Item 1. BUSINESS
GENERAL
Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in Item 7 - "Managements Discussion and Analysis of Financial Condition and Results of Operations," are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Changes to such risks and uncertainties, which could impact future financial performance, include, among others, (1)competitive pressures in the banking industry; (2)changes in interest rate environment; (3)general economic conditions, nationally, regionally and in operating market areas; (4)changes in the regulatory environment; (5)changes in business conditions and inflation; (6)changes in securities markets; and (7) Year 2000 compliance problems. Therefore, the information set forth herein should be carefully considered when evaluating the business prospects of the Company and the Bank.
Saratoga Bancorp (the "Company") is a registered bank holding company whose principal asset (and only subsidiary) is the common stock of Saratoga National Bank (the "Bank"). The Company itself does not engage in any business activities other than the ownership of the Bank and investment of its available funds. As used herein, the term "Saratoga Bancorp" or the "Company" includes the subsidiary of the Company unless the context requires otherwise. The Company was incorporated in California on December 8, 1981. The Bank commenced operations on November 8, 1982. The Bank provides a variety of banking services to businesses, governmental units and individuals. The Bank conducts a commercial and retail banking business, which includes accepting demand, savings and time deposits and making commercial, real estate and consumer loans. It also offers installment note collections, issues cashier's checks, sells traveler's checks and provides other customary banking services. The Bank's deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") up to the legal limits thereupon. The Bank does not offer trust services nor international banking services and does not plan to do so in the near future. At December 31, 1998, the Company had total assets of approximately $145 million and total deposits of approximately $103 million. At December 31, 1998, the Company had 24 full-time equivalent employees.
Most of the Bank's deposits are obtained from the Bank's primary service area. No material portion of the Bank's deposits have been obtained from a single person or group of related persons, the loss of any one or more of which would have a materially adverse effect on the business of the Bank, nor is a material portion of the Bank's loans concentrated within a single industry or group of related industries. Although real estate construction loans represent approximately 26% and other real estate loans represent approximately 45% of total loans, no material portion is located in a single geographic area. Furthermore, the extent to which the business of the Bank is seasonal is insignificant. The importance of, and risks attendant to, foreign sources and application of the Bank's funds is negligible.
For additional information concerning the Company and the Bank, see Selected Financial Data under Item 6 on page 17.
SUPERVISION AND REGULATION
The stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. The Company is also subject to the periodic reporting requirements of Section 15(d) of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, filing annual, quarterly and other current reports with the Securities and Exchange Commission.
The Bank is chartered under the national banking laws of the United States of America, and its deposits are insured by the FDIC. The Bank has no subsidiaries. Consequently, the Bank is regularly examined by the Office of the Comptroller of the Currency (the "OCC"), its primary regulator, and is subject to the supervision of the FDIC and the OCC. Such supervision and regulation include comprehensive reviews of all major aspects of the Bank's business and condition, including its capital ratios, allowance for possible loan losses and other factors. However, no inference should be drawn that such authorities have approved any such factors. The Company and the Bank are required to file reports with the OCC, the FDIC and the Board of Governors of the Federal Reserve System (the "Board of Governors") and provide such additional information as the Board of Governors, FDIC and - OCC may require.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with, and subject to the supervision of, the Board of Governors. The Company is required to obtain the approval of the Board of Governors before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act prohibits the Company from acquiring any voting shares of, or interest in, all or substantially all of the assets of, a bank located outside the State of California unless such an acquisition is specifically authorized by the laws of the state in which such bank is located. Any such interstate acquisition is also subject to the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 discussed below. The OCC regulates the number and locations of the branch offices of a national bank and may only permit a national bank to maintain branches in locations and under conditions imposed by state law upon state banks. The Company, and any subsidiaries which it may acquire or organize, are deemed to be "affiliates" of the Bank within the meaning of that term as defined in the Federal Reserve Act. This means, for example, that there are limitations (a) on loans by the Bank to affiliates, and (b) on investments by the Bank in affiliates' stock as collateral for loans to any borrower. The Company and the Bank are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.
In addition, regulations of the Board of Governors promulgated under the Federal Reserve Act require that reserves be maintained by the Bank in conjunction with any liability of the Company under any obligation (promissory note, acknowledgement of advance, banker's acceptance or similar obligation) with a weighted average maturity of less than seven (7) years to the extent that the proceeds of such obligations are used for the purpose of supplying funds to the Bank for use in its banking business, or to maintain the availability of such funds.
The Board of Governors, FDIC and OCC have adopted risk-based capital guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines are designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform nationally. Under the guidelines, the Company and the Bank are required to maintain capital equal to at least 8.0% of its assets and commitments to extend credit, weighted by risk, of which at least 4.0% must consist primarily of common equity (including retained earnings) and the remainder may consist of subordinated debt, cumulative preferred stock, or a limited amount of loan loss reserve.
Assets, commitments to extend credit, and off-balance sheet items are categorized according to risk and certain assets considered to present less risk than others permit maintenance of capital at less than the 8% ratio. For example, most home mortgage loans are placed in a 50% risk category and therefore require maintenance of capital equal to 4% of such loans, while commercial loans are placed in a 100% risk category and therefore require maintenance of capital equal to 8% of such loans.
The guidelines establish two categories of qualifying capital: Tier 1 capital comprising core capital elements, and Tier 2 comprising supplementary capital requirements. At least one-half of the required capital must be maintained in the form of Tier 1 capital. Tier 1 capital includes common shareholders' equity and qualifying perpetual preferred stock less intangible assets and certain other adjustments. However, no more than 25% of the Company's total Tier 1 capital may consist of perpetual preferred stock. The definition of Tier 1 capital for the Bank is the same, except that perpetual preferred stock may be included only if it is noncumulative. Tier 2 capital includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of reserve for credit losses.
Effective October 1, 1998 the Board of Governors and other federal bank regulatory agencies approved including in Tier 2 capital up to 45% of the pretax net unrealized gains on certain available-for-sale equity securities having readily determinable fair values (i.e. the excess, if any, of fair market value over the book value or historical cost of the investment security). The federal regulatory agencies reserve the right to exclude all or a portion of the unrealized gains upon the determination that the equity securities are not prudently valued. Unrealized gains and losses on other types of assets, such as bank premises and available-for-sale debt securities, are not included in Tier 2 capital, but may be taken into account in the evaluation of overall capital adequacy and net unrealized losses on available-for-sale equity securities will continue to be deducted for Tier 1 capital as a cushion against risk.
The Board of Governors and other federal banking agencies have adopted a revised minimum leverage ratio for banking organizations as a supplement to the risk-weighted capital guidelines. The old rule established a 3% minimum leverage standard for well-run banking organizations (bank holding companies and banks) with diversified risk profiles. Banking organizations which did not exhibit such characteristics or had greater risk due to significant growth, among other factors, were required to maintain a minimum leverage ratio 1% to 2% higher. The old rule did not take into account the implementation of the market risk capital measure set forth in the federal regulatory agency capital adequacy guidelines. The revised leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies and banks. . All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for banking organizations that have significant financial and/or operational weaknesses, a high risk profile, or are undergoing or anticipating rapid growth.
On December 19, 1991, President Bush signed the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDICIA"). The Board of Governors, FDIC and OCC adopted regulations effective December 19, 1992, implementing a system of prompt corrective action pursuant to Section 38 of the Federal Deposit Insurance Act and Section 131 of the FDICIA. The regulations establish five capital categories with the following characteristics: (1) "Well capitalized" - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive; (2) "Adequately capitalized" - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution; (3) "Undercapitalized" - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk- based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) "Significantly undercapitalized" - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; (5) "Critically undercapitalized" - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%.
The regulations established procedures for classification of financial institutions within the capital categories, filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. The regulations impose restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified within any one of the three "undercapitalized" categories, such as declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified within one of the "undercapitalized" categories. In addition, institutions which are classified in one of the three "undercapitalized" categories are subject to certain mandatory and discretionary supervisory actions. Mandatory supervisory actions include (1) increased monitoring and review by the appropriate federal banking agency; (2) implementation of a capital restoration plan; (3) total asset growth restrictions; and (4) limitation upon acquisitions, branch expansion, and new business activities without prior approval of the appropriate federal banking agency. Discretionary supervisory actions may include (1) requirements to augment capital; (2) restrictions upon affiliate transactions; (3) restrictions upon deposit gathering activities and interest rates paid; (4) replacement of senior executive officers and directors; (5) restrictions upon activities of the institution and its affiliates; (6) requiring divestiture or sale of the institution; and (7) any other supervisory action that the appropriate federal banking agency determines is necessary to further the purposes of the regulations. Further, the federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were "significantly undercapitalized." The FDICIA also restricts the solicitation and acceptance of and interest rates payable on brokered deposits by insured depository institutions that are not "well capitalized." An "undercapitalized" institution is not allowed to solicit deposits by offering rates of interest that are significantly higher than the prevailing rates of interest on insured deposits in the particular institution's normal market areas or in the market areas in which such deposits would otherwise be accepted.
