has been quoted under the symbol “BCAR” on the OTCQB marketplace operated by OTC Markets Group, Inc.
The following table shows the reported high and low bid prices for shares of our common stock on the OTCQB marketplace and cash dividends declared on our common stock for each calendar quarter during 2012:
*
Since March 5, 2012
The following table shows the reported high and low sales prices for shares of our common stock on the Nasdaq Global Market and cash dividends declared on our common stock for each calendar quarter during 2011:
On December 31, 2012, there were approximately 1,786 total beneficial holders of our common stock, including 925 shareholders of record and approximately 861 holders whose shares were in street name.
Under North Carolina law, subject to certain restrictions, we are authorized to pay dividends as declared by our Board of Directors. However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders and pay our own obligations is dividends we received from the Bank. For that reason, our ability to pay dividends effectively is subject to the same limitations that apply to the Bank. Information regarding restrictions on our and the Bank’s ability to pay dividends is contained in Item 1 of this Report under the caption “Payment of Dividends.”
In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. Also, the payment of cash dividends in the future will be subject to ongoing review by our banking regulators and to certain other legal and regulatory limitations including the requirement that our capital be maintained at certain minimum levels.
Our sale of Series A Preferred Stock to the U.S. Treasury during April 2009 under the TARP Capital Purchase Program resulted in additional restrictions on our ability to pay dividends on our common stock and to repurchase shares of our common stock. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common
stock. We began deferring dividend payments on our Series A Preferred Stock in February 2011. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase outstanding shares of our common stock, unless the Series A Preferred Stock has been redeemed in full or the U.S. Treasury has transferred all of the Series A Preferred Stock to third parties.
There is no assurance that, in the future, we will have funds available to pay cash dividends, or, even if funds are available, that we will pay or the Bank will be permitted to pay dividends in any particular amount or at any particular times, or that we will pay dividends at all.
Item 6.
Item 6. Selected Financial Data.
Smaller reporting companies such as the Company are not required to provide the information required by this item.
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 our financial condition and results of operations. The discussion is intended to assist in understanding our consolidated financial condition and results of operations, and it should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. All share and per share data have been adjusted to give retroactive effect to stock splits and stock dividends.
Bank of the Carolinas Corporation (the “Company”) is a North Carolina-chartered bank holding company that was incorporated on May 30, 2006, for the sole purpose of serving as the parent bank holding company for Bank of the Carolinas (the “Bank”). The Bank is an FDIC-insured, North Carolina-chartered bank that began operations on December 7, 1998.
Because the Company has no operations and conducts no business on its own other than owning the Bank, the discussion contained in these footnotes concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and its subsidiary are collectively referred to herein as the Company unless otherwise noted.
Critical Accounting Policies
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The notes to our audited financial statements for the years ended December 31, 2012, 2011, and 2010 contain a summary of our significant accounting policies. We believe our policies with respect to methodology for the determination of our allowance for loan losses, and our asset impairment judgments, such as the recoverability of other real estate values, involve a higher degree of complexity and require us to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, we consider the policies related to those areas critical.
The allowance for loan losses represents our best estimate of probable losses that are inherent in the loan portfolio at the balance sheet date. The allowance is based on generally accepted accounting principles, which require that losses be accrued when they are probable of occurring and estimable and require that losses be accrued based on the differences between the value of collateral, the present value of future cash flows or values that are observable in the secondary market, and the loan balance.
The allowance for loan losses is created by direct charges to income. Losses on loans are charged against the allowance in the period in which those loans, in our opinion, become uncollectible. Recoveries during the period are credited to the allowance. The factors that influence our judgment in determining the amount charged against operating income include analyzing historical loan and lease losses, current trends in delinquencies and charge-offs, current assessment of problem loan administration, the results of regulatory examinations, and changes in the size, composition and risk assessment of the loan and lease portfolio. Also included in our estimates for loan losses are considerations with respect to the impact of current economic events, the outcomes of which are uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas and industries in which we conduct business.
The factors that are enumerated above form the basis for a model which we utilize in calculating the appropriate level of our allowance for loan losses at the balance sheet date. This model has three main components. First, losses are estimated on loans we have individually identified and determined to be “impaired”. A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. The loss allowance applicable to impaired loans is the difference, if any, between the loan balances outstanding and the value of the impaired loans as determined by either 1) an estimate of the cash flows that we expect to receive from those borrowers discounted at the loan’s effective rate, or 2) in the case of collateral-dependent loans, the fair value of the collateral securing those loans less estimated costs to sell.
Second, for all other loans, we divide the loan portfolio into groups or pools based on similarity of risk characteristics. Historical loss rates, which are weighted toward current experience, are then applied to determine an appropriate allowance for each pool or group.
Finally, an adjustment is applied, if appropriate, to give effect to qualitative or environmental factors that could cause estimated credit losses within the existing loan portfolio to differ from the historical loss experience.
We review our allowance on a quarterly basis and believe that it is adequate to cover inherent loan losses on the loans outstanding as of each reporting date. However, the appropriateness of the allowance using our procedures and methods is dependent upon the accuracy of various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not, in any particular period, sustain loan losses that are significantly different from the amounts reserved for those loans, or that subsequent evaluations of the loan portfolio and our allowance, in light of conditions and factors then prevailing, will not require material changes in the allowance for loan losses or future charges to earnings. In addition, various regulatory agencies, as an integral part of their routine examination process, periodically review our allowance. Those agencies may require that we make additions to the allowance based on their judgments about information available to them at the time of their examinations.
In 2011, the Company modified its methodology for determining the allowance for loan losses. Prior to these changes, the loan loss methodology calculated historical loss rates using a three-year loss history with a quarter lag and a weighted average. During the first quarter of 2011, the Company began using a three-year average annual loss rate. At the end of 2011, the loan loss methodology was modified further to include the current quarter-end, which eliminated the quarter lag used previously. As a result of these changes, there was a net decrease to the Company’s allowance for loan losses of approximately $80,000 in 2011.
Accounting for intangible assets is as prescribed by generally accepted accounting principles. We account for recognized intangible assets based on their estimated useful lives. Intangible assets with finite useful lives are amortized, while intangible assets with an indefinite useful life are not amortized. Goodwill is not amortized, but is subject to fair value impairment tests on at least an annual basis. If we determine that impairment has occurred based on our evaluation, the impairment charge is recognized at that time.
Accrued taxes represent the estimated amount payable to or receivable from taxing jurisdictions, either currently or in the future, and are reported, on a net basis, as a component of either “other assets” or “other liabilities” in the consolidated balance sheets. The calculation of the Company’s income tax expense is complex and requires the use of many estimates and judgments in its determination.
Management’s determination of the realization of the net deferred tax asset is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income and the implementation of various tax plans to maximize realization of the deferred tax asset. As of December 31, 2012, a $14.4 million valuation allowance has been established primarily due to the possibility that all of the deferred tax asset associated with the allowance for loan losses may not be realized. See Note 10 Income Taxes in the notes to the audited consolidated financial statements for further disclosure on this matter.
From time to time, management bases the estimates of related tax liabilities on its belief that future events will validate management’s current assumptions regarding the ultimate outcome of tax-related exposures. While the Company has obtained the opinion of advisors that the anticipated tax treatment of these transactions should prevail and has assessed the relative merits and risks of the appropriate tax treatment, examination of the Company’s income tax returns, changes in tax law and regulatory guidance may impact the treatment of these transactions and resulting provisions for income taxes.
Overview
The past few years have been difficult ones for the financial services industry in general. Bank failures have been numerous, particularly among community banks in some southeastern states, primarily brought about by the severe downturn in real estate markets. Our operating results have been adversely affected by the weakness in the economy in general and real estate in particular. Our net loss available to common shareholders was $5.5 million for 2012, $29.2 million for 2011, and $3.6 million for 2010. The losses in all years were driven by substantial increases in loan loss provisions due to deterioration in our loan portfolio, significant losses and net operating expenses associated with foreclosed real estate, as well as lost interest revenue caused by elevated levels of nonperforming assets.
In addition to the effect on our operating results noted above, the economic environment has led to a decline of $37.5 million in our loan portfolio during 2012. Given the prominence of real estate loans in our lending activities, it has been and continues to be a challenge to generate quality credit in sufficient volume to outpace payments.
We strive to serve the financial needs of small to medium-sized businesses and individuals in our market area, offering an array of financial products emphasizing superior customer service.
Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, made up almost 89% of our loan portfolio at December 31, 2012, with the remainder of our loans consisting of commercial and industrial loans and loans to individuals. We also offer certain loan products through associations with various mortgage lending companies. Through these associations, we originate 1-4 family residential mortgages, at both fixed and variable rates. We earn fees for originating these loans and transferring the loan package to the mortgage lending companies.
The deposit services we offer include small business and personal checking accounts, savings accounts, money market checking accounts and certificates of deposit. The Company concentrates on providing customer service to build its customer deposit base.
Additional funding includes certificates of deposit acquired through deposit brokers, advances from the Federal Home Loan Bank, term repurchase agreements from two money center financial institutions and federal funds lines of credit from correspondent banks.
Over 90% of our revenue (net interest income plus noninterest income) was comprised of net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Therefore, the levels of interest rates and our ability to effectively manage the effect that changes in interest rates have on net interest income can have a significant impact on revenue and results of operations. Results of operations may also be materially affected by our provision for loan losses, which has been much higher during the past three years than our long-term trend. Service charges and fee income generated from customer services represented less than 10% of revenue in each of the past two years and represents an area of potential revenue growth. Noninterest expense is the third major driver of operating results along with net interest income and the provision for loan losses. Total noninterest expenses absorbed over 114% of our revenue in 2012 and 141% in 2011. Noninterest expenses include compensation and employee benefits, occupancy and equipment expenses, FDIC insurance premiums, expenses related to foreclosed real estate, professional services, expenditures for data processing services and various other costs of doing business.
In addition, due to the establishment of the valuation allowance against the deferred tax asset, there was no tax expense or benefit in 2012. Results for 2011 were significantly impacted by a provision for income taxes of $4.5 million that was made to establish a deferred income tax valuation allowance to reduce the carrying value of the Company’s net deferred tax asset to zero, thereby increasing a loss before income taxes of $23.7 million to a net loss of $28.3 million. For the year 2010, the Company’s income tax provision represented tax benefits of approximately 38% of income before income taxes.
Regulatory Action
Consent Order with FDIC and North Carolina Commissioner of Banks. The Bank entered into a Stipulation to the Issuance of a Consent Order (the “Stipulation”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Office of the Commissioner of Banks (the “Commissioner”) and the FDIC and the Commissioner issued the related Consent Order (the “Order”), effective April 27, 2011. The description of the Stipulation and the Order set forth below is qualified in its entirety by reference to the Stipulation and the Order, copies of which are included as exhibits 10.14 and 10.15 to this Form 10-K, and incorporated herein by reference.
Management. The Order requires that the Bank have and retain qualified management, including a chief executive officer, senior lending officer, and chief operating officer with qualifications and experience commensurate with their assigned duties and responsibilities within 60 days from the effective date of the Order. Within 30 days of the effective date of the Order, the board of directors was required to retain a bank consultant to develop a written analysis and assessment of the Bank’s management needs. Following receipt of the consultant’s management report, the Bank was required to formulate a written management plan that incorporated the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a time frame for completing each action.
Capital Requirements. While the Order is in effect, the Bank must maintain a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%. If the Bank’s capital ratios are below these levels as of the date of any call report or regulatory examination, the Bank must, within 30 days from receipt of a written notice of capital deficiency from its regulators, present a plan to increase capital to meet the requirements of the Order.
Allowance for Loan and Lease Losses and Call Report. Upon issuance of the Order, the Bank was required to make a provision to replenish the allowance for loan and lease losses (“ALLL”). Within 30 days of the effective date of the Order, the Bank was required to review its call reports filed with its regulators on or after December 31, 2010, and amend those reports if necessary to accurately reflect the financial condition of the Bank. Within 60 days of the effective date of the Order, the Bank was required to submit a comprehensive policy for determining the adequacy of the ALLL.
Concentrations of Credit. Within 60 days of the issuance of the Order, the Bank was required to perform a risk segmentation analysis with respect to its concentrations of credit and develop a written plan for systematically reducing and monitoring the Bank’s commercial real estate and acquisition, construction, and development loans to an amount commensurate with the Bank’s business strategy, management expertise, size, and location.
Charge-Offs, Credits. The Order requires that the Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified “loss” and 50% of those assets classified “doubtful.” If an asset is classified “doubtful,” the Bank may alternatively charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment. The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, “loss” or “doubtful” and is uncollected. The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.” These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.
Asset Growth. While the Order is in effect, the Bank must notify its regulators at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition. The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from its regulators.
Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of its regulators. In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior regulatory approval.
Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area. An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.
Written Plans and Other Material Terms. Under the terms of the Order, the Bank was required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:
-
Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management
-
Plan to reduce assets of $500,000 or greater classified “doubtful” and “substandard”
-
Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions
-
Effective internal loan review and grading system
-
Policy for managing the Bank’s other real estate
-
Business/strategic plan covering the overall operation of the Bank
-
Plan and comprehensive budget for all categories of income and expense for the year 2011
-
Policy and procedures for managing interest rate risk
-
Assessment of the Bank’s information technology function
Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities. The Bank was also required to establish a board committee to monitor and coordinate compliance with the Order.
The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
Written Agreement with the Federal Reserve Bank of Richmond. The Company entered into a written agreement (the “Agreement”) with the Federal Reserve Bank of Richmond, on August 26, 2011. The description of the Agreement set forth below is qualified in its entirety by reference to the Agreement, a copy of which is included as exhibit 10.16 to this Form 10-K, and is incorporated herein by reference.
Source of Strength. The Agreement requires that the Company take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to its wholly-owned subsidiary, Bank of the Carolinas (the “Bank”), and ensure that the Bank complies with the requirements of the consent order entered into between the North Carolina Commissioner of Banks, the FDIC and the Bank.
Dividends, Distributions, and other Payments. The Agreement prohibits the Company’s payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation. It also prohibits the Company from directly or indirectly taking any dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank of Richmond.
Under the terms of the Agreement, the Company and the Bank may not make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.
Debt and Stock Redemption. The Agreement requires that the Company and any non-bank subsidiary of the Company not, directly or indirectly, incur, increase or guarantee any debt without the prior written approval of the Federal Reserve Bank. The Agreement also requires that the Company not, directly or indirectly, purchase or redeem any shares of its capital stock without the prior written approval of the Federal Reserve Bank of Richmond.
Capital Plan, Cash Flow Projections and Progress Reports. The Agreement requires that the Company file an acceptable capital plan and certain cash flow projections with the Federal Reserve Bank of Richmond. It also requires that the Company file a written progress report within 30 days after the end of each calendar quarter while the Agreement remains in effect.
The Order will remain in effect until modified or terminated by the Federal Reserve Bank of Richmond.
Financial Condition at December 31, 2012 and December 31, 2011
Total assets at December 31, 2012, decreased by $48.6 million or 10.0% to $437.4 million compared to $486.0 million at December 31, 2011. We had earning assets of $398.5 million at December 31, 2012 consisting of $262.4 million in accruing loans, $106.9 million in investment securities and $29.2 million in temporary investments. Stockholders’ equity was $9.1 million at December 31, 2012 compared to $14.6 million at December 31, 2011.
