ITEM 1. BUSINESS
City National Corporation (the Corporation) was organized in Delaware in 1968 to acquire the outstanding capital stock of City National Bank (the Bank). Because the Bank comprises substantially all of the business of the Corporation, references to the "Company" reflect the consolidated activities of the Corporation and the Bank. The Corporation owns all the outstanding shares of the Bank.
The Bank, which was founded in 1953 and opened for business in January 1954, conducts business in Southern California. After giving effect to the opening of the Bank's Burbank branch on March 1, 1999, the bank operates twenty five banking offices in Los Angeles County, five in Orange County, three in San Diego County, three in Riverside County and three in Ventura County.
On January 17, 1997, the Company completed its acquisition of Ventura County National Bancorp (VCNB), a two bank holding company with six branches and total assets at December 31, 1996 of $279.8 million. The total purchase price was approximately $49.1 million. The Company issued approximately 1.3 million treasury shares with a market value of approximately $28.1 million and paid the remainder in cash.
On January 24, 1997, the Company completed its acquisition of Riverside National Bank (RNB), a four branch bank with total assets at December 31, 1996 of $252.2 million. The total purchase price was approximately $41.4 million. The Company issued approximately 1.0 million treasury shares with a market value of approximately $20.7 million and paid the remainder in cash.
On January 9, 1998, the Company completed its acquisition of Harbor Bancorp (HB), a one-bank holding company with six branches and total assets at December 31, 1997 of $241.8 million. The total purchase price was approximately $34.5 million. The Company issued approximately 540,000 shares, primarily from treasury with an aggregate market value of $17.9 million and paid the remainder in cash. The Company closed the Huntington Beach branch of Harbor Bank on January 26, 1998.
On February 27, 1998, the Company sold its Wilmington branch, which was acquired as part of the 1997 acquisition of VCNB, to Banco Popular, N.A. (California).
On May 15, 1998, the Bank closed its former Magnolia branch, which had been acquired as part of the Company's 1997 acquisition of RNB.
On December 31, 1998, the Company completed its acquisition of North American Trust Company (NATC), an independent trust company, for $11.5 million in an all cash transaction. NATC had approximately $4 billion in total assets under management or administration.
The Company is engaged in one operating segment: providing private and business banking services. The Bank operates primarily in the Southern California market, and is the largest commercial bank headquartered in that region. The Bank's principal customer base comprises small- to middle-market companies with annual sales revenue of up to $250 million, entrepreneurs, professionals, and high net worth individuals. The Bank typically serves customers seeking relationship banking, which it seeks to provide through a high level of personal service, tailored products, and private banking teams. The Bank offers commercial and personal loans of all types, deposit, cash management, international banking and other products and services. In addition, the Bank lends, invests and provides services in accordance with its Community Reinvestment Act commitment. Through City National Investments, the bank offers personal and employee benefit trust and estate services and deals in money market and other investments for its own account and for the customers. The Bank also offers mutual funds in association with other companies.
COMPETITION
The banking business is highly competitive. The Bank competes with domestic and foreign banks for deposits, loans and other banking business. In addition, other financial intermediaries, such as savings and loans, money market mutual funds, credit unions and other financial services companies, compete with the Bank. Furthermore, the geographic constraints on portions of the financial services industry can be expected to erode.
Non-depository institutions can also be expected to increase the extent to which they act as financial intermediaries.
MONETARY POLICY
The net income of the Bank is affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities in the U.S. and abroad. In particular, the Board of Governors of the Federal Reserve System (Federal Reserve Board) exerts a substantial influence on interest rates and credit conditions, primarily through open market operations in U.S. government securities, varying the discount rate on member bank borrowings and setting reserve requirements against deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of financial institutions in the past and are expected to continue to do so in the future.
SUPERVISION AND REGULATION
Bank holding companies, banks and their non-bank affiliates are extensively regulated under both federal and state law. The following is not intended to be an exhaustive description of the statutes and regulations applicable to the Corporation's or the Bank's business. The description of statutory and regulatory provisions is qualified in its entirety by reference to the particular statutory or regulatory provisions.
Moreover, major new legislation and other regulatory changes affecting the Corporation, the Bank, banking and the financial services industry in general have occurred in the last several years and can be expected to occur in the future. The nature, timing and impact of new and amended laws and regulations cannot be accurately predicted.
BANK HOLDING COMPANIES
Bank holding companies are regulated under the Bank Holding Company Act (BHC Act) and are supervised by the Federal Reserve Board. Under the BHC Act, the Corporation files reports of its operations with the Federal Reserve Board and is subject to examination by it.
