Item 1. Business.
General
Independence Bancshares, Inc. (the “Company”) is a South Carolina corporation organized to operate as a bank holding company pursuant to the Federal Bank Holding Company Act of 1956 and the South Carolina Banking and Branching Efficiency Act of 1996, and to own and control all of the capital stock of Independence National Bank (the “Bank”), a national association organized under the laws of the United States. Since opening for business on May 16, 2005, the Bank has operated as a traditional community bank in Greenville, South Carolina, fulfilling the financial needs of individuals and small businesses in its market. The Bank provides traditional checking and savings products insured by the Federal Deposit Insurance Corporation (the “FDIC”) and consumer, commercial and mortgage loans, as well as ATM and online banking, cash management and safe deposit boxes.
As previously reported, on September 25, 2015, the Company suspended development of its digital banking, payments and transaction services business and subsequently began evaluating strategic alternatives for the Company. A key goal of the Company’s digital banking business was to reduce costs for banking activities and operate more efficiently through utilizing mobile and online delivery channels. In furtherance of this goal and based in part upon the institutional knowledge acquired in the pursuit of the digital banking strategy, the Company plans to supplement its current lending strategy by expanding its consumer lending program with online offerings, targeting prime and super-prime borrowers in the Bank’s current market area as well as throughout South Carolina. The Company’s board of directors is focused on profitably growing the Bank and enhancing shareholder value through this targeted expansion of its consumer lending program which may include purchases of in-market consumer loans that meet our underwriting criteria.
Banking Services
Market
Our primary focus and target market is to fulfill the financial needs of individual consumers, small business owners, the legal and medical communities, insurance agencies, and clients owning and developing income producing properties primarily in the Greenville metropolitan area. In our consumer lending line of business, we focus on a broader market area that currently includes the entire state of South Carolina. We intend to use our “closeness” to the market via local ownership, quick response time, pricing discretion, person-to-person relationships and an experienced, well known senior management team in leveraging our market share in the greater
Greenville area while looking for ways to differentiate the Bank from our competition. Our new on-line consumer lending program is one of these ways we seek to differentiate the Bank from our competition.
Location and Service Area
Our primary market is Greenville County, which is located in the upstate region of South Carolina. The cities of Fountain Inn, Greenville, Greer, Mauldin, Simpsonville, and Travelers Rest make up Greenville County. The Greenville metropolitan area, positioned on the I-85 corridor, is home to one of the strongest manufacturing centers in the country, including approximately 250 international companies, such as the North American headquarters of BMW and Michelin, as well as Fluor Corporation, General Electric, and Lockheed Martin. Greenville County has a population of approximately 492,000, with a five-year projected annual growth rate of approximately 2.1%, according to the South Carolina Community Profiles published by the South Carolina Budget and Control Board’s Office of Research and Statistics. The area’s demographics have changed considerably over the past 10 years and currently over 42,000 businesses are operating within the county limits, according to the U.S. Census Bureau.
Our main office is located in Greenville, South Carolina, one block off a major artery, and provides excellent visibility for the Bank. We also have full-service branches on Wade Hampton Boulevard in Taylors, South Carolina and in Simpsonville, South Carolina. These branch offices have extended the market reach of our Bank and have increased our personal service delivery capabilities to all of our customers. We plan to continue to take advantage of existing contacts and relationships with individuals and companies in this area to more effectively market the banking services of the Bank.
With respect to our on-line consumer lending program, we believe that because the business has been structured to be overwhelmingly conducted on-line, we will be able to expand our lending area outside of the area served by our physical branch network.
Competition
The Greenville market is highly competitive, with all of the largest banks in the state, as well as super regional banks, represented in our market area. The competition among the various financial institutions is based upon a variety of factors, including interest rates offered on deposit accounts, interest rates charged on loans, credit and service charges, the quality of services rendered, the convenience of banking facilities and, in the case of loans to large commercial borrowers, relative lending limits. In addition to banks and savings associations, we compete with other financial institutions including securities firms, insurance companies, credit unions, leasing companies and finance companies. Size gives larger banks certain advantages in competing for business from large corporations. These advantages include higher lending limits and the ability to offer services in other areas of South Carolina. As a result, we do not generally attempt to compete for the banking relationships of large corporations, but concentrate our efforts on small- to medium-sized businesses and retail customers. We believe we have competed effectively in this market by offering quality and personal service.
With respect to our on-line consumer lending program, our greatest source of competition is non-bank lenders and we believe that we can effectively compete in this product through utilizing mobile and online delivery channels as well as advantages - such as state law preemption - afforded to us as a national bank.
Products and Services
The Bank is primarily engaged in the business of accepting demand and time deposits and providing consumer, commercial and mortgage loans to the general public. With respect to our on-line consumer lending business, we provide unsecured consumer loans up to $35,000 to individual borrowers. Deposits in the Bank are insured by the FDIC up to a maximum amount, which is currently set at $250,000 per depositor. Other services which the Bank offers include mobile banking, online banking, commercial cash management, remote deposit capture, safe deposit boxes, bank official checks, traveler’s checks, and wire transfer capabilities.
Lending Activities
General. We emphasize a range of lending services, including commercial, real estate, unsecured consumer loans and equity-line consumer loans to individuals and small- to medium-sized businesses and professional firms that are located in or conduct a substantial portion of their business in our market area. The larger, well-established banks in our service area make proportionately more loans to medium- to large-sized businesses than we do. Our small- to medium-sized borrowers may be less able to withstand competitive, economic, and financial conditions than larger borrowers. Our underwriting standards vary for each type of loan, as described below. We compete for these loans with competitors who are well established in our service area and have greater resources and lending limits.
Loan Approval. Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. We attempt to mitigate repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, the loan request will be considered by an executive officer with a higher lending limit, executive officers combining authority or the directors’ loan committee. We do not make any loans to any director or executive officer of the Bank unless the loan is approved by the full board of directors of the Bank and is on terms not more favorable than would be available to a person not affiliated with the Bank.
Credit Administration and Loan Review. We maintain a continuous loan review system. We also apply a credit grading system to each loan, and we use an independent consultant to review the loan files on a test basis to confirm our loan grading. Each loan officer is responsible for each loan he or she makes, regardless of whether other individuals or committees joined in the approval. This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.
Lending Limits. Our lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. These limits will increase or decrease in response to increases or decreases in the Bank’s level of capital. We are able to sell participations in our larger loans to other financial institutions, which allows us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.
Consumer Loans. We have historically made a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit but have this year increased our focus on this line of business by implementing an on-line unsecured consumer loan product to individual borrowers of up to $35,000 per loan. Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral, if a secured loan. Consumer rates are both fixed and variable, with terms negotiable. Our installment loans typically amortize over periods up to 60 months. We will offer consumer loans with a single maturity date when a specific source of repayment is available. We typically require monthly payments of interest and a portion of the principal on our revolving loan products. Consumer loans are generally considered to have a greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.
Real Estate Mortgage Loans. The principal component of our loan portfolio is loans secured by real estate mortgages. We obtain a security interest in real estate whenever possible, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan. At December 31, 2016, loans secured by mortgages on real estate - first mortgages of approximately $45.2 million and second mortgages of approximately $3.9 million - made up approximately 71% of our loan portfolio.
These loans generally fall into one of four categories: commercial real estate loans, construction and development loans (including land loans), residential real estate loans, or home equity loans. Most of our real estate loans are secured by residential or commercial property. Interest rates for all categories may be fixed or adjustable, and will more likely be fixed for shorter-term loans. We generally charge an origination fee for each loan. Other loan fees consist primarily of late charge fees or prepayment penalties. Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, credit-worthiness, and ability to repay the loan.
•Commercial Real Estate Loans. Commercial real estate loans generally have terms of five years or less, although payments may be structured on a longer amortization basis. We evaluate each borrower on an individual basis and attempt to determine their business risks and credit profile. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan-to-value ratio, established by independent appraisals, does not exceed 85% at origination. We generally require that debtor cash flow exceed 120% of monthly debt service obligations. We typically review all of the personal financial statements of the principal owners and require their personal guarantees. These reviews generally reveal secondary sources of payment and liquidity to support a loan request.
•Construction and Development Real Estate Loans (Including Land Loans). We offered adjustable and fixed rate residential and commercial construction loans in the past. We continue to offer construction and development loans on a limited basis to certain qualified borrowers. The terms of construction and development loans have generally been limited to eighteen months, although some payments have been structured on a longer amortization basis. Most loans mature and require payment in full upon the sale of the property. We believe that construction and development loans generally carry a higher degree of risk than long term financing of existing properties. Repayment depends on the ultimate completion of the project and usually on the sale of the property. Specific risks include:
•cost overruns;
•mismanaged construction;
•inferior or improper construction techniques;
•economic changes or downturns during construction;
•a downturn in the real estate market;
•rising interest rates which may prevent sale of the property; and
•failure to sell completed projects in a timely manner.
We attempt to reduce risk by obtaining personal guarantees where possible, and by keeping the loan-to-value ratio of the completed project below specified percentages. We previously reduced risk by selling participations in larger loans to other institutions when possible.
•Residential Real Estate Loans and Home Equity Loans. We generally do not originate traditional long term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. Generally, we limit the loan-to-value ratio on our residential real estate loans to 80% at origination. We offer fixed and adjustable rate residential real estate loans with terms of up to years. We typically offer these fixed rate loans through a third party rather than originating and retaining these loans ourselves. We typically originate and retain residential real estate loans only if they have adjustable rates. We also offer home equity lines of credit. Our underwriting criteria and the risks associated with home equity loans and lines of credit are generally the same as those for first mortgage loans. Home equity lines of credit typically have terms of fifteen years or less. We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.
Commercial Business Loans. We make commercial loans across various lines of business. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or if they are secured, the value of the security may be difficult to assess and more likely to decrease than real estate.
Equipment loans typically will be made for a term of five years or less at fixed or variable rates, with the loan fully amortized over the term and secured by the financed equipment. Generally, we limit the loan-to-value ratio on these loans to 80% or less at origination. Working capital loans typically have terms not exceeding one year and usually are secured by accounts receivable, inventory, or personal guarantees of the principals of the business. For loans secured by accounts receivable or inventory, principal will typically be repaid as the assets securing the loan are converted into cash, and in other cases principal will typically be due at maturity. Trade letters of credit, standby letters of credit, and foreign exchange will generally be handled through a correspondent bank as agent for the Bank.
Deposit Services
Our principal source of funds is core deposits. We offer a full range of deposit services, including checking accounts, commercial accounts, NOW accounts, savings accounts, and time deposits of various types, ranging from daily money market accounts to long-term certificates of deposit. We solicit these accounts from individuals, businesses, associations, organizations and governmental authorities. Deposit rates are reviewed regularly by senior management of the Bank and the asset/liability management committee (“ALCO”) of the Bank’s board of directors. We believe that the rates we offer are competitive with those offered by other financial institutions in our area.
Credit Cards
The Bank offers Visa branded credit cards for personal and business clients in coordination with a third party vendor known as ServisFirst Bank. Two types of credit cards are offered to consumers and businesses: Visa Platinum Card with no annual fee and Visa Platinum Card with cash back feature that is charged an annual fee. Clients enjoy the freedom of Visa acceptance worldwide with available 24/7 customer support as well as protection and security services.
Merchant Services
The Bank offers merchant transaction processing and equipment for clients in coordination with a third party vendor known as Merchants’ Choice Payment Solutions. Clients enjoy the capability, as well as the specialized equipment, to accept debit and credit card transactions to conduct business with speed, ease and security. Clients are able to accept payments from Visa, MasterCard, American Express and Discover. Equipment and services available include POS terminals, wireless units, web based processing, online debit and TeleCheck services.
Other Banking Services
We offer other community bank services including cashier’s checks, banking by mail, direct deposit, remote deposit capture, United States Savings Bonds, and travelers’ checks. We earn fees for most of these services, in addition to fees earned from debit and credit card transactions, sales of checks, and wire transfers. We are associated with the Plus and Star ATM networks, which are available to our clients throughout the country. We offer merchant banking and credit card services through a correspondent bank. We also offer online banking services, bill payment services, and cash management services.
Market Share
As of June 30, 2016, the most recent date for which FDIC deposit market share data is available, total deposits in the Greenville-Anderson-Mauldin, South Carolina MSA were over $15.4 billion, an increase of approximately 3.5% from $14.8 billion as of June 30, 2015. At June 30, 2016 and 2015, the Bank’s deposits represented 0.53% and 0.62% of this market, respectively.
Research and Development
All costs incurred to establish the technological feasibility of computer software to be sold, leased or otherwise marketed as research and development are expensed as incurred. Once technological feasibility has been established, the subsequent costs of producing, coding and testing the products should be capitalized. The expensing of computer software costs is discontinued when the product is available for general release for customers. The Company did not achieve technological feasibility in connection with the development its digital banking, payments and transaction services business and therefore expensed all computer software purchases and development expenses related to research and development. On September 25, 2015 the Company suspended the development of its digital banking business. During the year ended December 31, 2016 and 2015, we incurred product research and development expenses of approximately $250,000 and $2.2 million, respectively. The 2016 expenses related to remaining monthly contract costs which have since been completed.
Employees
As of March 23, 2017, we had 33 full-time employees and two part-time employees.
Business Segments
The Company reports its activities as four business segments - Community Banking, Transaction Services, Asset Management and Parent Only. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment. Please refer to “Note 19 - Business Segments” for further information on the reporting for the four business segments.
Supervision and Regulation
Both the Company and the Bank are subject to extensive state and federal banking laws and regulations that impose specific requirements or restrictions on and provide for general regulatory oversight of virtually all aspects of our operations. These laws and regulations are generally intended to protect depositors, federal insurance deposit funds, and the banking system as a whole and not our shareholders. Changes in applicable laws or regulations may have a material effect on our business and prospects.
The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on our operations. It is intended only to briefly summarize some material provisions. The following summary is qualified by reference to the statutory and regulatory provisions discussed.
General Overview
Compliance with legal and regulatory requirements is a highly complex and integral part of our day-to-day operations. Our products and services are generally subject to federal, state and local laws and regulations, including:
•anti-money laundering laws;
•privacy and information safeguard laws;
•consumer protection laws; and
•bank regulations.
These laws are often evolving and sometimes ambiguous or inconsistent, and the extent to which they apply to us or our customers is at times unclear. Any failure to comply with applicable law - either by us or by our third-party vendors and service providers, over which we have limited legal and practical control - could result in restrictions on our ability to provide our products and services, as well as the imposition of civil fines and criminal penalties and the suspension or revocation of a license or registration required to sell our products and services. See “Risk Factors” under Part I, Item 1A
Item 1A. Risk Factors.
The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently now to us or that we currently deem immaterial may also impact our business operations. If any of the following risks occur, our business, financial condition, operating results, and cash flows could be materially adversely affected.
Risks Related to Our Business
If we do not generate positive earnings, there will be an adverse effect on our future results of operations.
For the years ended December 31, 2016 and 2015, we incurred net losses of $2.6 million and $4.8 million, respectively. For 2016, the $2.6 million loss was largely due to $1.1 million in professional fees, $407,000 in provisions for loan losses and $511,268 in expenses related to real estate owned. For 2015, the $4.8 million loss was largely due to $2.2 million in expenses for product research and development relating to our technology and infrastructure investments, $275,000 in license fees, and $457,173 in expenses related to real estate owned. Our failure to generate earnings could result in negative consequences, including that the regulatory authorities could implement enforcement actions against the Company and/or the Bank.
Working capital needs could adversely affect our results of operations and financial condition.
Our Bank’s primary funding sources are customer deposits and loan repayments. Deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. Scheduled loan repayments are a relatively stable source of funds; however, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors outside of our control, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Accordingly, we may be required from time to time to rely on secondary sources of working capital to meet withdrawal demands or otherwise fund operations. Those sources may include borrowings from the FHLB or Federal Reserve, federal funds lines of credit from correspondent banks and brokered deposits, to the extent allowable by regulatory authorities. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future working capital demands, particularly if we were to experience atypical deposit withdrawal demands, increased loan demand or if regulatory decisions should limit available funding sources such as brokered deposits. We may be required to slow or discontinue loan growth (including through our new consumer lending program), capital expenditures or other investments or liquidate assets should those sources not be adequate.
We may need to raise additional capital and that capital may not be available on favorable terms, if at all.
Our management may adopt or deploy business strategies or plans, such as our new consumer lending program, the execution of which requires securing additional capital. Our ability to raise additional capital will depend on a number of factors outside of our control, including conditions in the capital markets. There is a risk we will not be able to raise the capital we need at all or upon favorable terms. If we cannot raise capital when needed, we would not be able to implement any such strategies or plans developed by management and we may be subject to increased regulatory supervision and restriction. Any restrictions imposed by regulators could have a material adverse effect on our financial condition and results of operations, whether directly or indirectly.
The Company may pursue additional financings to maintain adequate capital resources and/or execute on business strategies. Financings, if any, may include the issuance of debt or equity securities, which issuances could dilute the percentage ownership interests of our shareholders and dilute the per share book value of our stock. In addition, new investors could have rights, preferences, and privileges senior to our current shareholders.
The success of our growth strategy depends on our ability to identify and retain individuals with experience and relationships in the markets and lines of business in which we intend to expand.
To expand our franchise successfully, we must identify and retain experienced key management members with expertise and relationships in particular markets or lines of business. We expect that competition for qualified management in the markets in which we may expand will be intense and that there will be a limited number of qualified persons with knowledge of and experience in the banking industry in these markets or lines of business. Even if we identify individuals that we believe could assist us in establishing a presence in a new market or line of business, we may be unable to recruit these individuals away from more established financial institutions. In addition, the process of identifying and recruiting individuals with the combination of skills and attributes required to carry out our strategy requires both management and financial resources and is often lengthy. Our inability to identify, recruit, and retain talented personnel to manage new offices effectively would limit our growth and could materially adversely affect our business, financial condition, and results of operations.
A return of recessionary conditions could result in increases in our level of non-performing loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.
Economic conditions have improved since the end of the economic recession; however, economic growth has been slow and uneven, unemployment remains relatively high, and concerns still exist over the federal deficit, government spending and economic risks. A return of recessionary conditions and/or negative developments in the domestic and international credit markets may significantly affect the markets in which we do business, the value of our loans and investments, and our ongoing operations, costs and profitability. Declines in real estate value and sales volumes and high unemployment levels may result in higher than expected loan delinquencies and a decline in demand for our products and services. These negative events may cause us to incur losses and may adversely affect our capital, liquidity and financial condition.
Furthermore, the Federal Reserve, in an attempt to help the overall economy, has among other things, kept interest rates low through its targeted federal funds rate and the purchase of U.S. Treasury and mortgage-backed securities. The Federal Reserve increased the target range for the federal funds rate by 25 basis points in December 2016 and indicated the potential for further gradual increases in the target rate depending on the economic outlook. As the federal funds rate increases, market interest rates will likely rise, which may negatively impact the housing markets and the U.S. economic recovery.
A continuation of the current low interest rate environment or subsequent movements in interest rates may have an adverse effect on our profitability.
Changes in the interest rate environment may materially affect our business. Changes in interest rates affect the following areas, among others, of our business:
•the level of net interest income we earn;
•the volume of loans originated and prepayment of loans;
•the market value of our securities holdings; and
•gains from sales of loans and securities.
In recent years, it has been the policy of the Federal Reserve to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, yields on securities purchased, and market rates on the loans originated, have been at levels lower than were available prior to 2008. Consequently, the average yield on our interest-earning assets has decreased during the recent low interest rate environment. As a general matter, our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets; however, our ability to lower interest expense has been limited at these interest rate levels, while the average yield on interest-earning assets has continued to decrease. If a low interest rate environment persists, net interest income may further decrease, which may have an adverse effect on our profitability.
