SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
Quarterly Report Under Section 13 or 15 (d)
of the Securities Exchange Act of 1934
For Quarterly Period Ended March 31, 1995
Commission File # 2-76555
SDN BANCORP
- -------------------------------------------------------------------
(Exact name of small business issuer in its charter)
California 95-3683748
- ------------------------------- --------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
135 Saxony Road, Encinitas, California 92024-0905
- -------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code 619-436-6888
Check whether the issuer (1) 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
issuer was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days.
Yes /X/ No / /
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
Common Stock, no par value 564,145
- -------------------------- -----------------------------
Class Outstanding on March 31, 1995
SDN BANCORP AND SUBSIDIARY
SECURITIES AND EXCHANGE COMMISSION FORM 10-QSB
INDEX
Page
PART I - Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Condition -
March 31, 1995 and December 31, 1994
Condensed Consolidated Statements of Operations
For the three months ended March 31, 1995 and 1994
Condensed Consolidated Statements of Cash Flows -
For the three months ended March 31, 1995 and 1994
Notes to Condensed Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
PART II - Other Information
Item 6. Exhibits and Reports on Form 8-K
Signatures
Item 1. Financial Statements
SDN BANCORP AND SUBSIDIARY
Condensed Consolidated Statements of Condition
March 31, 1995 and December 31, 1994
(Dollars in thousands)
(Unaudited)
March 31, December31,
1995 1994
(Unaudited)
----------- -----------
Assets
Cash and due from banks $ 3,906 $2,842
Interest bearing deposits with
financial institutions 1,078 1,078
Investment securities: at cost,
approximate market value 1995 -
$4,394,000; 1994 - $4,450,000 4,430 4,535
Federal funds sold 3,000 -
Loans 43,737 46,313
Less allowance for loan loss 802 821
------- ------
Loans, net 42,935 45,492
Premises and equipment, net 730 779
Real estate acquired through foreclosure 1,075 1,288
Accrued interest receivable
and other assets 1,914 1,672
------- ------
$ 59,068 $ 57,686
======= =======
Liabilities and Shareholders' Equity
Deposits:
Demand:
Non-interest bearing $12,102 $12,570
Interest bearing 11,248 10,206
Savings:
Regular 5,692 6,110
Money market 9,029 10,234
Time:
Under $100,000 15,118 12,212
$100,000 or more 4,346 4,544
------- ------
Total deposits 57,535 55,876
Accrued expenses and other liabilities 717 864
Notes payable 675 675
Mandatory Convertible Debentures 1,219 1,219
------- ------
Total liabilities 60,146 58,634
Shareholders' Equity:
Contributed capital 2,951 2,951
Accumulated deficit (4,029) (3,899)
Total Shareholders' Equity (Deficit) (1,078) (948)
------- -------
$ 59,068 $ 57,686
======= ======
See accompanying notes to condensed consolidated financial
statements.
SDN BANCORP AND SUBSIDIARY
Condensed Consolidated Statements of Operations
Three months ended March 31, 1995 and 1994
(Dollars in thousands, except for per share amounts)
(Unaudited)
Three Months Ended
March 31,
1995 1994
---- ----
Interest Income:
Interest and fees on loans $ 1,070 $ 979
Interest on Federal funds sold 28 2
Interest on deposits with
financial institutions 15 10
Interest and dividends on
investment securities 64 68
----- -----
Total interest income 1,177 1,059
Interest Expense:
Deposits 405 317
Other borrowed funds 53 41
----- -----
Total interest expense 458 358
----- -----
Net interest income 719 701
Provision for loan losses 60 50
----- -----
Net interest income after
provision for loan losses 659 651
Non-interest income 134 155
Non-interest expense 923 1,068
----- -----
Net loss $ (130) $ (262)
====== ======
Loss per share $ (0.23)$ (0.46)
====== ======
See accompanying notes to condensed consolidated financial
statements.
