-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PxiPHqsAkv2T33NzKfbwHQNOx/pf4p79C1DHINWBG2PAWO9ivL1Nl6MJY4j5tAXt Aob82S7ByCBrZqwbGWBiXw== 0000950137-06-008748.txt : 20060807 0000950137-06-008748.hdr.sgml : 20060807 20060807111553 ACCESSION NUMBER: 0000950137-06-008748 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060807 DATE AS OF CHANGE: 20060807 FILER: COMPANY DATA: COMPANY CONFORMED NAME: BAYLAKE CORP CENTRAL INDEX KEY: 0000275119 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 391268055 STATE OF INCORPORATION: WI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-16339 FILM NUMBER: 061007756 BUSINESS ADDRESS: STREET 1: 217 N FOURTH AVE STREET 2: PO BOX 9 CITY: STURGEON BAY STATE: WI ZIP: 54235-0009 BUSINESS PHONE: 9207435551 10-Q 1 c07528e10vq.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _____________ Commission file number 0-8679 BAYLAKE CORP. - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Wisconsin 39-1268055 - -------------------------------------------------------------------------------- (State or other jurisdiction of incorporation (Identification No.) or organization) 217 North Fourth Avenue, Sturgeon Bay, WI 54235 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (920)-743-5551 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) None - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the 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 [X] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Applicable Only to Corporate Issuers: Number of outstanding shares of common stock as of August 1, 2006: 7,843,127 shares BAYLAKE CORP. AND SUBSIDIARIES INDEX
PAGE NO. -------- PART I - FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets (Unaudited) as of June 30, 2006 and December 31, 2005 3 Consolidated Statements of Income and Comprehensive Income (Unaudited) for the three and six months ended June 30, 2006 and 2005 4 Consolidated Statements of Changes in Stockholders' Equity (Unaudited) for the six months ended June 30, 2006 and 2005 5 Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2006 and 2005 6-7 Notes to Consolidated Unaudited Financial Statements 8-11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12-37 Item 3. Quantitative and Qualitative Disclosures About Market Risk 37-38 Item 4. Controls and Procedures 38 PART II - OTHER INFORMATION Signatures 40 EXHIBIT INDEX Exhibit 10.9 Baylake Bank employment agreement with Robert J. Cera 1-10 Exhibit 31.1 Certification pursuant to Section 302 Exhibit 31.2 Certification pursuant to Section 302 Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350
BAYLAKE CORP. CONSOLIDATED BALANCE SHEETS June 30, 2006 and December 31, 2005 (Amounts in thousands of dollars)
June 30, 2006 December 31, (Unaudited) 2005 ------------- ------------ ASSETS Cash and due from financial institutions $ 24,530 $ 32,855 Federal funds sold - 199 ------------- ------------ Cash and cash equivalents 24,530 33,054 Securities available for sale 183,955 171,638 Loans held for sale 273 374 Loans, net of allowance after $9,425 and $9,551 812,279 802,745 Cash value of life insurance 23,760 22,814 Premises held for sale 1,128 1,167 Premises and equipment, net 27,694 24,703 Federal Home Loan Bank stock 7,266 8,081 Foreclosed assets, net 1,374 3,333 Goodwill 5,723 5,723 Accrued interest receivable 5,690 5,354 Other assets 11,015 10,422 ------------- ------------ Total assets $ 1,104,687 $ 1,089,408 ============= ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest-bearing $ 102,383 $ 110,641 Interest-bearing 768,659 746,070 ------------- ------------ Total deposits 871,042 856,711 Federal Home Loan Bank advances 105,182 125,185 Federal funds purchased and repurchase agreements 22,194 1,315 Subordinated debentures 16,100 16,100 Accrued expenses and other liabilities 11,744 10,310 Dividends payable - 1,243 ------------- ------------ Total liabilities 1,026,262 1,010,864 Common stock, $5 par value, authorized 10,000,000; issued- 7,828,286 shares in 2006, 7,805,586 shares in 2005; outstanding- 7,805,127 shares in 2006, 7,782,427 shares in 2005 39,142 39,028 Additional paid-in capital 9,669 9,466 Retained earnings 33,661 32,461 Treasury stock (23,159 shares in 2006 and 2005) (625) (625) Accumulated other comprehensive income (3,422) (1,786) ------------- ------------ Total stockholders' equity 78,425 78,544 ------------- ------------ Total liabilities and stockholder equity $ 1,104,687 $ 1,089,408 ============= ============
See accompanying notes to Unaudited Consolidated Financial Statements. 3 BAYLAKE CORP. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited) Three and Six Months ended June 30, 2006 and 2005 (Amounts in thousands of dollars except per share data)
Three months ended Six months ended June 30 June 30 2006 2005 2006 2005 Interest and dividend income Loans, including fees $ 15,418 $ 12,944 $ 30,082 $ 24,607 Taxable securities 1,570 1,729 3,141 3,458 Tax exempt securities 378 489 738 892 Federal funds sold and other 156 16 207 33 -------- -------- -------- -------- Total interest and dividend income 17,522 15,178 34,168 28,990 -------- -------- -------- -------- Interest expense Deposits 7,090 4,494 13,432 8,321 Federal funds purchased and repurchase agreements 89 318 264 491 Federal Home Loan Bank advances and other debt 1,399 1,014 2,761 1,751 Subordinated debentures 257 462 1,146 923 -------- -------- -------- -------- Total interest expense 8,835 6,288 17,603 11,486 -------- -------- -------- -------- NET INTEREST INCOME 8,687 8,890 16,565 17,504 Provision for loan losses 61 91 261 121 -------- -------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,626 8,799 16,304 17,383 -------- -------- -------- -------- Other income Fees from fiduciary activities 240 184 541 363 Fees from loan servicing 275 288 535 571 Fees for other services to customers 1,246 1,185 2,385 2,283 Gains from sales of loans 209 177 410 385 Net gains (loss) from sale and disposal of premises and equipment 185 (151) 185 (151) Increase in cash surrender value of life insurance 175 190 401 417 Other income 151 153 262 421 -------- -------- -------- -------- Total other income 2,481 2,026 4,719 4,289 -------- -------- -------- -------- Non-interest expenses Salaries and employee benefits 4,525 4,329 9,517 8,857 Occupancy expense 585 602 1,164 1,138 Equipment expense 445 340 840 647 Data processing and courier 315 298 615 576 Operation of other real estate 74 81 117 129 Other operating expenses 1,749 1,441 3,564 2,789 -------- -------- -------- -------- Total non-interest expenses 7,693 7,091 15,817 14,136 -------- -------- -------- -------- INCOME BEFORE INCOME TAX EXPENSE 3,414 3,734 5,206 7,536 Income tax expense 1,044 1,174 1,512 2,392 -------- -------- -------- -------- NET INCOME $ 2,370 $ 2,560 $ 3,694 $ 5,144 -------- -------- -------- -------- COMPREHENSIVE INCOME $ 1,095 $ 3,612 $ 2,059 $ 4,204 -------- -------- -------- -------- BASIC EARNINGS PER SHARE $ 0.30 $ 0.33 $ 0.47 $ 0.67 DILUTED EARNINGS PER SHARE $ 0.30 $ 0.33 $ 0.47 $ 0.66
See accompanying notes to Unaudited Consolidated Financial Statements. 4 BAYLAKE CORP. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) Six months ended June 30, (Amounts in thousands of dollars except for per share data)
Accumulated Other Common Stock Additional Comprehensive --------------------- Paid-in Retained Treasury Income Total Shares Amount Capital Earnings Stock (loss) Equity --------- ----------- ----------- ----------- -------- ------------- ------- BALANCE, JANUARY 1, 2005 7,692,777 $ 38,580 $ 8,806 $ 28,275 $ (625) $ 1,169 $76,205 Net income for the year - - - 5,144 - - 5,144 Net changes in unrealized gain (loss) on securities available for sale, net of $(526) deferred taxes - - - - - (940) (940) ------- Total comprehensive income 4,204 Stock options exercised 33,000 165 134 - - - 299 Tax benefit from exercise of stock options - - 116 - - - 116 Cash dividends declared ($0.30 per share) - - - (2,309) - - (2,309) --------- ----------- ----------- ----------- -------- ------------- ------- BALANCE, JUNE 30, 2005 7,725,777 $ 38,745 $ 9,056 $ 31,110 $ (625) $ 229 $78,515 ========= =========== =========== =========== ======== ============= ======= BALANCE, JANUARY 1, 2006 7,782,427 $ 39,028 $ 9,466 $ 32,461 $ (625) $ (1,786) $78,544 Net income for the year - - - 3,694 - - 3,694 Net changes in unrealized gain (loss) on securities available for sale, net of $(894) deferred taxes - - - - - (1,636) (1,636) Total comprehensive income 2,058 ------- Stock compensation expense recognized - - 26 - - - 26 Stock options exercised 22,700 114 97 - - - 211 Tax benefit from exercise of stock options - - 80 - - - 80 Cash dividends declared ($0.32 per share) - - - 2,494) - - (2,494) --------- ----------- ----------- ----------- -------- ------------- ------- BALANCE, JUNE 30, 2006 7,805,127 $ 39,142 $ 9,669 $ 33,661 $ (625) $ (3,422) $78,425 ========= =========== =========== =========== ======== ============= =======
See accompanying notes to Unaudited Consolidated Financial Statements. 5 BAYLAKE CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Six months ended June 30, 2006 and 2005 (Amounts in thousands of dollars)
2006 2005 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Reconciliation of net income to net cash provided by operating activities: Net income $ 3,694 $ 5,144 Adjustments to reconcile net income to net cash provided to operating activities: Depreciation and amortization 812 900 Amortization of debt issuance costs 475 118 Amortization of core deposit intangible 26 26 Provision for losses on loans 261 121 Net amortization of securities 85 314 Increase in cash surrender value of life insurance (401) (417) Federal Home Loan Bank stock dividend - (211) Net gain on sale of loans (410) (385) Proceeds from sale of loans held for sale 21,882 8,572 Origination of loans held for sale (21,372) (8,635) Provision for valuation allowance on other real estate owned 47 20 Net (gain) loss from disposal of other real estate (53) 28 Net (gain) loss from disposal of bank premises and equipment (185) 151 Stock option compensation expense recognized 26 - Changes in assets and liabilities: Accrued interest receivable and other assets 497 (871) Accrued expenses and other liabilities 1,273 623 ----------- ----------- Net cash provided by operating activities 6,657 5,498 CASH FLOWS FROM INVESTING ACTIVITIES: Principal payments on securities available-for-sale 10,291 6,675 Purchase of securities available-for-sale (25,222) (20,886) Proceeds from sale of other real estate owned 2,356 828 Proceeds from sale of premises and equipment - 290 Loan originations and payments, net (10,205) (39,939) Additions to premises and equipment (3,579) (4,649) Investment in bank-owned life insurance (583) (469) ------------ ------------ Net cash used in investing activities (26,942) (58,150)
See accompanying notes to Unaudited Consolidated Financial Statements. 6 BAYLAKE CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS Six months ended June 30, 2006 and 2005 (Amounts in thousands of dollars)
2006 2005 --------------- --------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net change in deposits $ 14,331 $ 411 Net change in federal funds purchased and repurchase agreements 20,879 40,301 Proceeds from Federal Home Loan Bank advances 45,000 15,000 Repayments on Federal Home Loan Bank advances (65,003) (4) Redemption of subordinated debt (16,100) - Proceeds from issuance of subordinated debt 16,100 - Proceeds from exercise of stock options 211 299 Tax benefit from exercises of stock options 80 - Cash dividends paid (3,737) (3,463) --------------- --------------- Net cash provided by financing activities 11,761 52,544 --------------- --------------- Net change in cash and cash equivalents (8,524) (108) Beginning cash and cash equivalents 33,054 26,172 --------------- --------------- ENDING CASH AND CASH EQUIVALENTS $ 24,530 $ 26,064 =============== ===============
See accompanying notes to Unaudited Consolidated Financial Statements. 7 BAYLAKE CORP. NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS JUNE 30, 2006 1. The accompanying consolidated financial statements should be read in conjunction with Baylake Corp.'s 2005 annual report on Form 10-K. The accompanying consolidated financial statements are unaudited. These interim financial statements are prepared in accordance with the requirements of Form 10-Q, and accordingly do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial information included in this report reflects all adjustments, consisting of normal recurring accruals, which are necessary for a fair statement of the financial position as of June 30, 2006 and December 31, 2005. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of results to be expected for the entire year. 2. To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, foreclosed assets, and fair values of financial instruments are particularly subject to change. 3. Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options were exercised and stock awards were fully vested and resulted in the issuance of common stock that then shared in the earnings of the Company, is computed by dividing net income by weighted average number of common shares and common stock equivalents. The following table shows the computation of the basic and diluted earnings per share for the three and six months ended June 30 (dollars in thousands, except per share amounts):
Three months ended June 30, Six months ended June 30, ----------------------------------- ----------------------------------- (Net income in thousands) 2006 2005 2006 2005 ---------- ------------ ----------- ------------ (NUMERATOR): Net income $ 2,370 $ 2,560 $ 3,694 $ 5,144 (DENOMINATOR): Weighted average number of common shares outstanding-basic 7,803,193 7,700,952 7,794,127 7,698,351 Dilutive effect of stock options 50,450 97,143 51,745 94,323 ---------- ------------ ----------- ------------ Weighted average number of common shares outstanding-diluted 7,853,643 7,798,095 7,845,872 7,792,674 BASIC EPS $ 0.30 $ 0.33 $ 0.47 $ 0.67 DILUTED EPS $ 0.30 $ 0.33 $ 0.47 $ 0.66
8 BAYLAKE CORP. 4. Baylake Corp. declared a cash dividend of $0.16 per share paid on June 15, 2006 to shareholders of record as of June 1, 2006. 5. The Company has a non-qualified stock option plan, which is described more fully in the Company's December 31, 2005 Annual Report on Form 10-K. Beginning in 2006, the Company accounts for stock compensation expense under the provisions of FASB Statement No. 123R, "Accounting for Stock-Based Compensation" ("FAS 123R") on a modified prospective basis. FAS 123R requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This applies to awards granted, modified, or vesting in fiscal years beginning in 2006. Compensation cost is recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. The Company may no longer issue stock options under the current plan and thus there will be no further grants thereunder. Existing options that will vest after the adoption date are expected to result in an immaterial amount of compensation expense during 2006 through 2008. For the first six months of 2006, the amount of compensation expense reflected in the financial statements is $26,000, including $13,000 in the second quarter of 2006. As a matter of comparing the three and six months ended June 30, 2006 with the same period in 2005, the following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of SFAS 123 "Accounting for Stock-Based Compensation," to stock-based employee compensation for periods prior to January 1, 2006.
