10QSB 1 c79219e10qsb.txt FORM 10-QSB UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-QSB [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003 [ ] 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 [ ] Transitional Small Business Disclosure Format Yes [ ] No [X] Common stock outstanding on August 14, 2003: 9,926,244 shares SURETY CAPITAL CORPORATION INDEX
Page No. -------- PART I - FINANCIAL INFORMATION ITEM 1 Financial Statements (Unaudited) Consolidated Balance Sheets 3 Consolidated Statements of Operations 4 Consolidated Statements of Comprehensive Income 5 Condensed Consolidated Statements of Changes in Shareholders' Equity 6 Condensed Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 16 ITEM 3 Controls and Procedures 24 PART II - OTHER INFORMATION ITEM 1 Legal Proceedings 25 ITEM 2 Changes in Securities and Use of Proceeds 25 ITEM 3 Defaults Upon Senior Securities 25 ITEM 4 Submission of Matters to a Vote of Security Holders 25 ITEM 5 Other Information 25 ITEM 6 Exhibits and Reports on Form 8-K 25
SURETY CAPITAL CORPORATION CONSOLIDATED BALANCE SHEETS
June 30, December 31, 2003 2002 -------------- ------------- (Unaudited) Assets: Cash and due from banks $ 4,315,051 $ 3,036,069 Federal funds sold 10,943,947 15,375,333 ------------- ------------- Total cash and cash equivalents 15,258,998 18,411,402 Interest-bearing time deposits in other financial institutions 28,449 28,330 Securities available for sale, at fair value 4,348,318 4,522,298 Loans, net 67,464,254 71,045,339 Premises and equipment, net 4,831,944 5,057,699 Accrued interest receivable 373,482 334,990 Other real estate and repossessed assets 3,404,711 1,798,022 Goodwill, net 2,536,679 2,536,679 Other assets 370,826 314,304 ------------- ------------- Total assets $ 98,617,661 $ 104,049,063 ============= ============= Liabilities: Noninterest-bearing demand deposits $ 18,970,273 $ 17,162,910 Savings, NOW and money market accounts 24,374,635 31,086,993 Time deposits, $100,000 and over 16,098,580 16,290,328 Other time deposits 29,526,955 29,485,465 ------------- ------------- Total deposits 88,970,443 94,025,696 Convertible subordinated debt 4,350,000 4,350,000 Accrued interest payable and other liabilities 1,121,561 1,046,121 ------------- ------------- Total liabilities 94,442,004 99,421,817 ------------- ------------- 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, 100,061 100,061 10,006,080 and 10,006,080 shares issued, respectively Additional paid-in capital 18,085,533. 18,085,533 Accumulated deficit (13,726,292) (13,272,759) Treasury stock, 79,836 shares at cost (375,443) (375,443) Accumulated other comprehensive income 91,798 89,854 ------------- ------------- Total shareholders' equity 4,175,657 4,627,246 ------------- ------------- Total liabilities and shareholders' equity $ 98,617,661 $ 104,049,063 ============= =============
See accompanying notes to consolidated financial statements. SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
Three Months Ended Six Months Ended ---------------------------- ---------------------------- June 30, June 30, June 30, June 30, 2003 2002 2003 2002 ----------- ----------- ----------- ----------- Interest income: Loans, including fees $ 1,353,335 $ 1,426,411 $ 2,792,032 $ 2,712,316 Securities, all taxable 40,725 112,531 82,374 215,243 Federal funds sold and interest bearing deposits 32,409 40,004 64,300 78,681 ----------- ----------- ----------- ----------- Total interest income 1,426,469 1,578,946 2,938,706 3,006,240 Interest expense: Deposits 445,705 452,458 908,218 945,340 Notes payable 97,875 97,875 195,750 195,750 ----------- ----------- ----------- ----------- Total interest expense 543,580 550,333 1,103,968 1,141,090 ----------- ----------- ----------- ----------- Net interest income 882,889 1,028,613 1,834,738 1,865,150 Provision for credit losses -- 250,000 -- 250,000 ----------- ----------- ----------- ----------- Net interest income after provision for credit losses 882,889 778,613 1,834,738 1,615,150 Noninterest income: Service charges on deposit accounts 147,754 197,593 310,330 366,511 Other fee income 3,402 6,524 9,858 11,585 Other income 32,154 144,159 94,345 195,022 ----------- ----------- ----------- ----------- Total noninterest income 183,310 348,276 414,533 573,118 Noninterest expense: Salaries and employee benefits 735,469 821,987 1,481,817 1,606,979 Occupancy and equipment 236,426 263,519 476,926 524,158 Other expenses 380,753 518,953 744,061 963,322 ----------- ----------- ----------- ----------- Total noninterest expense 1,352,648 1,604,459 2,702,804 3,094,459 ----------- ----------- ----------- ----------- Net loss before income taxes (286,449) (477,570) (453,533) (906,191) Income tax (benefit) -- -- -- -- ----------- ----------- ----------- ----------- Net income (loss) $ (286,449) $ (477,570) $ (453,533) $ (906,191) =========== =========== =========== =========== Net income (loss) per share - Basic $ (0.03) $ (0.05) $ (0.05) $ (0.10) =========== =========== =========== =========== Net income (loss) per share - Diluted $ (0.03) $ (0.05) $ (0.05) $ (0.10) =========== =========== =========== ===========
See accompanying notes to consolidated financial statements. SURETY CAPITAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
