UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ý | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2017
or
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to .
Commission file number: 001-37497
LIVE OAK BANCSHARES, INC. | ||
(Exact name of registrant as specified in its charter) | ||
North Carolina | 26-4596286 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
1741 Tiburon Drive, Wilmington, NC | 28403 | |
(Address of principal executive offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (910) 790-5867 | ||
Securities registered pursuant to Section 12(b) of the Act: | ||
Title of each class | Name of each exchange on which registered | |
Voting Common Stock, no par value per share | The NASDAQ Stock Market LLC | |
Securities registered pursuant to Section 12(g) of the Act: None | ||
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. YES ¨ NO ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨ NO ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ý NO ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ý NO ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer | ¨ | Accelerated Filer | x | |||
Non-accelerated Filer | ¨ (Do not check if smaller reporting company) | Smaller Reporting Company | ¨ | |||
Emerging growth company | x | |||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO ý
The aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant as of June 30, 2017, was approximately $593,149,164. Shares of common stock held by each officer and director have been excluded in that such persons may be deemed to be affiliates. There is no public market for the registrant's non-voting common stock. For purposes of this calculation, the registrant has assumed that the market value of each share of non-voting common stock is equal to a share of voting common stock.
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.
As of March 7, 2018, there were 35,307,888 shares of the registrant’s voting common stock outstanding and 4,643,530 shares of the registrant’s non-voting common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement for the 2018 Annual Meeting of Shareholders, which the registrant plans to file subsequent to the date hereof, are incorporated by reference into Part III. Portions of the registrant's annual report to shareholders for the year ended December 31, 2017, which will be posted on the registrant's website subsequent to the date hereof, are incorporated by reference into Part II.
Live Oak Bancshares, Inc.
Report on Form 10-K
December 31, 2017
TABLE OF CONTENTS
Page | ||
PART I | ||
Item 1. | ||
Item 1A. | ||
Item 1B. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
PART II | ||
Item 5. | ||
Item 6. | ||
Item 7. | ||
Item 7A. | ||
Item 8. | ||
Item 9. | ||
Item 9A. | ||
Item 9B. | ||
PART III | ||
Item 10. | ||
Item 11. | ||
Item 12. | ||
Item 13. | ||
Item 14. | ||
PART IV | ||
Item 15. | ||
Important Note Regarding Forward-Looking Statements
This Annual Report on Form 10-K (this “Report”) contains statements that management believes are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. These statements generally relate to the financial condition, results of operations, plans, objectives, future performance or business of Live Oak Bancshares, Inc. (the "Company"). They usually can be identified by the use of forward-looking terminology, such as “believes,” “expects,” or “are expected to,” “plans,” “projects,” “goals,” “estimates,” “will,” “may,” “should,” “could,” “would,” “continues,” “intends to,” “outlook” or “anticipates,” or variations of these and similar words, or by discussions of strategies that involve risks and uncertainties. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to, those described in this Report. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements management may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information actually known to the Company at the time. Management undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements contained in this Report are based on current expectations, estimates and projections about the Company’s business, management’s beliefs and assumptions made by management. These statements are not guarantees of the Company’s future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements. These risks, uncertainties and assumptions include, without limitation:
• | deterioration in the financial condition of borrowers resulting in significant increases in the Company’s loan and lease losses and provisions for those losses and other adverse impacts to results of operations and financial condition; |
• | changes in Small Business Administration ("SBA") rules, regulations and loan products, including specifically the Section 7(a) program, changes in SBA standard operating procedures or changes to the status of Live Oak Banking Company (the "Bank") as an SBA Preferred Lender; |
• | changes in rules, regulations or procedures for other government loan programs, including those of the United States Department of Agriculture; |
• | changes in interest rates that affect the level and composition of deposits, loan demand and the values of loan collateral, securities, and interest sensitive assets and liabilities; |
• | the failure of assumptions underlying the establishment of reserves for possible loan and lease losses; |
• | changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments; |
• | a reduction in or the termination of the Company’s ability to use the technology-based platform that is critical to the success of the Company’s business model, including a failure in or a breach of the Company’s operational or security systems or those of its third party service providers; |
• | changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts operations, including reductions in rates of business formation and growth, demand for the Company’s products and services, commercial and residential real estate development and prices, premiums paid in the secondary market for the sale of loans, and valuation of servicing rights; |
• | changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking; |
• | fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing; |
• | the effects of competition from other commercial banks, non-bank lenders, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet; |
• | the Company's ability to attract and retain key personnel; |
• | changes in governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA lending programs and investment tax credits; |
• | changes in political and economic conditions; |
• | the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau; |
• | the Company's ability to comply with any requirements imposed on it by regulators, and the potential negative consequences that may result; |
• | operational, compliance and other factors, including conditions in local areas in which the Company conducts business such as inclement weather or a reduction in the availability of services or products for which loan proceeds will be used, that could prevent or delay closing and funding loans before they can be sold in the secondary market; |
• | the effect of any mergers, acquisitions or other transactions, to which the Company or the Bank may from time to time be a party, including management’s ability to successfully integrate any businesses acquired; |
• | other risk factors listed from time to time in reports that the Company files with the SEC, including those described under “Risk Factors” in this Report; and |
• | the success at managing the risks involved in the foregoing. |
Except as otherwise disclosed, forward-looking statements do not reflect: (i) the effect of any acquisitions, divestitures or similar transactions that have not been previously disclosed; (ii) any changes in laws, regulations or regulatory interpretations; or (iii) any change in current dividend or repurchase strategies, in each case after the date as of which such statements are made. All forward-looking statements speak only as of the date on which such statements are made, and the Company undertakes no obligation to update any statement, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
PART I
Item 1. | BUSINESS |
General
Live Oak Bancshares, Inc. (“LOB” and, collectively with its subsidiaries including Live Oak Banking Company, the “Company,” also referred to as "our" and "we"), headquartered in Wilmington, North Carolina, is the bank holding company for Live Oak Banking Company (the “Bank” or "Live Oak Bank"). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank and operates an established national online platform for small business lending. LOB was incorporated under the laws of the state of North Carolina on December 18, 2008, for the purpose of serving as the bank holding company of Live Oak Bank. LOB completed its initial public offering (“IPO”) in July 2015.
The Company
The Company predominantly originates loans partially guaranteed by the U.S. Small Business Administration (the "SBA") and to a lesser extent by the U.S. Department of Agriculture ("USDA") Rural Energy for America Program ("REAP") and Business & Industry ("B&I") loan programs. These loans are to small businesses and professionals with what the Company believes are lower risk characteristics. Industries, or “verticals,” on which the Company focuses its lending efforts are carefully selected. Within each vertical the Company retains individuals who possess extensive industry-specific experience. Additionally, the Company’s domain experts are engaged and active in each of the industries served.
In addition to focusing on industry verticals, the Company emphasizes developing detailed knowledge of its customers’ businesses. This knowledge is developed, in part, through regular visits to customers’ operations, wherever they are located. These regular visits are designed to foster both for the Company and for the customer a deep and personalized experience throughout the lending relationship. The Company has developed and continues to refine a technology-based platform to facilitate providing financial services to the small business community on a national scale and has leveraged this technology to optimize the Company's loan origination process, customer experience, reporting metrics, and servicing activity. The Company services customers efficiently throughout the loan process and monitors their performance by means of the technology-based platform, which eliminates the need to maintain traditional branch locations.
For additional information on the Company's business, financial performance and results of operations, see “Overview” and “Executive Summary” in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Report. For information on the Company’s financial information about geographic areas, see Part II, Item 8 of this Report.
LOB's voting common stock trades on the NASDAQ Global Select Market (“Nasdaq”) under the symbol “LOB.” As of January 31, 2018, there were 342 holders of record of LOB's voting common stock. The Company's principal executive office is located at 1741 Tiburon Drive, Wilmington, North Carolina 28403, telephone number (910) 790-5867. The Company maintains a website at www.liveoakbank.com. Documents available on the website include: (i) the Company's Code of Ethics and Conflict of Interest Policy; and (ii) charters for the Audit and Risk, Compensation, and Nominating and Corporate Governance Committees of the Board of Directors. These documents also are available in print to any shareholder who requests a copy.
In addition, available free of charge through the Company's website is the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after electronically filing or furnishing such material to the U.S. Securities and Exchange Commission (“SEC”). These filings are also accessible on the SEC’s website at www.sec.gov. You may read and copy any material LOB files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.
The Company also will provide without charge a copy of this Report, as well as any documents available on the Company's website, to any shareholder by mail. Requests should be sent to Live Oak Bancshares, Inc., Attention: Corporate Secretary, 1741 Tiburon Drive, Wilmington, NC 28403.
1
Competition
Commercial banking in the United States is extremely competitive. The Company competes with national banking organizations, including the largest commercial banks headquartered in the country, all of which have small business lending divisions. The Company also competes with other federally and state chartered financial institutions such as community banks and credit unions, finance and business development companies, peer-to-peer and marketplace lenders and other non-bank lenders. Many of the Company's competitors have higher legal lending limits and are also able to provide a wider array of services and make greater use of media advertising given their size and resources.
Despite the intense level of competition among small business lenders, the Company believes that it occupies a lending category distinct from its competitors. One of the Company's principal advantages is the technology-based platform it uses, which management believes has accelerated the Company's ability to issue proposals, complete credit due diligence, finalize commitments and improve the overall customer experience. The Company believes that its personnel also provide a competitive advantage because they are industry participants with relevant experience in the Company's identified verticals.
Employees
As of December 31, 2017, the Company had 504 full-time employees and 24 part-time employees. None of these employees are covered by a collective bargaining agreement, and management considers relations with employees to be good.
Subsidiaries
In addition to the Bank, the Company held the following wholly-owned subsidiaries as of December 31, 2017:
• | Reltco, Inc. and National Assurance Title, Inc. (collectively referred to as “Reltco”), two companies under common control acquired on February 1, 2017, that provide nationwide title agency and settlement services; |
• | Live Oak Clean Energy Financing LLC, formed in November 2016 for the purpose of providing financing to entities for renewable energy applications; |
• | Canapi, Inc (formerly Live Oak Ventures, Inc.), formed in August 2016 for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology; |
• | Live Oak Grove, LLC, opened in September 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location; |
• | Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans; and |
• | 504 Fund Advisors, LLC (“504FA”), formed to serve as the investment advisor to the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans. |
In 2010, the Bank formed Live Oak Number One, Inc., a wholly owned subsidiary, to hold properties foreclosed on by the Bank.
SUPERVISION AND REGULATION
Federal Bank Holding Company Regulation and Structure
As a registered bank holding company, LOB is subject to regulation under the Bank Holding Company Act, or BHCA, and to the supervision, examination and reporting requirements of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is a North Carolina-chartered commercial bank and is subject to regulation, supervision and examination by the FDIC and the North Carolina Commissioner of Banks, or NCCOB.
2
The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve before:
• | it may acquire direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the voting shares of the bank; |
• | it or any of its subsidiaries, other than a bank, may acquire all or substantially all of the assets of any bank; or |
• | it may merge or consolidate with any other bank holding company. |
The BHCA further provides that the Federal Reserve may not approve any transaction that would result in a monopoly or that would substantially lessen competition in the banking business, unless the public interest in meeting the needs of the communities to be served outweighs the anti-competitive effects. The Federal Reserve is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks involved and the convenience and needs of the communities to be served. Consideration of financial resources generally focuses on capital adequacy, and consideration of convenience and needs issues focuses, in part, on the performance under the Community Reinvestment Act of 1977, both of which are discussed elsewhere in more detail.
Subject to various exceptions, the BHCA and the Change in Bank Control Act, together with related regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company. Control is also presumed to exist, although rebuttable, if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:
• | the bank holding company has registered securities under Section 12 of the Securities Exchange Act of 1934, as amended, or the Exchange Act; or |
• | no other person owns a greater percentage of that class of voting securities immediately after the transaction. |
LOB's common stock is registered under Section 12 of the Exchange Act. The regulations provide a procedure for challenging rebuttable presumptions of control.
The BHCA generally prohibits a bank holding company from retaining direct or indirect ownership or control of any voting shares of any company which is not a bank or bank holding company or engaging in activities other than banking, managing or controlling banks or other permissible subsidiaries and acquiring or retaining direct or indirect control of any company engaged in any activities other than activities closely related to banking or managing or controlling banks. In determining whether a particular activity is permissible, the Federal Reserve considers whether performing the activity can be expected to produce benefits to the public that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve has the power to order a bank holding company or its subsidiaries to terminate any activity or control of any subsidiary when the continuation of the activity or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company.
Under the BHCA, a bank holding company may file an election with the Federal Reserve to be treated as a financial holding company and engage in an expanded list of financial activities. The election must be accompanied by a certification that all of the company’s insured depository institution subsidiaries are “well capitalized” and “well managed.” Additionally, the Community Reinvestment Act of 1977 rating of each subsidiary bank must be satisfactory or better. If, after becoming a financial holding company and undertaking activities not permissible for a bank holding company, the company fails to continue to meet any of the prerequisites for financial holding company status, the company must enter into an agreement with the Federal Reserve to comply with all applicable capital and management requirements. If the company does not return to compliance within 180 days, the Federal Reserve may order the company to divest its subsidiary banks or the company may discontinue or divest investments in companies engaged in activities permissible only for a bank holding company that has elected to be treated as a financial holding company. LOB has filed an election and became a financial holding company in 2016.
Under Federal Reserve policy and as codified by the Dodd-Frank Act, the Company is expected to act as a source of financial strength for Live Oak Bank and to commit resources to support Live Oak Bank. This support may be required at times when LOB might not be inclined to provide it or it might not be in LOB's best interests or the best interests of its shareholders. In addition, any capital loans made by the Company to Live Oak Bank will be repaid only after Live Oak Bank’s deposits and various other obligations are repaid in full.
3
Live Oak Bank is also subject to numerous state and federal statutes and regulations that affect its business, activities and operations and is supervised and examined by state and federal bank regulatory agencies. The FDIC and the NCCOB regularly examine the operations of Live Oak Bank and are given the authority to approve or disapprove mergers, consolidations, the establishment of branches and similar corporate actions. These agencies also have the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law.
Bank Merger Act
Section 18(c) of the Federal Deposit Insurance Act, popularly known as the “Bank Merger Act,” requires the prior written approval of appropriate federal bank regulatory agencies before any bank may (i) merge or consolidate with, (ii) purchase or otherwise acquire the assets of, or (iii) assume the deposit liabilities of, another bank if the resulting institution is to be a state nonmember bank.
The Bank Merger Act prohibits the applicable federal bank regulatory agency from approving any proposed merger transaction that would result in a monopoly, or would further a combination or conspiracy to monopolize or to attempt to monopolize the business of banking in any part of the United States. Similarly, the Bank Merger Act prohibits the applicable federal bank regulatory agency from approving a proposed merger transaction whose effect in any section of the country may be substantially to lessen competition, or to tend to create a monopoly, or which in any other manner would be in restraint of trade. An exception may be made in the case of a merger transaction whose effect would be to substantially lessen competition, tend to create a monopoly, or otherwise restrain trade, if the applicable federal bank regulatory agency finds that the anticompetitive effects of the proposed transaction are clearly outweighed in the public interest by the probable effect of the transaction in meeting the convenience and needs of the community to be served.
In every proposed merger transaction, the applicable federal bank regulatory agency must also consider the financial and managerial resources and future prospects of the existing and proposed institutions, the convenience and needs of the community to be served, and the effectiveness of each insured depository institution involved in the proposed merger transaction in combating money-laundering activities, including in overseas branches.
State Law
Live Oak Bank is subject to extensive supervision and regulation by the NCCOB. The NCCOB oversees state laws that set specific requirements for bank capital and that regulate deposits in, and loans and investments by, banks, including the amounts, types, and in some cases, rates. The NCCOB supervises and performs periodic examinations of North Carolina-chartered banks to assure compliance with state banking statutes and regulations, and banks are required to make regular reports to the NCCOB describing in detail their resources, assets, liabilities, and financial condition. Among other things, the NCCOB regulates mergers and consolidations of state-chartered banks, capital requirements for banks, loans to officers and directors, record keeping, types and amounts of loans and investments, and the establishment of branches.
The NCCOB has extensive enforcement authority over North Carolina banks. Such authority includes the ability to issue cease and desist orders and to seek civil money penalties. The NCCOB may also take possession of a North Carolina bank in various circumstances, including for a violation of its charter or of applicable laws, operating in an unsafe and unsound manner, or as a result of an impairment of its capital, and may appoint a receiver.
The NCCOB also enforces specific requirements for bank capital, the payment of dividends, loans to officers and directors, record keeping, and types and amounts of loans and investments made by commercial banks.
The Company is also required to maintain registration as a bank holding company with the NCCOB. Subject to certain exceptions, the Company may not acquire control over another bank or bank holding company or consummate a merger or other combination transaction with another company without the prior approval of the NCCOB. The NCCOB also has authority to assert civil money penalties against a holding company if the NCCOB determines such holding company to be in violation of any banking laws and the holding company fails to comply with an NCCOB order to cease and desist from such violations of law.
4
Payment of Dividends and Other Restrictions
The Company is a legal entity separate and distinct from the Bank. While there are various legal and regulatory limitations under federal and state law on the extent to which banks can pay dividends or otherwise supply funds to holding companies, the principal source of cash revenues for the Company is dividends from the Bank. The relevant federal and state regulatory agencies have authority to prohibit a state bank or bank holding company, which would include the Bank and the Company, from engaging in what, in the opinion of such regulatory body, constitutes an unsafe or unsound practice in conducting its business. The payment of dividends could, depending upon the financial condition of a bank, be deemed to constitute an unsafe or unsound practice in conducting its business.
North Carolina commercial banks, such as Live Oak Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. Specifically, an insured depository institution, such as Live Oak Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is defined in the applicable law and regulations).
