ITEM 1. BUSINESS
GENERAL
Franklin Finance Corporation ("Company") is a Michigan corporation incorporated on September 25, 1997, and created for the purpose of acquiring and holding real estate mortgage assets. The Company elected to be treated as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended ("Code"), and generally will not be subject to Federal income tax to the extent that it distributes its earnings to its shareholders and maintains its qualification as a REIT. All of the shares of the Company's common stock, par value $300.00 per share ("Common Stock"), are owned by Franklin Bank, N.A., a nationally chartered and federally insured national bank ("Bank"). The Company was formed by the Bank to provide the Bank with a cost-effective means of raising capital.
On December 22, 1997, the Company offered to the public and sold 2,070,000 shares of the Company's 8.70% noncumulative exchangeable preferred stock, Series A, liquidation preference $10.00 per share ("Series A Preferred Shares"). Simultaneous with the consummation of the preferred stock offering, the Bank purchased Common Stock in the amount of $20.9 million, net of offering cost.
The Company used the net proceeds raised from the initial public offering of the Series A Preferred Shares and the sale of the Common Stock in the Bank to purchase from the Bank the Company's initial portfolio of $41.5 million residential and commercial mortgage loans ("Mortgage Loans") at their estimated fair value.
The Company's principal executive office is located at 24725 Twelve Mile Road, Southfield, Michigan 48034. The Company's telephone number at such address is (248) 358-4710.
The Company's principal business is to acquire, hold and manage mortgage loans that will generate net income for distribution to shareholders. The Company currently acquires all of its mortgage loans from the Bank, consisting of whole loans secured by first mortgages or deeds of trust on single-family (one-to- four-unit) residential real estate properties ("Residential Mortgage Loans") or by commercial real estate properties ("Commercial Mortgage Loans"). The Company also from time to time acquires investment grade mortgage securities that qualify as real estate assets under Section 856(c)(6)(B) of the Internal Revenue Code of 1986, as amended ("Code"). Mortgage loans underlying the mortgage securities are secured by single-family residential, multifamily, or commercial real estate properties located in the United States.
The Company's policy is not to acquire any commercial mortgage loan if such commercial mortgage loan constitutes more than 5% of the total book value of the Mortgage Loans of the Company at the time of its acquisition. The Company's policy also prohibits the acquisition of any mortgage loan or any interest in a Mortgage Loan (other than an interest resulting from the acquisition of Mortgage securities), which mortgage loan (i) is delinquent in the payment of principal or interest: (ii) is or was at any time during the preceding 12 months (a) classified, (b) in nonaccrual status, or (c) renegotiated due to financial deterioration of the borrower; or (iii) has been, more than once during the preceding 12 months, more than 30 days past due in the payment of principal or interest. Loans that are in nonaccrual status are generally loans that are past due 90 days or more in principal or interest and classified loans are troubled loans which are deemed substandard or doubtful and where the full collectibilty of principal and interest on such loan is doubtful.
Substantially all of the real estate properties underlying the Company's Residential Mortgage Loans and all of the commercial properties underlying the Company's Commercial Mortgage Loans included in the current portfolio are located in Michigan. Consequently, these Mortgage Loans may be subject to a greater risk of default than other comparable mortgage loans in the event of adverse economic, political or business developments and natural hazards in Michigan that may affect the ability of property owners in Michigan to make payments of principal and interest on the underlying mortgages.
Mortgage-backed securities represent an ownership interest in mortgage loans by financial institutions such as savings and loans, commercial banks or mortgage companies to finance the borrowers purchase of a home or other real estate.
The majority of mortgage-backed securities are issued and/or guaranteed by an agency of the U.S. Government, the Government National Mortgage Association (GNMA or Ginnie Mae), or by government-sponsored enterprises such as the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), Ginnie Mae is a government-owned corporation within the Department of Housing and Urban Development.
Issuers of mortgage-backed securities are typically very selective in choosing the mortgages that make up their pools. Beyond the basic security of the mortgage loans themselves, mortgage-backed securities issued by Ginnie Mae, Fannie Mae, and Freddie Mac carry additional guarantees, which enhance their credit worthiness. These guarantees pertain to the timely payment of principal and interest.
Unlike Ginnie Mae's guarantee, neither Fannie Mae's nor Freddie Mac's guarantees are backed by the full faith and credit of the U.S. Government. However, the credit markets consider the securities of these two entities to be nearly equivalent to those issued by agencies which have the full faith and credit guarantee. Thus, they carry an implied AAA rating.