Loans. Total loans declined by $37.5 million or 12.2% during the twelve months of 2012, from $307.9 million on December 31, 2011 to $270.4 million at December 31, 2012. On December 31, 2012, real estate loans made up 89.3% of total loans while commercial non-real estate loans comprised another 10.7% of the portfolio. Total loans represented 61.8% and 63.4% of our total assets on December 31, 2012 and 2011, respectively.
Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulation also influence interest rates. On average, our loan portfolio yielded 4.97% for the year ending December 31, 2012 as compared to an average yield of 5.10% during 2011.
The following table contains selected data relating to the composition of our loan portfolio by type of loan on the dates indicated.
Table I.
Analysis of Loan Portfolio (dollars in thousands)
The following table reflects the scheduled maturities of commercial real estate loans, construction and development loans, and commercial business loans (dollars in thousands):
The following table reflects the scheduled maturities of all fixed and variable interest rate loans (dollars in thousands):
Allowance for Loan Losses. On December 31, 2012, our allowance totaled approximately $6.9 million and amounted to 2.55% of total loans and 89.1% of our nonperforming loans. This compares to an allowance of $8.1 million, or 2.63% of loans and 42.5% of nonperforming loans at December 31, 2011 and $6.9 million, or 1.87% of loans and 27.8% of nonperforming loans as of December 31, 2010.
The following table contains an analysis of our allowance for loan losses for the time periods indicated.
Table II.
Summary of Loan Loss Experience (dollars in thousands)
During 2012, we incurred net loan charge-offs of $3.6 million, compared to $16.3 million in 2011 and $7.7 million in 2010. These levels of net charge-offs produced net loss ratios of 1.24% for 2012, 4.78% for 2011, and 2.08% for 2010. The loss ratios for 2012, 2011, and 2010 were substantially higher than our longer-term trend which contributed to increased loan loss provisions in all three years. The deterioration in our loan portfolio, as evidenced by rising loss ratios and nonperforming loans, resulted in the increases in our allowance for loan losses for 2011 and 2010. By late 2012, our nonperforming loans had decreased significantly compared to the two prior years and we had our first quarter of net loan recoveries in five years.
An analysis of the allowance for loan losses for the years ended December 31, 2012, 2011, 2010, 2009, and 2008 is contained in the following table:
Table III.
Allocation of Allowance for Loan Losses (1) (dollars in thousands)
(1) The allowance has been allocated on an approximate basis. The entire amount of the allowance is available to absorb losses occurring in any category.
The allocation is not necessarily indicative of future losses.
Asset Quality. Credit risks are inherent in making loans. We assess these risks and attempt to manage them effectively by adhering to internal credit underwriting policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies. A loan is placed in non-accrual status when, in our judgment, the collection of interest appears doubtful. Nonperforming assets are defined as nonaccrual loans, loans contractually past due for more than 90 days but still accruing interest, and foreclosed or idled properties. At December 31, 2012, the Company’s non-performing assets totaled $12.7 million, or 4.62% of loan-related assets, compared to $27.6 million, or 8.72% of loan-related assets at December 31, 2011.
On December 31, 2012, we had no loans that were delinquent over 90 days and still accruing interest, and $7.7 million that were in non-accrual status. Interest accrued, but not recognized as income on non-accrual loans, was approximately $159,000 during 2012. Compared to December 31, 2011, we had no loans that were delinquent over 90 days and still accruing interest, and $19.1 million that were in non-accrual status. Interest accrued, but not recognized as income on non-accrual loans, was approximately $569,000 during 2011.
“Other real estate owned,” also referred to as “OREO,” generally consists of all real estate, other than bank premises, that is owned or controlled by a financial institution, including real estate acquired through foreclosure. Financial institutions such as the Company typically acquire OREO through foreclosure or a deed in lieu of foreclosure after a borrower defaults on a loan.
Other real estate owned at December 31, 2012 amounted to $5.0 million compared to $8.5 million as of December 31, 2011. Other real estate is carried at the lower of cost or estimated net realizable value. During the year ended December 31, 2012 and 2011, $5.8 million and $10.5 million of real property, respectively, was foreclosed on and transferred to OREO. Properties transferred to OREO are initially recorded at the lower of the loan balance or the fair value of the property, less estimated costs to sell the property at the date of the foreclosure. The $5.8 million and $10.5 million transferred to OREO in 2012 and 2011 represents the fair value of the properties at the date of transfer. As a result of obtaining the fair values of these properties prior to transferring them to OREO, the Company charged $2.2
million to the allowance for loan losses in 2012 and $5.3 million to the allowance for loan losses in 2011. As noted above, the Company also considers the estimated costs to sell a property when transferring a property to OREO. The Company takes the following factors into consideration when estimating the costs to sell a property:
­
potential discount for liquidation,
­
prior liens on the property,
­
taxes,
­
sales commissions, and
­
closing expenses.
The estimated cost to sell a property is subtracted from the fair value of the property prior to transferring the property to OREO.
The following table provides a roll-forward of OREO for the periods ended December 31, 2012, 2011, and 2010:
Table IV.
OREO Rollforward (dollars in thousands)
In April 2011, the Company established a special assets department to provide expertise in the areas of problem loans and OREO. This new department revised the Company’s procedures with respect to foreclosed properties. Previously, when a property was in foreclosure, the balance of the loan was transferred to OREO. Losses on the OREO property were taken upon the sale of the property. As a result, the charge-off did not become part of the loss history of the loan. The special assets department implemented changes such that management now obtains updated fair values for properties and prepares an impairment analysis when there is an indication that the loan is problematic. Any resulting impairment is charged to the allowance for loan losses and becomes part of the loan’s loss history. The Company conducts an annual review of problem loans to ensure that proper fair value is recognized.
The following table summarizes information regarding our nonperforming assets on December 31, 2012, 2011, 2010, 2009, and 2008.
Table V.
Nonperforming Assets (dollars in thousands)
Investment Securities. Our investment securities totaled $106.9 million at December 31, 2012, and $112.4 million at December 31, 2011. Our investment portfolio includes U.S. Government Agency bonds, mortgage backed securities, state and municipal bonds and corporate subordinated debt of other financial institutions, all of which are classified as held to maturity or available for sale. Held to maturity securities are carried at amortized cost value and available for sale securities are carried at fair value.
We use our investment portfolio to employ liquid funds and as a tool in the management of interest rate risk, while at the same time providing interest income. Practically all of our securities are classified as available for sale and, as such, may be sold from time to time to increase liquidity or re-balance the interest rate sensitivity profile of our balance sheet. However, we do have the available liquidity to hold our securities to maturity should we have the need to. In fact, we have classified some of our more illiquid securities as held to maturity because we fully intend to hold them until their maturity date. All securities classified as held to maturity were purchased in 2008 and consist of subordinated debt and trust preferred securities issued or guaranteed by other financial institutions. In December 2011, we recorded an additional impairment charge of $397,000 for a total impairment of $1.0 million on a $1.0 million investment in a trust preferred security as a result of the guarantor bank holding company exercising its right to defer interest payments to the issuing trust in December 2009. In 2012, the guarantor bank holding company’s sole subsidiary bank was closed by regulatory authorities. As a result, we removed the investment from our portfolio.
The following table summarizes the carrying value of our investment securities on the dates indicated.
Table VI.
Investment Securities (dollars in thousands)
The following tables summarize information regarding the scheduled maturities, amortized cost, and weighted average yields on a tax equivalent basis for our investment securities portfolio on December 31, 2012 and 2011.
Table VII.
Investment Securities (dollars in thousands)
At December 31, 2012:
At December 31, 2011:
Deposits. Our deposit service offerings include business and individual checking accounts, savings accounts, NOW accounts, certificates of deposit and money market checking accounts. On December 31, 2012, total deposits were $373.0 million compared with $416.2 million on December 31, 2011. During the year, there was increase in all deposit areas, with the exception of brokered and institutional CDs.
The growth in money market deposits began in July 2008 when we offered a special money market rate that was guaranteed through June 30, 2009. Since the rate promotion expired we began to reduce the rates paid on money market deposits to levels more in-line with the markets we serve and at December 31, 2012 money market deposits totaled $97.9 million. Under FDIC regulations and the terms of the regulatory consent order discussed under the heading “Regulatory Action” above, we may not currently solicit deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yield on insured deposits of comparable maturity in our market area or the market area where the deposits are being solicited.
Brokered deposits have decreased from $42.7 million at December 31, 2011 to $15.1 million at December 31, 2012, a decrease of $27.6 million. On December 31, 2012, approximately 4.0% our total deposits were made up of brokered deposits as compared to 10.3% at December 31, 2011 and 17.5% as of December 31, 2010. Under FDIC regulations and the terms of the regulatory consent order discussed under the heading “Regulatory Action” above, we may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. These regulations prohibit undercapitalized institutions, such as the Bank, from accepting, renewing, or rolling over any brokered deposits. On December 31, 2012, total time deposits issued in denominations of $100,000 or more made up approximately 31.1% of our total deposits as compared to 36.6% as of December 31, 2011 and 35.4% at December 31, 2010.
Retail deposits gathered through our branch network continue to be our principal source of funding. It is our intent to focus our efforts and marketing resources on the growth of our deposit base as we believe this to be the most effective long term strategy for profitable growth.
The following table summarizes our average deposits for the years ended December 31, 2012, 2011, and 2010.
Table VIII.
Deposit Mix (dollars in thousands)
The following table contains an analysis of our time deposits of $100,000 or more at December 31, 2012, 2011, and 2010.
Borrowed Funds. The following table summarizes our borrowings at December 31, 2012, 2011, and 2010.
Table IX.
Borrowed Funds (dollars in thousands)
The following table presents our average balances as well as the average cost associated with those balances for the specified periods.
During 2008, we entered into term repurchase agreements with two money center financial institutions. These two borrowing arrangements total $45.0 million in the aggregate and currently bear interest at an effective annual blended rate of 4.38%. These borrowings were secured by marketable securities totaling approximately $57.9 million at December 31, 2012. The agreements have final maturity dates in July 2018 and August 2015 but may be terminated by the lenders beginning July 2013 and August 2011, respectively.
On December 31, 2012, we had no advances from the Federal Home Loan Bank (“FHLB”). We have immediate availability of $7.2 million as we have pledged our eligible one-to-four family mortgages, commercial real estate loans and home equity loans with aggregate outstanding principal balances of approximately $15.9 million.
During 2008, the Company issued $5.2 million of junior subordinated debentures to Bank of the Carolinas Trust I (the “Trust”), which, in turn, issued $5.0 million in trust preferred securities having a like liquidation amount and $155,000 in common securities (all of which are owned by the Company). The Company has fully and unconditionally guaranteed the Trust’s obligations related to the trust preferred securities. The Trust has the right to redeem the trust preferred securities in whole or in part, on or after March 26, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest. In addition, the Trust may redeem the trust preferred securities in whole (but not in part) at any time within 90 days following the occurrence of a tax event, an investment company event or a capital treatment event at a special redemption price (as defined in the debenture). The trust preferred securities bear interest at the annual rate of 90-day LIBOR plus 300 basis points adjusted quarterly. In February 2011, the Company announced its election to defer its regularly scheduled March 2011 interest payment on the junior subordinated debentures related to the trust preferred securities and continued to defer interest payments throughout 2011 and 2012.
The Company also has issued $2.7 million of subordinated debt in a private transaction with another banking institution. This subordinated note has a floating interest rate equal to 75 basis points over the Prime Rate published by the Wall Street Journal and a maturity date of August 13, 2018. This debt can be repaid in full at any time with no penalty.
Capital Resources. Total stockholders’ equity decreased by $5.5 million to $9.1 million on December 31, 2012, compared to $14.6 million on December 31, 2011. The decrease was substantially the net result of the current year’s net loss and net unrealized gains on securities available for sale.
On April 17, 2009, the Company became a participant in the U.S. Department of the Treasury Capital Purchase Program by selling shares of Series A preferred stock to the Treasury having a liquidation value of $13.2 million. The preferred shares have a cumulative dividend rate of 5% per annum for the first five years and 9% per annum thereafter. As a part of the transaction, the Company also issued the Treasury warrants to purchase 475,204 shares of the Company’s common stock at $4.16 per share for a term of ten years.
Off-Balance Sheet Transactions. Certain financial transactions are entered into by the Company in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet transactions as of December 31, 2012 and 2011 were commitments to extend credit and financial letters of credit. Except as disclosed in this report, the Company does not have any ownership interest in any off-balance sheet subsidiaries or special purpose entities.
Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates. Since many of these commitments expire without being funded, the commitment amounts do not necessarily represent liquidity requirements.
Contractual Obligations. The following disclosure shows the contractual obligations that the Company had outstanding at December 31, 2012.
(1)
Obligations in this category are classified as to maturity dates. One repurchase agreement, with a principal balance of $20 million,may be called by the holder on a quarterly basis beginning August 20, 2011. The other repurchase agreement included above, which has a principal balance of $25 million, may be called by the holder on a quarterly basis beginning July 8, 2013.
Comparison of Results of Operations for the Years Ended December 31, 2012, 2011, and 2010
Net Income (Loss). We had a net loss available to common shareholders of $5.5 million or $1.42 per diluted common share for the year ended December 31, 2012, compared to net loss of $29.2 million or $7.49 per diluted common share for the year ended December 31, 2011 and net loss for the year ended December 31, 2010 of $3.6 million, or $0.92
per diluted common share. As noted earlier, the principal reason for the losses incurred during the past three years has been related to deterioration in our loan portfolio which has resulted in materially higher loan loss provisions and increased expenses related to the ownership and disposal of foreclosed real estate.
In addition, due to the establishment of the valuation allowance against the deferred tax asset, there was no tax expense or benefit in 2012. Results for 2011 were significantly impacted by a provision for income taxes of $4.5 million that was made to establish a deferred income tax valuation allowance to reduce the carrying value of the Company’s net deferred tax asset to zero, thereby increasing a loss before income taxes of $23.7 million to a net loss of $28.3 million. For the year 2010, the Company’s income tax provisions represented tax benefits of approximately 38% of income before income taxes.
Net Interest Income. Our primary source of revenue is net interest income, which is the difference between interest income generated by our interest-earning assets (primarily loans and investment securities) and interest expense on interest-bearing liabilities (primarily deposits and borrowed funds). Net interest income decreased $2.0 million to $11.6 million in 2012 from 2011 after decreasing $2.8 million from 2010. Our net interest margin decreased in 2012 to 2.72% compared to a margin in 2011 of 2.86% and in 2010 of 3.26%. Our net interest spread declined to 2.68% in 2012 from 2.79% in 2011 and from 3.15% in 2010. The volatility in our net interest margin and net interest spread and resulting net interest income over the past three years has been primarily due to the declines in short-term rates brought about by very aggressive Federal Reserve policies, declining total balances of loans and investments, and increased levels of nonperforming assets.
Table X summarizes the average balances of our various categories of assets and liabilities and their associated yields or costs for the years ended December 31, 2012, 2011, and 2010.
Table X.
Summary of Net Interest Income and Average Balances (dollars in thousands)
Non-accrual loans are included in the table for the years ended December 31, 2012, 2011, and 2010.
Loan fees and late charges of $146,000, $143,000, and $208,000 for 2012, 2011, and 2010, respectively, are included in interest income.
