UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 or 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the fiscal year ended September 30, 2003
OR
[ ] TRANSITIONAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from to
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Commission File No. 0-25859
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1st STATE BANCORP, INC.
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(Exact Name of Registrant as Specified in Its Charter)
VIRGINIA 56-2130744
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
445 S. MAIN STREET, BURLINGTON, NORTH CAROLINA 27215
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (336) 227-8861
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Securities registered pursuant to Section 12(b) of the Act:
NONE
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $.01 PER SHARE
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(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes No X
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As of December 12, 2003, the aggregate market value of the 1,524,779 shares
of Common Stock of the registrant issued and outstanding held by nonaffiliates
on such date was approximately $45.0 million based on the closing sale price of
$29.50 per share of the registrant's Common Stock as listed on the Nasdaq
National Market on December 12, 2003. For purposes of this calculation, it is
assumed that directors, executive officers and beneficial owners of more than 5%
of the registrant's outstanding voting stock are affiliates.
Number of shares of Common Stock outstanding as of December 12, 2003:
2,971,902
DOCUMENTS INCORPORATED BY REFERENCE
The following lists the documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:
1. Portions of the Annual Report to Stockholders for the fiscal year
ended September 30, 2003. (Parts II and IV)
2. Portions of Proxy Statement for 2004 Annual Meeting of Stockholders.
(Part III)
PART I
ITEM 1. BUSINESS
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GENERAL
1st State Bancorp, Inc. We organized 1st State Bancorp, Inc. (the
"Company") in November 1998 to be the holding company for 1st State Bank,
Burlington, North Carolina (the "Bank"), following the Bank's conversion from
mutual to stock form (the "Stock Conversion"), and then as a bank holding
company of 1st State Bank following its conversion from a North
Carolina-chartered savings bank to a North Carolina commercial bank (the "Bank
Conversion"). 1st State Bancorp acquired all the outstanding stock of 1st State
Bank in connection with the Stock Conversion on April 23, 1999. Prior to that
time, the Company did not own assets or conduct operations. Portions of this
discussion as of dates and for periods prior to April 23, 1999 relate to the
financial condition and results of operations of 1st State Bank. 1st State
Bancorp is primarily engaged in the business of directing, planning and
coordinating the business activities of 1st State Bank. In the future, 1st State
Bancorp may conduct operations or acquire or organize other operating
subsidiaries, including other financial institutions, though we have no current
plans in this regard. Currently, 1st State Bancorp does not maintain offices
separate from those of 1st State Bank nor employ any persons other than its
officers who are not separately compensated for their service.
1st State Bank. Founded in 1914, 1st State Bank is a community and customer
oriented North Carolina-chartered commercial bank headquartered in Burlington,
North Carolina. We have seven full service offices located in north central
North Carolina on the Interstate 85 corridor between the Piedmont Triad and
Research Triangle Park. We conduct most of our business in Alamance County,
North Carolina.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of the interest we
pay on deposits and borrowed funds. We also earn income from miscellaneous fees
related to our loans and deposits, mortgage banking income and commissions from
sales of annuities and mutual funds.
MARKET AREA
We conduct most of our business in Alamance County in north central North
Carolina, located on the Interstate 85 corridor between the Piedmont Triad and
Research Triangle. Historically, the Alamance County economy has been heavily
dependent on the textile industry. During the past 20 years, the economy has
diversified to some extent, with increasing employment in the areas of
insurance, banking, manufacturing and services. Major employers in the area
include LabCorp, Burlington Industries, Alamance - Burlington Schools, Glen
Raven Mills. Great American Knitting, Culp, Elon University and Alamance Health
Services. Nevertheless, the economy in Alamance County continues to be heavily
dependent on the textile industry.
2
LENDING ACTIVITIES
Loan Portfolio Composition. At September 30, 2003, our gross loan portfolio
totaled $234.5 million and represented 64.7% of total assets. The following
table sets forth information relating to the composition of our loan portfolio
by type of loan at the dates indicated. At September 30, 2003, we had no
concentrations of loans exceeding 10% of gross loans other than as disclosed
below. Excluded from this table are mortgage loans held for sale, which are
presented separately on our consolidated balance sheets and in "Selected
Consolidated Financial Information and Other Data" in the Annual Report to
Stockholders for the fiscal year ended September 30, 2003 (the "Annual Report").
At September 30,
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2003 2002 2001 2000 1999
--------------- ---------------- ----------------- ------------------ --------------------
Amount % Amount % Amount % Amount % Amount %
------ ----- ------ ----- ------ ----- ------ ---- ------ ----
(Dollars in thousands)
Real estate loans:
Single-family residential........$ 47,728 20.35% $ 66,708 28.00% $ 86,886 37.33% $ 97,989 41.27% $ 90,883 44.06%
Commercial....................... 35,214 15.01 34,431 14.45 40,957 17.60 46,525 19.59 40,816 19.79
Home equity...................... 29,188 12.45 24,878 10.44 22,167 9.52 21,225 8.94 18,888 9.16
Construction..................... 16,580 7.07 33,080 13.88 19,230 8.26 21,991 9.26 16,496 8.00
-------- ------ --------- ------ --------- ------ -------- ------ --------- ------
Total real estate loans........ 128,710 54.88 159,097 66.77 169,240 72.71 187,730 79.06 167,083 81.01
Commercial......................... 100,149 42.70 72,061 30.24 56,938 24.46 42,949 18.09 32,502 15.76
Consumer........................... 5,684 2.42 7,117 2.99 6,583 2.83 6,782 2.85 6,658 3.23
-------- ------ --------- ------ --------- ------ -------- ------ --------- ------
234,543 100.00% 238,275 100.00% 232,761 100.00% 237,461 100.00% 206,243 100.00%
-------- ====== --------- ====== --------- ====== -------- ====== --------- ======
Less:
Construction loans in process.... (4,870) (14,273) (6,573) (9,972) (7,289)
Deferred fees and discounts...... (92) (223) (291) (358) (208)
Allowance for loan losses........ (3,856) (3,732) (3,612) (3,536) (3,454)
-------- --------- --------- -------- ---------
Total.......................... $225,725 $ 220,047 $ 222,285 $223,595 $ 195,292
======== ========= ========= ======== =========
3
Loan Maturity Schedule. The following table sets forth certain information
at September 30, 2003 regarding the dollar amount of loans maturing in our
portfolio based on their contractual terms to maturity, including scheduled
repayments of principal. Demand loans, loans having no stated schedule of
repayments, such as lines of credit, and overdrafts are reported as due in one
year or less. The table does not include any estimate of prepayments which
significantly shorten the average life of mortgage loans and may cause our
repayment experience to differ from that shown below.
Due After 1
Due During Through Due After
the Year Ending 5 Years After 5 Years After
September 30, 2004 September 30, 2003 September 30, 2003 Total
------------------ ------------------ ------------------ -----
(In thousands)
Real estate loans:
Single-family residential......... $ 2,350 $ 4,796 $ 40,582 $ 47,728
Commercial........................ 6,792 16,057 12,365 35,214
Home equity....................... 719 2,890 25,579 29,188
Construction...................... 7,600 4,078 32 11,710
Commercial.......................... 47,307 32,171 20,671 100,149
Consumer............................ 2,543 3,075 66 5,684
----------- ----------- ----------- ----------
Total........................... $ 67,311 $ 63,067 $ 99,295 $ 229,673
=========== =========== =========== ==========
The following table sets forth at September 30, 2003, the dollar amount of
all loans due one year or more after September 30, 2003 which have predetermined
interest rates and have floating or adjustable interest rates.
Predetermined Floating or
Rate Adjustable Rates Total
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(In thousands)
Real estate loans:
Single-family residential........................ $ 21,720 $ 23,658 $ 45,378
Commercial....................................... 8,705 19,717 28,422
Home equity...................................... 93 28,376 28,469
Construction..................................... 989 3,121 4,110
Commercial......................................... 12,634 40,208 52,842
Consumer .......................................... 2,535 606 3,141
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Total.......................................... $ 46,676 $ 115,686 $ 162,362
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Scheduled contractual principal repayments of loans do not reflect the
actual life of the loans. The average life of loans can be substantially less
than their contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give us the right to declare a loan immediately due
and payable in the event that, among other things, the borrower sells the real
property subject to the mortgage and the loan is not repaid. The average life of
mortgage loans tends to increase when current mortgage loan market rates are
substantially higher than rates on existing mortgage loans and, conversely,
decrease when current mortgage loan market rates are substantially lower than
rates on existing mortgage loans.
Originations, Purchases and Sales of Loans. We generally have authority to
originate and purchase loans secured by real estate located throughout the
United States. Consistent with our emphasis on being a community-oriented
financial institution, we concentrate our lending activities in Alamance County.
4
The following table sets forth certain information with respect to our loan
origination, purchase and sale activity for the periods indicated.
Year Ended September 30,
2003 2002 2001
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(In thousands)
Loans originated:
Real estate loans:
Single-family residential................................. $ 100,076 $ 69,434 $ 54,284
Commercial................................................ 16,505 17,613 4,735
Home equity............................................... 20,469 15,989 11,855
Construction.............................................. 9,808 23,565 13,393
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Total real estate loans................................... 146,858 126,601 84,267
Commercial.................................................. 33,830 26,398 36,147
Consumer.................................................... 5,730 7,310 6,918
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Total loans originated.................................. $ 186,418 $ 160,309 $ 127,332
========== ========= =========
Loans purchased:
Real estate loans........................................... $ 50 $ 100 $ 345
Other loans................................................. -- -- --
---------- --------- ---------
Total loans purchased.................................... $ 50 $ 100 $ 345
========== ========= =========
Proceeds from loans sold (1):................................. $ 103,739 $ 62,712 $ 47,936
========== ========= =========
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(1) All loans sold were whole loans.
We obtain our loan originations from a number of sources, including
referrals from depositors, borrowers and realtors, repeat customers, advertising
and calling officers, as well as walk-in customers. We also advertise in local
media and participate in various community organizations and events. Real estate
loans are originated by our loan officers. All of our loan officers are salaried
and are eligible to receive commissions for loans originated. We accept loan
applications at our offices and do not originate loans on an indirect basis such
as through arrangements with automobile dealers. In all cases, we have final
approval of the application. Historically, we have purchased limited quantities
of loans. During the years ended September 30, 2003, 2002 and 2001, virtually
all loans purchased were small participation interests in multi-family
residential real estate loans to finance low income housing.
In recent years, and particularly during the years ended September 30, 2003
and 2002, we have sold the majority of fixed-rate, single-family mortgage loans
that we originated. During the years ended September 30, 2003, 2002 and 2001, we
sold $103.7 million, $62.7 million and $47.9 million, respectively, of such
loans. Typically, in the current low interest rate environment, we have been
selling fixed-rate, single-family mortgage loans with terms of 15 years or more
except in cases where the interest rate is sufficient to compensate us for the
risk of retaining a long-term, fixed-rate loan in our portfolio. Most loans have
been sold to private purchasers with servicing released. In addition, we sell a
smaller amount of loans in the secondary market to the Federal Home Loan
Mortgage Corporation. We retain servicing on loans sold to the Federal Home Loan
Mortgage Corporation.
Loan Underwriting Policies. We have established written, non-discriminatory
underwriting standards and loan origination procedures. We obtain detailed loan
applications to determine the borrower's ability to repay, and verify the more
significant items on these applications through the use of credit reports,
financial statements and confirmations. Individual officers have been granted
authority by the board of directors to approve mortgage, consumer and commercial
loans up to varying specified dollar amounts, depending upon the type of loan. A
loan committee consisting of our President, Executive Vice President, Chief
Financial Officer, senior credit officer and head of mortgage lending has
authority to approve any loan in an amount exceeding individual lending
authorities where our total loans to that borrower would not exceed $350,000.
Our executive committee, which consists of the Chairman of the Board, the
President, two additional board members that serve on a permanent basis and one
board member selected on a rotating basis that serves for a three-month period,
has authority to approve any loan where our total loans to that borrower would
not exceed $1.0 million. Loans above that amount may not be made unless
5
approved by the full board of directors. These authorities are based on
aggregate borrowings of an individual or entity. On a monthly basis, the
executive committee reviews the actions taken by the loan committee and the full
board of directors reviews the actions taken by the executive committee.
Applications for single-family real estate loans are underwritten and
closed in accordance with the standards of Federal Home Loan Mortgage
Corporation. Generally, upon receipt of a loan application from a prospective
borrower, we order a credit report and verifications to confirm specific
information relating to the loan applicant's employment, income and credit
standing. If a proposed loan is to be secured by a mortgage on real estate, we
usually obtain an appraisal of the real estate from an appraiser approved by us
and licensed by the State of North Carolina. Except when we become aware of a
particular risk of environmental contamination, we generally do not obtain a
formal environmental report on real estate at the time a loan is made.
Our policy is to record a lien on the real estate securing a loan and to
obtain title insurance which insures that the property is free of prior
encumbrances and other possible title defects. Borrowers must also obtain hazard
insurance policies prior to closing and, when the property is in a flood plain
as designated by the Department of Housing and Urban Development, pay flood
insurance policy premiums.
On single-family residential mortgage loans, we make a loan commitment of
between 30 and 60 days for each loan approved. If the borrower desires a longer
commitment, we may extend the commitment for good cause. We guarantee the
interest rate for the commitment period.