The mortgage-backed securities owned by the Company at December 31, 1998 were issued by FNMA and the FHLMC.
TAX STATUS OF THE COMPANY
The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Code, commencing with its taxable year ended December 31, 1997. As a REIT, the Company generally will not be subject to Federal income tax on its net income (excluding capital gains) provided that it distributes annually 95 percent of its REIT taxable income to its shareholders, and meets certain organizational, stock ownership and operational requirements. If in any taxable year the Company fails to qualify as a REIT, the Company would not be allowed a deduction for distributions to shareholders in computing its taxable income and would be subject to Federal and state income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates. In addition, the Company would also be disqualified from treatment as a REIT for the four taxable years following the year during which qualification was lost.
The Company does not anticipate that it will engage in the business of originating mortgage loans and does not expect to compete with mortgage conduit programs, investment banking firms, savings and loan associations, banks, mortgage bankers, thrift and loan associations, finance companies, or insurance companies in acquiring its mortgage loans. As described above, the Company anticipates that it will purchase all mortgage loans from the Bank.
EMPLOYEES
The Company has four officers. All of the officers of the Company are also officers of the Bank. The Company does not anticipate that it will require any additional employees because it has retained the Bank to perform certain functions pursuant to an Advisory Agreement ("Advisory Agreement").
THE ADVISOR
On December 22, 1997, the Company entered into an Advisory Agreement with the Bank to administer the day-to-day operations of the Company,(i) monitoring the credit quality of the mortgage loans held by the Company, (ii) advising the Company with respect to the acquisition, management, financing and disposition of the Company's mortgage loans and (iii) maintaining custody of the documents related to the Company's mortgage loans. The Advisory Agreement has an initial term of five years, and will be renewed automatically for additional five-year periods unless notice of nonrenewal is delivered to the Bank by the Company. The Bank will be entitled to receive an annual advisory fee equal to $125,000 with respect to the advisory and management services provided by it to the Company.
The Company also entered into two servicing agreements with the Bank to service the Residential Mortgage Loans and Commercial Mortgage Loans. Pursuant to each servicing agreement the Bank receives a fee equal to .375% per annum on the principal balances of the mortgage loans serviced.
The servicing agreements require the mortgage loans to be serviced in a manner generally consistent with accepted secondary market practices, with any servicing guidelines promulgated by the Company and, in the case of Residential Mortgage Loans, with FNMA and FHLMC guidelines and procedures. The servicing agreements can be terminated without cause with at least sixty days notice to the Bank and payment of a termination fee.
The Company intends to operate in a manner that will not subject it to regulation under the Investment Company Act of 1940. The Company may, under certain circumstances, purchase the Series A Preferred Shares and other shares of its capital stock in the open market or otherwise, provided, however, that the Company will not redeem or repurchase any shares of its Common Stock for so long as any Series A Preferred Shares are outstanding without the approval of a majority of the Independent Directors (as defined in the
Certificate of Designation relating to the Series A Preferred Shares). The Company has no present intention of causing the Company to repurchase any shares of its capital stock, and any such action would be taken only in conformity with applicable federal and state laws and regulations and the requirement for qualifying as a REIT.
The Company currently intends to make investments and operate its business at all times in such a manner as to be consistent with the requirements of the Code to qualify as a REIT. However, future economic, market, legal, tax or other considerations may cause the Board of Directors, subject to approval by a majority of independent directors, to determine that it is in the best interest of the Company and its shareholders to revoke its REIT status. As of December 31, 1998, management of the Company believes that it was in full compliance with the REIT tax rules and that it will continue to qualify as a REIT under the provisions of the Code.
The Company has no foreign operations.
ITEM 2.
ITEM 2. PROPERTIES
None.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not the subject of any material litigation. None of the Company, the Bank or any affiliate of the Bank is currently involved in nor, to the Company's knowledge, is currently threatened with any material litigation with respect to the mortgage loans included in the Company's portfolio which litigation would have a material effect on the business or operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None. PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
GENERAL
The Company is authorized to issue up to 60,000 shares of common stock $300.00 par value per share and 2,500,000 shares of Preferred Stock, $10.00 liquidation preference per share ("Preferred Stock"). Preferred Stock totaling 2,070,000 shares have been issued as the Series A Preferred Shares. The Bank owns 100% of the Company's 22,077 shares of Common Stock outstanding at December 31, 1998 and accordingly, there is no trading market for the Common Stock. In addition, the Bank intends that, as long as any Series A Preferred Shares are outstanding, it will maintain ownership of the outstanding Common Stock of the Company. Subject to the rights, if any, of the holders of the Series A Preferred Shares, all voting rights are vested in the Common Stock. The holders of the Common Stock are entitled to one vote per share.