The BHC Act requires, among other things, the Federal Reserve Board's prior approval whenever a bank holding company proposes to (i) acquire all or substantially all the assets of a bank, (ii) acquire direct or indirect ownership or control of 5% or more of the voting shares of a bank, or (iii) merge or consolidate with another bank holding company. In 1996, legislation was approved to substantially streamline the application process for well-capitalized and well-managed bank holding companies, and in 1997 regulations were adopted by the bank regulatory authorities to implement such legislation.
In September 1994, the Riegle-Neal Interstate Banking and Branch Efficiency Act (the Riegle-Neal Act) was enacted. Under the Riegle-Neal Act, interstate banking is allowed in three different forms:
- A bank owned by a holding company may acquire a subsidiary bank anywhere in the United States.
- A bank owned by a holding company may act as an agent in accepting deposits or servicing loans for any other bank or savings and loan owned by the holding company.
- A bank itself may establish a branch in another state, but only if the bank's home state permits interstate mergers and branches, and the other state has not passed a law to prohibit interstate mergers or branches.
Interstate bank subsidiaries and branch banks are subject to concentration limits, Community Reinvestment Act requirements, bank supervisory controls and other restrictions of the Riegle-Neal Act and of state law.
California law permits bank holding companies in other states to acquire California banks and bank holding companies, provided the acquiring company's home state has enacted "reciprocal" legislation that expressly authorizes California bank holding companies to acquire banks or bank holding companies in that state on terms and conditions substantially no more restrictive than those applicable to such an acquisition in California by a bank holding company from the other state.
The BHC Act also prohibits a bank holding company, with certain exceptions, from acquiring 5% or more of the voting shares of any company that is not a bank and from engaging in any activities without the Federal Reserve Board's prior approval other than (1) managing or controlling banks and other subsidiaries authorized by the BHC Act, or (2) furnishing services to, or performing services for, its subsidiaries. The BHC Act authorizes the Federal Reserve Board to approve the ownership of shares in any company the activities of which have been determined to be closely related to banking or to managing or controlling banks as to be a proper incident thereto.
Consistent with its "source of strength" policy (see "Capital Adequacy Requirements," below), the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company generally should not pay cash dividends unless its net income available to common shareholders is sufficient to fund fully the dividends, and the prospective rate of net income retention appears consistent with the company's capital needs, asset quality and overall financial condition.
A bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with the extension of credit.
The Federal Reserve Board may, among other things, issue cease-and-desist orders with respect to activities of bank holding companies and nonbanking subsidiaries that represent unsafe or unsound practices or violate a law, administrative order or written agreement with a federal banking regulator. The Federal Reserve Board can also assess civil money penalties against companies or individuals who violate the BHC Act or other federal laws or regulations, order termination of nonbanking activities by nonbanking subsidiaries of bank holding companies and order termination of ownership and control of a nonbanking subsidiary by a bank holding company.
NATIONAL BANKS
The Bank is a national bank and, as such, is subject to supervision and examination by the Office of the Comptroller of the Currency (OCC) and requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged, and limitations on the types of investments that may be made and services that may be offered. Various consumer laws and regulations also affect the Bank's operations. These laws primarily protect depositors and other customers of the Bank, rather than the Corporation and its shareholders.
The Corporation's principal asset is its investment in the Bank. Bank dividends are one of the Corporation's principal sources of liquidity. The Bank's ability to pay dividends is limited by certain statutes and regulations. OCC approval is required for a national bank to pay a dividend if the total of all dividends declared in any calendar year exceeds the total of the bank's net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years, less any required transfer to surplus. A national bank may not pay any dividend that exceeds its net profits then on hand after deducting
its loan losses and bad debts, as defined by the OCC. The OCC and the Federal Reserve Board have also issued banking circulars emphasizing that the level of cash dividends should bear a direct correlation to the level of a national bank's current and expected earnings stream, the bank's need to maintain an adequate capital base and other factors. National banks that are not in compliance with regulatory capital requirements generally are not permitted to pay dividends. The Bank is in compliance with such requirements. The OCC also can prohibit a national bank from engaging in an unsafe or unsound practice in its business. Depending on a bank's financial condition, payment of dividends could be deemed to constitute an unsafe or unsound practice. Except under certain circumstances and with prior regulatory approval, a bank may not pay a dividend if, after so doing, it would be undercapitalized. The Bank's ability to pay dividends in the future is, and could be further, influenced by regulatory policies or agreements and by capital guidelines.
The Bank's ability to make funds available to the Corporation is also subject to restrictions imposed by federal law on the Bank's ability to extend credit to the Corporation to purchase assets from it, to issue a guarantee, acceptance or letter of credit on its behalf (including an endorsement or standby letter of credit), to invest in its stock or securities, or to take such stock or securities as collateral for loans to any borrower. Such extensions of credit and issuances generally must be secured and are generally limited, with respect to the Corporation, to 10% of the Bank's capital stock and surplus.