Our net interest margin would narrow if the cost of funding increases without a correlative increase in the interest we earn from loans and investments. Because we rely extensively on deposits to fund operations, our cost of funding would increase if there is an increase in the interest rate we are required to pay customers to retain their deposits. In addition, if the interest rates we are required to pay in respect of other sources of funding, either in the interbank or capital markets, increases, our cost of funding would increase. If either of these risks occurs, our net interest margin would narrow without a correlative increase in the interest we earn from loans and investments. Our assets currently reprice faster than our liabilities, which would result in a benefit to net interest income as interest rates rise; however, the benefit from rising rates could be less than assumed as interest rates rise if increased competition for deposits causes the deposit expense to rise faster than assumed.
In addition, increases in interest rates may decrease customer demand for loans as the higher cost of obtaining credit may deter customers from new loans. Further, higher interest rates might also lead to an increased number of delinquent loans and defaults, which would impact the value of our loans.
We cannot control or predict with certainty changes in interest rates. Global, national, regional and local economic conditions, competitive pressures and the policies of regulatory authorities, including monetary policies of the Federal Reserve, affect interest income and interest expense. Although we have policies and procedures designed to manage the risks associated with changes in market interest rates, changes in interest rates still may have an adverse effect on profitability.
If our assumptions regarding borrower behavior are wrong or overall economic conditions are significantly different than we anticipate, then risk mitigation may be insufficient to protect against interest rate risk and net income would be adversely affected.
	Competition with other financial institutions may have an adverse effect on our ability to retain and grow our client base, which could have a negative effect on our financial condition or results of operations.
The banking and financial services industry is very competitive and includes services offered from other banks, savings and loan associations, credit unions, mortgage companies, other lenders, and institutions offering uninsured investment alternatives. Legal and regulatory developments have made it easier for new and sometimes unregulated businesses to compete with us. The financial services industry has and is experiencing an ongoing trend towards consolidation in which fewer large national and regional banks and other financial institutions are replacing many smaller and more local banks. These larger banks and other financial institutions hold a large accumulation of assets and have significantly greater resources and a wider geographic presence or greater accessibility. In some instances, these larger entities operate without the traditional brick and mortar facilities that restrict geographic presence. Some competitors have more aggressive marketing campaigns and better brand recognition, and are able to offer more services, more favorable pricing or greater customer convenience than the Bank. In addition, competition has increased from new banks and other financial services providers that target our existing or potential customers. As consolidation continues among large banks, we expect other smaller institutions to try to compete in the markets we serve. This competition could reduce our net income by decreasing the number and size of the loans that the Bank originates and the interest rates the Bank charges on these loans. Additionally, these competitors may offer higher interest rates, which could decrease the deposits the Bank attracts or require it to increase rates to retain existing deposits or attract new deposits.
Increased deposit competition could adversely affect the Bank’s ability to generate the funds necessary for lending operations, which could increase the cost of funds.
The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge as part of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Technological developments have allowed competitors, including some non-depository institutions, to compete more effectively in local markets and have expanded the range of financial products, services and capital available to our target customers. If we are unable to implement, maintain and use such technologies effectively, we may not be able to offer products or achieve cost efficiencies necessary to compete in the industry. In addition, some of these competitors have fewer regulatory constraints and lower cost structures.
Clients could pursue alternatives to bank deposits, causing us to lose a relatively inexpensive source of funding.
Checking and savings account balances and other forms of client deposits could decrease if clients perceive alternative investments, such as the stock market, provide superior expected returns. When clients move money out of bank deposits in favor of alternative investments, we can lose a relatively inexpensive source of funds, increasing our funding costs.
We may be adversely affected by credit exposures to other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by the Bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Bank. Any such losses could have a material adverse effect on our financial condition and results of operations.
Negative public opinion could damage our reputation and adversely affect earnings.
Reputation risk, or the risk to our business, earnings and capital from negative public opinion, is inherent in our operations. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action and adversely affect our results of operations. Although we take steps to minimize reputation risk in dealing with clients and communities, this risk will always be present given the nature of our business.
We are subject to a variety of operational risks, including reputational risk, legal risk and regulatory and compliance risk, and the risk of fraud or theft by employees or outsiders, which may adversely affect business and results of operations.
We are exposed to many types of operational risks, including reputational risk, legal, regulatory and compliance risk, the risk of fraud or theft by employees or outsiders, including unauthorized transactions by employees, or operational errors, such as clerical or
record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. In addition, negative public opinion can adversely affect our ability to attract and keep customers and can expose it to litigation and regulatory action. Actual or alleged conduct by us can result in negative public opinion about our other business. Negative public opinion could also affect our credit ratings, which are important to its access to unsecured wholesale borrowings.
Our business involves storing and processing sensitive consumer and business customer data. If personal, nonpublic, confidential or proprietary information of customers in its possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
Because the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions and its large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. We also may be subject to disruptions of operating systems arising from events that are wholly or partially beyond our control, such as computer viruses, electrical or telecommunications outages, natural disasters, or other damage to property or physical assets which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that its external vendors may be unable to fulfill our contractual obligations, or will be subject to the same risk of fraud or operational errors by their respective employees as it is, and to the risk that our, or our vendors’, business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability to operate our business, as well as potential liability to clients, reputational damage and regulatory intervention, which could adversely affect our business, financial condition or results of operations.
Our operational or security systems may experience an interruption or breach in security.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems, including as a result of cyber-attacks, could result in failures or disruptions in our customer relationship management, deposit, loan, and other systems and also the disclosure or misuse of confidential or proprietary information. While we have systems, policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.
Furthermore, information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. Our technologies, systems, networks, and our customers’ devices may become the target of cyberattacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our customers’ confidential, proprietary and other information, or otherwise disrupt our or our customers’ or other third parties’ business operations. As cyber threats continue to evolve, we may also be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
While we have not experienced any material losses relating to cyberattacks or other information security breaches to date, we may suffer such losses in the future and any information security breach could result in significant costs to us, which may include fines and penalties, potential liabilities from governmental or third party investigations, proceedings or litigation, legal, forensic and consulting fees and expenses, costs and diversion of management attention required for investigation and remediation actions, and the negative impact on our reputation and loss of confidence of our customers and others, any of which could have a material adverse impact on our business, financial condition and operating results.
Our controls and procedures may fail or be circumvented.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
If our nonperforming assets increase, earnings will be adversely affected.
At December 31, 2016, our nonperforming assets (which consist of nonaccrual loans and other real estate owned) totaled $2.5 million, or 2.8% of total assets. At December 31, 2015, our nonperforming assets were $2.9 million, or 3.1% of total assets. Our nonperforming assets adversely affect our earnings in various ways:
•We do not record interest income on any nonperforming assets.
•We must provide for probable loan losses through a charge to the provision for loan losses.
•Noninterest expense increases when we must write down the value of properties in our other real estate owned portfolio to reflect changing market values.
•There are legal fees associated with the resolution of problem assets, as well as carrying costs, such as taxes, insurance, and maintenance fees related to other real estate owned.
•The resolution of nonperforming assets requires the active involvement of management, which can distract them from more profitable activity.
If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our nonperforming assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our results of operations.
We have previously sustained losses from a decline in credit quality and may see further losses.
Our ability to generate earnings is significantly affected by the ability to properly originate, underwrite and service loans. We have previously sustained losses primarily because borrowers, guarantors or related parties have failed to perform in accordance with the terms of their loans and we failed to detect or respond to deterioration in asset quality in a timely manner. We could sustain additional losses for these reasons. Further problems with credit quality or asset quality could cause interest income and net interest margin to further decrease, which could adversely affect our business, financial condition and results of operations. We have identified credit deficiencies with respect to certain loans in our loan portfolio which were primarily related to the downturn in the real estate industry. As a result of the decline of the residential housing market between 2007 and 2012, property values for this type of collateral declined substantially. In response to this determination, we increased our loan loss reserve throughout 2010 and 2011 to address the risks inherent within our loan portfolio. Since that time, we consistently applied our methodology in calculating the reserve, and because charge offs dropped and market conditions stabilized, our reserve has declined from its peak. At December 31, 2016, our loan loss reserve was $1.3 million, or 2.21% of gross loans. Although credit quality has generally improved, future deterioration in the South Carolina real estate market as a whole or individual deterioration in the financial condition of our borrowers may cause management to adjust its opinion of the level of credit quality in our loan portfolio. Such a determination may lead to an increase in our provisions for loan losses, which could also adversely affect our business, financial condition, and results of operations.
A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market hurt our business.
As of December 31, 2016, approximately 71% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A weakening of the real estate market in our primary market area could result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could adversely affect our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.
We are subject to certain risks related to originating and selling mortgages. We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, or borrower fraud, and this could harm our liquidity, results of operations and financial condition.
We originate and often sell mortgage loans. When we sell mortgage loans, we are required to make customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event that we breach certain of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud or in the event of early payment default of the borrower on a mortgage loan. Therefore, if a purchaser enforces its remedies against us, we may not be able to recover our losses from third parties. We have received repurchase and indemnity demands from purchasers. These have resulted in an increase in the amount of losses for repurchases. While we have taken steps to enhance its underwriting policies and procedures, these steps will not reduce risk associated with loans sold in the past. If repurchase and indemnity demands increase materially, then our results of operations may be adversely affected.
Our decisions regarding the allowance for loan losses and credit risk may materially and adversely affect our business.
Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, our loans and other extensions of credit may not be repaid. The risk of nonpayment is affected by a number of factors, including:
•the duration of the credit;
•credit risks of a particular customer;
•changes in economic and industry conditions; and
•in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.
We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including, but not limited to:
•an ongoing review of the quality, mix, and size of our overall loan portfolio;
•historical loan loss experience;
•evaluation of economic conditions;
•regular reviews of loan delinquencies and loan portfolio quality;
•ongoing review of financial information provided by borrowers; and
•the amount and quality of collateral, including guarantees, securing the loans.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations.
While we generally underwrite the loans in our portfolio in accordance with our own internal underwriting guidelines and regulatory supervisory guidelines, in certain circumstances we have made loans which exceed either our internal underwriting guidelines, supervisory guidelines, or both. We are permitted to hold loans that exceed supervisory guidelines up to 100% of our regulatory capital. We have made loans that exceed our internal guidelines to a limited number of customers who have significant liquid assets, net worth, and amounts on deposit with the Bank. As of December 31, 2016, approximately $1.8 million of our loans, or a loan balance equal to 18.5% of the Bank’s regulatory capital, had loan-to-value ratios that exceeded regulatory supervisory guidelines. In addition, supervisory limits on commercial loan-to-value exceptions are generally set at 30% of the Bank’s capital. At December 31, 2016, $691,746 of our commercial loans, or a loan balance equal to 7.0% of the Bank’s regulatory capital, exceeded the supervisory loan-to-value ratio. The number of loans in our portfolio with loan-to-value ratios in excess of supervisory guidelines, our internal guidelines, or both could increase the risk of delinquencies and defaults in our portfolio.
An economic downturn, in particular an economic downturn in South Carolina, could reduce our customer base, level of deposits, and demand for financial products such as loans.
Our success significantly depends upon the growth in population, income levels, deposits, and housing starts in our markets. Although negative developments that began in the latter half of 2007 have shown signs of improvement in recent years both nationally and in our primary markets of South Carolina, if the communities in which we operate do not grow or if economic conditions locally or nationally are unfavorable, our business may not succeed. An economic downturn or prolonged recession would likely result in further deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would hurt our business. Interest received on loans represented approximately 92% of our interest income for the year ended December 31, 2016. If we experience an economic downturn or a prolonged economic recession occurs in the economy as a whole, borrowers will be less likely to repay their loans as scheduled. Moreover, in many cases the value of the real estate or other collateral that secures our loans was adversely affected by the recent economic downturn, and a more severe economic downtown or a prolonged economic recession could further negatively affect such values. Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies. An economic downturn could, therefore, result in losses that materially and adversely affect our business.
Our small- to medium-sized business target markets may have fewer financial resources to weather financial stress.
We target the banking and financial services needs of small- and medium-sized businesses. These businesses generally have fewer financial resources in terms of capital borrowing capacity than larger entities. If general economic conditions negatively impact these businesses in the markets in which we operate, our business, financial condition, and results of operation may be adversely affected.
Lack of seasoning of loans may increase the risk of credit defaults in the future.
Due to the periodic addition of new loans in our loan portfolio, there is a relatively short credit history on some of our loans. In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process we refer to as “seasoning.” As a result, a portfolio of older loans will usually behave more predictably than a newer portfolio. Because our loan portfolio includes new loans, the current level of delinquencies and defaults may not be representative of the level that will prevail when the portfolio becomes more seasoned, which may be higher than current levels. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Failure to keep pace with technological change could adversely affect our business.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
We depend on third-party providers, and the inability of these providers to deliver, or their refusal to deliver, necessary technological and customer services support for our systems in a timely manner at prices, quality levels, and volumes acceptable to us could have material adverse effects on our financial condition and operating results.
Our existing digital banking services, including mobile banking, online banking, and remote deposit capture use third-party providers for technological and customer service support. We also outsource check processing, check imaging, electronic bill
payment, statement rendering, internal audit and other services to third-party vendors. While we believe that such providers will be able to continue to supply us with these essential services, they may be unable to do so in the short term or at prices or costs that are favorable to us, or at all. In addition, our agreements with each service provider are generally cancelable without cause by either party upon specified notice periods. If one of our third-party service providers terminates its agreement with us and we are unable to replace it with another service provider, our operations may be interrupted. In particular, while we believe that we will be able to secure alternate providers for most of this essential technological and customer services support in a relatively short time frame, qualifying alternate providers or developing our own replacement technology services may be time consuming, costly, and may force us to change our services offered. If an interruption were to continue for a significant period of time, our earnings could decrease, we could experience losses, and we could lose customers. In addition, we are obligated to exercise comprehensive risk management and oversight of third-party providers involving critical activities, including through the adoption of risk management processes commensurate with the level of risk and complexity of our third-party providers. If in the future we expand our digital banking and payment and transaction services, our dependence on third-party providers will likely increase, and more robust compliance policies and procedures to monitor third party providers will need to be implemented.
If our security is breached, our business could be disrupted, our operating results could be harmed, and customers could be deterred from using our products and services.
Our business relies on the secure electronic transmission, storage, and hosting of sensitive information, including financial information and other sensitive information relating to our customers. As a result, we face the risk of a deliberate or unintentional incident involving unauthorized access to our computer systems that could result in misappropriation or loss of assets or sensitive information, data corruption, or other disruption of business operations. To our knowledge, the Company has not experienced a data breach. In light of this risk, we have devoted significant resources to protecting and maintaining the confidentiality of our information, including implementing security and privacy programs and controls, training our workforce, and implementing new technology. We have no guarantee that these programs and controls will be adequate to prevent all possible security threats. We believe that any compromise of our electronic systems, including the unauthorized access, use, or disclosure of sensitive information or a significant disruption of our computing assets and networks, would adversely affect our reputation and our ability to fulfill contractual obligations, and would require us to devote significant financial and other resources to mitigate such problems, and could increase our future cyber security costs. Moreover, unauthorized access, use or disclosure of such sensitive information could result in significant contractual, supervisory or other liability, or exposure of our trade secrets or other confidential or proprietary information. In addition, any real or perceived compromise of our security or disclosure of sensitive information may result in lost revenues by deterring customers from using or purchasing our products and services in the future or prompting them to use competing service providers.
Risks Related to the Legal and Regulatory Environment
We are subject to extensive regulation that could limit or restrict our activities, have an adverse impact on our operations, and impose financial requirements or limitations on the conduct of our business.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various regulatory agencies. We are subject to Federal Reserve regulation. The Bank is subject to extensive regulation, supervision, and examination by our primary federal regulators, the OCC and the FDIC, the regulating authority that insures customer deposits. Also, as a member of the FHLB, the Bank must comply with applicable regulations of the Federal Housing Finance Board and the FHLB. Regulation by these agencies is intended primarily for the protection of the Bank’s depositors and the Deposit Insurance Fund and not for the benefit of our shareholders. The Bank’s activities are also regulated under consumer protection laws applicable to its lending, deposit, and other activities. A sufficient claim against the Bank under these laws could have a material adverse effect on our results of operations.
Further, changes in laws, regulations and regulatory practices affecting the financial services industry could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
Failure to comply with government regulation and supervision could result in sanctions by regulatory agencies, civil money penalties, and damage to our reputation.
Our operations are subject to extensive regulation by federal, state, and local governmental authorities. Given the current disruption in the financial markets, we expect that the government will continue to pass new regulations and laws that will impact us. Compliance with such regulations may increase our costs and limit our ability to pursue business opportunities. Failure to comply with laws, regulations, and policies could result in sanctions by regulatory agencies, civil money penalties, and damage to our reputation. While we have policies and procedures in place that are designed to prevent violations of these laws, regulations, and policies, there can be no assurance that such violations will not occur.
The final Basel III capital rules generally require insured depository institutions and their holding companies to hold more capital, which could adversely affect our financial condition and operations.
In July 2013, the federal bank regulatory agencies issued a final rule that will revise their risk based capital requirements and the method for calculating risk weighted assets to make them consistent with agreements that were reached by Basel III and certain provisions of the Dodd Frank Act. This rule substantially amended the regulatory risk based capital rules applicable to us. The requirements in the rule began to phase in on January 1, 2015 for the Bank. The requirements in the rule will be fully phased in by January 1, 2019.
The rule includes certain new and higher risk-based capital and leverage requirements than those currently in place. Specifically, the following minimum capital requirements apply to us:
•a new common equity Tier risk-based capital ratio of 4.5%;
•a Tier risk-based capital ratio of 6% (increased from the former 4% requirement);
•a total risk-based capital ratio of 8% (unchanged from the former requirement); and
•a leverage ratio of 4% (also unchanged from the former requirement).
Under the rule, Tier 1 capital is redefined to include two components: common equity Tier 1 capital and additional Tier 1 capital. The new and highest form of capital, common equity Tier 1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as noncumulative perpetual preferred stock. Tier 2 capital consists of instruments that currently qualify in Tier 2 capital plus instruments that the rule has disqualified from Tier 1 capital treatment. Cumulative perpetual preferred stock, formerly includable in Tier 1 capital, is now included only in Tier 2 capital. Accumulated other comprehensive income (AOCI) is presumptively included in common equity Tier 1 capital and often would operate to reduce this category of capital. The rule provided a one-time opportunity at the end of the first quarter of 2015 for covered banking organizations to opt out of much of this treatment of AOCI. We made this opt-out election and, as a result, will retain the pre-existing treatment for AOCI. 	
In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three measurements (common equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer will be phased in incrementally over time, becoming fully effective on January 1, 2019, and will consist of an additional amount of common equity equal to 2.5% of risk-weighted assets. As of January 1, 2017, we are required to hold a capital conservation buffer of 1.25%, increasing by 0.625% each successive year until 2019.
In general, the rules have had the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate, certain loans past due 90 days or more or in nonaccrual status, mortgage servicing rights not includable in Common Equity Tier 1 capital, equity exposures, and claims on securities firms, that are used in the denominator of the three risk-based capital ratios.
In addition, in the current economic and regulatory environment, bank regulators may impose capital requirements that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, and result in regulatory actions if we are unable to comply with such requirements. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital or additional capital conservation buffers, could result in
management modifying our business strategy and could limit our ability to make distributions, including paying dividends or buying back our shares.
Higher FDIC deposit insurance premiums and assessments could adversely affect our financial condition.
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain deposit insurance. As an FDIC-insured institution, the Bank is required to pay quarterly deposit insurance premium assessments to the FDIC. Although the Bank cannot predict what the insurance assessment rates will be in the future, deterioration in the Bank’s risk-based capital ratios or adjustments to the base assessment rates could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulation, which risk increases as we expand our business model.
The Bank Secrecy Act, the USA PATRIOT Act, and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The Financial Crimes Enforcement Network, established by the U.S. Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the rules enforced by the OFAC. Federal and state bank regulators also have begun to focus on compliance with Bank Secrecy Act and anti-money laundering regulations. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to potentially obtain regulatory approvals to further expand our new consumer lending program, which would negatively impact our business, financial condition and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.
Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. Loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may be protected from liability to a borrower for failing to make the necessary determinations. In either case, we may find it necessary to tighten our mortgage loan underwriting standards in response to the CFPB rules, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.
