-----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, CNtEnmF7BOu91L4ihAeADoBzPWznpFTPXSK0KIsthlG/LC4fus+HmitY0WLQMR3l 7Xnbtl3JUkfdGnR4dx3UKA== 0000784932-01-500006.txt : 20020410 0000784932-01-500006.hdr.sgml : 20020410 ACCESSION NUMBER: 0000784932-01-500006 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SURETY CAPITAL CORP /DE/ CENTRAL INDEX KEY: 0000784932 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 752065607 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 001-12818 FILM NUMBER: 1785858 BUSINESS ADDRESS: STREET 1: 1501 SUMMIT AVENUE CITY: FORT WORTH STATE: TX ZIP: 76102 BUSINESS PHONE: 8173355955 MAIL ADDRESS: STREET 1: 1501 SUMMIT AVENUE CITY: FORT WORTH STATE: TX ZIP: 76102 FORMER COMPANY: FORMER CONFORMED NAME: K CAPITAL INC DATE OF NAME CHANGE: 19870407 10QSB 1 surfinals.txt 21 FORM 10-QSB SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 Mark One [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2001, OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________ TO _____________. Commission file number 001-12818 SURETY CAPITAL CORPORATION (Exact name of small business issuer as specified in its charter) Delaware 75-2065607 (State or other jurisdiction of (IRS Employer Incorporation or organization) Identification Number) 1501 Summit Avenue, Fort Worth, Texas 76102 (Address of principal executive offices) 817-335-5955 (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Common stock outstanding on October 13, 2001, 7,028,563 shares SURETY CAPITAL CORPORATION INDEX PART I - FINANCIAL INFORMATION Page No. Item 1 Financial Statements (Unaudited) Consolidated Balance Sheets 3 Consolidated Statements of Operations 4 Consolidated Statements of Comprehensive 5 Income Condensed Consolidated Statements of Changes 6 in Shareholders' Equity Condensed Consolidated Statements of Cash 7 Flows Notes to Consolidated Financial Statements 8 Item 2 Management's Discussion and Analysis of 13 Financial Condition and Results of Operations PART II - OTHER INFORMATION Item 1 Legal Proceedings 20 Item 2 Changes in Securities and Use of Proceeds 20 Item 3 Defaults Upon Senior Securities 20 Item 4 Submission of Matters to a Vote of Security 20 Holders Item 5 Other Information 20 Item 6 Exhibits and Reports on Form 8-K 20 SURETY CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETS September December 30, 31, 2001 2000 Assets: (Unaudited) Cash and due from banks $ 3,998,886 $ 2,198,209 Federal funds sold 3,585,000 8,825,000 Total cash and cash equivalents 7,583,886 11,023,209 Interest-bearing time deposits in other financial institutions 27,584 26,548 Securities available for sale, at fair value 12,637,438 12,310,134 Other securities 764,504 761,104 Loans, net 62,447,957 58,238,060 Premises and equipment, net 5,424,037 5,703,372 Accrued interest receivable 634,668 621,178 Other real estate and repossessed 739,000 960,155 assets Goodwill, net 2,602,264 2,799,019 Other assets 506,727 737,528 Total assets $93,368,065 $93,180,307 Liabilities: Noninterest-bearing demand deposits $15,942,740 $14,961,725 Savings, NOW and money market 25,552,682 23,303,934 accounts Time deposits, $100,000 and over 13,105,099 14,350,316 Other time deposits 25,820,740 27,044,793 Total deposits 80,421,261 79,660,768 Convertible subordinated debt 4,350,000 4,350,000 Notes payable 148,746 297,746 Accrued interest payable and other 1,032,382 1,194,124 liabilities Total liabilities 85,952,389 85,502,638 Shareholders' Equity: Preferred stock, $0.01 par value, 1,000,000 shares authorized, none issued Common stock, $0.01 par value, 20,000,000 shares authorized, 7,094,511 and 5,975,071 shares issued, respectively 70,945 59,751 Additional paid-in capital 17,544,393 17,152,587 Accumulated deficit (9,878,077) (8,968,077) Treasury stock, 79,836 shares at cost (375,443) (375,443) Accumulated other comprehensive 53,858 (191,149) income (loss) Total shareholders' equity 7,415,676 7,677,669 Total liabilities and shareholders' equity $93,368,065 $93,180,307 SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Interest income: Loans, including fees $1,624,628 $1,653,666 $4,562,568 $4,773,417 Securities, all 200,530 205,912 609,912 628,531 taxable Federal funds sold and interest bearing deposits 53,557 106,783 241,157 250,673 Total interest 1,878,715 1,966,361 5,413,637 5,652,621 income Interest expense: Deposits 697,397 759,745 2,235,241 2,179,099 Notes payable 97,875 97,875 293,625 293,625 Total interest 795,272 857,620 2,528,866 2,472,724 expense Net interest income 1,083,443 1,108,741 2,884,771 3,179,897 Provision for credit --- (70,000) --- 35,000 losses Net interest income after provision for credit losses 1,083,443 1,178,741 2,884,771 3,144,897 Noninterest income: Service charges on deposit accounts 156,588 166,830 467,584 475,759 Loan collection fees and late charges 31,355 11,468 119,212 341,851 Other income 20,456 355,725 69,634 834,239 Total noninterest 208,399 534,023 656,430 1,651,849 income Noninterest expense: Salaries and employee 658,775 710,116 1,946,499 2,433,415 benefits Occupancy and equipment 296,671 331,689 929,493 1,022,196 Other expenses 703,153 494,869 1,575,209 1,936,306 Total noninterest expense 1,658,599 1,536,674 4,451,201 5,391,917 Income (loss) before income taxes (366,757) 176,090 (910,000) (595,171) Income tax (benefit) -- 98,991 -- (90,803) Net income (loss) $(366,757) $ 77,099 $(910,000) $(504,368) Net income (loss) per share- Basic $ (0.05) $ 0.01 $ (0.14) $ (0.09) Net income (loss) per share - Diluted $ (0.05) $ 0.01 $ (0.14) $ (0.09) SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Net income (loss) $(366,757) $ 77,099 $(910,000) $(504,368) Other comprehensive income (loss): Unrealized gain (loss) on available-for-sale securities arising during period 110,527 196,272 371,222 294,408 Tax effect (37,579) (66,733) (126,215) (100,099) Total other comprehensive 72,948 129,539 245,007 194,309 income (loss) Comprehensive income $(293,809) $ 206,638 $ (664,993) $ (310,059) (loss) SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) Nine Months Ended September September 30, 30, 2001 2000 Balance at beginning of period $ 7,677,669 $11,322,970 Issuance of Common Stock 403,000 -- Net income (loss) (910,000) (504,368) Change in fair value of securities available for sale, net of tax 245,007 194,309 Balance at end of period $ 7,415,676 $11,012,911 SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine Months Ended September September 30, 30, 2001 2000 Net cash from operating activities $ (133,259) $(1,015,887) Cash flows from investing activities: Net change in loans (4,234,897) 5,937,448 Securities available for sale: Purchases (1,710,863) (937,900) Maturities and repayments 1,761,437 217,472 Proceeds from sales -- 775,550 Proceeds from sale of other real estate and repossessed assets 37,455 709,598 Premises and equipment expenditures (173,689) (68,484) Net cash from investing activities (4,320,557) 6,633,684 Cash flows from financing activities: Increase in notes payable 31,000 -- Repayments of notes payable (40,000) -- Issuance of common stock 263,000 -- Net change in deposits 760,493 (5,032,993) Net cash from financing activities 1,014,493 (5,032,993) Net change in cash and cash equivalents (3,439,323) 584,804) Cash and cash equivalents at beginning of period 11,023,209 9,751,228 Cash and cash equivalents at end of period $ 7,583,886 $10,336,032 Supplemental disclosures: Cash paid for interest $ 2,392,989 $ 2,497,430 Cash paid (refunds received) for federal income taxes -- $(1,293,200) Significant non-cash transactions: Write-down carrying value of other real estate owned $ ( 204,000) -- Transfers of repossessed collateral to other real estate and repossessed assets $ 