Three months ended June Six months ended June 30, 30, 2005 2005 ----------------------- ------------------------- (In thousands, except per share amounts) ------------------------------------------------------------ Net income, as reported $ 2,560 $ 5,144 Less: Total stock-based employee compensation cost determined under the fair value method, net of income taxes (15) (29) ------- ------- Pro forma net income 2,545 5,115 Earnings per share: Basic - as reported $ 0.33 $ 0.67 Basic - pro forma $ 0.33 $ 0.66 Diluted - as reported $ 0.33 $ 0.66 Diluted - pro forma $ 0.33 $ 0.66
The fair value of each option granted was estimated as of the date of grant using the Black-Scholes option pricing model. The resulting compensation cost was amortized over the vesting period. 9 BAYLAKE CORP. A summary of the Company's stock-based compensation activity for the six months ended June 30, 2006, is presented below.
Weighted average Weighted remaining Aggregate average contractual intrinsic value Stock options Shares exercise price term (000's) - ------------------------------------ -------- -------------- ----------- --------------- Outstanding at December 31, 2005 486,869 $ 13.95 Granted - - Exercised 22,700 9.27 Forfeited - - Outstanding at June 30, 2006 464,169 14.18 Outstanding and in the money options at June 30, 2006 404,169 12.57 3.1 $ 1,366 Options exercisable and in the money at June 30, 2006 367,788 12.47 3.1 $ 1,280
During the first six months of 2006, $210,000 was received for the exercise of 22,700 stock options. 6. The Company redeemed on March 31, 2006 all of its 10.00% Cumulative Trust Preferred Securities (the "Trust Preferred Securities") and its 10.00% Common Securities (the "Trust Common Securities") at a redemption price equal to the $10.00 liquidation amount of each security plus all accrued and unpaid interest per security to March 31, 2006, the redemption date, through Baylake Capital Trust I (the "Trust"). The Trust took such action in connection with the concurrent redemption by Baylake Corp. of all of its $16.6 million 10.00% debentures due March 31, 2031 (the "Debentures") which are held exclusively by the Trust. The Debentures were redeemed on March 31, 2006 at a redemption price equal to the principal outstanding of the Debentures plus interest accrued on the Debentures up to March 31, 2006. In connection with the redemption of the Debentures, the Company expensed during the first quarter $475,015, pre-tax, of unamortized origination cost associated with the Debentures. The Company funded the redemption through the issuance of $16.1 million of trust preferred securities and $498,000 of trust common securities that will adjust quarterly at a rate equal to 1.35% over the three-month LIBOR. The rates for the second and third quarters, respectively, are 6.31% and 6.85%, respectively. There were no debt issuance costs associated with this most recent issuance. 7. Effect of Newly Issued But Not Yet Effective Accounting Standards: In March 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting 10 BAYLAKE CORP. Standards ("SFAS") No. 156, "Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140, " ("SFAS 156"). SFAS 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. All separately recognized servicing assets and servicing liabilities are to be initially measured at fair value, if practicable. SFAS 156 permits an entity to choose either the Amortization method or the Fair Value Measurement Method for subsequently measuring each class of separately recognized servicing assets or servicing liabilities. Under the amortization method, servicing assets or servicing liabilities are amortized in proportion to and over the period of estimated net servicing income or loss and servicing assets or servicing liabilities are assessed for impairment based on fair value at each reporting date with the changes in fair value recognized in earnings in the period in which the changes occur. SFAS 156 is effective for fiscal years beginning after September 15, 2006, and earlier adoption is permitted as of the beginning of an entity's fiscal year, provided the entity has not yet issued financial statements for any period of that fiscal year. Total servicing rights as of June 30, 2006, include $510,000 of mortgage servicing rights and $749,000 of servicing rights on SBA loans. The Company will adopt SFAS 156 in 2007 and is in the process of assessing the impact on its results of operations, financial position, and liquidity. In June 2006, the FASB issued Interpretation No. 48 "Accounting for Uncertainty in Income Taxes" - an interpretation of FASB No. 109" (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation is effective for fiscal years beginning after December 31, 2006. The Company is currently evaluating the impact of the adoption of FIN 48, with respect to its results of operations, financial position and liquidity. 8. The Bank owns a 49% interest in United Financial Services, Inc. ("UFS") a data processing service. The Bank's ownership interest totals $3.1 million and $2.7 million, respectively, at June 30, 2006 and 2005, respectively, and is reflected in the Other Assets in the "Consolidated Balance Sheets". In addition to the ownership interest, UFS and the Company have a common member on each respective Board of Directors. The investment in this entity is carried under the equity method of accounting, and the pro rata share of its income is included in other income. On June 27, 2006, an amendment to an earlier agreement dated September 11, 1991 for employment was entered into with a key employee of UFS allowing that individual the option to purchase up to 20%, or 240 shares, of the authorized shares of UFS. The option price is $1,000 per share, less dividends or distributions to owners. Current book value for UFS is approximately $6,300 per share. Any exercise of the option will have an effect of reducing the Company's interest in UFS and decreasing other income as those options are exercised. 9. In its previous report, the Company indicated that one loan of about $8.1 million might be repaid upon sale of collateral real estate under an accepted full price offer to purchase, but that closing was subject to settlement of liens and claims against the property. However, despite negotiations, the lien claims were not resolved and the offer has been withdrawn. The Company then filed and has completed a foreclosure on a portion of the loans in the amount of $4.0 million. Upon withdrawal of the offer to purchase, the Company is initiating additional foreclosure proceedings on the remaining loans of about $4.1 million. 11 PART 1 - FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Baylake is a full-service financial services company, providing a wide variety of loan, deposit and other banking products and services to its business, individual or retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Company is the bank holding company of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member bank of the Federal Reserve and Federal Home Loan Bank. The following sets forth management's discussion and analysis of the consolidated financial condition and results of operations of Baylake Corp. ("Baylake" or the "Company") for the three and six months ended June 30, 2006 and 2005 which may not be otherwise apparent from the consolidated financial statements included in this report. Unless otherwise stated, the "Company" or "Baylake" refers to this entity and to its subsidiaries on a consolidated basis when the context indicates. For a more complete understanding, this discussion and analysis should be read in conjunction with the financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report. FORWARD-LOOKING INFORMATION This discussion and analysis of financial condition and results of operations, and other sections of this report, may contain forward-looking statements that are based on the current expectations of management. Such expressions of expectations are not historical in nature and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "projects," and other such words are intended to identify in such forward-looking statements. The statements contained herein and in such forward-looking statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the control of the Company, that may cause actual future results to differ materially from what may be expressed or forecasted in such forward-looking statements. Readers should not place undue expectations on any forward-looking statements. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the relationships; demand for financial products and financial services; the degree of competition by traditional and non-traditional financial services competitors; changes in banking legislation or regulations; changes in tax laws and the results of recent Wisconsin state tax developments; changes in interest rates; changes in prices; the impact of technological advances; governmental and regulatory policy changes; trends in customer behavior as well as their ability to repay loans; and changes in the general economic conditions, nationally or in the State of Wisconsin. 12 CRITICAL ACCOUNTING POLICIES In the course of the Company's normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in the consolidated financial statements of the Company. Some of these policies are more critical than others. Allowance for Loan Losses: The allowance for loan losses ("ALL") is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and the estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Foreclosed Assets: Foreclosed assets acquired through or instead of loan foreclosure are initially recorded at fair value when acquired, less estimated costs to sell, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Costs after acquisition are expensed. Income tax accounting: The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management's current assessment, the impact of which could be significant to the consolidated results of the Company's operations and reported earnings. The Company believes that the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. The reserve does not include any specific reserves relative to any position recently taken by state taxing authorities. Income tax expense may be affected by developments in the state of Wisconsin. Like many financial institutions that are located in Wisconsin, a subsidiary of the Bank located in the state of Nevada holds and manages various investment securities. Due to that fact that these subsidiaries are out of state, income from their operations has not been subject to Wisconsin state taxation. Although the Wisconsin Department of Revenue issued favorable tax rulings regarding Nevada subsidiaries of Wisconsin financial institutions, the Department representatives have stated that the Department intends to revoke those rulings and tax some or all these subsidiaries' income, even though there has been no intervening change in the law. The Department also implemented a program in 2003 for the audit of Wisconsin financial institutions who have 13 formed and contributed assets to subsidiaries located in Nevada; to date, the Company and its subsidiaries have not been audited on these matters. The Department did make contact with the Company's outside counsel in June 2006 with the intention of gathering various financial data from the Company. To this point, the Department has not provided counsel with any formal request. The Company will respond to the Department's request once a formal request is provided. The Department sent letters in July 2004 to financial institutions in Wisconsin, whether or not they are undergoing an audit, reporting on settlements involving 17 banks and their out-of-state investment subsidiaries. The letter provided a summary of currently available settlement parameters. For periods before 2004, they include: restrictions on the types of subsidiary income excluded from Wisconsin taxation; assessment of certain back taxes for a limited period of time; and interest (but not penalties) on any past-due taxes. For 2004 and going forward, there are similar provisions plus limits on the amount of subsidiaries' assets as to which their income will be excluded from Wisconsin tax. Settlement on the terms outlined would result in the Department's rescission of related prior letter rulings, and would purport to be binding going forward except for future legislation or change by mutual agreement. By implication, the Department appears to accept the general proposition that some out-of-state investment subsidiary income is not subject to Wisconsin taxes. The Company continues to believe that it has reported income and paid Wisconsin taxes correctly in accordance with applicable tax laws and the Department's prior longstanding interpretations thereof, including interpretations issued specifically to it. However, in view of the Department's subsequent change in position (even if that change does not have a basis in law), the aggressive stance now being taken by the Department, the settlements by some other banks, and the potential effect that decisions by other similarly situated institutions may have on the Company's alternatives going forward, the Company has determined that it would consider a settlement proposal from the Department; however, the Company has not yet received a specific proposal nor has any assessment been made against the Company or its subsidiaries. The Company will need to review any settlement proposal in more specific detail to quantify in any definitive way the Department's view of its exposure and to evaluate alternatives. Although there will likely be challenges to the Department's actions and interpretations, the Bank's net income would be reduced if the Department succeeds in its actions and interpretations. The Bank could also incur costs in the future to address any action taken against it by the Department. RESULTS OF OPERATIONS The following table sets forth the Company's net income and related summary information for the three and six-months periods ended June 30, 2006 and 2005, as well as comparisons between the respective periods. TABLE 1 SUMMARY RESULTS OF OPERATIONS ($ in thousands, except per share data)
Three months Three months Six months Six months ended June, ended June 30, ended June 30, ended June 30, 2006 2005 2006 2005 ------------ -------------- -------------- -------------- Net income, as reported $ 2,370 $ 2,560 $ 3,694 $ 5,144 EPS-basic, as reported $ 0.30 $ 0.33 $ 0.47 $ 0.67
14 EPS-diluted, as reported $ 0.30 $ 0.33 $ 0.47 $ 0.66 Cash dividends declared $ 0.16 $ 0.15 $ 0.32 $ 0.30 Return on average assets, as reported 0.86% 0.94% 0.67% 0.96% Return on average equity, as reported 12.12% 13.27% 9.47% 13.38% Efficiency ratio, as reported (1) 67.21% 63.05% 72.46% 63.04%