Any financial institution which is classified as "critically undercapitalized" must be placed in conservatorship or receivership within 90 days of such determination unless it is also determined that some other course of action would better serve the purposes of the regulations. Critically undercapitalized institutions are also prohibited from making (but not accruing) any payment of principal or interest on subordinated debt without the prior approval of the FDIC and the FDIC must prohibit a critically undercapitalized institution from taking certain other actions without its prior approval, including (1) entering into any material transaction other than in the usual course of business, including investment expansion, acquisition, sale of assets or other similar actions; (2) extending credit for any highly leveraged transaction; (3) amending articles or bylaws unless required to do so to comply with any law, regulation or order; (4) making any material change in accounting methods; (5) engaging in certain affiliate transactions; (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at rates which would increase the weighted average costs of funds beyond prevailing rates in the institution's normal market areas.
The capital ratio requirements for the "adequately capitalized" category generally are the same as the existing minimum risk-based capital ratios applicable to the Company and the Bank.
Under the FDICIA, the federal financial institution agencies have adopted regulations which require institutions to establish and maintain comprehensive written real estate policies which address certain lending considerations, including loan-to-value limits, loan administrative policies, portfolio diversification standards, and documentation, approval and reporting requirements. The FDICIA further generally prohibits an insured state bank from engaging as a principal in any activity that is impermissible for a national bank, absent FDIC determination that the activity would not pose a significant risk to the Bank Insurance Fund, and that the bank is, and will continue to be, within applicable capital standards. Similar restrictions apply to subsidiaries of insured state banks. The Company does not currently intend to engage in any activities which would be restricted or prohibited under the FDICIA.
The federal financial institution agencies have established safety and soundness standards for insured financial institutions covering (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; (6) compensation, fees and benefits; (7) excessive compensation for executive officers, directors or principal shareholders which could lead to material financial loss. If an agency determines that an institution fails to meet any standard the agency may require the financial institution to submit to the agency an acceptable plan to achieve compliance with the standard. If the agency requires submission of a compliance plan and the institution fails to timely submit an acceptable plan or to implement an accepted plan, the agency must require the institution to correct the deficiency. Under the final rule, an institution must file a compliance plan within 30 days of a request to do so from the institution's primary federal regulatory agency. The agencies may elect to initiate enforcement action in certain cases rather than rely on an existing plan particularly where failure to meet one or more of the standards could threaten the safe and sound operation of the institution.
The Board of Governors issued final amendments to its risk-based capital guidelines to be effective December 31, 1994, requiring that net unrealized holding gains and losses on securities available for sale determined in accordance with Statement of Financial Accounting Standards (the "SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," are not to be included in the Tier 1 capital component consisting of common stockholders' equity. Net unrealized losses on marketable equity securities (equity securities with a readily determinable fair value), however, will continue to be deducted from Tier 1 capital. This rule has the general effect of valuing available for sale securities at amortized cost (based on historical cost) rather than at fair value (generally at market value) for purposes of calculating the risk-based and leverage capital ratios.
On December 13, 1994, the Board of Governors issued amendments to its risk-based capital guidelines regarding concentration of credit risk and risks of non-traditional activities, which were effective January 17, 1995. As amended, the risk-based capital guidelines identify concentrations of credit risk and evaluate an institution's ability to manage such risks and the risk posed by non-traditional activities as important factors in assessing an institution's overall capital adequacy.
The federal banking agencies during 1996 issued a joint agency policy statement regarding the management of interest-rate risk exposure (interest rate risk is the risk that changes in market interest rates might adversely affect a bank's financial condition) with the goal of ensuring that institutions with high levels of interest-rate risk have sufficient capital to cover their exposures. This policy statement reflected the agencies' decision at that time not to promulgate a standardized measure and explicit capital charge for interest rate risk, in the expectation that industry techniques for measurement of such risk will evolve.
However, the Federal Financial Institution Examination Counsel (the "FFIEC") on December 13, 1996, approved an updated Uniform Financial Institutions Rating System (the "UFIRS"). In addition to the five components traditionally included in the so-called "CAMEL" rating system which has been used by bank examiners for a number of years to classify and evaluate the soundness of financial institutions (including capital adequacy, asset quality, management, earnings and liquidity), UFIRS includes for all bank regulatory examinations conducted on or after January 1, 1997, a new rating for a sixth category identified as sensitivity to market risk. Ratings in this category are intended to reflect the degree to which changes in interest rates, foreign exchange rates, commodity prices or equity prices may adversely affect an institution's earnings and capital. The rating system henceforth will be identified as the "CAMELS" system. At December 31, 1998, the Bank and the Company are in compliance with the risk-based capital and leverage ratios described above. See Item 7 below for a listing of the Company's risk-based capital ratios at December 31, 1998 and 1997.
Community Reinvestment Act (the "CRA") regulations effective as of July 1, 1995 evaluate banks' lending to low and moderate income individuals and businesses across a four-point scale of "outstanding", "satisfactory", "needs to improve" and "substantial noncompliance," and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in "substantial noncompliance" with the CRA regulations may be subject to enforcement proceedings.
The Bank has a current rating of "satisfactory" CRA compliance, and is scheduled for further examination for CRA compliance during 1999.
During 1998, the Company's primary source of income was interest income. In the future, the Company also expects to receive dividends and management fees from the Bank. The Bank's ability to make such payments is subject to restrictions established by federal banking law, and subject to approval by the OCC. Such approval is required if the total of all dividends declared by the Bank's Board of Directors in any calendar year will exceed the Bank's net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or to a fund for the retirement of preferred stock. The OCC generally prohibits national banks from, among other matters, adding the allowance for loan and lease losses to undivided profits then on hand when calculating the amount of dividends which may be paid. Additionally, while the Board of Governors has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Board of Governors, FDIC and/or OCC, might, under certain circumstances, place restrictions on the ability of a bank to pay dividends based upon peer group averages and the performance and maturity of that bank, or object to management fees on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arms length transaction. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the Bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991. See the discussion of dividends in Item 5 below for additional information regarding dividends. Under the formulas discussed in Item 5, at December 31, 1998, approximately $3,974,000 of the Bank's net profits were available for distribution as dividends without the necessity of any prior governmental approvals. These net profits constitute part of the capital of the Bank and sound banking practices require the maintenance of adequate levels of capital.
COMPETITION
The banking business in Santa Clara County, as it is elsewhere in California, is highly competitive, and each of the major branch banking institutions has one or more offices in the Bank's service area. The Bank competes in the marketplace for deposits and loans, principally against these banks, independent community banks, savings and loan associations, thrift and loan companies, credit unions, mortgage banking companies, and other miscellaneous institutions that claim a portion of the market.
Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns. They also perform services, such as trust services, international banking, discount brokerage and insurance services which the Bank is not authorized or prepared to offer currently. The Bank has made arrangements with its correspondent banks and with others to provide such services for its customers. For borrowers requiring loans in excess of the Bank's legal lending limit, the Bank has offered, and intends to offer in the future, such loans on a participating basis with its correspondent banks and with other independent banks, retaining the portion of such loans which is within its lending limit. As of December 31, 1998, the Bank's legal lending limit to a single borrower and such borrower's related parties was $2,300,000 based on regulatory capital of $15,553,000.
The Bank's business is concentrated in its service area, which primarily encompasses Santa Clara County, and also includes, to a lesser extent, the contiguous areas of Alameda, San Mateo and Santa Cruz counties.
In order to compete with major financial institutions in its primary service area, the Bank uses to the fullest extent possible the flexibility which is accorded by its independent status. This includes an emphasis on specialized services, local promotional activity, and personal contacts by the Bank's officers, directors and employees. The Bank also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, furniture, tools of the trade or expansion of practices or businesses. In the event there are customers whose loan demands exceed the Bank's lending limit, the Bank seeks to arrange for such loans on a participation basis with other financial institutions. The Bank also assists those customers requiring services not offered by the Bank to obtain such services from correspondent banks.
Banking is a business which depends on interest rate differentials. In general, the difference between the interest rate paid by the Bank to obtain its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and on securities held in the Bank's portfolio comprise the major portion of the Bank's earnings.
Commercial banks compete with savings and loan associations, credit unions, other financial institutions and other entities for funds. For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies and other lending institutions.
The interest rate differentials of the Bank, and therefore its earnings, are affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policies of the United States as set by statutes and as implemented by federal agencies, particularly the Federal Reserve Board. This agency can and does implement national monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States government securities, adjustments in the amount of interest free reserves that banks and other financial institutions are required to maintain, and adjustments to the discount rates applicable to borrowing by banks from the Federal Reserve Board. These activities influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their impact on the Bank cannot be predicted.
