ITEM 1. BUSINESS
Royal Bancshares of Pennsylvania, Inc.
Royal Bancshares of Pennsylvania, Inc. (the “Company”), is a Pennsylvania business corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the “Holding Company Act”). The Company is supervised by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). The Company’s legal headquarters are located at 732 Montgomery Avenue, Narberth, Pennsylvania, 19072. On December 30, 2010, the Company completed the sale of all of the outstanding common stock of Royal Asian Bank (“Royal Asian”), a wholly-owned banking subsidiary of the Company, to an ownership group led by the President and Chief Executive Officer of Royal Asian.
The principal activities of the Company are supervising Royal Bank America (“Royal Bank”) which engages in general banking business principally in Montgomery, Delaware, Chester, Bucks, Philadelphia and Berks counties in Pennsylvania, southern New Jersey, and Delaware. The Company also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities. On November 21, 2007, the Company established Royal Captive Insurance Company, a wholly owned subsidiary. Royal Captive Insurance was formed to insure commercial property and provide comprehensive umbrella liability coverage for the Company and its affiliates. During the fourth quarter of 2010, Royal Captive Insurance was dissolved. The investments were sold for a gain of approximately $8,000, $2.0 million was paid to the Company as a dividend, and the remaining funds, in the approximate amount of $500,000, were transferred to the Company.
At December 31, 2012, the Company had consolidated total assets of approximately $773.7 million, total deposits of approximately $554.9 million and shareholders’ equity of approximately $58.4 million. The Company’s two Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II, are not consolidated per requirements under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation” (“ASC Topic 810”). The Company has two reportable operating segments, “Community Banking” and “Tax Liens”. After announcing the retirements of the Company’s Chief Executive Officer (“CEO”) and President during the second quarter of 2012, the Company’s Board conducted an executive search for a candidate for the combined role of President and CEO. On December 18, 2012 the Company announced F. Kevin Tylus as President and CEO of Royal Bank. On February 20, 2013, the Company announced that Mr. Tylus was appointed President, CEO and a Class III member of the board of directors of the Company. Former CEO, Robert Tabas, remains as Chairman of the Board of Directors.
Regulatory Actions
FDIC and Department of Banking Orders
On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the Federal Deposit Insurance Corporation (“FDIC”) and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”). Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%. At December 31, 2012, based on capital levels calculated under regulatory accounting purposes (“RAP”), Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 8.53% and 16.1%, respectively.
Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders. Management has reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and maintained capital ratios above the required minimums which were all factors that contributed to replacing the Orders with the MOU. Management has continued to improve in each of these areas since the Orders were replaced with the MOU.
Federal Reserve Agreement
On March 17, 2010, the Company agreed to enter into a written agreement (“the Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Reserve Bank”). The material terms of the Federal Reserve Agreement provide that: (i) the Company’s board of directors will take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to its subsidiary banks; (ii) the Company’s board of directors will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank a written plan to strengthen board oversight of the management and operations of the consolidated operation; (iii) the Company will not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (iv) the Company and its non-bank subsidiaries will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (v) the Company and its nonbank subsidiaries will not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Reserve Bank; (vi) the Company will not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank; (vii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank an acceptable written capital plan to maintain sufficient capital at the Company on a consolidated basis, which plan will at a minimum address: regulatory requirements for the Company and Royal Bank, the adequacy of Royal Bank’s capital taking into account the volume of classified credits, the allowance for loan and lease losses, current and projected asset growth, and projected retained earnings; the source and timing of additional funds necessary to fulfill the consolidated organization’s and Royal Bank’s future capital requirements; supervisory requests for additional capital at Royal Bank or the requirements of any supervisory action imposed on Royal Bank by federal or state regulators; and applicable legal requirements that the Company serve as a source of strength to Royal Bank; (viii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank cash flow projections for 2010 showing planned sources and uses of cash for debt service, operating expenses, and other purposes, and will submit similar cash flow projections for each subsequent calendar year at least one month prior to the beginning of such year; (ix) the Company will comply with applicable legal notice provisions in advance of appointing any new director or senior executive officer or changing the responsibilities of any senior executive officer such that the officer would assume a different senior executive officer position, and comply with restrictions on indemnification and severance payments imposed by the Federal Deposit Insurance Act; and (x) the Company’s board of directors will, within 45 days after the end of each quarter, submit progress reports to the Reserve Bank detailing the form and manner of all actions taken to secure compliance with the Agreement and the results thereof, together with a parent company-level balance sheet, income statement, and, as applicable, report of changes in shareholders’ equity.
The Federal Reserve Agreement will remain in effect and enforceable until stayed, modified, terminated or suspended by the Reserve Bank. The Company has submitted all progress reports and responses required under the Federal Reserve Agreement as of the date of this Report.
Royal Bank America
Royal Bank was incorporated in the Commonwealth of Pennsylvania on July 30, 1963, was chartered by the Department and commenced operation as a Pennsylvania state-chartered bank on October 22, 1963. Royal Bank is the successor of the Bank of King of Prussia, the principal ownership of which was acquired by the Tabas family in 1980. The deposits of Royal Bank are insured by the FDIC. On October 17, 2008, Royal Bank established RBA Property LLC, a wholly owned subsidiary. RBA Property was formed to hold other real estate owned acquired through foreclosure of collateral associated with non-performing loans. On December 1, 2008, Royal Bank established Narberth Property Acquisition LLC, a wholly owned subsidiary. Narberth Property Acquisition was formed to hold other real estate owned acquired through foreclosure of collateral associated with non-performing loans. On November 4, 2009, Royal Bank established Rio Marina LLC, a wholly owned subsidiary. Rio Marina LLC was formed to hold other real estate owned acquired through foreclosure of collateral associated with non-performing loans. Royal Bank also holds a 60% equity interest in each of Crusader Servicing Corporation (“CSC”) and Royal Tax Lien Services, LLC (“RTL”). CSC and RTL acquired, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders.
Royal Bank derives its income principally from interest charged on loans, interest earned on investment securities, and fees received in connection with the origination of loans and other services. Royal Bank’s principal expenses are interest expense on deposits and borrowings and operating expenses. Operating revenues, deposit growth, investment maturities, loan sales and the repayment of outstanding loans provide the majority of funds for activities.
Royal Bank conducts business operations as a commercial bank offering checking accounts, savings and time deposits, and loans, including residential mortgages, home equity and SBA loans. Royal Bank also offers safe deposit boxes, collections, internet banking and bill payment along with other customary bank services (excluding trust) to its customers. Drive-up, ATM, and night depository facilities are available. Services may be added or deleted from time to time. Royal Bank’s business and services are not subject to significant seasonal fluctuations. Royal Bank is a member of the Federal Reserve FedLine Wire Transfer System.
Service Area: Royal Bank’s primary service area includes Pennsylvania, primarily Montgomery, Chester, Bucks, Delaware, Berks and Philadelphia counties, and Camden County, New Jersey. This area includes residential areas and industrial and commercial businesses of the type usually found within a major metropolitan area. Royal Bank serves this area from fifteen branches located throughout Montgomery, Philadelphia, Delaware and Berks counties and Camden County, New Jersey. Royal Bank also considers New York, Maryland, and Delaware as a part of its service area for certain products and services. In the past, Royal Bank had frequently conducted business with clients located outside of its service area. Royal Bank has loans in twenty-two states via loan originations and/or participations with other lenders who have broad experience in those respective markets. Royal Bank’s headquarters are located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072.
Competition: The financial services industry in our service area is extremely competitive. Competitors within our service area include banks and bank holding companies with greater resources. Many competitors have substantially higher legal lending limits. In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, brokerage firms, mortgage companies, leasing companies, finance companies and other financial services companies offer products and services similar to those offered by Royal Bank, on competitive terms.
Many bank holding companies have elected to become financial holding companies under the Gramm-Leach-Bliley Act of 1999, which give a broader range of products with which Royal Bank must compete. Management believes this statute further narrowed the differences and intensified competition among commercial banks, investment banks, insurance firms and other financial services companies. The Company has not elected financial holding company status.
Employees: Royal Bank employed approximately 152 persons on a full-time equivalent basis as of December 31, 2012.
Deposits: At December 31, 2012, total deposits of Royal Bank were distributed among demand deposits (11%), money market deposit, savings and NOW accounts (43%) and time deposits (46%). At year-end 2012, deposits decreased $21.2 million to $561.0 million, from year-end 2011, or 3.6%. Demand deposits and savings accounts increased $3.8 million and $1.2 million, respectively. NOW and money market accounts decreased $2.7 million while time deposits decreased $23.5 million primarily due to the intentional run-off of maturing CDs. Included in Royal Bank’s deposits are approximately $6.1 million of intercompany deposits that are eliminated through consolidation.
Current market and regulatory trends in banking are changing the basic nature of the banking industry. Royal Bank intends to keep pace with the banking industry by being competitive with respect to interest rates and new types or classes of deposits insofar as it is practical to do so consistent with Royal Bank’s size, objective of profit maintenance and stable capital structure.
Lending: At December 31, 2012, Royal Bank had a total net loan portfolio of $326.9 million, representing 42% of total assets. The loan portfolio is categorized into commercial demand, commercial mortgages, residential mortgages (including home equity lines of credit), construction, real estate tax liens, asset based loans, small business leases and installment loans. At year-end 2012, net loans decreased $71.0 million from year end 2011.
Royal Asian Bank
Royal Asian was incorporated in the Commonwealth of Pennsylvania on October 4, 2005, and was chartered by the Commonwealth of Pennsylvania Department of Banking and commenced operation as a Pennsylvania state-chartered bank on July 17, 2006. Royal Asian was an insured bank by the FDIC. Royal Asian derived its income principally from interest charged on loans and fees received in connection with other services. Royal Asian’s principal expenses were interest expense on deposits and operating expenses. Operating revenues, deposit growth, and the repayment of outstanding loans provided the majority of funds for activities. The sale of all of the outstanding common stock of Royal Asian owned by the Company was completed on December 30, 2010.
Non-Bank Subsidiaries
On June 30, 1995, the Company established a special purpose Delaware investment company, Royal Investment of Delaware (“RID”), as a wholly owned subsidiary. RID’s legal headquarters is 1105 N. Market Street, Suite 1300, Wilmington, Delaware 19899. RID buys, holds and sells investment securities. At December 31, 2012, total assets of RID were $29.0 million, of which $1.6 million was held in cash and cash equivalents and $2.9 million was held in investment securities. RID had net interest income of $665,000 and $673,000 for 2012 and 2011, respectively. Non-interest income for 2012 was a loss of $1.7 million and included other-than-temporary impairment (“OTTI”) on investment securities of $2.4 million which was partially offset by gains on sale of investment securities of $654,000. Non-interest income for 2011 was $619,000. RID recorded a net loss for 2012 of $1.0 million compared to net income of $1.3 million in 2011. Royal Bank has previously extended loans to RID, secured by securities and as per the provisions of Regulation W. At December 31, 2012 no loans were outstanding. During the third quarter of 2010, RID paid a $2.5 million dividend to Royal Bancshares. The amounts above include the activity related to RID’s wholly owned subsidiary Royal Preferred LLC.
The Company, through its wholly owned subsidiary Royal Bank, holds a 60% ownership interest in CSC. CSC’s legal headquarters is located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072. CSC acquired, through auction, delinquent property tax liens in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens on the property, and obtaining certain foreclosure rights as defined by local statute. Due to a change in CSC management, Royal Bank and other shareholders, constituting a majority of CSC shareholders, voted to liquidate CSC under an orderly, long term plan adopted by CSC management. At December 31, 2012, total assets of CSC were $6.7 million. Included in total assets is $601,000 for the Strategic Municipal Investments (“SMI”) portfolio, which is comprised of residential, commercial, and land tax liens, primarily in Alabama. In 2005, the Company entered into a partnership with SMI, ultimately acquiring a 50% ownership interest in SMI. In connection with acquiring this ownership interest, CSC extended an $18 million line of credit to SMI, which was used by SMI to purchase tax lien portfolios at a discount. As a result of the deterioration in residential, commercial and land values principally in Alabama, management concluded that the loan was impaired based on an analysis of the portfolio in the fourth quarter of 2008. Through 2011, CSC charged-off $3.6 million related to this loan. Additional charge-offs of $171,000 related to SMI were recorded in 2012. The outstanding SMI loan balance was $601,000 at December 31, 2012. In 2012, CSC’s net interest income declined $179,000 from $253,000 for 2011 to $74,000 due to the continued liquidation of the portfolio. The 2012 provision for lien losses was $236,000 compared to $619,000 for 2011. The provision is mainly related to the SMI impairments mentioned above. For 2012 and 2011 other income was $86,000 and $289,000, respectively. Other income is mostly comprised of gain on sale of other real estate owned (“OREO”) properties. Other expense was $2.9 million and $285,000 for 2012 and 2011, respectively. The $2.6 million increase in other expense was principally driven by a $2.0 million fine assessed by the United States Department of Justice (“DOJ”) related to its investigation. Please read “Item 3 Legal Proceedings” of this Form 10-K for additional information regarding the DOJ investigation. CSC recorded a net loss of $3.0 million in 2012 compared to $361,000 in 2011. The 2012 loss was impacted by the $2.0 million fine and OREO impairment of $495,000.
On June 23, 2003, the Company, through its wholly owned subsidiary Royal Bank, established Royal Investments America, LLC (“RIA”) as a wholly owned subsidiary. RIA’s legal headquarters is located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072. RIA was formed to invest in equity real estate ventures subject to limitations imposed by regulation. At December 31, 2012, total assets of RIA were $5.9 million, which included $5.3 million in cash. For 2012, RIA had net income of $69,000 as compared to $1.9 million for 2011. The $1.8 million decline in net income was related to a decrease in income related to equity investments in real estate as a result of substantial completion of the project in 2011.
On October 27, 2004, the Company formed two Delaware trust affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II, in connection with the sale of an aggregate of $25.0 million of trust preferred securities.
On July 25, 2005, the Company, through its wholly owned subsidiary Royal Bank, formed Royal Bank America Leasing, LP (“Royal Leasing”). Royal Bank holds a 60% ownership interest in Royal Leasing. Royal Leasing’s legal headquarters is located at 550 Township Line Road, Blue Bell, Pennsylvania 19422. Royal Leasing was formed to originate small business leases. Royal Leasing originates small ticket leases through its internal sales staff and through independent brokers located throughout its business area. In general, Royal Leasing will portfolio individual small ticket leases in amounts of up to $250,000. Leases originated in amounts in excess of that are sold for a profit to other leasing companies. These purchases are at market based on pricing and terms that Royal Leasing would expect to receive from unrelated third-parties. From time to time Royal Leasing will sell small lease portfolios to third-parties and will, on occasion, purchase lease portfolios from other originators. During 2012 and 2011, neither sales nor purchases of lease portfolios were material. At December 31, 2012, total assets of Royal Leasing were $37.1 million. For 2012, Royal Leasing had net interest income of $2.2 million compared to $2.3 million for 2011. For 2012 provision for lease losses was $230,000 compared to $504,000 for 2011. The decrease in the provision was primarily related to improvement in the credit quality of the leasing portfolio year over year. Other income for 2012 was $574,000 compared to $558,000 for 2011. Other expense was $1.2 million and $1.0 million for 2012 and 2011, respectively. The increase in other expense was related to an increase of $125,000 in distribution of management fees. Royal Leasing recorded net income of $474,000 for the year ended December 31, 2012 compared to a $479,000 for the year ended December 31, 2011.
On November 17, 2006, the Company, through its wholly owned subsidiary Royal Bank, formed RTL. Royal Bank holds a 60% ownership interest in RTL. Its legal headquarters is located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072. RTL was formed to purchase and service delinquent tax certificates. RTL typically acquires delinquent property tax liens through public auctions in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens that are on the property, and obtaining certain foreclosure rights as defined by local statute. At December 31, 2012, total assets of RTL of which the majority was held in tax liens were $30.6 million compared to $61.8 million at December 31, 2011. Tax certificates declined $22.6 million from $44.5 million at December 31, 2011 to $21.9 million at December 31, 2012. For 2012, RTL had net interest income of $2.3 million compared to $4.8 million for 2011 due to the reduction in average tax liens outstanding for RTL over the past year. Provision for lien losses was $584,000 compared to $464,000 for 2012 and 2011, respectively. Other expense was $2.3 million and $1.2 million for 2012 and 2011, respectively. The $1.1 million increase in other expense was mostly related to an increase of $676,000 in legal fees. Net income for 2012 declined $1.9 million from $2.0 million for 2011 to $44,000 for 2012.
On November 21, 2007, the Company established Royal Captive Insurance Company, a wholly owned subsidiary. Royal Captive Insurance was formed to insure commercial property and comprehensive umbrella liability for the Company and its affiliates. During the fourth quarter of 2010, Royal Captive Insurance was dissolved. The investments were sold for a gain of approximately $8,000, $2.0 million was paid to the Company as a dividend, and the remaining funds, in the approximate amount of $500,000, were transferred to the Company.
On June 16, 2006, the Company, through its wholly owned subsidiary RID, established Royal Preferred LLC as a wholly owned subsidiary. Royal Preferred LLC was formed to purchase a subordinated debenture from Royal Bank. At December 31, 2012, Royal Preferred LLC had total assets of approximately $21.8 million.
Website Access to Company Reports
We post publicly available reports required to be filed with the SEC on our website, www.royalbankamerica.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website. Information available on our website is not part or incorporated by reference into this Report or any other report filed by this Company with the SEC.
Products and Services with Reputation Risk
The Company offers a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies become dissatisfied or object to any product or service offered by the Company or any of its subsidiaries, whether legally justified or not, the resulting negative publicity with respect to any such product or service could have a negative impact on the Company’s reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on the Company’s reputation.
Future Acquisitions
The Company’s acquisition strategy consists of identifying financial institutions, insurance agencies and other financial companies with business philosophies that are similar to our business philosophies, which operate in strong markets that are geographically compatible with our operations, and which can be acquired at an acceptable cost. In evaluating acquisition opportunities, we generally consider potential revenue enhancements and operating efficiencies, asset quality, interest rate risk, and management capabilities. The Company currently has no formal commitments with respect to future acquisitions.
Concentrations, Seasonality
The Company does not have any portion of its business dependent on a single or limited number of customers, the loss of which would have a material adverse effect on its business. No substantial portion of loans or investments is concentrated within a single industry or group of related industries, except a significant majority of loans are secured by real estate. The Company has seen a deterioration in economic conditions as it pertains to real estate loans. Commercial real estate, commercial loans, and construction and land loans represent 52%, 22%, and 19%, respectively, of the total $23.0 million in non-accrual loans at December 31, 2012. The business of the Company and its subsidiaries is not seasonal in nature.
Environmental Compliance
The Company and its subsidiaries’ compliance with federal, state and local environment protection laws had no material effect on capital expenditures, earnings or their competitive position in 2012, and are not expected to have a material effect on such expenditures, earnings or competitive position in 2013.
Supervision and Regulation
Bank holding companies and banks operate in a highly regulated environment and are regularly examined by federal and state regulatory authorities. The following discussion concerns various federal and state laws and regulations and the potential impact of such laws and regulation on the Company and its subsidiaries. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. The Company cannot determine the likelihood or timing of any such proposals or legislations or the impact they may have on the Company and its subsidiaries. A change in law, regulations or regulatory policy may have a material effect on the Company’s business.
Holding Company
The Company, as a Pennsylvania business corporation, is subject to the jurisdiction of the Securities and Exchange Commission (the “SEC”) and of state securities commissions for matters relating to the offering and sale of its securities. Accordingly, if the Company wishes to issue additional shares of its Common Stock, in order, for example, to raise capital or to grant stock options, the Company will have to comply with the registration requirements of the Securities Act of 1933 as amended, or find an applicable exemption from registration.
The Company is subject to the provisions of the Holding Company Act, and to supervision, regulation and examination by the Federal Reserve Board. The Holding Company Act requires the Company to secure the prior approval of the Federal Reserve Board before it owns or controls, directly or indirectly, more than 5% of the voting shares of any corporation, including another bank.
A bank holding company also is prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any such company engaged in non-banking activities unless the Federal Reserve Board, by order or regulation, has found such activities to be closely related to banking or managing or controlling banks as to be a proper incident thereto. In making this determination, the Federal Reserve Board considers whether the performance of these activities by a bank holding company would offer benefits to the public that outweigh possible adverse effects.
As a bank holding company, the Company is required to file an annual report with the Federal Reserve Board and any additional information that the Federal Reserve Board may require pursuant to the Holding Company Act. The Federal Reserve Board may also make examinations of the Holding Company and any or all of its subsidiaries. Further, under the Holding Company Act and the Federal Reserve Board’s regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit or provision of credit of any property or services. The so called “anti-tying” provisions state generally that a bank may not extend credit, lease, sell property or furnish any service to a customer on the condition that the customer obtain additional credit or service from the banks, its bank holding company or any other subsidiary of its bank holding company, or on the condition that the customer not obtain other credit or services from a competitor of the banks, its bank holding company or any subsidiary of its bank holding company.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act and by state banking laws on any extensions of credit to the bank holding company or any of the holding company’s subsidiaries, on investments in the stock or other securities of the bank holding company and on taking of such stock or securities as collateral for loans to any borrower.
Under the Pennsylvania Banking Code of 1965, as amended, the (“Code”), the Company is permitted to control an unlimited number of banks. However, the Company would be required under the Holding Company Act to obtain the prior approval of the Federal Reserve Board before it could acquire all or substantially all of the assets of any bank, or acquiring ownership or control of any voting shares of any bank other than Royal Bank, if, after such acquisition, the registrant would own or control more than 5% of the voting shares of such bank.
A bank holding company located in Pennsylvania, another state, the District of Columbia or a territory or possession of the United States may control one or more banks, bank and trust companies, national banks, interstate banks and, with the prior written approval of the Department, may acquire control of a bank and trust company or a national bank located in Pennsylvania. A Pennsylvania-chartered institution may maintain a bank, branches in any other state, the District of Columbia, or a territory or possession of the United States upon the written approval of the Department.
Federal law also prohibits the acquisition of control of a bank holding company without prior notice to certain federal bank regulators. Control is defined for this purpose as the power, directly or indirectly, to direct the management or policies of a bank or bank holding company or to vote 25% or more of any class of voting securities of a bank or bank holding company.
Royal Bank
Royal Bank is subject to supervision, regulation and examination by the Department and by the FDIC. As previously mentioned under “Regulatory Actions”, in December 2011, the FDIC and the Department replaced the Orders to which Royal Bank was subject with a memorandum of understanding. The deposits of Royal Bank are insured by the FDIC. In addition, Royal Bank is subject to a variety of local, state and federal laws that affect its operation.
The Department and the FDIC routinely examine Pennsylvania state-chartered, non-member banks such as Royal Bank in areas such as reserves, loans, investments, management practices and other aspects of operations. These examinations are designed for the protection of depositors rather than the Company’s shareholders.
Federal and state banking laws and regulations govern, among other things, the scope of a bank’s business, the investments a bank may make, the reserves against deposits a bank must maintain, the types and terms of loans a bank may make and the collateral it may take, the activities of banks with respect to mergers and consolidations, and the establishment of branches. Pennsylvania law permits statewide branching.
Under the Federal Deposit Insurance Act (“FDIC Act”), the FDIC possesses the power to prohibit institutions regulated by it (such as Royal Bank) from engaging in any activity that would be an unsafe and unsound banking practice or in violation of applicable law. Moreover, the FDIC Act: (i) empowers the FDIC to issue cease-and-desist or civil money penalty orders against Royal Bank or its executive officers, directors and/or principal shareholders based on violations of law or unsafe and unsound banking practices; (ii) authorizes the FDIC to remove executive officers who have participated in such violations or unsound practices; (iii) restricts lending by Royal Bank to its executive officers, directors, principal shareholders or related interests thereof; and (iv) restricts management personnel of a bank from serving as directors or in other management positions with certain depository institutions whose assets exceed a specified amount or which have an office within a specified geographic area. Additionally, the FDIC Act provides that no person may acquire control of Royal Bank unless the FDIC has been given 60-days prior written notice and within that time has not disapproved the acquisition or extended the period for disapproval.
Under the Community Reinvestment Act (“CRA”), the FDIC uses a five-point rating scale to assign a numerical score for a bank’s performance in each of three areas: lending, service and investment. Under the CRA, the FDIC is required to: (i) assess the records of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community (including low-and moderate-income neighborhoods) which they serve, and (ii) take this record into account in its evaluation of any application made by any such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of another bank. The CRA also requires the federal banking agencies to make public disclosures of their evaluation of each bank’s record of meeting the credit needs of its entire community, including low-and moderate-income neighborhoods. This evaluation will include a descriptive rate (“outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance”) and a statement describing the basis for the rating.
A subsidiary bank of a holding company is subject to certain restrictions imposed by the Federal Reserve Act, as amended, on any extensions of credit to the bank holding company or its subsidiaries, on investments in the stock or other securities of the bank holding company or its subsidiaries, and on taking such stock or securities as collateral for loans. The Federal Reserve Act, as amended and Federal Reserve Board regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person who becomes a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship.
From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of Royal Bank. It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of Royal Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, Royal Bank’s business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business.
Under the Bank Secrecy Act (“BSA”), banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions in any one day of which the banks are aware that exceed $10,000 in the aggregate. Civil and criminal penalties are provided under the BSA for failure to file a required report, for failure to supply information required by the BSA or for filing a false or fraudulent report.
Federal Deposit Insurance Corporation Improvement Act of 1991
General: The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDIC Improvement Act”) includes several provisions that have a direct impact on Royal Bank. The most significant of these provisions are discussed below.
The FDIC is required to conduct periodic full-scope, on-site examinations of Royal Bank. In order to minimize losses to the deposit insurance funds, the FDIC Improvement Act establishes a format to monitor FDIC-insured institutions and to enable “prompt corrective action” by the appropriate federal supervisory agency if an institution begins to experience any difficulty. The FDIC Improvement Act establishes five “capital” categories. They are: (1) well capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. The overall goal of these capital measures is to impose scrutiny and operational restrictions on banks as they descend the capital categories from well capitalized to critically undercapitalized.
Under current regulations, a “well-capitalized” institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio, a 5% Tier 1 Leverage Ratio, and is not subject to any written order or final directive by the FDIC to meet and maintain a specific capital level. Under the informal agreement as described in “Regulatory Action” under “Item 1 - Business” of this Report, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12% during the term of the informal agreement. Royal Bank has met all of the capital ratio requirements under the informal agreement.
An “adequately capitalized” institution is one that meets the required minimum capital levels, but does not meet the definition of a “well-capitalized” institution. The existing capital rules generally require banks to maintain a Tier 1 Leverage Ratio of at least 4% and an 8% total risk-based capital ratio. Since the risk-based capital requirement is measured in the form of Tier 1 capital, this also will mean that a bank would need to maintain at least 4% Tier 1 risk-based capital ratio. An institution must meet each of the required minimum capital levels in order to be deemed “adequately capitalized.”
An “undercapitalized” institution is one that fails to meet one or more of the required minimum capital levels for an “adequately capitalized” institution. Under the FDIC Improvement Act, an “undercapitalized” institution must file a capital restoration plan and is automatically subject to restrictions on dividends, management fees and asset growth. In addition, the institution is prohibited from making acquisitions, opening new branches or engaging in new lines of business without the prior approval of its primary federal regulator. A number of other restrictions may be imposed.
A “critically undercapitalized” institution is one that has a tangible equity (Tier 1 capital) ratio of 2% or less. In addition to the same restrictions and prohibitions that apply to “undercapitalized” and “significantly undercapitalized” institutions, any institution that becomes “critically undercapitalized” is prohibited from taking the following actions without the prior written approval of its primary federal supervisory agency: engaging in any material transactions other than in the usual course of business; extending credit for highly leveraged transactions; amending its charter or bylaws; making any material changes in accounting methods; engaging in certain transactions with affiliates; paying excessive compensation or bonuses; and paying interest on liabilities exceeding the prevailing rates in the institution’s market area. In addition, a “critically undercapitalized” institution is prohibited from paying interest or principal on its subordinated debt and is subject to being placed in conservatorship or receivership if its tangible equity capital level is not increased within certain mandated time frames.
Truth in Savings Act: The FDIC Improvement Act also contains the Truth in Savings Act. The purpose of this Act is to require the clear and uniform disclosure of the rates of interest that are payable on deposit accounts by Royal Bank and the fees that are assessable against deposit accounts, so that consumers can make a meaningful comparison between the competing claims of banks with regard to deposit accounts and products. This Act requires Royal Bank to include, in a clear and conspicuous manner, the following information with each periodic statement of a deposit account: (1) the annual percentage yield earned; (2) the amount of interest earned; (3) the amount of any fees and charges imposed; and (4) the number of days in the reporting period. This Act allows for civil lawsuits to be initiated by customers if Royal Bank violates any provision or regulation under this Act.
Real Estate Lending Guidelines: Pursuant to the FDIC Improvement Act, the FDIC has issued real estate lending guidelines that establish loan-to-value (“LTV”) ratios for different types of real estate loans. A LTV ratio is generally defined as the total loan amount divided by the appraised value of the property at the time the loan is originated. If a bank does not hold a first lien position, the total loan amount would be combined with the amount of all senior liens when calculating the ratio. In addition to establishing the LTV ratios, the FDIC’s real estate guidelines require all real estate loans to be based upon proper loan documentation and a recent independent appraisal of the property.