The Bank is insured by the FDIC and therefore is subject to its regulations. Among other things, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provided authority for special assessments against insured deposits and required the FDIC to develop a general risk-based assessment system. During 1995, the Bank Insurance Fund reached its targeted level of 1.25% of estimated insured deposits. The FDIC reduced the assessment rate for well capitalized banks to $2,000 per year for 1996. Beginning January 1, 1998, the FDIC collected an assessment against Bank Insurance Fund-assessable deposits to be paid to the Financing Corporation of approximately 1.26 basis points on total deposits, as defined.
Banks and bank holding companies are also subject to the Community Reinvestment Act of 1977, as amended (CRA). CRA requires the Bank to ascertain and meet the credit needs of the communities it serves, including low-income and moderate-income neighborhoods. The Bank's compliance with CRA is reviewed and evaluated by the OCC, which assigns the Bank a publicly available CRA rating at the conclusion of the examination. Further, an assessment of CRA compliance is also required in connection with applications for OCC approval of certain activities, including establishing or relocating a branch office that accepts deposits or merging or consolidating with, or acquiring the assets or assuming the liabilities of, a federally regulated financial institution. An unfavorable rating may be the basis for OCC denial of such an application, or approval may be conditioned upon improvement of the applicant's CRA record. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve Board will assess the CRA record of each subsidiary bank of the applicant, and such records may be the basis for denying the application.
In the most recently completed CRA compliance examination, conducted in 1997, the OCC assigned the Bank a rating of "Satisfactory," the second highest of four possible ratings. The CRA regulations governing the Corporation and the Bank emphasize measurements of performance in the area of lending (specifically, the bank's home mortgage, small business, small farm and community development loans), investment (the bank's community development investments) and service (the bank's community development services and the availability of its retail banking services), although examiners are still given a degree of flexibility in taking into account unique characteristics and needs of the bank's community and its capacity and constraints in meeting such needs. The regulations also require certain levels of collection and reporting of data regarding certain kinds of loans.
Regulations adopted pursuant to FDICIA incorporate guidelines establishing standards for safety and soundness, including operational and managerial standards relating to internal controls and information
systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, assets growth and compensation, fees and benefits, and prohibit compensation deemed excessive. If the OCC finds that a bank has failed to meet any applicable standard, it may require the institution to submit an acceptable plan to achieve compliance, and if the bank fails to comply, the OCC must, by order, require it to correct the deficiency.
Banking regulations also mandate that the Bank maintain an adequate allowance for loan losses. In compliance with these regulations, a quarterly Analysis and Recommendation of the Allowance for Credit Losses is presented to the Audit Committee of the Board of Directors by the Bank's Risk Management and Credit Administration departments, to make certain that the allowance is maintained within an acceptable range. While the allowance is allocated to portfolio segments, the allowance is general in nature and is available for the portfolio in its entirety. The allowance is allocated to loan portfolios based on previous loan loss experience, management's evaluation of the current loan portfolio including trends and concentrations, and current and expected economic conditions. Classified loans are evaluated based on previous loan loss experience while certain loans possessing similar credit risks are evaluated in groups. Results of the Company's ongoing credit examination process and that of its regulators also factor into the determination of the adequacy of the allowance.
Banking agencies have also adopted regulations which mandate that regulators take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. Banking agencies also have adopted regulations requiring regulators to consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of a bank's capital adequacy.
The OCC has enforcement powers with respect to national banks for violations of federal laws or regulations that are similar to the powers of the Federal Reserve Board with respect to bank holding companies and nonbanking subsidiaries. See "Bank Holding Companies," above.
CAPITAL ADEQUACY REQUIREMENTS
Both the Federal Reserve Board and the OCC have adopted similar, but not identical, "risk-based" and "leverage" capital adequacy guidelines for bank holding companies and national banks, respectively. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, ranging from zero percent for risk-free assets (E.G., cash) to 100% for relatively high-risk assets (E.G., commercial loans). These risk weights are multiplied by corresponding asset balances to determine a risk-adjusted asset base. Certain off-balance sheet items (E.G., standby letters of credit) are added to the risk-adjusted asset base. The minimum required ratio of total capital to risk-weighted assets for both bank holding companies and national banks is presently 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, a limited amount of perpetual preferred stock, trust preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain intangible items. The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock and a limited amount of the general loan-loss allowance. As of December 31, 1998, the Corporation had a ratio of total capital to risk-weighted assets (Total risk- based capital ratio) of 13.20% and a ratio of Tier 1 capital to risk-weighted assets (Tier 1 risk-based capital ratio) of 9.43%, while the Bank had a total risk-based capital ratio of 12.65% and a Tier 1 risk-based capital ratio of 8.90%.
