ITEM 1. BUSINESS
Skagit State Bancorp, Inc. is a bank holding company with one wholly owned subsidiary - Skagit State Bank (collectively, “Bancorp” or “Company”). On June 30, 2006, at the completion of the corporate reorganization, pursuant to the Plan and Agreement of Reorganization and Merger dated January 17, 2006, Skagit State Bank became a wholly-owned subsidiary of Skagit State Bancorp, Inc.
Skagit State Bank (“the Bank”) was established in 1958 by the late James P. Bishop and other investors. The Bank was formed under the laws of the State of Washington and is regulated by the Department of Financial Institutions, Division of Banks (“Director”) and by the Federal Deposit Insurance Corporation (“FDIC”), its primary federal regulator and the insurer of its deposits. The Bank is headquartered in Burlington, Skagit County, Washington. At December 31, 2007, Bancorp had 721 shareholders of record owning 671,837 shares of the Bank’s no par value common stock (“Common Stock”).
Bancorp’s Primary Market Area
Skagit State Bank conducts its banking business through its main office in Burlington and twelve other branches located within Skagit, Snohomish and Whatcom Counties. The Bank focuses its banking and other services on individuals, professionals, and small to medium-sized businesses throughout its market area. Bancorp provides a full range of banking services and products to both businesses and individuals. Bancorp operates its main office and one branch in Burlington (Skagit County), three branches in Mount Vernon (Skagit County), two branches in Sedro-Woolley (Skagit County), a branch in Anacortes (Skagit County), a branch in Stanwood (Snohomish County), two branches in Bellingham (Whatcom County), one branch in Arlington (Snohomish County) and one branch in Lynden (Whatcom County). As of December 31, 2007, Bancorp had total assets of $592.7 million.
Competition
The banking industry is highly competitive and Bancorp competes with a number of financial institutions within Skagit, Snohomish and Whatcom Counties, including state-wide banking organizations, local community banks, savings banks, savings and loans, and credit unions. In addition to competition from other banking institutions, Bancorp competes against financial service companies, brokerage houses, mutual funds and other financial service organizations. Although Bancorp has been able to compete effectively in its market areas to date, there can be no assurance that it will be able to continue to do so in the future.
Services Provided
Lending Activities. Bancorp concentrates on five areas of lending: loans to individuals for business purposes, loans for small and medium-sized businesses, agricultural loans, loans to commercial enterprises for real estate transactions and consumer purpose loans. Bancorp’s primary lending activities includes commercial real estate loans, commercial loans which include agriculture production loans and consumer purpose loans. Most of Bancorp’s business activity is with customers located within Skagit, Snohomish and Whatcom Counties. Bancorp originates commercial, real estate and consumer loans. Generally, loans are secured by accounts receivable, inventory, deposit accounts, personal property or real estate. Rights to collateral vary and are legally documented to the extent practicable.
Real estate loans comprise the largest category of loans at 70.4% of the loan portfolio. Real estate loans increased 10.6% or $24.1 million to $251.1 million and $227.0 million as of December 31, 2007 and 2006, respectively. Bancorp is committed to providing competitive commercial real estate lending within our primary market areas. Our real estate portfolio consists of commercial and residential loans. These loans are secured by property such as office buildings, retail buildings, owner occupied commercial business properties, farm land, timber land, residential land development properties and residential properties. While Bancorp has significant balances secured by real estate,
Bancorp believes that its lending policies and concentration policies are sufficient to minimize risks. Also, economic conditions may affect a borrower’s ability to meet the stated repayment terms.
Residential mortgage loans are offered primarily through Bancorp’s residential lending department. During 2007, Bancorp expanded its residential lending department. Loans originated are primarily for the purchase or refinance of residential properties. Bancorp brokers or sells a majority of these loans. In 2007, Bancorp brokered or sold $22.6 million compared to $15.2 million during 2006.
Commercial loans were $70.0 million or approximately 19.6% of the loan portfolio as of December 31, 2007 and $72.0 million as of December 31, 2006. Commercial loans, secured and unsecured, are made primarily to small and medium-sized businesses operating within Skagit, Snohomish and Whatcom Counties. These loans are available for general operating purposes, acquisition of fixed assets, purchases of equipment and machinery, financing of inventory and accounts receivable, and other business purposes. Bancorp originates Small Business Administration (SBA) loans, including 504 and 7A loans.
