Item 1
Business
Item 1A
Item 1A
Risk Factors
Item 1B
Item 1B
Unresolved Staff Comments
Item 2
Item 2. Properties
We conduct our business at 27 retail banking center locations. We own 25 and lease 2 of our banking center locations. The two leased locations are leased through March 2015 and August 2016. We believe that all of our properties and equipment are well maintained, in good operating condition and adequate for all of our present and anticipated needs.
Set forth below is information relating to each of our offices as of December 31, 2013. The total net book value of our premises and equipment (including land and land improvements, buildings, furniture and equipment, and buildings and leasehold improvements) at December 31, 2013, was $46.0 million.
Principal Business Office:
37 South River Street, Aurora, Illinois
Banking Office Locations:
Cook County
195 West Joe Orr Road, Chicago Heights, Illinois
DeKalb County
1810 DeKalb Avenue, Sycamore, Illinois
1100 South County Line Road, Maple Park, Illinois
DuPage County
4080 Fox Valley Center Drive, Aurora, Illinois
3101 Ogden Road, Lisle, Illinois
Kane County
1991 West Wilson Street, Batavia, Illinois
555 Redwood Drive, Aurora, Illinois
200 West John Street, North Aurora, Illinois
1350 North Farnsworth Avenue, Aurora, Illinois
Cross Street and State Route 47, Sugar Grove, Illinois
801 South Kirk Road, Saint Charles, Illinois
1230 North Orchard Road, Aurora, Illinois
1078 East Wilson Street, Batavia, Illinois
1000 South Mclean Boulevard, Elgin, Illinois (1)
3290 U.S. Highway 20 and Nesler Road, Elgin, Illinois
749 North Main Street, Elburn, Illinois
40W422 IL Route 64, Wasco, Illinois
194 South Main Street, Burlington, Illinois
2S101 Harter Road, Kaneville, Illinois (1)
Kendall County
1200 Douglas Road, Oswego, Illinois
26 West Countryside Parkway, Yorkville, Illinois
7050 Burroughs Avenue, Plano, Illinois
La Salle County
323 East Norris Drive, Ottawa, Illinois
Will County
850 Essington Road, Joliet, Illinois
20201 South Lagrange Road, Frankfort, Illinois
951 East Lincoln Highway, New Lennox, Illinois
(1) Leased facility
Item 3.
Item 3. Legal Proceedings
The Company and its subsidiaries have, from time to time, collection suits and other actions that arise in the ordinary course of business against its borrowers and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities
Market for the Company’s Common Stock
The Company’s common stock trades on The Nasdaq Global Select Market under the symbol “OSBC”. As of December 31, 2013, the Company had 1,011 stockholders of record of its common stock. The following table sets forth the range of prices during each quarter for 2013 and 2012.
The Company incorporates by reference the information contained Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption “Capital”.
The Company also incorporates by reference the information contained under the “Notes to Consolidated Financial Statements Note 15: Regulatory & Capital Matters”.
The Company did not pay any dividends in 2012 or 2013 as set forth in the table above. The Company’s shareholders are entitled to receive dividends when, as and if declared by the board of directors out of funds legally available therefore. The Company’s ability to pay dividends to shareholders is largely dependent upon the dividends it receives from the Bank, certain regulatory restrictions and the terms of its debt and equity securities, and the Bank is subject to regulatory limitations on the amount of cash dividends it may pay.
As of December 31, 2013, we had $58.4 million of junior subordinated debentures held by two statutory business trusts that we control. We have the right to defer interest payments on the junior subordinated debentures, which were approximately $5.3 million in the year ended December 31, 2013, for a period of up to 20 consecutive quarters, and we elected to begin such a deferral period in August 2010. All deferred interest must be paid before we may pay dividends on our capital stock. Therefore, we will not be able to pay dividends on our common stock until all deferred interest on these debentures has been paid in full. The total amount of such deferred interest as of December 31, 2013, was $17.0 million.
Furthermore, as with the debentures discussed above, the Company is prohibited from paying dividends on its common stock unless it has fully paid all accrued dividends on its Series B Preferred Stock. In August 2010, the Company also announced the payment deferral of dividends on such preferred stock and must also fully pay all accrued and unpaid dividends on the Series B Preferred Stock before it may reinstate the payment of dividends on the common stock.
Finally, the Written Agreement between the Company and the Reserve Bank prohibited the Company from paying dividends without prior regulatory approval. Although the Written Agreement was terminated, the Company expects that it will continue to seek approval from the Reserve Bank prior to paying any dividends on its common stock.
Form 10-K and Other Information
Transfer Agent/Stockholder Services
Inquiries related to stockholders records, stock transfers, changes of ownership, change of address and dividend payments should be sent to the transfer agent at the following address:
Old Second Bancorp, Inc.
c/o Shirley Cantrell,
Executive Administrative Department
37 River Street
Aurora, Illinois 60506-4172
(630) 906-2303
scantrell@oldsecond.com
Stockholder Return Performance Graph. The following graph indicates, for the period commencing December 31, 2008 and ending December 31, 2013, a comparison of cumulative total returns for the Company, the Nasdaq Bank Index and the S&P 500. The information assumes that $100 was invested at the closing price at December 31, 2008 in the common stock of the Company and each index and that all dividends were reinvested.
Purchases of Equity Securities By the Issuer and Affiliated Purchasers
There were purchases of 88,877 shares made by or on behalf of the Company of shares of its common stock during the year ended December 31, 2013, primarily for the payment of taxes relating to the vesting of stock awards. During 2013 there were 178,943 shares recaptured on shares previously awarded to certain officers after the Treasury’s auction of the Old Second Bancorp Series B Preferred Stock.
The following table shows certain information relating to purchases or recapture of common stock for the twelve months ended December 31, 2013:
Item 6.
Item 6. Selected Financial Data
Old Second Bancorp, Inc. and Subsidiaries
Financial Highlights
(In thousands, except share data)
The following represents unaudited quarterly financial information for the periods indicated:
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion provides additional information regarding the Company’s operations for the twelve-month periods ending December 31, 2013, and 2012 and financial condition at December 31, 2013, and 2012. This discussion should be read in conjunction with “Selected Financial Data” and the Company’s consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
The Company provides a wide range of financial services through its 27 branch locations located in Kane, Kendall, DeKalb, DuPage, LaSalle, Will and southwestern Cook counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. The Company focuses its business upon establishing and maintaining relationships with its clients while maintaining a commitment to providing for the financial services needs of the communities in which it operates through its retail branch network. The Company emphasizes relationships with individual customers as well as small to medium-sized businesses throughout our market area. The Company’s market area includes a mix of commercial and industrial, real estate, and consumer related lending opportunities, and provides a stable core deposit base. The Company also has extensive wealth management services, which now include a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts, including employee benefit plan administration services.
The health of the overall real estate market has improved in the Company’s market area. While the precipitous decline in the value of certain real estate assets slowed in the latter part of 2010, continued market sluggishness resulted in smaller declines in the values of real estate and associated asset types during the reporting period that ended December 31, 2013. The availability of ready local markets for real estate, while improved in 2013, remained limited and continued to affect the ability of many borrowers to pay on their obligations. The Company’s net income for 2013 as measured under generally accepted accounting principles (“GAAP”) was $82.1 million, largely from tax related benefits. The Company recorded a net loss of $72,000 for the year of 2012 as measured under GAAP.
The Company recorded income tax expense totaling $41.9 million in 2010 as it established a valuation reserve on substantially all of its deferred tax assets. In 2011 and 2012, management determined that the realization of the deferred tax assets was not more likely than not and maintained a valuation allowance on substantially all of its net deferred tax assets. The Company, in making this tax valuation estimate considered forecasts of future income, available tax planning strategies, and assessments of the current and future economic and business conditions. In 2013, the Company’s management reevaluated these conditions and whether there was support for a change in the valuation allowance against its deferred tax
assets. The 2013 evaluation concluded in the third quarter and management determined that, after comprehensive review of both positive and negative considerations, it was now more likely than not that the deferred tax assets could be realized. A significant portion of the valuation allowance against deferred tax assets consequently was reversed. A discussion related to the realizability of tax benefits and related items is included in our results of operations that follows as well as in Notes 1 and 11 of the consolidated financial statements included in this annual report.
The Company sold certain collateralized debt obligations (“CDOs”) in the fourth quarter of 2013 at a pre-tax loss of $4.1 million. The CDOs were originally purchased by the Bank in late 2007 and mid-2008. Credit ratings on these securities, which were issued by prominent rating agencies were upgraded between December 31, 2012, and September 30, 2013. The Company sold these securities following the December 2013 announcements of the implementation of Section 619 of the Dodd - Frank Wall Street Reform and Consumer Protection Act, commonly referred to as the Volcker Rule. As originally released, the Volcker Rule required banking entities to divest investments in these types of CDOs by July 2015. As a result of the regulatory uncertainty and the possibility that the Company would not be allowed to hold the CDOs to maturity, the Company determined that the best course of action was to liquidate the CDOs. These securities were carried at an unrealized loss of $6.1 million as of September 30, 2013, and were sold in December 2013 at a pre-tax loss of $4.1 million, contributing $1.2 million net of tax to tangible capital in the fourth quarter of 2013.
In 2013, the Bank continued to reposition its balance sheet to reduce asset quality risk and maintain its capital ratios with continued strong liquidity. The Company also continued to take steps to cut operating expenses and increase net earnings. In this environment, the Company significantly reduced problem loans and nonperforming assets. Reduced other real estate owned holdings resulted in lower property valuation and maintenance expenses. As the Company focused on reducing expenses, it was able to maintain its profitable wealth management business and extensive residential real estate business as important sources of the noninterest income.
The Company’s primary deposit products are checking, NOW, money market, savings, and certificate of deposit accounts, and the Company’s primary lending products are commercial mortgages, construction lending, commercial loans, residential mortgages and consumer loans. Major portions of the Company’s loans are secured by various forms of collateral including real estate, business assets, and consumer property although borrower cash flow is the primary source of repayment at the time of loan origination.
For 2013, the Company recorded net income of $82.1 million, or $5.45 per diluted share, which compares with a net loss of $72,000 or $0.36 diluted loss per share in 2012. The basic income per share was $5.45 in 2013 and the basic loss per share was $0.36 in 2012. The Company recorded an $8.6 million release of reserves for loan losses in 2013, compared to $6.3 million provision for reserves in 2012 which was a decrease of $14.9 million. The Company recorded a release of reserve for loan losses of $2.5 million in the fourth quarter of 2013. Net charge-offs were $2.8 million during 2013, including a net recovery of $234,000 in the fourth quarter. Net charge-offs were $19.7 million in 2012 which included $1.7 million in the fourth quarter. The net income available to common stockholders was $76.8 million for the year ended December 31, 2013, with a net loss available to common stockholders of $5.1 million for the year ended December 31, 2012.
Net interest and dividend income decreased $4.1 million, or 6.9%, from $59.3 million for the year ended 2012 to $55.3 million for the year ended 2013. Average earning assets increased $24.8 million, or 1.4%, from $1.74 billion in 2012 to $1.76 billion in 2013, as management continued to focus on asset quality and capital management. Average loans, including loans held-for-sale during the year, decreased $163.7 million, in part, from a continued low level of qualified borrower demand within the Company’s market areas, combined with charge-off activity. Average interest bearing liabilities decreased $1.1 million, or 0.08%, to $1.47 billion in 2012 and 2013, as the need for funding remained low with the stabilization in assets.
Application of critical accounting policies
The Company’s consolidated financial statements are prepared in accordance with GAAP and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
Significant accounting policies are presented in Note 1 of the financial statements included in this annual report. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.
Management firmly believes that the Company’s accounting policies with respect to the allowance for loan losses is an accounting area requiring subjective or complex judgments very important to the Company’s financial position and results of operations. Therefore, the allowance policy is one of the Company’s most critical accounting policies. The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment. The amounts of estimated losses on pools of homogeneous loans are based on historical loss experience, consideration of current economic trends and conditions, as well as estimated collateral valuations, all of which may be susceptible to significant change. As a result of management’s analysis of the adequacy of the allowance for loan losses, loan loss reserve releases were recorded during the year ended December 31, 2013.
The loan portfolio represents the largest asset class on the consolidated balance sheets. The allowance for loan losses is a valuation allowance for loan losses, increased by the provision for loan losses and decreased by both loan loss reserve releases and charge-offs less recoveries. Management estimates the allowance balance required using an assessment of various risk factors including, but not limited to, past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations, estimated collateral values, volume trends in delinquencies, nonaccruals, economic conditions, and other credit market considerations. Allocations of the allowance may be made for specific loans, but the entire allowance is available for losses inherent in the loan portfolio.
A loan is considered impaired when it is probable that not all contractual principal or interest due will be received according to the original terms of the loan agreement. Management defines the measured value of an impaired loan based upon the present value of the future cash flows, discounted at the loan’s original effective interest rate, or the fair value reflecting costs to sell the underlying collateral, if the loan is collateral dependent. Impaired loans at December 31, 2013, and 2012, were $46.6 million and $89.0 million, respectively. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Allowances for Loan Losses section that follows.
The Company recognizes expense for federal and state income taxes currently payable as well as deferred federal and state taxes, estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the consolidated balance sheets, as well as loss carryforwards and tax credit carryforwards. The Company maintained deferred tax assets for deductible temporary differences, the largest of which related to the goodwill amortization/impairment. For income tax return purposes this relates to Section 197 goodwill amortization and goodwill impairment charges. Realization of deferred tax assets is dependent upon generating sufficient taxable income in either the carryforward or carryback periods to cover net operating losses generated by the reversal of temporary differences.
A valuation allowance was provided in the past by way of a charge to income tax expense when it was determined that it was more likely than not that some or all of the deferred tax asset would not be realized. That determination reflected management’s evaluation of both positive and negative evidence, including recent Company profits, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Examples of positive evidence that it was more likely than not that some or all of the deferred tax asset would be realized included the existence, if any, of taxes paid in available carry-back years, positive credit quality trends, improving economic or business conditions and the likelihood that taxable income will be generated in future periods. Examples of negative evidence included a cumulative loss and less than robust tax planning opportunities, as well as improving but still sluggish trends in real estate conditions in our primary market areas. In 2013, management determined that realization of a significant portion of the deferred tax asset was more likely than not, and accordingly, reversed a significant portion of the previously established valuation allowance. At September 30, 2013, management concluded that internal projections and positive evidence were sufficient under GAAP to overcome the offsetting negative evidence. In addition, general uncertainty surrounding future economic and business conditions has diminished so that the likelihood of volatility in future earnings is similarly diminished. Accrual of income taxes payable and the remaining portion of the valuation allowances against deferred tax assets are estimates subject to change based upon the outcome of future events.
Future issuances or sales of common stock or other equity securities could also result in an “ownership change” as defined for U.S. federal income tax purposes. If an ownership change were to occur, the Company could realize a loss of a portion of its U.S. federal and state deferred tax assets, including certain built-in losses that have not been recognized for tax purposes, as a result of the operation of Section 382 of the Internal Revenue Code of 1986, as amended. The amount of the permanent loss would be determined by the annual limitation period and the carryforward period (generally up to 20 years for federal net operating losses) and any resulting loss could have a material adverse effect on the results of operations and financial condition. On September 12, 2012, the Company and the Bank, as rights agent, entered into the Rights Plan which is designed to protect the Company’s deferred tax assets against an unsolicited ownership change.
Income tax returns are also subject to audit by the Internal Revenue Service (the “IRS”) and state taxing authorities. Income tax expense for current and prior periods is subject to adjustment based upon the outcome of such audits. All audit work by the IRS has been completed through and including 2011. The Company believes it has adequately accrued for all probable income taxes payable. The Company is under examination by the State of Illinois for the tax years 2008 and 2009.
Another of the Company’s critical accounting policies relates to the fair value measurement of various nonfinancial and financial instruments including investment securities, valuation of OREO, derivative instruments and the expanded fair value measurement disclosures that are related to Accounting Standards Codification (“ASC”) 820-10 in detail in Notes 1 and 17 to the consolidated financial statements included in this annual report.
Results of operations
Net interest income
Net interest income decreased $4.1 million, from $59.3 million for the year ended December 31, 2012, to $55.3 million for the year ended December 31, 2013. Average earning assets increased $24.8 million, or 1.4%, from $1.74 billion for the year ended December 31, 2012, to $1.76 billion for the year ended December 31, 2013, as a result of growth in investment securities. Management continued to emphasize asset quality in marketable securities purchases as new loan originations continued to be limited despite the increased loan growth late in the year. Management continues to develop loan pipelines that can be expected to generate future loan originations and loan growth. Average loans, including loans held-for-
sale, decreased $163.7 million from December 31, 2012, to December 31, 2013.
At $13.7 million, net interest income for the fourth quarter of 2013 was down from the $14.3 million recorded in the third quarter. Except for loan growth late in the fourth quarter, the trends discussed above for the year generally continued in the fourth quarter. The decline from the third quarter is largely attributable to interest income recognized in the third quarter on loans returning to performing status after a period of nonaccrual that did not reoccur in the fourth quarter as well as reduced loan-related fees. The net interest margin was 3.13% for the fourth quarter of 2013 compared to 3.17% for the fourth quarter of 2012.
At $55.3 million, net interest income for the year ended December 31, 2013, was similarly down from the $59.3 million recorded for the year ended December 31, 2012. The year over year decline is driven by a sizable decrease in average balance for higher yielding loan earning assets over the period only partially offset by a sizable increase in average balance for lower yielding investment securities in the same period.
The Company’s net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction. The Company’s asset and liability committee (“ALCO”) seeks to manage interest rate risk under a variety of rate environments by structuring the Company’s balance sheet and off-balance sheet positions. This process is discussed in more detail in the interest rate risk section.
Asset Quality
Nonperforming loans consist of nonaccrual loans, nonperforming restructured accruing loans and loans 90 days or greater past due but still accruing. The largest decrease in the nonperforming loans since December 31, 2012, was in the real estate-commercial, nonfarm segment as this segment’s upgrades and migration of these loans to OREO was greater than the migration of loans to nonperforming status. Total nonperforming loans were $39.8 million at December 31, 2013, from $82.6 million at December 31, 2012.
Net recoveries of $234,000 for the fourth quarter of 2013 reflect charge-offs of $1.9 million against previously established specific reserves on nonaccrual loans deemed uncollectible offset by recoveries of $2.1 million. Charge-off activity improved for the year ended December 31, 2013, compared to the same period in 2012 and in the fourth quarter compared to the third quarter of 2013, reflecting an improved economy in our target markets and past work done on loan quality improvement.
The following table shows classified loans by segment for the following periods.
Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered Substandard. All three components are down since December 31, 2012. Classified assets include both classified loans and OREO. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the allowance for loan loss reserve. This ratio reflects another measure of overall improvement in loan related asset quality. The decline in both classified loans and OREO as well as improved Bank Tier 1 capital in the fourth quarter again strengthened this ratio.
Other positive trends included continued reduction in nonaccrual loans. The December 31, 2013, nonaccrual total of $38.9 million reflects a trend of reduced nonaccrual loans that has been seen since January 2011. Similarly, total past due loans, including nonaccrual loans, of $28.5 million for year end 2013 is the most recent decreased total for this metric in a trend of reductions seen since November 2011. Both results reflect aggressive portfolio management process and diligent follow up by individual relationship managers on specific credits.
Summarizing numerous encouraging developments, the classified asset ratio showed a positive change from 49.76% at September 30, 2013, to 43.44% at December 31, 2013, after standing at 82.94% at December 31, 2012.
Allowance for Loan Losses
The bank’s allowance for loan losses methodology reasonably estimates loan and lease losses as of the financial statement date(s) and incorporates management’s current judgments about the credit quality of the loan portfolio through a disciplined and consistently applied methodology. The methodology follows GAAP including, but not limited to, guidance included in Accounting Standards Codification (“ASC”) 310 and ASC 450, formally known as FAS 114 and FAS 5, respectively. Analysis is prepared in accordance with guidelines established by the SEC, the Federal Financial Institutions Examination Council, the American Institution of Certified Public Accountants Audit and Accounting Guide for Banks and Savings Institutions, and banking industry practices. Methodology is periodically reviewed by the bank’s independent accountants and banking regulators. No significant methodology changes were made in 2013. Only minor changes in the risk evaluation factors for commercial loans and commercial real estate credits were made in 2013.
The coverage ratio of the allowance for loan losses to nonperforming loans was 68.6% as of December 31, 2013, which reflects an increase from 46.7% as of December 31, 2012. A decrease of $42.8 million, or 51.8%, in nonperforming loans in 2013 drove the overall coverage ratio change. Following established methodology, management updated the estimated specific allocations in the fourth quarter after receiving more recent appraisal valuations or information on cash flow trends related to the impaired credits. General allocations decreased by $7.5 million from December 31, 2012, as the overall loan balances
subject to general factors decreased at December 31, 2013. Management determined the estimated amount to include in the allowance for loan losses based upon a number of factors, including an evaluation of credit market circumstances, loan growth or contraction, the quality and composition of the loan portfolio and loan loss experience. The latter item was also weighted more heavily based upon recent loss experience.
Management reviews the performance of the higher risk loan pool within commercial real estate loans, and adjusts the population and the related loss factors taking into account adverse market trends including collateral valuation as well as its assessments of the credits in that pool. Changes are identified in the Company’s comprehensive loan review process and made in the related risk factors when needed with a formal affirmation at each quarter end. Those assessments capture management’s estimate of the potential for adverse migration to an impaired status as well as its estimation of what the potential valuation impact from that migration would be if it were to occur. The amount of assets subject to this pool factor decreased by $5.4 million, or 24.0%, at December 31, 2013, as compared to December 31, 2012. Also, compared to December 31, 2012, management increased the loss factor assigned to this pool by 4.4% based on risk characteristics of the remaining credits. Management has also observed that many stresses in those credits were generally attributable to cyclical economic events that are showing some signs of stabilization. Those signs included a reduction in loan migration to watch status, as well as some stabilization in values of certain properties.
Management conducts a full annual review of all Home Equity Lines of Credit (“HELOC”) by looking at credit scores and collateral values. When the Company is notified of a foreclosure on a first mortgage, the HELOC loan is moved to nonaccrual and a decision is made if the loan is collectible. Loan balances are actively charged-off in the absence of sufficient equity unless the borrower reaffirms or notifies us of an intention to reaffirm.
The above changes in estimates were made by management to be consistent with observable trends on asset quality within loan portfolio segments (as discussed in the Asset Quality section above) and in conjunction with market conditions and credit review administration activities. Several environmental factors are also evaluated monthly when appropriate with formal affirmation each quarter end and are included in the assessment of the adequacy of the allowance for loan losses. Further and importantly, significant improvement was seen in 2013 net charge-offs and nonperforming loans. Net charge-offs of $19.7 million in 2012 declined by 85.9% to $2.8 million in 2013. Nonperforming loans of $82.6 million at year end 2012 declined 51.8% to $39.8 million at December 31, 2013. Based on this assessment management determined that an overall improvement in loan asset quality justified a $2.5 million loan loss reserve release in the fourth quarter and a total loan loss reserve release of $8.6 million for the year. When measured as a percentage of loans outstanding, the total allowance for loan losses decreased from 3.4% of total loans as of December 31, 2012, to 2.5% of total loans at December 31, 2013. In management’s judgment, an adequate allowance for estimated losses has been established for inherent losses at December 31, 2013; however, there can be no assurance that actual losses will not exceed the estimated amounts in the future.
The allowance for loan losses consists of three components: (i) specific allocations established for losses resulting from an analysis developed through reviews of individual impaired loans for which the recorded investment in the loan exceeds the measured value of the loan; (ii) reserves based on historical loss experience for each loan category; and (iii) reserves based on general current economic conditions as well as specific economic and other factors believed to be relevant to the Company’s loan portfolio. The components of the allowance for loan losses represent an estimation performed pursuant to ASC Topic 450, “Contingencies”, and ASC Topic 310, “Receivables” including “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures”. See Note 1 on Summary of Significant Accounting Policies for further detail.