SDN BANCORP AND SUBSIDIARY
Condensed Consolidated Statements of Cash Flows
For the Three Months Ended March 31, 1995 and 1994
(Dollars in thousands)
(Unaudited)
1995 1994
Operating Activities:
Net loss $(130) $(262)
Adjustments to reconcile net loss to net
cash used by operating activities:
Provision for loan losses 60 50
Depreciation and amortization 50 52
(Increase) decrease in accrued interest receivable (16) 7
Increase (decrease) in accrued interest payable 68 (43)
Other - net (326) 87
----- -----
Net cash used by operating activities (294) (109)
----- -----
Investing Activities:
Net decrease in interest bearing deposits
other financial institutions - 390
Purchases of investment securities (501) (849)
Proceeds from sales and maturities of investment
securities 606 1,520
Net decrease in loans 2,382 505
Purchases of premises and equipment (1) (30)
Proceeds from sale of real estate acquired
through foreclosures 213 -
----- -----
Net cash provided by investing activities 2,699 1,536
----- -----
Financing Activities:
Net increase in deposits 1,659 586
Net proceeds from issuance of notes payable - 14
----- ---
Net cash provided by financing activities 1,659 600
----- -----
Net Increase (Decrease) in cash and cash equivalents 4,064 2,027
Cash and cash equivalents at January 1, 1995
and 1994 2,842 4,183
Cash and cash equivalents at March 31, 1995 ----- -----
and 1994 $ 6,906 $6,210
===== =====
Supplemental disclosure of cash flow activities:
Cash paid for income taxes - -
===== =====
Cash paid for interest 390 343
===== =====
Supplemental disclosure of non-cash flow activities:
Other real estate sold and financed by Bank $ 115 $ -
===== =====
See accompanying notes to condensed consolidated financial
statements.
SDN BANCORP AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 1995
(Unaudited)
NOTE 1:
The condensed consolidated financial statements include the
accounts of SDN Bancorp ("Bancorp"), a Bank holding company, and
its wholly-owned subsidiary, San Dieguito National Bank ("Bank").
In the opinion of management, the accompanying unaudited
interim condensed consolidated financial statements contain all
adjustments, consisting of only normal recurring accruals,
necessary to present fairly the financial positionas of March 31,
1995 and the results of operations and statements of cash flows for
the three months ended March 31, 1995 and 1994.
While management believes that the disclosures presented are
adequate to make the information not misleading, it is recommended
that these financial statements be read in conjunction with the
financial statements and the notes included in Bancorp's 1994
annual report.
NOTE 2:
On September 21, 1992, the Bank entered into an agreement (the
"OCC Agreement") with the Office of the Comptroller of the Currency
("OCC") which, among other matters, requires the Bank to achieve
and maintain certain capital ratios. On October 23, 1992, Bancorp
signed a Memorandum of Understanding ("MOU") with the Federal
Reserve Bank to confirm a plan to correct certain concerns. See
"Capital Resources" on page 18 and "Administrative Proceedings" on
page 25 for information on these matters.
The Bank is considered "significantly undercapitalized" under
the Prompt Corrective Action provisions of the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA") and would
be considered "critically undercapitalized" if its ratio of
tangible equity to total assets should equal or be less than 2%.
At March 31, 1995, the Bank's such ratio was 2.5%. Subject to
certain exceptions, in the case of critically undercapitalized
depository institutions, the appropriate Federal banking agency is
required to appoint a conservator or receiver, generally within 90
days.
If the Bank is unable to comply with the terms of the OCC
Agreement or the MOU, one or more regulatory sanctions may result,
including the possible termination of the Bank's Federal Deposit
Insurance Corporation's insured status. Bancorp has total notes
payable of $975,000 at March 31, 1995 (including $300,000 due to
the Bank) all with maturities on or before March 31, 1996 and
Mandatory Convertible Debentures of $1,219,000. See Note 5.
Bancorp has not been able to make full and timely interest payments
on the notes or the Debentures during 1994and does not have current
liquidity to repay the notes as scheduled during 1995. These
uncertainties and the net losses incurred during 1994, 1993 and
1992, among others, may indicate that the Bancorp and the Bank will
be unable to continue as a going concern. The financial statement
impact, if any, from the outcome of these uncertainties cannot
presently be determined. Accordingly, no adjustment that may
result from the resolution of these matters has been made in the
accompanying financial statements.
Management and the directors are taking a number of steps to
increase the capital of both the Bancorp and the Bank or otherwise
satisfy the requirements of the OCC Agreement and the MOU and to
provide funds required to service futuredebt payments on the
Debentures and other Bancorp debt. This includes manyactive
discussions and negotiations with potential investors or
purchasers. The Bancorp is also using industry professionals for
advice and to provide assistance in locating investors or
purchasers. No assurance can be given as to the eventual outcome
of these efforts.
NOTE 3:
Per share data is computed by dividing net loss by the weighted
average number of shares of common stock and common stock
equivalents outstanding. Stock options, which are common stock
equivalents, have not been included in the calculation of loss per
share. The assumed conversion of the Mandatory Convertible
Debentures ("Debentures"), which are not common stock equivalents,
were antidilutive for the three months ended March 31, 1995 and
1994.
NOTE 4:
Bancorp adopted the provisions of Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes"
effective January 1, 1993. On January 1, 1994 Bancorp adopted the
provision of Statement of Financial Standards No. 115 "Accounting
for Certain Investments in Debt and Equity Securities". There were
no material effects of adoption of either statements.