The minimum Tier 1 leverage ratio, consisting of Tier 1 capital to average adjusted total assets, is 3% for bank holding companies and national banks that have the highest regulatory examination rating and are not contemplating significant growth or expansion. All other bank holding companies and national banks are expected to maintain a ratio of at least 1% to 2% or more above the stated minimum. As of
December 31, 1998, the Corporation had a Tier 1 leverage ratio of 7.99%, and the Bank's Tier 1 leverage ratio was 7.53%.
The OCC has adopted regulations under FDICIA establishing capital categories for national banks and prompt corrective actions for undercapitalized institutions. The regulations create five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The following table shows as of December 31, 1998 the minimum total risk-based capital, Tier 1 risk-based capital and Tier 1 leverage ratios, all of which must be satisfied for a bank to be classified as well capitalized, adequately capitalized or undercapitalized, respectively, together with the Bank's ratios which in all cases exceed the well capitalized minimums.
- - ------------------------
(1) A bank may not be classified as well capitalized if it is subject to a specific agreement with the OCC to meet and maintain a specified level of capital.
(2) 3% for institutions having a composite rating of "1" in the most recent OCC examination.
If any one or more of a bank's ratios are below the minimum required to be classified as undercapitalized, it will be classified as significantly undercapitalized. In addition, if its ratio of tangible equity to total assets is 2% or less, it will be classified as critically undercapitalized. A bank may be reclassified by the OCC to the next level below that determined by the criteria described above if the OCC finds that it is in an unsafe or unsound condition or if it has received a less-than-satisfactory rating for any of the categories of asset quality, management, earnings or liquidity in its most recent examination and the deficiency has not been corrected, except that a bank cannot be reclassified as critically undercapitalized for such reasons.
Under FDICIA and its implementing regulations, the OCC may subject national banks to a broad range of restrictions and regulatory requirements. A national bank may not pay management fees to any person having control of the institution, nor, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after doing so, it would be undercapitalized. Undercapitalized banks are subject to increased monitoring by the OCC, are restricted in their asset growth, must obtain regulatory approval for certain corporate activities, such as acquisitions, new branches and new lines of business, and, in most cases, must submit to the OCC a plan to bring their capital levels to the minimum required in order to be classified as adequately capitalized. The OCC may not approve a capital restoration plan unless each company that controls the bank guarantees that the bank will comply with it. Significantly and critically undercapitalized banks are subject to additional mandatory and discretionary restrictions and, in the case of critically undercapitalized institutions, must be placed into conservatorship or receivership unless the OCC and the FDIC agree otherwise.
Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support each such bank. In addition, a bank holding company is required to guarantee that its subsidiary bank will comply with any capital restoration plan required under FDICIA. The amount of such a guarantee is limited to the lesser of (i) 5% of the bank's total assets at the time it became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all applicable capital standards as of the time the bank fails to comply with the capital restoration plan. A holding company guarantee of a capital restoration plan for the Bank would result in a priority claim to the holding company's assets ahead
of its other unsecured creditors and shareholders that is enforceable even in the event of the holding company's bankruptcy or the subsidiary bank's insolvency.
YEAR 2000 ISSUES
During 1996, 1997, and 1998 the Federal Financial Institutions Examination Council ("FFIEC"), an organization comprised of representatives of the major bank regulatory agencies, including the Federal Reserve Board, the OCC and the FDIC, issued a number of statements relating to Year 2000 Issues-the risks attributed to the programming codes in many existing computer systems that may result in inaccurate calculations based on any two-digit field containing the value "00". For many systems, the two-digit "00" field will not permit accurate calculations based on current formulas on or after January 1, 2000 because that date may be read as January 1, 1900. The potential impact, particularly in the financial services industry, is that date-sensitive calculations could be based on erroneous data or could cause a systems failure.
The FFIEC Statement of May 5, 1997 (the "Statement"), as supplemented by the FFIEC Guidelines of December 17, 1997 (the "Guidelines"), emphasize the need to make all information processing systems Year 2000 compliant and to identify specific concerns which should be considered in managing such a conversion program. Among other things, the Statement and Guidelines: (a) outline the Year 2000 project management process; (b) identify certain external risk issues that a Year 2000 conversion plan should consider, including reliance on vendors, data exchange with other firms and Year 2000 compliance by borrowers; and (c) describe other operational issues that may be relevant to a Year 2000 plan. The Guidelines also outline the responsibilities of senior management and the board of directors for addressing Year 2000 problems through active management and oversight of efforts to ensure that adequate resources and personnel are devoted to Year 2000 efforts. The Guidelines stress that Year 2000 Issues are an enterprise-wide challenge, and not solely a technology issue, require management to provide the board at least quarterly status reports on management's Year 2000 efforts and require development of a project planning process. The Guidelines also clarify the Statement regarding Year 2000 compliance by an institution's vendors. See the Noninterest Expense section of Management's Discussion and Analysis for information regarding the Company's "Year 2000 Readiness Disclosures."
