Item 1. BUSINESS
General Development of Business
CU Bancorp, (the "Company") was incorporated under the laws of the State of California on September 3, 1981. It is the parent of California United Bank, a National Banking Association (the "Bank") which is a wholly owned subsidiary of the Company and the sole subsidiary of the Company.
DESCRIPTION OF BUSINESS
Commercial Banking Business
CU Bancorp is a California corporation incorporated in 1981 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. The Company does not conduct any activities other than in connection with its ownership of the Bank which is CU Bancorp's sole subsidiary. The company functions primarily as the sole stockholder of the Bank and establishes general policies and activities for the Bank. The Bank was founded in April 1982 and provides an extensive range of commercial banking services.
The Bank is a commercial bank which delivers a mix of banking products and services to middle market businesses, the entertainment industry and high net worth individuals. The Bank offers lending, deposit, accounts receivable financing, letters of credit, cash management, SBA and international trade services from seven full -service offices. The Bank's primary focus is to engage in middle market lending to businesses, professionals, the entertainment industry, and high net-worth individuals. While the Bank does not actively solicit retail or consumer banking business, it offers these services primarily to owners, officers, and employees of its business customers, and customers of accounting and business management firms with which the Bank regularly does business.
The Entertainment Division specializes in meeting the banking needs of Southern California's entertainment industry, including motion picture and television financing, record labels, talent agencies, business managers, commercial houses and a variety of other related business activities. This division offers certain specialty products aimed at the entertainment industry and related individuals.
The SBA division offers financing alternatives to businesses in the Bank's market through the use of government guaranteed loans. This division offers both term and shorter term credit products.
The International Trade Services Group offers a broad range of services to support the import/export activities of customers. The division has direct correspondent relationships with major overseas banks, providing business customers with a broad international reach. The division facilitates a wide variety of international banking transactions, including letters of credit, short term trade related financing, domestic and foreign collections, wire transfers, standby commitments and government assisted programs.
The Bank attracts customers and deposits by offering a personalized approach and a high degree of service. The key to the Bank's deposit generation is personal contacts and services rather than rate competition. A significant portion of its business is with business customers who conduct substantially all of their banking business with the Bank.
Either alone or in concert with correspondent banks, the Bank offers a wide variety of credit and deposit services to its customers. Management believes that its current and prospective customers favorably respond to the individualized tailored banking services that the Bank provides. Deposit services,
which the Bank offers, include personal and business checking accounts and savings accounts, insured money market deposit accounts, interest-bearing negotiable orders of withdrawal ("NOW") accounts, and time certificates of deposit, along with IRA and Keogh accounts. The Bank offers sophisticated on line banking capabilities to customers through its electronic banking programs. The Bank has not requested and does not have regulatory approval to offer trust services; nor does it have any present intention to seek such approval. The Bank has made arrangements with a number of trust companies to refer prospective customers, in connection with which the Bank may receive a referral fee.
Continued development of a diversified commercial oriented deposit and lending base is the Bank's highest priority. Loans and time and demand deposits are actively solicited by the directors, officers, and employees of the Bank. The executive and senior officers of the Bank have had substantial experience in soliciting bank deposits and in serving the comprehensive banking needs of small and mid-size businesses.
During 1995, the Bank serviced the commercial banking business from five offices including: its head office at 16030 Ventura Boulevard, in Encino, California 91436, a suburb of Los Angeles; an office in West Los Angeles, located at 10880 Wilshire Boulevard, Los Angeles California 90024, in the Westwood commercial and retail district, with close freeway access; a Ventura County (Camarillo) Regional Office; a South Bay Regional office in Gardena, California; and a San Gabriel Valley Regional Office, located in City of Industry, which serves the San Gabriel Valley and northern Orange County. In January 1996, the Bank added branches in Santa Ana and Anaheim in Orange County as a result of its merger with Corporate Bank.
In January 1996, the Company completed the acquisition of Corporate Bank of Santa Ana California which was merged into the Bank. Corporate Bank served both small and mid market business entities, as well as offering certain consumer based products such as home equity lines of credit and auto loans and leases. It is contemplated that upon full integration of the Corporate Bank business that the business of these offices will mirror those of the Bank as a whole.
On January 10, 1996, the Bank announced an agreement to merge with Home Interstate Bancorp, parent of Home Bank, based in the South Bay. The merger with Home Bank is expected to be completed in mid - 1996, and will create a Bank with 22 branches and over $800 million in assets.
Historical Regulatory Matters
In 1992, the Bank and Bancorp both consented to agreements with their primary regulators, a Formal Agreement with the OCC and a Memorandum of Understanding with the Federal Reserve Bank of San Francisco. In June of 1992, a new management team replaced substantially all of prior management. In November of 1993, following the first OCC examination subsequent to new management's implementation of internal controls and other new management techniques, the OCC released The Bank from the Formal Agreement and later that same month the Federal Reserve Bank of San Francisco determined that Bancorp had met all the requirements of the Memorandum of Understanding and terminated that document. The Bank's capital ratios, as of December 31, 1995, are in excess of all minimums imposed by law and regulation and qualify to rate the Bank as a "well capitalized" bank. For further information see Note 16 to the Financial Statements.
The Formal Agreement required the implementation of certain policies and procedures for the operation of the Bank to improve lending operations and management of the loan portfolio. The Formal Agreement required the Bank to maintain a Tier 1 risk weighted capital ratio of 10.5% and a 6% Tier 1 capital ratio based on adjusted total assets. The Formal Agreement mandated the adoption of a written program to essentially reduce criticized assets, maintain adequate loan loss reserves and improve bank administration, real estate appraisal, asset review management and liquidity policies, and restricted the payment of dividends.
The agreement specifically required the Bank to: 1) create a compliance committee; 2) have a competent chief executive officer and senior loan officer, satisfactory to the OCC, at all times; 3) develop a plan for supervision of management; 4) create and implement policies and procedures for loan administration; 5) create a written loan policy; 6) develop and implement an asset review program; 7) develop and implement a written program for the maintenance of an adequate Allowance for Loan and Lease Losses, and review the adequacy of the Allowance; 8) eliminate criticized assets; 9) develop and implement a written real estate appraisal policy; 10) obtain and improve procedures regarding credit and collateral documentation; 11) develop a strategic plan; 12) develop a capital program to maintain adequate capital (this provision also restricts the payment of dividends by the Bank unless :(a) the Bank is in compliance with its capital program; (b) the Bank is in compliance with 12 U.S.C. Sections 55 and 60; and (c) with the prior written approval of the OCC Regional Administrator; 13) develop and implement a written liquidity, asset and liability management policy; 14) document and support the reasonableness of any management and other fees to any director or other party; 15) correct violations of law; and 16) provide reports to the OCC regarding compliance.
The Company's Memorandum of Understanding ("MOU") with the Federal Reserve required: 1) a plan to improve the financial condition of CU Bancorp and the Bank; 2) development of a formal policy regarding the relationship of CU Bancorp and the Bank, with regard to dividends, intercompany transactions, tax allocation and management or service fees; 3) a plan to assure that CU Bancorp has sufficient cash to pay its expenses; 4) ensure that regulatory reporting is accurate and submitted on a timely basis; 5) prior approval of the Federal Reserve Bank prior to the payment of dividends; 6) prior approval of the Federal Reserve Bank prior to CU Bancorp incurring any debt and 7) quarterly reporting regarding the condition of the Company and steps taken regarding the Memorandum of Understanding.
The release of both agreements indicates that the Company has complied with the Formal Agreement and the Memorandum of Understanding, including improvement of asset and management quality, the development and implementation of policies and procedures as well as reporting methodologies and the maintenance of the required capital ratios.
The Company
Bancorp is a legal entity separate and distinct from the Bank. There are various legal limitations on the ability of the Bank to finance or otherwise supply funds to Bancorp. In particular, under federal banking law, a national bank, such as the Bank, may not declare a dividend that exceeds undivided profits, and the approval of the OCC is required if the total of all dividends declared in any calendar year exceeds such bank's net profits, as defined, for that year combined with its retained net profits for the preceding two years. In addition, federal law significantly limits the extent to which the Bank may supply funds to Bancorp, whether through direct extensions of credit or through purchases of securities or assets, issuance of guarantees or the like. Generally, any loan made by the Bank to Bancorp must be secured by certain kinds and amounts of collateral and is limited to 10% of the Bank's capital and surplus (as defined), and all loans by the Bank to Bancorp are limited to 20% of the Bank's capital and surplus. The Bank may extend credit to Bancorp without regard to these restrictions to the extent such extensions of credit are secured by specific kinds of collateral such as obligations of or guaranteed by the U.S. Government or its agencies and certain bank deposits.
Mortgage Banking
Until November 1993, the Bank operated in two distinct segments, commercial banking and mortgage banking. The Bank sold the origination portion of its mortgage banking division in November 1993 to Republic Bancorp of Ann Arbor Michigan. This division had been established in February of 1988. The purpose of this division was to underwrite residential mortgages and subsequently sell them into the secondary market. Mortgages were originated on both a servicing retained and servicing released basis.
Substantially all the loans originated by this division were presold to institutional investors or government agencies and are only originated subject to this forward commitment.
The Bank retained the mortgage servicing portfolio after the sale of the division, although it retained the former division to service the loans. At December 31, 1995 substantially all of the mortgage loan servicing portfolio had been sold. See Management's Discussion and Analysis for further amplification on operating contributions of this division and the effect of the sale.
Entertainment Division
The Bank's entertainment division, based in its West Los Angeles Regional Office, is designed specifically to serve the needs of accountants and business managers serving artists and other entertainment industry related companies and individuals, while providing a more diverse source of deposits for the Bank as a whole.
Customers and Business Concentration
The Bank believes that there is no single customer whose loss would have a material adverse effect on the Bank. At year end 1995, the Bank obtained approximately 7.2% of its deposits from companies associated with the real estate business, primarily title and escrow companies. While this appears to be a significant deposit concentration, because these deposits are attributable to a large number of companies in a diverse market (from small single family homes to larger projects), the Bank does not believe there is a problematical concentration in any one industry. To account for seasonal and economic variations in this industry, the Bank has taken a number of steps to insure liquidity. Regarding business concentrations in both lending and deposit activities, see Management's Discussion and Analysis.
Competition
The Company does not conduct any business unrelated to the business of the Bank and thus is affected by competition only in the Banking industry.
The Bank's primary commercial banking market area consists of the area encompassed in an approximately sixty mile radius from the downtown Los Angeles area, including much of Ventura County, the San Fernando Valley, Beverly Hills, West Los Angeles, the San Gabriel Valley, the South Bay area and metropolitan areas of the City and County of Los Angeles. The Bank also serves Orange County.
The banking and financial services business in California generally, and in the Bank's market areas specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers. The Bank competes for loans and deposits and customers for financial services with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions and other nonbank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. In order to compete with the other financial services providers, the Bank principally relies upon local promotional activities, personal relationships established by officers, directors and employees with its customers, and specialized services tailored to meet its customers' needs. In those instances where the Bank is unable to accommodate a customer's needs, the Bank will arrange for those services to be provided by its correspondents.
To compete with major financial institutions, the Bank relies upon specialized services, responsive handling of customer needs, local promotional activity, and personal contacts by its officers, directors, and staff, as opposed to large multi-branch banks which compete primarily by rate and location of branches.
For customers whose loan demands exceed the Bank's lending limit, the Bank seeks to arrange for such loans on a participation basis with correspondent banks.
In the past, an independent bank's principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations, and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies, and insurance companies. In the past several years, the trend has been for other financial intermediaries to offer financial services traditionally offered by banks. Other institutions, such as brokerage houses, credit card companies, and even retail establishments, have offered new investment vehicles such as money-market funds or cash advances on credit card accounts. This led to increased cost of funds for most financial institutions. Even within the Banking industry, the trend has been towards offering more varied services, such as discount brokerage, often through affiliate relationships. The direction of federal legislation seems to favor and foster competition between different types of financial institutions and to encourage new entrants into the financial services market. However, it is not possible to forecast the impact such developments will have on commercial banking in general, or on the Bank in particular.