NOTE 5:
At March 31, 1995, Bancorp has two promissory notes totaling
$300,000 payable to the Bank, both of which bear interest at Wall
Street Journal prime plus 2.0%. Both of these notes are due June
30, 1995. The notes are collateralized by certain real property
owned by two of Bancorp's directors. In the accompanying
consolidated statements of condition, these Bancorp notes payable
and the Bank loans receivable have been eliminated.
Bancorp has a $250,000 line of credit from a director. At
March 31, 1995, the balance outstanding on this line of credit was
$250,000. This note bears interest at Wall Street Journal prime
plus 2.5%. and is due December 30, 1995.
Bancorp has promissory notes payable to directors aggregating
$300,000 and promissory notes payable to three shareholders
totaling $125,000. These notes bear interest at Wall Street
Journal prime plus 2.0%. Principal and interest on these notes
are due March 31, 1996.
The Bancorp's $1,219,000 aggregate principal amount Mandatory
Convertible Debentures bear interest at Wall street Journal prime
plus 3.0%, payable quarterly. The Debentures are not subject to
any sinking fund requirements and are subordinated in right of
payment to the obligations of the Bancorp under anyother
indebtedness. The indenture does not provide for a right of
acceleration of Debentures upon a default in payment of interest or
principal or in the performance of any covenant in the Debentures
or the indenture, and no trustee is appointed under the indenture
to enforce the rights of Debenture holders. Prior to conversion of
the Debentures, a Debenture holder has none of the rights or
privileges of a shareholder of the Bancorp.
In January 1994, certain directors began making cash advances
to Bancorp to provide the funds necessary to pay debt service on
$700,500 in principal of Debentures owned by non-directors and on
three notes totaling $550,000, of which $300,000 is payable to the
Bank under two notes due June 30, 1995 and $250,000 is a line of
credit payable to a director due December 30, 1995. Effective
April 1,1994, the directors continued to advance additional funds
sufficient to service only the debt requirements of these three
notes totaling $550,000. The total of all advances was $81,000 as
of March 31, 1995. The aggregate accrued unpaid interest on all
notes and Debentures is $261,000 as of March 31, 1995. The
Directors agreed to defer payment of all interest and principal due
on advances and Debentures payable to them through March 31,1996.
In July 1994, the non-director debentureholders were notified
that Bancorp no longer had the funds to continue paying interest on
the Debentures; and therefore, the quarterly interest payments due
for the second, third, and fourth quarters of 1994 and the first
quarter of 1995 were not made. This constituted a payment default
under Section 8.02 of the Indenture. Debentureholders were asked
to waive the quarterly payment defaults. According to the
Indenture, such a default in the payment of interest can be waived
by a majority of the principal amount of the Debentures
outstanding, not including the amount owned by Bancorp directors
and officers. Signed waivers have been received from a sufficient
number of debenture holders thus waiving Bancorp's default in the
above mentioned quarterly payments under the Debentures.
As of May 10, 1995, Bancorp did not have the funds available to
meet future debt service requirements of the notes and Debentures.
No assurance can be given that Bancorp ultimately will be
successful in obtaining a source of funds to meet Bancorp's debt
service requirements or that advances from directors will continue.
Failure to meet the debt service requirements could force Bancorp
to seek bankruptcy protection which could result in a significant
adverse impact to Bancorp noteholders, debentureholders and
shareholders.
NOTE 6:
Real estate acquired through foreclosure or deed-in-lieu of
(Other Real Estate Owned or OREO) are recorded at the lessor of the
outstanding loan amount or market value less estimated cost to
sell, at the time of foreclosure.
NOTE 7:
Effective January 1, 1995 the Bank adopted Statement of
Financial Accounting Standards No. 114 (SFAS No. 114) "Accounting
by Creditors for Impairment of a Loan" as amended by SFAS No. 118
"Accounting by Creditors for Impairment of a Loan-Income
Recognition and Disclosures".
The balance of impaired loans as defined by SFAS No. 114 was
$1,186,000 at March 31, 1995. At March 31, 1995 $1,186,000 of
impaired loans had related allowance for loan losses of $153,000.
The Bank's average investment in impaired loans was $1,196,000
during the three month period ending March 31, 1995. Cash receipts
for impaired loans placed an non-accrual status are first applied
to reduce principal.
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Three months ended
March 31, 1995
SUMMARY:
SDN Bancorp ("Bancorp") owns 100% of San Dieguito National Bank
("Bank"). Bancorp has had no significant business activities
independent from the Bank. Accordingly, the following discussion
relates primarily to the operating results and financial condition
of the Bank.
Average earning assets of the Bank for the first three months
of 1995 were approximately $52.3 million, a decrease of $2.4
million or 4.3% from the average for the comparable three-month
period in 1994. Average earning assets have generally decreased
since the second quarter of 1992. Total assets at March 31, 1995
were $59.1 million compared to total assets of $57.7 million at
December 31, 1994 and $61.9 million at March 31, 1994.