The FDIC’s guidelines establish the following limits for LTV ratios:
The guidelines provide exceptions to the LTV ratios for government-backed loans; loans facilitating the sale of real estate acquired by the lending institution in the normal course of business; loans where Royal Bank’s decision to lend is not based on the offer of real estate as collateral and such collateral is taken only out of an abundance of caution; and loans renewed, refinanced, or restructured by the original lender to the same borrower, without the advancement of new money. The regulation also allows institutions to make a limited amount of real estate loans that do not conform to the proposed LTV ratios. Under this exception, Royal Bank would be allowed to make real estate loans that do not conform to the LTV ratio limits, up to an amount not to exceed 100% of their total capital.
Basel III and Capital Requirements
The Basel Committee on Banking Supervision and the Financial Stability Board (“Basel Committee”), which was established by the Group of 20 (“G-20”) Finance Ministers and Central Bank Governors to take action to strengthen regulation and supervision of the financial system with greater international consistency, cooperation and transparency, have both committed to raise capital standards and liquidity buffers within the banking system. In December 2010 and January 2011, the Basel Committee published the final reforms on capital and liquidity generally referred to as “Basel III”. Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by United States banking regulators in developing new regulations applicable to other banks in the United States, including Royal Bank.
When fully phased in on January 1, 2019, Basel III requires banks to maintain the following new standards and introduces a new capital measure “Common Equity Tier 1”, or “CET1”. Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity. For all banks in the United States, among the most significant provisions of Basel III concerning capital are the following:
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A minimum ratio of CET1 to risk-weighted assets reaching 4.5%, plus an additional 2.5% as a capital conservation buffer.
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A minimum ratio of Tier 1 capital to risk-weighted assets reaching 6.0% plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%.
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A minimum ratio of total capital to risk-weighted assets of 8.00%, plus the additional 2.5% capital conservation buffer, reaching 10.5% by 2019 after a phase -in period.
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For capital instruments issued on or after January 13, 2013 (other than common equity), a loss-absorbency requirement such that the instrument must be written off or converted to common equity if a trigger event occurs, either pursuant to applicable law or at the direction of the banking regulator. A trigger event is an event under which the banking entity would become nonviable without the write-off or conversion, or without an injection of capital from the public sector. The issuer must maintain authorization to issue the requisite shares of common equity if conversion were required. This principle increases the contribution from the private sector to resolve future banking crises.
The Basel III provisions on liquidity include complex criteria establishing a liquidity coverage ratio (“LCR”) and a net stable funding ratio (“NSFR”). The purpose of the LCR is to ensure that a bank maintains adequate unencumbered, high quality liquid assets to meet its liquidity needs for 30 days under a severe liquidity stress scenario. The purpose of the NSFR is to promote more medium and long-term funding of assets and activities, using a one-year horizon. Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by United States banking regulators.
In June 2012, the federal bank regulatory agencies issued three notice of proposed rulemakings (“NPRs”) that would revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with Basel III and certain provisions of the Dodd-Frank Act. One NPR (the “Basel NPR”) proposes the majority of the reforms covered in Basel III. Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as Tier 1 capital would be phased out over a ten-year period. The proposed rules also required unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The Basel NPR proposes limiting a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of CET1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The Basel NPR would also revise the “prompt corrective action” regulations described above by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III proposal does not change the total risk-based capital requirement for any category.
Another NPR (the “Standardization Approach NPR”) proposes new methodologies for computing risk-weighted assets to enhance risk sensitivity. The Standardization Approach NPR would also increase the required capital for certain categories of assets, including higher-risk residential mortgages, higher-risk construction real estate loans and certain exposures related to securitizations. Both the Basel NPR and the Standardization Approach NPR would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies. The third NPR, the Advanced Approaches NPR, does not apply to the Company or Royal Bank because consolidated total assets are less than $250 billion.
In November 2012, the federal banking agencies stated that the new capital rules that would have taken effect on January 1, 2013 have been delayed due to volume of comments received on the NPRs. Management believes that, as of December 31, 2012, the Company and Royal Bank would meet all capital adequacy requirements under the proposed rules on a fully phased-in basis if such requirements were currently effective. There can be no guarantee that the rule proposals will be adopted in their current form, what changes may be made before adoption, or when ultimate adoption will occur. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s results of operations.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was enacted into law. The Dodd-Frank Act significantly changes regulation of financial institutions and the financial services industry, including: creating a Financial Services Oversight Council to identify emerging systemic risks and improve interagency cooperation; centralizing the responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, which will be responsible for implementing, examining and enforcing compliance with federal consumer financial laws; permanently raising the current standard maximum deposit insurance amount to $250,000; establishing strengthened capital standards for banks, and disallowing trust preferred securities as qualifying as Tier 1 capital (subject to certain exceptions and grandfather provisions for existing trust preferred securities); amending the Truth in Lending Act with respect to mortgage originations and establishing new minimum mortgage underwriting standards; strengthening the SEC’s powers to regulate securities markets; granting the Federal Reserve Board the power to regulate debit card interchange fees; allowing the FDIC to raise the ratio of reserves to deposits from 1.15% to 1.35% for deposit insurance purposes by September 30, 2020 and to offset the effect of increased assessments on insured depository institutions with assets of less than $10 billion; allowing financial institutions to pay interest on business checking accounts; and implementing provisions that affect corporate governance and executive compensation at all publicly traded companies.
It is difficult to predict at this time the specific impact the Dodd-Frank Act and the yet to be written implementing rules and regulations will have on community banks. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is presently unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.
FDIC Insurance Assessments
Royal Bank is a member of the FDIC. The FDIC assigns each depository institution to one of several supervisory groups based on both capital adequacy and the FDIC's judgment of the institution's strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to measuring the risk posed by the institution. The temporary unlimited coverage for non-interest bearing deposit accounts provided under the Dodd Frank Act expired on December 31, 2012. Each depositor is insured to at least $250,000.
Beginning with the second quarter of 2011, the Dodd-Frank Act, changed the assessment base used to calculate insurance premiums. Instead of deposits the assessment base is a bank’s average assets minus average tangible equity. As the asset base of the banking industry is larger than the deposit base, the range of base assessment rates is lower; however, the dollar amount of the actual premiums is expected to be roughly the same. The FDIC is required under the Dodd-Frank Act to establish assessment rates that will allow the Deposit Insurance Fund to achieve a reserve ratio of 1.35% of Insurance Fund insured deposits by September 2020. In attempting to achieve the mandated 1.35% ratio, the FDIC implemented assessment formulas that charge banks over $10 billion in asset size more than banks under that size. Those new formulas do not affect Royal Bank. Under the Dodd-Frank Act, the FDIC is authorized to make reimbursements from the insurance fund to banks if the reserve ratio exceeds 1.50%, but the FDIC has adopted the “designated reserve ratio” of 2.0%. In lieu of reimbursements, the FDIC has set lower base assessment rates if the reserve ratio for the prior assessment period is equal to or exceeds 2.0%.
In addition to deposit insurance, Royal Bank is also subject to assessments to pay the interest on Financing Corporation bonds. The Financing Corporation was created by Congress to issue bonds to finance the resolution of failed thrift institutions. Commercial banks and thrifts are subject to the same assessment for Financing Corporation bonds. The FDIC sets the Financing Corporation assessment rate every quarter. For the first quarter of 2013, the Financing Corporation’s assessment for Royal Bank (and all other banks), is an annual rate of $.0064 for each $100 of deposits. The Financing Corporation bonds are expected to be paid off between 2017 and 2019.
American Recovery and Reinvestment Act of 2009
On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. ARRA is intended to provide a stimulus to the U.S. economy in the wake of the economic downturn brought about by the subprime mortgage crisis and the resulting credit crunch. The bill included federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, healthcare, and infrastructure, including the energy structure.
Under ARRA, an institution that received funds under the Troubled Asset Relief Program (“TARP”), such as the Company, is subject to certain restrictions and standards throughout the period in which any obligation arising under TARP remains outstanding (except for the time during which the federal government holds only warrants to purchase common stock of the issuer). The following summarizes the significant requirements of ARRA and applicable the United States Department of Treasury (“Treasury”) regulations:
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Limits on compensation incentives for risks by senior executive officers;
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A requirement for recovery of any compensation paid based on inaccurate financial information;
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A prohibition on “golden parachute payments” to specified officers or employees, which term is generally defined as any payment for departure from a company for any reason;
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A prohibition on compensation plans that would encourage manipulation of reported earnings to enhance the compensation of employees;
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A prohibition on bonus, retention award, or incentive compensation to designated employees, except in the form of long-term restricted stock;
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A requirement that the board of directors adopt a luxury expenditures policy;
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A requirement that shareholders be permitted a separate nonbinding vote on executive compensation;
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A requirement that the chief executive officer and the chief financial officer provide a written certification of compliance with the standards, when established, to the SEC.
Under ARRA, subject to consultation with the appropriate federal banking agency, Treasury is required to permit a recipient of TARP funds to repay any amounts previously provided to or invested in the recipient by Treasury without regard to whether the institution has replaced the funds from any other source or to any waiting period.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted on October 3, 2008. EESA was designed to enable the federal government, under terms and conditions developed by the Secretary of the Treasury, to insure troubled assets, including mortgage-backed securities, and collect premiums from participating financial institutions. EESA includes, among other provisions: (a) the $700 billion TARP, under which the Secretary of the Treasury was authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages originated or issued on or before March 14, 2008; and (b) an increase in the amount of deposit insurance provided by the FDIC.
Under the TARP, Treasury authorized a voluntary Capital Purchase Program (“CPP”) to purchase up to $250 billion of senior preferred shares of qualifying financial institutions that elected to participate by November 14, 2008. On February 20, 2009, the Company issued to Treasury, 30,407 shares of Series A Preferred Stock and a warrant to purchase 1,104,370 shares of Class A common stock for an aggregate purchase price of $30.4 million under the TARP CPP. (See “Note 14 - Shareholders’ Equity” of the Notes to Consolidated Financial Statements in Item 8 of this Report.) Companies participating in the TARP CPP were required to adopt certain standards relating to executive compensation. The terms of the TARP CPP also limit certain uses of capital by the issuer, including with respect to repurchases of securities and increases in dividends.
Financial Services Regulatory Relief Act of 2006
This legislation is a wide ranging law that affects many previously enacted financial regulatory laws. The overall intent of the law is to simplify regulatory procedures and requirements applicable to all banks, and to conform conflicting provisions. The Relief Act conforms a number of separate statutes to provide equal definitions and treatment for national banks, state banks, and for federal savings banks in a number of respects. The law streamlines certain reporting requirements, and provides for bank examinations on an 18 month schedule for smaller banks that qualify. The law also authorizes the Federal Reserve to pay interest to banks for the required deposit reserves maintained by banks at the Federal Reserve, but such interest would not begin to be paid until 2012. While this law has many facets that overall should benefit Royal Bank, the individual provisions of this law are not considered currently material to Royal Bank when considered alone.
Sarbanes-Oxley Act of 2002
The primary aims of the Sarbanes-Oxley Act of 2002 (“SOX”) was to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX addresses, among other matters, requirements for audit committee membership and responsibilities, requirements of management to evaluate the Company’s disclosure controls and procedures and its internal control over financial reporting, including certification of financial statements and the effectiveness of internal controls by the primary executive officer and primary financial officer; established standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; and expanded the disclosure requirements for our Company insiders; and increased various civil and criminal penalties for fraud and other violations of securities laws.
USA Patriot Act of 2001
A major focus of governmental policy in recent years that impacts financial institutions has been combating money laundering and terrorist financing. The Patriot Act broadened anti-money laundering regulations to apply to additional types of financial institutions and strengthened the ability of the U. S. Government to help prevent and prosecute international money laundering and the financing of terrorism. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act requires regulated financial institutions, among other things, to establish an anti-money laundering program that includes training and auditing components, to take additional precautions with non-U.S. owned accounts, and to comply with regulations related to verifying client identification at account opening. The Patriot Act also provides rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Failure of a financial institution to comply with the requirements of the Patriot Act could have serious legal and reputational consequences for the institution. The Company has implemented systems and procedures to meet the requirements of the regulation and will continue to revise and update policies, procedures and necessary controls to reflect changes required by the Patriot Act.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 (“GLBA”), also known as the Financial Services Modernization Act repeals the two anti-affiliation provisions of the Glass-Steagall Act. GLBA establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers. It revises and expands the framework of the Holding Company Act to permit a holding company to engage in a full range of financial activities through a new entity known as a financial holding company. “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
In addition, GLBA provides a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies; broadens the activities that may be conducted by national banks, banking subsidiaries of bank holding companies, and their financial subsidiaries; and adopts a number of provisions related to the capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system.
Privacy provision: GLBA provides an enhanced framework for protecting the privacy of consumer information. The FDIC and other banking regulatory agencies, as required under GLBA, have adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. Among other things, these provisions require banks and other financial institutions to have in place safeguards to ensure the security and confidentiality of customer records and information, to protect against anticipated threats or hazards to the security or integrity of such records, and to protect against unauthorized access to or use of such records that could result in substantial harm or inconvenience to a customer. GLBA also requires financial institutions to provide customers at the outset of the relationship and annually thereafter written disclosures concerning the institution’s privacy policies.
GLBA also expressly preserves the ability of a state bank to retain all existing subsidiaries. Because Pennsylvania permits commercial banks chartered by the state to engage in any activity permissible for national banks, Royal Bank will be permitted to form subsidiaries to engage in the activities authorized by GLBA to the same extent as a national bank. In order to form a financial subsidiary, Royal Bank must be well-capitalized, and would be subject to the same capital deduction, risk management and affiliate transaction rules as applicable to national banks.
To the extent that GLBA permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. GLBA is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company and Royal Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and Royal Bank.
Regulation W
Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Sections 23A and 23B of Federal Reserve Act. The FDIC Act applies Sections 23A and 23B to insured nonmember banks in the same manner and to the same extent as if they were members of the Federal Reserve System. The Federal Reserve Board has also recently issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions. Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, the bank’s holding company and companies that are under common control with the bank. The Company is considered to be an affiliate of Royal Bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates:
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To an amount equal to 10% of Royal Bank’s capital and surplus, in the case of covered transactions with any one affiliate; and
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To an amount equal to 20% of Royal Bank’s capital and surplus, in the case of covered transactions with all affiliates.
In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A “covered transaction” includes:
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A loan or extension of credit to an affiliate;
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A purchase of, or an investment in, securities issued by an affiliate;
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A purchase of assets from an affiliate, with some exceptions;
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The acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and
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This issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, under Regulation W:
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A bank and its subsidiaries may not purchase a low-quality asset from an affiliate;
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Covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and
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With some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.
Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates.
Concurrently with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of Royal Bank’s capital and surplus.
Other Legislation/Regulatory Requirements
Congress is currently considering major financial industry legislation, and the federal banking agencies routinely propose new regulations. The Company cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business or the business of Royal Bank in the future.
Monetary Policy
The earnings of Royal Bank are affected by the policies of regulatory authorities including the Federal Reserve Board. An important function of the Federal Reserve System is to influence the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities, changes in reserve requirements against member bank deposits and limitations on interest rates that member banks may pay on time and savings deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans and investments and deposits. Their use may also affect rates charged on loans or paid for deposits.
The policies and regulations of the Federal Reserve Board have had and will probably continue to have a significant effect on its reserve requirements, deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect Royal Bank’s operations in the future. The effect of such policies and regulations upon the future business and earnings of Royal Bank cannot be predicted.
Effects of Inflation
Inflation can impact the country’s overall economy, which in turn can impact the business and revenues of the Company and its subsidiaries. Inflation has some impact on the Company’s operating costs. Unlike many industrial companies, however, substantially all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Company’s performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.
Available Information
Upon a shareholder’s written request, a copy of the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as required to be filed with the SEC pursuant to Exchange Act Rule 13a-1, may be obtained without charge from our Chief Executive Officer, Royal Bancshares of Pennsylvania, Inc. 732 Montgomery Avenue, Narberth, Pennsylvania 19072 or on our website www.royalbankamerica.com.
ITEM 1A.
ITEM 1A.
RISK FACTORS
An investment in our common stock involves risks. Before making an investment decision, investors should carefully consider the risks described below in conjunction with the other information in this Report, including our consolidated financial statements and related notes. If any of the following risks or other risks, which have not been identified or which we may believe are immaterial or unlikely, actually occurs, our business, financial condition and results of operations could be harmed. In such a case, the trading price of our common stock could decline, and investors may lose all or part of their investment.
Risks Related to Our Business
Our business may be impacted by the existence of the informal agreement for Royal Bank and the Federal Reserve Agreement with the Federal Reserve Bank of Philadelphia.
Our success as a business is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the informal agreement and the Federal Reserve Agreement limits and impacts our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the informal agreement and the Federal Reserve Agreement. Our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be potentially impacted and thereby limit liquidity alternatives. Royal Bank’s ability to pay dividends to the Company, which provides funding for cash dividends to the Company’s shareholders, is subject to prior written consent of the FDIC and Department. Moreover, the Company is prohibited from paying cash dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System. Our ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the informal agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the informal agreement and the Federal Reserve Agreement. Under the MOU, Royal Bank must maintain a minimum Tier 1 leverage ratio and a minimum total risk-based capital ratio of 8% and 12%, respectively. At December 31, 2012, based on capital levels calculated under RAP, Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 8.53% and 16.10%, respectively.
Our business is subject to the success of the local economies and real estate markets in which we operate.
Our success significantly depends on the growth in population, income levels, loans and deposits and on the continued stability in real estate values in our markets. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may be adversely affected. Adverse economic conditions in our specific market areas, specifically decreases in real estate property values due to the nature of our loan portfolio, over 80% of which is secured by real estate, could reduce our growth rate, affect the ability of customers to repay their loans and generally affect our financial condition and results of operations. The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.
Our concentration of commercial real estate and construction loans is subject to unique risks that could adversely affect our earnings.
Our commercial real estate and construction and land development loan portfolio held for investment was $204.3 million at December 31, 2012 comprising 59% of total loans. Commercial real estate and construction and development loans are often riskier and tend to have significantly larger balances than home equity loans or residential mortgage loans to individuals. While we believe that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis, the repayments of these loans usually depends on the successful operation of a business or the sale of the underlying property. As a result, these loans are more likely to be unfavorably affected by adverse conditions in the real estate market or the economy in general. The remaining loans in the portfolio are commercial or industrial loans. These loans are collateralized by various business assets the value of which may decline during adverse market and economic conditions. Adverse conditions in the real estate market and the economy may result in increasing levels of loan charge-offs and non-performing assets and the reduction of earnings. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss.
Further, under guidance adopted by the federal banking regulators, banks which have concentrations in construction, land development or commercial real estate loans (other than loans for majority owner occupied properties) would be expected to maintain higher levels of risk management and, potentially, higher levels of capital. It is possible that Royal Bank may be required to maintain higher levels of capital than it would be otherwise expected to maintain as a result of Royal Bank’s commercial real estate loans, which may require the Company to obtain additional capital sooner than it would otherwise seek it, which may reduce shareholder returns.
Our allowance for loan and lease losses may not be adequate to cover actual losses.
Like all financial institutions, we maintain an allowance for loan and lease losses to provide for loan and lease defaults and non-performance. Our allowance for loan and lease losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, current economic conditions and geographic concentrations within the portfolio. Our allowance for loan and lease losses may not be adequate to cover actual loan and lease losses and future provisions for loan and lease losses could materially and adversely affect our financial results.
Our current level of non-performing loans and future growth may require us to raise additional capital but that capital may not be available.
We are required by regulatory authorities to maintain adequate capital levels to support our operations. We anticipate that our current capital will satisfy our regulatory requirements for the foreseeable future. However, in order to maintain our well-capitalized status and to support future growth we may need to raise capital. Our ability to raise additional capital will depend, in part, on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Under the informal agreement as described in “Regulatory Actions” under “Item 1 - Business” of this Report, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12% during the term of the informal agreement. In addition, on February 20, 2009, we issued 30,407 shares of Fixed Rate Cumulative Preferred Stock, Series A, to the United States Department of Treasury under its TARP Capital Purchase Program, The Series A Preferred Stock issued to Treasury has a liquidation preference of $1,000 per share and contains other provisions, including restrictions on the payment of dividends on common stock and on repurchases of any shares of preferred stock ranking equal to or junior to the Series A Preferred Stock or common stock while the Series A Preferred Stock is outstanding, which provisions may make it more difficult to raise additional capital on favorable terms while the Series A Preferred Stock is outstanding. Therefore, we may be unable to raise additional capital, or to raise capital on terms acceptable to us. If we cannot raise additional capital when required, our ability to further expand operations through both internal growth and acquisitions could be materially impaired. In addition, if we decide to raise additional capital, the existing shareholders are subject to dilution.
We may suffer losses in our loan portfolio despite our underwriting practices.
The Company seeks to mitigate the risks inherent in its loan portfolio by adhering to specific underwriting practices. These practices often include: analysis of a borrower’s credit history, financial statements, tax returns and cash flow projections; valuation of collateral based on reports of independent appraisers; and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for the various kinds of loans we make, the Company may incur losses on loans that meet these criteria.
Holders of our Series A Preferred Stock have certain voting rights that may adversely affect our common shareholders, and the holders of the Series A Preferred Stock may have interests different from our common shareholders.
As a consequence of missing the sixth dividend payment in the fourth quarter of 2010, the Treasury had the right to appoint two directors to our board of directors until all accrued but unpaid dividends have been paid. The Treasury exercised its right and appointed two directors to the Company’s board of directors during 2011. Otherwise, except as required by law, holders of the Series A Preferred Stock have limited voting rights.
For as long as shares of the Series A Preferred Stock are outstanding, in addition to any other vote or consent of the shareholders required by law or our Articles of Incorporation, the vote or consent of holders of at least 66 2/3% of the shares of the Series A Preferred Stock outstanding is required for any authorization or issuance of shares ranking senior to the Series A Preferred Stock; any amendments to the rights of the Series A Preferred Stock so as to adversely affect the rights, privileges, or voting power of the Series A Preferred Stock; or initiation and completion of any merger, share exchange or similar transaction unless the shares of Series A Preferred Stock remain outstanding, or if we are not the surviving entity in such transaction, are converted into or exchanged for preference securities of the surviving entity and the shares of Series A Preferred Stock remaining outstanding or such preference securities have the rights, preferences, privileges and voting power of the Series A Preferred Stock.
The holders of our Series A Preferred Stock, including the Treasury, may have different interests from the holders of our common stock, and could vote to block the forgoing transactions, even when considered desirable by, or in the best interests of the holders of our common stock.
Our ability to pay dividends depends primarily on dividends from our banking subsidiary, which are subject to regulatory limits. Additionally, we are subject to other dividend limitations.
We are a bank holding company and our operations are conducted by direct and indirect subsidiaries, each of which is a separate and distinct legal entity. Substantially all of our assets are held by our direct and indirect subsidiaries. Our ability to pay dividends depends on our receipt of dividends from our direct and indirect subsidiaries. Our banking subsidiary, Royal Bank is our primary source of dividends. Dividend payments from our banking subsidiary are subject to legal and regulatory limitations, generally based on net profits and retained earnings, imposed by the various banking regulatory agencies. The ability of Royal Bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. At December 31, 2012, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. There is no assurance that our subsidiaries will be able to pay dividends in the future or that we will generate adequate cash flow to pay dividends in the future. Royal Bank must receive prior written approval from the FDIC and the Department before declaring and paying a dividend to the Company.
Under the terms of the TARP CPP, we are not permitted to declare or pay cash dividends on, or redeem or otherwise acquire, stock that is junior to or on parity with the Series A Preferred Stock issued to Treasury at any time when we have not declared and paid full dividends on the Series A Preferred Stock. We suspended regular quarterly cash dividends on the Series A Preferred Stock in August 2009 and, accordingly, are not permitted at this time to pay dividends on our Class A or Class B Common Stock.
Under the terms of the Federal Reserve Agreement, we are prohibited from paying any dividends on shares of our stock without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
Failure to pay dividends on our stock could have a material adverse effect on the market price of our Class A Common Stock.
Competition from other financial institutions may adversely affect our profitability.
We face substantial competition in originating loans, both commercial and consumer. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.
In attracting business and consumer deposits, Royal Bank faces substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.
The Company’s banking and non-banking subsidiaries also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, credit unions, insurance agencies, peer to peer lenders and governmental organizations which may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our banking operations. As a result, such non-bank competitors may have advantages over the Company’s banking and non-banking subsidiaries in providing certain products and services. This competition may reduce or limit our margins on banking and non-banking services, reduce our market share, and adversely affect our earnings and financial condition.
Our ability to manage liquidity is always critical in our operation, but more so today given the uncertainty within the capital markets.
We monitor and manage our liquidity position on a regular basis to insure that adequate funds are in place to manage the day to day operations and to cover routine fluctuations in available funds. However, our funding decisions can be influenced by unplanned events. These unplanned events include, but are not limited to, the inability to fund asset growth, difficulty renewing or replacing funds that mature, the ability to maintain or draw down lines of credit with other financial institutions, significant customer withdrawals of deposits, and market disruptions. The Federal Home Loan Bank of Pittsburgh had imposed an over collateralized delivery requirement of 105% on Royal Bank. The available amount for future borrowings will be based on the amount of collateral to be pledged. We have a liquidity contingency plan in the event liquidity falls below an acceptable level, however in today’s economic environment, we are not certain that those sources of liquid funds will be available in the future when required. As a result, loan growth may be curtailed to maintain adequate liquidity, loans may need to be sold in the secondary market, investments may need to be sold or deposits may need to be raised at above market interest rates to maintain liquidity.
We may face substantial potential legal liability which would adversely impact our business and financial results and damage our reputation.
On September 26, 2012, CSC voluntarily entered into a plea agreement with the DOJ in which CSC entered a guilty plea in the United States District Court of New Jersey to one count of bid-rigging at certain auctions for tax liens in New Jersey Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and will not bring criminal charges against RTL, or any current or former director, officer, or employee of CSC or RTL (with the exception of the former President of CSC and RTL and persons who bid at tax lien auctions on behalf of CSC or RTL), for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The DOJ further agreed to recommend that the appropriate fine to CSC would be $2.0 million, which has been recognized in the Company’s financial statements. At the sentencing hearing held in December 2012, the sentencing judge agreed with the DOJ’s recommendation and imposed a $2.0 million fine for CSC, which, as stated above, has been recognized in the Company’s financial statements. Additionally, RTL, CSC, the Company, and certain other parties were named as defendants in putative class action lawsuits arising from the tax lien operations. While the outcome of these cases and similar ones that may be filed is uncertain, the final resolution and the legal costs incurred defending the Company may materially affect our results of operations and financial condition and harm our reputation.
A number of our loans are secured by properties located on the Southern New Jersey barrier islands and surrounding areas, which may have been damaged by Hurricane Sandy.
We have extended loans to customers that are secured by properties located in the Southern New Jersey barrier islands and surrounding areas. These areas were severely damaged by Hurricane Sandy, which impacted the Mid-Atlantic and Northeastern regions of the United States from October 28, 2012 to October 30, 2012. On most collateral dependent loans, our exposure is limited due to the existence of flood and property insurance. We monitor our borrower’s insurance coverage on a regular basis and force place insurance, as necessary. We have been assessing the condition of the underlying properties since there was a risk that collateral for these loans had been damaged. As of the date of this filing, the Company does not expect to record losses on these loans related to collateral damage.
Negative publicity could damage our reputation and adversely impact our business and financial results.
Reputation risk, or the risk to the Company’s earnings and capital from negative publicity, is inherent in our business. Negative publicity can result from the Company’s actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and actions taken by government regulators and community organizations in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose the Company to litigation and regulatory action. Although the Company takes steps to minimize reputation risk in dealing with customers and other constituencies, the Company, as a larger diversified financial services company with a high industry profile, is inherently exposed to this risk.
Risks Related to Our Industry
Difficult market conditions and economic trends have adversely affected our industry and our business.
We are exposed to downturns in the U. S. housing market. Dramatic declines in the housing market over the past few years, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage, consumer, commercial and construction loan portfolios resulting in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment may negatively impact the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have also experienced decreased access to borrowings. While the economy and market conditions have improved, the current economic recovery has been much weaker than recent economic recoveries post recession and unemployment, despite recent improvement, remains high. The existing economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price. A worsening of current economic conditions would likely exacerbate the adverse effects of existing market conditions on us and others in the industry. In particular, we may face the following risks in connection with these events:
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We expect to face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities.
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Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions.
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We also may be required to pay even higher Federal Deposit Insurance Corporation premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions have depleted and may continue to deplete the deposit insurance fund and reduce its ratio of reserves to insured deposits.
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Our ability to borrow from other financial institutions or the Federal Home Loan Bank on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events.
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We may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.
Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
Changes in the interest rate environment may reduce profits. The primary source of our income is the differential or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. As prevailing interest rates change, net interest spreads are affected by the difference between the maturities and re-pricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. An increase in the general level of interest rates may also adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially adversely affect our net interest spread, asset quality, loan origination volume and overall profitability.
Recent and future governmental regulation and legislation could limit our future growth.