We are subject to federal and state fair lending laws, and failure to comply with these laws could lead to material penalties.
Federal and state fair lending laws and regulations, such as the Equal Credit Opportunity Act and the Fair Housing Act, impose nondiscriminatory lending requirements on financial institutions. The Department of Justice, CFPB and other federal and state agencies are responsible for enforcing these laws and regulations. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. A successful challenge to our performance under the fair lending laws and regulations could adversely affect the Bank’s rating under the CRA and result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on merger and acquisition activity and restrictions on expansion activity, which could negatively impact our reputation, business, financial condition and results of operations.
The Federal Reserve may require us to commit capital resources to support the Bank.
The Federal Reserve requires a bank holding company to act as a source of financial and managerial strength to a subsidiary bank and to commit resources to support such subsidiary bank. Under the “source of strength” doctrine, the Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. In addition, the Dodd-Frank Act directs the federal bank regulators to require that all companies that directly or indirectly control an insured depository institution
serve as a source of strength for the institution. Under these requirements, in the future, we could be required to provide financial assistance to the Bank if the Bank experiences financial distress.
A capital injection may be required at times when we do not have the resources to provide it, and therefore we may be required to borrow the funds. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of its note obligations. Thus, any borrowing that must be done by the holding company in order to make the required capital injection becomes more difficult and expensive and will adversely affect the holding company’s cash flows, financial condition, results of operations and prospects.
Our business is subject to laws and regulations regarding privacy, data protection, and other matters. Many of these could result in claims, changes to our business practices, increased cost of operations, or otherwise harm our business.
We are subject to a variety of laws and regulations in the United States that involve matters central to our business, including user privacy, electronic contracts and other communications, consumer protection, taxation, and online payment services. These U.S. federal and state laws and regulations, which can be enforced by private parties or government entities, are constantly evolving and can be subject to significant change. In addition, the application and interpretation of these laws and regulations are often uncertain, particularly in the new and rapidly evolving industry in which we operate. These existing and proposed laws and regulations can be costly to comply with and can delay or impede the development of new products, and a failure to comply with such laws and regulations could result in negative publicity, increase our operating costs, require significant management time and attention, and subject us to inquiries or investigations, claims or other remedies, including fines or demands that we modify or cease existing business practices.
Changes in accounting standards could materially affect our financial statements.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time, the Financial Accounting Standards Board (the “FASB”), the SEC and our bank regulators change the financial accounting and reporting standards, or the interpretation thereof, and guidance that govern the preparation and disclosure of external financial statements. For example, in 2012, the FASB issued a proposed standard on accounting for credit losses. The standard would replace multiple existing impairment models, including replacing an “incurred loss” model for loans with an “expected loss” model. The FASB has indicated a tentative effective date of January 1, 2019, and final guidance is expected to be issued in the second quarter of 2016. These changes are beyond our control, can be hard to predict and could materially impact how we report and disclose our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retrospectively, or apply an existing standard differently, also retrospectively, which under some circumstances could potentially result in a need to revise or restate prior period financial statements.
Risks Related to our Common Stock
We are a holding company and depend on the Bank for dividends, distributions, and other payments.
Substantially all of our activities are conducted through the Bank, and consequently, as the parent company of the Bank, we receive substantially all of our revenue as dividends from the Bank. We are currently prohibited from paying dividends without the prior approval Federal Reserve Bank of Richmond. There can be no assurance such approvals would be granted or with regard to how long these restrictions will remain in place. In the future, any declaration and payment of cash dividends will be subject to the board’s evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. The payment of cash dividends by us in the future will also be subject to certain other legal and regulatory limitations (including the requirement that our capital be maintained at certain minimum levels) and ongoing review by our banking regulators.
There is no liquid market for our shares.
There is currently no established trading market for our common stock. As a result, any investor in shares of our common stock may find it difficult or impossible to resell such shares.
If securities or industry analysts publish inaccurate or unfavorable research about our business, our stock price could decline.
The trading market for the common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. If one or more of the analysts who cover us downgrades the common stock or publishes inaccurate or unfavorable research about our business, the common stock price would likely decline.
Our securities are not FDIC insured.
Our securities, including the outstanding shares of common stock, are not savings or deposit accounts or other obligations of ours and are not insured by the Deposit Insurance Fund, the FDIC, or any other governmental agency, and therefore are subject to investment risk, including the possible loss of the entire investment.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not Applicable.
Item 2.
Item 2. Properties.
Our principal executive offices consist of 6,500 square feet of leased space in downtown Greenville, South Carolina. The Bank has two branch offices located in Taylors, South Carolina, and Simpsonville, South Carolina. We lease our Greenville and Taylors offices in South Carolina and believe these premises will be adequate for present and anticipated needs and that we have adequate insurance to cover our owned and leased premises. For each property that we lease, we believe that upon expiration of the lease we will be able to extend the lease on satisfactory terms or relocate to another acceptable location.
Item 3.
Item 3. Legal Proceedings. 	
In the ordinary course of operations, we may be a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.
Item 4.
Item 4. Mine Safety Disclosures.
Not Applicable.
PART II
Item 5.
Item 5. Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information, Holders, and Dividends
No established public trading market exists for our common stock, and there can be no assurance that a public trading market for our common stock will develop. Our common stock is quoted on the OTC Bulletin Board under the symbol “IEBS,” and we have a sponsoring broker-dealer to match buy and sell orders for our common stock. Although we are quoted on the OTC Bulletin Board, the trading markets on the OTC Bulletin Board lack the depth, liquidity, and orderliness necessary to maintain a liquid market, and trading and quotations of our common stock have been limited and sporadic. The OTC Bulletin Board prices are quotations, which reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not represent actual transactions.
The following table sets forth for the period indicated the high and low bid prices for our common stock reported by the OTC Bulletin Board for the periods indicated:
As of March 23, 2017, there were 20,502,760 shares of common stock outstanding held by approximately 580 shareholders of record, and 8,425 shares of series A preferred convertible stock outstanding held by 11 shareholders.
We have not declared or paid any cash dividends on our common stock since our inception. For the foreseeable future, we do not intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen our capital base. Our ability to pay dividends depends on the ability of the Bank to pay dividends to the Company. As a national bank, the Bank may only pay dividends out of its net profits, after deducting expenses, including losses and bad debts. In addition, the Bank is prohibited from declaring a dividend on its shares of common stock until its surplus equals its stated capital, unless there has been transferred to surplus no less than one-tenth of the Bank’s net profits of the preceding two consecutive half-year periods (in the case of an annual dividend). The approval of the OCC will be required if the total of all dividends declared in any calendar year by the Bank exceeds the Bank’s net profits to date for that year combined with its retained net profits for the preceding two years less any required transfers to surplus. The OCC also has the authority under federal law to enjoin a national bank from engaging in what in its opinion constitutes an unsafe or unsound practice in conducting its business, including the payment of a dividend under certain circumstances.
Equity-Based Compensation Plan Information
For information regarding equity-based compensation awards outstanding and available for future grants at December 31, 2016, see Part III, Item 12 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” included in this Annual Report on Form 10-K.
Item 6.
Item 6. Selected Financial Data.
Not applicable.
Item 7.
Item 7. Management’s Discussion and Analysis or Plan of Operation.
Overview
We derive the majority of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income earned on our interest-earning assets, such as loans and investments, and the expense cost of our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.
The Company has reported losses from operations during 2016 and 2015, primarily due to expenses incurred in 2016 as a result of professional fees relating to the expansion of the Bank’s consumer lending program, credit write-downs, and losses on other real estate owned sold and due to expenses incurred in 2015 related to the costs associated with the transaction services segment, credit write-downs, and losses on other real estate owned sold. Due to regulatory restrictions, the Bank may not be a source of cash or capital for affiliates, including the Company, and may not be relied on as a source of financing. The foregoing discussion is a summary only and is qualified by reference to the report of the Company’s independent registered public accounting firm, Elliott Davis Decosimo, LLC, on page and the disclosure in other sections of this Form 10-K, including this section, the Risk Factors and our financial statements.
The Consolidated Company
At December 31, 2016, we had total assets of $90.5 million, a decrease of $7.0 million, or 7.2%, from total assets of $97.5 million at December 31, 2015. This decrease in assets was primarily driven by a decrease in investment securities of $8.2 million, a decrease in net loans of $7.3 million, and a decrease in cash and due from banks and federal funds sold of $3.1 million, partially offset by an increase in interest-bearing deposits in other institutions of $9.0 million and an increase in bank-owned life insurance of $2.5 million. Total assets at December 31, 2016 consisted of cash and due from banks of $4.6 million, interest bearing deposits in other institutions of $10.5 million, federal funds sold of $6.1 million, investment securities available for sale of $2.5 million, bank-owned life insurance of $2.5 million, non-marketable equity securities of $380,050, property, equipment and software of $2.0 million, other real estate owned and repossessed assets of $2.2 million, loans net of allowances for loan losses of $59.1 million, and accrued interest receivable and other assets of $358,277. Total liabilities at December 31, 2016 were $80.5 million compared to $84.8 million at December 31, 2015, a decrease of $4.3 million, or 5.1%. At December 31, 2016, liabilities consisted of deposits of $79.7 million, securities sold under agreements to repurchase of $113,598, and accrued interest payable and accounts payable and accrued expenses of $683,446. Shareholders’ equity at December 31, 2016 was $9.9 million, compared to $12.6 million at December 31, 2015, a decrease of $2.7 million or 21.4%. This decrease was primarily due to the recognition of a net loss of $2.6 million and a decrease in the unrealized gain on investment securities of $121,902.
Our net loss for the year ended December 31, 2016 was $2.6 million, or $0.13 per share, a decrease in loss of $2.2 million, or 46.7%, compared to a net loss of $4.8 million for the year ended December 31, 2015, or $0.23 per share. The Company’s decrease in net loss for the year was primarily driven by a decrease in noninterest expenses due to the suspension of further development of its digital banking business in September 2015. As a result, product research and development decreased $2.0 million. In addition, compensation and benefits expenses decreased $392,994, despite expenses incurred as a result of the filling of open positions during the year. Each of these components is discussed in greater detail below.
The Company
The Company’s cash balances, independent of the Bank, were $1.8 million and its real estate held for sale was zero at December 31, 2016 compared to cash balances of approximately $2.9 million and real estate held for sale of $631,320 at December 31, 2015. The Company’s accrued and other liabilities, independent of the Bank, were $304,346 at December 31, 2016 compared to $905,824 at December 31, 2015. The decrease in liquid assets of approximately $1.1 million and the decrease in payables of $601,478 is due primarily to a decrease in expenses incurred related to the transaction services segment as the Company suspended further development of its digital banking, payments and transaction services business in September 2015. The existing liabilities for the Company are related to deferred director fees and accrued audit and professional fees. See “Note 22 - Parent Company Financial Information” for additional information related to the transaction services segment.
The Bank
At December 31, 2016, we had total assets at the Bank of $90.4 million compared to $96.6 million at December 31, 2015. Total assets at December 31, 2016 consisted of cash and due from banks of $4.6 million, federal funds sold of $6.1 million, investment securities available for sale of $2.5 million, nonmarketable equity securities of $380,050, property, equipment, and software of $2.0 million, other real estate owned and repossessed assets of $2.23 million, net loans of $59.1 million, interest-bearing deposits in other
institutions of $10.5 million, bank-owned life insurance of $2.5 million and accrued interest receivable and other assets of $731,838. At December 31, 2016, we had total liabilities at the Bank of approximately $82.0 million compared to approximately $86.8 million at December 31, 2015. The largest components of total liabilities at the Bank are deposits which were $81.6 million, respectively. We have included a number of tables to assist in our description of our results of operations. For example, the “Average Balances” table shows the average balance during 2016 and 2015 of each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we have channeled a substantial percentage of our earning assets into our loan portfolio. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included a table to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, and our deposits and other borrowings.
There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section we have included a detailed discussion of this process.
In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this non-interest income, as well as our non-interest expenses, in the following discussion.
Throughout our discussion we have identified significant factors that we believe have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in this report.
Critical Accounting Policies
We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in Note 1 to our audited consolidated financial statements as of December 31, 2016.
Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.
Provision and Allowance for Loan Losses
We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.
Other Real Estate Owned and Repossessed Assets
Real estate and other property acquired in settlement of loans is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis when acquired. Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell. Recoveries of value are recorded only to the extent of previous write-downs on the property in accordance with FASB ASC Topic 360 “Property, Plant, and Equipment”. Write-downs or recoveries of value resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.
Income Taxes
We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in our consolidated financial statements and income tax returns, and income tax benefit or expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets. These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized. No assurance can be given that either the tax returns submitted by us or the income tax reported on the financial statements will not be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service. We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.
Research and Development
All costs incurred to establish the technological feasibility of computer software to be sold, leased or otherwise marketed as research and development are expensed as incurred. Once technological feasibility has been established, the subsequent costs of producing, coding and testing the products should be capitalized. The expensing of computer software costs is discontinued when the product is available for general release for customers. The Company did not achieve technological feasibility in connection with the development of its digital banking business and therefore expensed all computer software purchases and development expenses related to research and development. As previously noted, on September 25, 2015, the Company suspended the development of its digital banking business.
Results of Operations
Net Interest Income
Net interest income is the Company’s primary source of revenue. Net interest income is the difference between interest earned on assets and interest paid on deposits and borrowings used to support such assets. Net interest income is determined by the rates earned on the Company’s interest-earning assets and the rates paid on its interest-bearing liabilities and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income was $3.2 million for the year ended December 31, 2016, a slight decrease of $1,787, or 0.1%, over net interest income of $3.2 million in 2015. Total interest income decreased by $2,935, or 0.1%, during the year, primarily due to a decrease in interest income on investment securities. Total interest expense decreased by $4,722, or 1.4%, during the year due to decreases in interest expense on deposits and borrowings.
Our consolidated net interest margin for the year ended December 31, 2016 was 3.89%, a 27 basis point increase over the net interest margin for the year ended December 31, 2015 of 3.62%. The net interest margin is calculated as net interest income divided by year-to-date average earning assets. Earning assets averaged $83.2 million in 2016, a decrease of $6.4 million, or 7.2%, from $89.6 million in 2015. This decrease in earning assets is due to the $4.4 million decrease in average investment securities available for sale and a decrease in average net loans of $2.6 million, partially offset by an increase in federal funds sold between years of $542,044. Our yield on earning assets increased during the year, moving from 3.99% for the year ended December 31, 2015 to 4.28% for the year ended December 31, 2016. This increase is largely attributable to an increase in yield on loans and investment securities. These increases were accompanied by an increase in the cost of interest-bearing liabilities, which moved from 0.44% for the year ended December 31, 2015 to 0.48% for the year ended December 31, 2016. The increase in this area was a result of several factors, including the repricing of deposits, specifically money market accounts and retail time deposits, which increased to a rate of 0.25% and 0.86%, respectively, for the year ended December 31, 2016 from 0.24% and 0.77%, respectively, for the year ended December 31, 2015. In pricing deposits, we considered our liquidity needs, the direction and levels of interest rates and local market conditions. At times, higher rates are paid initially to attract deposits. Borrowings averaged $135,708 for the year ended December 31, 2016 compared to $553,599 for the year ended December 31, 2015, primarily as a result of the repayment of the note payable. Our net interest spread was 3.81% for 2016 compared to 3.54% in 2015. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.
The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. The net amount of capitalized loan fees is amortized into interest income on loans.
(1)Nonaccrual loans are included in average balances for yield computations.
(1)Nonaccrual loans are included in average balances for yield computations.
Rate/Volume Analysis
Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.
(1)Nonaccrual loans are included in average balances for yield computations.
Provision for Loan Losses
We have established an allowance for loan losses through a provision for loan losses charged to expense to our consolidated statement of operations. We review our loan portfolio at least quarterly to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion below under “Provision and Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.
The provision, reversal of provision and allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
We recorded a provision for loan losses of $407,000 for the year ended December 31, 2016, an increase of $257,000, or 171% from a provision for loan losses of $150,000 for the year ended December 31, 2015. The increase in provision for loan losses is primarily due to the recognition of specific reserves during 2016 on six impaired loans. The allowance as a percentage of gross loans increased to 2.21% at December 31, 2016 from 1.68% at December 31, 2015. Specific reserves were approximately $611,000 on impaired loans of $2.2 million as of December 31, 2016 compared to specific reserves of approximately $375,000 on impaired loans of $2.4 million as of December 31, 2015. As of December 31, 2016, the general reserve allocation was 1.22% of gross loans not impaired compared to 1.17% as of December 31, 2015. The provision for loan losses is discussed further below under “Provision and Allowance for Loan Losses.”
Non-interest Income
Non-interest income for the year ended December 31, 2016 was $840,100, an increase of 26.0% from non-interest income of $666,907 for the year ended December 31, 2015. Our largest components of non-interest income in 2016 were from residential loan origination fees, which were $231,495 for 2016, or approximately 27.6% of total non-interest income, and from the recognition of gains on sales of investments of $296,723, or approximately 35.3% of total non-interest income. Residential loan origination fees increased by $6,832, or 3.0%, during the year due to the changes in mortgage loan underwriting and compensation regulations as well as increased customer demand. The remaining increase is primarily due to the recognition of income related to the collection of SBA loan fees of $119,306. For the year ended December 31, 2016, service fees on deposit accounts totaled $95,431, an increase of $14,272, or 17.6%, from 2015 due primarily to an increase in NSF/return check fees. Other income includes ATM surcharges, wire fees, and commissions on insurance referrals. Other income was $97,145 for 2016, an increase of $51,310, or 111.9%, compared to $45,835 for the year ended December 31, 2015 due primarily to an increase related to commissions received and income recognized for bank-owned life insurance.
The Company recognized a gain on sale of investment securities available for sale of approximately $297,000 during 2016. The Company recognized a loss on sale of investment securities available for sale of approximately $88,000 during 2015.
Non-interest Expenses	
The following table sets forth information related to our non-interest expenses for the years ended December 31, 2016 and 2015.
Non-interest expenses decreased by approximately $2.3 million, or 26.8%, for the year ended December 31, 2016. This decrease was primarily due to decreases in product research and development expenses, professional fees, and compensation and benefits expenses, partially offset by increases in data processing costs and other expenses. Product research and development expenses decreased $2.0 million due to the suspension of further development of the transaction services segment in September 2015. Product research and development expenses consisted primarily of outside service fees to developers, software licenses, compensation expense, consulting fees and research and development expense. Compensation and benefits decreased $392,994 due to the reduction in staffing related to the suspension of the product development segment as well as by a decrease of $293,703 in expense incurred related to stock option expense. Professional fees decreased $270,443 due to a decrease in consulting fees. These decreases were offset by a $128,869 increase in data processing costs and an increase of $208,387 in other expenses related to marketing and costs related to our consumer lending program.
Income Tax Expense
No income tax benefit or expense was recognized for the year ended December 31, 2016. In 2015, we recognized approximately $5,100 in state income taxes due with the Bank’s state tax return.
Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized. The determination of whether a deferred tax asset is realizable is based on weighing all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. We will continue to analyze our deferred tax assets and related valuation allowance on a quarterly basis, taking into account performance compared to forecasted earnings as well as current economic or internal information.
Balance Sheet Review
Investments
The purpose of the investment portfolio is to provide liquidity and stable returns through the purchase of high quality investment securities. At December 31, 2016, our investment portfolio of $2.5 million represented approximately 2.8% of total assets. The portfolio decreased from $10.7 million at December 31, 2015, or 11.0% of total assets. Decreases in investment balances during 2016 were due to normal investment maturities and repayments as well as due to the October 2016 sale of the mortgage-backed and municipal security portfolios. At December 31, 2016, we held one US Treasury note as an investment security available for sale. At December 31, 2015, we held government-sponsored mortgage-backed securities, non-taxable and taxable municipal bonds as investment securities available for sale. The amortized costs and the fair value of our investments at December 31, 2016, 2015 and 2014 are shown in the following table.