(1) Non-interest expense divided by sum of taxable equivalent net interest income plus non-interest income, excluding investment securities gains, net The decrease in net income for the three-month period is primarily due to decreased net interest income and an increase in non-interest expense. These were partially offset by an increase in other income, a decrease in the provision for loan losses and a decrease in income tax expense. The decrease in net income for the six-month period is primarily for the same reasons except that the provision for loan losses increased for the six-month period. Net Interest Income Net interest income is the largest component of the Company's operating income (net interest income on a tax-equivalent basis plus other non-interest income), accounting for 78.3% of total operating income for the three months ended June 30, 2006, as compared to 82.0% for the same period in 2005. Net interest income represents the difference between interest earned on loans, investments and other interest earning assets offset by the interest expense attributable to the deposits and the borrowings that fund such assets. Interest fluctuations together with changes in the volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of earned interest income. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable. Net interest income on a tax equivalent basis for the three months ended June 30, 2006 decreased $255,000, or 2.8%, to $9.0 million from $9.2 million over the comparable period a year ago. The decrease results from a decrease in our net interest margin which resulted partially from an increase in interest foregone on non-accrual loans (due to an increase in the level of non-performing loans, which did not accrue interest), offset partially by an increase in average loans for the period. See "Balance Sheet-'"Non-Performing Loans, Potential Problem Loans and Other Real Estate" below. The decrease in net interest income for the period results from a decrease in net interest margin offset partially by increased loan levels. During the six months ended June 30, 2006, net interest income on a tax equivalent basis decreased $1.0 million, or 5.7%, to $17.1 million from $18.1 million for the comparable period in 2005. The decrease resulted for the same reasons as listed above, including the impact of approximately $592,000 in non-accrual interest foregone for the period. In addition, amortization expense of issuance costs related to the redemption of trust preferred securities (totaling $475,015 in the first quarter) affected results for the six months ended June 30, 2006. See "Balance Sheet Analysis-Long Term Debt" below. Net interest margin is tax-equivalent net interest income expressed as a percentage of average earning assets. The net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds to fund a portion of earning assets. As a result, the level of 15 funds available without interest cost (demand deposits and equity capital) is an important component increasing net interest margin. The net interest margin for the second quarter of 2006 was 3.53%, down 14 basis points ("bps") from 3.67% for the comparable period in 2005. This comparable period decrease was attributable to a 22 bps decrease in interest rate spread (the net result of a 82 bps increase in the yield on earning assets more than offset by a 104 bps increase in the cost of interest-bearing liabilities). During the six months ended June 30, 2006, the net interest margin was 3.38% compared to 3.67% for the comparable period in 2005. Net interest margin decreased as a result of an increase in earning assets relative to interest-bearing liabilities and a 38 bps decrease in interest rate spread (the net result of a 86 bps increase in the yield on earning assets more than offset by a 124 bps increase in the cost of interest-bearing liabilities). As the Federal Reserve Board ("FRB") has steadily increased short-term interest rates during the latter half of 2004 thru the second quarter of 2006 in an attempt to keep inflation in control, average interest rates were higher in 2006 than in 2005. Comparatively, the Federal Funds rate at June 30, 2006 was at 5.25% compared to 3.25% at June 30, 2005, while the average Federal Funds rate for the first six months of 2006 was 197 bps higher than for the same period in 2005. Financial institutions' competition for deposits has driven up the cost of funds and as a result, net interest margin decreased in the first six months of 2006. Net interest margin was affected by the impact of short-term rate changes and its affect on wholesale funding costs for the first six months of 2006. For the three months ended June 30, 2006, average-earning assets increased $12.2 million, or 1.2%, when compared to the same period last year. The Company recorded an increase in average loans of $33.2 million, or 4.2%, for the second quarter of 2006 compared to the same period a year ago. For the six months ended June 30, 2006, average-earning assets increased $24.2 million, or 2.5%, when compared to the same period last year. The Company recorded an increase in average loans of $46.6 million, or 6.0%, for the first six months of 2006 compared to the same period a year ago. Loans have typically resulted in higher rates of interest income to the Company than have investment securities, which further positively affected income in the period. Interest rate spread is the difference between the tax-equivalent rate earned on average earning assets and the rate paid on average interest-bearing liabilities. The interest rate spread decreased for the quarter ended June 30, 2006 when compared to the same period a year ago. The interest rate spread decreased 21 bps to 3.15% at June 30, 2006 from 3.36% in the same quarter in 2005. While the average yield on earning assets increased 82 bps during the period, the average rate paid on interest-bearing liabilities increased 104 bps over the same period. For the six months ended June 30, 2006, the interest rate spread decreased 38 bps to 3.00% from 3.38% when compared to the same period a year earlier. The average yield on earning assets increased 86 bps to 6.85% from 5.99% during the six-month period, while the average rate paid on interest-bearing liabilities increased 124 bps. The increase in the rates paid on interest-bearing liabilities occurred as a result of a higher cost of funding from deposits and other wholesale funding such as federal funds purchased and loans from the Federal Home Loan Bank. We would expect that trend to continue in light of the recent Federal Reserve Board interest rate increases. 16 TABLE 2 NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS ($ in thousands) Three months ended June 30,
2006 2005 ----------------------------------- ------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance expense Rate Balance expense rate ----------- -------- ------- ----------- -------- ------- ASSETS Earning assets: Loans, net $ 823,936 $ 15,501 7.53% $ 790,764 $ 13,024 6.59% Taxable securities 145,043 1,570 4.33% 167,638 1,730 4.13% Tax exempt securities 35,104 574 6.54% 43,477 739 6.80% Federal funds sold and interest bearing due from banks 12,569 156 4.96% 2,541 16 2.52% ----------- -------- ------ ----------- -------- ------ Total earning assets 1,016,652 17,801 7.00% 1,004,420 15,509 6.18% ----------- -------- ------ ----------- -------- ------ Non-interest earning assets 84,408 81,328 ----------- ----------- Total assets $ 1,101,060 $ 1,085,748 ----------- ----------- LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: Total interest-bearing deposits 775,806 7,090 3.66% 723,435 4,494 2.48% Short-term borrowings 6,394 78 4.88% 37,798 310 3.28% Customer repurchase agreements 1,086 11 4.05% 1,170 8 2.74% Federal Home Loan Bank advances 118,534 1,399 4.72% 115,262 1,014 3.52% Subordinated debentures 16,100 257 6.39% 16,100 462 11.48% ----------- -------- ------ ----------- -------- ------ Total interest-bearing liabilities $ 917,920 8,835 3.85% $ 893,765 $ 6,288 2.81% ----------- -------- ------ ----------- -------- ------ Demand deposits 92,205 105,922 Accrued expenses and other liabilities 12,696 8,891 Stockholders' equity 78,239 77,170 ----------- ----------- Total liabilities and stockholders' equity $ 1,101,060 $ 1,085,748 ----------- ----------- Interest rate spread $ 8,966 3.15% $ 9,221 3.36% Net interest margin 3.53% 3.67% ------ ------
17 TABLE 3 NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS ($ in thousands) Six months ended June 30,
2006 2005 -------------------------------- ------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance Expense Rate Balance expense Rate ----------- -------- ------- ----------- -------- ------- ASSETS Earning assets: Loans, net $ 824,989 $ 30,249 7.33% $ 778,416 $ 24,780 6.37% Taxable securities 145,745 3,141 4.31% 168,524 3,458 4.10% Tax exempt securities 33,955 1,117 6.58% 39,360 1,351 6.86% Federal funds sold and interest bearing due from banks 8,760 207 4.73% 2,911 33 2.27% ----------- -------- ------ ----------- -------- ------ Total earning assets 1,013,449 34,714 6.85% 989,211 29,622 5.99% ----------- -------- ------ ----------- -------- ------ Non-interest earning assets 83,374 78,963 ----------- ----------- Total assets $ 1,096,823 $ 1,068,174 ----------- ----------- LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: Total interest-bearing deposits 765,228 13,432 3.51% 722,533 8,321 2.30% Short-term borrowings 9,720 241 4.96% 30,527 475 3.11% Customer repurchase agreements 1,214 23 3.79% 1,354 16 2.36%
18 Federal Home Loan Bank advances 121,537 2,761 4.54% 108,643 1,751 3.22% Subordinated debentures 16,456 1,146 13.93% 16,100 923 11.47% ----------- -------- ------ ----------- -------- ------ Total interest-bearing liabilities $ 914,155 $ 17,603 3.85% $ 879,157 $ 11,486 2.61% ----------- -------- ------ ----------- -------- ------ Demand deposits 92,730 103,979 Accrued expenses and other liabilities 11,922 8,132 Stockholders' equity 78,016 76,906 ----------- ----------- Total liabilities and stockholders' equity $ 1,096,823 $ 1,068,174 Interest rate spread $ 17,111 3.00% $ 18,136 3.38% Net interest margin 3.38% 3.67% ------ ------
The ratio of average earning assets to average total assets measures management's ability to employ overall assets for the production of interest income. This ratio was 92.4% and 92.6%, respectively, for the first six months of 2006 and 2005, respectively. Provision for Loan Losses The provision for loan losses ("PFLL") is the cost of providing an allowance for probable incurred losses. As previously discussed, the allowance consists of specific and general components. The Company's internal risk system is used to identify loans that meet the criteria as being "impaired" under the definition of SFAS 114. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. These identified loans for potential impairment are assigned a loss allocation based upon that analysis. The general component covers non-classified and is based on historical loss experience adjusted for current factors. These current factors include loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's evaluation of loan quality, general economic factors and collateral values. As a result of this process, the PFLL for the first six months of 2006 was $261,000 as compared to a PFLL of $121,000 for the first six months in 2005. The calculation of the amount took into account overall asset quality in the loan portfolio during the period, including the substantial increase in non-performing assets. Net loan charge-offs in the first six months of 2006 were $387,000 compared with net charge-offs of $1.0 million for the same period in 2005. Net charge-offs as a percentage of average loans is a key measure of asset quality. Net charge-offs to average loans were 0.09% for the first six months of 2006 compared to 0.26% for the same period in 2005. For the six months ended June 30, 2006, non-performing loans increased $21.7 million; see below for further information. 19 TABLE 4 ALLOWANCE FOR LOAN LOSSES ($ in thousands)
For the six For the six months ended months ended June 30, 2006 June 30, 2005 ------------- ------------- Allowance for Loan Losses ("ALL) Balance at beginning of period $ 9,551 $ 10,445 Provision for loan losses 261 121 Charge-offs 782 1,235 Recoveries 395 233 Balance at end of period $ 9,425 $ 9,564 Net charge-offs ("NCOs:) $ 387 $ 1,002
As described more fully in Table 8 below, non-accrual loans increased significantly during the period from December 31, 2005. However, despite the increase in non-accrual loans during the six months ended June 30, 2006, the required allocation of the allowance for these loans only increased $102,000, as these loans had previously been assessed for impairment under the requirements of SFAS 114. The amount of non-performing loans increased substantially during the six-month period ended June 2006. The provision did not increase as significantly because of management's belief and expectations that collateral values on these loans and other factors will likely ultimately minimize any related loss (although there can be no assurances). See "Balance Sheet Analysis - Non-Performing Loans, Potential Problem Loans and Other Real Estate" below. In addition, the reduction in net charge-offs for the six months ended June 30, 2006 were factors in the determination of a provision of $261,000 for the first six months of 2006. Management believes that the current provision conforms to the Company's loan loss reserve policy and is adequate in view of the present condition of the Company's loan portfolio. However, a decline in the quality of our loan portfolio, as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the allowance. Also, negative developments relating to our non-performing loans, including diminution of value of the collateral or increased costs of collection, could affect the adequacy of the allowance. If there are significant charge-offs against the allowance, or we otherwise determine that the allowance is inadequate, we will need to make higher provisions in the future which would negatively affect our earnings taken. See "Risk Management and the Allowance for Loan Losses" and "Non-Performing Loans, Potential Problem Loans and Other Real Estate" below for more information related to non-performing loans. NON-INTEREST INCOME Total non-interest income increased $455,000, or 22.5% to $2.5 million for the second quarter of 2006 when compared to the second quarter of 2005. For the six months ended June 30, 2006, total non-interest income was $4.7 million, an increase of $430,000, or 10.0%, when compared to the same period in 2005. The non-interest income to average assets ratio was 0.90% for the three months ended June 30, 2006 compared to 0.75% for the same period in 2005. For the six months ended June 30, 2006, the non-interest income to average assets ratio was 0.86% compared to 20 0.80% for the same period in 2005. The increase in non-interest income for the three-month and six-month periods is due primarily to increases in net gains from sales and disposals of premises and equipment of $185,000 in 2006 compared to net losses of $151,000 for the same period in 2005. Table 5 reflects the various components of non-interest income for the comparable quarters. TABLE 5 NON-INTEREST INCOME ($ in thousands)
Second Second quarter quarter Percent YTD YTD Percent 2006 2005 change 2006 2005 change ------- ------- -------- ------ ------ -------- Fees from fiduciary services $ 240 $ 184 30.4% $ 541 $ 363 49.0% Fees from loan servicing 275 288 (4.5%) 535 571 (6.1%) Service charges on deposit accounts 851 845 0.7% 1,645 1,570 4.8% Other fee income 165 163 1.2% 330 350 (5.7%) Financial services income 230 177 29.9% 410 363 12.9% Gains from sales of loans 209 177 18.1% 410 385 6.5% Net gains (loss) from sale and disposal of premises and equipment 185 (151) NM 185 (151) NM Increase in cash surrender value of life insurance 175 190 (7.9%) 401 417 (3.8%) Death benefits realized 23 - NM 23 - NM Gain on sale of bank assets - 21 NM - 200 NM Other income 128 132 (3.0%) 239 221 8.1% ------- ------- ------ ------ ------ ------ Total Other Income $ 2,481 $ 2,026 22.5% $4,719 $4,289 10.0%