In 1995 the FDIC, pursuant to Congressional mandate, reduced bank deposit insurance assessment rates to a range from $0 to $0.27 per $100 of deposits, dependent upon a bank's risk. The FDIC has continued these assessment rates through the first semiannual assessment period of 1998. Based upon the above risk-based assessment rate schedule, the Bank's current capital ratios, the Bank's current level of deposits, and assuming no further change in the assessment rate applicable to the Bank during 1998, the Bank estimates that its annual noninterest expense attributed to assessments will remain unchanged during 1999.
Since 1986, California has permitted California banks and bank holding companies to be acquired by banking organizations based in other states on a "reciprocal" basis (i.e., provided the other state's laws permit California banking organizations to acquire banking organizations in that state on substantially the same terms and conditions applicable to local banking organizations). Some increase in merger and acquisition activity among California and out-of-state banking organizations has occurred as a result of this law, as well as increased competition for loans and deposits.
Since October 2, 1995, California law implementing certain provisions of prior federal law has (1) permitted interstate merger transactions; (2) prohibited interstate branching through the acquisition of a branch business unit located in California without acquisition of the whole business unit of the California bank; and (3) prohibited interstate branching through de novo establishment of California branch offices. Initial entry into California by an out-of-state institution must be accomplished by acquisition of or merger with an existing whole bank which has been in existence for at least five years.
Recently, the Federal banking agencies, especially the Board of Governors and the OCC, have taken steps to increase the types of activities in which national banks and bank holding companies can engage, and to make it easier to engage in such activities. On November 20, 1996, the OCC issued final regulations permitting national banks to engage in a wider range of activities through subsidiaries. "Eligible institutions" (those national banks that are well capitalized, have a high overall rating and a satisfactory CRA rating, and are subject to an enforcement order) may engage in activities related to banking through operating subsidiaries after going through a new expedited application process. In addition, the new regulations include a provision whereby a national bank may apply to the OCC to engage in an activity through a subsidiary in which the bank itself may not engage. Although the Bank is not currently intending to enter into any new type of business, this OCC regulation could be advantageous to the Bank if the Bank determines to expand its operations in the future, depending on the extent to which the OCC permits national banks to engage in new lines of business and whether the Bank qualifies as an "eligible institution" at the time of making application.
Certain legislative and regulatory proposals that could effect the Bank and the banking business in general are pending or may be introduced before the United States Congress, the California State Legislature and Federal and state government agencies. The United States Congress is considering numerous bills that could reform banking laws substantially. For example, proposed bank modernization legislation under consideration would, among other matters, include a repeal of the Glass-Steagall Act restrictions on banks that now prohibit the combination of commercial and investment banks.
It is not known to what extent, if any, the legislation proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. It is likely, however, that many of these proposals would subject the Bank to increased regulation, disclosure and reporting requirements and would increase competition to the Bank and its cost of doing business.
In addition to pending legislative changes, the various banking regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such rules and regulations may have on the Bank's business.
ACCOUNTING PRONOUNCEMENTS
In October, 1995, the Financial Accounting Standards Board (the "FASB")issued SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 establishes accounting and disclosure requirements using a fair value method of accounting for stock based employee compensation plans. Under SFAS No. 123, the Company may either adopt the new fair value based accounting method or continue the intrinsic value based method and provide proforma disclosures of net income and earnings per share as if the accounting provisions of SFAS No. 123 had been adopted. The provisions of SFAS No. 123 became effective January 1, 1996. The Company adopted only the disclosure requirements of SFAS No. 123 and such adoption had no effect on the Company's consolidated net earnings or cash flows.
In June, 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 125 establishes accounting and reporting standards for transfers and servicing of financial assets and extinguishment of liabilities based on a financial-component approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. In December 1996, the FASB reconsidered certain provisions of SFAS No. 125 and issued SFAS 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125" to defer for one year the effective date of implementation for transactions related to repurchase agreements, dollar-roll repurchase agreements, securities lending and similar transactions. Earlier adoption or retroactive application of this statement with respect to any of its provisions was not premitted. The Company adopted SFAS 125 effective January 1, 1997. The adoption of SFAS 125 had no effect on the Company's financial condition or results of operations.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share." SFAS No. 128 requires restatement of all prior year earnings per share (EPS) and presentation of basic and diluted EPS. Basic EPS is computed by dividing net income by the weighted average common shares outstanding during the period. Diluted EPS reflects the potential dilution if securities or other contracts to issue common stock are exercised or converted to common shares. The Company adopted SFAS 128 during 1997 and all EPS amounts have been retroactively adjusted to comply with SFAS 128.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which requires that an enterprise report, by major components and as a single total, the change in net assets during the period from nonowner sources; and SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas and major customers. The Company adopted both SFAS 130 and SFAS 131 in 1998 and such adoption had no effect on the Company's financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, "Acounting for Derivative Instruments and Hedging Activities" which establishes accounting and reporting standards for derivative instruments and hedging activities. The Company adopted SFAS 133 effective July 1, 1998. In connection with the adoption of SFAS 133 the Company
reclassified certain investment securities from held-to-maturity to available-for-sale. Adoption of this statement did not have any other impact on the Company's financial position and had no impact on the Company's results of operations or cash flows.
Item 2.
Item 2. Properties
As of December 31, 1998, the Bank had three banking offices located in Santa Clara County. The first banking office, which is owned by the Bank, is also the principal executive office of the Company, and is located at 12000 Saratoga-Sunnyvale Road, Saratoga, California, comprising of approximately 5,500 square feet. The office was purchased by the Company in 1988 for $1,800,000. The foregoing description of the office and purchase of the office is qualified by reference to the Agreement of Purchase and Sale dated July 27, 1988 attached as Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, filed with the Securities and Exchange Commission on March 27, 1989.
The second banking facility, which is located at 15405 Los Gatos Blvd., Suite 103, Los Gatos, California, was opened March 9, 1988. The 3,082 square foot facility is leased under a noncancellable operating lease which expires in 2003. Current lease payments are $6,387 per month for the building and ground lease. Effective March, 1998, the lease payments were tied to the Consumer Price Index. The foregoing description of the lease is qualified by reference to the lease agreement dated October 19, 1987 attached as Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987, filed with the Securities and Exchange Commission on March 31, 1988.
The third banking facility located at 160 West Santa Clara Street, in San Jose, California, was opened on October 3, 1989. The lease agreement for the 7,250 square foot location in the downtown area of San Jose is under a noncancellable operating lease which expires in 1999. Current lease payments are $11,495 per month for the ground floor and $4,274 for the second floor. The lease payments for the second floor are tied to the Consumer Price Index with the increase not to exceed 4% per year. It is anticipated that the lease will be renewed during 1999 without substantial changes to the terms or conditions. The foregoing description of the lease is qualified by reference to the lease agreement dated January 17, 1989 attached as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, filed with the Securities and Exchange Commission on March 27, 1990.
Item 3.
Item 3. LEGAL PROCEEDINGS
Neither the Company nor the Bank is a party to, nor is any of their property the subject of, any material pending legal proceedings other than ordinary routine litigation incidental to their respective businesses, nor are any such proceedings known to be contemplated by governmental authorities.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable. PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters.
There is limited trading in and no established public trading market for the Company's Common Stock. The Company's Common Stock is not listed on any exchange. Hoefer and Arnett, Incorporated, Burford Capital and Sutro and Company facilitate trades in the Company's Common Stock.
The following table summarizes those trades of which the Company has knowledge based on information provided by Hoefer and Arnett, Incorporated, Burford Capital and Sutro and Company, setting forth the approximate high and low bid prices for the periods indicated, restated to reflect 3-for-2 stock split declared by the Board of Directors on March 27, 1998. The prices indicated below may not necessarily represent actual transactions.
(1) As estimated by the Company based upon trades of which it was aware, and not including purchases of stock pursuant to the exercise of employee stock options.
The Company had 255 shareholders of record as of March 1, 1999. The Company's shareholders are entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available therefore, subject to the restrictions set forth in the California General Corporation Law (the "Cor- poration Law"). The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation's retained earnings equal at least the amount of the proposed distribution. The Corporation Law further provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation's assets equal at least 1-1/4 times its liabilities; and (ii) the corporation's current assets equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation's interest expenses for such fiscal years, then the corporation's current assets must equal at least 1-1/4 times its current liabilities. Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends and/or management fees from the Bank. The payment of cash dividends by the Bank may be subject to the approval of the OCC, as well as restrictions established by federal banking law, the Board of Governors and the FDIC.
Approval of the OCC is required if the total of all dividends declared by the Bank's Board of Directors in any calendar year will exceed the Bank's net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or to a fund for the retirement of preferred stock.
Additionally, the Board of Governors,FDIC and/or OCC, might, under certain circumstances, place restrictions on the ability of a bank to pay dividends based upon peer group averages and the performance and maturity of that bank, or object to management fees on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arms length transaction.