The analysis of these factors involves a high degree of judgment by management. Because of the imprecision surrounding these factors, the Company estimates a range of inherent losses and maintains a general allowance that is not allocated to a specific category. At December 31, 2013, the general allowance not allocated to a specific category was $2.0 million down from $4.4 million at December 31, 2012. Changes in the allowance for loan losses are detailed in Note 5 on the consolidated financial statements of this report.
Noninterest income
Noninterest income declined in the fourth quarter of 2013 from the third quarter reflecting the $4.1 million loss on the sale of certain CDOs. Operationally, residential mortgage revenue increased in the fourth quarter of 2013 from the third quarter of 2013 along with an improvement in trust income. The Company’s results in other categories except for other noninterest income remain flat or slightly better. Other noninterest income decreased in the fourth quarter from the third quarter due to recognition in the third quarter income of a forfeited purchase deposit from a loan sale where the purchaser did not complete the sale as contractually required.
The Company had a 4.9% increase in trust income year over year while many noninterest income categories remained flat or down year over year. Reflecting residential mortgage market conditions, year over year improvement in mortgage servicing gain net of changes in fair value was offset by sharply reduced fees and gains on sales. Notably, the other noninterest income category increased year over year on items like the first quarter clawback of restricted stock and the third quarter purchase deposit forfeiture discussed above.
Noninterest expense
All categories of noninterest expense were essentially flat to down in the fourth quarter from the third quarter of 2013, except for other expense. A modest amount was reserved in the fourth quarter other expense for expenses related to the debit card security compromise at TargetTM stores. An additional amount was recorded in the quarter for possible expenses related to an ongoing dispute.
All categories were flat to down year over year except salaries and benefits covering board approved bonus programs, amortization of intangibles and other expenses. Other expense for the year includes the fourth quarter items discussed above as well as increased expenses for items related to marketing or public relations, recruitment expense and expense for required property appraisals in 2013. The Company also realized reduced 2013 yearly expenses on a late 2012 general insurance renewal at lower cost and effective management of legal expenses in 2013.
Year over year expense related to OREO properties decreased sharply in 2013 as the Company had fewer OREO properties with related operating expenses and valuation expense adjustments were more moderate. These factors also were significant in a similar decrease in 2013 from 2012 when considering other real estate expense, net as shown on the Consolidated Statement of Operations in Item 8. The most significant factor in the year over year decrease in other real estate expense net of revenue is the full year expense reduction of $8.1 million on valuation expense adjustments or provision for unrealized losses. Similarly, operating expenses on OREO properties were down $2.3 million in 2013 from 2012. However, with fewer properties year over year, lease revenue from OREO is also down $2.2 million. Similarly, while real estate sales markets have shown moderate improvement year over year, property sales generated a reduced level of net gain on sales in 2013 compared to net gains realized on sales in 2012.
As of December 31, 2013, there were certain legal proceedings against the Company and its subsidiaries that arose in the ordinary course of business. The Company does not believe that liabilities, individually or in the aggregate, arising from these proceedings, if any, would have a material adverse effect on the consolidated financial condition of the Company as of December 31, 2013.
Income taxes
The Company recorded a tax benefit of $70.2 million on $11.8 million pre-tax income for the year 2013. The tax benefit was composed of $134,000 in current income tax expense and $3.8 million in deferred income tax expense offset by a $74.1 million reversal of the deferred tax valuation allowance reserve.
The valuation allowance against the Company’s deferred tax assets was first established as of December 31, 2010. Under GAAP, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be fully realized.
On September 12, 2012, the Company and the Bank, as rights agent, entered into the Rights Plan. The Rights Plan amends the Rights Agreement, dated September 17, 2002. The purpose of the Rights Plan is to protect the Company’s deferred tax asset against an unsolicited ownership change, which could significantly limit the Company’s ability to utilize its deferred tax assets. The Rights Plan was ratified by the Company’s stockholders at the Company’s 2013 annual meeting.
The determination of being able to realize the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies, and assessments of the current and future economic and business conditions. Management considered both positive and negative evidence regarding the Company’s ability to ultimately realize the deferred tax assets, which is largely dependent upon the ability to derive benefits based upon future taxable income. As of September 30, 2013, management determined that the realization of most of the deferred tax asset was “more likely than not” as required by accounting principles and reversed a significant portion of an established valuation allowance to reflect this judgment. The remaining valuation allowance is for a portion of the state net operating loss carryforward the Company could possibly use, but does not meet the threshold of “more likely than not” at September 30, 2013 and December 31, 2013.
The Company considered the federal and state net operating loss carryforwards separately when determining if a valuation allowance was required. After considering tax-planning strategies, the Company reserved a portion of the state net operating loss carryfoward management did not anticipate using by December 31, 2016, based on forecasts made at September 30, 2013. While the state net operating loss carryfoward does not begin to expire until 2021, management acknowledges that forecasts are inherently subjective and only periods in the foreseeable future should be considered when determining if net deferred tax assets will be utilized. In each future accounting period, the Company’s management will reevaluate whether the current conditions in conjunction with positive and negative evidence support a change in the valuation allowance against the Company’s deferred tax assets. Any such subsequent reduction in the estimated valuation allowance would lower the amount of income tax expense recognized in the Company’s consolidated statements of operations in future periods.
The positive evidence considered included the following: (1) the current quarter results reflect the Company’s sixth consecutive quarter of pre-tax earnings (2) reduced nonperforming assets for the eleventh consecutive quarter (3) strongly encouraging indications from OCC on the removal of the Consent Order subsequently confirmed with the removal of the Consent Order effective October 17, 2013. Negative evidence considered included the decrease in the Company’s net interest margin and reduced noninterest income, primarily from decreased mortgage banking income. The only tax planning strategy considered was selling the Company’s bank-owned life insurance which would result in immediate taxable income of approximately $11.4 million if it were to be sold effective September 30, 2013. While the Company does not anticipate completing this sale, management would consider the sale in the event a deferred tax asset was close to expiration.
Financial condition
General
Total assets decreased $41.8 million, or 2.0%, from December 31, 2012, to close at $2.00 billion as of December 31, 2013. Loans decreased by $48.8 million, or 4.2%, to $1.10 billion over the course of 2013 as management continued to emphasize balance sheet stabilization and credit quality while demand from qualified borrowers remained limited. At the same time, loan charge-off activity reduced balances and
collateral that previously secured loans moved to OREO. In total, OREO assets decreased $30.9 million, or 42.6%, for the year ended December 31, 2013, compared to December 31, 2012, as sale activity and valuation writedowns exceeded new properties added. Offsetting these reductions, total securities increased by $48.9 million, or 8.4%, for the year ended December 31, 2013, reflecting continued management emphasis on securities investments in the absence of qualified loan demand. Management continued to maintain available-for-sale securities and held-to-maturity securities in the fourth quarter consistent with the Company’s past practice of utilizing available liquid funds supplemented by short term borrowings from the Federal Home Loan Bank of Chicago (the “FHLBC”). For the year ended December 31, 2013, large dollar purchases were made in collateralized mortgage backed securities and asset-backed securities (many backed by student loan assets) totaling $266.6 million, and $302.6 million, respectively. At December 31, 2013, the largest changes by loan type included decreases in commercial real estate, real estate construction, and residential real estate loans of $19.5 million, $12.8 million and $24.3 million, or 3.4%, 30.4%, and 5.9%, respectively.
In response to the pending implementation of the Volker Rule, the Company sold CDOs at a before tax loss of $4.1 million. The CDOs were originally purchased by the Bank in late 2007 and mid-2008. These securities were carried at an unrealized loss of $6.1 million as of September 30, 2013, and were sold in December 2013 at a pre-tax loss of $4.1 million, contributing $1.2 million net of tax to tangible capital in the fourth quarter of 2013.
Investments
As shown below, net investments purchases during 2013 changed the composition of the Company’s securities portfolio as total loans, except for modest improvement from September 30, 2013, to December 31, 2013, continued to decline.
The Company’s total securities show a net decrease of $2.8 million since September 30, 2013, with all categories declining except total (including available-for-sale and held-to-maturity) collateralized mortgage obligations and asset-backed securities, which were up $14.2 million and $4.2 million in the period. Securities held with the intent to hold to maturity were established in the third quarter in response to increases in overall market interest rates. Management decisions on securities to be classified as held-to-maturity were made based on the characteristics of individual securities. At December 31, 2013, the total securities portfolio was $48.9 million higher when compared to December 31, 2012, reflecting both slow to develop loan opportunities and investment decisions made by management under supervision of the Company’s ALCO process.
Of note, in response to the pending implementation of the Volker Rule, the Company sold certain CDOs in December 2013 at a before tax loss of $4.1 million. Because these securities were carried at an unrealized loss of $6.1 million as of September 30, 2013 and sold at a before tax loss of $4.1 million, the sales contributed $1.2 million net of tax to 2013 tangible capital.
Loans
Fourth quarter loan production provided a positive close to 2013 and an increase in loans outstanding from the third quarter. This loan production reflects extensive work done earlier in the year to build business origination pipelines. Significant new business was realized during the quarter in the multi-family, commercial real estate (both owner occupied and nonowner occupied) and commercial & industrial classifications. Management found the multi-family segment to have stabilized, and while not yet as strong as was found in 2012, reflecting an overall segment recovery. Other commercial real estate credits were realized in the fourth quarter on relationships in our targeted customer and geographic markets, in one instance via a participation in a transaction originated by a larger Illinois based financial institution. Similarly, significant new commercial & industrial lending was realized in the quarter to businesses that conform to the Company’s profile of customers we seek. Additionally, we strive to serve customers near our geographical locations in communities served by the Company. The Company continues to seek opportunities in its primary lending markets that will develop additional relationship banking customers; however, markets remain very competitive for new loan business.
Total loans were $1.10 billion as of December 31, 2013, a decrease of $48.8 million, or 4.2%, from $1.15 billion as of December 31, 2012. While the Company worked diligently to rebuild and build loan origination pipelines during 2013, the lack of demand from qualified borrowers, including borrower reluctance to drawdown on existing credit lines through the year, as well as the competitive landscape, hindered growth in the loan portfolio. As discussed in the Asset Quality section above, management continued to emphasize loan portfolio quality in 2013 and, as a result, $2.8 million of net loan charge-offs were recorded in 2013 down from $19.7 million in 2012.
The quality of the loan portfolio is in large part a reflection of the economic health of the communities in which the Company operates. The local economies have been affected by the difficult economic conditions that have been experienced nationwide. The less than vibrant economic conditions continue to affect business regions served in particular and financial markets generally. Real estate related activity, including valuations and transactions, while improved from past severe conditions, continues to be less than expansive. Because the Company is located in a growth corridor with significant open space and undeveloped real estate, real estate lending (including commercial, residential, and construction) has been
and continues to be a sizable portion of the portfolio. During 2013, new negotiating strategies were employed in addressing maturing real estate facilities and both additional collateral and guarantor support were taken. Credit structuring has taken a more proactive approach to harness the benefit of stronger borrower assets to support lowering loan risk profiles and improve loan quality ratings.
Real estate lending categories comprised 89.0% of the portfolio as of December 31, 2013, compared to 90.1% of the portfolio as of December 31, 2012. The commercial loan portfolio increased $7.8 million, or 9.0%, to $94.7 million at December 31, 2013, from $86.9 million at December 31, 2012. The Company remains committed to overseeing and managing its loan portfolio to avoid unnecessarily high credit concentrations in accordance with the general interagency guidance on risk management. Consistent with those commitments, management updated its asset diversification plan and policy and anticipates that the percentage of real estate lending to the overall portfolio will decrease in the future. Consumer loans, overdrafts, and lease financing receivables also increased $3.3 million, or 32.5% in the aggregate, to $13.5 million at December 31, 2013, from $10.2 million at December 31, 2012.
The allowance for loan losses was $27.3 million and $38.6 million at year end 2013 and 2012, respectively. One measure of the adequacy of the allowance for loan losses is the ratio of the allowance to total loans. The allowance for loan losses as a percentage of total loans was 2.5% as of December 31, 2013, compared to 3.4% as of December 31, 2012. In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that losses will not exceed the estimated amounts in the future.
Management remains cautious about the current tepid recovery in the overall economic environment. Furthermore, the sustained difficulties in the real estate market, while showing signs of improvement, could continue to adversely affect collateral values. These events may adversely affect cash flows generally for both commercial and individual borrowers, and, as a result, the Company could continue to experience reduced but undesirable levels of problem assets, delinquencies, and losses on loans in future periods.
Other Real Estate Owned
OREO decreased $7.5 million from $49.1 million at September 30, 2013, to $41.5 million at December 31, 2013. OREO activity (property additions, disposals) as well as period valuation adjustments recorded in the fourth quarter of 2013 is specified below. Overall, a net gain on sale of $781,000 was realized in the fourth quarter up from $608,000 in the third quarter. A similar reduction in overall holdings at December 31, 2013, from December 31, 2012, is also shown below. The year over year data show continued valuation adjustments but at a lower level in 2013 compared to 2012. Also, 2013 property disposals outweighed 2013 property additions to OREO by over $22.5 million.
The OREO valuation reserve ended 2013 at $22.3 million, which was 34.9% of gross OREO at December 31, 2013. The valuation reserve represented 33.4% and 30.3% of gross OREO at September 30, 2013, and December 31, 2012, respectively. In management’s judgment, an adequate property
valuation allowance has been established to present OREO at current estimates of fair value less costs to sell; however, there can be no assurance that additional losses will not be incurred on dispositions or updates to valuation in the future.
OREO Properties by Type
As shown above, OREO holdings decreased year over year across all property types.
Deposits & Borrowings
The Company saw a modest $35.1 million decline in total deposits during 2013 from $1.72 billion at December 31, 2012. Overall total deposits were essentially flat during the fourth quarter. In both periods slowly developing loan activity and availability of other liquidity sources reduced the need for deposit funding. Market interest rates decreased generally and the average cost of interest bearing deposits decreased from 0.73% in the year ended December 31, 2012, to 0.57%, or 16 basis points, in the same period of 2013. Similarly, the average total cost of interest bearing liabilities decreased 13 basis points from 1.07% in the year ended December 31, 2012, to 0.94% in the same period of 2013.
The Company’s most significant borrowing relationship continued to be the $45.5 million credit facility with Bank of America. The credit facility was originally composed of a $30.5 million senior debt facility, which included $500,000 in term debt, and $45.0 million of subordinated debt. The Company has remaining debt of $500,000 in principal outstanding in term debt, and $45.0 million in principal outstanding in subordinated debt under that facility at the end of December 31, 2013, and December 31, 2012. The term debt is secured by all of the outstanding capital stock of the Bank. The subordinated debt and term debt portion of the senior debt facility mature on March 31, 2018. At December 31, 2013, the Company was out of compliance with one of the financial covenants contained within the credit agreement. The Company has made all required interest payments on the outstanding principal amounts on a timely basis. Pursuant to the Written Agreement, the Company was required to receive the Reserve Bank’s approval prior to making any interest payment on the subordinated debt. In January 2014, the Reserve Bank notified the Company that the Written Agreement was terminated.
Prior to 2013, the Company had been out of compliance with two of the financial covenants of the Bank of America credit facility. The agreement provides that noncompliance is an event of default and as the result of the Company’s failure to comply with a financial covenant, the lender may (i) terminate all commitments to extend further credit, (ii) increase the interest rate on the revolving line of the term debt by 200 basis points, (iii) declare the senior debt immediately due and payable and (iv) exercise all of its rights and remedies at law, in equity and/or pursuant to any or all collateral documents, including foreclosing on the collateral. Because the subordinated debt is treated as Tier 2 capital for regulatory capital purposes, the senior debt agreement does not provide the lender with any rights of acceleration or other remedies with regard to the subordinated debt upon an event of default caused by the Company’s failure to comply with a financial covenant.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC and total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of December 31, 2013, the Bank took an advance of $5.0 million at 0.13% interest on the FHLBC stock valued at $5.5 million. This advance matured on January 3, 2014 and was replaced with short term FHLBC advances that matured in January 2014.
Capital
As of December 31, 2013, total stockholders’ equity was $147.7 million, which was an increase of $75.1 million, or 103.6%, from $72.6 million as of December 31, 2012. This increase was driven primarily by the reversal of the valuation allowance on a significant portion of the Company’s net deferred tax assets, made possible by recent profits and an evaluation of all available evidence, both for and against reversing the valuation allowance. Unrealized loss on securities available-for-sale net of deferred taxes was $1.3 million at December 31, 2012, and $7.0 million (including unamortized losses and gains not accreted on securities transferred from available-for-sale to held-to-maturity in the year) at December 31, 2013, causing a reduction in stockholders’ equity of $5.7 million. Additionally, total stockholders’ equity benefited by the Company not declaring and accruing a dividend in 2013 on its Series B Stock.
In January 2009, the Company issued and sold (i) 73,000 shares of Series B Preferred Stock and (ii) a warrant to purchase 815,339 shares of its common stock at an exercise price of $13.43 per share to the Treasury through the CPP. The total liquidation value of the Series B Stock and the warrant is $73.0 million.
All of the Series B Stock held by Treasury was sold to third parties, including certain of the Company’s directors, in public auctions that were completed in the first quarter of 2013. The warrant was also sold at a subsequent auction to a third party. At December 31, 2012, the Company carried $71.9 million of Series B Stock in total stockholders’ equity. At December 31, 2013, the Company carried $72.9 million of Series B Stock in total stockholders’ equity.
At December 31, 2013, the Bank’s Tier 1 capital leverage ratio was 10.97%, up 130 basis points from December 31, 2012. The Bank’s total capital ratio was 18.04%, up 318 basis points from December 31, 2012. The Company’s regulatory capital ratios of total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets increased to 15.88%, 10.65% and 6.96%, respectively, compared to 13.62%, 6.81% and 4.85%, respectively, at December 31, 2012. The Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” at December 31, 2013.
As discussed in the section entitled “Supervision and Regulation,” on May 16, 2011 the Bank entered into the Consent Order with the OCC that was terminated on October 17, 2013. In addition, in July 2011 the Company entered into the Written Agreement with the Reserve Bank designed to maintain the financial soundness of the Company. In January 2014, the Reserve Bank terminated the Written Agreement. Although the Written Agreement was terminated, the Company expects that it will continue to seek approval from the Reserve Bank prior to paying any dividends on its common stock and incurring any additional indebtedness.
As discussed in greater detail in the section entitled “Supervision and Regulation,” in July 2013, the U.S. federal banking authorities approved the implementation of the Basel III Rules. The Basel III Rules are applicable to all U.S. banks that are subject to minimum capital requirements as well as to bank and savings and loan holding companies. The Basel III Rules not only increase selected minimum regulatory capital ratios, but also introduce a new Common Equity Tier 1 capital ratio and the concept of a capital conservation buffer. The Basel III Rules also revise the criteria that certain instruments must meet to qualify as Tier 1 or Tier 2 capital. A number of instruments that now qualify as Tier 1 capital will not qualify under the Basel III rules. The Basel III Rules also permit smaller banking organizations to retain,
through a one-time election, the existing treatment of accumulated other comprehensive income. The Basel III Rules have maintained the general structure of the current prompt corrective action framework while incorporating the increased requirements. The Basel III Rules also revise prompt corrective action guidelines to add the Common Equity Tier 1 capital ratio. Generally, the new Basel III Rules become effective on January 1, 2015, although parts of the Basel III Rules will be phased in through 2019. Management is reviewing the new rules to assess their impact on the Company.
At December 31, 2013, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “adequately capitalized” under current regulatory defined capital ratios. The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Generally, if adequately capitalized, regulatory approval is not required to accept brokered deposits. In addition to the above regulatory ratios, the Company’s non-GAAP tangible common equity to tangible assets increased to 3.67% at December 31, 2013, compared to (0.13)% at December 31, 2012, largely attributable to increased capital resulting from the reversal of the valuation allowance on a significant portion of net deferred tax assets, made possible by recent profits and an evaluation of all available positive and negative evidence. The Tier 1 common equity to risk weighted assets increased to 0.77% at December 31, 2013, compared to (0.12)% at December 31, 2012.
The Company completed the sale of $32.6 million of cumulative trust preferred securities by its subsidiary, Old Second Capital Trust I in July 2003. These trust preferred securities remain outstanding for a 30-year term, but subject to regulatory approval, they can be called in whole or in part at the Company’s discretion after an initial five-year period, which has since passed. The Company does not currently intend on seeking regulatory approval to call these securities. Dividends are payable quarterly at an annual rate of 7.80% and are included in interest expense in the consolidated financial statements even when deferred. Likewise, the Company issued an additional $25.0 million of cumulative trust preferred securities through a private placement completed by a second unconsolidated subsidiary, Old Second Capital Trust II in April 2007. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part in 2017. When not in deferral the quarterly cash distributions on the securities are fixed at 6.766% through June 15, 2017 and float at 150 basis points over the three-month LIBOR rate thereafter. As of December 31, 2013, trust preferred proceeds of $51.6 million qualified as Tier 1 regulatory capital and $5.0 million qualified as Tier 2 regulatory capital. As of December 31, 2012, trust preferred proceeds of $24.6 million qualified as Tier 1 regulatory capital and $32.0 million qualified as Tier 2 regulatory capital. Additionally, the $45.0 million in subordinated debt that was obtained to finance the February 2008 acquisition qualified as Tier 2 regulatory capital as of December 31, 2013, and December 31, 2012.
As announced and implemented in the third quarter of 2010, the Company elected to defer regularly scheduled interest payments on $58.4 million of junior subordinated debentures related to the trust preferred securities issued by its two statutory trust subsidiaries, Old Second Capital Trust I and Old Second Capital Trust II (collectively the “Trust Preferred Securities”). Because of the deferral on the subordinated debentures, the trusts will defer regularly scheduled dividends on their Trust Preferred Securities. The total accumulated interest on the Trust Preferred Securities including compounded interest from July 1, 2010, on the deferred payments totaled $17.0 million at December 31, 2013. Under the terms of the junior subordinated debentures, the Company is allowed to defer payments of interest for 20 quarterly periods on the Trust Preferred Securities without default or penalty, but such amounts will continue to accrue. Also during the deferral period, the Company generally may not pay cash dividends on or repurchase its common stock or preferred stock, including the Series B Preferred Stock.
Under the terms of the Series B Preferred Stock, the Company is required to pay dividends on a quarterly basis at a rate of 5% per year for the first five years, after which the dividend rate automatically increases to 9%. Dividend payments on the Series B Preferred Stock may be deferred without default, but the dividend is cumulative, and, if the Company fails to pay dividends for an aggregate of six quarters, whether or not consecutive, the holder will have the right to appoint representatives to the Company’s
board of directors. A new director, Mr. Duane Suits, was appointed by the Treasury to join the board during the fourth quarter of 2012. Following Treasury’s sale of the Series B Preferred Stock at auction in the first quarter of 2013, this ability to appoint a director transferred to the new holders of the Series B Preferred Stock, who re-elected Mr. Suits at the Company’s 2013 annual meeting. The dividend payments on the Series B Preferred Stock have been deferred since November 15, 2010, and while in deferral these dividends are compounded quarterly. The accumulated unpaid Series B Preferred Stock dividends totaled $13.3 million at December 31, 2013. At December 31, 2012, the Company carried $71.9 million of Series B Stock in total stockholders’ equity. At December 31, 2013, the Company carried $72.9 million of Series B Stock in total stockholders’ equity.
As a result of the completed auctions, the Company’s Board elected to stop accruing the dividend on the Series B Stock in first quarter of 2013. Previously, the Company had accrued the dividend on the Series B Stock quarterly throughout the deferral period. Given the discount reflected in the results of the auction, the Board believed that the Company would likely be able to repurchase the Series B Stock in the future at a price less than the face amount of the Series B Stock plus accrued and unpaid dividends. Therefore, under GAAP, the Company did not fully accrue the dividend on the Series B Stock in the first quarter of 2013 and did not accrue for it in subsequent quarters. The Company will evaluate whether accruing dividends on the Series B Stock is appropriate in future periods. Pursuant to the terms of the Series B Stock, the dividends paid on the Series B Stock will increase from 5% to 9% in February 2014.