We are permitted to lend up to 95% of the lesser of the appraised value or
the purchase price of the real property securing a mortgage loan. However, if
the amount of a residential loan originated or refinanced exceeds 80% of the
appraised value, our policy generally is to obtain private mortgage insurance at
the borrower's expense on that portion of the principal amount of the loan that
exceeds 80% of the appraised value of the property. We will make a single-family
residential mortgage loan with up to a 95% loan-to-value ratio if the required
private mortgage insurance is obtained. We generally limit the loan-to-value
ratio on commercial real estate mortgage loans to 80%, although the
loan-to-value ratio on commercial real estate loans in limited circumstances has
been as high as 90%. We limit the loan-to-value ratio on multi-family
residential real estate loans to 80%.
Under applicable law, with certain limited exceptions, loans and extensions
of credit by a financial institution to a person outstanding at one time and not
fully secured by collateral having a market value at least equal to the amount
of the loan or extension of credit shall not exceed 15% of net worth plus the
general loan loss reserve. Loans and extensions of credit fully secured by
readily marketable collateral may comprise an additional 10% of net worth.
Applicable law additionally authorizes financial institutions to make loans to
one borrower, for any purpose:
o in an amount not to exceed $500,000;
o in an amount not to exceed the lesser of $30,000,000 or 30% of net
worth to develop residential housing, provided (a) the purchase price
of each single-family dwelling in the development does not exceed
$500,000 and (b) the aggregate amount of loans made under this
authority does not exceed 150% of net worth; or
o loans to finance the sale of real property in satisfaction of debts
previously contracted in good faith, not to exceed 50% of net worth.
Under these limits, our loans to one borrower were limited to $8.6 million
at September 30, 2003. At that date, we had no lending relationships in excess
of the loans-to-one-borrower limit. At September 30, 2003, our ten largest
lending relationships ranged in size from $3.3 million to $7.0 million.
Single-Family Residential Real Estate Lending. We historically have been
and continue to be an originator of single-family, residential real estate loans
in our market area. At September 30, 2003, single-family, residential mortgage
loans, excluding home equity loans, totaled $47.7 million, or 20.3% of our gross
loan portfolio.
6
We originate fixed-rate mortgage loans at competitive interest rates. At
September 30, 2003, $21.9 million, or 9.3%, of our gross loan portfolio was
comprised of fixed-rate, single-family mortgage loans. Generally, in the current
interest rate environment, we have been retaining fixed-rate mortgages with
maturities of ten years or less while fixed-rate loans with longer maturities
may be retained in the portfolio or sold in the secondary market.
We also offer adjustable-rate residential mortgage loans. The
adjustable-rate loans we currently offer have interest rates which adjust every
one, three or five years from the closing date of the loan or on an annual basis
commencing after an initial fixed-rate period of three or five years in
accordance with a designated index, plus a stipulated margin. The primary index
we utilize is the weekly average yield on the one year U.S. Treasury securities
adjusted to a constant comparable maturity equal to the loan adjustment period,
as made available by the Federal Reserve Board (the "Treasury Rate"). The
maximum adjustment on the bulk of our loans is 2% per adjustment period with a
maximum aggregate adjustment of 6% over the life of the loan. We offer
adjustable-rate mortgage loans that provide for initial rates of interest
slightly below the rates that would prevail when the index used for repricing is
applied, i.e., "teaser" rates. All of our adjustable-rate loans require that any
payment adjustment resulting from a change in the interest rate of an
adjustable-rate loan be sufficient to result in full amortization of the loan by
the end of the loan term and, thus, do not permit any of the increased payment
to be added to the principal amount of the loan, or so-called negative
amortization. At September 30, 2003, $25.8 million, or 54.1%, of our
single-family residential mortgage loans were adjustable-rate loans.
The retention of adjustable-rate loans in our portfolio helps reduce our
exposure to increases or decreases in prevailing market interest rates. However,
there are unquantifiable credit risks resulting from potential increases in
costs to borrowers in the event of upward repricing of adjustable-rate loans. It
is possible that during periods of rising interest rates, the risk of default on
adjustable-rate loans may increase due to increases in interest costs to
borrowers. Further, although adjustable-rate loans allow us to increase the
sensitivity of our interest-earning assets to changes in interest rates, the
extent of this interest sensitivity is limited by the initial fixed-rate period
before the first adjustment and the lifetime interest rate adjustment
limitations. Accordingly, yields on our adjustable-rate loans may not fully
adjust to compensate for increases in our cost of funds.
Commercial Real Estate Lending. Our commercial real estate loan portfolio
includes loans secured by small office buildings, commercial and industrial
buildings and small apartment buildings. These loans generally range in size
from $100,000 to $4.2 million. At September 30, 2003, our commercial real estate
loans totaled $35.2 million, which amounted to 15.0%, of our gross loan
portfolio. We originate commercial real estate loans for terms of up to 15 years
and with interest rates that adjust daily based on the prime rate plus a
negotiated margin typically up to 1% or that carry predetermined rates fixed for
one, three or five years.
Commercial real estate lending entails significant additional risks as
compared with single-family residential property lending. Commercial real estate
loans typically involve larger loan balances to single borrowers or groups of
related borrowers. The payment experience on such loans typically is dependent
on the successful operation of the real estate project, retail establishment,
apartment building or business. These risks can be significantly affected by
supply and demand conditions in the market for office, retail and residential
space, and, as such, may be subject to a greater extent to adverse conditions in
the economy generally. To minimize these risks, we generally originate loans
secured by collateral located in our market area or to borrowers with which we
have prior experience or who are otherwise known to us. It has been our policy
to obtain annual financial statements of the business of the borrower or the
project for which commercial real estate loans are made. In addition, in the
case of commercial mortgage loans made to a partnership or a corporation, we
seek, whenever possible, to obtain personal guarantees and annual financial
statements of the principals of the partnership or corporation.
Home Equity Loans. At September 30, 2003, we had approximately $29.2
million in home equity line of credit loans, representing approximately 12.5% of
our gross loan portfolio. Our home equity lines of credit generally have
adjustable interest rates tied to our prime interest rate plus a margin. Home
equity lines of credit must be repaid in 15 years or less and require monthly
interest payments. Home equity lines of credit generally are secured by
subordinate liens against residential real property. We require that fire and
extended coverage casualty insurance and, if appropriate, flood insurance, be
maintained in an amount at least sufficient to cover the loan. Home equity loans
generally are limited so that the amount of such loans, along with any senior
indebtedness, does not exceed 90% of the value of the real estate security.
7
Construction Lending. We offer residential and commercial construction
loans, with a significant portion of such loans originated to date being for the
construction of owner-occupied, single-family dwellings in our market area.
Residential construction loans are offered primarily to individuals building
their primary or secondary residence, as well as to selected local developers to
build single-family dwellings. In addition, on occasion, we make acquisition and
development loans to local developers to acquire and develop land for sale to
builders who will construct single-family residences. At September 30, 2003,
$16.6 million, or 7.1%, of our gross loan portfolio consisted of construction
loans.
Generally, we originate loans to owner/occupants for the construction of
owner-occupied, single-family residential properties in connection with the
permanent loan on the property, and these loans have a construction term of six
to 12 months. Interest rates on residential construction loans made to the
owner/occupant have interest rates during the construction period equal to the
prime rate. Upon completion of construction, the loan is converted into a
one-year adjustable-rate loan, and the owner may lock in a fixed-rate loan at
any time during the one-year period, or for a fee the borrower may lock in a
market rate fixed rate loan upon completion of the house.
We make construction loans to builders on either a pre-sold or speculative
basis. However, we limit the number of outstanding loans on unsold homes under
construction to individual builders, with the amount dependent on the financial
strength of the builder, the present exposure of the builder, the location of
the property and prior sales of homes in the development. At September 30, 2003,
speculative construction loans amounted to $7.2 million or 3.1% of our gross
loan portfolio. At September 30, 2003, the largest exposure to one borrower for
speculative construction was $2.5 million. Interest rates on residential
construction loans to builders are typically set at our prime rate plus a margin
typically up to 1% and adjust with changes in the prime rate, and are made for
terms of up to 24 months.
Interest rates on commercial construction loans are based on the prime rate
plus a negotiated margin typically up to 1%, and adjust with changes in our
prime rate, and are made for terms of up to 24 months, with construction terms
generally not exceeding 12 months.
We make acquisition and development loans at a rate that adjusts daily,
based on our prime rate plus a negotiated margin, for terms of up to three
years. Interest only is paid during the term of the loan, and the principal
balance of the loan is paid down as developed lots are sold to builders. At
September 30, 2003, $6.1 million of our gross loan portfolio consisted of
acquisition and development loans. We had eight such loans. All acquisition and
development loans were performing in accordance with their terms at such date.
Prior to making a commitment to fund a construction loan, we require an
appraisal of the property by appraisers approved by our board of directors. We
also review and inspect each project at the commencement of construction and
periodically during the term of the construction loan. We may charge a
construction fee and/or an inspection fee on construction loans. Advances are
made on a percentage of completion basis.
We consider construction financing generally to involve a higher degree of
risk of loss than long-term financing on improved, occupied real estate. Risk of
loss on a construction loan is dependent largely upon the accuracy of the
initial estimate of the property's value at completion of construction or
development and the estimated cost, including interest, of construction. During
the construction phase, a number of factors could result in delays and cost
overruns. If the estimate of construction costs proves to be inaccurate and the
borrower is unable to meet our requirements of putting up additional funds to
cover extra costs or change orders, then we will demand that the loan be paid
off and, if necessary, institute foreclosure proceedings or refinance the loan.
If the estimate of value proves to be inaccurate, the collateral may not have
sufficient value to assure full repayment. We have sought to minimize this risk
by limiting construction lending to borrowers based in Alamance County who
satisfy all credit requirements and whose loans satisfy all other underwriting
standards which would apply to our permanent mortgage loan financing for the
subject property. On loans to builders, we work only with selected builders with
whom we have experience and carefully monitor the creditworthiness of the
builders.
Commercial Lending. We originate commercial loans to small and medium-sized
businesses in our market area. Our commercial borrowers are generally small
businesses engaged in manufacturing, distribution or retailing, or professionals
in healthcare, accounting and law. Commercial loans generally are made to
finance the purchase of inventory, new or used equipment or commercial vehicles
and for short-term working capital. Such loans generally
8
are secured by equipment and inventory, and, if possible, cross-collateralized
by a real estate mortgage, although commercial loans are sometimes granted on an
unsecured basis. Commercial loans generally are made for terms of five years or
less, depending on the purpose of the loan and the collateral, with loans to
finance operating expenses made for one year or less, with interest rates that
adjust at least annually at a rate equal to the prime rate plus a margin
typically up to 2%. Generally, we make commercial loans in amounts ranging
between $50,000 and $1.0 million. At September 30, 2003, commercial loans
totaled $100.1 million, or 42.7%, of our gross loan portfolio.
We underwrite commercial loans on the basis of the borrower's cash flow and
ability to service the debt from earnings rather than on the basis of underlying
collateral value, and we seek to structure such loans to have more than one
source of repayment. The borrower is required to provide us with sufficient
information to allow us to make our lending determination. In most instances,
this information consists of at least two years of financial statements, a
statement of projected cash flows, current financial information on any
guarantor and any additional information on the collateral. For loans with
maturities exceeding one year, we require that borrowers and guarantors provide
updated financial information at least annually throughout the term of the loan.
Our commercial loans may be structured as term loans or as lines of credit.
Commercial term loans are generally made to finance the purchase of assets and
have maturities of five years or less. Commercial lines of credit are typically
made for the purpose of providing working capital and are usually reviewed on an
annual basis but may be called on demand. We also offer standby letters of
credit for commercial borrowers. Standby letters of credit are written for a
maximum term of one year.
Commercial loans are often larger and may involve greater risk than other
types of lending. Because payments on commercial loans are often dependent on
successful operation of the business involved, repayment of such loans may be
subject to a greater extent to adverse conditions in the economy. We seek to
minimize these risks through our underwriting guidelines, which require that the
loan be supported by adequate cash flow of the borrower, profitability of the
business, collateral and personal guarantees of the individuals in the business.
In addition, we limit this type of lending to our market area and to borrowers
with which we have prior experience or who are otherwise well known to us.
Consumer Lending. Our consumer loans include automobile loans, savings
account loans, unsecured lines of credit and miscellaneous other consumer loans,
including unsecured loans. At September 30, 2003, our consumer loans totaled
$5.7 million, or 2.4%, of our gross loan portfolio.
We generally underwrite automobile loans in amounts up to 80% of the lesser
of the purchase price of the automobile or, with respect to used automobiles,
the loan value as published by the National Automobile Dealers Association. The
terms of most such loans do not exceed 60 months. We require that the vehicles
be insured and that we be listed as loss payee on the insurance policy.
We make savings account loans for up to 90% of the depositor's savings
account balance. The interest rate is normally 2.5% above the annual percentage
yield paid on the savings account. The account must be pledged as collateral to
secure the loan. Interest generally is paid on a monthly basis.
Consumer lending affords us the opportunity to earn yields higher than
those obtainable on single-family residential lending. However, consumer loans
entail greater risk than do residential mortgage loans, particularly in the case
of loans which are unsecured, as is the case with lines of credit, or secured by
rapidly depreciable assets such as automobiles. Repossessed collateral for a
defaulted consumer loan may not provide an adequate source of repayment of the
outstanding loan balance as a result of the greater likelihood of damage, loss
or depreciation. The remaining deficiency often does not warrant further
substantial collection efforts against the borrower. In addition, consumer loan
collections are dependent on the borrower's continuing financial stability, and
thus are more likely to be adversely affected by events such as job loss,
divorce, illness or personal bankruptcy. Further, the application of various
state and federal laws, including federal and state bankruptcy and insolvency
law, may limit the amount which may be recovered. In underwriting consumer
loans, we consider the borrower's credit history, an analysis of the borrower's
income and ability to repay the loan, and the value of the collateral.