The Company has paid cash dividends on the outstanding shares of common stock totaling $0.175 per share in 1997 and $0.20 per share in 1998.
It is the intention of the Company to pay cash and stock dividends, subject to the restrictions on the payment of cash dividends as described above, depending upon the level of earnings, management's assessment of future capital needs and other factors considered by the Board of Directors.
Item 6.
Item 6. Selected Financial Data
The following table presents certain consolidated financial information concerning the business of the Company and the Bank. This information should be read in conjunction with the Consolidated Financial Statements and the notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations contained elsewhere herein.
DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY, INTEREST RATES, AND INTEREST DIFFERENTIAL. The following are the Company's daily average balance sheets for the years ended December 31, 1998 and 1997.
(1) Including average non-accrual loans of Nil and loan fees of $458,000. (2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Yields are based on historical cost for held to maturity securities and fair market value for available for sale securities. (3) Net of average deferred loan fees of $318,000 and average allowance for credit losses of $685,000.
(1) Including average non-accrual loans of $60,000 and loan fees of $357,000. (2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Yields are based on historical cost for held to maturity securities and fair market value for available for sale securities. (3) Net of average deferred loan fees of $374,000 and average allowance for credit losses of $605,000. Interest Differential - Rate/Volume Changes
Interest differential is affected by changes in volume, changes in rates and a combination of changes in volume and rates. Volume changes are caused by changes in the levels of average earning assets and average interest bearing deposits and borrowings. Rate changes result from changes in yields earned on assets and rates paid on liabilities. Changes not solely attributable to volume or rates have been allocated to the rate component. The following table shows the effect on the interest differential of volume and rate changes for the years ended December 31, 1998 and 1997.
(1)Including non accrual loans. (2)Interest income is reflected on an actual basis, not a fully taxable equivalent basis.
INVESTMENT PORTFOLIO
The amortized cost and fair values of securities at December 31 are as follows:
As investment securities mature, to the extent that the proceeds are reinvested in investment securities, management expects that the categories of taxable investment securities purchased will be in approximately the same proportion as existed at December 31, 1998. The maturities and yields of the investment portfolio at December 31, 1998 are shown below.
(1) Yields are actual, not fully taxable equivalent.
Mortgage-backed securities generally have stated maturities of 4 to 15 years but are subject to likely and substantial prepayments which effectively accelerate actual maturities.
LOAN PORTFOLIO
The composition of the loan portfolio at December 31, 1998 and 1997 is summarized in the following table.
Of the loans due after one year, $34,685,000 have fixed rates and $3,879,000 have variable interest rates.
RISK ELEMENTS
There were no nonaccrual loans at December 31, 1998. Nonaccrual loans were $360,000 at December 31, 1997.
At December 31, 1998 and 1997, there were no loans past due 90 days or more as to principal or interest and still accruing interest. There were no loans at December 31, 1998 or 1997 which were troubled debt restructurings.
There were four potential problem loans at December 31, 1998 having a combined principal balance of $2,033,000 ($305,000 at December 31, 1997). Potential problem loans are loans which are generally current as to principal and interest but have been identified by the Company as potential problem loans due either to a decrease in the underlying value of the property securing the credit or some other deterioration in the creditworthiness of the borrower. All of the four loans identified as potential problem loans are secured by real estate and personal property.
The Company does not believe there to be any concentration of loans in excess of 10% of total loans which is not disclosed above which would cause them to be similarly impacted by economic or other conditions. See Management's Discussion and Analysis of Financial Condition and Results of Operations-Provision for Credit Losses, regarding discussion of California economic conditions.
SUMMARY OF CREDIT EXPERIENCE
DEPOSITS
The average balance sheets for 1998 and 1997 set forth the average amount and average interest rate paid for deposits.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Changes to such risks and uncertainties, which could impact future financial performance, include, among others, (1) competitive pressures in the banking industry; (2)changes in interest rate environment; (3)general economic conditions, nationally, regionally and in operating market areas; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; (6) changes in securities markets; and (7) Year 2000 compliance problems. Therefore, the information set forth therein should be carefully considered when evaluating business prospects of the Company and the Bank.
Overview
Net income in 1998 was $1,948,000 ($1.19 basic earnings per share, $1.07 diluted earnings per share) compared to $1,596,000 ($1.01 basic earnings per share, $0.92 diluted earnings per share) in 1997 and $1,101,000 ($.71 basic earnings per share, $0.64 diluted earnings per share) in 1996. The increase in net income in 1998 resulted primarily from an increase in the volume of earning assets, offset, in part, by a decrease in the yield on earning assets and an increase in the volume of interest-bearing liabilities. The increase in net income in 1997 resulted primarily from an increase in the volume and yield of earning assets, offset, in part by an increase in interest expense due to the increased volume of interest-bearing liabilities. The table below highlights the changes in the nature and sources of income and expense from 1997 to 1998 and from 1996 to 1997.
Net Interest Income
Net interest income is affected by changes in the nature and volume of earning assets held during the year, the rates earned on such assets and the rates paid on interest-bearing liabilities. The table below details the average balances, interest income and expense and the effective yields/rates for earning assets and interest bearing liabilities.
Average earning assets increased $7.1 million or 6%, to $122.9 million during 1998 compared to $115.8 million in 1997. In 1997, Average earning assets increased $19.3 million or 20% from $96.5 million in 1996 to $115.8 million in 1997. The increase in 1998 was primarily in construction loans and the longer term real estate loan portfolio. These longer term loans are generally made for a term of between five and fifteen years and are matched against specific blocks of deposits or borrowings in order to alleviate interest rate risk. The increase in 1997 was primarily in Small Business Administration and U.S. Department of Agriculture loans which were purchased as a means to diversify the loan portfolio. Average interest- bearing liabilities increased $3.1 million, or 3%, during 1998 to $92.8 million from $89.7 million in 1997 primarily due to an increase in Federal Home Loan Bank borrowings which were matched against specific longer term real estate
loans and an increase in interest bearing checking deposits. Average interest-bearing liabilities increased $15.4 million, or 21%, to $89.7 million, in 1997 from $74.3 million in 1996. This increase was primarily due to an increase in Federal Home Loan Bank borrowings which were matched against specific longer term real estate loans and an increase in interest bearing checking deposits.
EARNING ASSETS-LOANS
The average loan portfolio increased $10.4 million, or 19%, from $54.5 million in 1997 to $64.9 million in 1998. The increase was primarily in the longer term real estate loan portfolio as a result of marketing efforts in that area. Average loans increased $13.2 million from $41.3 million in 1996 to $54.5 million in 1997. The increase was primarily in SBA and USDA loans which were purchased in order to diversify the loan portfolio. The average loan to average deposit ratio for 1998 was 70% compared to 61% in 1997 and 68% in 1996. The average yield on loans decreased from 10.6% in 1996 to 10.2% in 1997 and 9.8% in 1998. The decrease in yield in 1998 primarily reflects a decrease in interest rates on loans originated as a result of the decrease in prime rate during the year as compared to 1997. The decrease in yield in 1997 is primarily attributable to the purchase of SBA and USDA loans which generally had lower average yields as compared to the rest of the loan portfolio.
OTHER EARNING ASSETS
Average other earning assets, consisting of Investment securities, Federal funds sold and interest bearing deposits in other banks, decreased $3.3 million or 5% during 1998 from $61.3 million to $57.9 million. During 1997, average other earning assets increased $6.1 million from $55.2 million in 1996. The decrease in 1998 was primarily due to the increased level of loans. The increase in the securities portfolio in 1997 was primarily due to the increased level of deposits. The yield earned on average other earning assets increased from 5.8% in 1996 to 6.2% in 1997 and then decreased to 5.8% in 1998. In 1998, the change in the volume and yields resulted in a decrease in interest income of $420,000 on other earning assets. In 1997, the change in the volume and yields of other earning assets resulted in an increase in interest income of $585,000 on other earning assets.
INTEREST BEARING LIABILITIES
Average interest bearing liabilities increased $3.1 million, or 3%, from $89.7 million in 1997 to $92.8 million in 1998 and increased $15.4 million, or 21%, from $74.3 million in 1996 to $89.7 million in 1997. The increase in 1998 was primarily a result
of increased interest-bearing checking accounts and Federal Home Loan Bank borrowings. The increase in 1997 was primarily a result of increased Federal Home Loan Bank borrowings which were matched against certain longer term real estate loans to alleviate the impact of interest rate risk. Average non- interest bearing deposits increased $2.1 million, or 10%, in 1998 to $23.4 million and increased $3.2 million, or 18%, to $21.3 million in 1997 from an average of $18.1 million in 1996. Overall rates on interest bearing deposits decreased from 4.4% in 1996 to 4.3% in 1997 and 1998. The net result of the changes in average balances and rates was an increase in total interest expense of $127,000 in 1998 from 1997 and an increase of $715,000 in 1997 from 1996.