The Company purchased or recaptured 267,820 shares of common stock in 2013, resulting in an increase in treasury stock to 4,912,626 shares as of December 31, 2013. The purchase or recapture of these shares increased treasury stock by $847,000 or 0.9% to $95.8 million at December 31, 2013. The Company had repurchased 51,939 shares in 2012, resulting in an increase in treasury stock to 4,644,806 shares as of December 31, 2012. The repurchase of these shares increased treasury stock by $63,000, or 0.07%, to $95.0 million at December 31, 2012. Treasury stock repurchased decreases stockholders’ equity, but also increases earnings per share by reducing the number of shares outstanding. No options were exercised in the years ended December 31, 2013, and 2012. Return on average equity was 90.09% and (0.10)% in 2013 and 2012, respectively.
Bank regulatory agencies have adopted capital standards by which all banks and bank holding companies are evaluated. Those agencies define the basis for these calculations including the prescribed methodology for the calculation of the amount of risk-weighted assets. The risk based capital guidelines were designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks. In addition to the regulatory capital ratios disclosed above, information regarding capital levels and minimum required levels can be found in Note 15 of the consolidated financial statements.
Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance sheet arrangements
The Company has various financial obligations that may require future cash payments. The following table presents, as of December 31, 2013, significant fixed and determinable contractual obligations (all dollars in thousands) to third parties by payment date:
Purchase obligations represent obligations under agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The purchase obligation amounts presented above primarily relate to certain contractual payments for services provided for information technology, capital expenditures, and the outsourcing of certain operational activities. The Company routinely enters into contracts for services. These contracts may require payment for services to be provided in the future and may also contain penalty clauses for early termination. In this disclosure, the Company has have made an effort to estimate such payments, where applicable. Additionally, where necessary, all data reflects reasonable estimates as to certain purchase obligations as of December 31, 2013. Management has used the information available to make the estimations necessary to value the related purchase obligations.
Derivative contracts, which include contracts under which the Company either receives cash from, or pays cash to, counterparties reflecting changes in interest rates are carried at fair value on the consolidated balance sheet as disclosed in Note 18 of the Notes to the Consolidated Financial Statements provided in Part II, Item 8, “Financial Statements and Supplementary Data”. Because the fair value of derivative contracts changes daily as market interest rates change, the derivative assets and liabilities recorded on the balance sheet at December 31, 2013, do not necessarily represent the amounts that may ultimately be paid. As a result, these assets and liabilities are not included in the table of contractual obligations presented above.
Assets under management are held in the investment advisory company. In addition, assets under management and assets under custody are held in fiduciary or custodial capacity for clients. In accordance with GAAP, these assets are not included on the Company’s balance sheet.
Financial instruments with off-balance sheet risk address the financing needs of our clients. These instruments include commitments to extend credit as well as performance, standby and commercial letters of credit. Further discussion of these commitments is included in Note 14 of the Notes to Consolidated Financial Statements provided in Part II, Item 8, “Financial Statements and Supplementary Data.”
The following table details the amounts and expected maturities of significant commitments to extend credit as of December 31, 2013:
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Liquidity and market risk
Liquidity is the Company’s ability to fund operations, to meet depositor withdrawals, to provide for customer’s credit needs, and to meet maturing obligations and existing commitments. The liquidity of the Company principally depends on cash flows from net operating activities, including pledging requirements, investment in, and both maturity and repayment of assets, changes in balances of deposits and borrowings, and its ability to borrow funds. The Company continually monitors its cash position and borrowing capacity as well as performs monthly stress tests of contingency funding as part of its liquidity management process. In the first quarter of 2011, management expanded the methodology for stress testing of liquidity for contingency funding purposes to include tests that outline scenarios for specifically identified liquidity risk events, which are then aggregated into a Bank-wide assessment of liquidity risk stress levels. The outcomes of these tests are reviewed by management and the Company’s Board of Directors monthly.
Net cash inflows from operating activities were $35.3 million during 2013, compared with $43.3 million in 2012. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale, was a source of inflow for 2013 and 2012. Interest received, net of interest paid, combined with changes in provision for loan losses, and other assets and liabilities were a source of inflow for 2013 and 2012. The Company did not record an income tax benefit for the year ended December 31, 2012, despite a $72,000 pre-tax loss during the year, due to the establishment of a valuation allowance against the Company’s deferred tax assets established as of December 31, 2010. Management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible as part of the balance sheet management process.
Net cash inflows from investing activities were $9.6 million in 2013, compared to net cash outflow of $59.1 million in 2012. In 2013, securities transactions accounted for a net outflow of $53.7 million, net principal received on loans accounted for net inflows of $21.5 million, and proceeds from the sales of OREO assets accounted for inflows of $43.7 million. In 2012, securities transactions accounted for a net outflow of $264.8 million, and net principal received on loans accounted for net inflows of $167.5 million whereas proceeds from the sale of OREO assets accounted for inflows of $39.1 million.
Net cash outflows from financing activities in 2013, were $125.7 million compared with net cash inflows of $93.3 million in 2012. Significant cash outflows from financing activities in 2013 included reductions of $35.1 million in deposits and $95.0 million in other short-term borrowings. Net increase in securities sold under repurchase agreements were $4.7 million during 2013. Significant cash inflows from financing
activity in 2012 included an increase in securities sold under repurchase agreements of $17.0 million and an increase in other short term borrowings of $100.0 million, offset by decreases in deposits of $23.6 million.
Interest rate risk
As part of its normal operations, the Company is subject to interest-rate risk on the assets it invests in (primarily loans and securities) and the liabilities it funds (primarily customer deposits and borrowed funds), as well as its ability to manage such risk. Fluctuations in interest rates may result in changes in the fair market values of the Company’s financial instruments, cash flows, and net interest income. Like most financial institutions, the Company has an exposure to changes in both short-term and long-term interest rates.
The Company manages various market risks in its normal course of operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of the Company’s business activities and operations. In addition, since the Company does not hold a trading portfolio, it is not exposed to significant market risk from trading activities. The changes in the Company’s interest rate risk exposures at December 31, 2013, and December 31, 2012, are outlined in the table below.
Like most financial institutions, the Company’s net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction. The Company’s ALCO seeks to manage interest rate risk under a variety of rate environments by structuring the Company’s balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 18 of the financial statements included in this annual report. The risk is monitored and managed within approved policy limits.
The Company utilizes simulation analysis to quantify the impact of various rate scenarios on net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by the Company are incorporated into the simulation model. Earnings at risk is calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. Due to the significant declines in interest rates that occurred during the first half of 2012, and the historically low interest rates that have continued through 2013, it is no longer possible to calculate valid interest rate scenarios that represent declines of 0.5% or more. Consequently, net interest income sensitivity is currently only calculated for interest rate increases. Compared to December 31, 2012, the Company would have less earnings gains (in dollars) if interest rates should rise. This decline in rising-rate benefit reflects the Company’s emphasis on increasing loan originations, some of which may be fixed rate, and funding the added loans through sales of securities which are predominantly variable rate. Such activity over time will further erode the benefit from rising interest rates. Federal Funds rates and the Bank’s prime rate were stable throughout the year at 0.25% and 3.25%, respectively.
The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve. The -2% -1% and -0.5% sections of the table do not show model changes for those magnitudes of decrease due to the historically low interest rate environment over the relevant time periods:
The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.
Effects of Inflation
In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in the expected rate of inflation, as well as on changes in monetary and fiscal policies. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in today’s volatile economic environment. The Company seeks to insulate itself from interest rate volatility by ensuring that rate sensitive assets and rate sensitive liabilities respond to changes in interest rates in a similar time frame and to a similar degree.
Item 8.
Item 8. Financial Statements and Supplementary Data
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 2013 and 2012
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Statements of Operations
Years Ended December 31, 2013 and 2012
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss)
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2013 and 2012
(In thousands)
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Statements of Cash Flows - Continued
(In thousands)
See accompanying notes to consolidated financial statements.
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Statements of Changes in
Stockholders’ Equity
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Old Second Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2013 and 2012
(Table amounts in thousands, except per share data)
Note 1: Summary of Significant Accounting Policies
The Company uses the accrual basis of accounting for financial reporting purposes. Certain reclassifications were made to prior year amounts to conform to the current year presentation.
Use of Estimates - The preparation of consolidated financial statements in conformity with generally accepted accounting principles (“GAAP”) and following general practices within the banking industry requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Although these estimates and assumptions are based on the best available information, actual results could differ from those estimates.
Principles of Consolidation - The accompanying consolidated financial statements include the accounts and results of operations of the Company and its subsidiaries after elimination of all significant intercompany accounts and transactions. Assets held in a fiduciary or agency capacity are not assets of the Company or its subsidiaries and are not included in the consolidated financial statements.
Cash and Cash Equivalents - For purposes of the Consolidated Statements of Cash Flows, management has defined cash and cash equivalents to include cash and due from banks, interest-bearing deposits in other banks, and other short-term investments, such as federal funds sold and securities purchased under agreements to resell.
Securities - Securities are classified as available-for-sale or held-to-maturity at the time of purchase or transfer.
Securities that are classified as available-for-sale are carried at fair value. Unrealized gains and losses, net of related deferred income taxes, are recorded in stockholders’ equity as a separate component of accumulated other comprehensive income.
Securities held-to-maturity are carried at amortized cost and the discount or premium created in the transfer from available-for-sale is accreted or amortized to the maturity or expected payoff date but not an earlier call. The Company reclassified certain securities, chosen by management, to held-to-maturity effective September 1, 2013. No new purchases were made in the held-to-maturity classification during the fourth quarter.
The historical cost of debt securities is adjusted for amortization of premiums and accretion of discounts over the estimated life of the security, using the level yield method. Amortization of premium and accretion of discount are included in interest income from the related security.
Purchases and sales of securities are recognized on a trade date basis. Realized securities gains or losses are reported in securities gains, net in the Consolidated Statements of Operations. The cost of securities sold is based on the specific identification method. On a quarterly basis, the Company makes an assessment (at the individual security level) to determine whether there have been any events or circumstances indicating that a security with an unrealized loss is other-than-temporarily impaired (“OTTI”). In evaluating OTTI, the Company considers many factors, including the severity and duration of the impairment; the financial condition and near-term prospects of the issuer, which for debt securities considers external credit ratings and recent downgrades; its ability and intent to hold the security for a
period of time sufficient for a recovery in value; and the likelihood that it will be required to sell the security before a recovery in value, which may be at maturity. The amount of the impairment related to other factors is recognized in other comprehensive income (loss) unless management intends to sell the security or believes it is more likely than not that it will be required to sell the security prior to full recovery.
Federal Home Loan Bank and Federal Reserve Bank Stock - The Company owns the stock of the Federal Home Loan Bank of Chicago (“FHLBC”) and the Federal Reserve Bank of Chicago (“Reserve Bank”). Both of these entities require the Bank to invest in their nonmarketable stock as a condition of membership. The FHLBC is a governmental sponsored entity. The Bank continues to utilize the various products and services of the FHLBC and management considers this stock to be a long-term investment. FHLBC members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLBC stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. The Company’s ability to redeem the shares owned is dependent on the redemption practices of the FHLBC. The Company records dividends in income on the ex-dividend date. Reserve Bank stock is redeemable at par, therefore, market value equals cost.
Loans Held-for-Sale - The Bank originates residential mortgage loans, which consist of loan products eligible for sale to the secondary market. Residential mortgage loans eligible for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices on similar loans.
Loans - Loans held-for-investment are carried at the principal amount outstanding, including certain net deferred loan origination fees. Interest income on loans is accrued based on principal amounts outstanding. Loan and lease origination fees, commitment fees, and certain direct loan origination costs are deferred, and the net amount is amortized over the life of the related loans or commitments as a yield adjustment. Fees related to standby letters of credit, whose ultimate exercise is remote, are amortized into fee income over the estimated life of the commitment. Other credit-related fees are recognized as fee income when earned.
Concentration of Credit Risk - Most of the Company’s business activity is with customers located within Kane, Kendall, DeKalb, DuPage, LaSalle, Will and southwestern Cook counties in Illinois. These banking centers surround the Chicago metropolitan area. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in that market area since the Bank generally makes loans within its market. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector.
Commercial and Industrial Loans - Such credits typically comprise working capital loans, loans for physical asset expansion, asset acquisition loans and other business loans. Loans to closely held businesses will generally be guaranteed in full or for a meaningful amount by the businesses’ major owners. Commercial loans are made based primarily on the historical and projected cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not behave as forecasted and collateral securing loans may fluctuate in value due to economic or individual performance factors. Minimum standards and underwriting guidelines have been established for all commercial loan types.
Commercial Real Estate Loans - Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans. These are loans secured by mortgages on real estate collateral. Commercial real estate loans are viewed primarily as cash flow loans and the repayment of these loans is largely dependent on the successful operation of the property. Loan performance may be adversely affected by factors impacting the general economy or conditions specific to the real estate market such as geographic location and/or property type.
Residential Real Estate Loans - These are loans that are extended to purchase or refinance 1 - 4 family residential dwellings, or to purchase or refinance vacant lots intended for the construction of a 1 - 4 family home. Residential real estate loans are considered homogenous in nature. Homes may be the primary or secondary residence of the borrower or may be investment properties of the borrower.
Real Estate Construction & Development Loans - The Company defines construction loans as loans where the loan proceeds are controlled by the Company and used exclusively for the improvement of real estate in which the Company holds a mortgage. Due to the inherent risk in this type of loan, they are subject to other industry specific policy guidelines outlined in the Company’s Credit Risk Policy and are monitored closely.
Consumer Loans - Consumer loans include loans extended primarily for consumer and household purposes although they may include very small business loans for the purchase of vehicles and equipment to a single-owner enterprise and could include business purpose lines of credit if made under the terms of a small business product whose features and underwriting criteria are specified in advance by the Loan Committee. These also include overdrafts and other items not captured by the definitions above.
Nonaccrual loans - Generally, commercial loans and loans secured by real estate are placed on nonaccrual status (i) when either principal or interest payments become 90 days or more past due based on contractual terms unless the loan is sufficiently collateralized such that full repayment of both principal and interest is expected and is in the process of collection within a reasonable period or (ii) when an individual analysis of a borrower’s creditworthiness indicates a credit should be placed on nonaccrual status whether or not the loan is 90 days or more past due. When a loan is placed on nonaccrual status, unpaid interest credited to income is reversed. After the loan is placed on nonaccrual, all debt service payments are applied to the principal on the loan. Nonaccrual loans are returned to accrual status when the financial position of the borrower and other relevant factors indicate there is no longer doubt that the Company will collect all principal and interest due.
Commercial loans and loans secured by real estate are generally charged-off when deemed uncollectible. A loss is recorded at that time if the net realizable value can be quantified and it is less than the associated principal and interest outstanding.
Troubled Debt Restructurings (“TDRs”) - A restructuring of debt is considered a TDRs when (i) the borrower is experiencing financial difficulties and (ii) the creditor grants a concession, such as forgiveness of principal, reduction of the interest rate, changes in payments, or extension of the maturity, that it would not otherwise consider. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. The Company’s TDRs are determined on a case-by-case basis in connection with ongoing loan collection processes.
The Company does not accrue interest on any TDRs unless it believes collection of all principal and interest under the modified terms is reasonably assured. For a TDRs to accrue interest, the borrower must demonstrate both some level of past performance and the capacity to perform under the modified terms. Generally, six months of consecutive payment performance by the borrower under the restructured terms is required before a TDRs is returned to accrual status. However, the period could vary depending on the individual facts and circumstances of the loan. An evaluation of the borrower’s current creditworthiness is used to assess whether the borrower has the capacity to repay the loan under the modified terms. This evaluation includes an estimate of expected cash flows, evidence of strong financial position, and estimates of the value of collateral, if applicable.
Impaired Loans - Impaired loans consist of nonaccrual loans and TDRs (both accruing and on nonaccrual). A loan is considered impaired when it is probable that the Company will be unable to collect all contractual principal and interest due according to the terms of the loan agreement based on current information and events. With the exception of TDRs still accruing interest, loans deemed to be
impaired are classified as nonaccrual and are exclusive of smaller homogeneous loans, such as home equity, 1-4 family mortgages, and consumer loans. When a loan is designated as impaired, any subsequent principal and interest payments received are applied to the principal on the loan.
90-Days or Greater Past Due Loans - 90-days or more past due loans are loans with principal or interest payments three months or more past due, but that still accrue interest. The Company continues to accrue interest if it determines these loans are sufficiently collateralized and the process of collection will conclude within a reasonable time period.
Allowance for Loan Losses - The allowance for loan losses is comprised of the allowance for loan losses calculated according to GAAP standards and is maintained by management at a level believed adequate to absorb estimated losses inherent in the existing loan portfolio. Determination of the allowance for loan losses is inherently subjective since it requires significant estimates and management judgment, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on a migration analysis that uses historical loss experience, consideration of current economic trends, and other credit market factors.
Loans deemed to be uncollectible are charged-off against the allowance for loan losses while recoveries of amounts previously charged-off are credited to the allowance for loan losses. Approved releases from previously established loan loss reserves authorized under our allowance methodology also reduce the allowance for loan losses. Additions to the allowance for loan losses are established through the provision for loan losses charged to expense. The amount charged to operating expense depends on a number of factors, including historic loan growth, changes in the composition of the loan portfolio, net charge-off levels, and the Company’s assessment of the allowance for loan losses based on the methodology discussed below. The Company had no major methodology changes in 2013 and only minor changes in two management factors included in the methodology calculations.
The allowance for loan losses methodology consists of (i) specific reserves established for probable losses on individual loans for which the recorded investment in the loan exceeds the value of the loan, (ii) an allowance based on a loss migration analysis that uses historical credit loss experience for each loan category, and (iii) the impact as assessed by management in detailed loan review sessions of other internal and external qualitative and credit market factors.
The specific reserves component of the allowance for loan losses is based on a periodic analysis of impaired loans exceeding a fixed dollar amount. This analysis follows GAAP standards for collateral based loans.
An additional component of the allowance for loan losses is based on actual loss experience for a rolling 20-quarter period and the related internal risk rating and category of loans charged-off, including any charge-off on TDRs. The loss migration analysis is performed quarterly, and the loss factors are updated based on actual experience.
Management takes into consideration many internal and external qualitative factors when estimating an additional adjustment for management factors, including:
· Changes in the composition of the loan portfolio, trends in the volume and terms of loans, and trends in delinquent and nonaccrual loans that could indicate that historical trends do not reflect current conditions.
· Changes in credit policies and procedures, such as underwriting standards and collection, charge-off, and recovery practices.
· Changes in the experience, ability, and depth of credit management and other relevant staff.
· Changes in the quality of the Company’s loan review system and board of directors’ oversight.
· Changes in the value of the underlying collateral for collateral-dependent loans.
· Changes in the national and local economy that affect the collectability of various segments of the portfolio.
· Changes in other external factors, such as competition and legal or regulatory requirements are considered when determining the level of estimated loss in various segments of the portfolio.
The establishment of the allowance for loan losses involves a high degree of judgment and includes a level of imprecision given the difficulty of identifying and assessing the factors impacting loan repayment and estimating the timing and amount of losses. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond the Company’s direct control, including the performance of its loan portfolio, the economy, changes in interest rates and property values, and the interpretation of loan risk classifications by regulatory authorities. While each component of the allowance for loan losses is determined separately, the entire balance is available for the entire loan portfolio.
Mortgage Servicing Rights - The Bank is also involved in the business of servicing mortgage loans. Servicing activities include collecting principal, interest, and escrow payments from borrowers, making tax and insurance payments on behalf of the borrowers, monitoring delinquencies, executing foreclosure proceedings, and accounting for and remitting principal and interest payments to the investors. Mortgage servicing rights represent the right to a stream of cash flows and an obligation to perform specified residential mortgage servicing activities.
Mortgage loans that the Company is servicing for others aggregated to $591.5 million and $552.0 million at December 31, 2013, and 2012, respectively. Mortgage loans that the Company is servicing for others are not included in the consolidated balance sheets. Fees received in connection with servicing loans for others are recognized as earned. Loan servicing costs are charged to expense as incurred.
Servicing rights are recognized separately as assets when they are acquired through sales of loans and servicing rights are retained. Servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. The Company compares the valuation model inputs and results to published industry data in order to validate the model results and assumptions.
Servicing fee income, which is included on the Consolidated Statements of Operations as mortgage servicing income, net of fair value changes, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned.
Under the fair value measurement method, the Company measures servicing rights at fair value at each reporting date, reports changes in fair value of servicing assets in earnings in the period in which the changes occur, and includes mortgage servicing rights in mortgage servicing income, net of fair value changes, on the Consolidated Statements of Operations. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Other Real Estate Owned (“OREO”) - Real estate assets acquired in settlement of loans are recorded at fair value when acquired, less estimated costs to sell, establishing a new cost basis. Any deficiency between the net book value and fair value at the foreclosure or deed in lieu date is charged to the allowance for loan losses. If fair value declines after acquisition, a valuation allowance is established for
the decrease between the recorded value and the updated fair value less costs to sell. Such declines are included in other noninterest expense. A subsequent reversal of an OREO valuation adjustment can occur, but the resultant carrying value cannot exceed the cost basis established at transfer to OREO. OREO properties are valued at the lower of cost or estimated market less costs subsequent to acquisition. Operating costs after acquisition are also expensed.
Premises and Equipment - Premises, furniture, equipment, and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation expense is determined by the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on a straight-line basis over the shorter of the life of the asset or the lease term including anticipated renewals. Rates of depreciation are generally based on the following useful lives: buildings, 25 to 40 years; building improvements, 3 to 15 years but longer under limited circumstances; and furniture and equipment, 3 to 10 years. Gains and losses on dispositions are included in other noninterest income in the Consolidated Statements of Operations. Maintenance and repairs are charged to operating expenses as incurred, while improvements that extend the useful life of assets are capitalized and depreciated over the estimated remaining life.
Bank-Owned Life Insurance (“BOLI”) - BOLI represents life insurance policies on the lives of certain Company employees (both current and former) for which the Company is the sole owner and beneficiary. These policies are recorded as an asset on the Consolidated Statements of Financial Condition at their cash surrender value (“CSV”) or the amount that could be realized. The change in CSV and insurance proceeds received are recorded as BOLI income in the Consolidated Statements of Operations in noninterest income.
Core Deposit Intangible Assets - The core deposit intangible (“CDI”) is amortized over its useful life. The CDI was initially measured at fair value and is amortized on an accelerated method over their estimated useful life of twelve years. It is also evaluated for impairment and impairment, if needed, would be recorded to earnings.
Impairment testing is performed using a two-step process. The first step of the impairment review uses an undiscounted cash flow approach to determine if the core deposit intangible is recoverable. If the results of the undiscounted cash flow indicate the CDI is recoverable, the second step of the impairment test is not required. If necessary, the second step of the impairment test compares the implied fair value of the deposits with the carrying amount of the deposits. The implied fair value of deposits is determined using a discounted cash flow approach. An impairment loss would be recognized if the carrying amount of the reported CDI exceeded the carrying value less the implied fair value of the deposits.
The annual impairment analysis, completed as of November 30, 2012, indicated the core deposit intangible was not impaired as the Company passed the first step of the impairment test. However, during 2012 management determined that the fair value of the intangible asset had declined largely due to a significant reduction in the cost of funds compared to the alternative funds rate used in the impairment analysis. Expecting these circumstances to continue throughout 2012 and beyond, management believed the useful life of the core deposit intangible has decreased. Management increased the amortization expense for the year ended December 31, 2012, by $622,000. The Company’s November 30, 2013 annual impairment analysis indicated the core deposit intangible was not impaired. The carrying value of the intangible asset decreased from $3.3 million at December 31, 2012, to $1.2 million at December 31, 2013. Further, estimated future amortization expense as of December 31, 2013, indicates that the asset will be fully amortized by December 31, 2014.