Three Months Ended Six Months Ended ------------------------ ------------------------ June 30, June 30, June 30, June 30, 2003 2002 2003 2002 --------- --------- --------- --------- Net income (loss) $(286,449) $(477,570) (453,533) $(906,191) Other comprehensive income (loss): Unrealized gain (loss) on available -for sale securities arising during period, net of Tax effect 7,908 72,349 1,944 48,812 --------- --------- --------- --------- Total other comprehensive income (loss) 7,908 72,349 1,944 48,812 --------- --------- --------- --------- Comprehensive income (loss) (278,541) $(405,221) $(451,589) $(857,379) ========= ========= ========= =========
See accompanying notes to consolidated financial statements. SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Six Months Ended ---------------------------- June 30, June 30, 2003 2002 ----------- ----------- Balance at beginning of period $ 4,627,246 $ 6,974,692 Issuance of Common Stock -- 221,506 Net income (loss) (453,533) (906,191) Change in fair value of securities available for sale, net of tax 1,944 48,812 ----------- ----------- Balance at end of period $ 4,175,657 $ 6,338,819 =========== ===========
See accompanying notes to consolidated financial statements. SURETY CAPITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six Months Ended ----------------------------- June 30, June 30, 2003 2002 ------------- ------------ Net cash from operating activities $ (285,341) $ (535,313) Cash flows from investing activities: Net change in loans 1,929,757 (7,001,986) Securities available for sale: Purchases - Available for sale (101,389) (8,200,000) Maturities, calls, and repayments 262,066 7,544,274 Proceeds from the sales of other real estate and repossessed assets 105,166 Premises and equipment expenditures (7,410) (125,328) ------------- ------------- Net cash from investing activities 2,188,190 (7,783,040) ------------- ------------- Cash flows from financing activities: Issuance of common stock - 221,506 Increase (decrease) in notes payable - (132,746) Net change in deposits (5,055,253) 5,072,320 ------------- ------------- Net cash from financing activities (5,055,253) 5,161,080 ------------- ------------- Net change in cash and cash equivalents (3,152,404) (3,157,273) Cash and cash equivalents at beginning of period 18,411,402 14,402,913 ------------- ------------- Cash and cash equivalents at end of period $ 15,258,998 $ 11,245,640 ============= ============= Supplemental disclosures: Cash paid for interest $ 929,885 $ 759,996 Cash paid (refunds received) for federal income taxes -- -- Significant non-cash transactions: Conversion of notes payable to common stock -- $ 95,000 Transfers of repossessed collateral to other real estate and repossessed assets $ 1,651,328 $ 8,351 Issuance of common stock in settlement of notes payable and -- $ 221,506 accrued director fees Write-down of carrying value of other real estate owned -- $ (41,000)
See accompanying notes to consolidated financial statements. 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 June 30, 2003, 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, 2002, included in its annual report on Form 10-KSB for the fiscal year ended December 31, 2002 (the "2002 Form 10-KSB"). Please refer to the accounting policies of the Company described in the notes to financial statements contained in the 2002 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. Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and other Intangible Assets." Goodwill, which represents the excess of cost over the fair value of the net assets of an acquired business, was amortized on a straight-line method up to fifteen years prior to the adoption of SFAS No. 142. Effective January 1, 2002, goodwill is no longer amortized but tested for impairment annually or whenever events or changes in circumstances indicate that the carrying amount should be assessed. Impairment, if any, for goodwill is recognized as a permanent charge to noninterest expense. Management has determined that there is no goodwill impairment as of December 31, 2002. The Company applies the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations, in accounting for its stock-based compensation plans. Under Opinion 25, compensation cost is measured as the excess, if any, of the market price of the Company's stock at the date of the grant above the amount an employee must pay to acquire the stock. No compensation expense is recognized when the exercise price is equal to the market value of the stock on the day of grant. The Financial Accounting Standards Board ("FASB") published SFAS No. 123, "Accounting for Stock-Based Compensation" (SFAS No. 123) on January 1, 1996 which encourages, but does not require, companies to recognize compensation expense for grants of stock, stock options and other equity instruments to employees based on new fair value accounting rules. Companies that choose not to adopt the new rules will continue to apply the existing rules, but will be required to disclose pro forma net income under the new method. The following table reflects charges calculated under SFAS No. 123 of $0 and $7,840 for the three and six months ending June 30, 2003 and 2002, respectively.