NET INTEREST MARGIN
The net interest margin increased from 4.2% in 1996 to 4.4% in 1997 and 1998. The changes in the net interest margin are primarily attributable to fluctuations in the loan, deposit and borrowing mix and the relationship between rates charged and rates paid.
PROVISION FOR CREDIT LOSSES
The Bank maintains an allowance for credit losses which is based, in part, on the Bank's historical loss experience, the impact of forecasted economic conditions within the Bank's market area, and, as applicable, the State of California, the value of underlying collateral, loan performance and inherent risks in the loan portfolio. The allowance is reduced by charge-offs and increased by provisions for credit losses charged to operating expense and recoveries of previously charged-off loans. During 1998, the Bank provided $136,000 to the allowance for credit losses. During 1997, the Bank did not provide any additional provision for credit losses. In 1996, $150,000 was reversed from the allowance for credit losses. The allowance for credit losses was $716,000 in 1998, compared to $578,000 for 1997 and $628,000 for 1996. At December 31, 1998, the allowance was approximately 0.96% of total loans, compared to approximately 0.90% at December 31, 1997. There were no nonaccrual loans at December 31, 1998 or 1996. Nonaccrual loans were $360,000 at December 31, 1997. Interest income foregone on nonaccrual loans during 1997 was $13,000. The nonaccrual loans consisted of one loan secured by real estate which was paid off on January 22, 1998.
At December 31, 1998 and 1997, there were no loans past due 90 days or more as to principal or interest and still accruing interest.
There was no Other Real Estate Owned ("OREO") at December 31, 1998 or 1997.
Management is of the opinion that the allowance for credit losses is maintained at a level adequate for known and currently anticipated future risks inherent in the loan portfolio. However, the Bank's loan portfolio, which includes approximately $53,000,000 in real estate loans, representing approximately 71% of the portfolio, could be adversely affected if California economic conditions and the real estate market in the Bank's market area were to weaken. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and OREO and the level of the allowance for loan losses, which could adversely affect the Company's and the Bank's future growth and profitability.
NONINTEREST INCOME
Noninterest income increased $288,000, or 60%, to $765,000 during 1998 compared to $477,000 during 1997. During 1997, noninterest income increased $124,000, or 35%, from $353,000 in 1996. The increase in 1998 is primarily attributable to an increase in net gain on sale of securities of $120,000, an increase of $85,000 in rental income on leased assets and income from an increase in the cash surrender value of life insurance policies. The increase in 1997 was primarily attributable to a net gain on sale of securities of $34,000 and an increase of $74,000 in charges assessed on deposit accounts.
NONINTEREST EXPENSES
Noninterest expenses were approximately $3.0 million in 1998 and 1997, compared to approximately $2.9 million in 1996.
Generally, expenses have grown at a slower rate than the growth in assets and increases in the volume of transactions. As a percentage of average earning assets, noninterest expense decreased to 2.4% in 1998 from 2.6% in 1997 and 3.0 in 1996. As pressure continues on net interest margins and net asset growth, management of operating expenses will continue to be a priority.
INCOME TAXES
The Company's effective tax rate was 35.4% for 1998, 38.0% for 1997 and 33.7% for 1996. See Note 9 to the consolidated financial statements for additional information on income taxes.
LIQUIDITY/INTEREST RATE SENSITIVITY
The Bank manages its liquidity to provide adequate funds at an acceptable cost to support borrowing requirements and deposit flows of its customers. At December 31, 1998 and 1997, liquid assets as a percentage of deposits were 52% and 36%, respectively. In addition to cash and due from banks, liquid assets include interest bearing deposits with other banks, Federal funds sold and securities which are available for sale. The Bank has $10.0 million in Federal funds lines of credit available with correspondent banks to meet liquidity needs.
Management regularly reviews general economic and financial conditions, both external and internal, and determines whether the positions taken with respect to liquidity and interest rate sensitivity continue to be appropriate. The Bank also utilizes a monthly "Gap" report which identifies rate sensitivity over the short- and long-term.
The following table sets forth the distribution of repricing opportunities, based on contractual terms, of the Company's earning assets and interest- bearing liabilities at December 31, 1998, the interest rate sensitivity gap (i.e. interest rate sensitive assets less interest rate sensitive liabilities), the cumulative interest rate sensitivity gap, the interest rate sensitivity gap ratio (i.e. interest rate sensitive assets divided by interest rate sensitive liabilities) and the cumulative interest rate sensitivity gap ratio.
Based on the contractual terms of its assets and liabilities, the Bank is currently liability sensitive in terms of its short-term exposure to interest rates. In other words, the Bank's liabilities reprice faster than its assets.
DISTRIBUTION OF REPRICING OPPORTUNITIES At December 31, 1998 (Dollars in thousands)
INFLATION
The impact of inflation on a financial institution differs significantly from that exerted on manufacturing, or other commercial concerns, primarily because its assets and liabilities are largely monetary. In general, inflation primarily affects the Company indirectly through its effect on the ability of its customers to repay loans, or its impact on market rates of interest, and thus the ability of the Bank to attract loan customers. Inflation affects the growth of total assets by increasing the level of loan demand, and potentially adversely affects the Company's capital adequacy because loan growth in inflationary periods may increase more rapidly than capital. Interest rates in particular are significantly affected by inflation, but neither the timing nor the magnitude of the changes coincides with changes in the Consumer Price Index, which is one of the indicators used to measure the rate of inflation. Adjustments in interest rates may be delayed because of the possible imposition of regulatory constraints. In addition to its effects on interest rates, inflation directly affects the Company by increasing the Company's operating expenses. The effect of inflation during the three-year period ended December 31, 1998 has not been significant to the Company's financial position or results of operations.
CAPITAL RESOURCES
The Company's capital resources consist of shareholders' equity and (for regulatory purposes) the allowance for credit losses. During the year ended December 31, 1998, the Company's regulatory capital increased $1,790,000. Tier 1 capital increased $1,652,000 due primarily to the retention of earnings and sale of stock. Tier 2 capital increased $138,000 due primarily to the increase in the allowance for credit losses.
The Company and the Bank are subject to capital adequacy guidelines issued by the Board of Governors and the OCC. The Company and the Bank are required to maintain total capital equal to at least 8% of assets and commitments to extend credit, weighted by risk, of which at least 4% must consist primarily of common equity including retained earnings (Tier 1 capital) and the remainder may consist of subordinated debt, cumulative preferred stock or a limited amount of loan loss reserves. Certain assets and commitments to extend credit present less risk than others and will be assigned to lower risk-weighted categories requiring less capital allocation than the 8% total ratio. For example, cash and government securities are assigned to a 0% risk-weighted category, most home mortgage loans are assigned to a 50% risk-weighted category requiring a 4% capital allocation and commercial loans are assigned to a 100% risk-weighted category requiring an 8% capital allocation. As of December 31, 1998, the Company's total risk-based capital ratio was approximately 16.8% (approximately 16.4% for the Bank) compared to approximately 18.1% (approximately 17.0% for the Bank) at December 31, 1997.
The Board of Governors and other federal banking agencies have adopted a revised minimum leverage ratio for banking organizations as a supplement to the risk-weighted
capital guidelines. The old rule established a 3% minimum leverage standard for well-run banking organizations (bank holding companies and banks) with diversified risk profiles. Banking organizations which did not exhibit such characteristics or had greater risk due to significant growth, among other factors, were required to maintain a minimum leverage ratio 1% to 2% higher. The old rule did not take into account the implementation of the market risk capital measure set forth in the federal regulatory agency capital adequacy guidelines. The revised leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies and banks. All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for banking organizations that have significant financial and/or operational weaknesses, a high risk profile, or are undergoing or anticipating rapid growth.
The following table reflects the Company's Leverage, Tier 1 and total risk-based capital ratios for the three year period ended December 31, 1998.
On December 19, 1991, President Bush signed the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDICIA"). The FDICIA, among other matters, substantially revised banking regulations and established a framework for determination of capital adequacy of financial institutions. Under the FDICIA, financial institutions are placed into one of five capital adequacy catagories as follows: (1) "Well capitalized" - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive; (2) "Adequately capitalized" - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution; (3) "Undercapitalized" - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) "Significantly undercapitalized" - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; (5) "Critically undercapitalized" - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%.
Financial institutions classified as undercapitalized or below are subject to various limitations including, among other matters, certain supervisory actions by bank regulatory authorities and restrictions related to (i) growth of assets, (ii) payment of interest on subordinated indebtedness, (iii) payment of dividends or other capital distributions, and (iv) payment of management fees to a parent holding company. The FDICIA requires the
bank regulatory authorities to initiate corrective action regarding financial institutions which fail to meet minimum capital requirements. Such action may result in orders to, among other matters, augment capital and reduce total assets. Critically undercapitalized financial institutions may also be subject to appointment of a receiver or implementation of a capitalization plan.