ITEM 2.
ITEM 2. PROPERTIES
The Company has its principal offices in the City National Center, 400 North Roxbury Drive, Beverly Hills, California 90210, which the Bank owns and occupies. After giving effect to the opening of the Bank's Burbank branch on March 1, 1999, the Company and its subsidiaries actively maintain operations in 39 banking offices and certain other properties.
Since 1967, the Bank's Pershing Square Banking Office and a number of Bank departments have been the major tenant of the office building located at 606 South Olive Street in downtown Los Angeles. The building was originally developed and built by a partnership between a wholly-owned subsidiary of the Bank, Citinational Bancorporation, and Buckeye Construction Co. and Buckeye Realty and Management Corporation (two corporations then affiliated with Mr. Bram Goldsmith, Chairman of the Board of the Corporation). Since its completion, the building has been owned by Citinational-Buckeye Building Co., a limited partnership of which Citinational Bancorporation and Olive-Sixth Buckeye Co. are the only general partners, each with a 29% partnership interest. Citinational Bancorporation has an additional 3% interest as a limited partner of Citinational-Buckeye Building Co.; the remainder is held by other, unaffiliated limited partners. Olive-Sixth Buckeye Co. is a limited partnership of which Mr. Goldsmith is a 49% general partner; therefore, Mr. Goldsmith has an indirect 14% ownership interest in Citinational-Buckeye Building Co. The remaining general partner and all limited partners of Olive-Sixth Buckeye Co. are not affiliated with the Corporation. Since 1990, Citinational-Buckeye Building Co. has managed the building, which is almost fully leased.
The major encumbrance on real properties owned directly by the Bank or its subsidiaries is a deed of trust on the 606 South Olive Street building, securing Citinational-Buckeye Building Company's note to City National Bank, which matured on December 31, 1998 and on which the unpaid balance at December 31, 1998, was $15,491,182. Citinational-Buckeye Building Co. and the Bank are in the process of renewing and/or extending the mortgage, although there can be no assurance that such renewal and/or extension will be accomplished.
The Bank's subsidiary, Citinational Bancorporation, as of December 31, 1998 owned two buildings located on Olympic Boulevard in downtown Los Angeles, which are occupied primarily by the Bank's support departments and one of which contains a banking office. In addition, as of December 31, 1998, the Bank owned three other branch properties; the former main office of Riverside National Bank and one of its branches located in Riverside, and a branch located in Studio City plus one former branch property in Riverside.
The remaining banking offices and other properties throughout Southern California are leased by the Bank. Total annual rental payments (exclusive of operating charges and real property taxes) approximate $15.2 million, with lease expiration dates ranging from 1999 to 2009, exclusive of renewal options.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Corporation and its subsidiaries are defendants in various pending lawsuits. Based on present knowledge, management and in-house counsel are of the opinion that the final outcome of such lawsuits will not have a material adverse effect upon the Corporation.
The Company is not aware of any material proceedings to which any director, officer or affiliate of the Company, any owner of record or beneficially of more than 5% of the voting securities of the Company, or any associate of any such director, officer or security holder is a party adverse to the Company or any of its subsidiaries or has a material interest adverse to the Company or any of its subsidiaries.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 1998.
EXECUTIVE OFFICERS OF THE REGISTRANT
Shown below are names and ages of all executive officers of the Corporation and officers of the Bank who may be deemed to be executive officers of the Corporation, with indication of all positions and offices with the Corporation and the Bank. Mr. Russell Goldsmith is the son of Mr. Bram Goldsmith.
Capacities in which served:
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Corporation's common stock is listed and traded principally on the New York Stock Exchange under the symbol "CYN," information concerning the range of high and low sales prices for the Corporation's common stock, and the dividends declared, for each quarterly period within the past two fiscal years in set forth below.
As of February 26, 1999 the closing price of the Corporation's stock on the New York Stock Exchange was $32.25 per share. As of that date, there were approximately 2,100 record holders of the Corporation's common stock. On January 27, 1999, the Board of Directors authorized a regular quarterly cash dividend on its common stock at an increased rate of $0.165 per share payable on February 22, 1999.