Loan Fees and Servicing. We receive fees in connection with late payments
and for miscellaneous services related to our loans and deposits. We also charge
fees in connection with loan originations. These fees can consist
9
of origination, discount, application, construction and/or commitment fees,
depending on the type of loan. We generally do not service loans for others
except for mortgage loans we originate and sell with servicing retained.
Mortgage servicing rights were $547,000 and $370,000 at September 30, 2003 and
2002, respectively. See Note 1 of Notes to Consolidated Financial Statements.
Nonperforming Loans and Other Problem Assets. We continually monitor our
loan portfolio to anticipate and address potential and actual delinquencies.
When a borrower fails to make a payment on a loan, we take immediate steps to
have the delinquency cured and the loan restored to current status. Loans which
are delinquent more than 15 days incur a late fee of 4% of the monthly payment
of principal and interest due. As a matter of policy, we will contact the
borrower after the loan has been delinquent 15 days. If payment is not promptly
received, we contact the borrower again, and we try to formulate an affirmative
plan to cure the delinquency. Generally, after any loan is delinquent 45 days or
more, we send a default letter to the borrower. If the default is not cured
after 30 days, we commence formal legal proceedings to collect amounts owed.
Generally we charge off, or reserve through an allowance for uncollected
interest account, interest on loans, including impaired loans, that are
contractually 90 days or more past due. The allowance for uncollected interest
is established by a charge to interest income equal to all interest previously
accrued. In certain circumstances, interest on loans that are contractually 90
days or more past due is not charged off or reserved through an allowance for
uncollected interest account when we believe that the loan is both well secured
and in the process of collection. If amounts are received on loans for which the
accrual of interest has been discontinued, we decide whether payments received
should be recorded as a reduction of the principal balance or as interest income
depending on our analysis of the collectibility of principal. The loan is
returned to accrual status when we believe the borrower has demonstrated the
ability to make periodic interest and principal payments on a timely basis.
We classify real estate acquired as a result of foreclosure as real estate
acquired in settlement of loans until such time as it is sold and is recorded at
the lower of the estimated fair value of the underlying real estate, less costs
to sell the property, or the carrying amount of the loan. Subsequent costs
directly related to development and improvement of property are capitalized,
whereas costs related to holding the property are expensed. We charge any
required write-down of the loan to its fair value less estimated selling costs
upon foreclosure against the allowance for loan losses. See Note 1 of Notes to
Consolidated Financial Statements.
The following table sets forth information with respect to our
nonperforming assets at the dates indicated. At the dates shown, we had no
restructured loans within the meaning of Statement of Financial Accounting
Standards No. 114, as amended.
At September 30,
-----------------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
(Dollars in thousands)
Loans accounted for on a nonaccrual basis (1) $ 4,153 $ 4,204 $ 878 $ 2,893 $ 366
======== ======== ======== ======== ========
Accruing loans which are contractually past due
90 days or more ........................... $ -- $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
Total nonperforming loans................ $ 4,153 $ 4,204 $ 878 $ 2,893 $ 366
======== ======== ======== ======== ========
Total loans.................................. $229,581 $ 223,779 $ 225,897 $227,131 $ 198,746
======== ========= ========= ======== =========
Percentage of total loans.................... 1.81% 1.88% 0.39% 1.27% 0.18%
======== ========= ========= ======== =========
Other nonperforming assets (2)............... $ 95 $ 183 $ 1,981 $ -- $ --
======== ========= ========= ======== =========
Loans modified in troubled debt restructuring $ -- $ -- $ -- $ -- $ --
======== ========= ========= ======== =========
- --------------
(1) Payments received on a nonaccrual loan are either applied to the
outstanding principal balance or recorded as interest income, depending on
management's assessment of the collectibility of the loan.
(2) Other nonperforming assets consist of property acquired through foreclosure
or repossession.
During the year ended September 30, 2003, gross interest income of $281,000
would have been recorded on loans accounted for on a nonaccrual basis if the
loans had been current throughout the year. Interest on such loans included in
income during the year ended September 30, 2003 amounted to $244,000.
10
At September 30, 2003 there were no loans which are not currently
classified as nonaccrual, 90 days past due or restructured, but where known
information about possible credit problems of borrowers causes management to
have serious concerns as to the ability of the borrowers to comply with present
loan repayment terms and may result in disclosure as nonaccrual, 90 days past
due or restructured. See "-- Classified Assets" for information regarding
classified assets.
At September 30, 2003, we had $4.2 million of nonaccrual loans, which
consisted of two one-to-four family mortgage loans, two home equity loans,
twelve commercial and commercial real estate loans and two consumer loans. At
September 30, 2003, real estate owned totaled $95,000. Real estate owned
consists of one duplex in Burlington, North Carolina and one residential lot in
Graham, North Carolina. The Bank is actively marketing both properties.
At September 30, 2003, we had impaired loans with three unrelated borrowers
of $3.8 million of which all were on nonaccrual status. The related allowance
for loan losses on these loans was $210,000. The average carrying value of
impaired loans was $3.7 million for the year ended September 30, 2003. These
loans are primarily secured by business assets and real estate properties in
Alamance County.
Classified Assets. Regulations require that we classify our assets on a
regular basis. In addition, in connection with examinations of insured
institutions, examiners have authority to identify problem assets and if
appropriate, classify them in their reports of examination. There are three
regulatory classifications for problem assets: "substandard," "doubtful" and
"loss." Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
existing facts, conditions and values, questionable, and there is a high
possibility of loss. An asset classified as loss is considered uncollectible and
of such little value that continuance as an asset of the institution is not
warranted. Assets classified as substandard or doubtful require a financial
institution to establish general allowances for loan losses. If an asset or
portion thereof is classified as loss, a financial institution must either
establish a specific allowance for loan losses in the amount of the portion of
the asset classified loss, or charge off such amount. 1st State Bank regularly
reviews its assets to determine whether any assets require classification or
re-classification. At September 30, 2003, we had $4.9 million in classified
assets, consisting of $4.8 million in substandard loans and $95,000 in other
real estate owned.
In addition to regulatory classifications, we also classify as special
mention and watch assets that are currently performing in accordance with their
contractual terms but may be classified or become nonperforming assets in the
future. At September 30, 2003, we have identified approximately $953,000 in
assets classified as special mention and $35.6 million as watch. Included in the
total of watch list assets are five loans with an aggregate outstanding balance
of $4.5 million at September 30, 2003 to a company affiliated with one of our
directors. In addition, the director has the ability to borrow an additional
$172,000 from us under a line of credit. All the loans are secured by a first
lien on all assets, including accounts receivable, inventory, equipment,
furniture and real property occupied by the borrower. In addition, the director
and his spouse have personally guaranteed repayment of the loans. At September
30, 2003, such loans were current with respect to their payment terms and,
except for the waiver of certain debt covenants by the Bank, were performing in
accordance with the related loan agreements. Based on an analysis of the
borrower's current financial statements received in December 2003, management
has concerns that the borrower may have difficulty in complying with the present
loan repayment terms on an ongoing basis. Accordingly, this loan may become an
impaired loan in future periods. Management will continue to closely monitor the
performance of these loans in future periods.
Allowance for Loan Losses. We maintain the allowance for loan losses at a
level we believe to be adequate to absorb probable losses in the portfolio. Our
determination of the adequacy of the allowance is based on an evaluation of the
portfolio, past loss experience, current economic conditions, volume, growth and
composition of the portfolio, and other relevant factors. The allowance is
increased by provisions for loan losses which are charged against income.
Although we believe we use the best information available to make
determinations with respect to the allowance for loan losses and believe such
allowances are adequate, future adjustments may be necessary if economic
conditions differ substantially from the economic conditions in the assumptions
used in making the initial
determinations. We anticipate that our allowance for loan losses will increase
in the future through provisions as we implement the board of directors'
strategy of continuing existing lines of business while gradually increasing our
credit risk profile by expanding commercial and consumer lending, which loans
generally entail greater risks than single-family residential mortgage loans.
We charge provisions for loan losses to earnings to maintain the total
allowance for loan losses at a level we consider adequate to provide for
probable loan losses, based on prior loss experience, volume and type of lending
we conduct, industry standards and past due loans in our loan portfolio. Our
policies require the review of assets on a regular basis, and we assign risk
grades to loans based on the relative risk of the credit, considering such
factors as repayment experience, value of collateral, guarantors, etc. We
believe we use the best information available to make a determination with
respect to the allowance for loan losses, recognizing that future adjustments
may be necessary depending upon a change in economic conditions. The provision
for loan losses was $240,000, charge-offs were $117,000 and recoveries were
$1,000 for the year ended September 30, 2003 compared with a provision of
$240,000, charge-offs of $121,000 and recoveries were $1,000 for the year ended
September 30, 2002.
The allowance for loan losses was $3.9 million at September 30, 2003 and
$3.7 million at September 30, 2002, which we think is adequate to absorb
probable losses in the loan portfolio. As a result of our continued shift toward
higher risk commercial, consumer and home equity loans as well as the continued
recession in the local and regional economy, the ratio of the allowance for loan
losses to total loans, net of loans in process and deferred loan fees was 1.68%
at September 30, 2003 compared to 1.67% at September 30, 2002. While management
uses the best information available to make evaluations, future adjustments to
the allowance may be necessary based on changes in economic and other
conditions. Additionally, various regulatory agencies, as an integral part of
their examination process, periodically review the Company's allowance for loan
losses. Such agencies may require the recognition of adjustments to the
allowance for loan losses based on their judgments of information available to
them at the time of their examinations.
Banking regulatory agencies, including the FDIC, have adopted a policy
statement regarding maintenance of an adequate allowance for loan and lease
losses and an effective loan review system. This policy includes an arithmetic
formula for checking the reasonableness of an institution's allowance for loan
loss estimate compared to the average loss experience of the industry as a
whole. Examiners will generally review an institution's allowance for loan
losses and compare it against the sum of:
o 50% of the portfolio that is classified doubtful;
o 15% of the portfolio that is classified as substandard; and
o for the portions of the portfolio that have not been classified,
including those loans designated as special mention, estimated credit
losses over the upcoming 12 months given the facts and circumstances
as of the evaluation date.
This amount is considered neither a "floor" nor a "safe harbor" of the level of
allowance for loan losses an institution should maintain, but examiners will
view a shortfall relative to the amount as an indication that they should review
management's policy on allocating these allowances to determine whether it is
reasonable based on all relevant factors.
We have our own allowance for loan loss model which is similar to the FDIC
model, but uses different factors and assumptions to arrive at an estimate of
the allowance for loan losses under accounting principles generally accepted in
the United States of America. Our model indicated that the allowance for loan
losses was adequate at September 30, 2003.
12
The following table sets forth an analysis of our allowance for loan losses
for the periods indicated.
Year Ended September 30,
-------------------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
(Dollars in thousands)
Balance at beginning of period............... $ 3,732 $ 3,612 $ 3,536 $ 3,454 $ 3,228
---------- --------- --------- --------- ----------
Loans charged off:
Commercial real estate.................... -- -- 125 -- --
1-4 family residential.................... -- 85 19 159 --
Commercial................................ 96 -- -- -- --
Consumer.................................. 21 36 24 5 23
---------- --------- --------- --------- ----------
Total.................................. 117 121 168 164 23
Recoveries................................... 1 1 4 6 4
---------- --------- --------- --------- ----------
Net loans charged off........................ 116 120 164 158 19
---------- --------- --------- --------- ----------
Provision for loan losses.................... 240 240 240 240 245
---------- --------- --------- --------- ----------
Balance at end of period..................... $ 3,856 $ 3,732 $ 3,612 $ 3,536 $ 3,454
========== ========= ========= ========= ==========
Average loans outstanding.................... $ 227,951 $ 219,071 $ 229,058 $ 219,381 $ 198,603
========== ========= ========= ========= ==========
Ratio of net loans charged off to average
loans outstanding during the period........ 0.0509% 0.0548% 0.0716% 0.0720% 0.0096%
========== ========= ========= ========= ==========
13
The following table allocates the allowance for loan losses by loan
category at the dates indicated. The allocation of the allowance to each
category is not necessarily indicative of future losses and does not restrict
the use of the allowance to absorb losses in any category.
At September 30,
2003 2002 2001 2000 1999
------------------ ------------------- ------------------ ------------------ ------------------
Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in
Category to Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
Real estate mortgage:
Single-family residential....$ 222 20.35% $ 240 28.00% $ 253 37.33% $ 320 41.27% $ 559 44.06%
Commercial................... 1,084 15.01 1,054 14.45 932 17.60 1,084 19.59 934 19.79
Home equity.................. 182 12.45 128 10.44 131 9.52 179 8.94 244 9.16
Construction................. 240 7.07 348 13.88 231 8.26 213 9.26 275 8.00
Commercial..................... 1,987 42.70 1,838 30.24 1,970 24.46 1,616 18.09 1,273 15.76
Consumer....................... 141 2.42 124 2.99 95 2.83 124 2.85 169 3.23
------- ------ ------ ------ ------- ------ ------ ------ ------- -----
Total allowance for
loan losses...............$ 3,856 100.00% $3,732 100.00% $ 3,612 100.00% $3,536 100.00% $ 3,454 100.00%
======= ====== ====== ====== ======= ====== ====== ====== ======= ======
14
INVESTMENT ACTIVITIES
General. Interest income from investment securities generally provides our
second largest source of income after interest on loans. Our board of directors
has authorized investment in U.S. Government and agency securities, state
government obligations, municipal securities, obligations of the FHLB,
mortgage-backed securities issued by Federal National Mortgage Association, the
Government National Mortgage Association and Federal Home Loan Mortgage
Corporation. Our objective is to use these investments to reduce interest rate
risk, enhance yields on assets and provide liquidity. At September 30, 2003, the
amortized cost of our investment securities portfolio amounted to $112.4
million, which included $109.4 million of U.S. Government and agency securities,
$3.0 million of North Carolina municipal bonds, and $10,000 of collateralized
mortgage obligations ("CMOs"). At that date, we had an unrealized loss of
$768,000, net of deferred taxes, with respect to our investment securities
classified as available for sale.