Effect of Governmental Policies and Recent Legislation
Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank's portfolio comprise the major portion of the Company's earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board 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 institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
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 institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The likelihood of any major legislative changes and the impact such changes might have on the Company are impossible to predict. See "Item 1. Business - Supervision and Regulation."
Supervision and Regulation
Bank holding companies and banks are extensively regulated under both federal and state law. Set forth below is a summary description of certain laws which relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
The Company
The Company, as a registered bank holding company, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company is required to file with the Federal
Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the BHCA. The Federal Reserve Board may conduct examinations of the Company and its subsidiaries.
The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest certain subsidiaries or affiliates when the Federal Reserve Board believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.
Under the BHCA and regulations adopted by the Federal Reserve Board, a bank holding company and its nonbanking subsidiaries are prohibited from requiring certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Further, the Company is required by the Federal Reserve Board to maintain certain levels of capital. See "Item 1. Business - Supervision and Regulation - Capital Standards."
The Company is required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company.
The Company is prohibited by the BHCA, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company, subject to the prior approval of the Federal Reserve Board, may engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making any such determination, the Federal Reserve Board is required to consider whether the performance of such activities by the Company or an affiliate can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities commenced de novo and activities commenced by acquisition, in whole or in part, of a going concern.
The FRB has determined, by regulation, that certain activities are so closely related to banking as to be a proper incident thereto within the meaning of the BHC Act. These activities include, but are not limited to: opening an industrial loan company, industrial bank, Morris Plan Bank, mortgage company, finance company, credit card company, or factoring company; performing certain data processing operations; providing investment and financial advice; operation as a trust company in certain instances; selling traveler's checks, U.S. Savings Bonds, and certain money orders; providing certain courier services; providing real estate appraisals; providing management consulting advice to non affiliated depository institutions in some instances; acting as an insurance agent for certain types of credit related insurance; leasing property or acting as agent, broker, or advisor for leasing property on a "full payout basis"; acting as a consumer financial counselor, including tax planning and return preparation; performing futures, options, and advisory services, check guarantee services and discount brokerage activities; operating a collection or credit bureau; or performing personal property appraisals.
Recent amendments to this list allow bank holding companies to own savings associations, arrange commercial real estate equity financing, engage in certain securities brokerage activities, underwrite and deal in government obligations and money market instruments, conduct foreign exchange advisory and transactional services, act as a futures commission merchant, provide investment advice on financial futures
and options on futures, provide consumer financial counseling, provide tax planning and preparation, operate a check guarantee service, operate a collection agency, and operate a credit bureau. The Company has no present intention to engage in any of such newly permitted activities.
The FRB has determined that certain other activities are not so closely related to banking as to be a proper incident thereto within the meaning of the BHC Act. Such activities include: real estate brokerage and syndication; real estate development; property management; underwriting of life insurance not related to credit transactions; and, with certain exceptions previously noted, securities underwriting and equity funding. The area of securities underwriting is under review and will likely be expanded. In the future, the FRB may add or delete from the list of activities permissible for bank holding companies.
Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve Board's policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both. This doctrine has become known as the "source of strength" doctrine. Although the United States Court of Appeals for the Fifth Circuit found the Federal Reserve Board's source of strength doctrine invalid in 1990, stating that the Federal Reserve Board had no authority to assert the doctrine under the BHCA, the decision, which is not binding on federal courts outside the Fifth Circuit, was recently reversed by the United States Supreme Court on procedural grounds. The validity of the source of strength doctrine is likely to continue to be the subject of litigation until definitively resolved by the courts or by Congress.
The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the California State Banking Department.
Finally, the Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, including but not limited to, filing annual, quarterly and other current reports with the Securities and Exchange Commission.
The Bank
The Bank, as a national banking association, is subject to primary supervision, examination and regulation by the Comptroller of the Currency (the "Comptroller"). If, as a result of an examination of a Bank, the Comptroller should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of the Bank's operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, various remedies are available to the Comptroller. Such remedies include the power to enjoin "unsafe or unsound practices," to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the Bank, to assess civil monetary penalties, and to remove officers and directors. The FDIC has similar enforcement authority, in addition to its authority to terminate a Bank's deposit insurance in the absence of action by the Comptroller and upon a finding that a Bank is in an unsafe or unsound condition, is engaging in unsafe or unsound activities, or that its conduct poses a risk to the deposit insurance fund or may prejudice the interest of its depositors. The Bank is not currently subject to any such actions by the Comptroller or the FDIC.
The deposits of the Bank are insured by the FDIC in the manner and to the extent provided by law. For this protection, the Bank pays a semiannual statutory assessment. See "Item 1. Business - Supervision and Regulation Premiums for Deposit Insurance." The Bank is also subject to certain regulations of the
Federal Reserve Board and applicable provisions of California law, insofar as they do not conflict with or are not preempted by federal banking law.
Various other requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes and regulations relate to many aspects of the Bank's operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends, locations of branch offices, capital requirements and disclosure obligations to depositors and borrowers. Further, the Bank is required to maintain certain levels of capital. See "Item 1. Business - Supervision and Regulation - Capital Standards."
Restrictions on Transfers of Funds to the Company by the Bank
The Company is a legal entity separate and distinct from the Bank. The Company's ability to pay cash dividends is limited by state law.
There are statutory and regulatory limitations on the amount of dividends which may be paid to the Company by the Bank. The prior approval of the Comptroller is required if the total of all dividends declared by a national bank in any calendar year exceeds the bank's net profits (as defined) for that year combined with its retained net profits (as defined) for the preceding two years, less any transfers to surplus.
The Comptroller also has authority to prohibit the Bank from engaging in activities that, in the Comptroller's opinion, constitute unsafe or unsound practices in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the Comptroller could assert that the payment of dividends or other payments might, under some circumstances, be such an unsafe or unsound practice. Further, the Comptroller and the Federal Reserve Board have established guidelines with respect to the maintenance of appropriate levels of capital by banks or bank holding companies under their jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of federal law could limit the amount of dividends which the Bank or the Company may pay. The Superintendent may impose similar limitations on the conduct of California-chartered banks. See "Item 1. Business - Supervision and Regulation - Prompt Corrective Regulatory Action and Other Enforcement Mechanisms" and - "Capital Standards" for a discussion of these additional restrictions on capital distributions.
At present, substantially all of the Company's revenues, including funds available for the payment of dividends and other operating expenses, is, and will continue to be, primarily dividends paid by the Bank and exercise of options and warrants to purchase shares of the Company.
The Bank is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, the Company or other affiliates, the purchase of or investments in stock or other securities thereof, the taking of such securities as collateral for loans and the purchase of assets of the Company or other affiliates. Such restrictions prevent the Company and such other affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in the Company or to or in any other affiliate is limited to 10% of the Bank's capital and surplus (as defined by federal regulations) and such secured loans and investments are limited, in the aggregate, to 20% of the Bank's capital and surplus (as defined by federal regulations). Additional restrictions on transactions with affiliates may be imposed on the Bank under the prompt corrective action provisions of federal law. See "Item 1. Business - - Supervision and Regulation - Prompt Corrective Action and Other Enforcement Mechanisms."
Capital Standards
The Federal Reserve Board, the Comptroller and the FDIC have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and
transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which includes off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists primarily of common stock, retained earnings, noncumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, cumulative preferred stock, long term preferred stock, eligible term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%.
In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets is 3%. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum, or 4% to 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
In August 1995, the federal banking agencies adopted final regulations specifying that the agencies will include, in their evaluations of a bank's capital adequacy, an assessment of the exposure to declines in the economic value of the bank's capital due to changes in interest rates. The final regulations, however, do not include a measurement framework for assessing the level of a bank's exposure to interest rate risk, which is the subject of a proposed policy statement issued by the federal banking agencies concurrently with the final regulations. The proposal would measure interest rate risk in relation to the effect of a 200 basis point change in market interest rates on the economic value of a bank. Banks with high levels of measured exposure or weak management systems generally will be required to hold additional capital for interest rate risk. The specific amount of capital that may be needed would be determined on a case-by-case basis by the examiner and the appropriate federal banking agency. Because this proposal has only recently been issued, the Bank currently is unable to predict the impact of the proposal on the Bank if the policy statement is adopted as proposed.
In January 1995, the federal banking agencies issued a final rule relating to capital standards and the risks arising from the concentration of credit and nontraditional activities. Institutions which have significant amounts of their assets concentrated in high risk loans or nontraditional banking activities and who fail to adequately manage these risks, will be required to set aside capital in excess of the regulatory minimums. The federal banking agencies have not imposed any quantitative assessment for determining when these risks are significant, but have identified these issues as important factors they will review in assessing an individual bank's capital adequacy.
In December 1993, the federal banking agencies issued an interagency policy statement on the allowance for loan and lease losses which, among other things, establishes certain benchmark ratios of loan loss reserves to classified assets. The benchmark set forth by such policy statement is the sum of (a) assets classified loss; (b) 50 percent of assets classified doubtful; (c) 15 percent of assets classified substandard; and (d) estimated credit losses on other assets over the upcoming 12 months.
Federally supervised banks and savings associations are currently required to report deferred tax assets in accordance with SFAS No. 109. See "Item 1. Business -- Supervision and Regulation -- Accounting Changes." The federal banking agencies recently issued final rules, effective April 1, 1995, which limit the amount of deferred tax assets that are allowable in computing an institution's regulatory capital. The standard has been in effect on an interim basis since March 1993. Deferred tax assets that can be realized for taxes paid in prior carryback years and from future reversals of existing taxable temporary differences are generally not limited. Deferred tax assets that can only be realized through future taxable earnings are limited for regulatory capital purposes to the lesser of (i) the amount that can be realized within one year of the quarter-end report date, or (ii) 10% of Tier 1 Capital. The amount of any deferred tax in excess of this limit would be excluded from Tier 1 Capital and total assets and regulatory capital calculations.
Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends. The banking agencies have issued a final rule which requires them to revise their risk based capital guidelines to ensure that their standards take adequate account of interest rate risk ("IRR"). These amendments to risk-based capital guidelines had not been finalized for banks as of December 31, 1995.
The following table presents the amounts of regulatory capital and the capital ratios for the Bank, compared to its minimum regulatory capital requirements as of December 31, 1995.
Prompt Corrective Action and Other Enforcement Mechanisms
Federal law 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. The law required each federal banking agency to promulgate 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.
In September 1992, the federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of federal law. An insured depository institution generally will be classified in the following categories based on capital measures indicated below:
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. The federal banking agencies, however, may not treat an institution as "critically undercapitalized" unless its capital ratio actually warrants such treatment.
The law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions if after such transaction the institution would be undercapitalized. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency, subject to asset growth restrictions and required to obtain prior regulatory approval for acquisitions, branching and engaging in new lines of business. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate federal banking agency 45 days after becoming undercapitalized. The appropriate federal banking agency cannot accept a capital plan unless, among other things, it determines that the plan (i) specifies the steps the institution will take to become adequately capitalized, (ii) is based on realistic assumptions and (iii) is likely to succeed in restoring the depository institution's capital. In addition, each company controlling an undercapitalized depository institution must guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the appropriate federal banking agency may impose any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the prompt correction action provisions.
An insured depository institution that is significantly undercapitalized, or is undercapitalized and fails to submit, or in a material respect to implement, an acceptable capital restoration plan, is
subject to additional restrictions and sanctions. These include, among other things: (i) a forced sale of voting shares to raise capital or, if grounds exist for appointment of a receiver or conservator, a forced merger; (ii) restrictions on transactions with affiliates; (iii) further limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage; (v) modification or termination of specified activities; (vi) replacement of directors or senior executive officers; (vii) prohibitions on the receipt of deposits from correspondent institutions; (viii) restrictions on capital distributions by the holding companies of such institutions; (ix) required divestiture of subsidiaries by the institution; or (x) other restrictions as determined by the appropriate federal banking agency. Although the appropriate federal banking agency has discretion to determine which of the foregoing restrictions or sanctions it will seek to impose, it is required to force a sale of voting shares or merger, impose restrictions on affiliate transactions and impose restrictions on rates paid on deposits unless it determines that such actions would not further the purpose of the prompt corrective action provisions. In addition, without the prior written approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to its senior executive officers or provide compensation to any of them at a rate that exceeds such officer's average rate of base compensation during the 12 calendar months preceding the month in which the institution became undercapitalized.
Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. For example, a critically undercapitalized institution generally would be prohibited from engaging in any material transaction other than in the ordinary course of business without prior regulatory approval and could not, with certain exceptions, make any payment of principal or interest on its subordinated debt beginning 60 days after becoming critically undercapitalized. Most importantly, however, except under limited circumstances, the appropriate federal banking agency, not later than 90 days after an insured depository institution becomes critically undercapitalized, is required to appoint a conservator or receiver for the institution. The board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator or to an acquisition or merger as required by the regulator.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators 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 and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.
Safety and Soundness Standards
In July 1995, the federal banking agencies adopted final guidelines establishing standards for safety and soundness, as required by FDICIA. The guidelines set forth operational and managerial standards relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. Guidelines for asset quality and earnings standards will be adopted in the future. The guidelines establish the safety and soundness standards that the agencies will use to identify and address problems at insured depository institutions before capital becomes impaired. If an institution fails to comply with a safety and soundness standard, the appropriate federal banking agency may require the institution to submit a compliance plan. Failure to submit a compliance plan or to implement an accepted plan may result in enforcement action.
In December 1992, the federal banking agencies issued final regulations prescribing uniform guidelines for real estate lending. The regulations, which became effective on March 19, 1993, require insured depository institutions to adopt written policies establishing standards, consistent with such guidelines, for extensions of credit secured by real estate. The policies must address loan portfolio management, underwriting standards and loan to value limits that do not exceed the supervisory limits prescribed by the regulations.
Appraisals for "real estate related financial transactions" must be conducted by either state certified or state licensed appraisers for transactions in excess of certain amounts. State certified appraisers are required for all transactions with a transaction value of $1,000,000 or more; for all nonresidential transactions valued at $250,000 or more; and for "complex" 1-4 family residential properties of $250,000 or more. A state licensed appraiser is required for all other appraisals. However, appraisals performed in connection with "federally related transactions" must now comply with the agencies' appraisal standards. Federally related transactions include the sale, lease, purchase, investment in, or exchange of, real property or interests in real property, the financing or refinancing of real property, and the use of real property or interests in real property as security for a loan or investment, including mortgage-backed securities.
Premiums for Deposit Insurance
Federal law has established several mechanisms to increase funds to protect deposits insured by the Bank Insurance Fund ("BIF") administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. The result of these provisions is that the assessment rate on deposits of BIF members could increase in the future. The FDIC also has authority to impose special assessments against insured deposits.
The FDIC implemented a final risk-based assessment system, as required by FDICIA, effective January 1, 1994, under which an institution's premium assessment is based on the probability that the deposit insurance fund will incur a loss with respect to the institution, the likely amount of any such loss, and the revenue needs of the deposit insurance fund. As long as BIF's reserve ratio is less than a specified "designated reserve ratio," 1.25%, the total amount raised from BIF members by the risk-based assessment system may not be less than the amount that would be raised if the assessment rate for all BIF members were .023% of deposits. On August 8, 1995, the FDIC announced that the designated reserve ratio had been achieved and, accordingly, issued final regulations adopting an assessment rate schedule for BIF members of 4 to 31 basis points effective on June 1, 1995. On November 14, 1995, the FDIC further reduced deposit insurance premiums to a range of 0 to 27 basis points effective for the semi-annual period beginning January 1, 1996.
Under the risk-based assessment system, a BIF member institution such as the Bank is categorized into one of three capital categories (well capitalized, adequately capitalized, and undercapitalized) and one of three categories based on supervisory evaluations by its primary federal regulator (in the Bank's case, the Comptroller). The three supervisory categories are: financially sound with only a few minor weaknesses (Group A), demonstrates weaknesses that could result in significant deterioration (Group B), and poses a substantial probability of loss (Group C). The capital ratios used by the Comptroller to define well-capitalized, adequately capitalized and undercapitalized are the same in the Comptroller's prompt corrective action regulations. The BIF assessment rates are summarized below; assessment figures are expressed in terms of cents per $100 in deposits.
Assessment Rates Effective Through the First Half of 1995
Assessment Rates Effective through the Second Half of 1995
Assessment Rates Effective January 1, 1996
*Subject to a statutory minimum assessment of $1,000 per semi-annual period (which also applies to all other assessment risk classifications).
At December 31, 1995, the Bank was well capitalized (Group A).
A number of proposals have recently been introduced in Congress to address the disparity in bank and thrift deposit insurance premiums. On September 19, 1995, legislation was introduced and referred to the House Banking Committee that would, among other things: (i) impose a requirement on all SAIF member institutions to fully recapitalize the SAIF by paying a one-time special assessment of approximately 85 basis points on all assessable deposits as of March 31, 1995, which assessment would be due as of January 1, 1996; (ii) spread the responsibility for FICO interest payments across all FDIC-insured institutions on a pro-rata basis, subject to certain exceptions; (iii) require that deposit insurance premium assessment rates applicable to SAIF member institutions be no less than deposit insurance premium assessment rates applicable to BIF member institutions; (iv) provide for a merger of the BIF and the SAIF as of January 1, 1998; (v) require savings associations to convert to state or national bank charters by January 1, 1998; (vi) require savings associations to divest any activities not permissible for commercial banks within five years; (vii) eliminate the bad-debt reserve deduction for
savings associations, although savings associations would not be required to recapture into income their accumulated bad-debt reserves; (viii) provide for the conversion of savings and loan holding companies into bank holding companies as of January 1, 1998, although unitary savings and loan holding companies authorized to engage in activities as of September 13, 1995 would have such authority grandfathered (subject to certain limitations); and (ix) abolish the OTS and transfer the OTS' regulatory authority to the other federal banking agencies. The legislation would also provide that any savings association that would become undercapitalized under the prompt corrective action regulations as a result of the special deposit premium assessment could be exempted from payment of the assessment, provided that the institution would continue to be subject to the payment of semiannual assessments under the current rate schedule following the recapitalization of the SAIF. The legislation was considered and passed by the House Banking Committee's Subcommittee on Financial Institutions on September 27, 1995, and has not yet been acted on by the full House Banking Committee.
On September 20, 1995, similar legislation was introduced in the Senate, although the Senate bill does not include a comprehensive approach for merging the savings association and commercial bank charters. The Senate bill remains pending before the Senate Banking Committee.
The future of both these bills is linked with that of pending budget reconciliation legislation since some of the major features of the bills are included in the Seven-Year Balanced Budget Reconciliation Act. The budget bill, which was passed by both the House and Senate on November 17, 1995 and vetoed by the President on December 6, 1995, would: (i) recapitalize the SAIF through a special assessment of between 70 and 80 basis points on deposits held by institutions as of March 31, 1995; (ii) provide an exemption to this rule for weak institutions, and a 20% reduction in the SAIF-assessable deposits of so-called "Oakar banks;" (iii) expand the assessment base for FICO payments to include all FDIC-insured institutions; (iv) merge the BIF and SAIF on January 1, 1998, only if no insured depository institution is a savings association on that date; (v) establish a special reserve for the SAIF on January 1, 1998; and (vi) prohibit the FDIC from setting semiannual assessments in excess of the amount needed to maintain the reserve ratio of any fund at the designated reserve ratio. The bill does not include a provision to merge the charters of savings associations and commercial banks.
In light of ongoing debate over the content and fate of the budget bill, the different proposals currently under consideration and the uncertainty of the Congressional budget and legislative processes in general, management cannot predict whether any or all of the proposed legislation will be passed, or in what form. Accordingly, the effect of any such legislation on the Bank cannot be determined.
Interstate Banking and Branching
In September 1994, the Riegel-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Act") became law. Under the Interstate Act, beginning one year after the date of enactment, a bank holding company that is adequately capitalized and managed may obtain approval under the BHCA to acquire an existing bank located in another state without regard to state law. A bank holding company would not be permitted to make such an acquisition if, upon consummation, it would control (a) more than 10% of the total amount of deposits of insured depository institutions in the United States or (b) 30% or more of the deposits in the state in which the bank is located. A state may limit the percentage of total deposits that may be held in that state by any one bank or bank holding company if application of such limitation does not discriminate against out-of-state banks. An out-of-state bank holding company may not acquire a state bank in existence for less than a minimum length of time that may be prescribed by state law except that a state may not impose more than a five year existence requirement.
The Interstate Act also permits, beginning June 1, 1997, mergers of insured banks located in different states and conversion of the branches of the acquired bank into branches of the resulting bank. Each state may permit such combinations earlier than June 1, 1997, and may adopt legislation to prohibit interstate mergers after that date in that state or in other states by that state's banks. The same concentration limits discussed in the preceding paragraph apply. The Interstate Act also permits a national or state bank to establish branches in a state other than its home state if permitted by the laws of that state, subject to the same requirements and conditions as for a merger transaction.
In October 1995, California adopted "opt in" legislation under the Interstate Act that permits out-of-state banks to acquire California banks that satisfy a five-year minimum age requirement (subject to exceptions for supervisory transactions) by means of merger or purchases of assets, although entry through acquisition of individual branches of California institutions and de novo branching into California are not permitted. The Interstate Act and the California branching statute will likely increase competition from out-of-state banks in the markets in which the Company operates, although it is difficult to assess the impact that such increased competition may have on the Company's operations.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. The Bank's compliance with CRA is monitored by the Comptroller, which assigns the Bank a publicly available CRA rating. An assessment of CRA compliance is required by both the Comptroller and the Federal Reserve Board in connection with applications for approval of certain activities such as mergers with or acquisitions of other banks or bank holding companies. In April of 1995, the federal regulatory agencies issued a comprehensive revision to the rules governing CRA compliance. In assigning a CRA rating to a bank, the new regulations place greater emphasis on measurements of performance in the areas of lending (specifically the bank's home mortgage, small business, small farm and community development loans), investment (the bank's community development investments) and service (the bank's community development services and the availability of its retail banking services), although examiners are still given a degree of flexibility in taking into account unique characteristics and needs of the bank's community and its capacity and constraints in meeting such needs. The new regulations also require increased collection and reporting of data regarding certain kinds of loans. Although the new regulations became generally effective on July 1, 1995, various provisions have different effective dates, and the new CRA evaluation criteria will go into effect for examinations beginning on July 1, 1997. Although management cannot predict the impact of the substantial changes in the new rules on the Bank's CRA rating, it will continue to take steps to comply with the requirements in all respects.
In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities. The Comptroller has rated the Bank "satisfactory" in complying with its CRA obligations.
In May 1995, the federal banking agencies issued final regulations which change the manner in which they measure a bank's compliance with its CRA obligations. The final regulations adopt a performance-based evaluation system which bases CRA ratings on an institution's actual lending service and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach or complies with other procedural requirements. In March 1994, the Federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending. The policy statement describes the three methods that federal agencies will
use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment and evidence of disparate impact.
Accounting Changes
In February 1992, the Financial Accounting Standards Board ("FASB") issued SFAS No. 109, "Accounting for Income Taxes," which superseded SFAS No. 96 of the same title. SFAS No. 109, which was adopted by the Company effective January 1, 1993, employs an asset and liability approach in accounting for income taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and as measured by the provisions of enacted tax laws. Adoption by the Company of SFAS No. 109 did not have a material impact on the Company's results of operations.
In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan". SFAS No. 114 prescribes the recognition criterion for loan impairment and the measurement methods for certain impaired loans and loans whose terms are modified in troubled debt restructurings. SFAS No. 114 states that a loan is impaired when it is probable that a creditor will be unable to collect all principal and interest amounts due according to the contracted terms of the loan agreement. A creditor is required to measure impairment by discounting expected future cash flows at the loan's effective interest rate, or by reference to an observable market price, or by determining that foreclosure is probable. SFAS No. 114 also clarifies the existing accounting for in-substance foreclosures by stating that a collateral-dependent real estate loan would be reported as real estate owned only if the lender had taken possession of collateral.