The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve’s view that a bank holding company should pay cash dividends only to the extent that the holding company’s net income for the past four quarters is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a holding company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve, the Federal Reserve may prohibit a bank holding company from paying any dividends if any of the holding company’s bank subsidiaries are classified as undercapitalized.
A bank holding company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of its consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order or any condition imposed by, or written agreement with, the Federal Reserve.
Capital Adequacy
The Company must comply with the Federal Reserve’s established capital adequacy standards, and Live Oak Bank is required to comply with the capital adequacy standards established by the FDIC. The Federal Reserve has promulgated two basic measures of capital adequacy for bank holding companies: a risk-based measure and a leverage measure. A bank holding company must satisfy all applicable capital standards to be considered in compliance.
The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies, account for off-balance-sheet exposure and minimize disincentives for holding liquid assets.
Assets and off-balance-sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance-sheet items. Under applicable capital standards the minimum risk-based capital ratios are a common equity Tier 1 capital to risk-weighted assets ratio of 4.5%, a Tier 1 capital to risk-weighted assets ratio of 6%, and a total capital to risk-weighted assets ratio of 8%. In addition, to avoid restrictions on capital distributions and discretionary bonus payments, the Company and the Bank are required to meet a capital conservation buffer of common equity Tier 1 capital in addition to the minimum common equity Tier 1 capital ratio. The capital conservation buffer is being phased in from January 1, 2016 until January 1, 2019, at which point it will be set at 2.5% common equity Tier 1 capital to risk-weighted assets, which sits “on top” of the 4.5% minimum common equity Tier 1 to risk-weighted assets ratio. Common equity Tier 1 capital is predominantly comprised of retained earnings and common stock instruments (that meet strict delineated criteria), net of treasury stock, and after making necessary capital deductions and adjustments. Tier 1 capital is comprised of common equity Tier 1 capital plus Additional Tier 1 capital, which consists of noncumulative perpetual preferred stock and similar instruments meeting specified eligibility criteria and “TARP” preferred stock and other instruments issued under the Emergency Economic Stabilization Act of 2008. Total capital is comprised of Tier 1 capital plus Tier 2 capital, which consists of subordinated debt with a minimum original maturity of at least five years and a limited amount of loan loss reserves.
At December 31, 2017, the Company's risk-based capital ratios, as calculated under applicable capital standards were 17.81% common equity Tier 1 capital to risk weighted assets, 17.81% Tier 1 capital to risk weighted assets, and 18.91% total capital to risk weighted assets.
5
In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 capital to average total on-balance sheet assets, less goodwill and certain other intangible assets, of 4% for bank holding companies. The Company’s ratio at December 31, 2017 was 15.50% compared to 12.00% at December 31, 2016. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve has indicated that it will consider a “tangible Tier 1 Capital leverage ratio” and other indications of capital strength in evaluating proposals for expansion or new activities.
Failure to meet capital guidelines could subject a bank to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on taking brokered deposits and certain other restrictions on its business. As described below, the FDIC can impose substantial additional restrictions upon FDIC-insured depository institutions that fail to meet applicable capital requirements.
The Federal Deposit Insurance Act, or FDI Act, requires the federal bank regulatory agencies to take “prompt corrective action” if a depository institution does not meet minimum capital requirements. The FDI Act establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.
The federal bank regulatory agencies have adopted regulations establishing relevant capital measures and relevant capital levels applicable to FDIC-insured banks. The relevant capital measures are the Total Risk-Based Capital ratio, Tier 1 Risk-Based Capital ratio, Common Equity Tier 1 Capital ratio and the leverage ratio. Under current regulations, an FDIC-insured bank was:
• | “well capitalized” if it has a Total Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capital ratio of 8% or greater, a Common Equity Tier 1 Capital ratio of 6.5% or greater and a leverage ratio of 5% or greater and is not subject to any order or written directive by the appropriate regulatory authority to meet and maintain a specific capital level for any capital measure; |
• | “adequately capitalized” if it has a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-Based Capital ratio of 6% or greater, a Common Equity Tier 1 Capital ratio of 4.5% or greater and a leverage ratio of 4% or greater and is not “well capitalized”; |
• | “undercapitalized” if it has a Total Risk-Based Capital ratio of less than 8%, a Tier 1 Risk-Based Capital ratio of less than 6%, a Common Equity Tier 1 Capital ratio of less than 4% or a leverage ratio of less than 4%; |
• | “significantly undercapitalized” if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1 Risk-Based Capital ratio of less than 4%, a Common Equity Tier 1 Capital ratio of less than 3% or a leverage ratio of less than 3%; and |
• | “critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets. |
An institution may be downgraded to, or deemed to be in, a capital category that is lower than is indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. As of December 31, 2017, Live Oak Bank had capital levels that qualify as “well capitalized” under the applicable regulations.
The FDI Act generally prohibits an FDIC-insured bank from making a capital distribution (including payment of a dividend) or paying any management fee to its holding company if the bank is or would thereafter be “undercapitalized.” “Undercapitalized” banks are subject to growth limitations and are required to submit a capital restoration plan. The federal regulators may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the bank’s capital. In addition, for a capital restoration plan to be acceptable, the bank’s parent holding company must guarantee that the institution will comply with such capital restoration plan until the institution has been adequately capitalized on average during each of four consecutive calendar quarters. The aggregate liability of the parent holding company under such guaranty is limited to the lesser of: (i) an amount equal to 5% of the bank’s total assets at the time it became “undercapitalized”; and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a bank fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”
“Significantly undercapitalized” insured banks may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets and the cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator. A bank that is not “well capitalized” is also subject to certain limitations relating to brokered deposits.
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The regulatory capital framework under which the Company and Live Oak Bank operate changed in significant respects as a result of the Dodd-Frank Act, which was enacted in July 2010, and other regulations, including the separate regulatory capital requirements put forth by the Basel Committee on Banking Supervision, commonly known “Basel III.”
In July 2013, the Federal Reserve, FDIC and Office of the Comptroller of the Currency approved final rules that established an integrated regulatory capital framework that addressed shortcomings in certain capital requirements. The rules implemented in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. These rule began to apply to the Company effective January 1, 2015.
The major provisions of the rule applicable to the Company are:
• | The rule implements higher minimum capital requirements, includes a new common equity Tier1 capital requirement, and establishes criteria that instruments must meet in order to be considered Common Equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. These enhancements are intended to both improve the quality and increase the quantity of capital required to be held by banking organizations. The minimum capital to risk-weighted assets (“RWA”) requirements under the rule are a common equity Tier 1 capital ratio of 4.5% and a Tier 1 capital ratio of 6.0%, which is an increase from 4.0%, and a total capital ratio of 8.0%. The minimum leverage ratio (Tier 1 capital to total assets) is 4.0%. The rule maintained the general structure of the current prompt corrective action, or PCA, framework while incorporating these increased minimum requirements. |
• | The rule implements changes to the definition of capital. Among the most important changes are stricter eligibility criteria for regulatory capital instruments that disallow the inclusion of instruments such as trust preferred securities in Tier 1 capital going forward, and constraints on the inclusion of minority interests, mortgage-servicing assets (“MSAs”), deferred tax assets (“DTAs”), and certain investments in the capital of unconsolidated financial institutions. In addition, the rule requires that certain regulatory capital deductions be made from common equity Tier 1 capital. |
• | Under the rule, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to RWA. A three-year phase-in of the capital conservation buffer requirements began on January 1, 2016. A banking organization with a buffer greater than 2.5% would not be subject to limits on capital distributions or discretionary bonus payments; however, a banking organization with a buffer of less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The rule also prohibits a banking organization from making distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. When the rule is fully phased in, the minimum capital requirements plus the capital conservation buffer will exceed the PCA well-capitalized thresholds. |
• | The rule also increases the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors. |
On July 9, 2013, the FDIC confirmed that it would join in the Basel III standards and, on September 10, 2013, issued an “interim final rule” applicable to the Bank that is identical in substance to the final rules issued by the Federal Reserve described above. The Bank was required to comply with the interim final rule beginning on January 1, 2015. Compliance by LOB and the Bank with these capital requirements affects their respective operations by increasing the amount of capital required to conduct operations.
Acquisitions
The Company must comply with numerous laws related to any potential acquisition activity. Under the BHCA, a bank holding company may not directly or indirectly acquire ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank or merge or consolidate with another bank holding company without the prior approval of the Federal Reserve. The acquisition of non-banking companies is also regulated by the Federal Reserve. Current federal law authorizes interstate acquisitions of banks and bank holding companies without geographic limitation. Furthermore, a bank headquartered in one state is authorized to merge with a bank headquartered in another state, as long as neither of the states has opted out of such interstate merger authority prior to such date, and subject to any state requirement that the target bank shall have been in existence and operating for a minimum period of time, not to exceed five years, and to certain deposit market-share limitations. After a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law. Additionally, since passage of the Dodd-Frank Act, a bank is now permitted to open a de novo branch in any state if that state would permit a bank organized in that state to open a branch.
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Restrictions on Affiliate Transactions
Sections 23A and 23B of the Federal Reserve Act establish parameters for a bank to conduct “covered transactions” with its affiliates, with the objective of limiting risk to the insured bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such bank’s capital stock and surplus, and limit the aggregate of all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the bank or subsidiary as those that would be provided to a non-affiliate. The term “covered transaction” includes the making of loans to the affiliate, purchase of assets from the affiliate, issuance of a guaranty on behalf of the affiliate and several other types of transactions.
The Dodd-Frank Act imposed additional restrictions on transactions between affiliates by amending these two sections of the Federal Reserve Act. Under the Dodd-Frank Act, restrictions on transactions with affiliates are enhanced by (i) including among “covered transactions” transactions between bank and affiliate-advised investment funds; (ii) including among “covered transactions” transactions between a bank and an affiliate with respect to securities repurchase agreements and derivatives transactions; (iii) adopting stricter collateral rules; and (iv) imposing tighter restrictions on transactions between banks and their financial subsidiaries.
FDIC Insurance Assessments
The assessment rate paid by each DIF member institution is based on its relative risks of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category. An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. Live Oak Bank’s insurance assessments during 2017 and 2016 were $3.2 million and $1.4 million, respectively. An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required. The FDIC may terminate insurance of deposits upon a finding that an institution has engaged in unsafe and 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.
The Dodd-Frank Act expanded the base for FDIC insurance assessments, requiring that assessments be based on the average consolidated total assets less tangible equity capital of a financial institution. On February 7, 2011, the FDIC approved a final rule to implement the foregoing provision of the Dodd-Frank Act. Among other things, the final rule revised the assessment rate schedule to provide initial base assessment rates ranging from 5 to 35 basis points, subject to adjustments which could increase or decrease the total base assessment rates. The FDIC has three possible adjustments to an institution’s initial base assessment rate: (1) a decrease of up to five basis points (or 50% of the initial base assessment rate) for long-term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt; (2) an increase for holding long-term unsecured or subordinated debt issued by other insured depository institutions known as the Depository Institution Debt Adjustment; and (3) for institutions not well rated and well capitalized, an increase not to exceed 10 basis points for brokered deposits in excess of 10 percent of domestic deposits.
The law also gives the FDIC enhanced discretion to set assessment rate levels.
The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of the Financing Corporation, or the FICO. The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and was .135 basis points for each the first three quarters and .115 basis points for the fourth quarter of 2017, per $100 of assessable deposits. These assessments will continue until the debt matures in 2018 through 2019.
Community Reinvestment Act
The Community Reinvestment Act requires federal bank regulatory agencies to encourage financial institutions to meet the credit needs of low and moderate-income borrowers in their local communities. An institution’s size and business strategy determines the type of examination that it will receive. Large, retail-oriented institutions are examined using a performance-based lending, investment and service test. Small institutions are examined using a streamlined approach. All institutions may opt to be evaluated under a strategic plan formulated with community input and pre-approved by the bank regulatory agency.
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The Community Reinvestment Act regulations provide for certain disclosure obligations. Each institution must post a notice advising the public of its right to comment to the institution and its regulator on the institution’s Community Reinvestment Act performance and to review the institution’s Community Reinvestment Act public file. Each lending institution must maintain for public inspection a file that includes a listing of branch locations and services, a summary of lending activity, a map of its communities and any written comments from the public on its performance in meeting community credit needs. The Community Reinvestment Act requires public disclosure of the regulators’ written Community Reinvestment Act evaluations of financial institutions. This promotes enforcement of Community Reinvestment Act requirements by providing the public with the status of a particular institution’s community reinvestment record.
The Gramm-Leach-Bliley Act made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual Community Reinvestment Act reports relating to such agreements must be made available to a bank’s primary federal regulator. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the Gramm-Leach-Bliley Act may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a satisfactory Community Reinvestment Act rating in its latest Community Reinvestment Act examination.
The Volcker Rule
Under provisions of the Dodd-Frank Act referred to as the “Volcker Rule,” certain limitations are placed on the ability of insured depository institutions and their affiliates to engage in sponsoring, investing in and transacting with certain investment funds, including hedge funds and private equity funds. The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities. The Volcker Rule became fully effective in July 2015, and banking entities had until July 21, 2017, to divest certain legacy investments in covered funds.
Additional Legislative and Regulatory Matters
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, requires each financial institution: (i) to establish an anti-money laundering program; (ii) to establish due diligence policies, procedures and controls with respect to its private banking accounts involving foreign individuals and certain foreign banks; and (iii) to avoid establishing, maintaining, administering or managing correspondent accounts in the United States for, or on behalf of, foreign banks that do not have a physical presence in any country. The USA PATRIOT Act also requires the Secretary of the Treasury to prescribe by regulation minimum standards that financial institutions must follow to verify the identity of customers, both foreign and domestic, when a customer opens an account. In addition, the USA PATRIOT Act contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities.
Sarbanes-Oxley mandates for public companies, such as the Company, a variety of reforms intended to address corporate and accounting fraud and provides for the establishment of the PCAOB, which enforces auditing, quality control and independence standards for firms that audit SEC-reporting companies. Sarbanes-Oxley imposes higher standards for auditor independence and restricts the provision of consulting services by auditing firms to companies they audit and requires that certain audit partners be rotated periodically. It also requires chief executive officers and chief financial officers, or their equivalents, to certify the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement, and increases the oversight and authority of audit committees of publicly traded companies.
Fiscal and Monetary Policy
Banking is a business which depends on interest rate differentials for success. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes a significant portion of a bank’s earnings. Thus, the Company's earnings and growth will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve and the reserve requirements on deposits. The nature and timing of any changes in such policies and their effect on the Company's business and results of operations cannot be predicted.
Current and future legislation and the policies established by federal and state regulatory authorities will affect the Company's future operations. Banking legislation and regulations may limit the Company's growth and the return to its investors by restricting certain of its activities.
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In addition, capital requirements could be changed and have the effect of restricting the activities of the Company or requiring additional capital to be maintained. The Company cannot predict with certainty what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on the Company's business and results of operations.
Real Estate Lending Evaluations
The federal regulators have adopted uniform standards for evaluations of loans secured by real estate or made to finance improvements to real estate. Banks are required to establish and maintain written internal real estate lending policies consistent with safe and sound banking practices and appropriate to the size of the institution and the nature and scope of its operations. The regulations establish loan to value ratio limitations on real estate loans. Live Oak Bank’s respective loan policies establish limits on loan to value ratios that are equal to or less than those established in such regulations.
Commercial Real Estate Concentrations
Lending operations of commercial banks may be subject to enhanced scrutiny by federal banking regulators based on a bank’s concentration of commercial real estate, or CRE, loans. On December 6, 2006, the federal banking regulators issued final guidance to remind financial institutions of the risk posed by commercial real estate, or CRE, lending concentrations. CRE loans generally include land development, construction loans, and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines for bank examiners to help identify institutions that are potentially exposed to significant CRE risk and may warrant greater supervisory scrutiny:
• | total reported loans for construction, land development and other land, or C&D, represent 100% or more of the institution’s total capital; or |
• | total CRE loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s CRE loan portfolio has increased over 50% or more during the prior 36 months. |
As of December 31, 2017, the Bank's C&D concentration as a percentage of bank capital totaled 182.3% and the Bank's CRE concentration, net of owner-occupied loans, as a percentage of capital totaled 112.3%.
Limitations on Incentive Compensation
In October 2009, the Federal Reserve issued proposed guidance designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking or undermine the safety and soundness of the organization. In connection with the proposed guidance, the Federal Reserve announced that it would review incentive compensation arrangements of bank holding companies such as the Company as part of the regular, risk-focused supervisory process.
In June 2010, the Federal Reserve issued the incentive compensation guidance in final form and was joined by the FDIC, and the Office of the Comptroller of the Currency. The final guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide employees incentives that appropriately balance risk and reward and, thus, do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Any deficiencies in compensation practices that are identified may be incorporated into the organization’s supervisory ratings, which can affect its ability to make acquisitions or perform other actions. The guidance provides that enforcement actions may be taken against a banking organization if its incentive compensation arrangements or related risk-management control or governance processes pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
As required by the Dodd-Frank Act, in March 2011 the SEC and the federal bank regulatory agencies (including the Federal Reserve and the FDIC) proposed regulations that would prohibit financial institutions with assets of at least $1 billion from maintaining executive compensation arrangements that encourage inappropriate risk taking by providing excessive compensation or that could lead to material financial loss. These proposed regulations incorporate the principles discussed in the Federal Reserve’s June 2010 incentive compensation guidance. In May 2016, the federal bank regulatory agencies replaced the regulations proposed in 2011 with a new proposal. If the regulations are adopted in the form proposed, they will impose limitations on the manner in which the Company may structure compensation for its executives. The comment period for these proposed regulations has closed, but a final rule has not been published.
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Economic Environment
The policies of regulatory authorities, including the monetary policy of the Federal Reserve, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid on deposits. The Federal Reserve’s monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of these policies on the Company's business and earnings cannot be predicted.