Service charges on deposit accounts increased $75,000 for the six-month period ended June 30, 2006 due in part to the implementation of new product offerings such as High Performance Checking ("HPC") and other price increases implemented during the latter part of 2005. In the first six months of 2006, gains from sales of loans totaling $410,000 were similar to the $385,000 recorded in the first six months of 2005. During the first six months of 2006, secondary mortgage loan activity increased although gains from sale of these loans did not increase in the 21 same proportion as a result of a change in the mix of commercial/mortgage loans sold, tighter spreads and competitive pressures with respect to pricing. Although interest rates have increased over the six-month period, the Company has not seen a decrease in the number of loan applications. Secondary loan production increased $12.7 million between the comparable six-month periods ($21.3 million in the first six months of 2006 versus $8.6 million in the first six months of 2005). The increase in loan production was driven primarily by secondary mortgage and commercial loan production (loan production to be sold to the secondary market) and resulting sales. For the three-month and six-month periods ended June 30, 2006, net gains (loss) from the sale of bank premises and equipment were related to non-recurring gains of $188,000 on the sale of bank land located in the Green Bay market area. The net loss on disposal of bank premises of $151,000 for the same time period in 2005 related to the sale of two buildings and land formerly used as branch offices. For the three-month and six-month periods ended June 30, 2006 compared to the same period in 2005, the decrease in gain on sale of bank assets was related to a gain on sale of stock of $200,000 ($21,000 recognized in the second quarter of 2005) in connection with a third party acquisition of Pulse (an ATM operator/provider) in which the Bank held an ownership interest. Non-Interest Expense Non-interest expense increased $602,000 or 8.5%, to $7.7 million for the three months ended June 30, 2006 compared to the same period in 2005. For the six months ended June 30, 2006, total non-interest expense increased $1.7 million or 11.9%, to $15.8 million compared to the same period in 2005. The non-interest expense to average assets ratio was 2.79% for the three months ended June 30, 2006 compared to 2.61% for the same period in 2005. For the six months ended June 30, 2006, the non-interest expense ratio to average assets was 2.88% compared to 2.65% for the same period in 2005. Net overhead expense is total non-interest expense less total non-interest income excluding securities gains. The net overhead expenses to average assets ratio was 1.89% for the three months ended June 30, 2006 compared to 1.87% for the same period in 2005. For the six months ended June 30, 2006, the net overhead expenses to average assets ratio was 2.02% compared to 1.84% for the same period in 2005. The efficiency ratio is total non-interest expense as a percentage of the sum of net-interest income on a fully taxable equivalent basis and total non-interest income. The efficiency ratio for the three months ended June 30, 2006 was 67.21% compared to 63.05% for the same period in 2005. For the six months ended June 30, 2006, the efficiency ratio was 72.46% compared to 63.04% for the same period in 2005. TABLE 6 NON-INTEREST EXPENSE ($ in thousands)
Second Second quarter quarter Percent YTD YTD Percent 2006 2005 change 2006 2005 change -------- -------- -------- -------- -------- -------- Salaries and employee benefits $ 4,525 $ 4,329 4.5% $ 9,517 $ 8,857 7.5% Occupancy 585 602 (2.8%) 1,164 1,138 2.3% Equipment 445 340 30.9% 840 647 29.8%
22 Data processing and courier 315 298 5.7% 615 576 6.8% Operation of other real estate owned 74 81 (8.6%) 117 129 (9.3%) Business development and advertising 243 284 (14.4%) 477 488 (2.3%) Charitable contributions 30 55 (45.5%) 106 147 (27.9%) Stationary and supplies 158 155 1.9% 262 267 (1.9%) Director fees 152 110 38.2% 271 192 41.1% FDIC 26 29 (10.3%) 53 56 (5.4%) Mortgage servicing rights amortization 41 54 (24.1%) 96 116 (17.2%) Legal and professional 45 128 (64.8%) 250 304 (17.8%) Loan and collection 263 101 160.4% 307 154 99.4% Other operating 791 525 50.7% 1,742 1,065 63.6% -------- -------- ------- -------- -------- ------- Total non-interest expense $ 7,693 $ 7,091 8.5% $ 15,817 $ 14,136 11.9%
Salaries and employee benefits showed an increase of $196,000, or 4.5%, to $4.5 million for the second quarter of 2006 compared to the same period in 2005. The number of full-time equivalent employees was 326 as of June 30, 2006 compared to 308 at June 30, 2005, primarily the result of additional staffing for the remodeled downtown Green Bay branch opened in June 2005. For the three months ended June 30, 2006, salary-related expenses increased $386,000, or 13.3%, due principally to merit increases between the years and related staff increases. For the six months ended June 30, 2006, salary-related expenses increased $755,000, or 13.2% compared to the same period in 2005 for the reasons listed previously. In the first quarter of 2005, the Company implemented the Baylake Bank Supplemental Executive Retirement Plan ("Plan"), which is intended to provide certain management and highly compensated employees of the Bank who have contributed, and are expected to continue to contribute, to the Bank's success by providing for deferred compensation in addition to that available under the Bank's other retirement programs. It amounted to approximately $45,000 in expenses related to the Plan in the second quarter of 2006 compared to $94,000 in the second quarter of 2005 and $380,000 for the six months ended June 30, 2006 compared to $398,000 for the same period a year earlier. The fluctuation in Plan expenses are driven from the timing of determining the discretionary contribution in addition to the change in market prices on a periodic basis. Benefit costs, principally for health insurance and pension costs, represent the remaining increase in personnel-related costs. The increase in health insurance costs is expected to continue for the balance of 2006. Bonus expense decreased $92,000 to $166,000 for the second quarter of 2006 ($167,000 decrease to $317,000 for the first six months of 2006), as various income-related goals were not met during the period. Management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to continue in future years. Occupancy and equipment expense, collectively, increased $88,000, or 9.3%, to $1.0 million for the second quarter of 2006 compared to the same period in 2005. For the six months ended June 30, 2006, occupancy and equipment expense, collectively, increased $219,000, or 12.3%, to $2.0 23 million compared to the same period in 2005. The increase for both the three-month and six-month periods for 2006 were attributable to additional depreciation resulting from the downtown Green Bay branch as mentioned previously, costs related to various equipment upgrades and increased utility costs. Expenses related to the operation of other real estate owned decreased $7,000 to $74,000 for the 2006 three-month period ended June 30 compared to the same period in 2005. For the six -- month period ended June 30, 2006, other real estate owned expenses decreased $12,000 to $117,000 compared to the same period in 2005. Included in these results for the six - month period ended June 30, 2006 were net gains taken on the sale of other real estate owned amounting to $53,000 compared to net losses of $29,000 for the same period in 2005. In addition, costs related to the holding of other real estate owned properties increased $70,000 to $170,000 for the six months ended June 30, 2006. Loan and collection expense increased $162,000 to $263,000 for the three months ended June 30, 2006 compared to the same period in 2005. For the six months ended June 30, 2006, loan and collection expense increased $153,000 to $307,000 compared to the same period in 2005. $220,000 of the expense totaling $307,000 for the six months ended June 30, 2006 relates to legal and operating costs on two commercial loan credits, one of which is a non-performing loan and the other related to an impaired letter of credit for a commercial credit previously mentioned in filings from the third quarter of 2005. Both properties are listed for sale through an independent third party. Costs on these properties are expected to continue through the balance of 2006. Other operating expense increased $266,000 for the three months ended June 30, 2006 and $677,000 to $1.7 million for the six-month period ended June 30, 2006 compared to the same periods in 2005. The increase was due in part to costs of $216,000 related to various employee recruitment and search expenses, including those costs related to the searches for a new bank president/chief operating officer and a market president. $184,000 of the increase was related to new product offering costs, including those for the HPC product introduced in the fourth quarter of 2005. Income Taxes Income tax expense for the Company for the three months ended June 30, 2006 was $1.0 million, a decrease of $130,000, or 11.1%, compared to the same period in 2005. For the six months ended June 30, 2006, income tax expense resulted in a decrease of $880,000 to $1.5 million compared to an income tax expense of $2.4 million for the same period in 2005. The lower tax expense for the three-month and six-month periods ended June 30 reflected the Company's decrease in income before income tax resulting in an increased proportion of non-taxable income to total income before income taxes. The Company's effective tax rate (income tax expense divided by income before taxes) was 29.0% for the six months ended June 30, 2006 compared with 31.7% for the same period in 2005. The effective tax rate of 29.0% consisted of a federal effective tax rate of 23.7% and Wisconsin state effective tax rate of 5.3%. For the three and six-month periods ended June 30, 2006, taxable income decreased while tax-exempt interest income from municipal investments and income from BOLI increased proportionately, which caused the change in the effective tax rate. Income tax expense recorded in the consolidated statements of income involves interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Company undergoes examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax 24 expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. See "Critical Accounting Policies-Income Tax Accounting" above regarding Wisconsin tax matters which may affect our income tax expense in future periods. BALANCE SHEET ANALYSIS Loans At June 30, 2006, total loans (including loans held for sale) increased $9.4 million, or 1.2%, to $821.7 million from $812.3 million at December 31, 2005. Growth in the Company's loan portfolio resulted primarily from an increase in real estate construction loans to $97.9 million at June 30, 2006 compared to $85.7 million at December 31, 2005. A decrease of $5.2 million or 1.1% occurred in the commercial real estate loan totals from December 31, 2005 to June 30, 2006 as a result of competitive pricing pressures and principal paydowns on several large commercial credits during the period. Growth in commercial real estate mortgages and commercial loans will continue to be the focus for the Company although the higher interest rate environment along with competitive pricing pressures will continue for the balance of 2006. The following table reflects the composition (mix) of the loan portfolio: TABLE 7 LOAN PORTFOLIO ANALYSIS ($ in thousands)
June 30, December Percent 2006 31, 2005 change -------- -------- ------- Amount of loans by type Real estate-mortgage Commercial $462,726 $467,956 (1.1%) 1-4 family residential First liens 92,173 90,946 1.3% Junior liens 25,088 23,470 6.9% Home equity 32,074 34,320 (6.5%) Commercial, financial and agricultural 82,854 80,260 3.2% Real estate-construction 97,872 85,729 14.2% Installment Credit cards and related plans 2,079 2,088 (0.4%) Other 13,372 12,175 9.8% Obligations of states and political subdivisions 13,918 15,785 (11.8%) Less: deferred origination fees, net of costs 452 433 4.4% Total $821,704 $812,296 1.2%
Risk Management and the Allowance for Loan Losses The loan portfolio is the Company's primary asset subject to credit risk. To reflect this credit risk, the Company sets aside an allowance for probable incurred credit losses through periodic charges to earnings. These charges are shown in the Company's consolidated income statement as provision for loan losses. See "Provision for Loan Losses" above. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and 25 an on-going review of payment performance. Asset quality administration, including early identification of problem loans and timely resolution of problems, further enhances management of credit risk and minimization of loan losses. All specifically identifiable and quantifiable losses are charged off against the allowance. Charged-off loans are subject to periodic review, and specific efforts are taken to achieve maximum recovery of principal and interest. As indicated in Table 4 above, the ALL at June 30, 2006 was $9.4 million compared with $9.6 million at the end of 2005. This was based on management's analysis of the loan portfolio risk at June 30, 2006. As such a provision expense of $261,000 was recorded for the six months ended June 30, 2006. The quarter to date provision has increased by $140,000 compared to the same period in 2005, as discussed previously. The provision for loan losses is predominately a function of management's evaluation of the loan portfolio, with particular emphasis directed toward non-performing and other potential problem loans. During these evaluations, consideration is also given to such factors as management's evaluation of specific loans, the level and composition of impaired loans, other non-performing loans, historical loan experience, results of examinations by regulatory agencies and various other factors. On a quarterly basis, management reviews the adequacy of the ALL. Commercial credits are graded by the loan officers and the loan review function validates the officers' grades. In the event that the loan review function downgrades the loan, it is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (i.e., collateral value is nominal, etc.). To establish the appropriate level of the allowance, a sample of loans (including impaired and non-performing loans) are reviewed and classified as to potential loss exposure. Based on an estimation computed pursuant to the requirements of Financial Accounting Standards Board ("FASB") Statement No. 5, "Accounting for Contingencies," and FASB Statements No. 114 and 118, "Accounting by Creditors for Impairment of a Loan," the analysis of the ALL consists of two components: (i) specific credit allocation established for expected losses resulting from analysis developed through specific credit allocations on individual loans for which the recorded investment in the loan exceeds its fair value; (ii) general portfolio allocation based on historical loan loss experience for each loan category and adjusted for economic conditions as well as specific and other factors in the markets in which the Company operates. The specific credit allocation of the ALL is based on a regular analysis of loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the market price of the loan, or, if the loan is collateral dependent, the fair value of the underlying collateral less cost of sale. The general portfolio allocation component of the ALL is determined statistically using a loss migration analysis that examines historical loan loss experience. The loss migration analysis is performed quarterly and loss factors are updated regularly based on actual experience. The general portfolio allocation element of the ALL also includes consideration of the amounts necessary for concentrations and changes in portfolio mix and volume. The ALL is based on estimates, and