25,000 $ 868,000 Additions to loans to facilitate sale of other real estate -- $ (78,000) Conversion of notes payable to common stock $ 140,000 -- SURETY CAPITAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies The accompanying consolidated financial statements include the accounts of Surety Capital Corporation (the "Holding Company") and its wholly-owned subsidiary, Surety Bank, National Association (the "Bank"), together, with the Holding Company, referred to as the "Company". All significant intercompany accounts and transactions have been eliminated in consolidation. These interim financial statements are unaudited and reflect all adjustments that, in the opinion of management, are necessary to present fairly the financial position of the Company at September 30, 2001, and its results of operations and cash flows for the periods presented. All such adjustments are normal and recurring in nature. The accompanying financial statements have been prepared in accordance with the instructions of Form 10-QSB and, therefore, do not purport to contain all necessary financial disclosures required by generally accepted accounting principles that might otherwise be necessary in the circumstances, and should be read in conjunction with financial statements, and notes thereto, of the Company for the year ended December 31, 2000, included in its annual report on Form 10-KSB for the fiscal year ended December 31, 2000 (the "2000 Form 10-KSB"). Please refer to the accounting policies of the Company described in the notes to financial statements contained in the 2000 Form 10-KSB. The Company has consistently followed these policies in preparing this Form 10-QSB. Some items in prior financial statements have been reclassified to conform to the current presentation. On June 29, 2001, the FASB issued financial accounting standard No.142 (FAS142) Goodwill and Other Intangible Assets. FAS 142 primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition. The provisions of FAS 142 will be effective to the Company beginning January 1, 2002. Note 9 discusses the potential effects to the Company. 2. Earnings Per Share Earnings per share is computed in accordance with SFAS No. 128, which requires dual presentation of basic and diluted earnings per share ("EPS") for entities with complex capital structures. Basic EPS is based on net income divided by the weighted- average number of shares outstanding during the period. Diluted EPS includes the dilutive effect of stock options granted using the treasury stock method. Earnings per common share are computed by dividing net income by the weighted-average number of shares outstanding for the year. The weighted-average number of common shares outstanding for basic and diluted earnings per share computations was as follows: Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Weighted-average shares outstanding- Basic 7,014,675 5,895,235 6,343,768 5,895,235 Effect of stock options -- -- -- -- Weighted-average shares outstanding- Diluted 7,014,675 5,895,235 6,343,768 5,895,235 The Company reported a net loss for the nine-month periods ended September 30, 2001 and 2000. Accordingly, the dilutive effect of stock options is not considered in the net loss per share calculations for these periods. 3. Securities Securities available for sale and other securities consisted of the following: Gross Gross Estimated Amortized Unrealized Unrealized Fair Value Cost Gains Losses Value September 30, 2001: U.S. Treasury notes $ 199,513 $ 59 $ -- $ 199,572 U.S. government agencies 11,460,804 74,583 -- 11,535,387 Mortgage-backed securities 895,518 6,961 -- 902,479 Other securities 764,504 -- -- 764,504 Total securities $13,320,339 $ 81,603 $ -- $13,401,942 December 31, 2000: U.S. government $12,150,224 $ 4,925 $ 293,383 $11,861,766 agencies Mortgage-backed 449,529 578 1,739 448,368 securities Other securities 761,104 -- -- 761,104 Total securities $13,360,857 $ 5,503 $ 295,122 $ 13,071,238 There were no holdings of securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of shareholders' equity at December 31, 2000 or September 30, 2001. Mortgage-backed securities are backed by pools of mortgages that are insured or guaranteed by the Federal Home Loan Mortgage Corporation and the Government National Mortgage Corporation. Other securities include stock holdings in Independent Bankers Financial Corporation, the Federal Reserve Bank and the Federal Home Loan Bank. The amortized cost and estimated fair value of securities at September 30, 2001 by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mortgage-backed securities and other securities are shown separately since they are not due at a single maturity date. Amortized Estimated Cost Fair Value Due within one year $ 6,667,040 $ 6,700,038 Due after one year 2,301,569 2,322,187 through five years Due after five years 3,079,420 3,107,400 through ten years Mortgage-backed 507,806 507,813 securities Other securities 764,504 764,504 Total securities $13,320,339 $13,401,942 Sales of securities available for sale were as follows: Nine Months Ended September September 30, 30, 2001 2000 Proceeds $ -- $775,550 Gross Gains -- -- Gross Losses -- -- . 4. Loans Loans consisted of the following: September December 30, 31, 2001 2000 Real estate loans $39,513,088 $37,280,209 Insurance premium financing 5,481,774 5,951,300 Commercial loans 12,888,942 10,919,098 Consumer loans 6,121,040 5,511,651 Total gross loans 64,004,844 59,662,258 Unearned interest (163,950) (160,237) Allowance for credit losses (1,392,937) (1,263,961) Loans, net $62,447,957 $58,238,060 Activity in the allowance for credit losses on loans was as follows: Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Beginning balance $1,321,241 $1,325,620 $1,263,961 $1,434,041 Provision for -- (70,000) -- 35,000 credit losses Charge-offs (77,956) (159,116) (238,726) (601,579) Recoveries 149,652 178,751 367,702 407,793 Ending balance $1,392,937 $1,275,255 $1,392,937 $1,275,255 Impaired loans were as follows: September December 30 31, 2001 2000 Impaired loans with allowance allocated $3,357,528 $1,941,947 Impaired loans with no allowance allocated 948,852 1,256,490 Total impaired loans $4,306,380 $3,198,437 Amount of the allowance $ 481,989 $ 504,346 allocated Nonperforming loans were as follows: September December 30, 31, 2001 2000 Loans past due over 90 days still on accrual $ 156,884 $ -- Nonaccrual loans 820,858 1,282,785 Total nonperforming loans $ 977,742 $ 1,282,785 5. Convertible Subordinated Debt and Notes Payable On March 31, 1998, the Company issued $4,350,000 in 9% Convertible Subordinated Notes Due 2008 (the "Notes"), pursuant to an indenture between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (the "Trustee"). The Notes are general unsecured obligations of the Company. The terms of the Notes are such that they qualify as Tier II capital under the Federal Reserve Board's regulatory capital guidelines applicable to bank holding companies. The Notes bear interest at a rate of 9% per annum until maturity. Interest on the Notes is payable semi-annually on March 31 and September 30 of each year. No principal payments are due until maturity on March 31, 2008. Payment of interest due September 30, 2001 was paid subsequent to the end of the quarter. The amount of the principal and any accrued and unpaid interest on the Notes are subordinated in right of payment to the prior payment in full of all senior indebtedness of the Company, including the Bank's deposits. Upon the occurrence of certain events involving the bankruptcy, insolvency, reorganization, receivership or similar proceedings of the Company, either the Trustee or the holders of not less than 25% in aggregate principal