PacWest Bancorp 10-K 2006
Documents found in this filing:
Washington, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File No. 00-30747
FIRST COMMUNITY BANCORP
(Exact Name of Registrant as Specified in Its Charter)
Registrants telephone number, including area code: (858) 756-3023
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common stock, no par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of Accelerated Filer and Large Accelerated Filer in Rule 12b-2 of the Exchange Act. (check one): Large Accelerated Filer o Accelerated Filer x Non-accelerated Filer o
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act.) Yes o No x
As of June 30, 2005, the aggregate market value of the voting common stock held by non-affiliates of the registrant, computed by reference to the average high and low sales prices on the Nasdaq National Market as of the close of business on June 30, 2005, was approximately $632.4 million. Registrant does not have any nonvoting common equities.
As of March 3, 2006, there were 20,104,282 shares of registrants common stock outstanding, excluding 731,164 shares of unvested restricted stock and performance stock.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K will be found in the Companys definitive proxy statement for its 2006 Annual Meeting of Shareholders, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, and such information is incorporated herein by this reference.
We are a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Our principal business is to serve as a holding company for our banking subsidiaries. As of December 31, 2005, those subsidiaries were First National Bank, which we refer to as First National, and Pacific Western National Bank, or Pacific Western. On August 12, 2005, we acquired First American Bank, or First American, which was merged with and into Pacific Western, with Pacific Western surviving the merger. On October 7, 2005, we acquired Pacific Liberty Bank, or Pacific Liberty, and merged Pacific Liberty into Pacific Western, with Pacific Western surviving the merger. We refer to Pacific Western and First National herein as the Banks and when we say we, our or the Company, we mean the Company on a consolidated basis with the Banks. When we refer to First Community or to the holding company, we are referring to the parent company on a standalone basis. Discussions about the Company and the Banks as of and for the year ended December 31, 2005 include First American and Pacific Liberty from and after their respective dates of acquisition.
The Banks are full-service community banks offering a broad range of banking products and services including: accepting time and demand deposits, originating commercial loans, including asset-based lending and factoring of accounts receivable, real estate and construction loans, Small Business Administration guaranteed loans, or SBA loans, consumer loans, mortgage loans, international loans for trade finance and other business-oriented products. At December 31, 2005, the gross loans of the Banks totaled $2.5 billion of which approximately 30% were commercial loans, 68% were commercial real estate loans, including construction loans, and 2% were consumer and other loans. These percentages include some foreign loans, primarily to individuals or entities with business in Mexico, representing 4% of total loans. In addition, special services and requests beyond the lending limits of the Banks can be arranged through correspondent banks.
We derive our income primarily from interest received
on commercial real estate loans, commercial loans and consumer loans and, to a
lesser extent, from interest received on investment securities, fees received
in connection with deposit services as well as loans and other services
offered, including foreign exchange services. Our major operating expenses are
the interest paid by the Banks on deposits and borrowings, employee
compensation and general operating expenses. The Banks rely on a foundation of
locally generated deposits. Our Banks have a relatively low cost of funds due
to a high percentage of noninterest bearing and low cost deposits. Our
operations, like those of other financial institutions operating in Southern
California, are significantly influenced by economic conditions in Southern
California, including the strength of the real estate market, and the fiscal
and regulatory policies of the federal and state government and the regulatory
authorities that govern financial institutions. See
We are committed to maintaining premier, relationship-based community banks in Southern California which serve the needs of small to medium-sized businesses and the owners and employees of those businesses, as well as serving the needs of growing businesses that may not yet meet the credit standards of the Banks through tightly controlled asset-based lending and factoring of accounts receivable. The strategy for serving our target markets is the delivery of a finely-focused set of value-added products and services that satisfy the primary needs of our customers, emphasizing superior service and relationships as opposed to transaction volume or low pricing.
Through our holding company structure, First Community creates operating efficiencies for the Banks by consolidating core administrative, operational and financial functions that serve both of the Banks.
These centralized functions include finance and accounting, legal and compliance, human resources, operations and systems, and credit administration. The most senior level oversight of these functions is performed at the holding company level for the benefit of the Banks, though each function may have a limited number of Bank employees performing such functions. By consolidating these activities at the holding company and negotiating with vendors for services on behalf of the Company as a whole, we believe the Company is better able to integrate systems and manage consistently across the organization as well as provide such services for lower cost than if the Banks were to obtain or perform such services directly. The Banks reimburse the holding company for the cost of the services performed on their behalf, pursuant to an expense allocation agreement.
As of December 31, 2005, our assets totaled approximately $3.2 billion. As of March 3, 2006, we have two wholly-owned banking subsidiaries, First National with 13 branches located in San Diego County and Pacific Western with 35 branches located in Los Angeles, Orange, Riverside, and San Bernardino Counties and in San Francisco, California. First Nationals business includes the asset-based lending and accounts receivable factoring operations of its wholly-owned subsidiary FC Financial, based in Phoenix, Arizona, with lending production offices in Dallas, Texas and Los Angeles and Orange, California.
The Company was organized on October 22, 1999 as a California corporation for the purpose of becoming a bank holding company and to acquire all the outstanding capital stock of Rancho Santa Fe National Bank, First Nationals predecessor.
We have grown rapidly through a series of acquisitions. The following chart summarizes the completed acquisitions since our inception, which are described in more detail below and in Note 2 of Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
We have financed our acquisitions, in part, with cash raised from the sale of our common stock or from the issuance of subordinated debentures. In January 2002, we raised $23.0 million in a private placement from the sale, via a rights offering, of 1.2 million shares of our common stock. The proceeds of the rights offering were used to help fund the acquisition of Pacific Western National Bank. In July 2002, we raised $89.3 million via the sale of 3.9 million shares of our common stock in a registered public offering, which we refer to as the 2002 offering. The proceeds of the 2002 offering were used to help fund
the acquisitions of Upland Bank, Marathon Bancorp, First National Bank and Bank of Coronado. In August and September 2005, we raised $49.0 million via the sale of 1.0 million shares of our common stock in a registered public offering, which we refer to as the 2005 offering. The proceeds of the 2005 offering were used to help fund the acquisition of First American Bank. In January 2006, we raised $109.5 million via the sale of 1.9 million shares of our common stock in a registered public offering. The proceeds of the January 2006 offering were used to provide regulatory capital to support the acquisition of Cedars Bank. We have issued and have outstanding a total of $121.7 million in subordinated debentures as follows: $8.2 million issued in 2000, $20.6 million issued in 2001, $10.3 million in 2002, $20.6 million issued in 2003, and $61.9 million issued in the first quarter of 2004. The proceeds from the last issuance were used to help fund the FC Financial and Harbor National acquisitions. See Note 8 of the Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data. As described in more detail below, we have also financed the acquisitions with the exchange of our common stock for the stock of the target company. Below is a summary of the acquisitions which have occurred since the beginning of 2003.
Bank of Coronado Acquisition
On January 9, 2003, we acquired Bank of Coronado. We paid approximately $11.6 million in cash for all of the shares of common stock and options of Bank of Coronado. Upon completion of the acquisition, Bank of Coronado was merged into First National.
Verdugo Banking Company Acquisition
On August 22, 2003, we acquired Verdugo Banking Company. We paid approximately $34.3 million in cash for all of the outstanding shares of common stock and options of Verdugo Banking Company. At the time of the acquisition, Verdugo Banking Company was merged into Pacific Western.
First Community Financial Corporation
On March 1, 2004, we acquired FC Financial, a privately-held commercial finance company based in Phoenix, Arizona. We paid $40.0 million in cash for all of the outstanding common stock and options of FC Financial. At the time of the acquisition, FC Financial became a wholly-owned subsidiary of First National.
Harbor National Bank Acquisition
On April 16, 2004, we acquired Harbor National. We paid approximately $35.7 million in cash for all of the outstanding shares of common stock and options of Habor National. At the time of the acquisition, Harbor National was merged into Pacific Western.
First American Bank Acquisition
On August 12, 2005, we acquired First American Bank, or First American, based in Rosemead, California. We paid approximately $59.7 million in cash to First American shareholders, and caused First American to pay $2.6 million in cash for all outstanding options to purchase First American common stock. The aggregate deal value was approximately $62.3 million. We made this acquisition to expand our presence in Los Angeles County, California. At the time of the acquisition, First American was merged into Pacific Western.
On October 7, 2005, we acquired Pacific Liberty Bank, or Pacific Liberty, based in Huntington Beach, California. We issued approximately 784,000 shares of our common stock to the Pacific Liberty
shareholders and caused Pacific Liberty to pay $5.0 million in cash for all outstanding options to purchase Pacific Liberty common stock. The aggregate deal value was approximately $41.6 million. We made this acquisition to expand our presence in Orange County, California. At the time of the acquisition, Pacific Liberty was merged into Pacific Western.
On January 4, 2006, we acquired Cedars Bank, or Cedars, based in Los Angeles, California. We paid approximately $120.0 million in cash for all of the outstanding shares of common stock and options of Cedars. At the time of the merger, Cedars was merged into Pacific Western We made this acquisition to expand our presence in Los Angeles, California. At the time of the acquisition, Cedars was merged into Pacific Western. In January 2006, we issued 1,891,086 shares of common stock for net proceeds of $109.5 million. We used these proceeds to augment our regulatory capital in support of the Cedars acquisition.
Foothill Independent Bancorp
On December 15, 2005, First Community announced that it had entered into a definitive agreement to acquire all of the outstanding common stock and options of Foothill Independent Bancorp in exchange for $238.0 million in consideration consisting of First Community Bancorp common stock for the outstanding common stock of Foothill and cash for the Foothill stock options. Foothill Independent Bancorp had $799 million in assets and twelve branch offices at December 31, 2005. The acquisition of Foothill Independent Bancorp is subject to regulatory approval and the approval of Foothill shareholders, and is currently expected to close in the second quarter of 2006. Upon completion of the acquisition, Foothill Independent Bancorp will be merged into Pacific Western.
