of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain activities authorized by Office of Thrift Supervision regulation.
A savings and loan holding company is prohibited from, directly or indirectly, acquiring more than 5% of the voting stock of another financial institution or savings and loan holding company, without prior written approval of the Office of Thrift Supervision and from acquiring or retaining control of a depository institution that is not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision considers the financial and managerial resources and future prospects of the Company and institution involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community and competitive factors.
The Office of Thrift Supervision may not approve any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Although savings and loan holding companies are not currently subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, federal regulations do prescribe such restrictions on subsidiary savings institutions as described below. The Bank must notify the Office of Thrift Supervision 30 days before declaring any dividend to the Company. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the Office of Thrift Supervision and the agency has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution.
The Sarbanes-Oxley Act of 2002, which implemented legislative reforms intended to address corporate and accounting fraud, restricts the scope of services that may be provided by accounting firms to their public company audit clients and any non-audit services being provided to a public company audit client will require preapproval by the company’s audit committee. In addition, the Sarbanes-Oxley Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission, subject to civil and criminal penalties if they knowingly or willingly violate this certification requirement.
Under the Sarbanes-Oxley Act, bonuses issued to top executives before restatement of a company’s financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives (other than loans by financial institutions permitted by federal rules and regulations) are restricted. The legislation accelerates the time frame for disclosures by public companies and changes in ownership in a company’s securities by directors and executive officers.
The Sarbanes-Oxley Act also increases the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company’s “registered public accounting firm.” Among other requirements, companies must disclose whether at least one member of the committee is a “financial expert” (as such term is defined by the Securities and Exchange Commission) and if not, why not.
Although the Company has incurred additional expense in complying with the provisions of the Sarbanes-
Oxley Act and the resulting regulations, management does not believe that such compliance had a material impact on results of operations or financial condition.
Federal Savings Institution Regulation
Business Activities. Federal law and regulations govern the activities of federal savings banks. These laws and regulations delineate the nature and extent of the activities in which federal savings banks may engage. In particular, certain lending authority for federal savings banks,e.g., commercial, non-residential real property loans and consumer loans, is limited to a specified percentage of the institution’s capital or assets.
Capital Requirements. The Office of Thrift Supervision capital regulations require their regulated institutions to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS system), and, together with the risk-based capital standard itself, a 4% Tier 1 risk-based capital standard. The Office of Thrift Supervision regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank.
The risk-based capital standard for savings institutions requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100%, assigned by the Office of Thrift Supervision capital regulation based on the risks believed inherent in the type of asset. Core (Tier 1) capital is defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, and minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.
The OTS has authority to establish higher capital requirements where it determines that the circumstances of a particular institution require it. At September 30, 2006 the Bank met each of its capital requirements. See Note 14 of the Notes to Consolidated Financial Statements for further information.
Prompt Corrective Regulatory Action. The Office of Thrift Supervision is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of undercapitalization. Generally, an institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be “undercapitalized.” An institution that has a total risk-based capital ratio less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be “significantly undercapitalized” and an institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” Subject to a narrow exception, the Office of Thrift Supervision is required to appoint a receiver or conservator for an institution that is “critically undercapitalized.” The regulation also provides that a capital restoration plan must be filed with the Office of Thrift Supervision within 45 days of the date an institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by any parent holding company. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The Office of Thrift Supervision could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.
Insurance of Deposit Accounts. Deposits of Coastal Federal are insured by the Deposit Insurance Fund
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(“DIF”) of the FDIC. The FDIC determines insurance premiums based on a number of factors, primarily the risk of loss that insured institutions pose to the DIF. Recent legislation eliminated the minimum 1.25% reserve ratio for the insurance funds, the mandatory assessments when the ratio falls below 1.25% and the prohibition on assessing the highest quality banks when the ratio is above 1.25%. The FDIC has the ability to adjust the new insurance fund’s reserve ratio between 1.15% and 1.5%, depending on projected losses, economic changes and assessment rates at the end of a calendar year. The FDIC has adopted regulations that set assessment rates that took effect at the beginning of 2007. The new assessment rates for most banks vary between five cents and seven cents for every $100 of deposits. A change in insurance premiums could have an adverse effect on the operating expenses and results of operations of Coastal Federal. The Bank cannot predict what insurance assessment rates will be in the future. Assessment credits have been provided to institutions that paid high premiums in the past, and Coastal Federal will have credits of approximately $450,000 to offset premiums in 2007.
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The Bank does not know of any practice, condition or violation that might lead to termination of its deposit insurance.
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize a predecessor deposit insurance fund.