For a discussion of dividend restrictions on the Corporation's common stock, see Note 11 (Availability of Funds From Subsidiaries, Restrictions on Cash Balances; Capital) to the consolidated financial statements on page A-53 of this report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this item appears on page A-2 under the caption "SELECTED FINANCIAL INFORMATION," and is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item appears on pages A-3 through A-30, under the caption "MANAGEMENT'S DISCUSSION AND ANALYSIS," and is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item appears on pages A-15 through A-18 under the caption "MANAGEMENT'S DISCUSSION AND ANALYSIS" and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item appears on pages A-33 through A-61, and on page A-31 under the captions "1998 QUARTERLY OPERATING RESULTS" and "1997 QUARTERLY OPERATING RESULTS" and is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item, to the extent not included under the caption "Executive Officers of the Registrant" in Part I of this report, or below, will appear under the caption "Election of Directors" in the Corporation's definitive proxy statement for the 1999 Annual Meeting of Stockholders (the "1999 Proxy Statement"), and such information either shall be (i) deemed to be incorporated herein by reference from that portion of the 1999 Proxy Statement, if filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the Corporation's most recently completed fiscal year, or (ii) included in an amendment to this report filed with the Commission on Form 10-K/A.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will appear under the captions "Compensation of Directors and Executive Officers," "Board Compensation and Directors Nominating Committee Report on Executive Compensation" and "Stockholder Return Graph" in the 1999 Proxy Statement, and such information either shall be (i) deemed to be incorporated herein by reference from those portions of the 1999 Proxy Statement, if filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the Corporation's most recently completed fiscal year, or (ii) included in an amendment to this report filed with the Commission on Form 10-K/A.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item will appear under the captions "Record Date, Number of Shares Outstanding and Voting Rights; Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" in the 1999 Proxy Statement, and such information either shall be (i) deemed to be incorporated herein by reference from that portion of the 1999 Proxy Statement, if filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the Corporation's most recently completed fiscal year, or (ii) included in an amendment to this report filed with the Commission on Form 10-K/A.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will appear under the caption "Certain Transactions with Management and Others" in the 1999 Proxy Statement, and such information either shall be (i) deemed to be incorporated herein by reference from that portion of the 1999 Proxy Statement, if filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the Corporation's most recently completed fiscal year, or (ii) included in an amendment to this report filed with the Commission on Form 10-K/A. Also see Note 5 (Loans and Allowance for Credit Losses) to the consolidated financial statements on page A-44 through A-46 of this report.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. Financial Statements:
2. All other schedules and separate financial statements of 50% or less owned companies accounted for by the equity method have been omitted because they are not applicable.
3. Exhibits (listed by numbers corresponding to Exhibit Table of Item 601 in Regulation S-K)
(b) During the calendar quarter ended December 31, 1998, the registrant did not file any current reports on Form 8-K.
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.
March 15, 1999
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.
FINANCIAL HIGHLIGHTS
A-1
SELECTED FINANCIAL INFORMATION
A-2
MANAGEMENT'S DISCUSSION AND ANALYSIS
OVERVIEW
City National Corporation (the "Company") is the holding company for City National Bank (the "Bank"). In light of the fact that the Bank comprises substantially all of the business of the Company, references to the "Company" mean the Company and the Bank together.
See "Cautionary Statement for Purposes of the "Safe Harbor' Provision of the Private Securities Litigation Reform Act of 1995", below in connection with "forward looking" statements included in this section and in the Results of Operations and Balance Sheet Analysis sections.
The Company regularly evaluates, and holds discussions with, various potential acquisition candidates. As a general rule the Company does not publicly announce such acquisitions until after a definitive agreement has been reached. Also as a matter of policy, the Company generally does not make any specific projections as to future earnings nor does it endorse any projections regarding future performance, which may be made by others.
Consolidated net income was $96.2 million, or $2.00 per diluted common share in 1998, compared to $80.1 million, or $1.68 per diluted common share in 1997. Net income per basic share was $2.08 in 1998 compared with $1.74 in 1997. The increase in net income reflects the growth in the Company's loans and deposits during 1998 including the impact from the acquisition of HB in January 1998. Fully taxable equivalent net interest income in 1998 increased $41.1 million over 1997 and noninterest income increased $14.3 million compared with 1997. Partially offsetting these increases were a $29.6 million increase in noninterest expense, compared with 1997 and a $8.6 million increase in income tax expense in 1998.
The return on average assets was 1.71% and the return on average common equity was 17.87%, compared with 1.70% and 16.95%, respectively, in 1997.