The Banks are full-service community banks that offer a broad range of banking products and services, including many types of business and personal savings and checking accounts and other commercial and consumer banking services, including foreign exchange services. We derive our income primarily from the interest received on the various loan products, interest on investment securities and to a lesser extent from fees, providing deposit services, foreign exchange services and extending credit. The Banks originate several types of loans, including secured and unsecured commercial and consumer loans, commercial real estate mortgage loans, SBA loans and construction loans. We extend credit to customers located primarily in the counties we serve and through certain programs at First National, we also extend credit and make commercial and real estate loans to businesses located in Mexico. Special services, including international banking services, multi-state deposit services and investment services, or requests beyond the lending limits of the Banks can be arranged through correspondent banks. The Banks issue ATM and debit cards as well as have a network of ATMs and offer access to ATM networks through other major service providers. Through the Banks, we provide these banking and financial services throughout Southern California to small and medium-sized businesses and the owners and employees of those businesses. We also provide asset-based lending and factoring of accounts receivable to small businesses located throughout the southwestern United States through FC Financials office in Phoenix, Arizona, and its employees located in Dallas, Texas and Los Angeles and Orange, California.
Through the Banks, the Company concentrates its lending activities in three principal areas:
(1) Real Estate Loans. Real estate loans are comprised of construction loans, miniperm loans collateralized by first or junior deeds of trust on specific commercial properties and equity lines of credit. The properties collateralizing real estate loans are principally located in our primary market areas of Los Angeles, Orange, San Bernardino, Riverside and San Diego counties in California and the contiguous communities. Construction loans are comprised of loans on commercial, residential
and income producing properties that generally have terms of less than two years and typically bear an interest rate that floats with the Banks base rate, prime rate or another established index. Miniperm loans finance the purchase and/or ownership of commercial properties, including owner-occupied and income producing properties. Miniperm loans are generally made with an amortization schedule ranging from 15 to 25 years with a lump sum balloon payment due in one to ten years. Equity lines of credit are revolving lines of credit collateralized by junior deeds of trust on residential real properties. They generally bear a rate of interest that floats with the Banks base rate or the prime rate and have maturities of five years. From time to time, we purchase participation interests in loans originated by other financial institutions. These loans are subject to the same underwriting criteria and approval process as loans originated directly by us.
The Banks real estate portfolio is subject to certain risks, including, but not limited to (i) a possible downturn in the Southern California economy, (ii) interest rate increases, (iii) reduction in real estate values in Southern California, (iv) increased competition in pricing and loan structure, and (v) environmental risks, including natural disasters. We strive to reduce the exposure to such risks by (a) reviewing each loan request and renewal individually, (b) using a dual signature approval system for the approval of each loan request for loans over a certain dollar amount, (c) adhering to written loan policies, including, among other factors, minimum collateral requirements, maximum loan-to-value ratio requirements, cash flow requirements and personal guarantees, (d) obtaining secondary appraisals, (e) obtaining external independent credit reviews, (f) evaluating concentrations as a percentage of capital and loans, and (g) conducting environmental reviews, where appropriate. We review each loan request on the basis of our ability to recover both principal and interest in view of the inherent risks.
(2) Commercial Loans. Commercial loans are made to finance operations, to provide working capital or for specific purposes, such as to finance the purchase of assets, equipment or inventory. Since a borrowers cash flow from operations is generally the primary source of repayment, our policies provide specific guidelines regarding required debt coverage and other important financial ratios. Commercial loans include lines of credit and commercial term loans. Lines of credit are extended to businesses or individuals based on the financial strength and integrity of the borrower and generally (with some exceptions) are collateralized by short-term assets such as accounts receivable, inventory, equipment or real estate and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with the Banks base rate, the prime rate, LIBOR or another established index. Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debt originally used to purchase fixed assets or, in rare cases, to finance the purchase of businesses. Commercial term loans generally have terms from one to five years. They may be collateralized by the asset being acquired or other available assets and bear interest rates which either float with the Banks base rate, the prime rate, LIBOR or another established index or is fixed for the term of the loan.
The Banks portfolio of commercial loans is subject to certain risks, including, but not limited to (i) a possible downturn in the Southern California economy, (ii) interest rate increases, (iii) deterioration of the value of the underlying collateral, and (iv) the deterioration of a borrowers or guarantors financial capabilities. We strive to reduce the exposure to such risks through (a) reviewing each loan request and renewal individually, (b) using a dual signature approval system, (c) adhering to written loan policies, (d) obtaining independent credit reviews and (e) in the case of certain commercial loans to Mexican or foreign entities, third party insurance which limits our exposure to anywhere from 20 to 30 percent of the underlying loan. In addition, loans based on short-term asset values and factoring arrangements are monitored on a daily, weekly, monthly or quarterly basis and may include lockbox or control account arrangements. In general, the Banks receive and
review financial statements and other documents of borrowing customers on an ongoing basis during the term of the relationship and respond to any deterioration noted.
(3) Consumer Loans. Consumer loans include personal loans, auto loans, boat loans, home improvement loans, equipment loans, revolving lines of credit and other loans typically made by banks to individual borrowers. The Banks consumer loan portfolio is subject to certain risks, including (i) amount of credit offered to consumers in the market, (ii) interest rate increases and (iii) consumer bankruptcy laws which allow consumers to discharge certain debts. We strive to reduce the exposure to such risks through the direct approval of all consumer loans by (a) reviewing each loan request and renewal individually, (b) using a dual signature approval system, (c) adhering to written credit policies, and (d) obtaining external independent credit reviews.
As part of our efforts to achieve long-term stable profitability and respond to a changing economic environment in Southern California and in other areas where we operate, we constantly evaluate a variety of options to augment our traditional focus by broadening the services and products we provide. Possible avenues of growth include more branch locations, expanded days and hours of operation and new types of loan products. To date, we have not expanded into areas of brokerage, annuity, insurance or similar investment products and services and have concentrated primarily on the core businesses of accepting deposits, making loans and extending credit.
No individual or single group of related accounts is considered material in relation to our total assets or to the assets or deposits of either of the Banks, or in relation to the overall business of the Company. However, approximately 68% of our loan portfolio held for investment at December 31, 2005 consisted of real estate-related loans, including construction loans, miniperm loans, commercial real estate mortgage loans and commercial loans secured by commercial real estate. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancial ConditionLoans. Moreover, our business activities are currently focused primarily in Southern California, with the majority of our business concentrated in Los Angeles, Riverside, Orange, San Bernardino and San Diego Counties. Consequently, our results of operations and financial condition are dependent upon the general trends in the Southern California economies and, in particular, the residential and commercial real estate markets. In addition, the concentration of our operations in Southern California exposes us to greater risk than other banking companies with a wider geographic base in the event of catastrophes, such as earthquakes, fires and floods in this region. We conduct foreign lending activities through First National, including commercial and real estate lending, consisting predominantly of loans to individuals or entities located in Mexico. All of our foreign loans are denominated in U.S. dollars and most are collateralized by assets located in the United States or guaranteed or insured by businesses located in the United States. Through its operating subsidiary FC Financial, First National also conducts asset-based lending and factoring of accounts receivable primarily in the states of Arizona, California and Texas.
The banking business in California, specifically in the Banks primary service areas, is highly competitive with respect to originating both loans and deposits as well as other banking and mortgage banking services. The market is dominated by a relatively small number of major banks with a large number of offices and full-service operations over a wide geographic area. Among the advantages such major banks have in comparison to the Banks are their ability to finance and engage in wide-ranging advertising campaigns and to allocate their investment assets to regions of higher yield and demand. These competitors offer certain services which we do not offer directly. In addition, by virtue of their greater total capitalization, such banks have substantially higher lending limits than we offer. Other entities, in both the public and private sectors, seeking to raise capital through the issuance and sale of debt or equity securities
also compete with us for the acquisition of deposits. To obtain deposits, we compete with money market funds and other money market instruments which are not subject to interest rate ceilings. In recent years, increased competition has also developed from specialized finance and non-finance companies that offer wholesale finance, credit card and other consumer finance services (including on-line banking services and personal financial software). Competition for deposit and loan products remains strong from both banking and non-banking institutions and this competition directly affects the rates of those products and the terms on which they are offered to consumers and businesses.
Technological innovation continues to contribute to greater competition in domestic and international financial services markets. Technological innovation has, for example, made it possible for non-depository institutions to offer customers automated transfer payment services previously limited to traditional banking products. In addition, customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATMs, self-service branches and in-store branches.
Mergers between financial institutions have placed additional pressure on banks within the industry to consolidate their operations, reduce expenses and increase revenues to remain competitive. In addition, competition has intensified due to federal and state interstate banking laws, which permit banking organizations to expand geographically with fewer restrictions than in the past. These laws allow banks to merge with other banks across state lines, thereby enabling banks to establish or expand banking operations in our most significant markets. The competitive environment is also significantly affected by federal and state legislation which make it easier for non-bank financial institutions to compete with us.
Economic factors, along with legislative and technological changes, will have an ongoing impact on the competitive environment within the financial services industry. We strive to anticipate and adapt to dynamic competitive conditions, but we can make no assurance as to the effectiveness of these efforts on our future business or results of operations or as to our continued ability to anticipate and adapt to changing conditions. In order to compete with other financial services providers in their primary service areas, we attempt to use, to the fullest extent possible, the flexibility which our independent status permits, including an emphasis on specialized services, local promotional activity and personal contacts. Each of our Banks strives to offer highly personalized banking services. In addition, we intend to continue improving our services and banking products and to cross-market services and banking products provided by one of our Banks but not the other. We believe that through the cross-marketing of products, our Banks can distinguish themselves from other community banks with which we compete based on the range of services provided and products offered. However, we can provide no assurance that we will be able to sufficiently improve our services and/or banking products or successfully compete in our primary service areas.