Holders of Common Stock are entitled to receive dividends when, as and if declared by the Board of Directors of the Company out of funds legally available therefore, provided that, so long as any shares of Preferred Shares are outstanding, no dividends or other distributions (including redemptions and purchases) may be made with respect to the Common Stock unless full dividends on the shares of all series of Preferred Stock have been paid for the prior four quarters. In order to remain qualified as a REIT, the Company must distribute annually at least 95% of its annual "REIT Taxable Income" (not including capital gains) to shareholders.
In the event of the liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, after there have been paid or set aside for the holders of all series of Preferred Stock the full preferential amounts to which such holders are entitled, the holders of Common Stock will be entitled to share equally and ratable in any assets remaining after the payment of all debts and liabilities.
RESTRICTIONS ON OWNERSHIP AND TRANSFER
The Company's Articles of Incorporation contain certain restrictions on the number of shares of Common Stock and Preferred Stock that individual shareholders may own. For the Company to qualify as a REIT under the Code, no more that 50% in number or value of its outstanding shares of capital stock my be owned, directly or indirectly, by five or fewer individuals (as defined in the Code to include certain entities) during the last half of a taxable year (other that the first year) or during a proportionate part of a shorter taxable year (the "Five or Fewer Test"). The capital stock of the Company must also be beneficially owned by 100 or more persons during at least 335 days of a taxable year or during a proportionate part of a shorter taxable year (the "one Hundred Persons Test"). The ownership by the Bank of 100% of the shares of Common Stock of the REIT will not adversely affect the Company's REIT qualification because each shareholder of the Bank counts as a separate beneficial owner for purposes of the Five or Fewer Test and the capital stock of the Bank is widely held. Further, the Articles of Incorporation of the Company contain restrictions on the acquisition of Preferred Stock intended to ensure compliance with the One Hundred Persons Test. Such provisions include a restriction that if any transfer of shares of capital stock of the Company would cause the Company to be beneficially owned by fewer that 100 persons, such transfer shall be null and void and the intended transferee will acquire no rights to the stock.
COMMON STOCK
There is no established public trading market in the Company's Common Stock. As of March 26, 1999, there were 22,077 issued and outstanding shares of Common Stock held by one shareholder, the Bank. On December 31, 1998, the Company declared a cash dividend of $43.58 per common share of Common Stock to the shareholder of record on December 31, 1998. The dividend was paid on January 31, 1999.
PREFERRED STOCK
The Series A Preferred Shares are listed on the NASDAQ National Market under the trading symbol "FSVBP". As of March 26, 1999, there were 2,070,000 issued and outstanding Series A Preferred Shares held by approximately 69 holders of record. The following table reflects the respective high and low sales prices for the Series A Preferred Shares for the year ended December 31, 1998. The table also indicates the distributions paid by the Company during this period.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Company herein has been derived from the Financial Statements of the Company, which statements have been audited by Grant Thornton LLP, independent certified public accountants, as indicated by their report with respect thereto included elsewhere in this form 10-K. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Financial Statements included in this form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
RESIDENTIAL MORTGAGE LOANS. At December 31, 1998 and 1997, the Company had $13.8 million and $22.8 million, respectively, invested in Residential Mortgage Loans. The decrease is due to repayments of mortgage loans in 1998. The Company reinvested the proceeds recovered from the repayment of Residential Mortgage Loans in Mortgage-backed Securities.
At December 31, 1998 and 1997, there were no delinquent or nonaccrual Residential Mortgage Loans.
COMMERCIAL MORTGAGE LOANS. At December 31, 1998 and 1997, the Company had $11.2 million and $18.8 million, respectively, invested in Commercial Mortgage Loans. The decrease is due to repayments of mortgage loans in 1998. The Company reinvested the proceeds recovered from the repayment of Commercial Mortgage Loans in Mortgage-backed Securities.
The following table reflects the composition of Mortgage Loans at December 31, 1998:
The following table reflects the composition of Mortgage Loans at December 31, 1997:
MORTGAGE-BACKED SECURITIES. At December 31, 1998, the Company had $15.0 million invested in mortgage-backed securities. At December 31, 1997, the Company had no investment in mortgage-backed securities. The increase in 1998 is due to the Company's reinvestment of mortgage loan repayments in mortgage-backed securities. The weighted average maturity and yield of these investments at December 31, 1998 are 1.61 years and 5.88%, respectively.