Loss Contingencies - Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that
will have a material effect on the financial statements.
Wealth Management - Assets held in a fiduciary or agency capacity for customers are not included in the consolidated financial statements as they are not assets of the Company or its subsidiaries. Fee income is recognized on a cash basis and is included as a component of noninterest income in the Consolidated Statements of Operations.
Advertising Costs - All advertising costs incurred by the Company are expensed in the period in which they are incurred.
Long-term Incentive Plan - Compensation cost is recognized for stock options and restricted stock awards issued to employees based upon the fair value of the awards at the date of grant. A binomial model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. Once the award is settled, the Company would determine whether the cumulative tax deduction exceeded the cumulative compensation cost recognized in the income statement. The cumulative tax deduction would include both the deductions from the dividends and the deduction from the exercise or vesting of the award. If the tax benefit received from the cumulative deductions exceeds the tax effect of the recognized cumulative compensation cost, the excess would be recognized as an increase to additional paid-in capital.
Income Taxes - The Company files income tax returns in the U.S. federal jurisdiction and in Illinois. The provision for income taxes is based on income in the consolidated financial statements, rather than amounts reported on the Company’s income tax return. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the enacted tax rates that are expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. A full valuation allowance was previously established for the deferred tax assets excluding an asset associated with a net unrealized gain or loss on available-for-sale investment securities. At September 30, 2013, the Company reversed a significant portion of the valuation allowance after an analysis of both positive and negative evidence concerning the likelihood of deferred tax asset recognition under GAAP. Due to the implicit recovery of the book basis of the underlying securities along with management’s intent and ability to hold the securities to recovery or maturity, no valuation allowance on this specific deferred tax asset has been established.
The Company is under examination by the State of Illinois for the tax years 2008 and 2009. The Company conducts a regular assessment of uncertain tax positions and will establish reserves for tax related interest and penalties with those amounts reflected in income tax expense. The Company did not have any material amounts accrued for interest and penalties at either December 31, 2013, or December 31, 2012.
Earnings Per Common Share (“EPS”) - Basic EPS is computed by dividing net income applicable to common shares by the weighted-average number of common shares outstanding for the period. The basic EPS computation excludes the dilutive effect of all common stock equivalents. Diluted EPS is computed by dividing net income applicable to common shares by the weighted-average number of common shares outstanding plus all potential common shares. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Company’s potential common shares represent shares issuable under its long-term incentive compensation plans and under the common stock warrant issued to Treasury through the CPP and
subsequently sold to a third party at auction. Such common stock equivalents are computed based on the treasury stock method using the average market price for the period.
Treasury Stock - Treasury stock acquired is recorded at cost and is carried as a reduction of stockholders’ equity in the Consolidated Statements of Financial Condition. Treasury stock issued is valued based on the “last in, first out” inventory method. The difference between the consideration received upon issuance and the carrying value is charged or credited to additional paid-in capital.
Mortgage Banking Derivatives - As part of ongoing residential mortgage business, the Company enters into mortgage banking derivatives such as forward contracts and interest rate lock commitments. The derivatives and loans held-for-sale are carried at fair value with the changes in fair value recorded in current earnings. The net gain or loss on mortgage banking derivatives is included in gain on sale of loans.
Derivative Financial Instruments - The Company occasionally enters into derivative financial instruments as part of its interest rate risk management strategies. These derivative financial instruments consist primarily of interest rate swaps. Under accounting guidance all derivative instruments are recorded on the balance sheet, in either other assets or other liabilities, at fair value. The accounting for the gain or loss resulting from changes in fair value depends on the intended use of the derivative. For a derivative used to hedge changes in fair value of a recognized asset or liability, or an unrecognized firm commitment, the gain or loss on the derivative will be recognized in earnings, together with the offsetting loss or gain on the hedged item. This results in an earnings impact only to the extent that the hedge is not completely effective in achieving offsetting changes in fair value. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued, and the adjustment to fair value of the derivative instrument is recorded in earnings. For a derivative used to hedge changes in cash flows associated with forecasted transactions, the gain or loss on the effective portion of the derivative are deferred and reported as a component of accumulated other comprehensive income, which is a component of shareholders’ equity, until such time the hedged transaction affects earnings. For derivative instruments not accounted for as hedges, changes in fair value are recognized in noninterest income/expense. Counterparty risk with correspondent banks is considered through loan covenant agreements and, as such, does not have a significant impact on the fair value of the swaps. The credit valuation reserve recorded on customer interest rate swap positions was determined based upon management’s estimate of the amount of credit risk exposure, including available collateral protection and/or by utilizing an estimate related to a probability of default as indicated in the Bank credit policy. Deferred gains and losses from derivatives that are terminated are amortized over the shorter of the original remaining term of the derivative or the remaining life of the underlying asset or liability.
Comprehensive Income (Loss) - Comprehensive income (loss) is the total of reported earnings all other revenues, expenses, gains, and losses that are not reported in earnings under GAAP. The Company includes the following items, net of tax, in other comprehensive income (loss) in the Consolidated Statements of Comprehensive Income (Loss): (i) changes in unrealized gains or losses on securities available-for-sale, (ii) changes in unrealized gains or losses on securities held-to-maturity established upon transfer from securities available-for-sale, and (iii) changes in the fair value of derivatives designated under cash flow hedges (when applicable).
New Accounting Pronouncements: In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2013-02 “Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. The impact of ASU 2013-02 on the Company’s consolidated financial statements is
reflected in the consolidated statement of comprehensive income (loss) and has been reflected in the Company’s financial statements since January 1, 2013.
Note 2: Cash and Due from Banks
The Bank is required to maintain reserve balances with the Reserve Bank. In accordance with the Reserve Bank requirements, the average reserve balances were $8.5 million and $8.4 million, for the years ending December 31, 2013, and 2012, respectively.
The nature of the Company’s business requires that it maintain amounts with other banks and federal funds which, at times, may exceed federally insured limits. Management monitors these correspondent relationships, and the Company has not experienced any losses in such accounts. The Bank also has a $4.4 million pledge requirement, met with cash, to a correspondent bank as it relates to credit card processing services.
Note 3: Securities
Investment Portfolio Management
Our investment portfolio serves the liquidity and income needs of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio will also serve as income producing assets. The size of the portfolio reflects liquidity needs, loan demand and interest income objectives.
Portfolio size and composition may be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.
Investments are comprised of debt securities and non-marketable equity investments. Until the third quarter of 2013, all debt securities had been classified as available-for-sale. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.
As of September 1, 2013, securities with a fair value of $237.2 million, a cost basis of $245.4 million, with an August 31, 2013, unrealized loss of $8.2 million, were transferred from available-for-sale to held-to-maturity. In addition, new held-to-maturity securities purchases were made during September 2013. Specifically, two purchases were made of securities issued by the Government National Mortgage Association. In accordance with GAAP, the Company has the positive intent and ability to hold the securities to maturity. Securities held-to-maturity are carried at amortized cost and the discount or premium created in the transfer is accreted or amortized to the maturity or expected payoff date but not an earlier call. The Company has followed and will follow GAAP accounting on all securities holdings.
Nonmarketable equity investments include FHLBC stock and Reserve Bank stock. FHLBC stock was recorded at a value of $5.5 million at December 31, 2013, a decrease of $910,000 from December 31, 2012. Reserve Bank stock was recorded at $4.8 million at December 31, 2013, which was unchanged from December 31, 2012. Our FHLBC stock is necessary to maintain our continued access to FHLBC advances. In late 2011, management at the Bank evaluated the October 17, 2011, FHLBC Capital Plan and determined the best overall course for the Bank was to accept the stock conversion as of January 1, 2012. Subsequently, during the first half of 2012 management redeemed excess FHLBC stock held by the Bank reducing the value of FHLBC stock held by the Bank to $6.4 million at December 31, 2012.
The following table summarizes the amortized cost and fair value of securities at December 31, 2013, and 2012 and the corresponding amounts of gross unrealized gains and losses:
During the twelve months ended December 31, 2013, we added $48.9 million to the total securities portfolio (net of payoffs, maturities, sales, calls, amortization and accretion). This change is largely found in the collateralized mortgage obligations and asset-backed securities components.
Securities valued at $266.7 million as of December 31, 2013, (up from $210.1 million at year-end 2012) were pledged to secure deposits and for other purposes.
The fair value, amortized cost and weighted average yield of debt securities at December 31, 2013, by contractual maturity, were as set forth below. Securities not due at a single maturity date, mortgage-backed securities, collateralized mortgage obligations and asset-backed securities are shown separately.
At December 31, 2013, the Company’s investments include asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, not less than 97% of the original principal amount of the loans made under FFEL were guaranteed by the U.S. Department of Education. A number of major student loan originators packaged loans and sold them as asset-backed securities. The Company has accumulated the securities of the following three different originators that individually amount to over 10% of the Company’s stockholders equity. Information regarding these three issuers and the value of the securities issued follows:
The Company has also invested over ten percent of the Company’s stockholders equity in mortgage-backed securities issued by Credit Suisse Mortgage Trust, a trust formed by Credit Suisse Mortgage Corporation. The securities held by the Company are backed by residential mortgage loans that were not eligible for securitization by the U.S. Government or any of its agencies. As of December 31, 2013, the book value of the securities issued by Credit Suisse Mortgage Corporation was $28.9 million and the market value of such securities was $26.3 million and are rated “AAA” by Standard & Poor’s. The “AAA” rating is supported by other bonds in the issuance structure that are subordinate to the securities purchased by the Company, meaning that the subordinate bonds will absorb losses to principal before any loss can impact the Company’s securities.
Securities with unrealized losses at December 31, 2013, and 2012 aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:
In determining when OTTI exists for debt securities, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security, or more likely than not will be required to sell the debt security, before its anticipated recovery. The assessment of whether an OTTI decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
Note 4: Loans
Major classifications of loans at December 31 were as follows:
It is the policy of the Company to review each prospective credit in order to determine if an adequate level of security or collateral was obtained prior to making a loan. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is generally protected through adherence to state lending laws, the Company’s lending standards and credit monitoring procedures. The Bank generally makes loans within its market area. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, although the real estate related categories listed above represent 89.0% and 90.1% of the portfolio at December 31, 2013, and December 31, 2012, respectively.
Aged analysis of past due loans by class of loans as of December 31, 2013, and December 31, 2012, were as follows:
1. The “All other” class includes overdrafts and net deferred loan fees and costs.
Credit Quality Indicators:
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison against industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding loans or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves
management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated. Loans listed as not rated have outstanding loans or commitments less than $50,000 or are included in groups of homogeneous loans.
Credit Quality Indicators by class of loans as of December 31, 2013, and December 31, 2012, were as follows:
1 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans
Impaired loans by class of loan as of December 31, 2013, were as follows:
Impaired loans by class of loan as of December 31, 2012, were as follows:
TDRs are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession of principal or interest and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank does participate in the Treasury’s Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.
The specific allocation of the allowance for loan losses on TDRs is determined by discounting the
modified cash flows at the original effective rate of the loan before modification or is based on the underlying collateral value less costs to sell, if repayment of the loan is collateral-dependent. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e. specific reserve) as a component of the allowance for loan losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan losses also includes an allowance based on a loss migration analysis for each loan category for loans that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.
TDRs that were modified during the period are summarized as follows:
1 Deferral: Refers to the deferral of principal
2 Other: Change of terms from bankruptcy court
3 Interest: Refers to change of interest rate
4 Bifurcate: Refers to an “A/B” restructure separated into two notes, charging off the entire B portion of the note.
5 HAMP: Home Affordable Modification Program
TDRs are classified as being in default on a case-by-case when they fail to be in compliance with the modified terms. The following table presents TDRs that defaulted during the periods shown and were restructured within the 12-month period prior to default:
The Bank had no commitments to borrowers whose loans were classified as impaired at December 31, 2013.
Loans to principal officers, directors, and their affiliates, which are made in the ordinary course of business, were as follows at December 31:
No loans to principal officers, directors, and their affiliates were past due greater than 90 days at either December 31, 2013, or December 31, 2012.
Note 5: Allowance for Loan Losses
Changes in the allowance for loan losses by segment of loans based on method of impairment as of and for the year ending December 31, 2013, were as follows:
1 As of December 31, 2013, this segment consisted of performing loans that included a higher risk pool of loans rated as substandard that totaled $17.2 million. The amount of general allocation that was estimated for that portion of these performing substandard rated loans was $2.1 million at December 31, 2013.
The Company’s allowance for loan loss is calculated in accordance with GAAP and relevant supervisory guidance. All management estimates were made in light of observable trends within loan portfolio segments, market conditions and established credit review administration practices.
Changes in the allowance for loan losses by segment of loans based on method of impairment as of and for the year ending December 31, 2012, were as follows:
1 As of December 31, 2012, this segment consisted of performing loans that included a higher risk pool of loans rated as substandard that totaled $22.7 million. The amount of general allocation that was estimated for that portion of these performing substandard rated loans was $1.8 million at December 31, 2012.
Note 6: Other Real Estate Owned
Details related to the activity in the net OREO portfolio for the periods presented is itemized in the following table:
Activity in the valuation allowance was as follows:
Expenses related to foreclosed assets includes:
Note 7: Premises and Equipment
Premises and equipment at December 31 were as follows:
Note 8: Deposits
Major classifications of deposits at December 31 were as follows:
The Company had no brokered certificates of deposit as of December 31, 2013, and 2012. Deposits held by senior officers and directors, including their related interests, totaled $3.4 million and $2.1 million, respectively, as of December 31, 2013, and 2012.
At December 31, 2013, scheduled maturities of time deposits were as follows:
The following table sets forth the amount and maturities of deposits of $100,000 or more at December 31:
Note 9: Borrowings
Borrowings at December 31 are as follows:
1Included in other short-term borrowing on the balance sheet.
The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature within 1 to 90 days from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U. S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $22.6 million at December 31, 2013, and $17.9 million at December 31, 2012. The fair value of the pledged collateral was $39.2 million and $26.0 million at December 31, 2013 and December 31, 2012, respectively. At year end 2013, there were no customers with secured balances exceeding 10% of stockholders’ equity.
The following table is a summary of additional information related to repurchase agreements:
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC and the Company’s total borrowings from the FHLBC are generally limited to the lower of 35% of the Company’s total assets or 60% of the book value of certain mortgage loans. As of December 31, 2013, the Bank had taken an advance of $5.0 million at 0.13% interest on the FHLBC stock valued at $5.5 million. This advance matured on January 2, 2014 and was replaced with short term FHLBC advances that matured in January 2014. Additional drawdowns and repayments of FHLBC advances have been and will be conducted in the normal course of Company business. Previous borrowing capacity at the Reserve Bank that was not used at either December 31, 2013, or December 31, 2012, was dropped by the Company in October 2013, as management determined that it was not needed given current and prospective liquidity projections.
One of the Company’s most significant borrowing relationships continued to be the $45.5 million credit facility with a correspondent bank. That credit began in January 2008 and was originally composed of a $30.5 million senior debt facility, which included $500,000 in term debt, and $45.0 million of subordinated debt. The subordinated debt and the term debt portion of the senior debt facility mature on March 31, 2018. The interest rate on the senior debt facility resets quarterly and at the Company’s option, is based on, either the lender’s prime rate or three-month LIBOR plus 90 basis points. The interest rate on the subordinated debt resets quarterly, and is equal to three-month LIBOR plus 150 basis points. The Company had no principal outstanding balance on the senior line of credit when it matured and the senior line of credit has been terminated. The Company had $500,000 in principal outstanding in term debt and $45.0 million in principal outstanding in subordinated debt at the end of both December 31, 2012, and December 31, 2013. The term debt is secured by all of the outstanding capital stock of the Bank. The Company has made all required interest payments on the outstanding principal amounts on a timely basis.
Pursuant to the Written Agreement (the “Written Agreement”) the Company entered into with the Reserve Bank, the Company was required to receive the Reserve Bank’s approval prior to making any interest payments on the subordinated debt. In January 2014 the Reserve Bank notified the Company that the Written Agreement was terminated.
The credit facility agreement contains usual and customary provisions regarding acceleration of the senior debt upon the occurrence of an event of default by the Company under the senior debt agreement. The senior debt agreement also contains certain customary representations and warranties and financial covenants. At December 31, 2013, the Company was out of compliance with one of the financial covenants contained within the credit agreement. Prior to 2013, the Company had been out of compliance with two of the financial covenants. The agreement provides that noncompliance is an event of default and as the result of the Company’s failure to comply with a financial covenant, the lender may (i) terminate all commitments to extend further credit, (ii) increase the interest rate on the revolving line of the term debt by 200 basis points, (iii) declare the senior debt immediately due and payable and (iv) exercise all of its rights and remedies at law, in equity and/or pursuant to any or all collateral documents, including foreclosing on the collateral. The total outstanding principal amount of the senior debt is the $500,000 in term debt. Because the subordinated debt is treated as Tier 2 capital for regulatory capital purposes, the senior debt agreement does not provide the lender with any rights of acceleration or other remedies with regard to the subordinated debt upon an event of default caused by the Company’s failure to comply with a financial covenant.
Scheduled maturities and weighted average rates of borrowings for the years ended December 31, were as follows:
Note 10: Junior Subordinated Debentures
The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I in June 2003. An additional $4.1 million of cumulative trust preferred securities were sold in July 2003. The costs associated with the issuance of the cumulative trust preferred securities are being amortized over 30 years. The trust preferred securities may remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company. The stated call period commenced on June 30, 2008 and can be exercised by the Company from time to time thereafter. When not in deferral, cash distributions on the securities are payable quarterly at an annual rate of 7.80%. The Company issued a new $32.6 million subordinated debenture to the trust in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
The Company issued an additional $25.0 million of cumulative trust preferred securities through a private
placement completed by an additional unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. Although nominal in amount, the costs associated with that issuance are being amortized over 30 years. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities are fixed at 6.77% through June 15, 2017 and float at 150 basis points over three-month LIBOR thereafter. The Company issued a new $25.8 million subordinated debenture to the trust in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
Under the terms of the subordinated debentures issued to each of Old Second Capital Trust I and II, the Company is allowed to defer payments of interest for 20 quarterly periods without default or penalty, but such amounts will continue to accrue. Also during the deferral period, the Company generally may not pay cash dividends on or repurchase its common stock or preferred stock, including the Series B Fixed Rate Cumulative Perpetual Preferred Stock (the “Series B Preferred Stock”) as discussed in Note 20. In August of 2010, the Company elected to defer regularly scheduled interest payments on the $58.4 million of junior subordinated debentures. Because of the deferral on the subordinated debentures, the trusts will defer regularly scheduled dividends on the trust preferred securities. Both of the debentures issued by the Company are recorded on the Consolidated Balance Sheets as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Operations. The total accumulated unpaid interest on the junior subordinated debentures including compounded interest from July 1, 2010, on the deferred payments totaled $17.0 million and $11.7 million at December 31, 2013, and December 31, 2012, respectively.
Note 11: Income Taxes
Income tax expense (benefit) for the year ended December 31 was as follows:
The following were the components of the deferred tax assets and liabilities as of December 31:
At December 31, 2013, the Company had $80.1 million federal net operation loss (“NOL”) carryforward of which, $25.3 million expires in 2030, $31.4 million expires in 2031, $8.6 million expires in 2032 and $14.8 million expires in 2033. The Company had $124.7 million state NOL carryforward of which, $29.4 million expires in 2021, and $95.3 million expires in 2025. In addition, the Company had $1.4 million in alternative minimum tax credit that can be carried forward indefinitely.
The components of the provision for deferred income tax expense (benefit) were as follows:
Effective tax rates differ from federal statutory rates applied to financial statement loss due to the following:
The Company recorded a tax benefit of $70.2 million on $11.8 million pre-tax income for the year 2013. The tax benefit was composed of $134,000 in current income tax expense and $3.8 million in deferred income tax expense offset by a $74.1 million reversal of the deferred tax valuation allowance reserve. The Company evaluated positive and negative evidence in order to determine if it was more likely than not that the deferred tax asset would be recovered through future income. Significant positive evidence evaluated included recent and projected earnings, significantly improved asset quality and an improved capital position. Negative evidence identified included a reduction in net interest margin as a result of the current rate environment, and historic runoff of loans. After evaluating all of the evidence, the Company believes it will more likely than not utilize the net deferred tax assets and reversed a significant portion of the valuation reserve on the net deferred tax asset in the third quarter of 2013.
Note 12: Long-Term Incentive Plan
The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,908,332 shares of the Company’s common stock, including the granting of qualified stock options, nonqualified stock options, restricted stock, restricted stock units, and stock appreciation rights. Total shares issuable under the plan were 45,368 at December 31, 2013. Stock based awards may be granted to selected directors, officers or employees at the discretion of the board of directors.
The Company’s board of directors has discretionary authority to establish or change some terms, on a grant-by-grant basis, including the amount of time until the awards vest. Awards under the Incentive Plan become fully vested upon a merger or change in control of the Company.
Total compensation cost that has been charged against income for those plans was $167,000 and $291,000, in 2013 and 2012, respectively.
The fair value of each option award is estimated on the date of grant using a closed form option valuation (binomial) model that uses the assumptions noted in the table below. Expected volatilities are based on the previous five-year historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the Treasury yield curve in effect at the time of the grant.
There were no stock options exercised during 2013 or 2012. The Company did not grant any options of the Company’s common stock during either of those periods. All stock options, when granted, are for a term of ten years. There was no unrecognized compensation cost related to nonvested stock options
granted under the Incentive Plan as of December 31, 2013, or 2012.
A summary of stock option activity in the Incentive Plan is as follows for the year ended December 31, 2013:
Under the incentive plan, restricted stock was granted beginning in 2005 and the grant of restricted units began in February 2009. Restricted stock has voting rights and both of these restricted awards have dividend rights, and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Both restricted stock and restricted units are redeemable in common stock when they vest. There were 155,500 of restricted units issued in 2013 and 60,000 of restricted awards issued in 2012. There were no restricted units issued in 2012 and no restricted awards were issued in 2013. Compensation expense is recognized over the vesting period of the restricted award based on the market value of the award at issue date.
A summary of changes in the Company’s nonvested restricted awards are as follows for the year ended December 31, 2013:
As of December 31, 2013, there was $342,000 of total unrecognized compensation cost related to nonvested restricted awards granted under the Plan. The cost is expected to be recognized over a weighted-average period of 2.22 years. There were 241,920 and 144,976 shares that vested during the years ended December 31, 2013, and 2012, respectively.
Note 13: Earnings (Loss) per Share
The above earnings (loss) per share calculation did not include 815,339 in a common stock warrant that was outstanding as of December 31, 2013 and 2012.
Note 14: Commitments
In the normal course of business, there are outstanding commitments that are not reflected in the financial statements. Commitments include financial instruments that involve, to varying degrees, elements of credit, interest rate, and liquidity risk. In management’s opinion, these do not represent unusual risks and management does not anticipate significant losses as a result of these transactions. The Company uses the same credit policies in making commitments and conditional obligations for borrowers as it does for on-balance sheet instruments.
The following table is a summary of financial instrument commitments (in thousands):
The Bank occupies facilities under long-term operating leases, some of which include provisions for future rent increases. In addition, the Company leases space at sites that house ATM’s. As of December 31, 2013, the estimated aggregate minimum annual rental commitments under these leases totaled $129,000 in 2014, $112,000 in 2015, $67,000 in 2016, and $9,000 in 2017 and each year thereafter. The Company also receives rental income on certain leased properties. As of December 31, 2013, aggregate future minimum rental income to be received under noncancelable leases totaled $291,000. Total facility net operating lease revenue/expense recorded under all operating leases was $64,000 of revenue in 2013, and $50,000 of revenue in 2012. Total ATM lease expense, including the costs related to servicing those ATM’s, was $830,000 in 2013 and $941,000 in 2012.