Income before the amortization of goodwill and core deposit intangibles (net of applicable taxes) ("cash" earnings) for the year ended December 31, 1998 were $101.7 million, or $2.11 per diluted common share, compared with $84.1 million, or $1.76 per diluted common share for the year ended December 31, 1997. On the same basis, the return on average assets was 1.82% and the return on average common equity was 20.98%, compared with 1.80% and 19.53%, respectively, in 1997. "Cash" income is presented because it measures the Company's ability to support growth, pay dividends and repurchase stock. The Company's "cash" income per share and other ratios are not necessarily comparable to similarly titled measures reported by other companies.
Average assets increased to $5,633.8 million in 1998 from $4,703.9 million in 1997, an increase of $929.9 million or 19.8%, largely due to increased loans and the acquisition of HB. Total average loans increased $826.1 million or 24.4% between 1997 and 1998 due to internal loan originations of both commercial, residential first trust deed and construction loans, approximately $152.8 million from the HB acquisition and participations in domestic bank non-relationship syndicated loans. Average core deposits (checking, savings and money market accounts and time certificates of deposit of less than $100,000) increased to $3,506.6 million in 1998 from $3,079.6 million in 1997, an increase of $427.0 million or 13.9% due to the Company's increased marketing efforts in 1998 and approximately $163.6 million from the acquisition of HB.
Nonaccrual loans decreased to $23.1 million at December 31, 1998, or 0.51% of total loans, compared to $27.6 million, or 0.72% a year earlier. ORE totaled $3.5 million at year end, up from $2.1 million a year earlier.
The allowance for credit losses at December 31, 1998 was $135.3 million or 3.0% of loans outstanding at year end. Net chargeoffs totaled $5.2 million in 1998, compared with net recoveries of $0.7 million in 1997. Based on its review of the loan portfolio, management considers the allowance for credit losses to be adequate. Based on expected loan growth, the level of nonperforming loans, anticipated recoveries in the
A-3
first half of 1999 of loans previously charged-off and a relatively constant low level of chargeoffs, it is anticipated that the level of the allowance will remain stable through the first half of 1999 without a provision for credit losses. However, credit quality will be influenced by underlying trends in the economic cycle, particularly for Southern California, among a variety of other factors, which are beyond management's control. Consequently, no assurances can be given that the Company will not sustain loan losses, in any particular period, that are sizable in relation to the allowance for credit losses. Additionally, subsequent evaluations of the loan portfolio, in light of factors then prevailing, by the Company and its regulators may indicate a requirement for increases in the allowance for credit losses through charges to the provision for credit losses.
On January 9, 1998, the Company completed its acquisition of HB for $34.5 million. The Company issued approximately 540,000 shares, primarily treasury shares, with an aggregate market value of $17.9 million and paid the remainder in cash. HB had total assets, loans and deposits of $241.8 million, $152.8 million and $221.3 million, respectively, at December 31, 1997. The acquisition of HB resulted in the recording of goodwill and intangibles of approximately $24.0 million.
On January 12, 1998, the Company's wholly owned subsidiary, City National Bank, issued $125 million of 6 3/8% Subordinated Notes, due in 2008, in a private offering. Proceeds, which qualify as Tier II capital, were used for general corporate purposes.
On February 27, 1998, the Company sold its Wilmington branch, which was acquired as part of the 1997 acquisition of VCNB, to Banco Popular, N.A. (California). With the sale the purchaser received approximately $40 million of deposits.
On May 15, 1998, the Bank closed its former Magnolia branch, which had been acquired as part of the Company's 1997 acquisition of RNB, transferring accounts to other nearby offices.
In September 1998, the Company announced a program for the repurchase of up to 1.0 million shares of its common stock. At December 31, 1998, a total of 128,000 shares had been repurchased at a cost of $3.5 million, or an average price of $27.38 per share. Also in September, the Company completed another 1.0 million common shares stock buyback program that had been announced in April at a cost of $34.3 million, or an average price of $34.27 per share. On April 29, 1998, the Company completed a share repurchase program announced in March 1997 of 1.5 million shares of its common stock at a total cost of $42.7 million, or an average price of $28.46 per share.
On December 31, 1998, the Company completed its acquisition of North American Trust Company (NATC), an independent trust company, for $11.5 million in an all cash transaction. NATC had approximately $4 billion in total assets under management or administration.
The Company paid dividends of $0.56 per share of common stock in 1998 and $0.44 per share of common stock in 1997. On January 27, 1999, the Board of Directors authorized a regular quarterly cash dividend on common stock at an increased rate of $0.165 per share to shareholders of record on February 10, 1999, payable on February 22, 1999.
A-4
RESULTS OF OPERATIONS
OPERATIONS SUMMARY
- - ------------------------------
(1) Includes amounts to convert nontaxable income to a fully taxable equivalent basis.