Table XI summarizes the dollar amount of changes in interest income and interest expense for the major components of our interest-earning assets and interest-bearing liabilities during the twelve months ended December 31, 2012, 2011, and 2010. The table shows changes in interest income and expense attributable to volume changes and interest rate changes. The changes attributable to both rate and volume changes have been allocated between the two components on a relative basis. As the table indicates, the decrease in net interest income realized in 2012 in comparison to 2011 was the result of the decrease in volume and rates resulting in a negative effect on the current year results. The table also indicates that rates reduced the cost of interest-bearing liabilities, but not to the extent to which it could offset the reduced income from interest-earning assets.
Table XI.
Volume / Rate Variance Analysis (dollars in thousands)
Provision for Loan Losses. Provisions for loan losses are charged to income in order to maintain the allowance for loan losses at a level we deem appropriate under circumstances known to exist at the balance sheet date. In evaluating the allowance for loan losses, we consider factors that include portfolio size, composition and industry diversification of the portfolio, historical loan loss experience, current levels of impaired and delinquent loans, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors. The allowance for loan losses expressed as a percentage of total loans was 2.55%, 2.63%, and 1.87% at December 31, 2012, 2011, and 2010, respectively. The allowance includes $755,000 at December 31, 2012, $770,000 at December 31, 2011, and $2.6 million at December 31, 2010 allocated to specific loans with principal balances totaling approximately $26.6 million, $23.8 million, and $20.9 million, respectively. See “Critical Accounting Policies”.
The provision for loan losses decreased 86.6% to $2.4 million in 2012 from $17.6 million in 2011 and decreased 63.4% from $6.4 million in 2010. The sizable provisions recorded in 2012, 2011, and 2010 were the result of net charge-offs and nonperforming asset levels that were significantly above long-term historic trends on a relative basis.
Losses on loans are charged against the allowance for loan losses. These charge-offs are made in the period in which we determine that the loans in question have become uncollectible. For additional details regarding our methodology for the determination of our allowance for loan losses, see ‘Critical Accounting Policies’ above.
Net loan charge-offs for 2012 totaled $3.6 million which equates to 1.24% of average loans for the year and a 78.1% decrease from 2011 net charge-offs of $16.3 million, which represented 4.78% of average loans outstanding for that year, and a 53.9% decrease from 2010 net charge-offs of $7.7 million, which represented 2.08% of average loans outstanding for that year. For the five years prior to the current credit cycle (2006 - 2010), our net charge-offs averaged 0.91% of average loans on an annual basis. The following table shows the Company’s net loan charge-offs by loan category for each quarter in 2012, 2011, and 2010:
Table XII.
Net Charge-offs by Quarter (dollars in thousands)
Net loan charge-offs increased from 2010 to 2011. This trend may have been due, in part, to the economic conditions experienced in our market areas during 2010 and 2011, which may have made it more difficult for our borrowers to repay their loans.Net loan charge-offs during 2011 were also affected by certain changes in the Company’s policies and procedures with respect to problem loans implemented by the Company’s special assets department. For a description of these policy changes, please refer to the discussion of other real estate owned under the heading “Asset Quality” above. Of the $16.3 million in net charge-offs in 2011, $12.4 million was related to eighteen large commercial relationships. The real property that served as collateral for these commercial relationships was ultimately sold during the foreclosure process or transferred to other real estate owned. Of the $3.6 million in net charge-offs in 2012, $1.2 million was related to a restructured loan and $2.3 million was related to ten relationships that were ultimately sold during the foreclosure process or transferred to other real estate owned. Net loan charge-offs of $3.6 million in 2012 were significantly less than the $16.3 million in net loan charge-offs in 2011. In 2011, our special assets department was aggressive in addressing our substandard loans. As a result, in 2012 we have seen a decrease in our net loan-chargeoffs.
Total nonperforming assets amounted to $12.7 million at December 31, 2012, a decrease of 53.9% from the year-end 2011 total of $27.6 million. Total nonperforming assets as a percent of loan-related assets (loans plus foreclosed real estate) amounted to 4.62% at December 31, 2012 compared to 8.72% as of year-end 2011. For the five year-ends preceding the current credit cycle, nonperforming assets averaged 5.47% of loan-related assets. Nonperforming assets as a percent of total assets was 2.91% of total assets at the end of 2012 compared to 5.68% at December 31, 2011 and 6.17% at December 31, 2010. On a historic basis, nonperforming assets as a percent of total assets averaged 2.88% for the 2006 - 2010 year-ends.
Noninterest Income. In addition to net interest income, we derive revenues from providing a variety of financial services to our customers. Fees from providing these services totaled $1.2 million in 2012 and $1.3 million in 2011 and 2010. The largest component of customer service fees is revenues from deposit services which totaled $620,000 in 2012, $698,000 in 2011 and $732,000 in 2010. While this is a mature and very competitive part of our business, we believe this is an area of opportunity. The fastest growing area of fee revenue is from debit card services. Our revenues in this area increased from $290,000 to $418,000 over the past three years. Fees from loan services, which primarily includes fees related to real estate loan production, declined 25% in 2012 compared to 2011 and 82.8% compared to 2010 as real estate lending slowed.
Other significant components of noninterest income are gains and losses on investment securities and increase in the cash value of life insurance policies we hold on our officer level employees. In 2012, we realized $2.2 million in net gains on investment securities compared to a net loss of $391,000 in 2011and a net gain of $344,000 in 2010. This includes an other than temporary impairment charge of $397,000 and $105,000 for 2011 and 2010, respectively, on a $1.0 million investment in the trust preferred securities of another financial institution as a result of the guarantor exercising its right to defer interest payments to the issuing trust. The increase in the cash value of life insurance policies was $359,000 in 2012 compared to $361,000 for 2011 and 2010. The Bank also received net proceeds from a bank owned life insurance policy of $415,000 due to the death of a prior officer.
The following is a tabular presentation of our non-interest income for the years ended December 31, 2012, 2011, and 2010.
Table XIII.
Noninterest Income (dollars in thousands)
Non-interest Expense. Non-interest expense totaled $17.9 million for the year ended December 31, 2012, a decrease of $3.0 million, or 14.4% from the $21.0 million reported for the year ended December 31, 2011, which was a $4.7 million increase, or 28.3%, above the 2010 amount. The major factors contributing to the decrease in noninterest expenses in 2012 compared to 2011 were (1) a decrease of $2.8 million, or 53.7%, in valuation allowances and net operating cost associated with foreclosed real estate, (2) a decrease of $171,000, or 8.2%, in occupancy and equipment expenses, (3) a decrease of $131,000, or 58.7%, in advertising costs, and (4) a decrease of $92,000, or 6.1%, in professional services due to a reduction in consulting fees.
The major factors contributing to the increase in noninterest expenses in 2011 compared to 2010 were (1) an increase of $541,000, or 55.5%, in FDIC insurance cost, as the result increased rates, (2) an increase of $451,000, or 42.3%, in professional services resulting from requirements stemming from the consent order, (3) an increase of $3.4 million, or 185.5%, in valuation allowances and net operating cost associated with foreclosed real estate, and (4) an increase of $251,000, or 73.0%, in director and shareholder expense due to increased premiums on our director and officer liability insurance.
One of the largest components of the Company’s noninterest expense for the year ended December 31, 2011, were valuation allowances and net operating costs associated with foreclosed real estate. During 2011, properties were transferred to OREO at an average of 51% of their book value. Upon sale of these properties, the Company was able to recover 89% of the balance transferred to OREO. Although the Company was able to recover a high percentage of the transferred balances upon sale, there were $5.2 million in valuation allowances and net operating costs associated with foreclosed real estate for the year ended December 31, 2011. Of the $5.2 million in valuation allowances and net operating costs, there were valuation allowances of approximately $3.1 million that were related to properties added to OREO in 2010 and 2009, for which the Company received a current appraisal in 2011. A new fair value calculation was performed, which resulted in valuation allowances. The Company managed approximately 152 OREO properties in 2011, including a golf course, restaurants, and 1-4 family residential housing. The remainder of the $5.2 million in valuation allowances and other operating costs consists of operating costs related to paying delinquent taxes, obtaining current appraisals, managing, and repairing these OREO properties.
The following table summarizes the major components of our non-interest expense for the years ended December 31, 2012, 2011, and 2010.
Table XIV.
Noninterest Expenses (dollars in thousands)
Income Taxes. There was no income tax provision in 2012. We recorded income tax expense of $4.5 million in 2011 and income tax benefits of $1.7 million in 2010. The benefits for 2010 as a percentage of loss before income taxes was 38.5%. However, as of year-end 2011 the Company updated its evaluation of the likelihood of realization of a net deferred tax asset that had arisen principally as a result of operating losses incurred during the previous four years. Based upon that evaluation the Company determined that it is unlikely that any significant realization of any portion of the net deferred tax asset is likely to occur within a timeframe that would support a decision to continue to include a net deferred tax asset in the Company’s consolidated balance sheet. Accordingly, the Company recorded a provision for income taxes of $4.5 million for 2011 to reduce the carrying value of the Company’s net deferred tax asset to zero. As of December 31, 2012 the net deferred tax asset had a value of $607,000 as a result of a deferred tax asset of $15.1 million and an allowance of $14.4 million.
Capital Adequacy
The Bank is required to comply with the capital adequacy standards established by the Federal Deposit Insurance Corporation (FDIC). The FDIC has issued risk-based capital and leverage capital guidelines for measuring the adequacy of a bank’s capital, and all applicable capital standards must be satisfied for the Bank to be considered in compliance with the FDIC’s requirements. On December 31, 2012, the Bank’s Total Capital Ratio and Tier 1 Capital Ratio were 6.25% and 4.99%, respectively, both below the minimum levels required by the FDIC’s “well-capitalized” guidelines. On December 31, 2012 our Tier 1 Leverage Capital Ratio was 3.56%, which was also well below the minimum level required by the FDIC’s “well-capitalized” guidelines. As described above, the Bank is subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks. The consent order requires that the Bank maintain capital levels in excess of normal statutory minimums, including a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%. As of December 31, 2012, the Bank had not achieved these minimum levels.
Liquidity and Interest Rate Sensitivity
Liquidity. Liquidity management is the process of managing assets and liabilities as well as their maturities to ensure adequate funding for loan and deposit activity. Sources of liquidity come from both balance sheet and off-balance sheet sources. We define balance sheet liquidity as the relationship that net liquid assets have to unsecured liabilities. Net liquid assets is the sum of cash and cash items, less required reserves on demand and NOW deposits, plus demand deposits due from banks, plus temporary investments, including federal funds sold, plus the fair value of investment securities, less collateral requirements related to public funds on deposit and repurchase agreements. Unsecured liabilities is equal to
total liabilities less required cash reserves on noninterest-bearing demand deposits and interest-checking deposits and less the outstanding balances of all secured liabilities, whether secured by liquid assets or not. We consider off-balance sheet liquidity to include unsecured federal funds lines from other banks and loan collateral which may be used for additional advances from the Federal Home Loan Bank. As of December 31, 2012 our balance sheet liquidity ratio (net liquid assets as a percent of unsecured liabilities) amounted to 20.80% and our total liquidity ratio (balance sheet plus off-balance sheet liquidity) was 22.30%.
In addition, we have the ability to borrow $10.0 million from the Discount Window of the Federal Reserve subject to our pledge of marketable securities, which could be used for temporary funding needs. We also have the ability to borrow from the Federal Home Loan Bank on similar terms. While we consider these arrangements sources of back-up funding, we do not consider them as liquidity sources because they require our pledge of liquid assets as collateral. We regularly borrow from the Federal Home Loan Bank as a normal part of our business. These advances are secured by various types of real estate-secured loans. The Company closely monitors and evaluates its overall liquidity position. The Company believes its liquidity position at December 31, 2012 is adequate to meet its operating needs.
Interest Rate Sensitivity. Our goal is to maintain a neutral interest rate sensitivity position whereby little or no change in interest income would occur as interest rates change. On December 31, 2012, we were cumulatively liability sensitive for the next twelve months, which means that our interest-bearing liabilities would reprice more quickly than our interest bearing assets. Theoretically, our net interest margin will decrease if market interest rates rise or increase if market interest rates fall. However, the repricing characteristics of assets are different from the repricing characteristics of funding sources. Therefore, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.
The following table shows the interest rate sensitivity of our balance sheet on December 31, 2012, but is not necessarily indicative of our position on other dates. Each category of assets and liabilities is shown with projected repricing and maturity dates. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. NOW accounts, savings accounts, and money market accounts are assumed to be subject to immediate repricing and depositor availability. Prepayment assumptions on mortgage loans and decay rates on deposit accounts have not been included in this analysis. Also, the table does not reflect scheduled principal repayments that will be received on loans. The interest rate sensitivity of our assets and liabilities may vary substantially if different assumptions are used or if our actual experience differs from that indicated by the assumptions.
Table XV.
Interest Sensitivity (dollars in thousands)
Quarterly financial data for 2012 and 2011 is summarized in the table below.
Table XVI.
Quarterly Financial Data (dollars in thousands except per share amounts)
Effects of Inflation and Changing Prices
A commercial bank has an asset and liability structure that is distinctly different from that of a company with substantial investments in plant and inventory because the major portion of its assets is monetary in nature. As a result, a bank’s performance may be significantly influenced by changes in interest rates. Although the banking industry is more affected by changes in interest rates than by inflation in the price of goods and services, inflation also is a factor that may influence interest rates. Yet, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect our operating expense in that personnel expense and the cost of supplies and outside services tend to increase more during periods of high inflation.
DISCLOSURES ABOUT FORWARD LOOKING STATEMENTS
This Report and its exhibits may contain statements relating to our financial condition, results of operations, plans, strategies, trends, projections of results of specific activities or investments, expectations or beliefs about future events or results, and other statements that are not descriptions of historical facts. Those statements may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “forecasts,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of the Company’s management about future events. Forward-looking information is inherently subject to risks and uncertainties, and actual results could differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, risk factors discussed in the Company’s Annual Report on Form 10-K and in other documents the Company files with the Securities and Exchange Commission from time to time. Copies of those reports are available directly through the Commission’s website at www.sec.gov. Other factors that could influence the accuracy of forward-looking statements include, but are not limited to, (a) pressures on the earnings, capital and liquidity of financial institutions resulting from current and future adverse conditions in the credit and equity markets and the banking industry in general; (b) changes in competitive pressures among depository and other financial
institutions or in the Company’s ability to compete successfully against the larger financial institutions in its banking markets; (c) the financial success or changing strategies of the Company’s customers; (d) actions of government regulators, or changes in laws, regulations or accounting standards, that adversely affect the Company’s business; (e) changes in the interest rate environment and the level of market interest rates that reduce the Company’s net interest margins and/or the volumes and values of loans it makes and securities it holds; (f) changes in general economic or business conditions and real estate values in the Company’s banking markets (particularly changes that affect the Company’s loan portfolio, the abilities of its borrowers to repay their loans, and the values of loan collateral); (g) governmental action as of a result of our inability to comply with regulatory orders and agreements; and (h) other unexpected developments or changes in the Company’s business. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. All forward-looking statements attributable to the Company are expressly qualified in their entirety by the cautionary statements in this paragraph. The Company has no obligation, and does not intend, to update these forward-looking statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Smaller reporting companies such as the Company are not required to provide the information required by this item.
Item 8.
Item 8. Financial Statements and Supplementary Data.