As described under “Supervision and Regulation” the Company and our subsidiaries are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of the operations of the Company and our subsidiaries. These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. Any changes to these laws may negatively affect our ability to expand our services and to increase the value of our business. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on the Company, these changes could be materially adverse to shareholders.
Changes in consumers’ use of banks and changes in consumers’ spending and saving habits could adversely affect the Company’s financial results.
Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This disintermediation could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.
Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions.
Geopolitical conditions may also affect our earnings. Acts or threats or terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions.
Other Risks
Our directors, executive officers and principal shareholders own a significant portion of our common stock and can influence shareholder decisions.
Our directors, executive officers and principal shareholders, as a group, beneficially owned approximately 56% of Class A common stock and 83% of Class B common stock as of February 28, 2013. As a result of their ownership, the directors, executive officers and principal shareholders will have the ability, by voting their shares in concert, to influence the outcome of any matter submitted to our shareholders for approval, including the election of directors. The directors and executive officers may vote to cause the Company to take actions with which the other shareholders do not agree or that are not beneficial to all shareholders.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
At December 31, 2012, Royal Bank had fifteen banking offices, which are located in Pennsylvania and New Jersey.
15th Street Office
Bala Plaza Office (3)
Bridgeport Office (1)
30 South Street
231 St. Asaph's Road
105 W. 4th Street
Philadelphia, PA 19102
Bala Cynwyd, PA 19004
Bridgeport, PA 19406
Castor Office (1)
Fairmount Office (1)
Grant Avenue Office (1)
6331 Castor Avenue
401 Fairmount Avenue
1650 Grant Avenue
Philadelphia, PA 19149
Philadelphia, PA 19123
Philadelphia, PA 19115
Henderson Road Office
Jenkintown Office (1)
King of Prussia Office (1)
Beidler and Henderson Roads
600 Old York Road
655 West DeKalb Pike
King of Prussia, PA 19406
Jenkintown, PA 19046
King of Prussia, PA 19406
Narberth Office (1)
Narberth Training Center (1)(2)
Phoenixville Office (1)
732 Montgomery Avenue
814 Montgomery Avenue
808 Valley Forge Road
Narberth, PA 19072
Narberth, PA 19072
Phoenixville, PA 19460
Shillington Office
Sicklerville Office
Trooper Office (1)
516 East Lancaster Avenue
1990 New Brooklyn-Erial Rd
Trooper and Egypt Roads
Shillington, PA 19607
Sicklerville, NJ 08081
Trooper, PA 19401
Villanova Office
Walnut Street Office
Storage Facility (1)
801 East Lancaster Avenue
1230 Walnut Street
3836 Spring Garden Street
Villanova, PA 19085
Philadelphia, PA 19107
Philadelphia, PA 19104
(1) Owned
(2) Used for employee training
(3) Loan production office
Royal Bank owns eleven of the above properties. In January 2013, Royal Bank consolidated the leased Henderson Road office among the King of Prussia and Bridgeport offices and retained the majority of the deposits. The remaining six properties are leased with expiration dates between 2013 and 2021. During 2012, Royal Bank made aggregate lease payments of approximately $795,000. The Company believes that all of its properties are sufficiently insured, maintained and are adequate for Royal Bank’s purposes.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
As described under “Item 1 - Business” of this Report, Royal Bank holds a 60% equity interest in each of Crusader Servicing Corporation (“CSC”) and Royal Tax Lien Services, LLC (“RTL”). CSC and RTL acquired, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders. On March 4, 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States Department of Justice (“DOJ”). The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey. Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation. On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009. The former President’s employment with CSC and RTL was terminated in November 2010. As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation. Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against CSC, RTL or both. As a result, the Company accrued $2.0 million during 2012 as an estimate for a DOJ fine relating to the DOJ investigation. After adjusting for the noncontrolling interest, the Company’s 60% share of the fine amounted to $1.2 million. On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey. Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this non-prosecution protection. At the sentencing hearing held in December 2012, the sentencing judge agreed with the DOJ’s recommendation and imposed a $2.0 million fine for CSC, which, as stated above, has been recognized in the Company’s consolidated financial statements. The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
As a result of the plea agreements of the former President of CSC and RTL, and others resulting from the DOJ investigation, a number of lawsuits have been filed against the former President of CSC and RTL, CSC, RTL, the Company and certain other parties. On March 13, 2012, the former president of RTL and CSC, RTL, CSC, the Company and certain other parties were named as defendants in a putative class action lawsuit filed in the Superior Court of New Jersey, Chancery Division on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations (Boyer v. Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., Superior Court of New Jersey, Chancery Division) (“the Boyer Action”). On March 28, 2012, CSC, RTL and the Company removed this case to the U.S. District Court for the District of New Jersey. The lawsuit alleges violations of the New Jersey Antitrust Act and unjust enrichment, and seeks treble damages, attorney fees and injunctive relief. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this class action lawsuit.
On March 30, 2012, April 20, 2012, May 2, 2012, May 11, 2012, May 18, 2012, June 18, 2012 and June 29, 2012, the former President of CSC and RTL, CSC, RTL and the Company were named defendants, among others, in putative class action lawsuits filed in the U.S. District Court for the District of New Jersey (“Court”) on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations: Contarino v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; MSC LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; English v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Ledford v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; T&B Associates v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Jacobs et al v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Senatore Builders, LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey, respectively alleging a conspiracy to rig bids in municipal tax lien auctions. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions, including the ones mentioned above. On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from these class action lawsuits.
On or about March 15, 2012, CSC, RTL and the Company were named defendants, among others, in a complaint filed by Marina Bay Towers Urban Renewal II, LP (“MBT”) in the Superior Court of New Jersey, Law Division, Cape May County. The complaint alleges essentially the same claims as asserted in the Boyer Action. However MBT does not seek to represent a class and only seeks remedies related to itself. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
In 2005, the Company purchased $25.0 million in Class B-1 Notes of a collateralized debt obligation (“CDO”) offered by Lehman Brothers, Inc. Concurrently with the issuance of the notes, the issuer entered into a credit swap with Lehman Brothers Special Financing, Inc. (“LBSF”). Lehman Brothers Holdings, Inc. (“LBHI”) guaranteed LBSF’s obligations to the issuer under the credit swap. When LBHI filed for bankruptcy in September 2008, an event of default under the indenture occurred, and the trustee declared the notes to be immediately due and payable. The Company was repaid its principal on the notes in September 2008. In September 2010, LBSF filed suit in the United States Bankruptcy court for the Southern District of New York against certain indenture trustees, certain special-purpose entities (issuers) and a class of noteholders and trust certificate holders who received distributions from the trustees, to recover funds that were allegedly improperly paid to the noteholders in forty-seven separate CDO transactions. In July 2012, LBSF added the Company as a defendant in the proceeding. As of the date of this filing, the Company cannot determine whether this proceeding will have a material adverse effect on its results of operations and cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, AND RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company’s Class A Common Stock commenced trading on the NASDAQ Global Market under the symbol RBPAA. There is no market for the Company’s Class B Common Stock. The Class B shares may not be transferred in any manner except to the holder’s immediate family. Class B shares may be converted to Class A shares at the rate of 1.15 to 1.
The following table shows the range of high and low closing prices for the Company’s stock as reported by NASDAQ.
The approximate number of recorded holders of the Company’s Class A and Class B Common Stock, as of February 28, 2013, is shown below:
Dividends
Subject to certain limitations imposed by law or the Company’s articles of incorporation, the Board of Directors of the Company may declare a dividend on shares of Class A or Class B Common Stock.
Stock dividends: Future stock dividends, if any, will be at the discretion of the board of directors and will be dependent on the level of earnings and compliance with regulatory requirements. Stock dividends have not been declared since 2006.
Cash Dividends: The Company did not pay cash dividends on its common stock in 2012, 2011, and 2010. Future dividends depend upon net income, capital requirements, and appropriate legal restrictions and other factors relevant at the time the Board of Directors of the Company considers dividend policy. Cash necessary to fund dividends available for dividend distributions to the shareholders of the Company must initially come primarily from dividends paid by its direct and indirect subsidiaries, including Royal Bank to the Company.
Under the Pennsylvania Business Corporation Law, the Company may pay dividends only if, after giving effect to the dividend payment, the total assets of the Company would exceed the total liabilities of the Company plus the amount necessary to satisfy preferential rights of holders of senior shareholders, and the Company is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the “Code”) and in the Federal Deposit Insurance Act (“FDIA”) concerning the payment of dividends by the Company. Under the Code, no dividends may be paid except from “accumulated net earnings” (generally retained earnings). Under the FDIA, no dividend may be paid if a bank is in arrears in the payment of any insurance assessment due to the FDIC. In addition, dividends paid by Royal Bank to the Company would be prohibited if the effect thereof would cause Royal Bank’s capital to be reduced below applicable minimum capital requirements. Therefore, the restrictions on Royal Bank’s dividend payments are directly applicable to the Company. See “Note 14 - Shareholder’s Equity” of the Notes to Consolidated Financial Statements in Item 8 of this Report.
On August 13, 2009, the Company’s board of directors determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock. The Company’s board of directors took this action in consultation with the Federal Reserve Bank of Philadelphia as required by regulatory policy guidance. The Company currently has sufficient capital and liquidity to pay the scheduled dividends on the preferred stock; however, this decision better supports the capital position of Royal Bank, a wholly owned subsidiary of the Company. As of December 31, 2012, the Series A Preferred stock dividend in arrears was $5.8 million and has not been recognized in the consolidated financial statements. As a consequence of missing the sixth dividend payment in the fourth quarter of 2010, the Treasury had the right to appoint two directors to our board of directors until all accrued but unpaid dividends have been paid. The Treasury exercised its right and appointed two directors to the Company’s board of directors during 2011.
At December 31, 2012, as a result of significant losses within Royal Bank and cash and stock dividends declared and paid in previous years, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve Agreement as described under “Regulatory Actions” in “Item 1 - Business” of this Report, the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
COMMON STOCK PERFORMANCE GRAPH
The performance graph shows cumulative investment returns to shareholders based on the assumption that an investment of $100 was made on December 31, 2007, (with all dividends reinvested), in each of the following:
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Royal Bancshares of Pennsylvania, Inc. Class A common stock;
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The stock of all United States companies trading on the NASDAQ Global Market;
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Common stock of 2012 Peer Group consists of nineteen banks headquartered in the Mid-Atlantic region, trade on the major exchange and have total assets between $750 million and $1.5 billion; and
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SNL Bank and Thrift Index.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial and operating information for the Company should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and accompanying notes in Item 8 of this Report:
(1)
Includes obligations through VIE equity investments and subordinated debt.
(2)
Includes premises and equipment of VIE for years 2008 through 2010
(3)
Excludes noncontrolling interest
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of the Company and the related Notes in Item 8 of this Report.
Critical Accounting Policies, Judgments and Estimates
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry. Critical accounting policies, judgments and estimates relate to allowance for loan and lease losses, loans held for sale, the valuation of other real estate owned, the valuation of deferred tax assets, other-than-temporary impairment losses on investment securities, net periodic pension costs and the pension benefit obligation. The policies which significantly affect the determination of the Company’s financial position, results of operations and cash flows are summarized in “Note 1 - Summary of Significant Accounting Polices” to the Consolidated Financial Statements and are discussed in the section captioned “Recent Accounting Pronouncements” of Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in Items 7 and 8 of this Report, each of which is incorporated herein by reference.
Investment Securities
Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date.
Investments in debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized holding gains and losses included in earnings. Debt and equity securities not classified as trading securities, nor as held to maturity securities are classified as available for sale securities and reported at fair value, with unrealized holding gains or losses, net of deferred income taxes, reported in the accumulated other comprehensive income component of shareholders’ equity. The Company did not hold trading securities at December 31, 2012 and 2011. Discounts and premiums are accreted/amortized to income by use of the level-yield method. Gain or loss on sales of securities available for sale is based on the specific identification method.
The Company evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis. The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”). The non-agency collateralized mortgage obligations that are rated below AA are evaluated under FASB ASC Topic 320 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” under FASB ASC Topic 325, “Investments-Other”.
Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security. If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings.
For more information on the fair value of the Company’s investment securities and other financial instruments refer to “Note 3 - Investment Securities” and “Note 20 - Fair Values of Financial Instruments” to the Consolidated Financial Statements included in Item 8 of this Report.
Allowance for Loan and Lease Losses
The Company considers that the determination of the allowance for loan and lease losses (“allowance”) involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb estimated credit losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts of timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan and lease losses may be required that would adversely impact earnings in future periods. See “Note 1 - Summary of Significant Accounting Policies” to the Consolidated Financial Statements included in Item 8 of this report.
Deferred Tax Assets
The Company recognizes deferred tax assets and liabilities for the future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realization is more likely than not. If management determines that the Company may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.
RECENT ACCOUNTING PRONOUNCEMENTS
See “Note 1 - Summary Of Significant Accounting Policies” to the Consolidated Financial Statements included in Item 8 of this Report.
Results of Operations
Financial Highlights and Business Results: The Company’s results of operations depend primarily on net interest income, which is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities. Interest-earning assets consist principally of loans and investment securities, while interest-bearing liabilities consist primarily of deposits and borrowings. Net income is also affected by the provision for loan and lease losses and the level of non-interest income as well as by non-interest expenses, including salary and employee benefits, occupancy expenses and other operating expenses.
Like many other financial institutions the Company’s financial results were negatively impacted by the recession, but the effects on the Company were more pronounced than the effects on its competitors. The concentration of commercial real estate loans coupled with the introduction of additional lines of business resulted in a much higher level of non-performing loans and losses. The past losses were partially attributed to charge-offs and impairment of commercial, construction and land loans associated with real estate projects, many of which were participation loans outside the Company’s primary market. Some of the participation loans were located in Florida, Nevada, North Carolina and other markets that were overbuilt during the construction boom within the United States from 2000-2007. The Company also launched new business initiatives such as mezzanine lending, real estate joint ventures, hard money lending and equity investments in real estate shortly before the housing bubble burst which contributed to the losses. Additionally, the Company experienced a high level of investment impairment associated with corporate bonds, common stocks, private label mortgage backed securities and real estate investment funds that experienced declines in value during the past few years. Also contributing to the losses were increased costs associated with the high level of non-performing assets, legal expenses related to credit quality issues and the DOJ tax lien investigation (for additional information please read Item 3 “Legal Proceedings” of this Form 10-K), and higher Federal Deposit Insurance Corporation (“FDIC”) assessments resulting from the higher rates for deposit insurance due to the Orders to Cease and Desist (the “Orders”) which were issued in 2009 and replaced in 2011 with an informal agreement, known as a memorandum of understanding (“MOU”). Finally, the establishment of a valuation allowance in 2008 and subsequent years that currently amounts to $39.6 million, has prevented the Company from utilizing tax credits on losses during the past four years.
While the Company’s deleveraging strategy improved the risk profile of the Company by shedding higher risk assets and paying off higher cost brokered CDs, it has had a negative impact on income. The deleveraging has resulted in lower average loan balances and a higher proportion of lower yielding investment securities, which have negatively impacted net interest income, a principal source of income. While the Company still expects external headwinds and credit quality costs associated with non-performing assets to negatively affect financial results, over time their impact may decline as the overall level of non-performing assets declines.
After announcing the retirements of the Company’s CEO and President during the second quarter of 2012, the Company’s Board conducted an executive search for a candidate for the combined role of President and CEO. On December 18, 2012 the Company announced F. Kevin Tylus as President and CEO of Royal Bank. On February 20, 2013, the Company announced that Mr. Tylus was appointed President, CEO and a Class III member of the board of directors of the Company. Former CEO, Robert Tabas, remains as Chairman of the Board of Directors. The Company is focused on transitioning Royal Bank into a true community bank with the branches becoming selling centers and not just service centers. Traditional consumer products such as home equity loans and a new mobile banking application are part of our enhanced product offerings. The Company has developed a Profitability Improvement Program to generate steady revenue growth, expense management and gain operational efficiencies. During 2012, Royal Bank hired a new Chief Lending Officer (“CLO”) who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. Through the restructuring of the Lending and Credit departments during the last half of 2012, Royal Bank has been able to increase commitments to extend credit by $23.8 million from $20.7 million at December 31, 2011 to $44.5 million at December 31, 2012.
Net Loss: The Company recorded a net loss of $15.6 million in 2012, which represented an increase of $7.0 million from the loss recorded in 2011 of $8.6 million. The increase in net loss was primarily related to a $3.2 million reduction in net interest income, a $2.0 million DOJ fine related to the tax lien subsidiaries, a $1.3 million reduction in net gains on other real estate owned (“OREO”), a $1.2 million increase in OREO impairment charges, and a $1.7 million increase in impairment on LHFS. Net loan balances, including loans held for sale, amounted to $328.5 million at year end 2012, which amounted to a decline of $81.9 million from balance at the end of 2011 due to charge-offs and impairments, loan sales, pay-downs, pay offs and transfers to OREO. Partially offsetting these unfavorable changes were a $1.7 million decline in the provision for loan and lease losses and a $934,000 decline in FDIC and state assessments.
Net interest income, which amounted to $22.1 million in 2012, decreased by $3.2 million, or 12.7%, from the prior year’s results of $25.3 million. The continued decline in loan balances negatively impacted net interest income during the past year. In addition, the accelerated amortization of premiums coupled with the reinvestment of cash flows from the investment portfolio into lower yielding government agency securities during the continued low interest rate environment has had a significant adverse impact on the yield earned on investment securities. Other income of $3.6 million in 2012 was $3.2 million below the result for 2011 mainly due to a $1.8 million decline in income from real estate joint ventures, a $1.3 million decline in net gains on OREO, a $752,000 decrease in net gains on the sales of AFS investment securities, a $563,000 increase in impairment on investment securities resulting primarily from write-downs of two private equity funds, and a $478,000 decline in income related to real estate owned via equity investments as a result of the substantial completion of the remaining project during 2011. Partially offsetting these declines year over year for 2012 was a $1.7 million increase in gains on the sales of loans and leases which was primarily related to the sale of one non-performing loan in the second quarter of 2012.
Total non-performing loans at December 31, 2012 were $23.0 million and were comprised of $21.4 million in loans held for investment (“LHFI”) and $1.6 million in loans held for sale (“LHFS”), which amounted to an improvement of $28.3 million, or 55.2%, from the level at December 31, 2011 resulting from charge-offs and impairments, sales of loans, transfers to OREO and improved credit quality. Total non-performing loans at December 31, 2011 were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS. Non-performing loans were $65.8 million at December 31, 2010 and were comprised of $43.2 million in LHFI and $22.6 million in LHFS. OREO at December 31, 2012, amounted to $13.4 million versus $21.0 million at year end 2011, which amounted to a decline of $7.6 million, or 36.1%. As a consequence of the housing market’s slow recovery and the sluggish growth in the overall economy, the Company continued to experience a high level of non-performing assets despite the continued progress in reducing the level of those assets. Impaired and non-accrual loans and OREO assets are reviewed in the “Credit Quality” section of this report. Basic and diluted losses per common share were both $1.33 for 2012 compared to basic and diluted losses per common share of $0.80 in 2011.
The Company recorded a net loss of $8.6 million in 2011, which represented an improvement of $15.5 million, or 64.5%, from loss recorded in 2010 of $24.1 million. The improved results were primarily related to a reduction in the provision for loan and lease losses of $14.4 million and a decline of $8.7 million in total other expense. The favorable change in the provision resulted primarily from a decrease in the outstanding loan balances year over year as well as a decline in the level of non-performing loans. Loan balances, including loans held for sale, amounted to $410.4 million at year end 2011, which amounted to a decline of $94.9 million from balance at the end of 2010 due to charge-offs, loan sales, pay-downs, pay offs and transfers to OREO. Other expenses of $32.1 million resulted in a year over year decline of $8.7 million, or 21.3%, and was attributed to an overall reduction of expenses related to the sale of Royal Asian at year end 2010, which amounted to $3.8 million; a reduction of $1.9 million in OREO impairment charges; lower FDIC and state assessments of $1.1 million associated with reduced deposit balances, mainly brokered CDs and deposits of Royal Asian; and the absence of impairment on real estate joint ventures which was $1.6 million in 2010 and the VIE related to real estate owned via equity investments being deconsolidated in 2011. The impairment related to the VIE in 2010 was $2.6 million.
Partially offsetting these favorable changes year over year for 2011 were a decline in both net interest income and other income. Net interest income, which amounted to $25.3 million in 2011, decreased by $6.0 million, or 19.1%, from $31.3 million for 2010. The decline in loan balances negatively impacted net interest income during the past year. In addition, a reduction in the yields on loans and investments and a 2010 non-recurring adjustment amounting to $905,000 also contributed to the decline in net interest income. The non-recurring adjustment was related to previously reversed interest income on a participation loan from a previous year. The overall decline in net interest income was partially mitigated by the continued reduction in interest expense related to lower interest rates principally associated with the re-pricing of maturing retail CDs and the redemption of brokered deposits and FHLB advances. Other income of $6.8 million in 2011 was $947,000 below the result for 2010 mainly due to impairment on investment securities of $1.8 million, resulting primarily from a complete write-down of one trust preferred security in the amount of $1.7 million.
Net Interest Income and Margin: Net interest income is the Company’s primary source of income. Its level is a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities, and the spread between the yield on assets and liabilities. In turn, these factors are influenced by the pricing and mix of the Company’s interest-earning assets and funding sources. Additionally, net interest income is affected by market and economic conditions, which influence rates on loan and deposit growth.
The Company utilizes the effective yield interest method for recognizing interest income as required by ASC Subtopic 20, “Nonrefundable Fees and Other Costs” (“ASC Subtopic 20”) under FASB ASC Topic 310, “Receivables” (“ASC Topic 310”). ASC Subtopic 20 also guides our accounting for nonrefundable fees and costs associated with lending activities such as discounts, premiums, and loan origination fees. In the case of loan restructurings, if the terms of the new loan resulting from a loan refinancing or restructuring other than a troubled debt restructuring are at least as favorable to the Company as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the Company, the refinanced loan is accounted for as a new loan. This condition is met if the new loan’s effective yield is at least equal to the effective yield for such loans. Any unamortized net fees or costs and any prepayment penalties from the original loan shall be recognized in interest income when the new loan is granted.
Net interest income amounted to $22.1 million in 2012 as compared to $25.3 million in 2011, which resulted in a decline of $3.2 million, or 12.7%. The decrease was attributed mainly to a year-over-year decline in average loan balances and a declining yield on the investment portfolio despite an increase in average investment securities. The decline was partially offset by a reduction in the average interest-bearing deposit and borrowing balances. Additionally the average rate paid on the interest-bearing deposits continued to decline, specifically maturing retail CDs. (See the “Average Balance” table included in this discussion.) Net interest income amounted to $25.3 million in 2011 as compared to $31.3 million in 2010, which resulted in a decline of $6.0 million, or 19.1%. The decrease was attributed mainly to a decline in interest-earning assets, both loans and investments, primarily attributable to the de-leveraging of the balance sheet, a decline in the yields of those interest-earning assets, again principally loans and investments, and a nonrecurring favorable adjustment of $905,000 for interest income in 2010. The decline was partially offset by a reduction of the average balances and the average rate paid on interest-bearing liabilities associated with the redemption of brokered CDs and lower rates paid on maturing retail CDs.
Interest income of $32.0 million in 2012 amounted to a reduction of $7.4 million, or 18.8%, from the level of $39.4 million in 2011. The decrease was primarily driven by a $90.6 million decline in average loan balances year-over-year and a 107 basis point decline in the yield on investments, which were partially offset by the increased yield on loans. Interest income for loans declined by $4.4 million, or 14.8%, and was mainly attributed to the reduction of average total loans. Average total loans for 2012 were $384.4 million compared to $475.0 million for 2011. The decline in loan balances during 2012 was attributed to minimal new loan growth, loan prepayments, loan pay downs including $24.0 million in higher yielding tax lien certificates, charge-offs, impairments and transfers to OREO through foreclosure proceedings. Average investment securities of $344.9 million in 2012 amounted to an increase of $24.5 million, or 7.6%, from the average in 2011. For 2012, interest income on investment securities amounted to $6.7 million and declined $2.9 million, or 30.8%, from 2011.
The decline in the yield on average interest-earning assets contributed to the decline in interest income year over year (4.25% in 2012 versus 4.76% in 2011). The 51 basis point reduction was primarily comprised of a decline of 107 basis points on investment securities which was partially offset by a 33 basis point increase in total loans. The yield on investment securities was 1.94% for 2012 compared to 3.01% for 2011. As a result of the historically sustained low interest rates, the yield on investment securities declined despite the increase in average balances. This decline in yield was due to the replacement of sold and called higher yielding investment securities and the reinvestment of increased payments received on cash flowing investment securities during 2012 with lower yielding government agency securities. In addition, accelerated amortization of premiums paid on investment securities within the MBS/CMO portfolio due to a higher level of prepayments also contributed to the declining yield on investments. The increase in loan yield reflected a reduced concentration of non-performing loans within the loan portfolio, a higher concentration of higher yielding leases coupled with minimal interest reversals on new non-performing loans, which were partially offset by a reduced concentration of higher yielding tax liens.
Interest income of $39.4 million in 2011 amounted to a reduction of $17.9 million, or 31.2%, from the level of $57.3 million in 2010. The decline was attributable to a lower yield on interest-earning assets year over year for loans and investment securities, and a lower level of average interest-earning assets again related to both loans and investment securities. The reduction in loan balances and investment securities was driven in part by the Company’s strategic capital initiative of de-leveraging the balance sheet. Interest income for loans declined by $13.0 million, or 30.5%, and was mainly attributed to the reduction of average total loans but was also related to a decline in the yield on the loan portfolio. Average balance of total loans amounted to $475.0 million during 2011 versus $643.5 million during 2010, which amounted to a decline of $168.5 million, or 26.2%, year over year. The reduction was comprised of charge-offs, pay downs, payoffs, the sale of Royal Asian Bank (“RAB”) at year end 2010 and transfers to OREO that was accompanied by minimal new loan growth. The sale of RAB accounted for almost 40% of the overall decline. The interest income on investment securities amounted to $9.6 million and declined $4.8 million, or 33.3%, resulting from a decline in average investment securities coupled with a decline in the yield on the investment securities. Average investment securities of $320.4 million in 2011 amounted to a decline of $61.4 million, or 16.1%, from the average in 2010.
The decline in the yield on average interest-earning assets contributed to the decline in interest income year over year (4.76% in 2011 versus 5.29% in 2010). The 53 basis point reduction was comprised of a decline of 78 basis points on investment securities and a 39 basis point decrease in total loans. The decline in the yield on investment securities was mainly related to the replacement of sold investment securities and principal payments and prepayments on government agency investment securities with comparable investment securities at lower interest rates. The yield decrease on average total loans primarily resulted from the $905,000 favorable adjustment to interest income in 2010 as previously mentioned, the lower yields on new loans recorded during the past year and a change in the composition of the loans within the portfolio during 2011. The loan composition change was related to a decrease in the percentage of tax liens, which have the highest yields within the loan portfolio. At year end 2011, the variable rate portfolio represented approximately 40% of total loans; however the Company has mitigated a portion of this negative impact through the utilization of rate floors in many of the commercial loan agreements that exceed the current prime rate.
At December 31, 2012, non-performing loans to total loans amounted to 6.7%, whereas the same ratio at December 31, 2011, amounted to 12.0%. The favorable change year over year was primarily associated with the $28.3 million decline in non-performing loans during 2012, which was partially offset by the decline in the loan portfolio during 2012. The total interest income lost as a result of non-performing loans during 2012 amounted to $3.1 million, which resulted in a decrease of $2.0 million from 2011.
For the full year ended December 31, 2012, interest expense amounted to $9.9 million, which resulted in a decline of $4.2 million, or 29.7%, from the level recorded in the previous year. The decline in interest expense during 2012 was primarily due to a $75.0 million, or 10.1%, decline in average interest-bearing liabilities relative to 2011 and a 42 basis point decline in the interest rates paid on interest-bearing liabilities year over year. During 2012, average interest-bearing deposits of $517.6 million decreased $46.9 million, or 8.3%, compared to 2011. The reduction was entirely associated with CDs, which was primarily due to the intentional runoff of brokered CDs and higher priced retail CDs, that was partially offset by an increase in money market deposits and savings accounts. Average time deposits amounted to $276.0 million during 2012, which resulted in a decline of $51.6 million, or 15.8%, from the level during 2011 for the reasons previously noted. Average money market deposits increased $3.6 million, or 2.0%, year over year. Average borrowings of $123.6 million in 2012 declined $28.1 million, or 18.5%, from the level in 2011 due to the redemption and pay down of FHLB advances. In March of 2012, a maturing FHLB advance of $30.0 million at a rate of 4.32% was partially replaced with a five-year FHLB advance of $15.0 million with a fixed rate of 1.39%, which improved funding costs.
Average rates paid on all major liability categories declined year over year due to the continued lower re-pricing of maturing retail certificates of deposit and the redemption of higher cost brokered CDs, the redemption of higher cost FHLB advances; and the reduction of rates paid on NOW, money market accounts, and savings accounts. The average interest rate paid on average interest-bearing liabilities in 2012 of 1.48% amounted to a reduction of 42 basis points from the prior year. Significant declines in average interest rates paid on interest-bearing liabilities year over year included certificates of deposits of 47 basis points, money market accounts of 31 basis points, borrowings of 28 basis points, NOW accounts of 23 basis points, and savings accounts of 16 basis points.