ultimate losses will vary from current estimates. These estimates are reviewed monthly, and as adjustments, either positive or negative, become 26 necessary, a corresponding increase or decrease is made in the provision for loan losses. The composition of the loan portfolio has not significantly changed since year-end 2005. Management remains watchful of credit quality issues and believes that issues within the portfolio are reflective of the challenging economic environment experienced over the past few years. Should the economic climate deteriorate from current levels, borrowers may experience difficulty, and the level of non-performing loans, charge-offs and delinquencies could rise and require further increases in the provision. Consideration for making such allocations is consistent with the factors discussed above, and all of the factors are subject to change; thus, the allocation is not necessarily indicative of the loan categories in which future loan losses will occur. It would also be expected that the amount allocated for any particular type of loan will increase or decrease proportionately to both the changes in the loan balances and to increases or decreases in the estimated loss in loans of that type. In other words, changes in the risk profile of the various parts of the loan portfolio should be reflected in the allowance allocated. While there exists probable asset quality problems in the loan portfolio, in view of collateral values, management believes sufficient reserves have been provided in the ALL to absorb probable incurred losses in the loan portfolio at June 30, 2006. Ongoing efforts are being made to collect these loans, and the Company involves the legal process when necessary to minimize the risk of further deterioration of these loans for full collection. While management uses available information to recognize losses on loans, future adjustments to the ALL may be necessary based on changes in economic conditions and the impact of such change on the Company's borrowers. As an integral part of their examination process, various regulatory agencies also review the Company's ALL. Such agencies may require that changes in the ALL be recognized when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. Non-Performing Loans, Potential Problem Loans and Other Real Estate Management encourages early identification of non-accrual and problem loans in order to minimize the risk of loss. This is accomplished by monitoring and reviewing credit policies and procedures on a regular basis. Non-performing loans are a leading indicator of future loan loss potential. Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days or more past due but still accruing, and restructured loans. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collection of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income. 27 TABLE 8 NON-PERFORMING ASSETS ($ in thousands)
At or for the At or for the At or for the period ended June period ended June period ended 30, 2006 30, 2005 December 31, 2005 ----------------- ----------------- ----------------- Nonperforming Assets: Nonaccrual loans $ 28,677 $ 7,907 $ 6,942 Accruing loans past due 90 days or more 0 0 0 ---------- ---------- ---------- Total nonperforming loans ("NPLs") $ 28,677 $ 7,907 $ 6,942 Other real estate owned 1,374 2,096 3,333 ---------- ---------- ---------- Total nonperforming assets ("NPAs") $ 30,051 $ 10,003 $ 10,275 Ratios: ALL to NCO's (annualized) 12.18 4.77 2.32 NCO's to average loans (annualized) 0.09% 0.26% 0.52% ALL to total loans 1.15% 1.20% 1.18% NPL's to total loans 3.49% 0.99% 0.85% NPA's to total assets 2.72% 0.91% 0.94% ALL to NPL's 32.87% 120.96% 137.58%
As indicated in Table 8, non-performing loans at June 30, 2006 were $28.7 million compared to $6.9 million at December 31, 2005. Real estate non-accrual loans accounted for $28.1 million of the total, of which $2.6 million was residential real estate, $5.3 million was real estate construction and $20.2 million was commercial real estate. Commercial and industrial non-accrual loans totaled $479,000. Non-accrual loans increased during the six months ended June 30, 2006 by $21.7 million. The increase is primarily attributable to six commercial loans totaling $21.3 million for businesses that are experiencing difficulties in sales, cash flow, fiscal operations, and/or general management issues. Of these, two loans totaling $2.7 million are commercial real estate development loans, two loans totaling $11.4 million are recreational real estate golf properties; one loan totaling $2.9 million is a hotel facility and one loan totaling $4.3 million is a retail shopping mall. Each of these six non-performing loans is secured primarily by commercial or residential real estate, and secondarily, by personal guarantees from principals of the respective borrowers. The Company has initiated or is in the process of initiating foreclosure actions on three of these loans involving $8.3 million and it anticipates protracted litigation of at least twelve months in duration in each case. Management has allocated $911,000 in the ALL on the basis of a SFAS 114 analysis for any loss estimated with respect to these loans. One loan, totaling $8.1 million has been partially foreclosed for an amount of $4.0 million and an additional foreclosure is being initiated on the remaining $4.1 million. Two loans totaling $4.9 million are subject to voluntary liquidation plans that propose to sell underlying real estate assets in amounts sufficient to repay the outstanding loan balances. Current impairments have been established for each of these credits and the Company does not anticipate any further loss at this time, in part due to expected collateral values. 28 As a result the ratio of non-performing loans to total loans at June 30, 2006 was 3.49% compared to 0.85% at end of year 2005. The Company's ALL was 32.9% of total non-performing loans at June 30, 2006 compared to 137.6% at end of year 2005. Non-performing assets (non-performing loans plus other real estate owned assets) at June 30, 2006 were $30.1 million compared to $10.3 million at December 31, 2005. Other real estate owned, which represents property that the Company acquired through foreclosure or in satisfaction of debt, consisted of ten commercial properties totaling $1.4 million. Other real estate owned at December 31, 2005 totaled $3.3 million and consisted of seventeen properties. Investment Portfolio The investment portfolio is intended to provide the Company with adequate liquidity, flexibility in asset/liability management and, lastly, an increase in its earning potential. At June 30, 2006, the investment portfolio (which includes investment securities available for sale) increased $12.3 million, or 7.2%, to $184.0 million from $171.6 million at December 31, 2005. At June 30, 2006, the investment portfolio represented 16.7% of total assets compared with 15.8% at December 31, 2005. Securities available for sale consist of the following: TABLE 9 INVESTMENT SECURITY ANALYSIS At June 30, 2006 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. agencies 24 2,144 60,170 Mortgage-backed securities 0 2,813 80,059 Obligations of states & political subdivisions 239 659 39,552 Private placement 18 0 1,015 Other securities 0 0 3,159 -------- -------- -------- Total securities available for sale $ 281 $ 5,616 $183,955
At December 31, 2005 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. Agencies $ 179 $ 1,153 $ 59,819 Mortgage-backed securities 2 2,015 72,531 Obligations of states & political subdivisions 407 269 33,827 Private placement 44 0 1,040 Other securities 0 0 4,421 -------- -------- -------- Total investment securities $ 632 $ 3,437 $171,638
29 The increases in unrealized losses are related principally to changes in interest rates. As the Company has the ability to hold these securities for the foreseeable future, no declines were deemed to be other than temporary. Deposits Total deposits at June 30, 2006 increased $14.3 million, or 1.7%, to $871.0 million from $856.7 million at December 31, 2005. Non-interest bearing deposits at June 30, 2006 decreased $8.3 million, or 7.5%, to $102.4 million from $110.6 million at December 31, 2005. Interest-bearing deposits at June 30, 2006 increased $22.6 million, or 3.0%, to $768.7 million from $746.1 million at December 31, 2005. Brokered CD's and other brokered deposits totaled $155.7 million at June 30, 2006 compared to $155.1 million at December 31, 2005. Time deposits greater than $100,000 and brokered time deposits were priced within the framework of the Company's rate structure and did not materially increase the average rates on deposit liabilities. If liquidity concerns arose, the Company has alternative sources of funds such as lines with correspondent banks and borrowing arrangements with FHLB should the need present itself. Increased competition for consumer deposits and customer awareness of interest rates continues to limit the Company's core deposit growth in these types of deposits. Typically, overall deposits for the first six months tend to decline slightly as a result of the seasonality of the Company's customer base as customers draw down deposits during the first half of the year in anticipation of the summer tourist season. Emphasis has been, and will continue to be, placed on generating additional core deposits in the remainder of 2006 and 2007 through competitive pricing of deposit products and through the branch delivery systems that have already been established and a new branch in Green Bay that is planned to open in the third quarter of 2006. The Company will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. The Company also may increase brokered time deposits during the remainder of the year 2006 and in 2007 as an additional source of funds to provide for loan growth in the event that core deposit growth goals would not be accomplished. Under that scenario, the Company will continue to look at other wholesale sources of funds, if the brokered CD market became illiquid or more costly in terms of interest rate. 30 Other Funding Sources Federal funds purchased and securities under agreements to repurchase at June 30, 2006 increased $20.9 million to $22.2 million from $1.3 million at December 31, 2005. Federal funds purchased increased from no federal funds purchased at December 31, 2005 to $21.2 million at June 30, 2006, accounting for the majority of the increase. They have increased to fund the growth in the investment and loan portfolios which was coupled with slower growth in core deposits and a reduction in Federal Home Loan Bank Advances during the six-month period ended June 30, 2006. Federal Home Loan Bank Advances totaled $105.2 million at June 30, 2006 compared to $125.2 million at December 31, 2005. Typically, borrowings increase in order to fund growth in the loan portfolio in periods when borrowings increase more rapidly than deposits. The Company will borrow monies if borrowing is a less costly form of funding loans compared to the cost of acquiring deposits or if deposit growth is not sufficient. Additionally, the availability of deposits also determines the amount of funds the Company needs to borrow in order to fund loan demand. The Company anticipates it will continue to use wholesale funding sources of this nature, if these borrowings add incrementally to overall profitability. Long-term Debt In connection with the issuance of Trust Preferred Securities in 2001 (see "Capital Resources"), the Company issued long-term subordinated debentures to Baylake Capital Trust I, a Delaware Business Trust, formed by the Company. The aggregate principal amount of the debentures due 2031, to the trust is $16,597,940. These securities were redeemed on March 31, 2006. The redemption of these securities were funded through the issuance of $16.1 million of trust preferred securities and $498,000 of trust common securities, and underlying debt securities, that will adjust quarterly at a rate equal to 1.35% over the three month LIBOR. The rate on this financing for the second quarter was 6.31% and will be 6.85% for the third quarter of 2006 compared to a fixed rate of 10% for the trust preferred securities issued under Baylake Capital Trust I. This lower interest rate has provided interest savings in the second quarter of 2006 and thereafter depending upon the changes in the interest rate environment. Management believes that this new financing should provide a better match for the overall interest rate sensitivity position of the Company going forward. For additional details, please make reference to the Consolidated Financial Statements and the accompanying footnotes on the Company's Form 10-Q for the period ended June 30, 2006. CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT LIABILITIES The Company utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2005 for discussion with respect to the Company's quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in Form 10-K have not materially changed since that report was filed. 31 The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments: TABLE 10 LENDING RELATED COMMITMENTS ($ in thousands)
June 30, 2006 December 31, 2005 ------------- ----------------- Commitments to fund home equity line loans $ 48,370 $ 45,435 Commitments to fund residential real estate construction loans 2,917 3,409 Commitments unused on various other lines of credit loans 154,899 164,112 --------- ----------- Total commitments to extend credit $ 206,186 $ 212,956 Financial standby letters of credit $ 21,713 $ 22,160
The following table summarizes the Company's significant contractual obligations and commitments at June 30, 2006: TABLE 11 CONTRACTUAL OBLIGATIONS ($ in thousands)
WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL ------------- --------- --------- ------------- --------- Certificates of deposit and other time deposit obligations $ 255,649 $ 140,947 $ 4,437 $ 61 $ 401,094 Federal funds purchased and repurchase agreements 22,194 $ 0 $ 0 $ 0 22,194 Federal Home Loan Bank advances 70,000 10,081 101 25,000 105,182 Construction of branch facility 288 0 0 0 288 Subordinated debentures 0 0 0 16,100 16,100 Operating leases 41 7 0 0 48 ---------- --------- --------- ---------- --------- Total $ 348,172 $ 151,035 $ 4,538 $ 41,161 $ 544,906