The board of directors has established an investment policy that sets forth
investment and aggregate investment limitations and credit quality parameters of
each class of investment security. Securities transactions are subject to the
oversight of our Executive Committee. The President has authority to make
specific investment decisions within the parameters determined by the board of
directors.
We had securities with an aggregate cost of $93.0 million and an
approximate fair value of $91.7 million at September 30, 2003 classified as
available for sale. The impact on our financial statements was an after-tax
decrease in stockholders' equity of approximately $768,000 as of September 30,
2003. The net unrealized losses at September 30, 2003 in our portfolio of
investment securities were due to increases in interest rates and a steepening
of the yield curve after we bought the securities. Upon acquisition, we classify
securities as to our intent. Securities designated as "held to maturity" are
those assets which we have the ability and intent to hold to maturity. The held
to maturity investment portfolio is not used for speculative purposes and is
carried at amortized cost. Securities designated as "available for sale" are
those assets which we may not hold to maturity and thus are carried at fair
value with unrealized gains or losses, net of tax effect, recognized in
stockholders' equity.
At September 30, 2003, we had $93.0 million of U.S. Government and agency
securities classified as available for sale, which carry unrealized after-tax
losses of $768,000, and $19.5 million of investment securities classified as
held to maturity. We attempt to maintain a high degree of liquidity in our
investment securities portfolio by choosing those securities that are readily
marketable. As of September 30, 2003, the estimated weighted average life of our
U.S. Government and agency securities classified as available for sale was
approximately six years, and the average yield on our portfolio of U.S.
Government and agency securities classified as available for sale was 4.21%. In
addition, at September 30, 2003, we had $1.7 million of FHLB of Atlanta stock.
See Notes 1 and 3 of the Notes to Consolidated Financial Statements for a
description of our accounting policies.
The following table sets forth the carrying value of our investment
securities portfolio at the dates indicated.
At September 30,
---------------------------------------------
2003 2002 2001
----- ------ -------
(In thousands)
Securities available for sale:
U.S. government and agency securities...................... $ 91,709 $ 78,572 $ 54,632
Federal Home Loan Mortgage Corporation..................... -- -- 227
Government National Mortgage Association................... -- -- 668
--------- ---------- ---------
Total................................................... $ 91,709 $ 78,572 $ 55,527
========= ========== =========
Securities held to maturity:
U.S. government and agency securities...................... $ 16,408 $ 8,430 $ 10,986
Municipal bonds............................................ 3,044 2,670 1,164
CMOs....................................................... 10 14 19
--------- ---------- ---------
Total................................................... $ 19,462 $ 11,114 $ 12,169
========= ========== =========
15
The following table sets forth the scheduled maturities, carrying values,
amortized cost and average yields for our investment securities at September 30,
2003.
One Year or One to Five Five to Ten More than Total Investment
Less Years Years Ten Years Portfolio
-------------- --------------- --------------- ------------- -----------------------
Carrying Average Carrying Average Carrying Average Carrying Average Carrying Market Average
Value Yield Value Yield Value Yield Value Yield Value Value Yield
-------- ------- -------- ------- --------- ------- -------- ------- -------- ------ -------
(Dollars in thousands)
Securities available for sale:
U.S. government and agency
securities.................. $ -- --% $17,133 3.79% $71,595 4.24% $2,981 5.89% $91,709 $91,709 4.21%
======= ======= ======= ====== ======= =======
Securities held to maturity:
U.S. government and agency
securities.................. 2,422 5.68 2,992 4.38 5,994 5.34 5,000 5.81 16,408 16,216 5.36
CMOs........................... -- -- -- -- -- -- 10 1.92 10 10 1.92
Municipal bonds................ -- -- 1,010 3.79 1,681 3.98 353 4.60 3,044 3,171 3.99
------- ---- ------- ---- ------- ---- ------ ---- ------- ------- ----
Total..................... $ 2,422 5.68% $ 4,002 4.23% $ 7,675 5.04% $5,363 5.72% $19,462 $19,397 5.14%
======= ==== ======= ==== ======= ==== ====== ==== ======= ======= ====
16
DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS
General. Deposits are our primary source of funds for lending, investment
activities and general operational purposes. In addition to deposits, we derive
funds from loan principal and interest repayments, maturities of investment
securities and interest payments thereon. Although loan repayments are a
relatively stable source of funds, deposit inflows and outflows are
significantly influenced by general interest rates and money market conditions.
Borrowings may be used on a short-term basis to compensate for reductions in the
availability of funds, or on a longer term basis for general operational
purposes. We have access to FHLB of Atlanta advances as a source of borrowings.
Deposits. We attract deposits principally from within Alamance County by
offering a variety of deposit instruments, including checking accounts, money
market accounts, passbook and statement savings accounts, Individual Retirement
Accounts, and certificates of deposit which range in maturity from seven days to
five years. Deposit terms vary according to the minimum balance required, the
length of time the funds must remain on deposit and the interest rate.
Maturities, terms, service fees and withdrawal penalties for our deposit
accounts are established by us on a periodic basis. We review our deposit
pricing on a weekly basis. In determining the characteristics of our deposit
accounts, we consider the rates offered by competing institutions, lending and
liquidity requirements, growth goals and applicable regulations. We believe we
price our deposits comparably to rates offered by our competitors. We do not
accept brokered deposits.
We compete for deposits with other institutions in our market area by
offering competitively priced deposit instruments that are tailored to the needs
of our customers. Additionally, we seek to meet customers' needs by providing
convenient customer service to the community, efficient staff and convenient
hours of service. Substantially all of our depositors are North Carolina
residents. To provide additional convenience, we participate in the STAR and
CIRRUS Automatic Teller Machine networks at locations throughout the world,
through which customers can gain access to their accounts at any time. To better
serve our customers, we have installed automatic teller machines at all seven
office locations.
17
Our deposits at September 30, 2003 consisted of the various types of
programs described below.
Weighted
Average
Interest Minimum Minimum Balance (in Percentage of
Rate Term Category Amount Thousands) Total Deposits
- -------- ------- -------- -------- ----------- --------------
--% None Noninterest bearing accounts $ 100 $ 13,579 5.17%
0.22 None Checking accounts 300 35,468 13.50
0.60 None Passbook and statement savings accounts 100 30,534 11.62
0.67 None Money market accounts 1,000 18,496 7.04
Certificates of Deposit
-----------------------
0.90 3 months Fixed-term, fixed-rate 500 3,153 1.20
1.25 6 months Fixed-term, fixed-rate 500 6,536 2.49
1.25 7 months (1) Fixed-term, fixed-rate 5,000 54,933 20.90
1.54 9 months Fixed-term, fixed-rate 500 527 0.20
1.37 10 months Fixed-term, fixed-rate 5,000 1,333 0.51
1.48 12 months Fixed-term, fixed-rate 500 20,731 7.89
2.01 15 months Fixed-term, fixed-rate 5,000 9,569 3.64
1.00 18 months Floating rate individual retirement
account 50 746 0.28
2.43 18 months Fixed-term, fixed-rate 500 1,672 0.64
1.68 20 months Fixed-term, fixed-rate 500 29 0.01
3.59 21 months Fixed-term, fixed-rate 10,000 12,603 4.80
2.42 24 months Fixed-term, fixed-rate 500 4,830 1.84
2.69 30 months Fixed-term, fixed-rate 500 3,581 1.36
3.21 36 months Fixed-term, fixed-rate 500 6,058 2.31
4.84 48 months Fixed-term, fixed-rate 500 3,298 1.26
4.57 60 months Fixed-term, fixed-rate 500 17,785 6.77
1.23 7 to 365 days Fixed-term, fixed-rate 100,000 17,251 6.57%
---------- --------
$ 262,712 100.00%
========== ========
- ---------------------
(1) These certificates of deposit do not carry a penalty for early withdrawal.
As a result, we believe that should interest rates increase materially
after September 30, 2003, borrowers may withdraw funds invested in these
certificates prior to maturity, causing our cost of funds to increase.
18
The following table sets forth the distribution of our deposit accounts at
the dates indicated and the change in dollar amount of deposits in the various
types of accounts we offer between the dates indicated.
Balance Balance at Balance at
September 30, % of Increase September 30, % of Increase September 30, % of
2003 Deposit (Decrease) 2002 Deposits (Decrease) 2001 Deposits
------------- ------- ---------- ------------- -------- ---------- ------------- --------
(Dollars in thousands)
Noninterest bearing accounts........$ 13,579 5.2% $ 52 $ 13,527 5.2% $ 2,542 $ 10,985 4.42%
Interest bearing checking accounts.. 35,468 13.5 3,036 32,432 12.4 2,486 29,946 12.06
Money market accounts .............. 18,496 7.0 (2,864) 21,360 8.2 (271) 21,631 8.71
Passbook and statement savings
accounts........................... 30,534 11.6 1,306 29,228 11.2 3,108 26,120 10.52
Certificates of deposit............. 164,635 62.7 515 164,120 63.0 4,432 159,688 64.29
--------- ------ ---------- ---------- ----- ---------- ---------- ------
$ 262,712 100.0% $ 2,045 $ 260,667 100.0% $ 12,297 $ 248,370 100.00%
========== ====== ========== ========== ===== ========== ========== ======
19
The following table sets forth the average balances and average interest
rates based on daily balances for various types of deposits at the dates
indicated for each category of deposits presented.
Year Ended September 30,
-----------------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
------- -------- ------- -------- ------- --------
(Dollars in thousands)
Noninterest bearing accounts............ $ 13,508 0.00% $12,976 0.00% $13,170 0.00%
Interest bearing checking accounts...... 33,894 0.36 31,805 0.48 30,040 1.38
Money market accounts................... 22,042 0.91 26,374 1.36 21,185 3.77
Passbook and statement savings accounts. 30,024 0.91 27,656 1.50 26,580 2.25
Certificates of deposit................. 156,116 2.48 158,335 3.61 167,481 5.59
--------- -------- ---------
Total............................... $ 255,584 1.75% $257,146 2.58% $ 258,456 4.32%
========= ======== =========
The following table sets forth our time deposits classified by rates at the
dates indicated.
At September 30,
-------------------------------------------
2003 2002 2001
----- ------ ------
(In thousands)
Rate
- -----
0.00 - 1.99%................................................ $ 110,007 $ 16,772 $ --
2.00 - 3.99%................................................ 37,615 118,554 45,066
4.00 - 5.99%................................................ 13,160 23,125 80,465
6.00 - 7.99%................................................ 3,853 5,525 34,024
8.00 - 9.99%................................................ -- 144 133
--------- ---------- ---------
$ 164,635 $ 164,120 $ 159,688
========= ========== =========
The following table sets forth the amount and maturities of our time
deposits at September 30, 2003.
Amount Due
---------------------------------------------------------------------------------
Less Than After
Rate One Year 1-2 Years 2-3 Years 3 Years Total
- ---- -------- --------- --------- ------- -----
(In thousands)
0.00 - 1.99%................... $ 105,294 $ 4,134 $ 579 $ -- $ 110,007
2.00 - 3.99%................... 22,314 4,046 5,639 5,616 37,615
4.00 - 5.99%................... 3,884 1,682 2,716 4,878 13,160
6.00 - 7.99%................... 1,713 1,259 881 -- 3,853
--------- -------- ---------- ---------- ----------
$ 133,205 $ 11,121 $ 9,815 $ 10,494 $ 164,635
========= ======== ========== ========== ==========
The following table indicates the amount of our certificates of deposit of
$100,000 or more by time remaining until maturity as of September 30, 2003. At
that date, such deposits represented 22.6% of total deposits and had a weighted
average rate of 1.79%.
Certificates
Maturity Period of Deposit
--------------- ------------
(In thousands)
Three months or less....................... $25,516
Over three through six months.............. 13,901
Over six through 12 months................. 10,722
Over 12 months............................. 7,531
-------
Total................................ $57,670
=======
20
We estimate that more than $32.9 million of certificates of deposit in
amounts of $100,000 or more maturing within one year of September 30, 2003 were
held by our retail and commercial customers, while the remainder of such
deposits were from schools, municipalities and other public entities and were
obtained through competitive rate bidding. We believe certificates of deposit
held by our retail and commercial customers are more likely to be renewed upon
maturity than certificates of deposit obtained through competitive bidding.
The following table sets forth our savings activities for the periods
indicated.
Year Ended September 30,
---------------------------------------------
2003 2002 2001
---- ------ ------
(In thousands)
Net increase (decrease) before interest credited.............. $ (1,636) $ 6,729 $ (15,271)
Interest credited............................................. 3,681 5,568 9,236
--------- -------- ---------
Net increase (decrease) in deposits....................... $ 2,045 $ 12,297 $ (6,035)
========= ======== =========
Borrowings. Savings deposits historically have been the primary source of
funds for our lending, investments and general operating activities. We are
authorized, however, to use advances from the FHLB of Atlanta to supplement our
supply of lendable funds and to meet deposit withdrawal requirements. The FHLB
of Atlanta functions as a central reserve bank providing credit for member
financial institutions. As a member of the FHLB system, we are required to own
stock in the FHLB of Atlanta and are authorized to apply for advances. Advances
are obtained pursuant to several different programs, each of which has its own
interest rate and range of maturities. We have a blanket agreement for advances
with the FHLB under which we may borrow up to 16% of assets subject to normal
collateral and underwriting requirements. Advances from the FHLB of Atlanta are
secured by our stock in the FHLB of Atlanta and other eligible assets. During
the year ended September 30, 2003 we used short term FHLB advances to fund LIBOR
based loans as part of our asset liability strategy.
