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City National 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.0
  5. Ex-32.0

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED

 

 

 

For the quarterly period ended June 30, 2008

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE TRANSITION PERIOD FROM              TO              

 

COMMISSION FILE NUMBER: 1-10521

 

CITY NATIONAL CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

Delaware

 

95-2568550

(State of Incorporation)

 

(I.R.S. Employer Identification No.)

 

City National Center

400 North Roxbury Drive, Beverly Hills, California, 90210

(Address of principal executive offices)(Zip Code)

 

(310) 888-6000

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days. Yes  x        No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act). (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

 

Smaller reporting company o

 

 

 

 

(Do not check if a smaller
reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes          x No

 

As of August 1, 2008, there were 47,835,465 shares of Common Stock outstanding.

 

 

 




Table of Contents

 

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

CITY NATIONAL CORPORATION

CONSOLIDATED BALANCE SHEET

 

 

 

June 30

 

December 31,

 

June 30

 

Dollars in thousands, except share amounts

 

2008

 

2007

 

2007

 

 

 

(Unaudited)

 

 

 

(Unaudited)

 

Assets

 

 

 

 

 

 

 

Cash and due from banks

 

$

513,736

 

$

365,918

 

$

513,463

 

Due from banks - interest-bearing

 

88,149

 

88,151

 

139,539

 

Federal funds sold

 

 

 

170,000

 

Securities available-for-sale - cost $2,349,032; $2,484,903; and $2,879,736 at June 30, 2008, December 31, 2007 and June 30, 2007, respectively

 

 

 

 

 

 

 

Securities pledged as collateral

 

222,912

 

212,233

 

109,535

 

Held in portfolio

 

2,080,070

 

2,250,422

 

2,687,831

 

Trading account securities

 

204,825

 

293,355

 

117,456

 

Loans and leases

 

12,178,330

 

11,630,638

 

11,018,834

 

Less allowance for loan and lease losses

 

185,070

 

168,523

 

157,849

 

Net loans and leases

 

11,993,260

 

11,462,115

 

10,860,985

 

 

 

 

 

 

 

 

 

Premises and equipment, net

 

122,959

 

118,067

 

106,672

 

Deferred tax asset

 

145,150

 

129,403

 

144,028

 

Goodwill

 

460,186

 

452,480

 

427,909

 

Customer-relationship intangibles, net

 

54,398

 

67,647

 

91,009

 

Bank-owned life insurance

 

73,503

 

72,220

 

71,146

 

Affordable housing investments

 

70,627

 

73,640

 

67,158

 

Customers’ acceptance liability

 

3,981

 

3,549

 

7,958

 

Other real estate owned

 

9,113

 

 

 

Other assets

 

296,389

 

300,090

 

281,307

 

Total assets

 

$

16,339,258

 

$

15,889,290

 

$

15,795,996

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

Demand deposits

 

$

5,861,823

 

$

5,858,497

 

$

5,926,048

 

Interest checking deposits

 

807,734

 

879,062

 

753,428

 

Money market deposits

 

3,771,824

 

3,421,691

 

3,751,589

 

Savings deposits

 

132,261

 

135,519

 

164,433

 

Time deposits-under $100,000

 

200,788

 

220,928

 

240,660

 

Time deposits-$100,000 and over

 

1,121,907

 

1,306,808

 

2,294,247

 

Total deposits

 

11,896,337

 

11,822,505

 

13,130,405

 

Federal funds purchased and securities sold under repurchase agreements

 

1,221,428

 

1,544,411

 

269,938

 

Other short-term borrowings

 

955,000

 

100,000

 

72,818

 

Subordinated debt

 

157,080

 

273,559

 

266,962

 

Long-term debt

 

237,867

 

233,465

 

219,282

 

Reserve for off-balance sheet credit commitments.

 

24,154

 

19,704

 

17,832

 

Other liabilities

 

143,463

 

204,814

 

160,422

 

Acceptances outstanding

 

3,981

 

3,549

 

7,958

 

Total liabilities

 

14,639,310

 

14,202,007

 

14,145,617

 

Minority interest in consolidated subsidiaries-includes redeemable minority interests with a redemption value of $30,641; $34,498; and $29,018 at June 30, 2008, December 31, 2007, and June 30, 2007, respectively

 

32,300

 

34,498

 

29,029

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

 

 

Preferred Stock authorized - 5,000,000; none outstanding

 

 

 

 

Common Stock-par value-$1.00; authorized - 75,000,000; Issued - 50,971,611; 50,824,178; and 50,825,254 shares at June 30, 2008, December 31, 2007 and June 30, 2007, respectively

 

50,972

 

50,824

 

50,825

 

Additional paid-in capital

 

421,689

 

420,168

 

419,277

 

Accumulated other comprehensive loss

 

(24,853

)

(9,349

)

(50,709

)

Retained earnings

 

1,403,062

 

1,369,999

 

1,307,638

 

Treasury shares, at cost - 2,811,898; 2,588,299; and 1,578,322 shares at June 30, 2008, December 31, 2007 and June 30, 2007, respectively

 

(183,222

)

(176,035

)

(105,681

)

Total shareholders’ equity

 

1,667,648

 

1,655,607

 

1,621,350

 

 

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

16,339,258

 

$

15,889,290

 

$

15,795,996

 

 

See accompanying Notes to the Unaudited Consolidated Financial Statements.

 

3



Table of Contents

 

CITY NATIONAL CORPORATION

CONSOLIDATED STATEMENT OF INCOME

(Unaudited)

 

 

 

For the three months ended

 

For the six months ended

 

 

 

June 30

 

June 30

 

In thousands, except per share amounts

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Interest Income

 

 

 

 

 

 

 

 

 

Loans and leases

 

$

166,158

 

$

192,356

 

$

345,469

 

$

373,026

 

Securities available-for-sale

 

26,565

 

31,704

 

53,841

 

63,824

 

Trading account

 

397

 

910

 

976

 

1,697

 

Due from banks - interest-bearing

 

529

 

535

 

1,051

 

1,016

 

Federal funds sold and securities purchased under resale agreements

 

58

 

320

 

122

 

503

 

Total interest income

 

193,707

 

225,825

 

401,459

 

440,066

 

Interest Expense

 

 

 

 

 

 

 

 

 

Deposits

 

27,292

 

57,434

 

66,122

 

107,758

 

Federal funds purchased and securities sold under repurchase agreements

 

7,611

 

6,190

 

17,242

 

13,746

 

Subordinated debt

 

1,587

 

4,048

 

3,815

 

8,072

 

Other long-term debt

 

2,234

 

3,721

 

5,287

 

7,318

 

Other short-term borrowings

 

4,815

 

1,528

 

10,660

 

2,999

 

Total interest expense

 

43,539

 

72,921

 

103,126

 

139,893

 

Net interest income

 

150,168

 