amount of the outstanding Notes may declare the principal of the Notes, together with any accrued and unpaid interest, to be immediately due and payable. The Notes do not otherwise provide for any right of acceleration of the payment of principal thereof. In October and November 2000, certain current and former members of the Company's Board of Directors and one employee loaned the Company $260,000 to enable the Company to meet its cash obligations and a former director accepted a $38,000 noninterest bearing note in exchange for fees owed the director's firm. The promissory notes evidencing the loans mature on January 2, 2002 and bear no interest from the date of issuance until maturity, except the $38,000 note held by a former director, which matures December 31, 2001. Additionally, $260,000 of the promissory notes are convertible into common stock at a rate of one share of common stock per $0.36 of principal amount of the notes. During the first nine months of 2001, $40,000 of the convertible notes were repaid and an additional $140,000 were converted into 111,111 shares of Company common stock . In March 2001, certain Board members committed to advance up to $460,000, if needed, to enable the Company to meet its cash obligations in 2001. Any advances under the commitment will be evidenced by noninterest bearing notes convertible into common stock at the lower of $0.36 per share or a price computed at 75% of the closing bid price ten days prior to advance. During the first nine months of 2001, the Company borrowed $294,000 under the commitment of which $263,000 was converted into common stock at $0.36 per share. The promissory notes evidencing the loans are noninterest-bearing, mature in 2002, and are convertible into common stock of the Company at a rate of $0.36 per share. In November the Company received permission from the Federal Reserve and borrowed $260,000 from certain directors convertible into common stock at $0.27 per share. Proceeds were used to pay interest due on the convertible subordinated debt and other general corporate purposes. 6. Common stock issued to insiders During the first nine months of 2001, certain current and former directors and other insiders converted $403,000 of funds advanced to the Company into 1,119,444 shares of common stock at $0.36 per share. 388,889 of the shares issued were in exchange for noninterest bearing convertible notes issued in 2000. The remaining 730,555 shares were in exchange for funds invested during 2001. At September 30, 2001, $110,000 of noninterest bearing notes convertible into Holding Company common stock at $0.36 per share were outstanding. Proceeds from the debt were used to pay interest due on the $4,350,000 in 9% Convertible Subordinated Notes Due 2008 discussed in note 5. In August, 2001, the Board approved the award of 550,000 shares of unregistered common stock, lettered for two years, to certain members of its board of directors in consideration of extraordinary time and efforts given to the Company. The shares will be issued in the fourth quarter. The effect of the stock grants will be recorded at time of issue. 7. Financial Instruments With Off-Balance-Sheet Risk and Concentration of Credit Risk Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued in the normal course of business to meet the financing needs of customers. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met. These agreements usually have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being used, the total commitments do not necessarily represent future cash requirements. Off-balance- sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. Financial instruments with off-balance sheet risk at September 30, 2001 and December 31, 2000 included unfunded loan commitments of $4,676,000 and $5,940,000 and letters of credit of $ 207,000 and $150,000. Unfunded loan commitments carrying fixed interest rates totaled $563,000 at September 30, 2001, with interest rates ranging from 7.00% to 18.00%. Unfunded loan commitments carrying fixed rates totaled $5,927,000 at December 31, 2000, with interest rates ranging from 7.5% to 18.0%. Unfunded letters of credit carrying fixed interest rates totaled $50,000 at either September 30, 2001 at a 6.55% interest rate and $0 at December 31, 2000. Federal funds sold totaled $3,585,000 and $8,825,000 at September 30, 2001 and December 31, 2000. These funds represent uncollateralized loans, in varying amounts, to other commercial banks with which the Company has correspondent relationships. The Company maintains deposits with other financial institutions in amounts that exceed federal deposit insurance coverage. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risks on cash and cash equivalents. The Company has geographic concentrations of credit in its principal market areas of Bexar, Comal, Grayson, and Tarrant Counties, Texas. Additionally, the Company has a significant concentration of credit, based upon like collateral. Insurance premium financing loans, secured by the residual value of unearned insurance premiums, comprised $5,482,000, or 8.56%, and $5,951,000, or 9.97%, of gross loans at September 30, 2001 and December 31, 2000. 8. Other Noninterest Expense Other noninterest expense consisted of the following: Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Professional $ services $135,745 $ 17,111 $354,096 $ 508,676 Postage and delivery 38,956 30,377 113,530 121,506 Telephone 41,009 41,211 117,376 146,396 Office supplies 26,092 27,668 62,168 91,215 Amortization of intangibles and debt issuance costs 44,791 142,313 196,756 364,554 Insurance 31,668 36,516 94,687 104,282 FDIC and OCC assessments 23,576 41,724 66,109 63,160 Write-down other real estate 204,000 -- 204,000 -- Interest on IPF refunds -- -- -- 38,700 Other 157,316 157,949 366,487 497,817 Total other noninterest expense $ 703,153 $ 494,869 $1,575,209 $1,936,306 9. Effect of prospective accounting change On June 29, 2001, the FASB issued financial accounting standard No.142 ("FAS 142") Goodwill and Other Intangible Assets. FAS 142 primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition. The provisions of FAS 142 will be effective to the Company beginning January 1, 2002 and the Company plans to implement the accounting change at that time. The most significant changes made by FAS 142 are: (1) goodwill and indefinite life intangible assets will no longer be amortized, (2) goodwill will be tested for impairment at least annually, (3) intangible assets with an indefinite life will be tested for impairment at least annually, and (4) the amortization period of intangible assets with finite lives will no longer be limited to forty years. Currently, the Company amortizes goodwill over a forty-year life. Upon adoption of FAS 142, the Company will no longer record an expense for amortization of goodwill. The Company will test goodwill at least annually for impairment. The Company tested its goodwill for impairment in the fourth quarter of 2000. For the year ended December 31, 2000, the Company recorded a $2,194,407 expense for impairment of long-lived assets that consisted of a writedown in the carrying value of goodwill and other intangibles relating to the Company's San Antonio area branches. The amount of the writedown was determined by use of a third party appraisal performed as of December 31, 2000. The Company will continue to test goodwill for impairment on at least an annual basis. The provisions of FAS142 are not retroactive and the Company will not restate prior periods as a result of adopting the standard. If FAS 142 were in effect for the periods presented below it would have had the following effect on the Company's financial