Evolving Legislation and Regulatory Action
The Dodd-Frank Act was signed into law in 2010 and implemented many new changes in the way financial and banking operations are regulated in the United States, including through the creation of a new resolution authority, mandating higher capital and liquidity requirements, requiring banks to pay increased fees to regulatory agencies and numerous other provisions intended to strengthen the financial services sector. Pursuant to the Dodd-Frank Act the Financial Stability Oversight Council, or the FSOC, was created and is charged with overseeing and coordinating the efforts of the primary U.S. financial regulatory agencies (including the Federal Reserve, the FDIC and the SEC) in establishing regulations to address systemic financial stability concerns. Under the Dodd-Frank Act, the Consumer Financial Protection Bureau, or the CFPB, was also created as a new consumer financial services regulator. The CFPB is authorized to prevent unfair, deceptive and abusive practices and ensure that consumers have access to markets for consumer financial products and services and that such markets are fair, transparent and competitive.
In 2017, both the House of Representatives and the Senate introduced legislation that would repeal or modify provisions of the Dodd-Frank Act and significantly impact financial services regulation. Although the bills vary in content, certain key aspects include revisions to rules related to mortgage loans, delayed implementation of rules related to the Home Mortgage Disclosure Act, and reform and simplifications of certain Volcker Rule requirements.
New laws or regulations or changes to existing laws and regulations, including changes in interpretation or enforcement, could materially adversely affect the Company's financial condition or results of operations. Many aspects of the Dodd-Frank Act are subject to further rulemaking and will take effect over several years. As a result, the overall financial impact on the Company and Live Oak Bank cannot be anticipated at this time.
February 3, 2017, Executive Order
On February 3, 2017, the President of the United States issued an executive order identifying “core principles” for the administration’s financial services regulatory policy and directing the Secretary of the Treasury, in consultation with the heads of other financial regulatory agencies, to evaluate how the current regulatory framework promotes or inhibits the principles and what actions have been, and are being, taken to promote the principles. In response to the executive order, on June 12, 2017, October 6, 2017 and October 26, 2017, respectively, the U.S. Department of the Treasury issued the first three of four reports recommending a number of comprehensive changes in the current regulatory system for U.S. depository institutions, the U.S. capital markets and the U.S. asset management and insurance industries.
Federal and State Taxation
The Company and its subsidiaries file a consolidated federal income tax return and separate state income tax returns in North Carolina. All the returns are filed on a calendar year basis. Consolidated income tax returns have the effect of eliminating intercompany income and expense, including dividends, from the computation of consolidated taxable income for the taxable year in which the items occur. In accordance with an income tax sharing agreement, income tax charges or credits are allocated among Live Oak and its subsidiaries on the basis of their respective taxable income or taxable loss that is included in the consolidated income tax return.
Banks and bank holding companies are subject to federal and state income taxes in essentially the same manner as other corporations. Taxable income is generally calculated under applicable sections of the Internal Revenue Code of 1986, as amended (the “Code”), with some modifications required by state law and the December 2017 tax legislation commonly referred to as the Tax Cut and Jobs Act (the "Tax Act"). Although Live Oak’s federal income tax liability is determined under provisions of the Code, which is applicable to all taxpayers, Sections 581 through 597 of the Code apply specifically to financial institutions.
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Among other things, the new Tax Act (i) establishes a new, flat corporate federal statutory income tax rate of 21%, (ii) eliminates the corporate alternative minimum tax and allows the use of any such carryforwards to offset regular tax liability for any taxable year, (iii) limits the deduction for net interest expense incurred by U.S. corporations, (iv) allows businesses to immediately expense, for tax purposes, the cost of new investments in certain qualified depreciable assets, (v) eliminates or reduces certain deductions related to meals and entertainment expenses, (vi) modifies the limitation on excessive employee remuneration to eliminate the exception for performance-based compensation and clarifies the definition of a covered employee and (vii) limits the deductibility of deposit insurance premiums. The Tax Cuts and Jobs Act also significantly changes U.S. tax law related to foreign operations, however, such changes do not currently impact the Company. Based upon current 2018 projections, the effective tax rate for 2018 is expected to be in the low-to-mid single digits; however, there can be no assurance as to the actual amount because it will be dependent upon the nature and amount of future income and expenses as well as investments generating investment tax credits and transactions with discrete tax effects and any possible changes in the Company's provisional adjustments in revaluing the deferred tax liability at December, 31 2017. The accounting for the impact of the Tax Act is expected to be completed during the fourth quarter of 2018 and the final amount may differ from the provisional amount due to additional analysis, regulatory guidance that may be issued or changes in interpretation.
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Item 1A. | RISK FACTORS |
An investment in LOB common stock involves certain risks. The following discussion highlights the risks that management believes are material for the Company, but do not necessarily include all the risks that we may face. Additional risks and uncertainties that are not currently known or that management does not currently deem material could also have a material adverse impact on our business, results of our operations and financial condition. You should carefully consider the risk factors and uncertainties described below and elsewhere in this Report in evaluating an investment in LOB’s common stock.
Risks Related to Our Business
We may experience increased delinquencies and credit losses, which could have a material adverse effect on our capital, financial condition, and results of operations.
Like other lenders, we face the risk that our customers will not repay their loans. A customer’s failure to repay us is usually preceded by missed monthly payments. In some instances, however, a customer may declare bankruptcy prior to missing payments, and, following a borrower filing bankruptcy, a lender’s recovery of the credit extended is often limited. Since many of our loans are secured by collateral, we may attempt to seize the collateral if and when a customer defaults on a loan. However, the value of the collateral might not equal the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our customer. The resolution of nonperforming assets, including the initiation of foreclosure proceedings, requires significant commitments of time from management, which can be detrimental to the performance of their other responsibilities, and which expose us to additional legal costs. Elevated levels of loan delinquencies and bankruptcies in our market areas, generally, and among our customers specifically, can be precursors of future charge-offs and may require us to increase our allowance for loan and lease losses, or ALLL. Higher charge-off rates, delays in the foreclosure process or in obtaining judgments against defaulting borrowers or an increase in our ALLL may negatively impact our overall financial performance, may increase our cost of funds, and could materially adversely affect our business, results of operations and financial condition.
SBA lending is an important part of our business. Our SBA lending program is dependent upon the federal government, and we face specific risks associated with originating SBA loans.
Our SBA lending program is dependent upon the federal government. As an SBA Preferred Lender, we enable our clients to obtain SBA loans without being subject to the potentially lengthy SBA approval process necessary for lenders that are not SBA Preferred Lenders. The SBA periodically reviews the lending operations of participating lenders to assess, among other things, whether the lender exhibits prudent risk management. When weaknesses are identified, the SBA may request corrective actions or impose enforcement actions, including revocation of the lender’s Preferred Lender status. If we lose our status as a Preferred Lender, we may lose some or all of our customers to lenders who are SBA Preferred Lenders, and as a result we could experience a material adverse effect to our financial results. Any changes to the SBA program, including changes to the level of guarantee provided by the federal government on SBA loans, may also have a material adverse effect on our business.
We generally sell the guaranteed portion of our SBA 7(a) loans in the secondary market. These sales have resulted in premium income for us at the time of sale and created a stream of future servicing income. We may not be able to continue originating these loans or selling them in the secondary market. Furthermore, even if we are able to continue originating and selling SBA 7(a) loans in the secondary market, we might not continue to realize premiums upon the sale of the guaranteed portion of these loans. When we sell the guaranteed portion of our SBA 7(a) loans, we incur credit risk on the non-guaranteed portion of the loans, and if a customer defaults on the non-guaranteed portion of a loan, we share any loss and recovery related to the loan pro-rata with the SBA. If the SBA establishes that a loss on an SBA guaranteed loan is attributable to significant technical deficiencies in the manner in which the loan was originated, funded or serviced by us, the SBA may seek recovery of the principal loss related to the deficiency from us, which could materially adversely affect our business, results of operations and financial condition.
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The laws, regulations and standard operating procedures that are applicable to SBA loan products may change at any time. For example, effective January 1, 2018, the SBA changed its procedures relating to equity levels required to qualify for an SBA loan. We expect these changes will have an adverse impact on originations, particularly in our Agriculture vertical and other verticals where the borrowers historically have faced challenges meeting equity requirements for eligibility. In March 2018, the Office of Inspector General (the “OIG”) for the SBA issued its Evaluation of SBA 7(a) Loans Made to Poultry Farmers. The report summarized the OIG’s review of SBA 7(a) loans made to poultry farmers along with its findings and recommendations. Among other things, the OIG report concluded that the loans to poultry farmers it had reviewed did not meet regulatory and SBA requirements for eligibility. The SBA’s response to the OIG report suggests that it will review the report and recommendations and determine whether to take any further action. We are still assessing the potential impact of the report and any SBA actions in response. We cannot predict the effects of future changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies and especially our organization, changes in the laws, regulations and procedures applicable to SBA loans could adversely affect our ability to operate profitably.
We are dependent upon the use of intellectual property owned by third parties, and any change in our ability to use, or the terms upon which we may use, this intellectual property could have a material adverse effect on our business.
The technology-based platform that is pivotal to our success is dependent on the use of the nCino Bank Operating System and Salesforce.com, Inc.’s Force.com cloud computing infrastructure platform. We rely on a non-exclusive license to use nCino’s platform. Because our license is non-exclusive, the nCino Bank Operating System is available to other lenders and nothing would prevent our competitors from developing, licensing or using similar technology. Our license currently expires on November 15, 2018. Notwithstanding the term of our agreement, our license may be terminated if we are in material breach of the license and do not cure the breach within 30 days. In addition, nCino relies on a license to use the Salesforce.com platform, and if nCino were unable to maintain its rights under that license, our ability to rely on the nCino license could be adversely affected. We can offer no assurance that we will be able to renew or maintain our license to use the nCino Bank Operating System on terms that are acceptable. Termination of either of these licenses or the reduction or elimination of our licensed rights may result in our having to negotiate new licenses with less favorable terms, or the inability to obtain access to such licensed technology at all. Similarly, Apiture provides the Bank significant engineering, development, professional and other services under an agreement we signed with Apiture in connection with the closing of the joint venture in October 2017. It would be difficult for the Bank to replace these services with a third party. Notwithstanding the Bank's ownership of 50% of the voting control of Apiture, there can be no assurance that Apiture will continue to provide such services at appropriate service levels or at prices that would be market competitive. If we were to lose access to any of this technology, or were only able to access the technology on less favorable terms, we would not be able to offer our customers the technology-based platform services they seek from us and our business would be materially and adversely affected.
A failure in or breach of our operational or security systems, or those of our third party service providers, including as a result of cyber-attacks, could disrupt our business, result in unintentional disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses.
As a financial institution, our operations rely heavily on the secure data processing, storage and transmission of confidential and other information on our computer systems and networks. Any failure, interruption or breach in security or operational integrity of these systems could result in failures or disruptions in our online banking system, customer relationship management, general ledger, deposit and loan servicing and other systems. The security and integrity of our systems and the technology we use could be threatened by a variety of interruptions or information security breaches, including those caused by computer hacking, cyber-attacks, electronic fraudulent activity or attempted theft of financial assets. We may fail to promptly identify or adequately address any such failures, interruptions or security breaches if they do occur. While we have certain protective policies and procedures in place, the nature and sophistication of the threats continue to evolve. We may be required to expend significant additional resources in the future to modify and enhance our protective measures.
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The nature of our business may make it an attractive target and potentially vulnerable to cyber-attacks, computer viruses, physical or electronic break-ins or similar disruptions. The technology-based platform we use processes sensitive data from our borrowers and investors. While we have taken steps to protect confidential information that we have access to, our security measures and the security measures employed by the owners of the technology in the platform that we use could be breached. Any accidental or willful security breaches or other unauthorized access to our systems could cause confidential customer, borrower, employee, vendor, partner or investor information to be stolen and used for criminal purposes. Security breaches or unauthorized access to confidential information could also expose us to liability related to the loss of the information, time-consuming and expensive litigation, and negative publicity. If security measures are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in the technology-based platform that we use are exposed and exploited, our relationships with customers, borrowers, employees, vendors, partners and investors could be severely damaged, and we could incur significant liability.
Because techniques used to sabotage or obtain unauthorized access to systems change frequently and generally are not recognized until they are launched against a target, we and our collaborators may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, federal regulators and many federal and state laws and regulations require companies to notify individuals of data security breaches involving their personal data. These mandatory disclosures regarding a security breach are costly to implement and often lead to widespread negative publicity, which may cause customers, borrowers, employees, vendors, partners or investors to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, would harm our reputation, we could lose customers, borrowers, employees, vendors, partners, or investors, and our business and operations could be adversely affected.
Additionally, we face the risk of operational disruption, failure, termination or capacity constraints of any of the third parties that facilitate our business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an attack on, or breach of, our operational systems. Any failures, interruptions or security breaches in our information systems could damage our reputation, result in a loss of customer business, result in a violation of privacy or other laws, or expose us to civil litigation, regulatory fines or losses not covered by insurance.
Our business is dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems and third-party providers. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If significant, sustained or repeated, a system failure or service denial could compromise our ability to operate effectively, damage our reputation, result in a loss of customer business, and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could materially adversely affect our business, financial condition, results of operations and prospects, as well as the value of our common stock.
A return of recessionary conditions could result in increases in our level of nonperforming loans and/or reduce demand for our products and services, which could have a material adverse effect on our results of operations.
Like all financial institutions, we are subject to certain risks resulting from a weakened economy, such as increased charge-offs and levels of past-due loans and nonperforming assets. Although the U.S. economy has emerged from the severe recession that occurred from 2007 to 2009, economic growth has been slow and uneven, and unemployment levels remain elevated in many areas of the country. In addition, recovery by many businesses has been impaired by lower consumer spending. A return of prolonged deteriorating economic conditions could adversely affect the ability of our customers to repay their loans, the value of our investments, and our ongoing operations, including our equipment leasing and title insurance businesses, costs and profitability. These events may cause us to incur losses and may materially adversely affect our business, results of operations and financial condition.
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Our loan portfolio mix, which includes owner-occupied commercial real estate loans, could result in increased credit risk in a challenging economy.
Our loan portfolio is concentrated in owner-occupied commercial real estate and owner-occupied commercial business loans. These types of loans generally are viewed as carrying more risk of default than residential real estate loans or certain other types of loans or investments. In fact, the FDIC has issued pronouncements alerting banks of its concern about heavy loan concentrations in certain types of commercial real estate loans, including acquisition, construction and development loans, and heavy loan concentrations in certain geographic segments. Because a portion of our loan portfolio is composed of these types of higher-risk loans, we face an increased risk of nonperforming loans that could result in a loss of earnings from these loans, an increase in the provision for loan and lease losses, or an increase in loan charge-offs, any of which could have a material adverse impact on our business, results of operations and financial condition.
The current economic environment and any deterioration or downturn in the economies or real estate values in the markets we serve could have a material adverse effect on both borrowers’ ability to repay their loans and the value of the real property securing those loans. Our ability to recover on defaulted loans would then be diminished, and we would be more likely to suffer losses on defaulted loans. Any of these developments could materially adversely affect our business, financial condition, results of operations and prospects.
The fair value of our investment securities can fluctuate due to factors outside of our control.
As of December 31, 2017, the fair value of our investment securities portfolio was approximately $93 million. Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by the issuer or with respect to the underlying securities, monetary tapering actions by the Federal Reserve, and changes in market interest rates and potential instability in the capital markets. Any of these factors, among others, could cause other-than-temporary impairments and realized or unrealized losses in future periods and declines in other comprehensive income, which could materially and adversely affect our business, results of operations, financial condition and prospects, as well as the value of our common stock. The process for determining whether impairment of a security is other-than-temporary usually requires complex, subjective judgments about the future financial performance and liquidity of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security. Our inability to accurately predict the future performance of an issuer or to efficiently respond to changing market conditions could result in a decline in the value of our investment securities portfolio, which could have a material and adverse effect on our business, results of operations and financial condition.
Our allowance for loan losses may prove to be insufficient to cover actual loan losses, which could have a material adverse effect on our financial condition and results of operations.
Our future success depends to a significant extent upon the quality of our assets, particularly loans. In originating loans, there is a substantial likelihood that we will experience credit losses. The risk of loss will vary with, among other things, general economic conditions, including the current economic environment and real estate market, the type of loan, the creditworthiness of the borrower over the term of the loan, and, in the case of a collateralized loan, the quality of the collateral for the loan.
Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. As a result, we may experience significant loan losses, which could have a material adverse effect on our operating results. Our management makes various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses that may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions, and other pertinent information.
If our assumptions are wrong, our current allowance may not be sufficient to cover future loan losses, and we may need to make adjustments to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance in the form of provisions for loan losses would materially decrease our net income. We expect our allowance to continue to fluctuate; however, given current and future market conditions, our allowance may not be adequate to cover future loan losses.
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In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan and lease losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulators could have a negative effect on our operating results and could materially adversely affect our business, results of operations and financial condition.
The valuation of our servicing rights is based on estimates and subject to fluctuation based on market conditions and other factors that are beyond our control.
The fair value of our servicing rights is estimated based upon projections of expected future cash flows generated by the loans we service, historical prepayment rates, future prepayment estimates, portfolio characteristics, interest rates based on interest rate yield curves, volatility, market demand for servicing rights and other factors. While this evaluation process uses historical and other objective information, the valuation of our servicing rights is ultimately an estimate based on our experience, judgment and expectations regarding our servicing portfolio and the broader market. This is an inherently uncertain process and the value of our servicing rights may be adversely impacted by factors that are beyond our control, which may in turn have a material adverse effect on our business, results of operations and financial condition.
The recognition of gains on the sale of loans reflects certain assumptions.