INTEREST RATE RISK. The Company's income consists primarily of interest payments on mortgage loans. Currently, the Company does not use any derivative products or manage its interest rate risk. If there is a decline in interest rates (as measured by the indices upon which the interest rates of the adjustable rate mortgage loans are based), then the Company will experience a decrease in income available to be distributed to its shareholders. There can be no assurance that an interest rate environment in which there is a significant decline in interest rates, over an extended period of time, would not adversely affect the Company's ability to pay dividends on the Series A Preferred Shares.
SIGNIFICANT CONCENTRATION OF CREDIT RISK. Concentration of credit risk arises when a number of customers engage in similar business activities, or activities in the same geographical region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Concentration of credit risk indicates the relative sensitivity of the Company's performance to both positive and negative developments affecting a particular industry.
Geographically, the Company's Mortgage Loans are generally located in the Michigan. Geographic concentration of loans may present risks in addition to those present with respect to Mortgage Loans generally. Mortgage Loans secured by properties located in Michigan may be subject to a greater risk of default than other comparable mortgage loans in the event of adverse economic, political or business developments or natural hazards that may affect Michigan and the ability of property owners in Michigan to make payments of principal and interest on the underlying mortgages.
LIQUIDITY AND CAPITAL RESOURCES. The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company's financial commitments. In managing liquidity, the Company takes into account various legal limitations and requirements placed on a REIT.
The Company's principal liquidity needs are to maintain the current portfolio size through the acquisition of additional mortgage loans as Mortgage Loans currently in the portfolio mature or prepay and to pay dividends on the Series A Preferred Shares. The acquisition of additional mortgage loans is intended to be funded with the proceeds obtained from repayment of principal balances by the individual mortgagees. The Company does not have and does not anticipate having any material capital expenditures.
To the extent that the Board of Directors determines that additional funding is required, the Company may raise such funds through additional equity offerings, debt financing or retention of cash flows (after consideration of provisions of the Code requiring the distribution by a REIT of at least 95% of its "REIT taxable income" and taking into account taxes that would be imposed on undistributed income), or a combination of these methods, subject to certain approvals as described in the Company's organizational documents.
RESULTS OF OPERATIONS
For the years ended December 31, 1998 and the period from December 22, 1997 (inception) through December 31,1997, the Company reported net income of $962,105 and $102,547, respectively. Interest income on Residential Mortgage Loans totaled $1,464,172 for 1998 and $50,358 for the period from December 22, 1997 (inception) through December 31,1997, which represents an average yield on such loans of 8.02% and 8.20%, respectively. Interest income on Commercial Mortgage Loans totaled $1,415,079 for 1998 and $52,189 for the period from December 22, 1997 (inception) through December 31,1997, which represents an average yield on such loans of 9.43% and 9.04%, respectively. The average loan balance of the Residential Mortgage Loan portfolio for the years ended December 31, 1998 and 1997 was $67,976 and $79,644, respectively. The average loan balance of the Commercial Mortgage Loan portfolio for the years ended December 31, 1998 and 1997 was $965,143 and $776,315,respectively,
Operating expenses totalled $300,974 and $0, respectively, for the years ended December 31, 1998 and the period from December 22, 1997 (inception) through December 31,1997.
The Company also declared a cash dividend of $43.58 per Common Share, which was paid on January 31, 1999.
The Company also declared a cash dividend of $.2175 on Preferred Shares to shareholders of record on December 31, 1998.
YEAR 2000 COMPLIANCE
As with many other companies, the Company is dependant on others for its computer technology. The Bank provides computer programming and administrative services through the Advisory Agreement and the Servicing Agreement.
Although the Bank has conducted internal development and testing of their computer systems to insure millennium compliance, they cannot give the Company assurance that their internal systems will be completely free of errors. Furthermore, they cannot give any assurance that all of their vendors will deliver Year 2000 compliant certificates or that the vendors will in fact be Year 2000 compliant despite their certification of compliance. If either their computer systems or those of their vendors fail to function properly because of the Year 2000 problem, the results of our operations may materially suffer.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors and Shareholders of Franklin Finance Corporation:
We have audited the accompanying balance sheets of Franklin Finance Corporation (the "Company") as of December 31, 1998 and 1997 and the related statements of income, comprehensive income, shareholders' equity and cash flows for the year ended December 31, 1998 and for the period from December 22, 1997 (inception) to December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statement is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statement. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Franklin Finance Corporation as of December 31, 1998 and 1997, and the results of its operations and its cash flows for the year ended December 31, 1998 and for the period from December 22, 1997 (inception) to December 31, 1997 in conformity with generally accepted accounting principles.
