SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____
Commission File Number: 000-31825
HERITAGE FINANCIAL HOLDING CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 63 - 1259533
- -------------------------------------- ----------------------------------
(State of Incorporation) (IRS Employer Identification No.)
211 Lee St., N.E.
Decatur, Alabama 35601
(Address of principal executive office)
(256) 355-9500
(Issuer's telephone number, including area code)
(Former name,former address and former fiscal year,if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the past 12 months (or for 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
---------- ----------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, $0.01 par value
Outstanding at September 30, 2002: 8,821,144 Shares
Form 10-Q
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
September 30, 2002
TABLE OF CONTENTS
Page No.
Part I - Financial Information
Item 1 - Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
September 30, 2002 and December 31, 2001....................................................... 3
Consolidated Statements of Income For the Three Months
Ended September 30, 2002 and 2001.............................................................. 4
Consolidated Statements of Comprehensive Income For the
Three Months Ended September 30, 2002 and 2001................................................. 5
Consolidated Statements of Income For the Nine Months Ended
September 30, 2002 and 2001.................................................................... 6
Consolidated Statements of Comprehensive Income For the
Nine Months Ended September 30, 2002 and 2001.................................................. 7
Consolidated Statement of Stockholders' Equity For the
Nine Months Ended September 30, 2002........................................................... 8
Consolidated Statements of Cash Flows For the
Nine Months Ended September 30, 2002 and 2001.................................................. 9
Notes to Consolidated Financial Statements..................................................... 10
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations.................................................. 16
Item 3 - Quantitative and Qualitative Disclosures About Market Risk..................................... 29
Item 4 - Controls and Procedures........................................................................ 31
Part II - Other Information
Item 6 - Exhibits and Reports on Form 8-K............................................................... 32
Signatures
Certification of Periodic Financial Reports
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, 2002 (Unaudited) and December 31, 2001
September 30,
2002 December 31,
(Unaudited) 2001
Assets ---------------- -----------------
Cash and due from banks................................................... $ 7,685,073 $ 6,660,032
Interest bearing deposits with other banks................................ 61,978 325,736
Federal funds............................................................. 11,621,000 6,716,000
---------------- -----------------
Cash and Cash Equivalents............................................... 19,368,051 13,701,768
Securities available-for-sale............................................. 68,590,088 25,893,863
Mortgage loans held-for-sale.............................................. 13,823,273 12,548,322
Loans, net of unearned income............................................. 548,205,205 505,380,611
Allowance for loan losses................................................. (13,754,471) (6,074,230)
Premises and equipment, net............................................... 6,997,530 6,407,022
Accrued interest.......................................................... 3,555,814 3,873,413
Foreclosed real estate.................................................... 3,110,172 4,227,926
Other assets.............................................................. 6,395,614 2,332,392
---------------- -----------------
Total Assets.......................................................... $ 656,291,276 $ 568,291,087
================ =================
Liabilities and Stockholders' Equity
Liabilities
Deposits
Noninterest bearing..................................................... $ 21,452,110 $ 21,295,986
Interest-bearing........................................................ 564,722,058 483,013,752
---------------- -----------------
Total Deposits........................................................ 586,174,168 504,309,738
Accrued interest.......................................................... 2,951,883 4,204,515
FHLB advances............................................................. 23,000,000 13,000,000
Guaranteed preferred beneficial interest in the Company's
subordinated debentures................................................. 10,000,000 10,000,000
Other liabilities......................................................... 417,367 652,954
---------------- -----------------
Total Liabilities..................................................... 622,543,418 532,167,207
---------------- -----------------
Stockholders' Equity
Preferred stock - par value $0.01 per share; 10,000,000
authorized, none issued................................................. -- --
Common stock ($.001 par value; 40,000,000 shares authorized,
8,821,144 issued and outstanding at September 30, 2002;
40,000,000 shares authorized, 8,515,147 issued and outstanding
at December 31, 2001)................................................... 88,211 85,151
Paid-in capital........................................................... 32,287,409 30,359,218
Retained earnings......................................................... 1,152,430 5,736,259
Accumulated other comprehensive income (loss): net unrealized
holding gains (losses) on securities available-for-sale, net of
deferred income tax..................................................... 219,808 (56,748)
---------------- -----------------
Total Stockholders' Equity............................................ 33,747,858 36,123,880
---------------- -----------------
Total Liabilities and Stockholders' Equity............................ $ 656,291,276 $ 568,291,087
================ =================
See notes to consolidated financial statements
3
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended September 30, 2002 and 2001
(Unaudited)
Three Months Ended
September 30,
-----------------------------------
2002 2001
---------------- -----------------
Interest Income
Interest and fees on loans................................................ $ 10,043,832 $ 10,471,050
Interest and dividends on securities:
Taxable securities...................................................... 340,147 367,080
Nontaxable securities................................................... 39,154 30,954
Interest on deposits with other banks..................................... 1,500 6,000
Interest earned on federal funds sold and securities purchased............ 130,756 473,498
---------------- -----------------
Total Interest Income................................................... 10,555,389 11,348,582
---------------- -----------------
Interest Expense
Interest on deposits...................................................... 4,904,736 7,022,075
Interest on FHLB borrowings............................................... 244,500 201,000
Interest on guaranteed preferred beneficial interest in
the Company's subordinated debentures................................... 255,000 255,861
---------------- -----------------
Total Interest Expense.................................................. 5,404,236 7,478,936
---------------- -----------------
Net Interest Income.......................................................... 5,151,153 3,869,646
Provision for loan losses................................................. 9,380,339 849,907
---------------- -----------------
Net Interest Income (Loss) After Provision for Loan Losses................... (4,229,186) 3,019,739
Noninterest Income
Customer service fees..................................................... 295,199 235,530
Mortgage banking fee income............................................... 199,433 143,465
Investment security gains................................................. 1,133 --
Other operating income.................................................... 77,180 30,907
---------------- -----------------
Total Noninterest Income................................................ 572,945 409,902
---------------- -----------------
Noninterest Expenses
Salaries and employee benefits............................................ 1,659,380 1,377,335
Occupancy and equipment expense........................................... 411,780 327,943
Other operating expenses.................................................. 1,321,015 900,751
---------------- -----------------
Total Noninterest Expenses.............................................. 3,392,175 2,606,029
---------------- -----------------
Income (loss) before income taxes............................................ (7,048,416) 823,612
Provision for income tax expense (benefit)................................... (2,626,161) 323,158
---------------- -----------------
Net Income (Loss)............................................................ $ (4,422,255) $ 500,454
================ =================
Earnings (Loss) Per Common Share
Basic..................................................................... $ (0.50) $ 0.06
Diluted................................................................... (0.44) 0.05
Cash Dividends Declared
Cash dividends declared per common share.................................. $ 0.00 $ 0.00
Weighted Average Shares Outstanding
Basic..................................................................... 8,816,300 8,487,131
Diluted................................................................... 10,157,201 10,549,935
See notes to consolidated financial statements
4
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Three Months Ended September 30, 2002 and 2001
(Unaudited)
Three Months Ended
September 30,
-----------------------------------
2002 2001
---------------- -----------------
Net Income (Loss)............................................................ $ (4,422,255) $ 500,454
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during the period...................... 181,590 257,763
Reclassification adjustments for gains included in net income........... (1,133) (18,383)
---------------- -----------------
Net unrealized gains.................................................... 180,457 239,380
Income tax related to items of other comprehensive loss................... (72,183) (95,752)
---------------- -----------------
Other comprehensive income................................................... 108,274 143,628
---------------- -----------------
Comprehensive Income (Loss).................................................. $ (4,313,981) $ 644,082
================ =================
See notes to consolidated financial statements
5
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Nine Months Ended September 30, 2002 and 2001
(Unaudited)
Nine Months Ended
September 30,
-----------------------------------
2002 2001
---------------- -----------------
Interest Income
Interest and fees on loans................................................ $ 30,279,045 $ 31,224,198
Interest and dividends on securities:
Taxable securities...................................................... 990,610 1,152,873
Nontaxable securities................................................... 105,159 92,796
Interest on deposits with other banks..................................... 4,763 26,000
Interest earned on federal funds sold and securities purchased............ 263,655 864,209
---------------- -----------------
Total Interest Income................................................... 31,643,232 33,360,076
---------------- -----------------
Interest Expense
Interest on deposits...................................................... 14,665,453 20,626,823
Interest on FHLB borrowings............................................... 711,849 676,700
Interest on short-term borrowings......................................... -- 1,888
Interest on guaranteed preferred beneficial interest in
the Company's subordinated debentures................................... 757,029 626,849
---------------- -----------------
Total Interest Expense.................................................. 16,134,331 21,932,260
---------------- -----------------
Net Interest Income.......................................................... 15,508,901 11,427,816
Provision for loan losses................................................. 13,075,825 2,876,605
---------------- -----------------
Net Interest Income After Provision for Loan Losses.......................... 2,433,076 8,551,211
Noninterest Income
Customer service fees..................................................... 778,461 649,433
Mortgage banking fee income............................................... 508,528 361,468
Investment securities gains............................................... 72,894 18,383
Other operating income.................................................... 213,735 87,492
---------------- -----------------
Total Noninterest Income................................................ 1,573,618 1,116,776
---------------- -----------------
Noninterest Expenses
Salaries and employee benefits............................................ 6,588,241 4,148,089
Occupancy and equipment expense........................................... 1,120,011 895,919
Other operating expenses.................................................. 3,584,871 2,491,230
---------------- -----------------
Total Noninterest Expenses.............................................. 11,293,123 7,535,238
---------------- -----------------
Income (loss) before income taxes............................................ (7,286,429) 2,132,749
Provision for income tax expense (benefit)................................... (2,702,600) 783,502
---------------- -----------------
Net Income (Loss)............................................................ $ (4,583,829) $ 1,349,247