Loans to One Borrower. Federal law provides that OTS regulated institutions are generally subject to the limits on loans to one borrower applicable to national banks. Such an institution may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily marketable collateral. At September 30, 2006, the Bank’s limit on loans to one borrower was $21.1 million, and the Bank’s largest aggregate outstanding balance of loans to one borrower was $15.6 million.
QTL Test. The Home Owners Loan Act requires OTS regulated institutions to meet a qualified thrift lender test. Under the test, such an institution is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least 9 months out of each 12 month period.
An institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. As of September 30, 2006, the Bank met the qualified thrift lender test. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered “qualified thrift investments.”
Limitation on Capital Distributions. Office of Thrift Supervision regulations impose limitations upon all capital distributions by a regulated institution, including cash dividends, payments to repurchase its shares and payments to stockholders of another institution in a cash-out merger. Under the regulations, an application to and the prior approval of the Office of Thrift Supervision is required prior to any capital distribution if the institution does not meet the criteria for “expedited treatment” of applications under Office of Thrift Supervision regulations (i.e., generally, examination ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with Office of Thrift Supervision. If an application is not required, the institution must still provide prior notice to Office of Thrift Supervision of the capital distribution if, like the Bank, it is a subsidiary of a holding company. In the event the Bank’s capital fell below its regulatory requirements or the Office of Thrift Supervision notified it that it was in need of more than normal supervision, the Bank’s ability to make capital distributions could be restricted. In addition, the Office of Thrift Supervision could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if the Office of Thrift Supervision determines that such distribution would constitute an unsafe or unsound practice.
Assessments. OTS regulated institutions are required to pay assessments to the Office of Thrift Supervision to fund the agency’s operations. The general assessments, paid on a semi-annual basis, are computed upon the
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institution’s total assets, including consolidated subsidiaries, as reported in the Bank’s latest quarterly thrift financial report. The assessments paid by the Bank for the fiscal year ended September 30, 2006 totaled $289,000.
Transactions with Related Parties. The Bank’s authority to engage in transactions with “affiliates” (e.g., any company that controls or is under common control with an institution, including the Company and its non-OTS regulated institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the institution’s capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. The transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, OTS regulated institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no such institution may purchase the securities of any affiliate other than a subsidiary.
The Bank’s authority to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities such persons control, is also governed by federal law. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. Recent legislation created an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. The law limits both the individual and aggregate amount of loans the Bank may make to insiders based, in part, on the Bank’s capital position and requires certain board approval procedures to be followed.
Enforcement. The Office of Thrift Supervision has primary enforcement responsibility over their regulated institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order, to removal of officers and/or directors, to institution of receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The Federal Deposit Insurance Corporation has the authority to recommend to the Director of the Office of Thrift Supervision that enforcement action to be taken with respect to a particular regulated institution. If the Director does not take action, the Federal Deposit Insurance Corporation has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.
Standards for Safety and Soundness. The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the Office of Thrift Supervision determines that a regulated institution fails to meet any standard prescribed by the guidelines, the Office of Thrift Supervision may require the institution to submit an acceptable plan to achieve compliance with the standard.
Federal Home Loan Bank System
The Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. The Bank, as a member of the Federal Home Loan Bank, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank in an amount at least equal to $500, 1.0% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the Federal Home Loan Bank, whichever is greater. The Bank was in compliance with this requirement with an investment in Federal Home Loan Bank stock of $20.3 million at September 30, 2006.
The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts in the late 1980s and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on
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future Federal Home Loan Bank advances increased, the Bank’s net interest income would likely also be reduced. Recent legislation has changed the structure of the Federal Home Loan Banks funding obligations for insolvent thrifts, revised the capital structure of the Federal Home Loan Banks and implemented entirely voluntary membership for Federal Home Loan Banks. Management cannot predict the effect that these changes may have with respect to its Federal Home Loan Bank membership.
Federal Reserve System
The Federal Reserve Board regulations require OTS regulated institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: a 3% reserve ratio is assessed on net transaction accounts up to and including $47.6 million; a 10% reserve ratio is applied above $47.6 million. The first $7.0 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The amounts are adjusted annually. The Bank complies with the foregoing requirements.
Privacy Requirements of the GLBA
The Gramm-Leach-Bliley Act of 1999 provides for sweeping financial modernization for commercial banks, savings banks, securities firms, insurance companies, and other financial institutions operating in the United States. Among other provisions, the Gramm-Leach-Bliley Act places limitations on the sharing of consumer financial information with unaffiliated third parties. Specifically, the Gramm-Leach-Bliley Act requires all financial institutions offering financial products or services to retail customers to provide such customers with the financial institution’s privacy policy and provide such customers the opportunity to “opt out” of the sharing of personal financial information with unaffiliated third parties.