The following table sets forth certain information regarding our short-term
borrowings at the dates and for the periods indicated:
At or for the
Year Ended September 30,
---------------------------------------
2003 2002 2001
------ ------ ------
(Dollars in thousands)
Amounts outstanding at end of period:
FHLB advances............................................. $ 31,500 $ 20,000 $ 20,000
Weighted average rate paid on:
FHLB advances............................................. 4.98% 5.18% 5.50%
For the Year
Ended September 30,
------------------------------------
2003 2002 2001
----- ------ ------
(Dollars in thousands)
Maximum amount of borrowings outstanding at any month end:
FHLB advances............................................. $ 39,500 $ 35,000 $ 25,000
Average amounts outstanding:
FHLB advances............................................. $ 23,115 $ 21,811 $ 20,521
Approximate weighted average rate paid on (1):
FHLB advances............................................. 4.84% 5.05% 5.42%
- ------------------
(1) Based on month-end balances.
21
SUBSIDIARY ACTIVITIES
In prior years, we had one subsidiary, First Capital Services, Inc., a
North Carolina corporation ("First Capital"), that engaged in sales of
annuities, mutual funds and insurance products on an agency basis. In September
1997, that corporation transferred its assets and liabilities to a newly formed
North Carolina limited liability company, First Capital Services Company, LLC
(the "LLC"), and the corporation was dissolved. 1st State Bank is the sole
member of the LLC, and since the transfer of assets and liabilities, the LLC has
conducted the activities previously conducted by First Capital. We earned
$258,000, $258,000 and $391,000 on a pre-tax basis from the activities of the
LLC during the years ended September 30, 2003, 2002 and 2001, respectively.
COMPETITION
We face strong competition in originating real estate, commercial business
and consumer loans and in attracting deposits. We compete for real estate and
other loans principally on the basis of interest rates, the types of loans we
originate, the deposit products we offer and the quality of services we provide
to our customers. We also compete by offering products which are tailored to the
local community. Our competition in originating real estate loans comes
primarily from savings institutions, commercial banks, mortgage bankers and
mortgage brokers. Commercial banks, credit unions and finance companies provide
vigorous competition in consumer lending. Competition may increase as a result
of the continuing reduction of restrictions on the interstate operations of
financial institutions.
We attract our deposits through our branch offices primarily from the local
communities. Consequently, competition for deposits is principally from savings
institutions, commercial banks, credit unions and brokers in our primary market
area. We compete for deposits and loans by offering what we believe to be a
variety of deposit accounts at competitive rates, convenient business hours, a
commitment to outstanding customer service and a well-trained staff. We believe
we have developed strong relationships with local realtors and the community in
general.
We consider our primary market area for gathering deposits and originating
loans to be Alamance County in north central North Carolina, which is the county
in which our offices are located. Based on data provided by a private marketing
firm, we estimate that at June 30, 2003, we had 14.4% of deposits held by all
banks and savings institutions in our market area.
EMPLOYEES
As of September 30, 2003, we had 77 full-time and 13 part-time employees,
none of whom were represented by a collective bargaining agreement. We believe
that our relationship with our employees is good.
DEPOSITORY INSTITUTION REGULATION
General. We are a North Carolina-chartered commercial bank and a member of
the FHLB of Atlanta, and our deposits are insured by the FDIC through the
Savings Association Insurance Fund administered by the FDIC. 1st State Bank is
subject to supervision, examination and regulation by the North Carolina Banking
Commission and the FDIC and to North Carolina and federal statutory and
regulatory provisions governing such matters as capital standards, mergers,
subsidiary investments and establishment of branch offices. We are also subject
to the FDIC's authority to conduct special examinations. 1st State Bank is
required to file reports with the North Carolina Banking Commission and the FDIC
concerning its activities and financial condition and is required to obtain
regulatory approvals prior to entering into certain transactions, including
mergers with, or acquisitions of, other depository institutions.
As a federally insured depository institution, 1st State Bank is subject to
various regulations promulgated by the Federal Reserve Board, including
Regulation B (Equal Credit Opportunity), Regulation D (Reserve Requirements),
Regulation E (Electronic Fund Transfers), Regulation Z (Truth in Lending),
Regulation CC (Availability of Funds and Collection of Checks) and Regulation DD
(Truth in Savings).
22
The system of regulation and supervision applicable to us establishes a
comprehensive framework for our operations and is intended primarily for the
protection of the FDIC and our depositors. Changes in the regulatory framework
could have a material effect on us and our operations.
Financial Modernization Legislation. On November 12, 1999, legislation was
enacted which could have a far-reaching impact on the financial services
industry. The Gramm-Leach-Bliley ("G-L-B") Act authorizes affiliations between
banking, securities and insurance firms and authorizes bank holding companies
and national banks to engage in a variety of new financial activities. Among the
new activities that will be permitted to bank holding companies are securities
and insurance brokerage, securities underwriting, insurance underwriting and
merchant banking. The Federal Reserve Board, in consultation with the Secretary
of the Treasury, may approve additional financial activities. The G-L-B Act,
however, prohibits future acquisitions of existing unitary savings and loan
holding companies by firms which are engaged in commercial activities and limits
the permissible activities of unitary holding companies formed after May 4,
1999.
The G-L-B Act imposes new requirements on financial institutions with
respect to customer privacy. The G-L-B Act generally prohibits disclosure of
customer information to non-affiliated third parties unless the customer has
been given the opportunity to object and has not objected to such disclosure.
Financial institutions are further required to disclose their privacy policies
to customers annually. Financial institutions, however, will be required to
comply with state law if it is more protective of customer privacy than the
G-L-B Act. The privacy provisions became effective in July 2001.
The G-L-B Act contains significant revisions to the Federal Home Loan Bank
("FHLB") System. The G-L-B Act imposes new capital requirements on the FHLBs and
authorizes them to issue two classes of stock with differing dividend rates and
redemption requirements. The G-L-B Act deletes the current requirement that the
FHLBs annually contribute $300 million to pay interest on certain government
obligations in favor of a 20% of net earnings formula. The G-L-B Act expands the
permissible uses of FHLB advances by community financial institutions (under
$500 million in assets) to include funding loans to small businesses, small
farms and small agri-businesses.
The G-L-B Act contains a variety of other provisions including a
prohibition against ATM surcharges unless the customer has first been provided
notice of the imposition and amount of the fee. The G-L-B Act reduces the
frequency of Community Reinvestment Act examinations for smaller institutions
and imposes certain reporting requirements on depository institutions that make
payments to non-governmental entities in connection with the Community
Reinvestment Act. The G-L-B Act also eliminated the Savings Association
Insurance Fund special reserve.
Capital Requirements. The Federal Reserve Board and the FDIC have
established guidelines with respect to the maintenance of appropriate levels of
capital by bank holding companies with consolidated assets of $150 million or
more and state non-member banks, respectively. The regulations impose two sets
of capital adequacy requirements: minimum leverage rules, which require bank
holding companies and state non-member banks to maintain a specified minimum
ratio of capital to total assets, and risk-based capital rules, which require
the maintenance of specified minimum ratios of capital to "risk-weighted"
assets. The regulations of the FDIC and the Federal Reserve Board require bank
holding companies and state non-member banks, respectively, to maintain a
minimum leverage ratio of "Tier 1 capital" to total assets of 3%. Although
setting a minimum 3% leverage ratio, the capital regulations state that only the
strongest bank holding companies and banks, with composite examination ratings
of 1 under the rating system used by the federal bank regulators, would be
permitted to operate at or near such minimum level of capital. All other bank
holding companies and banks are expected to maintain a leverage ratio of at
least Tier 1 capital to total assets of not less than 4%. Tier 1 capital is the
sum of common stockholders' equity, certain perpetual preferred stock, which
must be noncumulative with respect to banks, including any related surplus, and
minority interests in consolidated subsidiaries; minus all intangible assets
other than certain purchased mortgage servicing rights and purchased credit card
receivables, identified losses and investments in certain subsidiaries.
As a Savings Association Insurance Fund of the FDIC-insured,
state-chartered bank, we must also deduct from Tier 1 capital an amount equal to
our investments in, and extensions of credit to, subsidiaries engaged
23
in activities that are not permissible for national banks, other than debt and
equity investments in subsidiaries engaged in activities undertaken as agent for
customers or in mortgage banking activities or in subsidiary depository
institutions or their holding companies. Any bank or bank holding companies
experiencing or anticipating significant growth would be expected to maintain
capital well above the minimum levels. In addition, the Federal Reserve Board
has indicated that whenever appropriate, and in particular when a bank holding
company is undertaking expansion, seeking to engage in new activities or
otherwise facing unusual or abnormal risks, it will consider, on a case-by-case
basis, the level of an organization's ratio of tangible Tier 1 capital to total
assets in making an overall assessment of capital.
In addition to the leverage ratio, the regulations of the Federal Reserve
Board and the FDIC require bank holding companies and state-chartered nonmember
banks to maintain a minimum ratio of qualifying total capital to risk-weighted
assets of at least 8% of which at least 4% must be Tier 1 capital. Qualifying
total capital consists of Tier 1 capital plus Tier 2 or "supplementary" capital
items which include allowances for loan losses in an amount of up to 1.25% of
risk-weighted assets, cumulative preferred stock and preferred stock with a
maturity of 20 years or more, certain other capital instruments and up to 45% of
unrealized gains on equity securities. The includable amount of Tier 2 capital
cannot exceed the institution's Tier 1 capital. Qualifying total capital is
further reduced by the amount of the bank's investments in banking and finance
subsidiaries that are not consolidated for regulatory capital purposes,
reciprocal cross-holdings of capital securities issued by other banks and
certain other deductions. The risk-based capital regulations assign balance
sheet assets and the credit equivalent amounts of certain off-balance sheet
items to one of four broad risk weight categories. The aggregate dollar amount
of each category is multiplied by the risk weight assigned to that category
based principally on the degree of credit risk associated with the obligor. The
sum of these weighted values equals the bank holding company or the bank's
risk-weighted assets.
The federal bank regulators, including the Federal Reserve Board and the
FDIC, have revised their risk-based capital requirements to ensure that such
requirements provide for explicit consideration of interest rate risk. Under the
rule, a bank's interest rate risk exposure would be quantified using either the
measurement system set forth in the rule or the bank's internal model for
measuring such exposure, if such model is determined to be adequate by the
bank's examiner. If the dollar amount of a bank's interest rate risk exposure,
as measured under either measurement system, exceeds 1% of the bank's total
assets, the bank would be required under the rule to hold additional capital
equal to the dollar amount of the excess. We believe that the interest rate risk
component does not have a material effect on our capital. Further, the FDIC has
adopted a regulation that provides that the FDIC may take into account whether a
bank has significant risks from concentrations of credit or non-traditional
activities in determining the adequacy of its capital. We have not been advised
that we will be required to maintain any additional capital under this
regulation. The interest rate risk component does not apply to bank holding
companies on a consolidated basis.
In addition to FDIC regulatory capital requirements, the North Carolina
Commissioner of Banks requires us to have adequate capitalization which is
determined based upon each bank's particular set of circumstances. We are
subject to the North Carolina Bank Commissioner's capital surplus regulation
which requires commercial banks to maintain a capital surplus of at least 50% of
common capital. Common capital is defined as the total of the par value of
shares times the number of shares outstanding.
At September 30, 2003, we complied with each of the capital requirements of
the FDIC and the North Carolina Banking Commission.
Prompt Corrective Regulatory Action. Under the Federal Deposit Insurance
Corporation Improvement Act ("FDICIA"), the federal banking regulators are
required to take prompt corrective action if an insured depository institution
fails to satisfy certain minimum capital requirements, including a leverage
limit, a risk-based capital requirement, and any other measure deemed
appropriate by the federal banking regulators for measuring the capital adequacy
of an insured depository institution. All institutions, regardless of their
capital levels, are restricted from making any capital distribution or paying
any management fees if the institution would thereafter fail to satisfy the
minimum levels for any of its capital requirements. An institution that fails to
meet the minimum level for any relevant capital measure (an "undercapitalized
institution") may be: (i) subject to increased monitoring by the appropriate
federal banking regulator; (ii) required to submit an acceptable capital
restoration plan within 45 days; (iii) subject to asset growth limits; and (iv)
required to obtain prior regulatory approval for acquisitions, branching and new
lines of businesses. The capital restoration plan must include a guarantee by
the institution's holding company that the institution will comply with the plan
until it has been adequately capitalized on average for four
24
consecutive quarters, under which the holding company would be liable up to the
lesser of 5% of the institution's total assets or the amount necessary to bring
the institution into capital compliance as of the date it failed to comply with
its capital restoration plan. A "significantly undercapitalized" institution, as
well as any undercapitalized institution that does not submit an acceptable
capital restoration plan, may be subject to regulatory demands for
recapitalization, broader application of restrictions on transactions with
affiliates, limitations on interest rates paid on deposits, asset growth and
other activities, possible replacement of directors and officers, and
restrictions on capital distributions by any bank holding company controlling
the institution. Any company controlling the institution may also be required to
divest the institution or the institution could be required to divest
subsidiaries. The senior executive officers of a significantly undercapitalized
institution may not receive bonuses or increases in compensation without prior
approval and the institution is prohibited from making payments of principal or
interest on its subordinated debt. In their discretion, the federal banking
regulators may also impose the foregoing sanctions on an undercapitalized
institution if the regulators determine that such actions are necessary to carry
out the purposes of the prompt corrective provisions. If an institution's ratio
of tangible capital to total assets falls below the "critical capital level"
established by the appropriate federal banking regulator, the institution will
be subject to conservatorship or receivership within specified time periods.