Contractual maturities and yields on our investment securities available for sale at December 31, 2016 are shown in the following table. Expected maturities may differ from contractual maturities as issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2016 and 2015, we also held non-marketable equity securities, which consisted of Federal Reserve Bank stock of $293,050 and $303,500, respectively, and FHLB stock of $87,000 and $89,000, respectively. These investments are carried at cost, which approximates fair market value.
Loans
Since loans typically provide higher interest yields than other types of interest-earning assets, a significant percentage of our earning assets are invested in our loan portfolio. Average loans for the year ended December 31, 2016 were $64.0 million, a decrease of $2.6 million, or 3.9%, compared to average loans of $66.6 million for the year ended December 31, 2015. Before allowance for loan losses, gross loans outstanding at December 31, 2016 were $60.5 million, or 66.9% of total assets, compared to $67.5 million, or 69.3% of total assets at December 31, 2015.
The principal component of our loan portfolio is loans secured by real estate mortgages. Most of our real estate loans are secured by residential or commercial property. We do not generally originate traditional long term residential mortgages for the Bank’s portfolio, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. We obtain a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans we make to 80%. The total amount of second lien mortgage collateral and home equity loans as of December 31, 2016, 2015, 2014, 2013 and 2012 were approximately $4.3 million, $5.8 million, $8.3 million, $7.3 million, and $8.6 million, respectively.
The largest component of our loan portfolio at year-end was commercial real estate loans, which represented 36.4% of the portfolio. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration of certain types of collateral. Refer to Item 1, “Lending Activities”, for a detailed discussion regarding the risks inherent in each loan category noted above. Due to the short time our portfolio has existed, the current mix may not be indicative of the ongoing portfolio mix.
As previously disclosed, although traditionally we have maintained only a small percentage of the Bank’s loan portfolio in consumer loans, we plan to supplement our current lending strategy by expanding our consumer lending program with on-line offerings, targeting prime and super-prime borrowers in the Bank’s current market area as well as throughout South Carolina. We are focused on profitably growing the Bank and enhancing shareholder value through this targeted expansion of our consumer lending program, which may include purchases of in-market consumer loans that meet the Bank’s underwriting criteria.
The following tables summarize the composition of our loan portfolio as of December 31, 2016, 2015, 2014, 2013 and 2012.
Maturities and Sensitivity of Loans to Changes in Interest Rates
The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.
The following table summarizes the loan maturity distribution by type and related interest rate characteristics at December 31, 2016.
Loan Performance and Asset Quality
Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest (unless the loan is well-collateralized and in the process of collection), or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectability of principal or interest based on current available information or as evidenced by sufficient payment history, which generally is six months. Foregone interest income related to nonaccrual loans equaled $60,633 and $129,066 for the years ended December 31, 2016 and 2015, respectively. No interest income was recognized on nonaccrual loans during 2016 and 2015. At both December 31, 2016 and 2015, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.
The following tables summarize delinquencies and nonaccruals, by portfolio class, as of December 31, 2016, 2015, 2014, 2013, and 2012.
Total delinquent and nonaccrual loans decreased from $2,055,160 at December 31, 2015 to $1,773,473 at December 31, 2016, a decrease of $281,687 or 13.7%. This decrease was a result of the movement of three nonaccrual loans transferring to other real estate owned, which decreased by $1.4 million from 2015 to 2016, partially offset by an increase in loans past due 30-59 days of $983,457 and an increase in loans past due 60-89 days of $95,595 as discussed below. Nonaccrual decreases were seen in single and multifamily residential, construction and development, commercial real estate and residential lot real estate loans due to successful
foreclosure of the properties collateralizing these loans and their transfer to other real estate owned. At December 31, 2016, nonaccrual loans represented 0.5% of gross loans. Loans past due 30-89 days are considered potential problem loans and amounted to $1,469,022 and $389,970 at December 31, 2016 and 2015, respectively. The increase in 30-89 delinquent loans is due to seven loans moving into the 30-59 days delinquent category and two loans moving into the 60-89 days delinquent category.
Another method used to monitor the loan portfolio is credit grading. As part of the loan review process, loans are given individual credit grades, representing the risk we believe is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. The following tables summarize management’s internal credit risk grades, by portfolio class, as of December 31, 2016 and 2015.
Loans graded one through four are considered “pass” credits. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade. At December 31, 2016, approximately 95% of the loan portfolio had a credit grade of “pass” compared to 93% at December 31, 2015. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.
Loans with a credit grade of five are not considered classified; however they are categorized as a special mention or watch list credit, and are considered potential problem loans. This classification is utilized by us when we have an initial concern about the financial health of a borrower. These loans are designated as such in order to be monitored more closely than other credits in our portfolio. We then gather current financial information about the borrower and evaluate our current risk in the credit. We will then either reclassify the loan as “substandard” or back to its original risk rating after a review of the information. There are times when we
may leave the loan on the watch list, if, in management’s opinion, there are risks that cannot be fully evaluated without the passage of time, and we determine to review the loan on a more regular basis. Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard. As of December 31, 2016, we had loans totaling $835,501 on the watch list compared to $1.6 million as of December 31, 2015. This decrease was primarily related to two loans from 2015 being deemed as acceptable and one loan being repaid in full, partially offset by two loans being deemed special mention during 2016.
Loans graded six or greater are considered classified credits. At December 31, 2016 and 2015, classified loans totaled $2.2 million and $2.9 million, respectively, with the vast majority of these loans being collateralized by real estate. The decrease was primarily related to three loans moving to other real estate owned and three loans being repaid in full during 2016. Classified credits are evaluated for impairment on a quarterly basis.
A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan-by-loan basis by calculating either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The resulting shortfall is charged to provision for loan losses and is classified as a specific reserve. When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.
At December 31, 2016, impaired loans totaled $2.2 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral. Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower. During 2016, the average recorded investment in impaired loans was $2.1 million compared to $2.4 million during 2015. As of December 31, 2016 and December 31, 2015, we had loans totaling approximately $835,501 and $498,437, respectively that were classified in accordance with our loan rating policies but were not considered impaired. On March 7, 2017, one impaired loan was transferred to other real estate owned for $165,000, net of a specific reserve of $35,000. The specific reserve was included in the December 31, 2016 allowance amounts. The following tables summarize information relative to impaired loans, by portfolio class, at December 31, 2016 and 2015.
Troubled debt restructurings (“TDRs”) are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.
At December 31, 2016, the principal balance of TDRs was zero as the one loan previously constituting our sole TDR during the year had been repaid in full at maturity in August 2016. At December 31, 2015, the principal balance of TDRs was zero as the one loan previously constituting our sole TDR had been transferred to other real estate owned. No TDRs went into default during the year ended December 31, 2015 and 2016. A TDR can be removed from “troubled” status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.
There were no loans modified as TDRs within the previous 12- month period for which there was a payment default during the years ended December 31, 2015 and 2016.
Provision and Allowance for Loan Losses
We have established an allowance for loan losses through a provision for loan losses charged to expense on our consolidated statements of operations. At December 31, 2016, the allowance for loan losses was $1.3 million, or 2.20% of gross loans, compared to $1.1 million at December 31, 2015, or 1.68% of gross loans. This increase in the allowance for loan losses is due to the recognition of provision for loan losses, partially offset by charge-offs taken against specific reserves, as well as payoffs in our commercial real estate portfolio, which carries a higher historical loss ratio and, consequently, a higher reserve factor within our allowance model.
The provision, reversal of provision and allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and
prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. We strive to follow a comprehensive, well-documented, and consistently applied analysis of our loan portfolio in determining an appropriate level for the allowance for loan losses. Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate. Our determination of the allowance for loan losses is based on what we believe are all significant factors that impact the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical loan loss experience, and a review of specific problem loans. We also consider subjective issues such as changes in lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of directors’ oversight, concentrations of credit, and peer group comparisons.
Our allowance for loan losses consists of both specific and general reserve components. The specific reserve component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. Loans determined to be impaired are excluded from the general reserve calculation described below and evaluated individually for impairment. Impaired loans totaled $2.2 million at December 31, 2016, with an associated specific reserve of approximately $611,000. See above discussion under “Loan Performance and Asset Quality” for additional information related to impaired loans.
The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors. The total general reserve is based upon the individual loan categories and their historical loss factors over an eight quarter moving average, adjusted for other risk factors as well. Therefore, the general allocation will move among the categories depending on if some loss factors increased while others decreased. Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio. The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.
The following tables summarize activity related to our allowance for loan losses for the years ended December 31, 2016, 2015, 2014, 2013, and 2012 by portfolio segment.
Net loan charge-offs increased during 2016 from $43,267 for the year ended December 31, 2015 to $208,360 for the year ended December 31, 2016, an increase of $165,093. Charge-offs in 2016 of approximately $220,000 were partial charge-offs taken on certain collateral-dependent loans within our commercial real estate and construction segments. Charge-offs in 2015 of approximately $43,000 were full charge-offs taken on one loan within our commercial real estate segment. Partial charge-offs were based on recent appraisals and evaluations on commercial real estate loans in the process of foreclosure. Loans with partial charge-offs are typically considered impaired loans and remain on nonaccrual status. In addition, when collateral is obtained in satisfaction of a loan, a charge-off is taken through the allowance at the time of repossession to move the collateral to other real estate owned at fair value less costs to sell.
The allowance as a percentage of gross loans increased from 1.68% at December 31, 2015 to 2.21% at December 31, 2016. The increase in the reserve percentage is due to an increase in allowance for loan losses of $198,640. The increase in allowance is attributed to the recognition of a provision for loan losses of $407,000, net of recoveries and charge-offs taken against specific reserves of $208,360. The general reserve as a percentage of non-impaired loans has increased from 1.17% at December 31, 2015 to 1.22% at December 31, 2016.
Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charge-off. While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.
Other Real Estate Owned and Repossessed Assets
As of December 31, 2016, we had $2.2 million in other real estate owned. This compares to $1.9 million in other real estate owned as of December 31, 2015. During 2016, collateral was obtained from three loan relationships that went through the foreclosure process. We also completed the sale of three repossessed properties.
During 2016, other real estate owned for the Company decreased due to the sale of real estate owned that were purchased from the Bank for proceeds of approximately $613,000, which resulted in a loss of approximately $18,000 to the Company. Real estate owned for the Bank increased due to three pieces of real estate being moved to other real estate owned for $1.3 million, partially offset by the sale of one piece of real estate held by the Bank for proceeds of approximately $24,000, which resulted in a loss of approximately $6,000. In addition, the Bank recognized writedowns on real estate owned of approximately $284,000 during 2016. On March 7, 2017, one impaired loan was transferred to other real estate owned for $165,000, net of a specific reserve of $35,000. The specific reserve was included in the December 31, 2016 allowance amounts. The following table summarizes changes in the consolidated balance of other real estate owned and repossessed assets during the periods noted:
The following table summarizes the composition of other real estate owned and repossessed assets as of the dates noted:
The remaining assets are being actively marketed with the primary objective of liquidating the collateral at a level which most accurately approximates fair value and allows recovery of as much of the unpaid principal loan balance as possible upon the sale of the asset within a reasonable period of time. Based on currently available valuation information, the carrying value of these assets is believed to be representative of their fair value less estimated costs to sell, although there can be no assurance that the ultimate
proceeds from the sale of these assets will be equal to or greater than their carrying values, particularly in the current real estate environment and the downward, though stabilizing, trends in third party appraised values.
Deposits and Other Interest-Bearing Liabilities
Our primary source of funds for loans and investments is our deposits and short-term repurchase agreements. Average total deposits for the years ended December 31, 2016 and 2015 were $83.1 million and $85.0 million, respectively. The following table shows the balance outstanding and the weighted-average rates paid on deposits held by us as of December 31, 2016, 2015, and 2014.
Core deposits, which exclude time deposits of $100,000 or more, provide a relatively stable funding source for our loan portfolio and other earning assets. Core deposits decreased $4.9 million, or 4.7%, from $61.9 million at December 31, 2015 to $58.9 million at December 31, 2016. Total retail, or customer, deposits decreased $1.1 million during 2016, or 4.1%. Our loan-to-deposit ratio was 74.2% and 78.1% at December 31, 2016 and 2015, respectively.
All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $100,000 or more, excluding brokered deposits, at December 31, 2016 is as follows:
Time deposits that meet or exceed the FDIC insurance limit at $250,000 amounted to $8,913,592 and $7,578,706 as of December 31, 2016 and 2015, respectively.
Short-Term Borrowings
At December 31, 2016, 2015, and 2014, the Bank had sold $113,598, $113,080, and $153,603, respectively, of securities under agreements to repurchase with brokers with a weighted rate of 0.12%, 0.10%, and 0.15%, respectively that mature in less than 90 days. These agreements were secured with approximately $50,000, $107,000, and $130,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $135,708 during 2016, with $279,628 being the maximum amount outstanding at any month-end. The average rate paid in 2016 was 0.10%. The securities, under agreements to repurchase, averaged $98,636 during 2015, with $354,739 being the maximum amount outstanding at any month-end. The average rate paid in 2015 was 0.10%. The securities, under agreements to repurchase, averaged $110,307 during 2014, with $221,467 being the maximum amount outstanding at any month-end. The average rate paid in 2014 was 0.10%.
At December 31, 2016, the Bank had an unused unsecured line of credit to purchase federal funds of $2.0 million. The line of credit is available on a one to fourteen day basis for general corporate purposes of the Bank. The lender has reserved the right to withdraw the line at its option. At December 31, 2016, the Bank had pledged $15.5 million in loans to the FRB’s Borrower-in-Custody of Collateral program. Our available credit under this line was approximately $11.4 million as of December 31, 2016.
Federal Home Loan Bank Advances
From time to time, the Bank utilizes FHLB advances as a source of funding. However, at December, 31, 2016 and 2015, the Bank had no advances from the FHLB. In February 2017, an advance of $4,000,000 was obtained from the FHLB with a weighted average rate of 0.89% and a maturity date of November 2017.
Capital Resources
Total shareholders’ equity was $9.9 million at December 31, 2016, a decrease of $2.7 million, or 21.4%, from $12.6 million at December 31, 2015. Shareholders’ equity decreased during 2016 primarily due to the recognition of a net loss of $2.6 million and a decrease in the unrealized gain on investment securities of $121,902. For 2016, the $2.6 million net loss was primarily the result of $1.1 million in professional fees, $407,000 in provisions for loan losses and $512,407 in expenses related to real estate owned. Our shareholders’ equity is also affected by fluctuations in our other comprehensive income (loss). The highest month end reported unrealized loss in other comprehensive income during calendar 2016 was $288,014 in August 2016 as compared to the highest month end unrealized gain in December 2015 of $113,846.
Our Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.
The Basel III capital rules, which were released in July 2013, implement new capital standards and apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies with more than $1 billion in total consolidated assets. The requirements of the rules began to phase in on January 1, 2015 for the Bank, and the requirements of the rules will be fully phased in by January 1, 2019. Under the rules, the following minimum capital requirements apply to the Bank:
•a new common equity Tier risk-based capital ratio of 4.5%,
•a Tier risk-based capital ratio of 6% (increased from the former 4% requirement),
•a total risk-based capital ratio of 8% (unchanged from the former requirement), and
•a leverage ratio of 4% (also unchanged from the former requirement).
Under the rule, Tier 1 capital is redefined to include two components: common equity Tier 1 capital and additional Tier 1 capital. The new and highest form of capital, common equity Tier 1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as noncumulative perpetual preferred stock. Tier 2 capital consists of instruments that currently qualify in Tier 2 capital plus instruments that the rule has disqualified from Tier 1 capital treatment. Cumulative perpetual preferred stock, formerly includable in Tier 1 capital, is now included only in Tier 2 capital. Accumulated other comprehensive income (AOCI) is presumptively included in common equity Tier 1 capital and often would operate to reduce this category of capital. The rule provided a one-time opportunity at the end of the first quarter of 2015 for covered banking organizations to opt out of much of this treatment of AOCI. We made this opt-out election and, as a result, will retain the pre-existing treatment for AOCI.
In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three measurements (common equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer will be phased in incrementally over time, becoming fully effective on January 1, 2019, and will consist of an additional amount of common equity equal to 2.5% of risk-weighted assets. As of January 1, 2017, the Bank is required to hold a capital conservation buffer of 1.25%, increasing by 0.625% each successive year until 2019.
Under the regulations adopted by the federal regulatory authorities, the Bank will be categorized as:
•Well capitalized if the institution (i) has total risk-based capital ratio of 10% or greater, (ii) has a Tier risk-based capital ratio of 8% or greater, (iii) has a common equity Tier risk-based capital ratio of 6.5% or greater, (iv) has a leverage capital ratio of 5% or greater, and (v) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.
•Adequately capitalized if the institution (i) has a total risk-based capital ratio of 8% or greater, (ii) has a Tier risk-based capital ratio of 6% or greater, (iii) has a common equity Tier risk-based capital ratio of 4.5% or greater, and (iv) has a leverage capital ratio of 4% or greater.
•Undercapitalized if the institution (i) has a total risk-based capital ratio of less than 8%, (ii) has a Tier risk-based capital ratio of less than 6%, (iii) has a common equity Tier risk-based capital ratio of less than 4.5% or greater, or (iv) has a leverage capital ratio of less than 4%.
•Significantly undercapitalized if the institution (i) has a total risk-based capital ratio of less than 6%, (ii) has a Tier risk-based capital ratio of less than 4%, (iii) has a common equity Tier risk-based capital ratio of less than 3% or greater, or (iv) has a leverage capital ratio of less than 3%.
•Critically undercapitalized if the institution has a ratio of tangible equity to total assets that is equal to or less than 2%.
In addition, the Bank may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. The Bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the Bank’s overall financial condition or prospects for other purposes.
See additional discussion above under “Business - Supervision and Regulation.”
The following table sets forth the Bank’s and the Company’s various capital ratios at December 31, 2016, 2015, and 2014.
Since December 31, 2016, no conditions or events have occurred, of which we are aware, that have resulted in a material change in the Company’s or the Bank’s capital category. As of December 31, 2016, there were no commitments outstanding, and there were no new commitments as of March 23, 2017. Under Regulation W, the Bank may not be a source of cash or capital for the Company. As disclosed in “Note 22 - Parent Company Financial Information,” the Company’s cash balances were $1.8 million and it had no real estate held for sale at December 31, 2016.
Return on Equity and Assets
The following table shows the return on average assets (net income (loss) divided by average total assets), return on average equity (net income (loss) divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the years ended December 31, 2016, 2015 and 2014. Since our inception, we have not paid cash dividends.
Effect of Inflation and Changing Prices
The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on a historical cost basis in accordance with GAAP.
Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude.
Off-Balance Sheet Risk
Commitments to extend credit are agreements to lend to a client as long as the client has not violated any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2016, unfunded commitments to extend credit were $8.6 million, of which approximately $7.9 million is at fixed rates and $677,000 is at variable rates. A significant portion of the unfunded commitments related to commercial lines of credit. Based on historical experience, we anticipate that a significant portion of these lines of credit will not be funded. We evaluate each client’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.
We are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements, or other transactions that could result in liquidity needs or other commitments that significantly impact earnings.
Market Risk
Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.
We actively monitor and manage our interest rate risk exposure principally by measuring our interest sensitivity “gap,” which is the positive or negative dollar difference between assets and liabilities that are subject to interest rate repricing within a given period of time. Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available for sale, replacing an asset or liability at maturity, or adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities repricing in this same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates. We generally would benefit from increasing market rates of interest when we have an asset-sensitive gap position and generally would benefit from decreasing market rates of interest when we are liability-sensitive.
Approximately 67.7% of our loans were variable rate loans at December 31, 2016, an increase from 64.6% at December 31, 2015. As of December 31, 2016, our ratio of cumulative gap to total earning assets after 12 months but within five years was 18.84% because in a rate change scenario, $17.5 million more liabilities would reprice in a 12 month period than assets. However, our gap analysis is not a precise indicator of our interest sensitivity position. The analysis presents only a static view of the timing of maturities and repricing opportunities, without taking into consideration that changes in interest rates do not affect all assets and liabilities equally. For example, rates paid on a substantial portion of core deposits may change contractually within a relatively short time frame, but those rates are viewed by us as significantly less interest-sensitive than market-based rates such as those paid on noncore deposits. Net interest income may be affected by other significant factors in a given interest rate environment, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities.