Three Months Ended Six Months Ended --------------------------- -------------------------- June 30, June 30, June 30, June 30, 2003 2002 2003 3002 ------------ ----------- ----------- --------- Net income (loss) As reported $ (286,449) $ (477,570) $ (453,533) (906,191) Pro forma $ (286,449) (488,689) $ (453,533) (928,429) Net income (loss) per share As reported Basic $ (0.03) $ (0.05) $ (0.05) $ (0.10) Diluted Pro forma Basic $ (0.03) $ (0.05) (0.09) (0.11) Diluted $ (0.03) $ (0.05) (0.02) (0.11)
The financial statements have been prepared on a going concern basis, which contemplates realization of assets and liquidation of liabilities in the ordinary course of business. The Company has incurred significant losses, is operating under a written formal agreement with the OCC and a memorandum of understanding with the Federal Reserve Board and is in default on the interest payments on the subordinated debt. The appropriateness of using the going concern basis is dependent upon the Company's ability to improve profitability through increasing marketing efforts, introducing new deposit products, emphasizing loan growth and reducing non-interest expense. In addition, the Company must meet the requirements of the formal agreement and the memorandum of understanding. The uncertainty of these conditions raises substantial doubt about its ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. 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 Six Months Ended ------------------------ ------------------------ June 30, June 30, June 30, June 30, 2003 2002 2003 2002 --------- --------- --------- --------- Weighted-average shares outstanding- 9,926,244 9,239,244 9,926,244 8,620,490 Basic Effect of stock options -- -- -- -- --------- --------- --------- --------- Weighted-average shares outstanding-Diluted 9,926,244 9,239,244 9,926,244 8,620,490 ========= ========= ========= =========
The Company reported a net loss for the three and six-month periods ended June 30, 2003 and 2002. 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 consisted of the following:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains ( Losses) Value ------------ ------------ ------------ ------------ June 30, 2003: U.S. Treasury notes $ 99,572 $ -- $ 3,136 $ 96,436 U.S. government agencies 3,014,205 86,733 -- 3,100,938 Mortgage-backed securities 370,740 8,201 -- 378,941 Other securities 772,003 -- -- 772,003 ------------ ------------ ------------ ------------ Total $ 4,256,520 $ 94,934 $ 3,136 $ 4,348,318 ============ ============ ============ ============ December 31, 2002: U.S. government agencies $ 3,228,569 $ 86,150 $ -- $ 3,314,719 Mortgage-backed securities 433,771 3,704 -- 437,475 Other securities 770,104 -- -- 770,104 ------------ ------------ ------------ ------------ Total $ 4,432,444 $ 89,854 $ -- $ 4,522,298 ============ ============ ============ ============
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, 2002 or June 30, 2003. 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 ("FHLB"). The amortized cost and estimated fair value of securities available for sale at June 30, 2003 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.
Estimated Amortized Fair Cost Value ------------ ----------- Due within one year $ 1,111,374 $ 1,120,812 Due after one year through five years 2,002,403 2,076,562 Due after five years through ten years -- -- Mortgage-backed securities 370,740 378,941 Other securities 772,003 772,003 ------------ ----------- Total securities available for sale $ 4,256,520 $ 4,348,318 ============ ===========
There were no sales of securities available for sale during the three-month or six month periods ended June, 2003 and June 30, 2002. However, various bonds were called and principal payments were received on mortgage backed securities during each period. 4. Loans Loans consisted of the following:
June 30, December 31, 2003 2002 ------------ ------------- Real estate loans $ 41,000,340 $ 42,521,100 Insurance premium financing 8,759,379 10,221,479 Commercial loans 12,388,048 13,219,136 Consumer loans 6,709,904 6,514,280 Accounts receivable factoring 575,803 309,044 ------------ ------------ Total gross loans 69,433,474 72,785,039 Unearned interest (391,653) (278,213) Allowance for credit losses (1,577,567) (1,461,487) ------------ ------------ Loans, net $ 67,464,254 $ 71,045,339 ============ ============
Activity in the allowance for credit losses on loans was as follows:
Three Months Ended Six Months Ended --------------------------- --------------------------- June 30, June 30, June 30, June 30, 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Beginning balance $ 1,577,545 $ 1,102,020 $ 1,461,487 $ 1,266,463 Provision for credit losses -- $ 250,000 -- 250,000 Charge-offs (56,471) (113,757) (94,787) (350,292) Recoveries 56,493 89,765 210,867 161,857 ------------ ------------ ------------ ------------ Ending balance $ 1,577,567 $ 1,328,028 $ 1,577,567 $ 1,328,028 ============ ============ ============ ============
Impaired loans were as follows:
June 30, December 31, 2003 2002 ------------- ------------- Impaired loans with allowance allocated $ 7,676,762 $ 7,597,872 Impaired loans with no allowance allocated -- 60,183 ------------- ------------- Total impaired loans $ 7,675,762 $ 7,658,055 ============= ============= Amount of the allowance allocated $ 910,785 $ 955,740 ============= =============
Nonperforming loans were as follows:
June 30, December 31, 2003 2002 ------------- ------------- Loans past due over 90 days still on accrual $ 1,698,062 $ 1,206,742 Nonaccrual loans 1,265,473 2,817,722 ------------- ------------- Total nonperforming loans $ 2,963,535 $ 4,024,464 ============= =============
5. Convertible Subordinated Debt and Notes Payable On March 31, 1998, the Holding 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. The Company did not pay the interest due March 31, 2002, September 31, 2002, or March 31, 2003. In February 2002, the Company notified holders of its convertible debt that it will not have funds to make future interest payments and offered the holders certain options as alternatives to interest payments. As of June 30, 2003, no agreement had been reached as to any restructuring of the convertible debt. The amount of the principal and any accrued and unpaid interest on the Notes is 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. The Notes are not subject to mandatory redemption or sinking fund provision. At any time after March 31, 2002 and prior to maturity, the Notes are redeemable for cash at the option of the Company, on at least 30 but not more than 60 days notice, in whole or in part, at the redemption prices set forth in the table below, plus accrued interest to the date of redemption.