SFAS No. 118 amended SFAS No. 114, to allow a creditor to use existing methods for recognizing interest income on an impaired loan. To accomplish that it eliminated the provisions in SFAS No. 114 that described how a creditor should report income on an impaired loan. SFAS No. 118 did not change the provisions in SFAS No. 114 that require a creditor to measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, or as a practical expedient, at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent. SFAS No. 118 amends the disclosure requirements in SFAS No. 114 to require information about the recorded investments in certain impaired loans and about how a creditor recognizes interest income related to those impaired loans. The Company adopted SFAS No. 114 and No. 118 as of January 1, 1995. The Bank had previously measured the allowance for loan losses using methods similar to that prescribed in SFAS 114. As a result, no additional provision was required by the adoption of this pronouncement.
In December 1990, FASB issued SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions" effective for fiscal years beginning after December 15, 1992. In November 1992, FASB issued Statement of Financial Standards No. 112, "Employers' Accounting For Post-Employment Benefits," effective for fiscal years beginning after December 15, 1993. SFAS No. 106 and SFAS No. 112 focus primarily on post-retirement health care benefits. The Company does not provide post-retirement benefits, and SFAS No. 106 and SFAS No. 112 will have no impact on net income in 1996.
In May 1993, the FASB issued SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" addressing the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. These investments would be classified in three categories and accounted for as follows: (i) debt and equity securities that the entity has the positive intent and ability to hold to maturity would be classified as "held to maturity" and reported at amortized cost; (ii) debt and equity securities that are held for current resale would be classified as trading securities and reported at fair value, with unrealized gains and losses included in operations; and (iii) debt and equity securities not classified as either securities
held to maturity or trading securities would be classified as securities available for sale, and reported at fair value, with unrealized gains and losses excluded from operations and reported as a separate component of shareholders' equity. The Company adopted SFAS No. 115 in 1993. The adoption of SFAS 115 did not have a material impact on the financial position or results of operations of the Bank.
EMPLOYEES
As of December 31, 1995, the Company had three employees, its President ,Chief Executive Officer and Chief Financial Officer. At December 31, 1995, the Bank had 115 full-time employees or equivalents. Of these employees, 11 held titles of senior vice president or above. At December 31, 1995, none of the executive officers of the Bank served pursuant to written employment agreements. None of the Company's or the Bank's employees are represented by a labor union. The Company considers its relationship and the Bank's relationship with each company's respective employees to be excellent.
Item 2.

Item 2. PROPERTIES
The principal offices of the Company are located in a multi-story office building located at 16030 Ventura Boulevard, Encino, California 91364 for which it pays a monthly rental of $60,000. The lease contains a ceiling on cost on living adjustments of 5% per year. The lease is renewable. The Bank also has certain month to month or short term leases for offices in West Los Angeles, the South Bay, Ventura and the San Gabriel Valley. Each of these leases is short term in nature and is not material to the Company. Management believes that the existing leases will provide for their space requirements for the foreseeable future, at least until the completion of the proposed merger with Home Interstate Bancorp.
Item 3.

Item 3. LEGAL PROCEEDINGS
In the normal course of business the Bank occasionally becomes a party to litigation. In the opinion of management, based upon consultation with legal counsel, pending or threatened litigation involving the Bank will have no adverse material effect upon its financial condition, or results of operations. For further information, see Note 15 to the Consolidated Financial Statements of the Company.
Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were presented for a vote of shareholders during fourth quarter 1995.
Item 4(A). EXECUTIVE OFFICERS OF THE COMPANY
Set forth below are brief summaries of the background and business experience of each of the directors and executive officers of the Company and the Bank as of December 31, 1995:
None of the directors or officers of CU Bancorp or CU Bank were selected pursuant to any arrangement or understanding other than with the directors and officers of CU Bancorp and CU Bank acting in their capacities as such. There are no family relationships between any two or more of the directors, or officers.
Set forth below are brief summaries of the background and business experience, including principal occupation, of the directors.
KENNETH L. BERNSTEIN, was elected to the Board of CU Bancorp and CU Bank in December 1993, and assumed the positions in February 1994. He is the President of BFC Financial Corporation and has served in such capacity since 1965. BFC Financial Corporation performs a variety of service for both the finance industry and clients of that industry.
STEPHEN G. CARPENTER, joined CU Bank in 1992 from Security Pacific National Bank where he was Vice Chairman in charge of middle market lending from July 1989 to June 1992. Mr. Carpenter was previously employed at Wells Fargo Bank from July 1980 to July 1989, where he was an Executive Vice President. He assumed the additional role of Chairman of CU Bank in February, 1994 and Chairman of CU Bancorp in 1995.
RICHARD H. CLOSE has been a principal in the law firm of Shapiro, Rosenfeld & Close, a Professional Corporation, in Los Angeles, California, since 1977.
PAUL W. GLASS is a certified public accountant and has been a principal in the accountancy firm of Glass & Rosen, in Encino, California, since 1980.
RONALD S. PARKER has been the Chairman of Parker, Mulcahy & Associates, a regional merchant banking firm, since May 1992. Prior to that he was the Executive Vice President and Group Head of the Corporate Banking Group of Security Pacific National Bank from March of 1991 to May of 1992. He held a similar position at Wells Fargo National Bank from 1984 to 1991. Mr. Parker resigned from the Board in December 1993. He was reappointed in 1994.
DAVID I. RAINER was appointed Executive Vice President of CU Bank in June 1992 and assumed the position of Chief Operating Officer in late 1992. He assumed the additional title of President of CU Bank in February, 1994 and President and Chief Operating Officer of CU Bancorp in 1995. He was elected to the Board of Directors of CU Bancorp and California United Bank in 1993. From July 1989 to June 1992, Mr. Rainer was employed by Bank of America (Security Pacific National Bank) where he held the position of Senior Vice President. From March 1989 to July 1989, Mr. Rainer was a Senior Vice President at Faucet & Company, where he co-managed a stock and bond portfolio. From July 1982 to March 1989, Mr. Rainer was employed by Wells Fargo Bank, where he held the positions of Vice President and Manager.
No director, officer or affiliate of CU Bancorp or of CU Bank, no owner of record or beneficially of more than five percent of any class of voting securities of CU Bancorp or no associate of any such director, officer or affiliate is a party adverse to CU Bancorp or CU Bank in any material pending legal proceed
The following are officers of CU Bancorp and the Bank as of December 31, 1995:
Set forth below are brief summaries of the background and business experience, including principal occupation, of the executive officers of CU Bancorp who have not previously been discussed herein.
PATRICK HARTMAN has been employed by CU Bank since November, 1992. Prior to assuming his present positions he was Senior Vice President/Chief Financial Officer for Cenfed Bank for a period during 1992. Mr. Hartman held the post of Senior Vice President/Chief Financial Officer of Community Bank, Pasadena, California, for thirteen years.
ANNE WILLIAMS joined CU Bank in 1992 as Senior Loan Officer. She was named to the position of Chief Credit Officer in July 1993. Prior to that time she spent five years at Bank of America / Security Pacific National Bank, where she was a credit administrator in asset based lending, for middle market in the Los Angeles Area. Ms. Williams was trained at Chase Manhattan Bank in New York, and was a commercial lender at Societe Generale in Los Angeles and Boston Five Cents Savings Bank where she managed the corporate lending group.
PART II
ITEM 5.

ITEM 5. MARKET FOR COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for information relative to the market for the Company's Common Stock.
Holders of Company's Common Stock
As of the close of business on December 31, 1995 there were 416 record holders of the Company's issued and outstanding Common Stock.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
CU BANCORP AND SUBSIDIARY
Amounts in thousands of dollars, except per share data and amounts expressed as percentages
ITEM 7.

ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS
OVERVIEW
The Company earned $2.9 million, or $0.60 per share, during in 1995, compared to $2.6 million, or $0.56 per share, in 1994 and $2.1 million, or $.47 per share in 1993. Composition of the earnings has changed substantially in 1995. Prior to that, a substantial portion of the Bank's earnings had been attributable to the Mortgage Banking operation, which was sold in November 1993. The Mortgage origination operation contributed about two thirds of the earnings for 1993, and approximately 56% of the earnings in 1994 were attributable to a gain on the sale of mortgage servicing rights retained when the origination operation was sold. Since then, the earnings of the core commercial bank have grown steadily as the mortgage related income has been eliminated. For the year ended December 31, 1995, income related to sales of mortgage servicing was less than 8% of the Bank's earnings.
The Bank's asset quality ratios continue to be exceptionally strong. At December 31, 1995, nonperforming assets were $1 million, compared with $36 thousand in 1994. The Bank did not have any real estate acquired through foreclosure at December 31, 1995 or December 31, 1994. The Bank's allowance for loan losses as a percent of both nonperforming loans and nonperforming assets at December 31, 1995 was 677%, compared to 1994 levels of 20,631%.
Capital ratios are strong, substantially exceeding levels required for the "well capitalized" category established by bank regulators. The Total Risk-Based Capital Ratio was 16.19%, the Tier 1 Risk-Based Capital Ratio was 14.92%, and the Leverage Ratio was 10.52% at December 31, 1995, compared to 15.40%, 14.12%, and 10.44%, respectively, at year-end 1994. Regulatory requirements for Total Risk-Based, Tier 1 Risk-Based, and Leverage capital ratios are a minimum of 8%, 4%, and 3%, respectively, and for classification as well capitalized, 10%, 6%, and 5%, respectively.
The Bank's strong capital and asset quality position allows the Bank to continue to grow its core business which provides relationship based services to middle market customers and positions the Bank for its acquisition strategy. During the year ended December 31, 1995, the Bank generated approximately $135 million in new loan commitments, compared with about $121 million and $101 million for the comparable periods of 1994 and 1993.
The Bank announced actions taken in 1995 and early 1996 that supplement the Bank's successful internal growth with strategically selected mergers and acquisitions. In March of 1995, the Bank had announced the signing of an agreement to acquire Corporate Bank, a Santa Ana based community bank with approximately $70 million in assets. This purchase was completed in January of 1996. In January 1996, the Bank also announced the signing of an agreement to merge with Home Interstate Bancorp, the parent of Home Bank, based in the South Bay. This merger, targeted to be completed near the end of the second quarter of 1996, would create a combined bank with over $800 million in assets and 22 branches.
BALANCE SHEET ANALYSIS
LOAN PORTFOLIO COMPOSITION AND CREDIT RISK
The Bank's loan portfolio at December 31, 1995 has maintained the high standards of credit quality that have been established as the commercial loan portfolio has been built over the past three years. Non performing assets have been reduced to insignificant levels and exposures to real estate have been greatly reduced to consist primarily of loans secured by real estate made to the Bank's core middle market customers as a secondary part of their total business relationship.
Total loans at December 31, 1995 increased by $16 million during the year. Portfolio growth in the last three quarters of 1995 were partially offset by the decline of $6 million in the first quarter of 1995. Loan paydowns for the first quarter were unusually high, with Entertainment related loans declining $7 million as a number of project related loans paid off, combined with normal payoffs and seasonality in the commercial portfolio.
The Bank's focus on middle market lending, in its infancy at year-end 1992, gained momentum in 1993 and further accelerated in 1994. Total loans increased $34 million during 1994. Offsetting this, the remaining Held for Sale mortgages of $10.4 million at December 31, 1993 were sold in the first quarter of 1994. Excluding this planned liquidation, loans increased by $44 million, or 34%, for the year ended December 31, 1994.
TABLE 1 LOAN PORTFOLIO COMPOSITION
Amounts in thousands of dollars
TABLE 1A: LOAN PORTFOLIO MATURITIES AT DECEMBER 31, 1995 (in Thousands)
Table 1a above summarizes the maturities of the loan portfolio based upon the contractual terms of the loans. The Bank does not automatically rollover any loans at maturity. Maturing loans must go through the Bank's normal credit approval process in order to receive a new maturity date.