================ =================
Earnings (Loss) Per Common Share
Basic..................................................................... $ (0.53) $ 0.16
Diluted................................................................... (0.45) 0.13
Cash Dividends Declared
Cash dividends declared per common share.................................. $ 0.00 $ 0.00
Weighted Average Shares Outstanding
Basic..................................................................... 8,682,310 8,481,713
Diluted................................................................... 10,122,745 10,506,786
See notes to consolidated financial statements
6
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Nine Months Ended September 30, 2002 and 2001
(Unaudited)
Nine Months Ended
September 30,
-----------------------------------
2002 2001
---------------- -----------------
Net Income (Loss)............................................................ $ (4,583,829) $ 1,349,247
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during the period...................... 533,821 469,856
Reclassification adjustments for gains included in net income........... (72,894) (18,383)
---------------- -----------------
Net unrealized gains.................................................... 460,927 451,473
Income tax related to items of other comprehensive loss................... (184,371) (180,589)
---------------- -----------------
Other comprehensive income................................................... 276,556 270,884
---------------- -----------------
Comprehensive Income (Loss).................................................. $ (4,307,273) $ 1,620,131
================ =================
See notes to consolidated financial statements
7
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Nine Months Ended September 30, 2002
(Unaudited)
Accumulated
Other
Common Paid-In Retained Comprehensive
Stock Capital Earnings Income (Loss) Total
----------- ------------- ------------ ------------------ --------------
Balance at December 31, 2001.......... $ 85,151 $ 30,359,218 $ 5,736,259 $ (56,748) $ 36,123,880
Net loss - September 30, 2002......... -- -- (4,583,829) -- (4,583,829)
Unrealized gains on securities
available-for-sale, net of
reclassification adjustment,
net of tax of ($184,371)........... -- -- -- 276,556 276,556
--------------
Comprehensive loss.................... -- -- -- -- (4,307,273)
--------------
Compensatory options.................. -- 1,119,986 -- -- 1,119,986
Stock option exercise................. 4,510 1,747,826 -- -- 1,752,336
Stock used by optionees to
purchase options................... (1,473) (1,727,292) -- -- (1,728,765)
Tax benefit on stock options.......... -- 762,500 -- -- 762,500
Issuance of shares under
employee stock purchase plan....... 23 25,171 -- -- 25,194
----------- ------------- ------------ ---------------- --------------
Balance at September 30, 2002......... $ 88,211 $ 32,287,409 $ 1,152,430 $ 219,808 $ 33,747,858
=========== ============= ============ ================ ==============
See notes to consolidated financial statements
8
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2002 and 2001
(Unaudited)
Nine Months Ended
September 30,
---------------------------------
2002 2001
--------------- ----------------
Operating Activities
Net Income (loss)............................................................ $ (4,583,829) $ 1,349,247
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses.................................................. 13,075,825 2,876,605
Depreciation, amortization, and accretion, net............................. 410,772 333,902
Deferred tax benefit....................................................... (281,026) --
Realized investment security gains......................................... (72,894) (18,383)
Decrease in accrued interest receivable.................................... 317,599 239,977
Decrease in accrued interest payable....................................... (1,252,632) (3,119)
Other, net................................................................. (3,439,655) (246,678)
--------------- ----------------
Net Cash Provided By Operating Activities................................ 4,174,160 4,531,551
--------------- ----------------
Investing Activities
Increase in mortgage loans held-for-sale..................................... (1,274,951) --
Net increase in investment securities available-for-sale..................... (42,162,403) (1,418,231)
Net increase in loans to customers........................................... (48,220,178) (88,594,554)
Capital expenditures, net.................................................... (1,001,280) (1,148,690)
Proceeds from disposition of foreclosed real estate.......................... 1,117,754 --
--------------- ----------------
Net Cash Used In Investing Activities...................................... (91,541,058) (91,161,475)
--------------- ----------------
Financing Activities
Net increase in demand deposits, NOW
accounts and savings accounts.............................................. 18,753,877 29,909,592
Net increase in certificates of deposit...................................... 63,110,553 84,361,285
Issuance of shares........................................................... 48,765 69,632
Net proceeds from FHLB loans................................................. 10,000,000 1,000,000
Issuance of guaranteed preferred beneficial interest
in the Company's subordinated debentures................................... -- 10,000,000
Compensatory options......................................................... 1,119,986 --
--------------- ----------------
Net Cash Provided By Financing Activities.................................. 93,033,181 125,340,509
--------------- ----------------
Net Increase in Cash and Cash Equivalents....................................... 5,666,283 38,710,585
Cash and Cash Equivalents At Beginning of Period................................ 13,701,768 15,640,016
--------------- ----------------
Cash and Cash Equivalents At End of Period...................................... $ 19,368,051 $ 54,350,601
=============== ================
Supplemental Disclosures of Cash Flow Information
Cash paid during the period for:
Interest................................................................... $ 17,386,963 $ 21,935,379
Taxes...................................................................... 645,436 770,781
See notes to consolidated financial statements
9
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2002
(Unaudited)
Note A - Basis of Presentation
The consolidated financial statements include the accounts of Heritage Financial
Holding Corporation and its subsidiaries Heritage Bank (the "Bank") and Heritage
Financial Statutory Trust I ("Heritage Trust"), collectively, the Company. The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the nine-month period ended September 30, 2002,
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2002.
The consolidated statement of financial condition at December 31, 2001, has been
derived from the audited consolidated financial statements at that date, but
does not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto for Heritage Financial Holding Corporation and subsidiaries
for the year ended December 31, 2001, included in Form 10-K/A filed in April
2002.
Note B - Income Taxes
The effective tax rates of approximately 37.3 percent and 39.2 percent for the
three months ended September 30, 2002 and 2001, and 37.1 percent and 36.7
percent for the nine months ended September 30, 2002 and 2001, respectively,
differ from the statutory rate principally because of the effect of state income
taxes.
Note C - Securities
The Company applies the accounting and reporting requirements of Statement of
Financial Accounting Standards No. 115, Accounting for Certain Investments in
Debt and Equity Securities ("SFAS 115"). This pronouncement requires that all
investments in debt securities be classified as either "held-to-maturity"
securities, which are reported at amortized cost; "trading" securities, which
are reported at fair value, with unrealized gains and losses included in
earnings; or "available-for-sale" securities, which are reported at fair value,
with unrealized gains and losses excluded from earnings and reported in a
separate component of stockholders' equity (net of deferred tax effect).
At September 30, 2002, the Company had net unrealized gains of approximately
$366,346 in available-for-sale securities which are reflected in the presented
assets and resulted in an increase in stockholders' equity of $219,808, net of
deferred tax liability. There were no held-to-maturity or trading securities at
September 30, 2002 or December 31, 2001. The net increase in stockholders'
equity as a result of the SFAS 115 adjustment from December 31, 2001 to
September 30, 2002, was $276,556. See also Note D - Stockholders' Equity.
10
Note D - Stockholders' Equity
Equity decreased by $2,376,022 due to net loss of $4,583,829, the effects of
compensatory stock options totaling an increase of $1,119,986, stock option
exercise totaling a net increase of $23,571, tax benefit on stock options
totaling an increase of $762,500, the issuance of shares under the employee
stock purchase plan of $25,194, and the increase from an unrealized loss to an
unrealized gain on securities available for sale totaling $276,556, net of
deferred taxes.
Note E - Segment Information
All of the Company's offices offer similar products and services, are located in
the same geographic region, and serve similar segments of the market. As a
result, management considers all units as one operating segment and therefore
feels that the basic financial statements and related footnotes provide
sufficient details related to segment reporting.
Note F - Guaranteed Preferred Beneficial Interests in the Company's Subordinated
Debentures
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage Trust"), a
Connecticut statutory trust established by the Company, received $10,000,000 in
proceeds in exchange for $10,000,000 principal amount of Heritage Trust's 10.20%
cumulative trust preferred securities (the "preferred securities") in a pooled
trust preferred private placement. The proceeds of that transaction were then
used by Heritage Trust to purchase an equal amount of 10.20% subordinated
debentures (the "subordinated debentures") of the Company. The Company has fully
and unconditionally guaranteed all obligations of Heritage Trust on a
subordinated basis with respect to the preferred securities. The Company
accounts for Heritage Trust as a minority interest. Subject to certain
limitations, the preferred securities qualify as Tier 1 capital and are
presented in the Consolidated Statements of Financial Condition as "Guaranteed
preferred beneficial interests in the Company's subordinated debentures." The
sole asset of Heritage Trust is the subordinated debentures issued by the
Company. Both the preferred securities of Heritage Trust and the subordinated
debentures of the Company each have 30-year lives. However, both the Company and
Heritage Trust have a call option of ten years, subject to regulatory approval,
or earlier, depending upon certain changes in tax or investment company laws, or
regulatory capital requirements.
11
Note G - Recent Developments
During the course of a targeted, limited scope review of the loan portfolio of
the Company's wholly-owned subsidiary Heritage Bank, an Alabama state banking
corporation (the "Bank"), and concurrent safety and soundness audit and
information systems examination conducted by regulatory authorities, management
identified certain assets of the Bank that management believed should be
classified. The Company and the Bank have been engaged in an on-going evaluation
of the loan portfolio of the Bank and have taken, or are in the process of
taking, actions to address asset quality at the Bank. The Bank has taken and is
continuing to take steps to charge off or establish additional loan loss
reserves for specified assets and to adjust the Bank's levels of loan loss
provisions.
Regulatory Background
On July 24, 2002, bank regulatory authorities informed the Company and the Bank
of their desire to immediately perform a targeted, limited scope review of the
Bank's loan portfolio based upon certain information received involving certain
loans. Such review was commenced and during the course of such review, bank
regulatory authorities determined to conduct the safety and soundness audit of
the Bank which was scheduled to commence in October 2002.
As previously reported in the Form 10-Q of the Company for the quarterly period
ended June 30, 2002, in conjunction with the review of the Bank's loan
portfolio, the Company and the Bank discovered that one of its non-executive
employees had improperly advanced monies on certain loans. Said employee offered
to resign, and the Bank accepted the resignation, based on violations of the
Bank's loan policies. Also, as reported on the Form 10-Q of the Company for the
quarterly period ended June 30, 2002, the Company increased its "Allowance for
loan losses" on its consolidated balance sheet by $2,000,000 to account for
potential loan losses due to a variety of events including an erosion of asset
quality in certain loans in the Bank's portfolio.
Allowance for Loan Losses
During the course of the safety and soundness examination, management conducted
a review of a significant portion of the loan portfolio of the Bank, identified
and classified additional assets of the Bank, and determined to take appropriate
steps to charge off or establish additional loan loss reserves with respect to
such assets. Accordingly, the Board of Directors has determined to increase the
allowance for loan losses, net of charge offs and recoveries, on the Company's
consolidated balance sheet by $5,229,624. This amount is in addition to the
$2,000,000 added to the "Allowance for loan losses" reported on the Company's
Form 10-Q for the quarterly period ended June 30, 2002. After such increase, as
of September 30, 2002 the allowance for loan losses on the Company's
consolidated balance sheet totaled $13,754,471.