Legal proceedings
The Company and its subsidiaries, from time to time, pursue collection suits and other actions that arise in the ordinary course of business against their borrowers and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company based on all known information at this time.
Note 15: Regulatory & Capital Matters
On May 16, 2011, the Bank, a wholly-owned subsidiary of the Company, entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) with the Office of the Comptroller of the Currency (“OCC”). Pursuant to the Consent Order, the Bank took certain actions and operated in compliance with the Consent Order’s provisions during its terms. On October 17, 2013, the OCC terminated the Consent Order.
Even though the Consent Order has been terminated, the Bank is still subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighting of the Bank’s assets, developed by the OCC and the other bank regulatory agencies. In connection with the current economic environment, the Bank’s current level of nonperforming assets and the risk-based capital guidelines, the Bank’s board of directors has determined that the Bank should maintain a Tier 1 leverage
capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). The Bank currently exceeds those thresholds.
The Bank exceeded both board of directors’ capital ratio objectives. At December 31, 2013, the Bank’s Tier 1 capital leverage ratio was 10.97%, up 130 basis points from December 31, 2012, and 297 basis points above the 8.00% objective. The Bank’s total capital ratio was 18.04%, up 318 basis points from December 31, 2012, and 604 basis points above the objective of 12.00%.
On July 22, 2011, the Company entered into a Written Agreement with the Reserve Bank designed to maintain the financial soundness of the Company. Pursuant to the Written Agreement, the Company took certain actions and operated in compliance with the Written Agreement’s provisions during its term. On January 17, 2014, the Reserve Bank terminated the Written Agreement.
Under the terms of the now terminated Written Agreement, the Company was required to, among other things: (i) serve as a source of strength to the Bank, including ensuring that the Bank complies with the Consent Order it entered into with the OCC on May 16, 2011; (ii) refrain from declaring or paying any dividend, or taking dividends or other payments representing a reduction in the Bank’s capital, each without the prior written consent of the Federal Reserve and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve (the “Director”); (iii) refrain, along with its nonbank subsidiaries, from making any distributions on subordinated debentures or trust preferred securities without the prior written consent of the Federal Reserve and the Director; (iv) refrain, along with its nonbank subsidiaries, from incurring, increasing or guaranteeing any debt, and from purchasing or redeeming any shares of its capital stock, each without the prior written consent of the Federal Reserve; (v) provide the Federal Reserve with a written plan to maintain sufficient capital at the Company on a consolidated basis; (vi) provide the Federal Reserve with a projection of the Company’s planned sources and uses of cash; (vii) comply with certain regulatory notice provisions pertaining to the appointment of any new director or senior executive officer, or the changing of responsibilities of any senior executive officer; and (viii) comply with certain regulatory restrictions on indemnification and severance payments. The Company was required to submit and has submitted certain reports to the Federal Reserve with respect to the foregoing requirements. Although the Written Agreement has been terminated, the Company expects that it will continue to seek approval from the Reserve Bank prior to paying any dividends on its capital stock and incurring any additional indebtedness.
Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve Capital guidelines. The general bank and holding company capital adequacy guidelines are described in the accompanying table, as are the capital ratios of the Company and the Bank, as of December 31, 2013, and December 31, 2012. These ratios are calculated on a consistent basis with the ratios disclosed in the most recent filings with the regulatory agencies.
At December 31, 2013, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “adequately capitalized” under regulatory defined capital ratios and exceeded the heightened capital requirements set forth in the now terminated Consent Order. The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies.
Capital levels and industry defined regulatory minimum required levels:
1 The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized”.
The Company’s credit facility with Bank of America includes $45.0 million in subordinated debt. That debt obligation continues to qualify as Tier 2 regulatory capital. In addition, the trust preferred securities continue to qualify as Tier 1 regulatory capital, and the Company treats the maximum amount of this security type allowable under regulatory guidelines as Tier 1 capital. As of December 31, 2013, trust preferred proceeds of $51.6 million qualified as Tier 1 regulatory capital and $5.0 million qualified as Tier 2 regulatory capital. As of December 31, 2012, trust preferred proceeds of $24.6 million qualified as Tier 1 regulatory capital and $32.0 million qualified as Tier 2 regulatory capital. All of the Series B Preferred Stock qualified as Tier 1 regulatory capital as of December 31, 2013 and 2012.
Dividend Restrictions and Deferrals: In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above.
As discussed in Notes 1 and 10, as of December 31, 2013, the Company had $58.4 million of junior subordinated debentures held by two statutory business trusts that it controls. The Company has the right to defer interest payments, which were approximately $5.3 million in the year ended December 31, 2013, on the debentures for a period of up to 20 consecutive quarters, and elected to begin such a deferral period in August 2010. However, all deferred interest must be paid before the Company may pay dividends on its capital stock. Therefore, the Company will not be able to pay dividends on its common stock until all deferred interest on these debentures has been paid in full. The total amount of such deferred and unpaid
interest as of December 31, 2013, was $17.0 million.
Furthermore, as with the debentures discussed above, the Company is prohibited from paying dividends on its common stock unless it has fully paid all accrued and unpaid dividends on its Series B Preferred Stock. In August 2010, the Company also announced the deferral of dividends on such preferred stock. Therefore, in addition to paying all the accumulated and unpaid distributions on the debentures set forth above, the Company must also fully pay all accrued and unpaid dividends on the Series B Preferred Stock before it may reinstate the payment of dividends on the common stock. The total amount of such deferred and unpaid Series B Preferred Stock dividends as of December 31, 2013, was $13.3 million.
Further detail on the subordinated debentures, the Series B Preferred Stock and the deferral of interest and dividends thereon is described in Notes 10 and 20 of this report.
Note 16: Mortgage Banking Derivatives
Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to sell mortgage-backed securities (“MBS”) contracts for the future delivery to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These contracts are also derivatives and collectively with the forward commitments for the future delivery of mortgage loans are considered forward contracts. These mortgage banking derivatives are not designated in hedge relationships using the accepted accounting for derivative instruments and hedging activities at December 31 (dollars in thousands).
Fair values were estimated based on changes in mortgage interest rates from the date of the commitments. Changes in the fair values of these mortgage banking derivatives are included in net gains on sales of loans. The Company sold $185.4 million in loans to investors receiving proceeds of $191.0 million and resulting in a gain on sale of $5.6 million for the year ended December 31, 2013. Sales to investors included $126.3 million or 68.2% to Federal National Mortgage Association, $29.3 million, or 15.8% to Wells Fargo and $18.9 million or 10.2% to Federal Home Loan Mortgage Corporation for the year ended December 31, 2013. No other individual investor was sold more than 10% of the total loans sold.
Periodic changes in value of both forward MBS contracts and rate lock commitments are reported in current period earnings as net gain on sale of mortgage loans. Net gain recognized in earnings for the years ended December 31, 2013, and 2012 were $315,000 and $567,000, respectively.
Note 17: Fair Value Measurements
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 fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.
Transfers between levels are deemed to have occurred at the end of the reporting period. For the years ended December 31, 2013, and 2012 there were no significant transfers between levels.
Except for certain CDOs sold by the Company in December 2013 and auction rate asset-backed securities, all securities (available-for-sale and held-to-maturity) are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:
· Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.
· Other government-sponsored agency securities, MBS, real estate mortgage investment conduits and collateralized mortgage obligations and non auction rate asset-backed securities are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.
· State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems). Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities,
· Prior to their sale in December 2013, certain CDOs held by the Company were collateralized by trust preferred security issuances of other financial institutions. These CDOs were valued utilizing a discounted cash flow analysis. To reflect an appropriate fair value measurement, management included a risk premium adjustment to provide an estimate of the amount that a market participant would demand because of uncertainty in cash flows in the discounted cash flow analysis. Changes in unobservable inputs such as future cash flows, prepayment speeds and market rates may result in a significantly higher or lower fair value measurement. Due to the significant amount of unobservable inputs for the security and limited market activity, these securities were considered Level 3 valuations.
· During 2013, asset-backed auction rate securities were acquired and priced using data from dealer market participants until December 31, 2013. At December 31, 2013, the Company utilized pricing data from a nationally recognized valuation firm providing specialized securities
valuation services. Therefore, the valuation of auction rate asset-backed securities are considered Level 3 valuations
· Residential mortgage loans eligible for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices.
· Lending related commitments to fund certain residential mortgage loans, e.g. residential mortgage loans with locked in interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors as well as forward commitments for future delivery of MBS are considered derivatives. Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.
· The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value. The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.
· Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.
· Both the credit valuation reserve on current interest rate swap positions and on receivables related to unwound customer interest rate swap positions were determined based upon management’s estimate of the amount of credit risk exposure, including by available collateral protection and/or by utilizing an estimate related to a probability of default as indicated in the Bank credit policy. Such adjustments would result in a Level 3 classification.
· The fair value of impaired loans with specific allocations of the allowance for loan losses is essentially based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
· Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at December 31, 2013, and December 31, 2012, respectively, which are measured by the Company at fair value on a recurring basis:
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs are summarized as follows:
The following table and commentary presents quantitative (dollars in thousands) and qualitative information about Level 3 fair value measurements as of December 31, 2013:
The following table and commentary presents quantitative (dollars in thousands) and qualitative information about Level 3 fair value measurements as of December 31, 2012:
The $125,000 on the State and political subdivisions line at December 31, 2013, represents a security from a small, local municipality. This is categorized as a Level 3 security based on the payment stream received by the Company from the municipality. That payment stream is otherwise an unobservable input.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:
The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of, impaired loans and OREO. For assets measured at fair value on a nonrecurring basis on hand at December 31, 2013, and December 31, 2012, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans, had a carrying amount of $11.5 million, with a valuation allowance of $2.4 million, resulting in a decrease of specific allocations within the provision for loan losses of $3.9 million for the year ending December 31, 2013. The carrying value of loans fully charged-off is zero.
2 OREO is measured at the lower of carrying or fair value less costs to sell, had a net carrying amount of $41.5 million, which is made up of the outstanding balance of $65.9 million, net of a valuation allowance of $22.3 million and participations of $2.1 million, at December 31, 2013, resulting in a charge to expense of $8.3 million for the year ended December 31, 2013.
The Company also has assets that under certain conditions are subject to measurement at fair value on a nonrecurring basis. These assets include OREO and impaired loans. The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical range of
unobservable inputs for these valuation assumptions are not meaningful.
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans, had a carrying amount of $27.8 million, with a valuation allowance of $6.3 million, resulting in a decrease of specific allocations within the provision for loan losses of $6.8 million for the year ending December 31, 2012. The carrying value of loans fully charged-off is zero.
2 OREO is measured at the lower of carrying or fair value less costs to sell, had a net carrying amount of $72.4 million, which is made up of the outstanding balance of $109.7 million, net of a valuation allowance of $31.4 million and participations of $5.9 million, at December 31, 2012, resulting in a charge to expense of $16.4 million for the year ended December 31, 2012.
Note 18: Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions
To meet the financing needs of its customers, the Bank, as a subsidiary of the Company, is a party to various financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate and sell loans as well as financial standby, performance standby and commercial letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and letters of credit are represented by the dollar amount of those instruments. Management generally uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Interest Rate Swaps
The Company also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments. These derivative positions relate to transactions in which the Bank enters into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. Due to financial covenant violations relating to nonperforming assets, the Bank had $3.1 million in investment securities pledged to support interest rate swap activity with three correspondent financial institutions at December 31, 2013. The Bank had $7.4 million in investment securities pledged to support interest rate swap activity with a correspondent financial institution at December 31, 2012. In connection with each transaction, the Bank agreed to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, the Bank agreed to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the client to effectively convert a variable rate loan to a fixed rate loan and is also part of the Company’s interest rate risk management strategy. Because the Bank acts as an intermediary for the client, changes in the fair value of the underlying derivative contracts offset each other and do not generally impact the results of operations. Fair value measurements include an assessment of credit risk related to the client’s ability to perform on their contract position, however, and valuation estimates related to that exposure are discussed in Note 17 above. At December 31, 2013, the notional amount of nonhedging interest rate swaps was $51.9 million
with a weighted average maturity of 1.5 years. At December 31, 2012, the notional amount of nonhedging interest rate swaps was $82.1 million with a weighted average maturity of 1.3 years. The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.
The Bank also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed by entering into contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking income. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.
The following table presents derivatives not designated as hedging instruments as of December 31, 2013, and periodic changes in the values of the interest rate swaps and the risk participation agreement contract are reported in other noninterest income. Periodic changes in the value of the forward contracts related to mortgage loan origination are reported in the net gain on sales of mortgage loans.
1Includes unused loan commitments and interest rate lock commitments.
2Includes forward MBS contracts.
The following table presents derivatives not designated as hedging instruments as of December 31, 2012.
1Includes unused loan commitments, interest rate lock commitments, and forward rate lock.
2Includes forward mortgage backed securities and forward loan contracts.
Note 19: Fair Values of Financial Instruments
The estimated fair values of financial instruments approximate carrying amount for all items except those described in the following table. Investment security fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The fair value of the CDOs included in investment securities, as of December 31, 2012, and subsequently sold in December 2013, includes a risk premium adjustment to provide an estimate of the amount that a market participant would demand because of uncertainty in cash flows and the methods for determining fair value of securities as discussed in detail in Note 17. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable, and can only be sold to the FHLBC or another member institution at par. During the year ended December 31, 2013, and 2012, we participated in multiple redemptions with the FHLBC and using the redemption values as the carrying value, FHLBC stock has been transferred to a Level 2 fair value as of December 31, 2012. Fair values of loans were estimated for portfolios of loans with similar financial characteristics, such as type and fixed or variable interest rate terms. Cash flows were discounted using current rates at which similar loans would be made to borrowers with similar ratings and for similar maturities. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off-balance sheet items is not considered material. The fair value of mortgage banking derivatives is discussed above in Note 16.
The carrying amount and estimated fair values of financial instruments were as follows:
Note 20: Preferred Stock
The Series B Preferred Stock was issued to Treasury as part of the Treasury’s Troubled Asset Relief Program and Capital Purchase Program (the “CPP”). The Series B Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends on the liquidation preference amount on a quarterly basis at a rate of 5% per annum for the first five years, and 9% per annum thereafter effective in February 2014. Concurrent with issuing the Series B Preferred Stock, the Company issued to the Treasury a ten year warrant to purchase 815,339 shares of the Company’s common stock at an exercise price of $13.43 per share.
The Company allocated the $73 million in proceeds received from the Treasury in the first quarter of 2009 between the Series B Preferred Stock and the warrant that was issued. The warrant was classified as equity, and the allocation was based on their relative fair values in accordance with accounting guidance. The fair value was determined for both the Series B Preferred Stock and the warrant as part of the allocation process in the amounts of $68.2 million and $4.8 million, respectively.
As discussed in Note 15, on August 31, 2010, the Company announced that it would begin deferring quarterly cash dividends on its outstanding Series B Preferred Stock. Further, as discussed in Note 10 and Note 15, the Company has elected to defer interest payments on certain of its subordinated debentures. However, if the Company fails to pay dividends for an aggregate of six quarters on the Series B Preferred Stock, whether or not consecutive, the holders have the right to appoint representatives to the Company’s board of directors. As the Company elected to defer dividends for more than six quarters, a new director was appointed by the Treasury to join the board during the fourth quarter of 2012. The terms of the Series B Preferred Stock also prevent the Company from paying cash dividends or generally repurchasing its common stock while Series B Preferred Stock dividends are in arrears. The total amount of unpaid and deferred Series B Preferred Stock dividends as of December 31, 2013, was $13.3 million.
All of the Series B Preferred Stock held by Treasury was sold to third parties, including certain of our directors, in auctions that were completed in the first quarter of 2013. The warrant was also sold at a subsequent auction to a third party. Upon completion by Treasury of the auction, the Company’s board affirmed the director appointed by Treasury to ongoing board membership, and the Series B director was elected by the holders of the Series B Preferred Stock at the Company’s 2013 annual meeting. At December 31, 2012, the Company carried $71.9 million of Series B Preferred Stock in total stockholders’ equity. At December 31, 2013, the Company carried $72.9 million of Series B Preferred Stock in total stockholders’ equity.
As a result of the completed auctions, the Company’s Board elected to stop accruing the dividend on the Series B Preferred Stock in the first quarter 2013. Previously, the Company had accrued the dividend on the Series B Preferred Stock quarterly throughout the deferral period. Given the discount reflected in the results of the auction, the board believes that the Company will likely be able to repurchase the Series B Preferred Stock in the future at a price less than the face amount of the Series B Preferred Stock and the accrued and unpaid dividends. Therefore, the Company did not fully accrue the dividend on the Series B Preferred Stock in the first quarter and did not accrue for it in subsequent quarters. The Company will continue to evaluate whether accruing dividends on the Series B Preferred Stock is appropriate in future periods.
Note 21: Parent Company Condensed Financial Information
Condensed Balance Sheets as of December 31 were as follows:
Condensed Statements of Operations for the years ended December 31 were as follows:
Condensed Statements of Cash Flows for the years ended December 31 were as follows:
Note 22: Stockholders’ Rights Plan
On September 12, 2012, the Company and the Bank, as rights agent, entered into the Amended and Restated Rights Plan and Tax Benefits Preservation Plan (the “Rights Plan”). The Rights Plan amended the Rights Agreement, dated September 17, 2002. The purpose of the Rights Plan is to protect the Company’s deferred tax asset against an unsolicited ownership change, which could significantly limit the Company’s ability to utilize its deferred tax assets. The Rights Plan was ratified by the Company’s stockholders at the Company’s 2013 annual meeting. For a description of the Rights Plan, please refer to the Company’s Form 8-A, filed September 13, 2012.
Note 23: Employee Benefit Plans
Old Second Bancorp, Inc. Employees 401(k) Savings Plan and Trust
The Company sponsors a qualified, tax-exempt defined contribution plan (the “Plan”) qualifying under section 401(k) of the Internal Revenue Code. Virtually all employees are eligible to participate after meeting certain age and service requirements. Eligible employees are permitted to contribute up to a dollar limit set by law of their compensation to the 401(k) plan. For the years ended December 31, 2013 and 2012, a discretionary match equal to 100% of the first 2% of the participant’s compensation was contributed to participants of the Plan. Participants are 100% vested in the discretionary matching contributions. The profit sharing portion of the 401(k) plan arrangement provides an annual discretionary contribution to the retirement account of each employee based in part on the Company’s profitability in a given year, and on each participant’s annual compensation. Participants can choose between several different investment options under the 401(k) plan, including shares of the Company’s common stock.
The total expense relating to the 401(k) plan was approximately $468,000 and $441,000 in 2013 and 2012, respectively.
Old Second Bancorp, Inc. Voluntary Deferred Compensation Plan for Executives
The Company sponsors an executive deferred compensation plan, which is a means by which certain executives may voluntarily defer a portion of their salary or bonus. This plan is an unfunded, nonqualified deferred compensation arrangement. Company obligations under this arrangement as of December 31, 2013, and 2012 were $1.8 million and $1.5 million, respectively, and are included in other liabilities.
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Old Second Bancorp, Inc. and Subsidiaries
Aurora, Illinois
We have audited the accompanying consolidated balance sheets of Old Second Bancorp, Inc. and Subsidiaries as of December 31, 2013, and 2012, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for the years then ended. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included 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 and 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 Old Second Bancorp, Inc. and Subsidiaries as of December 31, 2013, and 2012, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Old Second Bancorp, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 26, 2014, expressed an unqualified opinion thereon.
/s/ Plante & Moran, PLLC
Chicago, Illinois
February 26, 2014
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
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of December 31, 2013. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2013, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and such information is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers as appropriate to allow timely decisions regarding required disclosure.
There were no changes in the Company’s internal control over financial reporting during the quarter ended December 31, 2013, that have materially affected or are reasonably likely to affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2013, management assessed the effectiveness of the Company’s internal control over financial reporting based on the framework established in the 1992 “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management has determined that the Company’s internal control over financial reporting was effective as of December 31, 2013, based on the criteria specified.
Plante & Moran PLLC, the independent registered public accounting firm that audited the consolidated financial statements of the Company incorporated by reference to this Annual Report on Form 10-K, has issued an attestation report, included herein, on the Company’s internal control over financial reporting as of December 31, 2013.
Report of Independent Registered Public Accounting Firm
To the Audit Committee
Old Second Bancorp, Inc. and Subsidiaries
Aurora, Illinois
We have audited Old Second Bancorp, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (referred to as (“COSO”). Old Second Bancorp, Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying “Management’s Report on Internal Control Over Financial Reporting.” Our responsibility is to express an opinion on Old Second Bancorp, Inc. and Subsidiaries’ internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Old Second Bancorp, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Old Second Bancorp, Inc. and Subsidiaries as of December 31, 2013, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity and cash flows for the year then ended, and our report dated February 26, 2014, expressed an unqualified opinion on those financial statements.
/s/ Plante & Moran, PLLC
Chicago, Illinois
February 26, 2014
Item 9B.
Item 9B. Other Information
None
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Directors, Executive Officers, Promoters and Control Persons
The Company’s board of directors is divided into three classes, approximately equal in number, which are elected by the Company’s common stockholders (the “Common Stock Directors”), and one class that is elected by the holders of the Company’s Series B Preferred Stock (the “Class B Directors”). Each of the Company’s directors has been duly elected by the Company’s shareholders at the applicable annual meeting of shareholders. The Common Stock Directors were elected at the 2013 annual meeting following such directors’ nomination by the Company’s Nominating and Corporate Governance Committee, and the Class B Director, Duane Suits, was elected to the board at the 2013 annual meeting.
Treasury, as the holder of the Series B Preferred Stock, had the right to appoint two directors to the Company’s board following the Company’s deferral of the dividend payments on the Series B Preferred Stock for an aggregate of six quarters and partially exercised this right in 2012 with the appointment of Mr. Suits to the board. In November 2012, Mr. Suit’s appointment was approved by the unanimous written consent of the board. Following Treasury’s sale of the Series B Preferred Stock at auction in the first quarter of 2013, Mr. Suits was elected a Class B Director by the current holders of the Series B Preferred Stock at the 2013 annual meeting. In addition to Mr. Suits, the current holders of the Series B Preferred Stock have the right to appoint a second Class B Director. Set forth below is information concerning the Company’s directors, including their age, year first elected or appointed as a director and business experience during the previous five years. None of the directors serve on the boards of any other publicly traded companies besides the Company
DIRECTORS
Common Stock Directors
Class B Directors
All Common Stock Directors will hold office for the terms indicated, or until their earlier death, resignation, removal or disqualification and until their respective successors are duly elected and qualified. The Class B Director will hold office for a one-year term, until his earlier death, resignation, removal or disqualification and until his respective successor is duly elected and qualified. The Class B Directorship will terminate if the Company either pays all accumulated but unpaid interest on, or redeems in full, the Series B Preferred Stock.
There are no arrangements or understandings between any of the nominees, directors or executive officers and any other person pursuant to which any of the Company’s nominees, directors or executive officers have been selected for their respective positions. No nominee, member of the board of directors or executive officer is related to any other nominee, member of the board of directors or executive officer.
Director Qualifications
The Company has established minimum criteria that the Company believes each director should possess to be an effective member of the Company’s board. The particular experience, qualifications, attributes or skills that led the board to conclude that each member is qualified to serve on the board and any committee he or she serves on is as follows:
Mr. Bonifas: The Company considers Mr. Bonifas to be qualified for service on the board, the Audit Committee and the Compensation Committee due to his skills and expertise acquired as a leader of a successful business and his prominence in the community.
Mr. Cheatham: The Company considers Mr. Cheatham to be qualified for service on the board due to his experience in the financial services industry and the familiarity with Old Second’s operations he has acquired as Chief Financial Officer of the Company.
Mr. Eccher: The Company considers Mr. Eccher to be qualified for service on the board due to his experience in the financial services industry and the familiarity with the Company’s operations he has acquired as the Chief Operating Officer of the Company and President of the Bank.