Average loans for the first three months of 1995 were
approximately $44.8 million, a decrease of $3.9 million or 8.1%
from the average for the comparable three month period in 1994.
Total loans at March 31, 1995 were $43.7 million compared to $46.3
million at December 31, 1994. This $2.6 million decrease was a
result of a $1.2 million decrease in construction and real estate
loans, a $0.9 million decrease in commercial loans, and a $0.5
million decrease in consumer and equity loans.
Average deposits for the first three months of 1995 were
approximately $45.8 million, a decrease of $2.5 million or 5.3%
from the average for the comparable three month period in 1994.
Total deposits increased to $57.5 million at March 31, 1995
compared to $55.9 million at December 31, 1994. This $1.6 million
increase is primarily due to a $2.9 increase in certificates of
deposit, offset by a $1.2 million decrease in money market
accounts.
For the three months ended March 31, 1995, Bancorp had a net
loss of $130,000 compared to a net loss of $262,000 for the same
period in 1994. The 1995 net loss is considerably less than the
comparable 1994 three-month loss due to a $145,000 reduction in
non-interest expenses in 1995 compared to 1994 as a result of a
$121,000 provision for OREO losses in March 1994.
Net Interest Income and Net Interest Margin
In the first three months of 1995, Bancorp's net interest
income increased $18,000 (including loan fees) as the result of an
increase in interest rates offset by a decrease in average earning
assets. The prime lending rate was 6.25% at March 31, 1994 and
increased several times in 1994 and once in the first quarter of
1995. The prime lending rate was 9.0% at March 31, 1995. See
"Economic Considerations"
Comparing the first three months of 1995 to those of 1994, the
yield on average earning assets increased to 9.1% from 7.9%, while
the average cost of interest bearing liabilities increased to 3.9%
from 2.9%. The net interest margin was 5.6% for the first three
months of 1995 compared to 5.2% for the first three months of 1994.
This higher net interest margin reflects the increase in the prime
lending rate.
Loan fee income decreased $8,000 for the first three months of
1995 compared to 1994. This decrease reflects the continued
decline in local construction lending as well as difficulties in
competing for construction loans with a reduced lending limit.
Allowance and Provision for Loan Losses
The allowance for loan losses represents the amounts which have
been set aside for the specific purpose of absorbing losses which
may occur in the Bank's loan portfolio. The provision for loan
losses is an expense charged against operating income and added to
the allowance for loan losses. Management of the Bank continues to
carefully monitor the allowance for loan losses in relation to the
size of the Bank's loan portfolio and known risks or problem loans.
The allowance for loan losses was $802,000 at March 31, 1995
compared to $821,000 at December 31, 1994. The allowance for loan
losses was 1.8% of gross loans at March 31, 1995, 1.8% at December
31, 1994 and 1.7% at March 31, 1994. During the first three months
of 1995, the provision for loan losses was $60,000, loan charge-
offs were $183,000 and recoveries were $4,000.
At March 31, 1995, $32.1 million or 73% of total loans were
secured by deeds of trust on real estate. This includes loans to
companies or individuals for business purposes which are also
secured by real estate. The Bank, like other banks, also makes a
number of loans to companies and individuals which are secured by
other collateral or based solely upon the cash flow, income,
character and/or net worth of the borrower. At March 31, 1995, the
Bank had $11.6 million or 27% of total loans in this category. The
majority of these loans are collateralized by business property,
personal property and/or governmental agency guarantees. The
collection of these loans is more dependent upon the borrower's
financial capability at maturity than loans that are secured by
real estate.
Non-performing loans and other real estate owned ("OREO") are
summarized as follows:
(Dollars in Thousands)
March 31, December 31,
1995 1994
---- ----
Non-performing loans:
Loans past due 90 days or more
and still accruing $ 594 $ 826
Loans on non-accrual 2,189 1,666
----- -----
Non-performing loans $2,783 $2,492
===== =====
As a percent of total loans 6.4% 5.4%
=== ===
OREO $ 1,075 $1,288
----- -----
Non-performing assets $3,858 $3,780
===== =====
As a percent of total assets 6.5% 6.5%
=== ====
The $2,189,000 in loans on non-accrual at March 31, 1995 consists
of twenty loans of which eleven loans totaling 91% of the total
amount are secured by real estate. Foreclosure proceedings on some
of these loans are likely to result in OREO. At December 31, 1994,
the $1,666,000 in loans on non-accrual consisted of sixteen loans,
of which seven loans totaling 88% of the total dollar amount were
secured by real estate.