Under the implementing regulations, the federal banking regulators,
including the FDIC, generally measure an institution's capital adequacy on the
basis of its total risk-based capital ratio (the ratio of its total capital to
risk-weighted assets), Tier 1 risk-based capital ratio (the ratio of its core
capital to risk-weighted assets) and leverage ratio (the ratio of its core
capital to adjusted total assets). The following table shows the capital ratios
required for the various prompt corrective action categories.
Adequately Significantly
Well Capitalized Capitalized Undercapitalized Undercapitalized
---------------- ----------- ---------------- ----------------
Total risk-based
capital ratio 10.0% or more 8.0% or more Less than 8.0% Less than 6.0%
Tier 1 risk-based
capital ratio 6.0% or more 4.0% or more Less than 4.0% Less than 3.0%
Leverage ratio 5.0% or more 4.0% or more * Less than 4.0% * Less than 3.0%
- -----------
* 3.0% if institution has a composite 1 CAMELS rating.
A "critically undercapitalized" savings institution is defined as an institution
that has a ratio of "tangible equity" to total assets of less than 2.0%.
Tangible equity is defined as core capital plus cumulative perpetual preferred
stock (and related surplus) less all intangibles other than qualifying
supervisory goodwill and certain purchased mortgage servicing rights. The FDIC
may reclassify a well capitalized savings institution as adequately capitalized
and may require an adequately capitalized or undercapitalized institution to
comply with the supervisory actions applicable to institutions in the next lower
capital category (but may not reclassify a significantly undercapitalized
institution as critically undercapitalized) if the FDIC determines, after notice
and an opportunity for a hearing, that the institution is in an unsafe or
unsound condition or that the institution has received and not corrected a
less-than-satisfactory rating for any CAMELS rating category.
The Bank meets the definition of "well-capitalized" under the FDIC's prompt
corrective action regulations.
Safety and Soundness Guidelines. Under FDICIA, as amended by the Riegle
Community Development and Regulatory Improvement Act of 1994 (the "CDRI Act"),
each federal banking agency was required to establish safety and soundness
standards for institutions under its authority. The interagency guidelines
require depository institutions to maintain internal controls and information
systems and internal audit systems that are appropriate for the size, nature and
scope of the institution's business. The guidelines also establish certain basic
standards for loan documentation, credit underwriting, interest rate risk
exposure, and asset growth. The guidelines further provide that depository
institutions should maintain safeguards to prevent the payment of compensation,
fees and benefits that are excessive or that could lead to material financial
loss, and should take into account factors such as comparable compensation
practices at comparable institutions. If the appropriate federal banking agency
determines that a depository institution is not in compliance with the safety
and soundness guidelines, it may require the institution to submit an acceptable
plan to achieve compliance with the guidelines. A depository institution must
submit an acceptable compliance plan to its primary federal regulator within 30
days of receipt of a request for such
25
a plan. Failure to submit or implement a compliance plan may subject the
institution to regulatory sanctions. Management believes that 1st State Bank
meets all the standards adopted in the interagency guidelines.
Community Reinvestment Act. 1st State Bank, like other financial
institutions, is subject to the Community Reinvestment Act ("CRA"). The purpose
of the CRA is to encourage financial institutions to help meet the credit needs
of their entire communities, including the needs of low- and moderate-income
neighborhoods.
The federal banking regulatory agencies have implemented an evaluation
system that rates institutions based on their actual performance in meeting
community credit needs. Under the regulations, a bank will first be evaluated
and rated under three categories: a lending test, an investment test and a
service test. For each of these three tests, the bank will be given a rating of
either "outstanding," "high satisfactory," "low satisfactory," "needs to
improve," or "substantial non-compliance." A set of criteria for each rating has
been developed and is included in the regulation. If an institution disagrees
with a particular rating, the institution has the burden of rebutting the
presumption by clearly establishing that the quantitative measures do not
accurately present its actual performance, or that demographics, competitive
conditions or economic or legal limitations peculiar to its service area should
be considered. The ratings received under the three tests will be used to
determine the overall composite CRA rating. The composite ratings currently
given are: "outstanding," "satisfactory," "needs to improve" or "substantial
non-compliance."
During our last compliance examination, we received a "satisfactory" rating
for CRA compliance.
Our CRA rating would be a factor considered by the Federal Reserve Board
and the FDIC in considering applications to acquire branches or to acquire or
combine with other financial institutions and take other actions and, if such
rating was less than "satisfactory," could result in the denial of such
applications.
Federal Home Loan Bank System. The FHLB System consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB"). The FHLBs provide a central credit facility primarily for member
institutions. As a member of the FHLB of Atlanta, we are required to acquire and
hold shares of capital stock in the FHLB of Atlanta in an amount at least equal
to 1% of the aggregate unpaid principal of home mortgage loans, home purchase
contracts, and similar obligations at the beginning of each year, or 1/20 of
advances from the FHLB of Atlanta, whichever is greater. We were in compliance
with this requirement with investment in FHLB of Atlanta stock at September 30,
2003 of $1.7 million. The FHLB of Atlanta serves as a reserve or central bank
for its member institutions within its assigned district. It is funded primarily
from proceeds derived from the sale of consolidated obligations of the FHLB
System. It offers advances to members in accordance with policies and procedures
established by the FHFB and the board of directors of the FHLB of Atlanta.
Long-term advances may only be made for the purpose of providing funds for
residential housing finance, small businesses, small farms and small
agri-businesses. At September 30, 2003, we had $31.5 million in advances
outstanding from the FHLB of Atlanta.
Reserves. Under Federal Reserve Board regulations, we must maintain average
daily reserves equal to 3% on transaction accounts up to $41.3 million, plus 10%
on the remainder. This percentage is subject to adjustment by the Federal
Reserve Board. Because required reserves must be maintained in the form of vault
cash or in a non-interest bearing account at a Federal Reserve Bank, the effect
of the reserve requirement is to reduce the amount of the institution's
interest-earning assets. As of September 30, 2003, we met our reserve
requirements.
We are also subject to the reserve requirements of North Carolina
commercial banks. North Carolina law requires state non-member banks to
maintain, at all times, a reserve fund in an amount set by regulation of the
North Carolina Banking Commission. As of September 30, 2003, we met our reserve
requirements.
Deposit Insurance. We are required to pay assessments based on a percentage
of insured deposits to the FDIC for insurance of our deposits by the Savings
Association Insurance Fund of the FDIC. Under the FDIC's risk-based deposit
insurance assessment system, the assessment rate for an insured depository
institution depends on the assessment risk classification assigned to the
institution by the FDIC, which is determined by the institution's capital level
and supervisory evaluations. Based on the data reported to regulators for the
date closest to the last day of the seventh month preceding the semi-annual
assessment period, institutions are assigned to one of three capital groups ---
well capitalized, adequately capitalized or undercapitalized -- using the same
percentage criteria as in the prompt
26
corrective action regulations. See "-- Prompt Corrective Regulatory Action" for
definitions and percentage criteria for the capital group categories. Within
each capital group, institutions are assigned to one of three subgroups on the
basis of supervisory evaluations by the institution's primary supervisory
authority and such other information as the FDIC determines to be relevant to
the institution's financial condition and the risk posed to the deposit
insurance fund. Subgroup A consists of financially sound institutions with only
a few minor weaknesses. Subgroup B consists of institutions that demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the institution and increased risk of loss to the deposit insurance fund.
Subgroup C consists of institutions that pose a substantial probability of loss
to the deposit insurance fund unless effective corrective action is taken.
The assessment rate for SAIF members ranges from zero for well capitalized
institutions in Subgroup A to 0.27% of deposits for undercapitalized
institutions in Subgroup C. In addition, both Bank Insurance Fund of the FDIC
and Savings Association Insurance Fund of the FDIC members are assessed an
amount for interest payments on certain bonds issued by the Financing
Corporation, an agency of the federal government to finance takeovers of
insolvent thrifts.
Liquidity Requirements. FDIC policy requires that banks maintain an average
daily balance of liquid assets in an amount which it deems adequate to protect
safety and soundness of the bank. Liquid assets include cash, certain time
deposits, bankers' acceptances and specified United States government, state, or
federal agency obligations. The FDIC currently has no specific level which it
requires.
North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the North Carolina Banking Commission to account for the level of
liquidity necessary to assure the safety and soundness of the State banking
system. At September 30, 2003, our liquidity ratio exceeded the North Carolina
regulations.
Dividend Restrictions. Under FDIC regulations, we are prohibited from
making any capital distributions if after making the distribution, we would
have:
o a total risk-based capital ratio of less than 8%;
o a Tier 1 risk-based capital ratio of less than 4%; or
o a leverage ratio of less than 4%.
Our earnings appropriated to bad debt reserves and deducted for Federal
income tax purposes are not available for payment of cash dividends or other
distributions to stockholders without payment of taxes at the then current tax
rate on the amount of earnings removed from the pre-1988 reserves for such
distributions. We intend to make full use of this favorable tax treatment and do
not contemplate use of any earnings in a manner which would create federal tax
liabilities.
We may not pay dividends on our capital stock if our regulatory capital
would thereby be reduced below the amount then required for the liquidation
account established for the benefit of certain depositors at the time of the
conversion.
1st State Bancorp is subject to limitations on dividends imposed by the
Federal Reserve Board.
Transactions with Related Parties. Transactions between a state non-member
bank and any affiliate are governed by Sections 23A and 23B of the Federal
Reserve Act. An affiliate of a state non-member bank is any company or entity
which controls, is controlled by or is under common control with the state
non-member bank. In a holding company context, the parent holding company of a
state non-member bank, such as 1st State Bancorp, and any companies which are
controlled by the parent holding company are affiliates of the savings
institution or state non-member bank. Generally, Sections 23A and 23B (i) limit
the extent to which an institution or its subsidiaries may engage in "covered
transactions" with any one affiliate to an amount equal to 10% of such
institution's capital stock and surplus, and contain an aggregate limit on all
such transactions with all affiliates to an amount equal to 20% of such capital
stock and surplus, and (ii) require that all such transactions be on terms
substantially the same, or at least as favorable, to the institution or
subsidiary as those provided to a non-affiliate. The term "covered
27
transaction" includes the making of loans, purchase of assets, issuance of a
guarantee and similar other types of transactions. In addition to the
restrictions imposed by Sections 23A and 23B, no state non-member bank may (i)
loan or otherwise extend credit to an affiliate, except for any affiliate which
engages only in activities which are permissible for bank holding companies, or
(ii) purchase or invest in any stocks, bonds, debentures, notes or similar
obligations of any affiliate, except for affiliates which are subsidiaries of
the state non-member bank.
Loans to Directors, Executive Officers and Principal Stockholders. State
non-member banks also are subject to the restrictions contained in Section 22(h)
of the Federal Reserve Act and the Federal Reserve Board's Regulation O
thereunder on loans to executive officers, directors and principal stockholders.
Under Section 22(h), loans to a director, executive officer and to a greater
than 10% stockholder of a state non-member bank and certain affiliated interests
of such persons, may not exceed, together with all other outstanding loans to
such person and affiliated interests, the institution's loans-to-one-borrower
limit and all loans to such persons may not exceed the institution's unimpaired
capital and unimpaired surplus. Section 22(h) also prohibits loans, above
amounts prescribed by the appropriate federal banking agency, to directors,
executive officers and greater than 10% stockholders of a depository
institution, and their respective affiliates, unless such loan is approved in
advance by a majority of the board of directors of the institution with any
"interested" director not participating in the voting. Regulation O prescribes
the loan amount, which includes all other outstanding loans to such person, as
to which such prior board of director approval is required as being the greater
of $25,000 or 5% of capital and surplus up to $500,000. Further, Section 22(h)
requires that loans to directors, executive officers and principal stockholders
be made on terms substantially the same as offered in comparable transactions to
other persons. Section 22(h) also generally prohibits a depository institution
from paying the overdrafts of any of its executive officers or directors.
State non-member banks also are subject to the requirements and
restrictions of Section 22(g) of the Federal Reserve Act on loans to executive
officers. Section 22(g) of the Federal Reserve Act requires loans to executive
officers of depository institutions not be made on terms more favorable than
those afforded to other borrowers, requires approval by the board of directors
of a depository institution for such extensions of credit to executive officers
of the institution, and imposes reporting requirements for and additional
restrictions on the type, amount and terms of credits to such officers. In
addition, Section 106 of the BHCA prohibits extensions of credit to executive
officers, directors, and greater than 10% stockholders of a depository
institution by any other institution which has a correspondent banking
relationship with the institution, unless such extension of credit is on
substantially the same terms as those prevailing at the time for comparable
transactions with other persons and does not involve more than the normal risk
of repayment or present other unfavorable features.
Additionally, North Carolina statutes set forth restrictions on loans to
executive officers of state-chartered banks, which provide that no bank may
extend credit to any of its executive officers nor a firm or partnership of
which such executive officers is a member, nor a company in which such executive
officer owns a controlling interest, unless the extension of credit is made on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions by the bank with persons who
are not employed by the bank, and provided further that the extension of credit
does not involve more than the normal risk of repayment.