If Redeemed During Percentage of If Redeemed During Percentage of 12 Months Ending Principal 12 Months Ended Principal March 31, Amount March 31, Amount ------------------ ------------- ------------------ ------------- 2003 105% 2006 102% 2004 104% 2007 101% 2005 103% 2008 100%
In October and November 2001, certain current and former members of the Company's Board of Directors and one employee loaned the Company $297,746 to enable the Company to meet its cash obligations. $37,746 of the promissory notes evidencing the loans advanced in 2001 matured December 31, 2001 and was due to a company in which a former director held an interest. This note was settled in January 2002 with payment of $25,000. During 2002, an additional $195,000 was lent to the Company. $95,000 and $320,000 of the promissory notes were converted into common stock during the years ending December 31, 2002 and 2001, respectively. A total of 438,392 and 888,885 shares of common stock were issued upon conversion of the above notes payable in 2002 and 2001, respectively. 6. 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 June 30, 2003 and December 31, 2002 included unfunded loan commitments of $4,876,000 and $4,341,000 and letters of credit of $611,000 and $450,000, respectively. Federal funds sold totaled $10,943,947 and $15,375,333 at June 30, 2003 and December 31, 2002, respectively. 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 Finance ("IPF") loans, secured by the residual value of unearned insurance premiums, comprised $8,759,379 or 12.62%, and $10,221,479, or 14.0%, of gross loans at June 30, 2003 and December 31, 2002, respectively. 7. Other Noninterest Expense Other noninterest expense consisted of the following:
Three Months Ended Six Months Ended ------------------------- ------------------------- June 30, June 30, June 30, June 30, 2003 2002 2003 2002 ---------- ---------- ---------- ---------- Legal, auditing, and other professional services $ 110,547 $ 157,639 $ 204,746 $ 251,149 Postage and delivery 52,528 32,459 84,247 64,120 Telephone 23,124 27,094 50,605 61,313 Office supplies 17,177 23,033 39,993 43,213 Amortization of intangibles and debt issuance costs 10,398 10,398 20,796 20,796 Insurance 49,083 44,329 75,166 81,792 FDIC and OCC assessments 25,978 25,256 57,414 50,346 Other 91,918 198,745 211,094 390,593 ---------- ---------- ---------- ---------- Total other noninterest expense $ 380,753 $ 518,953 $ 744,061 $ 963,322 ========== ========== ========== ==========
NOTE 8. BUSINESS SEGMENTS The accounting policies of the segments are the same as those described above in Note 1. The Company evaluates segment performance based on interest income and profit or loss from operations.
Insurance Community Premium Banking Financing Total -------------- -------------- -------------- Six month period ended June 30, 2003: Interest income $ 2,393,408 $ 545,298 $ 2,938,706 Provision for credit losses -- -- -- Noninterest income 414,533 -- 414,533 Noninterest expense 2,352,667 350,137 2,702,804 Net income (loss) (648,694) 195,161 (453,533) Six month period ended June 30, 2002: Interest income $ 2,492,161 $ 514,079 $ 3,006,240 Provision for credit losses 250,000 - 250,000 Noninterest income 573,118 -- 573,118 Noninterest expense 2,747,250 347,209 3,094,459 Net income (loss) (1,073,061) 166,870 (906,191) Three month period ended June 30, 2003: Interest income $ 1,183,336 $ 243,133 $ 1,426,469 Provision for credit losses -- -- -- Noninterest income 183,310 -- 183,310 Noninterest expense 1,171,869 180,779 1,352,648 Net income (loss) (407,859) 121,410 (286,449) Three month period ended June 30, 2002: Interest income $ 1,202,322 $ 376,624 $ 1,578,946 Provision for credit losses 250,000 - 250,000 Noninterest income 348,276 -- 348,276 Noninterest expense 1,441,197 163,262 1,604,459 Net income (loss) (617,181) 139,611 (477,570) At June 30, 2003: Loans, gross $ 60,556,162 $ 8,579,379 $ 69,433,474 Total assets $ 90,449,826 $ 8,167,835 $ 98,617,661 At December 31, 2002 Loans, gross $ 62,563,560 $ 10,221,479 $ 72,785,039 Total assets $ 94,697,845 $ 9,351,218 $ 104,049,063
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 June 30, 2003 compared to December 31, 2002, and the consolidated results of operations for the six-month and three-month periods ended June 30, 2003 compared to the same periods in 2002. 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 This document contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have material adverse effects on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following: - The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets. - The economic impact of past and any future terrorist attacks, acts of war or threats thereof and the response of the United States (which may include military action) to any such threats and attacks. - The costs, effects and outcomes of existing or future litigation. - The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters. - The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company's assets) and the policies of the Board of Governors of the Federal Reserve System. - The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector. - The inability of the Company to obtain new customers and to retain existing customers. - The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. - Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers. - The ability of the Company to develop and maintain secure and reliable electronic systems. - The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner. - Consumer spending and saving habits which may change in a manner that affects the Company's business adversely. - Business combinations and the integration of acquired businesses that may be more difficult or expensive than expected. - Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. - The ability of the Company to manage the risks associated with the foregoing as well as its inability to meet its obligations under the subordinated convertible notes including interest payments that became due March 31, 2002 and subsequent periods which the Company has not made. - The ability of the Company to comply with the terms of the Formal Agreement with the OCC entered into on February 18, 2003 as more fully discussed below under "Regulatory Relations". These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission. REGULATORY RELATIONS FORMAL AGREEMENT WITH THE OCC. On November 19, 1998, the Board of Directors of the Bank entered into a formal written agreement (the "Formal Agreement") with the Office of the Comptroller of the Currency (the "OCC") pursuant to which the Bank was required to achieve certain capital levels and adopt and implement certain plans, policies and strategies by March 31, 1999. The Bank initially was unable to achieve the capital requirements set forth in the Formal Agreement and after receiving an extension from the OCC the Bank achieved the required levels of capital upon completion of the sale of the Midlothian and Waxahachie branches on June 30, 1999. It remained in compliance until 2002. At December 31, 2002 and March 31, 2003, the Bank was not in compliance with two of the capital ratio requirements. Tier I capital to average assets was 6.69% at March 31, 2003 and 6.36% at