Mr. Finn: The Company considers Mr. Finn to be qualified for service on the board and the Nominating and Corporate Governance Committee and the Audit Committee due to his business and financial expertise acquired as an executive at a successful local medical center, as well as his prominence in the community.
Mr. Kane: The Company considers Mr. Kane to be qualified for service on the board and the Compensation Committee due to his experience as a partner at a successful local business, his general experience in business and his prominence in the community.
Mr. Ladowicz: The Company considers Mr. Ladowicz to be qualified for service on the board, the Audit Committee and the Nominating and Corporate Governance Committee due to his previous experience as a
chief executive officer in the financial services industry, as well as his extensive knowledge of the market areas the Company entered through the acquisition of HeritageBanc, Inc. in 2008.
Mr. Meyer: The Company considers Mr. Meyer to be qualified for service on the board, the Compensation Committee and the Nominating and Corporate Governance Committee due to his skills and expertise acquired as president of a well-established local business and his prominence in the local business community.
Mr. Palmer: The Company considers Mr. Palmer to be qualified for service on the board, the Compensation Committee and the Nominating and Corporate Governance Committee due to his skills and expertise acquired as vice president of a successful publicly traded company, his experience in the industrial manufacturing industry and his knowledge of the business community in the markets the Company serves.
Mr. Schmitz: The Company considers Mr. Schmitz to be qualified for service on the board and the Audit Committee due to his skills and expertise in tax consulting and his familiarity with the Company’s local market areas.
Mr. Skoglund: The Company considers Mr. Skoglund to be qualified for service on the board due to his skills and experience in the financial services industry and the intimate familiarity with the Company’s operations he has acquired as the Chief Executive Officer of the Company.
Mr. Suits: Pursuant to the terms of the Company’s outstanding Series B Preferred Stock, Treasury appointed Mr. Suits to the Company’s board as a Class B Director in 2012. Mr. Suits’ appointment was approved by the unanimous written consent of the board on November 20, 2012. Mr. Suits was also appointed to the Audit Committee. Following Treasury’s sale of the Series B Preferred Stock at auction, Mr. Suits was elected by the holders of the Series B Preferred Stock at the 2013 annual meeting. Although holders of the Company’s common stock are not entitled to vote for the election of Mr. Suits to the Company’s board of directors, the Company considers Mr. Suits to be qualified for service due to his skills and experience in the financial services industry and his familiarity with the Company’s operations.
Security 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires that the Company’s directors, executive officers and ten percent stockholders file reports of ownership and changes in ownership with the Securities and Exchange Commission. Such persons are also required to furnish us with copies of all Section 16(a) forms they file. No person failed to comply with the filing requirements of Section 16(a) during 2013 and there are no late filings to report. Based solely on its review of the copies of Section 16(a) forms received from its directors and executive officers and written representations that no other reports were required, the Company believes that all Section 16(a) reports applicable to its directors and officers during 2013 were filed, with two exceptions. Messrs. Skoglund and Eccher each filed one late form all of which all related to the grant and forfeiture of certain restricted stock awards in April 2013.
Corporate Governance
Currently, the board of directors is made up of eleven directors of which ten are Common Stock Directors, who are elected by the holders of the Company’s common stock every three years to serve staggered terms, and one is a Class B Director, who is elected annually by the holders of the Company’s Series B Preferred Stock. Under the terms of the Series B Preferred Stock, the Series B Preferred Stockholders also have the right to appoint a second Class B Director.
Generally, the board oversees the Company’s business and monitors the performance of the Company’s management. In accordance with the Company’s corporate governance procedures, the board does not
involve itself in the day-to-day operations of the Company, which is monitored by the Company’s executive officers and management. The Company’s directors fulfill their duties and responsibilities by attending regular meetings of the board and through committee membership, which is discussed below. The board has determined that all of the Company’s directors are “independent” as defined by the Nasdaq Stock Market, with the exception of Messrs. Skoglund, Cheatham and Eccher, each of whom is an executive officer.
The Company’s board of directors believes that it is important to encourage the highest level of corporate ethics and responsibility. Among other things, the board adopted a Code of Business Conduct and Ethics, which applies to all of the Company’s directors, officers and employees, as well as a procedure for allowing employees to anonymously report any problems they may detect with respect to the Company’s financial reporting. The Code of Business Conduct and Ethics, as well as other information pertaining to the Company’s committees, corporate governance and reporting with the Securities and Exchange Commission, can be found on the Company’s website at www.oldsecond.com.
The board of directors has standing Audit, Nominating and Corporate Governance and Compensation Committees, each of which is made up solely of directors who are deemed to be “independent” under the rules of Nasdaq. Nasdaq’s independence rules include certain instances that will preclude a director from being deemed independent and the board reviews those requirements each year to determine a director’s status as an independent director.
Audit Committee
The Audit Committee assists the board in carrying out its oversight responsibilities for the Company’s financial reporting process, audit process and internal controls. The Audit Committee is solely responsible for the pre-approval of all audit and non-audit services to be provided by the Company’s independent registered public accounting firm and exercises its authority to do so in accordance with a policy that it has adopted. Additionally, the Audit Committee reviews and approves all related party transactions between the Company and related parties in accordance with Nasdaq’s rules and regulations.
The members of the Company’s Audit Committee during 2013 were Messrs. Finn, (who served as Chairman), Bonifas, Ladowicz, Schmitz and Suits, each of whom is deemed to be an independent director under Nasdaq’s rules. The Company expects that these members will continue to serve on the committee in 2014. Mr. Finn was appointed as chairman of the Audit Committee in 2008. Mr. Schmitz will serve as chairman of the Audit Committee at any meeting Mr. Finn is unable to attend or if Mr. Finn is otherwise unable to carry out the duties of Audit Committee chairman. The Audit Committee met six times in 2013.
The board has designated Mr. Finn, who is currently President and Chief Executive Officer of Rush-Copley Medical Center and previously served as its Chief Operating Officer and Chief Financial Officer, as the “audit committee financial expert,” as such term is defined by the regulations of the SEC. The board’s determination was based upon Mr. Finn’s level of knowledge and experience regarding financial matters and his experience overseeing and managing the audit of an organization, which he has gained both from his formal education and from his professional experience as the Chief Financial Officer of a regional hospital organization. The board believes that each of the other members of the Audit Committee possesses knowledge and experience sufficient to understand the complexities of the financial statements of The Company. Mr. Finn, or another member of the Audit Committee, met on a quarterly basis during 2013 with the Company’s independent registered public accounting firm.
The Audit Committee’s duties, responsibilities and functions are further described in its charter, which is available on the Company’s website at www.oldsecond.com. A copy of the audit committee’s charter can be requested by sending a written request to the Corporate Secretary at 37 South River Street, Aurora, Illinois 60506, or by sending an e-mail requesting same to corporatesecretary@oldsecond.com.
Item 11.
Item 11. Executive Compensation
COMPENSATION DISCUSSION AND ANALYSIS
Introduction
This Compensation Discussion and Analysis describes our compensation philosophy and policies for 2013 and 2014 as applicable to the executive officers named in the Summary Compensation Table set forth below. This section explains the structure and rationale associated with each material element of our named executive officers compensation, and it provides important context for the more detailed disclosure tables and specific compensation amounts provided following the section. It is important to note that the Company and the Bank share an executive management team, the members of which are compensated by the Bank rather than the Company. The compensation packages of the named executive officers are determined and approved by our Compensation Committee based upon their performances and roles for both the Company and the Bank.
The Compensation Committee has overall responsibility for evaluating the compensation plans, policies and programs relating to our executive officers. Further, as required by the rules established by Treasury, guidance issued by the Federal Reserve and other financial institution regulatory agencies, and the SEC’s guidance regarding risk associated with compensation arrangements (each as described more fully below), the Compensation Committee is also responsible for a more expansive risk review with respect to most of the compensation plans, policies and programs maintained for our employees. The Compensation Committee relies upon the input of management, particularly Mr. Skoglund, when carrying out its responsibilities in establishing executive compensation. Management provides the Compensation Committee with evaluations as to employee performance, guidance on establishing performance targets and objectives and recommends salary levels and equity awards. The Compensation Committee also consults with management on matters that are relative to executive compensation and benefit plans where board or stockholder action is expected, including the adoption of new plans or the amendment of existing plans. Finally, the Compensation Committee consults with our management, specifically the Bank’s Chief Risk Officer, in completing the risk review with respect to employee compensation plans. No executive officer participates in any recommendation or decision regarding his or her own compensation.
The Compensation Committee’s charter gives it the authority to delegate its responsibility to members or subcommittees of the Compensation Committee. Also, the charter gives the Compensation Committee the authority to hire outside consultants to further its objectives and responsibilities. In prior years, the Compensation Committee has retained ChaseCompGroup LLC on a bi-annual basis to provide services in connection with a review and analysis of compensation paid to our named executive officers and board of directors. In keeping with the Compensation Committee’s historical philosophy of comparing our compensation with that of the local marketplace every other year, the Compensation Committee did not retain a consultant during 2013 but will likely do so during 2014. In addition, during 2014 the Compensation Committee engaged the services of Towers-Watson to perform a review and analysis of our existing equity incentive plan.
During 2013, the Compensation Committee convened in January, February and November. Mr. Palmer, Chairman of the Compensation Committee, also met as needed with internal staff members, to compile compensation information for this Form 10-K. The Compensation Committee also met in February 2014 to approve salaries, incentive plans and performance metrics for 2014.
Participation in the CPP
We continued as a participant in the CPP through the time of the Treasury’s auction sale of our Series B Preferred Stock and related warrant during the first quarter of 2013. As such, for the period of time from January 1, 2013 through March 11, 2013 (the “2013 CPP Period”), the Company and the Bank, and
certain employees of both, continued to be subject to the CPP compensation-related limitations and restrictions. The CPP compensation limitations and restrictions included the following:
· Except in limited circumstances, our five most highly compensated employees (as determined on an annual basis) were prohibited from receiving cash bonus payments during the 2013 CPP Period. Messrs. Skoglund, Cheatham and Eccher were subject to this prohibition during the 2013 CPP Period.
· Except in limited circumstances, our named executive officers and our next five most highly compensated employees (each as determined on an annual basis) were prohibited during the 2013 CPP Period from receiving any severance payments upon a termination of employment or any payments triggered by the occurrence of a change in control.
· Our named executive officers and next 20 most highly compensated employees were subject to a “clawback” of incentive compensation if that compensation was based on materially inaccurate financial statements or performance metrics. Further, no one in this group of employees could have received any tax gross-up payment during the 2013 CPP Period.
· We were limited to an annual deduction of $500,000 with respect to the compensation paid to each of our named executive officers.
In addition to the specific CPP limitations and restrictions described above, the CPP rules and regulations have required the Compensation Committee to undertake a semi-annual risk assessment with respect to certain of the compensation plans, programs and arrangements maintained by us, regardless of whether the individual employee(s) covered by the plan, program or arrangement is a named executive officer. The risk assessments were performed by the Bank’s Chief Risk Officer and the Compensation Committee. The Bank’s Chief Risk Officer and the Compensation Committee review all compensation plans and arrangements to ensure that risks are identified and mitigated. The intent of these risk assessments is to minimize the opportunity that any employee will be incentivized to take unacceptable risks in order to maximize his or her compensation under such plans and arrangements. Following the end of the 2013 CPP Period, we were no longer subject to the CPP compensation limitations and restrictions.
Regulatory Impact on Compensation
As a publicly-traded financial institution, we and the Bank must contend with several often overlapping layers of regulations, in addition to the CPP compensation-related limitations and restrictions, when considering and implementing compensation-related decisions. These regulations are primarily intended to focus attention on the risks that often go hand-in-hand with compensation programs designed to incentivize the achievement of better than average performance. We and the Compensation Committee strive to incorporate the broad principles of these regulations into the compensation decisions made with respect to our named executive officers and other employees.
Under its long-standing Interagency Guidelines Establishing Standards for Safety and Soundness, the FDIC has long held that excessive compensation is prohibited as an unsafe and unsound practice. In describing a framework within which to make a determination as to whether compensation is to be considered excessive, the FDIC has indicated that financial institutions should consider whether aggregate cash amounts paid, or noncash benefits provided, to employees are unreasonable or disproportionate to the services performed by an employee. The FDIC encourages financial institutions to review an employee’s compensation history and to consider internal pay equity, and, as appropriate, to consider benchmarking compensation to peer groups. Finally, the FDIC provides that, in order to give proper context, such an assessment must be made in light of the institution’s overall financial condition.
In addition to the Safety and Soundness standards, the Compensation Committee must also take into account the joint agency Guidance on Sound Incentive Compensation Policies. Various financial institution regulatory agencies worked together to issue the Guidance, which is intended to serve as a
compliment to the Safety and Soundness standards. The Guidance sets forth a framework for assessing and mitigating risk associated with incentive compensation plans, programs and arrangements maintained by financial institutions. The Guidance is narrower in scope than the Safety and Soundness standards because it applies only to senior executive officers and those other individuals who, either alone or as a group, could pose a material risk to an institution. With respect to such individuals, the Guidance is intended to focus an institution’s attention on balanced risk-taking incentives, compatibility of incentives with effective controls and risk management, and a focus on general principles of strong corporate governance in establishing, reviewing and maintaining incentive compensation programs.
The Compensation Committee, with the assistance of its advisors and our management, continues to monitor the status of compensation-related rules and regulations expected to be finalized or issued under the Dodd-Frank Act. While the Compensation Committee believes its own risk assessment procedures are effective, the Compensation Committee is prepared to implement any additional steps that may be deemed necessary to fully comply with such rules and regulations when finally finalized or issued. The Compensation Committee does note, however, that the proposed risk assessment rules issued under the Dodd-Frank Act nearly mirror the Safety and Soundness standards and the framework of the Guidance. As such, the Compensation Committee already adheres, in many respects, with the proposed rules and regulations under the Dodd-Frank Act.
Finally, in addition to the foregoing, as a publicly-traded corporation, we are also subject to the SEC’s rules regarding risk assessment. Those rules require a publicly-traded company to determine whether any of its existing incentive compensation plans, programs or arrangements create risks that are reasonably likely to have a material adverse effect on the company.
The Compensation Committee continues to believe in and practice a sensible approach to balancing risk-taking and rewarding reasonable, but not necessarily easily attainable, goals and this has always been a component of its overall assessment of the compensation plans, programs and arrangements it has put in place for our named executive officers. In this regard, the Compensation Committee has regularly revisited the components of the frameworks set forth in the Safety and Soundness standards and the Guidance as an effective tool for conducting its own assessment of the balance between risk and reward built into our compensation programs for named executive officers. The Compensation Committee believes we have adequate policies and procedures in place to balance and control any risk-taking that may be incentivized by the employee compensation plans. The Compensation Committee further believes that such policies and procedures will work to limit the risk that any employee would manipulate reporting earnings in an effort to enhance his or her compensation.
Impact of Prior Say-on-Pay Votes on Compensation Decisions
At our 2013 Annual Meeting, approximately 95% of stockholders present and entitled to vote approved the non-binding advisory proposal on the compensation of certain executive officers. We, our board and the Compensation Committee pay careful attention to communications received from stockholders regarding executive compensation, including the non-binding advisory vote. We considered the positive result of the 2013 advisory vote on executive compensation but not for specific 2013 compensation decisions. Based on this consideration and the other factors described in this Compensation Discussion & Analysis, the Compensation Committee did not alter the policies or structure for named executives’ compensation for 2013.
Financial and Operational Performance
In 2013, we continued our emphasis on returning to sustained profitability and growth as its primary objectives. Specific accomplishments in 2013 that directly impacted those objectives include:
· Reduction in classified assets by 45%;
· Net income of $11.8 million highlighted by lower credit costs, loan loss reserve releases and lower insurance costs; and
· Balance sheet stability allowing renewed focus on commercial loan relationship generation.
Accordingly, our executive compensation, particularly metrics for the organization’s short-term incentive plans, focused on the following goals and accountabilities: our and the Bank’s net income growth; specific profit center performance; asset-credit quality risk; reduction in classified assets; and cost savings initiatives. These metrics were prudently designed to contain and minimize risk while at the same time emphasizing growth and profitability.
Compensation Philosophy and Objectives
Our philosophy is intended to align the interests of management with those of our stockholders without creating undue risk to us. The executive compensation program is designed in a manner which the Compensation Committee believes does not provide our executives with incentives to engage in business activities or other behavior that would threaten our value or the investments of our stockholders.
The executive compensation program is intended to accomplish the following objectives:
· align the interests of our named executive officers with those of our stockholders;
· maintain a corporate environment which encourages stability and a long-term focus for both us and our management;
· maintain a program which:
o clearly motivates personnel to perform and succeed according to our current goals;
o retains key personnel critical to our long-term success; and
o does not create undue risk to us; and
· ensure that management:
o fulfills its oversight responsibility to its constituents which include stockholders, customers, employees, the community and government regulatory agencies;
o conforms its business conduct to the highest ethical standards;
o remains free from any influences that could impair or appear to impair the objectivity and impartiality of its judgments or treatment of our constituents; and
o continues to avoid any conflict between its responsibilities to us and each individual’s personal interests.
Compensation Components
General. In recent years, the Compensation Committee has been required to reevaluate the components of our compensation program because of the continuing impact of the CPP executive compensation rules. Historically, we have included four major components in our named executive officers’ compensation program: (i) base salary, (ii) annual cash bonus, (iii) equity awards and (iv) additional benefits. However, until recently, the Compensation Committee was unable to rely on annual cash bonuses as a component for some of our named executive officers because of the impact of the CPP compensation limitations and restrictions. As such, for our named executive officers, the Compensation Committee has focused primarily on base salary, equity awards permitted under the CPP rules, and additional benefits. This began to change somewhat during 2013 with our exit from the CPP when cash incentive bonuses again became a possibility for our named executive officers.
The Compensation Committee’s decisions regarding each of the components for the named executive officers are based in part on the Compensation Committee’s subjective judgment and take into account qualitative and quantitative factors, as are discussed below. In reviewing an executive officer’s compensation, the Compensation Committee considers and evaluates all components of the officer’s total compensation package. This involves reviewing base salary, bonus, incentive stock awards, perquisites,
participation in our non-qualified executive plans, participation in our 401(k) plan and any other payments, awards or benefits that an officer earns (to the extent each is permitted under the CPP compensation limitations and restrictions). Additionally, the Compensation Committee takes into consideration any amounts an executive officer is entitled to upon retirement, termination or a change-in-control event, including the impact of the CPP compensation limitations and restrictions on these amounts. In this regard, in establishing compensation for 2013 and 2014, the Compensation Committee utilized tally sheets summarizing these aggregated amounts.
Base Compensation - Salary. The Compensation Committee believes that base compensation should offer security to each executive sufficient to maintain a stable management team and environment. Because of the need to provide stability, salaries make up the largest portion of the executives’ compensation. In establishing a senior executive officer’s initial base salary the Compensation Committee considers, among other things, the executive’s level of responsibility, prior experience, breadth of knowledge, the competitive salary practices at peer companies, internal performance objectives, education, internal pay equity, potential bonus and equity awards, level of benefits and perquisites and the tax deductibility of base salary.
The Compensation Committee reviews salaries of the named executive officers on an annual basis. As with all of its decisions regarding compensation levels, when reviewing salaries the Compensation Committee considers the levels of all aspects and components of the officer’s compensation, including the individual’s potential bonus and equity awards as well as the level of benefits and perquisites offered. All of these factors are considered on a subjective basis in the aggregate, and none of the factors is accorded a specific weight.
Cash Incentive Awards - Bonus. The executive compensation restrictions contained in the CPP rules prohibited us from paying or accruing cash bonuses on behalf of the top five most highly paid employees (as determined on an annual basis) during the 2013 CPP Period. Messrs. Skoglund, Cheatham and Eccher were subject to the bonus prohibition during the 2013 CPP Period, but were eligible to receive cash bonuses with respect to any part of 2013 following the 2013 CPP Period.
In anticipation of our possible exit from the CPP during 2013, the Compensation Committee adopted a non-equity incentive compensation plan for our named executive officers. The 2013 plan established a structure under which Messrs. Skoglund, Cheatham and Eccher would be eligible for cash bonus payments if our performance during 2013 met or exceeded certain performance goals; provided that, the Compensation Committee ultimately had discretion to determine the amount of any bonuses awarded. Any such bonus payments were contingent upon our exit from the CPP and were required to be prorated to reflect the period of time during 2013 that we continued to be a participant in the CPP.
The 2013 bonus plan was designed to provide an incentive to achieve corporate financial goals while considering the mitigation of any risks which may affect our overall financial performance. Generally speaking, thresholds and targets are set so that improvement in a performance metric is necessary in order to receive any or all of the bonus payout with respect to that metric.
In setting the performance metrics, Mr. Skoglund provided recommendations with respect to members of management other than himself to the Compensation Committee. The Compensation Committee then, outside the presence of Mr. Skoglund, considers factors applicable to Mr. Skoglund’s annual bonus.
In 2013, pursuant to our bonus plan, Mr. Skoglund was potentially eligible for an annual bonus equal to 51.25% of his salary, or $258,761. Mr. Eccher was potentially eligible for an annual bonus equal to 45% of his salary, or $146,250, and Mr. Cheatham was potentially eligible for an annual bonus equal to 40% of his salary, or $100,800. Based on our performance during 2013 and the adjustment required under the CPP rules, Messrs. Skoglund and Eccher earned 81% of their bonuses, and Mr. Cheatham earned 61% of his bonus
The components designated by the Compensation Committee and the target percentage of salary that the named executive officers were eligible to earn for 2013 performance and resulting actual bonus received, were as follows:
Named Executive
Officer
Company
Income Growth
Bank Capital
Ratio
Asset/Credit
Quality
Cost Savings
TTotal
William B. Skoglund
25%
10%
10%
---
45%
J. Douglas Cheatham
20%
5%
---
10%
35%
James Eccher
20%
10%
10%
---
40%
In October 2013, our named executive officers also received payment of bonus amounts that were earned during 2008 but could not be paid until after each executive was no longer subject to the bonus restrictions applicable under the CPP. Mr. Skoglund received a payment of $235,669, Mr. Cheatham received a payment of $93,094 and Mr. Eccher received a payment of $122,119. These payments were not factored into our bonus decisions with respect to 2013.
Company Income Growth. The Compensation Committee believes that our growth, as measured by reference to our net income, is an appropriate measure because it focuses on our financial performance, which in turn reflects stockholder value. Each named executive officer has a portion of his bonus tied to this metric. The Compensation Committee applied the following scale to determine how much of the target percentage any named executive officer would receive based on our net income:
Net Income
Amount of Target
Percentage
$2.0 million
50%
$3.0 million
75%
$4.0 million
100%
$5.0 million
125%
Our 2013 net income exceeded $5.0 million, and, therefore, the named executive officers earned 125% of this component.
Capital Ratios. The Compensation Committee believes that our and the Bank’s capital ratios are another way in which we can measure our return to sustained profitability. As such, each of our named executive officers has a portion of his bonus tied to this metric. Provided that we maintained at the Bank during 2013 a Tier 1 capital leverage capital ratio of 10% or better and a total capital ratio of 14% or better, our named executive officers would earn 100% of the bonus attributable to this metric. If we fell below either level, our executives would receive no bonus with respect to this metric.
The Bank’s leverage capital ratio was 10.97% and its total capital ratio was 18.04% as of December 31, 2013. Therefore, the named executive officers earned 100% of this component.
Asset/Credit Quality. With respect to Messrs. Skoglund and Eccher, because classified assets were a difficult issue for the company to navigate the last several years, the Compensation Committee believes incentivizing them to focus on our asset/credit quality will further ensure that we are working toward sustainable growth and profitability. As such, the Compensation Committee determined that a bonus component for them would appropriately be tied to our classified asset ratio. If the ratio remained at 61.90% or lower, each of Messrs. Skoglund and Eccher would be entitled to 100% of their bonus with respect to this metric. If the ratio exceeded 61.90%, then no bonus would be earned with respect to our asset/credit quality.