Bank of the Carolinas Corporation and Subsidiary
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
of Bank of the Carolinas Corporation
We have audited the accompanying consolidated balance sheets of Bank of the Carolinas Corporation and Subsidiary (hereinafter referred to as the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive loss, changes in stockholders’ equity, and cash flows for the years ended December 31, 2012, 2011, and 2010. Bank of the Carolinas Corporation and Subsidiary’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated 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 audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Bank of the Carolinas Corporation and Subsidiary as of December 31, 2012 and 2011, and the results of its operations and cash flows for years ended December 31, 2012, 2011, and 2010 in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 18 to the financial statements, the Company has suffered recurring credit losses that have eroded certain regulatory capital ratios. As of December 31, 2012, the Company is considered undercapitalized based on their regulatory capital level. This raises substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 18. The financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.
/s/ Turlington and Company, LLP
Lexington, North Carolina
April 1, 2013
Bank of the Carolinas Corporation and Subsidiary
Consolidated Balance Sheets
December 31, 2012 and 2011
(In thousands except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
Bank of the Carolinas Corporation and Subsidiary
Consolidated Statements of Operations
For the Years Ended December 31, 2012, 2011, and 2010
(In thousands except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
Bank of the Carolinas Corporation and Subsidiary
Consolidated Statements of Comprehensive Loss
For the Years Ended December 31, 2012, 2011, and 2010
(In thousands except per share data)
Bank of the Carolinas Corporation and Subsidiary
Consolidated Statements of Changes in Stockholders’ Equity
For the Years Ended December 31, 2012, 2011, and 2010
(In thousands except share data)
The accompanying notes are an integral part of these consolidated financial statements.
Bank of the Carolinas Corporation and Subsidiary
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2012, 2011, and 2010
(In thousands)
(continued)
Bank of the Carolinas Corporation and Subsidiary
Consolidated Statements of Cash Flows, Continued
For the Years Ended December 31, 2012, 2011, and 2010
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements
December 31, 2012, 2011, and 2010
1. Summary of Significant Accounting Policies
Organization-Bank of the Carolinas Corporation (“the Company”) is a North Carolina-chartered bank holding company that was incorporated on May 30, 2006, for the sole purpose of serving as the parent bank holding company for Bank of the Carolinas (“the Bank”). The Bank is a FDIC-insured, North Carolina-chartered bank that began operations on December 7, 1998.
Because the Company has no significant operations and conducts no business on its own other than owning the Bank, the discussion contained in these footnotes concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and its subsidiary are collectively referred to herein as the Company unless otherwise noted.
The accounting and reporting policies of the Company follow accounting principles generally accepted in the United States of America and general practices within the banking industry. The following is a summary of the more significant accounting policies.
Business-The Company provides a variety of financial services to individuals and small businesses through its retail offices. Its primary deposit products are demand deposits and time certificate accounts and its primary lending products are consumer, commercial, and mortgage loans. The Company does not have significant concentrations to any one industry or customer.
Use of Estimates-The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses.
Cash and Cash Equivalents-The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents are defined as those amounts included in the balance sheet captions “cash and due from banks” and “interest-bearing deposits in banks.” At times, the Company places deposits with high credit quality financial institutions in amounts which may be in excess of federally insured limits.
Investment Securities-Securities available for sale are carried at fair value and held to maturity securities are carried at amortized cost. The unrealized holding gains or losses on securities available for sale are reported, net of related income tax effects, as accumulated other comprehensive income unless a valuation reserve has been established. Changes in unrealized holding gains or losses are included as a component of other comprehensive income until realized. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in income as realized losses. Gains or losses on sales of securities available for sale are based on the specific identification method.
Loans Receivable-The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is invested within the central North Carolina region. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses, loans in process, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan using the interest method.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection. All interest accrued, but not collected, for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses-The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
Premises and Equipment-Land is carried at cost. Buildings, leasehold improvements and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the lesser of estimated useful lives of the assets or lease terms ranging from 3 to 40 years. The cost of maintenance and repairs are charged to expense as incurred while expenditures that materially increase the useful lives of property are capitalized.
Federal Home Loan Bank Stock-Investment in stock of the Federal Home Loan Bank is required by law of every member. The investment is carried at cost since redemptions of this stock have historically been at par. No ready market exists for the stock, and it has no quoted market value. The stock is presented in other assets. Due to the redemption provisions of the FHLB, the Bank estimates carrying value equals fair value and that it was not impaired at December 31, 2012. The stock had a carrying value of $728,700 and $1.6 million at December 31, 2012 and 2011, respectively.
Other Real Estate Owned-Assets acquired through, or in lieu of, loan foreclosure are held for sale and initially recorded at the lower of the loan balance or the fair value less costs to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management, and the assets are carried at the lower of carrying amount or fair value. Expenses associated with maintaining these properties, are included in other non-interest expense. The provision for real estate losses is included in other non-interest expense. Realized gains and losses on disposal of real estate are included in other non-interest expense. Foreclosed assets are presented in other real estate owned. As of December 31, 2012, the Company held a variety of properties in other real estate owned, including 1-4 family residential real estate and commercial real estate. These properties are generally held within the Company’s market area.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Income Taxes-The Company utilizes the liability method of computing income taxes. Under the liability method, deferred tax liabilities and assets are established for future tax return effects of the temporary differences between the stated value of assets and liabilities for financial reporting purposes and their tax bases. The focus is on accruing the appropriate balance sheet deferred tax amount, with the statement of income effect being the result of the changes in the balance sheet amounts from period to period. The current portion of income tax expense is provided based upon the actual tax liability incurred for tax return purposes.
An evaluation of the probability of being able to realize the future benefits of deferred tax assets is made. A valuation allowance is provided for the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized.
The Company’s policy is to report interest and penalties, if any, in tax expense in the Consolidated Statements of Operations. The Company and its subsidiary each reflect the tax expense or benefit associated with the results of their individual operating results. During 2010, the Internal Revenue Service performed an audit of the Company’s federal tax returns for the years ended 2008 and 2009. Their audit was triggered by the amount of refund received when the Company filed NOL carrybacks to tax years 2006 and 2007 of the tax losses incurred for the years ended December 31, 2008 and 2009. These carrybacks resulted in federal refunds of $1.3 million and $728,000, respectively. The IRS concluded their audit as of February 23, 2011 with the Company paying income tax of $210,000 for the tax year 2006 and $52,000 in alternative minimum tax for tax year 2007. Due to the audits of 2008 and 2009, only the Company’s 2010, 2011, and 2012 federal and state income tax returns are open and subject to examination.
Earnings Per Share-Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and warrants, and are determined using the treasury stock method.
Losses per share have been computed based on the following:
The Company had 497,205, 497,605, and 508,605 stock options and warrants that were considered anti-dilutive because the Company incurred net losses for the years ended December 31, 2012, 2011, and 2010, respectively.
Stock Compensation Plans-The Company under generally accepted accounting principles accounts for stock option expense using the modified prospective method. The Company records expense as options are issued.
Advertising Expense - The Company’s policy is to expense advertising cost as incurred.
Comprehensive Income (Loss)-Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income (loss). Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section in the balance sheet, such items, along with net income (loss), are components of comprehensive income (loss).
Reclassifications - In certain instances, amounts reported in prior years’ consolidated financial statements have been reclassified to conform to the current presentation. Such reclassifications had no effect on previously reported cash flows, stockholders’ equity or net loss.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Restatement of Previously Issued Financial Statements
The Corporation has restated its previously issued financial statements to correct the accounting for dividends on preferred stock. The preferred stock issued to the U.S. Treasury pursuant to the Capital Purchase Program has a cumulative dividend rate of 5% per year. Although the Corporation had deferred payment of all dividends, a liability was recorded for each of the quarters in the period March 31, 2011 - June 30, 2012. The accounting guidance for recording dividends prohibits a dividend from being accrued until it has been declared. The Corporation and the Bank are prohibited from declaring dividends as a result of a written agreement between the Corporation and the FDIC and the North Carolina Commissioner of Banks. (See the Corporation’s Management Discussion and Analysis for further discussion.) As a result, since the dividend was never declared, a liability should not have been established and other liabilities was overstated and retained earnings was understated as outlined below. Because of the nature of the misclassification, there was no impact on the net loss available to common shareholders. The following is a summary of the effects of the restatement for December 31, 2011 (dollars in thousands):
See Note 19 for the further effects of the restatement on the annual financial information.
New Accounting Pronouncements - In January 2010, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update No. 2010-06, Fair Value Measurements and Disclosures: Improving Disclosures about Fair Value Measurements, which amends Subtopic 820-10 of the FASB Accounting Standards Codification to require new disclosures for fair value measurements and provides clarification for existing disclosures requirements. More specifically, this update will require (a) an entity to disclose separately the amounts of significant transfers in and out of Levels 1 and 2 fair value measurements and to describe the reasons for the transfers; and (b) information about purchases, sales, issuances and settlements to be presented separately (i.e. present the activity on a gross basis rather than net) in the reconciliation for fair value measurements using significant unobservable inputs (Level 3 inputs). This update clarifies existing disclosure requirements for the level of disaggregation used for classes of assets and liabilities measured at fair
value and requires disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements using Level 2 and Level 3 inputs. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company does not anticipate that the adoption of this statement will materially expand its consolidated financial statement footnote disclosures.
In March 2010, the FASB issued Accounting Standard Update No. 2010-18, Receivables: Effect of a Loan Modification When the Loan is Part of a Pool that is Accounted for as a Single Asset. The new guidance clarifies that a modification to a loan that is part of a pool of loans that were acquired with deteriorated credit quality should not result in the removal of the loan from the pool. This guidance is effective for any modifications of loans accounted for within a pool in the first interim or annual reporting period ending after July 15, 2010. The adoption of this guidance was not material to the Company’s consolidated financial statements.
In July 2010, the FASB issued Accounting Standard Update No. 2010-20, Receivables: Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The new guidance requires additional disclosures that will allow users to understand the nature of credit risk inherent in a company’s loan portfolios, how that risk is analyzed and assessed in arriving at the allowance for loan and lease losses, and changes and reasons for those changes in the allowance for loan and lease losses. The new disclosures that relate to information as of the end of the reporting period
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
are required as of December 31, 2010. The disclosures related to activity that occurs during a reporting period are effective for reporting periods beginning on or after December 15, 2010, except for the disclosure requirements relating to troubled debt restructurings, which have been indefinitely delayed pending the outcome of the FASB’s deliberations related to the definition of a troubled debt restructuring.
In January 2011, the FASB issued Accounting Standards Update 2011-01, Receivables: Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. Under the existing effective date in Update 2010-20, public-entity creditors would have provided disclosures about troubled debt restructurings for periods beginning on or after December 15, 2010. The amendments in this Update temporarily defer the effective date for interim and annual periods ending after June 15, 2011, enabling public-entity creditors to provide those disclosures after the Board clarifies the guidance for determining what constitutes a troubled debt restructuring. The deferral in this Update will result in more consistent disclosures about troubled debt restructurings. This amendment does not defer the effective date of the other disclosure requirements in Update 2010-20. The deferral in this amendment is effective upon issuance and is not expected to have a significant impact on the Company.
In April 2011, the FASB issued Accounting Standards Update 2011-02, Receivables: A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This update provides additional guidance and amendments to Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: the restructuring constitutes a concession, and the debtor is experiencing financial difficulties. The amendments clarify the guidance on a creditor’s evaluation of whether it has granted a concession, and on a creditor’s evaluation of whether a debtor is experiencing financial difficulties.
The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. An entity should disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired under Section 310-10-35 for which impairment was previously measured under Subtopic 450-20, Contingencies-Loss Contingencies. An entity should disclose the information required by paragraphs 310-10-50-33 through 50-34, which was deferred by Accounting Standards Update No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, for interim and annual periods beginning on or after June 15, 2011. The amendments are not expected to have a significant impact on the Company.
In April 2011, the FASB issued Accounting Standards Update 2011-03, Transfers and Servicing: Reconsideration of Effective Control for Repurchase Agreements. The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this Update. Those criteria indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) for agreements that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity when all of the listed conditions have been met. The amendments in this Update are effective for public entities for fiscal year, and interim period within those years, beginning after December 15, 2011. The amendments are not expected to have a significant impact on the Company.
In May 2011, the FASB issued Accounting Standards Update 2011-04, Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, the Board does not intend for the amendments in this Update to result in a change in the application of the requirements in Topic 820.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments are not expected to have a significant impact on the Company.
In June 2011, the FASB issued Accounting Standards Update 2011-05, Comprehensive Income: Presentation of Comprehensive Income. Under the amendments to Topic 220, Comprehensive Income, in this Update, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income.
Regardless of whether an entity chooses to present comprehensive income in a single continuous statement or in two separate but consecutive statements, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented.
The amendments in this Update do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments do not change the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense or benefit related to the total of other comprehensive income items. In both cases, the tax effect for each component must be disclosed in the notes to the financial statements or presented in the statement in which other comprehensive income is presented. The amendments do not affect how earnings per share is calculated or presented. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments are not expected to have a significant impact on the Company.
In December 2011, the FASB issued Accounting Standards Update 2011-12, Comprehensive Income:Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. Under the amendments in Update 2011-05, entities are required to present reclassification adjustments and the effect of those reclassification adjustments on the face of the financial statements where net income is presented, by component of net income, and on the face of the financial statements where other comprehensive income is presented, by component of other comprehensive income. In addition, the amendments in Update 2011-05 require that reclassification adjustments be presented in interim financial periods.
The amendments in this Update supersede changes to those paragraphs in Update 2011-05 that pertain to how, when, and where reclassification adjustments are presented.
The objective of Update 2011-05 was to help financial statement users better understand the causes of an entity’s change in financial position and results of operations. However, it is important that the benefits of improving the usefulness of financial statement information to users of financial statements be justified by the related costs. The Board received more information about the systems challenges for preparers to comply with the presentation requirements for reclassifications out of accumulated other comprehensive income by the effective date since the issuance of Update 2011-05. The information received caused the Board to reassess the costs and benefits of those provisions in Update 2011-05
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
related to reclassifications out of accumulated other comprehensive income. Due to the time required to properly make such a reassessment and to evaluate alternative presentation formats, the Board decided that it is necessary to reinstate the requirements for the presentation of reclassifications out of accumulated other comprehensive income that were in place before the issuance of Update 2011-05. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments are not expected to have a significant impact on the Company.
In July 2012, the FASB issued Accounting Standards Update 2012-02, Intangibles - Goodwill and Other (Topic 350). The amendments in this Update are intended to reduce cost and complexity by providing an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment, which is equivalent to the impairment testing requirements for other long-lived assets. The amendments are not expected to have a significant impact on the Company.
In October 2012, the FASB issued Accounting Standards Update 2012-06, Business Combinations (Topic 805). When a reporting entity recognizes an indemnification asset (in accordance with Subtopic 805-20) as a result of a government-assisted acquisition of a financial institution and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets). For public and nonpublic entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. Early adoption is permitted. The amendments should be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption
arising from a government-assisted acquisition of a financial institution. The amendments are not expected to have a significant impact on the Company.
From time to time the FASB issues Proposed Accounting Standards Updates. Such proposed updates are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as Accounting Standards Updates. Management considers the effect of the proposed updates on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of proposed updates.
2. Investment Securities
The amortized cost, estimated fair values and carrying values of the investment securities portfolios are summarized as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The amortized cost and fair value of debt securities by contractual maturity at December 31, 2012 is as follows (dollars in thousands):
The fair values of securities with unrealized losses at December 31, 2012 and 2011 are as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Management of the Bank believes all unrealized losses on available for sale securities as of December 31, 2012 represent temporary impairments related to market fluctuations. The unrealized losses on our securities are a nominal portion of the total value of the portfolio. The Bank has no intention of selling these securities before their maturity and has the appropriate sources of liquidity to hold these securities until maturity so that no recognized losses will occur. The Bank believes that the unrealized losses are primarily the result of the interest rate environment and general illiquidity currently in the marketplace for these types of securities.