152,904

 

298,333

 

300,173

 

Provision for credit losses

 

35,000

 

 

52,000

 

 

Net interest income after provision for credit losses

 

115,168

 

152,904

 

246,333

 

300,173

 

Noninterest Income

 

 

 

 

 

 

 

 

 

Trust and investment fees

 

34,187

 

34,823

 

70,536

 

65,077

 

Brokerage and mutual fund fees

 

18,709

 

13,958

 

36,131

 

27,738

 

Cash management and deposit transaction charges

 

12,196

 

8,472

 

23,320

 

16,943

 

International services

 

8,176

 

7,562

 

15,863

 

14,025

 

Bank-owned life insurance

 

628

 

761

 

1,283

 

1,385

 

Loss on sale of other assets

 

(192

)

 

(192

)

(46

)

(Loss) gain on sale of securities

 

(417

)

866

 

552

 

1,135

 

Other

 

8,177

 

7,246

 

13,787

 

13,379

 

Total noninterest income

 

81,464

 

73,688

 

161,280

 

139,636

 

Noninterest Expense

 

 

 

 

 

 

 

 

 

Salaries and employee benefits

 

87,520

 

80,904

 

177,699

 

158,888

 

Net occupancy of premises

 

12,462

 

10,362

 

23,974

 

19,820

 

Legal and professional fees

 

7,531

 

8,590

 

16,091

 

17,311

 

Information services

 

6,388

 

5,750

 

12,594

 

11,301

 

Depreciation and amortization

 

5,460

 

5,122

 

10,962

 

10,122

 

Marketing and advertising

 

5,360

 

5,783

 

10,955

 

9,781

 

Office services

 

3,140

 

2,938

 

6,126

 

5,685

 

Amortization of intangibles

 

1,528

 

2,623

 

3,959

 

4,253

 

Equipment

 

746

 

797

 

1,659

 

1,515

 

Other real estate owned

 

320

 

 

320

 

 

Other operating

 

8,801

 

7,446

 

14,758

 

13,352

 

Total noninterest expense

 

139,256

 

130,315

 

279,097

 

252,028

 

Minority interest expense

 

2,262

 

2,325

 

5,568

 

4,401

 

Income before income taxes

 

55,114

 

93,952

 

122,948

 

183,380

 

Income taxes

 

19,630

 

34,799

 

43,477

 

67,682

 

Net income

 

$

35,484

 

$

59,153

 

$

79,471

 

$

115,698

 

 

 

 

 

 

 

 

 

 

 

Net income per share, basic

 

$

0.74

 

$

1.22

 

$

1.66

 

$

2.39

 

 

 

 

 

 

 

 

 

 

 

Net income per share, diluted

 

$

0.73

 

$

1.19

 

$

1.64

 

$

2.34

 

 

 

 

 

 

 

 

 

 

 

Shares used to compute income per share, basic

 

47,849

 

48,675

 

47,839

 

48,323

 

.

 

 

 

 

 

 

 

 

 

Shares used to compute income per share, diluted

 

48,447

 

49,838

 

48,482

 

49,461

 

 

 

 

 

 

 

 

 

 

 

Dividends per share

 

$

0.48

 

$

0.46

 

$

0.96

 

$

0.92

 

 

See accompanying Notes to the Unaudited Consolidated Financial Statements.

 

4



Table of Contents

 

CITY NATIONAL CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

 

 

 

For the six months ended

 

 

 

June 30

 

Dollars in thousands

 

2008

 

2007

 

 

 

 

 

 

 

Cash Flows From Operating Activities

 

 

 

 

 

Net income

 

$

79,471

 

$

115,698

 

Adjustments to net income:

 

 

 

 

 

Provision for credit losses

 

52,000

 

 

Amortization of intangibles

 

3,959

 

4,253

 

Depreciation and amortization

 

10,962

 

10,122

 

Amortization of cost and discount on long-term debt

 

264

 

354

 

Stock-based employee compensation expense

 

7,225

 

7,078

 

Loss on sale of other assets

 

192

 

46

 

Gain on sales of securities

 

(552

)

(1,135

)

Other, net

 

5,425

 

10,753

 

Net change in:

 

 

 

 

 

Trading account securities

 

88,530

 

30,451

 

Deferred income tax benefit

 

(15,747

)

(6,809

)

Other assets and other liabilities, net

 

(42,076

)

(44,442

)

 

 

 

 

 

 

Net cash provided by operating activities

 

$

189,653

 

126,369

 

 

 

 

 

 

 

Cash Flows From Investing Activities

 

 

 

 

 

Purchase of securities available-for-sale

 

(208,080

)

(119,342

)

Sales of securities available-for-sale

 

88,157

 

48,502

 

Maturities and paydowns of securities

 

255,395

 

272,842

 

Loan originations, net of principal collections

 

(582,379

)

(241,479

)

Purchase of premises and equipment

 

(15,854

)

(14,701

)

Acquisition of BBNV, net of cash acquired

 

 

(50,398

)

Acquisition of Convergent Wealth, net of cash acquired

 

 

(100,621

)

Other investing activities

 

(13,680

)

(5,244

)

 

 

 

 

 

 

Net cash used in investing activities

 

(476,441

)

(210,441

)

 

 

 

 

 

 

Cash Flows From Financing Activities

 

 

 

 

 

Net decrease in deposits

 

73,832

 

516,496

 

Net decrease in federal funds purchased and securities sold under repurchase agreements

 

(322,983

)

(152,965

)

Net increase (decrease) in short-term borrowings

 

855,000

 

(24,707

)

Net (decrease) increase in other borrowings

 

(111,230

)

96

 

Proceeds from exercise of stock options

 

6,985

 

15,840

 

Tax benefit from exercise of stock options

 

1,046

 

6,179

 

Stock repurchases

 

(21,638

)

(20,198

)

Cash dividends paid

 

(46,408

)

(44,721

)

 

 

 

 

 

 

Net cash provided by financing activities

 

434,604

 

296,020

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

147,816

 

211,948

 

Cash and cash equivalents at beginning of year

 

454,069

 

611,054

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

601,885

 

$

823,002

 

 

 

 

 

 

 

Supplemental Disclosures of Cash Flow Information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

116,097

 

$

142,645

 

Income taxes

 

55,148

 

52,595

 

 

 

 

 

 

 

Non-cash investing activities:

 

 

 

 

 

Transfer of loans to OREO

 

$

12,612

 

$

 

 

See accompanying Notes to the Unaudited Consolidated Financial Statements.