statements for the three and six month periods: Three Months Ended Nine Months Ended September September September September 30, 30, 30, 30, 2001 2000 2001 2000 Net income as reported $(366,757) $ 77,099 $(910,000) $(504,368) Add back Goodwill amortization 65,586 111,120 196,756 333,361 Tax Effect -- -- -- -- $(301,171) $188,219 $(713,244) $(171,007) Earnings per share As reported $ (0.04) $ (0.08) $ (0.09) $ ( 0.10) Add back Goodwill amortization 0.01 0 .02 0.02 0.04 Tax Effect -- -- -- -- $ (0.03) $ (0.06) $ (0.07) $ (0.06) Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion focuses on the consolidated financial condition of the Company at September 30, 2001 compared to December 31, 2000, and the consolidated results of operations for the three and nine month periods ended September 30, 2001 compared to the same periods in 2000. The purpose of this discussion is to provide the reader with a more thorough understanding of the consolidated financial statements. This discussion should be read in conjunction with the consolidated financial statements and related footnotes. Forward-Looking Statements When used in this document, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimated," "projected," or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties including changes in economic conditions in the Company's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Company's market area and competition, that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. Factors listed above could affect the Company's financial performance and could cause the Company's results for future periods to differ materially from any statements expressed with respect to future periods. The Company does not undertake, and specifically disclaims any obligation, to publicly revise any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. Regulatory Relations Formal Agreement with the OCC. On November 19, 1998 the Bank entered into a formal written agreement (the "Formal Agreement") with the OCC pursuant to which the Bank was required to achieve certain capital levels and adopt and implement certain plans, policies and strategies. Under the Formal Agreement the Bank is required to maintain total risk-based capital of at least 14% of risk-weighted assets and Tier I leverage capital of at least 7.5% of adjusted total assets. At September 30, 2001 and December 31, 2000 the Bank met the capital levels required by the Formal Agreement, with total risk- based capital of 15.07% and 15.99% of risk-weighted assets, respectively, and Tier I leverage capital of 10.15% and 9.83% of adjusted total assets, respectively. The agreement is still in effect. Memorandum of Understanding with the Federal Reserve Board. On October 28, 1999 the Holding Company entered into a Memorandum of Understanding (the "MOU") with the Federal Reserve Board (the "FRB"). Under the MOU, the Company is not permitted to declare or pay any corporate dividends or incur any additional debt without the prior approval of the FRB. Also, the Holding Company was required to develop and submit to the FRB a written three-year capital plan, a plan to service the Holding Company's existing debt without incurring any additional debt, and written procedures designed to strengthen and maintain the Holding Company's internal records and controls to ensure that future regulatory reports are filed in a timely and accurate manner. The Holding Company has submitted each of the requested plans and procedures to the FRB. Finally, the Holding Company is mandated under the MOU to comply fully with all formal and informal supervisory actions that have been or may be imposed on the Bank by the OCC. The MOU is still in effect. Analysis of Financial Condition The Company's assets totaled $93.4 million at September 30, 2001, and $93.2 million at December 31, 2000. While total assets were same for each period, the earning asset mix changed. Federal funds sold decreased $5.2 million while loans increased $4.2 million and securities increased $0.3 million. Total securities available for sale increased 2.7% and were $12.6 million at September 30, 2001. The $327,000 increase from December 31, 2000 was due to a $371,000 increase in market value. Net unrealized gains were $82,000 at September 30, 2001 compared to net unrealized losses of $290,000 at December 31, 2000. During the first nine months of 2001, $1.7 million of higher yielding securities were called by the issuing agencies. Proceeds were reinvested in investment securities but at a lower yield and shorter term than the called securities. The market yield on investment securities at period end fell from 6.57% at December 31, 2000 to 5.81% at September 30, 2001. Net loans increased $4.2 million, or 7.3%, from $58.2 million at December 31, 2000 to $62.4 million at September 30, 2001. Net loans were up $2.0 million from June 30, 2001. Net insurance premium financing ("IPF") loans decreased a total of $470,000, or 7.9%, from December 31, 2000, but were up $905,000 from the first quarter and $106,000 over the second quarter. The increase in IPF loan volumes for the third quarter of 2001 compared to each of the two previous quarters reverses a trend of steady decline in IPF loans since 1999. As discussed below, the Company is aggressively marketing IPF loans. The terrorist attack on September 11, 2001 had a negative affect on the IPF business since the division insures numerous trucking businesses and other entities whose businesses were indirectly affected. Real estate loans rose $2.2 million, or 6.0% from December 31 due to a significant loan secured by commercial real estate and other business occupied loans. Commercial loans increased $2.0 million, or 18.0%, during the nine months ended September 30, 2001 due to calling efforts of new management and the board of directors. Loans, net of unearned interest, as a percentage of total deposits were 79.3% at September 30, 2001 compared to 74.7% at December 31, 2000. Management is attempting to rebuild the IPF division and is pursuing new commercial business. A sales manager was hired in the second quarter to lead the IPF sales effort. While management is vigorously pursuing growth in the IPF division, there is no guarantee the growth strategies will succeed. The bank is concentrating on commercial loans and is not pursuing investment real estate type loans. During the first quarter of 2001, the Company initiated a new marketing concept, "beariffic banking", which targets specific industries. In the second quarter, the Company launched two mobile branches. The mobile branches allow the Company to provide a deposit pickup service to better serve commercial customers. Additionally, during the third quarter, the Company hired sales managers for two of its San Antonio branches and hired a credit analyst to increase its marketing to business deposit accounts and commercial loan candidates. The Company plans to more aggressively market loans guaranteed by the Small Business Administration ("SBA"). The SBA recently conducted a training seminar for all of the bank's loan and operational personnel. Loan growth was funded primarily by a $5.2 million decline in federal funds sold. Other assets decreased 231,000 from December 31, 2000 due primarily to the $98,000 reduction in deferred tax assets associated with the decrease in unrealized loss on available for sale securities and amortization of prepaid expenses. Total deposits were $80.4 million at September 30, 2001, an increase of $1.0 million, or 1.0%, from December 31, 2000. Noninterest-bearing demand deposits increased $1.0 million to $15.9 million and represented 19.8% of total deposits at September 30, 2001 compared to $15.0 million, or 