For the full year ended December 31, 2011, interest expense amounted to $14.1 million, which resulted in a decline of $11.9 million, or 45.8%, from the level recorded in the previous year. The favorable change was attributed to a reduced level of average interest-bearing liabilities year over year and a decline in the interest rates paid on those liabilities. Average interest-bearing liabilities amounted to $742.0 million in 2011, which represented a decline of $243.3 million, or 24.7%, from the previous year and was primarily related to the previously noted de-leveraging strategy and compliance with the previous Orders. Average time deposits, which included brokered CDs, amounted to $327.6 million in 2011 and represented a decrease of $175.6 million, or 34.9%, from the average level of 2010 due mainly to the redemption of higher cost brokered CDs. Average borrowings amounted to $151.7 million during 2011 and declined $77.8 million, or 33.9%, primarily due to the redemption of FHLB advances at the end of 2010.
For 2011, average rates paid on all major liability categories declined year over year due to the re-pricing of maturing retail certificates of deposit and the redemption of higher cost brokered CDs; the redemption of higher cost FHLB advances during 2010; and the reduction of rates paid on NOW, money market accounts, and savings accounts primarily during 2011. The average interest rate paid on average interest-bearing liabilities in 2011 of 1.90% amounted to a reduction of 74 basis points from 2010 as the Company was able to take advantage of the lower interest rate environment and the maturity of retail and brokered CDs as well as FHLB borrowings. Significant declines in average interest rates paid on interest-bearing liabilities year over year included certificates of deposits of 81 basis points and borrowings of 70 basis points.
The net interest margin for the full year 2012 amounted to 2.94%, which represented a decrease of 12 basis points from 2011. The Company has experienced pressure on its margin similar to many other financial institutions during 2012. Factors contributing to the net interest margin compression include a declining loan portfolio which is evidenced by the $90.6 million decline in the average balance of loans year over year and a reduction in the yields earned on the investment portfolio which is a result of accelerated amortization of premiums with the MBS/CMO portfolio as well as lower market rates on new purchases. The decline in the loan portfolio is primarily attributable to increased competition for new loans, the payoff or pay down of existing loans, a reduction in tax lien certificates, and transfers to OREO. As a result of the declining loan portfolio coupled with minimal new loan growth, the average balance of lower yielding investment securities has increased $24.5 million during this same period. However, the yield on investment securities has declined 107 basis points year over year. Due to the current interest rate environment, the Company has experienced accelerated amortization of premiums paid on its MBS/CMO portfolio due to higher prepayments. Many homeowners are refinancing into lower rates, including some that have previously refinanced. Additionally, prepayments have been effected by refinancing programs such as the Home Affordable Refinancing Program (“HARP”) being offered by the government for homeowners that are underwater on their homes. The accelerated amortization of premiums coupled with the redeployment of cash flows from sold and called higher yielding investment securities and payments received on MBS/CMO portfolio into lower yielding government agency securities has had a significant negative impact on the yield earned on investment securities.
Management has taken steps to improve the margin including reducing the cost of interest-bearing liabilities as reflected in the 42 basis point decline year over year. Additionally, in an effort to shift the mix of interest-earning assets to loans with an emphasis on commercial and industrial and small business lending, the Company hired a new CLO in 2012. The decline in the yield on interest earning assets of 51 basis points was partially offset by an improvement in the funding costs, which amounted to a reduction of 42 basis points as noted above. The decline in yield on interest-earning assets was driven by lower yields on average investment securities which more than offset the improved yield for average loans year over year. The Company continued to pay down maturing brokered CDs throughout 2012 and was also able to lower retail deposit costs through the re-pricing of maturing CDs at lower interest rates and also lowered rates offered on other interest-bearing deposit accounts. The increased concentration of higher yielding leases and the reduced concentration of non-performing loans were more than offset by a lower concentration of higher-yielding tax liens, within interest-earning assets year over year. During 2012, loans, which are the highest yielding interest-earning asset, amounted to 51.1% of total interest-earning assets compared to 57.4% in 2011 while the concentration of the lower yielding investment securities increased from 38.7% in 2011 to 45.9% of total interest-earning assets in 2012.
The net interest margin for the full year 2011 amounted to 3.06%, which represented an increase of 17 basis points from 2010. The improved margin was attributed to lower interest rates for all major categories of interest-bearing liabilities for the Company. The redemption of $83.2 million of higher cost brokered CDs, the retention of most of the $273 million maturing retail CDs at reduced rates of interest during 2011 and improved borrowings costs associated with the pay off of $57.5 million of FHLB advances at year end 2010 accounted for a majority of the improved net interest margin. The overall improvement was partially offset by a decline of 53 basis points on the yield on average interest-earning assets, which resulted from a decline in yields on both loans and investment securities. The decline in the yield on investment securities was associated with a lower reinvestment rate on sold securities and payments and prepayments of cash-flowing agency investments due to the lower interest rates throughout 2011. The decline for loan yields was related to a reduction of higher yielding tax liens within the loan portfolio during 2011, the pay off of higher yielding loans, lower interest rates on new loans and a nonrecurring favorable adjustment of $905,000 that positively impacted the loan yield in 2010.
Average Balances
The following table represents the average daily balances of assets, liabilities and shareholders’ equity and the respective interest earned and paid on interest-bearing assets and interest-bearing liabilities, as well as average rates for the periods indicated:
(1)
Non-accrual loans have been included in the appropriate average loan balance category, but interest on these loans has not been included.
(2)
Portions of interest related to obligations through VIE are capitalized on the VIE’s books.
The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income exclusive of interest on obligation through VIE, for the years ended December 31, 2012 and 2011, as compared to respective previous periods, into amounts attributable to both rate and volume variances.
Provision for Loan and Lease Losses
The provision for loan and lease losses declined $1.7 million from 2011 to $6.0 million for 2012. During 2012 loan balances decreased $70.0 million. The declining loan balances favorably impacted the 2012 recorded provision. The Company recorded $5.1 million in net charge-offs in 2012, which were primarily related to specific reserves.
The provision for loan and lease losses declined $14.4 million from 2010 to $7.7 million for 2011. During 2011 loan balances declined $82.6 million, which includes net charge-offs of $12.5 million. This lower level of loan and lease balances required a lower allowance which enabled the provision to decline.
The provision for loan and lease losses was $22.1 million in 2010. Included in the 2010 provision was $11.4 million in charge-offs on loans transferred to loans held for sale. The Company recorded $30.4 million in net charge-offs in 2010.
Total Other Income
Other income includes service charges on depositors’ accounts, safe deposit rentals and fees for various services such as wire transfers and issuing Treasurers’ checks. In addition, other forms of non-interest income are derived from changes in the cash value of bank owned life insurance (“BOLI”) and income related to income producing properties within other real estate owned. Most components of other income are a modest and stable source of income, with exceptions of one-time gains and losses from the sale of investment securities, OREO, and loans. From period to period these sources of income may vary considerably. Service charges on depositors’ accounts, safe deposit rentals and other fees are periodically reviewed by management to remain competitive with other local banks.
For 2012 and 2011, total other income amounted to $3.6 million and $6.8 million, respectively. The $3.2 million decline was primarily attributable to a $1.8 million drop in income from real estate joint ventures related to a partial recovery of a fully impaired real estate joint venture in 2011 ($0 in 2012 versus $1.8 million in 2011), a $1.3 million decrease in gains on sale of OREO ($363,000 in 2012 versus $1.6 million in 2011) and a $563,000 increase in OTTI charges on AFS securities ($2.4 million in 2012 versus $1.8 million in 2011). The OTTI charges were related to two private equity funds and included the entire carrying value of one of the private equity funds in the amount of $1.5 million and credit related impairment charge of $859,000 on another private equity fund. Other unfavorable fluctuations year over year in other income amounted to a $752,000 decrease in net gains on the sale of available for sale investment securities ($1.0 million in 2012 compared to $1.8 million in 2011), a $478,000 decrease in income related to real estate owned via equity investments, and a $363,000 decrease in other income ($747,000 in 2012 versus $1.1 million in 2011). The decline in income related to real estate owned via equity investments is attributable to the 2011 deconsolidation of the VIE as a result of the substantial completion of the real estate partnership project. The decline in other income was mostly attributed to a decrease in rental income associated with OREO properties acquired through foreclosures.
Partially offsetting these decreases was a $1.7 million increase in net gain on the sales of loans and leases ($2.1 million in 2012 compared to $337,000 in 2011) and a $162,000 increase in BOLI income ($553,000 in 2012 versus $391,000 million in 2011). The increase in net gain on the sales of loans and leases was primarily due to the sale of one non-performing loan during 2012.
Total other income in 2011 amounted to $6.8 million resulting in a decline of $947,000, or 12.2%, from 2010, which was primarily attributable to an increase of $1.3 million in OTTI charges on AFS securities ($1.8 million in 2011 versus $479,000 in 2010). This was mainly associated with the impairment of one trust preferred security within the Company’s investment portfolio which was completely written off in 2011. For 2011, other unfavorable fluctuations year over year in other income amounted to a $329,000 decrease in gain on the sales of loans and leases ($337,000 in 2011 compared to $666,000 in 2010), and decreases in both income related to real estate owned via equity investments and gains on the sale of premises and equipment related to real estate owned via equity investments of $86,000 and $667,000, respectively. The decline in income related to real estate owned via equity investments and gains on the sale of premises and equipment related to real estate owned via equity investment is attributable to the deconsolidation of the VIE as a result of the substantial completion of the real estate partnership project. As a result of deconsolidation, income of $278,000 is reflected in income related to real estate owned via equity investments.
Partially offsetting these decreases was a $619,000 increase in net gains on the sale of other real estate owned ($1.6 million in 2011 versus $1.0 million in 2010), a $492,000 increase in net gains on the sale of available for sale investment securities ($1.8 million in 2011 versus $1.3 million in 2010), a $1.8 million increase in income from real estate joint ventures related to a partial recovery of a fully impaired real estate joint venture and an increase in other income of $373,000. The improvement in other income was mostly attributed to rental income associated with two OREO properties acquired through foreclosures.
Total Other Expense
For the period ended December 31, 2012 non-interest expense of $36.3 million amounted to an increase of $4.2 million from the results in 2011. The unfavorable increase in expenses was primarily attributable to a $2.0 million DOJ fine related to the tax lien subsidiaries (for additional information please read “Item 3. Legal Proceedings” of this Form 10-K) and a $1.7 million increase in impairments on LHFS due to loan sale agreements ($2.0 million in 2012 versus $340,000 in 2011). Other increases year over year included a $1.2 million increase in impairments on OREO ($6.7 million in 2012 versus $5.5 million in 2011) and a $563,000 increase in salaries and benefits ($11.6 million in 2012 versus $11.0 million in 2011). The additional OREO impairment was primarily due to the declining values of four of the vacant land properties in the portfolio. Due to the length of time these properties have been classified as OREO, the Company has become more aggressive in marketing them. The increase in salaries and benefits were primarily related to annual merit and promotion increases, the hiring of a new CLO, retention payments and increased pension costs.
Partly mitigating the increases mentioned above was a $934,000 improvement in FDIC Insurance and Pennsylvania Department of Banking assessments ($1.1 million in 2012 versus $2.0 million in 2011) and a $436,000 decline in loan collection expenses ($465,000 in 2012 versus $901,000 in 2011). The improvement in FDIC Insurance and Pennsylvania Department of Banking assessments was the result of lower assessment rates based on the replacement of the previous Orders with the MOU during the fourth quarter of 2011. While loan collection expenses declined year over year they continue to be high along with OREO and professional and legal fees as the Company works to resolve credit quality issues. Other operating expense is comprised of data processing, postage, telephone, travel and entertainment, advertising, printing and supplies, dues and subscriptions and other miscellaneous expenses.
For the period ended December 31, 2011 non-interest expense of $32.1 million amounted to a decrease of $8.7 million, or 21.3%, from the results in 2010. The improvement in expenses was primarily attributable to a decrease of $3.5 million related to the sale of Royal Asian at the end of 2010 that impacted most expense categories, a $1.9 million decrease in OREO impairments, a $2.6 million decrease in impairments on real estate owned via equity investments, a $1.6 million decrease in impairments of real estate joint ventures, and an $1.1 million decrease in FDIC Insurance and Pennsylvania Department of Banking assessments. The VIE was deconsolidated in 2011. During 2010 impairments of real estate joint ventures was the net impact of a $2.6 million impairment, which was the entire amount of an investment in which the Company had a subordinate debt position, due to the reduction in the collateral value as a consequence of a significant decline in the cash flows generated from the property and a recovery of $968,000 from another investment in a real estate joint venture that was written off in 2007.
Salaries and benefits of $11.0 million in 2011, which declined $613,000, or 5.3%, also contributed to the favorable results for other expense. The improvement was comprised of a reduction associated with the sale of Royal Asian amounting to $1.1 million and a partially offsetting increase of $417,000 mainly related to annual merit raises for most employees, the reinstatement of the 401K match and increased benefit costs. The $888,000 decline in occupancy and equipment expense in 2011 was primarily associated with the reduction of expenses related to the Royal Asian retail branch network. While professional and legal fees of $4.1 million and OREO and loan collection expenses of $2.6 million in 2011, respectively, were relatively flat year over year, they remain elevated due to credit quality issues.
Accounting for Income Tax Expense
In 2012, 2011 and 2010, the Company recorded no tax expense. The Company did not record a tax benefit despite the net loss for 2012, 2011 and 2010 since it concluded at December 31, 2012, 2011 and 2010 that it was more likely than not that the Company would not generate sufficient taxable income to realize all of the deferred tax assets.
As of December 31, 2012 and December 31, 2011, management concluded that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets. Management’s conclusion was based on consideration of the relative weight of the available evidence and the uncertainty of future market conditions on results of operations. The Company recorded a non-cash charge of $15.5 million in the consolidated statements of operations in the period ended December 31, 2008 related to the establishment of a valuation allowance for the deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. During 2009, 2010, 2011 and 2012, the Company established additional valuation allowances of $10.2 million, $7.7 million, $3.0 million, and $3.2 million respectively, which was a result of the net operating losses for each year and the portion of the future tax benefit that more likely than not will not be utilized in the future. The additional valuation allowance did not impact the net loss as no tax benefit was recorded during 2012. As of December 31, 2012 the valuation allowance for deferred tax assets totaled $39.6 million.
The Company’s effective tax rate is the provision for federal income taxes, excluding the tax effect of extraordinary items, expressed as a percentage of income or loss before federal income taxes. The effective tax rate for the twelve months ended December 31, 2012, 2011 and 2010 was 0%. In general our effective tax rate is different from the federal statutory rate primarily due to the establishment of a valuation allowance which was $39.6 million as of December 31, 2012.
Results of Operations by Business Segments
Under FASB ASC Topic 280, “Segment Reporting” (“ASC Topic 280”), management of the Company has identified two reportable operating segments, “Community Banking” and “Tax Liens”. In years prior to 2011, the Company reflected “Equity Investments” and “Leasing” as operating segments. Management has determined that the operating results and assets related to Equity Investments and Leasing should be reflected under the Community Banking segment. The determination related to Equity Investments was based on the deconsolidation of the VIE as a result of the substantial completion of the project during 2011. The determination related to Leasing was based on not meeting the quantitative thresholds for requiring disclosure.
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Community Bank segment: At December 31, 2012, the Community Bank segment had total assets of $736.4 million, a decrease of $41.2 million or 5.3% from $777.6 million at December 31, 2011. Total deposits declined $21.0 million or 3.7% from $575.9 million at December 31, 2011 to $554.9 million at December 31, 2012. Net interest income for 2012 was $19.8 million compared to $20.3 million for 2011 representing a decrease of $505,000, or 2.5%. The decline in net interest income was primarily attributed to a significant reduction in average loan balances, a lower yield on investment securities, the re-pricing of time deposit maturities and the payoff of a higher interest-bearing FHLB advance. The interest rates paid on deposits declined in 2012 largely due to the maturities of brokered and retail certificates of deposits. The loan loss provision was $5.2 million for 2012 compared to $6.6 million for 2011 primarily as a result of the declining loan portfolio. For 2012, total other income was $2.9 million compared to a total other income of $6.3 million for 2011. The decline is mostly attributed to a $1.8 million decline in real estate joint venture income and a $1.3 million decrease in gains on OREO sales. For 2012 and 2011, total other expense was $31.1 million and $30.4 million, respectively. The net loss for 2012 was $13.8 million compared to a net loss of $9.6 million for 2011, which represents an increase of $4.2 million, or 44.3%.
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Tax Lien segment: At December 31, 2012, the Tax Lien segment had total assets of $37.3 million compared to $70.9 million at December 31, 2011 representing a decrease of $33.6 million, or 47.4%. Net interest income decreased $2.7 million, or 53.7%, from $5.0 million in 2011 to $2.3 million in 2012. The provision for lien losses decreased $264,000 from $1.1 million in 2011 to $820,000 in 2012. The small improvement in the 2012 provision was mostly related to the declining portfolio balance. Total other income was $741,000 in 2012 compared to $548,000 in 2011. Total other income is derived mostly from the gains on sale of OREO property. Total other expense increased $3.5 million from $1.7 million for 2011 to $5.2 million for 2012. The increase in total other expense was largely driven by a $2.0 million DOJ fine related to its investigation and a $637,000 increase in OREO impairment. Net loss was $1.8 million in 2012 compared to net income of $1.0 million for 2011.
Financial Condition
Total assets decreased $74.7 million, or 8.8%, to $773.7 million at December 31, 2012 from $848.4 million at year-end 2011.
Cash and Cash Equivalents: Cash and cash equivalents consist of cash on hand, and cash in interest bearing and non-interest bearing accounts in banks, in addition to federal funds sold. Cash and cash equivalents increased $4.3 million from $24.5 million at December 31, 2011 to $28.8 million at December 31, 2012. The average balance of cash and cash equivalents was approximately $32.2 million for 2012 versus $43.6 million for 2011. The Company has been committed to maintaining strong liquidity during this current economic environment. The majority of this average balance was held in interest-bearing accounts with other financial institutions which were paying a higher interest rate than federal funds. The excess cash is invested daily in overnight and federal funds. The average balance of these funds that earn interest was $22.6 million in 2012.
Investment Securities Available for Sale (“AFS”): AFS investment securities represented 46% of average interest earning assets during 2012 and consisted of government secured agency bonds, government secured mortgage-backed securities, collateralized mortgage obligations (“CMOs”), municipal bonds, domestic corporate debt and third party managed equity funds. At December 31, 2012, AFS investment securities were $349.2 million as compared to $329.0 million at December 31, 2011, an increase of $20.2 million. The increase was primarily due to the purchase of callable U. S. government agency bonds. These bonds carried a higher coupon and were purchased to enhance the yield on the investment portfolio. The purchase of these investments was partially offset by the sale of debt securities and government agencies to reduce credit risk and extension risk within the investment portfolio.
Loans: The Company’s primary earning assets are loans, representing approximately 51% of average interest-earning assets during 2012. The loan portfolio consists primarily of business demand loans and commercial mortgages secured by real estate, real estate tax liens, lease receivables, and to a significantly lesser extent, residential loans comprised of one to four family residential and home equity loans. During 2012, total loans held for investment decreased $70.0 million to $344.2 million at December 31, 2012 from $414.2 million at December 31, 2011. The decline was primarily due to net pay downs or payoffs, transfers to OREO of approximately $10.8 million in non-performing construction and land development loans, commercial real estate loans, and tax certificates, and loan charge-offs of $6.3 million.
Commercial real estate, and construction and land development loans make up a significant portion of our loan portfolio and represented 59% of total loans at December 31, 2012 compared to 57% of total loans at December 31, 2011. Management believes our current allowance for loan and lease losses is adequate at December 31, 2012 to cover losses arising from these loan categories as well as all others within the portfolio. We continue to monitor these loans as part of our loan review process to evaluate the impact these loans will have on our allowance.
Allowance for loan and lease losses: The Company’s loan and lease portfolio (the “credit portfolio”) is subject to varying degrees of credit risk. The Company maintains an allowance to absorb losses in the loan and lease portfolio. The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, “Contingencies” (“ASC Topic 450”) or FASB ASC Topic 310, “Receivables” (“ASC Topic 310”). The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level.
Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. The Company’s systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors.
The loan portfolio is stratified into loan segments that have similar risk characteristics. The general allowance is based upon historical loss rates using a three-year rolling average of the historical loss experienced within each loan segment. The qualitative factors used to adjust the historical loss experience address various risk characteristics of the Company’s loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, and (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff. Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation.
The specific reserves are determined utilizing standards required under ASC Topic 310. A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans and loans restructured under a troubled debt restructuring are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower’s overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant 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 and industrial loans, commercial real estate loans and commercial construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
The estimated fair values of substantially all of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. The Company obtains third-party appraisals to establish the fair value of real estate collateral. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. A specific reserve is established for an impaired loan for the amount that the carrying value exceeds its estimated fair value. Once a loan is determined to be impaired it will be deducted from the portfolio balance and the net remaining balance will be used in the general and qualitative analysis.
The amount of the allowance is reviewed and approved by the CLO, Chief Financial Officer (“CFO”), Chief Credit Officer (“CCO”) and the Chief Administrative Officer (“CAO”) on at least a quarterly basis. Management believes that the allowance for loan and lease losses at December 31, 2012 is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary. These changes could be based in the credits comprising the portfolio and changes in the financial condition of borrowers, as the result of changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination.
Analysis of the Allowance for Loan and Lease Losses:
Analysis of the Allowance for Loan and Lease Losses by Loan Type:
The provision for loan and lease losses was $6.0 million in 2012 compared to $7.7 million in 2011. Commercial real estate, commercial loans, and construction and land loans represent 52%, 22%, and 19%, respectively, of the total $23.0 million in non-accrual loans at December 31, 2012. Total charge-offs recorded in 2012 related to construction and land development loans and commercial real estate loans were $3.8 million, or 60%, of total charge-offs in 2012.
The provision for loan and lease losses was $7.7 million in 2011 compared to $22.1 million in 2010. Included in the 2010 provision was $11.4 million in charge-offs on loans transferred to LHFS. The historical loss calculation of the allowance for loan and lease losses has been specifically impacted by the recent charge-off history of the Company. The deterioration of the real estate market these past few years had significantly impacted construction and real estate loans throughout the banking industry. Construction and land, non-residential real estate, and commercial loans represent 43%, 40% and 9%, respectively of the $51.3 million in non-accrual loans held at December 31, 2011. Total charge-offs recorded in 2011 related to construction and land development loans and non-residential real estate loans were $7.4 million, or 56%, of total charge-offs in 2011.
The provision for loan and lease losses was $22.1 million in 2010 compared to $20.6 million in 2009. Included in the 2010 provision was $11.4 million in charge-offs on loans transferred to LHFS. Construction and land, non-residential real estate, and commercial loans represent 50%, 28% and 9%, respectively of the $65.8 million in non-accrual loans held at December 31, 2010. Total charge-offs recorded in 2010 related to construction and land development loans and non-residential real estate loans were $20.8 million, or 66%, of total charge-offs in 2010.
Deposits: The Company’s deposits are an important source of funding. Total deposits of $554.9 million at December 31, 2012 decreased $21.0 million, or 3.6%, from $575.9 million at December 31, 2011. Brokered deposits declined $5.8 million to $0 at December 31, 2012 as the Company redeemed all maturing brokered deposits as required under the previous Orders. Time deposit accounts of $255.6 million at December 31, 2012 decreased $17.7 million, or 6.5%, from $273.3 million at December 31, 2011 primarily as a result of the Company electing to partially run off the higher cost deposits.
FHLB Borrowings: Borrowings consist of long-term borrowings (advances) and short-term borrowings (overnight borrowings, advances). Total FHLB borrowings declined from $104.2 million at year end 2011 to $65.0 million at December 31, 2012. During 2012, the Company borrowed a $15.0 million advance to partially offset the $54.2 million repaid in short term borrowings. FHLB long term advances for the periods ending December 31, 2012 and 2011 were $65.0 million and $50.0 million, respectively.
Other Borrowings: During 2004, the Company completed a private placement of trust preferred securities in the aggregate amount of $25.0 million for a term of 30 years with a call feature of 5 years. These securities were eligible to be called in October 2009 by the Company. The maturity date of these securities is October 2034. On August 13, 2009, the Company’s Board of Directors determined to suspend interest payments on the trust preferred securities. The Company’s Board of Directors took this action in consultation with the Federal Reserve Bank of Philadelphia as required by recent regulatory policy guidance. The Company currently has sufficient liquidity to pay the scheduled interest payments; however, the Company believes this decision better supports the capital position of Royal Bank, a wholly owned subsidiary of the Company. As of December 31, 2012 the trust preferred interest payment in arrears was $2.5 million and has been recorded in interest expense and accrued interest payable.
At December 31, 2012, the Company has an amortizing loan outstanding with PNC Bank in the amount of $3.3 million. The Company also has $40.0 million in repurchase agreements with PNC. These repurchase agreements are callable quarterly and have a final maturity date of January 7, 2018.
Other Liabilities: At December 31, 2012, other liabilities of $22.5 million increased $3.2 million from December 31, 2011. This was principally due to an increase of $2.5 million related to unfunded pension plan obligations.
Shareholders’ Equity: Shareholders’ equity decreased $17.5 million, or 23.1%, in 2012 to $58.4 million primarily due net losses of $15.6 million and a $942,000 decrease in accumulated other comprehensive loss due to declines in valuations in the bond markets that negatively impacted the investment portfolio and pension. Noncontrolling interest declined $1.0 million from $4.9 million at December 31, 2011 to $3.9 million at December 31, 2012.
Asset Liability Management
The primary functions of asset-liability management are to ensure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. This process is overseen by the Asset-Liability Committee (“ALCO”) which monitors and controls, among other variables, the liquidity, balance sheet structure and interest rate risk of the consolidated company within policy parameters established and outlined in the ALCO Policy which are reviewed by the Board of Directors at least annually. Additionally, the ALCO committee meets periodically and reports on liquidity, interest rate sensitivity and projects financial performance in various interest rate scenarios.
Liquidity: Liquidity is the ability of the financial institution to ensure that adequate funds will be available to meet its financial commitments as they become due. In managing its liquidity position, the financial institution evaluates all sources of funds, the largest of which is deposits. Also taken into consideration is the repayment of loans. These sources provide the financial institution with alternatives to meet its short-term liquidity needs. Longer-term liquidity needs may be met by issuing longer-term deposits and by raising additional capital.
The Company generally targets liquidity ratios equal to or greater than 12% and 10% of total deposits and total liabilities, respectively. The liquidity ratios are specifically defined as the ratio of net cash, available FHLB and other lines of credit, and unpledged marketable securities relative to both total deposits and total liabilities. At December 31, 2012, liquidity as a percent of deposits was 48% and liquidity as a percent of total liabilities was 38%. At December 31, 2011, liquidity as a percent of deposits was 34% and liquidity as a percent of total liabilities was 26%. Management believes that the Company’s liquidity position continues to be adequate and meets or exceeds the liquidity target set forth in the Asset/Liability Management Policy. Management believes that due to its financial position, it will be able to raise deposits as needed to meet liquidity demands. However, any financial institution could have unmet liquidity demands at any time.
Our funding decisions can be influenced by unplanned events, which include, but are not limited to, the inability to fund asset growth, difficulty renewing or replacing funds that mature, the ability to maintain or draw down lines of credit with other financial institutions, significant customer withdrawals of deposits, and market disruptions. Royal Bank is in an overcollateralization status with the FHLB, with a 105% pledged collateral requirement. The available amount for future borrowings will be based on the amount of collateral to be pledged. The Company has a liquidity contingency plan in the event liquidity falls below an acceptable level, however in today’s economic environment, events could arise that may render sources of liquid funds unavailable in the future when required. The Company’s liquidity committee meets monthly to increase the oversight role of liquidity management during this challenging economic environment.
Contractual Obligations and Other Commitments: The following table sets forth contractual obligations and other commitments representing required and potential cash outflows as of December 31, 2012.
Interest-Rate Sensitivity: Interest rate sensitivity is a function of the re-pricing characteristics of the Company’s assets and liabilities. These include the volume of assets and liabilities re-pricing, the timing of re-pricing, and the interest rate sensitivity gaps which are a continual challenge in a changing rate environment. In managing its interest rate sensitivity positions, the Company seeks to develop and implement strategies to control exposure of net interest income to risks associated with interest rate movements. The interest rate sensitivity report examines the positioning of the interest rate risk exposure in a changing interest rate environment. Ideally, the rate sensitive assets and liabilities will be maintained in a matched position to minimize interest rate risk.
The interest rate sensitivity analysis is an important management tool; however, it does have some inherent shortcomings. It is a “static” analysis. Although certain assets and liabilities may have similar maturities or re-pricing, they may react in different degrees to changes in market interest rates. Additionally, re-pricing characteristics of certain assets and liabilities may vary substantially within a given period.
The following table summarizes re-pricing intervals for interest earning assets and interest bearing liabilities as of December 31, 2012, and the difference or “gap” between them on an actual and cumulative basis for the periods indicated. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net interest income. During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely. At December 31, 2012, the Company is in an asset sensitive position of $10.4 million, which indicates that within one year the re-pricing of assets is sooner than the re-pricing of liabilities.