/s/ Grant Thornton LLP - - ------------------------- Grant Thornton LLP Southfield, Michigan January 28, 1999
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FRANKLIN FINANCE CORPORATION BALANCE SHEETS
The accompanying notes are an integral part of these statements.
iii
FRANKLIN FINANCE CORPORATION STATEMENTS OF INCOME
The accompanying notes are an integral part of these statements.
FRANKLIN FINANCE CORPORATION
STATEMENTS OF COMPREHENSIVE INCOME
The accompanying notes are an integral part of these statements.
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FRANKLIN FINANCE CORPORATION STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these statements.
v
FRANKLIN FINANCE CORPORATION STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these statements.
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FRANKLIN FINANCE CORPORATION NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1998 AND 1997
NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION:
Franklin Finance Corporation (the "Company") is a Michigan corporation which was incorporated on September 25, 1997 and created for the purpose of acquiring and holding real estate mortgage assets. The Company is a wholly-owned subsidiary of Franklin Bank, N.A. (the "Bank"), a nationally chartered commercial bank.
On September 25, 1997, the Company was initially capitalized with the issuance to the Bank of 1,000 shares of the Company's common stock (the "Common Stock"), $1.00 par value. On December 22, 1997, the Company commenced its operations upon consummation of an initial public offering of 2,070,000 shares of the Company's 8.70% Noncumulative Preferred Stock, Series A (the "Series A Preferred Shares"), $10.00 liquidation preference. These offerings, together with a separate capital contribution made by the Bank on December 22, 1997, raised net capital of $42.0 million.
The Company used the proceeds from the initial public offering of the Series A Preferred Shares, the sale of Common Stock to the Bank and the additional capital contribution to the Company by the Bank to pay the expenses related to the offering and the formation of the Company and to purchase from the Bank the Company's initial portfolio of residential and commercial mortgage loans at their estimated fair value of approximately $41.5 million. Such loans were recorded in the accompanying balance sheets at their estimated fair values. See Note 7.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The following summarizes the significant accounting policies of the Company.
RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS:
Mortgage loans are carried at the principal amount outstanding. Interest income is accrued and recognized using the interest method or on a basis approximating a level rate of return over the term of the loan.
Loans are reviewed on a monthly basis and are placed on non-accrual status when, in the opinion of management, the full collection of principal or interest has become unlikely. Uncollectible accrued interest receivable on non-accrual loans is charged against current period income. The Company had no non-accrual loans at December 31, 1998 and 1997.
ALLOWANCE FOR LOAN LOSSES:
Management periodically reviews the mortgage loan portfolio to establish an allowance for loan losses if deemed necessary. An allowance is provided after considering such factors as the economy in lending areas, delinquency statistics, past loss experience and estimated future losses. The allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates. As adjustments to the allowance become necessary, provisions for loan losses are reported in operations in the periods they are determined to be necessary.
MORTGAGE-BACKED SECURITIES
Mortgage-backed securities purchased by the Company are classified as available for sale and carried at market value. Unrealized gains and losses on available for sale securities are excluded from income and recorded as an amount in a separate component of comprehensive income until realized.
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CONCENTRATIONS OF CREDIT:
All of the real estate properties underlying the Company's Mortgage Loans are located in Michigan. Consequently, these Mortgage Loans may be subject to a greater risk of default than other comparable Mortgage Loans in the event of adverse economic, political or business developments and natural hazards in Michigan that may affect the ability of residential property owners in Michigan to make payments of principal and interest on the underlying mortgages.
DUE FROM PARENT COMPANY:
Due from parent company represents principal and interest payments received from borrowers by the Bank as servicer of the mortgage loans which are being held by the servicer in a custodial account pending remittance to the Company.
DIVIDENDS:
Preferred Stock. Dividends on the Series A Preferred Shares are payable at a rate of 8.70% per annum of the liquidation preference (an amount equal to $0.87 per annum per share), if, when and as declared by the Board of Directors of the Company. Dividends are not cumulative and, if declared, are payable quarterly in arrears on March 31, June 30, September 30 and December 31.
Common Stock. The shareholder is entitled to receive dividends when, as and if declared by the Board of Directors out of funds legally available after all preferred dividends have been paid.