December 31, 2002 and total capital to risk-weighted assets was 10.02% at March 31, 2003 and 10.86% at December 31, 2002 versus the ratios required under the Formal Agreement of 7.00% and 14.00%, respectively. On February 18, 2003, the Bank and the OCC entered into a new formal written agreement (the "New Formal Agreement") that replaced the prior agreements. The New Formal Agreement requires the Bank to develop, within ninety days of the agreement, an action plan detailing the Board of Directors' assessment of how to improve the Bank including implementation and timetable. The New Formal Agreement also includes provisions for new appointments to the Board of Directors, management effectiveness, adoption of a three-year strategic plan, develop a three-year capital program, prepare a three-year business plan, develop a written program to improve the Bank's loan portfolio and implement an internal audit program. The Bank has complied with these requirements. In addition, the New Formal Agreement requires that the Bank achieve ratios of Tier I capital to average assets of at least 8.0% and total capital to adjusted total assets of 12.0% by June 30, 2003. The Board of Directors is also required to The New Formal Agreement sets forth time limits to achieve each of the required actions. The OCC may extend the time requirements for good cause upon written application from the Board of Directors. If the Bank fails to achieve substantial compliance with the New Formal Agreement within ninety (90) days of the expiration of the time limits (including any duly granted extensions of time), the Board of Directors must provide a written report setting out its plans to sell, merge, or liquidate the Bank. The Board of Directors and management intend to comply with the provisions of the New Formal Agreement. However, compliance with provisions of the Formal Agreement cannot be assured. As of July 8, 2003, the Bank was in compliance with seven of the nine Articles in the New Formal Agreement that required some type of action. The bank did not meet the new ratio requirements. At June 30, 2003, Tier I capital to average assets was 6.7% versus the 8% required under the New Formal Agreement. Risk based capital to total risk-based assets w as 9.99% vs 12.0% required under the New Formal Agreement. The OCC was also not satisfied with the Bank's compliance with an article within the New Formal Agreement that required the bank to develop a report and written action plan related to criticized assets. The Bank enhanced those reports to comply with the OCC's criticism and now feels it is in compliance. The Company is actively pursuing several other alternatives in an effort to strengthen capital positions. MEMORANDUM OF UNDERSTANDING. On October 28, 1999, the Board of Directors of the Company entered into a Memorandum of Understanding (the "MOU") with the Board of Governors of the Federal Reserve System (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 Company was required to develop and submit to the FRB a written three-year capital plan, a plan to service the Company's existing debt without incurring any additional debt, and written procedures designed to strengthen and maintain the Company's internal records and controls to ensure that future regulatory reports are filed in a timely and accurate manner. Finally, the 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 Company has not yet met any of its interest payment obligations on the $4.350 million convertible subordinated debt since missing the payment that was due March 31, 2002. At June 30, 2003 and December 31, 2002, the Company did not meet the capital ratios established for capital adequacy purposes. Tier I capital to average assets was 1.60% and 1.99%, respectively, Tier I capital to risk-weighted assets was 2.14% and 2.65%, respectively, and total capital to risk-weighted assets was 4.46% and 5.24%, respectively, versus ratios established by the FRB for capital adequacy purposes of 4.00%, 4.00% and 8.00%, respectively. The FRB may take formal action including requiring that capital be increased or that the Company divest the Bank. SECURITIES AND EXCHANGE COMMISSION AGREEMENT. The Company is subject to the reporting requirements of the Securities Exchange Act of 1934, as amended ("The Exchange Act"). The Securities and Exchange Commission ("SEC") investigated the Company and others with respect to various accounting irregularities found by the Company in its IPF division during an internal audit of the division conducted in 1999 and the first quarter of 2000. Upon finding the irregularities, the Company reported them to the SEC, the OCC as well as certain other legal authorities. The Company fully cooperated with the SEC as well as bank regulatory agencies involved in investigating the irregularities. In February 2002, the SEC issued a finding that the Company violated certain sections of the Exchange Act. In March 2002, the Company entered into a settlement with the SEC. In connection with the settlement, the Company acknowledged certain reporting and internal control deficiencies and agreed to cease and desist from the stipulated violations in the future. The Company and the Bank no longer employ the persons directly responsible for managing the IPF division during the period when the diversions occurred and the Company no longer uses the services of the accounting firm auditing the Company at that time. None of the current members of the Company or Bank's Board of Directors served in those capacities during the period when the violations of the Exchange Act occurred. ANALYSIS OF FINANCIAL CONDITION The Company's assets totaled $98.6 million at June 30, 2003, representing a $5.4 million, or 5.2%, decrease compared to $104.0 million at December 31, 2002. Cash and cash equivalents declined $3.1 million, securities available for sale declined $174 thousand and loans, adjusted for transfers to other real estate, declined $1.6 million. The decrease in assets was primarily the result of the management's decision to discontinue soliciting funds from cities, counties, and other political subdivisions ("public funds"). Public funds deposits declined $7.4 million. The decline was partly offset by increases in other deposit categories. The decline in cash and securities were directly related to the paying off of public fund deposit accounts Total securities declined $174,000, or 3.8%, due to primarily to a $100,000 net reduction in Treasury securities and repayments on mortgage-backed securities and were $4.3 million at June 30, 2003. Net unrealized gains were $92,000 at June 30, 2003 compared to $90,000 at December 31, 2002. Net loans decreased $3.6 million, or 5.0%, from $71.0 million at December 31, 2002 to $67.5 million at June 30, 2003. IPF loans decreased $1.5 million, or 14.3%, from December 31, 2002 due primarily from the loss of a customer that referred significant business to the Bank. Real estate loans decreased $1.5 million, or 3.6%, due primarily to the foreclosure on a loan secured by industrial property and transfer of the collateral to other real estate and repossessed assets. Commercial loans decreased $831 thousand, or 6.3%, due primarily to normal repayments. Loans, net of unearned interest, as