 

5



Table of Contents

 

CITY NATIONAL CORPORATION

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

(Unaudited)

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

Additional

 

other

 

 

 

 

 

Total

 

 

 

Shares

 

Common

 

paid-in

 

comprehensive

 

Retained

 

Treasury

 

shareholders’

 

Dollars in thousands

 

issued

 

stock

 

capital

 

income (loss)

 

earnings

 

stock

 

equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2006

 

50,718,794

 

$

50,719

 

$

412,248

 

$

(41,459

)

$

1,264,697

 

$

(195,363

)

$

1,490,842

 

Adjustment to initially apply FASB interpretation 48

 

 

 

 

 

(28,036

)

 

(28,036

)

Balance, January 1, 2007

 

50,718,794

 

50,719

 

412,248

 

(41,459

)

1,236,661

 

(195,363

)

1,462,806

 

Net income

 

 

 

 

 

 

 

115,698

 

 

115,698

 

Other comprehensive income net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of prior service cost

 

 

 

 

109

 

 

 

109

 

Net unrealized loss on securities available-for-sale, net of taxes of $7.7 million and reclassification of $0.4 million for net loss included in net income

 

 

 

 

(10,680

)

 

 

(10,680

)

Net unrealized gain on cash flow hedges, net of taxes of $1.0 million and reclassification of $2.0 million net loss included in net income

 

 

 

 

1,321

 

 

 

1,321

 

Total comprehensive income

 

 

 

 

(9,250

)

115,698

 

 

106,448

 

Issuance of shares for stock options

 

 

 

(13,936

)

 

 

29,776

 

15,840

 

Restricted stock grants, net of cancellations

 

106,460

 

106

 

(106

)

 

 

 

 

Stock-based employee compensation expense

 

 

 

6,981

 

 

 

 

6,981

 

Tax benefit from stock options

 

 

 

6,179

 

 

 

 

6,179

 

Cash dividends paid

 

 

 

 

 

(44,721

)

 

(44,721

)

Repurchased shares, net

 

 

 

 

 

 

(20,198

)

(20,198

)

Issuance of shares for acquisition

 

 

 

7,911

 

 

 

80,104

 

88,015

 

Balance, June 30, 2007

 

50,825,254

 

$

50,825

 

$

419,277

 

$

(50,709

)

$

1,307,638

 

$

(105,681

)

$

1,621,350

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, January 1, 2008

 

50,824,178

 

$

50,824

 

$

420,168

 

$

(9,349

)

$

1,369,999

 

$

(176,035

)

$

1,655,607

 

Net income

 

 

 

 

 

79,471

 

 

79,471

 

Other comprehensive income net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of prior service cost

 

 

 

 

(26

)

 

 

(26

)

Net unrealized loss on securities available-for-sale, net of taxes of $10.0 million and reclassification of $0.1 million net loss included in net income

 

 

 

 

(13,845

)

 

 

(13,845

)

Net unrealized loss on cash flow hedges, net of taxes of $1.2 million and reclassification of $1.5 million net income included in net income

 

 

 

 

(1,633

)

 

 

(1,633

)

Total comprehensive income

 

 

 

 

(15,504

)

79,471

 

 

63,967

 

Issuance of shares for stock options

 

 

 

(7,466

)

 

 

14,451

 

6,985

 

Restricted stock grants, net of cancellations

 

147,433

 

148

 

(148

)

 

 

 

 

Stock-based employee compensation expense

 

 

 

7,136

 

 

 

 

7,136

 

Tax benefit from stock options

 

 

 

1,268

 

 

 

 

1,268

 

Cash dividends paid

 

 

 

 

 

(46,408

)

 

(46,408

)

Repurchased shares, net

 

 

 

 

 

 

(21,638

)

(21,638

)

Net change in deferred compensation plans

 

 

 

731

 

 

 

 

731

 

Balance, June 30, 2008

 

50,971,611

 

$

50,972

 

$

421,689

 

$

(24,853

)

$

1,403,062

 

$

(183,222

)

$

1,667,648

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements.

 

6



Table of Contents

 

CITY NATIONAL CORPORATION

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.                  Organization - City National Corporation (the “Corporation”) is the holding company for City National Bank (“the Bank”).  The Bank delivers banking, trust and investment services through 62 offices in Southern California, the San Francisco Bay area, Nevada and New York City.  Additionally, the Corporation delivers investment and wealth advisory services through its wealth advisory affiliates.  The Corporation also has an unconsolidated subsidiary, Business Bancorp Capital Trust I. The Corporation is approved as a financial holding company pursuant to the Gramm-Leach-Bliley Act of 1999.  References to the “Company” mean the Corporation, Bank, all subsidiaries and affiliates together.

 

2.                  Consolidation - The financial statements of the Company include the accounts of the Corporation, its non-bank subsidiaries, the Bank and the Bank’s wholly-owned subsidiaries, after the elimination of all material intercompany transactions.  Preferred stock, issued by the Company’s REITs, and third-party equity ownership in affiliates are reflected as Minority interest in consolidated subsidiaries in the Consolidated Balance Sheet. The related minority share of earnings is shown as Minority interest expense in the Consolidated Statement of Income.

 

The Company’s investment management and wealth advisory affiliates are organized as limited liability companies.  The Corporation generally owns a majority position in each affiliate and certain management members of each affiliate own the remaining shares. The Corporation has contractual arrangements with its affiliates whereby a percentage of revenue is allocable to fund affiliate operating expenses (“operating share”) while the remaining portion of revenue (“distributable revenue”) is allocable to the Corporation and the minority owners.  All majority-owned affiliates are consolidated.  The Corporation’s interest in one investment management affiliate in which it holds a minority share is accounted for using the equity method.

 

3.                  Acquisitions - On February 28, 2007, the Company completed the acquisition of Business Bank Corporation, the parent of Business Bank of Nevada (“BBNV”) and an unconsolidated subsidiary, Business Bancorp Capital Trust I, in a cash and stock transaction valued at $167 million.  BBNV operated as a wholly-owned subsidiary of City National Corporation until after the close of business on April 30, 2007, at which time it was merged into the Bank.

 

On May 1, 2007, the Corporation completed the acquisition of Lydian Wealth Management in an all-cash transaction.   The investment advisory firm is headquartered in Rockville, Maryland and now manages or advises on client assets totaling $9.2 billion.  Lydian Wealth Management changed its name to Convergent Wealth Advisors (“Convergent Wealth”) and became a subsidiary of Convergent Capital Management LLC, the Chicago-based asset management holding company that the Company acquired in 2003.  All of the senior executives of Convergent Wealth signed employment agreements and acquired a significant minority ownership interest in Convergent Wealth.