On June 14, 2005, the Office of the Comptroller of the Currency, which we refer to as the OCC, informed the Companys subsidiary First National Bank that, as of June 13, 2005, the OCC had terminated the Memorandum of Understanding (the MOU) between the OCC and First National, dated April 8, 2004, relating to Bank Secrecy Act/Anti-Money Laundering (BSA/AML) matters. The memorandum required us to evaluate and strengthen our BSA/AML program and processes. The memorandum was limited in scope to BSA/AML issues and management believes that it did not have any material impact on our operating results or financial condition. The OCC stated that it had determined that First National had complied with its obligations under the terms of the MOU.
As of March 3, 2006, First National had 199 full time equivalent employees, Pacific Western had 382 full time equivalent employees, and First Community had 100 full time equivalent employees.
Certain of our statistical information is presented within Item 6. Selected Financial Data, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 7A. Qualitative and Quantitative Disclosure About Market Risk. This information should be read in conjunction with the consolidated financial statements contained in Item 8. Financial Statements and Supplementary Data.
The banking and financial services business in which we engage is highly regulated. Such regulation is intended, among other things, to protect depositors insured by the Federal Deposit Insurance Corporation, or FDIC, and the entire banking system. The commercial banking business is also influenced by the monetary and fiscal policies of the federal government and the policies of the FRB. The FRB implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments and deposits and also affects interest rates charged on loans and paid on deposits. Indirectly such actions may also impact the ability of non-bank financial institutions to compete with the Banks. The nature and impact of any future changes in monetary policies cannot be predicted.
The laws, regulations and policies affecting financial services businesses are continuously under review by Congress, state legislatures and federal and state regulatory agencies. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and by various bank regulatory agencies and other professional agencies. Changes in the laws, regulations or policies that impact us cannot necessarily be predicted, but they may have a material effect on our business and earnings.
Bank Holding Company Regulation
As a bank holding company, First Community is registered with and subject to regulation by the FRB under the Bank Holding Company Act of 1956, as amended, or the BHCA. In accordance with FRB policy, First Community is expected to act as a source of financial strength to the Banks and to commit resources to support the Banks in circumstances where it might not otherwise do so. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act (FDIA), the FDIC can hold any FDIC-insured depository institution liable for any loss suffered or anticipated by the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to such a commonly controlled institution. Because Castle Creek is a holding company for us as well as for a bank in Texas, in the event of a default at, or assistance to, the Texas bank, our Banks could have liability even though we have no control over the Texas bank. Under the BHCA, we are subject to periodic examination by the FRB. We are also required to file with the FRB periodic reports of our operations and such additional information regarding the Company and its subsidiaries as the FRB may require. Pursuant to the BHCA, we are required to obtain the prior approval of the FRB before we acquire all or substantially all of the assets of any bank or ownership or control of voting shares of any bank if, after giving effect to such acquisition, we would own or control, directly or indirectly, more than 5 percent of such bank.
Under the BHCA, we may not engage in any business other than managing or controlling banks or furnishing services to its subsidiaries that the FRB deems to be so closely related to banking as to be a proper incident thereto. We are also prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5 percent of the voting shares of any company unless the company is engaged in banking activities or the FRB determines that the activity is so closely related to banking to be a proper incident to banking. The FRBs approval must be obtained before the shares of any such company can be acquired and, in certain cases, before any approved company can open new offices.
Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in a wider range of nonbanking activities, including securities and insurance activities and any other activity that the FRB, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies. As of the date of this filing, we do not operate as a financial holding company.
The BHCA and regulations of the FRB also impose certain constraints on the redemption or purchase by a bank holding company of its own shares of stock.
Our earnings and activities are affected by legislation, by regulations and by local legislative and administrative bodies and decisions of courts in the jurisdictions in which we and the Banks conduct business. For example, these include limitations on the ability of the Banks to pay dividends to us and our ability to pay dividends to our shareholders. It is the policy of the FRB that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organizations expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding companys ability to serve as a source of strength to its banking subsidiaries. Various federal and state statutory provisions limit the amount of dividends that subsidiary banks and savings associations can pay to their holding companies without regulatory approval. In addition to these explicit limitations, the federal regulatory agencies have general authority to prohibit a banking subsidiary or bank holding company from engaging in an unsafe or unsound banking practice. Depending upon the circumstances, the agencies could take the position that paying a dividend would constitute an unsafe or unsound banking practice.
In addition, banking subsidiaries of bank holding companies are subject to certain restrictions imposed by federal law in dealings with their holding companies and other affiliates. Subject to certain exceptions set forth in the Federal Reserve Act, a bank can make a loan or extend credit to an affiliate, purchase or invest in the securities of an affiliate, purchase assets from an affiliate, accept securities of an affiliate as collateral for a loan or extension of credit to any person or company, issue a guarantee or accept letters of credit on behalf of an affiliate only if the aggregate amount of the above transactions of such subsidiary does not exceed 10 percent of such subsidiarys capital stock and surplus on an individual basis or 20 percent of such subsidiarys capital stock and surplus on an aggregate basis. Such transactions must be on terms and conditions that are consistent with safe and sound banking practices. A bank and its subsidiaries generally may not purchase a low-quality asset, as that term is defined in the Federal Reserve Act, from an affiliate. Such restrictions also prevent a holding company and its other affiliates from borrowing from a banking subsidiary of the holding company unless the loans are secured by collateral.
The FRB has cease and desist powers over parent bank holding companies and non-banking subsidiaries where the action of a parent bank holding company or its non-financial institutions represent
an unsafe or unsound practice or violation of law. The FRB has the authority to regulate debt obligations, other than commercial paper, issued by bank holding companies by imposing interest ceilings and reserve requirements on such debt obligations.
Regulation of the Banks
The Banks are extensively regulated under federal law, and to a lesser extent, state law.
The Banks are insured by the FDIC, which currently insures deposits of each member bank to a maximum of $100,000 per depositor. For this protection, the Banks, as is the case with all insured banks, pay a quarterly statutory assessment and are subject to the rules and regulations of the FDIC. First Community is a member of the Federal Reserve System and is subject to primary regulation by the FRB. First National and Pacific Western are national banks and therefore regulated primarily by the OCC.
Various requirements and restrictions under federal law affect the operations of the Banks. Federal statutes and regulations relate to many aspects of the Banks operations, including standards for safety and soundness, reserves against deposits, interest rates payable on deposits and loans, investments, mergers and acquisitions, borrowings, dividends, locations of branch offices, fair lending requirements, Community Reinvestment Act activities and loans to affiliates. Further, the Banks are required to maintain certain levels of capital. The following are the regulatory capital guidelines and the actual capitalization levels for First National, Pacific Western and the Company as of December 31, 2005:
The Company issued subordinated debentures to trusts that were established by us which, in turn, issued $118 million of trust preferred securities. These securities are currently included in our Tier I capital for purposes of determining the Companys Tier I and total risk-based capital ratios. The FRB, which is the holding companys banking regulator, has promulgated a modification of the capital regulations affecting trust preferred securities. Under this modification, effective March 31, 2009, the Company will be required to use a more restrictive formula to determine the amount of trust preferred securities that can be included in regulatory Tier I capital. At that time, the Company will be allowed to include in Tier I capital an amount of trust preferred securities equal to no more than 25% of the sum of all core capital elements, which is generally defined as shareholders equity, less goodwill net of any related deferred income tax liability. The regulations currently in effect through December 31, 2008, limit the amount of trust preferred securities that can be included in Tier I capital to 25% of the sum of core capital elements without a deduction for goodwill. We have determined that our Tier I capital ratios would remain above the well-capitalized level had the modification of the capital regulations been in effect at December 31, 2005. We expect that our Tier I capital ratios will be at or above the existing well capitalized levels on March 31, 2009, the first date on which the modified capital regulations must be applied.
Prompt Corrective Action
The Federal Deposit Insurance Corporation Improvement Act, or FDICIA, requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. Pursuant to FDICIA, the OCC promulgated regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under the
prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified as undercapitalized if its total risk-based capital is less than 8% or its Tier 1 risk-based capital or leverage ratio is less than 4%. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions and prohibitions, including restrictions on growth, prohibitions on payment of dividends and restrictions on the acceptance of brokered deposits. Furthermore, if a bank is classified in one of the undercapitalized categories, it is required to submit a capital restoration plan to the federal bank regulator, and the holding company must guarantee the performance of that plan.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties. The enforcement of such actions through injunctions or restraining orders may be based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.
Hazardous Waste Clean-Up
Since we are not involved in any business that manufactures, uses or transports chemicals, waste, pollutants or toxins that might have a material adverse effect on the environment, our primary exposure to environmental laws is through our lending activities and through properties or businesses we may own, lease or acquire. Based on a general survey of the loan portfolios of the Banks, conversations with local appraisers and the type of lending currently and historically done by the Banks, we are not aware of any potential liability for hazardous waste contamination that would be reasonably likely to have a material adverse effect on the Company as of March 3, 2006.
On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act aims to restore the credibility lost as a result of recent high profile corporate scandals by addressing, among other issues, corporate governance, auditing and accounting, executive compensation and enhanced and timely disclosure of corporate information. The Nasdaq National Market has adopted corporate governance rules intended to allow shareholders to more easily and effectively monitor the performance of companies and directors. The principal provisions of the Sarbanes-Oxley Act, many of which have been interpreted through regulations released in 2003, provide for and include, among other things: (i) the creation of an independent accounting oversight board; (ii) auditor independence provisions that restrict non-audit services that accountants may provide to their audit clients; (iii) additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer of a public company certify financial statements; (iv) the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuers securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; (v) an increase in the oversight of, and enhancement of certain requirements relating to, audit committees of public companies and how they interact with the Companys independent auditors; (vi) requirements that audit committee members must be independent and are barred from accepting
consulting, advisory or other compensatory fees from the issuer; (vii) requirements that companies disclose whether at least one member of the audit committee is a financial expert (as such term is defined by the SEC) and if not discussed, why the audit committee does not have a financial expert; (viii) expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods; (ix) a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on nonpreferential terms and in compliance with other bank regulatory requirements; (x) disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; (xi) a range of enhanced penalties for fraud and other violations; and (xii) expanded disclosure and certification relating to an issuers disclosure controls and procedures and internal controls over financial reporting.