12
Note G - Recent Developments - Continued
This increase in the allowance for loan losses, net of charge offs and
recoveries, reduced the Tier 1 capital of the Bank to 6.39%. Accordingly, the
Board of Directors and management of the Company and of the Bank have been
engaged in reviewing options available to the Bank to augment its capital
ratios. This review led to efforts by the Company to obtain a loan, a portion of
the proceeds of which immediately would be contributed to the capital of the
Bank.
Loan Agreement
On October 30, 2002, the Company entered into a Loan Agreement with First
Tennessee Bank National Association, pursuant to which the Company is able to
borrow up to $7.5 million (the "First Tennessee Loan"). As part of the First
Tennessee Loan, the Company pledged the stock of the Bank as collateral for such
loan. In addition, directors of the Company executed personal guaranty
agreements as additional security for the First Tennessee Loan. Immediately
following execution of the Loan Agreement, the Company drew down $5 million of
the First Tennessee Loan and contributed said loan proceeds to the capital of
the Bank. Following the $5 million contribution, the Bank's Tier 1 capital ratio
increased to approximately 7.28% as of October 30, 2002.
Going forward, the Company intends to take steps to attain and maintain a Tier 1
capital ratio at the Bank of 7.5% by December 31, 2002, and 8% by March 31,
2003. Although the Company cannot assure that it will be successful in achieving
these capital ratios within these timeframes, management believes that the steps
it is taking to access additional capital, implement management changes and
enhance internal controls and procedures will enable the Company to achieve
these objectives. The Board of Directors and management of the Company and the
Bank are actively engaged in the preparation and implementation of strategic
business plans for the Company and the Bank, to address, among other things, the
immediate and anticipated future capital requirements of the Company and the
Bank, taking into account the mix of loans in the Bank's loan portfolio,
earnings, and alternative sources of capital.
Additional Efforts
In addition to the First Tennessee Loan, the Board of Directors and management
of the Company and of the Bank are continuing to review and assess additional
actions to augment capital levels at the Bank and the Company. These actions
include focusing on core earnings at the Bank; attempting to convert non-earning
assets to earning status through aggressive collection and liquidation efforts;
and controlling and contracting the balance sheet of the Bank.
13
Note G - Recent Developments - Continued
As a result of the declining quality of the Bank's loan portfolio, related
reductions in the capital levels of the Bank, and other operational factors, the
Board of Directors and management is re-evaluating its lending strategy. The
Board of Directors and management are actively taking steps to improve the
underwriting and credit administration practices of the Bank in order to improve
overall asset quality. In addition, in October 2002 the Bank hired a new chief
lending officer to oversee the administration of the Bank's loan portfolio with
primary emphasis on improving overall credit quality of the portfolio. New
policies with respect to loan originations have been formulated which management
believes should enhance the quality of future loan production. Management
intends to continue efforts to originate new loans consistent with improving
overall credit quality, although significant emphasis is now being given to
problem loan administration.
Policies, Procedures, Systems and Control. In light of the increased level of
classified assets of the Bank and management's decision to increase its
allowance for loan losses, the Company is taking steps to implement enhanced
risk management and internal control procedures. These steps include increasing
the Company's investment in its infrastructure to enhance its technology, its
management information systems, its internal audit function and the formal
documentation of its policies and procedures. In this regard, the Company is
taking steps to expand its internal audit function and has engaged an outside
consulting firm to assist the Company to ensure that the Company's policies,
procedures, systems and controls are appropriate to its operations. Such review
and enhancement of the policies, procedures, systems and controls of the Company
and the Bank are being overseen by Larry R. Mathews, the new President and Chief
Executive Officer of the Bank and Thomas E. Hemmings, the new Chief Financial
Officer of the Company and the Bank.
Retention of President and Chief Executive Officer of the Bank
On October 23, 2002, the Bank engaged Mr. Larry R. Mathews as President and
Chief Executive Officer of the Bank. The decision of the Board of Directors of
the Bank to employ Mr. Mathews as President was based on a number of factors,
including Mr. Mathews' 17 years in senior executive positions at both regional
holding company banks and community banks. During his career, Mr. Mathews has
developed executive and management experience working with a number of banks
facing issues similar to those currently facing the Bank. In addition, Mr.
Mathews has developed a positive working relationship and reputation with
various bank regulatory authorities. The decision to retain Mr. Mathews, given
his experience in the areas of management, credit quality and internal controls
and procedures, is part of the Company's renewed focus on the loan portfolio of
the Bank and the overall credit quality of the Bank, as well as the operating
controls and procedures of the Bank. Mr. Mathews' initial primary
responsibilities will be focusing on improving asset quality and loan
administration, establishing and implementing internal controls and procedures
and improving overall performance. The Board of Directors also believes that Mr.
Mathews possesses the ability to mobilize and implement the necessary personnel
to accomplish the strategic objectives identified by the Board and senior
management. The Boards of Directors of the Company and the Bank, in conjunction
with Mr. Mathews, are continuing to evaluate and assess the management and
personnel needs and resources of the Bank in light of the significant emphasis
being devoted to credit quality and loan administration.
14
Note G - Recent Developments - Continued
Ongoing Analysis and Assessment
Management has commenced a comprehensive review of the Company's and the Bank's
internal control structures and procedures. In the course of this review,
management has identified significant weaknesses in the Company's internal
controls and procedures, particularly with respect to the Bank's lending
functions, including credit underwriting and loan review. Furthermore,
management has determined that certain internal controls and procedures relating
to loan policies and procedures have not been followed by Bank personnel. This
review is ongoing and further adjustments to loan loss reserves may be made as a
result of the continuation of management's review and assessment of the Bank's
loan portfolio and the adequacy of the allowance for loan losses.
15
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
September 30, 2002
Item 2. - Management's Discussion and Analysis of Financial Condition and
Results of Operations
Heritage Financial Holding Corporation (the "Company") is primarily engaged in
the business of directing and planning the activities of its wholly owned
subsidiary, Heritage Bank (the "Bank"). The Company's primary asset is comprised
of its investment in the Bank.
The consolidated operating results of the Company include those of the Bank. All
significant intercompany transactions and balances have been eliminated in
consolidation. The operating results of the Company depend primarily on net
interest income, which is the difference between interest income on
interest-earning assets, primarily loans and investment securities, and interest
expense on interest-bearing liabilities, primarily deposits and advances from
the Federal Home Loan Bank ("FHLB") and other sources. Net earnings are also
affected by non-interest income and non-interest expenses, such as loan fees,
compensation and benefits, building and occupancy expense, and other expenses.
The discussion and analysis included herein covers material changes in financial
condition, liquidity and capital resources that have occurred since December 31,
2001, as well as certain material changes in results of operations during the
nine months ended September 30, 2002 as compared to the same period in 2001.
This discussion is intended to assist in an understanding of the Company and its
subsidiaries' financial condition and results of operations. Unless the context
otherwise indicates, "the Company" shall include the Company and its
subsidiaries. This analysis should be read in conjunction with the consolidated
financial statements and related notes appearing in Item 1 of the September 30,
2002, Form 10-Q, and "Management's Discussion and Analysis of Financial
Condition and Results of Operations," appearing in the Company's Annual Report
on Form 10-K/A for the year ended December 31, 2001.
16
RISK FACTORS
The Company and the Bank Have Made Significant Changes to the Bank's Loan Loss
Reserves as a Result of Reviews of the Bank's Loan Portfolio.
During the course of a targeted, limited scope review of the loan portfolio of
the Company's wholly-owned subsidiary Heritage Bank, an Alabama state banking
corporation (the "Bank"), and a concurrent safety and soundness audit and
information systems examination conducted by regulatory authorities, management
identified certain assets in the Bank's loan portfolio that management believed
should be classified. Due to the erosion in asset quality identified by the
review, the Company increased its allowance for loan losses by $2,000,000 during
the quarterly period ended June 30, 2002. The continuing review of the Bank's
loan portfolio has identified additional asset quality problems, which resulted
in the Company increasing the allowance for loan losses net of charge offs and
recoveries by an additional $5,229,624. As of September 30, 2002, the allowance
for loan losses on the Company's consolidated balance sheet totaled $13,754,471,
compared to $6,074,230 at December 31, 2001.
The provision for loan losses in the amount of $9,380,339 contributed to a
quarterly loss of $4,422,255, which reduced the Tier 1 capital of the Bank to
6.39%. The Board of Directors and management of the Company and of the Bank
engaged in discussions regarding the Bank's Tier 1 capital that ultimately led
to the Company entering into a Loan Agreement with First Tennessee Bank National
Association dated October 30, 2002, pursuant to which the Company is able to
borrow up to $7.5 million (the "First Tennessee Loan"). Immediately following
the execution of the Loan Agreement, the Company drew down $5 million of the
First Tennessee Loan and contributed said loan proceeds to the capital of the
Bank. Following the $5 million contribution, the Bank's Tier 1 capital ratio
increased to approximately 7.28% as of October 30, 2002.
The Board of Directors of the Company intends to cause management of the Company
and the Bank to take steps to attain and maintain a Tier 1 capital ratio at the
Bank of 7.5% by December 31, 2002, and 8% by March 31, 2003. Although the
Company cannot give any assurance that it will be successful in achieving these
capital ratios within these timeframes, management believes that the steps it is
taking to access additional capital, implement management changes and enhance
internal controls and procedures will enable the Company to achieve these
objectives.
The Company and the Bank are Reviewing the Adequacy of Internal Controls and
Procedures of the Company and the Bank, Which May Result in Substantial
Revisions and Supplements to Such Controls and Procedures.
Management has commenced a comprehensive review of the Company's internal
control structures. Management's review of the internal control structures of
the Company and the Bank indicated significant weaknesses in the Company's and
the Bank's internal controls and procedures, particularly with respect to the
Bank's lending functions, including credit underwriting and loan review. As a
result of the information gathered in the course of these reviews, management of
both the Company and the Bank have taken steps to modify and supplement internal
controls and procedures in order to augment the Company's reporting and to
ensure timely evaluation of reporting regarding the operations of the Bank,
particularly with respect to the credit and asset quality of the Bank.
Furthermore, in the course of these reviews, the Company and the Bank determined
that certain internal controls relating to loan policies and procedures have not
been followed by Bank personnel, and have taken steps to correct these matters,
17
including the dismissal of certain employees of the Bank. The Bank has retained
a new President and Chief Executive Officer, and, additionally, the Company has
changed outside legal counsel. Management of the Company is continuing to review
and modify the Company's internal controls and procedures. This review process
is currently ongoing and is not complete as of the date of the filing of this
Quarterly Report on Form 10-Q.
The Company Has Had a Significant Change in Management since March 12, 2002, and
There Can Be No Assurance that the New Management Will Result in Improved
Financial Condition or Net Income.