Gains on the sale of loans comprise a significant component of our revenue. Noncash gains recognized in the years ended December 31, 2017, 2016 and 2015 were $6.2 million, $7.1 million and $6.1 million respectively. The determination of these noncash gains is based on assumptions regarding the value of unguaranteed loans retained, servicing rights retained and deferred fees and costs. The value of retained unguaranteed loans and servicing rights are determined by our wholly owned subsidiary, GLS, which applies market derived factors such as prepayment rates, current market conditions and recent loan sales to arrive at valuations. Deferred fees and costs are determined using internal analysis of the cost to originate loans. Significant errors in assumptions used to compute gains on sale of loans could result in material revenue misstatements, which may have a material adverse effect on our business, results of operations and profitability. In addition, while we believe that the valuations provided by GLS are at arm’s length, reflect fair value and are subject to validation by an independent third party on a biannual basis, if such valuations are not reflective of fair market value then our business, results of operations and financial condition may be materially and adversely affected.
We anticipate that going forward we will experience increasing growth in our held-for-sale and held-for-investment loan portfolios due to our increasing construction portfolio or strategic business decisions.
Our revenue model has historically been driven by selling loans that we originate, or a portion of the loans, in the secondary market when fully funded. The growth of our construction portfolio that typically funds in stages will result in a decrease in the volume of loans sold relative to production in any period, which, in turn, decreases our revenue relative to production in any period. In addition, we anticipate growth in our loans held for investment due to our origination of loans that we choose not to sell or for which there is no secondary market or due to other strategic choices, including the pursuit of potential opportunities in conventional lending outside of SBA or other government guarantee programs. Growth in our held-for-sale and our held-for-investment loan portfolios exposes us to increased interest rate and credit risks.
Our rental equipment is subject to residual value risk upon disposition, and may not sell at the prices or in the quantities we expect.
The market value of any given piece of rental equipment could be less than its depreciated value at the time it is sold. The market value of used rental equipment depends on several factors, including:
• | the market price for new equipment of a like kind; |
• | the age of the equipment at the time it is sold, as well as wear and tear on the equipment relative to its age; |
• | the supply of used equipment on the market; |
• | technological advances relating to the equipment; |
• | demand for the used equipment; and |
• | general economic conditions. |
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We include in income from operations the difference between the sales price and the depreciated value of an item of equipment sold. Changes in our assumptions regarding depreciation could change our depreciation expense, as well as the gain or loss realized upon disposal of equipment. Sales of our used rental equipment at prices that fall significantly below our projections or in lesser quantities than we anticipate will have a negative impact on our results of operations and cash flows.
We are subject to liquidity risk in our operations.
Liquidity risk is the possibility of being unable, at a reasonable cost and within acceptable risk tolerances, to pay obligations as they come due, to capitalize on growth opportunities as they arise, or to pay regular dividends because of an inability to liquidate assets or obtain adequate funding on a timely basis. Liquidity is required to fund various obligations, including credit obligations to borrowers, loan originations, withdrawals by depositors, repayment of debt, dividends to shareholders, operating expenses, and capital expenditures. Our liquidity is derived primarily from the sale of loans in the secondary market, retail deposit growth and retention, principal and interest payments on loans and investment securities, net cash provided from operations, and access to other funding sources. Historically, we have relied on brokered and Internet funds as a large portion of our deposit base. Our access to funding sources in amounts adequate to finance our activities or at a reasonable cost could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could adversely affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn, our lack of access to a traditional branch banking network designed to generate core deposits and adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a severe disruption in the financial markets or negative views and expectations about the prospects for the financial services industry as a whole. Our access to borrowed funds could become limited in the future, and we may be required to pay above market rates for additional borrowed funds, if we are able to obtain them at all, which may adversely affect our business, results of operations and financial condition.
The amount of other real estate owned, or OREO, may increase significantly, resulting in additional losses, and costs and expenses that will negatively affect our operations.
In connection with our banking business, we take title to real estate collateral from time to time through foreclosure or otherwise in connection with efforts to collect debts previously contracted. Such real estate is referred to as other real estate owned, or OREO. As the amount of OREO increases, our losses, and the costs and expenses to maintain the real estate, likewise increase. The amount of OREO we hold may increase due to various economic conditions or other factors. Any additional increase in losses and maintenance costs and other expenses due to OREO may have a material adverse effect on our business, results of operations and financial condition. Such effects may be particularly pronounced in a market of reduced real estate values and excess inventory, which may make the disposition of OREO properties more difficult, increase maintenance costs and other expenses, and reduce our ultimate realization from any OREO sales. In addition, at the time of acquisition of the OREO we are required to reflect its fair market value in our financial statements. If the OREO declines in value subsequent to its acquisition, we are required to recognize a loss. As a result, declines in the value of our OREO will have a negative effect on our business, results of operations and financial condition. As of December 31, 2017, we had four OREO properties with an aggregate carrying value of $1.3 million. For more information about amounts held in OREO, see Note 11 to our audited consolidated financial statements as of and for the year ended December 31, 2017 filed with this Report.
We are subject to environmental liability risk associated with our lending activities.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our business, results of operations and financial condition.
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Our use of appraisals in deciding whether to make a loan secured by real property or how to value the loan in the future may not accurately reflect the net value of the collateral that we can realize.
In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values may experience changes in value in relatively short periods of time, especially during periods of heightened economic uncertainty, this estimate might not accurately describe the net value of the real property collateral after the loan has been closed. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. In addition, we rely on appraisals and other valuation techniques to establish the value of our OREO and to determine certain loan impairments. If any of these valuations are inaccurate, our consolidated financial statements may not reflect the correct value of OREO, and our Allowance for loans losses may not reflect accurate loan impairments. The valuation of the properties securing the loans in our portfolio may negatively impact the continuing value of those loans and could materially adversely affect our business, results of operations and financial condition.
We could be subject to losses, regulatory action or reputational harm due to fraudulent and negligent acts on the part of loan applicants, our borrowers, our employees and vendors.
In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, property appraisals, title information, employment and income documentation, account information and other financial information. We may also rely on representations of clients and counterparties as to the accuracy and completeness of such information and, with respect to financial statements, on reports of independent auditors. Any such misrepresentation or incorrect or incomplete information may not be detected prior to funding a loan or during our ongoing monitoring of outstanding loans. In addition, one or more of our employees or vendors could cause a significant operational breakdown or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our loan documentation, operations or systems. Any of these developments could have a material adverse effect on our business, results of operations and financial condition.
We may fail to realize all of the anticipated benefits, including estimated cost savings, of potential future acquisitions.
In the future, we may encounter difficulties in obtaining required regulatory approvals for, or face unexpected contingent liabilities from, businesses we may acquire. Integration of an acquired business can be complex and costly, sometimes including combining relevant accounting and data processing systems and management controls, as well as managing relevant relationships with employees, customers, suppliers and other business partners. Integration efforts could divert management attention and resources, which could adversely affect our business, results of operations and financial condition. Additionally, given continued market volatility and uncertainty, we may also experience increased credit costs or need to take additional markdowns and allowances for loan losses on assets and loans we may acquire. These increased credit costs, markdowns and allowances could materially adversely affect our financial condition and results of operations, as well as the value of our common stock.
Implementation of our growth strategy depends, in part, on our ability to successfully identify acquisition opportunities and strategic partners that will complement our operating philosophy, and also on the successful integration of their operations with our own. To successfully acquire target companies or establish complementary lines of business, we must be able to correctly identify profitable or growing markets, as well as attract the necessary relationships and high caliber personnel to make these new business lines profitable. In addition, we may not be able to identify suitable opportunities for further growth and expansion. As consolidation of the financial services industry continues, the competition for suitable acquisition candidates may increase. We will compete with other financial services companies for acquisition opportunities, and many of these competitors have greater financial resources than we do and may be able to pay more for an acquisition than we are able or willing to pay. If we are unable to effectively implement our growth strategies, our business, results of operations and financial condition may be materially and adversely affected.
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Acquisitions may be delayed, impeded, or prohibited due to regulatory issues.
Acquisitions by the Company or the Bank, particularly those of financial institutions, are subject to approval by a variety of federal and state regulatory agencies. Regulatory approvals could be delayed, impeded, restrictively conditioned or denied due to regulatory issues we have, or may have, with regulatory agencies, including, without limitation, issues related to the CRA; fair lending laws; fair housing laws; consumer protection laws; unfair, deceptive, or abusive acts or practices regulations; and other similar laws and regulations. We may fail to pursue, evaluate or complete strategic and competitively significant acquisition opportunities as a result of our inability, or perceived or anticipated inability, to obtain regulatory approvals in a timely manner, under reasonable conditions or at all. Difficulties associated with potential acquisitions that may result from these factors could have a material adverse impact on our business, and, in turn, our financial condition and results of operations.
The value of our goodwill and other intangible assets may decline in the future.
In connection with our acquisitions, we have generally recognized intangible assets, including goodwill, in our consolidated balance sheet. We may not realize the value of these assets. Management performs an annual review of the carrying values of goodwill and indefinite-lived intangible assets and periodic reviews of the carrying values of all other intangible assets to determine whether events and circumstances indicate that an impairment in value may have occurred. A variety of factors could cause the carrying value of an asset to become impaired. Should a review indicate impairment, a write-down of the carrying value of the asset would occur, resulting in a non-cash charge which would adversely affect our results of operations for the period. All goodwill and intangibles recorded in 2017 are related to the acquisition of Reltco. During 2017, the Company recognized impairment on the entire balance of goodwill and a portion of other intangibles related to this acquisition. See Note 2. Title Insurance Business for further information on this transaction and related impairment.
New lines of business or new products and services may subject us to additional risks.
From time to time, we may develop, grow and/or acquire new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services, we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition. All service offerings, including current offerings and those which may be provided in the future, may become more risky due to changes in economic, competitive and market conditions beyond our control.
Changes in the interest rate environment could reduce our net interest income, which could reduce our profitability.
As a financial institution, our earnings depend in part on our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Additionally, changes in interest rates affect the premiums we may receive in connection with the sale of SBA 7(a) loans in the secondary market, pre-payment speeds of loans for which we own servicing rights, our ability to fund our operations with customer deposits, and the fair value of securities in our investment portfolio. Therefore, any change in general market interest rates, including changes in federal fiscal and monetary policies, affects us more than non-financial companies and can have a significant effect on our net interest income and results of operations. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin, noninterest income and results of operations. Further, since we began originating loans in May 2007 we have operated in a period of low market interest rates. Interest rates began increasing in 2017 and and may continue to increase in 2018 and future periods. In a rising interest rate environment, potential borrowers could seek to defer loans as they wait for interest rates to settle, and borrowers of variable rate loans may be subject to increased interest rates, which could result in a greater rate of prepayment or default. Rising interest rates may also present additional challenges to our business that we have not anticipated.
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We face strong competition from a diverse group of competitors.
The banking business is highly competitive, and we experience strong competition from many other financial institutions, including some of the largest commercial banks headquartered in the country, as well as other federally and state chartered financial institutions such as community banks and credit unions, finance and business development companies, consumer finance companies, peer-to-peer and marketplace lenders, securities brokerage firms, insurance companies, money market and mutual funds and other non-bank lenders.
We compete with these institutions both in attracting deposits and in making loans, primarily on the basis of the interest rates we pay and yield on these products. We also compete with these institutions in our other business lines, including equipment leasing and title insurance. Many of our competitors are well-established, much larger financial institutions. While we believe we can successfully compete with these other lenders in our industry verticals, we may face a competitive disadvantage as a result of our smaller size. Furthermore, nothing would prevent our competitors from developing or licensing a technology-based platform similar to the technology-based platform we currently use in our business. In addition, many of our non-bank competitors have fewer regulatory constraints and may have lower cost structures. We expect competition to continue to intensify due to financial institution consolidation, legislative, regulatory and technological changes, and the emergence of alternative banking sources.
Our ability to compete successfully will depend on a number of factors, including, among other things:
• | our ability to build and maintain long-term customer relationships while ensuring high ethical standards and safe and sound banking practices; |
• | the scope, relevance and pricing of products and services that we offer; |
• | customer satisfaction with our products and services; |
• | industry and general economic trends; and |
• | our ability to keep pace with technological advances and to invest in new technology. |
Increased competition could require us to increase the rates we pay on deposits or lower the rates we offer on loans, which could reduce our profitability. Our failure to compete effectively in our primary markets could cause us to lose market share and could have a material adverse effect our business, results of operations and financial condition.
Our investments and/or financings in certain tax-advantaged projects may not generate returns as anticipated and may have an adverse impact on our financial results.
We invest in and/or finance certain tax-advantaged projects promoting renewable energy sources. Our investments in these projects are designed to generate a return primarily through the realization of federal and state income tax credits, and other tax benefits, over specified time periods. We utilize an investment tax credit for the installation of certain solar power facilities. We are subject to the risk that previously recorded tax credits, which remain subject to recapture by taxing authorities based on compliance features required to be met at the project level, will fail to meet certain government compliance requirements and will not be able to be fully realized. The possible inability to realize these tax credits and other tax benefits can have a negative impact on our financial results. The risk of not being able to realize the tax credits and other tax benefits depends on many factors outside of our control, including changes in the applicable provisions of the tax code and the ability of the projects to be completed and properly managed. In addition, we make loans through the United States Department of Agriculture’s Rural Energy for America Program, which provides guaranteed loan financing and grant funding to agricultural producers and rural small businesses for renewable energy systems or to make energy-efficient improvements. Any changes to applicable provisions of the tax code or other developments could adversely impact demand for these loans even where we are not utilizing an investment tax credit.
Our loan portfolio may be affected by deterioration in real estate markets, including declines in the performance of loans.
Deterioration in real estate markets could result in declining prices and excess inventories. As a result, developers may experience financial deterioration and banking institutions may experience declines in the performance of construction, development and commercial loans. We make credit and reserve decisions based on the current conditions of borrowers or projects combined with our expectations for the future. If conditions are worse than forecast, we could experience higher charge-offs and delinquencies than is provided in the allowance for loan losses, which could materially adversely affect our business, results of operations and financial condition.
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A prolonged U.S. government shutdown or default by the U.S. on government obligations would harm our results of operations.
Our results of operations, including revenue, non-interest income, expenses and net interest income, would be adversely affected in the event of widespread financial and business disruption on account of a default by the United States on U.S. government obligations or a prolonged failure to maintain significant U.S. government operations, particularly those pertaining to the SBA or the FDIC. Any such failure to maintain such U.S. government operations would impede our ability to originate SBA loans and our ability to sell such loans in the secondary market, which would materially adversely affect our business, results of operations and financial condition.
Deterioration in the fiscal position of the U.S. federal government and downgrades in U.S. Treasury and federal agency securities could adversely affect us and our subsidiary’s banking operations.
The long-term outlook for the fiscal position of the U.S. federal government is uncertain, as illustrated by the 2011 downgrade by certain rating agencies of the credit rating of the U.S. government and federal agencies. In addition to causing economic and financial market disruptions, any future downgrade, failure to raise the U.S. statutory debt limit, or deterioration in the fiscal outlook of the U.S. federal government, could, among other things, materially adversely affect the market value of the U.S. government and federal agency securities that we hold, the availability of those securities as collateral for borrowing, and our ability to access capital markets on favorable terms. In particular, it could increase interest rates and disrupt payment systems, money markets, and long-term or short-term fixed income markets, adversely affecting the cost and availability of funding, which could negatively affect our profitability. Also, the adverse consequences could extend to those to whom we extend credit and could adversely affect their ability to repay their loans. Any of these developments could materially adversely affect our business, results of operations and financial condition.
Deterioration in the commercial soundness of our counterparties could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could create another market-wide liquidity crisis similar to that experienced in late 2008 and early 2009 and could lead to losses or defaults by us or by other institutions. The deterioration or failure of our counterparties would have a material adverse effect on our business, results of operations and financial condition.
We have different lending risks than larger, more diversified banks.
Our ability to diversify our economic risks is limited. We lend primarily to small businesses in selected industries, which may expose us to greater lending risks than those of banks lending to larger, better-capitalized businesses with longer operating histories. Small businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and may have limited operating histories. If economic conditions negatively impact the verticals in which we operate, our business, results of operations and financial condition may be adversely affected.
We attempt to manage our credit exposure through careful monitoring of loan applicants and through loan approval and review procedures. We have established an evaluation process designed to determine the adequacy of our allowance for loan losses. While this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses is an estimate based on experience, judgment and expectations regarding our borrowers, and the economies in which we and our borrowers operate, as well as the judgment of our regulators. This is an inherently uncertain process, and our loan loss reserves may not be sufficient to absorb future loan losses or prevent a material adverse effect on our business, results of operations and financial condition.
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We rely heavily on our management team, and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our chief executive officer, president, and other senior officers. The unexpected loss of any of our key employees could have an adverse effect on our business, results of operations and financial condition. The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. We are not party to non-compete or non-solicitation agreements with any of our officers or employees. The market for qualified employees in the businesses in which we operate is competitive, and we may not be successful in attracting, hiring or retaining key personnel. Our inability to attract, hire or retain key personnel could have a material adverse effect on our business, results of operations and financial condition.
Our risk management framework may not be effective in mitigating risks and/or losses to us.
We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance risks. Our framework also includes financial and other modeling methodologies which involve management assumptions and judgment. Our risk management framework may not be effective under all circumstances and it may fail to adequately mitigate risk or loss to us. If our framework is not effective, we could suffer unexpected losses and be subject to potentially adverse regulatory consequences, and our business, results of operations and financial condition could be materially and adversely affected.
Hurricanes or other adverse weather events could disrupt our operations, which could have an adverse effect on our business or results of operations.
North Carolina’s coastal region is affected, from time to time, by adverse weather events, particularly hurricanes. We cannot predict whether, or to what extent, damage caused by future hurricanes or other weather events will affect our operations. Weather events could cause a disruption in our day-to-day business activities and could have a material adverse effect on our business, results of operations and financial condition.
Outbreaks of avian disease, such as avian influenza, or the perception that outbreaks may occur, could have a material adverse effect on lending operations in our Agriculture vertical.