As a result of the Sarbanes-Oxley Act, and its implementing regulations, we have incurred substantial cost to interpret and ensure compliance with the law and its regulations. Future changes in the laws, regulation, or policies that impact us cannot necessarily be predicted and may have a material effect on our business and earnings.
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the Patriot Act), designed to deny terrorists and others the ability to obtain access to the United States financial system, has significant implications for depository institutions, brokers, dealers and other businesses involved in the transfer of money. The Patriot Act, as implemented by various federal regulatory agencies, requires financial institutions, including the Company, to implement new policies and procedures or amend existing policies and procedures with respect to, among other matters, anti money laundering, compliance, suspicious activity and currency transaction reporting and due diligence on customers. The Patriot Act and its underlying regulations also permit information sharing for counter terrorist purposes between federal law enforcement agencies and financial institutions, as well as among financial institutions, subject to certain conditions, and require the FRB, the OCC and other federal banking agencies to evaluate the effectiveness of an applicant in combating money laundering activities when considering applications filed under Section 3 of the BHCA or the Bank Merger Act. The Company has augmented its systems and procedures to accomplish this. We believe that the cost of compliance with the Patriot Act is not likely to be material to the Company.
On June 14, 2005, the OCC informed the Companys subsidiary First National Bank that, as of June 13, 2005, the OCC had terminated the MOU between the OCC and First National, dated April 8, 2004, relating to Bank Secrecy Act/Anti-Money Laundering matters. The memorandum required us to evaluate and strengthen our BSA/AML program and processes. The memorandum was limited in scope to BSA/AML issues and management believes that it did not have any material impact on our operating results or financial condition. The OCC stated that it had determined that First National had complied with its obligations under the terms of the MOU.
Federal Deposit Insurance
Because of favorable loss experience and a healthy reserve ratio in the Bank Insurance Fund, or the BIF, of the FDIC, well-capitalized and well-managed banks, including the Banks, have in recent years paid minimal premiums for FDIC insurance. While we have no expectation of increased premiums, the amount of any future premiums will depend on the BIF loss experience, legislation or regulatory initiatives and other factors, none of which we are in position to predict at this time.
The Community Reinvestment Act (CRA) generally requires insured depository institutions to identify the communities they serve and to make loans and investments and provide services that meet the credit needs of these communities. Furthermore, the CRA requires the OCC to evaluate the performance of each of the Banks in helping to meet the credit needs of their communities. As a part of the CRA program, the Banks are subject to periodic examinations by the OCC, and must maintain comprehensive records of their CRA activities for this purpose. During these examinations, the OCC rates such institutions compliance with CRA as Outstanding, Satisfactory, Needs to Improve or Substantial Noncompliance. Failure of an institution to receive at least a Satisfactory rating could inhibit such institution or its holding company from undertaking certain activities. The OCC must take into account the record of performance of banks in meeting the credit needs of the entire community served, including low-and moderate-income neighborhoods. Both of the Banks have a CRA rating of Satisfactory as of their most recent examinations.
Customer Information Security
The FRB, the OCC and other bank regulatory agencies have adopted final guidelines for safeguarding confidential, personal customer information. These guidelines require each financial institution, under the supervision and ongoing oversight of its board of directors or an appropriate committee thereof, to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazard to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. We have adopted a customer information security program to comply with such requirements.
The Gramm-Leach-Bliley Act of 1999 (the GLBA) requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to non-affiliated third parties. In general, the statute requires explanations to consumers on policies and procedures regarding the disclosure of such nonpublic personal information, and, except as otherwise required by law, prohibits disclosing such information except as provided in the Banks policies and procedures. Certain state statutes that affect the Company impose parallel or more extensive privacy restrictions. The Banks have implemented privacy policies addressing these restrictions which are distributed regularly to all existing and new customers of the Banks.
We maintain an Internet website at www.firstcommunitybancorp.com, and a website for each of our Banks at www.banksandiego.com and www.pacificwesternbank.com. At www.firstcommunitybancorp.com and via the Investor Relations link at each of the Banks websites, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available, free of charge, as soon as reasonably practicable after such forms are electronically filed with, or furnished to, the SEC. The public may read and copy any materials we file with the SEC at the SECs Public Reference Room, located at 450 Fifth Street, NW, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. You may obtain copies of the Companys filings on the SEC site. These documents may also be obtained in print upon request by our shareholders to our Investor Relations Department.
We have adopted a written code of ethics that applies to all directors, officers and employees of the Company, including our principal executive officer and senior financial officers, in accordance with Section 406 of the Sarbanes-Oxley Act of 2002 and the rules of the Securities and Exchange Commission promulgated thereunder. The code of ethics, which we call our Code of Business Conduct and Ethics, is available on our corporate web site, www.firstcommunitybancorp.com in the section entitled Corporate Governance. In the event that we make changes in, or provide waivers from, the provisions of this code of ethics that the SEC requires us to disclose, we intend to disclose these events on our corporate web site in such section. In the Corporate Governance section of our corporate web site, we have also posted the charters for our Audit Committee and our Compensation, Nominating and Governance Committee, as well as our Corporate Governance Guidelines. In addition, information concerning purchases and sales of our equity securities by our executive officers and directors is posted on our web site.
Our Investor Relations Department can be contacted at First Community Bancorp, 275 N. Brea Blvd., Brea, CA 92821, Attention: Investor Relations, telephone 714-671-6800, or via e-mail to email@example.com.
(All website addresses given in this document are for information only and are not intended to be an active link or to incorporate any website information into this document.)
This Annual Report on Form 10-K contains certain forward-looking information about the Company, which statements are intended to be covered by the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact are forward-looking statements. Such statements involve inherent risks and uncertainties, many of which are difficult to predict and are generally beyond the control of the Company. We caution readers that a number of important factors could cause actual results to differ materially from those expressed in, implied or projected by, such forward-looking statements. Risks and uncertainties include, but are not limited to:
· planned acquisitions and relative cost savings cannot be realized or realized within the expected time frame;
· revenues are lower than expected;
· credit quality deterioration which could cause an increase in the provision for loan losses;
· competitive pressure among depository institutions increases significantly;
· the integration of acquired businesses costs more, takes longer or is less successful than expected;
· the possibility that personnel changes will not proceed as planned;
· the cost of additional capital is more than expected;
· a change in the interest rate environment reduces interest margins;
· asset/liability repricing risks and liquidity risks;
· general economic conditions, either nationally or in the market areas in which the Company does or anticipates doing business, are less favorable than expected;
· the economic and regulatory effects of the continuing war on terrorism and other events of war, including the war in Iraq;
· legislative or regulatory requirements or changes adversely affect First Community Bancorps business;
· changes in the securities markets; and
· regulatory approvals for announced or future acquisitions cannot be obtained on the terms expected or on the anticipated schedule.
If any of these risks or uncertainties materializes or if any of the assumptions underlying such forward-looking statements proves to be incorrect, First Community Bancorps results could differ materially from those expressed in, implied or projected by, such forward-looking statements. First Community Bancorp assumes no obligation to update such forward-looking statements. For additional information concerning risk and uncertainties related to us and our operations, please refer to Items 1 through 7A of this Annual Report.
Ownership of our common stock involves risk. You should carefully consider, in addition to the other information set forth herein, the following risk factors.
Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.
Changes in the interest rate environment may reduce our profits. It is expected that we will continue to realize income from the differential or spread between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. We cannot assure you that we can minimize our interest rate risk. In addition, while an increase in the general level of interest rates may increase our net interest margins and loan yield, it may adversely affect the ability of certain borrowers with variable rate loans to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume and overall profitability.
We face strong competition from financial services companies and other companies that offer banking services which could negatively affect our business.
We conduct our banking operations primarily in Southern California. Increased competition in our market may result in reduced loans and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. Many competitors offer the same banking services that we offer in our service area. These competitors include national banks, regional banks and other community banks. We also face competition from many other types of financial institutions, including without limitation, savings and loan institutions, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, our competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and ATMs and conduct extensive promotional and advertising campaigns.
Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances enable more companies to provide financial services. We also face competition from out-of-state financial
intermediaries that have opened low-end production offices or that solicit deposits in our market areas. If we are unable to attract and retain banking customers, we may be unable to continue our loan growth and level of deposits and our results of operations and financial condition may otherwise be adversely affected.
Changes in economic conditions, in particular an economic slowdown in Southern California, could materially and negatively affect our business.
Our business is directly impacted by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, whether caused by national or local concerns, in particular an economic slowdown in Southern California, could result in the following consequences, any of which could hurt our business materially: loan delinquencies may increase; problem assets and foreclosures may increase; demand for our products and services may decrease; low cost or noninterest bearing deposits may decrease; and collateral for loans made by us, especially real estate, may decline in value, in turn reducing customers borrowing power, and reducing the value of assets and collateral associated with our existing loans. The State of California continues to face fiscal challenges upon which the long-term impact on the States economy cannot be predicted.
A downturn in the real estate market could negatively affect our business.
A downturn in the real estate market could negatively affect our business because a significant portion (approximately 68% as of December 31, 2005) of our loans are secured by real estate. Our ability to recover on defaulted loans by selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans.
Substantially all of our real property collateral is located in Southern California. If there is a significant decline in real estate values, especially in Southern California, the collateral for our loans would provide less security. Real estate values could be affected by, among other things, an economic slowdown, an increase in interest rates, earthquakes and other natural disasters particular to California.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
We currently depend heavily on the services of our chairman, John Eggemeyer, our chief executive officer, Matthew Wagner, and a number of other key management personnel. The loss of Mr. Eggemeyers or Mr. Wagners services or that of other key personnel could materially and adversely affect our results of operations and financial condition. Our success also depends, in part, on our ability to attract and retain additional qualified management personnel. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require.
We are subject to extensive regulation which could adversely affect our business.