Our classified asset ratio was 43.44% at December 31, 2013, thus entitling Messrs. Skoglund and Eccher to 100% of the bonus associated with this component.
Cost Savings. The Compensation Committee believes that expense control and efficiency of operations is a goal we must continually strive for in order to provide for the best financial return for our shareholders. Further, the Compensation Committee believes that Mr. Cheatham is the person best situated to impact our efforts in this regard. As such, the Compensation Committee deemed a bonus component in 2013 tied to cost savings as measured by total non-interest expense at the Company level to be merited. If our total non-interest expense was less than $84,200,000, Mr. Cheatham would earn 100% of the bonus with respect to this component. No bonus would be earned if our total non-interest expense was not below that level.
Although we reported non-interest expense of $83,144,000, the Compensation Committee determined that Mr. Cheatham was not eligible for a bonus with respect to this component because the reported non-interest expense reflects an adjustment that was not anticipated at the time performance metrics were established.
Long-Term Incentive Awards - Equity Awards. Our board and the Compensation Committee believe in senior management ownership of our common stock as an effective means to align the interests of senior management with those of the stockholders. In addition, because the CPP rules prohibited the payment of cash bonuses to our named executive officers, the Compensation Committee has in recent years placed a greater focus on equity awards, which were permitted under the CPP rules. Our current long-term incentive plan (the “Incentive Plan”), which was approved by stockholders at the 2008 annual meeting, is intended to promote equity ownership in the Company by the directors and selected officers and employees, focus the management team on increasing value to stockholders, increase their proprietary interest in the success of the Company and encourage them to remain in the employ of the Company or its subsidiaries for a long period of time. The current equity incentive plan authorizes the issuance of up to 575,000 shares of our common stock, including the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units and stock appreciation rights.
All awards are at the discretion of the Compensation Committee and are generally subjective in nature. In determining the number of equity awards to be granted to executive officers, the Compensation Committee considers individual and corporate performance and whether the respective goals were obtained, the person’s position and ability to affect profits and stockholder value, as well as the level of awards granted to individuals with similar positions at our peer organizations. Because of the nature of equity awards, the Compensation Committee also evaluates the prior awards of stock options and restricted stock and takes into account the overall wealth accumulation of a given executive officer through such awards.
Pursuant to a formal equity compensation policy, all equity grants are finalized in the beginning of each calendar year. This allows for a more complete review of the full prior year when making equity awards as well as coordinating the granting of equity awards to a time when there is less likelihood of there being existing material, non-public information, as the grants will normally be made after the public release of our financial information for the prior year.
Over the last few years, because of our participation in CPP, the Compensation Committee has made most equity awards in the form of restricted stock or restricted stock units. The CPP rules limited our ability to grant to our named executive officers equity awards other than restricted stock or restricted stock units. The CPP rules also dictated the terms and conditions of those awards. In 2013, the Compensation Committee granted restricted stock that complied with the CPP rules to the named executive officers. The Compensation Committee believes that restricted stock is an appropriate
employee retention tool because it aligns our executive officers’ interests with those of our stockholders. The awards subject to the CPP rules have a two-year vesting period.
The Compensation Committee did not make a new equity award to our named executive officers in early 2014 but retains the discretion to do so later in the year if it determines that circumstances warrant such award.
When considering our past equity awards that were made subject to the CPP rules, it is important to note that Treasury auctioned our Series B Preferred Stock and related warrant in early 2013. As a result, our named executive officers were required to forfeit 75% of each outstanding equity award that was granted pursuant to the CPP rules. For our named executive officers, this resulted in a forfeiture of 75% of each of the equity awards, even if previously vested, made to such officer during 2009, 2010, 2011 and 2012.
All Other Compensation. We provide general and customary benefit programs to executive officers and other employees. Benefits offered to executives are intended to serve a different purpose than base salary, bonus and equity awards. While the benefits offered are competitive with the marketplace and help attract and retain executives, the benefits also provide financial security for employees for retirement as well as in the event of illness, disability or death. The benefits we offer to executive officers are generally those offered to other employees with some variation to promote tax efficiency and replacement of benefit opportunities lost to regulatory limits although there are some additional perquisites that may only be offered to executive officers. Because of the nature of the benefits offered, the Compensation Committee normally does not adjust the level of benefits offered on a year-to-year basis. We will continue to offer benefits, the amount of which shall be determined from time-to-time in the sole discretion of the Compensation Committee, provided that such benefits are not in the future determined to be limited or prohibited by the CPP rules.
The following table summarizes the benefits and perquisites we do and do not provide as well as identifies those employees that may be eligible to receive them:
Executive
Officers
Other
Officers/Mgrs.
Full-Time
Employees
Health Plans:
Life & Disability Insurance
X
X
X
Medical/Dental/Vision Plans
X
X
X
Retirement Plans:
401(k) Plan/Profit-Sharing
X
X
X
Deferred Compensation Plan
X
X
Not Offered
Perquisites:
Automobile Allowance
X
Not Offered
Not Offered
Country Club Membership
X
Not Offered
Not Offered
Old Second Bancorp, Inc. Employees 401(k) Savings Plan and Trust. We sponsor a tax-qualified 401(k) savings plan and trust qualifying under Section 401(k) of the Internal Revenue Code. Virtually all employees are eligible to participate after meeting certain age and service requirements. Eligible employees are permitted to contribute up to a dollar limit set by law. Since we terminated our defined-benefit plan as of the end of 2005, the 401(k) plan became the primary retirement vehicle we provide to our officers and employees. Participants can choose between several different investment options under the 401(k) plan, including shares of our common stock.
During 2013, we provided a matching contribution on elective deferrals to eligible participants in an amount equal to 2% of each participant’s salary. There is also a profit-sharing portion of the 401(k) plan
which provides for an annual discretionary contribution to the retirement account of each employee based in part on our profitability in a given year and on each participant’s annual compensation. The contribution amount granted each year is on a discretionary basis and there is no set formula used by the Compensation Committee. No discretionary contribution was provided to employees based on our 2013 financial performance.
Old Second Bancorp, Inc. Amended and Restated Voluntary Deferred Compensation Plan for Executives. We sponsor an executive deferred compensation plan, which provides a means for certain executives to voluntarily defer all or a portion of their salary and/or bonus, if any, without regard to the statutory limitations applicable to tax-qualified plans, such as our 401(k) plan. The deferred compensation plan provides for participant deferrals, company matching contributions and discretionary employer profit-sharing contributions. A company matching contribution is credited to the plan on behalf of a participant when the participant elects to defer the maximum amount permitted under the 401(k) plan (including catch-up contributions, if applicable) and keeps that level of deferral for the entire plan year. The company matching contribution is an amount up to 3%, provided at least a 6% deferral was met, of the participant’s combined base salary and bonuses, less any matching contribution paid to the 401(k) plan on the participant’s behalf. The determination of whether a profit-sharing contribution is made and in what amount is entirely at the Compensation Committee’s discretion and there is no set formula. We suspended the matching contribution under the plan while we were a participant in CPP. Participants are permitted to make hypothetical investments in publicly-traded mutual funds that are held in an insurance company separate account with respect to the deferrals and our contributions credited to their accounts under the plan. Participants may elect to receive their plan balance in a lump sum or in installments. Participants may make a withdrawal from the plan during their employment in the event of hardship as approved by the plan’s administrator. The plan is administered through an independent service provider.
Other Perquisites. It is our belief that perquisites for executive officers should be very limited in scope and value. Due to this philosophy, we have generally provided very nominal benefits to executives that are not available to full-time employees, and we plan to continue this approach in the future. We do provide country club memberships to certain executives and managers in the ordinary course of business to give them the opportunity to bring in and recruit new business opportunities. These individuals are eligible to use the club membership for their own personal use. Additionally, we provide each of Mr. Skoglund and Mr. Eccher with an automobile allowance to enable them to visit our banking locations on a regular basis as well as to call on our customers. We have disclosed the value of all perquisites to named executive officers in the Summary Compensation Table even if they fall below the disclosure thresholds under the SEC rules. We will continue to offer perquisites, the amount of which shall be determined from time-to-time in the sole discretion of the Compensation Committee.
Compensation Decisions
This section describes the decisions made by the Compensation Committee with respect to the compensation for the named executive officers for 2013 and 2014.
The following is a brief summary of the Compensation Committee’s compensation decisions for 2013 and 2014:
· for 2013, minimal merit increases in base salary were granted to our named executive officers in keeping with the conservative compensation guidelines established for the organization;
· for 2014, merit increases in base salary ranging from 3% to 11.5% were granted to our named executive officers;
· $388,334 cash bonus payments were earned or awarded to our named executive officers with respect to 2013 performance; and
· benefits and perquisites remained substantially similar in 2013 compared to prior years and we expect that will continue through 2014.
Base Salary. We annually review the base salaries of the named executive officers to determine whether or not they will be adjusted, as described above. The salaries for 2013, determined by the Compensation Committee at the beginning of 2013, are set forth in the Summary Compensation Table below. In determining these salary levels, we generally considered the following:
· the compensation philosophy and guiding principles described above;
· the general economic factors in the financial industry beyond our control and the financial performance of the Company compared to our peers;
· the experience and industry knowledge of our named executive officers and the quality and effectiveness of their leadership;
· all of the components of executive compensation, including base salary, bonus, stock options, retirement and death benefits, as well as benefits and perquisites; and
· internal pay equity among our executives.
In early 2014, the Compensation Committee determined the base salaries for the executive directors for 2014. The base salaries for 2013 and 2014 are as follows:
Name
Position
William B. Skoglund
Chairman, Chief Executive Officer of the Company
$504,900
$530,000
J. Douglas Cheatham
Chief Financial Officer of the Company
$252,000
$260,000
James Eccher
Chief Executive Officer of the National Bank
$325,000
$362,500
In determining the base salaries for 2014, we considered the same general factors discussed above including the continuing general slowdown in the economy and growth of our earnings, return on average assets and overall assets.
Bonus. Based on our named executive officers’ achievement of the goals for earning a cash bonus established by the Compensation Committee, we awarded cash bonuses as set forth below:
Named Executive Officer
Bonus Earned in 2013
William B. Skoglund
$209,079
J. Douglas Cheatham
$61,085
James Eccher
$118,170
Because of our exit from the CPP in 2013, the Compensation Committee has again established for 2014 an incentive bonus program intended to focus our named executive officers on important performance measures.
Equity Awards. The Compensation Committee typically acts to award equity grants at the beginning of each year, specifically in the months of January and February. The Compensation Committee did not make equity award grants to our named executive officers in 2013 and not yet done so in 2014 although it retains the discretion to do so later in the year if economic conditions and our performance warrant such grants.
All Other Compensation. While the Compensation Committee reviews and monitors the level of other compensation offered to the named executive officers, the Compensation Committee typically does not adjust the level of benefits offered on an annual basis. The Compensation Committee does consider the benefits and perquisites offered to the named executive officers in its evaluation of the total compensation received by each. The perquisites received by the named executive officers in 2013 are reported in the Summary Compensation Table below. The benefits offered in 2013 to the named executive officers are expected to continue for 2014.
COMPENSATION COMMITTEE REPORT
The Compensation Committee has reviewed and discussed the foregoing Compensation Discussion and Analysis with management. Based on the Compensation Committee’s review and discussion with management, the Compensation Committee has recommended to our board of directors that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K for the year ended December 31, 2013.
Section 111(b)(2)(A) of the Emergency Economic Stabilization Act requires the Compensation Committee to conduct, in conjunction with the Bank’s Chief Risk Officer, a review of the incentive compensation arrangements in place between the Company and its employees. In February 2013, the Bank’s Chief Risk Officer presented his comprehensive risk assessment of the organization’s compensation plans to the Compensation Committee. Because of the CPP auction in early 2013, the second semi-annual risk assessment was not required. However, our management and the Compensation Committee have determined that it is appropriate for the Bank’s Chief Risk Officer to continue to conduct his risk assessments on an annual basis.
The Compensation Committee certifies that, at least once during the 2013 CPP Period (a) it reviewed with the Bank’s Chief Risk Officer the senior executive officer (“SEO”) compensation plans and has made all reasonable efforts to ensure that these plans do not encourage SEOs to take unnecessary and excessive risks that threaten the value of the Company; (b) it reviewed with the Bank’s Chief Risk Officer the employee compensation plans and has made reasonable efforts to limit any unnecessary risks these plans pose to the Company; and (c) it reviewed the employee compensation plans to eliminate any features of these plans that would encourage the manipulation of reported earnings of the Company to enhance the compensation of any employee ((a), (b) and (c) being collectively referred to as the “CPP Risk Assessment”).
In the course of conducting its CPP Risk Assessment, the Compensation Committee considered the overall business and risk environment confronting the Company and how the SEO compensation plans and employee compensation plans serve to motivate employee behavior when operating within that environment. In particular, the Compensation Committee’s CPP Risk Assessment focused on the following compensation plans (* denotes plans in which SEOs participate):
·
Amended and Restated Voluntary Deferred Compensation Plan for Executives*
·
Officers Incentive Plan*
·
Base Salary*
·
Residential Lending Commission Plan
·
Compensation and Benefits Assurance Agreements*
·
Residential Lending Override Plan
·
Customer Service/Support Center Plan
·
Retail Banking Plan
·
Employees 401(k) Savings Plan and Trust*
·
Special Recognition Awards Program
·
2008 Equity Incentive Plan*
·
Wealth Management Commission Plan
·
Loan Administration Plan
With the exception of individual bonus goals designated under the Officers Incentive Plan, the Company does not maintain any compensation plans in which only SEOs participate. For purposes of this discussion, references to “SEO compensation plans” mean the portion of an employee plan in which the SEOs participate.
With respect to the SEO compensation plans, the Compensation Committee believes that such plans do not encourage the Company’s SEOs to take unnecessary or excessive risks that could harm the value of the Company. The Compensation Committee believes this to be true because, as is more fully described in the Compensation Discussion and Analysis, the Compensation Committee strives to provide a balanced aggregate compensation package to the Company’s SEOs that serves to incentivize the Company’s SEOs to manage the business of the Company in a way that will result in Company-wide financial success and value growth for the Company’s stockholders.
The Compensation Committee believes it is appropriate for the Company’s executives to focus certain of their efforts on near-term goals that have importance to the Company; however, the Compensation Committee also acknowledges that near-term focus should not be to the detriment of a focus on the long-term health and success of the Company. In practice, providing base salary to any employee provides the most immediate reward for job performance. The Compensation Committee engages in an annual process, as is described in the Compensation Discussion and Analysis, to set base salary. The Compensation Committee believes its process for establishing base salary is relatively free from risk to the Company, as the Compensation Committee does not typically make significant adjustments to base salary based on a single year’s performance. The Compensation Committee believes it is appropriate to reward the Company’s executives’ focus on near-term goals, when such goals correspond to the overall Company or operating division goals and direction set by the Company’s board of directors. To reward the executives for such focus, the Compensation Committee maintains an annual cash incentive plan (i.e., Officers Incentive Plan) for the Company’s executives. In establishing the annual cash incentive plan, the Compensation Committee tries to provide an adequate level of incentive for the achievement of Company, operating division and individual goals, while also limiting the maximum amount that may be earned so that executives do not feel the need to strive for attainment of unreasonable or unrealistic levels of performance. In this way, the Compensation Committee believes the design of the annual cash incentive plan does not encourage the Company’s executives to take unnecessary or excessive risks that could harm the value of the Company.
The other incentive compensation elements offered to the Company’s SEOs, with the exception of perquisites, are intended to reward performance over the long-term or are intended to focus the Company’s executives’ attention on the long-term performance of the Company. The Compensation Committee feels there is little, if any, risk associated with the Company’s Employees 401(k) Savings Plan and Trust as it is a tax-qualified retirement plan that is subject to and maintained in accordance with the mandates of the Internal Revenue Code and the Employee Retirement Income Security Act. The Compensation Committee believes the Company’s 2008 Equity Incentive Plan helps to tie the Company’s executives’ interest more closely to those of the Company’s stockholders by giving them an equity interest in the Company. The Compensation Committee feels this equity interest in the Company promotes a long-term focus among the Company’s executives on the financial success of the Company. Finally, the Compensation Committee believes the deferred compensation arrangements (i.e., Amended and Restated Voluntary Deferred Compensation Plan for Executives, Compensation and Benefits Assurance Agreements) in place with respect to the Company’s SEOs encourage the Company’s executives to consider the long-term health of the Company because, pursuant to the Internal Revenue Code and applicable guidance, those arrangements must be unfunded, unsecured promises to pay a benefit in the future. In the case of the Company’s insolvency, the executives participating in those arrangements would be treated as general unsecured creditors, which encourages the executives to ensure a healthy organization remains after their tenures are concluded.
With respect to the employee compensation plans, the CPP Risk Assessment has not resulted in a determination by the Compensation Committee that changes were necessary to bring such plans into compliance with the CPP rules. The Compensation Committee believes the Company has adequate policies and procedures in place to balance and control any risk-taking that may be incentivized by the employee compensation plans. The Compensation Committee further believes that such policies and procedures will work to limit the risk that any employee would manipulate reporting earnings in an effort to enhance his or her compensation.
Submitted by:
Mr. Gerald Palmer, Chairman
Mr. Edward Bonifas
Mr. William Kane
Mr. William Meyer
Members of the Compensation Committee
EXECUTIVE COMPENSATION
Summary Compensation Table
The following table sets forth information concerning the compensation of our Chief Executive Officer, Chief Financial Officer and our next most highly compensated executive officer:
Name and
principal position
Year
Salary
Bonus(1)
Stock
awards(2)
All other
compensation(3)
Total ($)
(a)
(b)
(c)
(d)
(e)
(i)
(j)
William B. Skoglund
Chairman and Chief Executive Officer - Old Second; Chairman of Old Second National Bank
2012(4)
$504,900 495,000 495,000
$209,079
---
---
$ 98,400
25,000
37,450
$ 30,004
26,855
27,280
$842,383
546,855
559,730
J. Douglas Cheatham
Chief Financial Officer
2012(4)
$252,000 247,000 247,000
$61,085
---
---
$ 65,600
25,000
37,450
$ 19,119
15,945
16,470
$397,804
287,945
300,920
James Eccher
Chief Executive Officer - Old Second National Bank
2012(4)
$325,000 319,000 304,500
$118,170
---
---
$ 82,000
25,000
37,450
$ 30,004
26,855
27,280
$555,174
370,855
369,230
(1) In October 2013, our named executive officers also received payment of bonus amounts that were earned during 2008 but could not be paid until after each executive was no longer subject to the bonus restrictions applicable under the CPP. Mr. Skoglund received a payment of $235,669, Mr. Cheatham received a payment of $93,094 and Mr. Eccher received a payment of $122,119.
(2) The amounts represent the grant date fair value for equity awards in accordance with ASC 718 - “Compensation-Stock Compensation.” A discussion of the assumptions used in calculating the values may be found in the notes to our audited financial statements included in our annual report to stockholders.
(3) The 2013 amounts set forth in column (i) include the following:
Mr. Skoglund
Mr.
Cheatham
Mr. Eccher
401(k) match
$5,100
$5,023
$5,100
Life insurance
Automobile allowance
10,800
---
10,800
Country club dues
13,414
13,414
13,414
Total
$30,004
$19,119
$30,004
(4) The amounts reflected in the “All Other Compensation” and “Total” columns for 2012 were incorrectly calculated and have been adjusted by $975 when compared to our prior disclosure of these amounts.
Grants of Plan-Based Awards
Name
Grant date
All Other
Stock
Awards;
Number
of Shares
of Stock
or Units(1)
Grant Date
Fair Value
of Stock and
Option
Awards(2)
William B. Skoglund
Restricted Stock Award
4/16/13
30,000
$98,400
J. Douglas Cheatham
Restricted Stock Award
4/16/13
20,000
$65,600
James Eccher
Restricted Stock Award
4/16/13
25,000
$82,000
(1) The amounts represent shares of restricted stock. The restricted stock will vest 100% on the third anniversary of the grant date.
(2) The grant date fair value is based on the closing price of our stock on April 16, 2013, which was $3.28 per share. With respect to the amounts reflected for 2012 and 2011, it should be noted that 75% of those awards were forfeited due to Treasury’s auction of our Series B Preferred Stock and related warrant.
Outstanding Equity Awards at Fiscal Year-End
The following table sets forth information concerning the outstanding equity awards at December 31, 2013 held by the individuals named in the Summary Compensation Table:
(1) All options granted prior to December 31, 2005 vested on that date. Options granted on December 19, 2006 and December 18, 2007 vested in three equal installments on the first three anniversaries of the grant date.
(2) Each award of restricted stock granted to Messrs. Skoglund, Cheatham and Eccher will vest in full on the second anniversary of each date of grant. Includes 25% of the awards made in 2012 that were not forfeited due to Treasury’s auction of our Series B Preferred Stock and related warrant. (3) Based upon the December 31, 2013 closing price of $4.62 per share of common stock.
Nonqualified Deferred Compensation
We sponsor an executive deferred compensation plan, which is described in the Compensation Discussion and Analysis above, and a director deferred compensation plan, which is described below following the Directors Compensation Table. The plans provide a means by which certain executives and directors may voluntarily defer all or a portion of their compensation. The plans are funded by participant deferrals and, in the case of the executive plan, company matching contributions and discretionary employer profit sharing contributions. Participants are permitted to make hypothetical investments in publicly-traded mutual funds that are held in an insurance company separate account, with respect to their deferrals and our contributions, credited to their accounts under the plan. The deferrals to the director plan are credited earnings based on our stock price. Participants may elect to receive their plan balance in a lump sum or in installments. Participants are permitted, in the discretion of the administrator, to make a withdrawal from the plan during their employment in the event of hardship.
Potential Payments Upon Termination or Change in Control
Each of Messrs. Skoglund, Cheatham and Eccher entered into Compensation and Benefits Assurance Agreements with us (each, an “Assurance Agreement”), which provide for payments and benefits to a terminating executive following a change in control. In addition, our Cash Incentive Plan provides for termination related benefits. Other than the benefits provided by the Assurance Agreements and pursuant to the Cash Incentive Plan, none of our named executive officers will be entitled to any payments or benefits as a result of the occurrence of a change in control or as a result of a termination of employment in connection with a change in control. It should be noted that pursuant to regulations applicable to us, we would have to confer with our regulators before making any payment under the Assurance Agreements for a termination deemed to occur on December 31, 2013.
Assurance Agreements. Other than as is provided in the Assurance Agreements, and except as is provided in accordance with the terms of our equity incentive plan and our cash incentive plan for executive officers, no named executive officer will be entitled to any payments or benefits as a result of the occurrence of a change in control or as a result of a termination of employment in connection with a change in control. The Assurance Agreements have an initial term of one-year and, unless earlier terminated by either party, will automatically renew for successive one-year periods. Upon the occurrence of a change in control, the terms of the Assurance Agreements shall automatically renew for a two-year period (three-year period, in the case of Mr. Skoglund) and terminate following such extended period. The Assurance Agreements provide that, in the case of: (i) a termination of employment by us without “cause” within six months prior to, or 24 months (36 months, in the case of Mr. Skoglund) immediately following, a change in control, (ii) a termination of employment by an executive for “good reason” within 24 months (36 months, in the case of Mr. Skoglund) following a change in control or (iii) a material breach by us (or any successor) of a provision of the Assurance Agreement, an executive officer will be entitled to:
· Payment, in a single lump sum, of accrued base salary, accrued vacation pay, unreimbursed business expenses and all other items earned by or owed to the executive through and including the date of termination.