 

4.                  Accounting Policies - Our accounting and reporting policies conform to generally accepted accounting principles (“GAAP”) and practices in the financial services industry.  To prepare the financial statements in conformity with GAAP, management must make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and income and expenses during the reporting period. Circumstances and events that differ significantly from those underlying our estimates and assumptions could cause actual financial results to differ from our estimates. The material estimates included in the financial statements relate to the allowance for loan and lease losses, the reserve for off-balance sheet credit commitments, valuation of stock options, income taxes, goodwill and intangible asset values and valuation of financial assets and liabilities reported at fair value.  The Company has applied its critical accounting policies and estimation methods consistently in all periods presented in these financial statements to the periods in which they applied.  The allowance for loan and lease losses reflects management’s ongoing assessment of the credit quality of the company’s portfolio, which is affected by various economic trends, including weakness in the housing sector.  Additional factors affecting the provision include net loan charge-offs, nonaccrual loans, risk-rating migration and growth in the portfolio.  The Company’s estimates and assumptions are expected to change as changes in market conditions and the Company’s portfolio occur in subsequent periods.

 

The Company is on the accrual basis of accounting for income and expense.  The results of operations reflect any interim adjustments, all of which are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q, and which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented.  In accordance with the usual practice of banks, assets and liabilities of individual trust, agency and fiduciary funds have not been included in the financial statements.  These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on

 

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Form 10-K for the year ended December 31, 2007.  The results for the 2008 interim period are not necessarily indicative of the results expected for the full year.  The Company has not made any significant changes in its critical accounting policies or its estimates and assumptions from those disclosed in its 2007 Annual Report other than the adoption of SFAS 157 effective January 1, 2008. The Company has revised certain assumptions related to the adoption of SFAS 157 as discussed below and in Note 5 to these consolidated financial statements.

 

Certain prior period balances have been reclassified to conform to the current period presentation.

 

During the six months ended June 30, 2008, the following accounting pronouncements applicable to the Company were issued or became effective:

 

·                  The Company adopted FASB Statement No. 157, Fair Value Measurements (“SFAS 157”) effective January 1, 2008.  SFAS 157 defines fair value for financial reporting purposes, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  SFAS 157 does not require new fair value measurements, but does apply under other accounting pronouncements where fair value is required or permitted.  The provisions of the statement are being applied prospectively.  The Company was not required to record a transition adjustment upon adoption of the Statement.

 

·                  On February 12, 2008, the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP 157-2”).  FSP 157-2 amends FASB Statement No. 157, Fair Value Measurements (“SFAS 157”), to delay the effective date of SFAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).  Examples of non-financial assets for the Company include goodwill and intangible assets associated with acquisitions. FSP 157-2 defers the effective date of SFAS 157 for items within its scope to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years.

 

·                  The Company adopted FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”) as of January 1, 2008.  SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value on an instrument-by-instrument basis. Unrealized gains and losses on instruments for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The objective of the Statement is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently.  The Company has not elected the fair value option for any financial assets or liabilities previously reported at cost.

 

·                  FASB Staff Position, (“FSP”) FIN 39-1, which amends certain aspects of FASB Interpretation Number 39, Offsetting of Amounts Related to Certain Contracts—an interpretation of APB Opinion No. 10 and FASB Statement No. 105 (“FIN 39”) became effective for the Company on January 1, 2008.  The FSP amends paragraph 10 of FIN 39 to permit a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against fair value amounts, including amounts that approximate fair value, recognized for derivative instruments executed with the same counterparty under the same master netting arrangement.  Derivative instruments permitted to be netted for the purposes of the FSP include those instruments that meet the definition of a derivative in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, including those that are not included in the scope of SFAS 133.  The FSP only impacts the presentation of the derivative’s fair value and the related collateral on the balance sheet. From time to time the Company may require or accept cash collateral, but as of June 30, 2008 the Company did not have any cash collateral receivables and payables with the same counterparty that could be offset.  The FSP is not expected to have any impact on the Company’s financial statements in the future as the Company does not expect to have any cash collateral receivables and payables with the same counterparty that could be offset.

 

·                  EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards”, that became effective for the Company on January 1, 2008, provides that realized income tax benefits from dividends or dividend equivalents that are charged to retained earnings and paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options are to be recognized as an increase to additional paid-in capital.  The amount recognized in additional paid-in capital for the realized income tax benefit from dividends on those awards are to be included in the pool of excess tax benefits available to absorb tax deficiencies on share-based payment awards.  The Company previously recognized tax benefits associated with dividend payments on unvested shares as a reduction of income tax expense. The change in accounting for these tax benefits under the EITF did not have a significant impact on the Company’s financial statements.

 

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·                  On March 19, 2008, the FASB issued FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). The Statement expands disclosure requirements for derivative instruments and hedging activities. The new disclosures will address how derivative instruments are used, how derivatives and the related hedged items are accounted for under SFAS 133, how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. In addition, companies will be required to disclose the fair values of derivative instruments and their gains and losses in a tabular format. SFAS 161 is effective for fiscal years beginning after November 15, 2008.

 

·                  On April 25, 2008, the FASB issued FASB Staff Position No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP 142-3”).  FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). The intent of the FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under FASB Statement No. 141, Business Combinations, when the underlying arrangement includes renewal or extension terms. FSP 142-3 permits an entity to use its own assumptions, based on its historical experience, about the renewal or extension of an arrangement to determine the useful life of an intangible asset.  These assumptions are to be adjusted for the entity-specific factors detailed in SFAS 142. FSP 142-3 is effective on a prospective basis for fiscal years beginning after December 15, 2008.  The Company does not expect the adoption of FSP 142-3 to have a significant impact on its consolidated financial statements.

 

·                  In May 2008, the FASB issued FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”).  SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States.  SFAS 162 becomes effective 60 days following approval from the Securities and Exchange Commission, (“SEC”) of the Public Company Accounting Oversight Board, (“PCAOB”) amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.  SFAS 162 is not expected to result in a change in the Company’s financial reporting practices.

 

5.                  Fair Value Measurements - The Company adopted FASB Statement No. 157, Fair Value Measurements (“SFAS 157”) effective January 1, 2008 on a prospective basis.  SFAS 157 defines fair value for financial reporting purposes as the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction between market participants at the measurement date (reporting date).  Under the statement, fair value is based on an exit price in the principal market or most advantageous market in which the reporting entity could transact.

 

For each asset and liability required to be reported at fair value, management has identified the unit of account and valuation premise to be applied for purposes of measuring fair value.  The unit of account is the level at which an asset or liability is aggregated or disaggregated for purposes of applying SFAS 157.  The valuation premise is a concept that determines whether an asset is measured on a standalone basis or in combination with other assets.  For purposes of applying the provisions of SFAS 157, the Company measures its assets and liabilities on a standalone basis then aggregates assets and liabilities with similar characteristics for disclosure purposes.

 

Fair Value Hierarchy

 

Management employs market standard valuation techniques in determining the fair value of assets and liabilities.  Inputs used in valuation techniques are based on assumptions that market participants would use in pricing an asset or liability.  SFAS 157 prioritizes inputs used in valuation techniques as follows:

 

Level 1-Quoted market prices in an active market for identical assets and liabilities.