Anti-Money Laundering
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (referred to as the “USA PATRIOT Act”) significantly expands the responsibilities of financial institutions, including savings and loan associations, in preventing the use of the U.S. financial system to fund terrorist activities. Title III of the USA PATRIOT Act provides for a significant overhaul of the U.S. anti-money laundering regime. Among other provisions, it requires financial institutions operating in the United States to develop new anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations. Management has established policies and procedures to ensure compliance with the USA PATRIOT Act’s provisions, and the impact of the USA PATRIOT Act on our operations has not been material.
Other Regulations
Interest and other charges collected or contracted for by Coastal Federal are subject to state usury laws and federal laws concerning interest rates. Coastal Federal’s loan operations are also subject to federal laws applicable to credit transactions, such as the:
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| a. | Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers; |
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| b. | Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves; |
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| c. | Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit; |
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| d. | Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies; |
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| e. | Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and |
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| f. | rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws. |
The deposit operations of Coastal Federal also are subject to the:
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| g. | Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; |
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| h. | Electronic Funds Transfer Act and Regulation E promulgated thereunder, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and |
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| i. | Check Clearing for the 21st Century Act (also known as “Check 21”), which, effective October 28, 2004, gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check. |
TAXATION
Federal Taxation
General. The Company and the Bank report their income via a consolidated return on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank’s reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company.
Tax Bad Debt Reserves. For discussion related to the Bank’s Tax Bad Debt Reserves, please refer to Note 12 of the Notes to Consolidated Financial Statements.
Distributions. To the extent that the Bank makes “nondividend distributions” to the Company that are considered as made: (i) from the reserve for losses on qualifying real property loans, to the extent the reserve for such losses exceeds the amount that would have been allowed under the experience method; or (ii) from the supplemental reserve for losses on loans (“Excess Distributions”), then an amount based on the amount distributed will be included in the Bank’s taxable income. Nondividend distributions include distributions in excess of the Bank’s current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial or complete liquidation. However, dividends paid out of the Bank’s current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank’s bad debt reserve. Thus, any dividends to the Company that would reduce amounts appropriated to the Bank’s bad debt reserve and deducted for federal income tax purposes would create a tax liability for the Bank. The amount of additional taxable income attributable to an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if, the Bank makes a “nondividend distribution,” then approximately one and one-half times the amount so used would be includable in gross income for federal income tax purposes, assuming a 35% corporate income tax rate (exclusive of state and local taxes). See “Regulation” for limits on the payment of dividends by the Bank. The Bank does not intend to pay dividends that would result in a recapture of any portion of its tax bad debt reserve.
Corporate Alternative Minimum Tax. The Code imposes a tax on alternative minimum taxable income (“AMTI”) at a rate of 20%. Generally, only 90% of AMTI can be offset by net operating loss carryovers. AMTI is increased by an amount equal to 75% of the amount by which the Bank’s adjusted current earnings exceeds its AMTI (prior to reduction for net operating losses).
Dividends-Received Deduction and Other Matters. The Company may exclude from its income 100% of
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dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted.
State Income Taxation. South Carolina has adopted the Code as it relates to OTS regulated institutions, effective for taxable years beginning after December 31, 1985. Coastal Federal is subject to South Carolina income tax at the rate of 6% and North Carolina income tax at a rate of 6.9%. This rate of tax is imposed on OTS regulated institutions in lieu of the general state business corporation income tax.
For information regarding income taxes payable by Coastal Federal, see Note 12 of the Notes to Consolidated Financial Statements.
Audits. There have not been any audits of the Company’s federal or state income tax returns during the past five years.
Item 1.A. Risk Factors
Investing in our common stock involves various risks which are particular to our Company, our industry and our market area. Several risk factors regarding investing in our common stock are discussed below. This listing should not be considered as all-inclusive. If any of the following risks were to occur, we may not be able to conduct our business as currently planned and financial condition or operating results could be negatively impacted. These matters could cause the trading price of our common stock to decline in future periods.