The Bank lending effort is focused on business lending to middle market customers. Current credit policy permits commercial real estate lending generally only as part of a complete commercial banking relationship with a middle market customer. Commercial real estate loans are secured by first or second liens on office buildings and other structures. The loans are secured by real estate that had appraisals in excess of loan amounts at origination.
Monitoring and controlling the Bank's allowance for loan losses is a continuous process. All loans are assigned a risk grade, as defined by credit policies, at origination and are monitored to identify changing circumstances that could modify their inherent risks. These classifications are one of the criteria considered in determining the adequacy of the allowance for loan losses.
The amount and composition of the allowance for loan losses is as follows:
TABLE 2 ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
Amounts in thousands of dollars
Adequacy of the allowance is determined using management's estimates of the risk of loss for the portfolio and individual loans. Included in the criteria used to evaluate credit risk are, wherever appropriate, the borrower's cash flow, financial condition, management capabilities, and collateral valuations, as well as industry conditions. A portion of the allowance is established to address the risk inherent in general loan categories, historic loss experience, portfolio trends, economic conditions, and other factors. Based on this assessment a provision for loan losses may be charged against earnings to maintain the adequacy of the allowance. The allocation of the allowance based upon the risks by type of loan, as shown in Table 2, implies a degree of precision that is not possible when using judgments. While the systematic approach used does consider a variety of segmentations of the portfolio, management considers the allowance a general reserve available to address risks throughout the entire loan portfolio.
Activity in the allowance, classified by type of loan, is as follows:
TABLE 3 ANALYSIS OF THE CHANGES IN THE ALLOWANCE FOR LOAN LOSSES
Amounts in thousands of dollars
The Bank's policy concerning nonperforming loans is more conservative than is generally required. It defines nonperforming assets as all loans ninety days or more delinquent, loans classified nonaccrual, and foreclosed, or in substance foreclosed real estate. Nonaccrual loans are those whose interest accrual has been discontinued because the loan has become ninety days or more past due. In addition, it includes loans where there exists reasonable doubt as to
the full and timely collection of principal or interest. When a loan is placed on nonaccrual status, all interest previously accrued but uncollected is reversed against operating results. Subsequent payments on nonaccrual loans are treated as principal reductions. At December 31, 1995, nonperforming loans amounted to $1 million compared with $36 thousand at December 31, 1994.
Potential problem loans are defined as loans as to which there are serious doubts about the ability of the borrowers to comply with present loan repayment terms. It is the policy of the Bank to place all potential problem loans on nonaccrual status. At December 31, 1995, therefore, the Bank had no potential problem loans other than those disclosed in Table 4 as nonperforming loans.
TABLE 4: NONPERFORMING ASSETS
Amounts in thousands of dollars
(a) Past due with respect to principal and/or interest and continuing to accrue interest.
SECURITIES
The Securities Held to Maturity portfolio totaled $67 million at December 31, 1995, compared with $74 million at year-end 1994. In the fourth quarter of 1995, the Bank performed a one-time reassessment of the designations of securities as held to maturity or available for sale, in accordance with a special report issued by the Financial Accounting Standards Board on the subject of investments. As a result of this assessment, $5.9 million of collateralized mortgage obligations were transferred out of the held to maturity portfolio into the available for sale portfolio.
The Securities Available for Sale portfolio totaled $6.3 million at December 31, 1995, with no investments being included in this category in 1994. Included in the December 31, 1995 balance is an unrealized gain of $143 thousand.
There have been no realized gains or losses on securities in 1995 or 1994. Gains of $77 thousand were realized in 1993. At December 31, 1995, there were unrealized gains of $623 thousand and losses of $244 thousand in the securities held to maturity portfolio.
Additional information concerning securities is provided in the footnotes to the accompanying financial statements.
OTHER REAL ESTATE OWNED
There was no Other Real Estate Owned on the Bank's balance sheet at December 31, 1995 and 1994. The Bank's policy is to carry properties acquired in foreclosure at fair value less estimated selling costs, which is determined using recent appraisal values adjusted, if necessary, for other market conditions. Loan balances in excess of fair value are charged to the allowance for loan losses when the loan is reclassified to other real estate. Subsequent declines in fair value are charged against a valuation allowance for other real estate owned, created by charging a provision to other operating expenses. The Bank has not had any significant expenses related to Other Real Estate Owned in 1995 or 1994. In 1993, expenses related to Other Real Estate Owned totaled $234 thousand.
DEPOSIT CONCENTRATION
Prior to 1992, the Bank's focus on real estate-related activities resulted in a concentration of deposit accounts from title insurance and escrow companies. As the Bank has changed its focus to commercial lending, the amounts of title and escrow related deposits has declined for the past three years. These deposits are generally noninterest bearing transaction accounts that contribute to the Bank's interest margin. Noninterest expense related to these deposits is included in other operating expense. The Bank monitors the profitability of these accounts through an account analysis procedure.
The Bank offers products and services allowing customers to operate with increased efficiency. A substantial portion of the services, provided through third party vendors, are automated data processing and accounting for trust balances maintained on deposit at the Bank. These and other banking related services, such as deposit courier services, will be limited or charged back to the customer if the deposit relationship profitability does not meet the Bank's expectations.
Noninterest bearing deposits represent nearly the entire title and escrow relationship. These balances have been reduced substantially as the Bank focused on middle market business loans. The balance at December 31, 1995, was $20 million compared to $44 million at December 31, 1994. The bank has greatly reduced their reliance on title and escrow deposits, with these relationships representing approximately 7% of deposits in 1995, and 17% at year end 1994.
TABLE 5 REAL ESTATE ESCROW AND TITLE INSURANCE COMPANY DEPOSITS AMOUNTS IN THOUSANDS OF DOLLARS
The Bank had $45 million in certificates of deposit larger than $100 thousand dollars at December 31, 1995. The maturity distribution of these deposits is relatively short term, with $31 million maturing within 3 months and $43 million maturing within 12 months.
LIQUIDITY AND INTEREST RATE SENSITIVITY
The objective of liquidity management is to ensure the Bank's ability to meet cash requirements. The liquidity position is managed giving consideration to both on and off-balance sheet sources and demands for funds.
Sources of liquidity include cash and cash equivalents (net of Federal Reserve requirements to maintain reserves against deposit liabilities), securities eligible for pledging to secure borrowings from dealers pursuant to repurchase agreements, loan repayments, deposits, and borrowings from a $25 million overnight federal funds line available from a correspondent bank. Potential significant liquidity requirements are withdrawals from noninterest bearing demand deposits and funding of commitments to loan customers.
From time to time the Bank may experience liquidity shortfalls ranging from one to several days. In these instances, the Bank will either purchase federal funds, and/or sell securities under repurchase agreements. These actions are intended to bridge mismatches between funding sources and requirements, and are designed to maintain the minimum required balances. The Bank has had no Fed Funds purchased or borrowings under repurchase agreements during 1994 or 1995.
During 1994 and 1995, loan growth for the Bank outpaced growth of deposits from the Banks commercial customers. The Bank funded this growth, combined with the Bank's reduced concentration in title and escrow deposits, in part with certificates of deposit from customers from outside the Bank's normal service area. These out of area deposits are certificates of deposit of $90,000 or greater, that are priced competitively with similar certificates from other financial institutions throughout the country. At December 31, 1995, the Bank had approximately $83 million of these out of area deposits, up from $55 million at December 31, 1994. The Bank's experience with raising out of area deposits for the past two years indicates that the balances are quite stable when priced to the current market.
The Bank's portfolio of large certificates of deposit (those of $100 thousand or more), includes both deposits from its base of commercial customers and out of area deposits. At December 31, 1995 this funding source was 17% of average deposits, compared to 16% at December 31, 1994.
TABLE 6 INTEREST RATE MATURITIES OF EARNING ASSETS AND FUNDING LIABILITIES AT DECEMBER 31, 1995
Amounts in thousands of dollars
(1) Ratios greater than 1.0 indicate a net asset sensitive position. Ratios less than 1.0 indicate a liability sensitive position. A ratio of 1.0 indicates risk neutral position.
Assets and liabilities shown on Table 5 are categorized based on contractual maturity dates. Maturities for those accounts without contractual maturities are estimated based on the Bank's experience with these customers. Noninterest bearing deposits of title and escrow companies, having no contractual maturity dates, are considered subject to more volatility than similar deposits from commercial customers. The net cumulative gap position shown in the table above indicates that the Bank does not have a significant exposure to interest rate fluctuations during the next twelve months.
CAPITAL
Total shareholders' equity was $33 million at December 31, 1995, compared to $30 million at year-end 1994. This increase was due to earnings, plus the exercise of stock options and warrants. The Bank is guided by statutory capital requirements, which are measured with three ratios, two of which are sensitive to the risk inherent in various assets and which consider off-balance sheet activities in assessing capital adequacy. During 1995 and 1994, the Bank's capital levels substantially exceeded the "well capitalized" standards, the highest classification established by bank regulators.
TABLE 7 CAPITAL RATIOS
In February of 1995, the Company declared a dividend of $.02 per share payable March 13, 1995 to shareholders of record February 20, 1995. The Company also declared a dividend of $.02 per share for the quarter ended June 30, 1995, payable September 4, 1995 to shareholders of record August 15, 1995. During the third quarter, the company declared a dividend $.02 per share, payable November 27 to shareholders of record November 13. For the fourth quarter of 1995, the company declared a dividend of $.02 per share, payable February 28 to shareholders of record January 31. The dividend payout ratio was 13% for the year ending December 31, 1995. No dividends were paid in 1994 .
The common stock of the Company is listed on the National Association of Securities Dealers Automated Quotation (Nasdaq) National Market Systems where it trades under the symbol CUBN.
TABLE 8 STOCK PRICES - UNAUDITED
EARNINGS BY LINE OF BUSINESS
Prior to the sale of the mortgage origination operation in November, 1993, the Bank operated a commercial bank and a mortgage bank as two distinct business segments. Since 1994, real estate lending is generally only done as part of a commercial banking relationship. After 1993, therefore, the Bank operates as only a single segment, the commercial banking operation. Table 9 shows the pre-tax operating contributions.
TABLE 9 PRE-TAX OPERATING CONTRIBUTION BY LINE OF BUSINESS (i)
Amounts in thousands of dollars
(i) Inter-divisional transactions for 1993 have been eliminated at the division level.
NET INTEREST INCOME AND INTEREST RATE RISK
Net interest income is the difference between interest and fees earned on earning assets and interest paid on funding liabilities. Net interest income was $15.5 million for the year ended December 31, 1995 compared to $13.9 million in 1994 and $14.4 million in 1993. The change in 1995 is attributable to changes in volume and deposit mix. The Bank's net interest income has improved with the growth of the commercial loan portfolio from 1994 to 1995. This improvement was offset in part by the change in deposit mix away from non interest bearing title and escrow deposits, and the increase in certificates of deposit. The change in 1994 is primarily attributable to lower levels of average loans and deposits in 1994 being offset by favorable rate variations.
TABLE 10 ANALYSIS OF CHANGES IN NET INTEREST INCOME (1)
Amounts in thousands of dollars Increases(Decreases)
(1) The change in interest income or interest expense that is attributable to both change in average balance and average rate has been allocated to the changes due to (i) average balance and (ii) average rate in proportion to the relationship of the absolute amounts of the changes in each.
Yields on earning assets were approximately 8.9% for the year ended December 31, 1995, compared to 7.8% in 1994 and 7.6% in 1993. The higher average yield on earning assets in 1995 is the result of both an increase in the prime rate from an average of 7.1% in 1994 to an average of 8.8% in 1995, and an increasing percentage of assets being held in loans.
The higher average yield on earning assets in 1994 is largely due to the higher yield on loans as the prime rate began to rise in 1994. The average prime rate of 7.1% compares with 6% for 1993. Through October 8, 1993, net interest income continued to benefit from an interest rate swap agreement, discussed below.
Rates on interest bearing liabilities resulted in an average cost of funds of 4.2% in 1995, compared with 3.0% for the comparable period of 1994 and 2.9% for 1993. In addition to the generally higher level of interest rates in 1995, certificates of deposit represent a higher proportion of the funding liabilities, rather than lower cost money market or savings accounts.