EARNINGS PER COMMON SHARE:
Earnings per common share is computed by dividing net income after preferred dividends by the weighted average number of common shares outstanding. There are no dilutive securities which would require a diluted earnings per share computation. The Company had 22,077 weighted average common shares outstanding during 1998 and 1997.
COMPREHENSIVE INCOME:
The Financial Accounting Standards Board (FASB) has issued SFAS No. 130, "Comprehensive Income." The Statement requires that entities present items of other comprehensive income in a financial statement with the same prominence as other financial statements. The Company adopted SFAS No. 130 in 1998.
INCOME TAXES:
The Company has elected for Federal income tax purposes to be treated as a Real Estate Investment Trust ("REIT") and intends to comply with the provisions of the Internal Revenue Code of 1986 (the "IRC"), as amended. Accordingly, the Company will not be subject to Federal corporate income taxes to the extent it distributes 95% of its REIT taxable income to shareholders and as long as certain asset, income and stock ownership tests are met in accordance with the IRC. During the periods ended December 31, 1998 and 1997, the Company distributed 100% of its taxable income. Because the Company believes it qualifies as a REIT for Federal income tax purposes, no provision for income taxes is included.
USE OF ESTIMATES:
The financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the date of the statement of financial condition and income and expenses for the reporting period. Actual results could differ from those estimates.
viii
ISSUED BUT NOT YET ADOPTED ACCOUNTING STANDARDS:
The Financial Accounting Standards Board (FASB) has issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The statement requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective January 1, 2000 for the Company; however, management does not expect this pronoucement to have a significant impact on the Company's financial position.
The FASB has issued SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." The statement requires that an entity engaged in mortgage banking activities classify resulting mortgage-backed securities and other retained interests based on its ability and intent to sell or hold those investments. This statement is effective in 1999 for the Company; however, management does not expect this pronouncement to have an impact on the Company's financial position.
NOTE 3 - RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS:
The following reflects the composition of the Company's Mortgage Loans:
The properties collateralizing the Company's Commercial Mortgage Loans consist of retail strip centers, multi-family residential rental properties, warehouse, industrial and office center properties located in Michigan.
NOTE 4 - MORTGAGE-BACKED SECURITIES
The amortized cost and estimated market value of the mortgage-backed securities available for sale at December 31, 1998 are shown below.
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NOTE 5 - RELATED PARTY TRANSACTIONS:
The Company has entered into an advisory agreement (the "Advisory Agreement") with the Bank. The Bank provides advice to the Board of Directors and manages the operations of the Company as defined in the Advisory Agreement. The Advisory Agreement has an initial term of five years which began on December 22, 1997 and will automatically renew for additional five-year periods unless the Company delivers a notice of nonrenewal to the Bank. The Advisory Agreement may be terminated by the Company at any time upon ninety days' prior written notice. The advisory fee is $125,000 per annum payable in equal quarterly installments.
The Company also entered into a servicing agreement with the Bank for the servicing of its residential mortgage loans (the "Servicing Agreement"). Pursuant to the Servicing Agreement, the Bank performs the servicing of the residential mortgage loans owned by the Company, in accordance with normal industry practice. The Servicing Agreement can be terminated without cause with at least thirty days notice to the Bank and payment of a termination fee. The servicing fee rate is .375% of the outstanding principal balance of the residential mortgage loans.
The Company has cash balances of $106,546 and $268 as of December 31, 1998 and 1997, respectively, held in deposit accounts with the Bank.
NOTE 6 - ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS:
The majority of the Company's assets and liabilities are financial instruments; however, certain of these financial instruments lack an available trading market. Significant estimates, assumptions and present value calculations were therefore used for the purposes of deriving the Company's fair values, resulting in a great degree of subjectivity inherent in the indicated fair value amounts. Since the fair value is estimated as of the balance sheet date, the amount which will actually be realized or paid upon settlement or maturity could be significantly different. Comparability among REITs may be difficult due to the wide range of permitted valuation techniques and the numerous estimates and assumptions which must be made.
The following methods and assumptions were used to estimate the fair value amounts at December 31, 1998 and 1997.
CASH AND DUE FROM BANK: Carrying amount approximates fair value.
RESIDENTIAL AND COMMERCIAL MORTGAGE LOANS: Fair value of the residential and commercial mortgage loans is estimated using discounted cash flow analyses based on contractual repayment schedules. The discount rates used in these analyses are based on either the interest rates paid on U.S. Treasury securities of comparable maturities adjusted for credit risk and non-interest operating costs, or the interest rates currently offered for loans with similar terms to borrowers of similar credit quality. The carrying amount reflected on the balance sheet at December 31, 1998 and 1997, approximates fair value.