32 LIQUIDITY Liquidity management refers to the ability of the Company to ensure that cash is available in a timely manner to meet loan demand and depositors' needs, and to service other liabilities as they become due, without undue cost or risk, and without causing a disruption to normal operating activities. The Company and the Bank have different liquidity considerations. The Company's primary sources of funds are dividends from the Bank, investment income, and net proceeds from borrowings and the offerings of junior subordinated obligations, in addition to the issuance of its common stock securities. The Company manages its liquidity position in order to provide funds necessary to pay dividends to its shareholders. Dividends received from Bank totaled $2.5 million for the first six months of 2006 and will continue to be the Company's main source of long-term liquidity. The dividends from the Bank along with existing cash were sufficient to pay cash dividends to the Company's shareholders of $3.7 million in the first six months of 2006. The Bank meets its cash flow needs by having funding sources available to it to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity at the Bank is derived from deposit growth, maturing loans, the maturity of the investment portfolio, access to other funding sources, marketability of certain of its assets; the ability to use its loan and investment portfolios as collateral for secured borrowings and strong capital positions. Maturing investments have been a primary source of liquidity at the Bank. For the six months ended June 30, 2006, principal payments totaling $10.3 million were received on investments. The Company purchased $25.2 million in investments in the first six months of 2006. This resulted in net cash of $14.9 million used in investing activities for the first six months of 2006. At June 30, 2006 the investment portfolio contained $140.3 million of U.S. Treasury and federal agency backed securities representing 76.2% of the total investment portfolio. These securities tend to be highly marketable. Deposit growth is typically another source of liquidity for the Bank in the latter half of each year, although deposits typically shrink in the first half resulting in a use of cash. The seasonal pattern results from the tourism-oriented businesses in our market area. As a financing activity reflected in the June 30, 2006 Consolidated Statements of Cash Flows, deposits increased and resulted in $14.3 million of cash flow during the first six months of 2006. The Company's overall deposit base increased 1.7% for the six months ended June 30, 2006. Deposit growth is generally the most stable source of liquidity for the Bank, although brokered deposits, which are inherently less stable than locally generated core deposits, are sometimes used. The Company's reliance on these deposits remained constant during the six-month period. Affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause the Bank to develop alternative sources of funds which may not be as liquid and potentially a more costly alternative. The scheduled maturity of loans can provide a source of additional liquidity. The Bank has $245.2 million, or 29.8%, of loans maturing within one year. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing 33 loans. The Bank's liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand as a need for liquidity will cause the Company to acquire other sources of funding which could be harder to find; therefore more costly to acquire. Within the classification of short-term borrowings at June 30, 2006, federal funds purchased and securities sold under agreements to repurchase totaled $22.2 million compared to $1.3 million at the end of 2005. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Borrowings from FHLB, short-term or long-term, are another source of funds. They total $105.2 million at June 30, 2006 and $125.2 million at December 31, 2005. The Bank's liquidity resources were sufficient in the first six months of 2006 to fund the growth in loans and investments, increase the volume of interest earning assets and meet other cash needs when necessary. Management expects that deposit growth will continue to be the primary funding source of the Bank's liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities, and a strong capital position. Although federal funds purchased and borrowings from the FHLB provided funds in the first six months of 2006, management expects deposit growth to be a reliable funding source in the future as a result of branch expansion efforts and marketing efforts to attract and retain core deposits. In addition, the Bank may acquire additional brokered deposits as funding for short-term liquidity needs. Shorter-term liquidity needs will mainly be derived from growth in short-term borrowings, maturing federal funds sold and portfolio investments, loan maturities and access to other funding sources. In assessing liquidity, historical information such as seasonality (loan demand's affect on liquidity which starts before and during the tourist season and deposit draw down which affects liquidity shortly before and during the early part of the tourist season), local economic cycles and the economy in general are considered along with the current ratios, management goals and the unique characteristics of the Company. Management believes that, in the current economic environment, the Company's and the Bank's liquidity position is adequate. To management's knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material increase or decrease in the Bank's or the Company's liquidity. Capital Resources Stockholders' equity at June 30, 2006 and December 31, 2005, respectively, was $78.4 million and $78.5 million, respectively. In total, stockholders' equity decreased $119,000 or 0.2%. The decrease in stockholders' equity in 2006 was primarily composed of the change in accumulated other comprehensive loss (as a result of unrealized losses on available for sale securities) and the payment of dividends, almost completely offset by net income and proceeds from the exercise of stock options. The change in unrealized losses on available for sale securities amounted to $1.6 million (net of tax) for the first six months of 2006; this change resulted from the effects of the increasing interest rate environment. Total dividends paid increased to $3.7 million in the six-month period from $3.5 million in 2005, primarily as a result of an increase in the per share dividends rate to $0.32 from $0.30. Stockholders' equity to assets at June 30, 2006 was 7.10% compared to 7.21% at the end of 2005. 34 On March 31, 2006, the Company redeemed its outstanding junior subordinated indentures and trust preferred securities for a total of $16.6 million which constitutes the $16.1 million stated principal values of those amounts plus $510,389 in accrued interest. See "Management's Discussion of Analysis of Financial Condition and Results of Operations - Balance Sheet Analysis - Long Term Debt" above. The redemption of these securities were funded through the issuance of $16.1 million of trust preferred securities and $498,000 of trust common securities issued under the name Baylake Capital Trust II ("Trust II") that will adjust quarterly at a rate equal to 1.35% over the three month LIBOR. The initial rate on this financing for the second quarter was 6.31% and will be 6.85% for the third quarter. This lower rate will provide savings beginning in the second quarter of 2006 and management believes that the new financing should provide a better match for the overall interest rate sensitivity position of the Company going forward. For banking regulatory purposes, these securities are considered Tier 1 capital. Cash dividends declared in the first six months of 2006 were $0.32 per share compared with $0.30 in 2005. The Company provided a 6.7% increase in normal dividends per share in 2006 over 2005 as a result of earnings for 2006. Total funds utilized in the payment of dividends were $3.7 million in the first six months of 2006, as compared to $3.5 million in the corresponding period of 2005. On June 5, 2006, the Company's Board of Directors authorized management, in its discretion, to repurchase up to 300,000 shares, representing approximately 3.8% of the Company's common stock in a timeframe not to exceed June 30, 2007. Although the Company may not repurchase all 300,000 within the allotted time period, the program will allow the Company to repurchase its shares as opportunities arise at prevailing market prices in open market or privately negotiated transactions. Shares repurchased are held as treasury stock and accordingly, are accounted for as a reduction of stockholders' equity. The Company repurchased none of its common shares in the first six months of 2006. The adequacy of the Company's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. Management is confident that because of current capital levels and projected earnings levels, capital levels are more than adequate to meet the ongoing and future concerns of the Company. The Federal Reserve Board has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory -and possible additional discretionary- actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements. At June 30, 2006 and December 31, 2005, the Company was categorized as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. 35 To be "well capitalized" under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%. The following table presents the Company's and the Bank's capital ratios as of June 30, 2006 and December 31, 2005: TABLE 12 CAPITAL RATIOS ($ in thousands)
Required To Be Well Capitalized Required For under Prompt Capital Adequacy Corrective Action Actual Purposes Provisions ----------------- ------------------ ----------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------ ----- As of June 30, 2006 Total Capital (to Risk Weighted Assets) Company 101,295 10.82% 74,872 8.00% N/A N/A Bank 99,190 10.60% 74,836 8.00% 93,545 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 91,870 9.82% 37,436 4.00% N/A N/A Bank 89,765 9.60% 37,418 4.00% 56,127 6.00% Tier 1 Capital (to Average Assets) Company 91,870 8.39% 43,799 4.00% N/A N/A Bank 89,765 8.20% 43.799 4.00% 54,749 5.00% As of December 31, 2005 Total Capital (to Risk Weighted Assets) Company 99,882 10.73% 74,472 8.00% N/A N/A Bank 97,327 10.51% 74,404 8.00% 93,005 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 90,332 9.70% 37,236 4.00% N/A N/A Bank 87,778 9.44% 37,202 4.00% 55,803 6.00% Tier 1 Capital (to Average Assets) Company 90,332 8.27% 43,692 4.00% N/A N/A Bank 87,778 8.11% 43,590 4.00% 54,488 5.00%
Management believes that a strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share, and to provide depositor and investor confidence. The Company's capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. 36 Management actively reviews capital strategies for the Company to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. The Company's primary market risk exposure is interest rate risk. Interest rate risk is the risk that the Company's earnings and capital will be adversely affected by changes in interest rates. The Company does not use derivatives to mitigate its interest rate risk. The Company's earnings are derived from the operations of its direct and indirect subsidiaries with particular reliance on net interest income, calculated as the difference between interest earned on loans and investments and the interest expense paid on deposits and other interest bearing liabilities, including advances from FHLB and other borrowings. Like other financial institutions, the Company's interest income and interest expense are affected by general economic conditions and by the policies of regulatory authorities, including the monetary policies of the Board of Governors of the Federal Reserve System. Changes in the economic environment may influence, among other matters, the growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing. Fluctuations in interest rates are not predictable or controllable. As of June 30, 2006, the Company was in compliance with its management policies with respect to interest rate risk with the exception that the effect of an immediate 200 basis point decrease in the prime rate over a one-year horizon would impact negatively net interest income by 11.1%. The Company's guidelines have internal limits of not more than a 10% change. The dollar change in net interest income exceeds the Company's internal limits by $440,000 for the period. The Company has noted the issue and the Company feels that other mitigating factors minimize that potential effect given the current rate environment. The Company has not experienced any material changes to its market risk position since December 31, 2005, as described in the Company's 2005 Form 10-K Annual Report. The Company's overall interest rate sensitivity is demonstrated by net interest income analysis. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% to 2.0% increases and decreases in market interest rates. The table below presents the Company's projected changes in net interest income for the various rate shock levels at June 30, 2006. TABLE 13 INTEREST SENSITIVITY ($ in thousands)
Change in Net Interest Income over One Year Horizon - --------------------------------------------------------------------------------- At June 30, 2006 At December 31, 2005 --------------------------- --------------------------- Change in levels of Percentage Percentage interest rates Dollar change change Dollar change change - ------------------- ------------- ---------- ------------- ---------- +200 bp $ 1,644 4.2% $ 2,572 6.8% +100 bp 438 1.1% 1,842 4.9% Base 0 0% 0 0% - -100 bp (2,021) (5.2%) (2,351) (6.2%) - -200 bp (4,310) (11.1%) (4,905) (13.0%)
As shown above, at June 30, 2006, the effect of an immediate 200 basis point increase in interest rates would increase the Company`s net interest income by $1.6 million or 4.2%. The effect of an immediate 200 basis point reduction in rates would decrease the Company's net interest income by $4.3 million or 11.1%. 37 Changes in the mix of earning assets and interest - bearing liabilities decreased the Company's asset sensitivity during the past twelve months. Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. ITEM 4. CONTROLS AND PROCEDURES DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of June 30, 2006. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company's disclosure controls and procedures to the Company required to be included in this quarterly report on Form 10-Q. INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal controls subsequent to the date of such evaluation with the exception of enhancements made during the six-month period ended June 30, 2006 to the calculation of the allowance for loan loss reserve. Such enhancement is explained in Item 2, Management's Discussion and Analysis found in the sections entitled "Provision for Loan Losses" and "Balance Sheet Analysis-Risk Management and the Allowance for Loan Losses" which discussions are incorporated by reference in this item. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Baylake and its subsidiaries may be involved from time to time in various routine legal proceedings incidental to its business. Neither Baylake nor any of its subsidiaries is currently engaged in any legal proceedings that are expected to have a material adverse effect on the results of operations or financial position of Baylake. ITEM 1A. RISK FACTORS 38 See "Risk Factors" in Item 1A of the Company's annual report on Form 10-K for the year ended December 31, 2005. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS a) The Company's Annual Meeting of Shareholders was held on June 5, 2006. b) Not applicable c) The only matter voted upon was the election of two directors for terms expiring in 2009. The results are as follows:
Election of directors For Against or withheld - --------------------- --------- ------------------- Richard A. Braun 6,376,707 239,643 William C. Parsons 6,005,681 610,669
As a consequence of the Company's staggered board of directors, other directors remained in office. Directors continuing in office for terms expiring in 2007 are John W. Bunda, Roger G. Ferris, Thomas L. Herlache and Paul Jay Sturm. Directors continuing in office for terms expiring in 2008 are Robert W. Agnew, George Delveaux, Jr., Dee Geurts-Bengtson and Joseph Morgan. As previously disclosed on June 30, 2006, it was announced that Robert Cera would become a director effective August 21, 2006. His term will expire in 2009. ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION - -------------- ----------------------------------------------------------- 10.9 Baylake Bank Employment Agreement with Robert J. Cera 31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L. Herlache, Chief Executive Officer, is attached hereto. 31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D. Jennerjohn, Chief Financial Officer, is attached hereto. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto.