a percentage of total deposits were 79.6% at June 30, 2003 compared to 77.1% at December 31, 2002. Other real estate owned and repossessed assets increased $1.6 million to $3.4 million at June 30, 2003. During the second quarter, the Bank foreclosed on a loan secured by industrial property. The Small Business Administration ("SBA") owned a second lien on the property equal to approximately 40% of the original purchase price. The SBA's position was extinguished in the foreclosure proceedings and the Bank owns the land with no encumbrances. Accordingly, the appraised value of the property significantly exceeds the Bank's carrying value and no loan loss was recorded as a result of the foreclosure. Other assets and accrued interest receivable increased $95,000 from December 31, 2002. Total deposits were $89.0 million at June 30, 2003, a $5.0 million decrease, or 5.4%, from December 31, 2002. Noninterest-bearing demand deposits increased $1.8 million to $19.0 million and represented 21.3% of total deposits at June 30, 2003 compared to $17.2 million, or 18.3% of total deposits, at December 31, 2002. Savings, NOW and money market accounts decreased $6.7 million or 21.6 %, due primarily to a $5.0 million decrease in public funds deposits and a $2.4 million decline in money market accounts, offset partly by growth in other savings categories. Public funds deposits require the pledging of investment securities. Management decided not to pursue certain public fund accounts due to minimum profitability of public funds deposits and to decrease total assets to comply with capital ratios established under the New Formal Agreement. Time deposits over $100,000 and other time deposits decreased $150,000. Time deposits made up 51.3% of the deposit portfolio at June 30, 2003 compared to 48.7% at December 31, 2002. Substantially all of the Company's time deposits mature in less than five years and are obtained from customers in the Company's primary market. The Company does not purchase brokered deposits. 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 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 June 30, 2003 and December 31, 2002. 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 has not yet met any of its interest payment obligations on the $4.4 million convertible subordinated debt since missing the payment that was due March 31, 2002. In February 2002, the Company notified the holders of its convertible debt that it will not have funds to make future interest payments and offered the holders certain options as alternatives to interest payments. As of June 30, 2003, no agreement had been reached as to any restructuring of the convertible debt. Management does not know if it will be successful in these negotiations. The amount of the principal and any accrued and unpaid interest on the notes is 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. 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. In January 2003, the Company closed its branch office in Schertz, Texas. Approximately $2.0 million of loans and $6.5 million of deposits serviced by the branch were transferred to other branches in the area. The effects of the branch closing did not have a material effect on first or second quarter results of operations. The Company experienced a $286,000 net loss for the three months ended June 30, 2003 ($0.03 per share) compared to a $478,000 ($0.05 per share) net loss for the same period in 2002. For the six-month period ended June 30, 2003, the company recorded a $454,000 loss ($0.05 per share) compared to a $906,000 loss ($0.10 per share) during the same period of 2002. The Company did not reflect any tax benefit with the losses because the Company cannot be certain that it will receive a future income tax benefit. The loss is due primarily to the inability to generate sufficient levels of net interest income and fee income sufficient to offset normal operating expenses. The improvement in reducing the level of losses between periods is due primarily to a $250,000 provision for credit loss expense recorded in the 2002-second quarter and a $251,000 reduction in non-interest expenses. No provision for credit loss expense was recorded during 2003. Partly offsetting the benefits of these expense reductions were a $146,000 reduction in net interest income and a $164,000 reduction in non-interest income. Non-interest income for the 2002 second quarter included a $133,000 gain on the settlement of a retirement agreement with the former chairman. At June 30, 2003 total other real estate owned and repossessed assets was $3.4 million and loans on non-accrual status were $1.3 million. These non-performing assets represented $4.6 million or 4.8% of total assets. Resolution of these problem assets would have a positive effect for the Company's operations. 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. For the first quarter 2003, net interest income decreased $146,000, or 14%, compared to the same period last year. This is due to a decline in short term interest rates and a shift in asset mix. The Company's net interest margin was 4.13% for the second quarter of 2003 compared to 4.70% during the same period last year. The weighted average yield on total interest-earning assets was 6.67% for the second quarter of 2003, a 34 basis point decline from the 7.01% realized during the same quarter last year. The average balance invested in federal funds sold increased $1.9 million over last year to $11.2 million while the average yield on federal funds sold declined from 1.72% during the second quarter of 2002 to 1.16% during the second quarter of 2003, a 55 basis point decline. Average balance of securities available for sale declined $7.2 million and the yield fell 19 basis points as government agencies called higher yielding securities. The average yield on loans declined from 8.57% to 7.74% due primarily to a reduction in IPF loans and a decrease in short term interest rates. The prime rate of interest averaged 4.25% during the second quarter of 2002 versus 4.75% during the year ago period, a 50 basis point decrease. The average balance of IPF loans declined nearly $2 million from the second quarter of 2002. The average yield on total earning assets declined 55 basis points to 6.7% while the average rate paid on interest bearing liabilities declined 5 basis points to 2.89% resulting in a 36 basis point decrease in net interest margins to 4.13%. The average balance of non-interest bearing deposits was $18.4 million and $17.7 million during the second quarter of 2003 and 2002, respectively. For the six month period ended June 30, 2003, net interest income declined $67,000. Loans represented 81% of average earning assets and the yield declined 47 basis points, consistent with the 50 basis point drop in the average prime interest rate. Average yield on total earning assets declined only 26 primarily because total loan volumes rose $5.9 million and produced an average yield of 7.94% while average balance of securities available for sale, which yielded 3.24%, declined $6 million. The average balance of non-interest bearing deposits was $17.9 million and $22.0 million during the six month periods ended June 30, 2003 and 2002, respectively. The Company remains asset sensitive, whereby its interest-earning assets will generally reprice more quickly than its interest-bearing liabilities. Therefore, the Company's net interest margin will generally increase in periods of rising market interest rates and will decrease in periods of declining market interest rates. However, in a rising interest rate environment, the Company may need to increase rates to attract and retain deposits. 