Level 2-Observable inputs including quoted prices (other than level 1) in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability such as interest rates, yield curves, volatilities and default rates, and inputs that are derived principally from or corroborated by observable market data.

Level 3-Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available.

 

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If the determination of fair value measurement for a particular asset or liability is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. Management’s assessment of the significance of a particular input to the fair value measurement requires judgment and considers factors specific to the asset or liability measured.

 

Valuation Techniques

 

Securities

 

Fair values for U.S. Treasury securities, marketable equity securities and trading securities, with the exception of agency securities held in the trading account, are based on quoted market prices. Securities with fair values based on quoted market prices are classified in Level 1 of the fair value hierarchy. Level 2 securities include the Company’s portfolio of Federal agency, mortgage-backed, state and municipal securities for which fair values are calculated with models using quoted prices and other inputs directly or indirectly observable for the asset or liability.  Prices for 99 percent of these securities are obtained through a third-party valuation source. Management reviewed the valuation techniques and assumptions used by the provider and determined that the provider utilizes widely accepted valuation techniques based on observable market inputs appropriate for the type of security being measured.  Prices for the remaining securities are obtained from dealer quotes.  Securities classified in Level 3 are collateralized debt obligation instruments.  Fair values for these securities are obtained from dealer quotes based on discounted cash flow models.  Certain assumptions used in the dealers’ models are not observable in the market.

 

Loans

 

The Company does not record loans at fair value with the exception of impaired loans which are measured for impairment in accordance with SFAS 114, Accounting by Creditors for Impairment of a Loan (“SFAS 114”).  Under SFAS 114, loans measured for impairment based on the fair value of collateral or observable market prices are within the scope of SFAS 157.  Loans reported at fair value in the table below were measured for impairment by valuing the underlying collateral based on third-party appraisals. These loans are classified in Level 2 of the fair value hierarchy.

 

Derivatives

 

The Company uses interest rate swaps to manage its interest rate risk. The fair value of these swaps is obtained through third-party valuation sources that use conventional valuation algorithms.  The pricing model is a discounted cash flow model that relies on inputs, such as interest rate futures, from highly liquid and active markets. The Company also enters into interest rate risk protection products with certain clients. These contracts are offset by paired trades with derivative dealers. The fair value of these derivatives is obtained from a third-party valuation source that uses conventional valuation algorithms.

 

To comply with the provisions of FAS 157, the Company incorporates credit valuation adjustments to appropriately reflect nonperformance risk for both the Company and counterparties in the fair value measurements. Although the Company has determined that the majority of the inputs used to value derivative contracts fall within Level 2 of the fair value hierarchy, the credit valuation adjustments utilize Level 3 inputs, such as estimates of credit spreads. The Company has determined that the impact of the credit valuation adjustments is not significant to the overall valuation of these derivatives.  As a result, the Company has classified the derivative contract valuations in their entirety in Level 2 of the fair value hierarchy.

 

The fair value of foreign exchange options and transactions are derived from market spot and/or forward foreign exchange rates and are classified in Level 1 of the fair value hierarchy.

 

Other Real Estate Owned

 

The fair value of OREO is based on third-party appraisals of the properties performed in accordance with professional appraisal standards and Bank regulatory requirements under FIRREA. Appraisals are reviewed and approved by the Company’s appraisal department.  OREO is classified in Level 2 of the fair value hierarchy.

 

The Company records securities available-for-sale, trading securities and derivative contracts at fair value on a recurring basis.  Certain other assets such as impaired loans and OREO are recorded at fair value on a nonrecurring basis.  Nonrecurring fair value measurements typically involve assets that are evaluated for impairment and for which any

 

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impairment is recorded in the period in which the remeasurement is performed.  A distribution of asset and liability fair values according to the fair value hierarchy at June 30, 2008 is provided in the table below:

 

(Dollars in thousands)

 

 

 

Fair Value Measurements at Reporting Date Using

 

Asset or Liability 
Measured at Fair Value

 

June 30, 2008

 

Quoted Prices in 
Active Markets 
Level 1

 

Significant Other 
Observable Inputs
 Level 2

 

Significant
 Unobservable 
Inputs
 Level 3

 

Measured on a Recurring Basis

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Securities available-for-sale

 

 

 

 

 

 

 

 

 

Debt portfolio

 

$

2,178,926

 

$

55,793

 

$

2,123,133

 

$

 

Other equity securities

 

124,056

 

72,286

 

22,667

 

29,103

 

Trading account securities

 

204,825

 

184,393

 

20,432

 

 

Mark-to-market derivatives (1)

 

18,227

 

2,920

 

15,307

 

 

 

Total assets at fair value

 

$

2,526,034

 

$

315,392

 

$

2,181,539

 

$

29,103

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Mark-to-market derivatives (2)

 

$

5,457

 

$

3,215

 

$

2,242

 

$

 

Total liabilities at fair value

 

$

5,457

 

$

3,215

 

$

2,242

 

$

 

 

 

 

 

 

 

 

 

 

 

Measured on a Nonrecurring Basis

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Colleral dependent impaired loans (3)

 

$

55,884

 

$

 

$

55,884

 

$

 

Other real estate owned (4)

 

9,765

 

 

9,765

 

 

Total assets at fair value

 

$

65,649

 

$

 

$

65,649

 

$

 

 


(1)  Reported in Other assets in the Consolidated Balance Sheet.

(2)  Reported in Other liabilities in the Consolidated Balance Sheet.

(3) Impaired loans for which fair value was calculated using the collateral valuation method.

(4)  OREO balance of $9,113 included in the Consolidated Balance Sheet is net of estimated disposal costs.

 

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table. There were no purchases or sales of Level 3 assets during the period. As part of the regular quarterly review of assets, management determined that the CDOs in the Company’s investment portfolio should be classified as level 3 assets. The classification as Level 3 is based on limited market liquidity for these securities, and that certain inputs to the valuation model used to determine the fair value of CDOs may not be directly observable in the markets.  Unrealized gains and losses on Level 3 assets are reported as a component of other comprehensive income in the consolidated balance sheet.

 

Level 3 Assets Measured on a Recurring Basis

 

(Dollars in thousands)

 

Securities 
Available-for-Sale

 

Balance of recurring Level 3 assets at January 1, 2008

 

$

32,977

 

Total gains or losses (realized/unrealized):

 

 

 

Included in earnings-realized

 

 

Included in earnings-unrealized

 

 

Included in other comprehensive income

 

(1,652

)

Purchases, sales, issuances and settlements, net

 

(2,222

)

Transfers in and/or out of Level 3

 

 

Balance of recurring Level 3 assets at June 30, 2008

 

$

29,103

 

 

FSP 157-2 issued on February 12, 2008, amends SFAS 157, to delay its effective date for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a

 

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recurring basis (at least annually). Therefore, the Company’s goodwill and customer-relationship intangibles will be subject to the provisions of SFAS 157 effective January 1, 2009.