Our operations are subject to extensive regulation by federal governmental authorities, and to a lesser extent state and local authorities, and we are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Because our business is highly regulated, the laws, rules and regulations applicable to us are subject to regular modification and change. There are currently proposed laws, rules and regulations that, if adopted, would impact our operations. There can be no assurance that these proposed laws, rules and regulations, or any other laws, rules or regulations, will not be adopted in the future, which could (i) make compliance much more difficult or expensive, (ii) restrict our ability to originate, broker or sell loans or accept certain deposits, (iii) further limit or restrict the amount of commissions, interest or other charges earned on
loans originated or sold by us, or (iv) otherwise adversely affect our business or prospects for business. See Supervision and Regulation below.
We are exposed to transactional, currency and legal risk related to our foreign loans that is in addition to risks we face on loans to U.S.-based borrowers.
A portion of our loan portfolio is represented by credit we extend and loans we make to businesses located outside the United States, predominantly in Mexico. These loans, which include commercial loans, real estate loans and credit extensions for the financing of international trade, are subject to risks in addition to risks we face with our loans to businesses located in the United States including, but not limited to, currency risk, transaction risk, country risk and legal risk. While these loans are denominated in U.S. dollars, the ability of the borrower to repay may be affected by fluctuations in the borrowers home country currency relative to the U.S. dollar. Additionally, while most of our foreign loans are insured by U.S.-based institutions, guaranteed by a U.S.-based entity, or collateralized with U.S.-based assets or real property, our ability to collect in the event of default is subject to a number of conditions and we may not be successful in obtaining partial or full repayment. Furthermore, foreign laws may restrict our ability to foreclose on, take a security interest in, or seize collateral located in the foreign country.
We are exposed to risk of environmental liabilities with respect to properties to which we take title.
In the course of our business, we may own or foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.
Our ability to pay dividends is restricted by law and contractual arrangements and depends on capital distributions from the Banks which are subject to regulatory limits.
Our ability to pay dividends to our shareholders is subject to the restrictions set forth in California law. In addition, our ability to pay dividends to our shareholders is restricted in specified circumstances under indentures governing the trust preferred securities we have issued and under the revolving credit agreements to which we are a party. See Item 5. Market for Registrants Common Equity and Related Stockholder MattersDividends for more information on these restrictions. We cannot assure you that we will meet the criteria specified under California law or under these agreements in the future, in which case we may reduce or stop paying dividends on our common stock.
The primary source of our income from which we pay dividends is the receipt of dividends from our Banks.
The availability of dividends from the Banks is limited by various statutes and regulations. It is possible, depending upon the financial condition of the bank in question and other factors, that the Board of Governors of the Federal Reserve System, and/or the Office of the Comptroller of the Currency could assert that payment of dividends or other payments is an unsafe or unsound practice. In the event our subsidiaries were unable to pay dividends to us, we in turn would likely have to reduce or stop paying dividends on our common stock. Our failure to pay dividends on our common stock could have a material adverse effect on the market price of our common stock. See Supervision and Regulation for additional information on the regulatory restrictions to which we and our Banks are subject.
Only a limited trading market exists for our common stock which could lead to price volatility.
Our common stock was designated for quotation on the Nasdaq National Market in June 2000 and trading volumes since that time have been modest. The limited trading market for our common stock may cause fluctuations in the market value of our common stock to be exaggerated, leading to price volatility in excess of that which would occur in a more active trading market of our common stock. In addition, even if a more active market in our common stock develops, we cannot assure you that such a market will continue or that shareholders will be able to sell their shares.
Our allowance for credit losses may not be adequate to cover actual losses.
In accordance with accounting principles generally accepted in the United States, we maintain an allowance for loan losses to provide for loan defaults and non-performance and a reserve for unfunded loan committments, which when combined, we refer to as the allowance for credit losses. Our allowance for credit losses may not be adequate to cover actual credit losses, and future provisions for credit losses could materially and adversely affect our operating results. Our allowance for credit losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond our control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for credit losses. While we believe that our allowance for credit losses is adequate to cover current losses, we cannot assure you that we will not further increase the allowance for credit losses or that regulators will not require us to increase this allowance. Either of these occurrences could materially and negatively affect our earnings. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.
Concentrated ownership of our common stock creates a risk of sudden changes in our share price.
As of March 3, 2006, directors and members of our executive management team owned or controlled approximately 13.1% of our common stock, excluding shares that may be issued to executive officers upon payment of restricted and performance stock awards and exercise of stock options. Investors who purchase our common stock may be subject to certain risks due to the concentrated ownership of our common stock. The sale by any of our large shareholders of a significant portion of that shareholders holdings could have a material adverse effect on the market price of our common stock. In addition, the registration of any significant amount of additional shares of our common stock will have the immediate effect of increasing the public float of our common stock and any such increase may cause the market price of our common stock to decline or fluctuate significantly.
Our largest shareholder is a registered bank holding company and the activities and regulation of such shareholder may affect the permissible activities of the Company.
Castle Creek Capital, LLC, which we refer to as Castle Creek, is controlled by our chairman, John M. Eggemeyer, and beneficially owned approximately 9.1% of the Company as of March 3, 2006. Castle Creek is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and is regulated by the Board of Governors of the Federal Reserve System, or FRB. Under FRB guidelines, holding companies must be a source of strength for their subsidiaries. See Supervision and RegulationBank Holding Company Regulation. Regulation of Castle Creek by the FRB may adversely affect the activities and strategic plans of the Company should the FRB determine that Castle Creek or any other company in which Castle Creek has invested has engaged in any unsafe or unsound banking practices or activities. While we have no reason to believe that the FRB is proposing to take any action with respect to Castle Creek that would adversely affect the Company, we remain subject to such risk.
As of March 3, 2006, we had a total of 67 properties consisting of 47 branch offices, 3 annex office, 2 operations centers and 15 other properties of which 15 are subleased. We own 4 locations and the remaining properties are leased. All properties are located in Southern California except for the annex office used by FC Financial, which is located in Phoenix, Arizona and a Pacific Western branch office located in San Francisco. Pacific Western operates through 35 branches and its principal office is located at 120 Wilshire Blvd., Santa Monica, California 90401. First National operates through 13 branches and its principal office is located at 401 West A Street, San Diego, California 92101.
For additional information regarding properties of the Company and of the Banks, see Item 8. Financial Statements and Supplementary Data.
On June 8, 2004, the Company was served with an amended complaint naming First Community and Pacific Western as defendants in a class action lawsuit filed in Los Angeles Superior Court pending as Gilbert et. al v. Cohn et al, Case No. BC310846 (the Gilbert Litigation). A former officer of First Charter Bank, N.A. (First Charter), which the Company acquired in October 2001, was also named as a defendant. That former officer left First Charter in May of 1997 and later became a principal of Four Star Financial Services, LLC (Four Star), an affiliate of 900 Capital Services, Inc. (900 Capital).
On April 18, 2005, the plaintiffs filed the second amended class action complaint. The second amended complaint alleged that the former officer of First Charter improperly induced several First Charter customers to invest in 900 Capital or affiliates of 900 Capital and further alleges that Four Star, 900 Capital and some of their affiliated entities perpetuated their fraud upon investors through various accounts at First Charter, First Community and Pacific Western with those banks purported knowing participation in and/or willful ignorance of the scheme. The key allegations in the second amended complaint dated back to the mid-1990s and the second amended complaint alleged several counts for relief including aiding and abetting, conspiracy, fraud, breach of fiduciary duty, relief pursuant to the California Business and Professions Code, negligence and relief under the California Securities Act stemming from an alleged fraudulent scheme and sale of securities issued by 900 Capital and Four Star. In disclosures provided to the parties, plaintiffs have asserted that the named plaintiffs have suffered losses well in excess of $3.85 million, and plaintiffs have asserted that losses to the class total many tens of millions of dollars. While we understand that the plaintiffs intend to seek to certify a class for purposes of pursuing a class action, a class has not yet been certified and no motion for class certification has been filed. On June 15, 2005, we filed a demurrer to the second amended complaint, and on August 22, 2005, the Court sustained our demurrer as to each of the counts therein, granting plaintiffs leave to amend on four of the six counts, and dismissing the other counts outright.
On August 12, 2005, the Company was notified by Progressive Casualty Insurance Company (Progressive), its primary insurance carrier with respect to the Gilbert Litigation, that Progressive had determined that, based upon the allegations in the second amended complaint filed in the Gilbert Litigation, there is no coverage with respect to the Gilbert Litigation under the Companys insurance policy with Progressive. Progressive also notified the Company that it was withdrawing its agreement to fund defense costs for the Gilbert Litigation and reserving its right to seek reimbursement from the Company for any defense costs advanced pursuant to the insurance policy. Through December 31, 2005, Progressive had advanced to the Company approximately $690,000 of defense costs with respect to the Gilbert Litigation.
On August 12, 2005, Progressive filed an action in federal district court for declaratory relief, currently pending as Progressive Casualty Insurance Company, etc., v. First Community Bancorp, etc., et al., Case No. 05-5900 SVW (MAWx) (the Progressive Litigation), seeking a declaratory judgment with respect to the parties rights and obligations under Progressives policy with the Company. On October 11, 2005, the Company filed in federal court a motion to dismiss or stay the Progressive Litigation.
In November 2005, along with certain other defendants, we reached an agreement in principle with respect to the Gilbert Litigation. The proposed settlement, toward which First Community would contribute $775,000, is subject to the final settlement terms and documentation being agreed upon by First Community, the plaintiffs and other parties who are also contributing to this settlement. Additionally, the settlement is subject to approval by the Los Angeles Superior Court. While we believe that this settlement, if finalized, will end our exposure to the underlying claims by participating class members, we cannot be certain that a final settlement will be reached or that we will not be subject to further claims by parties related to the same claims who did not participate in the settlement. In connection with the Gilbert Litigation settlement, we also reached a settlement in principle with Progressive Casualty Insurance Co. in the Progressive Litigation. The settlement with Progressive, which includes an additional contribution by Progressive under First Communitys policy toward the settlement of the Gilbert Litigation and a dismissal by Progressive of any claims against First Community for reimbursement, is contingent upon the consummation of the Gilbert Litigation settlement.