Restrictions on Certain Activities. State-chartered banks with deposits
insured by the FDIC are generally prohibited from engaging in activities and
investments that are not permissible for a national bank. The foregoing
limitation, however, does not prohibit FDIC-insured state banks from acquiring
or retaining an equity investment in a subsidiary in which the bank is a
majority owner. State chartered banks are also prohibited from engaging as a
principal in any type of activity that is not permissible for a national bank.
Further subsidiaries of state chartered, FDIC-insured state banks may not engage
as a principal in any type of activity that is not permissible for a subsidiary
of a national bank, unless in either case, the FDIC determines that the activity
would pose no significant risk to the appropriate deposit insurance fund and the
bank is, and continues to be, in compliance with applicable capital standards.
The FDIC has adopted regulations to clarify the foregoing restrictions on
activities of FDIC-insured state-chartered banks and their subsidiaries. Under
the regulations, the term "activity" refers to the conduct of business by an
insured state bank and includes acquiring or retaining any investment other than
an equity investment as defined by regulation. An activity permissible for a
national bank includes any activity expressly authorized for national banks by
statute or recognized as permissible in regulations, official circulars,
bulletins, orders or written interpretations issued by the Office of the
Comptroller of the Currency. In its regulations, the FDIC indicates that it
28
will not permit state banks to directly engage in commercial ventures or
directly or indirectly engage in any insurance underwriting activity other than
to the extent such activities are permissible for a national bank or a national
bank subsidiary or except for certain other limited forms of insurance
underwriting permitted under the regulations. FDIC regulations permit state
banks that meet applicable minimum capital requirements to engage as principal
in certain activities that are not permissible to national banks including
guaranteeing obligations of others, activities which the Federal Reserve Board
has found by regulation or order to be closely related to banking and certain
securities activities conducted through subsidiaries.
Patriot Act. The Patriot Act is intended to strengthen U.S. law
enforcement's and the intelligence communities' abilities to work cohesively to
combat terrorism on a variety of fronts. The potential impact of the Patriot Act
on financial institutions of all kinds is significant and wide ranging. The
Patriot Act contains sweeping anti-money laundering and financial transparency
laws and imposes various regulations including standards for verifying client
identification at account opening, and rules to promote cooperation among
financial institutions, regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.
REGULATION OF 1st STATE BANCORP, INC.
General. 1st State Bancorp, as the sole shareholder of 1st State Bank, is a
bank holding company and is registered as such with the Federal Reserve Board.
Bank holding companies are subject to comprehensive regulation by the Federal
Reserve Board under the Bank Holding Company Act of 1956, as amended (the
"BHCA"), and the regulations of the Federal Reserve Board. As a bank holding
company, 1st State Bancorp is required to file with the Federal Reserve Board
annual reports and such additional information as the Federal Reserve Board may
require, and is subject to regular examinations by the Federal Reserve Board.
The Federal Reserve Board also has extensive enforcement authority over bank
holding companies, including, among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to require that
a holding company divest of subsidiaries, including its bank subsidiaries. In
general, enforcement actions may be initiated for violations of law and
regulations and unsafe or unsound practices. 1st State Bancorp is also required
to file certain reports with, and comply with the rules and regulations of the
Securities and Exchange Commission under the federal securities laws.
Under the BHCA, a bank holding company must obtain Federal Reserve Board
approval before:
o 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,
unless it already owns or controls the majority of such shares;
o acquiring all or substantially all of the assets of another bank or
bank holding company; or
o merging or consolidating with another bank holding company.
Satisfactory financial condition, particularly with respect to capital adequacy,
and a satisfactory CRA rating generally are prerequisites to obtaining federal
regulatory approval to make acquisitions.
The BHCA also prohibits a bank holding company, with certain exceptions,
from acquiring 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 Board regulation or order, have been
identified as activities closely related to the business of banking or managing
or controlling banks. The list of activities permitted by the Federal Reserve
Board includes, among other things:
o operating a savings institution, mortgage company, finance company,
credit card company or factoring company;
o performing certain data processing operations;
29
o providing certain investment and financial advice;
o underwriting and acting as an insurance agent for certain types of
credit-related insurance;
o leasing property on a full-payout, non-operating basis;
o selling money orders, travelers' checks and United States Savings
Bonds;
o real estate and personal property appraising;
o providing tax planning and preparation services; and,
o subject to certain limitations, providing securities brokerage
services for customers.
Other than the sales of money orders and travelers' checks to our customers, we
have no plans to engage in any of these activities.
Acquisition of Bank Holding Companies and Banks. Under the BHCA, any
company must obtain approval of the Federal Reserve Board prior to acquiring
control of 1st State Bancorp or 1st State Bank. For purposes of the BHCA,
"control" is defined as ownership of more than 25% of any class of voting
securities of 1st State Bancorp or 1st State Bank, the ability to control the
election of a majority of the directors, or the exercise of a controlling
influence over management or policies of 1st State Bancorp or 1st State Bank. In
addition, the Change in Bank Control Act and the related regulations of the
Federal Reserve Board require any person or persons acting in concert to file a
written notice with the Federal Reserve Board before such person or persons may
acquire control of 1st State Bancorp or 1st State Bank. The Change in Bank
Control Act defines "control" as the power, directly or indirectly, to vote 25%
or more of any voting securities or to direct the management or policies of a
bank holding company or an insured bank.
The Federal Reserve Board has adopted guidelines regarding the capital
adequacy of bank holding companies, which require bank holding companies to
maintain specified minimum ratios of capital to total assets and capital to
risk-weighted assets.
Interstate Banking. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (the "Riegle-Neal Act") was enacted to ease restrictions
on interstate banking. Effective September 29, 1995, the Act allows the Federal
Reserve Board to approve an application of an adequately capitalized and
adequately managed bank holding company to acquire control of, or acquire all or
substantially all of the assets of, a bank located in a state other than the
holding company's home state, without regard to whether the transaction is
prohibited by the laws of any state. The Federal Reserve Board may not approve
the acquisition of a bank that has not been in existence for a minimum of five
years, regardless of a longer minimum period specified by the law of the host
state. The Riegle-Neal Act also prohibits the Federal Reserve Board from
approving an application if the applicant and its depository institution
affiliates control or would control more than 10% of the insured deposits in the
United States or 30%, or more of the deposits in the target bank's home state or
in any state in which the target bank maintains a branch. The Riegle-Neal Act
does not affect a state's authority to limit the percentage of total insured
deposits in the state which may be held or controlled by a bank or bank holding
company to the extent such limitation does not discriminate against out-of-state
banks or bank holding companies. Individual states may also waive the 30%
statewide concentration limit contained in the Riegle-Neal Act.
Additionally, the federal banking agencies are authorized to approve
interstate merger transactions without regard to whether such transaction is
prohibited by the law of any state, unless the home state of one of the banks
has opted out of the Riegle-Neal Act by adopting a law, which applies equally to
all out-of-state banks and expressly prohibits merger transactions involving
out-of-state banks. Interstate acquisitions of branches will be permitted only
if the law of the state in which the branch is located permits such
acquisitions. Interstate mergers and branch acquisitions are subject to the
nationwide and statewide insured deposit concentration amounts described above.
North Carolina has enacted legislation permitting interstate banking
transactions.
30
The Riegle-Neal Act authorizes the FDIC to approve interstate branching de
novo by state banks only in states which specifically allow for such branching.
Pursuant to the Riegle-Neal Act, the appropriate federal banking agencies have
adopted regulations which prohibit any out-of-state bank from using the
interstate branching authority primarily for the purpose of deposit production.
These regulations include guidelines to ensure that interstate branches operated
by an out-of-state bank in a host state are reasonably helping to meet the
credit needs of the communities which they serve.
Dividends. The Federal Reserve Board has issued a policy statement on the
payment of cash dividends by bank holding companies, which expresses the Federal
Reserve Board's view that a bank holding company should pay cash dividends only
to the extent that the company's net income for the past year is sufficient to
cover both the cash dividends and a rate of earning retention that is consistent
with the company's capital needs, asset quality and overall financial condition.
The Federal Reserve Board also indicated that it would be inappropriate for a
company experiencing serious financial problems to borrow funds to pay
dividends. Furthermore, under the prompt corrective action regulations adopted
by the Federal Reserve Board, the Federal Reserve Board may prohibit a bank
holding company from paying any dividends if the holding company's bank
subsidiary is classified as "undercapitalized". For a definition of
"undercapitalized" institution, see "-- Depository Institution Regulation --
Prompt Corrective Regulatory Action."
Bank holding companies are required to give the Federal Reserve Board prior
written notice of any purchase or redemption of its outstanding equity
securities if the gross consideration for the purchase or redemption, when
combined with the net consideration paid for all such purchases or redemptions
during the preceding 12 months, is equal to 10% or more of the their
consolidated net worth. The Federal Reserve Board may disapprove such a purchase
or redemption if it determines that the proposal would constitute an unsafe or
unsound practice or would violate any law, regulation, Federal Reserve Board
order, directive, or any condition imposed by, or written agreement with, the
Federal Reserve Board. Bank holding companies whose capital ratios exceed the
thresholds for well capitalized banks on a consolidated basis are exempt from
the foregoing requirement if they were rated composite 1 or 2 in their most
recent inspection and are not the subject of any unresolved supervisory issues.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of
2002 ("SOX") was signed into law which mandated a variety of reforms intended to
address corporate and accounting fraud. SOX contained provisions which amend the
Securities Exchange Act of 1934, as amended (the "Act") and provisions which
directed the SEC to promulgate rules. The resultant law and regulations under
the Act as of the time of this annual report is set forth in the following
paragraphs. SOX provides for the establishment of a new Public Company
Accounting Oversight Board ("PCAOB"), which will enforce auditing, quality
control and independence standards for firms that audit Securities and Exchange
Commission ("SEC")-reporting companies and will be funded by fees from all
SEC-reporting companies. SOX imposed higher standards for auditor independence
and restricts provision of consulting services by auditing firms to companies
they audit. Any non-audit services being provided to an audit client will
require preapproval by the Company's audit committee members. In addition,
certain audit partners must be rotated periodically. SOX requires chief
executive officers and chief financial officers, or their equivalent, to certify
to the accuracy of periodic reports filed with the SEC, subject to civil and
criminal penalties if they knowingly or willfully violate this certification
requirement. In addition, under SOX, counsel will be required to report evidence
of a material violation of the securities laws or a breach of fiduciary duty by
a company to its chief executive officer or its chief legal officer, and, if
such officer does not appropriately respond, to report such evidence to the
audit committee or other similar committee of the board of directors or the
board itself.
Longer prison terms will also be applied to corporate executives who
violate federal securities laws, the period during which certain types of suits
can be brought against a company or its officers has been extended, and bonuses
issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from trading during
retirement plan "blackout" periods, and loans to company executives are
restricted. In addition, a provision directs that civil penalties levied by the
SEC as a result of any judicial or administrative action under the Act be
deposited in a fund for the benefit of harmed investors. Directors and executive
officers must also report most changes in their ownership of a company's
securities within two business days of the change, and as of the end of June
2003, all ownership reports must be electronically filed.
31
SOX also increases the oversight and authority of audit committees of
publicly traded companies. Audit committee members must be independent and are
barred from accepting consulting, advisory or other compensatory fees from the
issuer. In addition, all SEC-reporting companies must disclose whether at least
one member of the committee is an audit committee "financial expert" (as such
term is defined by the SEC rules) and if not, why not. Audit committees of
publicly traded companies will have authority to retain their own counsel and
other advisors funded by the company. Audit committees must establish procedures
for the receipt, retention and treatment of complaints regarding accounting and
auditing matters and procedures for confidential, anonymous submission of
employee concerns regarding questionable accounting or auditing matters. It is
the responsibility of the audit committee to hire, oversee and work on
disagreements with the Company's independent auditor.
Beginning six months after the SEC determines that the PCAOB is able to
carry out its functions, it will be unlawful for any person that is not a
registered public accounting firm ("RPAF") to audit an SEC-reporting company.
Under SOX, a RPAF is prohibited from performing statutorily mandated audit
services for a company if such company's chief executive officer, chief
financial officer, comptroller, chief accounting officer or any person serving
in equivalent positions has been employed by such firm and participated in the
audit of such company during the one-year period preceding the audit initiation
date. SOX also prohibits any officer or director of a company or any other
person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent public or certified
accountant engaged in the audit of the Company's financial statements for the
purpose of rendering the financial statement's materially misleading. The SEC
has prescribed rules requiring inclusion of an internal control report and
assessment by management of the Company's internal controls in the annual report
to shareholders. SOX requires the RPAF that issues the audit report to attest to
and report on management's assessment of the Company's internal controls. In
addition, SOX requires that each financial report required to be prepared in
accordance with (or reconciled to) generally accepted accounting principles and
filed with the SEC reflect all material correcting adjustments that are
identified by a RPAF in accordance with generally accepted accounting principles
and the rules and regulations of the SEC.
Although the Company anticipates it will incur additional expense in
complying with the provisions of the Act and the related rules, management does
not expect that such compliance will have a material impact on the Company's
financial condition or results of operations.
TAXATION
GENERAL
1st State Bancorp and 1st State Bank file a consolidated federal income tax
return based on a fiscal year ending September 30. They file separate state
returns.
FEDERAL INCOME TAXATION
Financial institutions such as 1st State Bank are subject to the provisions
of the Internal Revenue Code in the same general manner as other corporations.