Consumer loans increased 24.6% or $7.0 million to $35.4 million or approximately 9.9% of the loan portfolio at December 31, 2007 from $28.4 million as of December 31, 2006. During 2007, Bancorp continued to emphasize its consumer lending activities to provide more diversification in its loan portfolio as a means of minimizing both credit risk and interest rate risk. Bancorp makes secured and unsecured consumer loans including loans to individuals, primarily customers of Bancorp, for various purposes, including home equity loans, purchases of automobiles, mobile homes, boats and other recreational vehicles, home improvement loans and loans for education and personal investments.
The extension of credit to individuals and businesses is a significant portion of Bancorp’s principal business activity and requires ongoing portfolio and credit management. As such, Bancorp has established lending policies and procedures to manage and monitor risk. These lending policies and procedures include guidelines for concentrations of credit, loan terms, loan-to-value ratios, collateral appraisals and loan approval limits.
Information relating to “Loans” is set forth in the “Management Discussion and Analysis” section of the 2007 Annual Report, portions of which is contained in Exhibit 13 and is incorporated herein by reference.
Deposit Services. Bancorp offers a full range of deposit services including checking accounts, savings accounts, money market accounts and various types of certificates of deposit. The transaction accounts and certificates of deposit are tailored to Bancorp’s primary market area at rates competitive with those offered in the area. Bancorp offers both interest and non-interest bearing checking accounts. All deposit accounts, up to the maximum permitted by law, are insured by the FDIC.
Information relating to “Deposits” is set forth in the “Management Discussion and Analysis” section of the 2007 Annual Report, portions of which is contained in Exhibit 13 and is incorporated herein by reference.
Other Services. Bancorp provides other traditional commercial and consumer banking services, including safe deposit services, debit and automated teller machine cards, on-line banking, credit card services, savings bonds, cashiers’ checks, travelers’ checks, notary services, and other services. New technologies and services are reviewed for business development and cost saving purposes. Bancorp’s on-line banking service provides customers a convenient way to process balance inquiries, transfers, bill paying and other services. Bancorp’s website address is www.skagitbank.com.
Employees
As of December 31, 2007, Bancorp had 169 full-time equivalent employees.
Supervision and Regulation
General
The following discussion describes elements of the extensive regulatory framework applicable to Skagit State Bancorp (the “Company”) and Skagit State Bank (the “Bank”). This regulatory framework is primarily designed for the protection of depositors, federal deposit insurance funds and the banking system as a whole, rather than specifically for the protection of shareholders. Due to the breadth of this regulatory framework, our costs of compliance continue to increase in order to monitor and satisfy these requirements.
To the extent that this section describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. These statutes and regulations, as well as related policies, are subject to change by Congress, state legislatures and federal and state regulators. Changes in statutes, regulations or regulatory policies applicable to us, including interpretation or implementation thereof, could have a material effect on our business or operations.
Federal Bank Holding Company Regulation
General. The Company is a bank holding company as defined in the Bank Holding Company Act of 1956, as amended (“BHCA”), and is therefore subject to regulation, supervision and examination by the Federal Reserve. In general, the BHCA limits the business of bank holding companies to owning or controlling banks and engaging in other activities closely related to banking. The Company must also file reports with and provide the Federal Reserve with such additional information as it may require. Under the Financial Services Modernization Act of 1999, a bank holding company may apply to the Federal Reserve to become a financial holding company, and thereby engage (directly or through a subsidiary) in certain expanded activities deemed financial in nature, such as securities brokerage and insurance underwriting.
Holding Company Bank Ownership. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve before (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares; (ii) acquiring all or substantially all of the assets of another bank or bank holding company; or (iii) merging or consolidating with another bank holding company.
Holding Company Control of Nonbanks. With some exceptions, the BHCA also prohibits a bank holding company from acquiring or retaining direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks.
Transactions with Affiliates. Subsidiary banks of a bank holding company are subject to restrictions imposed by the Federal Reserve Act on extensions of credit to the holding company or its subsidiaries, on investments in their securities, and on the use of their securities as collateral for loans to any borrower. These regulations and restrictions may limit the Company’s ability to obtain funds from the Bank for its cash needs, including funds for payment of dividends, interest and operational expenses.