"Management agrees to furnish to the Securities and Exchange Commission, upon request, a copy of any other agreements or instruments of Baylake Corp. and its subsidiaries defining the rights of holders of any long-term debt whose authorization does not exceed 10% of total assets." 39 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BAYLAKE CORP. --------------------------------- Date: August 3, 2006 /s/ Thomas L. Herlache ---------------------------------------- Thomas L. Herlache President (CEO) Date: August 3, 2006 /s/ Steven D. Jennerjohn ---------------------------------------- Steven D. Jennerjohn Treasurer (CFO) 40 EX-10.9 2 c07528exv10w9.txt BANK EMPLOYMENT AGREEMENT EXHIBIT 10.9 EMPLOYMENT AGREEMENT THIS EMPLOYMENT AGREEMENT ("Agreement") is made as of this 30th day of June, 2006, by and between Baylake Bank ("Bank") and Robert J. Cera ("Employee"). RECITALS The Bank desires to employ Employee, and Employee desires to be employed by the Bank, on the terms and conditions set forth herein. The parties believe it is in their best interests to make provision for certain aspects of their relationship during and after the period in which Employee is employed by the Bank. NOW, THEREFORE, in consideration of the mutual agreements and covenants contained herein, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged by the Bank and Employee ("Parties"), the Parties agree as follows: ARTICLE I EMPLOYMENT 1.1 Term of Employment. The Bank employs Employee, and Employee accepts employment by the Bank, for the period commencing on the start date specified and ending on June 30, 2007 ("Employment Term"), subject to earlier termination as hereinafter set forth in Article III, below. Employee will start actively working full time on August 21, 2006, but the effective date of this Agreement shall be June 30, 2006; from June 30, 2006 through August 21, 2006, Employee will not be entitled to any compensation. Following the expiration of the Employment Term, this Agreement shall be automatically renewed for successive one (1) year periods (collectively, "Renewal Terms"; individually, "Renewal Term") unless, at least 30 days prior to the expiration of the Employment Term or the then current Renewal Term, either party provides the other with a written notice of intention not to renew, in which case this Agreement shall terminate as of the end of the Employment Term or said Renewal Term, as applicable. If this Agreement is renewed, the terms of this Agreement during such Renewal Term shall be the same as the terms in effect immediately prior to such renewal (including, but not limited to, the early termination provisions set forth in Article III, below), subject to any such changes or modifications as mutually may be agreed between the Parties as evidenced in a written instrument signed by both the Bank and Employee. 1.2 Position and Duties. Employee shall be employed in the position of President and COO of the Bank, and shall be subject to the authority of, and shall report to the CEO and the Board of Directors (Board) and/or other individual(s) as may be specified by the Board from time to time. Employee's duties and responsibilities shall include all those customarily attendant to the position of President of the Bank and such other duties and responsibilities as may be assigned from time to time by the Board. Employee shall devote Employee's entire business time, attention and energies 1 exclusively to the business interests of the Bank while employed by the Bank except as otherwise specifically approved in writing by or on behalf of the Board. ARTICLE II COMPENSATION AND OTHER BENEFITS 2.1 Base Salary. The Bank shall pay Employee an annual salary of Two Hundred Seventy-five Thousand Dollars ($275,000.00) ("Base Salary"), payable in accordance with the normal payroll practices and schedule of the Bank. 2.2 Board Attendance. Employee will not receive additional compensation for attendance at Board meetings or Board committee meetings. 2.3 Additional Compensation. Beginning with the 2007 calendar year, Employee may be eligible to earn an annual (calendar year) performance-based bonus of up to but not greater than One Hundred Thousand Dollars ($100,000.00) for each full calendar year during which Employee is employed by the Bank ("Bonus Year"), the terms and conditions of which, as well as Employee's entitlement thereto, shall be determined annually in the sole discretion of the Board ("Performance Bonus"). Employee shall be eligible for a performance bonus for the balance of the 2006 calendar year in an amount up to $33,000 under the same conditions as described in the preceding sentence. 2.4 Benefit Plans. Employee will be eligible to participate in the Bank's retirement plans that are qualified under Section 401(a) of the Internal Revenue Code of 1986, as amended, and in the Bank's welfare benefit plans that are generally applicable to all employees of the Bank, in accordance with the terms and conditions thereof. 2.6 Vehicle. After August 21, 2006, the Bank will purchase an automobile for Employee's use (purchase price up to $40,000); personal miles being allocated back to employee on no less than an annual basis. 2.7 Country Club. The Bank shall obtain for Employee a country club membership in Employee's name at a Green Bay or Door County, Wisconsin golf club in 2007. 2.8 Relocation Assistance. The Bank shall provide relocation benefits for the Employee's moving expenses, customary and reasonable realtor fees and closing costs (excluding real estate taxes) on sale of Employee's residence in Pewaukee Wisconsin, and all customary and reasonable closing costs associated with Employee's purchase of a primary residence in the area from Green Bay, Wisconsin to Sister Bay, Wisconsin. The move shall be before June 30, 2008. 2.9 Expenses. The Bank shall reimburse Employee for all reasonable and necessary expenses incurred in the course of the performance of Employee's duties and responsibilities pursuant to this Agreement and consistent with the Bank's policies with respect to travel, entertainment and miscellaneous expenses, and the requirements with respect to the reporting of such expenses. 2.10 Vacation. For the remainder of the 2006 calendar year, the Employee shall be entitled to a maximum of three (3) weeks of paid vacation; provided, however, that such vacation 2 time may not be carried over from year to year and that any vacation time that is unused at the conclusion of 2006 is forfeited by Employee. If Employee's employment is terminated for whatever reason during 2006, Employee forfeits any vacation time that is unused as of Employee's last date of employment. Beginning on January 1, 2007, the Employee will be eligible for an amount of vacation set forth in the Bank's vacation policy, which is applicable to all management employees, in accordance with the terms and conditions of such policy. 2.11 Equity Plans or Programs. Employee may, during the term of this Agreement, be eligible to participate in stock option, phantom stock, restricted stock or other similar equity-incentive plans or programs which the Bank may establish from time to time. The Board at its sole discretion shall establish the terms of any such plans or programs, and Employee's eligibility to participate in them. Employee will present a proposal to the Board for its consideration regarding the potential of annual eligibility of not less than 10,000 shares of Baylake Corp stock. Bank is also willing to give consideration to a Rabbi Trust, SERP, or etc., the amount varying dependent on the size of the program established, to cover part or all of Employee's compensation that does not qualify for Bank's 401k plan. Bank will give due consideration to the compensation study from State Financial Services Corporation, which is in Employee's possession, if and when establishing any proposed plan and other long-term compensation benefits. ARTICLE III TERMINATION 3.1 Right to Terminate; Automatic Termination. (a) Termination Without Cause. Subject to Section 3.2, the Bank may terminate Employee's employment and all of the Bank's obligations under this Agreement at any time and for any reason. (b) Termination For Cause. Subject to Section 3.2, the Bank may terminate Employee's employment and all of the Bank's obligations under this Agreement at any time for Cause (as defined below) by giving notice to Employee stating the basis for such termination, effective immediately upon giving such notice or at such other time thereafter as the Bank may designate. "Cause" shall mean any of the following: (i) Employee has breached this Agreement or any other agreement to which Employee and the Bank are parties or has breached any other obligation or duty owed to the Bank; (ii) Employee has, as determined solely by the Bank, participated in or been responsible (in whole or in part) for any violation of or default regarding any investment agreement or bank covenants to which the Bank is a party; (iii) Employee has committed negligence, misconduct or any violation of law in the performance of Employee's duties for the Bank; (iv) Employee has taken any action likely to result in discredit to or loss of business, reputation or goodwill of the Bank; (v) Employee has failed to follow reasonable instructions from the Board, officer, body or other entity or individual to whom Employee reports concerning the operations or business of the Bank; (vi) Employee has committed a crime the circumstances of which substantially relate to Employee's employment duties with the Bank; (vii) Employee has misappropriated funds or property of the Bank; (viii) Employee has attempted to obtain a personal profit from any transaction in which the Bank has an interest, and which constitutes a corporate opportunity of the Bank, or which is adverse to the interests of the Bank, unless the transaction was 3 approved in writing by the Bank's Board after full disclosure of all details relating to such transaction. (c) Termination by Death or Disability. Subject to Section 3.2, Employee's employment and the Bank's obligations under this Agreement shall terminate automatically, effective immediately and without any notice being necessary, upon Employee's death or a determination of Disability of Employee. For purposes of this Agreement, "Disability" means the inability of Employee, due to a physical or mental impairment, to perform the essential functions or job-related responsibilities of Employee's job with the Bank, with or without a reasonable accommodation. A determination of Disability shall be made by the Bank, which may, at its sole discretion, consult with a physician or physicians satisfactory to the Bank, and Employee shall cooperate with any efforts to make such determination. Any such determination shall be conclusive and binding on the parties. Any determination of Disability under this Section 3.1(c) is not intended to alter any benefits any party may be entitled to receive under any long-term disability insurance policy carried by either the Bank or Employee with respect to Employee, which benefits shall be governed solely by the terms of any such insurance policy. (d) Termination by Resignation. Subject to Section 3.2, Employee's employment and the Bank's obligations under this Agreement shall terminate automatically, effective immediately upon Employee's provision of written notice to the Bank of Employee's resignation from employment with the Bank or at such other time as may be mutually agreed between the Parties following the provision of such notice. (e) Termination Arising From Bank Insolvency. Subject to Section 3.2, the Bank may terminate Employee's employment and all of the Bank's obligations under this Agreement at any time as a result of (i) the Bank becoming insolvent or adjudicated bankrupt, (ii) the commencement or maintenance of proceedings related to the bankruptcy, liquidation or dissolution of the Bank, or (iii) the Bank's violation of or default regarding any investment agreement or bank covenants to which the Bank is a party by giving notice to Employee stating the basis for such termination, effective immediately upon giving such notice or at such other time thereafter as the Bank may designate. (f) Termination For Good Reason. Subject to Section 3.2, the Employee may terminate Employee's employment and all of the Bank's obligations under this Agreement at any time for Good Reason (as defined below) by giving notice to the Bank stating the basis for such termination, effective immediately upon giving such notice. "Good Reason" shall mean (i) any material breach of this Agreement by the Bank; (ii) other than for Cause, any material reduction in the nature or scope of Executive's title, authority, powers, functions, duties, reporting requirements or responsibilities as the President of the Bank; provided, however, that Good Reason shall not exist unless Employee first provides the Board with notice of the facts alleged to constitute Good Reason and the provision of this Section 3.1(f) which Employee alleges applies, and until such breach, reduction or requirement remains uncured for 30 business days following the Board's receipt of such written notice from Employee. 3.2 Rights Upon Termination. (a) Section 3.1(a) and (f) Terminations. If Employee's employment is terminated pursuant to Section 3.1(a) or (f) hereof, Employee shall have no further rights against the 4 Bank hereunder, except for the right to receive (i) any unpaid Base Salary with respect to the period prior to the effective date of termination, (ii) a Severance Payment (defined below), the payment of which is contingent upon Employee's execution of a written severance agreement (in a form satisfactory to the Bank) containing, among other things, a general release of claims against the Bank, and (iii) reimbursement of expenses to which Employee is entitled under Section 2.5, above. For purposes of this Agreement, "Severance Payment" means three (3) months of Base Salary payable following termination in accordance with the normal payroll practices and schedule of the Bank. (b) Sections 1.1 and 3.1(b), (c), (d) and (e) Terminations. If Employee's employment is terminated pursuant to Sections 3.1(b), (c) or (e), if Employee resigns pursuant to Section 3.1(d), or if either the Bank or Employee fails to renew this Agreement pursuant to Section 1.1, Employee or Employee's estate shall have no further rights against the Bank hereunder, except for the right to receive (i) any unpaid Base Salary with respect to the period prior to the effective date of termination and (ii) reimbursement of expenses to which Employee is entitled under Section 2.5, above. ARTICLE IV CONFIDENTIALITY; NON-COMPETITION 4.1. Confidentiality Obligations. During the term of Employee's employment under this Agreement, Employee will not directly or indirectly use or disclose any Confidential Information or Trade Secrets except in the interest and for the benefit of the Bank. After the termination, for whatever reason, of Employee's employment with the Bank, Employee will not directly or indirectly use or disclose any Trade Secrets unless such information ceases to be deemed a Trade Secret by means of one of the exceptions set forth in Section 4.4(c), below. For a period of two (2) years following termination, for whatever reason, of Employee's employment with the Bank, Employee will not directly or indirectly use or disclose any Confidential Information, unless such information ceases to be deemed Confidential Information by means of one of the exceptions set forth in Section 4.4(c), below. 