In the ordinary course of our business, we are party to various other legal actions, which we believe are incidental to the operation of our business. Although the ultimate outcome and amount of liability, if any, with respect to these other legal actions to which we are currently a party cannot presently be ascertained with certainty, in the opinion of management, based upon information currently available to us, any resulting liability is not likely to have a material adverse effect on the Companys consolidated financial position, results of operations or cash flows.
No matters were submitted to the shareholders of the Company, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 2005.
On June 1, 2000, our common stock was designated for quotation on the Nasdaq National Market® and trades under the symbol FCBP. The following table summarizes the high and low bid prices for each quarterly period ended since January 1, 2004 for our common stock, as quoted and reported by the Nasdaq National Market:
As of March 3, 2006, the closing price of our common stock on Nasdaq was $60.07 per share. As of that date, we believe, based on the records of our transfer agent, that there were approximately 1,375 record holders of our common stock.
Our ability to pay dividends to our shareholders is subject to the restrictions set forth in the California General Corporation Law, or the CGCL. The CGCL provides that a corporation may make a distribution to its shareholders if the corporations retained earnings equal at least the amount of the proposed distribution. The CGCL further provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions: (i) the corporations assets equal at least 11¤4 times its liabilities and (ii) the corporations current assets equal at least its current liabilities or, alternatively, if the average of the corporations earnings before taxes on income and interest expense for the two preceding fiscal years was less than the average of the corporations interest expense for such fiscal years, the corporations current assets equal at least 11¤4 times its current liabilities. Our ability to pay dividends is also subject to certain other limitations. See Item 1. BusinessSupervision and Regulation.
Our primary source of income is the receipt of dividends from the Banks. The availability of dividends from the Banks is limited by various statutes and regulations. It is possible, depending upon the financial condition of the bank in question, and other factors, that the FRB and/or the OCC could assert that payment of dividends or other payments is an unsafe or unsound practice. In addition, our ability to pay dividends is limited by certain provisions of our credit agreements with U.S. Bank, N.A. and The Northern Trust Company. Both agreements provide that we may not declare or pay any dividend on the Companys common stock in any quarter if such dividend, when added together with any purchases or redemptions of the Companys capital stock and the previous three quarterly cash dividends declared and paid, would exceed fifty percent (50%) of the Companys consolidated net income for the immediately preceding four
quarterly periods. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Note 17 of Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
Our ability to pay dividends is also limited by certain covenants contained in the indentures governing trust preferred securities that we have issued, and the debentures underlying the trust preferred securities. The indentures provide that if an Event of Default (as defined in the indentures) has occurred and is continuing, or if we are in default with respect to any obligations under our guarantee agreement which covers payments of the obligations on the trust preferred securities, or if we give notice of any intention to defer payments of interest on the debentures underlying the trust preferred securities, then we may not, among other restrictions, declare or pay any dividends (other than a dividend payable by the Banks to the holding company) with respect to our common stock. See Note 8 of the Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
Holders of our common stock are entitled to receive dividends declared by our Board of Directors out of funds legally available under the laws of the State of California, subject to the rights of holders of any preferred stock of the Company that may be issued in the future. Since January 1, 2004 we have declared the following quarterly dividends:
We believe that the Company will be able to continue paying quarterly dividends, however we can provide no assurance that we will continue to declare dividends on a quarterly basis or otherwise. The declaration of dividends by the Company is subject to the discretion of our Board of Directors. Our Board of Directors will take into account such matters as general business conditions, our financial results, capital requirements, contractual, legal and regulatory restrictions on the payment of dividends by us to our shareholders or by our subsidiaries to the holding company, and such other factors as our Board of Directors may deem relevant. See BusinessRegulation and Supervision in Part I, Item 1 of this Annual Report on Form 10-K for a discussion of potential regulatory limitations on the holding companys receipt of funds from the Banks.
The following table provides information as of December 31, 2005, regarding securities issued and to be issued under our equity compensation plans that were in effect during fiscal 2005:
(1) The First Community Bancorp 2003 Stock Incentive Plan (the Incentive Plan) was last approved by the shareholders of the Company at our 2004 Annual Meeting of Shareholders.
(2) Amount represents outstanding options only and does not include the 405,831 shares of unvested restricted and performance stock awarded since 2003 and outstanding as of December 31, 2005 with an exercise price of zero.
(3) The total number of shares of common stock that have been approved for issuance pursuant to awards granted or which may be granted in the future under the Incentive Plan is 2,500,000 shares. The number of securities remaining available for future issuance has been reduced by 405,831 shares which represents the sum of the number of unvested shares of restricted and performance stock awards outstanding at December 31, 2005 and the number of shares of restricted and performance stock awarded and vested by December 31, 2005.
(4) All of the 419,909 shares remaining available for issuance under the Incentive Plan may be issued not only for future grants of options, warrants and rights, but also for future grants of restricted and performance stock awards. In July 2003, the Company replaced the practice of granting stock options with awards of restricted stock and performance stock. While the Company has not issued any stock options since such time, it may do so in the future. In January and February 2006, the Company granted 327,000 of performance and restricted stock awards reducing the shares remaining available for issuance under the Incentive Plan to 92,909.
During the past three years, the Company has issued unregistered debt securities through three offerings of trust preferred securities. The details of those offerings are set forth below:
(1) The securities were sold in a private placement. We are informed by the initial purchasers that the securities were resold in transactions exempt from registration pursuant to Rule 144A under the Securities Act of 1933, as amended, to qualified institutional buyers as such term is defined in Rule 144A and in accordance with the procedures set forth in such Rule.
Additional information regarding the offering of our debt securities and the trust preferred securities is set forth in Note 8 of the Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
Through the Companys Directors Deferred Compensation Plan, or the DDCP, participants in the plan may reinvest deferred amounts in the Companys common stock. The Company has the discretion whether to track purchases of Common stock as if made, or to fully fund the DDCP via purchases of stock with deferred amounts. Purchases of Company common stock by the rabbi trust of the DDCP are considered repurchases of common stock by the Company since the rabbi trust is an asset of the Company. Actual purchases of Company common stock via the DDCP are made through open market purchases pursuant to the terms of the DDCP, which includes a predetermined formula and schedule for the purchase of such stock in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934. Pursuant to the terms of the DDCP, generally purchases are actually made or deemed to be made in the open market on the 15th of the month (or the next trading day) following the day on which deferred amounts are contributed to the DDCP, beginning March 15 of each year. Listed in the table below are the purchases made by the DDCP for the fourth quarter of 2005:
The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2005. This data should be read in conjunction with our audited consolidated financial statements as of December 31, 2005 and 2004, and for each of the years in the three-year period ended December 31, 2005, and related Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
(1) Operating results of acquired companies are included from the respective acquisition dates. See Note 2 of Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
(2) Includes 405,831 shares, 585,416 shares and 460,000 shares of unvested restricted and performance stock outstanding at December 31, 2005, 2004 and 2003.
(3) The 2001 balance includes the reserve for unfunded loan commitments.
(4) 2004 includes a short-term $365 million interest-bearing deposit received on December 31, 2004.
This section should be read in conjunction with the disclosure regarding Forward-Looking Statements set forth in Item 1. BusinessForward-Looking Statements, as well as the discussion set forth in Item 1. BusinessCertain Business Risks and Item 8. Financial Statements and Supplementary Data.
We are a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Our principal business is to serve as the holding company for our subsidiary banks, First National Bank and Pacific Western National Bank, which we refer to as the Banks. Through the holding company structure, First Community creates operating efficiencies for the Banks by consolidating core administrative, operational and financial functions that serve both of the Banks. The Banks reimburse the holding company for the cost of the services performed on their behalf, pursuant to an expense allocation agreement. See Item 1. BusinessGeneral above.
The Banks are full-service community banks offering a broad range of banking products and services including: accepting time and demand deposits, originating commercial loans, including asset-based lending and factoring, real estate and construction loans, Small Business Administration guaranteed loans, or SBA loans, consumer loans, mortgage loans, international loans for trade finance, and other business-oriented products. At December 31, 2005, our gross loans totaled $2.5 billion of which approximately 30% consisted of commercial loans, 68% consisted of commercial real estate loans, including construction loans, and 2% consisted of consumer and other loans. Accordingly, the portfolios value and credit quality is affected in large part by real estate trends in Southern California. These percentages include some foreign loans, primarily to individuals or entities with business in Mexico, representing 4% of total loans.
The Banks compete actively for deposits, and we tend to solicit noninterest-bearing deposits. In managing the top line of our business, we focus on loan growth and loan yield, deposit cost, and net interest margin, as net interest income accounts for 92% of our net revenues (net interest income plus noninterest income).
On August 12, 2005, we acquired First American Bank, or First American, and merged First American into Pacific Western. On October 7, 2005, we acquired Pacific Liberty Bank, or Pacific Liberty, and merged Pacific Liberty into Pacific Western. Discussions about the Company and the Banks as of and for the year ended December 31, 2005 includes First American and Pacific Liberty from and after their respective dates of acquisition.
Among other factors, our operating results depend generally on the following:
The Level of Our Net Interest Income
Net interest income is the excess of interest earned on our interest-earning assets over the interest paid on our interest-bearing liabilities. Our primary interest-earning assets are loans and investment securities. Our primary interest-bearing liabilities are deposits, borrowings, and subordinated debentures. We attempt to increase our net interest income by maintaining a high level of noninterest-bearing deposits. At December 31, 2005, approximately 49% of our deposits were noninterest-bearing. Although we have borrowing capacity under various credit lines, we have traditionally borrowed funds only for short term liquidity needs such as managing deposit flows and interim acquisition financing. Some of our long-term borrowings are matched to the asset-based loan portfolio acquired in the FC Financial acquisition. Net
proceeds from our other long-term borrowings, consisting of subordinated debentures, were used to fund certain of our acquisitions. Our general policy is to price our deposits in the bottom half or third-quartile of our competitive peer group, resulting in deposit products that bear interest rates at somewhat lower yields. While our deposit balances will fluctuate depending on deposit holders perceptions of alternative yields available in the market, we attempt to minimize these variances by attracting a high percentage of noninterest-bearing deposits, which have no expectation of yield. Cedars Bank, which we acquired on January 4, 2006, had a higher percentage of interest-bearing deposits than the Company has historically maintained. At the acquisition date, Cedars had 26% of its deposits in demand accounts compared to our 49%, and 44% in time deposits compared to our 11%. We expect that the addition of Cedars will reduce our ratio of demand deposits to total deposits and increase our ratio of time deposits to total deposits.