(1)
Interest earning assets are included in the period in which the balances are expected to be repaid and/or re-priced as a result of anticipated prepayments, scheduled rate adjustments, and contractual maturities.
(2)
Reflects principal maturing within the specified periods for fixed and re-pricing for variable rate loans; includes non-performing loans.
(3)
Includes FHLB stock.
The method of analysis of interest rate sensitivity in the table above has a number of limitations. Certain assets and liabilities may react differently to changes in interest rates even though they re-price or mature in the same time periods. The interest rates on certain assets and liabilities may change at different times than changes in market interest rates, with some changes in advance of changes in market rates and some lagging behind changes in market rates. Also, certain assets have provisions, which limit changes in interest rates each time the interest rate changes and for the entire term of the loan. Additionally, prepayments and withdrawals experienced in the event of a change in interest rates may deviate significantly from those assumed in the interest rate sensitivity table. Additionally, the ability of some borrowers to service their debt may decrease in the event of an interest rate increase.
Interest Rate Swaps: For asset/liability management purposes, the Company had used interest rate swaps which are agreements between the Company and another party (known as counterparty) where one stream of future interest payments is exchanged for another based on a specified principal amount (known as notional amount). The Company will use interest rate swaps to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts. Such derivatives are used as part of the asset/liability management process, are linked to specific liabilities, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.
The Company had utilized interest rate swap agreements to convert a portion of its fixed rate time deposits to a variable rate (fair value hedge), to fund variable rate loans and investments as well as convert a portion of variable rate borrowings (cash flow hedge) to fund fixed rate loans. Interest rate swap contracts represent a series of interest flows and are exchanged over a prescribed period.
As a consequence of the 2008 Lehman Brothers Holdings, Inc. (“Lehman”) bankruptcy filing, the swap agreements and cash flow hedge that existed at the time of the bankruptcy filing were terminated. The Company had an agency mortgage-backed security (approximately $5.0 million) that was pledged as collateral at Lehman for our swap agreements. In October 2008, the Company sued Lehman Brothers Special Financing, Inc. (“LBSF”) to recover possession of its collateral. Because of the uncertainty surrounding the litigation and the Lehman bankruptcy, the Company classified the collateral as other-than-temporarily impaired for the entire amount as of December 31, 2008. In the fourth quarter of 2010, the Company sold its claim and recorded a gain of $1.7 million. The Company did not have any interest rate swaps agreements at December 31, 2012, 2011, and 2010.
Capital Adequacy
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under regulatory accounting principles (“RAP”), that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for December 31, 2012 and the previous nine quarters in accordance with U.S. GAAP. The change in the method of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s capital ratios as shown below. Royal Bank is in discussions with the FDIC to resolve the matter.
The table below sets forth Royal Bank’s capital ratios under RAP, based on the FDIC’s interpretation of the Call Report instructions:
The tables below reflect the adjustments to the net loss as well as the capital ratios under U.S. GAAP:
The tables below reflect the Company’s capital ratios and the Company’s performance ratios:
The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) for December 31, 2012 consistent with U.S. GAAP and the FR Y-9C instructions. In the event that a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below.
The capital ratios set forth above compare favorably to the minimum required amounts of Tier 1 and total capital to risk-weighted assets and the minimum Tier 1 leverage ratio, as defined by the banking regulators. At December 31, 2012, the Company was required to have minimum Tier 1 and total capital ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of 4.0%. At December 31, 2012, the Company met the regulatory minimum capital requirements, and management believes that, under current regulations, the Company will continue to meet its minimum capital requirements in the foreseeable future. As described in “Regulatory Action” under “Item 1 - Business” in this Report, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12% as part of an informal agreement. Royal Bank met those requirements at December 31, 2012. See “Note 15 - Regulatory Capital Requirements” of the Notes to Consolidated Financial Statements in Item 8 of this Report. Royal Bank met the criteria for a well capitalized institution which is a leverage ratio of 5%, a Tier 1 ratio of 8%, and a total capital ratio of 10%.
On February 20, 2009, as part of the Capital Purchase Program (“CPP”) established by the United States Department of Treasury (“Treasury”), the Company issued to Treasury 30,407 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, without par value per share (the “Series A Preferred Stock”), and a liquidation preference of $1,000 per share. In conjunction with the purchase of the Series A Preferred Stock, Treasury received a warrant to purchase 1,104,370 shares of the Company’s Class A common stock. The aggregate purchase price for the Series A Preferred Stock and Warrant was $30.4 million in cash. The Series A Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series A Preferred Stock may generally be redeemed by the Company at any time following consultation with its primary banking regulators. The warrant issued to Treasury has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $4.13 per share of the common stock.
Management Options to Purchase Securities
The 2007 Long-Term Incentive Plan was approved by shareholders at the 2007 Annual Meeting. All employees and non-employee directors of the Company and its designated subsidiaries are eligible participants. The plan includes 1,000,000 shares of Class A common stock (of which 250,000 shares may be issued as restricted stock), subject to customary anti-dilution adjustments, or approximately 9.0% of total outstanding shares of the Class A common stock. As of December 31, 2012, 191,072 shares from this plan have been granted. The option price is equal to the fair market value at the date of the grant. The options are exercisable at 20% per year beginning one year after the date of grant and must be exercised within ten years of the grant. At December 31, 2012, 86,226 of the options that have been granted are outstanding, of which 75,706 are exercisable. The restricted stock is granted with an estimated fair value equal to the market value of the Company closing stock price on the date of the grant. Restricted stock will vest three years from the grant date, if the Company achieves specific goals set by the Compensation Committee and approved by the Board of Directors. These goals include a three year average return on assets compared to peers, a three year average return on equity compared to peers and a minimum return on both assets and equity over the three year period.
In May 2001, the directors of the Company approved the amended Royal Bancshares of Pennsylvania Non-qualified Stock Option and Appreciation Right Plan (the “Plan”). The shareholders in connection with the formation of the Holding Company re-approved the Plan. The Plan is an incentive program under which Bank officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1,800,000 shares of the Company’s Class A common stock (but not in excess of 19% of outstanding shares). In May 2006, the shareholders approved an increase of the number of shares of Class A Common Stock available for issuance under the Plan by 150,000 to 1,800,000 and extended the plan for an additional year At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. At December 31, 2012, 217,561 of the options that have been granted are outstanding and exercisable. The ability to grant new options under this plan has expired.
In May 2001, the directors of the Company approved an amended non-qualified Outside Directors’ Stock Option Plan. The shareholders in connection with the formation of the Holding Company re-approved this Plan. Under the terms of the plan, 250,000 shares of Class A stock are authorized for grants. Each director is entitled to a grant of an option to purchase 1,500 shares of stock annually, which is exercisable one year from the grant date. The options are granted at the fair market value at the date of the grant. At December 31, 2012, 58,306 of the options that have been granted are outstanding and exercisable. The ability to grant new options under this plan has expired.
Loans
The Company grants commercial and real estate loans, including construction and land development primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the Mid-Atlantic region. The Company also has participated with other financial institutions in selected construction and land development loans outside these geographic areas. The Company has a concentration of credit risk in commercial real estate, construction and land development loans at December 31, 2012. A substantial portion of its debtors’ ability to honor these contracts is dependent upon the housing sector specifically and the economy in general.
The Company classifies its leases as finance leases, in accordance to FASB ASC Topic 840, “Leases”. The difference between the Company’s gross investment in the lease and the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method.
The Company granted loans to the officers and directors of the Company and to their associates. In accordance with Regulation O related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectability. The aggregate dollar amount of these loans was $1.4 million and $8.8 million at December 31, 2012 and 2011. During 2012 there were no new related party loans. Total payments received on related party loans in 2012 were $18,000. Additionally, $7.4 million is no longer classified as related party due to the resignation of one of the directors during 2012.
The following table reflects the composition of the loan portfolio and the percent of gross loans outstanding represented by each category at the dates indicated.
Credit Quality
The following table presents the principal amounts of non-accrual loans held for investment and other real estate:
(1)
Generally, a loan is placed in non-accrual status when it has been delinquent for a period of 90 days or more, unless the loan is both well secured and in the process of collection.
Non-accrual loan activity for each of the four quarters in 2012 is set forth below:
*Charge-offs on LHFI were recorded in the allowance while impairment on LHFS was recorded in other expenses.
Total non-accrual loans at December 31, 2012 were $23.0 million and were comprised of $21.4 million in LHFI and $1.6 million in LHFS. Non-accrual loans were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS at December 31, 2011. The $28.3 million decline in total non-accrual loans was the result of a $18.4 million reduction in existing non-accrual loan balances through payments or loans becoming current and placed back on accrual, $8.3 million in charge-offs and write downs related to impairment analysis, and transfers to OREO of $10.8 million, which collectively were offset by $9.2 million in additions.
Impaired Loans
The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis. The Company recognizes income under the accrual basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to the Company. If these factors do not exist, the Company does not recognize income. If interest had been accrued, such income would have been approximately $3.1 million, $5.1 million, and $6.5 million, for the years ended December 31, 2012, 2011, and 2010, respectively. At December 31, 2012, the Company had no loans past due 90 days or more on which interest continues to accrue.
The following is a summary of information pertaining to impaired loans and leases:
Total cash collected on impaired loans and leases during 2012, 2011, and 2010 was $23.4 million, $29.9 million, and $21.7 million, respectively, of which $21.1 million, $29.7 million, and $21.4 million was credited to the principal balance outstanding on such loans, respectively.
Troubled Debt Restructurings
A loan modification is deemed a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics. If in modifying a loan the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession it would not normally consider then the loan modification is classified as a TDR. All loans classified as TDRs are considered to be impaired. TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual restructured principal and interest is no longer in doubt. At December 31, 2012, the Company had twelve TDRs, of which eight are on non-accrual status, with a total carrying value of $21.1 million. At the time of the modifications, seven of the loans were already classified as impaired loans. At December 31, 2011, the Company had twelve TDRs, of which seven were on non-accrual status, with a total carrying value of $14.2 million. At the time of the modifications, eight of the loans were already classified as impaired loans. The Company’s policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.
The following table details the Company’s TDRs that are on an accrual status and a non-accrual status at December 31, 2012.
The following table presents newly restructured loans that occurred during the year ended December 31, 2012.
At December 31, 2012, all of the TDRs were in compliance with their restructured terms.
Potential Problem Loans
Potential problem loans are loans not currently classified as non-performing loans, but for which management has doubts as to the borrowers’ ability to comply with present repayment terms. The loans are usually delinquent more than 30 days but less than 90 days. Potential problem loans amounted to approximately $13.3 million and $4.2 million at December 31, 2012 and December 31, 2011, respectively. The increase of $9.1 million in potential problem loans is primarily related to one $6.9 million relationship. While the loan relationship was not delinquent at December 31, 2012, the credit’s risk rating was downgraded.
Other Real Estate Owned (“OREO”):
OREO declined $7.6 million from $21.0 million at December 31, 2011 to $13.4 million at December 31, 2012. Set forth below is a table which details the changes in OREO from December 31, 2011 to December 31, 2012.
At December 31, 2012, OREO is comprised of $7.1 million in land, $3.7 million in commercial real estate, $2.1 million in tax liens, and single family homes with a fair value of $527,000. During the fourth quarter the Company sold a multi-family property and a commercial real estate property. The Company received net proceeds of $4.2 million and recorded a combined loss of $376,000 as a result of these sales. The Company also sold two condominiums related to the construction project in Minneapolis, Minnesota described below. The Company received its pro rata share of net proceeds in the amount of $38,000 and recorded a gain of $16,000. In addition to the sales mentioned above the Company sold 22 properties acquired through the tax lien portfolio. The Company received proceeds of $1.3 million and recorded net gains of $378,000 as a result of these sales. During the fourth quarter of 2012, based on annual updated appraisals and agreements of sale, the Company recorded impairment charges of $3.1 million on six land properties, $77,000 on a commercial real estate property, and $169,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $293,000 to OREO.
During the third quarter of 2012, the Company sold collateral related to residential real estate and construction loans. The Company received net proceeds of $35,000 and recorded a loss of $2,000 as a result of these sales. In addition to the sales mentioned above the Company sold eleven properties acquired through the tax lien portfolio. The Company received proceeds of $887,000 and recorded net gains of $230,000 as a result of these sales. During the third quarter of 2012, based on annual updated appraisals the Company recorded impairment charges of $2.3 million on properties related to land development and $58,000 on commercial real estate collateral. The Company also recorded impairment charges of $54,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.4 million to OREO.
During the second quarter of 2012, the Company sold collateral related to residential real estate and construction loans. The Company received net proceeds of $433,000 and recorded a gain of $133,000 as a result of these sales. In addition to the sales mentioned above the Company sold seven properties acquired through the tax lien portfolio. The Company received proceeds of $495,000 and recorded gains of $122,000 as a result of these sales. During the second quarter of 2012, the Company recorded impairment charges of $321,000 and $121,000 on collateral related to multi-family and residential construction loans, respectively, based on expected net sales proceeds and $554,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.1 million to OREO.
During the first quarter of 2012, the Company foreclosed on and sold collateral related to one commercial real estate loan. The Company received net proceeds of $4.1 million and recorded a gain of $36,000. Additionally the Company sold eight single family homes related to three loans. The Company received net proceeds of $104,000 and recorded a small net gain of $3,000. As a result of these sales the Company recorded an impairment charge of $44,000 on the remaining collateral for two of these loans. In addition to the sales mentioned above, the Company sold ten properties acquired through the tax lien portfolio. The Company received proceeds of $332,000 and recorded a net loss of $177,000 as a result of these sales. During the first quarter of 2012, the collateral for a completed hotel and condominium construction project in Minneapolis, Minnesota, in which the Company is a participant, was foreclosed on by the lead lender. The Company transferred the fair value of $3.2 million to OREO which represents the Company’s participation rate of approximately 7.5%. The Company had previously recorded total charge-offs of $1.5 million to the allowance for loan and lease losses during the period the participation loan was non-accrual. In addition the Company acquired collateral related to the tax lien portfolio and transferred $793,000 to OREO. The Company recorded impairment charges of $9,000 related to properties acquired through the tax lien portfolio.
The Company is working to satisfactorily sell the remaining OREO properties. However the Company recognizes that the successful disposition of the properties, specifically the land, will likely take considerable time.
Loans and Lease Financing Receivables
The following table summarizes the loan portfolio by loan category and amount that corresponds to the appropriate regulatory definitions.
Credit Classification Process
The loan review function is outsourced to a third party vendor which applies the Company’s loan rating system to specific credits. The Company uses a nine point grading risk classification system commonly used in the financial services industry. The first four classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. Upon completion of a loan review, a copy of any review receiving an adverse classification by the reviewer is presented to the Classified, Charge-off and Impairment Committee (“CCIC”) for discussion. The CCO is the primary bank officer dealing with the third party vendor during the reviews.
All loans are subject to initial loan review. Additional review is undertaken with respect to loans providing potentially greater exposure. This is accomplished by:
·
100% of loans with balances of $1.5 million or greater;
·
80% of loans with balances from $1.0 million up to $1.5 million;
·
25% of loans with balances from $500,000 up to $1 million;
·
5% of loans with balances below $500,000; and
·
Loans requested specifically by the Company’s management
Loans on the Company’s Special Assets Committee list are also subject to loan review even though they are receiving the daily attention of an assigned officer and monthly attention of the Special Assets Committee. A watch list is maintained and reviewed at each meeting of CCIC. CCIC was formed to formalize the process and documentation required to classify, remove from classification, impair or charge-off a loan. The CCIC, which is comprised of the CEO, CAO, CFO, CCO, CLO and Chief Risk Officer meet as required and provide regular updated reports to the Board of Directors. Loans are added to the watch list, even though the loans may be current or less than 30 days delinquent if they exhibit elements of substandard creditworthiness. The watch list contains a statement for each loan as to why it merits special attention, and this list is distributed to the Board of Directors on a monthly basis. Loans may be removed from the watch list if the CCIC determines that exception items have been resolved or creditworthiness has improved. Additionally, if loans become serious collection matters and are listed on the Company’s monthly delinquent loan or Special Assets Committee lists, they may be removed from the watch list. Minutes outlining the CCIC’s findings and recommendations are issued after each meeting for follow-up by individual loan officers.
All loans, at the time of presentation to the appropriate loan committee, are given an initial loan “risk” rating by the CCO. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.
Investment Securities
The following tables present the consolidated amortized cost and approximate fair value at December 31, 2012, 2011, and 2010, respectively, for each major category of the Company’s AFS investment securities portfolio.
The contractual maturity distribution and weighted average rate of the Company’s AFS debt securities at December 31, 2012 are presented in the following table. Mortgage-backed securities and collateralized mortgage obligations are presented within the category that represents the total weighted average expected maturity.
The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”). The non-agency collateralized mortgage obligation that is rated below AA is evaluated under FASB ASC Topic 320 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” under FASB ASC Topic 325, “Investments-Other”. In determining whether OTTI exists, management considers numerous factors, including but not limited to: (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments. If the Company intends to sell a security or will be required to sell a security, the OTTI is recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If the Company does not intend to sell a security and it is not more likely than not that the entity will be required to sell a security before the recovery of its amortized cost basis, the OTTI is separated into two amounts, the credit related loss and the loss related to other factors. The credit related loss is based on the present value of the expected cash flows and is recognized in earnings. The noncredit-related loss is based on other factors such as illiquidity and is recognized in other comprehensive income.
At December 31, 2012 investment securities were $349.2 million with a net unrealized gain of $5.3 million compared to $329.0 million with a net unrealized gain of $5.6 million at December 31, 2011. The decrease in the net unrealized gain of $244,000 is related to realized gains when bonds were sold during the reporting period. Refer to “Note 3- Investment Securities” to the Consolidated Financial Statements in Item 8 for more information.
Deposits
The average balance of the Company’s deposits by major classifications for each of the last three years is presented in the following table.
The remaining maturity of Certificates of Deposit of $100,000 or greater:
Short and Long Term Borrowings
(1)
This obligation is consolidated from requirements under ASC Topic 810 of which $0 was guaranteed by the Company.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
A simulation model is used to estimate the impact of various changes, both upward and downward, in market interest rates and volumes of assets and liabilities on the net income. This model produces an interest rate exposure report that forecast changes in the market value of portfolio equity under alternative interest rate environment. The market value of portfolio is defined as the present value of existing assets and liabilities. The calculated estimates of changes in the market value of portfolio value for Royal Bank are as follows:
The assumptions used in evaluating the vulnerability of earnings and capital to changes in interest rates are based on management’s considerations of past experience, current position and anticipated future economic conditions. The interest rate sensitivity of assets and liabilities as well as the estimated effect of changes in interest rates on the market value of portfolio equity could vary substantially if different assumptions are used or actual experience differs from what the calculations may be based.
The simulation model indicates that the Company is outside of policy limits in the rates up 300 and 400 basis points scenarios. The cause of the policy exceptions is primarily related to extension risk within the Company’s investment portfolio. In a rising interest rate environment general expectations are for prepayments of principal to slow down which cause the life of the Company’s mortgage-backed and CMO securities to extend. Management continues to work on changing the mix of interest-earning assets to mitigate this risk.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
Royal Bancshares of Pennsylvania, Inc.
We have audited the accompanying consolidated balance sheets of Royal Bancshares of Pennsylvania, Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of operations, changes in shareholders’ equity, comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2012. These financial statements are the responsibility of Royal Bancshares of Pennsylvania, Inc.’s management. 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Royal Bancshares of Pennsylvania, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America.
/s/ ParenteBeard LLC
ParenteBeard LLC
Philadelphia, Pennsylvania
March 27, 2013
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Statements of Consolidated Comprehensive Loss
The accompanying notes are an integral part of these consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Shareholders' Equity
For the years ended December 31, 2010, 2011, 2012
The accompanying notes are an integral part of these consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Continued)
The accompanying notes are an integral part of these consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
1.
Basis of Financial Statement Presentation
Nature of Operations
Royal Bancshares of Pennsylvania, Inc. (the “Company”), through its wholly-owned subsidiary Royal Bank America (“Royal Bank”) offers a full range of banking services to individual and corporate customers primarily located in the Mid-Atlantic states. Royal Bank competes with other banking and financial institutions in certain markets, including financial institutions with resources substantially greater than its own. Commercial banks, savings banks, savings and loan associations, credit unions and brokerage firms actively compete for savings and time deposits and for various types of loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors of Royal Bank with respect to one or more of the services it renders.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc., Royal Captive Insurance Company, Royal Preferred, LLC, and Royal Bank, including Royal Bank’s subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investment America, LLC, RBA Property LLC, Narberth Property Acquisition LLC, and Rio Marina LLC. In addition, the following are owned 60% by Royal Bank: Royal Bank America Leasing, LP, Crusader Servicing Corporation (“CSC”) and Royal Tax Lien Services (“RTL”), LLC. During the fourth quarter of 2010, Royal Captive Insurance was dissolved. The investments were sold for a gain of approximately $8,000, $2.0 million was paid to the Company as a dividend, and the remaining funds, in the approximate amount of $500,000, were transferred to the Company. On December 30, 2010, the Company completed the sale of all of the outstanding common stock of Royal Asian Bank (“Royal Asian”), a wholly-owned subsidiary, to an investor group. Royal Asian’s net loss of $ 953,000 through December 29, 2010 was consolidated into the Company’s consolidated financial statements. Both of the Company’s Trusts are not consolidated as further discussed below in “Variable Interest Entities”. All significant intercompany transactions and balances have been eliminated.
Use of Estimates
In preparing the consolidated financial statements in accordance with United States generally accepted accounting principles (“U.S. GAAP”), management is required to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates.
The principal estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan and lease losses, loans held for sale, the valuation of other real estate owned, the valuation of deferred tax assets, other-than-temporary impairment losses on investment securities, net periodic pension costs and the pension benefit obligation. In connection with the allowance for loan and lease losses estimate, management obtains independent appraisals for real estate collateral. However, future changes in real estate market conditions and the economy could affect the Company’s allowance for loan and lease losses. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Significant Concentration of Credit Risk
Most of the Company’s activities are with customers located within the Mid-Atlantic region of the country. “Note 3 - Investment Securities” to the Consolidated Financial Statements discusses the types of securities in which the Company invests. “Note 4 - Loans and Leases” to the Consolidated Financial Statements discusses the types of lending in which the Company engages. The Company does not have any portion of its business dependent on a single or limited number of customers, the loss of which would have a material adverse effect on its business. The Company has 95% of its investment portfolio in securities issued by government sponsored entities. The Company’s tax lien portfolio has a geographic concentration in the State of New Jersey.
No substantial portion of loans is concentrated within a single industry or group of related industries, except a significant majority of loans are secured by real estate. There are numerous risks associated with commercial and consumer lending that could impact the borrower’s ability to repay on a timely basis. They include, but are not limited to: the owner’s business expertise, changes in local, national, and in some cases international economies, competition, governmental regulation, and the general financial stability of the borrowing entity. Over the last few years, the Company has been impacted by deterioration in economic conditions as it pertains to real estate loans. Commercial real estate, commercial loans, and construction and land loans represent 52%, 22%, and 19%, respectively, of the total $23.0 million in non-accrual loans at December 31, 2012.
The Company attempts to mitigate these risks by making an analysis of the borrower’s business and industry history, its financial position, as well as that of the business owner. The Company will also require the borrower to provide financial information on the operation of the business periodically over the life of the loan. In addition, most commercial loans are secured by assets of the business or those of the business owner, which can be liquidated if the borrower defaults, along with the personal surety of the business owner.
Variable Interest Entities (“VIE”)
Real estate owned via equity investments: The Company, together with third party real estate development companies, formed variable interest entities (“VIEs”) to construct various real estate development projects. These VIEs account for acquisition, development and construction costs of the real estate development projects in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 970, “Real Estate-General”, and account for capitalized interest on those projects in accordance with FASB ASC Topic 835, “Interest”. Due to economic conditions, management decided to curtail new equity investments.
In accordance with ASC Topic 976, the full accrual method is used to recognize profit on real estate sales. Profits on the sales of this real estate are recorded when cash in excess of the amount of the original investment is received, and calculation of same is made in accordance with the terms of the partnership agreement, the Company is no longer obligated to perform significant activities after the sale to earn profits, there is no continuing involvement with the property and; finally, the usual risks and rewards of ownership in the transaction had passed to the acquirer. At December 31, 2011, the remaining VIE was deconsolidated as a result of the substantial completion of the project and the sales of the remaining units. At December 31, 2011, the carrying amount of the investment in and due from the Partnership totaled $325,000 and were received in the first quarter of 2012. At December 31, 2012 and 2011, the Company no longer had any VIEs consolidated into the Company’s financial statements.
Trust Preferred Securities: Royal Bancshares Capital Trust I/II (“Trusts”) issued mandatory redeemable preferred stock to investors and loaned the proceeds to the Company. The Trusts hold, as their sole asset, subordinated debentures issued by the Company in 2004. The Company does not consolidate the Trusts as ASC Topic 810 precludes consideration of the call option embedded in the preferred stock when determining if the Company has the right to a majority of the Trusts expected returns. The non-consolidation results in the investment in common stock of the Trusts to be included in other assets with a corresponding increase in outstanding debt of $774,000. In addition, the income accrued on the Company’s common stock investments is included in other income. Refer to “Note 10 - Borrowings and Subordinated Debentures” to the Consolidated Financial Statements for more information.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
U.S. GAAP RAP Difference
In connection with a prior bank regulatory examination, the Federal Deposit Insurance Company (“FDIC”) concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under regulatory accounting principles (“RAP”), that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for December 31, 2012 and the previous nine quarters in accordance with U.S. GAAP. However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 2 - Regulatory Matters and Significant Risks And Uncertainties” and “Note 15 - Regulatory Capital Requirements” to the Consolidated Financial Statements. Royal Bank is in discussions with the FDIC to resolve the matter.
Reclassifications
Certain items in the 2011 and 2010 consolidated financial statements and accompanying notes have been reclassified to conform to the current year’s presentation format. There was no effect on net loss for the periods presented herein as a result of reclassification.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.
Investment Securities
Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Investments in debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized holding gains and losses included in earnings. Debt and equity securities not classified as trading securities, nor as held to maturity securities are classified as available for sale securities and reported at fair value, with unrealized holding gains or losses, net of deferred income taxes (when applicable), reported in the accumulated other comprehensive income component of shareholders’ equity. The Company did not hold trading securities nor had securities classified as held to maturity at December 31, 2012 and 2011. Discounts and premiums are accreted/amortized to income by use of the level-yield method. Gain or loss on sales of securities available for sale is based on the specific identification method.
The Company evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis. The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”). The non-agency collateralized mortgage obligation that is rated below AA is evaluated under FASB ASC Topic 320 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” or under FASB ASC Topic 325, “Investments-Other”. In determining whether OTTI exists, management considers numerous factors, including but not limited to: (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security. If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings. The noncredit-related loss is based on other factors such as illiquidity and is recognized in other comprehensive income.
Other Investment
This investment includes the Solomon Hess SBA Loan Fund, which the Company invested in to partially satisfy its community reinvestment requirement. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. An investor can have their investment in the Fund redeemed for the balance of their capital account at any quarter end with 60 days notice to the Fund. The investment in this Fund is recorded at cost.
Federal Home Loan Bank Stock
As a member of the Federal Home Loan Bank of Pittsburgh (“FHLB”), the Company is required to purchase and hold stock in the FHLB to satisfy membership and borrowing requirements. The stock can only be sold to the FHLB or to another member institution, and all sales of FHLB stock must be at par. As a result of these restrictions, there is no active market for the FHLB stock. As of December 31, 2012 and 2011, FHLB stock totaled $6.0 million and $8.5 million, respectively.
FHLB stock is held as a long-term investment and its value is determined based on the ultimate recoverability of the par value. The Company evaluates impairment quarterly. The decision of whether impairment exists is a matter of judgment that reflects management’s view of the FHLB’s long-term performance, which includes factors such as the following: (1) its operating performance, (2) the severity and duration of declines in the fair value of its net assets related to its capital stock amount, (3) its liquidity position, and (4) the impact of legislative and regulatory changes on the FHLB. Based on the capital adequacy and the liquidity position of the FHLB, management believes that the par value of its investment in FHLB stock will be recovered. Accordingly, there is no other-than-temporary impairment related to the carrying amount of the Company’s FHLB stock as of December 31, 2012.
Loans Held for Sale
At December 31, 2012, the Company’s loans held for sale (“LHFS”) were comprised of one non-accrual commercial real estate loan for $1.6 million. The loan was transferred from loans held for investment (“LHFI”) to LHFS at the lower of cost or fair market value using expected net sales proceeds. At the time of transfer to LHFS, a credit loss of $1.4 million was charged against the allowance for loan and lease losses. Generally any subsequent credit losses on LHFS are recorded as a component of non-interest expense. Additional impairment on the LHFS of $2.0 million was recorded in 2012. At December 31, 2011, LHFS were comprised of $12.6 million in non-accrual construction and land development loans and commercial and residential real estate loans.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Loans and Leases
Loans and leases are classified as LHFI when management has the intent and ability to hold the loan or lease for the foreseeable future or until maturity or payoff. LHFI are stated at their outstanding unpaid principal balances, net of an allowance for loan and leases losses and any deferred fees or costs. 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 yield (interest income) of the related loans. The Company is generally amortizing these amounts over the contractual life of the loan. The Company grants commercial and real estate loans, including construction and land development loans primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the mid-Atlantic region. The Company also has participated with other financial institutions in selected construction and land development loans outside our geographic area. The Company has a concentration of credit risk in commercial real estate and construction and land development loans at December 31, 2012. A substantial portion of its debtors’ ability to honor their contracts is dependent upon the housing sector specifically and the economy in general.