Through tax years beginning before December 31, 1995, institutions such as 1st
State Bank which met certain definitional tests and other conditions prescribed
by the Internal Revenue Code benefitted from certain favorable provisions
regarding their deductions from taxable income for annual additions to their bad
debt reserve. For purposes of the bad debt reserve deduction, loans are
separated into "qualifying real property loans," which generally are loans
secured by interests in certain real property, and "nonqualifying loans", which
are all other loans. The bad debt reserve deduction with respect to
nonqualifying loans must be based on actual loss experience. The amount of the
bad debt reserve deduction with respect to qualifying real property loans may be
based upon actual loss experience (the "experience method") or a percentage of
taxable income determined without regard to such deduction (the "percentage of
taxable income method"). Under the experience method, the bad debt deduction for
an addition to the reserve for qualifying real property loans was an amount
determined under a formula based generally on the bad debts actually sustained
by a savings institution over a period of years. Under the percentage of taxable
income method, the bad debt reserve deduction for qualifying real property loans
was computed as 8% of a savings institution's taxable income, with certain
adjustments. We generally elected to use the method which has resulted in the
greatest deductions for federal income tax purposes in any given year.
32
Legislation that is effective for tax years beginning after December 31,
1995 requires institutions to recapture into taxable income over a six taxable
year period the portion of the tax loan reserve that exceeds the pre-1988 tax
loan loss reserve. As a result of changes in the law, institutions were required
to change to either the reserve method or the specific charge-off method that
applied to banks.
We are not required to provide a deferred tax liability for the tax effect
of additions to the tax bad debt reserve through 1987, the base year. Retained
income at September 30, 1998 includes approximately $4.2 million for which no
provision for federal income tax has been made. These amounts represent
allocations of income to bad debt deductions for tax purposes only. Reduction of
such amounts for purposes other than tax bad debt losses could create income for
tax purposes in certain remote instances, which would be subject to the then
current corporate income tax rate.
Our federal income tax returns have not been audited since 1993.
For additional information on our policies regarding tax and accounting
matters, see our consolidated financial statements and related notes in the
Annual Report filed as Exhibit 13 in this document.
STATE INCOME TAXATION
Under North Carolina law, the corporate income tax rate currently is 6.90%
of federal taxable income as computed under the Internal Revenue Code, subject
to certain prescribed adjustments. An annual state franchise tax, recorded in
other expense, is imposed at a rate of .15% applied to the greatest of the
institution's (i) capital stock, surplus and undivided profits, (ii) investment
in tangible property in North Carolina, or (iii) fifty-five percent of appraised
valuation of property in North Carolina.
For additional information regarding taxation, see Notes 1 and 11 of the
Notes to the Consolidated Financial Statements, which you can find in the Annual
Report.
ITEM 2. PROPERTIES
- -------------------
The following table sets forth the location and certain additional
information regarding our offices at September 30, 2003.
Book Value at Deposits at
Year Owned or September 30, Approximate September 30,
Opened Leased 2003 (1) Square Footage 2003
------ ------ ---------- -------------- -------
(Dollars in thousands)
Main Office:
445 S. Main Street 1988 Owned $ 3,471 33,700 $99,441
Burlington, NC 27215
BRANCH OFFICES:
2294 N. Church Street 1984 Leased (2) 233 2,600 24,330
Burlington, NC 27215
503 Huffman Mill Road 1982 Owned 335 2,600 36,232
Burlington, NC 27215
102 E. Washington Street 1973 Owned 342 2,300 34,928
Mebane, NC 27302
211 N. Main Street 1974 Owned 98 2,700 35,521
Graham, NC 27253
(table continued on next page)
33
3466 S. Church Street 1996 Owned 1,342 4,000 22,560
Burlington, NC 27215
1203 S. Main Street 2000 Owned 1,384 4,000 9,700
Graham, NC 27253
- ----------
(1) Land and building only.
(2) Land is leased. Lease expires on July 5, 2009, with options to extend for
three five-year periods.
The net book value of our investment in premises and equipment was $8.4
million at September 30, 2003. See Note 7 of Notes to Consolidated Financial
Statements, located in the annual report.
ITEM 3. LEGAL PROCEEDINGS
- -------------------------
From time to time, we are a party to various legal proceedings incident to
our business. There currently are no legal proceedings to which we are a party,
or to which any of our property was subject, except as described in the
following paragraph, and none which are expected to result in a material loss.
There are no pending regulatory proceedings to which we are a party or to which
any of our properties is subject which are expected to result in a material
loss.
A civil action was filed against 1st State Bank and Brokers, Incorporated
by Michael Locklar in Davidson County Superior Court, in the State of North
Carolina on May 16, 2003. Mr. Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County, North Carolina, which 1st State Bank wrongfully sold to Brokers,
Incorporated for $150,000 in breach of the option granted to Mr. Locklar. Mr.
Locklar is seeking to set aside the conveyance of property to Brokers,
Incorporated and to purchase the property from 1st State Bank for the option
price. Brokers, Incorporated has filed a cross-claim against 1st State Bank
seeking indemnification in the form of return of the purchase price they paid
for the property, damages and attorneys fees should Locklar be successful in
setting aside the real estate conveyance. 1st State Bank intends to vigorously
contest Mr. Locklar's allegations.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
- ----------------------------------------------------------
Not applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS'
MATTERS
- --------------------------------------------------------------------------------
The information contained under the sections captioned "Market Information"
in the Company's Annual Report to Stockholders for the Fiscal Year Ended
September 30, 2003 (the "Annual Report") filed as Exhibit 13 hereto is
incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
- --------------------------------
The information contained in the table captioned "Selected Consolidated
Financial and Other Data" on page 2 in the Annual Report is incorporated herein
by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
- --------------------------------------------------------------------------------
The information contained in the section captioned "Management's Discussion
and Analysis of Financial Condition and Results of Operations" on pages 4
through 21 in the Annual Report is incorporated herein by reference.
34
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- --------------------------------------------------------------------
The information contained under the sections captioned "Market Risk" on
pages 7 and 8 in the Annual Report is incorporated herein be reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ----------------------------------------------------
The Consolidated Financial Statements, Notes to Consolidated Financial
Statements, Independent Auditors' Report and Selected Financial Data contained
on pages 22 through 57 in the Annual Report, which are listed under Item 14
herein, are incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
- --------------------------------------------------------------------------------
Not applicable.
Item 9A. CONTROLS & PROCEDURES
- -------------------------------
As of the end of the period covered by this report, management of the
Company carried out an evaluation, under the supervision and with the
participation of the Company's principal executive officer and principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by the Company in reports that it files or submits under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported, within the time periods specified in the Securities and Exchange
Commission's rules and forms. It should be noted that the design of the
Company's disclosure controls and procedures is based in part upon certain
reasonable assumptions about the likelihood of future events, and there can be
no reasonable assurance that any design of disclosure controls and procedures
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote, but the Company's principal executive and
financial officers have concluded that the Company's disclosure controls and
procedures are, in fact, effective at a reasonable assurance level.
In addition, there have been no changes in the Company's internal control
over financial reporting identified in connection with the evaluation described
in the above paragraph that occurred during the Company's last fiscal quarter,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- ------------------------------------------------------------
The information contained under the sections captioned "Proposal I --
Election of Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's definitive proxy statement for the Company's 2004
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.
The Company has adopted a Code of Ethics that applies to the Company's
chief executive officer, chief financial officer, and all senior management.
ITEM 11. EXECUTIVE COMPENSATION
- --------------------------------
The information contained under the sections captioned "Proposal I --
Election of Directors -- Executive Compensation," in the Proxy Statement is
incorporated herein by reference.
35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
- --------------------------------------------------------------------------------
(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. Information required
by this item is incorporated herein by reference to the section
captioned "Voting Securities and Security Ownership" in the Proxy
Statement.
(b) SECURITY OWNERSHIP OF MANAGEMENT. Information required by this item is
incorporated herein by reference to the sections captioned "Voting
Securities and Security Ownership" and "Proposal I -- Election of
Directors" in the Proxy Statement.
(c) CHANGES IN CONTROL. Management of the Company knows of no
arrangements, including any pledge by any person of securities of the
Company, the operation of which may at a subsequent date result in a
change in control of the registrant.
(d) EQUITY COMPENSATION PLANS. The following table sets forth certain
information with respect to the Company's equity compensation plans as
of September 30, 2003.
(a) (b) (c)
Number of securities
remaining available
Number of securities to be Weighted-average for future issuance
issued upon exercise of exercise price of under equity compensation
outstanding options, outstanding options, plans (excluding securities
warrants & rights warrants and rights reflected in column (a))
----------------- ------------------- ------------------------
Equity compensation plans 316,312 $ 14.71 --
approved by security holders
Equity compensation plans not
approved by security holders -- -- --
------- -------- -----
Total 316,312 $ 14.71 --
======= ======== =====
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- --------------------------------------------------------
The information required by this item is incorporated herein by reference
to the section captioned "Proposal I -- Election of Directors -- Transactions
with Management" in the Proxy Statement.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
- --------------------------------------------------------------------------
(a) LIST OF DOCUMENTS FILED AS PART OF THIS REPORT
----------------------------------------------
(1) Financial Statements. The following consolidated financial statements
are incorporated by reference from Item 8 hereof (see Exhibit 13):
Independent Auditors' Report
Consolidated Balance Sheets as of September 30, 2003 and 2002
Consolidated Statements of Income for the Years Ended September 30,
2003, 2002 and 2001
Consolidated Statements of Stockholders' Equity and Comprehensive
Income for the Years Ended
September 30, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the Years Ended September 30,
2003, 2002 and 2001
Notes to Consolidated Financial Statements
36
(2) Financial Statement Schedules. All schedules for which provision is
made in the applicable accounting regulations of the Securities and Exchange
Commission are omitted because of the absence of conditions under which they are
required or because the required information is included in the consolidated
financial statements and related notes thereto.
37
(3) Exhibits. The following is a list of exhibits filed as part of this
Annual Report on Form 10-K and is also the Exhibit Index.
No. Description
--- -----------
3.1 Articles of Incorporation of 1st State Bancorp, Inc. (Incorporated herein by reference from
Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-68091))
3.2 Bylaws of 1st State Bancorp, Inc. (Incorporated herein by reference to the Company's Annual
Report on Form 10-K for the Fiscal Year Ended September 30, 2000)
4 Form of Common Stock Certificate of 1st State Bancorp, Inc. (Incorporated herein by reference
from Exhibit 4 to the Company's Registration Statement on Form 8-A)
10.1 1st State Bancorp, Inc. 2000 Stock Option and Incentive Plan (Incorporated herein by reference
to the Company's Annual Report on Form 10-K for the Fiscal Year Ended September 30, 2000) +
10.2 1st State Bancorp, Inc. Management Recognition Plan (Incorporated herein by reference to the
Company's Annual Report on Form 10-K for the Fiscal Year Ended September 30, 2000) +
10.3 Employment Agreements by and between 1st State Bank and James C. McGill, A. Christine Baker and
Fairfax C. Reynolds (Incorporated herein by reference from Exhibit 10.3 to the Company's
Registration Statement on Form S-1 (File No. 333-68091)) +
10.4 Form of Guaranty Agreement by and between 1st State Bancorp, Inc. and James C. McGill, A.
Christine Baker and Fairfax C. Reynolds (Incorporated herein by reference from Exhibit 10.4 to
the Company's Registration Statement on Form S-1 (File No. 333-68091)) +
10.5 1st State Bank Deferred Compensation Plan (Incorporated herein
by reference from Exhibit 10.5 to the Company's Registration
Statement on Form S-1 (File No. 333-68091)) +
13 Annual Report to Stockholders
14 Code of Ethics
21 Subsidiaries of the Registrant
23 Consent of KPMG LLP
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Certification pursuant to 18 U.S.C. Section 1350
----------
+ Management contract or compensation plan or arrangement.
(b) REPORTS ON FORM 8-K. The Registrant filed the following Current Report
--------------------
on Form 8-K during the last quarter covered by this Report:
Financial Statements
Date of Report Items Reported Filed
-------------- -------------- --------------------
July 23, 2003 7, 12 N/A
(c) EXHIBITS. The exhibits required by Item 601 of Regulation S-K are
---------
either filed as part of this Annual Report on Form 10-K or incorporated by
reference herein.
(d) FINANCIAL. STATEMENTS AND SCHEDULES EXCLUDED FROM ANNUAL REPORT. There
----------------------------------------------------------------
are no other financial statements and financial statement schedules which were
excluded from the Annual Report to Stockholders pursuant to Rule 14a-3(b) which
are required to be included herein.
38
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.
1st STATE BANCORP, INC.
December 26, 2003 By: /s/ James C. McGill
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James C. McGill
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
/s/ James C. McGill December 26, 2003
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James C. McGill
President, Chief Executive Officer and Director
(Principal Executive Officer)
/s/ A. Christine Baker December 26, 2003
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A. Christine Baker
Executive Vice President, Chief Financial
Officer, Secretary and Treasurer
(Principal Financial and Accounting Officer)
/s/ Richard C. Keziah December 26, 2003
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Richard C. Keziah
Chairman of the Board
/s/ James A. Barnwell, Jr. December 26, 2003
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James A. Barnwell, Jr.
Director
/s/ Bernie C. Bean December 26, 2003
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Bernie C. Bean
Director
/s/ Ernest A. Koury, Jr. December 26, 2003
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Ernest A. Koury, Jr.
Director
/s/ James G. McClure December 26, 2003
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James G. McClure
Director
/s/ T. Scott Quakenbush December 26, 2003
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T. Scott Quakenbush
Director
/s/ Richard H. Shirley December 26, 2003
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Richard H. Shirley
Director
/s/ Virgil L. Stadler December 26, 2003
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Virgil L. Stadler
Director