OTHER MATTERS
From time to time, the Company's Board of Directors reviews and consults with advisors, including investment banking, accounting and legal advisors, regarding banking industry trends and developments, as well as internal and external opportunities to maximize shareholder value. Such reviews and consultations include evaluating and comparing internal results of operations projections and external opportunities for mergers, acquisitions, reorganizations, or other transactions with third parties which may be in the interests of the Company's shareholders. The Company's Board of Directors considers such periodic review and consultation to be important as part of their analysis of the Company's value and prospects in the changing banking environment and in view of the current consolidation activity within the banking industry.
YEAR 2000
As the year 2000 approaches, a critical issue has emerged regarding how existing application software programs and operating systems can accommodate this date value. In brief, many existing application software products were designed to only accommodate a two digit date position which represents the year (e.g. "97" is stored on the system and represents the year 1997.) As a result, the year 1999 (i.e. "99") could be the maximum date value these systems will be able to accurately process. This is not just a banking problem, as corporations around the world and in all industries are similarly impacted.
During 1997, the Company began a plan that includes the five phases of Year 2000 compliance as defined by the FFIEC, awareness, assessment, renovation, validation, and implementation. The Company's Year 2000 Plan (the "Plan") addresses the proper function of the Company's in-house computer hardware and software, along with other products and services which the Company utilizes and which have potential for Year 2000 difficulties.
Awareness and Assessment Phases The Company completed the Awareness and Assessment Phases, as defined by the FFIEC, during early 1998 and continues to update its assessment as needed. Management of the Company reports at least monthly to the Board of Directors on its Year 2000 efforts.
Renovation Phase The FFIEC guideline date for institutions to substantially complete program changes and system upgrades for mission critical systems was December 31,
1998. By that date, the Company had completed replacements of all hardware and software components with the exception of the item processing subsystem of the mainframe. The replacement of this system was completed in March 1999.
Validation and Implementation Phases To reduce the possibility of unexpected failure of the Company's systems during and after the century date change, which could have an impact on the Company and its customers, the company continues to test its systems in accordance with a testing strategy and plan developed in 1998. The FFIEC guideline date for institutions to begin testing their mission critical applications and systems was September 1, 1998. During April 1998, the Company began testing various mission critical and non-mission critical systems. By December 31, 1998, the Company had substantially completed this testing, with the exception of leap year testing for the Company's mainframe computer and the item processing subsystem that was installed in the first quarter of 1999. This testing should be completed by the end of the second quarter of 1999.
Business Relationships As a part of the Company's Plan, all third party suppliers and service providers have been contacted and assessed as to their Year 2000 preparedness. In addition, the Bank has communicated with its large borrowers and major depositors to determine the extent to which the Company might be vulnerable if those third parties fail to resolve their Year 2000 issues. Because the company recognizes that its business and operations could be adversely affected if key business fail to achieve timely Year 2000 compliance, the Company is evaluating strategies to manage and mitigate the risk to the Company from their Year 2000 failures.
Contingency Plans FFIEC guidelines indicate that contingency plans covering mission critical systems in the event of Year 2000 problems are a prudent business practice. The Company has developed contingency plans for applications and systems used by the Bank that are deemed mission critical as well as plans to cover many non-mission critical applications and systems. The contingency plans are based on a review of various emergency scenarios ranging from the Year 2000 failure of a single software or hardware component to the total loss of systems and applications. Because business resumption planning is a dynamic process, the Company may further refine and test these plans throughout 1999.
Costs to Address Year 2000 Issues The majority of the costs associated with the Company's Year 2000 preparedness efforts would have been incurred in the normal course of business, as the Company regularly upgrades its various systems in an effort to more efficiently and effectively serve its clientele and conduct its operations. The Company estimates the total cost of compliance will be approximately $150,000, with the majority of this expense earmarked for the new item processing subsystem. The costs incurred in 1998 did not have a material effect on the Company's net income for 1998, and the Company does not expect the costs that will be incurred in 1999 to have a material impact on the Company's net income for 1999.
Even with all of the Company's preparation, there can be no assurance that problems will not arise which could have an adverse impact due, among other matters, to the complexities involved in computer programming related to resolution of Year 2000 problems and the fact that the systems of other companies on which the Company may rely must also be corrected on a timely basis. Delays, mistakes or failures in correcting Year 2000 system problems by such other companies could have a significant adverse impact upon the Company and its ability to mitigate the risk of adverse impact of Year 2000 problems for its customers.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Disclosures under this item are not applicable to the Company for the current fiscal year.
Item 8.
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page Independent Auditors' Report 39
Consolidated Balance Sheets, December 31, 1998 and 1997 40
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 1998, 1997, and 1996 41
Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996 42
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 43
Notes to Consolidated Financial Statements 44-60
All schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule or because the information required is included in the Consolidated Financial Statements or notes thereto.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Saratoga Bancorp:
We have audited the accompanying consolidated balance sheets of Saratoga Bancorp and subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of income and comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. 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, such consolidated financial statements present fairly, in all material respects, the financial position of Saratoga Bancorp and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
DELOITTE & TOUCHE LLP San Jose, California January 22, 1999
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
SARATOGA BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1. SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of Saratoga Bancorp and subsidiary conform to generally accepted accounting principles and prevailing practices within the banking industry.
Business - Saratoga Bancorp ("the Company") is a registered bank holding company whose principal asset (and only subsidiary) is the common stock of Saratoga National Bank (the "Bank"). It has been in business since 1982 and has three branches.The Bank conducts commercial and retail banking business, which includes accepting demand, savings and time deposits and making commercial, real estate and consumer loans. It also offers installment note collections, issues cashier's checks, sells travelers checks and provides other customary banking services.
Consolidation - The consolidated financial statements include Saratoga Bancorp and its wholly-owned subsidiary, Saratoga National Bank. All material intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues and expenses as of the dates and for the periods presented. A signifiant estimate included in the accompanying financial statements is the allowance for loan losses. Actual results could differ from those estimates.
Cash Equivalents - The Bank considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
Securities - The Company classifies its securities into two categories, securities available for sale and held to maturity, at the time of purchase. Securities available for sale are measured at market value with a corresponding recognition of the net unrealized holding gain or loss as a separate component of shareholders' equity, net of income taxes, until realized. Securities held to maturity are measured at amortized cost based on the Company's positive intent and ability to hold the securities to maturity. Premiums and discounts are recognized in interest income using the interest method over the period of maturity.
Gains and losses on sales of securities are computed on a specific identification basis.
Loans - Loans are stated at the principal amount outstanding less allowance for credit losses and deferred loan fees. Interest on loans is credited to income as earned. The accrual of interest is discontinued and any accrued and unpaid interest is reversed when the payment of principal or interest is 90 days past due unless the amount is well secured and in the process of collection. Income on nonaccrual loans is recognized only to the extent that cash is received and where the future collection of principal is probable.
Loan origination fees and costs are deferred and amortized to income by a method approximating the effective interest method over the lives of the underlying loans.
Allowance for Credit Losses - The allowance for credit losses is established through a provision charged to expense. Loans are charged against the allowance when management believes that the collection of principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of collectibility and prior loss experience.
The evaluations take into consideration such factors as changes in the composition of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current and anticipated economic conditions that may affect the borrowers' ability to repay. In evaluating the probability of collection, management is required to make estimates and assumptions.
Accounting for Impaired Loans - A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Impaired loans are required to be measured 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 loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Income recognition on impaired loans is consistent with the policy for income recognition on nonaccrual loans described above. The Bank had no impaired loans as of December 31, 1998 or 1997.
Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed on a straight-line basis over the shorter of the lease term or the estimated useful lives of the assets, which are generally three to fifteen years for furniture, equipment and leasehold improvements and 35 years for a building.
Leased Equipment - Leased equipment is stated at cost net of accumulated depreciation. Depreciation is computed on a straight-line basis over the lease term to an estimated residual value. Such leases are accounted for as operating leases. Revenue is recognized when earned and depreciation expense is recorded as other expense.
Other Real Estate Owned - Other real estate owned is carried at the lower of cost or fair value less estimated costs to sell. When the property is acquired through foreclosure, any excess of the related loan balance over its estimated fair value less estimated costs to sell is charged to the allowance for credit losses. Costs of maintaining other real estate owned and any subsequent declines in the estimated fair value are charged to other expenses.
Income taxes - Income taxes are provided using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Earnings Per Share - Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding during the period. Diluted earnings per share reflects the potential dilution if securities or other contracts to issue common stock are exercised or converted into common stock. Diluted earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period plus the dilutive effect of stock options.
The weighted average shares used in computing earnings per share are as follows:
Stock split - On March 27, 1998 the Board of Directors declared a 3-for-2 stock split, which was distributed on May 1, 1998 to shareholders of record as of April 15, 1998. All share and per share data have been retroactively adjusted to reflect the stock split.