Expressing net interest income as a percent of average earning assets is referred to as margin. Margin was 5.66% for 1995, compared to 5.99% in 1994 and 5.85% for 1993. The Bank's margin is strong because it has funded itself with a
significant amount of noninterest bearing deposits. Margin in 1995 is somewhat lower than 1994 due to the lower level of non interest bearing title and escrow deposits in the current year. Margin in 1994 was higher than 1993 as the benefits of rising interest rates offset the maturing of the interest rate swap agreement discussed below.
Through October 8, 1993, the Bank continued to benefit from an interest rate swap agreement entered into October 8, 1991, which had a notional amount of $100 million. Under this arrangement, the Bank received a fixed rate of 8.18% and paid interest at prime rate, which was 6.0% during 1993. The income earned from the interest rate swap agreement was $0 in 1994 and 1995, compared to $1.7 million in 1993.
TABLE 11 AVERAGE BALANCE SHEETS AND ANALYSIS OF NET INTEREST INCOME
Amounts in thousands of dollars
(1) Non-accrual loans are included in average loan balances, and loan fees earned have been included in interest income on loans. (2) Tax exempt securities do not materially affect reported yields.
OTHER OPERATING INCOME
A significant portion of other operating income in 1994 was earned as mortgage servicing rights were sold for a gain of $2.6 million. The Bank reported a gain of $383 thousand on the sale of mortgage servicing in 1995, representing final
settlement payments received related to open issues on servicing sales from prior quarters. At year end 1995, the Bank did not own any further servicing rights.
The majority of other operating income for 1993 was earned as the Mortgage Banking Operation originated and sold mortgage loans.
The Mortgage Banking Operation earned fee income on loans originated and gains as loans were sold to permanent investors. Loans for which servicing was retained were conventional mortgages under approximately $200 thousand which were sold to the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and other institutional investors. Excess servicing rights were capitalized, and related gains recognized, based on the present value of the servicing cash flows discounted over a period of seven years. When loan prepayments occurred within this period, the remaining capitalized cost associated with the loan was written off.
The servicing rights were retained by the Bank following sale of the mortgage origination operation. The Bank entered into an agreement with the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation to dispose of any remaining portion of this portfolio by the end of 1994 because, with the sale of the mortgage origination operation, the Bank was no longer a qualified seller/servicer of such loans. During 1994, the bank sold the retained servicing rights realizing gains of $2.6 million in 1994 and $383 thousand in 1995.
The trends and composition of other operating income are shown in the following table.
TABLE 12 OTHER OPERATING INCOME
Amounts in thousands of dollars
OPERATING EXPENSE
Total operating expenses for the Bank were $12.6 million year ended December 31, 1995 , compared to $14.7 million in 1994 and $36.9 million for 1993. The year ended December 31, 1995 reflected lower expenses, in part because of a reduction in FDIC insurance premiums paid, from $.23 to $.04 per $100 of deposits. The current level of operating expense is deemed to be adequate and will be leveraged further as the core middle market business is expanded.
The Bank restructured its branch operations functions in 1994, re-engineering its entire work flow and information handling activities. This resulted in a one time charge of $600 thousand for severance pay and other expenses associated with the changes to the operating policies and procedures. Operating expense for the commercial bank excluding this charge was
$12.6 million in 1995, compared to $14.1 million in 1994 and $13.9 million in 1993. Operating expenses for the consolidated Bank declined in 1994, primarily due to the sale of the mortgage origination operation at the end of 1993.
Expenses for the Mortgage Banking Division were $22.5 million in 1993. Premium on sales of mortgage loans included in other operating income is directly related to these expenses and subject to the same factors and conditions. The premium on sales of mortgage loans was $18.0 million in 1993.
PROVISION FOR LOAN LOSSES
The Bank has made no provision for loan losses in 1995 or 1994 , compared with $450 thousand for 1993. No loan loss provision has been deemed necessary for 1995 and 1994, due to the declining levels of nonperforming assets, net recoveries received in 1994, and the strong reserve position. The relationship between the level and trend of the allowance for loan losses and nonperforming assets, combined with the results of the ongoing review of credit quality, determine the level of provisions.
LEGAL AND REGULATORY
In the normal course of business the Bank occasionally becomes a party to litigation. In the opinion of management, based upon consultation with legal counsel, the Bank believes that pending or threatened litigation involving the Bank will have no adverse material effect upon its financial condition, or results of operations.
Since June 1992, the Bank has developed a very positive and proactive relationship with its primary regulators. Results of regular safety and soundness examinations have documented the progress the Bank has achieved. Management is committed to the continuation of this process and maintaining our high standing with our regulators. The following comments refer to regulatory situations that existed in prior years that are reflected in the prior period financial statements provided herein. All of these situations have been successfully resolved and repaired as management transitioned the Bank to its present condition and performance.
In June 1992, the Bank entered into an agreement with the Office of the Comptroller of the Currency (OCC), the Bank's primary federal regulator, which required the implementation of certain policies and procedures for the operation of the bank to improve lending operations and management of the loan portfolio. In November 1993, after completion of its annual examination, the OCC released the Bank from the Formal Agreement. Following this, the Federal Reserve Bank of San Francisco ("Fed") notified the Company on November 29, 1993, that the Memorandum of Understanding, which it had signed, was terminated because the requirements of the agreement were satisfied.
MARKET EXPANSION AND ACQUISITIONS
The Bank is committed to expanding the market penetration of the commercial bank, including the creation of new branches and pursuing acquisition opportunities. During 1995, the Bank converted its former loan production offices in Ventura County, the San Gabriel Valley and the South Bay to full service banking offices in improved facilities. This expanded the Bank's branch system to five full service locations serving the greater Los Angeles area.
In March, 1995, the Company entered into an agreement to acquire Santa Ana based Corporate Bank. The agreement was subsequently amended in October 1995 and the transaction was completed on January 12, 1996 for stock and cash. This acquisition brings two Orange County branches to the Bank, representing an important geographic expansion.
Table 13 is an approximation of how the Bank's balance sheet would have appeared had the acquisition of Corporate Bank closed by December 31, 1995:
On January 10, 1996, the Bank announced an agreement to merge with Home Interstate Bancorp, parent of Home Bank, based in the South Bay. The merger with Home Bank is expected to be completed in mid - 1996, and will create a Bank with 22 branches and over $800 million in assets.
Table 13: Pro Forma Balance Sheet
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors of CU Bancorp and Subsidiary:
We have audited the accompanying consolidated statements of financial conditions of CU Bancorp and Subsidiary (the Company) as of December 31, 1995 and 1994, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CU Bancorp and Subsidiary as of December 31, 1995 and 1994, and the results of its operations and its cash flows for each of the three years then ended in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Los Angeles, California January 19, 1996
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION CU BANCORP AND SUBSIDIARY
The accompanying notes are an integral part of these consolidated statements.
CONSOLIDATED STATEMENTS OF INCOME CU BANCORP AND SUBSIDIARY
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these consolidated statements
CONSOLIDATED STATEMENTS OF CASH FLOWS CU BANCORP AND SUBSIDIARY
The accompanying notes are an integral part of these consolidated statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CU BANCORP AND SUBSIDIARY DECEMBER 31, 1995 (Amounts in thousands unless otherwise specified)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES --
CU Bancorp, a bank holding company (the Company), is a California corporation. The accounting and reporting policies of the Company and its subsidiary conform with generally accepted accounting principles and general practice within the banking industry. The following comments describe the more significant of those policies.
(a) Principles of consolidation -- The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, California United Bank N.A. (the Bank). All significant transactions and accounts between the Company and the Bank have been eliminated in the consolidated financial statements.
(b) Investment portfolio -- The Bank's investment portfolio is separated into two groups, Securities Held to Maturity and Securities Available for Sale. Securities are segregated in accordance with management's intention regarding their retention. Accounting for each group of securities follows the requirements of SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities". The adoption of SFAS 115 in 1993 did not have a material impact on the financial position or results of operations of the Bank.
The Bank has the intent and ability to hold Securities Held to Maturity until maturity. Securities in this classification are carried at cost, adjusted for amortization of premiums and accretion of discounts on a straight-line basis. This approach approximates the effective interest method. Gains and losses recognized on the sale of investment securities are based upon the adjusted cost and determined using the specific identification method.
Securities Available for Sale are those where management has the willingness to sell under certain conditions. This category of securities is carried at current market value with unrealized gains or losses recognized as a tax affected adjustment to shareholders' equity in the statement of financial condition.
(c) Loans -- Loans are carried at face amount, less payments collected, allowance for loan losses, and unamortized deferred fees. Interest on loans is accrued monthly on a simple interest basis. The general policy of the Bank is to discontinue the accrual of interest and transfer loans to non-accrual (cash basis) status where reasonable doubt exists with respect to the timely collectibility of such interest. Payments on non-accrual loans are accounted for using a cost recovery method. No interest income is recorded on non-accrual loans.
Loan origination fees and commitment fees, offset by certain direct loan origination costs, are deferred and recognized over the contractual life of the loan as a yield adjustment.
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can reasonably be anticipated. Management considers the nature of the portfolio, current economic conditions, historical loan loss experience, and other factors in determining the adequacy of the allowance. The allowance is based on estimates and ultimate losses may differ from current estimates. These estimates are reviewed periodically and as adjustments become necessary, they are charged to earnings in the period in which they become known. The allowance is increased by provisions charged to operating expenses, increased for recoveries of loans previously charged-off, and reduced by charge-offs.
The Bank adopted SFAS 114, "Accounting by Creditors for Impairment of a Loan," and SFAS 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures," as of January 1, 1995. SFAS 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. When the measure of the impaired loan is less than the recorded balance of the loan, the impairment is
recorded through a valuation allowance included in the allowance for loan losses. The Bank had previously measured the allowance for loan losses using methods similar to the prescribed in SFAS 114. As a result, no additional provision was required by the adoption of this pronouncement.
The Bank considers all loans where reasonable doubt exists as to the payment of interest or principal to be impaired loans. All loans that are ninety days or more past due are automatically included in this category. An impaired loan will be charged off when the Bank determines that repayment of principal has become unlikely or subject to a lengthy collection process. All loans that are six months or more past due and not well secured or in the process of collection are charged off.
(d) Mortgage Banking Division -- The bank's real estate Mortgage Banking Division became operational in 1988. The mortgage origination operation was sold November 10, 1993. The Bank carried the first trust deed loans generated and held for sale by this Operation at the lower of aggregate cost or market. As of December 31, 1993, cost approximated market value. All loan inventory held for sale by this division had been sold prior to the end of 1994.
During 1993, the Bank capitalized $207 in connection with the right to service real estate mortgage loans originated in that Operation. This excess servicing asset, included in other assets, was initially capitalized at its discounted present value and amortized over a period of five to seven years. Amortization for 1995, 1994, and 1993, was $0, $15, and $983 respectively.
(e) Premises and equipment -- Premises and equipment are carried at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful life of the asset. Amortization is computed on the straight-line method over the useful life of leasehold improvements or the remaining term of the lease, whichever is shorter.
(f) Other real estate owned -- Other real estate owned, acquired through direct foreclosure or deed in lieu of foreclosure, is recorded at the lower of the loan balance or estimated fair market value. When a property is acquired, any excess of the loan balance over the estimated fair market value is charged to the allowance for loan losses. Subsequently, the assets are recorded at the lower of the new cost basis at foreclosure or fair market value less estimated selling expenses. Subsequent write-downs, if any, are included in other operating expenses in the period in which they become known. Gains or losses on sales are recorded in conformity with standards which apply to accounting for sales of real estate. The Bank had no real estate owned at December 31, 1995, and at December 31, 1994.
(g) Interest Rate Derivatives -- The Company enters into interest rate hedge agreements which involve the exchange of fixed and floating rate interest payments periodically over the life of the agreement without the exchange of the underlying principal amounts. The differential to be paid or received is accrued as interest rate change and recognized over the life of the agreements as an adjustment to interest expense.