18.9% of total deposits, at December 31, 2000. The growth in noninterest-bearing deposits is associated with growth in commercial accounts. Savings, NOW and money market accounts increased $2.2 million while time deposits with principal amounts over $100,000 declined $1.2 million and other time deposits declined $1.2 million. Other time declined primarily to an $832,000 reduction in IRA account. Shifts in deposit mix can be associated with seasonal customer cash-usage patterns. Time deposits made up 48.4% of the deposit portfolio at September 30, 2001 compared to 52.0% at December 31, 2000. Approximately 84% of time deposits mature within one year and substantially all of the Company's time deposits mature in less than five years. Based on past experience and the Company's prevailing pricing strategies, management believes a substantial percentage of such deposits will renew with the Company at maturity. If there is a significant deviation from historical experience, the Company can utilize borrowings from the Federal Home Loan Bank ("FHLB") as an alternative to this source of funds, subject to regulatory approval under the Formal Agreement. Convertible subordinated debt totaled $4.4 million at September 30, 2001 and December 31, 2000. Convertible subordinated notes were issued on March 31, 1998 to provide funds to finance the acquisition of TexStar National Bank. The notes bear interest at a rate of 9% per annum until maturity. No principal payments are due until maturity on March 31, 2008, while interest on the notes is payable semi- annually. The Company is dependent on borrowings from directors under noninterest bearing convertible notes to pay its interest obligations on the convertible subordinated notes. Notes payable represent funds borrowed from current and former directors, officers, and other insiders. The notes are noninterest bearing and $110,000 are convertible into common stock at $0.36 per share. Notes payable were $149,000 at September 30, 2001, a $149,000 decrease from December 31, 2000. The decline is due primarily to conversion of notes to common stock. During the first nine months of 2001, the Company borrowed $294,000 of which $263,000 was converted into common stock at $0.36 per share. An additional $140,000 borrowed under the notes during 2000 was converted into common stock and $40,000 was repaid. The promissory notes evidencing the loans are noninterest-bearing, mature in 2002, and are convertible into common stock of the Company at a rate of $0.36 per share. Comparison of Results of Operations Net Income. General economic conditions, the monetary and fiscal policies of federal agencies and the regulatory policies of agencies that regulate financial institutions affect the operating results of the Company. Interest rates on competing investments and general market rates of interest influence the Company's cost of funds. Lending activities are influenced by the demand for various types of loans, which in turn is affected by the interest rates at which such loans are made, general economic conditions and the availability of funds for lending activities. The Company's net income is primarily dependent upon its net interest income, which is the difference between interest income generated on interest-earning assets and interest expense incurred on interest- bearing liabilities. Provisions for credit losses, service charges, gains on the sale of assets and other income, noninterest expense and income taxes also affect net income. The Company experienced a $367,000 loss ($0.05 per share) for the three months ended September 30, 2001 compared to a $77,000 income ($0.01 per share) in the prior year period. During the third quarter of 2001 the Company recorded $204,000 expense due to the write-down in the carrying value of other real estate owned. Offsetting the effects of the write-down was a $150,000 recovery of interest and $10,000 recovery of legal fees associated with the repayment of a loan previous on non- accrual status. Results for the third quarter of 2000 include a $70,000 credit for provision for loan loss expense and income from a $396,000 bond recovery for fidelity losses incurred in prior periods. For the nine months ended September 30, 2001, the Company recorded a $910,000 loss ($0.14 per share) compared to a $504,000 loss ($0.09) during the same period of 2000. Results for the nine months ended September 30, 2000, include income realized from $785,000 of recoveries from fidelity bonds settlements (including the $396,000 realized during the third quarter of 2000) and a $39,000 gain from the sale of other real estate offset partly by a $35,000 expense for provision for credit losses. Results for the current nine-month period reflect a $204,000 write down in the carrying value of other real estate owned. The Company did not record any provision for credit losses expense or income from bond recovery or asset sales during 2001. The Company did not reflect any tax benefit with the loss incurred in 2001 because the Company cannot be certain that it will receive a future income tax benefit. The $99,000 tax expense and the $91,000 income tax benefit recorded in the third quarter and first nine months of 2000, respectively, were reversed in the fourth quarter of 2000 for the same reasons. Net Interest Income. Net interest income is the largest component of the Company's income and is affected by the interest rate environment and the volume and composition of interest-earning assets and interest-bearing liabilities. The Federal Reserve Board, in an attempt to stimulate the economy, reduced interest seven times during the first nine months of 2001. The Board increased rates three times during the first nine month of 2000. Future moves by the Federal Reserve are not accurately predictable. At September 30, 2000, the average prime interest rate was 9.50% and it is currently 5.00%. A significant portion of the bank's commercial loan portfolio is priced to fluctuate with changes in the prime interest rate. The average yield on federal funds purchased declined from 5.84% in January 2001 to 2.96% during September 2001. Mitigating the effect of declining interest rates were the effect of increasing loan volumes by decreasing federal funds purchased. In addition, yields on IPF and other components of the loan portfolio are not directly tied to movements in general interest rates. For the third quarter 2001, net interest income decreased $25,000, or 2.3%, compared to the same period last year due primarily to a 22 basis point decline in net interest margins. Third quarter 2001 results include $150,000 interest income from the repayment of a loan previously classified non-accrual. The Company's net interest margin was 5.20% for the third quarter of 2001 compared to 5.42% during the same period last year. The 22 basis point decrease in average net interest margin was primarily due to a 283 basis point decreased yields on federal funds, a 52 basis point decline in the yield on investment securities, and a 43 basis point reduction in average loan yields. Federal funds sold represented 7.3% of earning assets during the third quarter of 2001 versus 8.2% during the year ago period and the average yield declined from 6.33% to 3.5%. Yields on investment securities declined primarily due to the reinvestment of called or matured securities at lower yields. Average balance of loans increased $1.5 million from the year ago quarter while the average yield declined to 10.17% from 10.60%. The weighted-average yield on interest-earning assets was 9.01% versus 9.62% last year. For the nine months ended September 30, 2001, net interest income declined $260,000 due primarily to a $559,000 