Tying Arrangements. We are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (i) a requirement that the customer obtain additional services provided by us; or (ii) an agreement by the customer to refrain from obtaining other services from a competitor.
Support of Subsidiary Banks. Under Federal Reserve policy, the Company is expected to act as a source of financial and managerial strength to the Bank. This means that the Company is required to commit, as necessary, resources to support the Bank. Any capital loans a bank holding company makes to its subsidiary banks are subordinate to deposits and to certain other indebtedness of those subsidiary banks.
State Law Restrictions. As a Washington corporation, the Company is subject to certain limitations and restrictions under applicable Washington corporate law. For example, state law restrictions in Washington include limitations and restrictions relating to indemnification of directors, distributions to shareholders, transactions involving directors, officers or interested shareholders, maintenance of books, records and minutes, and observance of certain corporate formalities.
Federal and State Regulation of Skagit State Bank
General. The Bank is a Washington state-chartered commercial bank with deposits insured by the FDIC. As a result, the Bank is subject to supervision and regulation by the Washington Department of Financial Institutions, Division of Banks and the FDIC. These agencies have the authority to prohibit banks from engaging in what they believe constitute unsafe or unsound banking practices.
Community Reinvestment. The Community Reinvestment Act of 1977 requires that, in connection with examinations of financial institutions within their jurisdiction, the Federal Reserve or the FDIC evaluate the record of the financial institution in meeting the credit needs of its local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. A bank’s community reinvestment records are also considered by the applicable banking agencies in evaluating mergers, acquisitions and applications to open a branch or facility.
Insider Credit Transactions. Banks are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are at least as stringent, as those prevailing at the time for comparable transactions with persons not covered above; and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in the assessment of substantial civil monetary penalties, the imposition of a cease and desist order, and other regulatory sanctions.
Regulation of Management. Federal law (i) sets forth circumstances under which officers or directors of a bank may be removed by the institution’s federal supervisory agency; (ii) places restraints on lending by a bank to its executive officers, directors, principal shareholders and their related interests; and (iii) prohibits management personnel of a bank from serving as a director or in a management position of another financial institution whose assets exceed a specified amount or which has an office within a specified geographic area.
Safety and Soundness Standards. Federal law imposes certain non-capital safety and soundness standards upon banks. These standards cover, among other things, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits. Additional standards apply to asset quality, earnings and stock valuation. An institution that fails to meet these standards must develop a plan acceptable to its regulators, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions.
Interstate Banking And Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) relaxed prior interstate branching restrictions under federal law by permitting nationwide interstate banking and branching under certain circumstances. Currently, bank holding companies may purchase banks in any state, and states may not prohibit these purchases. Additionally, banks are permitted to merge with banks in other states, as long as the home state of neither merging bank has opted out under the legislation. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area. Federal banking
agency regulations prohibit banks from using their interstate branches primarily for deposit production and the federal banking agencies have implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.
Washington enacted “opting in” legislation in accordance with the Interstate Act, allowing banks to engage in interstate merger transactions, subject to certain “aging” requirements. Under Washington law, an out-of-state bank may, subject to Department of Financial Institutions’ approval, open de novo branches in Washington or acquire an in-state branch so long as the home state of the out-of-state bank has reciprocal laws with respect to de novo branching or branch acquisitions. Once an out-of-state bank has acquired a bank within Washington, either through merger or acquisition of all or substantially all of the bank’s assets or through authorized de novo branching, the out-of-state bank may open additional branches within the state.
Deposit Insurance
In 2006, federal deposit insurance reform legislation was enacted that (i) required the FDIC to merge the Bank Insurance Fund and the Savings Association Insurance Fund into a newly created Deposit Insurance Fund; (ii) increases the amount of deposit insurance coverage for retirement accounts; (iii) allows for deposit insurance coverage on individual accounts to be indexed for inflation starting in 2010; (iv) provides the FDIC more flexibility in setting and imposing deposit insurance assessments; and (v) provides eligible institutions credits on future assessments.
The Bank’s deposits are currently insured to a maximum of $100,000 per depositor through the Deposit Insurance Fund. The Bank is required to pay deposit insurance premiums, which are assessed and paid regularly. The premium amount is based upon a risk classification system established by the FDIC. Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern.