Fees received in connection with loan commitments are deferred in other liabilities until the loan is advanced and are then recognized over the term of the loan as an adjustment of the yield. Fees on commitments that expire unused are recognized in fees and commission revenue at expiration. Fees received for guarantees are recognized as fee revenue over the term of the guarantees.
(h) Income taxes -- As discussed in Note 8, effective January 1, 1993, the Bank adopted the Statement of Financial Accounting Standards No. 109 (SFAS No. 109), "Accounting for Income Taxes." Under SFAS No. 109, deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax basis of assets and liabilities using the enacted marginal tax rate. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period.
(i) Earnings per share (amounts in whole numbers) -- Earnings per share are computed based on the weighted average number of shares and common stock equivalents outstanding during each year of 4,857,221 in 1995, 4,593,103 in 1994, and 4,489,861 in 1993, retroactively restated for stock dividends and stock splits. Common stock equivalents include the number of shares issuable on the exercise of outstanding options and warrants reduced by the number of shares that could have been purchased with the proceeds from the exercise of the options and warrants plus any tax benefits, based on the average price of common stock.
(j) Statements of cash flows -- The Company presents its cash flows using the indirect method and reports certain cash receipts and payments arising from customer loans and deposits, and deposits placed with other financial institutions on a net basis. For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks and federal funds sold. Generally, federal funds are sold for one-day periods.
(k) Post-retirement benefits -- The Company provides no post-retirement benefits. Accordingly, the accounting prescribed by Statement of Financial Accounting Standards No. 106 "Accounting for Post-Retirement Benefits" has no effect on the Company's consolidated financial statements.
(l) Stock-Based Compensation In October 1995, the FASB issued SFAS No. 123 "Accounting for Stock-Based Compensation". SFAS 123 requires all companies to change what they disclose about their employee stock-based compensation plans, recommends that they change how they account for these plans and requires those companies who do not change their accounting to disclose what their earnings and earnings per share would have been if they had changed their method of accounting pursuant to this pronouncement. The Company has elected to continue to account for their Stock-Based Compensation in accordance with Accounting Principles Board Opinion (APBO 25) and to adopt only the disclosure requirements of SFAS 123. As a result, the adoption of SFAS 123 will not have an impact on the financial position or results of operations of the company.
(m) Reclassifications -- Certain amounts have been reclassified in the prior years to conform to classifications followed in 1995.
(n) Accounting Estimates -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. NATURE OF OPERATIONS --
The Bank engages in the commercial banking business serving the greater Southern California metropolitan area, with offices located in the San Fernando Valley, West Los Angeles, the San Gabriel Valley , the South Bay portion of the County of Los Angeles, and Ventura County. The Bank's primary focus is to engage in middle market lending to businesses, professionals, the entertainment industry and high net-worth individuals. Retail or consumer banking business is generally limited to the owners, officers and employees of its commercial customers, and customers of accounting and business management firms with which the Bank regularly does business. Deposit services which the Bank offers include personal and business checking accounts and savings accounts, insured money market deposit accounts, NOW accounts, and time certificates of deposits, along with IRA and Keogh accounts. The Bank also provides other customary banking services incidental to maintaining the commercial customer relationships.
3. AVERAGE FEDERAL RESERVE BALANCES --
The average cash reserve balances required to be maintained at the Federal Reserve Bank, under the Federal Reserve Act and Regulation D, were approximately $2.4 million and $6.0 million for the years ended December 31, 1995 and 1994, respectively.
4. INVESTMENT PORTFOLIO --
A summary of Securities Held to Maturity at December 31, 1995 and 1994, is as follows:
A summary of Securities Available for Sale for December 31, 1995 is as follows:
Investments with a book value of $27,900 and $29,200 were pledged as of December 31, 1995 and 1994, respectively, to secure court deposits and for other purposes as required or permitted by law. Included in interest on investments in 1995, 1994, and 1993, is $0, $19, and $33, respectively, of interest from tax-exempt securities.
Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
The amortized cost and market value of Securities Held to Maturity as of December 31, 1995, by maturity, are shown below.
At December 31, 1995, the securities available for sale portfolio consisted of Federal Reserve Bank stock and mortgage backed securities. The Federal Reserve Bank stock, with a 6% yield, has no stated maturity. The actual maturity of the mortgage-backed securities is determined by the rate of repayment of the loan pools collateralizing the securities. Actual cash maturities of the Bank's mortgage-backed securities, with an approximate yield of 7%, are expected to be from one to five years.
In December 1995, as permitted by a Special report of the Financial Accounting Standards Board "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities", the Bank made a one time transfer of investment securities into the Available for Sale portfolio. These securities had an amortized cost and market value of $5,769 and $5,912, respectively.
At December 31, 1994, there were no Securities Available for Sale.
Proceeds from the sales and maturities of debt securities during 1995, 1994, and 1993 were $17,722, $52,882, and $78,545, respectively. Gains of $0, $0, and $77 were realized on those transactions. There were no realized losses on sales in 1995, 1994, and 1993.
5. LOANS -- The loan portfolio, net of unamortized deferred fees of $522 at December 31, 1995, and $652 at December 31, 1994, consisted of the following:
At December 31, 1995, the Bank had $1,000 in impaired loans, against which a loss allowance of $318 has been provided. The recorded loss allowance for all impaired loans has been calculated based on the present value of expected cash flows discounted at the loan's effective interest rate. All impaired loans are on nonaccrual status, and as such no interest income is recognized. The Bank had an average investment in impaired loans of approximately $352 for the year ended December 31, 1995.
Total non-performing loans were $4,000 and $36 at December 31, 1995 and 1994, respectively. The interest income, which would have been recognized had non-accrual loans been current, amounted to $ 82, $6, and $469, in 1995, 1994, and 1993, respectively. No interest income has been reported on non-accrual loans for the years 1995, 1994, or 1993.
An analysis of the activity in the allowance for loan losses is as follows:
6. LOANS TO RELATED PARTIES --
There were no loans to directors and their affiliates for the years ended 1995 and 1994.
7. PREMISES AND EQUIPMENT -- Book value of premises and equipment is as follows:
The amounts of depreciation and amortization included in noninterest expense were $553, $459, and $821 for the years ended December 31, 1995, 1994 and 1993, respectively, and are based on estimated lives of 1 to 10 years for furniture, fixtures and equipment, and leasehold improvements.
The Bank leases facilities under renewable operating leases. Rental expense for premises included in occupancy expenses were $833 in 1995, $741 in 1994, $1,133 in 1993. As of December 31, 1995, the approximate future lease payable under the lease commitments is as follows:
8. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Financial instruments are defined as cash, evidence of an ownership interest in an entity or a contract that both imposes contractual obligations and rights to exchange cash, and/or other financial instruments on the parties to the transaction.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
Cash, Due From Banks and Federal Funds Sold For these short term investments, the carrying amount is a reasonable estimate of fair value.
Securities Quoted market prices are available for substantially all of the securities owned by the Bank, both in the Held to Maturity and Available for Sale portfolios. These market quotes have been used to estimate fair value. Loans The fair value of loans was estimated by discounting the future cash flows using current market rates adjusted for approximated credit risk, operating costs and interest rate risk inherent in the portfolios. Future cash flows are aggregated based upon the payment terms and maturities of the loans. The discount rate is calculated as the sum of the risk-free rate, a credit quality factor, an operating expense factor and a prepayment option price. The risk-free rate is based on the U.S. treasury curve for the stated maturity. The credit quality factor is based on a combination of the Bank's loss experience and industry standards for various categories of loans. The operating expense factor is based on an internal analysis of the Bank's costs to deliver and service products.
Deposit Liabilities Fair value for deposit liabilities without contractual maturities is equal to the carrying value of those liabilities. This includes the bank's demand deposits, NOW, savings and money market accounts. Fair value for certificates of deposit are calculated by discounting the future cash flows using a current market rate. The Bank's certificate of deposit portfolio has a fair value which reasonably approximates carrying value, due to the short duration of the portfolio.
Off Balance Sheet Items The Bank's loan commitments are generally for variable rate loans representing current market rates of interest. The Bank's letters of credit are generally short term and are at terms consistent with the current market. Current valuation of these off balance sheet instruments is immaterial. See footnote 11 for further description of these commitments.
Estimations of fair value of financial instruments are subject to significant uncertainty because active and liquid markets do not exist for a majority of them. The estimates include assumptions concerning financial conditions, risk characteristics, expected future losses, and market interest levels, among other factors, and if changed could have a significant impact on them. The resulting presentations of estimated fair value is not necessarily indicative of the value realizable in an actual exchange of financial instruments.
9. INCOME TAXES -
The provisions (benefits) for income taxes for the years ended December 31, 1995, 1994 and 1993 for financial reporting were as follows:
As of December 31, 1995 and 1994, the temporary differences which give rise to a significant portion of deferred tax assets and liabilities are as follows:
The Bank maintains a valuation reserve against net deferred tax assets to reflect the inherent uncertainty of the ultimate realization of those assets. The value of the Bank's largest deferred tax assets represent expenses, such as the loan loss provision, which will become deductible on a future tax return when an actual loss is incurred. Realization of deferred tax assets are dependent on the availability of taxable income in the future or prior years to offset these deductions. Because the State of California does not currently allow net operating loss carrybacks, realization of deferred tax assets related to California Franchise Taxes is subject to a greater degree of uncertainty.
The provisions (benefits) for income taxes varied from the Federal statutory rate of 34% for 1995, 1994, and 1993, for the following reasons:
The total net deferred tax of $2,513 in 1995 and $3,711 in 1994 is included in Other Assets in the Consolidated Statements of Financial Condition.
At December 31, 1993, the Company had a California Franchise Tax carryforward of $1.9 million, with the entire operating loss carryforward being utilized in 1994. The Bank had no operating loss carryforwards at December 31, 1994 or 1995.
10. SHAREHOLDERS' EQUITY -
The Company has three employee stock option plans. The 1983 plan, which authorized the issuance of 400,075 shares of common stock, and the 1985 plan, which authorized the issuance of 350,000 shares of common stock, expired in 1993 and 1995 respectively. The 1993 plan, authorizing the issuance of 400,000 shares of common stock, expires in 2003. Options are granted at a price not less than the fair market value of the stock at the date of grant. Options under these
plans expire up to ten years after the date of grant. The options granted under the 1983 and 1985 plans are incentive stock options, as defined in the Internal Revenue Code. Options under the 1993 plan can be either incentive stock options or non- qualified options. No shares remain available for future grants for the 1983 and 1985 plans, although outstanding options remain and are exercisable over the period designated by those plans.
In 1987, a special stock option plan was approved that is limited to directors of the Company and provides for the issuance of 120,960 shares of common stock. The plan expires in 1997. Options granted under the plan are non-qualified stock options. Each of the directors of the Company, at the time the special stock option plan was approved, received stock options to purchase 15,120 shares at $5.78 per share, which was in excess of the then prevailing market price. Options expire 10 years after the date of grant. There are no remaining options available for grant under the 1987 special stock plan.
In 1994, a non-employee director stock option plan was approved that provides for the issuance of 200,000 shares of common stock. The plan expires in 2004. Options granted under the plan are non-qualified stock options. During 1994, options were granted to purchase 27,500 shares at $6.25 per share , which was equal to the market price at the date of grant. During 1995, 27,500 options were granted at $6.88 per share. Options expire 10 years from the date of grant
The following table summarizes information on stock options outstanding for the years ended December 31, 1995 and 1994, as follows:
During 1994, 1,000 non-qualified stock options under the 1985 plan were exercised at $4.75 per share. In 1995, 15,120 non-qualified stock options under the 1987 plan were exercised at $5.78 per share. No other stock options were exercised in 1994 or 1995.
The following information is presented concerning the stock option plans as of December 31, 1995:
In 1984, certain members of the Board of Directors were granted warrants to purchase up to 360,067 shares of common stock at $4.17 per share, primarily for guaranteeing a capital note issued by the Company. These warrants became exercisable when the capital note was paid off in 1987, and had a maturity date of February 15, 1995. During 1995, all outstanding warrants were exercised. During 1995 and 1994, warrants for 135,024 and 57,012 shares were
exercised. In 1994, warrants to purchase 7,500 shares of common stock at the fair market value at date of grant of $7.00 per share, with an expiration date of February 1, 1999 , were issued to the former chairman of the board.