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. 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 experience any loan losses during the second quarter of 2003 versus $24,000 or loan losses, net of recoveries, during the same period of 2002. Recoveries of loans previously charged- off exceeded loan losses by $116,000 for the six months ended June 30, 2003 compared to Loan losses, net of recoveries, of $188,000 during the first six months of 2002. The allowance for credit losses at June 30, 2003 was $1.6 million, or 2.3% of period end loans, versus $1.3 million, or 2.0% of period end loans, loans at June 30, 2002. Nonperforming loans, defined as loans past due ninety days or more and loans for which the accrual of interest has been discontinued, totaled $3.0 million at June 30, 2003, a decrease from $4.0 million at December 31, 2002. Non-accrual loans declined $1.5 million due primarily to the foreclosure of a loan secured by industrial property. The decline in non accrual loans was partly offset by a $491 thousand increase in loans past due over 90 days and still on accrual. Nonperforming loans as a percentage of total loans were 4.3% at June 30, 2003 and 5.6%, at December 31, 2002. In May 2003, the Bank foreclosed on a $1.5 million commercial loan secured by industrial real estate and now owns the property. The loan was one of the loans for which the accrual of interest had been discontinued and was included in nonperforming loan totals for December 31, 2002. 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. NONINTEREST INCOME. Noninterest income totaled $183,000 in the second quarter of 2003, compared to $348,000 in the second quarter of 2002, a $165,000 decrease. Service charges on deposit account income declined $50,000. The decline is primarily due to overdraft charges assessed in 2002 to two companies that are no longer Bank customer. Other non-interest income declined $112,000. During the second quarter of 2002, the Company realized $133,000 benefit from the settlement of a retirement package with its former chairman. No such benefit was recorded in 2003. For the six month period ended June 30, 2003, total non-interest income declined $158,000. In addition to the transactions described above for the second quarters, other income includes a $46,000 gain realized for the first quarter of 2003 on the disposition of repossessed collateral. The results for the first quarter of 2002 include a $19,000 gain from the realization of the cash surrender value of a life insurance contract on the former chairman that was canceled. NONINTEREST EXPENSE. Noninterest expense totaled $1.4 million for the three-month period ended June 30, 2003, representing a $252,000 decrease, or 15.7%, from the same period in 2002. Salaries and employee benefits expense for the second quarter of 2003 decreased $87,000 or 11% compared to the second quarter of 2002 due to fewer employees. Occupancy and equipment expenses declined $28,000 due primarily to lower lease and property tax expense. The $138,000 reduction in other expenses was due to cost reductions over a broad range of categories. For the six month period ended June 30, 2003, non-interest expense declined $392,000. Salary and employee benefit expenses declined $125,000 or 7.8%. Occupancy and equipment expenses declined $47,000, or 9.05 and other expenses declined $219,000, or 22.7% The Company's efficiency ratio was 84% for the three-month period ended June 30, 2003 compared to 83% for the comparable period of 2002. The efficiency ratio measures the percentage of total revenues, on a taxable equivalent basis excluding securities gains and other nonrecurring gains, absorbed by non-interest expense. Expressed differently, for example, for every dollar of revenue the Company generated in the second quarter of 2003, the Company incurred $0.84 in overhead expenses. The Company's efficiency ratios compare unfavorably to other financial institutions in the Company's peer group. The Company operates six 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 improve as interest rates improve. INCOME TAXES. The Company recorded no income tax benefits during 2003 or 2002. 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 Bank has a $5,000,000 line of credit with an unrelated bank under which it can borrow federal funds. The Bank also has the ability to borrow from the FHLB, subject to regulatory approval under the New Formal Agreement. Finally, the Bank can sell any of its performing loans through participation agreements to other financial institutions. 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. Cash and cash equivalents were $15.3 million at June 30, 2003 and represented 15.5% of total assets and 17.2% of total deposits compared to 17.8% of total assets and 19.6% of total deposits at December 31, 2002. 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 Company, as a 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 , 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 New Formal Agreement, the Bank is currently precluded from declaring and paying any dividends without prior OCC approval. The Company has no source of funds to pay the interest that is past due on the debt or future interest requirements. The Company has not yet met any of its interest payment obligations on the $4.350 million convertible subordinated debt since missing the payment that was due March 31, 2002. In February 2002, the Company notified holders of its convertible debt that it will not have funds to make future interest payments and offered the holders certain options as alternatives to interest payments. As of June 30, 2003, no agreement had been reached as to any restructuring of the convertible debt. There are no commitments by any of the board of director members to lend additional funds. Accordingly, the Company does not have the financial means to service the interest payments on the notes. CAPITAL RESOURCES Total shareholders' equity was $4.2 million at June 30, 2003, representing a $452,000 or 9.7% decrease from December 31, 2002 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 I and total capital ratios meet or exceed 6.0% and 10.0% of risk-weighted assets, respectively, are considered "well capitalized." Institutions whose Tier I and total capital ratios meet or exceed 4.0% and 8.0% of risk-weighted assets, respectively, are considered "adequately capitalized." Tier I capital is shareholders' equity excluding the unrealized gain or loss on securities classified as available for sale and intangible assets. Tier II capital, or total capital, includes Tier I 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 I 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 I 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 New Formal Agreement and prompt corrective action regulations.