On March 12, 2002, Reginald D. Gilbert, President, Chief Executive Officer and
Director of the Company and the Bank, elected to voluntarily retire as an
employee and sever his relationship with the Company and the Bank. Harold B.
Jeffreys, a Director, has been serving as Interim President and Chief Executive
Officer of the Company until such time as the Company hires a new President, and
Chief Executive Officer. In addition, on April 9, 2002, the Board of Directors
accepted the resignations from the Board of Directors of three officers of the
Bank who had been serving on the Board.
During the second quarter of 2002, the Board of Directors hired Thomas E.
Hemmings as Chief Financial Officer of the Company. Mr. Hemmings has been
charged with taking steps to generate growth for the Company and, more recently,
helping the Company to address its internal controls and procedures.
On October 23, 2002, the Board of Directors engaged Larry R. Mathews as
President and Chief Executive Officer of the Bank. The decision to retain Mr.
Mathews, given his experience in the areas of management, credit quality and
internal controls and procedures, is part of the Company's renewed focus on the
loan portfolio of the Bank and the overall credit quality of the Bank, as well
as the operating controls and procedures of the Bank. The Board of Directors
intends for Mr. Mathews to focus his initial efforts on improving asset quality
and loan administration, continuing the review and implementation of internal
controls and procedures and improving the Company's overall performance.
Despite these changes in management and the Board of Directors' mandate to
management to address the Bank's asset quality and lending procedures, and to
improve the Company's financial results, there can be no assurance that the new
management will be successful in improving the financial condition or increasing
the net income of the Company.
18
FINANCIAL CONDITION
September 30, 2002 compared to December 31, 2001
Loans
Loans comprised the largest single category of the Company's earning assets on
September 30, 2002. Loans, net of unearned income and allowance for loan losses,
were 81.4% of total assets at September 30, 2002, and 87.9% of total assets at
December 31, 2001. Total net loans were $534,450,734 at September 30, 2002,
representing a 7.0% increase from the December 31, 2001 total of $499,306,381.
This increase is the result of increased loan demand. Management intends to
continue efforts to originate new loans consistent with the bank's strengthened
credit standards.
Allowance for Loan Losses
When determining the adequacy of the allowance for loan losses, management
considers changes in the size and character of the loan portfolio, changes in
non-performing and past due loans, regulatory classification of assets,
historical loan loss experience, the existing risk of individual loans,
concentrations of loans to specific borrowers or industries, existing and
prospective economic conditions, and other factors. The allowance for loan
losses increased $7,680,241 during the nine months ended September 30, 2002 to
$13,754,471 at September 30, 2002 from $6,074,230 at December 31, 2001. The
allowance for loan losses represented 2.51% and 1.20% of net loans receivable at
September 30, 2002 and December 31, 2001, respectively. (See further discussion
in "Provision for Loan Losses" below.)
In the opinion of management, the allowance for loan losses was adequate at
September 30, 2002, to provide for potential loan losses in the loan portfolio
at that date. Management is concerned about the results of its continuing review
of the loan portfolio, as well as the impact a decline in the local economy
could have upon the Bank's ability to improve the quality of its loan portfolio.
While management believes it has established its existing allowance for loan
losses in accordance with generally accepted accounting principles, there can be
no assurance that the Bank will not be required to increase the allowance in the
future. Such increases could have a material adverse affect on the Bank's
financial condition and results of operations. Losses ultimately confirmed will
vary from original estimates and adjustments, as necessary, are made in the
period in which these factors and other considerations become known.
Investment Securities and Other Earning Assets
The investment securities portfolio is used to make various term investments, to
provide a source of liquidity and to serve as collateral to secure certain
government deposits. Federal funds sold are a tool in managing the daily cash
position of the Company. Investment securities and federal funds sold increased
$47,601,225 from December 31, 2001 to $80,211,088 at September 30, 2002. This
increase primarily was due to deposit growth.
19
Asset Quality
Between December 31, 2001 and September 30, 2002, the Company experienced an
increase in nonperforming assets, (defined as nonaccrual loans, loans past due
90 days or greater, restructured loans, nonaccruing securities and other real
estate). Total nonperforming assets increased from $12,415,000 to $20,681,000
during this period of time. The ratio of nonperforming assets to total assets
increased from 2.18% to 3.15% and the ratio of nonperforming loans to total
loans increased from 1.62% to 3.21%. The ratio of loan loss allowance to total
nonperforming assets increased from 48.92% to 66.51%. The Company believes that
due to a continuing weak economy both on a national and statewide basis, these
ratios could further erode over the next several quarters. Moreover, the Company
competes for loans, and has made certain loans to businesses, along the
Birmingham-Huntsville-Decatur high-tech corridor. During the past year, the high
tech industry segment has experienced and continues to experience a more
significant downturn compared with other sectors of the economy. The Company and
the Bank have taken steps to intensively monitor its overall loan portfolio;
including the hiring of additional personnel to monitor credit quality and
adherence to credit policies and procedures. The Bank has hired a seasoned bank
executive as its chief lending officer, and has retained a manager of loan
review. Management believes that these additions, as well as those previously
disclosed, will provide the Bank with the necessary resources to improve
controls over the lending functions, identify any potential areas of concern in
a more timely manner, and ensure that future loans comply with the Bank's
lending policies and procedures.
Deposits
Total deposits of $586,174,168 at September 30, 2002, increased $81,864,430, or
16.2%, over total deposits of $504,309,738 at year-end 2001 primarily due to
demand from investors seeking a relatively safe return on their investments.
Deposits are the Company's primary source of funds with which to support its
earning assets. Noninterest-bearing deposits increased $156,124, or 0.7%, from
year-end 2001 to September 30, 2002, and interest-bearing deposits increased
$81,708,306, or 16.9%, from year-end 2001.
20
Stockholders' Equity
Stockholders' equity decreased $2,376,022 from December 31, 2001 to September
30, 2002, due to the net loss of $4,583,829, the issuance of shares under the
Employee Stock Purchase Plan totaling $25,194, the increase from an unrealized
loss to an unrealized gain on securities available for sale totaling $276,556,
net of deferred taxes, the exercise of stock options, net of shares surrendered,
of $23,571, the recognition of compensatory options of $1,119,986, and the tax
benefit on stock options of $762,500.
Liquidity Management
Liquidity is defined as the ability of a company to convert assets into cash or
cash equivalents without significant loss. Liquidity management involves
maintaining the Company's ability to meet the day-to-day cash flow requirements
of its customers, whether they are depositors wishing to withdraw funds or
borrowers requiring funds to meet their credit needs. Without proper liquidity
management, the Company would not be able to perform the primary function of a
financial intermediary and would, therefore, not be able to meet the production
and growth needs of the communities it serves.
The primary function of asset and liability management is not only to assure
adequate liquidity in order for the Company to meet the needs of its customer
base, but to maintain an appropriate balance between interest-sensitive assets
and interest-sensitive liabilities so that the Company can also meet the
investment requirements of its stockholders. Daily monitoring of the sources and
uses of funds is necessary to maintain an acceptable cash position that meets
both requirements. In the banking environment, both assets and liabilities are
considered sources of liquidity funding and both are, therefore, monitored on a
daily basis.
The asset portion of the balance sheet provides liquidity primarily through loan
principal repayments and sales, and maturities and sales of investment
securities. Loans that mature in one year or less equaled approximately
$190,071,000 or 34.7% of the total loan portfolio at September 30, 2002. Other
sources of liquidity include short-term investments such as federal funds sold
which amounted to $11, 621,000 at September 30, 2002.
The liability portion of the balance sheet provides liquidity through various
customers' interest-bearing and noninterest-bearing deposit accounts. At
September 30, 2002, funds were also available through the purchase of federal
funds from correspondent commercial banks from available lines of up to an
aggregate of $13,500,000. The Bank is also a member of the Federal Home Loan
Bank of Atlanta. Such membership provides the Bank with additional lines of
credit for liquidity needs. This line of credit with the Federal Home Loan Bank
of Atlanta is collateralized by a blanket lien on the Bank's single-family
mortgage portfolio, as well as certain commercial real estate mortgages. As of
September 30, 2002, the Federal Home Loan Bank line of credit permitted
borrowings of up to approximately $63 million and as of September 30, 2002, the
Bank had borrowed $23 million.
Capital Resources
A strong capital position is vital to the continued profitability of the Company
and the Bank because it promotes depositor and investor confidence and provides
a solid foundation for future growth of the organization.
21
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage Trust"), a
Connecticut statutory trust established by the Company, received $10,000,000 in
proceeds in exchange for $10,000,000 principal amount of Heritage Trust's 10.20%
cumulative trust preferred securities (the "preferred securities") in a pooled
trust preferred private placement. The proceeds of that transaction were then
used by Heritage Trust to purchase an equal amount of 10.20% subordinated
debentures (the "subordinated debentures") of the Company. The Company has fully
and unconditionally guaranteed all obligations of Heritage Trust on a
subordinated basis with respect to the preferred securities. The Company
accounts for the Heritage Trust preferred securities as a minority interest.
Subject to certain limitations, the preferred securities qualify as Tier 1
capital and are presented in the Consolidated Statements of Financial Condition
as "Guaranteed preferred beneficial interests in the Company's subordinated
debentures." The sole asset of Heritage Trust is the subordinated debentures
issued by the Company. Both the preferred securities of Heritage Trust and the
subordinated debentures of the Company each have 30-year lives. However, both
the Company and Heritage Trust have a call option of ten years, subject to
regulatory approval, or earlier, depending upon certain changes in tax or
investment company laws, or regulatory capital requirements.
Regulatory authorities are placing increased emphasis on the maintenance of
adequate capital. Capital strength is measured in two tiers that are used in
conjunction with risk-adjusted assets to determine the risk-based capital
ratios. The Company's Tier 1 capital, which consists of common equity less
goodwill and the newly issued guaranteed preferred beneficial interest in the
Company's subordinated debentures, subject to limitations, amounted to
approximately $43,528,000 at September 30, 2002. The Company's Tier 2 capital
components are comprised solely of the allowance for loan losses subject to
certain limitations. Tier 1 capital plus the Tier 2 capital components is
referred to as Total Risk-Based capital and was approximately $50,432,000 at
September 30, 2002.
A recent substantial increase in the allowance for loan losses reduced the Tier
1 capital leverage ratio of the Bank to 6.39% at September 30, 2002.
Accordingly, the Board of Directors and management of the Company and of the
Bank have been engaged in continuing discussions regarding options available to
the Bank to augment its capital ratios. These discussions led to efforts by the
Company to obtain a loan, a portion of the proceeds of which were immediately
contributed to the capital of the Bank.