The Bank had one held to maturity corporate security at December 31, 2012 that had an unrealized loss position of longer than 12 months in duration. The Bank has no intention of selling this security before its maturity and has the appropriate sources of liquidity to hold the security until maturity so that no recognized loss will occur.
Investment securities with market values of $69.4 million and $73.3 million at December 31, 2012 and 2011, respectively, were pledged as collateral on public deposits and for other purposes as required or permitted by law. Gross realized gains and losses for the years ended December 31, 2012, 2011, and 2010 are as follows (dollars in thousands):
3. Loans Receivable
Loans receivable are summarized as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The changes in the allowance for loan losses are summarized as follows (dollars in thousands):
In accordance with accounting principles generally accepted in the United States of America, loans totaling approximately $46.0 million in non-homogenous groups were determined to be impaired as of December 31, 2012 while approximately $46.4 million were determined to be impaired as of December 31, 2011. Specific loan loss reserves of $755,000 and $770,000, respectively, were related to these loans as of December 31, 2012 and 2011. These reserves were held against specific loan balances of $26.6 million and $23.8 million for 2012 and 2011, respectively. Income has been recognized on a cash basis on these loans since being placed in impaired status. The average balance invested in impaired loans was approximately $44.9 million and $38.2 million in 2012 and 2011, respectively. All impaired loans as of December 31, 2012 and 2011 have been evaluated to determine whether a specific loan loss reserve is necessary.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Impaired loans as of December 31, 2012 and 2011, segregated by class of loans, were as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Impaired loans include loans whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulties. Troubled debt restructurings (TDRs) are a subset of impaired loans and totaled $41.5 million and $35.6 million at December 31, 2012 and 2011. Of the $3.6 million in net charge-offs in 2012, $1.2 million was related to a restructured loan.
The following tables illustrate TDR information for the three months and year ended December 31, 2012 and 2011 (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
There were 2 loans restructured in the twelve months prior to December 31, 2011 that went into default during the three- or twelve-month period ended December 31, 2012. There were 3 loans restructured in the twelve months prior to December 31, 2011 that went into default during the three- or twelve-month period ended December 31, 2011. For the purposes of this report, default is defined as being 90-days past due or on non-accrual status without performance.
Some loan modifications classified as TDRs may not ultimately result in the full collection of principal and interest, as modified, and result in potential incremental losses. These potential incremental losses have been factored into our overall allowance for loan losses estimate. The level of any re-defaults will likely be affected by future economic conditions. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, reclassified to loans held for sale, or foreclosed and sold. Included in the allowance for loan losses at December 31, 2012 and 2011 was an impairment reserve for TDRs in the amount of $755,000 and $767,000, respectively.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Loans in non-accrual status were approximately $7.7 million and $19.1 million at December 31, 2012 and 2011, respectively. Interest accrued, but not recognized as income on these loans, was approximately $159,000 and $569,000 for the years ended December 31, 2012 and 2011, respectively. Non-accrual loans and an age analysis of past due loans, segregated by class of loans and including TDRs, were as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The Bank categorizes loans and leases 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. This categorization is made on all commercial, commercial real estate, and construction and development loans. The Bank uses the following definitions for risk ratings:
Pass-Loans and leases classified as pass should be performing relatively close to expectations, with adequate evidence that the borrower is continuing to generate adequate cash flow to service debt. There should be no significant departure from the intended source and timing of repayment, and there should be no undue reliance on secondary sources of repayment. To the extent that some variance exists in one or more criteria being measured, it may be offset by the relative strength of other factors and/or collateral pledged to secure the transaction.
Special Mention-Loans and leases classified as special mention, while still adequately protected by the borrower’s capital adequacy and payment capability, exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.
Substandard-Loans and leases classified as substandard are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.
Doubtful-Loans and leases classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or orderly repayment in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimated loss is deferred until its more exact status may be determined. The Company’s practice is to charge-off the portion of the loan amount determined to be doubtful in the quarter that the determination is made if the repayment of the loan is collateral dependent.
Loss-Loans and leases classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass-rated loans. As of December 31, 2012 and 2011, and based on the most recent analysis performed, the risk category of loans and leases is as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
All consumer-related loans, including residential real estate and non-real estate are evaluated and monitored based upon payment activity. Once a consumer related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment. At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances. Consumer related loans at December 31, 2012 and 2011, segregated by class of loans, were as follows (dollars in thousands):
Directors and officers of the Bank and companies with which they are affiliated are customers of the Bank in the ordinary course of business and are considered “insiders.” Outstanding balances for term loans and lines of credit to insiders as of December 31, 2012 and 2011 were approximately $2.8 and $3.1 million, respectively.
The following table summarizes the Bank’s loan transactions with insiders for the year ended December 31, 2012 (dollars in thousands):
Available lines of credit that can be drawn upon by insiders totaled $343,000 as of December 31, 2012.
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 allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.
The level of the allowance reflects management’s continuing evaluation of industry concentrations, 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. 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 the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.
Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Company’s pools of similar loans include commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and consumer and other loans. General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in delinquencies and impaired loans; (ii) levels of and trends in chargeoffs and recoveries; (iii) levels of non-impaired substandard loans; (iv) trends in volume and terms of loans; (v) effects of changes in risk selection and underwriting practices; (vi) experience, ability, and depth of lending management and staff; (vii) national and local economic trends and conditions; (viii) industry conditions; and (ix) effect of changes in credit concentrations. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.
In 2011, the Company modified its methodology for determining the allowance for loan losses. Prior to these changes, the loan loss methodology calculated historical loss rates using a three-year loss history with a quarter lag and a weighted average. During the first quarter of 2011, the Company began using a three-year average annual loss rate. At the end of 2011, the loan loss methodology was modified further to include the current quarter-end, which eliminated the quarter lag used previously. As a result of these changes, there was a net decrease to the Company’s allowance for loan losses of approximately $80,000 in 2011.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Changes in the allowance for loan losses by segment are as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
5. Premises and Equipment
Premises and equipment are summarized as follows (dollars in thousands):
The Bank has entered into non-cancelable lease agreements for certain branch facilities. The leases expire through December 2017 and contain various renewal options. For the years ended December 31, 2012, 2011, and 2010, rental expense was approximately $296,000, $277,000, and $275,000, respectively.
The approximate minimum future lease payments are as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
6. Deposits
The aggregate amount of time deposits with a minimum denomination of $100,000 was approximately $116.1 million and $152.5 million at December 31, 2012 and 2011, respectively.
Contractual maturities of time deposits are summarized as follows (dollars in thousands):
At December 31, 2012 and 2011, the Company had $15.1 million and $42.7 million, respectively, in brokered certificates of deposit. At December 31, 2012, the Company had pledged $6.0 million of investment securities to the North Carolina State Treasurer for public funds in excess of the FDIC insured limits.
7. Federal Home Loan Bank Advances
The Bank had no advances from the Federal Home Loan Bank (“FHLB”) as of December 31, 2012 and 2011.
The Bank has total credit availability through the FHLB of approximately $67.2 million; however, FHLB advances can only be obtained on a secured basis. As of December 31, 2012 and 2011, the Bank had pledged its FHLB stock and certain qualifying real estate loans as collateral to secure approximately $7.2 million and $14.6 million, respectively, in immediate availability.
8. Federal Funds Purchased and Repurchase Agreements
The Bank had no federal funds purchased outstanding at December 31, 2012 and 2011. The Bank had $45.4 million outstanding in securities sold under agreements to repurchase at December 31, 2012 and 2011. A total of $45.0 million of these borrowings relate to two term repurchase agreements entered into during 2008. These borrowings were secured by marketable securities totaling approximately $57.9 million at December 31, 2012. The following table contains certain pertinent information with respect to these two agreements at December 31, 2012 (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The remaining repurchase agreements were primarily overnight transactions offered as a cash management service to business customers. A summary of selected data related to federal funds purchased and securities sold under overnight agreements to repurchase follows (dollars in thousands):
(1)
Average rate for month of December
9. Subordinated Debt
The Company has issued $5.2 million of junior subordinated debentures to Bank of the Carolinas Trust I to fully and unconditionally guarantee the preferred securities issued by the trust. The Company owns all of the outstanding common securities of Bank of the Carolinas Trust I. This long term obligation constitutes a full and unconditional guarantee by the Company of the trust’s obligations. A description of the junior subordinated debenture outstanding is as follows:
The Company has the right to redeem the trust preferred securities in whole or in part, on or after March 26, 2013. If the trust preferred securities are redeemed on or after March 26, 2013, the redemption price will be 100% of the principal amount plus accrued and unpaid interest. In addition, the Company may redeem the trust preferred securities in whole (but not in part) at any time within 90 days following the occurrence of a tax event, an investment company event or a capital treatment event at a special redemption price (as defined in the indenture).
The Company also issued $2.7 million of subordinated debt in a private transaction with another banking institution. This subordinated debt has a rate of Prime plus 75 basis points and a maturity date of August 13, 2018. This debt can be repaid in full at any time with no penalty.
10. Income Taxes
The components of income tax expense (benefit) are as follows (dollars in thousands):
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The Company and its subsidiary each reflect the tax expense or benefit associated with the results of their individual operating results. The differences between actual income tax expense and the amount computed by applying the federal statutory income tax rate of 34% are reconciled as follows (dollars in thousands):
The components of deferred income taxes are as follows (dollars in thousands):
Management has established a deferred tax asset valuation allowance of $14.4 million and $12.7 million at December 31, 2012 and 2011, respectively. Although the Company has shown sufficient positive evidence and appears to have ample resources to remain viable into the future in order to utilize these benefits, we believe current overall credit trends, as well as actual and forecasted performance, raise significant concern over the ability of the Company to realize the components of its deferred tax assets relating to net operating losses and the allowances for losses on loans and OREO. Income tax expense (benefit) contains no interest or penalty amounts for the years ended December 31, 2012, 2011, or 2010.
The 2012 state net economic loss of approximately $7.0 million must be carried forward to future years. The Company has approximately $41.3 million in total state net economic loss carryovers which will expire between 2023 and 2027 if not previously utilized. The Company’s 2012 federal net operating loss of approximately $7.0 million may be carried forward for up to 20 years, if not previously utilized. The Company has approximately $35.5 million in total federal net operating loss carryovers which will expire between 2029 and 2032 if not previously utilized.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
11. Regulatory Matters
Dividends
The Company’s dividend payments, if any, will be made from dividends received from the Bank. Under North Carolina banking law, the Bank’s board of directors may declare dividends so long as they do not reduce the Bank’s capital below its applicable required capital. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure financial soundness of the Bank. The ability of the Company and the Bank to pay dividends is currently restricted by the terms of a consent order issued by the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks and a written agreement between the Company and the Federal Reserve Bank of Richmond. See “Other Regulatory Restrictions” below.
Dividends paid on the Company’s preferred stock issued to the U.S. Treasury pursuant to the TARP Capital Purchase Program reduces the net income available to common stockholders and earnings per common share. The Company began deferring dividend payments on its preferred stock issued to the U.S. Treasury in February 2011. The preferred stock also would receive preferential treatment in the event of liquidation, dissolution or winding up of the Company. Additionally, the ownership interest of existing common stockholders will be diluted to the extent the warrant issued to the U.S. Treasury in conjunction with the issuance of preferred stock is exercised.
Capital Requirements
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by 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 Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and 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 Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the regulations. As described below, the Bank is subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks. The consent order requires that the Bank maintain capital levels in excess of normal statutory minimums. See “Other Regulatory Restrictions” below.
Intercompany transactions
Restrictions on loans by the Bank to the Company are imposed by Federal Reserve Act Sections 23A and 23B, and differ from legal lending limits on loans to external customers. Generally, a bank may lend up to 10% of its capital and surplus to its parent or other affiliate, if the loan is secured and so long as certain safety and soundness requirements and market terms requirements are met. If collateral is in the form of stocks, or other real or personal property, it must have a market value when the loan is made of at least 30% more than the amount of the loan; if the collateral is in the form of debt instruments, it must have a market value when the loan is made of at least 20% more than the amount of the loan; and if the collateral is in the form of obligations of a state or political subdivision or agency thereof, it must have a market value of at least 10% more than the amount of the loan. If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers’ acceptances eligible for rediscount or purchase by a Federal Reserve Bank, requirements for collateral in excess of loan amount do not apply. Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $1.6 million at December 31, 2012. No 23A transactions existed at December 31, 2012 or 2011.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Other Regulatory Restrictions
As noted above, Banking Regulators generally have the ability to require more stringent standards than those otherwise set forth in the regulations. The Bank is subject to a consent order issued by the FDIC and the North Carolina Commissioner of Banks and the Company is party to a written agreement with the Federal Reserve Bank of Richmond. The consent order requires that the Bank maintain capital levels in excess of normal statutory minimums, including a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8% and a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 10%, and to take various other actions designed to improve the Bank’s lending procedures and various other conditions related to the Bank’s operations, and of the Company and the Bank to seek the approval of their respective regulators prior to the payment of any cash dividend. The Company’s Board agreed to take steps necessary to ensure the Bank’s compliance with its above agreement and, without the approval of its regulator, to not incur additional debt or issue hybrid-capital instruments, or use cash assets other than for the benefit of the Bank, investment in short term, liquid assets or payment of normal expenses.
As of December 31, 2012, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as undercapitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain the minimum capital ratios. The Bank’s actual capital amounts (in thousands) and ratios and minimum requirements are set forth in the table below:
*
As previously described, the Company’s Board of Directors agreed to maintain the Bank’s Leverage Capital Ratio of 8.0% which is above the minimum level required by regulatory capital guidelines.
12. Employee Benefit Plan
The Bank has a 401(k) Plan to benefit employees. Employees that meet certain age and service requirements may participate in the Plan. Employees may contribute up to 75 percent of their compensation subject to certain limits based on federal tax laws. The Bank may make contributions to the Plan as determined by the Bank’s Board of Directors. For the years ended December 31, 2012, 2011, and 2010, there was no expense attributable to the Plan.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
13. Commitments and Contingencies
To accommodate the financial needs of its customers, the Company makes commitments under various terms to lend funds. These commitments include revolving credit agreements, term loan commitments and short-term borrowing agreements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held includes first and second mortgages on one-to-four family dwellings, accounts receivable, inventory, and commercial real estate. Certain lines of credit are unsecured.
The Bank had outstanding commitments to originate commercial and construction loans of approximately $27.8 million at December 31, 2012. These commitments were composed of variable rate loans, with interest rates based upon the prime rate. The commitments included various maturity terms with balloon payments due between one to five years.
The following summarizes the Bank’s approximate remaining available balance to customers under commitments to fund lines of credit at December 31, 2012 (in thousands):
14. Employment and Change of Control Agreements
The Company has entered into an employment agreement with a key employee. The employment agreement provides for a rolling three-year term. In most circumstances, commencing on the first anniversary date and continuing each anniversary date thereafter, the agreement automatically extends for an additional year so that the remaining terms shall remain three years. The agreement provides for severance payments and other benefits in the event of involuntary termination of employment in connection with any change in control of the Company or the Bank. A severance payment will also generally be provided on a similar basis in connection with voluntary termination of employment where, subsequent to a change in control, the officer is assigned duties inconsistent with his position, duties, responsibilities and status immediately prior to such change in control. The severance payments are defined in the agreement, but in no case exceed 2.99 times the executive officer’s annual base salary in effect at the time the change in control becomes effective or as in effect at the time the officer’s termination becomes effective, whichever is greater. The employment agreement provides for termination by the Company for just cause at any time. The Company has not accrued any benefits under this post-employment agreement.