Pandemic events beyond our control, such as an outbreak of avian disease, or “bird flu,” could have a material adverse effect on the performance of our portfolio of loans in our Agriculture vertical and on the demand for new loans in this vertical. An outbreak of disease could result in governmental restrictions on the import and export of fresh and frozen chicken or other poultry products to or from our customers. This could result in the cancellation of orders and the curtailment of farming operations by our customers and could create adverse publicity that may have a material adverse effect on the performance of our existing loans and future business prospects in our Agriculture vertical. In addition, consumer fears about avian disease have, in the past, depressed demand for fresh poultry, which may adversely impact the demand for future loans and the performance of existing loans in our Agriculture vertical.
If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results. As a result, current and potential shareholders could lose confidence in our financial reporting which would harm our business and the trading price of our securities.
If we identify material weaknesses in our internal control over financial reporting or are otherwise required to restate our financial statements, we could be required to implement expensive and time-consuming remedial measures and could lose investor confidence in the accuracy and completeness of our financial reports. We may also face regulatory enforcement or other actions, including the potential delisting of our securities from NASDAQ. This could have a material adverse effect on our business, financial condition and results of operations, and could subject us to litigation.
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Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially impact our financial statements.
From time to time the SEC and the Financial Accounting Standards Board, or FASB, update accounting principles generally accepted in the United States ("GAAP") that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing our financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, we may experience unexpected material adverse consequences that could negatively affect our business, results of operations and financial condition.
The FASB has recently issued an accounting standard update that will result in a significant change in how we recognize credit losses and may have a material impact on our financial condition or results of operations.
In June 2016, the FASB issued an accounting standard update, “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss (“CECL”) model. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected over the contractual life of the financial instrument. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to materially increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.
The new CECL standard will become effective for us on January 1, 2020. We are currently evaluating the impact the CECL model will have on our accounting, but we expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations.
Our business reputation is important and any damage to it could have a material adverse effect on our business.
Our reputation is very important to sustain our business, as we rely on our relationships with our current, former and potential customers and shareholders, and the industries that we serve. Any damage to our reputation, whether arising from legal, regulatory, supervisory or enforcement actions, matters affecting our financial reporting or compliance with SEC and exchange listing requirements, negative publicity, the conduct of our business or otherwise could have a material adverse effect on our business, results of operations and financial condition.
Insiders have substantial control over us, and this control may limit our shareholders’ ability to influence corporate matters and may delay or prevent a third party from acquiring control over us.
As of January 31, 2018, our directors and executive officers and their related entities currently beneficially own, in the aggregate, approximately 25.7% of our outstanding common stock. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise. In addition, these shareholders will be able to exercise influence over all matters requiring shareholder approval, including the election of directors and approval of corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit your ability to influence corporate matters and may have the effect of delaying or preventing a change in control, including a merger, consolidation or other business combination involving us, or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control, even if that change in control would benefit our other shareholders. For information regarding the ownership of our outstanding stock by our executive officers and directors and related entities, see “Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters” in this Report.
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Risks Related to Our Investment in Apiture
If the market for Apiture’s digital banking solutions develops more slowly than we expect or changes in ways that we fail to anticipate, our operating results would be adversely affected.
Use of and reliance on digital banking solutions is at an early stage, and we do not know whether the market will develop more slowly than we anticipate. Many financial institutions have invested substantial resources in legacy software, and these institutions may be reluctant or unwilling to convert from their existing systems to Apiture’s digital banking solutions. Furthermore, for most financial institutions, transitioning from an existing software provider (or from an internally developed legacy system) to a new provider is a significant and expensive undertaking. Potential customers of Apiture’s digital banking solutions may conclude that switching providers involves too many potential disadvantages such as disruption of business operations, loss of accustomed functionality and increased costs (including conversion and transition costs). Furthermore, some financial institutions may be reluctant or unwilling to use a cloud-based solution over concerns such as the security of their data and reliability of the delivery model. These concerns or other considerations may cause potential customers to choose not to adopt cloud-based solutions such as those being developed by Apiture or to adopt alternative solutions, either of which could have a material adverse impact on our business, results of operations and financial condition.
Apiture's future success will depend on its ability to develop, sell and deliver new or enhanced solutions to financial institution clients; however, these solutions and related services may not be attractive to existing or prospective clients. In addition, promoting, selling and delivering these new and enhanced solutions may require increasingly costly sales, marketing and implementation efforts, and if existing or prospective clients choose not to adopt these solutions, our business, results of operations and financial condition could be materially and adversely affected.
Apiture may experience development delays or software defects, which could adversely impact its potential profitability and our results of operations.
Apiture’s digital banking solution will require sophisticated software and computing systems that may encounter development delays or software defects. Defects in Apiture’s software offerings or delays in the development of such software could result in unforeseen costs, diversion of technical and other resources, loss of credibility with existing and potential clients or reputational harm, any of which could materially adversely affect our business, results of operations and financial condition. Furthermore, to the extent that the Bank is involved in beta testing or early adoption of Apiture’s digital banking solutions, the Bank’s personnel and resources may be diverted from the day-to-day operation of the Bank and the Bank’s operations may be adversely impacted.
Apiture’s ability to anticipate and respond to changing industry trends and the needs and preferences of financial institution clients may affect its competitiveness or demand for its digital banking solutions, which may adversely affect our operating results.
The financial services, payments, and technology industries are subject to rapid technological advancements, new products and services, an evolving competitive landscape, developing industry standards and changing client and consumer needs and preferences. We expect that new services and technologies applicable to the financial services, payments and technology industries will continue to emerge and evolve. These changes in technology may limit the competitiveness of and demand for products or services offered by Apiture. Also, Apiture’s existing and prospective financial institution clients and their respective customers continue to adopt new technology for business and personal uses. Apiture must anticipate and respond to these changes in order to compete in its market.
Apiture’s failure to develop products and services that meet the needs and preferences of its clients could have an adverse effect on its ability to compete effectively. Furthermore, potential negative reaction to Apiture’s products and services can spread quickly through social media and damage its reputation before it has the opportunity to respond. If Apiture is unable to anticipate or respond to technological changes or evolving industry demands on a timely basis, our business, results of operations and financial condition could be materially adversely affected.
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If Apiture is unable to effectively integrate its digital banking solutions with other systems used by financial institutions, its solutions will not operate effectively and our results of operations could be adversely affected.
The functionality of Apiture’s digital banking solutions will depend on its ability to integrate with other third-party systems used by potential clients, including well-established core processing systems. Certain providers of these third-party systems also offer solutions that are competitive to the solutions being developed by Apiture and may have an advantage with clients already using their software by having better ability to integrate with their software and by being able to bundle their competitive products with other applications used by Apiture’s existing and prospective financial institution clients at favorable pricing.
Security breaches or attacks on Apiture’s systems may have a significant effect on our business.
In order to offer its products and services, Apiture must process, store, and transmit sensitive business information and personal consumer information, including, but not limited to, names, bankcard numbers, home or business addresses, social security numbers, driver's license numbers and bank account numbers. Under various federal, state and international laws, Apiture is responsible for information provided to it by financial institutions, merchants, third-party service providers, and others. Maintaining the confidentiality of such sensitive business information and personal consumer information will be critical to Apiture’s business; however, Apiture cannot be certain that the security measures and procedures it puts in place to protect this sensitive data will be successful or sufficient to counter all current and emerging technology threats designed to breach network security in order to gain access to confidential information. The increasing sophistication of cyber criminals and their continuous attempts to breach networks presents risk of a security breach of Apiture’s systems. A breach of Apiture’s systems processing or storing sensitive business information or personal consumer information could lead to claims against it, reputational damage, lost clients and lost revenue, substantial additional costs (including costs of notification of consumers, credit monitoring, card reissuance, contact centers and forensics), loss of clients' and their customers’ confidence, as well as imposition of fines and damages, all of which could materially adversely affect our business, results of operations and financial condition. In addition, as security threats continue to evolve, Apiture will be required to invest additional resources to modify and update the security of its systems. The level of required investment could materially adversely affect our business, results of operations and financial condition.
Apiture may experience breakdowns in its processing systems that could damage client relations and expose it to liability.
Apiture’s business will rely heavily on the reliability of its processing systems. A system outage could have a material adverse effect on Apiture’s business, financial condition, and results of operations. Not only would it suffer damage to its reputation in the event of a system outage, but Apiture may also be liable to third parties. To successfully operate its business, Apiture must be able to protect its processing and other systems from interruption, including from events that may be beyond its reasonable control. Events that could cause system interruptions include, but are not limited to, fire, natural disaster, unauthorized entry, power loss, telecommunications failure, computer viruses, terrorist acts, cyber attacks and war. To the extent Apiture outsources its disaster recovery functions, it is at risk of the vendor’s unresponsiveness or other failures in the event of system breakdowns.
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Risks Related to Our Regulatory Environment
We are subject to extensive regulation that could limit or restrict our activities.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various federal and state regulatory agencies. Our compliance with these regulations is costly and restricts certain of our activities, including the declaration and payment of cash dividends to shareholders, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth and operations. Should we fail to comply with these regulatory requirements, federal and state regulators could impose additional restrictions on the activities of the Company and the Bank, which could materially and adversely affect our business, results of operations and financial condition.
The laws and regulations applicable to the banking industry have changed in recent years and may continue to change, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our business, results of operations and financial condition.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was enacted on July 21, 2010. The provisions of the Dodd-Frank Act, and its implementing regulations may materially and adversely affect our business, results of operations and financial condition. Some or all of the changes, including the rulemaking authority granted to the Consumer Financial Protection Bureau, or the CFPB, may result in greater liability, reporting requirements, assessment fees, operational restrictions, capital requirements, and other regulatory burdens applicable to us while many of our non-bank competitors may remain free from such burdens. The changes arising out of the Dodd-Frank Act could adversely affect our ability to attract and maintain depositors, to offer competitive products and services, to attract and retain key personnel and to expand our business.
Congress may consider additional proposals to change substantially the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies. Such legislation may change existing banking statutes and regulations, as well as our current operating environment significantly. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand our permissible activities, or affect the competitive balance among banks, savings associations, credit unions, other financial institutions and non-bank lenders. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, results of operations or financial condition.
Our financial condition and results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve. Actions by monetary and fiscal authorities, including the Federal Reserve, could have an adverse effect on our deposit levels, loan demand, or business and earnings, as well as the value of our common stock.
On February 3, 2017, the President of the United States issued an executive order identifying “core principles” for the administration’s financial services regulatory policy and directing the Secretary of the Treasury, in consultation with the heads of other financial regulatory agencies, to evaluate how the current regulatory framework promotes or inhibits the principles and what actions have been, and are being, taken to promote the principles. In response to the executive order, on June 12, 2017, October 6, 2017 and October 26, 2017, respectively, the U.S. Department of the Treasury issued the first three of four reports recommending a number of comprehensive changes in the current regulatory system for U.S. depository institutions, the U.S. capital markets and the U.S. asset management and insurance industries. It is not clear whether the executive order will result in material changes to the current laws and rules, or those that are in process, applicable to financial institutions and financial services or products like ours. It also is not clear what the impact from any such changes would be on our business or the markets and industries in which we compete. There is no guarantee that any changes from this review would be positive for us, and any such changes could have a material adverse impact on our business and our prospects.
We may be required to raise additional capital in the future, including to comply with increased minimum capital thresholds established by our regulators as part of their implementation of Basel III, but that capital may not be available when it is needed and could be dilutive to our existing shareholders, which could adversely affect our financial condition and results of operations.
In July 2013, the Federal Reserve, FDIC and Office of the Comptroller of the Currency approved final rules that establish an integrated regulatory capital framework that addresses perceived shortcomings in certain capital requirements. The rules implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act.
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The major provisions of the rule applicable to the Company are:
• | The rule implements higher minimum capital requirements, includes a new common equity Tier1 capital requirement, and establishes criteria that instruments must meet in order to be considered Common Equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. These enhancements are intended to both improve the quality and increase the quantity of capital required to be held by banking organizations. The minimum capital to risk-weighted assets (“RWA”) requirements under the rule are a common equity Tier 1 capital ratio of 4.5% and a Tier 1 capital ratio of 6.0%, which is an increase from 4.0%, and a total capital ratio that remains at 8.0%. The minimum leverage ratio (Tier 1 capital to total assets) is 4.0%. The rule maintains the general structure of the current prompt corrective action, or PCA, framework while incorporating these increased minimum requirements. |
• | The rule implements changes to the definition of capital. Among the most important changes are stricter eligibility criteria for regulatory capital instruments that would disallow the inclusion of instruments such as trust preferred securities in Tier 1 capital going forward, and new constraints on the inclusion of minority interests, mortgage-servicing assets (“MSAs”), deferred tax assets (“DTAs”), and certain investments in the capital of unconsolidated financial institutions. In addition, the rule requires that certain regulatory capital deductions be made from common equity Tier 1 capital. |
• | Under the rule, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to RWA. A three-year phase-in of the capital conservation buffer requirements began on January 1, 2016. A banking organization with a buffer greater than 2.5% would not be subject to limits on capital distributions or discretionary bonus payments; however, a banking organization with a buffer of less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The rule also prohibits a banking organization from making distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. When the rule is fully phased in, the minimum capital requirements plus the capital conservation buffer will exceed the PCA well-capitalized thresholds. |
• | The rule also increases the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors. |
Compliance by LOB and the Bank with these capital requirements affects their respective operations by increasing the amount of capital required to conduct operations. In order to support the operations at the Bank, we may need to raise capital in the future. Our ability to raise capital will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we may be unable to raise capital on terms acceptable to us if at all. If we cannot raise capital when needed, our ability to operate or further expand our operations could be materially impaired. In addition, if we decide to raise equity capital under such conditions, the interests of our shareholders could be diluted.
Our deposit operations are subject to extensive regulation, and we expect additional regulatory requirements to be implemented in the future.
We are subject to significant anti-money laundering, “know your customer” and other regulations under applicable law, including the Bank Secrecy Act and the USA PATRIOT Act, and we could become subject in the future to additional regulatory requirements beyond those that are currently adopted, proposed or contemplated. We expect that federal and state bank regulators will increase their oversight, inspection and investigatory role over our deposit operations and the financial services industry generally. Furthermore, we intend to increase our deposit product offerings and grow our customer deposit portfolio in the future and, as a result, we are, and will continue to be, subject to heightened compliance and operating costs that could adversely affect our business, results of operations and financial condition. In addition, legal and regulatory proceedings and other contingencies will arise from time to time that may have an adverse effect on our business practices and results of operations.
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The FDIC Deposit Insurance assessments that we are required to pay may continue to materially increase in the future, which would have an adverse effect on our earnings.
As a member institution of the FDIC, we are assessed a quarterly deposit insurance premium. Failed banks nationwide have significantly depleted the insurance fund and reduced the ratio of reserves to insured deposits. As a result, we may be required to pay significantly higher premiums or additional special assessments that could adversely affect our business, results of operations and financial condition.
On October 19, 2010, the FDIC adopted a Deposit Insurance Fund, or DIF, Restoration Plan, which requires the DIF to attain a 1.35% reserve ratio by September 30, 2020. The Dodd-Frank Act directs the FDIC to “offset the effect” of the increased reserve ratio for insured depository institutions with total consolidated assets of less than $10 billion. In addition, the FDIC modified the method by which assessments are determined and, effective April 1, 2011, adjusted assessment rates, which will range from 2.5 to 45 basis points (annualized), subject to adjustments for unsecured debt and, in the case of small institutions outside the lowest risk category and certain large and highly complex institutions, brokered deposits. Further increased FDIC assessment premiums, due to our risk classification, emergency assessments, or implementation of the modified DIF reserve ratio, could have a material adverse effect on our business, results of operations and financial condition.
The effects of the Tax Cuts and Jobs Act on our business have not yet been fully analyzed and could have a significant impact on our net income.
On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Reform Act”) was signed into law. We are in the process of analyzing the Tax Reform Act and its possible effects on the Company and the Bank. The Tax Reform Act reduces the corporate tax rate to 21% from 35%, among other things. As a result of this Tax Reform Act, we have revalued our net deferred tax liability and recorded a provisional $18.9 million income tax benefit as of December 31, 2017. The Company will continue to evaluate the application of this Tax Reform Act and the related interpretations and guidance on our financial position, which could result in additional income tax expense or benefit during 2018.
Risks Related to our Common Stock
The low trading volume in our common stock may adversely affect your ability to resell shares at prices that you find attractive or at all.
Our common stock is listed for quotation on the Nasdaq Global Select Market under the ticker symbol “LOB”. The average daily trading volume for our common stock is less than that of larger financial institutions. Due to its relatively low trading volume, sales of our common stock may place significant downward pressure on the market price of our common stock. Furthermore, it may be difficult for holders to resell their shares at prices they find attractive, or at all.
We are an “emerging growth company,” and the reduced reporting requirements applicable to emerging growth companies may make our common stock less attractive to investors.
We are an “emerging growth company,” as defined in the federal securities laws. For as long as we continue to be an emerging growth company, we may take advantage of exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We could be an emerging growth company for up to five years, although we could lose that status sooner if our gross revenues exceed $1.0 billion, if we issue more than $1.0 billion in non-convertible debt in a three-year period, or if the market value of our common stock held by non-affiliates exceeds $700 million as of any June 30 before that time, in which case we would no longer be an emerging growth company as of the following December 31. We cannot predict if investors will find our common stock less attractive because we may rely on these exemptions, or if we choose to rely on additional exemptions in the future. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.
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Securities analysts may not initiate or continue coverage on our common stock.
The trading market for our common stock depends in part on the research and reports that securities analysts publish about us and our business. We do not have any control over these securities analysts, and they may not cover our common stock. If securities analysts do not cover our common stock, the lack of research coverage may adversely affect its market price. If we are covered by securities analysts, and our common stock is the subject of an unfavorable report, the price of our common stock may decline. If one or more of these analysts cease to cover us or fail to publish regular reports on us, we could lose visibility in the financial markets, which could cause the price or trading volume of our common stock to decline.