4.2 Restrictions on Competition. (a) During Employment. During the term of Employee's employment with the Bank, Employee shall not directly or indirectly compete against the Bank, or directly or indirectly divert or attempt to divert Customers' business from the Bank. (b) Following Employment. (i) Non-Solicitation. For eighteen (18) months following termination, for whatever reason, of Employee's employment with the Bank, Employee agrees not to directly or indirectly solicit or attempt to solicit any business from any Restricted Customer in any manner which competes with the services or products offered by the Bank, or to directly or indirectly divert or attempt to divert any Restricted Customer's business from the Bank. 5 (ii) Non-Competition. For eighteen (18) months following termination, for any reason, of Employee's employment with the Bank, Employee agrees not to provide services which are substantially similar to the services Employee provided to the Bank as an employee, agent, independent contractor or otherwise, to a "Venture in Competition." A "Venture in Competition" shall be defined as a bank, credit union or other entity which is in the business of lending money to individuals or businesses and which has a branch, office or place of business within a 100-mile radius of Sturgeon Bay, Wisconsin. 4.3 Assignment of Business Ideas. Employee shall immediately disclose to the Bank a list of all inventions, patents, applications for patent, copyrights, and applications for copyright in which Employee currently holds an interest. The Bank will own, and Employee hereby assigns to the Bank, all rights in all Business Ideas. All Business Ideas which are or form the basis for copyrightable works shall be considered "works for hire" as that term is defined by United States copyright law. Any works that are not found to be "works for hire" are hereby assigned to the Bank. While employed by the Bank and for one (1) year thereafter, Employee will promptly disclose all Business Ideas to the Bank and execute all documents which the Bank may reasonably require to perfect its patent, copyright and other rights to such Business Ideas throughout the world. After Employee's employment with the Bank terminates, for whatever reason, Employee will cooperate with the Bank to assist the Bank in perfecting its rights to any Business Ideas including executing all documents which the Bank may reasonably require. 4.4 Definitions. (a) Trade Secret. The term "Trade Secret" shall have that meaning set forth under applicable law. This term is deemed by the Bank to specifically include all computer source code created by or for the Bank and any confidential information received from a third party with whom the Bank has a binding agreement restricting disclosure of such confidential information. (b) Confidential Information. The term "Confidential Information" shall mean all non-Trade Secret or proprietary information of the Bank which has value to the Bank and which is not known to the public or the Bank's competitors, generally, including, but not limited to, new products, customer lists, pricing policies, employment records and policies, operational methods, marketing plans and strategies, product development techniques and plans, business acquisition plans, rate information, loan information, financial information regarding the Bank and its customers, technical processes, designs, inventions, research programs and results, and computer source code. (c) Exclusions. Notwithstanding the foregoing, the terms "Trade Secret" and "Confidential Information" shall not include, and the obligations set forth in this Agreement shall not apply to, any information which: (i) can be demonstrated by Employee to have been known by Employee prior to Employee's employment by the Bank; (ii) is or becomes generally available to the public through no act or omission of Employee; (iii) is obtained by Employee in good faith from a third party who discloses such information to Employee on a non-confidential basis without violating any obligation of confidentiality or secrecy relating to the information disclosed; or (iv) is independently developed by Employee outside the scope of Employee's employment without use of Confidential Information or Trade Secrets. 6 (d) Business Ideas. The term "Business Ideas" as used in this Agreement means all ideas, inventions, data, software, developments and copyrightable works, whether or not patentable or registrable, which Employee originates, discovers or develops, either alone or jointly with others while Employee is employed by the Bank and for one (1) year thereafter and which are (i) related to any business known by Employee to be engaged in or contemplated by the Bank, (ii) originated, discovered or developed during Employee's working hours, or (iii) originated, discovered or developed in whole or in part using materials, labor, facilities, Confidential Information, Trade Secrets, or equipment furnished by the Bank. (e) Customer. The term "Customer" shall mean any individual or entity for whom the Bank has provided services or products or made a proposal to provide services or products. (f) Restricted Customer. The term "Restricted Customer" shall mean any individual or entity for whom/which the Bank provided services or products and with or about whom/which the Employee had direct contact on behalf of the Bank or acquired confidential information or trade secrets on behalf of the Bank during the two (2) years preceding termination, for whatever reason, of Employee's employment. 4.5 Return of Records. Upon termination, for whatever reason, of employment or upon request by the Bank at any time, Employee shall immediately return to the Bank all documents, records, and materials belonging and/or relating to the Bank, and all copies of all such materials. Upon termination, for whatever reason, of employment or upon request by the Bank at any time, Employee further agrees to destroy such records maintained by Employee on Employee's own computer equipment. 4.6. Non-Solicitation of Employees. During the term of Employee's employment with the Bank and for one (1) year thereafter, Employee shall not directly or indirectly encourage any Bank employee to terminate his/her employment with the Bank or solicit such an individual for employment outside the Bank. 4.7 Employee Disclosures and Acknowledgments. (a) Prior Obligations. There no are prior obligations (written and oral), such as confidentiality agreements or covenants restricting future employment or consulting, that Employee has entered into which may restrict Employee's ability to perform Employee's duties as an Employee for the Bank. (b) Confidential Information of Others. Employee certifies that Employee has not, and will not, disclose or use during Employee's time as an employee of the Bank, any confidential information which Employee acquired as a result of any previous employment or under a contractual obligation of confidentiality or secrecy before Employee became an employee of the Bank. (c) Scope of Restrictions. By entering into this Agreement, Employee acknowledges the nature of the Bank's business and the nature and scope of the restrictions set forth in this Article IV, including specifically Wisconsin's Uniform Trade Secrets Act, presently Section 134.90(1)(c), Wis. Stats. Employee acknowledges and represents that the scope of the 7 restrictions are appropriate, necessary and reasonable for the protection of the Bank's business, goodwill, and property rights. Employee further acknowledges that the restrictions imposed will not prevent Employee from earning a living in the event of, and after, termination, for whatever reason, of Employee's employment with the Bank. Nothing herein shall be deemed to prevent Employee, after termination of Employee's employment with the Bank, from using general skills and knowledge gained while employed by the Bank. (d) Prospective Employers. Employee agrees, during the term of any restriction contained in this Article IV, to disclose this Agreement to any future or prospective employer. Employee further agrees that the Bank may send a copy of this Agreement to, or otherwise make the provisions hereof known to, any such employer. 4.8 Effect of Termination. Notwithstanding any termination of this Agreement, the Employee, in consideration of his employment hereunder, shall remain bound by the provisions of this Agreement which specifically relate to periods, activities or obligations upon or subsequent to the termination, for whatever reason, of the Employee's employment. 4.9 Effect of Breach. In the event that Employee breaches any provision of this Article IV, Employee agrees that the Bank may suspend all additional payments to Employee under this Agreement, recover from Employee any damages suffered as a result of such breach and recover from Employee any reasonable attorneys' fees or costs it incurs as a result of such breach. In addition, Employee agrees that the Bank may seek injunctive or other equitable relief as a result of a breach by Employee of any provision of this Article IV. ARTICLE V GENERAL PROVISIONS 5.1 Notices. Any and all notices, consents, documents or communications provided for in this Agreement shall be given in writing and shall be personally delivered, mailed by registered or certified mail (return receipt requested) or sent by courier, confirmed by receipt, and addressed as follows (or to such other address as the addressed party may have substituted by notice pursuant to this Section 5.1): (a) If to the Bank: Chair of the Board of Directors Baylake Bank P O Box 9 Sturgeon Bay, WI 54235-0009 (b) If to Employee: Robert J. Cera ____________________________ ____________________________ ____________________________ 8 Such notice, consent, document or communication shall be deemed given upon personal delivery or receipt at the address of the party stated above or at any other address specified by such party to the other party in writing, except that if delivery is refused or cannot be made for any reason, then such notice shall be deemed given on the third day after it is sent. 5.2 Entire Agreement. This Agreement contains the entire understanding and the full and complete agreement of the parties and supersedes and replaces any prior understandings and agreements among the parties, with respect to the subject matter hereof. 5.3 Injunctive Relief. The parties agree that damages will be an inadequate remedy for breaches of this Agreement and in addition to damages and any other available relief, a court shall be empowered to grant injunctive relief. 5.4 Headings. The headings of sections and paragraphs of this Agreement are for convenience of reference only and shall not control or affect the meaning or construction of any of its provisions. 5.5 Consideration. Execution of this Agreement is a condition of Employee's employment with the Bank and Employee's employment by the Bank, together with the benefits provided to the Employee herein, constitutes the consideration for Employee's undertakings hereunder. 5.6 Amendment. This Agreement may be altered, amended or modified only in a writing, signed by both of the parties hereto. Headings included in this Agreement are for convenience only and are not intended to limit or expand the rights of the parties hereto. References to Sections herein shall mean sections of the text of this Agreement, unless otherwise indicated. 5.7 Assignability. This Agreement and the rights and duties set forth herein may not be assigned by Employee, but may be assigned by the Bank, in whole or in part. This Agreement shall be binding on and inure to the benefit of each party and such party's respective heirs, legal representatives, successors and assigns. 5.8 Severability. If any court of competent jurisdiction determines that any provision of this Agreement is invalid or unenforceable, then such invalidity or unenforceability shall have no effect on the other provisions hereof, which shall remain valid, binding and enforceable and in full force and effect, and such invalid or unenforceable provision shall be construed in a manner so as to give the maximum valid and enforceable effect to the intent of the parties expressed therein. Nothing in this provision shall contemplate any blue-penciling prohibited under Wis. Stat. Section 103.465. The parties agree that paragraphs 4.1, 4.2(a), 4.2(b)(i), 4.2(b)(ii) and 4.3 contain separate restrictions and that the invalidity of one shall have no effect on the other restrictions. 5.9 Waiver of Breach. The waiver by either party of the breach of any provision of this Agreement shall not operate or be construed as a waiver of any subsequent breach by either party. 5.10 Governing Law; Construction. This Agreement shall be governed by the internal laws of the State of Wisconsin, without regard to any rules of construction concerning the draftsman hereof. 9 IN WITNESS WHEREOF, the parties have executed this Agreement as of the day and year written above. BAYLAKE BANK: _____________________________________ By:__________________________________ ________________, ________________ _____________________________________ Robert J. Cera 10 EX-31.1 3 c07528exv31w1.txt 302 CERTIFICATION OF CHIEF EXECUTIVE OFFICER EXHIBIT 31.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Thomas L. Herlache, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarter ended June 30, 2006 of Baylake Corp (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. DATE: AUGUST 1, 2006 /s/ THOMAS L. HERLACHE - -------------------------- THOMAS L. HERLACHE CHAIRMAN AND CEO EX-31.2 4 c07528exv31w2.txt 302 CERTIFICATION OF CHIEF FINANCIAL OFFICER EXHIBIT 31.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Steven D. Jennerjohn, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarter ended June 30, 2006 of Baylake Corp (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) an 15d-15(e) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-a5(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. DATE: AUGUST 1, 2006 /s/ STEVEN D. JENNERJOHN - -------------------------- STEVEN D. JENNERJOHN SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER EX-32.1 5 c07528exv32w1.txt 906 CERTIFICATION OF CHIEF EXECUTIVE OFFICER EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Baylake Corp. (the "Company") on Form 10-Q for the three and six months ended June 30, 2006 as filed with the Securities and Exchange Commission on or about the date hereof (the "Report"), I, Thomas L. Herlache, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Quarterly Report on Form 10-Q of the Company for the three and six months ended June 30, 2006 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ THOMAS L. HERLACHE - -------------------------- THOMAS L. HERLACHE PRESIDENT AND CHIEF EXECUTIVE OFFICER AUGUST 1, 2006 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Baylake Corp. and will be retained by Baylake Corp. and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 6 c07528exv32w2.txt 906 CERTIFICATION OF CHIEF FINANCIAL OFFICER EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Baylake Corp. (the "Company") on Form 10-Q for the three and six months ended June 30, 2006 as filed with the Securities and Exchange Commission on or about the date hereof (the "Report"), I, Steven D. Jennerjohn, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Quarterly Report on Form 10-Q of the Company for the three and six months ended June 30, 2006 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ STEVEN D. JENNERJOHN - ------------------------- STEVEN D. JENNERJOHN SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER AUGUST 1, 2006 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Baylake Corp. and will be retained by Baylake Corp. and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----