OTHER FINANCIAL ASSETS: The carrying amounts of due from parent company and accrued interest receivable approximate fair value.
FINANCIAL LIABILITIES: The carrying amounts of dividends payable - common and dividends payable - preferred approximate fair value.
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ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The persons who are directors and executive officers of the Company are as follows:
Name Age Position and Offices Held
Robert M. Walker 55 Director Lloyd A. Schwartz 70 Director Read P. Dunn 52 Chief Executive Officer Edward J. Shehab 39 Director and Senior Vice President David L. Shelp 52 Director, Treasurer and Chief Financial Officer David F. Simon 52 Director and Secretary
The following is a summary of the experience of the executive officers and directors of the Company:
Robert M. Walker, age 55, has served since 1992 as Senior associate at James V. McTevia & Associates, a Detroit area firm specializing in financial and management consulting services. Mr. Walker is a certified public accountant and certified fraud examiner. He has over 28 years of experience in public accounting, financial and management consulting, and the financial services industry. Mr. Walker is a member of the Company's Audit Committee.
Lloyd A. Schwartz, age 70, is a certified public accountant and has served as the Deputy Receiver/Rehabilator of two Michigan-based insurance companies since 1993. Mr. Schwartz has also served as a Technical Reviewer for the Michigan Association of Certified Public Accountants peer review program since 1990. Prior to 1990, Mr. Schwartz was a partner with the accounting firm of Coopers & Lybrand, LLP. Mr. Schwartz is a member of the Company's Audit Committee.
Read P. Dunn, age 52, is Chief Executive Officer of the Bank and has held these positions since its inception in 1983. He is a certified public accountant and was the former President and senior officer at another financial institution for over 14 years.
David L. Shelp, age 52, has been the Treasurer of the Bank since its inception in 1983. Mr. Shelp was an Assistant Treasurer of another financial institution in Lansing, Michigan from 1975 to 1981 and its Controller from 1981 to 1983. Mr. Shelp is a member of the Company's Credit Committee.
Edward J. Shehab, age 39, joined the Bank in 1985 as a financial analyst. Prior to that time, Mr. Shehab was an assistant secondary trader at another financial institution. Since 1991, Mr. Shehab has been Vice President of Finance at the Bank. Mr. Shehab is a member of the Company's Credit Committee.
David F. Simon, age 52, is Chairman of the Board of the Bank and has held this position since its inception in 1983. Mr. Simon is a member of the Company's Credit Committee. He formerly was an attorney in private practice specializing in securities and financial institutions law from 1971 to 1991.
INDEPENDENT DIRECTORS
The Company's Certificate of Designation establishing the Series A Preferred Shares requires that, so long as any Series A Preferred Shares are outstanding, certain actions by the Company be approved by a majority of the Independent Directors of the Company. Messrs. Walker and Schwartz are the Company's only Independent Directors. For so long as there are only two Independent Directors, any action that requires the approval of a majority of the Independent Directors must be approved by both Independent Directors.
If at any time the Company fails to pay or declare and set aside for payment a quarterly cash dividend payment on the Series A Preferred shares, the number of directors constituting the Board of Directors of the Company will be increased by two at the Company's next annual meeting and the holders of Series A Preferred Shares, voting together with the holder of any other outstanding series of Preferred Stock as a single class, will be entitled to elect two additional directors to serve on the Company's Board of Directors. Any member of the Board of Directors elected by holders of the Company's Preferred Stock will be deemed to be an Independent Director for purposes of the actions requiring the approval of a majority of the Independent Directors. Each director elected by the holders of shares of the Preferred Stock shall continue to serve as such director until the later of (i) the full term for which he or she shall have been elected or (ii) the payment of four quarterly dividends on the Preferred Stock, including the Series A Preferred Shares.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires the Company's officers, directors and persons who own more than ten percent of either the Common Stock or the Series A Preferred Shares to file reports of ownership on Form 3 and changes in ownership on Form 4 or 5 with the SEC. Such officers, directors and ten percent shareholders are also required by SEC rules to furnish the Company with copies of all Section 16(a) forms that they file.