We are incurring increased costs and obligations as a result of being a public company.
As a relatively new public company, we are required to comply with certain additional corporate governance and financial reporting practices and policies required of a publicly traded company. As a result, we have and will continue to incur significant legal, accounting and other expenses that we were not required to incur as a privately held company, due to compliance requirements of the Exchange Act, Sarbanes-Oxley, the Dodd-Frank Act, the listing requirements of Nasdaq, and other applicable securities rules and regulations. The Exchange Act requires, among other things, that we file annual, quarterly, and current reports with respect to our business and operating results with the SEC. We are also required to ensure that we have the ability to prepare financial statements that are fully compliant with all SEC reporting requirements on a timely basis. Compliance with these rules and regulations will increase our legal and financial compliance costs, and might make some activities more difficult, time-consuming or costly and increase demand on our systems and resources.
Future sales of shares of our common stock by existing shareholders could depress the market price of our common stock.
LOB had 39,903,186 shares of common stock outstanding at January 31, 2018. In addition, as of January 31, 2018, there were outstanding options to purchase 3,047,017 shares of our common stock that, if exercised, will result in these additional shares becoming available for sale. Also, as of January 31, 2018, there were 178,768 outstanding restricted stock units that vest over time and 2,532,808 outstanding restricted stock units that vest based on revenue and stock price performance criteria, that when vested will result in additional shares becoming available for sale. A large portion of these shares, options and restricted stock units are held by a small number of persons. Sales by these shareholders or option and restricted stock unit holders of a substantial number of shares could significantly reduce the market price of our common stock.
Our ability to pay cash dividends on our securities is limited and we may be unable to pay future dividends.
We may not declare or pay dividends on our securities, including our common stock, in the future. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our board of directors may deem relevant. The holders of our capital stock are entitled to receive dividends when, and if, declared by our board of directors out of funds legally available for that purpose. As part of our consideration to pay cash dividends, we intend to retain adequate funds from future earnings to support the development and growth of our business. In addition, our ability to pay dividends is restricted by federal policies and regulations. It is the current policy of the Federal Reserve that bank holding companies should pay cash dividends on capital stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. Further, our principal source of funds to pay dividends is cash dividends that we receive from the Bank, which, in turn, will be highly dependent upon the Bank’s historical and projected results of operations, liquidity, cash flows and financial condition, as well as various legal and regulatory prohibitions and other restrictions on the ability of the Bank to pay dividends, extend credit or otherwise transfer funds to LOB.
Additional issuances of common stock or securities convertible into common stock may dilute holders of our common stock.
LOB may, in the future, determine that it is advisable, or LOB may encounter circumstances where it is determined that it is necessary, to issue additional shares of common stock, securities convertible into, exchangeable for or that represent an interest in common stock, or common stock-equivalent securities to fund strategic initiatives or other business needs or to build additional capital. Our board of directors is authorized to cause us to issue additional shares of common stock from time to time for adequate consideration without any additional action on the part of our shareholders. The market price of our common stock could decline as a result of other offerings, as well as other sales of a large block of common stock or the perception that such sales could occur.
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LOB is subject to extensive regulation, and ownership of its common stock may have regulatory implications for holders thereof.
LOB is subject to extensive federal and state banking laws, including the Bank Holding Company Act of 1956, as amended, or BHCA, and federal and state banking regulations, that will impact the rights and obligations of owners of its common stock, including, for example, its ability to declare and pay dividends on its common stock. Shares of LOB’s common stock are voting securities for purposes of the BHCA and any bank holding company or foreign bank that is subject to the BHCA may need approval to acquire or retain more than 5% of the then outstanding shares of LOB’s common stock, and any holder (or group of holders deemed to be acting in concert) may need regulatory approval to acquire or retain 10% or more of the shares of LOB’s common stock. A holder or group of holders may also be deemed to control LOB if they own 25% or more of our total equity. Under certain limited circumstances, a holder or group of holders acting in concert may exceed the 25% percent threshold and not be deemed to control us until they own 33% percent or more of our total equity. The amount of total equity owned by a holder or group of holders acting in concert is calculated by aggregating all shares held by the holder or group, whether as a combination of voting or non-voting shares or through other positions treated as equity for regulatory or accounting purposes and meeting certain other conditions. Holders of LOB common stock should consult their own counsel with regard to regulatory implications.
Holders should not expect us to redeem or repurchase outstanding shares of LOB common stock.
LOB’s common stock is a perpetual equity security. This means that it has no maturity or mandatory redemption date and will not be redeemable at the option of the holders. Any decision LOB may make at any time to propose the repurchase or redemption of shares of its common stock will depend upon, among other things, our evaluation of the Company’s capital position, the composition of our shareholders’ equity, general market conditions at that time and other factors we deem relevant. LOB’s ability to redeem shares of its common stock is subject to regulatory restrictions and limitations, including those of the Federal Reserve Board.
Offerings of debt, which would rank senior to LOB’s common stock upon liquidation, may adversely affect the market price of LOB common stock.
The Company may attempt to increase its capital resources or, if regulatory capital ratios fall below the required minimums, The Company could be forced to raise additional capital by making additional offerings of debt or equity securities, senior or subordinated notes, preferred stock and common stock. Upon liquidation, holders of the Company’s debt securities and lenders with respect to other borrowings will receive distributions of available assets prior to the holders of LOB common stock.
Anti-takeover provisions could adversely affect LOB shareholders.
In some cases, shareholders would receive a premium for their shares if LOB were acquired by another company. However, state and federal law and LOB’s articles of incorporation and bylaws make it difficult for anyone to acquire the Company without approval of the LOB board of directors. For example, LOB’s articles of incorporation require a supermajority vote of two-thirds of our outstanding common stock in order to effect a sale or merger of the Company in certain circumstances. Consequently, a takeover attempt may prove difficult, and shareholders may not realize the highest possible price for their securities.
Shares of LOB common stock are not insured deposits and may lose value.
Shares of LOB common stock are not savings accounts, deposits or other obligations of any depository institution and are not insured or guaranteed by the FDIC or any other governmental agency or instrumentality, any other deposit insurance fund or by any other public or private entity. An investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section. As a result, if you acquire shares of our common stock, you may lose some or all of your investment.
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Item 1B. | UNRESOLVED STAFF COMMENTS |
There were no unresolved comments received from the SEC regarding LOB’s periodic or current reports.
Item 2. | PROPERTIES |
The following table sets forth the location of the Company’s main offices, as well as additional administrative offices and certain information relating to the facilities.
Office | Address | Year Opened | Approximate Square Footage | Owned or Leased | ||||
Main Offices | 1741 Tiburon Dr 1757 Tiburon Dr | 2013 2015 | 36,000 55,000 | Owned | ||||
Satellite Wilmington Office | 2605 Irongate Dr Ste. 100 | 2016 | 10,632 | Leased | ||||
Atlanta Loan Production Office | 3060 Peachtree Rd Ste. 1220 | 2010 | 4,455 | Leased | ||||
Santa Rosa, CA Office | 100 B Street Ste. 100 | 2015 | 2,386 | Leased | ||||
Houston, TX Relationship Office | 16801 Greenspoint Park Dr Ste. 395 | 2015 | 3,514 | Leased | ||||
Roseville, CA Office | 1223 Pleasant Grove Blvd Ste. 120 | 2016 | 1,186 | Leased | ||||
Tampa, FL Office | 13401 McCormick Dr | 2017 | 10,846 | Leased | ||||
Wilmington Flight Operations | 1890 Trask Drive | 2017 | 25,500 | Owned | ||||
Washington, DC Office | 2099 Pennsylvania Ave, NW | 2017 | 3,698 | Leased | ||||
The Company believes that its properties are maintained in good operating condition and are suitable and adequate for its operational needs.
Item 3. | LEGAL PROCEEDINGS |
In the ordinary course of operations, the Company is at times involved in legal proceedings. In the opinion of management, as of December 31, 2017 there are no material pending legal proceedings to which LOB, or any of its subsidiaries, is a party or of which any of their property is the subject.
Item 4. | MINE SAFETY DISCLOSURES |
Not applicable.
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PART II
Item 5. | MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
Market Information
The Company's voting common stock is traded on the NASDAQ Global Select Market under the symbol “LOB.” Quotations of the sales volume and the closing sales prices of the voting common stock of the Company are listed daily in the NASDAQ Global Select Market’s listings. As of December 31, 2017, there were 39,895,583 shares outstanding (comprised of 35,252,053 voting common shares and 4,643,530 non-voting common shares) and 330 holders of record (comprised of 325 holders of record for voting common shares and 5 holders of record for non-voting common shares) for the Company's common stock. The Company's non-voting common stock is not listed for trading on any exchange.
The following table sets forth the quarterly high and low closing prices for the Company's voting common stock as reported by the NASDAQ Global Select Market and the dividends declared per share of common stock for each quarter during 2016 and 2017:
Closing Price | Cash Dividends Declared | |||||||||||
Quarter ended | High | Low | ||||||||||
March 31, 2016 | $ | 15.29 | $ | 12.14 | $ | 0.02 | ||||||
June 30, 2016 | 16.50 | 13.70 | 0.01 | |||||||||
September 30, 2016 | 14.96 | 13.01 | 0.02 | |||||||||
December 31, 2016 | 19.85 | 14.10 | 0.02 | |||||||||
March 31, 2017 | 24.59 | 18.00 | 0.02 | |||||||||
June 30, 2017 | 26.05 | 20.95 | 0.02 | |||||||||
September 30, 2017 | 25.80 | 20.75 | 0.03 | |||||||||
December 31, 2017 | 26.35 | 22.00 | 0.03 | |||||||||
Dividend Policy
On September 9, 2015 the Company declared its first quarterly cash dividend of $0.01 per share after completing its IPO on July 23, 2015. Since declaring this dividend, the Company has declared a dividend to stockholders in each subsequent quarter, with the most recent declared in February 2018.
The timing and amount of cash dividends paid depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Although the Company has paid quarterly cash dividends to its stockholders, stockholders are not entitled to receive dividends. Downturns in domestic and global economies and other factors could cause the Company’s board of directors to consider, among other things, the elimination of or reduction in the amount and/or frequency of cash dividends paid on the Company’s common stock. See “Supervision and Regulation” under Item 1 of this Report for more information on restrictions on the Company’s ability to declare and pay dividends. The Company can offer no assurance that the board of directors will continue to declare or pay cash dividends in any future period.
Recent Sales of Unregistered Securities
None.
Securities Authorized for Issuance under Equity Compensation Plans
See Item 12 of this report for disclosure regarding securities authorized for issuance and equity compensation plans required by Item 201(d) of Regulation S-K.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
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Stock Performance Graph
The stock performance graph required by Item 201(e) of Regulation S-K is incorporated into this Report by reference from the Company’s annual report to shareholders for the year ended December 31, 2017, which will be posted on the Company’s website subsequent to the date of this Report. The stock performance graph shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, nor shall it be deemed to be “soliciting material” subject to Regulation 14A or incorporated by reference in any filing under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
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Item 6. | SELECTED FINANCIAL DATA |
The tables below set forth selected consolidated financial data as of the dates or for the periods indicated. This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and the Consolidated Financial Statements and Notes in Item 8 of this Report.
(dollars in thousands, except per share data) | As of and for the Year Ended December 31, | ||||||||||||||||||
2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||
Income Statement Data | |||||||||||||||||||
Net interest income | $ | 78,034 | $ | 42,649 | $ | 25,589 | $ | 14,713 | $ | 10,779 | |||||||||
Provision for (recovery of) loan and lease loss | 9,536 | 12,536 | 3,806 | 2,793 | (858 | ) | |||||||||||||
Noninterest income | 172,921 | 93,539 | 84,328 | 60,042 | 56,477 | ||||||||||||||
Noninterest expense | 143,165 | 106,445 | 71,715 | 54,526 | 40,172 | ||||||||||||||
Income, before income taxes | 98,254 | 17,207 | 34,396 | 17,436 | 27,942 | ||||||||||||||
Income tax (benefit) expense | (2,245 | ) | 3,443 | 13,795 | 7,388 | — | |||||||||||||
Net income | 100,499 | 13,764 | 20,601 | 10,048 | 27,942 | ||||||||||||||
Net income attributable to noncontrolling interest | — | 9 | 24 | — | 120 | ||||||||||||||
Net income to common shareholders | 100,499 | 13,773 | 20,625 | 10,048 | 28,062 | ||||||||||||||
Net income (net of tax effect) (1) | 100,499 | 13,773 | 20,625 | 10,723 | 17,258 | ||||||||||||||
Period End Balances | |||||||||||||||||||
Assets | 2,758,474 | 1,755,261 | 1,052,622 | 673,315 | 430,355 | ||||||||||||||
Loans held for sale | 680,454 | 394,278 | 480,619 | 295,180 | 159,438 | ||||||||||||||
Loans and leases held for investment | 1,343,973 | 907,566 | 279,969 | 203,936 | 141,349 | ||||||||||||||
Allowance for loan and lease losses | 24,190 | 18,209 | 7,415 | 4,407 | 2,723 | ||||||||||||||
Deposits | 2,260,263 | 1,485,076 | 804,788 | 522,080 | 356,620 | ||||||||||||||
Borrowings | 26,564 | 27,843 | 28,375 | 47,949 | 12,325 | ||||||||||||||
Shareholders' equity | 436,933 | 222,847 | 199,488 | 91,814 | 48,390 | ||||||||||||||
Per Common Share Data | |||||||||||||||||||
Net income per share - basic | 2.75 | 0.40 | 0.66 | 0.42 | 1.38 | ||||||||||||||
Net income per share - diluted | 2.65 | 0.39 | 0.65 | 0.41 | 1.37 | ||||||||||||||
Net income per share (net of tax effect) - basic (1) | 2.75 | 0.40 | 0.66 | 0.45 | 0.85 | ||||||||||||||
Net income per share (net of tax effect) - diluted (1) | 2.65 | 0.39 | 0.65 | 0.44 | 0.84 | ||||||||||||||
Operating net income per share (Non-GAAP) - basic (2) | 1.29 | 0.59 | 0.54 | 0.57 | 0.48 | ||||||||||||||
Operating net income per share (Non-GAAP) - diluted (2) | 1.25 | 0.57 | 0.53 | 0.56 | 0.48 | ||||||||||||||
Dividends declared | 0.10 | 0.07 | 0.10 | 2.18 | 0.48 | ||||||||||||||
Book value | 10.95 | 6.51 | 5.84 | 3.21 | 2.38 | ||||||||||||||
Tangible book value (2) | 10.85 | 6.51 | 5.84 | 3.20 | 2.36 | ||||||||||||||
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As of and for the Year Ended December 31, | |||||||||||||||||||
2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||
Performance Ratios | |||||||||||||||||||
Return on average assets | 4.55 | % | 0.96 | % | 2.26 | % | 1.77 | % | 6.53 | % | |||||||||
Return on average equity | 33.80 | 6.55 | 14.52 | 14.11 | 62.82 | ||||||||||||||
Return on average assets (net of tax effect) (1) | 4.55 | 0.96 | 2.26 | 1.89 | 4.02 | ||||||||||||||
Return on average equity (net of tax effect) (1) | 33.80 | 6.55 | 14.52 | 15.05 | 38.63 | ||||||||||||||
Net interest margin | 3.92 | 3.28 | 3.26 | 3.04 | 2.95 | ||||||||||||||
Efficiency ratio (2) | 57.05 | 78.16 | 65.25 | 72.87 | 59.74 | ||||||||||||||
Noninterest income to total revenue | 68.91 | 68.68 | 76.72 | 80.34 | 83.97 | ||||||||||||||
Average equity to average assets | 13.46 | 14.63 | 15.53 | 12.56 | 10.40 | ||||||||||||||
Dividend payout ratio (inclusive of tax distributions) | 3.64 | 17.50 | 15.15 | 447.33 | 10.65 | ||||||||||||||
Dividend payout ratio (net of tax effect) (1) | 3.64 | 17.50 | 15.15 | 419.17 | 17.32 | ||||||||||||||
Selected Loan Metrics | |||||||||||||||||||
Loans and leases originated | $ | 1,934,238 | $ | 1,537,010 | $ | 1,158,640 | $ | 848,090 | $ | 498,752 | |||||||||
Guaranteed loans sold | 787,926 | 761,933 | 640,886 | 433,912 | 339,342 | ||||||||||||||
Average net gain on sale of guaranteed loans | 100.38 | 98.86 | 105.14 | 115.18 | 112.64 | ||||||||||||||
Held for sale guaranteed loans (note amount) (3) | 1,087,636 | 754,834 | 497,875 | 326,723 | 144,228 | ||||||||||||||
Annual increase in held for sale guaranteed loans (note amount) | 332,802 | 256,959 | 171,152 | 182,495 | 22,562 | ||||||||||||||
Estimated net gain to be recognized on annual increase in guaranteed loans held for sale (4) | 33,407 | 25,403 | 17,995 | 21,020 | 2,541 | ||||||||||||||
Asset Quality Ratios | |||||||||||||||||||
Allowance for loan and lease losses to loans and leases held for investment | 1.80 | % | 2.01 | % | 2.65 | % | 2.16 | % | 1.93 | % | |||||||||
Net charge-offs | $ | 3,555 | $ | 1,742 | $ | 798 | $ | 1,109 | $ | 1,888 | |||||||||
Net charge-offs to average loans and leases held for investment | 0.32 | % | 0.29 | % | 0.37 | % | 1.21 | % | 3.47 | % | |||||||||
Nonperforming loans | $ | 23,480 | $ | 23,781 | $ | 12,367 | $ | 18,692 | $ | 8,697 | |||||||||
Foreclosed assets | 1,281 | 1,648 | 2,666 | 1,084 | 773 | ||||||||||||||
Nonperforming loans (unguaranteed exposure) | 3,610 | 4,784 | 2,037 | 3,137 | 1,714 | ||||||||||||||
Foreclosed assets (unguaranteed exposure) | 90 | 246 | 373 | 371 | 341 | ||||||||||||||
Nonperforming loans not guaranteed by the SBA and foreclosed assets | 3,700 | 5,030 | 2,410 | 3,508 | 2,055 | ||||||||||||||
Nonperforming loans not guaranteed by the SBA and foreclosed assets to total assets | 0.13 | % | 0.29 | % | 0.23 | % | 0.52 | % | 0.48 | % | |||||||||
Capital and Liquidity Ratios | |||||||||||||||||||
Common equity tier 1 capital (to risk-weighted assets) | 17.81 | % | 15.31 | % | 23.22 | % | N/A | N/A | |||||||||||
Total capital (to risk-weighted assets) | 18.91 | 16.56 | 24.12 | 19.63 | % | 15.95 | % | ||||||||||||
Tier 1 risk-based capital (to risk-weighted assets) | 17.81 | 15.31 | 23.22 | 17.41 | 15.09 | ||||||||||||||
Tier 1 leverage capital (to average assets) | 15.50 | 12.00 | 18.36 | 13.38 | 10.39 | ||||||||||||||
(1) | Net income (net of tax effect), earnings per share (net of tax effect) on a basic and diluted basis, return on average assets (net of tax effect), and return on average equity (net of tax effect) for each year shown was determined by calculating a provision for income taxes using an assumed annual effective income tax rate of 38.5% for the years ended December 31, 2014 and 2013, and adjusting our historical net income for each period presented to give effect to the pro forma provision for federal and state income taxes for such year. For the year ended December 31, 2014 the Company also excluded the initial deferred tax liability recorded as a result of the change in tax status on August 3, 2014 due to the conversion from an S corporation to a C corporation. |
(2) | See "Non-GAAP Measures" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations of this Report for more information and a reconciliation to the most closely related GAAP measure. |
(3) | Includes the entire note amount, including undisbursed funds for multi-advance loans. |
(4) | The estimated revenue from the sale of the annual increase in guaranteed loans is based on the average net gain on sale of loans for that year. This is an estimate based on the respective year activity and does not reflect actual gains to be recognized. |
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Item 7. | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Overview
The following presents management’s discussion and analysis of the more significant factors that affected the Company's financial condition as of December 31, 2017 and 2016 and results of operations for each of the years in the three-year period ended December 31, 2017. This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Results of operations for the periods included in this review are not necessarily indicative of results to be obtained during any future period.