reduction in average earning assets and a shift in earning assets from loans to federal funds sold. The declining IPF loan trend experienced during year 2000 by the Company's IPF division accounted for the decline in average loan volumes. Some of the funds generated by the reduction of IPF loan volumes funded commercial loan growth while the average balance invested in Federal Funds rose from $5.4 million during the nine months of 2000 to $7.0 million during the 2001 comparable period. The Company's net interest margin was 4.75% for the nine months of 2001 compared to 5.20% during the same period last year. The 45 basis point decrease in average net interest margin was primarily due to a 153 basis point decrease yields on federal funds, a 44 basis point decreased yield on investment securities and a 4 basis point decreased loan yield coupled with a $2.6 million reduction in average loan balances. The average balance of IPF loans for the nine-month period of 2001 fell $9.1 million from the previous year period. The decline in IPF loan volumes was partly offset by growth in commercial and real estate loans. Federal funds sold represented 8.6% of earning assets during the first nine months of 2001 versus 6.7% during the year ago period and average yield declined from 6.16% to 4.63%. Yield on investment securities declined from 6.64% to 6.20% primarily due to the reinvestment of called or matured securities at lower yields. The weighted-average yield on interest-earning assets was 8.92% versus 9.25% last year. On a one-year horizon, the Company is liability sensitive, whereby its interest-bearing liabilities will generally mature or reprice more quickly than its interest-bearing assets. At September 30, 2001, 84% of the Company's certificates of deposits are scheduled to mature while 63% of the Company's interest bearing assets either reprice or mature within twelve months. Based on the Company's gap position, income should generally fall in periods of rising market interest rates and rise in periods of declining market interest rates. However, in a falling interest rate environment, the Company may need to maintain or increase rates to attract and retain deposits and assets may reprice more quickly than supporting liabilities. A large portion of the Company's commercial loans is priced to fluctuate with changes in the prime interest rate and federal funds purchased re- price daily. The yield on prime based loans and federal fund purchased can be directly and immediately affected by Federal Reserve policy actions. The rates paid on certificates of deposit and interest bearing demand deposits are more sensitive to the competitive environment and may not re-price in direct response to Federal Reserve policy actions. Shifts in the earning asset base from low yielding federal funds to higher yielding loan categories benefit the Company's net income in either rate environment. The Company increased its balance of noninterest bearing deposits from $15.0 million at December 31, 2000 to $16.0 million at September 30, 2001 and decreased its reliance on time deposits in denominations over $100,000, which slightly mitigated the negative gap position. Since December 31, 2000, total loans increased $4.2 million and non-accrual loans decreased $462,000 while $1.7 million of investment securities either matured or were called and reinvested at lower rates. Allowance and Provision for Credit Losses. The Company maintains an allowance for credit losses in an amount that, in management's judgment, is adequate to absorb reasonably foreseeable losses inherent in the loan portfolio. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors, including the performance of the Company's loan portfolio, the economy, changes in real estate values and interest rates and the view of the regulatory authorities toward loan classifications. The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level that is considered adequate to absorb losses inherent in the loan portfolio. The amount of the provision is based on management's review of the loan portfolio and consideration of such factors as historical loss experience, general prevailing economic conditions, changes in the size and composition of the loan portfolio and specific borrower considerations, including the ability of the borrower to repay the loan and the estimated value of the underlying collateral. All lending activity contains risks of loan losses and the Company recognizes these credit risks as a necessary element of its business activity. To assist in identifying and managing potential loan losses, the Company contracts with independent auditors to provide loan review services to evaluate individual credit relationships as well as overall loan portfolio conditions. One of the primary objectives of the loan review function is to make recommendations to management as to both specific loss reserves and overall portfolio loss reserves. The Company did not record a provision for credit losses during 2001 as management considered the allowance for credit losses adequate to absorb reasonably foreseeable losses inherent in the loan portfolio. During the third quarter of 2000, the Company reversed to income a $70,000 provision for credit losses expense accrued earlier in the year. Loan recoveries exceeded loan charge-offs by $72,000 during the third quarter of 2001 versus $20,000 net loan recovery during the previous year period. For the nine months ended September 30, 2001, loan recoveries exceeded loan charge-offs by $129,000 versus $194,000 net loan charge offs during the previous year period. The allowance for credit losses at September 30, 2001 was $1.4 million or 2.18% of loans and at December 31, 2000 was $1.3 million or 2.12% of loans outstanding. Nonperforming loans, defined as loans past due 90 days or more and loans for which the accrual of interest has been discontinued, totaled $978,000 at September 30, 2001 and $1.3 million at December 31, 2000. Nonperforming loans as a percentage of total loans totaled 1.53% and 2.16% at such dates. Management is attempting to increase its IPF and commercial loans but does not anticipate significant changes in loan portfolio risk in the near future, and will continue to monitor the appropriate factors when considering future levels of provisions and the allowance for loan losses. While management believes that it uses the best information available to determine the allowance for estimated loan losses, unforeseen market conditions could result in adjustments to the allowance for estimated loan losses and net earnings could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. Along with other financial institutions, management shares a concern for the possible continued softening of the economy in 2001. Should the economic climate continue to deteriorate, borrowers may experience difficulty, and the level of non-performing loans, charge-offs, and delinquencies could rise and require further increases in the provision. The Company has not detected any credit deterioration in its portfolio as a result of the September 11, 2001 attack on America but will continue to monitor its loan portfolio for the potential effect a war time economy might have on its borrowing customers. Noninterest Income. Noninterest income totaled $208,000 in the third quarter of 2001, compared to $534,000 in the third quarter of 2000. During the 2000 third quarter, the Company realized income from a $396,000 bond recovery for fidelity losses incurred in prior periods. Noninterest income for the first nine months of 2001 was $0.7 million versus $1.7 million during the first nine months of 2000, a $1.0 million decrease. Results for the nine months