Based solely on its review of copies of such reports received or representations from certain reporting persons, the Company believes that, during the fiscal year ended December 31, 1998, all of its officers, directors and ten percent shareholders complied with all Section 16(a) filing requirements applicable to them with respect to transactions during fiscal 1998.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Since the Company's inception on December 22, 1997, no compensation has been awarded to, earned by or paid to any of the Company's directors. The Company does not intend to pay any compensation to any of its directors (other than its Independent Directors), officers or employees. The Company pays the Independent Directors a fee of $500 for attendance (in person or by telephone) at each meeting of the Board of Directors.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The Bank owns 100% of the Common Stock of the Company. All voting rights are vested in the Common Stock.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Set forth below are certain transactions between the Company and its directors and affiliates. Management believes that the transactions with related parties described herein have been conducted on substantially the same terms as similar transactions with unrelated parties. See Note 5 to the financial statements.
The Bank administers the day-to-day operations of the Company and is entitled to receive fees in connection with the Advisory Agreement. Advisory fees paid to the Bank for the period ended December 31, 1998 totalled $125,000.
The Bank services the Residential and Commercial Mortgage Loans included in the Company's portfolio and is entitled to receive fees in connection with the Servicing Agreement. The Company paid the Bank $125,053 in servicing fees for the year ended December 31, 1998.
The Company had cash balances of $106,546 and $268 as of December 31, 1998 and 1997 held in deposit accounts with the Bank.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following financial statements of the Company are included in Item 8 of this report:
Report of Independent Certified Public Accountants
Balance Sheets at December 31, 1998 and 1997
Statements of Income for the year ended December 31, 1998, and for the period from December 22, 1997 (inception) through December 31, 1997
Statements of Comprehensive Income for the year ended December 31, 1998 and for the period from December 22, 1997 (inception) through December 31, 1997
Statements of Shareholders' Equity for the year ended December 31, 1998, and for the period from December 22, 1997 (inception) through December 31, 1997
Statements of Cash Flows for the year ended December 31, 1998, and for the period from December 22, 1997 (inception) through December 31,
Notes to Financial Statements
(a)(2) All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and therefore have been omitted.
(a)(3) Exhibits: See Exhibit Index.
Sequential page number Exhibit where attached exhibits No. Document are located in the 10-K - - -------------------------------------------------------------------------------- 3.1 Articles of Incorporation of the Company, as amended (incorporated herein by reference to Exhibit 3(a) of Form S-11 (file number 333-10495) filed by the company).
3.2 Bylaws of the Company (incorporated herein by reference to Exhibit 3(b) of Form S-11 (file number 333-10495)filed by the company).
4.1 Certificate of Designation of 8.70% Noncumulative Exchangeable Preferred Stock, Series A (incorporated herein by reference to Exhibit 3(a)(1) of Form S-11 (file number 333-10495)filed by the company).
10.1 Residential Mortgage Loan Purchase Agreement and Commercial Mortgage Loan Purchase Agreement (incorporated herein by reference to Exhibits 10.1 and 10.2 of Form S-11 (file number 333-10495)filed by the company).
10.2 Residential Mortgage Loan Servicing Agreement and Commercial Mortgage Loan Servicing Agreement (incorporated herein by reference to Exhibit 10.3 and 10.4 of Form S-11(file number 333-10495)filed by the company).
10.3 Advisory Agreement between the Company and the Bank (incorporated herein by reference to Exhibit 10.5 of Form S-11(file number 333-10495)filed by the company).
11 Computation of net income per share.
12 Computation of ratio of income to fixed charges and Preferred Stock dividend Requirements.
27 Financial Data Schedule
(b) No reports on Form 8-K were issued during the year ended December 31, 1998
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, in Southfield, Michigan on March 31, 1999.
FRANKLIN FINANCE CORPORATION (Registrant)
By: /s/ Read P. Dunn ----------------------------------------- Read P. Dunn Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following officers and directors of the Registrant and in the capacities and on the dates indicated.
March 31, 1999 By: /s/ Lloyd A. Schwartz ----------------------------------------- Lloyd A. Schwartz Director
March 31, 1999 By: /s/ Edward J. Shehab ----------------------------------------- Edward J. Shehab Director and Senior Vice President
March 31, 1999 By: /s/ David L. Shelp ----------------------------------------- David L. Shelp Director, Treasurer and Chief Financial Officer
March 31, 1999 By: /s/ David F. Simon ---------------------------------------- David F. Simon Director and Secretary
March 31, 1999 By: /s/ Robert M. Walker ---------------------------------------- Robert M. Walker Director
EXHIBITS INDEX
Exhibit Page No.
11 Computation of net income per share. 17
12 Computation of ratio of income to fixed charges and Preferred Stock dividend Requirements. 17
27 Financial Data Schedule 18