Interest rate risk is the Company’s primary market risk exposure. As part of interest rate risk management, the Company may enter into swap agreements to provide protection from rising rates and the impact on the current gap. There were no swap agreements at December 31, 2016. Currently, the Company’s exposure to market risk is reviewed on a regular basis by management, and at the Bank level, the ALCO.
Liquidity and Interest Rate Sensitivity
Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.
The Consolidated Company
At December 31, 2016, our liquid assets, consisting of cash and due from banks and federal funds sold, amounted to $10.8 million, or 11.9% of total assets, a decrease from our cash liquidity ratio of 14.2% as of December 31, 2015. During 2016, the decrease in liquidity is due primarily to the decrease in cash and due from bank and fed funds sold.
The Company
The Company’s cash balances, independent of the Bank, were $1.8 million and its real estate held for sale was zero at December 31, 2016 compared to cash balances of approximately $2.9 million and real estate held for sale of $631,320 at December 31, 2015. The Company’s accrued and other liabilities, independent of the Bank, were $304,346 at December 31, 2016 compared to $905,824 at December 31, 2015. The decrease in liquid assets of approximately $1.1 million was primarily due to the repayment of accrued liabilities, approximately $250,000 in expenses incurred related to the transaction services segment, approximately $147,000 in other real estate owned expenses incurred related to the asset management segment and approximately $913,000 in professional fees and data processing expenses incurred at the Company. The decrease in payables of $601,478 was due primarily to the repayment of accrued liabilities related to the transaction services segment during 2016. See “Note 22 - Parent Company Financial Information” for additional information related to the transaction services segment.
Asset/liability management is the process by which we monitor and control the mix and maturities of our assets and liabilities. The essential purposes of asset/liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. Our ALCO monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.
The Bank
Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments and the generation of deposits within our market. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. Our investment securities available for sale at December 31, 2016 amounted to $2.5 million, or 2.8% of total assets. Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner. At December 31, 2016, $2.4 million of our investment portfolio was pledged against outstanding debt. Therefore, the related debt would need to be repaid prior to the securities being sold and converted to cash.
We are a member of the FHLB, from which applications for borrowings can be made for leverage purposes. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. At December 31, 2016, we had collateral that would support approximately $12.3 million in additional borrowings. Like all banks, we are subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.
At December 31, 2016, the Bank had an unused line of credit to purchase federal funds of $2.0 million. The line of credit is available on a one to fourteen day basis for general corporate purposes of the Bank. The lender has reserved the right to withdraw the line at its option. At December 31, 2016, the Bank had pledged $15.5 million in loans to the FRB’s Borrower-in-Custody of Collateral program. Our available credit under this line was approximately $11.4 million as of December 31, 2016.
The following table sets forth information regarding our rate sensitivity, as of December 31, 2016, at each of the time intervals. The information in the table may not be indicative of our rate sensitivity position at other points in time. In addition, the maturity distribution indicated in the table may differ from the contractual maturities of the earning assets and interest-bearing liabilities
presented due to consideration of prepayment speeds under various interest rate change scenarios in the application of the interest rate sensitivity methods described above.
Accounting, Reporting, and Regulatory Matters
The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:
In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. This topic was amended again in March 2016 to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for annual periods beginning after December 15, 2018, and interim periods within annual reporting periods beginning after December 15, 2019. The Company does not expect these amendments to have a material effect on its financial statements.
In January 2016, the FASB amended the Financial Instruments topic of the Accounting Standards Codification to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.
In February 2016, the FASB amended the Leases topic of the Accounting Standards Codification to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.
In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified
awards at fair value to measuring them at intrinsic value. The amendments will be effective for the Company for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company does not expect these amendments to have a material effect on its financial statements.
In June 2016, the FASB issued guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data.
FOR THE YEARS ENDED DECEMBER 31, 2016 and 2015
Page(s)
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Operations and Comprehensive Income (Loss)
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Independence Bancshares, Inc.
Greenville, South Carolina
We have audited the accompanying consolidated balance sheets of Independence Bancshares, Inc. and its subsidiary (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ Elliott Davis Decosimo, LLC
Greenville, South Carolina
March 23, 2017
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements that are an integral part of these consolidated statements.
INDEPENDENCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES
Independence Bancshares, Inc. (the “Company”) is a South Carolina corporation organized to operate as a bank holding company pursuant to the Federal Bank Holding Company Act of 1956 and the South Carolina Banking and Branching Efficiency Act of 1996, and to own and control all of the capital stock of Independence National Bank (the “Bank”), a national association organized under the laws of the United States. Since opening for business on May 16, 2005, the Bank has operated as a traditional community bank in Greenville, South Carolina, fulfilling the financial needs of individuals and small businesses in its market. The Bank provides traditional checking and savings products insured by the Federal Deposit Insurance Corporation (the “FDIC”) and consumer, commercial and mortgage loans, as well as ATM and online banking, cash management and safe deposit boxes.
As previously reported, on September 25, 2015, the Company suspended development of its digital banking, payments and transaction services business and has subsequently been evaluating strategic alternatives for the Company. A key goal of the Company’s digital banking business was to reduce costs for banking activities and operate more efficiently through utilizing mobile and on-line delivery channels. In furtherance of this goal and based in part upon the institutional knowledge acquired in the pursuit of the digital banking strategy, the Company plans to supplement its current lending strategy by expanding its consumer lending program with on-line offerings, targeting prime and super-prime borrowers in the Bank’s current market area as well as throughout South Carolina. The Company’s board of directors is focused on profitably growing the Bank and enhancing shareholder value through this targeted expansion of its consumer lending program, which may include purchases of in-market consumer loans that meet the Bank’s underwriting criteria.
The following is a description of the significant accounting and reporting policies that the Company follows in preparing and presenting consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Independence National Bank. In consolidation, all significant intercompany transactions have been eliminated. The accounting and reporting policies conform to accounting principles generally accepted in the United States and to general practices in the banking industry.
Subsequent Events
Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date.
Reclassifications
Certain amounts have been reclassified to state all periods on a comparable basis. Reclassifications had no effect on previously reported shareholders’ equity or net loss.
Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amount of income and expenses during the reporting periods. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, including valuation allowances for impaired loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and calculation of the provision for income taxes and deferred income tax assets and related valuation allowances. In connection with the determination of the allowance for loan losses and the valuation of foreclosed real estate,
management obtains independent appraisals for significant properties and takes into account other current market information. Management must also make estimates in determining the useful lives and methods for depreciating premises and equipment.
While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowance for loan losses and changes to valuation of foreclosed real estate may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and valuation of foreclosed real estate. Such agencies may require the Company to recognize additions to the allowance for loan losses or additional write-downs on foreclosed real estate based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowance for loan losses and valuation of foreclosed real estate may change materially in the near term.
Risks and Uncertainties
In the normal course of its business, the Company encounters two significant types of risks: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default within the Company’s loan portfolio that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable and the valuation of real estate held by the Company.
The Company is subject to the regulations of various governmental agencies. These regulations can change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to changes with respect to valuation of assets, amount of required loss allowance and operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examinations. The Bank makes loans to individuals and businesses in and around “Upstate” South Carolina for various personal and commercial purposes. The Bank has a diversified loan portfolio. Borrowers’ ability to repay their loans is not dependent upon any specific economic sector.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes cash, amounts due from banks and federal funds sold. Generally, federal funds are sold for one-day periods. Due to the short term nature of cash and cash equivalents, the carrying amount of these instruments is deemed to be a reasonable estimate of fair value.
At December 31, 2016 and 2015, the Company had restricted cash totaling $2,000 with the Federal Home Loan Bank (“FHLB”) of Atlanta. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.
Investment Securities
Investment securities are accounted for in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 320, “Investments - Debt and Equity Securities.” Management classifies securities at the time of purchase into one of three categories as follows: (1) Securities Held to Maturity: securities which the Company has the positive intent and ability to hold to maturity, which are reported at amortized cost; (2) Trading Securities: securities that are bought and held principally for the purpose of selling them in the near future, which are reported at fair value with unrealized gains and losses included in earnings; and (3) Securities Available for Sale: securities that may be sold under certain conditions, which are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity as accumulated other comprehensive income. The amortization of premiums and accretion of discounts on investment securities are recorded as adjustments to interest income. Gains or losses on sales of investment securities are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. Losses on securities, reflecting a decline in value or impairment judged by the Company to be other-than-temporary, are charged to earnings in the consolidated statements of operations.
Non-Marketable Equity Securities
The Bank, as a member of the Federal Reserve Bank (“FRB”) and the FHLB, is required to own capital stock in these organizations. The amount of FRB stock owned is based on the Bank’s capital levels and totaled $293,050 and $303,500 at December 31, 2016 and 2015, respectively. The amount of FHLB stock owned is determined based on the Bank’s balances of residential mortgages and advances from the FHLB and totaled $87,000 and $89,000 at December 31, 2016 and 2015, respectively. No ready
market exists for these stocks, and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value.
Loans Receivable
Loans are stated at their unpaid principal balance net of any charge-offs. Interest income is computed using the simple interest method and is recorded in the period earned. Fees earned and direct costs incurred on loans are amortized using the effective interest method over the life of the loan.
When serious doubt exists as to the collectability of a loan or when a loan becomes contractually 90 days past due as to principal or interest, interest income is generally discontinued unless the estimated net realizable value of collateral exceeds the principal balance and accrued interest. When interest accruals are discontinued, income earned but not collected is reversed. Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal. Generally, loans are returned to accrual status when the loan is brought current and ultimate collectability of principal and interest is no longer in doubt.
Allowance for Loan Losses
An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. In cases where management deems the amount of the reserve for loan losses to be less than previously determined, an adjustment to lower or reverse the provision will be recorded. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, as well as any reversal of provision, if any, are credited to the allowance.
The allowance for loan losses or any reversal of provision is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of both a specific and a general component. The specific component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”. For such loans, an allowance is established when either the discounted cash flows or collateral value (less estimated selling costs) or observable market price of the impaired loan is lower than the carrying value of that loan. The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors. Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio. The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.
The Company identifies impaired loans through its internal loan review process. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans on the Company’s problem loan watch list are considered potentially impaired loans. Generally, once loans are considered impaired and in the process of the foreclosure process, they are moved to nonaccrual status and recognition of interest income is discontinued. Impairment is measured on a loan-by-loan basis based on the determination of the most probable source of repayment which is usually liquidation of the underlying collateral, but may also include discounted future cash flows, or in rare cases, the market value of the loan itself.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.
The Company designates loan modifications as troubled debt restructurings (TDRs) when, for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that would not otherwise be considered. Upon initial
restructuring, TDRs are considered classified and impaired and are placed in nonaccrual status if not already categorized. TDRs are returned to accrual status when there is economic substance to the restructuring, any portion of the debt not expected to be repaid has been charged off, the remaining note is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated sustained repayment performance in accordance with the modified terms for a reasonable period of time (generally six months).
Property and Equipment and Software
Land is reported at cost. Buildings and improvements, furniture and equipment, capitalized software, and automobiles are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method, based on the estimated useful lives of 40 years for buildings and 3 to 15 years for software, furniture, equipment and automobiles. Leasehold improvements are amortized over the life of the lease. The cost of assets sold or otherwise disposed of, and the related allowance for depreciation, are eliminated from the accounts and the resulting gains or losses are reflected in the statement of operations when incurred. Maintenance and repairs are charged to current expense. The costs of major renewals and improvements are capitalized.
Other Real Estate Owned and Repossessed Assets
Real estate and other property acquired in settlement of loans, is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis at the time of acquisition. Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell. Write-downs resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.
Securities Sold Under Agreements to Repurchase
The Bank enters into sales of securities under agreements to repurchase. Repurchase agreements are treated as financing, with the obligation to repurchase securities sold being reflected as a liability and the securities underlying the agreements remaining as assets.
Fair Value
The Company determines the fair market values of its financial instruments based on the fair value hierarchy established in FASB ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”), which provides a framework for measuring and disclosing fair value under GAAP. ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).
ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1 - Valuations are based on quoted prices in active markets for identical assets or liabilities.
Residential Loan Origination Fees
The Company offers residential loan origination services to its customers. The loans are offered on terms and prices offered by the Company’s correspondents and are closed in the name of the correspondents. The Company receives fees for services it provides in conjunction with these origination services. The fees are recognized at the time the loans are closed by the Company’s correspondent. Residential loan origination fees are included in other income on the Company’s consolidated statements of operations.
Income Taxes
The Company accounts for income taxes in accordance with FASB ASC Topic 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized.
Net Loss per Common Share
Basic loss per common share represents net loss divided by the weighted-average number of common shares outstanding during the period. Diluted loss per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method. For the years ended December 31, 2016 and 2015 as a result of the Company’s net loss, all of the potential common shares (3,089,755 and 3,097,255 stock options, respectively, and zero warrants, as the warrants were not exercised and were deemed expired in May 2015) were considered anti-dilutive.
Research and Development
All costs incurred to establish the technological feasibility of computer software to be sold, leased or otherwise marketed as research and development are expensed as incurred. Once technological feasibility has been established, the subsequent costs of producing, coding and testing the products should be capitalized. The expensing of computer software costs is discontinued when the product is available for general release for customers. The Company did not achieve technological feasibility in connection with its digital banking business and therefore expensed all computer software purchases and development expenses related to research and development. On September 25, 2015 the Company suspended the development of its digital banking business.
Recently Issued Accounting Pronouncements
The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:
In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. This topic was amended again in March 2016 to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for annual periods beginning after December 15, 2018, and interim periods within annual reporting periods beginning after December 15, 2019. The Company does not expect these amendments to have a material effect on its financial statements.
In January 2016, the FASB amended the Financial Instruments topic of the Accounting Standards Codification to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.
In February 2016, the FASB amended the Leases topic of the Accounting Standards Codification to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.
In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. The amendments will be effective for the Company for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company does not expect these amendments to have a material effect on its financial statements.
In June 2016, the FASB issued guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
NOTE 2 - INVESTMENT SECURITIES
The amortized costs and fair values of investment securities available for sale are as follows:
The following table presents information regarding securities with unrealized losses at December 31, 2016:
The following table presents information regarding securities with unrealized losses at December 31, 2015:
At December 31, 2016, there were investment securities with a fair value of approximately $ 2.5 million which had been in a continuous loss position for less than twelve months. At December 31, 2016, there were no investment securities which had been in a continuous loss position for more than one year. The Company believes, based on industry analyst reports and credit ratings that the deterioration in the fair value of these investment securities available for sale is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary. The Company has the ability and intent to hold these securities until such time as the values recover or the securities mature. At December 31, 2015, there were investment securities with a fair value of approximately $ 951,000 which had been in a continuous loss position for less than twelve months. At December 31, 2015, investment securities with a fair value of approximately $1.8 million and unrealized losses of $50,030 had been in a continuous loss position for more than one year. All remaining investment securities were in an unrealized gain position.
The amortized costs and fair values of investment securities available for sale at December 31, 2016, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers have the right to prepay the obligations.
During 2016, the Company received proceeds from maturities and sales of securities of $15.0 million for a total gain of $296,723. During 2015, the Company received proceeds from sales of securities of $4.1 million for a total loss of $87,995. At December 31, 2016 and 2015, $2.4 million and $2.7 million, respectively, in securities were pledged as collateral for repurchase agreements, a credit line and public deposits.
The Company’s investment portfolio consists principally of obligations of the United States of America, its agencies or enterprises it sponsors. In the opinion of management, there is no concentration of credit risk in its investment portfolio.
NOTE 3 - LOANS
The composition of net loans by major category is as follows:
The Company, through the Bank, makes loans to individuals and small- to mid-sized businesses for various personal and commercial purposes primarily in Greenville County, South Carolina. Credit concentrations can exist in relation to individual borrowers or groups of borrowers, certain types of collateral, certain types of industries, certain loan products, or certain regions of the country. Credit risk associated with these concentrations could arise when a significant amount of loans, related by similar characteristics, are simultaneously impacted by changes in economic or other conditions that cause their probability of repayment to be adversely affected. The Company regularly monitors its credit concentrations. The Company does not have a significant concentration to any individual client. The major concentrations of credit arise by collateral type. As of December 31, 2016, management has determined that the Company has a concentration in commercial real estate and construction and development loans, including construction and development loans. At December 31, 2016, the Company had $29.9 million in commercial real estate loans, representing 49.4% of gross loans. Management has extensive experience in commercial real estate lending, and has implemented and continues to maintain heightened portfolio monitoring and reporting, and strong underwriting criteria with respect to its commercial real estate portfolio.
As noted above, the Company plans to supplement its current lending strategy by expanding its consumer lending program with on-line offerings, targeting prime and super-prime borrowers in the Bank’s current market area as well as throughout South Carolina. The Company’s board of directors is focused on profitably growing the Bank and enhancing shareholder value through this targeted expansion of its consumer lending program, which may include purchases of in-market consumer loans that meet the Bank’s underwriting criteria.
In addition to monitoring potential concentrations of loans to a particular borrower or groups of borrowers, industries and geographic regions, management monitors exposure to credit risk that could arise from potential concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Management has determined that there is no concentration of credit risk associated with its lending policies or practices.
The composition of gross loans, before the deduction for deferred origination fees, by rate type is as follows:
Directors, executive officers and associates of such persons are customers of and have transactions with the Bank in the ordinary course of business. Included in such transactions are outstanding loans and commitments, all of which were made under substantially the same credit terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectability. The aggregate dollar amount of these outstanding loans was $1.7 million and $2.8 million at December 31, 2016 and 2015, respectively. During 2016, there were approximately $95,000 in new loans and advances on these lines of credit and repayments were approximately $738,000. During 2015, there were $266,000 new loans and advances on these lines of credit and repayments were approximately $557,000. At December 31, 2015, there were commitments to extend additional credit to related parties in the amount of approximately $140,000. There were no commitments to extend additional credit to related parties at December 31, 2016. The Bank has a line of credit with the FHLB to borrow funds, subject to the pledge of qualified collateral. Acceptable collateral includes certain types of commercial real estate, consumer residential and home equity loans. At December 31, 2016, approximately $34.9 million of first and second mortgage loans, commercial loans and home equity lines of credit were specifically pledged to the FHLB, resulting in $12.3 million in lendable collateral. At December 31, 2016, the Bank had also pledged $15.5 million of commercial loans to the FRB’s Borrower-in-Custody of Collateral program, resulting in $11.4 million in lendable collateral.
Credit Quality
The following table summarizes delinquencies and nonaccruals, by portfolio class, as of December 31, 2016 and 2015.
At December 31, 2016 and 2015, there were nonaccrual loans of $304,451 and $1.7 million, respectively, included in the above loan balances. Foregone interest income related to nonaccrual loans equaled $60,633 and $129,066 for the years ended December 31, 2016 and 2015, respectively. No interest income was recognized on nonaccrual loans during 2016 and 2015. At both December 31, 2016 and 2015, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.
As part of the loan review process, loans are given individual credit grades, representing the risk the Company believes is associated with the loan balance. Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance. Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy. Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade.
The following table summarizes management’s internal credit risk grades, by portfolio class, as of December 31, 2016 and 2015.
Loans graded one through four are considered “pass” credits. At December 31, 2016, approximately 95% of the loan portfolio had a credit grade of “pass” compared to 93% at December 31, 2015. For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment. Loans totaling $835,501 and $1.6 million, respectively, were classified as special mention at December 31, 2016 and 2015. This classification is utilized when an initial concern is identified about the financial health of a borrower. Loans are designated as such in order to be monitored more closely than other credits in the loan portfolio. At December 31, 2016 and 2015, substandard loans totaled $2.2 million and $2.9 million, respectively, with the vast majority of these loans being collateralized by real estate. Substandard credits are evaluated for impairment on a quarterly basis.
The following table summarizes information relative to impaired loans, by portfolio class, at December 31, 2016 and 2015.
TDRs are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. The purpose of a TDR is to facilitate ultimate repayment of the loan.