Loan Agreement
On October 30, 2002, the Company entered into a Loan Agreement with First
Tennessee Bank National Association, pursuant to which the Company is able to
borrow up to $7.5 million (the "First Tennessee Loan"). As part of the First
Tennessee Loan, the Company pledged the stock of the Bank as collateral for such
loan. In addition, directors of the Company executed personal guaranty
agreements as additional security for the First Tennessee Loan. Immediately
following execution of the Loan Agreement, the Company drew down $5 million of
the First Tennessee Loan and contributed said loan proceeds to the capital of
the Bank. Following the $5 million contribution, the Bank's Tier 1 capital
leverage ratio increased to approximately 7.28% as of October 30, 2002.
Going forward, the Company intends to take steps to attain and maintain a Tier 1
capital ratio at the Bank of 7.5% by December 31, 2002, and 8% by March 31,
2003. Although the Company cannot assure that it will be successful in achieving
these capital ratios within these timeframes, management believes that the
22
steps it is taking to access additional capital, implement management changes
and enhance internal controls and procedures will enable the Company to achieve
these objectives. The Board of Directors and management of the Company and the
Bank are actively engaged in the preparation and implementation of strategic
business plans for the Company and the Bank, to address, among other things, the
immediate and anticipated future capital requirements of the Company and the
Bank, taking into account the mix of loans in the Bank's loan portfolio,
earnings, and alternative sources of capital.
Additional Efforts
In addition to the First Tennessee Loan, the Board of Directors and management
of the Company and of the Bank are continuing to review and assess additional
actions to augment capital levels at the Bank and the Company. These actions
include focusing on core earnings at the Bank; attempting to convert non-earning
assets to earning status through aggressive collection and liquidation efforts;
and controlling and contracting the balance sheet of the Bank.
As a result of the declining quality of the Bank's loan portfolio, related
reductions in the capital levels of the Bank, and other operational factors, the
Board of Directors and management is re-evaluating its lending strategy. The
Board of Directors and management are actively taking steps to improve the
underwriting and credit administration practices of the Bank in order to improve
overall asset quality. In addition, in October 2002 the Bank hired a new chief
lending officer to oversee the administration of the Bank's loan portfolio with
primary emphasis on improving overall credit quality of the portfolio. New
policies with respect to loan originations have been formulated which management
believes should enhance the quality of future loan production. Management
intends to continue efforts to originate new loans consistent with improving
overall credit quality, although significant emphasis is now being given to
problem loan administration.
RESULTS OF OPERATIONS
Three months and nine months ended September 30, 2002 and 2001
Summary
Net earnings (loss) of the Company for the quarter ended September 30, 2002 was
($4,422,255), compared to $500,454 for the same period in 2001, representing a
$4,922,709 decrease from prior period income. Net earnings of the Company for
the nine months ended September 30, 2002 were ($4,583,829), compared to
$1,349,247 for the same period in 2001, a $5,933,076 decrease. The Company
increased the allowance for loan losses, net of charge offs and recoveries, on
the September 30, 2002 consolidated balance sheet by $5,229,624. This amount is
in addition to the $2,000,000 added to the "allowance for loan losses" reported
on the Company's Form 10-Q for the quarterly period ended June 30, 2002. After
such increase, as of September 30, 2002, the allowance for loan losses on the
Company's consolidated balance sheet totaled $13,754,471. The financial
performance of the Company may continue to be adversely affected by asset
quality factors as management continues to focus on credit quality, enhanced
internal controls and the adequacy of the allowance for loan losses. As
management continues its evaluation and review of the Bank's credit portfolio,
additional credit losses may be identified.
23
Net Interest Income
Net interest income, the difference between interest earned on assets and the
cost of interest-bearing liabilities, is the largest component of the Company's
net income. Revenue from earning assets of the Company during the nine months
ended September 30, 2002 decreased $1,716,844, or 5%, from the same period in
2001. This decrease was largely a result of the decrease in interest and fee
income on loans. Interest expense for the nine months ended September 30, 2002
decreased $5,797,929, or 26.4%, over the corresponding period of 2001 due to
decreases in interest expense paid on interest-bearing deposits and borrowed
funds. These decreases were due to the impact of rapidly declining interest
rates which outpaced the related loan and deposit volume growth. As a result of
these factors, net interest income increased $4,081,085, or 37.7%, for the nine
months ended September 30, 2002, compared to the same period of 2001.
Provision for Loan Losses
The provision for loan losses represents the charge against current earnings
necessary to maintain the allowance for loan losses at a level which management
considers appropriate. This level is determined based upon the Bank's historical
charge-offs, management's assessment of current economic conditions, the
composition of the loan portfolio and the levels of nonaccruing and past due
loans. The provision for loan losses was $13,075,825 for the nine months ended
September 30, 2002, compared to $2,876,605 for the same period of 2001. The
allowance for loan losses as a percent of outstanding loans, net of unearned
income, was 2.51% at September 30, 2002 compared to 1.20% at year-end 2001.
During the course of a safety and soundness examination, management conducted a
review of a significant portion of the loan portfolio of the Bank, identified
and classified additional assets of the Bank and determined to take appropriate
steps to charge off or establish additional loan loss reserves with respect to
such assets. Accordingly, the Board of Directors determined to increase the
allowance for loan losses substantially, as shown by the increased provision for
loan losses at September 30, 2002.
Noninterest Income
Noninterest income for the nine months ended September 30, 2002 was $1,573,618
compared to $1,116,776 for the same period of 2001. This 40.9% increase
primarily was due to an increase in other operating income and in mortgage
banking fee income.
Noninterest Expenses
Noninterest expenses for the nine months ended September 30, 2002 were
$11,293,123, reflecting a 49.9% increase over the same period of 2001. The
primary component of noninterest expenses is salaries and employee benefits,
which increased to $6,588,241 for the nine months ended September 30, 2002,
58.8% higher than in the same period of 2001. Occupancy costs increased
$224,092, or 25.0%, and other operating expenses increased $1,093,641, or 43.9%,
from the same period of 2001. The primary cause for the noninterest expense
increase is because of the retirement agreement with the former president and
chief executive officer that allowed for a retirement obligation in the form of
salary and compensatory stock option expense of an aggregate pre-tax amount of
approximately $2.0 million.
24
Income Taxes
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of ($2,702,600) for the nine months ended September
30, 2002 decreased $3,486,102 compared to the same period of 2001. Taxes as a
percent of earnings (loss) increased from 36.7% to 37.1%. The effective tax rate
of approximately 37.1% for the nine months ended September 30, 2002, is more
than the federal statutory rate principally because of state income taxes.
Recently Issued Accounting Standards
In May 2001, the Auditing Standards Board issued Statement on Auditing Standards
("SAS") No. 94, The Effect of Information Technology on the Auditor's
Consideration of Internal Control in a Financial Statement Audit. This statement
amends SAS No. 55, Consideration of Internal Control in a Financial Statement
Audit, by providing additional guidance related to the understanding by the
auditor of an entity's use of information technology relevant to the audit. This
auditing standard is effective for audits of financial statements for periods
beginning on or after June 1, 2001. The impact on the audit of the Company's
consolidated financial statements resulting from the issuance of this auditing
standard is not expected to be material.
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 141, Business Combinations. This
statement addresses financial accounting and reporting for business combinations
and supersedes APB Opinion No. 16, Business Combinations, and SFAS No. 38,
Accounting for Preacquisition Contingencies of Purchased Enterprises. All
business combinations in the scope of SFAS No. 141 are to be accounted for using
one method, the purchase method. Prior to the issuance of this statement,
subject to certain criteria, business combinations were accounted for using one
of two methods, the pooling-of-interests method or the purchase method. The two
methods produce different financial statement results. The single-method
approach used in SFAS No. 141 reflects the conclusion that virtually all
business combinations are acquisitions and therefore should be accounted for in
the same manner as other asset acquisitions based on the values exchanged. This
statement provides expanded and revised guidance related to the allocation of
the purchase price to goodwill and other intangibles arising from the business
combination. The provisions of SFAS No. 141 apply to all business combinations
initiated after June 30, 2001.
Also in June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which addresses financial accounting and reporting for acquired goodwill
and other intangible assets and supersedes APB Opinion No. 17, Intangible
Assets. SFAS No. 142 provides new standards for accounting relating to
intangible assets after initial recognition in the financial statements. This
statement proscribes the accounting practice of amortizing or expensing
intangibles ratably over a prescribed period of time and imposes new guidance
requiring that goodwill and certain other intangibles be tested for impairment
at least annually by comparing fair values of those assets with their recorded
amounts. Additional disclosure requirements also are provided. The provisions of
SFAS No. 142 are required to be applied in fiscal years beginning after December
15, 2001.
The adoption of SFAS No. 141 and SFAS No. 142 are not expected to have a
material effect on the Company's consolidated financial statements due to the
absence of any goodwill or intangibles on the Company's books.
25
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations. This statement requires that the fair value of a liability for an
asset retirement obligation be recognized in the period in which it is incurred
if a reasonable estimate of fair value can be made. The associated asset
retirement costs are capitalized as part of the carrying amount of the
long-lived asset. This statement is effective for financial statements issued
for fiscal years beginning after June 15, 2002. The adoption of this statement
is not expected to have a material effect on the Company's consolidated
financial statements.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-lived Assets. This statement addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. This statement
supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and
reporting provisions of APB Opinion No. 30, Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for
the disposal of a segment of a business (as previously defined in that opinion).
This statement also amends Accounting Research Bulletin No. 51, Consolidated
Financial Statements, to eliminate the exception to consolidation for a
subsidiary for which control is likely to be temporary. The major changes
resulting from this statement relate to the establishment of a single method for
the recognition of impairment losses on long-lived assets to be held and used
whether from discontinuance of a business segment or otherwise. This statement
is effective for financial statements issued for fiscal years beginning after
December 15, 2001. The adoption of this statement is not expected to have a
material effect on the Company's consolidated financial statements.
In December 2001, the Accounting Standards Executive Committee issued Statement
of Position ("SOP") 01-6, Accounting by Certain Entities (Including Entities
With Trade Receivables) That Lend to or Finance the Activities of Others. This
statement reconciles and conforms the accounting and financial reporting
provisions for similar transactions as applied to different entities within the
financial services industry. It eliminates differences in disclosure practices
where not warranted and should provide greater consistency in reporting by
entities in the financial services industry. This statement is effective for
annual and interim financial statements issued for fiscal years beginning after
December 15, 2001. The adoption of SOP 01-6 is not expected to have a material
effect on the Company's consolidated financial statements.