15. Stockholders’ Equity
Preferred Stock
The Company has 3 million shares of preferred stock authorized. At December 31, 2012 and 2011, there were 13,179 shares of preferred stock issued and outstanding with a $1,000 per share liquidation preference. All of the shares were issued on April 17, 2009, in connection with the U.S. Treasury’s TARP Capital Purchase Program. In February 2011, the Company notified the U.S. Treasury of its intent to defer the payment of its regular quarterly cash dividend on its Series A Preferred Stock.
Common Stock
The Company has 15 million shares of $5 par value common stock authorized. There were 3,895,840 shares of common stock outstanding at December 31, 2012 and 2011.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Warrants
In connection with the issuance of the preferred shares under the U.S. Treasury’s (“UST”) TARP Capital Purchase Program, the Company issued the UST a warrant to purchase 475,204 shares of its common stock for $4.16 per share. The Warrant expires April 17, 2019.
Equity-Based Plans
Under the Company’s 2007 Omnibus Equity Plan (which was approved by the Company stockholders during 2007 to replace the previous Employee Stock Option Plan and Directors Stock Option Plan which expired in 2008), the Company may grant incentive and non-qualified stock options, restricted stock awards and performance share awards to its officers and employees, and non-qualified stock options and restricted stock awards to its directors, for up to an aggregate of 300,000 shares of common stock. The exercise price of each option equals the market price of the Company’s stock on the date of grant and grants have a maximum term of ten years.
The Company did not grant options during the years ended December 31, 2012, 2011, and 2010. The most recent options were granted with a weighted average fair market value of $5.25 per share. The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model.
The Company also granted 6,000 shares of restricted stock grants during 2008. These grants were granted with a weighted average fair value of $5.25. The weighted average period over which awards are expected to be recognized is 0.48 years. The restricted stock grants were granted using the same fair value assumptions as the option grants during the year. The restricted stock grant agreements are based upon continued employment with the Company and carry no performance provisions in order to receive the shares at the end of the vesting schedule. The shares will vest equally over a three year period. There was a forfeiture of 1,333 shares in 2011.
Stock based compensation benefit was $1,000 and $8,000 in 2012 and 2011, respectively, and expense was $2,000 in 2010. All stock based awards are vested and all expense has been recognized at December 31, 2012.
Accounting principles generally accepted in the United States of America require the cash flows from the tax benefits resulting from tax deductions in excess of the compensation expense recognized for those options (“excess tax benefits”) to be classified as financing cash flows. There were no excess tax benefits classified as a financing cash inflow for the years ended December 31, 2012, 2011, and 2010. There were no options exercised in 2012. There was a forfeiture of 2,400 options in 2012.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
A summary of the status of the Company’s stock options and stock awards as well as the warrants issued to the U.S. Treasury as of December 31, 2012 and changes during the year then ended is presented below:
16. Fair Value of Financial Instruments
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Bank’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Accounting principles generally accepted in the United States of America exclude certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Bank.
The following methods and assumptions were used by the Bank in estimating fair value disclosures for financial instruments:
Cash and Cash Equivalents-The carrying amounts of cash and short-term instruments approximate fair values.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Federal Funds Sold-The carrying amounts of federal funds sold approximate fair values.
Investment Securities-Fair values for securities are based on quoted market prices.
Loans Receivable-For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for other loans (e.g., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for non-performing loans, as applicable, are estimated using discounted cash flow analyses or underlying collateral values, where applicable.
Bank Owned Life Insurance-The carrying amount of bank owned life insurance is the current cash surrender value.
Other Assets-Other assets include interest receivable and Federal Home Loan Bank stock. The carrying amount of accrued interest receivable approximates fair value. The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.
Deposit Liabilities-The fair values disclosed for demand deposits (e.g., interest and non-interest checking, statement 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). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Federal Home Loan Bank Advances-The fair value of the Bank’s advances are estimated using discounted cash flow analyses based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements.
Repurchase Agreements-The Bank established two term repurchase agreements during 2008. These agreements are collateralized by securities held in our portfolio. The fair value amount for these agreements is based on the repurchase price and agreed upon terms.
Other Borrowings-Other borrowings includes federal funds purchased as well as repurchase agreements, trust preferred securities and subordinated debt. The carrying amounts approximate the fair value of these assets.
Other Liabilities-Other liabilities include accrued interest payable. The carrying amounts of accrued interest payable approximate fair value.
Off-Balance-Sheet Instruments-Fair values for off-balance-sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
The approximate carrying and estimated fair values of financial instruments are summarized below (in thousands):
Effective January 1, 2008, accounting principles generally accepted in the United States of America require that certain assets and liabilities be measured at fair value and to record any adjustments to the fair value of those assets. Securities are recorded at fair value on a recurring basis while other assets are recorded at fair value on a non-recurring basis such as impaired loans and other real estate owned.
The Company uses three levels of measurement to group those assets measured at fair value. These groupings are made based on the markets the assets are traded in and the reliability of the assumptions used to determine fair value. The groupings include:
•
Level 1 pricing for an asset or liability is derived from the most likely actively traded markets and considered very reliable. Quoted prices on actively traded equities, for example, fall into this category.
•
Level 2 pricing is derived from observable data including market spreads, current and projected rates, prepayment data and credit quality. Our bond price adjustments fall into this category as well as impaired loans and other real estate owned that use appraisals or brokered price opinions to determine fair value.
•
Level 3 pricing is used without observable data. In such cases, mark-to-market strategies are typically employed. Often, these types of instruments have no active market, possess unique characteristics and are thinly traded.
The Company’s investment securities are measured on a recurring basis through a model used by our bond agent. All of our bond price adjustments meet level 2 criteria. Prices are derived from a model which uses actively quoted rates, prepayment models and other underlying credit and collateral data.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
17. Parent Company Financial Information
The condensed balance sheets for 2012 and 2011, and the condensed statements of operations and cash flows for the parent company as of and for the years ended December 31, 2012, 2011, and 2010 are presented below (in thousands):
Condensed Balance Sheets
Condensed Statements of Operations
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
Condensed Statements of Cash Flows
18. Going Concern Considerations and Management’s Plans and Intentions
Going Concern Considerations
The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. It is the responsibility of management to assess the Company’s ability to continue as a going concern. In making this assessment, the Company has taken into account all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date of December 31, 2012. The Company has had a history of profitable operations prior to 2008 and sufficient sources of liquidity to meet its short-term and long-term funding needs.
The effects of the current economic environment are being felt across many industries, with financial services and real estate being particularly hard-hit, and have been particularly severe during the last 48 months. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, including residential construction and development loans, has seen a decline in the value of the collateral securing its portfolio as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets had increased substantially during 2010 and 2011. During 2012, the Bank saw significant improvement in levels of nonperforming assets. The significant losses in 2010, 2011, and 2012, which were primarily related to credit losses and the valuation allowance on deferred tax asset, reduced the Company’s capital levels. In order to again become well capitalized under federal banking agencies’ guidelines, management believes that the Company will need to raise additional capital to recapitalize the Bank and to absorb the potential future credit losses associated with the disposition of its nonperforming assets. Accordingly, management is in the process of evaluating various alternatives to increase tangible common equity and regulatory capital through the issuance of additional equity in public or private offerings. Management is actively evaluating a number of potential capital sources, asset reductions, and other balance sheet management strategies with the goal of increasing its level of regulatory capital to support its balance sheet long-term. Management is currently reducing and otherwise restructuring its balance sheet to improve capital ratios.
Current market conditions for banking institutions, the overall uncertainty in financial markets, and a depressed stock price are significant barriers to the success of any plan to issue additional equity in public or private offerings. An equity financing transaction would result in substantial dilution to the Company’s current stockholders and could adversely affect
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
the market price of the Company’s common stock. There can be no assurance as to whether these efforts will be successful, either on a short-term or long-term basis. Should these efforts be unsuccessful, due to existing regulatory restrictions on cash payments and dividends between the Bank and the holding company, the Company may be unable to discharge its liabilities in the normal course of business. There can be no assurance that the Company will be successful in any efforts to raise additional capital during 2013.
Both the Company and the Bank actively manage liquidity and cash flow needs. The Bank is prohibited from declaring or paying dividends without prior approval of the FDIC or the Commissioner and the Company is prohibited from declaring or paying dividends without the prior approval from the Federal Reserve. Even if these requirements were not in place, the Company does not intend to declare or pay dividends to shareholders at any time in the foreseeable future. At December 31, 2012, the Company had $7.8 million of cash and cash equivalents. The Company has no long-term debt maturing in 2012 or 2013.
Based on current capital levels and continued operating losses management believes the Company will require additional capital to be able to remain viable. Management has implemented various strategies to provide this needed capital. In spite of management’s best efforts, there is no guarantee management will be successful in raising the additional capital. The accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.
Management’s Plans and Intentions
The Company incurred significant net losses in 2010 and 2011, which have continued in 2012, primarily from the higher provisions for loan losses due to the significant level of nonperforming assets and increases in foreclosed real estate. The FDIC and the Commissioner issued the Consent Order in April 2011. The Company entered into a written agreement with the FRB in August 2011. The Company’s independent registered public accounting firm issued a report with respect to the Company’s audited financial statements for the fiscal year ended December 31, 2012, which contained an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern. The following strategies to improve the Company’s financial condition have been or are being implemented:
Deferring Preferred Stock and Trust Preferred Securities Payments - The Company began deferring the payment of cash dividends on its outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A, beginning in February 2011, as well as the payment of interest on the outstanding junior subordinated notes related to its trust preferred securities to enhance the Company’s liquidity. The expense associated with trust preferred securities continues to accrue and is reflected in the Company’s Consolidated Statements of Operations. The dividends on preferred stock are shown as an increase to net loss to derive net loss to common shareholders in the Consolidated Statements of Operations.
Balance Sheet Reduction - Management currently is implementing strategies to improve capital ratios through the reduction of assets and off-balance sheet commitments. At December 31, 2012, risk-weighted assets had been reduced by $47.9 million since December 31, 2011. Reductions occurred primarily in the commercial loan portfolio. Management expects future reductions in risk-weighted assets to be moderate and occur primarily in the loan portfolio. To offset the majority of asset reductions, liabilities declined primarily through reductions in brokered and institutional CDs by $38.7 million.
Earnings - In June 2011, the Bank retired $10.0 million in FHLB advances and paid an early redemption penalty of $273,000 to the FHLB for the retirement of these advances. In November 2011, the Bank retired an additional advance of $10.0 million due to the FHLB and paid an early redemption penalty of $7,000. The advances had a remaining average life of 1.0 year and an average interest rate of 1.21%. The Bank is prohibited from accepting or rolling over any brokered certificates of deposits. Since April 2011, the brokered certificates of deposit had maturities ranging from 2 months to 27 months with interest rates ranging from 0.75% to 2.40%. As these matured and continue to mature, the Bank replaced
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
and will continue to replace these funds with institutional certificates of deposit with average interest rates of 0.51%. In 2012, the Bank was able to start returning loans, previously in a non-accrual status, to accrual status after six months of payment performance. As a result of these changes, the Bank expects a positive impact on its net interest margin in 2013.
Additional Capital - The Company has engaged investment banking firms and is working to secure investors in a capital raise plan that may include issuing common stock, preferred stock or a combination of both, debt, or other financing alternatives that may be treated as capital for capital adequacy ratio purposes. Currently, the Company is working diligently to raise additional capital in the next few months; however, there are no assurances that an offering will be completed or that the Company will succeed in this endeavor. In addition, a transaction would more likely than not involve equity financing, resulting in substantial dilution to current shareholders and an adverse effect on the price of the Company’s common stock. The Company’s ability to raise capital is contingent on the current capital markets and on its financial performance. Available capital markets are not currently favorable, and the Company cannot be certain of its ability to raise capital on any terms.
Bank of the Carolinas Corporation and Subsidiary
Notes to Consolidated Financial Statements, Continued
19. Selected Annual Financial Information
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures in accordance with Exchange Act Rule 13a-15(b). Based upon their evaluation, the Company’s Chief Executive Officer and Principal Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that the Company is able to record, process, summarize, and report in a timely manner the information required to be disclosed in reports the Company files under the Exchange Act.
The Company’s Management’s Report on Internal Control Over Financial Reporting appears below.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING.
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. The Company’s internal control over financial reporting is a process designed under supervision of the Company’s Chief Executive Officer and Principal Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Management has made a comprehensive review, evaluation and assessment of the Company’s internal control over financial reporting as of December 31, 2012. In making its assessment of internal control over financial reporting, management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2012, the Company’s internal control over financial reporting is effective. In accordance with Section 404 of the Sarbanes-Oxley Act of 2002, management makes the following assertions:
•
Management has implemented a process to monitor and assess both design and operating effectiveness of internal control over financial reporting.
•
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.
This Annual Report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to an exemption from that requirement available to smaller reporting companies.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
In connection with the above evaluation of the Company’s disclosure controls and procedures, no change in the Company’s internal control over financial reporting was identified that occurred during the quarter ended December 31, 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Directors
Our Bylaws provide that:
•
our Board of Directors consists of not less than five nor more than 18 members, and our Board is authorized to set and change the actual number of our directors from time to time within those limits; and
•
our directors are elected each year at our Annual Meeting for terms of one year, or until their successors have been duly elected and qualified.
The following table lists information about each of our current directors, including a description of his or her principal occupation and business experience. There are no family relationships among directors and executive officers of the Company.
(1)
Members of certain committees of our Board are as follows:
Audit Committee
Corporate Governance
Committee
Risk Oversight
Committee
Executive Committee
Henry H. Land - Chairman
John A. Drye - Chairman
John W. Googe - Chairman
Francis W. Slate - Chairman
Jerry W. Anderson
Alan M. Bailey
John A. Drye
John W. Googe
Alan M. Bailey
John W. Googe
Henry H. Land
Henry H. Land
Lynne Scott Safrit
Grady L. McClamrock, Jr.
Lynne Scott Safrit
Grady L. McClamrock, Jr.
Francis W. Slate
Stephen R. Talbert
Stephen R. Talbert
(2)
“Year first elected” refers to the year in which each individual first became a director of the Bank. Each nominee first became our director at the time we were incorporated during 2006 as the Bank’s holding company. Messrs. Drye, Land and Talbert and Ms. Safrit previously served as directors of BOC Financial Corp and were appointed as directors of the Bank following our merger with that company on December 31, 2001.
(3)
Information regarding Mr. Talbert’s business experience is included in his listing below under the heading “Executive Officers.”
Factors Bearing on Qualifications of Directors
The experience, qualifications, attributes, skills and other factors that leads our Board to conclude that each of our directors listed in the table above should serve, or continue to serve, as a director are described below.