The Company classifies its leases as finance leases, in accordance with FASB ASC Topic 840, “Leases”. The difference between the Company’s gross investment in the lease and the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method.
For all classes of loans receivable, the accrual of interest is discontinued on a loan when management believes that the borrower’s financial condition is such that collection of principal and interest is doubtful or when a loan becomes 90 days past due. When a loan is placed on non-accrual all unpaid interest is reversed from interest income. Interest payments received on impaired nonaccrual loans are normally applied against principal. Excess proceeds received over the principal amounts due on impaired loans are recognized as income on a cash basis. Generally, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments.
A loan modification is deemed a troubled debt restructuring (“TDR”) when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) a concession is made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics. If in modifying a loan the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession it would not normally consider then the loan modification is classified as a TDR. All loans classified as TDRs are considered to be impaired. TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual restructured principal and interest is no longer in doubt. At December 31, 2012, the Company had twelve TDRs, of which eight are on non-accrual status, with a total carrying value of $21.1 million. At the time of the modifications, seven of the loans were already classified as impaired loans. At December 31, 2011, the Company had twelve TDRs, of which seven were on non-accrual status, with a total carrying value of $14.2 million. At the time of the modifications, eight of the loans were already classified as impaired loans. The Company’s policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.
The Company accounts for guarantees in accordance with FASB ASC Topic 460 “Guarantees” (“ASC Topic 460”). ASC Topic 460 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of the interpretation, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. The Company has financial and performance letters of credit. Financial letters of credit require the Company to make a payment if the customer’s condition deteriorates, as defined in agreements. Performance letters of credits require the Company to make payments if the customer fails to perform certain non-financial contractual obligations.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Allowance for Loan and Lease Losses
The Company’s loan and lease portfolio (the “credit portfolio”) is subject to varying degrees of credit risk. The Company maintains an allowance for loan and lease losses (the “allowance”) to absorb losses in the loan and lease portfolio. The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, “Contingencies” (“ASC Topic 450”) or FASB ASC Topic 310, “Receivables” (“ASC Topic 310”). The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level.
Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. The Company’s systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors.
The loan portfolio is stratified into loan segments that have similar risk characteristics. The general allowance is based upon historical loss rates using a three-year rolling average of the historical loss experienced within each loan segment. The qualitative factors used to adjust the historical loss experience address various risk characteristics of the Company’s loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff. Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation.
The allowance calculation methodology includes further segregation of loan classes into risk rating categories. The borrower’s overall financial condition, repayment sources, guarantors and value of collateral, if appropriate, are evaluated annually for commercial loans or when credit deficiencies arise, such as delinquent loan payments, for commercial and consumer loans. Credit quality risk ratings include regulatory classifications of special mention, substandard, doubtful and loss. Loans classified as special mention have potential weaknesses that deserve management’s close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They include loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable. Loans classified as a loss are considered uncollectible and are charged to the allowance for loan losses. Loans not classified are rated pass.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
The specific reserves are determined utilizing standards required under ASC Topic 310. A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans and loans restructured under a troubled debt restructuring are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower’s overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant 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 and industrial loans, commercial real estate loans and commercial construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.
The estimated fair values of substantially all of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. The Company obtains third-party appraisals to establish the fair value of real estate collateral. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. A specific reserve is established for an impaired loan for the amount that the carrying value exceeds its estimated fair value. Once a loan is determined to be impaired it will be deducted from the portfolio balance and the net remaining balance will be used in the general and qualitative analysis.
Based on management’s comprehensive analysis of the loan and lease portfolio, management believes the current level of the allowance is adequate at December 31, 2012. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary. These changes could be based in the credits comprising the portfolio and changes in the financial condition of borrowers, as the result of changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination, which may not be currently available to management.
Other Real Estate Owned
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost 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 less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in other expenses.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on accelerated methods over the estimated useful lives of the assets. Leasehold improvements are amortized on the accelerated methods over the shorter of the estimated useful lives of the improvements or the terms of the related leases. Expected term includes lease options periods to the extent that the exercise of such options is reasonably assured.
Interest Rate Swaps
For asset/liability management purposes, the Company had used interest rate swaps which are agreements between the Company and another party (known as counterparty) where one stream of future interest payments is exchanged for another based on a specified principal amount (known as notional amount). The Company will use interest rate swaps to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts. Such derivatives are used as part of the asset/liability management process, are linked to specific liabilities, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.
The Company had utilized interest rate swap agreements to convert a portion of its fixed rate time deposits to a variable rate (fair value hedge), to fund variable rate loans and investments as well as convert a portion of variable rate borrowings (cash flow hedge) to fund fixed rate loans. Interest rate swap contracts represent a series of interest flows and are exchanged over a prescribed period.
As a consequence of the 2008 Lehman Brothers Holdings, Inc. (“Lehman”) bankruptcy filing, the swap agreements and cash flow hedge that existed at the time of the bankruptcy filing were terminated. The Company had an agency mortgage-backed security (approximately $5.0 million) that was pledged as collateral at Lehman for our swap agreements. In October 2008, the Company sued Lehman Brothers Special Financing, Inc. (“LBSF”) to recover possession of its collateral. Because of the uncertainty surrounding the litigation and the Lehman bankruptcy, the Company classified the collateral as other-than-temporarily impaired for the entire amount as of December 31, 2008. In the fourth quarter of 2010, the Company sold its claim and recorded a gain of $1.7 million. The Company did not have any interest rate swaps agreements at December 31, 2012, 2011 and 2010.
Investments in Real Estate Joint Ventures
During 2012, the Company did not recognize any income from real estate joint ventures. During 2011, the Company recorded income from real estate joint ventures of $1.8 million. This income was related to a payment received from a guarantor on an investment which had been fully written down in 2007. During 2010, the Company had one investment in a real estate joint venture and accounted for it in accordance with ASC Topic 310 and FASB ASC Topic 976, “Real Estate-Retail Land” (“ASC Topic 976”) because the Company was not a party to an operating agreement and had no legal ownership of the entity that owns the real estate. The real estate joint venture was an investment in an Ohio marina project in which the Company had a subordinate debt position. During the second quarter of 2010, the Company fully impaired the investment and recorded a $2.5 million charge to earnings. The impairment was the result of a lower collateral value due to the significant reduction in the cash flows being generated from the property. During the third quarter of 2010, the first mortgage lender foreclosed on the property. Partially offsetting the $2.5 million impairment charge was a $968,000 recovery on another investment in a real estate in joint venture which had been written down in 2007. The Company no longer holds any investments in real estate joint ventures.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Bank-Owned Life Insurance
Royal Bank has purchased life insurance policies on certain executives. These policies are reflected on the consolidated balance sheets at their cash surrender value, or the amount that can be realized. During the fourth quarter of 2011, Royal Bank purchased an additional $5.0 million of bank owned life insurance. Income from these policies and changes in the cash surrender value are recorded in other income.
Transfer of Financial Assets
The Company accounts for the transfer of financial assets in accordance with FASB ASC Topic 860, “Transfers and Servicing” (“ASC Topic 860”). ASC Topic 860 revises the standards for accounting for the securitizations and other transfers of financial assets and collateral. Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred asset through an agreement to repurchase them before maturity.
Advertising Costs
Advertising costs are expensed as incurred. The Company’s advertising costs were $127,000, $116,000, and $109,000 for 2012, 2011, and 2010, respectively.
Benefit Plans
The Company has a noncontributory nonqualified, defined benefit pension plan covering certain eligible employees. The plan provides retirement benefits under pension trust agreements. The benefits are based on years of service and the employee’s compensation during the highest three consecutive years during the last 10 years of employment. Net pension expense consists of service costs and interest costs. The Company accrues pension costs as incurred.
The Company has a capital accumulation and salary reduction plan under Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the plan, all employees are eligible to contribute up to the maximum allowed by Internal Revenue Service (“IRS”) regulation, with the Company matching 100% of any contribution between 1% and 5% subject to a $2,500 per employee annual limit. During 2012 and 2010, no matching contribution was made as a result of a management decision to reduce costs. During 2011, the Company partially reinstated the matching contribution and contributed $128,000 to the plan.
Stock Compensation
FASB ASC Topic 718, “Compensation-Stock Compensation” (“ASC Topic 718”) requires that the compensation cost relating to share-based payment transactions be recognized in consolidated financial statements. The costs are measured based on the fair value of the equity or liability instruments issued. ASC Topic 718 covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The effect of ASC Topic 718 is to require entities to measure the cost of employee services received in exchange for stock options based on the grant-date fair value of the award, and to recognize the cost over the period the employee is required to provide services for the award. ASC Topic 718 permits entities to use any option-pricing model that meets the fair value objective in the Statement. The Company recorded compensation expense relating to stock options and restricted stock of $42,000, $93,000 and $35,000 during 2012, 2011, and 2010, respectively.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
At December 31, 2012, the Company had a director stock-based, an employee stock-based, and a long-term incentive compensation plan, which are more fully described in “Note 17 - Stock Compensation Plans” to the Consolidated Financial Statements.
Income Taxes
The Company accounts for income taxes in accordance with income tax accounting guidance (FASB ASC Topic 740, Income Taxes), which includes guidance related to accounting for uncertainty in income taxes, which sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions. The Company had no material unrecognized tax benefits or accrued interest and penalties as of December 31, 2012 and 2011. The Company’s policy is to account for interest as a component of interest expense and penalties as a component of other expense.
The Company and its subsidiaries file a consolidated federal income tax return. Income taxes are allocated to the Company and its subsidiaries based on the contribution of their income or use of their loss in the consolidated return. Separate state income tax returns are filed by the Company and its subsidiaries. The Company is no longer subject to examination by taxing authorities for the years before January 1, 2005.
Federal and state income taxes have been provided on the basis of reported income or loss. The amounts reflected on the tax returns differ from these provisions due principally to temporary differences in the reporting of certain items for financial reporting and income tax reporting purposes. The tax effect of these temporary differences is accounted for as deferred taxes applicable to future periods. Deferred income tax expense or benefit is determined by recognizing deferred tax assets and liabilities for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date. The realization of deferred tax assets is assessed and a valuation allowance provided for the full amount which is not more likely than not to be realized.
Treasury Stock
Shares of common stock repurchased are recorded as treasury stock at cost.
Earnings (Losses) Per Share Information
Basic per share data excludes dilution and is computed by dividing income (loss) available to common shareholders by the weighted average common shares outstanding during the period. Diluted per share data takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock, using the treasury stock method.
The Class B shares of the Company may be converted to Class A shares at the rate of 1.15 to 1.
Comprehensive Income (Loss)
The Company reports comprehensive income (loss) in accordance with FASB ASC Topic 220, “Comprehensive Income” (“ASC Topic 220”), which requires the reporting of all changes in equity during the reporting period except investments from and distributions to shareholders. Net income (loss) is a component of comprehensive income (loss) with all other components referred to in the aggregate as other comprehensive income (loss). Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on available for sale investment securities, non-credit related losses on other-than-temporarily impaired investment securities, and adjustment to net periodic pension cost.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Fair Value of Financial Instruments
For information on the fair value of the Company’s financial instruments refer to “Note 20 - Fair Value of Financial Instruments” to the Consolidated Financial Statements.
Restrictions on Cash and Amounts Due From Banks
Royal Bank is required to maintain average balances on hand with the Federal Reserve Bank. At December 31, 2012 and 2011, these reserve balances amounted to $100,000.
2. Recent Accounting Pronouncements
In May 2011, the FASB issued ASU 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (“ASU 2011-04”) which generally clarifies guidance in ASC Topic 820 “Fair Value Measurements and Disclosures”. The amendments in ASU 2011-004 explain how to measure fair value and change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. ASU 2011-04 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The Company adopted ASU 2011-04 during the first quarter of 2012. The adoption of ASU 2011-04 did not have a significant impact on the Company’s consolidated financial statements.
In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”) which amends ASC Topic 220 “Comprehensive Income”. To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and International Financial Reporting Standards (“IFRS”), the FASB decided to eliminate the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity, among other amendments in ASU 2011-05. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income. For public entities, ASU 2011-05 was effective for the first interim or annual period beginning after December 15, 2011. The adoption of ASU 2011-05 did not have a significant impact on the Company’s consolidated financial statements. The Company adopted the two-statement approach.
In December 2011, the FASB issued ASU 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”) which amends ASC Topic 210 “Balance Sheet”. Because of the significant differences in requirements under U.S. GAAP and IFRS, FASB and the International Accounting Standards Board (“IASB”) are issuing joint requirements that will enhance current disclosures. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS. ASU 2011-11 is effective for annual periods beginning on or after January 1, 2013 and interim periods within those annual periods. An entity should provide the disclosures required by these amendments retrospectively for all comparative periods presented. The adoption of ASU 2011-11 will not have a significant impact on the Company’s consolidated financial statements.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
In February 2012, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”) to improve the reporting of reclassifications out of accumulated comprehensive income. ASU 2013-02 does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, ASU 2013-02 requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. ASU 2013-02 is effective for reporting periods beginning after December 15, 2012. The adoption of ASU 2013-02 will not have a significant impact on the Company’s consolidated financial statements.
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES
FDIC and Department of Banking Orders
On July 15, 2009, Royal Bank agreed to enter into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “Orders”) with each of the FDIC and the Pennsylvania Department of Banking (the “Department”). The material terms of the Orders were identical and required Royal Bank among other items to maintain, after establishing an adequate allowance for loan and lease losses, a ratio of Tier 1 capital to total assets (“leverage ratio”) equal to or greater than 8% and a ratio of qualifying total capital to risk-weighted assets (“total risk-based capital ratio”) equal to or greater than 12%. The FDIC and the Department replaced the Orders in the fourth quarter of 2011 with an informal agreement, known as a memorandum of understanding (“MOU”). Included in the MOU is the continued requirement of maintaining a leverage ratio equal to or greater than 8% and a total risk-based capital ratio equal to or greater than 12%. At December 31, 2012, based on capital levels calculated under RAP, Royal Bank’s Tier 1 leverage and total risk-based capital ratios were 8.53% and 16.10%, respectively. Please refer to “Note 15 - Regulatory Capital Requirements” to the Consolidated Financial Statements.
Following the issuance of the Orders, management implemented plans to address key areas that were noted in the Orders. Management has reduced classified assets, delinquencies, commercial real estate concentrations, reliance on non-core deposits and wholesale funding sources and maintained capital ratios above required minimums which were all factors that contributed to replacing the Orders with the MOU. Management has continued to improve in each of these areas since the Orders were replaced with the MOU.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES- Continued
Federal Reserve Agreement
On March 17, 2010, the Company agreed to enter into the Federal Reserve Agreement with the Reserve Bank. The material terms of the Federal Reserve Agreement provide that: (i) the Company’s board of directors will take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to its subsidiary banks; (ii) the Company’s board of directors will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank a written plan to strengthen board oversight of the management and operations of the consolidated operation; (iii) the Company will not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (iv) the Company and its non-bank subsidiaries will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System; (v) the Company and its nonbank subsidiaries will not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Reserve Bank; (vi) the Company will not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Reserve Bank; (vii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank an acceptable written capital plan to maintain sufficient capital at the Company on a consolidated basis, which plan will at a minimum address: regulatory requirements for the Company and the Banks, the adequacy of the Banks’ capital taking into account the volume of classified credits, the allowance for loan and lease losses, current and projected asset growth, and projected retained earnings; the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Banks’ future capital requirements; supervisory requests for additional capital at the Banks or the requirements of any supervisory action imposed on the Banks by federal or state regulators; and applicable legal requirements that the Company serve as a source of strength to the Banks; (viii) the Company will, within 60 days of the Federal Reserve Agreement, submit to the Reserve Bank cash flow projections for 2010 showing planned sources and uses of cash for debt service, operating expenses, and other purposes, and will submit similar cash flow projections for each subsequent calendar year at least one month prior to the beginning of such year; (ix) the Company will comply with applicable legal notice provisions in advance of appointing any new director or senior executive officer or changing the responsibilities of any senior executive officer such that the officer would assume a different senior executive officer position, and comply with restrictions on indemnification and severance payments imposed by the Federal Deposit Insurance Act; and (x) the Company’s board of directors will, within 45 days after the end of each quarter, submit progress reports to the Reserve Bank detailing the form and manner of all actions taken to secure compliance with the Agreement and the results thereof, together with a parent company-level balance sheet, income statement, and, as applicable, report of changes in shareholders’ equity.
The Federal Reserve Agreement will remain in effect and enforceable until stayed, modified, terminated or suspended by the Reserve Bank. Royal Bancshares has submitted all progress reports and responses required under the Federal Reserve Agreement as of the date of this Report.
Our success as a Company is dependent upon pursuing various alternatives in not only achieving the growth and expansion of our banking franchise but also in managing our day to day operations. The existence of the MOU and the Federal Reserve Agreement may limit or impact our ability to pursue all previously available alternatives in the management of the Company. Our ability to retain existing retail and commercial customers as well as the ability to attract potentially new customers may be impacted by the existence of the MOU and the Federal Reserve Agreement. Additionally, our ability to expand into potentially attractive commercial real estate or construction loans at this time is limited. The Company’s ability to raise capital in the current economic environment could be potentially limited or impacted as a result of the MOU and the Federal Reserve Agreement. Attracting new management talent is critical to the success of our business and could be potentially impacted due to the existence of the MOU and the Federal Reserve Agreement.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES - Continued
Continued Losses
For the four years prior to 2012, the Company had recorded significant losses totaling $104.0 million which were primarily related to charge-offs on the loan and lease portfolio, impairment charges on investment securities, impairment charges on OREO, credit related expenses and the establishment of a deferred tax valuation allowance. The 2012 net loss amounted to $15.6 million, which represented an increase of $7.0 million, from the loss recorded in 2011. Included in the loss for 2012 was a $2.0 million fine from the U.S. Department of Justice related to the tax lien subsidiaries. After adjusting for the noncontrolling interest, the Company’s 60% share of the fine amounts to $1.2 million. Impairment on loans held for sale, OREO, and investments increased $1.7 million, $1.2 million and $563,000, respectively, to $2.0 million, $6.8 million and $2.4 million. In addition to reducing the total shareholders’ equity, the continued losses and negative retained earnings impacts the Company’s ability to pay cash dividends to its shareholders now and in future years. The Company’s deferred tax valuation allowance amounted to $39.6 million at the end of 2012. The deferred tax valuation allowance is a result of management’s conclusion that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets.
Credit Quality
Adverse economic conditions in our specific market areas and decreases in real estate property values due to the nature of our loan portfolio in particular have affected the ability of customers to repay their loans and generally impact our financial condition and results of operations. The financial services and real estate industries were hit particularly hard during the “Great Recession” and as a result the Company’s loan and investment portfolios were directly affected. The Company’s commercial real estate loans, including construction and land development loans, have seen a decline in the collateral values, and a reduction in the borrowers’ ability to meet the payment terms of their loans due to reduced cash flow. Further declines in collateral values and borrowers’ liquidity with sustained unemployment at current levels may lead to additional increases in foreclosures, delinquencies and customer bankruptcies. The Company is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of more diverse economies.
The Company had non-performing loans and recorded charge-offs of $23.0 million and $6.3 million at December 31, 2012, $51.3 million and $13.2 million at December 31, 2011, and $65.8 million and $31.7 million at December 31, 2010, respectively. OREO balances were $13.4 million, $21.0 million, and $29.2 million at December 31, 2012, 2011, and 2010, respectively.
Royal Bank has been successful in reducing net classified loans, which includes LHFS, and OREO. Net classified loans were $51.8 million, $74.2 million and $109.9 million at December 31, 2012, 2011, and 2010, respectively. Royal Bank’s delinquent loans held for investment (30 to 90 days) amounted to $4.6 million, $4.2 million, and $12.2 million at December 31, 2012, 2011, and 2010, respectively. No material advances were made on any classified or delinquent loan unless approved by the board of directors and determined to be in Royal Bank’s best interest. Royal Bank’s total non-performing loans were $23.0 million, $51.3 million and $65.8 million at December 31, 2012, 2011, and 2010, respectively. The Company has restructured the investment portfolio to reduce credit risk by selling corporate debt securities and equity securities and replacing their maturities with U.S. government issued or sponsored securities. Other-than-temporary-impairment losses were $2.4 million, $1.8 million, and $479,000 at December 31, 2012, 2011, and 2010, respectively.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES - Continued
Commercial Real Estate Concentrations
As mentioned previously the adverse economic conditions have primarily impacted the real estate secured loan portfolio. Commercial real estate and construction and development loans are often riskier and tend to have significantly larger balances than home equity loans or residential mortgage loans to individuals. While the Company believes that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis, the repayments of these loans usually depends on the profitable operation of a business or the sale of the underlying property. As a result, these loans are more likely to be unfavorably affected by adverse conditions in the real estate market or the economy in general, which may result in increasing levels of loan charge-offs and non-performing assets and the reduction of earnings. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss. It is possible that Royal Bank may be required to maintain higher levels of capital than it would be otherwise be expected to maintain as a result of the Bank’s commercial real estate loans, which may require the Company to obtain additional capital.
Commercial real estate, multi-family and construction and land development loans held for investment were $216.1 million at December 31, 2012 comprising 63% of total loans compared to $248.3 million or 60% of total loans at December 31, 2011. Based on capital levels calculated under U.S. GAAP and RAP, Royal Bank does not have a concentration of commercial real estate loans as defined in the joint agency “Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” issued on December 12, 2006. Please see discussions under “GAAP RAP Difference” under “Note 1 -Significant Accounting Policies” and “Note 15 - Regulatory Capital Requirements” to the Consolidated Financial Statements.
Liquidity and Funds Management
Royal Bank has limited capacity to borrow additional funds in the event it is needed for liquidity purposes. However, Royal Bank has continued to maintain liquidity measures that are in excess of the target levels. As discussed in “Note 10 - Borrowings and Subordinated Debentures” to the Consolidated Financial Statement, Royal Bank has an over collateralized delivery requirement of 105% with the FHLB as a result of the level of non-performing assets and the losses that have been experienced over the past four years. The ability to borrow additional funds is based on the amount of collateral that is available to be pledged. As of December 31, 2012, Royal Bank had approximately $21.2 million of available borrowing capacity at the FHLB as a result of excess collateral that has been pledged. In addition at December 31, 2012, Royal Bank had $212.1 million in unpledged agency securities that were available to be pledged as collateral if needed and $28.6 million in cash on hand. Royal Bank also has limited availability to borrow from the Federal Reserve Discount Window, which was approximately $4.2 million at December 31, 2012, and was based on collateral pledged.
At December 31, 2012, the liquidity to deposits ratio was 48.2% compared to Royal Bank’s 12% policy target and the liquidity to total liabilities ratio was 37.7% compared to Royal Bank’s 10% policy target. Brokered CDs were redeemed in full and were $0, $5.8 million, and $89.1 million at December 31, 2012, 2011, and 2010, respectively. Borrowings also continue to decline and were $108.3 million, $148.0 million and $154.9 million at December 31, 2012, 2011, and 2010, respectively.
The Company also has unfunded pension plan obligations of $16.9 million as of December 31, 2012 which potentially could impact liquidity. The Company plans to fund the pension plan obligations through existing Company owned life insurance policies.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES - Continued
Dividend and Interest Restrictions
Due to the MOU and the Federal Reserve Agreement, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives. On August 13, 2009, the Company’s Board determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock and to suspend interest payments on the $25.8 million in trust preferred securities. As of December 31, 2012, the Series A Preferred stock dividend in arrears was $5.8 million and has not been recognized in the consolidated financial statements. In the event the Company declared the preferred dividend the Company’s capital ratios would be negatively affected however they would remain above the required minimum ratios under U.S. GAAP. Please read “Note 15 - Regulatory Capital Requirements” to the Consolidated Financial Statements. As of December 31, 2012 the trust preferred interest payment in arrears was $2.5 million and has been recorded in interest expense and accrued interest payable. The Company believes the decision to suspend the preferred cash dividends and the trust preferred interest payments will better support the liquidity position of Royal Bank. As a result of the Company missing the sixth quarterly dividend payment due on November 16, 2010, the Treasury exercised its rights under the Capital Purchase Program and appointed two directors to our Board in 2011 until all accrued but unpaid dividends have been paid in full by the Company. The interest payment deferral period on the trust preferred securities ends after the second quarter of 2014. After the ending of the deferral period if the interest payments are not made then it would constitute an event of default which could impact the Company’s consolidated financial statements and liquidity.
At December 31, 2012 and 2011, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve Agreement the Company and its non-bank subsidiaries may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities and may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
Capital Adequacy
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Call Report instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for December 31, 2012 and the previous nine quarters in accordance with U.S. GAAP. However, the change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and potentially the Company’s capital ratios as disclosed in “Note 15 - Regulatory Capital Requirements” to the Consolidated Financial Statements. Royal Bank is in discussions with the FDIC to resolve the matter.
Under the MOU, Royal Bank must maintain a minimum total risk-based capital ratio and a minimum Tier 1 leverage ratio of 12% and 8%, respectively. At December 31, 2012, based on capital levels calculated under RAP, Royal Bank’s total risk-based capital and Tier 1 leverage ratios were 16.10% and 8.53%, respectively.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES - Continued
Department of Justice Investigation (“DOJ”)
Royal Bank holds a 60% equity interest in each of CSC and RTL. The Company acquired its ownership interest in CSC in 2001. CSC and RTL acquired, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders. On March 4, 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States DOJ. The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey. Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation. On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009. The former President’s employment with CSC and RTL was terminated in November 2010. As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation. Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against CSC, RTL or both. As a result, the Company accrued $2.0 million during 2012 for a DOJ fine relating to the DOJ investigation. After adjusting for the noncontrolling interest, the Company’s 60% share of the fine amounted to $1.2 million. On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey. Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this non-prosecution protection. At the sentencing hearing held in December 2012, the sentencing judge agreed with the DOJ’s recommendation and imposed a $2.0 million fine for CSC, which, as stated above, has been recognized in the Company’s consolidated financial statements. The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
Additionally a number of lawsuits have been filed in the Superior Court of New Jersey against the former President of CSC and RTL, CSC, RTL, Royal Bancshares of Pennsylvania and certain other parties on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations. These lawsuits allege violations of the New Jersey Antitrust Act and unjust enrichment, and seek treble damages, attorney fees and injunctive relief. CSC, RTL and Royal Bancshares removed these cases to the U.S. District Court for the District of New Jersey. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions. On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action. As of the date of this filing Royal Bancshares and Royal Bank cannot reasonably estimate the possible loss or range of loss that may result from these actions or proceedings. Please refer to “Note 13 - Legal Contingencies” to the Consolidated Financial Statements for additional information.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 2 - REGULATORY MATTERS and SIGNIFICANT RISKS and UNCERTAINTIES - Continued
Company Plans and Strategy
The Company has enhanced the Board through the addition of experienced directors with diverse backgrounds. The new members are comprised of the following: a former banking regulator with consulting experience, a former Chief Executive Officer (“CEO”) of a much larger financial institution who has bank turnaround experience, a former President of the lead bank within a larger financial institution (Treasury appointee), a former executive within the financial services industry (Treasury appointee) and a former senior partner of a public accounting firm. During the first quarter of 2012, the Board elected a Lead Independent Director to further improve corporate governance by serving as a liaison between the Chairman of the Board, management, and the independent directors. During 2012, Royal Bank hired a new Chief Lending Officer (“CLO”) who has significant experience in commercial and consumer lending with a larger bank within the Philadelphia market. After announcing the retirements of the Company’s CEO and President during the second quarter of 2012, the Company’s Board conducted an executive search for a candidate for the combined role of President and CEO. On December 18, 2012 the Company announced F. Kevin Tylus as President and CEO of Royal Bank. On February 20, 2013, the Company announced that Mr. Tylus was appointed President, CEO and a Class III member of the board of directors of the Company. Former CEO, Robert Tabas, remains as Chairman of the Board of Directors.
In order to meet the requirements in the previous Orders, the current MOU, and the Federal Reserve Agreement, management adopted a strategy to deleverage the balance sheet in order to maintain capital ratios at required regulatory minimums. The Board and management remain committed to meeting the capital level requirements for Royal Bank as set forth in the previous Orders and current MOU. As a result, the Board and management have developed a contingency plan to maintain capital ratios at required levels which may include selling interest-earning assets. This strategy also assisted in reducing the level of classified assets by giving management the ability to actively pursue exit strategies on loans and OREO which were at historically high levels. The deleveraging was largely accomplished by the continued reduction of brokered deposits from $89.1 million at December 31, 2010 to $0 as of December 31, 2012. In addition, borrowings were reduced by $46.6 million during the same period. The Company’s strategic plan includes improving the overall level of credit quality, maintaining reduced credit risk within the investment portfolio, reducing the overall level of expenses, and returning to profitability.