Dividends
The principal source of the Company’s cash is from dividends received from the Bank, which are subject to government regulation and limitations. Regulatory authorities may prohibit banks and bank holding companies from paying dividends in a manner that would constitute an unsafe or unsound banking practice or would reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. Washington law also limits a bank’s ability to pay dividends that are greater than the bank’s retained earnings without approval of the Department of Financial Institutions.
Capital Adequacy
Regulatory Capital Guidelines. Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. The guidelines are “risk-based,” meaning that they are designed to make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies.
Tier I and Tier II Capital. Under the guidelines, an institution’s capital is divided into two broad categories, Tier I capital and Tier II capital. Tier I capital generally consists of common stockholders’ equity, surplus and undivided profits. Tier II capital generally consists of the allowance for loan losses, hybrid capital instruments, and term subordinated debt. The sum of Tier I capital and Tier II capital represents an institution’s total capital. The guidelines require that at least 50% of an institution’s total capital consist of Tier I capital.
Risk-based Capital Ratios. The adequacy of an institution’s capital is gauged primarily with reference to the institution’s risk-weighted assets. The guidelines assign risk weightings to an institution’s assets in an effort to quantify the relative risk of each asset and to determine the minimum capital required to support that risk. An institution’s risk-weighted assets are then compared with its Tier I capital and total capital to arrive at a Tier I risk-based ratio and a total risk-based ratio, respectively. The guidelines provide that an institution must have a minimum Tier I risk-based ratio of 4% and a minimum total risk-based ratio of 8%.
Leverage Ratio. The guidelines also employ a leverage ratio, which is Tier I capital as a percentage of total assets, less intangibles. The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company may leverage its equity capital base. The minimum leverage ratio is 3%; however, for all but the most highly rated bank holding companies and for bank holding companies seeking to expand, regulators expect an additional cushion of at least 1% to 2%.
Prompt Corrective Action. Under the guidelines, an institution is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain subjective factors. The categories range from “well capitalized” to “critically undercapitalized.” Institutions that are “undercapitalized” or lower are subject to certain mandatory supervisory corrective actions.
In 2007, the federal banking agencies, including the FDIC and the Federal Reserve, approved final rules to implement new risk-based capital requirements. Presently, this new advanced capital adequacy framework, called Basel II, is applicable only to large and internationally active banking organizations. Basel II changes the existing risk-based capital framework by enhancing its risk sensitivity. Whether Basel II will be expanded to apply to banking organizations that are the size of the Company or the Bank is unclear at this time, and what effect such regulations would have on us cannot be predicted, but we do not expect our operations would be significantly impacted.
Regulatory Oversight and Examination
The Federal Reserve conducts periodic inspections of bank holding companies, which are performed both onsite and offsite. The supervisory objectives of the inspection program are to ascertain whether the financial strength of the bank holding company is being maintained on an ongoing basis and to determine the effects or consequences of transactions between a holding company or its non-banking subsidiaries and its subsidiary banks. For holding companies under $10 billion in assets, the inspection type and frequency varies depending on asset size, complexity of the organization, and the holding company’s rating at its last inspection.
Banks are subject to periodic examinations by their primary regulators. Bank examinations have evolved from reliance on transaction testing in assessing a bank’s condition to a risk-focused approach. These examinations are extensive and cover the entire breadth of operations of the bank. Generally, safety and soundness examinations occur on an 18-month cycle for banks under $500 million in total assets that are well capitalized and without regulatory issues, and 12-months otherwise. Examinations alternate between the federal and state bank regulatory agency or may occur on a combined schedule. The frequency of consumer compliance and CRA examinations is linked to the size of the institution and its compliance and CRA ratings at its most recent examinations. However, the examination authority of the Federal Reserve and the FDIC allows them to examine supervised banks as frequently as deemed necessary based on the condition of the bank or as a result of certain triggering events.
Corporate Governance and Accounting Legislation
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the “Act”) addresses, among other things, corporate governance, auditing and accounting, enhanced and timely disclosure of corporate information, and penalties for non-compliance. Generally, the Act (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission (the “SEC”); (ii) imposes specific and enhanced corporate disclosure requirements; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; (iv) requires companies to adopt and disclose information about corporate governance practices, including whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert;” and (v) requires the SEC, based on certain enumerated factors, to regularly and systematically review corporate filings.