At December 31, 2016, the principal balance of TDRs was zero as the one loan previously constituting our sole TDR during the year had been repaid in full at maturity in August 2016. At December 31, 2015, the principal balance of TDRs was zero as the one loan constituting our sole TDR had been transferred to other real estate owned. No TDRs went into default during the years ended December 31, 2016 and 2015. A TDR can be removed from “troubled” status once there is sufficient history of demonstrating the borrower can service the credit under market terms. We currently consider sufficient history to be approximately six months.
Provision and Allowance for Loan Losses
The provision, reversal of provision and allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The following table summarizes activity related to our allowance for loan losses for the years ended December 31, 2016 and 2015, by portfolio segment.
NOTE 4 - PROPERTY, EQUIPMENT AND SOFTWARE
Property, equipment and software are stated at cost less accumulated depreciation. Components of property, equipment and software included in the consolidated balance sheets are as follows:
Depreciation expense for the years ended December 31, 2016 and 2015 was $206,623 and $215,471, respectively. There were asset purchases of $34,167 and two disposals totaling $351,698 during 2016. There were asset purchases of $30,260 and no disposals during 2015.
NOTE 5 - OTHER REAL ESTATE OWNED AND REPOSSESSED ASSETS
The following table summarizes the composition of other real estate owned and repossessed assets as of the dates noted.
Changes in other real estate owned and repossessed assets are presented below:
During 2015, other real estate owned for the Company increased due to three pieces of real estate being moved to other real estate owned for $1.3 million, partially offset by the sale of one piece of real estate held by the Bank for proceeds of approximately $24,000, which resulted in a loss of approximately $6,000 and another sale of real estate owned that was purchased from the Bank for proceeds of approximately $613,000, which resulted in a loss of approximately $18,000 to the Company. In addition, the Bank recognized writedowns on real estate owned of approximately $284,000 during 2016. On March 7, 2017, one impaired loan was transferred to other real estate owned for $165,000, net of a specific reserve of $35,000.
NOTE 6 - DEPOSITS
Deposits at December 31, 2016 and 2015 are summarized as follows:
Interest expense on time deposits greater than $100,000 was $192,160 and $182,041 for the years ended December 31, 2016 and 2015 respectively.
Time deposits that meet or exceed the FDIC insurance limit at $250,000 amounted to $9,163,592 and $7,578,706 as of December 31, 2016 and 2015, respectively.
At December 31, 2016 the scheduled maturities of certificates of deposit (including brokered time deposits) are as follows:
At December 31, 2016, $2.3 million in securities were pledged as collateral for public deposits and approximately $50,000 in securities were pledged as collateral for business deposits.
NOTE 7 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
At December 31, 2016 and 2015, the Bank had sold $113,598 and $113,080, respectively, of securities under agreements to repurchase with brokers with a weighted rate of 0.10% for the comparable periods that mature in less than 90 days. These agreements were secured with approximately $50,000 and $107,000 of investment securities, respectively. The securities, under agreements to repurchase, averaged $135,708 during 2016, with $279,628 being the maximum amount outstanding at any month-end. The average rate paid in 2016 was 0.10%. The securities, under agreements to repurchase, averaged $98,636 during 2015, with $354,739 being the maximum amount outstanding at any month-end. The average rate paid in 2015 was 0.10%.
NOTE 8 - FEDERAL HOME LOAN BANK ADVANCES
At December 31, 2014, the Bank had $5.0 million of advances from the FHLB, with a weighted average rate of 0.25%. The advance was obtained in July 2014 with a maturity date of January 2015. The FHLB advance from 2014 was repaid in full in January 2015 upon maturity. There were no advances from the FHLB for the years ended December 31, 2016 and 2015. In February 2017, an advance of $4,000,000 was obtained from the FHLB with a weighted average rate of 0.89% and a maturity date of November 2017.
NOTE 9 - NOTE PAYABLE - RELATED PARTY
In September 2014, the Company closed a $600,000 one-year borrowing. The loan was provided by a board member of the Bank and as a result needed to comply with Regulation O. Proceeds of the loan were used primarily to fund the research and development effort in the transaction services business segment. The loan was collateralized by a first perfected security interest in certain real estate assets of the Company. The loan was fully drawn at closing, and carried an annual interest rate of 7% per annum for the first six months on any outstanding borrowings and then stepped up to 8% per annum for the remaining 6 months of the term. On March 18, 2015, one of the parcels of real estate was sold and a payment was made on the loan so that the outstanding balance of the loan was $149,774, which was equal to the balance on June 30, 2015. The outstanding balance of $149,774 plus accrued interest was repaid in its entirety on September 3, 2015.
NOTE 10 - UNUSED LINES OF CREDIT
At December 31, 2016 and 2015, the Bank had an unused unsecured line of credit to purchase federal funds of $2.0 million that has not been utilized. The line of credit is available on a one to fourteen day basis for general corporate purposes of the Bank. The lender has reserved the right to withdraw the line at its option.
The Bank has a line of credit with the FHLB to borrow funds, subject to the pledge of qualified collateral. At December 31, 2016, approximately $34.9 million of first and second mortgage loans, commercial loans and home equity lines of credit were specifically pledged to the FHLB, resulting in $12.3 million in lendable collateral. At December 31, 2015, approximately $39.9 million of first and second mortgage loans, commercial loans and home equity lines of credit were specifically pledged to the FHLB, resulting in $13.0 million in lendable collateral.
The Bank is subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. During the fourth quarter of 2010, the Bank’s credit risk rating was downgraded by the FHLB, which resulted in decreased borrowing availability (total line reduced to 15% of total assets from 20% of total assets) and increased collateral requirements (moved to 125% of borrowings from 115%). During the third quarter of 2013, the FHLB upgraded our credit risk rating, which resulted in increased borrowing availability
(total line increased from 15% of total assets to 20% of total assets) and decreased collateral requirements (moved to 115% of borrowings from 125%). The Bank’s ability to access available borrowing capacity from the FHLB in the future is subject to its rating and any subsequent changes based on financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.
At December 31, 2016, the Bank had pledged $15.5 million in loans to the FRB’s Borrower-in-Custody of Collateral program resulting in $12.3 million in lendable collateral. Our available credit under this line was approximately $11.4 million and $10.5 million as of December 31, 2016 and 2015, respectively. The Bank had no outstanding borrowings from the FRB as of December 31, 2016 and 2015.
NOTE 11 - INCOME TAXES
The components of income tax expense were as follows:
The following is a summary of the items that caused recorded income taxes to differ from taxes computed using the Company’s statutory federal income tax rate of 34%:
The components of the net deferred tax asset are as follows:
The valuation allowance for deferred tax assets as of December 31, 2016 and 2015 was $7.4 million and $6.4 million, respectively. Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not that the Company will not recognize the entire deferred tax asset. The determination of whether a deferred tax asset is realizable is based on the weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified. As of December 31, 2016 and 2015, the Company determined that it is not more likely than not that deferred tax assets will be recognized in future years.
The Company will continue to analyze deferred tax assets and the related valuation allowance on a quarterly basis, taking into account performance compared to forecasted earnings as well as current economic and internal information.
At December 31, 2016, the Company has federal operating loss carry-forwards of approximately $8.0 million that may be used to offset future taxable income and expire beginning in 2026. At December 31, 2016, the Company has state operating loss carry-forwards of approximately $1.2 million that may be used to offset future taxable income and expire beginning in 2035.
The Company has analyzed the tax positions taken or expected to be taken on its tax returns and concluded it has no liability related to uncertain tax positions in accordance with FIN 48. With limited exceptions, income tax returns for 2013 and subsequent years are subject to examination by the taxing authorities.
We have generated significant net operating losses, or NOLs, as a result of our operating results. We are generally able to carry NOLs forward to reduce taxable income in future years. However, the ability to utilize the NOLs is subject to the rules of Section 382 of the Internal Revenue Code. Section 382 generally restricts the use of NOLs after an “ownership change.” An ownership change occurs if, among other things, the shareholders (or specified groups of shareholders) who own or have owned, directly or indirectly, 5% or more of a corporation’s common stock or are otherwise treated as 5% shareholders under Section 382 and U.S. Treasury regulations promulgated thereunder because of an increase of their aggregate percentage ownership of that corporation’s stock by more than 50 percentage points over the lowest percentage of the stock owned by these shareholders over a rolling three-year period. In the event of an ownership change, Section 382 imposes an annual limitation on the amount of taxable income a corporation may offset with NOL carryforwards. This annual limitation is generally equal to the product of the value of the corporation’s stock on the date of the ownership change, multiplied by the long-term tax-exempt rate published monthly by the Internal Revenue Service. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOL carryforwards.
NOTE 12 - RELATED PARTY TRANSACTIONS
On December 31, 2016 and 2015, the Bank had various loans outstanding to directors and officers. All of these loans were made under normal credit terms and did not involve more than normal risk of collection. See Note 3 for further details.
In September 2014, the Company closed a $600,000 one-year borrowing. The loan was provided by a board member of the Bank and as a result needed to comply with Regulation O. Proceeds of the loan were used primarily to fund the research and development effort in the Transaction Services business segment. The loan was collateralized by a first perfected security interest in certain real estate assets of the Company. The loan was fully drawn at closing, and carried an annual interest rate of 7% per annum for the first six months on any outstanding borrowings and then stepped up to 8% per annum for the remaining 6 months of the term. On March 18, 2015, one of the parcels of real estate was sold and a payment was made on the loan so that the outstanding balance of the loan was $149,774, which was equal to the balance on June 30, 2015. The outstanding balance of $149,774 plus accrued interest was repaid in its entirety on September 3, 2015.
On May 14, 2015, the Company entered into a license agreement with MPIB pursuant to which it received a non-exclusive, non-transferable, non-licensable, worldwide license to use certain intellectual property of MPIB related to mobile payments and digital transactions. On January 4, 2016, the parties amended and restated the license agreement (the “Amended and Restated License Agreement”) pursuant to which MPIB agreed to make the license perpetual, subject to termination rights of the parties set forth in the Amended and Restated License Agreement, in exchange for the Company’s payment of an additional license fee of $275,000. In addition, as previously disclosed, on April 27, 2015, the Company submitted a proposed asset purchase agreement between the Company and MPIB to the Federal Reserve Bank of Richmond. The Company subsequently withdrew this application to the agency and no longer intends to enter into the asset purchase agreement or consummate the transaction contemplated therein.
NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF BALANCE SHEET RISK
In the ordinary course of business, and to meet the financing needs of its customers, the Company is a party to various financial instruments with off balance sheet risk. These financial instruments, which include commitments to extend credit and standby letters of credit, involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheets. The contract amount of those instruments reflects the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amounts of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2016, unfunded commitments to extend credit were $8.6 million, of which approximately $7.9 million is at fixed rates and $677,000 is at variable rates. The Company evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. The fair value of these off-balance sheet financial instruments is considered immaterial.
The Company does not have any commitments to lend additional funds to borrowers whose loans have been modified as a TDR.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
The Bank has a two-year operating lease on its main office facility which began in October 2008. The Bank exercised its remaining two-year renewal options in September 2012. The Bank renegotiated on terms similar to the current lease and amended the current lease in October 2014 for a term of five years. The monthly rent under the lease amendment is $10,370 from October 1, 2012 through September 30, 2014, $10,789 from October 1, 2014 through September 30, 2015, $11,005 from October 1, 2015 through September 30, 2016 and $11,225 from October 1, 2016 through September 30, 2017. The Bank has a ten-year operating lease on a branch facility which began in August 2007. The monthly rent under the lease is $9,229 from August 1, 2012 through July 31, 2017. The Company is currently in negotiations regarding the terms of renewing the lease. The Company had a 21- month operating lease on its New York office which began in May 2013. The monthly rent under the lease agreement allowed for one month free rent from May 23, 2013 through June 22, 2013, an installment of $2,680 for June 23, 2013 through June 30, 2013, and fixed monthly installments of $9,450 from July 1, 2013 through February 27, 2015. The New York office lease was not renewed in February 2015. At that time, the Company moved to a month to month lease for the New York office at a rate of $2,189 per month. The New York office month to month lease was terminated during 2015. Rent expense of $268,988 and $314,117 was recorded for the years ended December 31, 2016 and 2015, respectively.
Future minimum lease payments under these operating leases are summarized as follows:
As of December 31, 2016, there were no other commitments outstanding, and there were no new commitments as of March 23, 2017.
The board of directors has approved employment agreements with the president and chief executive officer of the Bank, the chief financial officer of the Company and Bank and the Bank’s chief operating officer. The agreements include provisions regarding term, compensation, benefits, annual bonus, incentive program, stock option plan and severance and non-compete upon early termination.
The Bank may become party to litigation and claims in the normal course of business. As of December 31, 2016, management believes there is no material litigation pending.
NOTE 15- STOCK COMPENSATION PLANS
On July 26, 2005, the Company adopted the Independence Bancshares, Inc. 2005 Stock Incentive Plan (the “2005 Incentive Plan”) for the benefit of the directors, officers and employees. The 2005 Incentive Plan initially reserved up to 260,626 shares of the Company’s common stock for the issuance of stock options and contained evergreen provision, which provided that the maximum number of shares to be issued under the 2005 Incentive Plan would automatically increase each time the Company issues additional shares of common stock such that the total number of shares issuable under the 2005 Incentive Plan would at all times equal 12.5% of the then outstanding shares of common stock.
In February 2013, our board of directors amended the 2005 Incentive Plan to cap the number of shares issuable thereunder at 2,466,720 and adopted the Independence Bancshares, Inc. 2013 Equity Incentive Plan (the “2013 Incentive Plan”) which was subsequently approved by the Company’s shareholders at the 2013 annual shareholders’ meeting. The 2013 Incentive Plan is an omnibus equity incentive plan which provides for the granting of various types of equity compensation awards, including stock options, restricted stock, and stock appreciation rights, to the Company’s employees and directors.
As of December 31, 2016 and 2015, 3,089,755 total options were outstanding at a weighted average price of $1.11. Of the 3,097,255 options outstanding, 3,067,255 options were vested.
A summary of the status of the plans and changes for the years ended December 31, 2016 and 2015 are presented below:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of 2016 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2016. This amount changes based on the fair market value of the Company’s stock. Fair market value is based on the most recent trade of common stock reported through the OTC Bulletin Board. As of December 31, 2016, the Company’s closing stock price was $0.15 resulting in no intrinsic value.
Compensation expense related to stock options granted was $10,126 and $303,829 for the years ended December 31, 2016 and 2015, respectively. Compensation expense is based on the fair value of the option estimated at the date of grant using the Black-Scholes option-pricing model. Compensation expense is recognized on a straight line basis over the vesting period of the option.
In 2005, the Company issued warrants to each of its organizers to purchase up to an additional 312,500 shares of common stock at $10.00 per share. These warrants vested six-months from the date the Bank opened for business, or May 16, 2005, and they were exercisable in whole or in part until May 16, 2015. No warrants were exercised by May 16, 2015, at which time the warrants were deemed expired.
NOTE 16 - EMPLOYEE BENEFIT PLAN
The Bank maintains an employee benefit plan for all eligible employees of the Bank under the provisions of Internal Revenue Code Section 401(k). The Independence National Bank 401(k) Profit Sharing Plan (the “Plan”), adopted in 2005, allows for employee contributions. Upon annual approval of the board of directors, the Company also matches 50% of employee contributions up to a maximum of 6% of annual compensation. For the year ended December 31, 2016 and 2015, $14,043 and $15,859, respectively, was charged to operations for the Company’s matching contribution. Employees are immediately vested in their contributions to the Plan and become fully vested in the employer matching contribution after six years of service.
NOTE 17 - REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets. Total capital includes Tier 1 and Tier 2 capital. Tier 2 capital consists of the allowance for loan losses subject to certain limitations.
In July 2013, the FDIC approved a final rule to implement the Basel III regulatory capital reforms among other changes required by the Dodd-Frank Act. The framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, taking into account the impact of risk. The approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% as well as a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The rule also raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking institutions. For the largest, most internationally active banking organizations, the rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures. In terms of quality of capital, the final rule emphasized common equity Tier 1 capital and implemented strict eligibility criteria for regulatory capital instruments. It also changed the methodology for calculating risk-weighted assets to enhance risk sensitivity. The changes began to take effect for the Bank on January 1, 2015.
The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements at December 31, 2016 and 2015.
The Federal Reserve has similar requirements for bank holding companies. The Company is currently not subject to these requirements because the Federal Reserve guidelines contain an exemption for bank holding companies of less than $1 billion in consolidated assets, subject to certain limitations.
Since December 31, 2016, no conditions or events have occurred, of which we are aware, that have resulted in a material change in the Company’s or the Bank’s category, other than as reported in this Annual Report on Form 10-K.
NOTE 18 - RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS, OR ADVANCES
The ability of the Company to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. However, certain restrictions exist regarding the ability of the subsidiary to transfer funds to Independence Bancshares, Inc. in the form of cash dividends, loans, or advances. The approval of the OCC is required to pay dividends in excess of the Bank’s net profits (as defined) for the current year plus retained net profits (as defined) for the preceding two years, less any required transfers to surplus. The Company also has to obtain the prior written approval of the Federal Reserve Bank of Richmond before declaring or paying any dividends.
NOTE 19- BUSINESS SEGMENTS
The Company reports its activities as four business segments - community banking, transaction services, asset management and parent only - as defined in “Item 1. Business”. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment.
The following table presents selected financial information for the Company’s reportable business segments for the year ended December 31, 2016 and 2015. See Note 22 for parent company condensed financial information.
(1) Excludes investment in wholly-owned Bank subsidiary
(1) Excludes investment in wholly-owned Bank subsidiary
The sole activity conducted within our asset management business segment is the resolution of assets purchased by the Company in the second quarter of 2013 from the Bank. All assets have been sold and resolved as of December 31, 2016.
The activities conducted within our transaction services business segment relate to the Company’s research and development efforts to enhance existing and develop new digital banking, payments and transaction services. The Company incurred approximately $250,000 and $2.2 million in research and development expenses during 2016 and 2015, respectively. The expenses paid since the suspension of the development of the transaction services segment in September 2015 relate to remaining monthly contract costs which have since been completed. The Company recognized approximately $383,000 in noninterest income during 2015 within the transaction services business segment and approximately $21,000 representing forgiveness of debt as a result of settling certain outstanding liabilities for the Company. As previously noted, on September 25, 2015, the Company suspended development of its digital banking business.
NOTE 20 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Assets and Liabilities Measured at Fair Value
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value are detailed in Note 1.
Available-for-sale investment securities ($2,499,805 and $10,687,851 at December 31, 2016 and 2015, respectively) are carried at fair value and measured on a recurring basis using Level 2 inputs (other observable inputs). Fair values are estimated by using bid prices and quoted prices of pools or tranches of securities with similar characteristics.
We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and a specific reserve within the allowance for loan losses is established or the loan is charged down to the fair value less costs to sell. At December 31, 2016, all impaired loans were evaluated on a nonrecurring basis based on the market value of the underlying collateral. Market values are generally obtained using independent appraisals or other market data, which the Company considers to be Level 3 inputs. The aggregate carrying amount, net of specific reserves, of impaired loans carried at fair value at December 31, 2016 and 2015 was $1.6 million and $2.0 million, respectively.
Other real estate owned and repossessed assets, generally consisting of properties or other collateral obtained through foreclosure or in satisfaction of loans, are carried at the lower or market value and measured on a non-recurring basis. Market values are generally obtained using independent appraisals which are generally prepared using the income or market valuation approach, adjusted for estimated selling costs which the Company considers to be Level 3 inputs. The carrying amount of other real estate owned and repossessed assets carried at fair value at December 31, 2016 and 2015 was $2,222,667 and $1,910,220, respectively. The Company utilizes two methods to determine carrying values, either appraised value, or if lower, current net listing price.
The Company has no assets whose fair values are measured using Level 1 inputs. The Company also has no liabilities carried at fair value or measured at fair value.