· Payment, in a single lump sum, of a severance benefit equal to two times (three times, in the case of Mr. Skoglund) the sum of (i) the greater of the executive’s annual rate of base salary in effect upon the date of termination or the executive’s annual rate of base salary in effect immediately prior to the occurrence of the change in control and (ii) the average of the annual cash bonus paid to the executive (including any portion of such bonus, payment of which the executive elected to defer) for the three calendar years immediately preceding the year in which the termination occurs. For a termination as of December 31, 2013, our named executive officers would have been entitled to the following payment amounts: Mr. Skoglund - $1,514,700; Mr. Cheatham - $504,000; and Mr. Eccher - $650,000.
· Immediate 100% vesting of all stock options and any other awards which have been provided to the executive by us under any of its incentive compensation plans. As of December 31, 2013, the fair market value of unvested restricted stock and restricted units held by our named executive officers was as follows: Mr. Skoglund - $161,700; Mr. Cheatham - $115,500; and Mr. Eccher - $138,600.
· At the exact same cost to the executive, and at the same coverage level as in effect as of the executive’s termination, a continuation of the executive’s (and the executive’s eligible dependents’) health insurance coverage for 24 months (36 months, in the case of Mr. Skoglund) from the date of termination. In the event that the executive (and/or his dependents, if any) becomes covered under the terms of any other health insurance coverage of a subsequent employer which does not contain any exclusion or limitation with respect to any preexisting condition of the executive or the executive’s eligible dependents, coverage under our plans will cease for the executive (and/or his dependents, if any). The monthly amount, based on rates in effect as of December 31, 2013, to be paid by us on behalf of our named executive officers was as follows: Mr. Skoglund - $660.90; Mr. Cheatham - $1,094.48; and Mr. Eccher - $1,010.96.
· At our expense, standard outplacement services for a period of up to one year from the date of executive’s termination. The maximum amount to be paid by us for such outplacement services is limited to $20,000.
· Where, upon the occurrence of a change in control, an executive is subject to certain excise taxes under Section 280G of the Internal Revenue Code, we will reimburse the executive for those excise taxes as well as any income and excise taxes payable by the executive as a result of any reimbursements for the 280G excise taxes. While circumstances could exist under which excise tax gross-up payments would be due to the executive officers, we do not believe that any payments made to any of the named executive officers as a result of a termination of employment in connection with a change in control occurring on December 31, 2013 would result in the imposition of an excise tax under the Internal Revenue Code.
In exchange for the payments and benefits provided under the Assurance Agreements, the executive officers agree to be bound by a 24 month (36 month, in the case of Mr. Skoglund) restrictive covenant. The restrictive covenant will prohibit the executive officers from using, attempting to use, disclosing or otherwise making known to any person or entity (other than our board of directors) confidential or proprietary knowledge or information which the executive officers may acquire in the course of their employment.
The Assurance Agreements define certain relevant terms, generally, as follows:
· “Cause” means the occurrence of any one or more of the following: (i) a demonstrably willful and deliberate act or failure to act by the executive (other than as a result of incapacity due to physical or mental illness) which is committed in bad faith, without reasonable belief that such action or inaction is in the best interests of us, which causes actual material financial injury to us, or any of its subsidiaries, and which action or inaction is not remedied within fifteen business days of written notice from us or the subsidiary for which the executive works; or (ii) the executive’s
conviction for committing an act of fraud, embezzlement, theft or any other act constituting a felony involving moral turpitude which causes material harm, financial or otherwise, to us or any of our subsidiaries.
· “Good reason” means the occurrence of any one or more of the following within the 24-month period (36-month period, in the case of Mr. Skoglund) following the change in control: (i) a material reduction or alteration in the nature or status of authorities, duties or responsibilities from those in effect as of 90 days prior to the change in control; (ii) moving the executive’s principal office more than 25 miles from its location immediately prior to the change in control; (iii) a material reduction of the executive’s base salary and/or other benefits; and, (iv) a material breach by us or a successor, of any term of the Assurance Agreement, including any failure by us to ensure assumption of the Assurance Agreement by a successor or any failure of a successor company to assume and agree to perform our entire obligations under the Assurance Agreement.
· “Change in control” means (i) any person, company or other entity, other than an employee benefit plan or subsidiary company of us, becoming the beneficial owner, either directly or indirectly, of 33% or more of our stock; (ii) during any two consecutive years, a change in a majority of the members of our board of directors; or (iii) consummation of a merger or consolidation where our stockholders before the merger or consolidation do not own more than 67% of the resulting entity, a complete liquidation or our dissolution or a sale or other disposition of substantially all of our assets.
In exchange for the payments and benefits provided under the Assurance Agreements, the executive officers agree to be bound by confidentiality, non-competition and non-disclosure provisions.
Except for payments and benefits provided by the Assurance Agreements, all other payments and benefits provided to any NEO upon termination of his or her employment are the same as the payments and benefits provided to our other eligible employees.
Retirement, Death and Disability. Generally speaking, a termination of employment due to retirement, death or disability does not entitle the named executive officers to any payments or benefits that are not available to other employees. Following a termination due to death or disability, an employee (or his or her estate) shall be entitled to the following:
· Upon a termination due to death or disability, all unvested stock options shall become immediately 100% vested and an employee or beneficiary shall have a period of twelve months following such termination during which to exercise his or her vested stock options.
· Any unvested restricted stock or restricted stock units outstanding at the time of an employee’s termination due to death or disability shall become immediately 100% vested upon such termination.
Also, it should be noted that, pursuant to existing agreements, as of the time of a termination of employment due to retirement, all unvested stock options shall become immediately 100% vested.
Acceleration of Vesting Upon a Change in Control. All employees, including the named executive officers, who receive equity awards under our equity incentive plan will immediately vest in any unvested equity awards held by such employees upon the occurrence of a change in control.
DIRECTOR COMPENSATION
Each of our directors also serves as a director of the Bank. In 2013 each non-employee director received $1,000 for every board meeting and $500 for every committee meeting attended if there were no other bank-level meetings held that day. Non-employee directors of the Bank received a $13,000 annual retainer. Due to increased responsibilities associated with mandates from Sarbanes-Oxley, the Lead Director and Compensation Committee Chairman, Mr. Palmer, received an $18,000 retainer in 2013 and
the Audit Committee Chairman, Mr. Finn, received a $20,000 annual retainer in 2013, due to increased meetings and increased time spent on behalf of the Audit Committee. Messrs. Skoglund, Eccher and Cheatham, as our executive officers, did not receive any board fees for their service on our board, nor did they receive board fees for their service on the board of the Bank. The following table sets forth the fees earned by each non-employee director and senior director in 2013:
Name
Fees earned
or paid in
cash
($)(1)
Total
($)
Edward Bonifas
$46,500
$46,500
Barry Finn
51,000
51,000
William Kane
38,000
38,000
John Ladowicz
47,000
47,000
William Meyer
38,500
38,500
Gerald Palmer
46,500
46,500
James C. Schmitz
46,500
46,500
(1) We maintain the Old Second Bancorp, Inc. Amended and Restated Voluntary Deferred Compensation Plan for Directors under which directors are permitted to defer receipt of their directors’ fees. The directors who participate in the plan are permitted to make hypothetical investments in publicly-traded funds that are held in an insurance company separate account, with respect to the contributions credited to their plan accounts. We may, but are not required to, contribute the deferred fees into a trust, which may hold our stock. The plan is a nonqualified deferred compensation plan and the directors have no interest in the trust. The deferred fees and any earnings thereon are our unsecured obligations. Any shares held in the trust are treated as treasury shares and may not be voted on any matter presented to stockholders. We do not pay any above-market interest on the compensation or fees deferred by the directors.
Compensation Committee Interlocks and Insider Participation
The members of the Compensation Committee in 2013 were Messrs. Bonifas, Kane, Meyer and Palmer (who served as Chairman), each of whom is an “independent” director as defined by Nasdaq, an “outside” director pursuant to Section 162(m) of the Internal Revenue Code and a “non-employee” director under Section 16 of the Securities Exchange Act of 1934. We expect that these members will continue to serve on the committee in 2014.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth certain information with respect to the beneficial ownership of the Company’s common stock at December 31, 2013, by each person known by us to be the beneficial owner of more than 5% of the outstanding common stock, by each director, by each executive officer named in the Summary Compensation Table (which can be found in Item 11 of this Form 10-K), and by all directors and executive officers of the Company as a group. Beneficial ownership has been determined for this purpose in accordance with Rule 13d-3 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under which a person is deemed to be the beneficial owner of securities if he or she has or shares voting power or investment power with respect to such securities or has the right to acquire beneficial ownership of securities within 60 days of December 31, 2013. Unless otherwise noted, the address of each 5% stockholder is 37 South River Street, Aurora, Illinois 60506.
Name of Individual and Number of Persons in Group
Amount and
Nature of
Beneficial
Percent
Ownership(1)
of Class
5% Stockholders:
Old Second Bancorp, Inc.(2)
Profit Sharing Plan & Trust
1,424,989
10.2%
Dimensional Fund Advisors LP(3)
Palisades West, Building One
6300 Bee Cave Road
Austin, Texas 78746
935,463
6.7%
Name of Individual and
Number of Persons in Group
Common
Stock
Percent of
Class of
Common Stock
Series B
Preferred Stock(4)
Percent of Class
of Series B
Preferred Stock
Directors:
Edward Bonifas(10)
34,326
*
*
J. Douglas Cheatham(5)
126,652
*
*
*
James Eccher(6)
117,656
*
*
Barry Finn(10)
25,296
*
*
*
William Kane(10)
53,296
*
*
*
John Ladowicz(7)
314,727
2.3%
*
William Meyer(10)
93,314
*
*
*
Gerald Palmer(10)
61,962
*
*
J. Carl Schmitz(8)(10)
59,496
*
*
William B. Skoglund(9)
247,284
1.8%
*
*
Duane Suits
4,700
*
*
All directors and executive officers as a group (11 persons)
1,151,965
8.3%
1,510
2.1%
* Less than 1%.
(1) Includes ownership of shares of our common stock by spouse (even though any beneficial interest is disclaimed) and in our profit sharing plan and trust and our salary savings plan.
(2) In addition, as of December 31, 2013, Old Second National Bank held in its trust department, in various fiduciary capacities (other than as trustee of our profit sharing plan and trust), 810,201 shares of our common stock. Old Second had full investment power with respect to 244,480 shares and shared investment power with respect to 58,166 shares.
(3) As reported on a Schedule 13G/A filed on February 11, 2013.
(4) Certain of our directors purchased shares of our Series B Preferred Stock from Treasury in the first quarter of 2013.
(5) Includes 51,000 shares issuable pursuant to options held by Mr. Cheatham as well as 5,000 shares of restricted stock, plus an additional 20,000 shares of restricted stock granted in February of 2013. Also includes 4,192 shares held in our profit sharing plan and trust, 36,058 shares held in our 401(k) plan, and 10,402 shares held in Mr. Cheatham’s name alone. The shares of restricted stock granted to Mr. Cheatham are subject to two-year cliff vesting, and therefore the 20,000 shares granted in February of 2012 will fully vest in 2014.
(6) Includes 56,000 shares issuable pursuant to options held by Mr. Eccher, as well as 5,000 shares of restricted stock in addition to 25,000 shares of restricted stock granted in February of 2013. Also includes 1,960 shares held in our profit sharing plan and trust, 6,242 shares held in our 401(k) plan, 50 in his name alone, 148 held with his spouse, and 23,256 shares held in brokerage. The shares of restricted stock granted to Mr. Eccher are subject to two-year cliff vesting, and therefore the 20,000 shares granted in February of 2012 will fully vest in 2014.
(7) Includes 268,181 shares held in our 401(k) plan.
(8) Mr. Schmitz has voting control of 50,000 shares held in the J. C. Schmitz Revocable Trust.
(9) Includes 136,000 shares issuable pursuant to options held by Mr. Skoglund, as well as 5,000 shares of restricted stock plus an additional 30,000 shares of restricted stock granted in February of 2013. The total also includes 47,038 shares held in our profit sharing plan and trust, 14,206 shares held in our 401(k) plan, and 15,040 shares held in Mr. Skoglund’s name alone. The shares of restricted stock granted to Mr. Skoglund are subject to two-year cliff vesting, and therefore the 20,000 shares granted in February of 2012 will fully vest in 2014.
(10) Each director, with the exception of Mr. Cheatham, Mr. Eccher, Mr. Skoglund and Mr. Ladowicz, holds a total of 7,500 options from grants of 1,500 shares in each of 2005-2009, as well as 596 restricted stock units for 2009. Mr. Ladowicz was appointed to the board on February 8, 2008 and was awarded options in February of 2009 of 1,500 shares, along with the other Board members, as well as 596 restricted stock units. In addition, in January of 2010, all non-employee directors were given 1,200 restricted stock units. All options vest in three equal installments on the first three anniversaries of the grant date and the exercisable portion is included in these totals. The 596 restricted stock units are subject to cliff vesting and fully vested in 2012. The 1,200 restricted stock units granted to all non-employee directors are subject to cliff vesting and fully vested in 2013.
The table below sets forth the following information as of December 31, 2013 for (i) all equity compensation plans previously approved by the Company’s stockholders and (ii) all equity compensation plans not previously approved by the Company’s stockholders:
(a) the number of securities to be issued upon the exercise of outstanding options, warrants and rights;
(b) the weighted-average exercise price of such outstanding options, warrants and rights;
(c) other than securities to be issued upon the exercise of such outstanding options, warrants and rights, the number of securities remaining available for future issuance under the plans.
EQUITY COMPENSATION PLAN INFORMATION
Security holders approved 100,000 shares in 1994, 250,000 shares in 2002 and 575,000 shares in 2008 to be issued upon the exercise of options. Subsequent stock splits are reflected in the table above.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The board has determined that all of the Company’s directors are “independent” as defined by the Nasdaq Stock Market, with the exception of Messrs. Skoglund, Cheatham and Eccher, each of whom is an executive officer. During its review of director independence, the board considered Mr. Finn’s roles as President and Chief Executive Officer of Rush-Copley Medical Center and Mr. Skoglund’s position as the Vice Chairman of Rush-Copley’s board of directors. The board determined that this does not preclude a finding that Mr. Finn is independent under Nasdaq’s rules because Mr. Skoglund does not serve on Rush-Copley’s compensation committee and has recused himself from any discussions or votes that involve Mr. Finn’s salary. The board also reviewed certain transactions between Alarm Detection Systems, Inc. and the Company. Mr. Bonifas is a Vice President of Alarm Detection Systems, Inc. The board determined that Mr. Bonifas qualified as an independent director because the amounts paid to Alarm Detection Systems by the Company were less than 5% of Alarm Detection System’s gross revenues for 2013.
Item 14.
Item 14. Principal Accountant Fees and Services
At the 2013 annual meeting of the Company, the Company’s shareholders ratified the appointment of Plante & Moran, PLLC, as the Company’s independent registered public accounting firm for the year ending December 31, 2013. The Company expects to appointment Plante & Moran, PLLC, as its independent registered public accounting firm for the year ending December 31, 2014, and to seek its shareholders ratification of that appointment at the 2014 annual meeting.
Audit Fees. The aggregate fees and expenses paid to Plante & Moran PLLC in connection with the audit of the Company’s annual financial statements and the related securities filings were $421,929 for 2013 and $281,563 for 2012.
Audit Related Fees. Audit related fees paid to Plante & Moran PLLC were $62,500 for 2013 and were $94,411 for 2012.
Tax Fees. There were no amounts for tax related services billed by Plante & Moran, PLLC for 2013 or 2012.
All Other Fees. All other fees paid to Plante & Moran PLLC were $23,500 for 2013, and there were no aggregate fees or pre-approved expenses billed by Plante & Moran, PLLC for all other services rendered to us for 2012.
The Audit Committee of the Company’s board of directors is solely responsible for the pre-approval of all audit and non-audit services to be provided by the independent accountants and the Audit Committee exercises its authority to do so in accordance with the Audit Committee policy that it has adopted. All services provided by Plante & Moran, PLLC were approved pursuant to the pre-approval policy. The pre-approval policy is available on our website at www.oldsecond.com.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(1) Index to Financial Statements: See Part II--Item 8. Financial Statements and Supplementary Data.
(2) Financial Statement Schedules
All financial statement schedules as required by Item 8 of Form 10-K have been omitted because the information requested is either not applicable or has been included in the consolidated financial statements or notes thereto.
(3) Exhibits: See Exhibit Index.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DATE: February 26, 2014
SIGNATURES (Continued)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
Chairman of the Board, Director
/s/ William B. Skoglund
President and Chief Executive Officer
February 26, 2014
William B. Skoglund
President and Chief Executive Officer
February 26, 2014
/s/ James Eccher
Old Second National Bank
James Eccher
Executive Vice President and
/s/ J. Douglas Cheatham
Chief Financial Officer, Director
February 26, 2014
J. Douglas Cheatham
/s/ Edward Bonifas
Director
February 26, 2014
Edward Bonifas
/s/ Barry Finn
Director
February 26, 2014
Barry Finn
/s/ William Kane
Director
February 26, 2014
William Kane
/s/ John Ladowicz
Director
February 26, 2014
John Ladowicz
/s/ William Meyer
Director
February 26, 2014
William Meyer
/s/ Gerald Palmer
Director
February 26, 2014
Gerald Palmer
/s/ James Carl Schmitz
Director
February 26, 2014
James Carl Schmitz
/s/ Duane Suits
Director
February 26, 2014
Duane Suits
EXHIBIT
NO.
EXHIBIT INDEX
Description of Exhibits
3.1
Restated Certificate of Incorporation of Old Second Bancorp, Inc. (incorporated herein by reference to Exhibit 3.1 to Form S-3 filed by Old Second Bancorp, Inc., on May 13, 2010.
3.2
Bylaws of Old Second Bancorp, Inc. (incorporated herein by reference to Exhibit 3.2 of the Form S-4 filed by Old Second Bancorp, Inc., on December 19, 2007).
4.1
Amended and Restated Rights Agreement and Tax Benefits Preservation Plan, dated September 12, 2012 (incorporated herein by reference to Exhibit 99.1 of Form 8-K filed by Old Second Bancorp, Inc., September 13, 2012).
4.2
Form of Stock Certificate for Series B Fixed Rate Cumulative Perpetual Preferred Stock (incorporated by reference to Exhibit 4.1 of the Company’s Form 8-K filed by Old Second Bancorp, Inc. on January 16, 2009).
4.3
Warrant to Purchase Shares of Common Stock, dated January 16, 2009 (incorporated herein by reference to Exhibit 4.2 of the Company’s Form 8-K filed on January 16, 2009).
10.1
Form of Compensation and Benefits Assurance Agreements for the executive officers (filed as Exhibit 10.1 to the Company’s Form 10-Q filed on November 8, 2006 and incorporated herein by reference).
10.2
Old Second Bancorp, Inc. Employees 401 (k) Savings Plan and Trust (filed with the Company’s Form S-8 filed on June 9, 2000 and incorporated herein by reference).
10.3
Form of Indenture relating to trust preferred securities (filed as Exhibit 4.1 to the Company’s registration statement on the Company’s Form S-3 filed on May 20, 2003 and incorporated herein by reference).
10.4
Indenture between Old Second Bancorp, Inc. as issuer, and Wells Fargo Bank, National Association, as Trustee, dated as of April 30, 2007 (filed as exhibit 99 (b) (2) to the Company’s Amendment No. 1 to Schedule TO filed on May 2, 2007 and incorporated herein by reference and incorporated herein by reference).
10.5
Old Second Bancorp, Inc. 2008 Long Term Incentive Plan (filed as Appendix A to the Company’s Form DEF14A filed on March 17, 2008 and incorporated herein by reference).
10.6
Compensation and Benefits Assurance Agreement for Mr. Eccher (filed as Exhibit 10.1 to the Company’s Form 8-K filed on February 10, 2005 and incorporated herein by reference).
10.7
Amended and Restated Voluntary Deferred Compensation Plan for Executives and Directors (filed as an Exhibit to the Company’s Form 8-K filed on March 28, 2005 and incorporated herein by reference).
10.8
Amendment to the Old Second Bancorp, Inc. Supplemental Executive and Retirement Plan (filed as Exhibit 10.1 to the Company’s Form 8-K filed on October 24, 2005 and incorporated herein by reference).
10.9
Form of Amended Stock Option Award Agreement (filed as Exhibit 10.1 to the Company’s Form 8-K filed on December 21, 2005 and incorporated herein by reference).
10.10
Loan and Subordinated Debenture Purchase Agreement, dated January 31, 2008, between LaSalle Bank National Association (now Bank of America) and Old Second Bancorp, Inc. (filed as Exhibit 10.11 to the Company’s Form 10-K filed on March 17, 2008 and incorporated herein by reference).
10.11
Agreed Upon Terms and Procedures, dated January 31, 2008, between LaSalle Bank National Association (now Bank of America) and Old Second Bancorp, Inc. (filed as Exhibit 10.12 to the Company’s Form 10-K filed on March 17, 2008 and incorporated herein by reference).
10.12
Letter Agreement, dated January 16, 2009, by and between Old Second Bancorp, Inc., and the United States Department of the Treasury, which includes the Securities Purchase Agreement - Standard Terms with respect to the issuance and sale of the Series B Preferred Stock and the Warrant (filed as Exhibit 10.1 to the Company’s Form 8-K filed on January 16, 2009 and incorporated herein by reference).
10.13
2008 Equity Incentive Plan Restricted Stock Award Agreement (filed as Exhibit 10.1 to the Company’s Form 8-K filed on February 23, 2009 and incorporated herein by reference).
10.14
2008 Equity Incentive Plan Restricted Stock Unit Award Agreement (filed as Exhibit 10.2 to the Company’s Form 8-K filed on February 23, 2009 and incorporated herein by reference).
10.15
2008 Equity Incentive Plan Incentive Stock Option (filed as Exhibit 10.3 to the Company’s Form 8-K filed on February 23, 2009 and incorporated herein by reference).
10.16
2008 Equity Incentive Plan Incentive Non-Qualified Stock Option (filed as Exhibit 10.4 to the Company’s Form 8-K filed on February 23, 2009 and incorporated herein by reference).
10.17
Written Agreement by and between Old Second Bancorp, Inc. and the Federal Reserve Bank of Chicago, dated July 22, 2011 (filed as Exhibit 10.1 to the Company’s Form 10-Q filed on August 9, 2011 and incorporated herein by reference).
21.1
A list of all subsidiaries of the Company (filed herewith).
23.1
Consent of Plante & Moran, PLLC (filed herewith).
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.2
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
99.1
Certification of Chief Executive Officer pursuant to Section III(b) of the Emergency Economic Stabilization Act of 2008.
99.2
Certification of Chief Financial Officer pursuant to Section III(b) of the Emergency Economic Stabilization Act of 2008.
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) consolidated balance sheets at December 31, 2013, and December 31, 2012; (ii) consolidated statements of operations for year ended December 31, 2013, and December 31, 2012; (iii) consolidated statements of stockholders’ equity for the twelve months ended December 31, 2013, and December 31, 2012; (iv) consolidated statements of cash flows for the twelve months ended December 31, 2013, and December 31, 2012; and (v) Notes to consolidated financial statements, tagged as blocks of text and in detail.
SUMMARY OF FEES FOR BOARD OF DIRECTORS
Each director of Old Second Bancorp, Inc. also serves as a director of Old Second National Bank, and may serve on boards of its other subsidiaries. In 2013, nonemployee directors received $1,000 for every board meeting attended and $500 for each committee meeting attended. Nonemployee directors of Old Second National Bank received a $13,000 annual retainer and Mr. Palmer who also serves as committee chair of the Compensation or Nominating Committee received an $18,000 annual retainer and Mr. Finn, as the Audit Committee financial expert received a $20,000 retainer in 2013.
Nonemployee directors of Old Second National Bank are also eligible to receive options and restricted stock awards pursuant to the Old Second Bancorp, Inc. 2008 Long Term Incentive Plan. The Company also maintains the Old Second Bancorp Directors Fee Deferral Plan, under which directors are permitted to defer receipt of their directors’ fees. The plan is unqualified and the directors have no interest in the trust. The deferred fees and any earnings thereon are unsecured obligations of Old Second National Bank.