Stock-based awards - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees."
Comprehensive income - In 1998 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income" which requires that an enterprise report, by major components and as a single total, the change in net assets during the period from nonowner sources. The adoption of this Statement resulted in a change in financial statement presentation but did not have an impact on the Company's consolidated financial position, results of operations or cash flows.
Segment Reporting - In 1998 the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. Management has determined that since all of the commercial banking products and services offered by the Bank are available in each branch of the Bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank's operations into a single operating segment.
Derivative Instruments - Effective July 1, 1998 the Company adopted SFAS No. 133, " Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments and hedging activities. In connection with the adoption of SFAS 133 the Company reclassified certain securities with an amortized cost of $19,751,000 and a fair value of $19,967,000 from held-to- maturity to available-for-sale. Adoption of this statement did not have any other impact on the Company's consolidated financial position and had no impact on the Company's results of operations or cash flows.
2. CASH AND DUE FROM BANKS
At December 31, 1998, aggregate reserves (in the form of deposits with the Federal Reserve Bank) of $1,151,000 were maintained, which satisfied federal regulatory requirements to maintain certain average reserve balances.
3. SECURITIES
The amortized cost and approximate fair values of securities at December 31 are as follows:
The scheduled maturities of securities (other than equity securities) available for sale and held to maturity at December 31, 1998, were as follows:
Mortgage-backed securities generally have stated maturities of four to fifteen years, but are subject to substantial prepayments which effectively accelerate actual maturities. The Company's investment in governmental mutual funds has no fixed maturity. At December 31, 1998 investments with an amortized cost of $35,544,000 were pledged to secure public and certain other deposits as required by law or contract.
Sales of securities resulted in gross realized gains of $154,000 for 1998, ($69,000 in 1997 and $1,000 in 1996) and gross realized losses of $35,000 in 1997 and $5,000 in 1996. There were no realized losses in 1998.
In connection with the adoption of SFAS 133 in 1998, the Company reclassified certain securities with an amortized cost of $19,751,000 and a fair value of $19,967,000 from held-to-maturity to available- for-sale. Included in such reclassification were certain securities that were previously transferred from available-for-sale to held- to-maturity in 1994. The net unrealized loss at the date of the transfer in 1994 was being amortized over the remaining lives of the investments and totaled $135,000 at December 31, 1997.
4. LOANS AND ALLOWANCES FOR CREDIT LOSSES
There were no nonaccrual loans at December 31, 1998 or 1996 ($360,000 at December 31, 1997). The reduction in interest income associated with these loans in 1997 was $13,000. Interest income recognized on such loans in 1997 was $26,000.
5. PREMISES AND EQUIPMENT
The Company's San Jose and Los Gatos branches are leased under noncancellable operating leases which expire in 1999 and 2003, respectively. The Bank has renewal options with adjustments to the lease payments based on changes in the consumer price index. Future minimum annual lease payments are as follows:
1999 $ 253,000 2000 77,000 2001 77,000 2002 77,000 2003 13,000 ------------ Total $ 497,000 ============
Rental expense under operating leases was $239,000 in 1998, $227,000 in 1997 and $236,000 in 1996.
6. OTHER REAL ESTATE OWNED
7. DEPOSITS
The aggregate amount of short-term jumbo time deposits, each with a minimun denomination of $100,000, was approximately $22,780,000 and 13,773,000 in 1998 and 1997, respectively.
At December 31, 1998, the scheduled maturities of all time deposits are as follows:
Year ending December 31,
1999 32,766,000 2000 2,870,000 2001 1,888,000 2002 197,000 2003 79,000 2004 100,000 $37,900,000 ===========
8. OTHER BORROWINGS
At December 31, 1998, the Company had borrowings from the Federal Home Loan Bank ($22,672,000) and the U.S. Treasury ($25,000) bearing interest at 5.59% to 6.74%. The borrowings are secured by U.S. Government and Agency securities and are due as follows:
1999 $ 25,000 2000 2,000,000 2001 9,115,000 2002 746,000 2003 2,661,000 Thereafter 8,150,000 $ 22,697,000 ============= 9. INCOME TAXES
The effective tax rate differs from the federal statutory rate as follows:
There was no valuation allowance at December 31, 1998 and 1997.
10. STOCK OPTION PLANS
The Company's stock option plans authorize the issuance to employees officers and directors of incentive and nonstatutory options to purchase common stock.
The Company's 1982 Amended Stock Option Plan (the "1982 Plan") expired on October 26, 1992, therefore, no options were granted by the Company during 1996, 1997 or 1998 under the 1982 Plan. Prior to expiration of the 1982 Plan, options were granted to key officers and employees of the Company and its subsidiary. Options granted under the 1982 Plan were either incentive options or nonstatutory options and became exercisable in accordance with a vesting schedule established at the time of grant. Vesting may not extend beyond ten years from the date of grant. Upon a change in control of the Company, all outstanding options under the 1982 Plan will become fully vested and exercisable. Options granted under the 1982 Plan are adjusted to protect against dilution in the event of certain changes in the Company's capitalization, including stock splits and stock dividends.
The Company's 1994 Stock Option Plan (the "1994 Plan") is substantially similar to the 1982 Plan regarding provisions related to option grants, vesting and dilution. Upon a change in control, options do not become fully vested and exercisable, but may be assumed or equivalent options may be substituted by a successor corporation.
At December 31, 1998, 112,421 shares are available for future grant.
The Company continues to account for its stock-based awards using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and its related interpertations. Accordingly, no compensation expense has been recognized in the financial statements for employee stock arrangements.
SFAS No. 123, "Accounting for Stock-Based Compensation" requires the disclosure of proforma net income and earnings per share had the Company adopted the fair value method as of the beginning of fiscal 1995. Under SFAS 123, the fair valur of stock-based awards to employees is calculated through the use of option pricing models,
even though such models were developed to estimate the fair value of freely tradable, fully transferrable options without vesting restriction, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercice, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 114 months; stock volatility, 19% in 1996 and 26.67% in 1998, risk free interest rates, 5.547%, 5.451% and 4.718% in 1998 and 6.54% and 6.68% in 1996, and a dividend yield of 5.50% as they occur. If the computed fair values of the 1998 and 1996 awards had been amortized to expense over the vesting period of the awards, pro forma net income would have been as follows:
The impact of outstanding non-vested stock options granted prior to 1995 has been excluded from the pro forma calculations shown above. Accordingly, the 1998, 1997 and 1996 pro forma adjustments are not indicative of future period pro forma adjustments, when the calculation will apply to all applicable stock options.
11. RETIREMENT PLAN
During 1998 the Company established a defined contribution retirement plan for the benefit of the directors and certain executive officers of the Company and, in connection with establishing the Plan, purchased single premium life insurance policies for each participant. Contributions to the plan are based on the excess of increases in the cash surrender values of the insurance policies over a specified rate, and such contributions continue until the death of the participant. The Company accrued pension expense related to the Plan of approximately $70,000 in 1998. The cash surrender value of the related life insurance policies totaled $3,953,000 at December 31, 1998 and is included in other assets.
12. COMMITMENTS AND CONTINGENT LIABILITIES
The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include loan commitments of $22,533,000 and standby letters of credit of $660,000 at December 31, 1998. The Bank's exposure to credit loss is limited to amounts funded or drawn; however, at December 31, 1998, no losses are anticipated as a result of these commitments.
Loan commitments are typically contingent upon the borrower's meeting certain financial and other covenants and such commitments typically have fixed expiration dates and require payment of a fee. As many of these commitments are expected to expire without being drawn upon, the total commitments do not necessarily represent future cash requirements. The Bank evaluates each potential borrower and the necessary collateral on an individual basis. Collateral varies, and may include real property, bank deposits, or business or personal assets.
Standby letters of credit are conditional commitments written by the Bank to guarantee the performance of a customer to a third party. These guarantees are issued primarily relating to inventory purchases by the Bank's commercial customers and such guarantees are typically short- term. Credit risk is similar to that involved in extending loan commitments to customers and the Bank, accordingly, uses evaluation and collateral requirements similar to those for loan commitments. Virtually all of such commitments are collateralized.
Officers of the Company have severance agreements which provide, in the event of a change in control meeting certain criteria, severance payments based on a multiple of their current compensation. At December 31, 1998, these payments would have aggregated up to $372,000.
13. LOAN CONCENTRATIONS
The Bank's customers are primarily located in Santa Clara County, which is located in the southern portion of the San Francisco Bay Area. Many of the Bank's customers are employed by or are otherwise dependent on the high technology and real estate development industries and, accordingly, the ability of the Bank's borrowers to repay loans may be affected by the performance of these sectors of the economy. Virtually all loans are collateralized. Generally, real estate loans are secured by real property and commercial and other loans are secured by business or personal assets. Repayment is generally expected from refinancing or sale of the related property for real estate construction loans and from cash flows of the borrower for all other loans.