 

6.                  Investment Securities – Securities are classified based on management’s intention on the date of purchase. All securities other than trading securities are classified as available-for-sale and are valued at fair value.  Unrealized gains or losses on securities available-for-sale are excluded from net income but are included as separate components of other comprehensive income, net of taxes. Premiums or discounts on securities available-for-sale are amortized or accreted into income using the interest method over the expected lives of the individual securities.  For most of the Company’s investments, fair values are determined based upon externally verifiable quoted prices or other observable inputs. On a quarterly basis, the Company makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis.  The Company considers such factors as the length of time and the extent to which the market value has been less than cost and the Company’s intent with regard to the securities in evaluating them for other-than-temporary impairment. The value of securities is reduced when unrealized losses are considered other-than-temporary, and a new cost basis is established for the securities. Any other-than-temporary loss is included in net income. Realized gains or losses on sales of securities available-for-sale are recorded using the specific identification method.  Trading securities are valued at fair value with any unrealized gains or losses included in net income.

 

7.                  Shareholders’ Equity - The following table provides information about purchases by the Company of equity securities that are registered by the Company pursuant to Section 12 of the Securities and Exchange Act of 1934 during the quarter ended June 30,  2008:

 

Period

 

Total Number 
of Shares (or 
Units)
Purchased

 

Average Price 
Paid per 
Share
(or Unit)

 

Total number of Shares 
(or Units) Purchased as 
Part of Publicly 
Announced Plans or 
Programs

 

Maximum Number of 
Shares that May Yet 
Be Purchased Under 
the Plans or Programs

 

04/01/08 - 04/30/08

 

30,000

 

$

44.87

 

30,000

 

1,340,400

 

05/01/08 - 05/31/08

 

 

 

 

1,340,400

 

06/01/08 - 06/30/08

 

200,000

 

$

43.35

 

200,000

 

1,140,400

 

 

 

230,000

(1)

$

43.55

 

230,000

 

1,140,400

 

 


(1)             On January 24, 2008, the Company’s Board of Directors authorized the Company to repurchase 1 million additional shares of the Company’s stock following the completion of its previously approved initiative.  Unless terminated earlier by resolution  of our Board of Directors, the program will expire when the Company has repurchased all shares authorized for repurchase thereunder.  We received no shares in payment for the exercise price of stock options.

 

On April 23, 2008 the Corporation’s shareholders approved the reservation of an additional 3.5 million shares for issuance under the Corporation’s 2008 Omnibus Plan.  In total there are 4.1 million shares available to be issued under this plan.

 

Basic earnings per share are based on the weighted average shares of common stock outstanding less unvested restricted shares and units.  Diluted earnings per share give effect to all potential dilutive common shares, which consist of stock options and restricted shares and units that were outstanding during the period, as well as shares that may be issued under our deferred compensation plan.  At June 30, 2008, there were 3,353,706 antidilutive options compared to 279,508 antidilutive options at June 30, 2007.

 

8.                  Share-Based Compensation - The Company applies FASB Statement No. 123 (revised), Share-Based Payment, (“SFAS 123R”) in accounting for stock option plans.  The Company uses a Black-Scholes methodology to determine the stock-based compensation expense for these plans.  On June 30, 2008, the Company had one stock-based compensation plan, the City National Corporation 2008 Omnibus Plan (the “Plan”), which was approved by the Company’s shareholders on April 23, 2008.  No new awards will be granted under predecessor plans.  A description of the Plan is provided below.  The compensation cost that has been recognized for all share-based awards was $3.7 million and $7.2 million for the three and six-month periods ended June 30, 2008, compared to $3.7 million and $7.1 million for the three and six-month periods ended June 30, 2007.  The Company received $7.0 million and $15.8 million in cash for the exercise of stock options during the six-month periods ended June 30, 2008 and June 30, 2007, respectively.  The total income tax benefit recognized in the income statement for share-based compensation arrangements was $1.3 million and $6.2 million for the six months ended June 30, 2008 and 2007, respectively.

 

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Plan Description

 

The Plan permits the grant of stock options, restricted stock, restricted stock units, performance shares, performance share units, performance units and stock appreciation rights, or any combination thereof, to the Company’s eligible employees and non-employee directors.  No grants of performance shares, performance share units, performance units or stock appreciation rights had been made as of June 30, 2008. The purpose of the Plan is to promote the success of the Company by providing an additional means to attract, motivate, retain and reward key employees of the Company with awards and incentives for high levels of individual performance and improved financial performance of the Company, and to link non-employee director compensation to shareholder interests through equity grants.  Stock option awards are granted with an exercise price equal to the market price of the Company’s stock at the date of grant.  These awards vest in four years and have 10-year contractual terms. Restricted stock awards granted under the Plan vest over a period of at least three years, as determined by the Compensation, Nominating and Governance Committee.  The participant is entitled to dividends and voting rights for all shares issued even though they are not vested.  Restricted stock awards issued under predecessor plans vest over five years.  The Plan provides for acceleration of vesting if there is a change in control (as defined in the Plan) or a termination of service, which may include disability or death.  Unvested options are forfeited upon termination of employment, except for those instances noted above, and the case of the retirement of a retirement-age employee for options granted prior to January 31, 2006.  All unexercised options expire 10 years from the grant date.  At June 30, 2008 there were approximately 4.1 million shares available for future grants.

 

Fair Value

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation methodology that uses the assumptions noted in the following table. The Company evaluates exercise behavior and values options separately for executive and non-executive employees.  Expected volatilities are based on the historical volatility of the Company’s stock.  As of February 2008, the Company began using a 20-year look back period to calculate the volatility factor.  The longer look back period reduces the impact of the recent disruptions in the capital markets, and provides values that management believes are more representative of expected future volatility.  Prior to this date, the Company used a look back period equal to the expected term of the options.  The Company uses historical data to predict option exercise and employee termination behavior.  The expected term of options granted is derived from the historical exercise activity over the past 20 years and represents the period of time that options granted are expected to be outstanding.  The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.  The dividend yield is equal to the dividend yield of the Company’s stock at the time of the grant.

 

To estimate the fair value of stock option awards, we use the Black-Scholes valuation method, which incorporates the assumptions summarized in the table below:

 

 

 

For the three months ended

 

For the six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Weighted-average volatility

 

29.72

%

21.06

%

29.28

%

21.96

%

Dividend yield

 

4.15

%

2.55

%

3.53

%

2.47

%

Expected term (in years)

 

6.50

 

5.88

 

6.04

 

6.11

 

Risk-free interest rate

 

4.06

%

4.75

%

3.97

%

4.67

%

 

Using the Black-Scholes methodology, the weighted-average grant-date fair values of options granted during the six-month periods ended June 30, 2008 and 2007 were $12.48 and $17.23, respectively.  The total intrinsic values of options exercised during the six-month periods ended June 30, 2008 and 2007 were $4.7 million, and $11.5 million, respectively.