During the past few years, the Company recorded significant impairment charges and carrying costs on non-accrual loans and OREO which has weighed heavily on earnings and was the largest contributing factor to the Company’s continued losses. While sustaining capital ratios above the required minimum, the Company has made progress in improving credit quality, reducing the CRE concentration, strengthening the Board and maintaining liquidity. As a result of the decline in level of classified assets, there has been a corresponding reduction in the provision for loan and lease losses and the overall carrying costs associated with classified assets. The deleveraging of the balance sheet has also reduced earning assets which has resulted in a decline in net interest income and has had a significant impact on overall earnings. To improve net interest margin and net interest income, management is diligently working on changing the mix of earnings assets and interest bearing liabilities. In the event further deleveraging is necessary to maintain the required capital levels, net interest income would be negatively impacted.
The Company is focused on transitioning Royal Bank into a true community bank with the branches becoming selling centers and not just service centers. Traditional consumer products such as home equity loans and a new mobile banking application are part of our expanded product offerings. The Company is also evaluating the addition of fee-based business lines to complement and enhance our existing services. The Company has developed a management Profitability Improvement Program to generate steady revenue growth, expense management and gain operational efficiencies. The Company has reorganized and relocated certain personnel to improve departmental synergies and better align managers and staff so they can work together in cohesive teams to accomplish these objectives. Additionally, the Company is currently developing a facilities rationalization plan as part of the overall strategic goal to return to profitability. Through the restructuring of the Lending and Credit departments during the last half of 2012, Royal Bank has been able to increase commitments to extend credit by $23.8 million from $20.7 million at December 31, 2011 to $44.5 million at December 31, 2012. All of these plans are focused on repositioning the Company for 2013 and beyond.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES
The amortized cost, gross unrealized gains and losses, and fair value of the Company’s available-for-sale investment securities are summarized as follows:
The investment portfolio grew $20.2 million from $329.0 million at December 31, 2011 to $349.2 million at December 31, 2012. The increase was primarily due to the reinvestment of cash flows from the loan and lease portfolio into government sponsored agency mortgage-backed securities and debt securities.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES - Continued
The amortized cost and fair value of investment securities at December 31, 2012, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sales of investments available for sale during 2012, 2011 and 2010 were $28.2 million, $113.0 million, and $181.3 million, respectively. The following table summarizes gross realized gains and losses realized on the sale of securities recognized in earnings in the periods indicated:
As of December 31, 2012, investment securities with a market value of $67.1 million were pledged as collateral to secure advances with the FHLB.
The Company evaluates securities for OTTI at least on a quarterly basis. The Company assesses whether OTTI is present when the fair value of a security is less than its amortized cost. All investment securities are evaluated for OTTI under FASB ASC Topic 320, “Investments-Debt & Equity Securities” (“ASC Topic 320”). The non-agency collateralized mortgage obligation that is rated below AA is evaluated under FASB ASC Topic 320 Subtopic 40, “Beneficial Interests in Securitized Financial Assets” or under FASB ASC Topic 325, “Investments-Other”. In determining whether OTTI exists, management considers numerous factors, including but not limited to: (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES - Continued
Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. In addition, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell or will more likely than not be required to sell the security. If an entity intends to sell the security or will be required to sell the security, the OTTI shall be recognized in earnings equal to the entire difference between the fair value and the amortized cost basis at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis, the OTTI shall be separated into two amounts, the credit-related loss and the noncredit-related loss. The credit-related loss is based on the present value of the expected cash flows and is recognized in earnings. The noncredit-related loss is based on other factors such as illiquidity and is recognized in other comprehensive income.
The tables below indicate the length of time individual securities have been in a continuous unrealized loss position at December 31, 2012:
The AFS portfolio had gross unrealized losses of $946,000 at December 31, 2012 compared to gross unrealized losses of $1.1 million at December 31, 2011. The slight improvement in gross unrealized losses of $175,000 is related to the overall improvement in the fair values of the securities in the Company’s investment portfolio. In determining the Company’s intent not to sell and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, management considers the following factors: current liquidity and availability of other non-pledged assets that permits the investment to be held for an extended period of time but not necessarily until maturity, capital planning, and any specific investment committee goals or guidelines related to the disposition of specific investments.
Common stocks: As of December 31, 2012, the Company had two common stocks of financial institutions with a total fair value of $47,000 and an unrealized gain of $14,000. During 2012 the Company sold one common stock investment and recorded a gain of $112,000.
For all debt security types discussed below the fair value is based on prices provided by brokers and safekeeping custodians with the exception of trust preferred securities which is described below.
U.S. government-sponsored agencies (“US Agencies”): As of December 31, 2012, the Company had eight US Agency bonds with a fair value of $23.8 million and gross unrealized losses of $78,000. These eight US Agency bonds have been in an unrealized loss position for less than twelve months and are callable at par. Management believes that the unrealized loss on these debt securities is a function of changes in investment spreads. Management expects to recover the entire amortized cost basis of these securities. The Company does not intend to sell the securities before recovery of the cost basis and will not more likely than not be required to sell these securities before recovery of the cost basis. Therefore, management has determined that these eight securities are not other-than-temporarily impaired at December 31, 2012.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES - Continued
Mortgage-backed securities issued by U.S. government agencies and U.S. government sponsored enterprises: As of December 31, 2012, the Company had two mortgage-backed securities with a fair value of $7.3 million and gross unrealized losses of $47,000. The two mortgage-backed securities had been in an unrealized loss position for less than twelve months. The unrealized loss is attributable to a combination of factors, including relative changes in interest rates since the time of purchase. The contractual cash flows for these securities are guaranteed by U.S. government agencies and U.S. government-sponsored enterprises. Based on its assessment of these factors, management believes that the unrealized losses on these debt securities are a function of changes in investment spreads and interest rate movements and not changes in credit quality. Management expects to recover the entire amortized cost basis of these securities. The Company does not intend to sell these securities before recovery of their cost basis and will not more likely than not be required to sell these securities before recovery of their cost basis. Therefore, management has determined that these securities are not other-than-temporarily impaired at December 31, 2012.
U.S. government issued or sponsored collateralized mortgage obligations (“Agency CMOs”): As of December 31, 2012, the Company had 17 Agency CMOs with a fair value of $48.9 million and gross unrealized losses of $611,000. Two of the Agency CMOs had been in an unrealized loss position for more than twelve months and the remaining 15 Agency CMOs have been in an unrealized loss position for less than twelve months. The unrealized loss is attributable to a combination of factors, including relative changes in interest rates since the time of purchase. The contractual cash flows for these securities are guaranteed by U.S. government agencies and U.S. government-sponsored enterprises. Based on its assessment of these factors, management believes that the unrealized losses on these debt securities are a function of changes in investment spreads and interest rate movements and not changes in credit quality. Management expects to recover the entire amortized cost basis of these securities. The Company does not intend to sell these securities before recovery of their cost basis and will not more likely than not be required to sell these securities before recovery of their cost basis. Therefore, management has determined that these securities are not other-than-temporarily impaired at December 31, 2012.
Non-agency collateralized mortgage obligations (“Non-agency CMOs”): As of December 31, 2012, the Company had one non-agency CMO with a fair value of $1.0 million and a gross unrealized gain of $4,000. The non-agency CMO is rated CCC.
Corporate bonds: As of December 31, 2012, the Company had three corporate bonds with a fair value of $3.1 million and gross unrealized losses of $72,000. One of the corporate bonds had been in an unrealized loss position for more than twelve months and the remaining two bonds have been in an unrealized loss position for less than twelve months. All three bonds are above investment grade. The Company’s unrealized losses in investments in corporate bonds represent interest rate risk and not credit risk of the underlying issuers. As previously mentioned management also considered (1) the length of time and the extent to which the fair value is less than the amortized cost, (2) the Company’s intent to hold or sell the security, (3) the financial condition and results of the issuer including changes in capital, (4) the credit rating of the issuer, (5) analysts earnings estimate, (6) industry trends specific to the security, and (7) timing of debt maturity and status of debt payments. Management utilized discounted cash flow analysis based upon the credit ratings of the securities, liquidity risk premiums, and the recent corporate spreads for similar securities as required under ASC Topic 320 to determine the credit risk component of the corporate bonds. Based on these analyses, there was no credit-related loss on the bonds. Because the Company does not intend to sell the corporate bonds and it is not more likely than not that the Company will be required to sell the bonds before recovery of their amortized cost basis, which may be maturity, the Company does not consider the three bonds to be other-than-temporarily impaired at December 31, 2012.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES - Continued
Municipal bonds: As of December 31, 2012, the Company had six municipal bonds with a fair value $5.5 million and an unrealized loss of $30,000. Five of the municipal bonds have been in an unrealized loss position for twelve months or less and one municipal bond has been in an unrealized position for more than twelve months. The one municipal bond that has been in an unrealized loss for more than twelve months was issued by the City of Chicago, has a fair value of $882,000 with a gross unrealized loss of $9,000 and is investment grade. The unrealized loss is attributable to a combination of factors, including Chicago’s financial situation. During the fourth quarter of 2011, the three major ratings agencies gave Chicago’s credit a stable outlook. Because the Company does not intend to sell the bonds and it is not more likely than not that the Company will be required to sell the bond before recovery of its amortized cost basis, which may be maturity, the Company does not consider the bond to be other-than-temporarily impaired at December 31, 2012.
Other securities: As of December 31, 2012, the Company had seven investments in private equity funds which were predominantly invested in real estate. In determining whether or not OTTI exists, the Company reviews the funds’ financials, asset values, and its near-term projections. At December 31, 2012, two of the private equity funds had a combined fair value of $544,000 and an unrealized loss of $108,000. OTTI charges were recorded in a prior period on these two funds. Management concluded that there was no additional impairment on these two funds in 2012. During 2012 the Company recorded impairment charges on two other private equity funds. The impairment charges included the entire carrying value of one of the private equity funds in the amount of $1.5 million and a credit related impairment charge of $859,000 on another private equity fund.
The Company will continue to monitor all of the above investments to determine if the discounted cash flow analysis, continued negative trends, market valuations or credit defaults result in impairment that is other-than-temporary.
The following table presents a roll-forward of the balance of credit-related impairment losses on debt securities held at December 31, 2012 and 2011 for which a portion of an other-than-temporary impairment was recognized in other comprehensive income:
The following table summarizes other-than-temporary impairment losses on securities recognized in earnings in the periods indicated:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 3 - INVESTMENT SECURITIES - Continued
The tables below indicate the length of time individual securities have been in a continuous unrealized loss position at December 31, 2011:
During 2011, the Company recorded a total impairment charge to earnings of $1.8 million related to trust preferred securities and common stocks. Management concluded that these investments were OTTI.
NOTE 4 - LOANS AND LEASES
Major classifications of LHFI are as follows:
The Company grants commercial and real estate loans, including construction and land development loans primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the mid-Atlantic region. The Company also has participated with other financial institutions in selected construction and land development loans outside our geographic area. The Company has a concentration of credit risk in commercial real estate, construction and land development loans at December 31, 2012. A substantial portion of its debtors’ ability to honor their contracts is dependent upon the housing sector specifically and the economy in general.
The Company granted loans to the officers and directors of the Company and to their associates. In accordance with Regulation O, related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectability. The aggregate dollar amount of these loans and commitments was $1.4 million and $8.8 million at December 31, 2012 and 2011. During 2012 there were no new related party loans. Total payments received on related party loans in 2012 were $18,000. Additionally, $7.4 million is no longer classified as related party due to the resignation of one of the directors during 2012.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 4 - LOANS AND LEASES - Continued
The Company classifies its leases as finance leases, in accordance with FASB ASC Topic 840, “Leases”. The difference between the Company’s gross investment in the lease and the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method.
The Company uses a nine point grading risk classification system commonly used in the financial services industry as the credit quality indicator. The first four classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. The risk rating is related to the underlying credit quality and probability of default. These risk ratings are used to calculate the historical loss component of the allowance.
·
Pass: includes credits that demonstrate a low probability of default;
·
Pass-Watch: a warning classification which includes credits that are beginning to demonstrate above average risk through declining earnings, strained cash flows, increased leverage and/or weakening market fundamentals;
·
Special mention: includes credits that have potential weaknesses that if left uncorrected could weaken the credit or result in inadequate protection of the Company’s position at some future date. While potentially weak, credits in this classification are marginally acceptable and loss of principal or interest is not anticipated;
·
Substandard accrual: includes credits that exhibit a well-defined weakness which currently jeopardizes the repayment of debt and liquidation of collateral even though they are currently performing. These credits are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected;
·
Non-accrual: (substandard non-accrual, doubtful, loss): includes credits that demonstrate serious problems to the point that it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.
All loans, at the time of presentation to the appropriate loan committee, are given an initial loan risk rating by the CCO. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 4 - LOANS AND LEASES - Continued
The following tables present risk ratings for each loan portfolio segment at December 31, 2012 and 2011, excluding LHFS.
The following tables are an aging analysis of past due payments for each loan portfolio segment at December 31, 2012 and 2011, excluding LHFS.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 4 - LOANS AND LEASES - Continued
The following table details the composition of the non-accrual loans.
Total non-accrual loans at December 31, 2012 were $23.0 million and were comprised of $21.4 million in LHFI and $1.6 million in LHFS. Non-accrual loans were $51.3 million and were comprised of $38.7 million in LHFI and $12.6 million in LHFS at December 31, 2011. The $28.3 million decline in total non-accrual loans was the result of a $18.4 million reduction in existing non-accrual loan balances through payments or loans becoming current and placed back on accrual, $8.3 million in charge-offs and write downs related to impairment analysis, and transfers to OREO of $10.8 million, which collectively were offset by $9.2 million in additions. Commercial real estate, commercial loans, and construction and land loans represent 52%, 22%, and 19%, respectively, of the total $23.0 million in non-accrual loans at December 31, 2012. If interest had been accrued, such income would have been approximately $3.1 million, $5.1 million, and $6.5 million, for the years ended December 31, 2012, 2011, and 2010, respectively. At December 31, 2012, the Company had no loans past due 90 days or more on which interest continues to accrue.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 4 - LOANS AND LEASES - Continued
Impaired Loans
The Company identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The Company does not accrue interest income on impaired non-accrual loans. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis.
Total cash collected on impaired loans and leases during 2012, 2011, and 2010 was $23.4 million, $29.9 million, and $21.7 million, respectively, of which $21.1 million, $29.7 million, and $21.4 million was credited to the principal balance outstanding on such loans, respectively.
The following is a summary of information pertaining to impaired loans:
Troubled Debt Restructurings
A loan modification is deemed a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics. If in modifying a loan the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession it would not normally consider then the loan modification is classified as a TDR. All loans classified as TDRs are considered to be impaired. TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectibility of the total contractual restructured principal and interest is no longer in doubt. At December 31, 2012, the Company had twelve TDRs, of which eight are on non-accrual status, with a total carrying value of $21.1 million. At the time of the modifications, seven of the loans were already classified as impaired loans. At December 31, 2011, the Company had twelve TDRs, of which seven were on non-accrual status, with a total carrying value of $14.2 million. At the time of the modifications, eight of the loans were already classified as impaired loans. The Company’s policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 4 - LOANS AND LEASES - Continued
The following table details the Company’s TDRs that are on an accrual status and a non-accrual status at December 31, 2012.
At December 31, 2012, all of the TDRs were in compliance with their restructured terms.
The following table presents newly restructured loans that occurred during the years ended December 31, 2012 and 2011.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 5 - ALLOWANCE FOR LOAN AND LEASE LOSSES
The following table presents the detail of the allowance and the loan portfolio disaggregated by loan portfolio segment as of December 31, 2012, 2011, and 2010.
Allowance for Loan and Leases Losses and Loans Held for Investment
For the year ended December 31, 2012
Allowance for Loan and Leases Losses and Loans Held for Investment
For the year ended December 31, 2011
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 5 - ALLOWANCE FOR LOAN AND LEASE LOSSES - Continued
Allowance for Loan and Leases Losses and Loans Held for Investment
For the year ended December 31, 2010
The following tables detail the impaired LHFI by loan segment.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 5 - ALLOWANCE FOR LOAN AND LEASE LOSSES - Continued
NOTE 6 - OTHER REAL ESTATE OWNED
OREO declined $7.6 million from $21.0 million at December 31, 2011 to $13.4 million at December 31, 2012. Set forth below is a table which details the changes in OREO from December 31, 2011 to December 31, 2012.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 6 - OTHER REAL ESTATE OWNED - Continued
At December 31, 2012, OREO is comprised of $7.1 million in land, $3.7 million in commercial real estate, $2.1 million in tax liens, and single family homes with a fair value of $527,000. During the fourth quarter the Company sold a multi-family property and a commercial real estate property. The Company received net proceeds of $4.2 million and recorded a combined loss of $376,000 as a result of these sales. The Company also sold two condominiums related to the construction project in Minneapolis, Minnesota described below. The Company received its pro rata share of net proceeds in the amount of $38,000 and recorded a gain of $16,000. In addition to the sales mentioned above the Company sold 22 properties acquired through the tax lien portfolio. The Company received proceeds of $1.3 million and recorded net gains of $378,000 as a result of these sales. During the fourth quarter of 2012, based on annual updated appraisals and agreements of sale, the Company recorded impairment charges of $3.1 million on six land properties, $77,000 on a commercial real estate property, and $169,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $293,000 to OREO.
During the third quarter of 2012, the Company sold collateral related to residential real estate and construction loans. The Company received net proceeds of $35,000 and recorded a loss of $2,000 as a result of these sales. In addition to the sales mentioned above the Company sold eleven properties acquired through the tax lien portfolio. The Company received proceeds of $887,000 and recorded net gains of $230,000 as a result of these sales. During the third quarter of 2012, based on annual updated appraisals the Company recorded impairment charges of $2.3 million on properties related to land development and $58,000 on commercial real estate collateral. The Company also recorded impairment charges of $54,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.4 million to OREO.
During the second quarter of 2012, the Company sold collateral related to residential real estate and construction loans. The Company received net proceeds of $433,000 and recorded a gain of $133,000 as a result of these sales. In addition to the sales mentioned above the Company sold seven properties acquired through the tax lien portfolio. The Company received proceeds of $495,000 and recorded gains of $122,000 as a result of these sales. During the second quarter of 2012, the Company recorded impairment charges of $321,000 and $121,000 on collateral related to multi-family and land loans, respectively, based on expected net sales proceeds and $554,000 related to properties acquired through the tax lien portfolio. In addition the Company acquired collateral related to the tax lien portfolio and transferred $1.1 million to OREO.
During the first quarter of 2012, the Company foreclosed on and sold collateral related to one commercial real estate loan. The Company received net proceeds of $4.1 million and recorded a gain of $36,000. Additionally the Company sold eight single family homes related to three loans. The Company received net proceeds of $104,000 and recorded a small net gain of $3,000. As a result of these sales the Company recorded an impairment charge of $44,000 on the remaining collateral for two of these loans. In addition to the sales mentioned above, the Company sold ten properties acquired through the tax lien portfolio. The Company received proceeds of $332,000 and recorded a net loss of $177,000 as a result of these sales. During the first quarter of 2012, the collateral for a completed hotel and condominium construction project in Minneapolis, Minnesota, in which the Company is a participant, was foreclosed on by the lead lender. The Company transferred the fair value of $3.2 million to OREO which represents the Company’s participation rate of approximately 7.5%. The Company had previously recorded total charge-offs of $1.5 million to the allowance for loan and lease losses during the period the participation loan was non-accrual. In addition the Company acquired collateral related to the tax lien portfolio and transferred $793,000 to OREO. The Company recorded impairment charges of $9,000 related to properties acquired through the tax lien portfolio.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 7 - PREMISES AND EQUIPMENT
Depreciation and amortization expense, related to premises and equipment, was approximately $417,000, $486,000, and $686,000, for the years ended 2012, 2011, and 2010, respectively.
NOTE 8 - LEASE COMMITMENTS
The Company leases various premises under non-cancelable operating lease agreements, which expire through 2021 and require minimum annual rentals. The approximate minimum rental commitments under the leases are as follows for the year ended December 31, 2012:
The leases contain options to extend for periods from one to ten years. The cost of such lease extensions is not included in the above table. Rental expense for all leases was approximately $795,000, $815,000, and $1.3 million for the years ended December 31, 2012, 2011 and 2010, respectively. The decline in rental expense in 2011 was related to the sale of Royal Asian in December 2010.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 9 - DEPOSITS
Deposits are summarized as follows:
Maturities of time deposits for the next five years and thereafter are as follows:
NOTE 10 - BORROWINGS AND SUBORDINATED DEBENTURES
1. Advances from the Federal Home Loan Bank
The available borrowing capacity with the FHLB is based on qualified collateral. Royal Bank has a collateralized delivery requirement of 105% with the FHLB due to the level of Royal Bank’s non-performing assets and net losses. The available amount for future borrowings will be based on the amount of collateral to be pledged. Total advances from the FHLB were $65.0 million at December 31, 2012 compared to $104.2 million at December 31, 2011. Royal Bank has a $150 million line of credit with the FHLB of which $0 was outstanding as of December 31, 2012. The FHLB advances had a weighted average interest rate of 2.35%. The advances and the line of credit are collateralized by FHLB stock, government agencies and mortgage-backed securities, residential loans, and commercial real estate loans. As of December 31, 2012, investment securities with a market value of $67.1 million and loans with a book value of $50.0 million were pledged as collateral to the FHLB. The average balance of advances with the FHLB during 2012 was $80.1 million.
At December 31, 2011, advances from FHLB totaled $104.2 million with maturities within one day to two years. These advances had a weighted average interest rate of 2.66%. The average balance of advances with the FHLB during 2011 was $107.7 million.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 10 - BORROWINGS AND SUBORDINATED DEBENTURES - Continued
Presented below are the Company’s FHLB borrowings allocated by the year in which they mature with their corresponding weighted average rates:
As of December 31, 2012, there are no FHLB borrowings maturing in 2014 through 2016.
2. Other borrowings
The Company has a note payable with PNC Bank (“PNC”) at December 31, 2012 in the amount of $3.3 million with a maturity date of August 25, 2016. The note payable balance at December 31, 2011 was $3.8 million. The interest rate is a variable rate using rate index of one month LIBOR + 15 basis points and adjusts monthly. The interest rate at December 31, 2012 and 2011 was 0.36% and 0.44%, respectively.
At December 31, 2012 and 2011, the Company had other borrowings of $40.0 million from PNC which will mature on January 7, 2018. These borrowings are secured by government agencies and mortgaged-backed securities. These borrowings have a weighted average interest rate of 3.65%. As of December 31, 2012, investment securities with a market value of $51.7 million were pledged as collateral to secure all borrowings with PNC.
3. Subordinated debentures
The Company has outstanding $25.0 million of Trust Preferred Securities issued through two Delaware trust affiliates, Royal Bancshares Capital Trust I (“Trust I”) and Royal Bancshares Capital Trust II (“Trust II”) (collectively, the “Trusts”). The Company issued an aggregate principal amount of $12.9 million of floating rate junior subordinated debt securities to Trust I and an aggregate principal amount of $12.9 million of fixed/floating rate junior subordinated deferrable interest to Trust II. Both debt securities bear an interest rate of 2.46% at December 31, 2012, and reset quarterly at 3-month LIBOR plus 2.15%.
Each of Trust I and Trust II issued an aggregate principal amount of $12.5 million of capital securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to an unaffiliated investment vehicle and an aggregate principal amount of $387,000 of common securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to the Company. The Company has fully and unconditionally guaranteed all of the obligations of the Trusts, including any distributions and payments on liquidation or redemption of the capital securities.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 10 - BORROWINGS AND SUBORDINATED DEBENTURES - Continued
On August 13, 2009, the Company’s Board of Directors determined to suspend interest payments on the trust preferred securities. Under the Federal Reserve Agreement as described in “Note 2 - Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company and its non-bank subsidiaries 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 Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System. As of December 31, 2012 the trust preferred interest payment in arrears was $2.5 million and has been recorded in interest expense and accrued interest payable.
NOTE 11 - INCOME TAXES
The Company did not record an income tax expense or benefit in 2012, 2011, and 2010.
The difference between the applicable income tax expense and the amount computed by applying the statutory federal income tax rate of 34% in 2012, and 35% in 2011, and 2010 is as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 11 - INCOME TAXES - Continued
Deferred tax assets and liabilities consist of the following:
As of December 31, 2012 the Company had net operating income tax loss carryforwards of approximately $61.2 million which are available to be carried forward to future tax years. These loss carryforwards will expire in 2032 if not utilized.
The Company has approximately $3.5 million available to be utilized as of December 31, 2012 related to net operating loss carryovers from the acquisition of Knoblauch State Bank. The utilization of these losses is subject to limitation under Section 382 of the Internal Revenue Code.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 11 - INCOME TAXES - Continued
The Company recognizes deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. The deferred tax assets, net of valuation allowances, totaled $414,000 at December 31, 2012 and 2011. Management evaluated the deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including historical profitability and projections of future reversals of temporary differences and future taxable income. The Company is required to establish a valuation allowance for deferred tax assets and record a charge to income or shareholders' equity if management determines, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, the Company estimates future taxable income based on management approved business plans and ongoing tax planning strategies. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between projected operating performance, actual results and other factors.
As of December 31, 2012, the Company was in a cumulative book taxable loss position for the three-year period ended December 31, 2012. For purposes of establishing a deferred tax asset valuation allowance, this cumulative book taxable loss position is considered significant objective evidence that the Company may not be able to realize some portion of the deferred tax assets in the future. The cumulative book taxable loss position was caused by the negative impact on results from the banking operations, investment impairments and loan and lease losses over the past three years. These conditions deteriorated dramatically during the three month period ended December 31, 2008 and continued throughout 2009, 2010, 2011 and 2012, causing a significant increase in the pre-tax losses due in part to much higher credit losses, and downward revisions to projections of future results.
As of December 31, 2012, 2011, and 2010, management concluded that it was more likely than not that the Company would not generate sufficient future taxable income to realize all of the deferred tax assets. Management’s conclusion was based on consideration of the relative weight of the available evidence and the uncertainty of future market conditions on results of operations. As a result, the Company recorded a non-cash charge of $15.5 million in the consolidated statements of operations in the period ended December 31, 2008 related to the establishment of a valuation allowance for the deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. During 2009, 2010, 2011, and 2012, the Company established additional valuation allowances of $10.2 million, $7.7 million, $3.0 million, and $3.2 million, respectively, which was a result of the net operating losses for each year and the portion of the future tax benefit that more likely than not will not be utilized in the future. The additional valuation allowance did not impact the net loss as no tax benefit was recorded during 2012 or 2011.
The Company is subject to income taxes in the U. S. and various state and local jurisdictions. As of December 31, 2012, tax years 2005 through 2012 are subject to examination by various taxing authorities. Tax regulations are subject to interpretation of the related tax laws and regulations and require significant judgment to apply.
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK-Continued
The Company’s exposure to credit loss in the event of non-performance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
The contract amounts are as follows:
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, and others are for staged construction, the total commitment amounts do not necessarily represent immediate cash requirements.
The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory or equipment.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Most guarantees extend for one year and expire in decreasing amounts through October 2013. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds personal or commercial real estate, accounts receivable, inventory or equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments is approximately 75%.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 13 - LEGAL CONTINGENCIES
As described under “Note 2 - Regulatory Matters and Significant Risks or Uncertainties”, Royal Bank holds a 60% equity interest in each of CSC and RTL. CSC and RTL acquire, through public auction, delinquent tax liens in various jurisdictions thereby assuming a superior lien position to most other lien holders, including mortgage lien holders. On March 4, 2009, each of CSC and RTL received grand jury subpoenas issued by the U.S. District Court for New Jersey (“Court”) upon application of the Antitrust Division of the United States DOJ. The subpoenas sought certain documents and information relating to an ongoing investigation being conducted by the DOJ relating to alleged bid-rigging at tax lien auctions in New Jersey. Royal Bank, CSC and RTL have produced to the DOJ documents responsive to the subpoenas and have been cooperating with the DOJ throughout the investigation. On February 23, 2012, the former President of CSC and RTL entered a plea of guilty to one count of conspiring to rig bids at certain auctions for tax liens in New Jersey from 1998 until approximately the spring of 2009. The former President’s employment with CSC and RTL was terminated in November 2010. As previously disclosed, Royal Bank had been advised that neither CSC nor RTL were targets of the DOJ investigation, but they were subjects of the investigation. Based on discussions with the DOJ and the plea entered by the former President of CSC and RTL, the Company believed that the outcome of the investigation would result in fines and penalties being assessed against CSC, RTL or both. As a result, the Company accrued $2.0 million during 2012 for a DOJ fine relating to the DOJ investigation. After adjusting for the noncontrolling interest, the Company’s 60% share of the fine amounted to $1.2 million. On September 26, 2012, as a result of the former President’s guilty plea and pursuant to a plea agreement with the DOJ, CSC entered a guilty plea in the United States District Court for the District of New Jersey to one count of conspiracy to commit bid-rigging at certain auctions for tax liens in New Jersey. Under the terms of the plea agreement, which the Court accepted at the September 26, 2012 plea hearing, the DOJ agreed not to bring further criminal charges against CSC and not to bring criminal charges against RTL, or any current or former director, officer, or employee of CSC and/or RTL, for any act or offense committed prior to the date of the plea agreement that was in furtherance of any agreement to rig bids at municipal tax lien sales or auctions in the State of New Jersey. The former President of CSC and RTL and any person who bid at any time at a tax lien auction on behalf of CSC and/or RTL are excluded from this non-prosecution protection. At the sentencing hearing held in December 2012, the sentencing judge agreed with the DOJ’s recommendation and imposed a $2.0 million fine for CSC, which, as stated above, has been recognized in the Company’s consolidated financial statements. The Company is evaluating appropriate legal action against the former President of CSC and RTL to attempt to recover legal expenses and any fines or penalties ultimately levied against CSC.