Minimum Requirements To Be Well Required Capitalized under New For Capital Under Prompt Actual Period-End Capital ratios Formal Adequacy Action June 30, 2003 Dec. 31, 2002 Agreement Purposes Requirements -------------------------------- --------- ----------- ------------- Leverage Ratio: Tier I capital to average assets: Consolidated 1.60% 1.99% -- 4.00% 5.00% Bank 6.66% 6.36% 8.00% 4.00% 5.00% Risk-Based Capital Ratios: Tier I capital to risk-weighted assets: Consolidated 2.10% 2.65% -- 4.00% 6.00% Bank 8.74% 8.80% -- 4.00% 6.00% Total capital to risk-weighted assets: Consolidated 4.39% 5.24% -- 8.00% 10.00% Bank 9.99% 10.86% 12.00% 8.00% 10.00%
ITEM 3. CONTROLS AND PROCEDURES Based upon an evaluation within the 90 days prior to the filing date of this report, the Company's Chief Executive Officer and Principal Financial Officer concluded that the Company's disclosure controls and procedures are effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's internal controls subsequent to the date of the evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. The Company engaged RSM McGladrey, Inc., a public accounting firm, to test its systems of internal controls. The Internal audit is scheduled to commence in August, 2003. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 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 these legal proceedings. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Although no default has been declared, the Company did not pay interest that was due March 31, 2002, September 30, 2002, or March 31, 2003, on $4,350,000 aggregate principal amount of 9% Convertible Subordinated Notes due 2008, issued under an indenture dated as of March 31, 1998 between the Company and Bank of New York, as trustee. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION Not applicable. 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 9 hereof. 31.1 - Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) 31.2 - Certification of Principal Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) 32.1 - Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 - Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. - (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the quarter ended June 30, 2003. 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: August 19, 2003 Surety Capital Corporation By: /s/ John Quiroz ------------------------------------------------------ John Quiroz, President and Director (Principal Executive Officer) By: /s/ Tim Raso ------------------------------------------------------ Tim Raso (Chief Operating Officer and Principal Financial Officer and Chief Accounting Officer) INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION PAGE NUMBER ------------------------------------------------------------------------------------------------------- 3.01 Certificate of Incorporation, as Filed with the Company's Form 10-K dated December amended 31, 1993 and incorporated by reference herein. ------------------------------------------------------------------------------------------------------- 3.02 Restated Bylaws of the Company Filed with the Company's Form 10-K dated December 31, 1994 and incorporated by reference herein. ------------------------------------------------------------------------------------------------------- 4.01 Form of Common Stock certificate Filed with the Company's Form 10-K dated December (specimen) 31, 1993 and incorporated by reference herein. ------------------------------------------------------------------------------------------------------- 4.02 Indenture dated as of March 31, 1998 Filed with the Company's Form 10-Q for the between the Company and Harris Trust quarter ended March 31, 1998 and incorporated by and Savings Bank, Chicago, Illinois, reference herein. as trustee ------------------------------------------------------------------------------------------------------- 4.03 Form of Notes (included in Filed with the Company's Form 10-Q for the Exhibit 4.02) quarter ended March 31, 1998 and incorporated by reference herein. ------------------------------------------------------------------------------------------------------- 4.04 Form of Note Purchase Agreements Filed with the Company's Registration Statement dated March 31, 1998 No. 333-57601 on Form S-3 and incorporated by reference herein. ------------------------------------------------------------------------------------------------------- 11 Statement Regarding the Computation Reference is hereby made to the Consolidated of Earnings Per Share Statements of Operations on page 4 and Note 2 to the Consolidated Financial Statements on page 8 hereof ------------------------------------------------------------------------------------------------------- 31.1 Certification of Chief Executive 29 Officer Pursuant to Rule 13a-14(a)/15d-14(a) ------------------------------------------------------------------------------------------------------- 31.2 Certification of Principal Financial 30 Officer Pursuant to Rule 13a-14(a)/15d-14(a) ------------------------------------------------------------------------------------------------------- 32.1 Certification of the chief executive 31 officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002. ------------------------------------------------------------------------------------------------------- 32.2 Certification of the chief financial 32 officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------------------------------