On June 29, 1995, the Company's shareholders approved adoption of a CU Bancorp 1995 Restricted Stock Plan, providing for the issuance of Common Stock to employees, subject to restrictions on sale or transfer. The restrictions on sale or transfer expire over a period of five years. During 1995, 19,000 restricted shares were issued with a market value of $185. This amount was recorded as unearned compensation and is shown as a separate component of shareholders' equity. Unearned compensation is being amortized to expense over the five year vesting period, with expense of $3 recorded for 1995.
11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND COMMITMENTS AND CONTINGENCIES --
The consolidated statements of financial condition do not reflect various commitments relating to financial instruments which are used in the normal course of business. These instruments include commitments to extend credit, standby and commercial letters of credit, and interest rate floor and swap agreements. Management does not anticipate that the settlement of these financial instruments will have a material adverse effect on the Bank's financial position.
These financial instruments carry various degrees of credit and market risk. Credit risk is defined as the possibility that a loss may occur from the failure of another party to perform according to the terms of the contract. Market risk is the possibility that future changes in market prices may make a financial instrument less valuable.
The Bank primarily grants commercial and real estate loan commitments with variable rates of interest and maturities of one year or less to customers in the greater Los Angeles area. The contractual amounts of commitments to extend credit and standby and commercial letters of credit represent the amount of credit risk. Since many of the commitments and letters of credit are expected to expire without being drawn, the contractual amounts do not necessarily represent future cash requirements. For interest rate floor and swap agreements, the notional amounts do not represent exposure to credit loss.
Commitments to extend credit are legally binding loan commitments with set expiration dates. They are intended to be disbursed, subject to certain conditions, upon request of the borrower. The Bank evaluates the creditworthiness of each customer. The amount of collateral obtained, if deemed necessary by the Bank upon the extension of credit, is based upon management's evaluation. Collateral held varies, but may include securities, accounts receivable, inventory, personal property, equipment, and income- producing commercial or residential property.
Standby letters of credit are provided to customers to guarantee their performance, generally in the production of goods and services or under contractual commitments in the financial markets. Standby letters of credit generally have terms of up to one year.
Commercial letters of credit are issued to customers to facilitate foreign and domestic trade transactions. They represent a substitution of the Bank's credit for the customer's credit. Such letters of credit are generally short term in nature and are collateralized by the merchandise covered by the transaction. At December 31, 1995 and 1994 there were $1.0 million and $1.5 million outstanding, respectively. These amounts reduce the availability under the applicable customer's loan facility.
Interest rate swaps and floors may be created to hedge certain assets and liabilities of the Bank. These transactions involve either an exchange of fixed or floating rate payment obligations on an underlying notional amount. In the case of a rate floor, there is a guaranteed payment of a rate differential on a notional amount, should a specific market rate fall below a specific agreed upon level. Credit risk related to interest rate swaps is limited to the interest receivable from the counterparty less the interest owed that party or, in the case of rate floors, to interest receivable on the differential between the specific rate contracted in the floor agreement and actual rates in effect at various settlement dates. Market risk fluctuates with interest rates.
The following is a summary of various financial instruments with off-balance sheet risk at December 31,1995 and 1994:
In response to continued economic declines and anticipating interest rate declines, the Bank entered into an interest rate swap agreement effective October 8, 1991, for $100 million. Terms of this agreement were that the Bank would receive a fixed rate of 8.18% over two years in exchange for paying the average prime rate. Accrued benefits from this transaction amounted to $1,726 in 1993, and are included in interest income. Amounts due the Bank or counterparty were settled quarterly. This agreement expired on October 8, 1993.
In the normal course of business, the Company occasionally becomes a party to litigation. See footnote 15.
12. OTHER OPERATING EXPENSES --
Other operating expenses included the following:
13. CONDENSED FINANCIAL INFORMATION OF CU BANCORP --
At December 31, 1995 and 1994, the condensed unconsolidated balance sheets of the Company are as follows:
For the years ended December 31, 1995, 1994, and 1993, the condensed unconsolidated statements of income of the Company are as follows:
For the years ended December 31, 1995, 1994 and 1993, the condensed unconsolidated statements of cash flows are as follows:
Amounts in thousands of dollars
Under National banking law, the Bank is limited in its ability to declare dividends to the Company to the total of its net income for the year, combined with its retained net income for the preceding two years less any required transfers to surplus. The effect of this law was to preclude the bank from declaring any dividends at December 31, 1994 and 1993. The Bank has received permission from the OCC to pay dividends to the Company in 1995, in anticipation of the cash dividends paid by the Company. No dividends were actually paid by the Bank in 1995,1994 or 1993.
14. SUBSEQUENT EVENTS
In March of 1995, the Bank had announced the signing of an agreement to acquire Corporate Bank, a Santa Ana based community bank with approximately $70 million in assets. This purchase was completed in January 1996, with Corporate Bank being acquired in exchange for the issuance of approximately 649 thousand shares of CU Bancorp common stock and $1.7 million cash. The acquisition of Corporate Bank will be reflected using the purchase method of accounting in the first quarter of 1996. Also in January 1996, the Bank announced the signing of an agreement to merge with Home Interstate Bancorp, the parent of Home Bank, based in the South Bay. Home Bank provides retail and business banking from its principal office in Signal Hill and fourteen additional branch locations. The agreement with Home Bank provides for the combination to be effected through the exchange of common stock, and is expected to be accounting for as a pooling of interests. This merger, which is targeted to be completed near the end of the second quarter of 1996, would create a combined bank with over $800 million in assets and 22 branches.
15. LEGAL MATTERS
In the normal course of business the Bank occasionally becomes a party to litigation. In the opinion of management, based upon consultation with legal counsel, the Bank believes that pending or threatened litigation involving the Bank will have no adverse material effect upon its financial condition, or results of operations.
Until third quarter 1995, the Bank was a defendant in multiple lawsuits related to the failure of two real estate investment companies, Property Mortgage Company, Inc., ("PMC") and S.L.G.H., Inc. ("SLGH"). The lawsuits, consisted of a federal action by investors in PMC and SLGH (the "Federal Investor Action"), at least three state court actions by groups of Investors (the "State Investor Actions"), and an action filed by the Resolution Agent for the combined and reorganized bankruptcy estate of PMC and SLGH (the "Neilson" Action). An additional action was filed by an individual investor and his related pension and profit sharing plans (the "Individual Investor Action"). Other defendants in these multiple actions and in related actions include financial institutions, title companies, professionals, business entities and individuals, including the principals of PMC and SLGH. The Bank was a depository bank for PMC, SLGH and related companies and was a lender to certain principals of PMC and SLGH ("Individual Loans"). Plaintiffs alleged that PMC/SLGH was or purported to be engaged in the business of raising money from investors by the sale and issuance of interests in loans evidenced by promissory notes secured by real property. Plaintiffs alleged that false representations were to the Bank's conduct with regard to the depository accounts, the lending relationship with the principals and certain collateral taken , pledged by PMC and SLGH in conjunction with the Individual Loans. The lawsuits alleged inter alia violations of federal and state securities laws, fraud, negligence, breach of fiduciary duty, and conversion as well as conspiracy and aiding and abetting counts with regard to these violations. The Bank denied all allegations of wrongdoing. Damages in excess of $100 million were alleged, and compensatory and punitive damages were sought generally against all defendants, although no specific damages were prayed for with regard to the Bank. A former officer and director of the Bank was also been named as a defendant.
The Bank entered into a settlement agreement with the representatives of the various plaintiffs, which has now been consummated, with the dismissal of all of the above referenced cases, with prejudice, against the Bank, its officers and directors, with the exception of the officer/director previously named pending. Court approval of these settlements has been received. In connection with the settlement, the Bank released its security interest in certain disputed collateral and cash proceeds thereof, which the Bank received from PMC, SLGH, or the principals, in connection with the Individual Loans. This collateral had been a subject of dispute in the Neilson Action, with both the Bank and the representatives of PMC/SLGH asserting the right to such collateral. All the Individual Loans have been charged off. The Bank also made a cash payment to the Plaintiffs in connection with the settlement. The effect of this settlement on CU Bancorp or the Bank's financial statements was immaterial. In connection with the settlement the Bank assigned its rights, if any, under various insurance policies, to the Plaintiffs. The settlement does not resolve the claims asserted against the officer/director. The Bank is still providing a defense to its former director/officer who continues as a defendant and who retains his rights of indemnity, if any, against the Bank arising out of his status as a former employee. At this time the only viable claims which appear to remain against the former director/employee are claims of negligence in connection with certain depository relationships with PMC/SLGH. While the Bank's Director and Officer Liability Insurer has not acknowledged coverage of any potential judgment or cost of defense, the Insurer is on notice of the action and has participated in various aspects of the case.
16. REGULATORY MATTERS
Since June 1992, the Bank has developed a very positive and proactive relationship with its primary regulators. Results of regular safety and soundness examinations have documented the progress the Bank has achieved. Management is committed to the continuation of this process and maintaining a high standing with the regulators. The following comments refer to regulatory situations that existed in prior years that are reflected in the prior period financial statements provided herein. All of these situations have been successfully resolved and repaired as management transitioned the Bank to its present condition and performance.
On November 2, 1993, the Office of the Comptroller of the Currency ("OCC"), after completion of their annual examination of the Bank, terminated the Formal Agreement entered into in June, 1992. In December 1993, the Fed terminated the Memo of Understanding entered into in August, 1992.
The Formal Agreement had been entered into in June 1992 and required the implementation of certain policies and procedures for the operation of the Bank to improve lending operations and management of the loan portfolio. The Formal Agreement required the Bank to maintain a Tier 1 Risk Weighted Capital ratio of 10.5% and a 6.0% Tier 1 Leverage Ratio. The Formal Agreement mandated the adoption of a written program to essentially reduce criticized assets, maintain adequate loan loss reserves and improve bank administration, real estate appraisal, asset review management and liquidity policies, and restricted the payment of dividends.
The agreement specifically required the Bank to: 1) create a compliance committee; 2) have a competent chief executive officer and senior loan officer, satisfactory to the OCC, at all times; 3) develop a plan for supervision of management; 4) create and implement policies and procedures for loan administration; 5) create a written loan policy; 6) develop and implement an asset review program; 7) develop and implement a written program for the maintenance of an adequate Allowance for Loan and Lease Losses, and review the adequacy of the Allowance; 8) eliminate criticized assets; 9) develop and implement a written real estate appraisal policy; 10) obtain and improve procedures regarding credit and collateral documentation; 11) develop a strategic plan; 12) develop a capital program to maintain adequate capital (this provision also restricts the payment of dividends by the Bank unless (a) the Bank is in compliance with its capital program; (b) the Bank is in compliance with 12 U.S.C. Section 55 and 60 and (c) the Bank receives the prior written approval of the OCC District Administrator); 13) develop and implement a written liquidity, asset and liability management policy; 14) document and support the reasonableness of any management and other fees to any director or other party; 15) correct violations of law; and 16) provide reports to the OCC regarding compliance.
The Memorandum of Understanding was executed in August 1992 and required 1) a plan to improve the financial condition of CU Bancorp and the Bank; 2) development of a formal policy regarding the relationship of CU Bancorp and the Bank, with regard to dividends, inter-company transactions, tax allocation and management or service fees; 3) a plan to assure that CU Bancorp has sufficient cash to pay its expenses; 4) ensure that regulatory reporting is accurate and submitted on a timely basis; 5) prior approval of the Federal Reserve Bank prior to the payment of dividends; 6) prior approval of the Federal Reserve Bank prior to CU Bancorp incurring any debt and 7) quarterly reporting regarding the condition of the Company and steps taken regarding the Memorandum of Understanding.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
NONE.
Part III
Incorporated by reference from Registrant's definitive proxy statement to be filed within 120 days of fiscal year ended December 31, 1995.
Part IV. Exhibits, Financial Statement Schedules and Reports on Form 8 K.
(A)
(1) and (2) Financial Statements and Financial Statement Schedules - See index at Item 8