In April 2002, the Financial Accounting Standards Board issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No.
13, and Technical Corrections. Management is currently evaluating the impact
that SFAS No. 145 will have on the Company's financials, but as a result of very
limited applicability, does not expect the adoption will have a material effect.
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal Activities. The statement
addresses financial reporting and accounting for costs associated with exit or
disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring). The
primary difference between SFAS No. 146 and Issue 94-3 relates to the
requirement for recognition of a liability related to the cost of an exit or
disposal activity when the liability is incurred. Under 94-3, such liability
would be recognized at the date of an entity's commitment to an exit plan. SFAS
No. 146 is effective for exit or disposal activities initiated after
26
December 31, 2002, with early application encouraged. Management does not
believe the adoption of SFAS No. 146 will have a material impact on the
Company's financials.
In October 2002, the Financial Accounting Standards Board issued SFAS No. 147,
Acquisitions of Certain Financial Institutions, an amendment of SFAS No. 72 and
144 and FASB Interpretation No. 9. Except for transactions between two or more
mutual enterprises, SFAS No. 147 removes acquisitions of financial institutions
from the scope of SFAS No. 72 and Interpretation 9 and requires those
transactions be accounted for in accordance with SFAS No. 141 and 142. SFAS No.
147 also amends SFAS No. 144 to include in its scope long-term
customer-relationship intangible assets of financial institutions such as
depositor and borrower relationship intangible assets and credit cardholder
intangible assets. Consequently, those intangible assets are subject to the same
undiscounted cash flow recoverability test and impairment loss recognition and
measurement provisions that SFAS No. 144 requires for other long-lived assets
that are held and used. SFAS No. 147 is essentially effective as of October 1,
2002. As a result, the Company adopted SFAS No. 147 on October 1, 2002, with no
material impact on the Company's financials.
Critical Accounting Policies
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a description of the
accounting policies applied by the Company which are deemed "critical." In
determining which accounting policies are "critical" in nature, the Company has
identified the policies that require significant judgment or involve complex
estimates. The application of these policies has a significant impact on the
Company's financial statements. Financial results could differ significantly if
different judgments or estimates are applied.
Allowance for Loan Losses
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of the
adequacy of the allowance for loan losses is based on a formal analysis which
assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, level of
nonperforming loans, loan concentrations, and review of certain individual
loans. Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the bank's allowances for loan
losses. Such agencies may require the bank to recognize additions to the
allowance for loan losses based on their judgments.
27
Forward-Looking Information
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements made by us or on our behalf. Some of the disclosures
in this Quarterly Report on Form 10-Q, including any statements preceded by,
followed by or which include the words "may," "could," "should," "will,"
"would," "hope," "might," "believe," "expect," "anticipate," "estimate,"
"intend," "plan," "assume" or similar expressions constitute forward-looking
statements.
These forward-looking statements, implicitly and explicitly, include the
assumptions underlying the statements and other information with respect to our
beliefs, plans, objectives, goals, expectations, anticipations, estimates,
intentions, financial condition, results of operations, future performance and
business, including our expectations and estimates with respect to our revenues,
expenses, earnings, return on equity, return on assets, efficiency ratio, asset
quality and other financial data and capital and performance ratios.
Any forward-looking statements are subject to numerous assumptions, risks and
uncertainties because of the possibility of changes in underlying factors and
assumptions. Actual results could differ materially from those contained in or
implied by such forward-looking statements for a variety of factors including:
recommendations made by or actions taken by banking regulatory authorities;
significant changes in the economic scenario from the current anticipated
scenario which could materially change anticipated credit quality trends; the
value of investment securities and the ability to generate loans; significant
delay in or inability to execute strategic initiatives designed to increase
capital, reduce non-performing loans and classified assets, grow revenues and
control expenses; ability to maintain sufficient liquidity and cash flow and
significant changes in accounting, tax or regulatory practices or requirements;
changes in interest rates; financial, legal, regulatory or other changes
affecting the banking and financial services industries in general; continued
intense competition from numerous providers of products and services which
compete with the Company's businesses, and other factors listed from time to
time in the Company's SEC reports, including, but not limited to, the Annual
Report on Form 10-K/A for the year ended December 31, 2001.
Whenever possible, the Company has identified these forward-looking statements
(as defined in Section 21E of the Securities Exchange Act of 1934) by words such
as "anticipates," "may," "believes," "estimates," "projects," "expects,"
"intends," and words of similar import. In addition to the statements included
in this Quarterly Report on Form 10-Q, the Company and its representatives may
from time to time make other oral or written statements that are also
forward-looking statements.
The Company expressly disclaims any obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
If one or more of the factors affecting our forward-looking information and
statements proves incorrect, then our actual results, performance or
achievements could differ materially from those expressed in, or implied by,
forward-looking information and statements contained in this Quarterly Report.
Therefore, we caution you not to place undue reliance on our forward-looking
information and statements. We do not intend to update our forward-looking
information and statements, whether written or oral, to reflect change. All
forward-looking statements attributable to us are expressly qualified by these
cautionary statements.
28
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk arising from adverse changes in the fair value of
financial instruments due to a change in interest rates, exchange rates and
equity prices. The Company's primary market risk is interest rate variations in
the short-term time horizons also known as interest rate risk.
The primary objective of Asset/Liability Management at the Company is to manage
interest rate risk and achieve reasonable stability in net interest income
throughout interest rate cycles. This is achieved by maintaining the proper
balance of rate sensitive earning assets and rate sensitive liabilities. The
relationship of rate sensitive earning assets to rate sensitive liabilities is
the principal factor in projecting the effect that fluctuating interest rates
will have on future net interest income. Rate sensitive earning assets and
interest-bearing liabilities are those that can be repriced to current market
rates within a relatively short time period. Management monitors the rate
sensitivity of securities over the entire life of these instruments, but places
particular emphasis on the first year. The Company's Asset/Liability Management
policy requires risk assessment relative to interest pricing and related terms.
The Company uses additional tools to monitor and manage interest rate
sensitivity. One of the primary tools is simulation analysis. Simulation
analysis is the primary method of estimating earnings at risk and capital at
risk under varying interest rate conditions. Simulation analysis is used to test
the sensitivity of the Company's net interest income and stockholders' equity to
both the level of interest rates and the slope of the yield curve. Simulation
analysis accounts for the expected timing and magnitude of assets and liability
cash flows, as well as the expected timing and magnitude of deposits that do not
reprice on a contractual basis. In addition, simulation analysis includes
adjustments for the lag between movements in market interest rates on loans and
interest-bearing deposits. These adjustments are made to reflect more accurately
possible future cash flows, repricing behavior and ultimately net interest
income.
[The remainder of this page intentionally left blank]
29
As of September 30, 2002, the Company's simulation analysis reflected that the
Company is at greatest risk in a decreasing interest rate environment. The table
below depicts the results of the simulation assuming one and two percent
decreases and increases in the prime interest rates in a one year time horizon.
Interest Rate Risk
(Amounts in thousands)
One Year Time Horizon
Estimated Repricing Amounts
Down Up Down Up
1 Percent 1 Percent 2 Percent 2 Percent
------------ ------------- ------------- --------------
Rate Sensitive Assets:
Loans......................................... $ 330,859 $ 315,800 $ 340,898 $ 310,780
Deposits in banks............................. 4,611 4,611 4,611 4,611
Federal funds sold............................ 11,621 11,621 11,621 11,621
Securities.................................... 44,354 38,168 46,051 33,277
------------ ------------- ------------- --------------
Total Rate Sensitive Assets................. 391,445 370,200 403,181 360,289
------------ ------------- ------------- --------------
Rate Sensitive Liabilities
Deposits - Demand............................. 26,504 35,327 26,504 35,327
Deposits - Time............................... 251,316 251,316 251,316 251,316
Other borrowings.............................. 33,000 33,000 33,000 33,000
------------ ------------- ------------- --------------
Total Rate Sensitive Liabilities............ 310,820 319,643 310,820 319,643
------------ ------------- ------------- --------------
Rate Sensitivity Gap............................. $ 80,625 $ 50,557 $ 92,361 $ 40,646
============ ============= ============= ==============
Change in Amount of Net Interest Margin.......... $ (1,136) $ 836 $ (2,507) $ 1,313
============ ============= ============= ==============
Change in Percent of Net Interest Margin......... (0.17)% 0.13% (0.38)% 0.20%
=========== ============ ============= =============
30
Item 4. Controls and Procedures
(a) Within the 90 days prior to the date of filing this Quarterly Report on
Form 10-Q, the Company carried out an evaluation, under the supervision and
participation of its management, including the Chief Executive Officer and
the Chief Financial Officer, of the effectiveness of the design and
operation of the Company's disclosure controls and procedures pursuant to
Exchange Act Rules 13a-14(c) and 15d-14(c). Based on that evaluation, the
Chief Executive Officer and the Chief Financial Officer concluded that the
Company's disclosure controls and procedures are effective in timely
alerting them to material information relating to the Company (including
its consolidated subsidiaries) required to be included in the Company's
periodic SEC filings. However, the Company recently has experienced several
changes in top management, and the effectiveness of such disclosure
controls and procedures is dependent on the Company's personnel to report
any issues or matters required to be disclosed in the Company's SEC filings
to the appropriate management personnel on a timely basis.
(b) As previously reported, banking regulatory authorities recently performed
both a targeted, limited scope review of the Bank's loan portfolio and a
safety and soundness examination of the Bank. In conjunction with these
reviews, management commenced a comprehensive review of the Company's
internal control structures. Management's review of the internal control
structures of the Company and the Bank indicated significant weaknesses in
the Company's and the Bank's internal controls and procedures, particularly
with respect to the Bank's lending functions, including credit underwriting
and loan review. As a result of the information gathered in the course of
these reviews, management of both the Company and the Bank have taken steps
to modify and supplement internal controls and procedures in order to
augment the Company's reporting and to ensure timely evaluation of
reporting regarding the operations of the Bank, particularly with respect
to the credit and asset quality of the Bank. Furthermore, in the course of
these reviews, the Company and the Bank determined that certain internal
controls relating to loan policies and procedures have not been followed by
Bank personnel, and have taken steps to correct these matters, including
the dismissal of certain employees of the Bank. The Bank has retained a new
President and Chief Executive Officer, and, additionally, the Company has
changed outside legal counsel. Management of the Company is continuing to
review and modify the Company's internal controls and procedures. This
review process is currently ongoing and is not complete as of the date of
the filing of this Quarterly Report on Form 10-Q. Management has disclosed
the control weaknesses to its Audit Committee and to the outside auditors
of the Company, and is continuing to seek their advice and support in
revising and supplementing the internal controls and procedures of the
Company and the Bank.