Using the peer group of all banks headquartered in San Diego
County with total assets less than $500 million as of December 31,
1994, the most recent peer group data available, the ratio of the
allowance for loan losses to non-performing loans was 54% for such
regional peer group compared to the Bank's ratio of 33%. At March
31, 1995 the same ratio for the Bank was 29% as a result of a
$19,000 decrease in the allowance for loan losses and a $291,000
increase in non-performing loans at March 31, 1995 compared to
December 31, 1994. This increase in non-performing loans was
largely a result of seven loans totaling $439,000 which were added
to non-performing status during the first quarter of 1995 offset by
the charge-off of three loans totaling $82,000. A $299,000 loan
past due ninety days at March 31, 1995 was paid in full by the
borrower in April 1995. As of December 31, 1994, non-performing
loans as a percentage of total loans was 4% for the regional peer
group compared to the Bank's percentage of 5%.
The OREO balance of $1,075,000 at March 31, 1995 is composed of
three properties. The decrease compared to December 31, 1994
resulted from one property with a carrying value of $213,000 which
was sold in March 1995 resulting in an additional loss of $13,000.
All of the OREO properties are recorded at amounts which are equal
to or less than the market value based on current independent
appraisals reduced by estimated selling costs. The Bank is in
compliance with SOP 92-3.
A portion of the non-performing loans represents the Bank's
willingness to allow loans to go into default in order to pursue
collection efforts rather than to grant liberal loan renewals. As
discussed above, most of the non-performing loans and OREO are
secured by residential real estate.
Given the current local economic conditions and the importance
of real estate values to the Bank's loan portfolio, it is possible
the level of non-performing loans may increase until the local
economy improves significantly. Current collection and foreclosure
activities are likely to result in additional non-accrual and OREO
amounts. See below under "Economic Considerations".
The calculation of the adequacy of the allowance for loans
losses requires the use of management estimates. These estimates
are inherently uncertain and depend on the outcome of future
events. Management's estimates are based upon previous loan loss
experience, current economic conditions as well as the volume,
growth and composition of the loan portfolio, the estimated value
of collateral and other relevant factors. The Bank's lending is
concentrated in Southern California, which has experienced adverse
economic conditions, including declining real estate values. These
factors have adversely affected borrowers' ability to repay loans.
Although management believes the level of the allowance as of March
31, 1995 is adequate to absorb losses inherent in the loan
portfolio, additional decline in the local economy may result in
increasing losses that cannot reasonably be predicted at this date.
The possibility of increased costs of collection, non-accrual of
interest on those which are or may be placed on non-accrual, and
further charge-offs could have an adverse impact on Bank's and
Bancorp's financial condition in the future.
Non-Interest Income
Non-interest income decreased by $21,000 for the first three
months of 1995 compared to the same period in 1994. This was
largely the result of deposit service charges which decreased
$17,000 in the first quarter of 1995 compared to the same three-
month period in 1994.
Non-Interest Expenses
Non-interest expenses for the first three months of 1995
decreased $145,000 compared to the first three months of 1994.
This is a result of decreases of $102,000 in OREO expenses (due
to a $121,000 provision for OREO losses in March 1994), $19,000 in
salaries and benefits, $15,000 in office and occupancy expenses,
and $9,000 in various other expenses.
During 1993, the Bank took a number of actions to reduce non-
interest expenses and increase non-interest income. Management
continues to evaluate ways to realize even greater efficiency and
ways to reduce overhead costs. Since many of the Bank's costs are
fixed, their impact on the overhead ratio cannot be substantially
improved without a significant increase in the Bank's size.
However, the Bank cannot grow to the size necessary to be
profitable without additional capital. The directors are
considering a number of alternatives to address these matters. See
"Capital Resources".
Provision for Income Taxes
As a result of a net operating loss for the first three months
of 1995, there is no provision for Federal or California income
tax. Bancorp and Bank have a substantial Federal income tax loss
carryforward available for use in future years.
Capital Resources
Current risk-based regulatory capital standards generally
require banks and holding companies (except for non-diversified
holding companies, such as Bancorp, with less than $150 million in
assets) to maintain a ratio of "core" or "Tier 1" capital
(consisting principally of common equity) to risk-weighted assets
of at least 4%, the ratio of Tier 1 capital to adjusted total
assets (leverage ratio) of at least 3% and a ratio of total capital
(which includes Tier 1 capital plus certain forms of subordinated
debt, a portion of the allowance for loan losses, and preferred
stock) to risk-weighted assets of at least 8%. Risk-weighted
assets are calculated by multiplying the balance in each category
of assets according to a risk factor which ranges from zero for
cash assets and certain government obligations to 100% for some
types of loans, and adding the products together.