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| • | We are geographically concentrated along the coastlines of South Carolina and North Carolina. Changes in local economic conditions and catastrophic weather could have a significantly adverse impact on our profitability. |
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| | We operate primarily along the coastlines of South Carolina and North Carolina and substantially all of our loan customers and most of our deposits and other customers live or have operations in these areas. Accordingly, our success significantly depends upon the growth in population, income levels, deposits and housing starts in the region, along with continued attraction of business ventures to the area. Our profitability is impacted by changes in economic conditions, particularly changes in the real estate and tourism industries. Exposure to changes in tourism or the real estate market, whether due to changing economic conditions or catastrophic weather, could reduce our growth rate, affect the ability of our customers to repay their loans to us, and generally affect our financial condition and results of operations. |
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| • | If our loan customers do not pay us as they have contracted to, we may experience losses. |
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| | Our principal revenue producing business is making loans. If our customers do not repay the loans, we will suffer losses. Even though we maintain an allowance for loan losses, the amount of the allowance may not be adequate to cover the losses we experience. We attempt to mitigate this risk by a thorough review of creditworthiness of loan customers. Nevertheless, there is risk that our credit evaluation will prove to be inaccurate due to changed circumstances or otherwise. |
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| • | Fluctuations in interest rates could reduce our profitability. |
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| | Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense. Interest rate fluctuations are caused by many factors which, for the most part, are not under our direct control. For example, national monetary policy plays a significant role in the determination of interest rates. Additionally, competitor pricing and the resulting negotiations that occur with customers also impact the rates we collect on loans and the rates we pay on deposits. |
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| | As interest rates change, we expect we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market rates should move contrary to our position, this “gap” may work against us, and our earnings may be negatively affected. |
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| | Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all ultimately affect our earnings. A decline in the market value of our assets may limit our ability to borrow additional funds. As a result, we could be required to sell some of our loans and investments under adverse market conditions, upon terms that are not favorable to us, in order to maintain our liquidity. If those sales are made at prices lower than the amortized cost of the investments, we will incur losses. |
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| • | The banking industry is highly competitive. |
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| | The banking industry in our market area is highly competitive. We compete with many different financial and financial services institutions. A substantial number of the banks in our market area are branches or subsidiaries of much larger organizations affiliated with statewide, regional, or national banking companies, and as a result, may have greater resources and lower costs of funds. These competitors aggressively solicit customers within their market area by advertising through direct mail, electronic media and other means. These competitors may offer services, such as international banking services, that we can offer only through correspondents, if at all. Additionally, larger competitors have greater capital resources and, consequently, higher lending limits. |
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| • | We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects. |
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| | Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge and experience in the South Carolina banking industry. The process of recruiting personnel with a combination of skills and attributes required to carryout our strategies is often lengthy. Our success depends, to a significant degree, upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel. We are dependent upon a number of key executives who are integral to implementing our business plan. The loss of the services of any one of our senior executive management team or other key executives could have a material adverse effect on our business, financial condition, results of operations and cash flows. |
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| • | Provisions in our articles of incorporation and Delaware law may discourage or prevent takeover attempts, and these provisions may have the effect of reducing the market price of our stock. |
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| | Our articles of incorporation include several provisions that may have the effect of discouraging or preventing hostile takeover attempts, and therefore, making the removal of incumbent management difficult. The provisions include staggered terms for our board of directors and requirements of supermajority votes to approve certain business transactions. In addition, Delaware law contains several provisions that may make it more difficult for a third party to acquire control of us without the approval of the board of directors, and may make it more difficult or expensive for a third party to acquire a majority of our outstanding stock. To the extent that these provisions are effective in discouraging or preventing takeover attempts, they may tend to reduce the market price for our stock. |
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| • | We are subject to governmental regulations which could change and increase our cost of doing business or have an adverse effect on our business. |
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| | We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies. Our compliance with the requirements of these agencies is costly and may limit our growth and restrict certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged and location of offices. We are also subject to capitalization guidelines established by federal authorities and our failure to meet those guidelines could result, in an extreme case, in our bank being placed in receivership. Supervision, regulation and examination of banks and bank holding companies by financial institution regulatory agencies are intended for the protection of depositors and our other customers rather than the holders of our common stock. |
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| • | Changes in accounting standards could impact reported earnings. |
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| | The accounting standard setters, including FASB, SEC and other regulatory bodies, periodically change financial accounting and reporting standards that govern the preparation of our consolidated statements. These changes can be hard to predict and can materially impact how the Company records and reports its |
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| | financial condition and results of operations. In some cases, we could be required to apply a new or revised accounting standard retroactively, resulting in the restatement of prior period financial statements. |