The composition of the loan portfolio at December 31, 1998 and 1997 is summarized in the following table.
1998 1997 Real estate: Construction: Single family construction 21% 11% Land Development 5 3 Other 45 46 Commerical 27 38 Installment 2 2 ---- ---- 100% 100% ==== ====
14. DISCLOSURE OF FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of he amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts.
The following table presents the carrying amount and estimated fair value of certain assets and liabilities of the Company at December 31, 1998 and 1997. The carrying amounts reported in the consolidated balance sheets approximate fair value for the following financial instruments: cash and due from banks, federal funds sold, interest bearing deposits in other banks, demand and savings deposits, federal funds purchased and other borrowings (See Note 3 for information regarding securities).
Loans
The fair value of loans with fixed rates is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings. For loans with variable rates which adjust with changes in market rates of interest, the carrying amount is a reasonable estimate of fair value.
Time deposits
The fair value of fixed maturity certificates of deposit is estimated using rates currently offered for deposits of similar remaining maturities.
Commitments to extend credit and standby letters of credit
Commitments to extend credit and standby letters of credit are issued in the normal course of business by the Bank. Commitments to extend credit are issued with variable interest rates tied to market interest rates at the time the commitments are funded and the amount of the commitments equal their fair value. Standby letters of credit are supported by commitments to extend credit with variable interest rates tied to market interest rates at the time the commitments are funded and the amount of standby letters of credit equals their fair value.
15. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 1998, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Company and the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
16. CONDENSED FINANCIAL INFORMATION OF SARATOGA BANCORP (PARENT ONLY)
The condensed financial statements of Saratoga Bancorp are as follows:
============ =============
The ability of the Company to pay future dividends will largely depend upon the dividends paid to it by the Bank. Under federal law regulating national banks, dividends declared by the Bank in any calendar year may not exceed the lesser of its undistributed net income for the most recent three fiscal years or its retained earnings. As of December 31, 1998, the amount available for distribution from the Bank to the Company was approximately $3,974,000, subject to approval by the Office of the Comptroller of the Currency. The Bank is also restricted as to the amount and form of loans, advances or other transfers of funds or other assets to the Company.
* * * * *
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant. The information required hereunder is incorporated by reference from the Company's definitive proxy statement for the Company's 1999 Annual Meeting of Shareholders (to be filed pursuant to Regulation 14A).
Item 11.
Item 11. Executive Compensation. The information required hereunder is incorporated by reference from the Company's definitive proxy statement for the Company's 1999 Annual Meeting of Shareholders (to be filed pursuant to Regulation 14A).
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required hereunder is incorporated by reference from the Company's definitive proxy statement for the Company's 1999 Annual Meeting of Shareholders (to be filed pursuant to Regulation 14A).
Item 13.
Item 13. Certain Relationships and Related Transactions. The information required hereunder is incorporated by reference from the Company's definitive proxy statement for the Company's 1999 Annual Meeting of Shareholders (to be filed pursuant to Regulation 14A).
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) (1) Financial Statements. This information is listed and included in Part II, Item 8.
(a) (2) Financial Statement Schedules. All schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule or because the information required is included in Consolidated Financial Statements or notes thereto.
(a) (3) Exhibits. The exhibits listed on the accompanying Exhibit Index are filed as part of this report.
(3.1) Articles of Incorporation, as amended, are incorporated by reference herein to Exhibit 3.1 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, as filed with the Securities and Exchange Commission on March 27, 1989.
(3.2) By-laws, as amended, are incorporated by reference herein to Exhibit 3.2 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993 as filed with the Securities and Exchange Commission on March 29, 1994.
(4.1) Specimen stock certificate is incorporated by reference to Exhibit 4.1 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994 as filed with the Securities and Exchange Commission on March 30, 1995.
(10.1) Lease agreement dated 10/19/87 for 15405 Los Gatos Blvd., Suite 103, Los Gatos, CA is incorporated by reference herein to Exhibit 10.1 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 as filed with the Securities and Exchange Commission on March 31, 1988.
(10.2) Agreement of Purchase and Sale dated July 27, 1988 for 12000 Saratoga-Sunnyvale Road, Saratoga, CA is incorporated by reference herein to Exhibit 10.1 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, as filed with the Securities and Exchange Commission on March 27, 1989.
*(10.3) Indemnification Agreements with directors and Executive Officers of the Registrant are incorporated by reference herein to Exhibit 10.2 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, as filed with the Securities and Exchange Commission on March 27, 1989.
(10.4) Lease agreement dated 1/17/89 for 160 West Santa Clara Street, San Jose, California is incorporated by reference herein to Exhibit 10.4 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, as filed with the Securities and Exchange Commission on March 27, 1990.
* (10.5) Bank of the West Master Profit Sharing and Savings Plan and Amendment, amended as of March, 1990 are incorporated by reference herein to Exhibit 10.5 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, as filed with the Securities and Exchange Commission on March 20, 1991.
*(10.6) Employment Agreement and Management Continuity Agreement and Chief Executive Officer Compensation Plan/Richard L. Mount is incorporated by reference herein to Exhibit 10.6 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, as filed with the Securities and Exchange Commission on March 20, 1991.
*(10.7) Saratoga Bancorp 1982 Stock Option Plan is incorporated by reference herein to the exhibits to Registration Statement No. 33-34674 on Form S-8 as filed with the Securities and Exchange Commission on May 7, 1990.
*(10.8) Saratoga National Bank Savings Plan dated June 19, 1995 is incorporated by reference herein to Exhibit 10.8 of Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1995, as filed with the Securities and Exchange Commission on March 27, 1996.
*(10.9) Saratoga Bancorp 1994 Stock Option Plan dated March 18,1994 is incorporated by referencce herein to Appendix A of Proxy Statement dated April 19, 1994 filed as with the Securities and Exchange Commission on April 27, 1994.
*(10.10) Forms of Incentive Stock Option Agreement, Non-Statutory Stock Option Agreement and Non-Statutory Agreement for Outside Directors, as amended is incorporated by reference herein to Exhibit 10.8 of Registrant's Quarterly Report on Form 10-Q for the Quarter ended June 30, 1994 as filed with the Securities and Exchange Commission on August 15, 1994.
(21) Subsidiaries of the registrant: Registrant's only subsidiary is Saratoga National Bank, a national banking association, which operates a commercial and retail banking operation in California.
(23) Independent Auditors' consent
(27) Financial Data Schedule
* Denotes management contracts, compensatory plans or arrangements.
(b) Reports on Form 8-K
On October 2, 1998, Registrant filed a Current Report on Form 8- K, dated September 18, 1998 reporting under Item 5 (Other Events)
a ten cent ($0.10) cash dividend on outstanding shares of common stock of Saratoga Bancorp, to be payable on November 6, 1998, to shareholders of record at the close of business on October 23, 1998.
On December 10, 1998, Registrant filed a Current report on Form 8-K under Item 5, Other Events, announcing the Company's intent to repurchase an amount of its outstanding shares which aggregated with its prior repurchases during the preceding 12 months would not exceed 10% of its consolidated net worth.
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT.
No annual report or proxy material has been sent to security holders. The Company shall furnish copies of such material to the Commission when it is sent to security holders.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SARATOGA BANCORP
RICHARD L. MOUNT By_______________________________ Richard L. Mount, President (Principal Executive Officer)
March 26, 1999 Date_____________________________
MARY PAGE ROURKE By_______________________________ Mary Page-Rourke, Treasurer (Principal Financial and Accounting Officer)
March 26, 1999 Date_____________________________
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name Title Date
VICTOR ABOUKHATER March 26, 1999 __________________ Director _______________ Victor Aboukhater
ROBERT G. EGAN March 26, 1999 __________________ Director _______________ Robert G. Egan
WILLIAM D. KRON March 26, 1999 __________________ Director _______________ William D. Kron
JOHN F. LYNCH III March 26, 1999 __________________ Director _______________ John F. Lynch III
V. RONALD MANCUSO March 26, 1999 __________________ Director _______________ V. Ronald Mancuso
RICHARD L. MOUNT Chairman of the Board March 26, 1999 __________________ President and Director _______________ Richard L. Mount (Principal Executive Officer)
MARY PAGE ROURKE March 26, 1999 __________________ Treasurer _______________ Mary Page-Rourke (Principal Financial and Accounting Officer)
INDEX TO EXHIBITS Sequentially Numbered Number Exhibits Page
27.1 Financial Data Schedule 66 23.1 Independent Auditors' Consent 67
Exhibit 23.1
INDEPENDENT AUDITORS CONSENT
We consent to the incorporation by reference in Registration Statement No. 33-34674 of Saratoga Bancorp on Form S-8 of our report dated January 22, 1999, appearing in the Annual Report on Form 10-K of Saratoga Bancorp for the year ended December 31, 1998.
DELOITTE & TOUCHE
San Jose, California March 26, 1999