As of March 31, 1995, the Bank's Tier 1 risk-weighted capital
ratio was 3.2%, the leverage ratio was 2.5% and the Bank's total
risk-weighted capital ratio was 4.5%. As of March 31, 1995, all of
Bancorp's capital ratios were negative. The difference in the
Bank's and Bancorp's capital ratios is because Bancorp has borrowed
funds which do not qualify as Tier 1 capital and has placed most of
such funds into the Bank as additional Tier 1 capital.
The Bank is required by the Office of the Comptroller of the
Currency ("OCC") to increase its capital ratios as further
described under "Administrative Proceedings." The Bank is
considered "significantly undercapitalized" under the Prompt
Corrective Action Provisions of the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA") and would be
considered "critically undercapitalized" if its ratio of tangible
equity to total assets should equal or be less than 2%. As a result
of becoming significantly undercapitalized, the Bank was required
to submit a capital plan to the OCC outlining how the Bank plans to
meet its required capital levels. Bancorp was required to guaranty
the plan. Because of the possible material effect of the
uncertainty of the Bank obtaining additional capital in a timely
manner, Bancorp's independent auditors were not able to express and
did not express an opinion on the Consolidated Financial Statements
for 1994. See "Administrative Proceedings".
As of March 31, 1995, approximately $3.0 million in additional
capital would be necessary to meet the OCC capital ratio
requirements. Bancorp also needs additional capital or debt funds
to pay past due and future debt service on its mandatory
convertible debentures, as well as the debt service and refinancing
of short term notes payable. Such capital, debentures, notes
payable and repayment plans are further described in Notes 2, 11
and 12 to the Consolidated Financial Statements included in
Bancorp's 1994 Annual Report, and Notes 2 and 5 hereto.
The Directors are taking a number of steps to meet the capital
requirements of the OCC Agreement (as defined below). This includes
active discussions and negotiations with potential investors or
purchasers. The Bancorp is also using industry professionals for
advice and to provide assistance in locating potential investors or
purchasers. No assurance can be given that adequate capital
resources will actually be obtained. In the event the Bancorp is
unable to raise funds to increase the Bancorp's and the Bank's
capital levels and the liquidity of the Bancorp, Bancorp and the
Bank could be subject to further regulatory intervention including
the appointment of a conservator or receiver or the termination of
deposit insurance. In addition, the OCC would be permitted to
enforce the provisions of the guaranty provided by Bancorp. If any
of these events were to occur, Bancorp shareholders and
debentureholders could suffer the elimination of the value of their
investments in Bancorp. Failure to obtain adequate capital in
Bancorp and in the Bank could result in a significant adverse
impact to both companies.
Liquidity
The Bank relies on deposits as its principal source of funds
and, therefore, must be in a position to service depositors' needs
as they arise. Management of the Bank attempts to maintain a loan-
to-deposit ratio of not greater than 85% and a liquidity ratio
(liquid investments to deposits and other short term liabilities)
of approximately 20%. The average loan-to-deposit ratio was 79%
for the three-month period ending March 31, 1995 and 82% for the
same period in 1994. The average liquidity ratio was 20% during
the first three months of 1995 and 18% during the same period in
1994. While fluctuations in the balances of a few large depositors
cause temporary increases and decreases in liquidity from time to
time, the Bank has not experienced difficulty in dealing with such
fluctuations from existing liquidity sources.
Should the level of liquid assets (primary liquidity) not meet
the liquidity needs of the Bank, other available sources of liquid
assets (secondary liquidity), including the purchase of federal
funds, sale of repurchase agreements, sale of loans, and the
discount window borrowing from the Federal Reserve Bank, could be
employed. The Bank has rarely used these sources in the past since
its liquidity levels have been maintained primarily through funds
provided by deposits. The Bank has identified loans which could be
sold if necessary.
Bancorp's liquidity needs are primarily limited to debt
service. In order for Bancorp to meet its debt service
requirements and pay prior loans, Bancorp obtained additional loans
as described in Note 11 to the Consolidated Financial Statement in
Bancorp's 1994 Annual Report, and Note 5 hereto.
The Directors agreed to defer payment of all interest and
principal due on all outstanding indebtedness payable to them
through March 31, 1996, except for the $250,000 line of credit.
Three non-director shareholders agreed to defer payment of interest
and principal on notes payable to them aggregating $125,000. In
January, 1994, certain Directors began making cash advances to
Bancorp to provide the funds necessary to pay debt service on
$700,500 in principal of Debentures owned by non-directors and on
three notes totaling $550,000, of which $300,000 is payable to the
Bank under two notes due June 30, 1995 and $250,000 is a line of
credit payable to a Director due December 30, 1995. Effective
April 1, 1994, the Directors continued to advance additional funds
sufficient to service only the debt requirements of these three
notes totaling $550,000. The total of all advances was $81,000 as
of March 31, 1995. The aggregate accrued unpaid interest on all
notes and Debentures is $261,000 as of March 31, 1995.