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| • | We are susceptible to changes in monetary policy and other economic factors which may adversely affect our ability to operate profitably. |
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| | Changes in governmental, economic and monetary policies may affect the ability of our bank to attract deposits and make loans. The rates of interest payable on deposits and chargeable on loans are affected by governmental regulation and fiscal policy as well as by national, state and local economic conditions. All of these matters are outside of our control and affect our ability to operate profitably. |
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| • | The preparation of financial statements requires the use of estimates that may vary from actual results. |
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| | Preparation of consolidated financial statements in conformity with accounting principles accepted in the United States of America requires management to make significant estimates that affect the financial statements. One of our most critical estimates is the level of the allowance for loan losses. Due to the inherent nature of this estimate, we cannot provide absolute assurance that we will not significantly increase allowances for losses that are significantly higher than the provided allowance. |
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| • | We rely on communications, information, operating and financial control systems, and technology from third-party service providers, and we may suffer an interruption in those systems that may result in lost business. Further, we may not be able to substitute providers on terms that are as favorable if our relationships with our existing service providers are interrupted. |
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| | We rely heavily on third-party service providers for much of our communications, information, operating and financial controls systems, and technology. Any failure or interruption or breach in security of these systems could result in failures or interruptions in our customer relationships management, general ledger, deposit, servicing and/or loan origination systems. We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. The occurrence of any failure or interruption could have a material adverse effect on our business, financial condition, results of operations and cash flows. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems, without the need to expend substantial resources, if at all. Any of these circumstances could have a material adverse effect on our business, financial condition, results of operations and cash flows. |
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| • | If the business continuity and disaster recovery plans that we have in place are not adequate to continue our operations in the event of a disaster, the business disruption can adversely impact our operations. |
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| | External events, including terrorist or military actions, or an outbreak of disease, such as Asian Influenza, or “bird flu” and resulting political and social turmoil could cause unforeseen damage to our physical facilities or could cause delays or disruptions to operational functions, including information processing and financial market settlement functions. Additionally, our customers, vendors and counterparties could suffer from such events. Should these events affect us, or our customers, or vendors or counterparties with which we conduct business, our results of operations could be adversely affected. |
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| • | From time to time, we are subject to claims and litigation from customers and other individuals. |
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| | Whether such claims and legal actions are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services. Any financial liability or reputation damage could have a material adverse effect on our business and financial performance. |
| | |
| • | Even though our common stock is currently traded on the Nasdaq Stock Market, it has less liquidity than the average stock quoted on national stock exchanges. |
| | |
| | The trading volume in our common stock on the Nasdaq Stock Market has been relatively low when compared with larger companies on the Nasdaq National Market or national stock exchanges. As a result, it may be more difficult for stockholders to sell a substantial number of shares for the same price at which |
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| | |
| | stockholders could sell a small number of shares. We also cannot predict the effect, if any, that future sales of our common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of our common stock. We can give no assurance that sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our future ability to raise capital through sales of common stock. The market price of our common stock may fluctuate in the future, and these fluctuations may be unrelated to our performance. General market price declines or overall stock market volatility in the future could adversely affect the price of our common stock. Further, the current market price of our stock may not be indicative of future market prices. |
| | |
| • | Decline in home values in the Company’s markets could adversely impact results from operations. |
| | |
| | Like all banks, the Company is subject to the effects of any economic downturn, and in particular, a significant decline in home values in the Company’s markets could have a negative effect on the results of operations A significant decline in home values would likely lead to a decrease in new home equity loan originations and increased delinquencies and defaults in both the consumer home equity loan and the residential real estate loan portfolios and result in increased losses in these portfolios. |
| | |
| • | The Company is subject to federal and state income tax regulations. |
| | |
| | Income tax regulations are often complex and require interpretation. Changes in income tax regulations could negatively impact the Company’s results of operations. If the Company’s REIT affiliate fails to qualify as a REIT, or should states enact legislation taxing these or related entities, the Company will be subject to a higher consolidated effective tax rate. The REIT and related companies must meet specific provisions of the Internal Revenue Code (“IRC”) and state tax laws. If these companies fail to meet any of the required provisions of the federal and state tax laws, tax expense could increase. Use of these companies is and has been the subject of federal and state audits. See “Management’s Discussion and Analysis of Operations-Income Taxes” for additional information. |
| | |
| • | The Company is subject to the USA Patriot and Bank Secrecy Acts. |
| | |
| | The USA Patriot and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury Department’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions. During the past year, several banking institutions have received large fines for non-compliance with these laws and regulations. The Company has developed policies and procedures designed to ensure compliance. |
| | |
| • | Our common stock is not insured, so you could lose your total investment. |
| | |
| | Our common stock is not a deposit or savings account, and will not be insured by the Federal Deposit Insurance Corporation any other government agency. Should our business decline or fail, you could lose your total investment. |
Item 1.B. Unresolved Staff Comments
Not applicable.