Jerry W. Anderson
•
Thorough understanding of our culture, values, and goals derived from service as our director since 1998
•
Owner/operator of Anderson Aggregates; in business for over 40 years
•
Board experience for over 25 years with Energy United
•
Active in civic clubs in Davie County
•
Over 40 years operating a business in Davie County leads to a thorough understanding of the banking needs of small business owners
Alan M. Bailey
•
Thorough understanding of our culture, values and goals derived from service as our director since 1998
•
Owner/operator of 801 Shell Service and Bailey’s Auto Sales for over 30 years
•
Graduate of NC Bank Directors’ College 1998
•
Well respected in the business community of Davie County as his family has been in business for over 100 years
•
Understands the banking and business needs of small business owners
John A. Drye
•
Thorough understanding of our culture, values and goals derived from service as our director since 2002
•
Over 20 years experience in the insurance industry as partner of a property/casualty insurance agency
•
Furman University, BA, graduated 1986; University of Georgia, MBA, concentration in finance and risk management, graduated 1988; Chartered Property and Casualty Underwriter 1997; Certified Builders Insurance Agent 2008
•
Active involvement in church and civic clubs of Rowan County
•
Good understanding of the banking needs of small businesses in Rowan and Cabarrus Counties
John W. Googe
•
Thorough understanding of our culture, values and goals derived from service as our director since 2001
•
Over 40 years professional experience, served as President and COO of a public company
•
Guilford College, Economics degree graduated 1950; Chartered Life Underwriter 1960
•
Past service on other public company boards of directors
•
Mr. Googe has started and sold 18 different companies, this gives him a great understanding of the banking needs in many different industries; he is also well-respected in the Winston-Salem business community
Henry H. Land
•
Thorough understanding of our culture, values and goals derived from service as our director since 2002; currently serves as Chairman of and financial expert for the Audit Committee
•
East Carolina University, AB degree in Business Administration; CPA certification in 1969 from state of North Carolina
•
Extensive experience in financial accounting and reporting with large industrial corporation
•
Public accounting experience with various small- to medium-size privately owned businesses
•
Able to identify the financial needs of small- and mid-size businesses in our market area
Grady L. McClamrock, Jr.
•
Thorough understanding of our culture, values and goals derived from service as our director since 2001.
•
North Carolina State University, construction engineering degree 1974; Wake Forest Law School, JD degree 1977
•
Significant business skills developed through owning and managing law practice
•
Visible and active as a community leader serving on various boards within our market area
•
Able to identify with the financial needs of small- and mid-size businesses in our market area
Lynne Scott Safrit
•
Thorough understanding of our culture, values and goals derived from service as our director since 2002
•
Substantial experience in commercial real estate with more than 15 years as president of a national real estate development company
•
Catawba College, BA Cum Laude 1980; UNCC, MA 1981
•
Graduate of NC Advanced Bank Directors’ College 2003
•
Very active in many civic and professional organizations; currently serving on the Board of Trustees of Catawba College and President of the Board of Directors of the Cabarrus County Economic Development Corp.
•
Member of the Catawba College Business Hall of Fame
•
Able to identify with the financial needs of small- and mid-size businesses in our market area
Francis W. Slate
•
Thorough understanding of our culture, values and goals derived from service as our director since 1998
•
Over 32 years experience in healthcare as a general surgeon
•
University of Cape Town, M. B. Ch. B degree 1947 (South African equivalent of M.D.) New York University Postgraduate Medical School 1952-1953; George Washington University Medical School residency in General Surgery 1953-1956
•
Very active in medical community and as a community leader serving 12 years as Davie County Commissioner; Mocksville Town Commissioner for 10 years; Mayor of Mocksville for 15 years
•
Able to identify with the financial needs of small- and mid-size businesses in our market area
Stephen R. Talbert
•
Thorough understanding of our culture, values and goals derived from 41 years experience in the banking industry and service as a director since 2002; currently serves as our Vice Chairman, President and Chief Executive Officer
•
Experience as President and Chief Executive Officer of Bank of the Carolinas until its merger with Bank of Davie in 2001
•
Catawba College, BA degree in Business Administration 1966
•
Very active in local community serving on many boards including Rowan County Chamber of Commerce, NorthEast Medical Center Foundation, Trinity Lutheran Church, and Catawba College Board of Visitors
•
Able to identify with the financial needs of small- and mid-size businesses in our market area
Executive Officers
We consider our three officers listed below to be our executive officers.
Stephen R. Talbert, age 67, serves as our and the Bank’s Vice Chairman, President, and Chief Executive Officer. He joined the Bank on December 31, 2001, in connection with the Bank’s acquisition of BOC Financial Corp. Previously, he had served as Chairman, President and Chief Executive Officer of BOC Financial Corp since its organization during 1998, and in the same positions with that company’s bank subsidiary or its predecessor since 1971. He served as the Bank’s Chairman and Executive Vice President from 2002 to 2004 and has been Vice Chairman since 2004. Prior to being appointed President and Chief Executive Officer, Mr. Talbert served as our Interim Chief Executive Officer from August to September 2010.
George E. (“Ed”) Jordan, age 54, was appointed to serve as Chief Operating Officer of the Bank on November 24, 2010. Mr. Jordan previously served as the Bank’s Executive Vice President since January 2008 and, in that position, supervised the Bank’s financial services, marketing and sales functions and served as regional executive for the Bank’s offices located in Stokes, Forsyth, Davidson and Randolph Counties. Prior to that, he served as the Bank’s President and Chief Operating Officer from May 2004 to January 2008. Prior to his employment with the Bank, Mr. Jordan was employed by Wachovia Bank for 24 years where his positions included supervisory responsibility over city executives for several of that bank’s Triad area offices and service as that bank’s Senior Vice President and Business Banking Sales Director with responsibilities for middle market lending.
Harry E. Hill, age 67, was elected as the Bank’s Executive Vice President during January 2001. He was employed by our organizing group during 1998 and became Senior Vice President of the Bank when it began operations during 1998, and he currently functions as the Bank’s business development officer in Davie County. Previously, he served as Vice President of Southern National Bank and its successor, Branch Banking & Trust Company, in Welcome, North Carolina, from 1994 to 1998, and as Business Development Officer of Davidson Savings Bank from 1992 to 1994.
Audit Committee
Our Board of Directors has a standing Audit Committee that operates under a written charter approved by our Board that sets out the Committee’s composition, authority, duties and responsibilities. A current copy of the charter of the Audit Committee is available on our website at www.bankofthecarolinas.com. We believe that each member of the Committee is an “independent director” as that term is defined by the listing standards of The Nasdaq Stock Market. Although the Company’s common stock is no longer listed on The Nasdaq Stock Market, the Board of Directors will continue to use Nasdaq’s definition of independence in determining whether or not a director or nominee for director is independent.
The current members of the Audit Committee are listed in the following table.
Audit Committee
Henry H. Land - Chairman
Jerry W. Anderson
Alan M. Bailey
Lynne Scott Safrit
Francis W. Slate
The Audit Committee is a joint committee of our and the Bank’s Boards of Directors. Under its charter, the Committee is responsible for:
•
appointing our independent accountants and approving their compensation and the terms of their engagement;
•
approving services proposed to be provided by the independent accountants; and
•
monitoring and overseeing the quality and integrity of our accounting and financial reporting process and systems of internal controls.
The Committee reviews various reports from our independent accountants (including its annual audit report on our consolidated financial statements), financial reports we file under the Securities Exchange Act of 1934, and reports of examinations by our regulatory agencies, and it generally oversees our internal audit program. Also, as described in this Report under Item 13 (Certain Relationships and Related Transactions, and Director Independence), our Board has directed the Audit Committee to monitor and make annual reports regarding the independence of our directors. The Committee met ten times during 2012.
Audit Committee Financial Expert
Mr. Land, the Chairman of the Audit Committee, is a certified public accountant with over 40 years of accounting experience, including approximately 20 years in public accounting. Our Board of Directors believes that Mr. Land is an “audit committee financial expert” as that term is defined by rules of the Securities and Exchange Commission.
Code of Ethics
Our Board of Directors has adopted a Code of Ethics which applies to our directors and executive officers, including our senior financial officers, and, among other things, is intended to promote:
•
honest and ethical conduct;
•
ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
•
full, fair, accurate, timely and understandable disclosure in reports and documents that we file with the Securities and Exchange Commission and in other public communications we make;
•
compliance with governmental laws, rules and regulations;
•
prompt internal reporting of violations of the Code to the Board’s Audit Committee; and
•
accountability for adherence to the Code.
A copy of the Code is posted on the Bank’s Internet website at www.bankofthecarolinas.com. Illegal or unethical behavior, violations of the Code, or accounting or auditing concerns may be reported, anonymously or otherwise, to the Chairman of our Audit Committee addressed as follows:
Henry H. Land
Post Office Box 166
Kannapolis, NC 28082
Section 16(a) Beneficial Ownership Reporting Compliance
Our directors and executive officers are required by federal law to file reports with the Securities and Exchange Commission regarding the amounts of and changes in their beneficial ownership of our common stock. Based on our review of copies of those reports, we are required to disclose failures to report shares beneficially owned or changes in beneficial ownership, and failures to timely file required reports, during previous years. We currently are not aware of any of our directors or executive officers who, during 2012, failed to report shares beneficially owned or to timely file a required report.
Item 11.
Item 11. Executive Compensation
EXECUTIVE COMPENSATION
Summary
The following table shows the cash and certain other compensation paid or provided to or deferred by the named executive officers for 2012 and 2011. Our named executive officers are compensated by the Bank for their services as its officers, and they receive no separate salaries or other cash compensation from us for their services as our officers
SUMMARY COMPENSATION TABLE
(1)
Mr. Talbert served as a member of our Board of Directors during 2012 and 2011. Mr. Talbert received no additional compensation for his service as a director.
(2)
Reflects total salary paid by the Bank each year, including the amount of salary deferred at each officer’s election under our Section 401(k) plan.
(3)
The following table describes each officer’s “Other Compensation” for 2012:
(a)
Our executive officers receive, or we may treat them as receiving, various non-cash personal benefits. During 2012, the personal benefits received by the named officers included:
•
for Mr. Talbert, an automobile allowance and the Bank’s payment of club dues;
•
for Mr. Jordan, an automobile allowance; and
•
for Mr. Hill, an automobile allowance and the Bank’s payment of club dues.
We also provide our officers with group life, health, medical and other insurance coverages that are generally available on the same basis to all salaried employees. The cost of that insurance is not included in the table.
Employment Agreement
Mr. Jordan is employed by the Bank under an employment agreement. The agreement has a “rolling” term of employment of three years that, at the end of each year, is extended by one additional year. On May 17, 2018, the term becomes a fixed three years expiring at the close of business on May 17, 2021. If Mr. Jordan remains employed by the Bank after May 17, 2021, his employment will be on an “at will” basis. The agreement also provides for:
•
an annual base salary (which is subject to review and periodic increase by the Bank’s Board) of $135,678; and
•
the right to participate in bonus or incentive plans and other benefits made available by the Bank to its executive officers.
The Bank may terminate the agreement at any time for cause. Subject to certain limitations, the agreement provides for payments and benefits to be provided to Mr. Jordan and limits his ability to compete against the Bank after a termination of his employment under various circumstances (including a termination following a change in control of the Company or the Bank). Those provisions, and the limitations on their operation, are described below under the caption “Potential Payments Upon Termination of Employment or a Change in Control.”
Plan-Based Awards
We maintain two arrangements under which awards may be granted from time to time to our officers and employees. They are our:
•
Omnibus Equity Plan, under which stock options, restricted stock awards, and performance share awards may be granted; and
•
Annual Management Incentive Compensation Plan, under which additional cash compensation may be paid each year based on the extent to which corporate and individual goals or other performance criteria are met or satisfied for the year.
Stock-Based Awards. Our shareholders approved the Omnibus Equity Plan at our 2007 Annual Meeting to replace both our Employee Stock Option Plan and Director Stock Option Plan which had been in effect since 1998 and under which we had granted options from time to time to our officers, employees and directors to purchase shares of our common stock. Those old plans have expired.
Under the new plan, awards may be granted to officers and employees consisting of either:
•
Incentive stock options;
•
Non-qualified stock options;
•
Restricted stock awards; or
•
Performance share awards.
As described under the caption “Director Compensation,” the Omnibus Equity Plan also authorizes the grant of non-qualified stock options and restricted stock awards to our non-employee directors.
A stock option gives the officer or employee to whom it is granted the right to buy shares of our common stock during a stated period of time (ordinarily ten years) at a fixed price per share equal to the fair market value of our stock on the date the option is granted. Options generally are granted to officers and employees on terms that provide for them to “vest,” or become exercisable, at intervals as to portions of the shares they cover based on a vesting schedule, and they do not include any performance-based conditions. They generally terminate immediately on the date of, or after a stated number of days following, the termination of an officer’s employment. Options granted to officers and employees may be “incentive stock options” that qualify for special tax treatment under the Internal Revenue Code, or they may be “non-qualified stock options” that do not qualify for that special tax treatment. We expect that options granted in the future to officers and employees under the Omnibus Equity Plan will be incentive stock options.
Restricted stock awards are conditional grants of shares of our common stock that are subject to forfeiture if specified conditions (usually the officer’s or employee’s continued performance) are not satisfied by the end of a specified restriction period. When an award is granted, the shares are issued and, if we pay dividends on our common stock during the restriction period, the officer or director would receive those dividends on the shares covered by his award at the same rate and on the same basis as they are paid to our other shareholders. However, the shares may not be sold or transferred until the restriction period ends. In most cases the restrictions lapse over time as to portions of the shares according to a “vesting” schedule. If the officer’s employment terminates for any reason prior to the end of the restriction period, he forfeits all unvested shares. As the restrictions expire, the shares become “vested” and are released to the officer.
Performance share awards are awards of shares of our common stock that may be earned based on performance objectives or criteria specified at the time the awards are granted. Like restricted stock awards, performance shares would be granted subject to conditions that must be satisfied before the officer or employee will own the shares outright. However, performance shares would be earned only to the extent that performance criteria are met by the end of a measurement period, while restricted stock awards usually are granted subject only to the condition of continued employment. Also, performance shares would not actually be issued until the end of the measurement period during which the performance criteria must be met, while restricted shares generally are issued at the time awards are granted and become unrestricted at the end of the restriction period.
The exercise price of stock options, and the other terms of options and stock awards, are determined by our Board, based on the recommendation of the Corporate Governance Committee, at the time they are granted.
Options covering a total of 6,000 shares have been granted to Mr. Jordan. All of these options were exercisable on December 31, 2012.
Cash Incentive Awards. Our Board first adopted our Management Incentive Compensation Plan during 2007. Under the plan, our executive officers and other employees chosen to participate each year may earn additional cash compensation based on the extent to which:
•
Our pre-tax profits set by the Board (before any deduction for the expense of payments under the plan) exceed a threshold amount; and
•
Other individual goals (which vary for different participants or groups of participants) set by the Board are achieved.
The plan contemplates that each year our Board will set the maximum award each participant may receive for that year (stated as a percentage of his or her base salary). No cash awards are paid unless our pre-tax, pre-incentive profits for that year exceed a minimum amount set by the Board. Subject to the extent to which individual goals set by the Board for each participant are met, the maximum incentive awards may be paid if our pretax, pre-incentive profits reach a higher target level set by the Board.
During April 2009, we became a participant in the U.S. Department of the Treasury’s TARP Capital Purchase Program. Under rules adopted by Treasury under the Emergency Economic Stabilization Act of 2008 that apply to participants in that program, and with limited exceptions, we are prohibited from paying or accruing any bonus, retention award or incentive compensation to our most highly compensated employee. Also, in connection with any bonuses or incentive compensation, we are required to implement provisions to “clawback” payments to our senior executive officers and our next 20 highest paid employees if any of the criteria on which those payments are based is later found to have been inaccurate.