We generally seek new lending opportunities in the $500,000 to $5 million range, try to limit loan maturities for commercial loans to one year, for construction loans up to 18 months, and for commercial real estate loans up to ten years, and to price lending products so as to preserve our interest spread and net interest margin. We sometimes encounter strong competition in pursuing lending opportunities such that potential borrowers obtain loans elsewhere at lower rates than those we offer.
The Magnitude of Credit Losses
We stress credit quality in originating and monitoring the loans we make and measure our success by the level of our nonperforming assets and the corresponding level of our allowance for credit losses. Our allowance for credit losses is the sum of our allowance for loan losses and our reserve for unfunded loan committments. Provisions for credit losses are charged to operations as and when needed for both on and off balance sheet credit exposure. Loans which are deemed uncollectible are charged off and deducted from the allowance for loan losses. Recoveries on loans previously charged off are added to the allowance for loan losses. Changes in economic conditions, however, such as increases in the general level of interest rates, could negatively impact our customers and lead to increased provisions for credit losses. See also Financial ConditionNonperforming Assets below.
The Level of Our Noninterest Expense
Our noninterest expense includes fixed and controllable overhead, the major components of which are compensation, occupancy, data processing, professional fees and communications. We measure success in controlling such costs through monitoring of the efficiency ratio. We calculate the efficiency ratio by dividing noninterest expense by the sum of net interest income and noninterest income. Accordingly, a lower percentage reflects lower expenses relative to income. The consolidated efficiency ratios have been as follows:
Additionally, our operating results have been influenced significantly by acquisitions. The six acquisitions we completed from January 1, 2003 through December 31, 2005 added approximately $1.1 billion in assets. Our assets at December 31, 2005 totaled approximately $3.2 billion. Our noninterest expenses have increased for all periods presented because of our acquisitions. However, our expense control programs and merger integration routines enabled us to improve our efficiency ratio. In addition to driving down our efficiency ratio during 2005, we have steadily improved this ratio over the last 3 years.
The following discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, and the notes thereto, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. On an ongoing basis, we evaluate our estimates and assumptions based upon historical experience and various other factors and circumstances. We believe that our estimates and assumptions are reasonable; however, actual results may differ significantly from these estimates and assumptions which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and on our results of operations for the reporting periods.
Our significant accounting policies and practices are described in Note 1 to the Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data. The accounting policies that involve significant estimates and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities, are considered critical accounting policies. We have identified our policies for the allowance for credit losses, the fair value of financial instruments, and the carrying values of goodwill, other intangible assets and deferred tax assets as critical accounting policies.
Allowance for Credit Losses
The allowance for loan losses and the reserve for unfunded loan commitments when combined are referred to as the allowance for credit losses. The allowance for loan losses is reported as a reduction of outstanding loan balances and the reserve for unfunded loan commitments is included within other liabilities. On December 31, 2004, we reclassified to other liabilities our reserve for unfunded loan commitments which was previously included with the allowance for loan losses. When we determined the amount of our allowance for loan losses applicable to the real estate loan portion of our portfolio, we included both real estate loan balances and real estate loan commitments because the commitments related to loans which existed and the commitment amounts were expected to be disbursed. We followed this practice through September 30, 2005. At December 31, 2005, we decided to use commitments for all categories of loans in determining our reserve for unfunded loan commitments. Accordingly, we reclassified from the allowance for loan losses to the reserve for unfunded loan commitments the commitment reserve related to real estate loans that was previously included in the allowance for loan losses prior to December 31, 2005. Generally, as loans are funded, the amount of the commitment reserve applicable to such funded loans will be transferred from the reserve for unfunded loan commitments to the allowance for loan losses based on our reserving methodology. The accompanying balance sheets and the allowance for loan losses tables included in Note 5 of Notes to Consolidated Financial Statements contained in Item 8 Financial Statements and Supplementary Data and within Managements Discussion and Analysis of Financial Condition and Results of Operations reflect the reclassification.
We maintain an allowance for loan losses at an amount which we believe is sufficient to provide adequate protection against losses inherent in the loan portfolio at the balance sheet date. Our periodic evaluation of the adequacy of the allowance is based on such factors as our past loan loss experience, known and inherent risks in the portfolio, adverse situations that have occurred but are not yet known that may affect the borrowers ability to repay, the estimated value of underlying collateral, and economic conditions. As we utilize information currently available to evaluate the allowance for loan losses, the allowance for loan losses is subjective and may be adjusted in the future depending on changes in economic conditions or other factors.
The Companys determination of the allowance for loan losses is sensitive to the assigned credit risk ratings and inherent loss rates at any given point in time. Therefore, we perform a sensitivity analysis to provide insight regarding the impact of adverse changes in risk ratings may have on our allowance for loan losses. The sensitivity analysis does not imply any expectation of future deterioration in our loans risk ratings and it does not necessarily reflect the nature and extent of future changes in the allowance for loan losses due to the numerous quantitative and qualitative factors considered in determining our allowance for loan losses. At December 31, 2005, in the event that 5 percent of our loans were downgraded from the pass to substandard category within our current allowance methodology, the allowance for loan losses would increase by approximately $16.9 million. Given current processes employed by the Company, management believes the risk ratings and inherent loss rates currently assigned are appropriate. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions that could be significant to the Companys financial statements.
Although we have established an allowance for loan losses that we consider adequate, there can be no assurance that the established allowance for loan losses will be sufficient to offset losses on loans in the future. Management also believes that the reserve for unfunded loan commitments is adequate. In making this determination, we use the same methodology for the reserve for unfunded loan commitments as we do for the allowance for loan losses and consider the same qualitative factors, as well as an estimate of the probability of drawdown of the commitments correlated to their credit risk rating. Please see Financial ConditionAllowance for Credit Losses and Notes 1(h) and 5 of Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data for more information.
Goodwill and Other Intangible Assets
As a result of our acquisition activity, goodwill and core deposit and customer relationship intangible assets have been added to our balance sheet. While the core deposit and customer relationship intangibles arising from several acquisitions are being amortized over their estimated useful lives of up to 10 years, the amortization of goodwill was discontinued for periods after December 31, 2001, in accordance with generally accepted accounting principles. Instead, goodwill, a long-lived asset, is evaluated for impairment at least annually. We selected June 30th as our interim impairment analysis date to evaluate the carrying value of goodwill each year.
The process of evaluating goodwill for impairment requires us to make several assumptions and estimates. We begin the valuation process by identifying the reporting units related to the goodwill. We identified one reporting unit, banking operations, in relation to our goodwill asset. If our impairment analysis indicates that the fair value of our reporting unit is less than its carrying amount, then we will have to writedown the amount of goodwill we carry on our balance sheet through a charge to our operations.
Our impairment analysis estimated the value of our reporting unit using three methods: an income approach which is a discounted cash flow model, a market comparison approach, and a market transaction approach. Each of these valuation methods include several assumptions, including forecasts of future earnings of our reporting unit, discount rates, market trends and market multiples of companies engaged in similar lines of business. If any of the assumptions used in the valuation of our goodwill change over time, the estimated value assigned to our goodwill could differ significantly, including a decrease in the value of goodwill which would result in a charge to our operations. The most significant element in the goodwill evaluation is the level of our earnings. If our earnings were to decline and cause our market capitalization to decline also, the market value of our Company may not support the carrying value of goodwill. The goodwill for our one reporting unit was last evaluated for impairment as of June 30, 2005, and no impairment was identified.
The calculation and subsequent amortization of core deposit and customer relationship intangible assets also requires several assumptions including, among other things, the estimated cost to service
deposits acquired, discount rates, estimated attrition rates of the acquired deposits and in the case of the customer relationship intangible the acquired loans, and estimated useful lives. If the value of the core deposit intangible or the customer relationship intangible is determined to be less than the carrying value in future periods, a writedown would be taken through a charge to our earnings. The most significant element in either intangible evaluation is the attrition rate of the acquired deposits or loans. If such attrition rate were to accelerate from that which we expected, the intangible may have to be reduced by a charge to operations. The attrition rate related to deposit flows or loan flows is influenced by many factors, the most significant of which are alternative yields available to customers and the level of competition from other financial institutions and financial services companies.
Deferred Income Tax Assets
Our deferred income tax assets arise from mainly two items: (1) differences in the dates that items of income and expense enter into our reported income and taxable income and (2) net operating loss carryforwards. Deferred tax assets are established for these items as they arise based on our judgments that they are realizable. From an accounting standpoint, we determine whether a deferred tax asset is realizable based on the historical level of our taxable income and estimates of our future taxable income. In most cases, the realization of the deferred tax asset is based on our future profitability. If we were to experience either reduced profitability or operating losses in a future period, the realization of our deferred tax assets would be questionable. In such an instance, we could be required to increase the valuation reserve on our deferred tax assets by charging earnings.