31
Part II - Other Information
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Exhibit Page
- ----------- ------------------------------------------------------------------------------------- --------
10.1 Employment Contract for Thomas E. Hemmings 36
11 Computation of Per Share Earnings 45
99.1 Chief Executive Officer - Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 46
99.2 Chief Financial Officer - Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 47
(b) Reports on Form 8-K
During the quarter ended September 30, 2002, no reports were filed for the
Company on Form 8-K.
32
SIGNATURES
Pursuant to the requirements 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.
HERITAGE FINANCIAL HOLDING CORPORATION
By: /s/ Harold B. Jeffreys November 19, 2002
------------------------------------- ---------------------------
Harold B. Jeffreys Date
Interim President and
Chief Executive Officer
By: /s/ Thomas E. Hemmings November 19, 2002
------------------------------------- ---------------------------
Thomas E. Hemmings Date
Chief Financial Officer
33
CERTIFICATIONS
I, Harold B. Jeffreys, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Heritage Financial
Holding Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 19, 2002
----------------------------------------
/s/ Harold B. Jeffreys
- ---------------------------------------------
Harold B. Jeffreys
Interim President and Chief Executive Officer
34
CERTIFICATIONS
I, Thomas E. Hemmings, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Heritage Financial
Holding Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 19, 2002
--------------------------------------
/s/ Thomas E. Hemmings
- -------------------------------------------
Thomas E. Hemmings
Chief Executive Officer
35
Exhibit 10.1 - Employment Agreement
EMPLOYMENT AGREEMENT
THIS AGREEMENT (this "Agreement"), is made and entered into this day of
September, 2002, but made effective as of July 11, 2002, by and among Heritage
Financial Holding Corporation, a Delaware corporation (hereinafter referred to
as the "Company"), Heritage Bank, an Alabama state banking corporation (the
"Bank"), and Thomas E. Hemmings (the "Executive").
W I T N E S S E T H:
- - - - - - - - - -
WHEREAS, the Company and the Bank desire to employ the Executive on the
terms and conditions hereinafter provided, and the Executive desires to be
employed by the Company and the Bank on such terms and conditions;
NOW, THEREFORE, in consideration of the mutual promises, covenants and
agreements set forth in this Agreement, the parties agree as follows:
SECTION 1: EMPLOYMENT OF EXECUTIVE; DUTIES AND RESPONSIBILITIES
1.1 Employment of Executive. The Company shall employ the Executive, and the
Executive shall provide services to the Company, as Chief Financial Officer
of the Company and the Bank, subject to the terms and conditions of this
Agreement.
1.2 Term of Employment of Executive. Subject to the provisions of Section 3
hereof, the employment of the Executive by the Company and the Bank
pursuant to this Agreement shall be for an initial term of two (2) years
commencing on July 11, 2002, and ending on July 10, 2004; provided that
unless the Executive's employment hereunder is sooner terminated pursuant
to Section 3 hereof or unless either party shall given written notice to
the other not later than thirty (30) days prior to the end of the term or
any renewal period thereof, of its intention not to renew the term of this
Agreement, the Agreement shall be automatically renewed for a renewal term
of two (2) years. The period of the Executive's employment hereunder is
referred to herein as the "Employment Period."
36
1.3 Offices and Positions of Executive. Effective as of July 11, 2002, except
as otherwise mutually agreed by the Company, the Bank and the Executive and
subject to Section hereof, the Executive shall serve as Chief Financial
Officer of the Company and of the Bank.
1.4 Duties and Responsibilities. During the Employment Period, the Executive
shall report directly to the Chief Executive Officer of the Company and
shall perform such duties and responsibilities as the Chief Executive
Officer shall reasonably assign to the Executive from time to time and as
are commensurate with his position with the Company. With respect to his
position with the Bank, during the Employment Period, the Executive shall
report directly to the Chief Executive Officer of the Bank and shall
perform such duties and responsibilities as the Chief Executive Officer of
the Bank shall reasonably assign to the Executive from time to time and as
are commensurate with his position with the Company. During the Employment
Period, Executive shall devote his full business time and attention to the
performance of his duties hereunder. The Executive's office shall be
located in, or within fifty miles, of the City of Decatur, Alabama, but the
Executive understands and agrees that performance of his duties hereunder
may involve extensive travel.
SECTION 2: COMPENSATION; REIMBURSEMENT; AND BENEFITS
2.1 Base Salary and Bonus. During the Employment Period, the Company shall pay
to the Executive the annual base salary (the "Base Salary") at the rate of
$127,500 per year, beginning July 11, 2002. The Base Salary shall be
reviewed no less frequently than annually by the compensation committee of
the Board of Directors of the Company; if the compensation committee
modifies the Base Salary upon any such review then, for purposes of this
Agreement, the term Base Salary shall thereafter mean such modified amount.
In addition to the Base Salary, the Company may pay the Executive such
bonus or bonuses, if any, as the Board of Directors of the Company may from time
to time determine. The Executive shall be eligible to be considered for bonuses
under the Executive Management Bonus Program of the Company, and the Company
will develop specific criteria for the position of Chief Financial Officer under
the terms of such Executive Management Bonus Program.
2.2 Payment of Base Salary and Bonus. The Company shall pay the Base Salary and
bonuses, if any, due the Executive in accordance with the policy or
policies of the Company as in effect from time to time for the payment of
salary and bonuses to senior executive personnel.
37
2.3 Other Benefits. The Executive shall be entitled to participate on the same
basis as other similarly situated employees of the Company and the Bank in
all incentive and benefit programs or arrangements made available by the
Company to such employees. If the Executive elects to participate in the
Company's health and dental benefit program, the Company will pay [____]
percent of Executive's premium payments due under such insurance benefit.
2.4 Automobile; Cellular Telephone. During the Employment Period, the Company
will furnish the Executive with the use of an automobile, having a purchase
price not exceeding $30,000, subject to the policies and procedures of the
Company with respect to the personal use of such automobile. During the
Employment Period, the Company will furnish the Executive with the use of a
cellular telephone subject to the policies and procedures of the Company
with respect to the personal use of such telephone.
2.5 Business Expenses. The Company shall reimburse the Executive for all
reasonable expenses incurred by him in accordance with the standard
policies and procedures of the Company in the course of rendering his
services pursuant to this Agreement; provided, however, that the Executive
shall promptly submit such reasonable documentation as may be requested by
the Company to verify such expenditures.
2.6 Education Fees and/or Professional Dues. During the Employment Period, the
Company will provide the Executive with an annual allowance of $2,000 to be
applied toward continuing education fees and/or professional dues incurred
by the Executive.
2.7 Vacation. The Executive shall be entitled to three (3) weeks of paid
vacation per year. The vacation to which the Executive is entitled pursuant
to this Section 2.7 shall be available under the same terms and conditions
(including, without limitation, the ability of the Executive to accrue and
carry over earned or unused vacation time from year to year) as are
applicable to similarly situated executive personnel of the Company and the
Bank. The Executive shall take into consideration the needs of the Company
and the Bank in setting his vacation schedule.
SECTION 3: TERMINATION OF EMPLOYMENT
3.1 Termination of Employment Period. The Employment Period may be terminated
in the following manner:
38
(a) Termination on Death or Disability. The Employment Period shall
automatically terminate upon the death or Disability of the Executive.
The term "Disability" shall mean the Executive's physical or mental
incapacity that renders him incapable of performing the essential
functions of the duties required of him by this Agreement for one
hundred eighty (180) or more consecutive days, even with reasonable
accommodation. In the case of termination upon the Disability of the
Executive, there shall be a determination by the Board of Directors of
the Company, or by an officer to whom the Board of Directors of the
Company has delegated the authority to make such determination, that
such grounds for termination exist.
(b) Termination upon Notice. The Employment Period may be terminated by
the Executive at any time, upon thirty (30) days' written notice to
the Company. The Employment Period may be terminated by the Company,
by resolution of the Board of Directors of the Company or by decision
of an officer to whom the Board of Directors of the Company has
delegated authority to make such decision, for any other reason other
than for "Cause" (as defined in Section 3.1(c) of this Agreement),
upon thirty (30) days written notice to the Executive.
(c) Termination for Cause. The Employment Period may be terminated by the
Company, by resolution of the Board of Directors of the Company or by
decision of the Chief Executive Officer or any other officer to whom
the Board of Directors of the Company has delegated authority to make
such decision, for "Cause" at any time during the Employment Period
immediately upon written notice to the Executive, which notice shall
state the facts constituting such "Cause." For the purpose of this
Section , the term "Cause" shall mean (i) intentional misconduct or
gross malfeasance, or an act or acts of gross negligence in the course
of employment or any material breach of Executive's obligations
contained herein, including, without limitation, acts competitive with
or deliberately harmful to the business of the Company or the Bank;
(ii) any intentional misstatement or omission to the directors or
executive officers of the Company or the Bank with respect to any
matter; (iii) the intentional failure of the Executive to follow the
reasonable instructions and policies of the Company or the Bank; (iv)
the Executive's conviction, admission or confession of any felony or
an unlawful act involving active and willful fraud or moral turpitude;
or (v) the violation by the Executive of applicable state and federal
regulations, rules, or statutes. The Company shall have the power to
temporarily suspend Executive with such pay, if any, as the Company
may determine from duty if there is substantial evidence of probable
Cause until Cause is either proved or disproved; if disproved, full
reinstatement will immediately be effected.