For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2016, the significant observable inputs used in the fair value measurements were as follows:
Description Fair Value at
December 31, 2016 Valuation Technique Significant
Unobservable Inputs
Other real estate owned and repossessed assets $2,222,667 Appraised value Discounts to reflect current
market conditions, abbreviated
holding period, and estimated
costs to sell
Impaired loans $1,606,590 Internal assessment of
appraised value Adjustments to estimated
value based on recent sales
of comparable collateral
For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2015, the significant unobservable inputs used in the fair value measurements were as follows:
Description Fair Value at
December 31, 2015 Valuation Technique Significant
Unobservable Inputs
Other real estate owned and repossessed assets $1,910,220 Appraised value Discounts to reflect current
market conditions and estimated
costs to sell
Impaired loans $2,005,168 Internal assessment of
appraised value Adjustments to estimated
value based on recent sales
of comparable collateral
Disclosures about Fair Value of Financial Instruments
FASB ASC Topic 825, “Financial Instruments” requires disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. FASB ASC Topic 825 defines a financial instrument as cash, evidence of an ownership interest in an entity or contractual obligations which require the exchange of cash or other financial
instruments. Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, property, equipment, and software and other assets and liabilities.
Fair value approximates carrying value for the following financial instruments due to the short-term nature of the instrument: cash and due from banks, federal funds sold, and securities sold under agreements to repurchase. Investment securities are valued using quoted market prices. No ready market exists for non-marketable equity securities, and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value. Fair value of loans is based on the discounted present value of the estimated future cash flows. Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality.
The carrying value of loans held for sale as of December 31, 2016 approximates fair value as these loans were discounted to their liquidation value which is equal to the minimum acceptable bid price established by the Company in connection with the Company’s intent to sell these loans to unaffiliated third party investors.
Fair value for demand deposit accounts and interest bearing accounts with no fixed maturity date is equal to the carrying value. The fair value of certificate of deposit accounts are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments. Fair value for FHLB Advances is based on discounted cash flows using the Company’s current incremental borrowing rate.
The Company has used management’s best estimate of fair value based on the above assumptions. Thus, the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument. In addition, any income taxes or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair value presented. The estimated fair values of the Company’s financial instruments at December 31, 2016 and 2015 are as follows:
NOTE 21 - BANK OWNED LIFE INSURANCE AND PRE-RETIREMENT BENEFIT PLAN
In June 2016, the Bank purchased two bank owned life insurance policies with aggregate death benefits of $2,500,000 for investment purposes. The Bank is responsible for paying all premiums and is the owner and beneficiary of the policies. At December 31, 2016, the cash surrender value of these policies was $2,542,910, and as a result $42, 910 in income recognized during the period.
In connection with the purchase of the bank owned life insurance policies, the Bank offered pre-retirement death benefits to selected employees of the Bank. The policies are not transferrable to the employees and are not impacted by a change in control. The pre-retirement death benefits are indirectly funded by the bank owned life insurance.
NOTE 22 - PARENT COMPANY FINANCIAL INFORMATION
Following is condensed financial information of Independence Bancshares, Inc. (includes transaction service, asset management and holding company segments - for further detail, see “Note 19 - Business segments”):
Condensed Balance Sheets
Condensed Statements of Operations
Condensed Statements of Cash Flows
NOTE 23 - SUBSEQUENT EVENTS
As part of our strategy to identify growth and sources of new operating revenues, including increasing net interest income, the Company purchased approximately $4.8 million in consumer loans during the first quarter of 2017. These loans are all personal unsecured loans with terms within 36 to 60 months and have a weighted interest rate of 10.42%. While the Company holds the loans, the servicing is retained by the seller for a 1% monthly fee.
PART II
Item 9.
Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.  Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Based on our management’s evaluation (with participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer as appropriate to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Controls over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the 1934 Act. Management has assessed the effectiveness of our internal control over financial reporting as of December 31, 2015 based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. As a result of this assessment, management concluded that, as of December 31, 2016, our internal control over financial reporting was effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
The effectiveness of the internal control over financial reporting as of December 31, 2016 was not required to be, and has not been, audited by Elliott Davis Decosimo, LLC, the Company’s independent registered public accounting firm.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting during our fourth quarter of fiscal 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B.  Other Information.
None.
PART III
Item 10.
Item 10.  Directors, Executive Officers, and Corporate Governance.
Directors and Executive Officers
The following table sets forth information about our directors, executive officers, and other officers. Our directors are elected by a plurality of the votes cast at our annual shareholders’ meetings and serve for one-year terms, which expire at the next annual shareholders’ meeting.
Set forth below is certain information about our directors, executive officers, and proposed executive officer, including their age, their business experience for at least the past five years, the names of other publicly-held companies where they currently serve as a director or served as a director during the past five years, and additional information about the specific experience, qualifications, attributes, or skills that led to the board’s conclusion that such person should serve as a director for the Company.
H. Neel Hipp, Jr., director and the chairman of the board of directors of the Bank, is the former vice president of Liberty Corporation and former chairman of Liberty Life Insurance Company with over 29 years of experience with the Liberty companies. He is the current owner of Hipp Investments, LLC, which he founded in 1998. Mr. Hipp was a founder and a director of Greenville Financial Corporation and Greenville National Bank. He received his B.A. in economics from Furman University, his M.B.A. from the University of North Carolina, Chapel Hill, and he also attended the Harvard Business School Program for Management Development. Mr. Hipp is actively involved in the community. He currently serves as a trustee of Wofford College, on the board of the Aircraft Owners and Pilots Association of Frederick, Maryland. Mr. Hipp was appointed chairman of the South Carolina Aeronautics Commission in 2006 by Governor Sanford. He has served as a member of the South Carolina Chamber of Commerce, the Greenville Downtown Airport Commission (chair), the Greenville County United Way, the board of the South Carolina Historical Society and the Furman University board of trustees. Mr. Hipp’s extensive business experience in a regulated industry, his past experience in the banking industry, including service as a bank director, as well as his ties to the Greenville community led the board to conclude that he should serve as a director.
Keith Stock, director, has served since 2011 as the chairman and chief executive officer of First Financial Investors, Inc. and senior executive advisor with The Brookside Group family-owned investment offices. Since 2014, Mr. Stock has served as chairman, and was previously a member of the executive office, of Clarien Bank Limited. He also served as chairman and chief executive officer of Clarien Group Limited, the bank holding company. Since 2014, he has been a director of Sun Bancorp, Inc. and Sun National Bank. Mr. Stock is a registered securities professional with Sword Securities, LLC. Since 2016, Mr. Stock has served as president, chief executive officer, treasurer and director of National Property REIT Corp. as well as executive officer of certain of its subsidiaries. From 2009 until 2011, Mr. Stock served as chief strategy officer and member of the Office of the CEO at TIAA-CREF. From 2004 until May 2008, he served as president of MasterCard Advisors, LLC and as a member of the MasterCard Worldwide Operating Committee and Management Council. Prior to that, Mr. Stock served as chairman and chief executive officer of St. Louis Bank, FSB,
chairman and president of Treasury Bank Ltd., and as a director of Severn Bancorp, Inc. He has held global management roles with AT Kearney, Capgemini, Ernst & Young and McKinsey & Company after beginning his career with BNY Mellon. He is a director of the Foreign Policy Association, a member of the Economic Club of New York, a member of the Governing Council of the Bermuda Stock Exchange and the Advisory Board of the Institute for Ethical Leadership at Rutgers University Business School. He is a graduate of Princeton University and received his MBA from The University of Pennsylvania Wharton School. Mr. Stock’s prior service as an executive officer and director of other banks, as well as his extensive payments services experience with MasterCard, led the board to conclude that he should serve as a director as the Company implements the expansion of its business model.
Robert B. Willumstad, director, has over 35 years of experience in the banking and financial services industry, and he presently serves as a partner with Brysam Global Partners, a specialty private equity firm that focuses in financial services, which he co-founded in 2005. Mr. Willumstad also previously served as the chairman, and briefly as chief executive officer, of American International Group until 2008. Prior to that, he held positions as president and chief operating officer, as well as a director, at Citigroup. Mr. Willumstad also served for over 20 years with Chemical Bank in various capacities of operations, retail banking and computer systems. Mr. Willumstad’s extensive banking and financial services experience led the board to conclude that he should serve as a director and as chairman of the board of directors.
Russell Echlov, director, was appointed to the board as a representative of RMB Capital Management, LLC, the investment adviser to certain private funds whose strategy focuses on the banking and financial services sectors (“Mendon Capital Strategy”) and which invested in the Company’s 2015 private offering of Series A preferred stock. Mr. Echlov has served as an assistant portfolio manager with RMB Capital Management, LLC focused on Mendon Capital Strategy since April 2014. Prior to that time, he was employed as an investment advisor for Spring Hill Capital, LLC from 2010 until January 2014. He is an experienced institutional investor with knowledge of banking and financial services and is a graduate of Dartmouth College. Mr. Echlov’s extensive experience as an institutional investor in banks and other financial institutions led the board to conclude that he should serve as a director of the Company.
Adam G. Hurwich, director, was appointed to the board as a representative of Ulysses Management LLC, the investment manager for Ulysses Partners, L.P. and Ulysses Offshore Fund, Ltd., which together invested in the Company’s 2015 private offering of Series A preferred stock. Mr. Hurwich has served as a portfolio manager at Ulysses Management LLC since January 2010. He has also served as a director of First Security Group, Inc. and FSGBank, National Association, from June 2013 to October 2015, when First Security Group merged with and into Atlantic Capital Bancshares, Inc. Mr. Hurwich has served as a director of Atlantic Capital Bancshares, Inc. and Atlantic Capital Bank since November 2015. Mr. Hurwich has worked over a period spanning almost a decade in various advisory committees to the Financial Accounting Standards Board - the last of which, the Financial Accounting Standards Advisory Council, he completed in December 2015. He is an experienced institutional investor with knowledge of banking and financial services. Mr. Hurwich received his A.B. from Harvard College in 1987 and his M.B.A. from Yale University in 1989. Mr. Hurwich’s extensive experience as an institutional investor, as well as a director of another financial institution, led the board to conclude that he should serve as a director of the Company. 	
Lawrence R. Miller, serves as the Company’s interim chief executive officer and the Bank’s president and chief executive officer. He has also served as a director of the Bank since its organization in 2005. Mr. Miller served as the Company’s and the Bank’s chief executive officer from organization until December 31, 2012, when he stepped down as the Company’s chief executive officer but continued to serve as the Bank’s chief executive officer. In October 2015, the Company’s board of directors appointed him as the Company’s interim chief executive officer. Mr. Miller has over 45 years of banking experience, having held various positions in the banking industry since November 1971. From 1995 until March 2004, he served as market chief executive officer for SouthTrust Bank, where he successfully opened seven offices in 10 years. He has lived in Upstate South Carolina for over 45 years and has been actively involved in the community and its future planning. He has served as a trustee for the College of Charleston for thirteen years for which he chaired both the Audit and Finance Committees; and is past board chairman of Christ School, Arden, North Carolina for which he served as a trustee for ten years. Mr. Miller is a member of the South Carolina Bankers Association Council and a former board member of the South Carolina Bankers Association. He has served on both the economic development board of the Greenville Chamber of Commerce and the board of directors of the Greer Chamber of Commerce. Mr. Miller graduated from Newberry College, from the School of Banking of the South at Louisiana State University, and from the National Commercial Lending Graduate School at the University of Oklahoma. Mr. Miller’s extensive knowledge of the Bank and the Company as well as his ties to the Greenville community led the board to conclude that he should serve as a director of the Company.
Additional information is set forth below regarding certain other executive officers of our Company and our Bank:
Martha L. Long, serves as the Company’s and the Bank’s chief financial officer. Ms. Long began assisting the Bank with financial accounting matters as an independent contractor beginning in June 2011, and in August 2012, she was appointed as chief financial officer of the Bank. She was appointed as chief financial officer of the Company in December 2013. Ms. Long has over 32 years of experience in various senior financial officer roles. Prior to her work with the Bank, Ms. Long served in various accounting capacities,
including most recently working for her own CPA firm from 2009 through 2012. Prior to that, she served as Senior Vice President for AIMCO, a publicly held real estate investment trust from 1998 to 2009 in various financial capacities. She has also served as Senior Vice President and Controller for two SEC-registered companies, The First Savings Bank and Insignia Financial Group, Inc., an owner and operator of multi-family housing facilities. Ms. Long is a graduate of Bob Jones University with a degree in Accounting and is a certified public accountant in South Carolina.
E. Fred Moore, serves as the executive vice president and chief credit officer of the Company and the Bank, and he has held these positions since 2006. He previously served as a senior vice president of risk management for First National Bank of the South in Spartanburg, South Carolina. He has over 32 years of experience in administrative banking and finance, including credit administration and internal audit. Mr. Moore was previously employed with American Federal as a senior credit analyst until November 2000, when he resigned to join First National Bank of the South. He graduated from University of South Carolina in 1982 where he received his B.A. in business economics.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires the Company’s officers and directors and persons who own more than 10% of the Company’s common stock to file reports of ownership and changes in ownership with the SEC. Based solely on the Company’s review of these forms and written representations from the officers and directors, the Company believes that all Section 16(a) filing requirements were met during fiscal 2016.
Code of Ethics
We expect all of our directors, executive officers, and other employees to conduct themselves honestly and ethically, particularly in handling actual and apparent conflicts of interest and providing full, accurate, and timely disclosure to the public.
We have adopted a Code of Ethics that is applicable to our directors, executive officers, principal shareholders, and other employees, including our principal executive officer and our principal financial officer. A copy of this Code of Ethics is available without charge to shareholders upon request to the secretary of the Company, at Independence Bancshares, Inc., 500 East Washington St., Greenville, South Carolina 29601.
Audit Committee and Audit Committee Financial Expert
Our audit committee is currently composed of Messrs. Stock and Hipp. Each of these members is considered “independent” under NASDAQ Rule 5605(c)(2). The board of directors has determined that Mr. Stock is an “audit committee financial expert” as defined in Item 407(d)(5) of the SEC’s Regulation S-K. The audit committee met four times in 2016. The audit committee functions are set forth in its charter, which was adopted on May 5, 2005 and was revised and approved by the board of directors on October 29, 2015. The audit committee has the responsibility of reviewing financial statements, evaluating internal accounting controls, reviewing reports of regulatory authorities, and determining that all audits and examinations required by law are performed. The committee recommends to the board the appointment of the independent auditors for the next fiscal year, reviews and approves the auditor’s audit plans, and reviews with the independent auditors the results of the audit and management’s responses. The audit committee is responsible for overseeing the entire audit function and appraising the effectiveness of internal and external audit efforts. The audit committee reports its findings to the board of directors.
Item 11.
Item 11.  Executive Compensation.
Summary Compensation Table
The following table summarizes the compensation paid to or earned by each of the named executive officers for the year ended December 31, 2016:
(1)Mr. Miller was appointed as the Company’s interim chief executive officer on October 4, 2015.
(2)Includes 401(k) matching contributions, excess premiums for life insurance at two times salary and premiums for long-term and short-term disability insurance policies. All of these benefits are provided to all full-time Bank employees on a non-discriminatory basis.
(3)Includes membership dues paid to country clubs, vehicle expenses, and premiums paid on additional life insurance.
Employment Agreements
Lawrence R. Miller
We entered into an employment agreement with Lawrence R. Miller on December 10, 2008, for an initial one-year term, annually renewing thereafter, pursuant to which he served as the president and the chief executive officer of the Company and the Bank. On December 31, 2012, the Company, the Bank, and Mr. Miller entered into an amendment to his employment agreement solely to remove references to his position as the Company’s president and chief executive officer. On December 15, 2016, the Company, the Bank and Mr. Miller entered into a second amendment to his employment agreement to eliminate the Employer’s (as defined therein) obligations to continue the medical, life, disability, or benefits to Mr. Miller, his dependents, and beneficiaries for a period of two years following a change in control, in favor or a provision allowing Mr. Miller to continue participation, in accordance with the terms of the applicable benefits plans, in the Employer’s group health plan pursuant to plan continuation rules under COBRA. The second amendment also requires that Mr. Miller terminate his membership in the Thornblade Club upon termination of employment following a change in control, and in connection therewith, the Employer shall pay to Mr. Miller, within 15 days of the date of his termination, a lump sum amount equal to the twelve required monthly payments relating to such membership termination. As of March 23, 2017, Mr. Miller receives an annual salary of $177,000, plus a portion of his yearly medical insurance premium. He is eligible to receive an annual increase in his salary as determined by the board of directors. He is eligible to receive an annual bonus of up to 50% of his annual salary if the Bank achieves certain performance levels to be determined from time to time by the board of directors. He is also eligible to participate in any management incentive program of the Bank or any long-term equity incentive program and is eligible for grants of stock options and other awards thereunder. As of March 2017, Mr. Miller has been granted options to purchase a total of 92,885 shares of common stock. These options were granted in 2005, 2007, 2008 and 2013 under our 2005 Incentive Plan, with each grant vesting over a three-year period beginning on the date of grant. All options have a term of 10 years. Additionally, Mr. Miller participates in the Bank’s retirement, welfare, and other benefit programs and is entitled to a life insurance policy and an accident liability policy and reimbursement for automobile expenses, club dues, and travel and business expenses.
Mr. Miller's employment agreement also provides that during his employment and for a period of 12 months following termination, he may not (a) compete with the Company, the Bank, or any of its affiliates by, directly or indirectly, forming, serving as an organizer, director or officer of, or consultant to, or acquiring or maintaining more than 1% passive investment in, a depository financial institution or holding company thereof if such depository institution or holding company has one or more offices or branches within a radius of 30 miles from the main office of the Company or any branch office of the Company, (b) solicit customers of the Bank with which he has had material contact for the purpose of providing financial services, or (c) solicit employees of the Bank for employment. If we terminate the employment agreement for Mr. Miller without cause, he will be entitled to severance in an amount equal to his then current monthly base salary multiplied by 12, excluding any bonus. If, following a change in control of the Company, Mr. Miller terminates his employment for good cause as that term is defined in the employment agreement, he will be entitled to
severance compensation of his then current monthly salary multiplied by 24, plus accrued bonus, all outstanding options and incentives will vest immediately. In addition, Mr. Miller and his covered dependents may continue participation, in accordance with the terms of the applicable benefits plans, in the Employer's group health plan pursuant to plan continuation rules COBRA. If Mr. Miller elects COBRA coverage for group health coverage, then for the first twelve months of COBRA coverage he will only be obligated to pay the portion of the full COBRA cost of the coverage equal to an active employee's share of premiums for coverage for the respective plan year of coverage and the Company's share of such premiums shall be treated as taxable income to the Executive, and thereafter he will be required the full COBRA of the full COBRA cost of the coverage.
Martha L. Long
We entered into a change in control agreement with Martha L. Long on December 19, 2014, for an initial one-year term, which was renewed on December 19, 2015 and annually renewing thereafter unless the Company delivers a notice of termination at least thirty days prior to the beginning of the renewal period. Upon the termination of Ms. Long’s employment by (i) the Executive for Good Reason upon delivery of a Notice of Termination to the Employer, or (ii) the Employer other than for Cause, in each case simultaneously with or within one year after the occurrence of a Change in Control, the Employer shall pay the Ms. Long (or in the event of her death during the term of this Agreement, her estate) in cash within 60 days of the date of termination, severance compensation in an amount equal to her then current monthly base salary multiplied by twelve, plus any bonus earned through the date of termination but unpaid as of the date of termination. In addition, Ms. Long and her covered dependents may continue participation, in accordance with the terms of the applicable benefits plans, in the Employer’s group health plan pursuant to plan continuation rules COBRA. If Ms. Long elects COBRA coverage for group health coverage, then for the first twelve months of COBRA coverage she will only be obligated to pay the portion of the full COBRA cost of the coverage equal to an active employee’s share of premiums for coverage for the respective plan year of coverage and the Company’s share of such premiums shall be treated as taxable income to the Executive, and thereafter she will be required the full COBRA of the full COBRA cost of the coverage.
E. Fred Moore
Neither the Company nor the Bank have entered into an employment agreement with Mr. Moore.