Like most financial institutions, our financial performance has been negatively affected by the economy and by reduced real estate values in our banking markets, and increased levels of non-performing loans, loan charge-offs and provisions to our allowance for loan losses. Our Board chose not to implement the plan in 2012. As a result, none of our officers and employees were eligible to receive any cash awards under the plan, and no such awards were paid in 2012.
Potential Payments Upon Termination of Employment or a Change of Control
The terms of Mr. Jordan’s employment agreement provide for him to receive payments and benefits if his employment is terminated under various circumstances or following a change in control of the Company or the Bank. However, during April 2009, we became a participant in the U.S. Department of the Treasury’s (“Treasury”) TARP Capital Purchase Program (the “CPP”). Under rules adopted by Treasury under the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009, that apply to CPP participants (the “CPP Rules”), we believe we are prohibited from paying severance, “golden parachute,” or other such payments to any of our senior executive officers, or to certain of our other employees, in connection with any termination of their employment for any reason while we remain a CPP participant, other than payments relating to services already performed or benefits already accrued.
In addition to the CPP Rules, the Bank is subject to a Consent Order issued by the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Office of the Commissioner of Banks (the “Commissioner”), effective April 17, 2011. Under the terms of the Consent Order, the Bank may not pay bonuses or any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of the FDIC and the Commissioner.
As a result of the CPP Rules and the terms of the Consent Order, notwithstanding the terms of Mr. Jordan’s employment agreement, we believe that no severance or golden parachute payments would have been made to him by the Bank if his employment had terminated on December 31, 2012.
In the event our participation in the CPP ceases and the Consent Order is lifted or modified, payments to Mr. Jordan under his employment agreement would no longer be prohibited. Under Mr. Jordan’s employment agreement, if his employment is terminated by the Bank without cause, or if he terminates his own employment for “good reason” (as defined below), he will continue to receive salary payments from the Bank for the unexpired term of the agreement. “Good reason” will exist if, without his consent:
•
his base salary is materially reduced;
•
his duties or responsibilities are materially reduced such that he no longer serves as an executive officer;
•
he is required to transfer his offices more than 50 miles from his principal work location; or
•
the Bank materially breaches any of the terms of the agreement.
The Agreement also provides that if, within 24 months following a change in control of the Company or the Bank, Mr. Jordan’s employment is terminated by the Bank or its successor without cause, or a “termination event” (as defined below) occurs and he voluntarily terminates his own employment within 90 days, then, in lieu of other termination payments provided for in the agreement, he will receive a lump-sum payment equal to 2.99 multiplied by his annual base salary in effect at the time the change in control becomes effective or at the time his employment terminates, whichever is greater. A “termination event” will occur under Mr. Jordan’s agreement if, following a change in control of the Company or the Bank:
•
his base salary is reduced below the annual rate in effect at the time of the change in control;
•
insurance or other benefits, including retirement benefits, being provided to him when the change in control becomes effective are reduced or eliminated without being replaced with substantially similar benefits, unless the reduction or elimination applies proportionately to all salaried employees who participated in those benefits before the change in control;
•
he is transferred to a job location more than 50 miles from his principal work location when the change in control becomes effective;
•
if the Bank is still a separate entity, he no longer serves in the position he served in before the change in control; or
•
if the Bank is no longer a separate entity, he is not an executive officer of the Bank’s successor or does not report directly to the successor’s chairman, president, or chief executive officer.
Generally, a “change in control” will have occurred if:
•
a person directly or indirectly acquires voting control over more than 50% of the Company’s or the Bank’s common stock or control over the election of a majority of the Company’s or the Bank’s directors;
•
the Company or the Bank consolidates or merges with or into another company, or are reorganized in another way, and are not the surviving company in the transaction; or
•
all or substantially all of the Company’s or the Bank’s assets are sold or transferred to, or acquired by, any other company.
The employment agreement provides that, notwithstanding the above provisions to the contrary, the Bank will have no obligation to make any payment or take any other action that the Board of Directors believes in good faith would be prohibited by or would violate any provision of state or federal law applicable to the Bank.
For a period of one year following any voluntary or involuntary termination of employment, Mr. Jordan may not compete with the Bank in a county in North Carolina in which the Bank maintains a business office on his employment termination date. However, in the case of an involuntary termination of his employment without case, or a voluntary termination of his employment for good reason (other than following a change in control), the restriction period will be the unexpired term of the agreement during which the Bank is obligated to continue to pay his salary as described above. The agreement also requires that, following any termination of his employment, Mr. Jordan must keep confidential all data and other information, financial or otherwise, relating to the Bank and its business, and must not disclose any of that information to any other person, remove it from the Bank, or use it for his own purposes or for the benefit of any other person.
Life Insurance Benefits. The Bank provides life insurance benefits to each of the named executive officers under our group life insurance plan in which all employees participate on the same terms. Under the group plan, death benefits are payable to a participant’s beneficiaries equal to two times the participant’s annual salary rate at the time of his or her death.
Accelerated Vesting of Stock Options. Under our Omnibus Equity Plan, in the event of a change in control of our company, our Corporate Governance Committee may provide for outstanding stock options and other equity awards under the plan to be assumed by or converted into awards covering shares of the acquiring or surviving company. Alternatively, the Committee may accelerate the vesting of outstanding awards so that they become exercisable in full immediately before the change in control becomes effective.
DIRECTOR COMPENSATION
General
Directors’ Fees. Our non-employee directors serve and are compensated as directors of the Bank. Our and the Bank’s Boards usually meet jointly, and directors do not receive any additional cash compensation for their services as our directors unless our Board meets separately. The following table describes our standard schedule of fees paid to our non-employee directors for their service during 2012.
(1)
This fee is not paid for attendance at meetings by telephone.
Mr. Talbert is compensated as an officer of the Bank, and he receives no additional compensation for his service as a director.
Stock Options. From time to time we have granted options to our non-employee directors to purchase shares of our common stock. As described above under the caption “Plan Based Awards,” during 2007 our shareholders approved our Omnibus Equity Plan which replaced our 1998 Director Stock Option Plan and which authorizes the grant of nonqualified stock options and restricted stock awards to our directors in a manner similar to that described for officers. Each stock option gives the director who holds it the right to buy shares of our common stock during a stated period of time (ordinarily ten years) at a fixed price per share that is equal to the market value of our stock on the date the option was granted. We have not yet granted any restricted stock awards to directors under the plan.
No stock options or other equity awards of any type were granted under the Omnibus Equity Plan to any of our directors during 2012.
Director Compensation for 2012
The following table summarizes the compensation paid or provided to our non-employee directors for their services during 2012. Although he served as a director during 2012, Stephen R. Talbert is not listed in the table. Mr. Talbert was compensated as an officer and employee of the Bank and he received no separate or additional compensation for his service as a director.
2012 DIRECTOR COMPENSATION
(1)
No stock options or other equity awards of any type were granted to any of our non-employee directors during 2012. On December 31, 2012, our non-employee directors held stock options covering the following aggregate numbers of shares: Messrs. Anderson, Bailey, Drye, Googe, Land, McClamrock, Dr. Slate, and Ms. Safrit - 1,500 shares each.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Beneficial Ownership of Securities
Principal Shareholders. The following table lists the only person who we believe owned, beneficially or of record, 5% or more of our outstanding common stock on December 31, 2012. This information is based on a Schedule 13G filed with the Securities and Exchange Commission on February 14, 2007.
(1)
The beneficial owner’s Schedule 13G filed with the Securities and Exchange Commission on February 14, 2007, indicates that, in its capacity as an investment adviser, it has shared voting power and shared investment power with respect to all of the listed shares, which are held of record by its clients.
Directors and Executive Officers. The following table describes the beneficial ownership of our common stock on December 31, 2012, by our current directors and named executive officers, individually, and by all our directors and named executive officers as a group.
(1)
Individuals named and included in the group have shared voting and investment power with respect to certain of the listed shares as follows: Mr. Anderson-12,066 shares; Mr. Bailey-175 shares; Mr. Drye-1,937 shares; Mr. Hill-4,988 shares; Mr. Jordan-1,200 shares; Ms. Safrit- 7,948 shares; Mr. Talbert-18,154 shares; and all persons included in the group-46,468 shares. The listed shares also include the following numbers of shares that could be purchased by individuals named and included in the group pursuant to stock options that could be exercised within 60 days of December 31, 2012 and with respect to which shares they may be deemed to have sole investment power: Mr. Anderson - 1,500 shares; Mr. Bailey-1,500 shares; Mr. Drye-1,500 shares; Mr. Googe-1,500 shares; Mr. Jordan-6,000 shares; Mr. Land-1,500 shares; Mr. McClamrock - 1,500 shares; Ms. Safrit-1,500 shares; Dr. Slate-1,500 shares; and all persons included in the group-18,000 shares. Except as otherwise noted, and to the best of our knowledge, the individuals named and included in the group exercise sole voting and investment power with respect to all remaining listed shares.
(2)
Percentages are calculated based on 3,895,840 total outstanding shares plus, in the case of each named individual and the group, the number of additional shares that could be purchased by that individual or by persons included in the group under stock options that could be exercised within 60 days of December 31, 2012.
(3)
Includes 4,758 shares owned by Mr. Hill’s spouse in her individual capacity. Mr. Hill disclaims beneficial ownership of these shares.
(4)
Includes 3,286 shares owned by Mr. McClamrock’s spouse in her individual capacity.
(5)
Includes 1,323 shares owned by Mr. Talbert’s spouse in her individual capacity.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table summarizes all compensation plans and individual compensation arrangements which were in effect on December 31, 2012, and under which shares of our common stock have been authorized for issuance.
EQUITY COMPENSATION PLAN INFORMATION
(1)
Includes outstanding options to purchase an aggregate of 8,000 shares previously granted under our Employee Stock Option Plan and Director Stock Option Plan and options for 12,000 shares granted under 2007 Omnibus Equity Plan which has replaced those plans.
(2)
Reflects the aggregate number of shares for which options and other equity-based awards could be granted in the future under the 2007 Omnibus Equity Plan. No additional options may be granted under our Employee Stock Option Plan and Director Stock Option Plan.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Related Person Transactions
The Bank has had, and expects to have in the future, banking transactions in the ordinary course of its business with certain of our current directors, nominees for director, executive officers, and our other related persons. All loans included in those transactions were made in the ordinary course of the Bank’s business on substantially the same terms, including interest rates, repayment terms and collateral, as those prevailing at the time the loans were made for comparable transactions with other persons, and those loans did not involve more than the normal risk of collectability or present other unfavorable features.
Director Independence
Each year our Board of Directors reviews transactions, relationships and other arrangements involving our directors and determines which of the directors the Board considers to be “independent.” In making those determinations, the Board applies the independence criteria contained in the listing requirements of The Nasdaq Stock Market. Although the Company’s common stock is no longer listed on The Nasdaq Stock Market, the Board will continue to use Nasdaq’s definition of independence in determining whether or not a director or nominee for director is independent.
The Board has directed our Audit Committee to assess each outside director’s independence and report its findings to the Board in connection with the Board’s annual determinations, and to monitor the status of each director on an ongoing basis and inform the Board of changes in factors or circumstances that may affect a director’s ability to exercise independent judgment. The following table lists our current directors who our Board believes are “independent” directors under Nasdaq’s criteria.
Jerry W. Anderson
John W. Googe
Lynne Scott Safrit
Alan M. Bailey
Henry H. Land
Francis W. Slate
John A. Drye
Grady L. McClamrock, Jr.
In addition to the specific Nasdaq criteria, in determining the independence of each director the Board considers whether it believes transactions that are disclosable in our proxy statements as “related person transactions,” or any other transactions, relationships, arrangements or factors, could impair a director’s ability to exercise independent judgment. In its determination that the directors named above are independent, those other factors considered by the Committee and the Board included (1) the Bank’s lending relationships with directors who are loan customers; (2) services provided to the
Bank by Mr. Googe’s firm in connection with payroll processing and administration services relating to the Bank’s 125 Plan (none of which were provided during 2012), and (3) legal services that Mr. McClamrock provides from time to time in connection with matters involving such things as loan closings or collections. In the case of Mr. McClamrock, the Board concluded that he is independent under Nasdaq’s criteria, but that he may not serve on our Audit Committee.
Item 14.
Item 14. Principal Accountant Fees and Services
Turlington and Company LLP was appointed by our Audit Committee on April 17, 2009, to serve as our independent accountants and audit our consolidated financial statements. Except as described below, under its current procedures our Audit Committee specifically preapproves all audit services and other services provided by our independent accountants. Since it is difficult to determine in advance the exact nature and extent of the tax services or advice we will need during the year, the Committee authorizes our management to obtain tax services from our accountants from time to time during the year up to preapproved aggregate amounts of fees set by the Committee. Requests for services with costs in addition to those amounts would require further Committee approval. The entire Audit Committee generally participates in the preapproval of services. However, in the case of proposals that arise during the year to obtain certain types of non-audit services from our accountants beyond what has been preapproved by the Committee, the Committee delegates authority to its Chairman to preapprove those additional services on behalf of the Committee. Any such action by the Chairman is to be reported to the full Committee at its next regularly scheduled meeting.
As our independent accountants for 2012 and 2011, Turlington and Company LLP provided us with various audit and other professional services for which we were billed, or expect to be billed, for fees as further described below. Our Audit Committee considers whether the provision of non-audit services by our independent accounting firm is compatible with maintaining its independence. The Committee believes that the provision of non-audit services by Turlington and Company LLP during 2012 and 2011 did not affect its independence.
The following table lists the aggregate amounts of fees paid to Turlington and Company LLP for audit services for 2012 and 2011 and for other services they provided during 2012 and 2011.
(1)
Audit-Related Fees for 2012 and 2011 include amounts paid in connection with audits of the Bank’s 401(k) plan.
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)
Financial Statements. The following financial statements are included in Item 8 of this Report:
(b)
Exhibits. An Exhibit Index listing exhibits that are being filed or furnished with, or incorporated by reference into, this Report appears immediately following the signature page and is incorporated herein by reference.
(c)
Financial Statement Schedules. No separate financial statement schedules are being filed as all required schedules either are not applicable or are contained in the financial statements listed above or in Item 8 of this Report.
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, we have caused this Report to be signed on our behalf by the undersigned, thereunto duly authorized.
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on our behalf and in the capacities and on the dates indicated.
EXHIBIT INDEX
*
An asterisk denotes a management contract or compensatory plan or arrangement.
**
Pursuant to Regulation 406T of Regulation S-T, these interactive data files are furnished and not filed or part of a registration statement or prospectus for purposes of section 11 or 12 of the Securities Act of 1933, as amended, or section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.
COPIES OF EXHIBITS ARE AVAILABLE UPON REQUEST TO:
MEGAN W. PATTON
VICE PRESIDENT AND PRINCIPAL FINANCIAL OFFICER
BANK OF THE CAROLINAS
P.O. BOX 129
MOCKSVILLE, N.C. 27028
This Annual Report on Form 10-K also serves as the annual disclosure statement
of Bank of the Carolinas pursuant to Part 350 of the
Federal Deposit Insurance Corporation’s Rules and Regulations.
THIS STATEMENT HAS NOT BEEN REVIEWED OR CONFIRMED FOR ACCURACY OR
RELEVANCE BY THE FEDERAL DEPOSIT INSURANCE CORPORATION.