Item 2. Properties
The principal offices of the Company are located in a 25,000 square foot Main Office at 2619 Oak Street in Myrtle Beach, SC. This facility also houses Coastal Mortgage Bankers and Realty Co, Inc, Coastal Investor Services, a division of Coastal Federal Bank, and many corporate functions. Several of the Bank’s operations groups, including loan and deposit servicing, human resources, marketing, and residential lending administration, are in separate buildings owned and leased by the Bank in Myrtle Beach. The Bank also owns a facility in Conway, SC, which houses its Item Processing and Technology functions.
At September 30, 2006, the Bank operated seventeen branches in South Carolina and seven branches in North
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Carolina. Of these, two branches have land leases, four of the branches lease land and building and eighteen are owned.
The net book value of the Company’s investment in office, properties and equipment totaled $29.9 million at September 30, 2006. See Note 6 of the Notes to Consolidated Financial Statements. Coastal Federal uses the services of an independent data processing service to process customer records and monetary transactions, post deposit and general ledger entries and record activity in installment lending, loan servicing and loan originations.
Item 3. Legal Proceedings
The Company is not a defendant in any lawsuits. The subsidiaries are defendants in lawsuits arising out of the normal course of business. Based upon current information received from counsel representing the subsidiaries in these matters, the Company believes none of the lawsuits would have a material impact on the Company’s financial status.
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable.
PART II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The information contained under the section captioned “Market for the Corporation’s Common Stock and Related Stockholder Matters” in the Corporation’s Annual Report to Stockholders for the Fiscal Year Ended September 30, 2006 (“Annual Report”) is incorporated herein by reference.
The Company did not repurchase any of its outstanding shares of common stock during the quarter and year ended September 30, 2006.
Item 6. Selected Financial Data
The information contained in the section captioned “Financial Highlights” in the Annual Report is incorporated herein by reference.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The information contained in the section captioned “Management’s Discussion and Analysis” in the Annual Report is incorporated herein by reference.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The information contained in the section captioned “Interest Rate Risk Disclosure” in the Annual Report is incorporated herein by reference.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements contained in the Annual Report which are listed under Item 14 herein are incorporated herein by reference.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
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The registrant has not, within the 24 months before the date of the most recent financial statements, changed its accountants, nor have there been any disagreements on accounting and financial disclosure.
Item 9A. Controls and Procedures
The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. In addition, based on that evaluation, no change in the Company’s internal control over financial reporting occurred during the year ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s annual report on internal control over financial reporting and the attestation report of the registered public accounting firm are incorporated herein by reference to the section captioned “Management’s Report on Internal Control over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” in the annual report.
Item 9B. Other Information
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
The information called for by Item 10 with respect to directors and Section 16 matters is set forth in the Registrant’s Proxy Statement for its 2007 Annual Meeting of Stockholders under the caption “Elections of Directors” and “ Section 16(a) Beneficial Ownership Reporting Compliance”, respectively, and is hereby incorporated by reference. The information called for by Item 10 with respect to the identification of the members of the Registrant’s Audit Committee and the presence of an audit committee financial expert is set forth in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders under the captions “Committees of the Board of Directors” and is hereby incorporated by reference.
Certain executive officers of the Bank also serve as executive officers of the Company. The day-to-day management duties of the executive officers of the Company and the Bank relate primarily to their duties as to the Bank. The executive officers of the Company and the Bank are elected annually by the respective Boards of Directors and hold office until their successors have been elected and qualified or until they are removed from office.