Outstanding Equity Awards at Fiscal Year-End
The following table sets forth information concerning equity awards that were outstanding to our named executive officers at December 31, 2016.
Ten percent of the options granted to each of Ms. Long and Mr. Miller on July 16, 2013 were to immediately vest on the grant date, with the remaining 90% subject to incremental vesting over a 3-year period (30% to vest annually on the first three anniversaries of the grant date) provided, in each case, that the Bank’s previously disclosed consent order with the OCC had been removed. The consent order was removed on June 5, 2014, and since then, all of the options have now vested for both executives.
The options previously granted to Mr. Miller, vested at a rate of 33% each year on the first three anniversaries of the date of grant.
Director Compensation
In 2015, we paid Mr. Willumstad an annual retainer of $130,000 as the chairman of the board. Mr. Willumstad agreed to defer $40,000 for 2015 and $120,000 for the year ended 2016 as a result of the Company suspending further development of its digital
banking, payments and transaction services business. This deferral is included in the payables of the Company. No other directors received any form of compensation.
Potential Payments upon Termination or Change in Control
For information regarding the potential payments that would be due upon Termination or Change in Control, see “Employment Agreements” in this Part III, Item 11 “Executive Compensation” included in this Annual Report on Form 10-K.
Item 12.
Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.
Equity Based Compensation Plan Information
The following table sets forth equity-based compensation plan information at December 31, 2016:
(1)At our annual meeting of shareholders held on May 16, 2006, our shareholders approved the 2005 Incentive Plan. The 260,626 of shares of common stock initially available for issuance under the 2005 Incentive Plan automatically increased to 2,466,720 shares on December 31, 2012, such that the number of shares available for issuance continued to equal 12.5% of our total outstanding shares. In February 2013, the board of directors adopted Amendment No. 2 to the 2005 Incentive Plan to provide that the maximum number of shares that may be issued thereunder shall be 2,466,720 and to eliminate the evergreen provision.
(2)At our annual meeting of shareholders held on May 15, 2013, our shareholders approved the 2013 Incentive Plan. The 2,466,720 shares of common stock initially available for issuance under the 2013 Incentive Plan automatically increased to 2,658,970 shares on August 1, 2013, such that the number of shares available for issuance (plus the 2,466,720 shares reserved for issuance under the 2005 Incentive Plan) continued to equal 20% of our total outstanding shares on an as-diluted basis.
See Item 8. Financial Statements and Supplementary Data, Note 1, Summary of Significant Accounting Policies, and Note 15, Equity-Based Compensation, for a discussion regarding matters related to our equity-based compensation.
Security Ownership of Certain Beneficial Owners and Management
The following tables set forth information known to the Company with respect to beneficial ownership of the Company’s common stock as of March 23, 2017 for (i) each current director of the Company, (ii) each of the Company’s named executive officers, (iii) each holder of 5.0% or greater of the Company’s common stock, and (iv) all of the Company’s directors and executive officers as a group. Unless otherwise indicated, the mailing address for each beneficial owner is care of Independence Bancshares, Inc., 500 East Washington St., Greenville, South Carolina 29601.
(1)Includes shares for which the named person has sole voting and investment power, has shared voting and investment power with a spouse, or holds in an IRA or other retirement plan program, unless otherwise indicated in these footnotes.
(2)Each share of Series A preferred stock is convertible, at the holder’s option, into 1,250 shares of our common stock. The Series A preferred stock is also automatically converted upon the satisfaction of certain conditions.
(3)For each individual, this percentage is determined by assuming the named person converts all shares of Series A preferred stock which he or she beneficially owns and exercises all options and warrants which he or she has the right to acquire within 60 days, but that no other persons convert any shares of Series A preferred stock or exercise any options or warrants. For the directors and executive officers as a group, this percentage is determined by assuming that each director and executive officer converts all shares of Series A preferred stock which he or she beneficially owns and exercises all options and warrants which he or she has the right to acquire within 60 days, but that no other persons convert any shares of Series A preferred stock or exercise any options or warrants. The calculations are based on 20,502,760 shares of common stock outstanding on March 23, 2017.
(4)Based on a Schedule 13D/A filing made on July 14, 2015, consists of 900,000 shares of common stock held by Baird Hageman & Co. Series 1, LLC and 172,250 shares of common stock individually owned by Gordon A. Baird. Mr. Baird and Alvin G. Hageman are the members of the board of managers of Baird Hageman & Co., LLC and therefore share voting and investment power over the shares. The foregoing is not an admission by Mr. Baird that he is the beneficial owner of the shares held by Baird Hageman & Co., LLC. The address of Baird Hageman & Co., LLC is c/o Baird Hageman & Co., LLC, 33 Christie Hill Road, Darien, CT 06820.
(5)Consists of 1,910 shares of Series A preferred stock, which are convertible into 2,387,500 shares of common stock, held by Mendon Capital Master Fund Ltd. and 290 shares of Series A preferred stock, which are convertible into 362,500 shares of common stock, owned by Mendon Capital QP LP. Mr. Echlov is an assistant portfolio manager with RMB Capital Management, LLC, an affiliate of Mendon Capital Master Fund Ltd. and Mendon Capital QP LP. Accordingly, Mr. Echlov may be deemed to be the beneficial owner of shares of Series A preferred stock held by Mendon Capital Master Fund Ltd. and Mendon Capital QP LP.
(6)Based on a Schedule 13D/A filing made on July 14, 2015, consists of 900,000 shares of common stock held by Baird Hageman & Co. Series 1, LLC and 490,250 shares of common stock individually owned by The Hageman 2013 Grantor Trust. Mr. Hageman and Gordon A. Baird are the members of the board of managers of Baird Hageman & Co., LLC and therefore share voting and investment power over the shares. The foregoing is not an admission by Mr. Hageman that he is the beneficial owner of the shares held by Baird Hageman & Co., LLC. The address of Baird Hageman & Co., LLC is c/o Baird Hageman & Co., LLC, 33 Christie Hill Road, Darien, CT 06820.
(7)Consists of 300 shares of Series A preferred stock, which are convertible into 375,000 shares of common stock, held by Ulysses Offshore Fund, Ltd. and 2,150 shares of Series A preferred stock, which are convertible into 2,687,500 shares of common stock, owned by Ulysses Partners, L.P. Mr. Hurwich is a portfolio manager with Ulysses Management LLC, the investment manager of Ulysses Offshore Fund, Ltd. and Ulysses Partners, L.P. Accordingly, Mr. Hurwich may be deemed to be the beneficial owner of shares of Series A preferred stock held by Ulysses Offshore Fund, Ltd. and Ulysses Partners, L.P.
(8)Consists of 125,000 shares of common stock held by First Financial Partners Fund II, LP. Mr. Stock serves as general partner for FFP Affiliates II, LP, which in turn serves as the general partner of First Financial Partners Fund II, LP. Its address is One Stamford Forum, 201 Tresser Blvd., Stamford, CT 06901.
(9)Consists of 100 shares of Series A preferred stock, which are convertible into 125,000 shares of common stock, held by First Financial Partners Fund II, LP. As noted above, Mr. Stock serves as general partner for FFP Affiliates II, LP, which in turn serves as the general partner of First Financial Partners Fund II, LP.
(10)The general partner of Aequitas Capital Opportunities Fund, LP, is Aequitas Capital Opportunities GP, LLC (“ACOF GP”), and its investment advisor is Aequitas Investment Management, LLC (“AIM”). Both ACOF GP and AIM are subsidiaries of Aequitas Capital Management, Inc. (“ACM”). Each of ACOF GP, AIM and ACM may be deemed to be beneficial owners of the 2,450 shares of Series A preferred stock, which are convertible into 3,062,500 shares of common stock, held directly by Aequitas Capital Opportunities Fund, LP. The principal address of each of the above entities is 5300 Meadows Road, Suite 400, Lake Oswego, Oregon 97035.
(11)The general partner of Iron Road Multi-Strategy Fund LP is Iron Road Capital Partners LLC and its investment adviser is RMB Capital Management LLC (“RMB Capital Management”). Iron Road Capital Partners LLC is owned by RMB Capital Management. RMB Capital Management is wholly-owned by RMB Capital Holdings LLC (“RMB Holdings”). Each of the foregoing may be deemed to be beneficial owners of the 250 shares of Series A preferred stock, which are convertible into 312,500 shares of common stock, held directly by Iron Road Multi-Strategy Fund LP. The principal address of each of the above entities is 115 S. LaSalle, 34th Floor, Chicago, IL 60603.
(12)Mendon Capital Master Fund Ltd. is owned by Mendon Capital LLC and Mendon Capital Ltd., and is managed by RMB Mendon Managers LLC and subadvised by RMB Capital Management. RMB Mendon Managers LLC is owned by Mendon Capital Advisers Corp. (“MCA”) and RMB Capital Management. RMB Capital Management is wholly-owned by RMB Capital Holdings LLC. Each of the foregoing may be deemed to be beneficial owners of the 1,910 shares of Series A preferred stock, which are convertible into 2,387,500 shares of common stock, held directly by Mendon Capital Master Fund Ltd. The principal address of each of the above entities is 115 S. LaSalle, 34th Floor, Chicago, IL 60603, except that MCA is located at 150 Allens Creek Road, Rochester, NY 14618.
(13)Mendon Capital QP LP (“MCQP”) is owned by Mendon Capital QP Ltd., and is managed by RMB Mendon Managers LLC and subadvised by RMB Capital Management. RMB Mendon Managers LLC is owned by MCA and RMB Capital Management. RMB Capital Management is wholly-owned by RMB Capital Holdings LLC. Each of the foregoing may be deemed to be beneficial owners of the 290 shares of Series A preferred stock, which are convertible into 362,500 shares of common stock, held directly by MCQP. The principal address of each of the above entities is 115 S. LaSalle, 34th Floor, Chicago, IL 60603, except that MCA is located at 150 Allens Creek Road, Rochester, NY 14618.
(14)Ulysses Management LLC, a Delaware limited liability company (“Ulysses Management”), in its capacity as investment manager, may be deemed to share voting and investment power over the shares beneficially owned by Ulysses Partners, L.P., a Delaware limited partnership (“Ulysses Partners”) and Ulysses Offshore Fund, Ltd., an exempted company incorporated and existing under the laws of the Cayman Islands (“Ulysses Offshore,” and collectively with Ulysses Partners, the “Ulysses Purchasers”). Joshua Nash LLC, a Delaware limited liability company (“Nash LLC”), as the managing general partner of Ulysses Partners, may be deemed to share voting and investment power over the shares beneficially owned by Ulysses Partners; and Joshua Nash, who is a United States citizen (“Mr. Nash”), as an executive of Ulysses Management, the sole member of Nash LLC and the President of Ulysses Offshore, may be deemed to share voting and investment power over the shares beneficially owned by each of Ulysses Management, Ulysses Partners and Ulysses Offshore. The address of each Ulysses Management affiliate is c/o Ulysses Management LLC, One Rockefeller Plaza, New York, New York 10020.
Item 13.
Item 13.  Certain Relationships and Related Transactions, and Director Independence.
Transactions with Related Persons
The Bank has had, and expects to have in the future, loans and other banking transactions in the ordinary course of business with directors (including our independent directors) and executive officers of the Company and its subsidiaries, including members of their families or corporations, partnerships or other organizations in which such officers or directors have a controlling interest. These loans are made on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with unrelated parties. Such loans do not involve more than the normal risks of repayment nor present other unfavorable features.
Loans to individual directors and officers must also comply with our Bank’s lending policies and statutory lending limits, and directors with a personal interest in any loan application are excluded from the consideration of the loan application.
In July 2011, Gordon A. Baird formed MPIB Holdings, LLC (“MPIB”), a Delaware limited liability company, for the purpose of developing the business and regulatory plans for a digital transaction services business. Alvin G. Hageman also invested in MPIB in December 2011. On December 31, 2012, Mr. Baird was appointed Chief Executive Officer and director of the Company and Mr. Hageman became a director of the Company in April 23, 2013. As previously disclosed, on May 14, 2015, the Company entered into a license agreement with MPIB, pursuant to which the Company received a non-exclusive, non-transferable, non-sublicensable, worldwide license to use certain intellectual property of MPIB related to mobile payments and digital transactions. On January 4, 2016, the parties amended and restated the license agreement (the “Amended and Restated License Agreement”) pursuant to which MPIB agreed to make the license perpetual, subject to termination rights of the parties set forth in the Amended and Restated License Agreement, in exchange for the Company’s payment of an additional license fee of $275,000. In addition, as previously disclosed, on April 27, 2015, the Company submitted a proposed asset purchase agreement between the Company and MPIB to the Federal Reserve Bank of Richmond. The Company subsequently withdrew this application to the agency and no longer intends to enter into the asset purchase agreement or consummate the transaction contemplated therein.
Director Independence
We apply the definition of independent director as defined by NASDAQ Rule 5605(a)(2). In accordance with this guidance, Messrs. Hipp, Stock and Willumstad are considered independent.
Item 14.
Item 14.  Principal Accounting Fees and Services.
Elliott Davis Decosimo, LLC was our auditor during the fiscal year ended December 31, 2016. A representative of Elliott Davis Decosimo, LLC will be present at the 2017 annual shareholders’ meeting and will be available to respond to appropriate questions and will have the opportunity to make a statement if he or she desires to do so. The following table shows the fees that we paid for services performed in fiscal years ended December 31, 2016 and 2015.
Audit Fees
This category includes the aggregate fees billed for professional services rendered by the independent auditors during the Company’s 2016 and 2015 fiscal years for the audit of the Company’s consolidated annual financial statements and quarterly reports on Form 10-Q.
Audit-Related Fees
This category includes the aggregate fees billed for non-audit services, exclusive of the fees disclosed relating to audit fees, during the fiscal years ended December 31, 2016 and 2015. These services principally include the assistance for various filings with the SEC and consultations regarding accounting and disclosure matters.
Tax Fees
This category includes the aggregate fees billed for tax services rendered in the preparation of federal and state income tax returns for the Company and its subsidiaries and consultations regarding tax and disclosure matters.
Oversight of Accountants; Pre-Approval of Accounting Fees
Under the provisions of its charter, the audit committee is responsible for the retention, compensation, and oversight of the work of the independent auditors. The charter provides that the audit committee must pre-approve the fees paid for the audit. The audit committee may delegate approval of non-audit services and fees to one or more designated audit committee members. The designated committee member is required to report such pre-approval decisions to the full audit committee at the next scheduled meeting. The policy specifically prohibits certain non-audit services that are prohibited by securities laws from being provided by an independent auditor. All of the accounting services and fees reflected in the table above were reviewed and approved by the audit committee, and none of the services were performed by individuals who were not employees of the independent auditor.
Item 15.
Item 15.  Exhibits, Financial Statement Schedules.
(a)(1)Financial Statements
The following consolidated financial statements are included in Item 8 of this report:
•Report of Independent Registered Public Accounting Firm
•Consolidated Balance Sheets as of December 31, 2016 and 2015
•Consolidated Statements of Operations and Comprehensive Income (Loss) for the Years Ended December 31, 2016 and 2015
•Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2016 and 2015
•Consolidated Statements of Cash Flows for the Years Ended December 31, 2016 and 2015
•Notes to Consolidated Financial Statements
(2)Financial Statement Schedules
These schedules have been omitted because they are not required, are not applicable or have been included in our consolidated financial statements.
(3)Exhibits
See the “Exhibit Index” immediate following the signature page to this report, which is incorporated by reference herein.
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.
INDEPENDENCE BANCSHARES, INC.
Dated: March 23, 2017 By: /s/ Lawrence R. Miller
Lawrence R. Miller
Interim Chief Executive Officer
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Lawrence R. Miller, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
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 in the capacities and on the dates indicated.
Signature
Title
Date
/s/Lawrence R. Miller
Interim Chief Executive Officer
(Principal Executive Officer) Director
March 23, 2017
Lawrence R. Miller
/s/Martha L. Long
Chief Financial Officer
(Principal Financial and Accounting Officer)
Martha L. Long
/s/H. Neel Hipp, Jr.
Director
H. Neel Hipp, Jr.
/s/Robert Willumstad
Chairman
Robert Willumstad
/s/Russell Echlov
Director
Russell Echlov
/s/Adam G. Hurwich
Director
Adam G. Hurwich
/s/Keith Stock
Director
Keith Stock
EXHIBIT INDEX
3.1 Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form SB-2, File No. 333-121485).
3.2 Articles of Amendment to the Articles of Incorporation (incorporated by reference to Appendix A of the Company’s Proxy Statement on Schedule 14A filed on May 2, 2011).
3.3 Articles of Amendment to the Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed on July 22, 2013).
3.4 Articles of Amendment to the Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed on May 15, 2015).
3.5 Amended and Restated Bylaws as of March 5, 2012 (incorporated by reference to Exhibit 3.2 of the Company’s Form 10-K for the fiscal year ended December 31, 2011).
4.1 See Exhibits 3.1 - 3.4 for provisions in Independence Bancshares, Inc.’s Articles of Incorporation and Bylaws defining the rights of holders of the common stock.
4.2 Form of certificate of common stock (incorporated by reference to Exhibit 4.2 of the Company’s Form SB-2, File No. 333-121485).
4.3 Certificate of Designations of Preferred Stock, Series of the Company (incorporated by reference to Exhibit 4.1 of the Company’s Form 8-K filed on May 15, 2015).
10.1 Amended and Restated Employment Agreement between Independence Bancshares, Inc. and Lawrence R. Miller dated December 10, 2008 (incorporated by reference to Exhibit 10.11 of the Company’s Form 10-K for the fiscal year ended December 31, 2008).*
10.2 Independence Bancshares, Inc. 2005 Stock Incentive Plan and Form of Option Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Form 10-QSB for the period ended June 30, 2005). *
10.3 Amendment No. 1 to the Independence Bancshares, Inc. 2005 Stock Incentive Plan (incorporated by reference to the Company’s Form 10-Q for the period ended September 30, 2008).*
10.4 Amendment to the Amended and Restated Employment Agreement by and among Independence Bancshares, Inc. and Lawrence R. Miller. (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed on January 7, 2013).*
10.5 Amendment No. 2 to the Independence Bancshares, Inc. 2005 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on March 5, 2013).*
10.6 Independence Bancshares, Inc. 2013 Equity Incentive Plan (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on March 5, 2013).*
10.7 Form of Restricted Stock Award Agreement (incorporated by reference to Exhibit 10.3 of the Company’s Form 8-K filed on March 5, 2013).*
10.8 Form of Stock Option Award Agreement (incorporated by reference to Exhibit 10.4 of the Company’s Form 8-K filed on March 5, 2013).*
10.9
Change in Control Agreement by and between Independence Bancshares, Inc. and Martha L. Long dated December 19, 2014 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on December 29, 2014). *
10.10 Form of Subscription Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on May 15, 2015).
10.11 Form of Registration Rights Agreement (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on May 15, 2015).
10.12 License Agreement between the Company and MPIB Holdings, LLC (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on May 15, 2015).
10.13 Form of Asset Purchase Agreement between the Company and MPIB Holdings, LLC (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on May 15, 2015).
10.14 Amended and Restated License Agreement between the Company and MPIB Holdings, LLC (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on January 5, 2016).
10.15 Severance and Release Agreement between the Company and Gordon A. Baird (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed on January 5, 2016). *
10.16 Second Amendment to the Amended and Restated Employment Agreement between Independence Bancshares, Inc., Independence National Bank, and Lawrence R. Miller, dated December 15, 2016 (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed on December 17, 2016).*
21.1 Subsidiaries of the Company.
23.1 Consent of Elliott Davis Decosimo, LLC.
24.1 Power of Attorney (filed as part of the signature page herewith).
31.1 Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2 Rule 13a-14(a) Certification of the Principal Financial Officer.
Section 1350 Certifications of the Principal Executive Officer and Principal Financial Officer.
The following materials from the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, formatted in eXtensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at December 31, 2016 and December 31, 2015, (ii) Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2016 and 2015, (iii) Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2016 and 2015, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2016 and 2015, and (iv) Notes to Consolidated Financial Statements.
* Management contract of compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K.