 

A summary of option activity and related information under the Plan for the six-month period ended June 30, 2008 is presented below:

 

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Weighted

 

Aggregate

 

Weighted-Average

 

 

 

Number of

 

Average

 

Intrinsic

 

Remaining

 

 

 

Options

 

Exercise

 

Value

 

Contractual

 

Options

 

(000)

 

Price

 

($ 000) (1)

 

Term (Years)

 

 

 

 

 

 

 

 

 

 

 

Outstanding at January 1, 2008

 

4,171

 

$

52.60

 

$

11,769

 

5.03

 

Granted

 

598

 

54.43

 

6

 

 

 

Exercised

 

(222

)

31.52

 

(4,678

)

 

 

Forfeited or expired

 

(71

)

67.37

 

(3

)

 

 

Outstanding at June 30, 2008

 

4,476

 

$

53.66

 

$

9,416

 

5.36

 

Exercisable at June 30, 2008

 

3,175

 

$

49.13

 

$

9,410

 

3.94

 

 


(1) Includes in-the-money options only

 

A summary of changes in unvested options and related information for the six-month period ended June 30, 2008 is presented below:

 

 

 

 

 

Weighted-Average

 

 

 

Number of

 

Grant-Date

 

Unvested Options

 

Options (000)

 

Fair Value

 

Unvested at January 1, 2008

 

1,141

 

$

17.29

 

Granted

 

598

 

12.48

 

Vested

 

(379

)

17.06

 

Forfeited

 

(59

)

16.58

 

Unvested at June 30, 2008

 

1,301

 

$

15.18

 

 

The number of options vested during the six-month period ended June 30, 2008 was 379,495.  The total fair value of options vested during the six-month period ended June 30, 2008 was $6.5 million.

 

Restricted stock is valued at the closing price of the Company’s stock on the date of award.  During the six-month period ending June 30, 2008, the Compensation, Nominating and Governance Committee (the “Committee”) of the Company’s Board of Directors awarded 169,515 shares of restricted common stock having an intrinsic value of $7.1 million. During the six-month period ending June 30, 2007, the Committee awarded 132,241 shares of restricted common stock having an intrinsic value of $10.1 million. The portion of the market value of the restricted stock related to the current service period was recognized as compensation expense during the six-month periods ending June 30, 2008 and 2007.  The portion of the market value relating to future service periods was recorded as deferred equity compensation and will be amortized over the remaining vesting period. The compensation expense related to restricted stock for the first six months of 2008 was $3.1 million compared to $3.0 million for the same period in 2007. As of June 30, 2008 the unrecognized compensation cost related to restricted shares granted under the plan was $7.4 million. There were 453,773 restricted shares that had not vested as of June 30, 2008.

 

As of June 30, 2008, there was $25.8 million of total unrecognized compensation cost related to unvested stock-based compensation arrangements granted under the Plan.  That cost is expected to be recognized over a weighted-average period of 3.5 years.

 

9.                  Derivatives and Hedging - As part of its asset and liability management strategies, the Company uses interest-rate swaps to reduce cash flow variability and to moderate changes in the fair value of financial instruments. In accordance with SFAS 133 the Company recognizes derivatives as assets or liabilities on the balance sheet at their fair value. The treatment of changes in the fair value of derivatives depends on the character of the transaction.

 

In accordance with SFAS 133, the Company documents its hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction at the time the derivative contract is executed. This includes designating each derivative contract as either (i) a “fair value hedge” which is a hedge of a recognized asset or liability, (ii) a “cash flow hedge” which hedges a forecasted transaction or the variability of the cash flows to be received or paid related to a recognized asset or liability or (iii) an “undesignated hedge,” a derivative contract not designated as a hedging instrument whose change in fair value is

 

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recognized directly in the consolidated statement of income.  All derivatives designated as fair value or cash flow hedges are linked to specific hedged items or to groups of specific assets and liabilities on the balance sheet.  As of June 30, 2008, the Company had derivative contracts with customers with a notional value of $161.1 million that would be considered “undesignated hedges.”   As of June 30, 2007, the Company did not have any undesignated hedges.

 

Both at inception and at least quarterly thereafter, the Company assesses whether the derivatives used in hedging transactions are highly effective (as defined in SFAS 133) in offsetting changes in either the fair value or cash flows of the hedged item.  Retroactive effectiveness is assessed, as well as the expectation that the hedge will remain effective prospectively.

 

For cash flow hedges, in which derivatives hedge the variability of cash flows (interest payments) on loans that are indexed to U.S. dollar LIBOR or the Bank’s prime interest rate, the effectiveness is assessed prospectively at the inception of the hedge, and prospectively and retrospectively at least quarterly thereafter.  Ineffectiveness of the cash flow hedges is measured using the hypothetical derivative method described in Derivatives Implementation Group Issue G7, “Measuring the Ineffectiveness of a Cash Flow Hedge of Interest Rate Risk under Paragraph 30(b) When the Shortcut Method is not Applied”.  For cash flow hedges, the effective portion of the changes in the derivatives’ fair value is not included in current earnings but is reported as Accumulated other comprehensive income (loss). When the cash flows associated with the hedged item are realized, the gain or loss included in Accumulated other comprehensive income is recognized on the same line in the consolidated statement of income as the hedged item, i.e., included in Interest income on loans and leases.  Any ineffective portion of the changes of fair value of cash flow hedges is recognized immediately in Other noninterest income in the consolidated statement of income.

 

For fair value hedges, the Company uses interest-rate swaps to hedge the fair value of certain certificates of deposits, subordinated debt and other long-term debt. The certificates of deposit are single maturity, fixed-rate, non-callable, negotiable certificates of deposit that pay interest only at maturity and contain no compounding features.  The certificates cannot be redeemed early without penalty except in the case of the holder’s death. The interest-rate swaps are executed at the time the deposit transactions are negotiated.  The subordinated debt and other long-term debt consists of City National Bank ten-year subordinated with a face value of $150.0 million due on September 1, 2011, and City National Corporation senior notes with a face value of $225.0 million due on February 15, 2013.  Interest-rate swaps are structured so that all key terms of the swaps match those of the underlying deposit or debt transactions, therefore ensuring no hedge ineffectiveness at inception. The Company ensures that the interest-rate swaps meet the requirements for utilizing the short-cut method in accordance with paragraph 68 of SFAS 133 and maintains appropriate documentation for each interest-rate swap.  On a quarterly basis, fair value hedges are analyzed to ensure that the key terms of the hedged items and hedging instruments remain unchanged, and the hedging counterparties are evaluated to ensure that there are no adverse developments regarding counterparty default, therefore ensuring continuous effectiveness.  For fair value hedges, the effective portion of the changes in the fair value of derivatives is reflected in current earnings, on the same line in the consolidated statement of income as the related hedged item.  For both fair value and cash flow hedges, the periodic accrual of interest receivable or payable on interest rate swaps is recorded as an adjustment to net interest income for the hedged items.