To deter wrongdoing, the Act (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.
As a publicly reporting company, we are subject to the requirements of the Act and related rules and regulations issued by the SEC and NASDAQ. After enactment, we updated our policies and procedures to comply with the Act’s requirements and have found that such compliance, including compliance with Section 404 of the Act relating to management control over financial reporting, has resulted in significant additional expense for the Company. We anticipate that we will continue to incur such additional expense in our ongoing compliance.
Anti-terrorism Legislation
USA Patriot Act of 2001. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, intended to combat terrorism, was renewed with certain amendments in 2006 (the “Patriot Act”). Certain provisions of the Patriot Act were made permanent and other sections were made subject to extended “sunset” provisions. The Patriot Act, in relevant part, (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports. The Act also includes provisions providing the government with power to investigate terrorism, including expanded government access to bank account records. While the Patriot Act has had minimal affect on our record keeping and reporting expenses, we do not believe that the renewal and amendment will have a material adverse effect on our business or operations.
Financial Services Modernization
Gramm-Leach-Bliley Act of 1999. The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 brought about significant changes to the laws affecting banks and bank holding companies. Generally, the Act (i) repeals historical restrictions on preventing banks from affiliating with securities firms; (ii) provides a uniform framework for the activities of banks, savings institutions and their holding companies; (iii) broadens the activities that may be conducted by national banks and banking subsidiaries of bank holding companies; (iv) provides an enhanced framework for protecting the privacy of consumer information and requires notification to consumers of bank privacy policies; and (v) addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. Bank holding companies that qualify and elect to become financial holding companies can engage in a wider variety of financial activities than permitted under previous law, particularly with respect to insurance and securities underwriting activities.
Recent Legislation
Financial Services Regulatory Relief Act of 2006. In 2006, the President signed the Financial Services Regulatory Relief Act of 2006 into law (the “Relief Act”). The Relief Act amends several existing banking laws and regulations, eliminates some unnecessary and overly burdensome regulations of depository institutions and clarifies several existing regulations. The Relief Act, among other things, (i) authorizes the Federal Reserve Board to set reserve ratios; (ii) amends regulations of national banks relating to shareholder voting and granting of dividends; (iii) amends several provisions relating to loans to insiders, regulatory applications, privacy notices, and golden parachute payments; and (iv) expands and clarifies the enforcement authority of federal banking regulators. Our business, expenses, and operations have not been significantly impacted by this legislation.
Effects Of Government Monetary Policy
Our earnings and growth are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government, particularly the Federal Reserve. The Federal Reserve implements national monetary policy for such purposes as curbing inflation and combating recession, but its open market operations in U.S. government securities, control of the discount rate applicable to borrowings from the Federal Reserve, and establishment of reserve requirements against certain deposits, influence the growth of bank loans, investments and deposits, and also affect interest rates charged on loans or paid on deposits. The nature and impact of future changes in monetary policies, such as the recent lowering of the Federal Reserve’s discount rate, and their impact on us cannot be predicted with certainty.
Forward-Looking Statements
The discussion following below and elsewhere in this Form 10-K contains forward-looking statements, which are subject to safe harbors under the Securities Act of 1933 and the Securities Exchange Act of 1934. When used in this discussion and elsewhere in this Form 10-K, the words “will,” “believe,” “expect,” “should,” and “anticipate” and words of similar construction are intended in part to help identify forward looking statements. Future events are difficult to predict, and the expectations described are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. Readers are cautioned to not place undue reliance on any such forward-looking statements, which speak only as of the date of this Form 10-K, and readers are advised that various factors, including (1) local, regional and national economic conditions; (2) substantial changes in levels of market interest rates, that may reduce interest margins and negatively affect funding sources; (3) deterioration of credit quality that could, among other things, increase defaults and delinquency risks in the loan portfolio; (4) a continued decline in the real estate market and other factors listed under Risk Factors in Item 1A
ITEM 1A. RISK FACTORS
There are certain risks inherent to Bancorp’s business. The material risk and uncertainties that management believes affect Bancorp are described below. Although we have risk management policies, procedures and verification procedures in place, additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair Bancorp’s business operations. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.