In July 1994, the non-director debentureholders were notified
that Bancorp no longer had the funds to continue paying interest on
the Debentures; and, therefore, the quarterly interest
payments due for the second, third, and fourth quarters of 1994 and
first quarter of 1995 were not made. This constituted a payment
default under Section 8.02 of the Indenture. Debentureholders were
asked to waive the quarterly payment defaults. According to the
Indenture, such a default in the payment of interest can be waived
by a majority of the principal amount of the Debentures
outstanding, not including the amount owed by Bancorp Directors and
officers. Signed waivers have been received from a sufficient
number of debentureholders thus waiving Bancorp's default in the
above mentioned quarterly payments under the Debentures.
As of May 10, 1995 Bancorp did not have the funds available to
meet future debt service requirements of the notes and Debentures
or to perform on the guarantee to the OCC. See "Administrative
Proceedings". No assurance can be given that Bancorp ultimately
will be successful in obtaining a source of funds to meet Bancorp's
debt service requirements or that advances from the Directors will
continue. Failure to meet the debt service requirements could
force Bancorp to seek bankruptcy protection which would result in
a significant adverse impact to Bancorp noteholders,
debentureholders and shareholders.
There are legal limitations restricting the extent to which the
Bank can make loans or pay dividends to Bancorp. The Bank cannot
currently declare dividends without the approval of the Comptroller
of the Currency. Bank policy precludes the payment of cash
dividends. Pursuant to a Memorandum of Understanding with the
Federal Reserve Bank ("FRB"), Bancorp has agreed not to pay
dividends or incur additional debt without the prior approval of
the FRB. See "Administrative Proceedings."
Economic Considerations
Approximately 75% of the Bank's loan portfolio at March 31,
1995 consisted of short-term loans tied to a floating interest rate
which changes annually or more frequently (34% is tied to a daily
floating prime rate). This loan portfolio mix enables the Bank to
adjust its yields quickly in a changing interest rate environment.
The Bank's assets are more sensitive to interest rate changes than
its liabilities. This is partly because it has more non-interest
bearing liabilities (demand deposits and capital) than non-interest
earning assets. Given these circumstances and absent other
factors, declining market rates of interest will generally have a
negative impact on the Bank's net interest income, while rising
interest rates will have a positive effect.
The majority of Bancorp's assets and liabilities are monetary
items held by the Bank, the dollar value of which is not affected
by inflation. Only a small portion of total assets are in premises
and equipment. The lower inflation rate of recent years did not
have the positive impact on the Bank that was felt in many other
industries. The small fixed asset investment of Bancorp minimizes
any material misstatement of asset values and depreciation expenses
which may result from fluctuating market values due to inflation.
A higher inflation rate, however, may increase operating expenses
or have other adverse effects on borrowers of the Bank, making
collection more difficult for the Bank. Rates of interest paid or
charged generally rise if the marketplace believes inflation rates
will increase.
The Bank concentrates on serving the needs of small and medium-
size businesses, professionals and individuals located in the San
Diego County area of California. The general economy in this
market area, and particularly the real estate market, is suffering
from the effects of a slow recovery from the prolonged recession
that has negatively impacted the ability of certain borrowers of
the Bank to perform their obligations to the Bank. In addition,
problems with the Mexican peso continue to adversely affect cross-
border traffic.
Although the assessment of recent economic reports and the
current economic environment in Bancorp's market areas are
encouraging, management believes that the negative impact of a slow
recovery from the prolonged California recession will continue in
1995.
The financial condition of the Bank has been, and is expected
to continue to be, affected by overall general economic conditions
and the real estate market in California. The future success of
the Bank is dependent, in large part, upon the quality of its
assets. Although management of the Bank has devoted substantial
time and resources to the identification, collection and workout of
nonperforming assets, the real estate markets and the overall
economy in California are likely to have a significant effect on
the Bank's assets in future periods and, accordingly, the Bancorp's
financial condition and results of operations.
Administrative Proceedings
On September 21, 1992, the Bank entered into an agreement with
the OCC (the "OCC Agreement") to address certain matters arising
from an examination of the Bank's condition conducted by the OCC as
of January 31, 1992.