ended September 30, 2000, include income realized from $785,000 recovery from fidelity bonds settlements (including the $396,000 realized during the third quarter of 2000) and a $39,000 gain from the sale of other real estate. No such gains were realized during 2001. Noninterest Expense. Noninterest expense totaled $1.7 million for the three- month period ended September 30, 2001, representing a $122,000 increase from the same period in 2000. Included in non- interest expense is $204,000 write-down in the carrying value of other real estate owned. For the nine month period ended September 30, 2001, noninterest expense decreased $0.9 million from the year earlier period. Expenses declined primarily due to a reduced amortization of goodwill expense and cost cutting measures initiated last year, exemplified by reductions in salary and benefit expenses and other operating expenses. The effect of the cost reductions was partly offset by a $204,000 write down in the carrying value of other real estate owned. Salary and employee benefit expenses declined 7% when the third quarter of 2001 is compared to 2000 and by 20% for the comparative nine month periods. Salary expenses will rise in future periods, reflecting management's decision to staff each branch with a business development manager. Professional service expenses has been the largest component of other noninterest expense over the comparable periods. The $119,00 increase in the third quarter of 2001 versus third quarter of 2000 is due primarily to increased legal fees and the engagement of an investment advisor earlier this year. The $154,000 reduction in the comparative nine month periods is a result of higher accounting fees incurred in early 2000 related to the cost associated with the investigation of accounting irregularities in the IPF division. Amortization of intangibles and debt issuance cost declined due to a $2.1 million write-down of the goodwill associated with the TexStar acquisition recorded in the fourth quarter of 2000 that resulted in lower amortization expenses for future periods. Note number 8 to the consolidated financial statements presents other noninterest expenses in comparative format for the third quarters and for the nine-month periods of 2001 and 2000. The Company's efficiency ratio, excluding the impact of bond claim settlements and the write down of other real estate owned, was 69.7% for the three month period ended September 30, 2001 compared to 77.8% for the comparable period of 2000 and was 69.7% for the nine months ended September 30, 2001 versus 82.7% for the comparable period of 2000. The efficiency ratio measures the percentage of total revenues, on a taxable equivalent basis excluding securities gains and other nonrecurring gains, absorbed by noninterest expense. Expressed differently, for example, for every dollar of revenue the Company generated in the third quarter of 2001, the Company incurred $0.69 in overhead expenses. While significantly improved from the prior periods, the Company's efficiency ratios for the comparable periods compare unfavorably to other financial institutions in the Company's peer group. The Company operates seven full service branches. Management believes that it has established an infrastructure which will allow it to grow with only modest increases in overhead expenses, and that its efficiency ratio will continue to improve as an expression of revenues. The bank plans to add managers to each branch to better market the bank to general commercial businesses. The Bank added managers to two of the San Antonio branches during the third quarter. Income Taxes. The change in income tax expense/(benefit) is primarily attributable to a change in management's assessment of the potential realization of deferred tax assets. The Company recorded no income tax benefits during 2001. In 2000 the Company recorded a $99,000 provision for federal income tax expense for the three month period ended September 30, 2000 and a $91,000 federal income tax benefit for the nine-month period. In the fourth quarter of 2000, the Company reversed these accruals and did not record a tax benefit or provision expense for the year ended December 31, 2000. Liquidity Liquidity is the ability of the Company to fund customers' needs for borrowing and deposit withdrawals. The purpose of liquidity management is to assure sufficient cash flow to meet all of the financial commitments and to capitalize on opportunities for business expansion. This ability depends on the institution's financial strength, asset quality and types of deposit and investment instruments offered to its customers. The Company's principal sources of funds are deposits, loan and securities repayments, maturities of securities, sales of securities available for sale and other funds provided by operations. The Company also has the ability to borrow from the FHLB, subject to regulatory approval under the Formal Agreement. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan and mortgage-backed security prepayments are more influenced by interest rates, general economic conditions and competition. The Company maintains investments in liquid assets based upon management's assessment of (1) need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets and (4) objectives of the asset/liability management program. The Company also has in effect a $5 million credit facility with its primary correspondent bank. Cash and cash equivalents decreased $3.4 million or 31%, from $11.0 million at December 31, 2000 to $7.6 million at September 30, 2001. Cash and cash equivalents represented 8.1% of total assets at September 30, 2001 compared to 11.8% of total assets at December 31, 2000. Subject to regulatory approval under the Formal Agreement, the Company has the ability to borrow funds from the FHLB and has various federal fund sources from correspondent banks, should the Company need to supplement its future liquidity needs in order to meet deposit flows, loan demand or to fund investment opportunities. Management believes the Company's liquidity position is strong based on its high level of cash, cash equivalents, core deposits, the stability of its other funding sources and the support provided by its capital base. The Holding Company is without significant assets other than its ownership of all the common stock of the Bank and is entirely dependent upon dividends received from the Bank or borrowings from its officers and directors in order to meet its cash obligations, including debt service on the $4,350,000 aggregate principal amount of 9% Convertible Subordinated Notes due 2008 (the "Notes"), issued under an indenture dated as of March 31, 1998 between the Company and Harris Trust and Savings Bank, Chicago, Illinois, as trustee (the"Indenture"). Under the Formal Agreement the Bank is currently precluded from declaring and paying any dividends without prior OCC approval. On March 28, 2000, the OCC approved a reduction in the Bank's surplus in the amount of $500,000 that enabled the Company to meet debt service obligations under the Notes and pay for other operating expenses. No assurance can be given, however, that the OCC will approve any other such reductions in the Bank's surplus, particularly if the Bank is unable to commence operating profitably in the near future. In October 2000, certain current and former members of the Company's Board of Directors and an employee loaned the Company $260,000 to enable the Company to meet its cash obligations. The promissory notes evidencing the loans mature on January 2, 2002 and bear no interest from date of issuance until maturity. Additionally, the promissory notes are convertible into common stock at a