Fluctuating interest rates can adversely affect Bancorp’s profitability
Bancorp’s profitability is dependent to a large extent upon net interest income. Earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference (or “spread”) between the interest earned on loans, securities and other interest-earning assets and Bancorp’s cost of funds, primarily interest expense on deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond our control including, but not limited to, general economic conditions, policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, impact the level of loans, deposits and investments, the credit profile of existing loans and the rates received on loans and investment securities and the rates paid on deposits and borrowings. If the interest on deposits increase at a faster rate than the interest received on loans and investment securities, Bancorp’s net interest income, and therefore earnings could be adversely affected. Earnings could also be adversely affected if interest received on loans and investments decrease faster than interest paid on deposits. In 2006, the Federal Reserve increased its targeted federal funds rate by 100 basis points to 5.25 percent, where it remained until September 18, 2007 when the Federal Reserve began decreasing rates rapidly. The Federal Reserve decreased rates 100 basis points in 2007 and 125 basis points in January 2008.
Borrowers unwilling or unable to repay loans could adversely affect Bancorp’s profitability
Credit risk, the possibility that borrowers will be unwilling or unable to repay their obligations when due, could profoundly impact our earnings. We maintain an allowance for loan losses for estimated future loan losses. The level of our allowance for loan losses is based on management’s judgments and various assumptions about the loan portfolio. If our assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses, which could adversely affect our results of operations.
Our allowance for loan losses may not be adequate to cover actual loan losses, which could adversely affect Bancorp’s earnings
Bancorp maintains an allowance for loan losses in an amount that we believe is adequate to provide for losses inherent in the portfolio. While Bancorp strives to carefully monitor credit quality and to identify loans that may become nonperforming or uncollectible, at any time there are loans included in the portfolio that will result in losses, but that have not been identified as nonperforming or potential problem loans. We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on those loans that are identified. As a result, future additions to the allowance may be necessary. Additionally, future additions to the allowance may be required based on changes in the loans comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions, or as a result of incorrect assumptions by management in determining the allowance. Additionally, federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses could have a negative effect on our financial condition and results of operation.
Bancorp’s concentration in real estate loans could adversely affect Bancorp’s earnings in an economic downturn.
Real estate loans comprise the largest category of loans and represent 70.4 percent of total loans. Our real estate portfolio consists of commercial and residential lending. These loans are secured by property such as office buildings, commercial business properties, healthcare buildings, agricultural land, timber land and residential properties. Commercial and commercial real estate loans generally are viewed as having more risk of default than residential real estate loans or certain other types of loans or investments. Typically, these types of loans are larger than residential real estate loans and other loans. Because the loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in; a loss of earnings from these loans; an increase in the provision for loan losses; or an increase in loan charge-offs, which could have an adverse impact on our results of operations and financial condition.
There has been an economic downturn in other parts of the country, particularly in the housing and commercial real estate sectors. The Pacific Northwest economy typically lags the national economy. Accordingly, an economic downturn in the market area we serve may cause us to have lower earnings and could increase our credit risk associated with our loan portfolio. The inability of borrowers to repay loans can erode our earnings. Substantially all of our loans are to businesses and individuals in Skagit, Snohomish or Whatcom Counties and any decline in the economy of this market area could impact us adversely. As a lender, we are exposed to the risk that our customers will be unable to repay their loans in accordance with their terms, and that any collateral securing the payment of their loans may not be sufficient to assure repayment.
Competition in our market area may limit Bancorp’s future success
Commercial banking is a highly competitive business. Bancorp competes with other commercial banks, savings and loan associations, credit unions and finance companies operating in our market area. We are subject to substantial competition for loans and deposits from other financial institutions. Some of our competitors are not subject to the same degree of regulation and restriction as we are. Some of our competitors have greater financial resources than we do. We compete for funds with other financial institutions that, in most cases, are larger and able to provide a greater variety of services than we do and thus may obtain deposits at lower rates of interest. If we are unable to effectively compete in our market area, our business and results of operations could be adversely affected.
We could find it difficult to attract and retain skilled employees
Competition for skilled employees in some areas can be intense and we may not be able to hire or retain the key employees we want or need. As our success, in large part, is due to our ability to attract and retain key employees, the loss of key employees or if we are unable to attract key employees, could adversely affect our business.