39
(d) Termination for Good Reason. The Employment Period may be terminated
by the Executive for "Good Reason," as hereinafter defined, at any
time during the Employment Period upon thirty (30) days' written
notice to the Company, which notice shall state the facts constituting
such "Good Reason." For the purpose of this Section 3.1(d), the term
"Good Reason" shall mean (i) following a Change in Control (as
hereinafter defined), a significant change, without the consent of the
Executive, in the nature or scope of the Executive's authorities or
duties from those described in Sections 1.3 and 1.4 or those generally
commensurate with the position of Chief Financial Officer; (ii)
following a Change in Control, the relocation by the Company of the
Executive's office more than fifty miles outside of the City of
Decatur, Alabama, or (iii) notification by the Company and the Bank
pursuant to Section 1.2 hereof that the Company and the Bank elect not
to renew the term of this Agreement. For the purpose of this Section
3.1(d), the term "Change in Control" means (A) the acquisition at any
time by a "person" or "group" (as such terms are used in Sections
13(d) and 14(d)(2) of the Securities Exchange Act of 1934 (the
"Exchange Act")) who or which are the beneficial owners (as defined in
Rule 13(d)-3 under the Exchange Act), directly or indirectly, of
securities representing more than 35% of the combined voting power in
the election of directors of the then outstanding securities of the
Company or any successor of the Company, unless the acquisition of
securities resulting in such ownership by such person or group had
been approved by the Board of Directors of the Company; (B) the
termination of service of directors, for any reason other than death,
disability or retirement from the Board of Directors, during any
period of two consecutive years or less, of individuals who at the
beginning of such period constituted a majority of the Board of
Directors, unless the election of or nomination for election of each
new director during such period was approved by a vote of at least a
majority of the directors still in office who were directors at the
beginning of the period; (C) approval by the shareholders of the
Company of any sale or disposition of substantially all of the assets
or earning power of the Company; or (D) approval by the shareholders
of the Company of any merger, consolidation, or statutory share
exchange to which the Company is a party as a result of which the
persons who were shareholders immediately prior to the effective date
of the merger, consolidation or share exchange shall have beneficial
ownership of less than 35 % of the combined voting power in the
election of directors of the surviving corporation.
3.2 Consequences of Termination.
(a) By the Company for Cause or By Executive other than for Good Reason.
In the event Executive's employment is terminated (i) by the Company
for Cause under Section hereof, (ii) by the Executive other than for
Good Reason under Section 3.1(d) hereof, (iii) as a result of the
Executive's death or Disability under Section hereof, or (iv) by the
Company for
40
any reason, with or without Cause, after the fifth anniversary of the
commencement of the initial term of the Employment Period, the Company
shall be under no further obligation to make any payments or provide
any benefits to the Executive, except for Base Salary earned but
unpaid at the time of such termination, expenses otherwise
reimbursable herein incurred by, but not yet reimbursed to, the
Executive at the time of such termination, any earned but unpaid
incentive awards due to the Executive, and group health coverage that
is required to be continued by applicable law.
(b) By the Company other than for Cause or By Executive for Good Reason.
In the event the Employment Period is terminated by the Executive for
Good Reason under Section 3.1(d) hereof or by the Company for a reason
other than Cause pursuant to Section 3.1(b) hereof, including without
limitation termination of Executive's employment in connection with an
election by the Company (without Cause) not to renew the term of this
Employment Agreement pursuant to Section 1.2 hereof, prior to the
fifth anniversary of the commencement of the initial term of the
Employment Agreement, the Company shall pay to the Executive a
lump-sum payment equal to one and one-half (1.5) times the Base
Salary.
(c) Obligation of the Company to make the payments under Section 3.2(b) of
this Agreement. Compliance by the Executive with Section 4 of this
Agreement is a condition precedent to the Company's obligation to
make, or to continue to make, the payments referred to in Section 3.2
of this Agreement.
(d) Payments made to the Executive net of Taxes. All payments made by the
Company to the Executive pursuant to this Agreement shall be received
by the Executive net of all applicable withholding and payroll taxes.
SECTION 4: CONFIDENTIALITY PROVISIONS; PROHIBITION OF INSIDER TRADING AND
TIPPING
4.1 Confidentiality. (a) The Executive hereby acknowledges that during the
Employment Period he will have contacts with and develop and service the
customers of the Company, the Bank and their affiliates and that in all of
his activities, and through the nature of complying with his obligations
pursuant to this Agreement, he will have access to and will acquire
confidential and proprietary information, including, but not limited to,
information relating to the business, assets, operations, customers,
suppliers, contractual parties and other persons with whom the Company, the
Bank and their affiliates do business. The Executive hereby acknowledges
and confirms that such information constitutes the exclusive and unique
41
property of the Company, the Bank or their affiliates, as the case may be,
and that such information is proprietary and confidential in nature.
(b) The Executive agrees that he shall not at any time during the term of
Employment or thereafter disclose to other persons or entities (except
as permitted in writing and as directed by the Chief Executive Officer
or Board of Directors of the Company or only as to the extent required
pursuant to a subpoena or order of a court of competent jurisdiction)
any such information referred to in Section 4.1(a) of this Agreement.
4.2 Prohibition of Insider Trading and Tipping. The Executive acknowledges that
during the Employment Period he may become aware of or be provided with
material non-public information concerning the Company. The Executive
acknowledges and agrees that the trading in, purchase or sale of any
security of the Company while in possession of any material non-public
information concerning the Company is prohibited as is the unauthorized
communication of any such information to any person or entity. The
Executive agrees to abide by these prohibitions and shall use all
reasonable efforts to cause his affiliates to abide by these prohibitions.
4.3 Specific Performance. The Executive agrees that in the event of a breach or
threatened breach of Section 4.1 or 4.2 of this Agreement, that the Company
and the Bank are likely to suffer, and will suffer, immediate and
irreparable injury for which there is no adequate remedy at law. Therefore,
in addition to any other rights or remedies which the Company and the Bank
may have under this Agreement, the Company and the Bank will be entitled to
enforce the specific performance of this Agreement by the Executive and to
obtain a preliminary injunction, without the requirement of posting a bond,
enjoining the Executive from engaging in any activity in violation thereof.
SECTION 5: GENERAL PROVISIONS
5.1 Non-assignability. Neither this Agreement nor any of the rights,
obligations or interest arising hereunder may be assigned by the Executive
without the prior written consent of the Company and the Bank; provided,
however, that nothing in this Section 5.1 shall preclude the Executive from
designating, in writing, a beneficiary to receive any compensation payable
to him or any other benefit receivable by him under this Agreement upon the
death or incapacity of the Executive, nor shall it preclude the executors,
administrators or any other legal representatives of the Executive or his
estate from assigning any rights hereunder to the person or persons
entitled thereto. Neither this Agreement nor any of the rights, obligations
42
or interest arising hereunder may be assigned by the Company and the Bank
without the prior written consent of the Executive to a person other than
(1) an affiliate of the Company, or (2) any party with which the Company
merges or consolidates, or to whomever the Company may sell all or
substantially all of its assets; provided, however, that any such affiliate
or successor shall expressly assume all of the Company's and the Bank's
obligations and liabilities to the Executive under this Agreement.
5.2 Severability. This Agreement shall be deemed severable and any part hereof
which may be held invalid by a court or other entity of competent
jurisdiction shall be deemed automatically excluded from this Agreement and
the remaining parts shall remain in full force and effect.
5.3 Merger. This Agreement contains the entire understanding of the parties
hereto and constitutes the only agreement between the Company, the Bank and
the Executive regarding the employment of the Executive by the Company and
the Bank. This Agreement supersedes all prior agreements, either express or
implied, between the parties hereto regarding the employment of the
Executive by the Company and/or the Bank.
5.4 Amendment. None of the terms and conditions of this Agreement shall be
amended or modified unless expressly consented to in writing and signed by
each of the parties hereto.
5.5 Governing Law. This Agreement shall be governed by and construed under the
laws of the State of Alabama without regard to provisions thereof governing
conflicts of law.
5.6 Notices. All notices or other communications to be given by the parties
among themselves pursuant to this Agreement shall be in writing, and all
payments to be made hereunder shall be deemed to have been duly made if
mailed by certified mail or hand delivered to either of the parties at
their respective addresses as they appear on the records of the Company.
Any of the parties hereto may change their respective addresses upon
written notice to the other given in the manner provided in this Section.
5.7 Waiver. No waiver by any of the parties to this Agreement of any condition,
term or provision of this Agreement shall be deemed to be a waiver of any
preceding or subsequent breach of the same or any other condition, term or
provision hereof.
43
5.8 Survival. Notwithstanding anything in this Agreement to the contrary, and
notwithstanding any termination of the Employment Period, the provisions of
this Agreement intended to govern the obligations of the parties hereto
upon the termination of the Executive's employment with the Company for any
reason, including, but not limited to Section 3 (inclusive of each of the
subsections thereof) and Section 4, shall continue in full force and
effect.
IN WITNESS WHEREOF, the parties hereto have duly executed this Agreement as
at the date and year first above written.
HERITAGE FINANCIAL HOLDING
CORPORATION
-----------------------------------
Timothy A. Smalley
Chairman of the Board of Directors
HERITAGE BANK
{-----------}
Its ____________________
Thomas E. Hemmings
44
Exhibit 11 - Statements Re: Computation of Per Share Earnings
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
COMPUTATION OF EARNINGS PER COMMON SHARE
The following tabulation presents the calculation of basic and diluted earnings
per common share for the three-month and nine-month periods ended September 30,
2002 and 2001.
Three Months Nine Months
Ended September 30, Ended September 30,
------------------------------- -------------------------------
2002 2001 2002 2001
--------------- ------------- --------------- --------------
Basic Earnings Per Share:
Net income (loss)............................. $ (4,422,255) $ 500,454 $ (4,583,829) $ 1,349,247
=============== ============= =============== ==============
Earnings (loss) on common shares.............. $ (4,422,255) $ 500,454 $ (4,583,829) $ 1,349,247
=============== ============= =============== ==============
Weighted average common shares
outstanding - basic......................... 8,816,300 8,487,131 8,682,310 8,481,713
=============== ============= =============== ==============
Basic earnings (loss) per common share........ $ (0.50) $ 0.06 $ (0.53) $ 0.16
=============== ============= =============== ==============
Diluted Earnings Per Share:
Net income (loss)............................. $ (4,422,255) $ 500,454 $ (4,583,829) $ 1,349,247
=============== ============= =============== ==============
Weighted average common shares
outstanding - diluted....................... 10,157,201 10,549,935 10,122,745 10,506,786
=============== ============= =============== ==============
Diluted earnings (loss) per common share...... $ (0.44) $ 0.05 $ (0.45) $ 0.13
=============== ============= =============== ==============
45
Exhibit 99.1
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002
In connection with Heritage Financial Holding Corporation's ("Company")
Quarterly Report on Form 10-Q for the period ended September 30, 2002
("Report"), the undersigned certifies that:
1. The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
Date: November 19, 2002 By: /s/ Harold B. Jeffreys
--------------------- ---------------------------------------------
Harold B. Jeffreys
Interim President and Chief Executive Officer
46
Exhibit 99.2
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002
In connection with Heritage Financial Holding Corporation's ("Company")
Quarterly Report on Form 10-Q for the period ended September 30, 2002
("Report"), the undersigned certifies that:
1. The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
2. The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
Date: November 19, 2002 By: /s/ Thomas E. Hemmings
--------------------- ---------------------------------------------
Thomas E. Hemmings
Chief Financial Officer
47