Under the terms of the OCC Agreement, the Bank is required,
among other things, to: (1) infuse not less than $500,000 of Tier
1 capital to achieve and maintain Tier 1 capital at least equal to
6.7% of risk-weighted assets and Tier 1 capital at least equal to
5.1% of actual adjusted total assets (leverage ratio) by December
31, 1992, (2) achieve and maintain Tier 1 capital at least equal to
9.5% of risk-weighted assets and a leverage ratio of at least equal
to 6% by March 31, 1993 (revised to March 31, 1994), (3) pay no
dividends without the prior written approval of the OCC, (4) adopt
and implement a strategic plan which includes a three-year capital
program and objectives for growth, earnings and reduction in
nonperforming assets, (5) revise the Bank's liquidity and funds
management policy, (6) formulate written policies and procedures
governing the use of funds obtained through a deposit broker, (7)
adopt and implement a written program to collect or strengthen
criticized assets, (8) develop and implement a written loan
administration program, (9) modify the Bank's loan review program
to assure timely identification and categorization of problem
loans; and (10) modify the Bank's program to review the adequacy of
the allowance for loan losses to be in accordance with recent
regulatory pronouncements.
The OCC conducted another examination of the Bank as of March
31, 1993. The OCC concluded that the Bank had satisfied the
requirements of above items 1 and 3 through 10 under the OCC
Agreement and the Bank was in non-compliance only with item 2,
minimum capital levels. As a result, certain reporting
requirements were eliminated. In January 1994, the OCC advised the
Bank its growth in average assets will be restricted.
On April 18, 1994, the OCC commenced its 1994 annual
examination. The OCC concluded that the Bank continues to be in
non-compliance with above item 2, minimum capital levels, and in
partial compliance with above items 7 and 8. Management believes
it is now in substantial compliance with items 7 and 8. At
December 31, 1994, the Bank's capital ratios did not meet those
required by the OCC Agreement as of such date.
As of December 31, 1993, the OCC notified the Bank that it was
deemed to be significantly undercapitalized under the prompt
corrective action provisions of FDICIA. As a result of becoming
significantly undercapitalized, the Bank is not only subject to
asset growth restrictions, and prohibitions on payment of dividends
and management fees, but is also subject to other additional
restrictions and sanctions being imposed by the OCC which could
include, among other things, a forced sale of the Bank to another
institution, further restrictions on growth or required shrinkage,
and limitations on interest rates paid on deposits to prevailing
rates in the Bank's market area for deposits of comparable size and
maturity.
In accordance with the prompt corrective action provisions of
FDICIA, in February 1994, the Bank submitted to the OCC a capital
restoration plan and Bancorp submitted to the OCC a guaranty of the
capital restoration plan. The amount of such guaranty is limited
to the lesser of (i) 5% of the Bank's total assets at December 31,
1993, the date the OCC deemed the Bank to have notice that it was
significantly undercapitalized or (ii) the amount which is
necessary to bring the Bank into compliance with all applicable
capital standards at the time the Bank fails to comply with the
capital restoration plan. The capital restoration plan provided
that the anticipated primary source of additional capital for the
Bank would be provided through funds received from an investor or
purchaser during the fourth quarter of 1994. That plan was
approved by the OCC in March 1994. Revised plans have since been
filed by the Bank. The revised plans also provide that the
anticipated primary source of additional capital will be provided
through funds received from an investor or purchaser. The OCC has
not approved the revised plans and is currently scheduled to begin
its 1995 annual examination on May 22, 1995.
On October 23, 1992, the Bancorp signed a Memorandum of
Understanding ("MOU") with the FRB to confirm a plan to correct
concerns arising from their inspection of the condition of the
Bancorp as of March 31, 1992. Bancorp agreed to not pay dividends,
add or replace a director or executive officer, or incur additional
debt without the prior approval of the FRB. In accordance with the
MOU, Bancorp submitted a plan to the FRB by December 30, 1992 which
set forth its plan to increase the capital of Bancorp and address
other procedural matters. Revised plans to increase capital are
submitted to the FRB as such plans are approved by the OCC. In
addition, Bancorp reports quarterly on its progress to correct
matters contained in the MOU. As of March 31, 1995 management of
Bancorp believed it was in compliance with the MOU, except for those items
related to increased capital.
PART II
ITEM 6.Exhibits and Reports on Form 8-K Page
(a) Exhibits: 30
10.7.2 Amendment dated as of March 31, 1995 to
the Amendment and Restated Employment
Agreements by and among SDN Bancorp,
the Bank and Paul E. Schedler dated
September 2, 1993 (filed as Exhibit 10.4
to Bancorp's Form 10-QSB for the
quarter ended September 30, 1993).
(b) Reports on Form 8-K: None
SDN BANCORP AND SUBSIDIARY
SECURITIES AND EXCHANGE COMMISSION FORM 10-QSB
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of
1934, the Issuer has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
SDN BANCORP
DATE: May 12, 1995 Paul E. Schedler /s/
------------------------------------------
Paul E. Schedler
President and Chief Executive Officer
DATE: May 12, 1995 Cathy J. Wingenbach /s/
-----------------------------------------
Cathy J. Wingenbach
Principal Accounting Officer