We analyze our performance based on net earnings determined in accordance with accounting principles generally accepted in the United States. The comparability of financial information is affected by our acquisitions. Operating results include the operations of acquired entities from the dates of acquisition. Bank of Coronado ($88 million in assets) was acquired in January 2003, Verdugo Banking Company ($212 million in assets) was acquired in August 2003, FC Financial ($106 million in assets) was acquired in March 2004, Harbor National ($198 million in assets) was acquired in April 2004, First American ($286 million in assets) was acquired in August 2005, and Pacific Liberty ($183 million in assets) was acquired in October of 2005. The following table presents net earnings and summarizes per share data and key financial ratios:
The 39% increase in net earnings during 2005 as compared to 2004 was due mainly to loan growth and acquisitions which together increased our revenues by 22%. The revenue increase was offset by a 7% increase in our noninterest expense. Our net interest income increased during 2005 largely due to a $334 million increase in our average loans over 2004. Noninterest income was $3.3 million lower for 2005
when compared to 2004 and is attributable to reduced gains on asset sales and lower service charges on deposit accounts. The increase in noninterest expenses for 2005 when compared to 2004 was a result of our acquisitions, increased compensation expense and professional fees, and a $775,000 legal settlement. The increased compensation expense for 2005 compared to 2004 is largely the result of an increased number of employees due to acquisitions, staff additions to support expanded lending activity and the amortization of restricted and performance stock awarded after June 30, 2003. Professional fees increased due to expenditures for compliance with the Sarbanes-Oxley Act and legal fees related to outstanding litigation. Other noninterest expense categories increased in order to support customer services and other growth.
The increase in net earnings for 2005 compared to 2004 was primarily due to acquisition activity.
Net Interest Income
Net interest income, which is one of our principal sources of income, represents the difference between interest earned on assets and interest paid on liabilities. Net interest margin is net interest income expressed as a percentage of average interest-earning assets. Net interest income is affected by changes in both interest rates and the volume of average interest-earning assets and interest-bearing liabilities. The following table presents, for the periods indicated, the distribution of average assets, liabilities and shareholders equity, as well as interest income and yields earned on average interest-earning assets and interest expense on average interest-bearing liabilities.
(1) Includes nonaccrual loans and loan fees.
(2) Yields on loans and securities have not been adjusted to a tax-equivalent basis because the impact is not material.
Our net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a volume change, as well as changes in the yields earned on interest-earning assets and rates paid on deposits and borrowed funds, referred to as a rate change. The change in interest income/expense attributable to volume reflects the change in volume multiplied by the prior years rate and the change in interest income/expense attributable to rate reflects the change in rates multiplied by the prior years volume. The changes in interest income and expense which are not attributable specifically to either volume or rate are allocated ratably between the two categories. The following table presents, for the years indicated, changes in interest income and expense and the amount of change attributable to changes in volume and rates.
2005 compared to 2004
The increase in net interest income in 2005 over 2004 was due primarily to a increase in both loan volume and loan yield. Loan volume increased due to loan growth, both from acquisitions and to a lesser extent from organic growth. Our net interest income is impacted by the significant amount of noninterest-bearing demand deposits in our balance sheet. We endeavor to acquire and maintain demand deposits which averaged $1.1 billion during 2005, or 46% of total average deposits. Maintaining this high percentage of noninterest-bearing demand deposits to total deposits contributed to our overall cost of deposits being 0.48% for 2005 compared to 0.33% for 2004. We estimated that as a result of the mix and rate structure of the deposits acquired in the Cedars acquisition our net interest margin was negatively impacted by approximately 20 basis points for the month of January 2006 compared to the month of December 2005. In addition, since Cedars entire loan portfolio is composed of variable rate loans, we expect that we will remain asset sensitive.
Loans increased $349.6 million during 2005. Such increase was composed of organic loan growth of $121.1 million and loans acquired of $228.5 million resulting in average loans increasing $334.2 million for the year. During 2005 average loans represented 89% of the total average interest-earning assets compared to 84% for 2004. Maintaining a high concentration of average loans to average interest-earning assets is a key factor in increasing interest income and maintaining our net interest margin, since loan yields are usually higher than yields on investment securities. The yield on average loans increased 94 basis points during 2005. During 2005, our base lending rate increased from 5.25% at December 31, 2004, to 7.25% at December 31, 2005, in response to the market interest rate changes made by the Federal Reserve Bank. Approximately 61% of our loan portfolio is eligible to reprice immediately as our base lending rate changes.
Interest expense increased in 2005 compared to 2004 due largely to an increase in the cost of our interest-bearing liabilities and, to a lesser extent, from the increase in amounts borrowed to fund loan growth and acquisitions. Interest-bearing deposit costs increased 30 basis points to 0.90% in 2005 compared to 2004, as a result of upward adjustments we made in rates offered on money market and certain time deposits in response to competition. The costs for borrowings and subordinated debentures also increased in 2005 as they have repriced in the higher interest rate enviroment. The increase in market interest rates contributed to both the increase in our deposit costs and the upward repricings of our borrowings which resulted in a 52 basis point increase in the cost of our interest-bearing liabilities for 2005
compared to 2004. In a rising interest rate environment we expect our cost of funds to increase and there can be no guarantee that we will be able to keep the net interest margin at the levels we achieved in 2005.
2004 compared to 2003
The increase in net interest income for 2004 compared to 2003 resulted largely from the increased volume in loans, which resulted primarily from organic loan growth and to a lesser extent from the loans acquired through our acquisition activity, coupled with the decrease in the rates paid on our interest-bearing liabilities. Noninterest-bearing demand deposits averaged $933.4 million during 2004, or 44% of total average deposits, and lowered our overall cost of deposits for 2004 to 0.33% compared to 0.51% for 2003. The rate decline on deposits and other interest-bearing liabilities was due largely to the continued low interest rate environment of 2004 and the increase in our noninterest-bearing deposits as a percentage of total deposits year-over-year. Average demand deposits as a percentage of total average deposits were 39% for 2003.
The increase in interest income in 2004 over 2003 was due largely to an increase in average loans. Loans increased by $522.3 million during 2004. Such increase was composed of organic loan growth of $312.5 million and loans acquired of $209.8 million resulting in average loans increasing $404.5 million for the year. The 32 basis point increase in yield on average interest-earning assets to 6.22% for 2004 from 5.90% for 2003 is the result of a change in the mix of earning assets. During 2004 average loans represented 84% of the total average interest-earning assets compared to 78% for 2003.
Total interest expense increased in 2004 compared with 2003 due largely to the $120.5 million increase in average borrowed funds, including subordinated debentures, used to fund loan growth and acquisitions. We increased our subordinated debentures $61.9 million through an offering of trust preferred securities in the first quarter of 2004. Interest expense related to our subordinated debentures totaled $6.1 million for 2004 and $2.9 million for 2003. Our interest expense on deposits decreased compared with 2003 largely as a result of the decline in interest rates paid on deposits during 2004. The cost of interest-bearing liabilities declined one basis point to 1.05% for 2004 compared to 2003 as the cost of borrowings and subordinated debt declined 167 basis points and they represented a higher proportion of interest-bearing liabilities.
Provision for Credit Losses
The amount of the provision for credit losses in each year is a charge against earnings in that year. The amount of provision is based upon managements evaluation of the loan portfolio, past loan loss experience, general economic conditions and other pertinent factors.
We made a provision for credit losses of $1.4 million during 2005 and $465,000 during 2004. The 2005 provision for credit losses was composed of a $1.3 million addition to the allowance for loan losses and $75,000 added to the reserve for unfunded loan commitments. The 2004 provision for credit losses was composed of a $521,000 reduction to the allowance for loan losses and $986,000 added to the reserve for unfunded loan commitments. The provision for 2005 was in response to loan growth and the level of nonaccrual loans. During 2005, approximately $9.5 million of foreign loans were placed on nonaccrual. By December 31, 2005, these loans were either repaid, charged off, or returned to accrual status. The provision for 2004 was in response to loan growth. The allowance for loan losses was $27.3 million at December 31, 2005, and represented 1.11% of loans, net of deferred fees and costs, and 324.2% of nonaccrual loans as of that date. The allowance for loan losses was $24.1 million at December 31, 2004, and represented 1.14% of loans, net of deferred fees and costs, and 270.3% of nonaccrual loans as of that date. The reserve for unfunded commitments totaled $5.7 million at December 31, 2005, and $5.4 million at December 31, 2004. The total reserve for credit losses was $33.0 million at December 31, 2005 and $29.5 million at December 31, 2004. Net loans charged-off in 2005 decreased by $371,000 to $1.2 million when compared to 2004.
The high level of credit quality in our loan portfolio along with modest charge-offs has resulted in moderate provisions for credit losses. Increased provisions for credit losses may be required in the future based on loan and unfunded commitment growth and the affect changes in economic conditions, such as the level of interest rates and real estate values, have on the ability of borrowers to repay their loans. See Critical Accounting Policies, Financial ConditionAllowance for Credit Losses, and Note 5 of Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data.
The following table sets forth the details of noninterest income for the years indicated. The columns titled Increase (Decrease) set forth the year-over-year changes between 2005 and 2004 and between 2004 and 2003.
2005 compared to 2004
Noninterest income was $13.9 million in 2005 compared to $17.2 million in 2004. This decrease in noninterest income results largely from lower service charges and fees on deposit accounts which have declined due to increased market interest rate-related earning credits on business accounts. NSF fees received have also declined approximately $470,000 as we have worked to reduce our overdraft exposure in relation to certain customers.
Gain on sale of loans declined $1.2 million. The 2004 balance includes a gain of $975,000 on the sale of an acquired charged-off loan; there was no such item in 2005. The remaining gain on sale of loans resulted from the sale of $6.8 million of SBA loans in both 2005 and 2004. Based on recently proposed changes to the accounting requirements for loan sales, we have suspended our SBA loan sale program and will instead retain such loans as earning assets. The loss on sale of securities of $45,000 in 2005 related to the write-off of the remaining balance of an interest-only strip initially recorded at the time of a loan sale.
Income from cash surrender value of life insurance policies declined for 2005 when compared to 2004. Income is recognized on the appreciation of the cash surrender value of life insurance policies. The income recognized is noncash income and not subject to income tax. The after-tax equivalent yield for our life insurance policies was 5.18% during 2005 compared to 6.38% during 2004. The decline in the yield on our life insurance policies results mostly from a decline in the market performance on the securities portfolio underlying the life insurance policies. Our crediting rate, or yield for our lif