Competition may adversely affect our ability to attract and retain customers at current levels
The banking and financial services industry is highly competitive. Competition may limit our ability to attract and retain customers. We face competition from other financial institutions as well as non-bank financial service companies. If we are unable to attract and retain customers, we may be unable to continue loan and deposit growth which could adversely affect our business and results of operations.
There is little trading activity in Bancorp’s stock
There is no active market for our outstanding shares, and it is unlikely that an established market for our shares will develop in the near future. We presently do not intend to seek listing of the shares on any securities exchange, or quotation on the NASDAQ interdealer quotation system. It is not known whether significant trading activity will take place for several years, if at all. Accordingly, our shares should be considered as a long-term investment.
There are restrictions on changes in control of Bancorp that could decrease our shareholders’ chance to realize a premium on their shares.
Provisions in our Articles of Incorporation include a staggered Board of Directors, and non-monetary factor provisions and an affirmative vote of two-thirds of shares (entitled to be counted) to approve an interested shareholder transaction, any or all of which could have the effect of hindering, delaying or preventing a takeover bid. These provisions may inhibit takeover bids and could decrease the chance of shareholders realizing a premium over market price for their shares as a result of the takeover bid.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
Bancorp is headquartered in Burlington, Washington. The building at 301 East Fairhaven Avenue is owned by Bancorp and houses a branch and administrative offices. Bancorp completed construction and occupied the building in 1961. There is also a building at 121 North Spruce Street in Burlington, a building at 323 E. Fairhaven Avenue and at 327 Fairhaven Avenue in Burlington that houses some of the administrative offices. There are twelve branches in addition to the head office.
Bancorp owns the buildings and land occupied by thirteen (13) branches. All offices are functional, properly located and provide adequate working facilities. In addition to the land and buildings owned by Bancorp, it also owns all of its furniture, fixtures and equipment including data processing equipment and much of its software. At December 31, 2007, the net book value of Bancorp’s premises and equipment was $12.1 million.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, Bancorp may be a plaintiff and/or defendant in certain claims and legal actions arising in the ordinary course of commercial banking involving real estate lending transactions and other ordinary routine litigation incidental to the business of Bancorp. Bancorp is not a party to any pending legal proceedings that Bancorp believes would have a material adverse effect on the financial condition of Bancorp.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Bancorp has only one class of stock, which is common stock and at December 31, 2007, there were 721 shareholders of record. Bancorp’s stock is not actively traded or quoted and no broker currently makes a market in the stock. However, sales and transfers of the stock do occur. Skagit State Bank acts as transfer agent for Bancorp stock. To facilitate trading, the Bank maintains a list of persons interested (known to the Bank) in either purchasing or selling Bancorp stock. Purchasers and sellers then negotiate their own transactions with the Bank acting as transfer agent for those transactions.
From time to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will be repurchased and the price that will be paid is the result of many factors including market and economic conditions, the number of shares available, Bancorp’s liquidity and capital needs and regulatory requirements. During 2007, Bancorp repurchased 2,870 shares of stock for $510,000 with a range of prices from $161-$181 per share. There were no shares repurchased during the last quarter of 2007. During 2006, Bancorp repurchased 33,805 shares of stock in private transactions for $5.6 million with a range of prices from $135 to $171 per share.
The stock transfer records maintained by the Bank, as transfer agent, indicate that there have been limited transactions involving Bancorp’s stock. The price information shown in the following table is to the best knowledge of Bancorp’s management based upon information provided informally by the parties to the transactions. No assurance can be given that such prices are representative of the actual market value of the Common Stock.
The following table summarizes information about the Bank’s equity compensation plan as of December 31, 2007.
*Represents unvested restricted shares granted to an executive officer as part of their employment agreement.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information captioned “Selected Financial Data” contained in the 2007 Annual Report to Shareholders (Annual Report), which is required by this item is incorporated by reference to the Section filed as Exhibit 13 to this report.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is incorporated by reference to the section captioned “Management Discussion and Analysis” section in the Annual Report, which is filed as Exhibit 13 to this report.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated by reference to the section “Market Risk” in the “Management Discussion and Analysis” in the Annual Report, which is filed as Exhibit 13 to this report.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by this item are incorporated by reference from the Annual Report, which is filed as Exhibit 13 to this report.