rate of one share of common stock per $0.36 of principal amount of the notes. A former director also accepted a $38,000 noninterest-bearing note payable that matures December 31, 2001 in exchange for professional fees to the director's firm. In March 2001, certain Board members committed to advance up to $460,000, if needed, to enable the Company to meet its cash obligations in 2001. Any advances under the commitment will be evidenced by noninterest bearing notes convertible into common stock at $0.36 per share. During the first nine months of 2001, the Company borrowed $294,000 from members of its Board and other insiders, of which $263,000 was converted into common stock at $0.36 per share. An additional $140,000 borrowed under the notes during 2000 was converted into common stock and $40,000 was repaid. Additional borrowings occurred in October, 2001 to provide funds necessary to service interest payable on the convertible subordinated debt. Capital Resources Total shareholders' equity was $7.4 million at September 30, 2001, representing a $262,000 decrease from December 31, 2000. The impact of the $910,000 net loss was partially offset by a $245,000 after-tax increase in the fair value of securities available for sale and conversion of $403,000 of notes payable into common stock. The Holding Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Bank regulators monitor capital adequacy very closely and consider it an important factor in ensuring the safety of depositors' accounts. As a result, bank regulators have established standard risk-based capital ratios that measure the amount of an institution's capital in relation to the degree of risk contained in the balance sheet, as well as off-balance sheet exposure. Federal law requires each federal banking regulatory agency to take prompt corrective action to resolve problems of insured depository institutions including, but not limited to, those that fall below one or more prescribed capital ratios. According to the regulations, institutions whose Tier 1 and total capital ratios meet or exceed 6.0% and 10.0% of risk-weighted assets, respectively, are considered "well capitalized." Institutions whose Tier 1 and total capital ratios meet or exceed 4.0% and 8.0% of risk-weighted assets, respectively, are considered "adequately capitalized." Tier 1 capital is shareholders' equity excluding the unrealized gain or loss on securities classified as available for sale and intangible assets. Tier 2 capital, or total capital, includes Tier 1 capital plus the allowance for loan losses not to exceed 1.25% of risk-weighted assets. Risk-weighted assets are the Company's total assets after such assets are assessed for risk and assigned a weighting factor based on their inherent risk. In addition to the risk-weighted ratios, all institutions are required to maintain Tier 1 leverage ratios of at least 5.0% to be considered "well capitalized" and 4.0% to be considered "adequately capitalized." The leverage ratio is defined as Tier 1 capital divided by average adjusted assets for the most recent quarter. As discussed above, the Bank is subject to more stringent capital requirements under the Formal Agreement. The table below sets forth consolidated and Bank-only actual capital levels in addition to the capital requirements under the Formal Agreement and prompt corrective action regulations. Minimum Requirement To Be Well Actual Period-End Bank Formal Capitalized Capital Ratios Agreement For Capital Under Prompt Sept. 30, Dec. 31, December 31, Adequacy Action 2001 2000 2000 Purposes Requirements Leverage Ratios: Tier I capital to average assets Consolidated 5.20% 5.17% -- 4.00% 5.00% Bank 10.15% 9.83% 7.00% 5.00% 5.00% Risk-Based CapitalRatios: Tier I Capital to risk-weighted assets Consolidated 7.10% 7.76% -- 4.00% 6.00% Bank 13.82% 14.75% 6.00% 4.00% 6.00% Total capital to risk-weighted assets Consolidated 11.90% 12.88% -- 8.00% 10.00% Bank 15.07% 15.99% 14.00% 8.00% 10.00% PART II - OTHER INFORMATION Item 1. Legal Proceedings From time to time the Company is a defendant in various legal proceedings arising in connection with its ordinary course of business. In the opinion of management, the financial position of the Company will not be materially affected by the final outcome of any legal proceedings currently pending. Item 2. Changes in Securities and Use of Proceeds None during the third quarter. During the first nine months of 2001, certain current and former directors and other insiders converted $403,000 of funds advanced to the Company under convertible notes into 1,119,444 shares of common stock at $0.36 per share. 388,889 of the shares issued were in exchange for noninterest bearing convertible notes issued in 2000. The remaining 730,555 shares were funds advanced during 2001. Proceeds from the debt and stock issuance were used to pay interest due on the $4,350,000 in 9% Convertible Subordinated Notes Due 2008 and other operating expenses. See notes 5 and 6 of the notes to consolidated financial statements on page 11 for a more detailed description. In addition, as more fully explained in the Company's proxy statement for its 2001 shareholder meeting, certain officers and directors were awarded shares of common stock, which have not yet been issued, for past service to the Company. The Company relied on Regulation D for the exemption of registration under the Securities Act of 1933, as amended. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders Various matters were submitted to a vote of securities holders on October 17, 2001. The shareholders, at its annual meeting held October 17,2001 voted on the following matters: Elected six directors to serve for one year as members of the Company's Board of Directors. The Directors elected were Richard N. Abrams, Charles M. Ireland, Garrett Morris, David F. Chappell, Thomas J. Kwentus, and Guy J. Butts. Approved and ratified the proposed amendment of the Amended and Restated 1998 Incentive Stock Option Plan of Surety Capital Corporation; Approved and ratified Fisk & Robinson, P.C. as our independent public accountants for the 2001 fiscal year. Since the annual meeting, Fisk & Robinson, P.C. was acquired by another accounting firm and the Company has chosen another firm, as described in its Form 8-k filed with the SEC on October 26, 2001. Defeated a stockholder proposal that would have required management to solicit offers to purchase the Company's assets and liquidate the Company. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 11 Statement Regarding the Computation of Earnings Per Share. - Reference is hereby made to the Consolidated Statements of Operations on page 4 and Note 2 to the Consolidated Financial Statements on page 8 hereof. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended September 30, 2001. The Company filed a Form 8-k October 26, 2001, reporting , the resignation of Fisk & Robinson, P.C. as our independent public accountants for the 2001 fiscal year due to its dissolution and the appointment of Weaver and Tidwell LLP as the Company's independent public accountants. SIGNATURES In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: OCTOBER 14, 2001 SURETY CAPITAL CORPORATION By: Richard N. Abrams, Chief Executive Officer and Director (Principal Executive Officer) By: Mary Jo Davis, Vice President and Comptroller (Principal Financial Officer and Chief Accounting Officer) INDEX TO EXHIBITS Exhibit Number DESCRIPTION PAGE NUMBER II Statement Regarding the Reference is hereby Computation of Earnings made to the Per Share Consolidated Statements of Operations on page 4 and Note 2 to the Consolidated Financial Statements on page 8 hereof -----END PRIVACY-ENHANCED MESSAGE-----