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| | |
Executive Officers of the Registrant |
| | |
Name, Age and Position | | Business Experience |
| |
|
| | |
Michael C. Gerald, 57 President, Chief Executive Officer and a Director | | Mr. Gerald has been associated with Coastal Federal since 1974 and serves as Director, President and Chief Executive Officer of the Corporation and Bank. Mr. Gerald also serves as Director and President of Coastal Mortgage Bankers & Realty Company, Inc., as Director and President of Coastal Real Estate Investment Corporation, and as a Director of Coastal Retirement, Estate and Tax Planners, Inc. He currently serves on the Board of Visitors of Coastal Carolina University’s Wall School of Business, as Chairman of the Board of Directors of the Waccamaw Community Foundation, on the Board of Directors of the Coastal Education Foundation, and on the Board of Trustees of the USC Business Partnership Foundation. |
| | |
Jimmy R. Graham, 58, Executive Vice President and Chief Operations Officer | | Mr. Graham serves as Executive Vice President and Chief Operations Officer of Coastal Federal. Mr. Graham serves as Executive Vice President of Coastal Financial Corporation. He has been associated with the bank since 1977. |
| | |
Jerry L. Rexroad, CPA, 46, Executive Vice President and Chief Financial Officer | | Mr. Rexroad joined the Company in April 1995 and is Executive Vice President and Chief Financial Officer of Coastal Federal and Coastal Financial Corporation. Mr. Rexroad also serves as the Chief Financial Officer and a Director for Coastal Mortgage Bankers & Realty Company, Inc., Coastal Investor Services, Inc., Coastal Planners Holding Corporation, Coastal Retirement Estate and Tax Planners, Coastal Real Estate Investment Corporation and President of Coastal Federal Holding Corporation. He is a Past Chairman of the Board of Directors for Junior Achievement of Horry County as well as Past Chairman of the Board of Directors for Junior Achievement of Greenville. Mr. Rexroad is a Director of PowerHouse Ministries, Inc. and Chairman of the Board of Deacons at Grand Strand Baptist Church. He is a certified public accountant, and is a member of the AICPA and SCACPA. Prior to joining the Company, Mr. Rexroad was a partner with KPMG LLP where he was partner in charge of the Financial Institutions practice in South Carolina. |
| | |
Phillip G. Stalvey, 50, Executive Vice President and Banking Group Leader | | Mr. Stalvey is Executive Vice President and Banking Group Leader for the Bank. He also serves as an Executive Vice President of the Corporation and is a director of Coastal Investor Services, Inc. He has been associated with Coastal Federal for the past 25 years. In addition, Mr. Stalvey is a member of the Florence Stake Presidency with his Church and a member of the Myrtle Beach Air Force Base Redevelopment Authority. |
| | |
Steven J. Sherry, 55 Executive Vice President and Director of Marketing | | Mr. Sherry joined the Company in May 1998 and is Executive Vice President and Director of Marketing for the Bank. He also serves as Executive Vice President and Chief Marketing Officer for Coastal Financial Corporation. He is active with a variety of local community groups and serves as the Chairman of the Board of Trustees of the Franklin G. Burroughs-Simeon B. Chapin Art Museum. Mr. Sherry holds numerous achievement awards for marketing and advertising. |
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| | |
Susan J. Cooke, 56
Senior Vice President and Corporate Secretary | | Ms. Cooke is Senior Vice President and Corporate Secretary for Coastal Federal and for Coastal Financial Corporation, Corporate Secretary for Coastal Mortgage Bankers & Realty Company, Inc., and Coastal Investor Services, Inc. Ms. Cooke has been employed with Coastal Federal for nineteen years. She is a member of the American Society of Corporate Secretaries, Inc. and the National Association for Female Executives. |
| | |
Robert D. Douglas, 47 Executive Vice President Human Resources/Coastal Federal University Group | | Mr. Douglas joined the corporation in June 1994 and serves as Executive Vice President of the Bank and Coastal Financial Corporation. He previously served as Chairman of the Human Resources Committee of the South Carolina Community Bankers Association. He has served on various advisory committees for the Horry County Drug and Alcohol Commission, the South Carolina Employment Security Commission, Coastal Carolina University and Horry Georgetown Technical College, and the Grand Strand Area Chamber of Commerce. He is a member of the Coastal Organization for Human Resources Management and serves as a member of Coastal Carolina University Career Services Advisory Board. He also serves on the Board of Directors for the Coastal Samaritan Counseling Center and is Chairman of the Finance Committee. |
The Company has adopted a Code of Ethics, a copy of which is incorporated by reference to the September 30, 2003 Form 10-K filed on December 22, 2003. The Company is required to disclose any amendments to or waivers from the Code of Ethics in a report on Form 8-K.
Item 11. Executive Compensation
The information contained under the section captioned “Proposal I –- Election of Directors –- Executive Compensation” in the Proxy Statement is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
| | |
| (a) | Security Ownership of Certain Beneficial Owners |
| | |
| | Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” of the Proxy Statement. |
| | |
| (b) | Security Ownership of Management |
| | |
| | Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” of the Proxy Statement. |
| | |
| (c) | Management of the Corporation knows of no arrangements, including any pledge by any person of securities of the Corporation, the operation of which may at a subsequent date result in a change in control of the registrant. |
35
| | |
| (d) | Equity Compensation Plan Information as of September 30, 2006 |
| | | | | | | | | | | | | | | | |
Plan Category
(a) | | Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(b) | | Weighted-average price
of outstanding options,
warrants and rights
(c) | | Number of securities
remaining available for future issuance under equity compensation
plans (excluding
securities reflected in
column (a))
(d) | |
| |
| |
| |
| |
Equity compensation plans approved by security holders | | | | 2,748,630 | | | | $ | 8.07 | | | | | 127,920 | | |
Equity compensation plans not approved by security holders | | | | N/A | | | | | N/A | | | | | N/A | | |
Total | | | | 2,748,630 | | | | $ | 8.07 | | | | | 127,920 | | |
Item 13. Certain Relationships and Related Transactions
The information required by this item is incorporated herein by reference to the section captioned “Transactions with Management” in the Proxy Statement.