Dollar amounts in tables are stated in thousands, except for per share amounts.
Nature of Operations
Live Oak Bancshares, Inc. is a bank holding company headquartered in Wilmington, North Carolina, incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company. The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending and deposit related services to small businesses nationwide in targeted industries. The Bank identifies and seeks to grow within selected industry sectors, or verticals, by leveraging expertise within those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration under the 7(a) program and to a lesser extent by the U.S. Department of Agriculture Rural Energy for America Program and Business & Industry loan programs.
In 2017, the Bank entered into a joint venture, Apiture LLC (“Apiture”), with First Data Corporation for the purpose of creating next generation technology for financial institutions. In addition to the Bank, the Company owns Reltco Inc. and National Assurance Title, Inc. (collectively referred to as "Reltco") which were acquired on February 1, 2017; Live Oak Clean Energy Financing LLC, formed in November 2016, for the purpose of providing financing to entities for renewable energy applications; Canapi, Inc. (formerly known as "Live Oak Ventures, Inc."), formed in August 2016 for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology; Live Oak Grove, LLC, formed in February 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location; Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans; and 504 Fund Advisors, LLC (“504FA”), which was formed to serve as the investment advisor to The 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans.
The Company generates revenue primarily from the sale of SBA-guaranteed loans and net interest income. During 2016, the Company also began originating and selling USDA-guaranteed REAP and B&I loans. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets and net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.
Executive Summary
Following is a summary of the Company's financial highlights and events for 2017:
• | The Company entered seven new verticals bringing the total number of vertical business units at year-end to twenty. |
• | Apiture, a digital banking joint venture formed with First Data Corporation, was established in the fourth quarter of 2017 generating a one-time gain for the Bank of $68.0 million. Apiture combines First Data’s and Live Oak Bank’s digital banking platforms, products, and services, delivering innovative technology solutions tailored for financial institutions. Both the Bank and First Data Corporation hold 50% voting control of Apiture. |
• | Net interest income and loan servicing revenue increased by $38.6 million, or 60.2%, to $102.6 million in 2017. |
• | Loan and lease production increased to $1.93 billion for 2017, a 25.8% increase over 2016. |
• | $24.9 million in investment tax credits were generated by the Company's investment of $90.6 million in renewable energy assets which are leased under operating lease arrangements. |
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• | During the third quarter, the Company completed a successful secondary public offering which generated an additional $113.1 million in capital. |
• | Guaranteed loan sales were relatively flat at $787.9 million in 2017, a 3.4% increase over 2016, as the Company focused on guaranteed loan retention to increase recurring revenue. |
• | Loans held for investment increased by $436.4 million, or 48.1%, to $1.34 billion at the end of 2017 as a result of robust 2017 loan originations. |
• | Total nonperforming unguaranteed loans and leases as a percentage of total loans and leases held for investment declined from 0.53% at the end of 2016 to 0.27% at the end of 2017. |
• | Net charge-offs as a percentage of average held for investment loans and leases, for the years ended December 31, 2017 and 2016, were 0.32% and 0.29%, respectively |
• | Core revenues consisting of net interest income, servicing revenue and gains on sale of loans increased to $181.2 million, a 30.0% increase over 2016. |
• | Total deposits rose by 52.2% to $2.26 billion at the end of 2017 following successful deposit gathering campaigns. |
• | As a result of the December 22, 2017 Tax Cut and Jobs Act, the Company recorded a one-time reduction in tax expense of $18.9 million arising from the revaluation of its net deferred tax liability. |
• | Reported net income increased by 630.2% over 2016 to $100.5 million. Non-GAAP net income, which excludes non-routine income and expenses, improved $27.0 million over 2016, or 134.2%, to $47.2 million. See "Non-GAAP Financial Measures" below for more information about Non-GAAP net income. The reconciliation of non-GAAP measures is presented at the conclusion of this Item 7. |
Business Outlook
Below is a discussion of management’s current expectations regarding company performance over the near-term based on market conditions, the regulatory environment and business strategies as of the time the Company filed this Report. Actual outcomes and results may differ materially from what is expressed or forecasted in these forward-looking statements. See “Important Note Regarding Forward-Looking Statements” in this Report for more information on forward-looking statements.
The Company's results for 2017 demonstrated strong underlying financial performance and solid growth momentum. Management continues to focus on building steady recurring revenue streams, promoting change within the financial technology industry, and building out existing verticals while incrementally adding new verticals to the Company's business model. Management anticipates that the Company's held-for-sale and held-for-investment loan portfolios will continue to grow as a result of continued healthy origination volumes and related loan retention to promote recurring revenue, ongoing growth in the construction portfolio as well as ongoing strategic initiatives, including the pursuit of potential opportunities in conventional lending outside of SBA or other government guarantee programs.
Non-GAAP Financial Measures
Statements included in this management's discussion and analysis include non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The reconciliation of non-GAAP measures is presented at the conclusion of this Item 7 section.
Management believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company without regard to transactional activities. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under GAAP, and investors should consider the Company's performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the Company's results or financial condition as reported under GAAP.
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Results of Operations
Years ended December 31, 2017 vs. 2016
The Company reported net income available to common shareholders totaling $100.5 million, or $2.65 per diluted share, for 2017 compared to $13.8 million, or $0.39 per diluted share, for 2016. This increase in net income was primarily attributable to the following items:
• | Increased net interest income of $35.4 million, or 83%, predominately driven by significant growth in the loans and leases held for sale and held for investment portfolios combined with a significantly higher net interest margin; |
• | A $68.0 million one-time gain arising from the Company's fourth quarter equity method investment in Apiture; and |
• | A decrease in income tax expense of $5.7 million, or 165.2%, due to the generation of investment tax credits by the Company's renewable energy leasing business combined with the positive impact of the enactment of the Tax Cuts and Jobs Act on December 22, 2017, as further discussed below. |
Other key factors contributing to the year-over-year increase in net income were comprised of the following:
• | Decreased provision for loan and lease losses of $3.0 million principally driven by the one-time transfer of $318.8 million in unguaranteed loans from held for sale to held for investment classification during the second quarter of 2016; |
• | Increased loan servicing revenue of $3.2 million, or 14.9%, as a result of continued growth in the servicing portfolio due to ongoing loan sales; |
• | Increased net gains on sales of loans of $3.3 million, or 4.3%, due to higher sale volumes combined with an increase in the average net gain per loan sold. |
Partially offsetting the above factors was an increase in noninterest expense of $36.7 million, or 34.5% largely attributable to the effects of continued investments to support growing levels of business and business diversification.
Years ended December 31, 2016 vs. 2015
The Company reported net income available to common shareholders totaling $13.8 million, or $0.39 per diluted share, for 2016 compared to $20.6 million, or $0.65 per diluted share, for 2015. This decrease in net income was primarily attributable to the following items:
• | An increase in the provision for loan and lease losses of $8.7 million, or 229.4%, arising primarily from significantly higher levels of loans held for investment, which included the transfer of $318.8 million in unguaranteed loans from being classified as held for sale to held for investment in the second quarter of 2016. This increase in the loan loss provision resulted in significant growth to the allowance for loan losses of $4.0 million. The higher provision also reflected the increase of $944 thousand in net charge-offs during 2016 as compared to 2015. |
• | Decreased noninterest income from a one-time gain of $3.8 million in the first quarter of 2015 related to the sale of an investment in nCino, Inc., a former subsidiary of the Company (“nCino”) combined with a higher negative loan servicing revaluation adjustment of $2.2 million; and |
• | Increased noninterest expense of $34.7 million, or 48.4%, attributable to the rapid growth of the business franchise. The increase in noninterest expense was predominantly driven by higher salaries and employee benefits of $22.7 million, or 56.2%, occupancy expense of $1.1 million, or 31.6%, data processing expense of $1.7 million, or 47.9%, and other expense of $3.3 million, or 56.9%. Factors driving these higher non-interest expense levels were increased investments in human capital, infrastructure and regulatory costs to support growing loan production from new and existing verticals as well as development of a new small business loan and deposit platform. Also contributing significantly to the increase in noninterest expense was a renewable energy tax credit investment impairment of $3.2 million related to a $4.6 million renewable energy tax credit investment in the fourth quarter. As reflected in lower income tax expense, this investment generated tax savings of $5.5 million for 2016. |
Partially offsetting the above factors were increases in net interest income of $17.1 million, or 66.7%, loan servicing revenue of $5.3 million, or 33.0%, net gains on sale of loans of $7.9 million, or 11.8%. construction supervision fee income of $1.0 million, or 64.3%, and reduced income tax expense of $10.4 million, or 75.0%.
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Net Interest Income and Margin
Net interest income represents the difference between the revenue that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays them respectively. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates the Bank offers are generally above the industry average.
Years ended December 31, 2017 vs. 2016
For 2017, net interest income increased $35.4 million, or 83.0%, to $78.0 million compared to $42.6 million in 2016. This increase was principally due to the significant growth in average interest earning assets and to a lesser extent by higher yields on these assets which outpaced the growth and change in the cost of interest bearing liabilities. Average interest earning assets rose by $686.6 million, or 52.7%, to $1.99 billion for 2017 compared to $1.30 billion for 2016, while the yield on average interest earning assets rose sharply by eighty basis points to 5.20% for 2017 versus 4.40% for 2016. A substantial portion of the Company's loan portfolio are variable rate loans that adjust regularly in accordance with changes in designated benchmark indices. The cost of funds on interest bearing liabilities for 2017 increased fourteen basis points to 1.38%, and the average balance in interest bearing liabilities increased by $658.5 million, or 55.6% during the same period. As indicated in the rate/volume table below, the increase in interest bearing liabilities and corresponding cost of funds was outpaced by the positive effects of the increased volume of interest earning assets along with much higher yields, resulting in increased interest income of $46.2 million versus increased interest expense of $10.8 million for 2017. The volume of interest bearing liabilities for 2017 was also mitigated somewhat by the August 2017 secondary public offering. For 2017 compared to 2016, net interest margin increased from 3.28% to 3.92% due to the aforementioned effects.
Years ended December 31, 2016 vs. 2015
For 2016, net interest income increased $17.1 million, or 66.7%, to $42.6 million compared to $25.6 million in 2015 due to favorable volume and interest rate factors. Average interest earning assets rose by $517.1 million, or 65.9%, to $1.30 billion for 2016 compared to $784.7 million for 2015, while the yield on average interest earning assets remained relatively static at 4.40% for 2016 versus 4.39% for 2015. The cost of funds on interest bearing liabilities for 2016 increased slightly by five basis points to 1.24%, and the average balance in interest bearing liabilities increased by $440.6 million, or 59.3% during the same period. As indicated in the rate/volume table below, the slight increase in rate and increased volume in interest bearing liabilities was outpaced by the effects of the increased volume and rate of interest earning assets, resulting in increased interest income of $22.8 million versus increased interest expense of $5.8 million for 2016. The volume of interest bearing liabilities for 2016 was also mitigated somewhat by the July 2015 initial public offering. For 2016 compared to 2015, net interest margin increased from 3.26% to 3.28% due to the aforementioned effects.
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Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented. Loan fees are included in interest income on loans.
2017 | 2016 | 2015 | |||||||||||||||||||||||||||||||
Average Balance | Interest | Average Yield/Rate | Average Balance | Interest | Average Yield/Rate | Average Balance | Interest | Average Yield/Rate | |||||||||||||||||||||||||
Interest earning assets: | |||||||||||||||||||||||||||||||||
Interest earning balances in other banks | $ | 232,398 | $ | 2,407 | 1.04 | % | $ | 222,704 | $ | 1,033 | 0.46 | % | $ | 84,782 | $ | 300 | 0.35 | % | |||||||||||||||
Investment securities | 76,250 | 1,432 | 1.88 | 62,746 | 1,132 | 1.80 | 50,431 | 811 | 1.61 | ||||||||||||||||||||||||
Loans held for sale | 582,245 | 34,567 | 5.94 | 413,468 | 22,645 | 5.48 | 435,508 | 22,590 | 5.19 | ||||||||||||||||||||||||
Loans and leases held for investment | 1,097,510 | 65,066 | 5.93 | 602,875 | 32,462 | 5.38 | 213,974 | 10,750 | 5.02 | ||||||||||||||||||||||||
Total interest earning assets | 1,988,403 | 103,472 | 5.20 | 1,301,793 | 57,272 | 4.40 | 784,695 | 34,451 | 4.39 | ||||||||||||||||||||||||
Less: Allowance for loan ad lease losses | (19,230 | ) | (10,899 | ) | (5,254 | ) | |||||||||||||||||||||||||||
Non-interest earning assets | 239,797 | 146,169 | 135,151 | ||||||||||||||||||||||||||||||
Total assets | $ | 2,208,970 | $ | 1,437,063 | $ | 914,592 | |||||||||||||||||||||||||||
Interest bearing liabilities: | |||||||||||||||||||||||||||||||||
Interest bearing checking | $ | 39,213 | $ | 256 | 0.65 | % | $ | 20,410 | $ | 116 | 0.57 | % | $ | 6,604 | $ | 39 | 0.59 | % | |||||||||||||||
Savings | 193,083 | 2,685 | 1.39 | — | — | — | — | — | — | ||||||||||||||||||||||||
Money market accounts | 413,648 | 4,060 | 0.98 | 423,035 | 3,197 | 0.76 | 347,429 | 2,562 | 0.74 | ||||||||||||||||||||||||
Certificates of deposit | 1,161,651 | 17,222 | 1.48 | 712,327 | 10,346 | 1.45 | 343,625 | 4,778 | 1.39 | ||||||||||||||||||||||||
Total deposits | 1,807,595 | 24,223 | 1.34 | 1,155,772 | 13,659 | 1.18 | 697,658 | 7,379 | 1.06 | ||||||||||||||||||||||||
Small business lending fund | — | — | — | — | — | — | 6,222 | 94 | 1.51 | ||||||||||||||||||||||||
Other borrowings | 34,968 | 1,215 | 3.47 | 28,250 | 964 | 3.41 | 39,515 | 1,389 | 3.52 | ||||||||||||||||||||||||
Total interest bearing liabilities | 1,842,563 | 25,438 | 1.38 | 1,184,022 | 14,623 | 1.24 | 743,395 | 8,862 | 1.19 | ||||||||||||||||||||||||
Non-interest bearing deposits | 40,831 | 21,665 | 15,131 | ||||||||||||||||||||||||||||||
Non-interest bearing liabilities | 28,248 | 21,046 | 14,004 | ||||||||||||||||||||||||||||||
Shareholders' equity | 297,328 | 210,311 | 142,044 | ||||||||||||||||||||||||||||||
Noncontrolling interest | 19 | 18 | |||||||||||||||||||||||||||||||
Total liabilities and shareholders' equity | $ | 2,208,970 | $ | 1,437,063 | $ | 914,592 | |||||||||||||||||||||||||||
Net interest income and interest rate spread | $ | 78,034 | 3.82 | % | $ | 42,649 | 3.16 | % | $ | 25,589 | 3.20 | % | |||||||||||||||||||||
Net interest margin | 3.92 | 3.28 | 3.26 | ||||||||||||||||||||||||||||||
Ratio of average interest-earning assets to average interest-bearing liabilities | 107.92 | % | 109.95 | % | 105.56 | % | |||||||||||||||||||||||||||
(1)Average loan balances include non-accruing loans.
41
Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by current period volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior period rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.