(a)(1) Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flow
Notes to Consolidated Financial Statements
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES AND CORPORATE GOVERNANCE
Evaluation of Disclosure Controls and Procedures
An evaluation was carried out under the supervision and with the participation of Bancorp’s management, including the President/Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures. Based on that evaluation, the President/CEO and CFO have concluded that as of the end of the period covered by this report, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and timely reported as provided in the SEC’s rules and forms.
Changes in Internal Controls
The management of Bancorp has assessed the effectiveness of its internal control over financial reporting at December 31, 2007. To make this assessment, Bancorp used the criteria for effective internal control over financial reporting described in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, Bancorp believes that as of December 31, 2007, the internal control system over financial reporting met those criteria.
This annual report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Additionally, management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permits us to provide only management’s report in this annual report.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE OF THE REGISTRANT
For information concerning directors and certain executive officers of Bancorp and compliance with Section 16 filing requirements, see the sections entitled “Information with Respect to Nominees and Continuing Other Directors” and “Compliance with Section 16(a) Filing Requirements” in Bancorp’s definitive 2008 Annual Meeting Proxy Statement (“Proxy Statement”) that is incorporated herein by reference.
For information regarding our code of ethics applicable to our principal executive officer and our principal financial officer see the section entitled “Corporate Governance - Code of Ethics” in Bancorp’s Proxy Statement which is incorporated herein by reference. Information regarding Bancorp’s audit committee and financial expert appears under the section entitled “Meetings and Committees of the Board of Directors - Certain Committees of the Board” in our Proxy Statement and is incorporated by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
For information concerning executive compensation see the sections entitled “Compensation of Directors” and “Executive Compensation” in Bancorp’s Proxy Statement that is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
For information concerning ownership of certain beneficial owners and management, see the section entitled “Security Ownership of Certain Beneficial Owners and Management” in Bancorp’s Proxy Statement that is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
For information concerning transactions with management and director independence, see the sections entitled “Transactions with Management” and “Corporate Governance - Director Independence” in Bancorp’s Proxy Statement that is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
For information concerning principal accountant fees and services, see the section entitled “Auditors” in Bancorp’s Proxy Statement that is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The index to the consolidated financial statements required by this item are set forth in Item 8 of this report.
(a)(2) Schedules: None
(a)(3) Exhibits:
Exhibit No.
Description
3.1
Amended and Restated Articles of Incorporation (1)
3.2
Bylaws (1)
10.1*
Change of Control Agreement between the Bank and Richard C. Humphrey dated August 15, 2006(1)
10.2*
Change in Control Agreement between the Bank and Carla Tucker dated November 26, 2007
10.3*
2005 Incentive Stock Plan(2)
10.4*
Restricted Stock Agreement(2)
10.5*
Form of Stock Option Agreement(2)
Portions of the 2007 Annual Report
Code of Ethics (3)
Consent of Moss Adams
31.1
Certification of Cheryl R. Bishop, Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Senior Vice President/Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certifications Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Denotes Compensation plan or agreement.
(1)
Incorporated by reference to Exhibits 3.1, 3.2 and 10.1, respectively of Bancorp’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.
(2)
Incorporated by reference to Exhibits 99-1-99.3, respectively, of Bancorp’s Registration Statement on Form S-8: (File No. 333-138665) filed on November 13, 2006.
(3)
Incorporated by reference to Exhibit 14 of Bancorp’s 2006 Annual Report on Form 10-K.
(b)
Exhibits: Exhibits are listed in response to Item 15(a) (3).
(c)
Financial Statement Schedules: None
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this amendment to the registration statement to be signed on its behalf by the undersigned, thereunto duly authorized,
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, on March 27, 2008.
/s/ Cheryl R. Bishop
Chief Executive Officer and Director
Cheryl R. Bishop
(Principal Executive Officer)
/s/ Carla F. Tucker
Senior Vice-President/Chief Financial Officer
Carla F. Tucker
(Chief Accounting Officer)
/s/ Marvin Omdal
Chairman of the Board
Marvin Omdal
/s/ Gerald W. Christensen
Director
Gerald W. Christensen
/s/ Mike Janicki
Director
Mike Janicki
/s/ Richard Nelson
Director
Richard Nelson
/s/ Michael E. Pegram
Director
Michael E. Pegram
/s/ Daniel R. Peth
Director
Daniel R. Peth