Item 14. Principal Accountant Fees and Services
The information required by this item is incorporated herein by reference to the section captioned “Auditing and Related Fees” in the Proxy Statement.
PART IV
Item 15. Exhibits and Financial Statement Schedules
| | | |
| 1. | Report of Independent Registered Public Accounting Firm (1) |
| | |
| 2. | All Financial Statements (1) |
| | |
| | (a) | Consolidated Statements of Financial Condition as of September 30, 2005 and 2006. |
| | | |
| | (b) | Consolidated Statements of Operations for the Years Ended September 30, 2004, 2005 and 2006. |
| | | |
| | (c) | Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the Years Ended September 30, 2004, 2005 and 2006. |
| | | |
| | (d) | Consolidated Statements of Cash Flows for the Years Ended September 30, 2004, 2005 and 2006. |
| | | |
| | (e) | Notes to Consolidated Financial Statements. |
| | | |
| 3. | All Schedules have been omitted, as the required information is either inapplicable or included in the Notes to consolidated Financial Statements. |
| | |
| 4. | Exhibits |
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| |
(1) | Incorporated by reference to Registration Statement on Form S-4 filed with the Securities and Exchange Commission on November 26, 1990. |
| |
(2) | Incorporated by reference to 1995 Form 10-K filed with the Securities and Exchange Commission on December 29, 1995. |
| |
(3) | Incorporated by reference to the proxy statement for the 1996 Annual Meeting of Stockholders. |
| |
(4) | Incorporated by reference to the proxy statement for the 2000 Annual Meeting of Stockholders. |
| |
(5) | Incorporated by reference to the March 31, 1998 Form 10-Q filed with the Securities and Exchange Commission on May 15, 1998. |
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| |
(6) | Incorporated by reference to the September 30, 2003 Form 10-K filed with the Securities and Exchange Commission on December 22, 2003. |
| |
(7) | Incorporated by reference to the March 31, 2006 Form 10-Q filed with the Securities and Exchange Commission on May 10, 2006. |
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SIGNATURES
| | | |
| Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. |
| | | COASTAL FINANCIAL CORPORATION |
| | | |
| Date: December 14, 2006 | By: | /s/ Michael C. Gerald |
| | |
|
| | | Michael C. Gerald |
| | | President/Chief Executive |
| | | Officer |
| | | (Duly Authorized Representative) |
39
| | | |
| Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. |
| |
By: | /s/ Michael C. Gerald | By: | /s/ Jerry L. Rexroad |
|
| |
|
| Michael C. Gerald
President/Chief Executive
Officer And a Director
(Principal Executive
Officer) | | Jerry L. Rexroad
Executive Vice President
And Chief Financial Officer
(Principal Financial and
Accounting Officer) |
| | | |
Date: | December 14, 2006 | | December 14, 2006 |
By: | /s/ James T. Clemmons | By: | /s/ Frank A. Thompson, II |
|
| |
|
| James T. Clemmons
Chairman of the Board | | Frank A. Thompson, II
Director |
| | | |
Date: | December 14, 2006 | Date: | December 14, 2006 |
| | | |
By: | /s/ William O. Marsh | By: | /s/ James P. Creel |
|
| |
|
| William O. Marsh
Director | | James P. Creel
Director |
| | | |
Date: | December 14, 2006 | Date: | December 14, 2006 |
By: | /s/ G. David Bishop | By: | /s/ James H. Dusenbury |
|
| |
|
| G. David Bishop
Director | | James H. Dusenbury
Director |
| | | |
Date: | December 14, 2006 | Date: | December 14, 2006 |
By: | /s/ E. Lawton Benton | By: | /s/ J. Robert Calliham |
|
| |
|
| E. Lawton Benton
Director | | J. Robert Calliham
Director |
| | | |
Date: | December 14, 2006 | Date: | December 14, 2006 |
By: | /s/ W. Cecil Worsley, III | | |
|
| | |
| W. Cecil Worsley, III
Director | | |
| | | |
Date: | December 14, 2006 | | |
40