 

The Company also offers various derivatives products to clients and enters into derivative transactions in due course.  These transactions are not linked to specific Company assets or liabilities in the balance sheet or to forecasted transactions in an accounting hedge relationship and, therefore, do not qualify for hedge accounting.  They are carried at fair value with changes in fair value recorded as part of Other noninterest income in the income statement.  Fair values are determined from verifiable third-party sources that have considerable experience with the derivative markets.  The credit component of the fair value of these derivative contracts is calculated using an internal model.

 

The Company discontinues hedge accounting prospectively when (i) a derivative is no longer highly effective in offsetting changes in the fair value or cash flows of a hedged item, (ii) a derivative expires or is sold, terminated, or exercised, (iii) a derivative is un-designated as a hedge, because it is unlikely that a forecasted transaction will occur; or (iv) the Company determines that designation of a derivative as a hedge is no longer appropriate.  If a fair value hedge derivative instrument is terminated or the hedge designation removed, the previous adjustments to the carrying amount of the hedged asset or liability would be subsequently accounted for in the same manner as other components of the carrying amount of that asset or liability. For interest-earning assets and interest-bearing liabilities, such adjustments would be amortized into earnings over the remaining life of the respective asset or liability. If a cash flow hedge derivative instrument is terminated or the hedge designation is removed, related amounts reported in other comprehensive income are reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings.

 

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10.            Income Taxes - The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, (“FIN 48”) on January 1, 2007.  Upon adoption, the Company recognized a cumulative effect adjustment of approximately $28 million, comprised of a $25.2 million increase to its tax liability and $2.8 million increase in accrued interest. The adjustment was recorded as a charge to January 1, 2007 retained earnings and the contingent tax reserve.

 

The Company recognizes accrued interest and penalties relating to unrecognized tax benefits as an income tax provision expense.   For the six-month period ended June 30, 2008, the Company accrued approximately $0.3 million in potential interest and penalties associated with uncertain tax positions.   The Company had approximately $9.2 million and $8.9 million of accrued interest and penalties as of June 30, 2008 and December 31, 2007, respectively.

 

The Company and its subsidiaries file a consolidated federal income tax return and also file income tax returns in various state jurisdictions.  The Internal Revenue Service (“IRS”) completed its audits of the Company for the tax years 2002 and 2003 resulting in no material financial statement impact. The Company is currently being audited by the IRS for the years 2006-2007 and by the Franchise Tax Board for the years 1998-2004. The potential financial statement impact, if any, resulting from completion of these audits cannot be determined at this time.

 

From time to time, there may be differences in opinion with respect to the tax treatment accorded transactions. If a tax position which was previously recognized on the financial statements is no longer “more likely than not” to be sustained upon a challenge from the taxing authorities, the tax benefit from the tax position will be derecognized. As of June 30, 2008, the Company does not have any tax positions which dropped below a “more likely than not” threshold.

 

11.     Retirement Plans - The Company has a profit-sharing retirement plan with an Internal Revenue Code Section 401(k) feature covering eligible employees. Employer contributions are made annually into a trust fund and are allocated to participants based on their salaries.  The profit sharing contribution requirement is based on a percentage of annual operating income subject to a percentage of salary cap. The Company recorded profit sharing contributions expense of $3.7 million and $8.5 million for the three and six-month periods ended June 30, 2008, compared to $4.2 million and $8.1 million for the three and six-month periods ended June 30, 2007, respectively.

 

The Company has a Supplemental Executive Retirement Plan (“SERP”) for one of its executive officers.  The SERP meets the definition of a pension plan per FASB Statement No. 87, Employers’ Accounting for Pensions. The Company applies FASB Statement No. 158, Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS 158”), in accounting for the SERP.  At June 30,  2008, there was a $3.6 million unfunded pension liability related to the SERP.  Pension expense for the three and six- month periods ended June 30, 2008 was $0.1 million and $0.2 million, respectively. Pension expense for the same periods of 2007 was $0.2 million and $0.4 million, respectively.

 

There is also a SERP covering three former executives of the Pacific Bank, which the Company acquired in 2000.  As of June 30, 2008 there was an unfunded pension liability for this SERP of $2.3 million.  Expense for both the three month periods ended June 30, 2008 and 2007 was insignificant.  Expense for both the six-month periods ended June 30, 2008 and 2007 was $0.1 million.

 

The Company does not provide any other post-retirement employee benefits beyond the profit-sharing retirement plan and the SERP.

 

12.            Guarantees - In connection with the liquidation of an investment acquired in a previous bank merger, the Company has an outstanding long-term guarantee.  The maximum liability under the guarantee is $23 million.  The Company does not expect to make any payments under the terms of this guarantee, and accordingly, has not accrued for any portion of it.

 

13.         Variable Interest Entities - The Company holds ownership interests in certain special-purpose entities formed to provide affordable housing.  The Company evaluates its interest in these entities to determine whether they meet the definition of a variable interest entity (“VIE”) and whether the Company is required to consolidate these entities.  None of the Company’s investments in VIEs met the criteria for consolidation at June 30, 2008, December 31, 2007, or June 30, 2007.  The Company initially records its investment in these entities at cost, which approximates the maximum exposure to loss as a result of its involvement with these unconsolidated entities.  Subsequently, the carrying value is amortized over the stream of available tax credits and benefits.  The Company expects to recover its investments over time, primarily through realization of federal low-income housing tax credits.  The balance of affordable housing investments was $70.6 million, $73.6 million and $67.2 million at June 30, 2008, December 31, 2007, and June 30,

 

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2007, respectively.  Affordable housing VIEs are included in Affordable housing investments in the consolidated balance sheet with associated income reported in Other noninterest income in the consolidated statement of income.

 

The Company also has ownership interests in several private equity and alternative investment funds that are variable interest entities.   The Company is not required to consolidate these VIEs.  The Company carries its investment in these entities at cost, which approximates the maximum exposure to loss as a result of its involvement with these entities.  The Company expects to recover its investments over time, primarily through the allocation of fund income or loss, gains or losses on the sale of fund assets or interest income.  The balance in these entities was $31.8 million, $28.4 million and $20.6 million at June 30, 2008, December 31, 2007, and June 30, 2007, respectively, and is included in Other assets in the consolidated balance sheet.  Income associated with these investments is reported in Other noninterest income in the consolidated statement of income. The Company reviews these investments at least quarterly for possible other-than-temporary impairment. In addition to the entities described above, Convergent Wealth is the administrative manager of the Barlow Long-Short Equity Fund, a hedge fund that is a variable interest entity.  Convergent Wealth is not required to consolidate this entity.

 

14.