As a result of the plea agreements of the former President of CSC and RTL, and others resulting from the DOJ investigation, a number of lawsuits have been filed against the former President of CSC and RTL, CSC, RTL, the Company and certain other parties. On March 13, 2012, the former president of RTL and CSC, RTL, CSC, the Company and certain other parties were named as defendants in a putative class action lawsuit filed in the Superior Court of New Jersey, Chancery Division on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations (Boyer v. Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., Superior Court of New Jersey, Chancery Division) (“the Boyer Action”). On March 28, 2012, CSC, RTL and the Company removed this case to the U.S. District Court for the District of New Jersey. The lawsuit alleges violations of the New Jersey Antitrust Act and unjust enrichment, and seeks treble damages, attorney fees and injunctive relief. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this class action lawsuit.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 13 - LEGAL CONTINGENCIES - Continued
On March 30, 2012, April 20, 2012, May 2, 2012, May 11, 2012, May 18, 2012, June 18, 2012 and June 29, 2012, the former President of CSC and RTL, CSC, RTL and the Company were named defendants, among others, in putative class action lawsuits filed in the U.S. District Court for the District of New Jersey (“Court”) on behalf of a proposed class of taxpayers who became delinquent in paying their municipal tax obligations: Contarino v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; MSC LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; English v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Ledford v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; T&B Associates v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Jacobs et al v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey; Senatore Builders, LLC v Robert W. Stein, Crusader Servicing Corp. Royal Tax Lien Services LLC, Royal Bancshares of Pennsylvania, Inc., et al., U.S. District Court for the District of New Jersey, respectively alleging a conspiracy to rig bids in municipal tax lien auctions. On June 12, 2012, the Court entered an Order consolidating for pretrial purposes the Boyer action with all subsequently filed or transferred related actions, including the ones mentioned above. On October 22, 2012, the Court appointed two law firms as interim class counsel and another law firm as liaison class counsel and further ordered appointed counsel to file on or before November 21, 2012 a master complaint for the consolidated action. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from these class action lawsuits.
On or about March 15, 2012, CSC, RTL and the Company were named defendants, among others, in a complaint filed by Marina Bay Towers Urban Renewal II, LP (“MBT”) in the Superior Court of New Jersey, Law Division, Cape May County. The complaint alleges essentially the same claims as asserted in the Boyer Action. However MBT does not seek to represent a class and only seeks remedies related to itself. As of the date of this filing, the Company cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
In 2005, the Company purchased $25.0 million in Class B-1 Notes of a collateralized debt obligation (“CDO”) offered by Lehman Brothers, Inc. Concurrently with the issuance of the notes, the issuer entered into a credit swap with LBSF. Lehman Brothers Holdings, Inc. (“LBHI”) guaranteed LBSF’s obligations to the issuer under the credit swap. When LBHI filed for bankruptcy in September 2008, an event of default under the indenture occurred, and the trustee declared the notes to be immediately due and payable. The Company was repaid its principal on the notes in September 2008. In September 2010, LBSF filed suit in the United States Bankruptcy court for the Southern District of New York against certain indenture trustees, certain special-purpose entities (issuers) and a class of noteholders and trust certificate holders who received distributions from the trustees, to recover funds that were allegedly improperly paid to the noteholders in forty-seven separate CDO transactions. In July 2012, LBSF added the Company as a defendant in the proceeding. As of the date of this filing, the Company cannot determine whether this proceeding will have a material adverse effect on its results of operations and cannot reasonably estimate the possible loss or range of loss that may result from this proceeding.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 14 - SHAREHOLDERS’ EQUITY
1. Preferred Stock
On February 20, 2009, as part of the Capital Purchase Program (“CPP”) established by the United States Department of Treasury (“Treasury”), the Company issued to Treasury 30,407 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, without par value per share (the “Series A Preferred Stock”), and a liquidation preference of $1,000 per share. In conjunction with the purchase of the Series A Preferred Stock, Treasury received a warrant to purchase 1,104,370 shares of the Company’s Class A common stock. The aggregate purchase price for the Series A Preferred Stock and warrant was $30.4 million in cash. The Series A Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series A Preferred Stock may generally be redeemed by the Company at any time following consultation with its primary banking regulators. The warrant issued to Treasury has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $4.13 per share of the common stock. The Company’s utilized the extra capital provided by the CPP funds to support its efforts to prudently and transparently provide lending and liquidity while also balancing the goal to remain well-capitalized.
2. Common Stock
The Company’s Class A common stock trades on the NASDAQ Global Market under the symbol RBPAA. There is no market for the Company’s Class B common stock. The Class B shares may not be transferred in any manner except to the holder’s immediate family. Class B shares may be converted to Class A shares at the rate of 1.15 to 1. Class B common stock is entitled to one vote for each Class A share and ten votes for each Class B share held. Holders of either class of common stock are entitled to conversion equivalent per share dividends when declared.
3. Payment of Dividends
Under the Pennsylvania Business Corporation Law, the Company may pay dividends only if it is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the “Code”) and in the Federal Deposit Insurance Act (“FDIA”) affecting the payment of dividends to the Company by Royal Bank. Under the Code, no dividends may be paid by a bank except from “accumulated net earnings” (generally retained earnings). Under the FDIA, no dividend may be paid if a bank is in arrears in the payment of any insurance assessment due to the FDIC. In addition, dividends paid by Royal Bank to the Company would be prohibited if the effect thereof would cause Royal Bank’s capital to be reduced below applicable minimum capital requirements.
On August 13, 2009, the Company’s Board determined to suspend regular quarterly cash dividends on the $30.4 million in Series A Preferred Stock. The Company’s Board took this action in consultation with the Federal Reserve Bank of Philadelphia as required by regulatory policy guidance. As of December 31, 2012, the Series A Preferred stock dividend in arrears was $5.8 million and has not been recognized in the consolidated financial statements. As a consequence of missing the sixth dividend payment in the fourth quarter of 2010, the Treasury has the right to appoint two directors to our Board until all accrued but unpaid dividends have been paid. The Treasury exercised its right and appointed two directors to the Company’s Board during 2011.
At December 31, 2012, as a result of significant losses within Royal Bank, the Company had negative retained earnings and therefore would not have been able to declare and pay any cash dividends. Royal Bank must receive prior approval from the FDIC and the Department before declaring and paying a dividend to the Company. Under the Federal Reserve Agreement as described in “Note 2 - Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company may not declare or pay any dividends without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 14 - SHAREHOLDERS’ EQUITY-Continued
Under the terms of the CPP, the Company is not permitted to declare or pay cash dividends on, or redeem or otherwise acquire, stock that is junior to or on parity with the Series A Preferred Stock issued to Treasury at any time when the Company has not declared and paid full dividends on the Series A Preferred Stock.
NOTE 15 - REGULATORY CAPITAL REQUIREMENTS
The Company and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Royal Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. At December 31, 2012, the Company and Royal Bank met all capital adequacy requirements to which it is subject. Under the informal agreement referenced in “Note 2 - Regulatory Matters and Significant Risks And Uncertainties” to the Consolidated Financial Statements, Royal Bank is required to maintain a minimum Tier 1 leverage ratio of 8% and a Total risk-based capital ratio of 12% during the term of the agreement. Royal Bank met these requirements as of December 31, 2012. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. As of December 31, 2012, Royal Bank met the criteria for a well capitalized institution.
In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Call Report instructions and under RAP, that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis. Royal Bank’s current accrual method is in accordance with U.S. GAAP. Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for December 31, 2012 and the previous nine quarters in accordance with U.S. GAAP. However, a change in the manner of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and the Company’s capital ratios as shown below. Royal Bank is in discussions with the FDIC to resolve the matter.
The table below sets forth Royal Bank’s capital ratios under RAP based on the FDIC’s interpretation of the Call Report instructions:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 15 - REGULATORY CAPITAL REQUIREMENTS - Continued
The tables below reflect the adjustments to the net loss as well as the capital ratios for Royal Bank under U.S. GAAP:
The tables below reflect the Company’s capital ratios:
The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) as of December 31, 2012 consistent with U.S. GAAP and the FR Y-9C instructions. In the event a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 15 - REGULATORY CAPITAL REQUIREMENTS - Continued
NOTE 16 - PENSION PLANS
The Company has a noncontributory nonqualified defined benefit pension plan covering certain eligible employees. The Company-sponsored pension plan provides retirement benefits under pension trust agreements. The benefits are based on years of service and the employee’s compensation during the highest three consecutive years during the last 10 years of employment. The Company accounts for its pension in accordance with FASB ASC Topic 715 “Compensation-Retirement Benefits” (“ASC Topic 715”). ASC Topic 715 requires the recognition of a plan’s over-funded or under-funded status as an asset or liability with an offsetting adjustment to AOCI. ASC Topic 715 requires the determination of the fair values of plans assets at a company’s year-end and recognition of actuarial gains and losses, prior service costs or credits, and transition assets or obligations as a component of Accumulated OCI. These amounts will be subsequently recognized as components of net periodic benefits cost. Further, actuarial gains and losses that arise in subsequent periods that are not initially recognized as a component of net periodic benefit cost will be recognized as a component of Accumulated OCI. Those amounts will subsequently be recognized as a component of net periodic benefit cost as they are amortized during future periods.
The following table sets forth the plan’s funded status and amounts recognized in the Company’s consolidated balance sheets:
The accumulated benefit obligation at December 31, 2012 and 2011 was $16.6 million and $14.1 million, respectively.
The table below reflects the assumptions used to determine the benefit obligations:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 16 - PENSION PLANS - Continued
The table below reflects the assumptions used to determine the net periodic pension cost:
Net pension cost included the following components:
Benefit payments to be made from the Non-qualified Pension Plan are as follows:
Benefit payments are expected to be made from insurance policies owned by the Company. The cash surrender value for these policies was approximately $3.3 million and $2.6 million as of December 31, 2012 and 2011, respectively.
Defined Contribution Plan
The Company has a capital accumulation and salary reduction plan under Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the plan, all employees are eligible to contribute up to the maximum allowed by IRS regulation, with the Company matching dollar for dollar of any contribution up to 5%, which is subject to a $2,500 per employee annual limit. During 2012 and 2010, no matching contribution was made as a result of a management decision to reduce costs. During 2011 the Company partially reinstated the matching contribution and contributed $128,000 to the plan.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 17 - STOCK COMPENSATION PLANS
Under the Company’s Directors’ and Employees’ Stock Option Plans, the Company may grant options to its directors, officers and employees for up to 2.1 million shares of common stock. Non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of the Company’s stock on the date of grant and an option’s maximum term is ten years. Vesting periods range from one to five years from the date of grant. The Company recognized compensation expense for stock options and restricted stock in the amounts of $42,000, $93,000 and $35,000 for December 31, 2012, 2011 and 2010, respectively. The Company did not grant any options to purchase common stock in 2012 and 2011.
1. Outside Directors’ Stock Option Plan
The Company adopted a non-qualified outside Directors’ Stock Option Plan (the “Directors’ Plan”). Under the terms of the Directors’ Plan, 250,000 shares of Class A stock were authorized for grants. Each director was entitled to a grant of an option to purchase 1,500 shares of stock annually. The options were granted at the fair market value at the date of the grant. The options are exercisable one year after the date of grant date and must be exercised within ten years of the grant.
A summary of the Directors’ Plan activity is presented below:
(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had they exercised their options on December 31, 2012. The intrinsic value varies based on the changes in the market value in the Company’s stock. Because the exercise price exceeded the market value of the options, the average intrinsic value was $0 at December 31, 2012.
Information pertaining to options outstanding at December 31, 2012 is as follows:
As of December 31, 2012 all outstanding shares are fully vested (exercisable). The ability to grant new options under this plan has expired.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 17 - STOCK COMPENSATION PLANS - Continued
2. Employee Stock Option and Appreciation Right Plan
The Company adopted a Stock Option and Appreciation Right Plan (the “Plan”). The Plan is an incentive program under which Company officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1.8 million shares of the Company’s Class A common stock (but not in excess of 19% of outstanding shares). At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. The options were exercisable at 20% per year beginning one year after the date of grant and must be exercised within ten years of the grant.
A summary of the Plan activity is presented below:
(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had they exercised their options on December 31, 2012. The intrinsic value varies based on the changes in the market value in the Company’s stock. Because the exercise price exceeded the market value of the options, the average intrinsic value was $0 at December 31, 2012.
Information pertaining to options outstanding at December 31, 2012 is as follows:
As of December 31, 2012 all outstanding shares are fully vested (exercisable). The ability to grant new options under this plan has expired.
3. Long-Term Incentive Plan
The 2007 Long-Term Incentive Plan was approved by Shareholders at the May 16, 2007 Annual Meeting. The plan consists of both a restricted and an unrestricted stock option plan. All employees and non-employee directors of the Company and its designated subsidiaries are eligible participants. The plan includes one million shares of Class A common stock, subject to customary anti-dilution adjustments, or approximately 9.0% of the total outstanding shares of the Class A common stock.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 17 - STOCK COMPENSATION PLANS - Continued
As of December 31, 2012, 172,390 shares from the unrestricted plan have been granted. The option price is equal to the fair market value at the date of the grant. The employee options are exercisable at 20% per year beginning one year after the date of grant and must be exercised within ten years of the grant date. Directors’ options are exercisable on the one year anniversary of the date of grant and must be exercised within ten years of the grant date.
A summary of the status of the unrestricted portion of the Plan is presented below:
(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had they exercised their options on December 31, 2012. The intrinsic value varies based on the changes in the market value in the Company’s stock. Because the exercise price exceeded the market value of the options, the average intrinsic value was $0 at December 31, 2012.
Information pertaining to options outstanding at December 31, 2012 is as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 17 - STOCK COMPENSATION PLANS - Continued
The following table provides detail for non-vested shares under the Long-Term Incentive Plan as of December 31, 2012:
There were a total of 10,520 unvested options at December 31, 2012, with a fair value of $25,000 and approximately $22,000 remained to be recognized in expense during 2013.
Under the aforementioned Long-Term Incentive Plan, approved by shareholders in May 2007, the Company is authorized to grant share-based incentive compensation awards for corporate performance to employees. These awards may be granted in form of shares of the Company’s common stock, performance-restricted restricted stock.
The vesting of awards is contingent upon meeting certain return on asset and return on equity goals. The awards are not permitted to be transferred during the restricted time period from the date of the award and are subject to forfeiture to the extent that the performance restrictions are not satisfied. Awards are also forfeited if the employee terminates his or her service prior to the end of the restricted time period, unless such termination is in accordance with the Company’s mandatory retirement age. Vested awards are converted to shares of the Company’s common stock at the end of the restricted time period. The fair market value of each employee based award is estimated based on the fair market value of the Company’s common stock on the date of the grant and probable performance goals to be achieved and estimated forfeitures. If such goals are not met then no compensation cost would be recognized and any recognized compensation cost would be reversed. There were no shares of restricted stock outstanding at December 31, 2012.
NOTE 18 - EARNINGS PER COMMON SHARE (“EPS”)
Basic and diluted EPS are calculated as follows:
At December 31, 2012, 362,093 options to purchase shares of common stock and restricted stock awards were anti-dilutive in the computation of diluted EPS, as exercise price exceeded average market price and as a result of the net loss for the year. Additionally 30,407 warrants were also anti-dilutive.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 18 - EARNINGS PER COMMON SHARE - Continued
At December 31, 2011, 520,979 options to purchase shares of common stock and restricted stock awards were anti-dilutive in the computation of diluted EPS, as exercise price exceeded average market price and as a result of the net loss for the year. Additionally 30,407 warrants were also anti-dilutive.
At December 31, 2010, 580,953 options to purchase shares of common stock and restricted stock awards were anti-dilutive in the computation of diluted EPS, as exercise price exceeded average market price and as a result of the net loss for the year. Additionally 30,407 warrants were also anti-dilutive.
NOTE 19 - COMPREHENSIVE (LOSS) INCOME
ASC Topic 220 requires the reporting of all changes in equity during the reporting period except investments from and distributions to shareholders. Net income (loss) is a component of comprehensive income (loss) with all other components referred to in the aggregate as other comprehensive income.
The components of other comprehensive (loss) income and the related tax effects for December 31, 2012, 2011, and 2010 are as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 19 - COMPREHENSIVE INCOME (LOSS) - Continued
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 19 - COMPREHENSIVE INCOME (LOSS) - Continued
The other components of accumulated other comprehensive income (loss) included in shareholders’ equity at December 31, 2012, 2011, and 2010 are as follows:
Refer to “Note 16 - Pension Plans” to the Consolidated Financial Statements for more information.
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Under FASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC Topic 820”), fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When available, management uses quoted market prices to determine fair value. If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.
Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.
ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly. ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC Topic 820 are as follows:
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company did not have transfers of financial instruments within the fair value hierarchy during the three and twelve months ended December 31, 2012 and 2011.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Items Measured on a Recurring Basis
The Company’s available for sale investment securities are recorded at fair value on a recurring basis.
Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges. Level 1 securities include preferred and common stocks, and one trust preferred security which is actively traded.
Level 2 securities include obligations of U.S. government-sponsored agencies, debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. The prices were obtained from third party vendors. This category generally includes mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds.
Level 3 securities include investments in seven private equity funds which are predominantly invested in real estate. The value of the private equity funds are derived from the funds’ financials and K-1 filings. The Company also reviews the funds’ asset values and its near-term projections. At December 31, 2011, level 3 securities also included five trust preferred securities. The fair values for the trust preferred securities were derived by using contractual cash flows and a market rate of return for each of these securities. Factors that affected the market rate of return included (1) any uncertainty about the amount and timing of the cash flows, (2) the credit risk, (3) liquidity of the instrument, and (4) observable yields from trading data and bid/ask indications. Credit risk spreads and liquidity premiums were analyzed to derive the appropriate discount rate.
For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2012 and 2011 are as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
The following tables present additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the years ended December 31, 2012 and 2011:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Items Measured on a Nonrecurring Basis
Non-accrual loans and TDRs are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”. The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending. When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2012 and 2011 are as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:
(1)
Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses. Fair value may also be based on negotiated settlements with the borrower.
(2)
Leases are measured using the salvageable value of the collateral.
The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at December 31, 2012 and 2011. The tables below indicate the fair value of the Company’s financial instruments at December 31, 2012 and 2011. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.
Cash and cash equivalents (carried at cost):
The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.
Securities:
Management uses quoted market prices to determine fair value of securities (level 1). If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, the Company uses unobservable inputs to determine appropriate valuation adjustments by reviewing the private equities funds’ financials and K-1 filings and for trust preferred securities using discounted cash flow methodologies (level 3).
Other Investment (carried at cost):
This investment includes the Solomon Hess SBA Loan Fund, which the Company invested in to partially satisfy its community reinvestment requirement. Shares in this fund are not publicly traded and therefore have no readily determinable fair market value. An investor can have their investment in the Fund redeemed for the balance of their capital account at any quarter end with 60 days notice to the Fund. The investment in this Fund is recorded at cost. The Company does not record this investment at fair value on a recurring basis, as this investment’s carrying amount approximates fair value.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Restricted investment in bank stock (carried at cost):
The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.
Loans held for sale (carried at the lower of cost or fair market value):
The fair values of loans held for sale are estimated using expected net sales proceeds.
Loans receivable (carried at cost):
The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.
Impaired loans (generally carried at fair value):
Impaired loans are accounted for under ASC Topic 310. Impaired loans are those in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based on the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.
Accrued interest receivable and payable (carried at cost):
The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.
Deposit liabilities (carried at cost):
The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short-term borrowings (carried at cost):
The carrying amounts of short-term borrowings approximate their fair values.
Long-term debt (carried at cost):
Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.
Subordinated debt (carried at cost):
Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms and remaining maturity.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Off-balance sheet financial instruments (disclosed at cost):
Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing. They are not shown in the table because the amounts are immaterial.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
NOTE 21 - SEGMENT INFORMATION
FASB ASC Topic 280, “Segment Reporting” (“ASC Topic 280”) established standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision makers in deciding how to allocate and assess resources and performance. The Company’s chief operating decision makers are the CEO and the Chief Financial Officer (“CFO”). The Company has identified its reportable operating segments as “Community Banking” and “Tax Liens”. In years prior to 2011, the Company reflected “Equity Investments” and “Leasing” as operating segments. Management has determined that the operating results and assets related to Equity Investments and Leasing should be reflected under the Community Banking segment. The determination related to Equity Investments was based on the deconsolidation of the VIE as a result of the completion of the project. The determination related to Leasing was based on not meeting the quantitative thresholds for requiring disclosure.
Community banking
The Company’s Community Banking segment consists of commercial and retail banking and leasing. This segment includes Royal Bank and in the 2010 period Royal Asian Bank. For 2010, Royal Asian Bank recorded a net loss of $953,000. The Community Banking business segment is managed as a single strategic unit which generates revenue from a variety of products and services provided by Royal Bank. For example, commercial lending is dependent upon the ability of Royal Bank to fund cash needed to make loans with retail deposits and other borrowings and to manage interest rate and credit risk. While Royal Bank makes few consumer loans, cash needed to make such loans would be funded similarly to commercial loans.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 21 - SEGMENT INFORMATION - Continued
Tax lien operation
The Company’s Tax Lien Operation consists of purchasing delinquent tax certificates from local municipalities at auction and then processing those liens to either encourage the property holder to pay off the lien, or to foreclose and sell the property. The tax lien operation earns income based on interest rates (determined at auction) and penalties assigned by the municipality, along with gains the on sale of foreclosed properties.
Selected segment information and reconciliations to consolidated financial information are as follows:
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 21 - SEGMENT INFORMATION - Continued
Interest income earned by the Community Banking segment related to the Tax Lien Operation was approximately $2.7 million, $2.5 million, and $3.4 million for the years ended December 31, 2012, 2011, and 2010, respectively.
NOTE 22 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
Condensed financial information for the parent company only follows.
CONDENSED BALANCE SHEETS
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 22 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY - Continued
CONDENSED STATEMENTS OF OPERATIONS
CONDENSED STATEMENTS OF CASH FLOWS
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 23 - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
The following summarizes the consolidated results of operations during 2012 and 2011, on a quarterly basis, for the Company:
Operating results for the fourth quarter of 2012 amounted to a loss of $8.0 million, which resulted in an increase of $7.0 million from the loss recorded in the fourth quarter of 2011. The year over year decline in the quarterly results was primarily related to a $2.4 million increase in OREO impairment, a $1.8 million decrease in interest income, a $1.5 million OTTI charge, and a $1.1 million increase in impairment on LHFS. The additional OREO impairment was primarily due to the declining values of four of the vacant land properties in the portfolio. The decrease in interest income was primarily driven by a decline in average loan balances year over year and a decline in the yield on investment securities. As a result of the historically sustained low interest rates, the yield on investment securities declined despite the increase in average balances. This decline in yield was due to the replacement of sold and called higher yielding investment securities and the reinvestment of increased payments received on cash flowing investment securities during 2012 with lower yielding government agency securities coupled with accelerated amortization of premiums paid on investment securities within the MBS/CMO portfolio. The $1.5 million increase in OTTI was entirely related to the complete write down of one private equity security. The increase in the impairment on LHFS was related to the challenges with the one remaining non-accrual LHFS and an agreement of sale.
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE 23 - SUMMARY OF QUARTERLY RESULTS (UNAUDITED) - Continued
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms. As of the end of the period covered by this report, the Company evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Exchange Act. Based on that evaluation our CEO and CFO concluded that the Company’s disclosure controls and procedures were effective as December 31, 2012.
Changes in Internal Control over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting during the fourth quarter of 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. The Company’s management, with the participation of the Company’s principal executive officer and principal financial officer, has assessed the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
Based on its assessment under the COSO framework, the Company’s management concluded that the Company’s control over financial reporting was effective as of December 31, 2012.
There are inherent limitations to the effectiveness of any controls system. A controls system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that its objectives are met. Further, the design of a control system must reflect the fact that there are limits on resources, and the benefits of controls must be considered relative to their costs and their impact on the business model.
This annual report does not include an attestation report of the Company’s registered 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 the Dodd-Frank Act, which permits smaller reporting companies, such as the Company, to provide only management’s report in this annual report.
By: /s/ F. Kevin Tylus
By: /s/ Michael S. Thompson
F. Kevin Tylus
Michael S. Thompson
Principal Executive Officer
Principal Financial Officer and Principal Accounting Officer
March 27, 2013
March 27, 2013
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III.
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
The information required in this Item, relating to directors, executive officers, and control persons is set forth in the Company’s Proxy Statement to be used in connection with the 2013 Annual Meeting of Shareholders under the captions “Information About Nominees, Continuing Directors and Executive Officers,” “ Section 16(a) Beneficial Ownership Reporting Compliance,” “Meetings and Committees of the Board of Directors,” and “Interests of Management and Others in Certain Transactions,” which pages are incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item, relating to executive compensation, is set forth in the Company’s Proxy Statement to be used in connection with the 2013 Annual Meeting of Shareholders, under the captions “Summary Compensation Table,” “Grants of Plan-Based Awards - 2012,” “Outstanding Equity Awards Table,” “Option Exercises and Stock Vested Table,” “Retirement Plans,” “Non-Qualified Deferred Compensation Plans,” “Other Potential Post-Employment Payments,” “Director Compensation Table,” “Outstanding Options Held by Directors,” and “Compensation Committee Report,” which pages are incorporated herein by reference.
In the TARP CPP Agreement, the Company agreed that, until such time as Treasury ceases to own any debt or preferred equity securities of the Company acquired pursuant to the Purchase Agreement, the Company will take all necessary action to ensure that its benefit plans with respect to its senior executive officers comply with Section 111(b) of the Emergency Economic Stabilization Act of 2008, as it may be amended from time to time (the “EESA”), and any rules or regulations promulgated thereunder, and has agreed to not adopt any benefit plans with respect to, or which covers, its senior executive officers that do not comply with the EESA any rules or regulations promulgated thereunder, and the applicable executives have consented to the foregoing.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS
The information required by this Item, relating to beneficial ownership of the Registrant’s Common Stock, is set forth in the Company’s Proxy Statement to be used in connection with the 2013 Annual Meeting of Shareholders, under the captions “Principal Shareholders” and “Information About Nominees, Continuing Directors and Executive Officers,” which pages are incorporated herein by reference.
Securities Authorized for Issuance Under Equity Compensation Plans
The following tables provide certain information regarding securities issued or issuable under the Company’s equity compensation plans as of December 31, 2012:
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item, relating to transactions with management and others, certain business relationships and indebtedness of management, is set forth in the Company’s Proxy Statement to be used in connection with the 2013 Annual Meeting of Shareholders, under the caption “Interests of Management and Others in Certain Transactions,” which pages are incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this item appears under the caption “Audit Committee Report” of the Proxy Statement to be used in connection with the 2013 Annual Meeting of Shareholders, which pages are incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a.)
1.
Financial Statements
The following financial statements are included by reference in Part II, Item 8 hereof.
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets.
Consolidated Statements of Operations.
Consolidated Statements of Changes in Shareholders’ Equity.
Consolidated Statement of Cash Flows.
Notes to Consolidated Financial Statements.
2.
Financial Statement Schedules
Financial Statement Schedules are omitted because the required information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto.
(b.)
The following Exhibits are filed herewith or incorporated by reference as a part of this Annual Report.
* Denotes compensation plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
By: /s/ F. Kevin Tylus
By: /s/ Michael S. Thompson
F. Kevin Tylus
Michael S. Thompson
President and Chief Executive Officer
Chief Financial Officer
(Principal Executive Officer)
(Principal Financial Officer
and Principal Accounting Officer)
March 27, 2013
March 27, 2013
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURES
By: /s/ Robert R. Tabas
By: /s/ F. Kevin Tylus
Robert R. Tabas
F. Kevin Tylus
Chairman of the Board
President and Chief Executive Officer/Director
March 27, 2013
March 27, 2013
By: /s/ Edward F. Bradley
By: /s/ William Hartman
Edward F. Bradley
William Hartman
Director
Lead Independent Director
March 27, 2013
March 27, 2013
By: /s/ Wayne R. Huey, Jr.
By: /s/ Michael Piracci
Wayne R. Huey, Jr
Michael Piracci
Director
Director
March 27, 2013
March 27, 2013
By: /s/ Linda Tabas Stempel
By: /s/ Murray Stempel, III
Linda Tabas Stempel
Murray Stempel, III
Director
Director
March 27, 2013
March 27, 2013
By: /s/ Edward B. Tepper
By: /s/ Gerard M. Thomchick
Edward B. Tepper
Gerard M. Thomchick
Director
Director
March 27, 2013
March 27, 2013
By: /s/ Howard Wurzak
Howard Wurzak
Director
March 27, 2013