2017 vs. 2016 | 2016 vs. 2015 | |||||||||||||||||||||||
Increase (Decrease) Due to | Increase (Decrease) Due to | |||||||||||||||||||||||
Rate | Volume | Total | Rate | Volume | Total | |||||||||||||||||||
Interest income: | ||||||||||||||||||||||||
Interest earning balances in other banks | $ | 1,301 | $ | 73 | $ | 1,374 | $ | 169 | $ | 564 | $ | 733 | ||||||||||||
Investment securities | 51 | 249 | 300 | 111 | 210 | 321 | ||||||||||||||||||
Loans held for sale | 2,290 | 9,632 | 11,922 | 1,230 | (1,175 | ) | 55 | |||||||||||||||||
Loans and leases held for investment | 4,625 | 27,979 | 32,604 | 1,473 | 20,239 | 21,712 | ||||||||||||||||||
Total interest income | 8,267 | 37,933 | 46,200 | 2,983 | 19,838 | 22,821 | ||||||||||||||||||
Interest expense: | ||||||||||||||||||||||||
Interest bearing checking | 25 | 115 | 140 | (3 | ) | 80 | 77 | |||||||||||||||||
Savings | — | 2,685 | 2,685 | — | — | — | ||||||||||||||||||
Money market accounts | 945 | (82 | ) | 863 | 71 | 564 | 635 | |||||||||||||||||
Certificates of deposit | 282 | 6,594 | 6,876 | 327 | 5,241 | 5,568 | ||||||||||||||||||
Small business lending fund | — | — | — | — | (94 | ) | (94 | ) | ||||||||||||||||
Other borrowings | 20 | 231 | 251 | (35 | ) | (390 | ) | (425 | ) | |||||||||||||||
Total interest expense | 1,272 | 9,543 | 10,815 | 360 | 5,401 | 5,761 | ||||||||||||||||||
Net interest income | $ | 6,995 | $ | 28,390 | $ | 35,385 | $ | 2,623 | $ | 14,437 | $ | 17,060 | ||||||||||||
Provision for Loan and Lease Losses. The provision for loan and lease losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for loan and lease losses at a level that is appropriate in relation to the estimated losses inherent in the loan and lease portfolio. A number of factors are considered in determining the required level of loan and lease loss reserves and the provision required to achieve the appropriate reserve level, including loan growth, credit risk rating trends, nonperforming loan levels, delinquencies, loan portfolio concentrations and economic and market trends.
Losses inherent in loan relationships are mitigated by the portion of the loan that is guaranteed by U.S. government loan programs. A typical SBA 7(a) loan carries a 75% guarantee while USDA guarantees range from 60% to 80% depending on loan size, which reduces the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from U.S. government loan programs are key factors to managing this risk.
Years ended December 31, 2017 vs. 2016
For 2017, the provision for loan and lease losses was $9.5 million, a decrease of $3.0 million, or 23.9%, compared to the same period in 2016. The decrease in the provision for loan and lease losses for 2017 was principally driven by the one-time transfer in the second quarter of 2016 of $318.8 million in unguaranteed loans and leases from being classified as held for sale to held for investment. This reclassification resulted in a $4.0 million increase in the provision for loan and lease losses during the second quarter of 2016. Partially offsetting the effects of the 2016 loan reclassification were additional reserves recorded to accommodate robust loan and lease growth in 2017.
Loans and leases held for investment as of December 31, 2017 increased by $436.4 million, or 48.1%, compared to December 31, 2016. This growth was fueled by strong loan origination volume of $1.93 billion for the year ended December 31, 2017.
Net charge-offs were $3.6 million, or 0.32% of average loans and leases held for investment, for 2017, compared to net charge-offs of $1.7 million, or 0.29% of average loans and leases held for investment, for 2016. Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for loan and lease losses.
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In addition, at December 31, 2017, nonperforming loans and leases not guaranteed by the SBA totaled $3.6 million, which was 0.27% of the held-for-investment loan and lease portfolio compared to $4.8 million, or 0.53%, of loans and leases held for investment at December 31, 2016.
Years ended December 31, 2016 vs. 2015
For 2016, the provision for loan and lease losses was $12.5 million, an increase of $8.7 million, or 229.4%, compared to the same period in 2015. The increase in the provision for loan and lease losses was principally driven by growth in loans and leases held for investment combined with the effect of higher net charge-offs.
Loans and leases held for investment as of December 31, 2016 increased by $627.6 million, or 224.2%, compared to December 31, 2015. A significant portion of the increase was the result of the Company transferring $318.8 million in unguaranteed SBA loans from being classified as held for sale to held for investment during the second quarter of 2016. Timing of this transfer was largely influenced by the intent and ability to retain quality credits with higher long term yields. Upon transfer from held for sale classification, loans and leases held for investment become subject to the allowance for loan and lease loss review process. The result of this loan reclassification increased the provision for loan and lease losses by $4.0 million during the second quarter of 2016.
During the second quarter of 2016, the Company also implemented enhancements to the methodology for estimating the allowance for loan and lease losses, including refinements to the measurement of qualitative factors in the estimation process. Management believes these enhancements have improved the precision of the process for estimating the allowance. The Company estimated that the effect of revisions to the allowance methodology resulted in an approximately $390 thousand reduction in the provision for loan and lease losses during the second quarter of 2016.
Net charge-offs were $1.7 million, or 0.29% of average loans and leases held for investment, for 2016, compared to net charge-offs of $798 thousand, or 0.37% of average loans and leases held for investment, for 2015. In addition, at December 31, 2016, nonperforming loans and leases not guaranteed by the SBA totaled $4.8 million, which was 0.53% of the held-for-investment loan and lease portfolio compared to $2.0 million, or 0.73%, of loans and leases held for investment at December 31, 2015.
43
Noninterest Income
Noninterest income is principally comprised of net gains from the sale of SBA and USDA-guaranteed loans along with servicing revenue and revaluation. Revenue from the sale of loans depends upon volume and rates of underlying loans as well as cost and availability of funds in the secondary markets prevailing in the period between completed loan funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates. Other less common elements of noninterest income include nonrecurring gains and losses on investments.
The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
Years Ended December 31, | 2016/2017 Increase (Decrease) | 2015/2016 Increase (Decrease) | ||||||||||||||||||||||||
2017 | 2016 | 2015 | Amount | Percent | Amount | Percent | ||||||||||||||||||||
Noninterest income | ||||||||||||||||||||||||||
Loan servicing revenue | $ | 24,588 | $ | 21,393 | $ | 16,081 | $ | 3,195 | 14.93 | % | $ | 5,312 | 33.03 | % | ||||||||||||
Loan servicing revaluation | (13,171 | ) | (8,391 | ) | (6,229 | ) | (4,780 | ) | (56.97 | ) | (2,162 | ) | (34.71 | ) | ||||||||||||
Net gains on sales of loans | 78,590 | 75,326 | 67,385 | 3,264 | 4.33 | 7,941 | 11.78 | |||||||||||||||||||
Equity in loss of non-consolidated affiliates | — | — | (26 | ) | — | — | 26 | 100.00 | ||||||||||||||||||
Gain of sale of investment in non-consolidated affiliate | — | — | 3,782 | — | — | (3,782 | ) | (100.00 | ) | |||||||||||||||||
Gain on contribution to equity method investment | 68,000 | — | — | 68,000 | 100.00 | — | — | |||||||||||||||||||
Gain (loss) on sale of securities available-for-sale | — | 1 | 13 | (1 | ) | (100.00 | ) | (12 | ) | (92.31 | ) | |||||||||||||||
Construction supervision fee income | 1,776 | 2,667 | 1,623 | (891 | ) | (33.41 | ) | 1,044 | 64.33 | |||||||||||||||||
Title insurance income | 7,565 | — | — | 7,565 | 100.00 | — | — | |||||||||||||||||||
Other noninterest income | 5,573 | 2,543 | 1,699 | 3,030 | 119.15 | 844 | 49.68 | |||||||||||||||||||
Total noninterest income | $ | 172,921 | $ | 93,539 | $ | 84,328 | $ | 79,382 | 84.87 | % | $ | 9,211 | 10.92 | % | ||||||||||||
Years ended December 31, 2017 vs. 2016
For 2017, noninterest income increased by $79.4 million, or 84.9%, compared to 2016. The increase from the prior year was largely driven by the $68.0 million one-time gain recognized as a result of the fourth quarter equity method investment in Apiture, see Note 3. Unconsolidated Joint Venture for further discussion. Other contributors to the increase in noninterest income was higher year-over-year levels in the serviced loan portfolio and the volume of loans sold in the secondary market, which generated $3.2 million of increased servicing revenue and $3.3 million of increased net gains on sale of loans. Also driving increased levels of noninterest income was $7.6 million in title insurance revenue from the acquisition of a nationwide title insurance business in early 2017 and increased other noninterest income of $3.0 million. The increase in other noninterest income was primarily comprised of $1.9 million of operating lease income from renewable energy assets and trust management income of $1.1 million. Partly offsetting the overall increase in noninterest income was a higher negative loan servicing revaluation adjustment of $4.8 million.
The tables below reflect loan and lease production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold that are being serviced. These components are key drivers of the Company's recurring noninterest income.
44
Three months ended December 31, | Three months ended September 30, | Three months ended June 30, | Three months ended March 31, | ||||||||||||||||||||||||||||
2017 | 2016 | 2017 | 2016 | 2017 | 2016 | 2017 | 2016 | ||||||||||||||||||||||||
Amount of loans and leases originated | $ | 483,422 | $ | 514,565 | $ | 395,682 | $ | 381,050 | $ | 586,471 | $ | 356,865 | $ | 468,663 | $ | 284,530 | |||||||||||||||
Guaranteed portions of loans sold | 211,654 | 260,125 | 163,843 | 210,610 | 203,714 | 135,555 | 208,715 | 155,643 | |||||||||||||||||||||||
Outstanding balance of guaranteed loans sold (1) | 2,680,641 | 2,278,618 | 2,584,163 | 2,102,468 | 2,521,506 | 1,970,908 | 2,410,791 | 1,894,428 | |||||||||||||||||||||||
Years ended December 31, | ||||||||||||||||||||
2017 | 2016 | 2015 | 2014 | 2013 | ||||||||||||||||
Amount of loans and leases originated | $ | 1,934,238 | $ | 1,537,010 | $ | 1,158,640 | $ | 848,090 | $ | 498,752 | ||||||||||
Guaranteed portions of loans sold | 787,926 | 761,933 | 640,886 | 433,912 | 339,342 | |||||||||||||||
Outstanding balance of guaranteed loans sold (1) | 2,680,641 | 2,278,618 | 1,779,989 | 1,302,828 | 1,005,764 | |||||||||||||||
(1) | This represents the outstanding principal balance of guaranteed loans serviced, as of the last day of the applicable period, which have been sold into the secondary market. |
Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Revenue: While portions of the loans that the Bank originates are sold and generate gain on sale revenue, servicing rights for all loans that the Bank originates, including loans sold, are retained by the Bank. In exchange for continuing to service loans that are sold, the Bank receives fee income represented in loan servicing revenue equivalent to one percent of the outstanding balance of SBA loans sold and 0.40% of the outstanding balance of USDA loans sold. In addition, the standard cost of servicing sold loans is approximately 0.40% of the balance of the loans sold, which is included in the loan servicing revaluation computations. Unrecognized servicing revenue above the cost to service is reflected in a servicing asset recorded on the balance sheet. Revenues associated with the servicing of loans are recognized over the expected life of the loan through the income statement, and the servicing asset is reduced as this revenue is recognized. For the year ended December 31, 2017, loan servicing revenue increased $3.2 million, or 14.9%, to $24.6 million as compared to the year ended December 31, 2016, as a result of an increase in the average outstanding balance of guaranteed loans sold. At December 31, 2017, the outstanding balance of guaranteed loans sold in the secondary market was $2.68 billion. At December 31, 2016, the outstanding balance of guaranteed loans sold was $2.28 billion.
Loan Servicing Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The revaluation considers the amortization of the portfolio, current market conditions for loan sale premiums, and current prepayment speeds. For the years ended December 31, 2017 and 2016, there was a net negative loan servicing revaluation of $13.2 million and $8.4 million, respectively. The higher negative service revaluation amount for 2017 was principally driven by the increased amortization speed of the serviced portfolio which was largely impacted by the rising rate environment.
In consideration of the sensitivity of servicing rights as discussed above and in Note 6 to the accompanying audited financial statements, the following table is provided as of December 31, 2017 reflecting the effect on fair value due to changes in yield curve rates.
Change in Yield Curve Assumption | Increase (Decrease) in Value | |
+300 basis point | $(5,235) | |
+200 basis point | (3,613) | |
+100 basis point | (1,872) | |
- 100 basis point | 2,020 | |
Net Gains on Sale of Loans: For the year ended December 31, 2017, net gains on sales of loans increased $3.3 million, or 4.3%, compared to 2016. This increase was primarily due to a higher volume of guaranteed loans sold and to a lesser extent an increase in the average net gain per loan sold. For 2017, the volume of guaranteed loans sold increased $26.0 million, or 3.4%, from $761.9 million in 2016 to $787.9 million in 2017. The average net gain on sale for 2017 was somewhat higher at $100 thousand of revenue for each $1 million in loans sold, compared to $99 thousand of revenue for each $1 million sold for 2016.
45
Years ended December 31, 2016 vs. 2015
For 2016, noninterest income increased by $9.2 million, or 10.9%, compared to 2015. Increases in the serviced loan portfolio and the volume of loans sold in the secondary market, the core components of the Company’s business, contributed $13.3 million to noninterest income growth, including $5.3 million of increased servicing revenue and $7.9 million of increased net gains on sale of loans. Other factors contributing to the increase in noninterest income were an increase of $1.0 million in construction supervision fees earned for monitoring higher levels of multi-advance loans in addition to $844 thousand in higher earnings from other noninterest income. The increase in other noninterest income was comprised principally of revenue growth at the Company's new trust division. Offsetting these increases were higher downward adjustments in the valuation of servicing rights of $2.2 million during 2016 compared to the same period in 2015 along with a one-time gain of $3.8 million in the first quarter of 2015 related to the sale of an investment in nCino.
Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Revenue: While portions of the loans that the Bank originates are sold and generate premium revenue, servicing rights for all loans that the Bank originates, including loans sold, are retained by the Bank. In exchange for continuing to service loans that are sold, the Bank receives fee income represented in loan servicing revenue equivalent to one percent of the outstanding balance of SBA loans sold and 0.40% of the outstanding balance of USDA loans sold. In addition, the standard cost of servicing sold loans is approximately 0.40% of the balance of the loans sold, which is included in the loan servicing revaluation computations. Unrecognized servicing revenue above the cost to service is reflected in a servicing asset recorded on the balance sheet. Revenues associated with the servicing of loans are recognized over the expected life of the loan through the income statement, and the servicing asset is reduced as this revenue is recognized. For the year ended December 31, 2016, loan servicing revenue increased $5.3 million, or 33.0%, to $21.4 million as compared to the year ended December 31, 2015, as a result of an increase in the average outstanding balance of guaranteed loans sold. At December 31, 2016, the outstanding balance of guaranteed loans sold in the secondary market was $2.28 billion, with a weighted average servicing fee rate of 1.04%. At December 31, 2015, the outstanding balance of guaranteed loans sold was $1.78 billion, with a weighted average servicing fee rate of 1.07%. Prior to January 2010, the Company sold loans for servicing in excess of 1.0%. As loans sold for servicing fee rates in excess of 1.0% prior to fiscal year 2010 amortize, the Company expects that the weighted average servicing fee rate will approach and stabilize at approximately 1.0%.
Loan Servicing Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The revaluation considers the amortization of the portfolio, current market conditions for loan sale premiums, and current prepayment speeds. For the years ended December 31, 2016 and 2015, there was a net negative loan servicing revaluation of $8.4 million and $6.2 million, respectively. The higher negative service revaluation amount for 2016 was due to an increase in the prepayment rates and a decline in the premium market.
In consideration of the sensitivity of servicing rights as discussed above and in Note 6 to the accompanying audited financial statements, the following table is provided as of December 31, 2016 reflecting the effect on fair value due to changes in yield curve rates.
Change in Yield Curve Assumption | Increase (Decrease) in Value | |
+300 basis point | $(5,027) | |
+200 basis point | (3,461) | |
+100 basis point | (1,789) | |
- 100 basis point | 1,918 | |
Net Gains on Sale of Loans: For the year ended December 31, 2016, net gains on sales of loans increased $7.9 million, or 11.8%, compared to 2015. This increase was primarily due to a higher volume of guaranteed loans sold. For 2016, the volume of guaranteed loans sold increased $121.0 million, or 18.9%, from $640.9 million in 2015 to $761.9 million in 2016. The volume-driven increases in the net gain on loan sale comparisons were partially mitigated by lower average premiums paid in the secondary market. The lower gain per million in 2016 was influenced by the Company's entry into renewable energy lending with high volumes but characteristically lower gains per million sold. The average net gain on sale for 2016 was somewhat lower at $99 thousand of revenue for each $1 million in loans sold, compared to $105 thousand of revenue for each $1 million sold for 2015.
46
Noninterest Expense
Noninterest expense comprises all operating costs of the Company, such as employee related costs, travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.
The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.
Years Ended December 31, | 2016/2017 Increase (Decrease) | 2015/2016 Increase (Decrease) | |||||||||||||||||||||||
2017 | 2016 | 2015 | Amount | Percent | Amount | Percent | |||||||||||||||||||
Noninterest expense | |||||||||||||||||||||||||
Salaries and employee benefits | $ | 74,669 | $ | 62,996 | $ | 40,323 | $ | 11,673 | 18.53 | % | $ | 22,673 | 56.23 | % | |||||||||||
Non-staff expenses: | |||||||||||||||||||||||||
Travel expense | 8,124 | 8,205 | 7,379 | (81 | ) | (0.99 | ) | 826 | 11.19 | ||||||||||||||||
Professional services expense | 4,937 | ||||||||||||||||||||||||