OPERATIONS SUMMARY ANALYSIS
NET INTEREST INCOME
1998 COMPARED WITH 1997
Taxable equivalent net interest income totaled $304.2 million in 1998, up $41.1 million, or 15.6% from 1997. The increase from 1997 to 1998 was due to a $897.4 million, or 20.9% increase in average total earning assets less a decrease in the net interest margin to 5.86% from 6.13% despite interest recovered on nonaccrual and charged off loans increasing $0.7 million for the year.
Average loans increased to $4,213.9 million in 1998 from $3,387.8 million in 1997, an increase of $826.1 million or 24.4%. The majority of this increase reflects higher average commercial loans outstanding, up $562.5 million or 34.6%. This increase resulted from the Bank's increased marketing efforts, including the formation of several specialized industry teams in 1998 and the expanding of the media-communications group, the acquisition of HB and participations in domestic bank non-relationship syndicated loans that add geographic and industry diversification and liquidity to the portfolio. Average residential first mortgage loans increased $86.6 million or 9.2% due to continued strong internal loan originations, primarily of fixed rate mortgages. Average construction loans increased $63.9 million or 50.0% due to the Bank's emphasis in this area. Average real estate mortgage loans increased $108.1 million or 16.7% primarily due to the impact of the acquisition of HB. Average loan balances are expected to increase in 1999, resulting from continued loan growth.
Average total investment and available-for-sale securities increased $12.8 million or 1.5% between 1997 and 1998 from investing excess deposit and borrowing growth which were not yet needed to fund loan growth.
Average noninterest-bearing deposits increased to $1,858.0 million in 1998 from $1,522.7 million in 1997, an increase of $335.2 million or 22.0%, while average interest-bearing core deposits increased to $1,648.6 million in 1998 from $1,556.9 million in 1997, an increase of $91.7 million or 5.9%. Average time deposits of $100,000 or more increased $226.6 million or 42.4% between 1997 and 1998. These increases resulted from the Bank's increased marketing efforts as well as from the acquisition of HB.
A-5
RATIOS TO AVERAGE ASSETS
- - ------------------------
(1) Fully taxable equivalent basis.
1997 COMPARED WITH 1996
Taxable equivalent net interest income totaled $263.2 million in 1997, up $57.5 million, or 28.0% from 1996. The increase from 1996 to 1997 was due to a $785.0 million, or 22.4% increase in total earning assets and an increase in the net interest margin to 6.13% from 5.87%.
Average loans increased to $3,387.8 million in 1997 from $2,539.3 million in 1996, an increase of $848.5 million or 33.4%. The majority of this increase reflects higher average commercial loans outstanding, up $500.0 million or 44.5%. This increase resulted from the Bank's increased marketing efforts, including the formation of several specialized industry teams in 1997, the acquisitions of VCNB and RNB and participations in domestic bank non-relationship syndicated loans that add geographic and industry diversification and liquidity to the portfolio. Average residential first mortgage loans increased $158.7 million or 20.3% due to continued strong internal loan originations, primarily of fixed rate mortgages. The Company purchased $74.7 million in single family mortgages during 1997, which was substantially less than mortgage loan repayments and prepayments from purchased mortgages. Average construction loans increased $39.4 million or 44.5% due to the Bank's emphasis in this area. Average real estate mortgage loans increased $138.1 million or 27.1% primarily due to the impact of the acquisitions of VCNB and RNB.
Average total investment and available-for-sale securities decreased $10.0 million or 1.2% between 1996 and 1997 as a result of the redeployment of the proceeds from securities maturities and sales to fund the growth in loans.
Average noninterest-bearing deposits increased to $1,522.7 million in 1997 from $1,193.0 million in 1996, an increase of $329.7 million or 27.6%, while average interest-bearing core deposits increased to $1,556.9 million in 1997 from $1,315.3 million in 1996, an increase of $241.6 million or 18.4%. Average time deposits of $100,000 or more increased $170.8 million or 47.0% between 1996 and 1997. These increases resulted from the Bank's increased marketing efforts as well as from the acquisitions of VCNB and RNB.
The following table shows the change in net interest income broken down between volume and rate. The change in interest due to both rate and volume has been allocated to the change due to volume and rate in proportion to the relationship of the absolute dollar amounts of the change in each.
A-6
CHANGES IN NET INTEREST INCOME
A-7
The following table shows average balances and interest rates for the last five years.
NET INTEREST INCOME SUMMARY
- - ------------------------------
(1) Fully taxable equivalent basis.
(2) Includes average nonaccrual loans of $32,140, $37,879, $45,813, $46,931 and $69,164 for 1998, 1997, 1996, 1995 and 1994, respectively.
(3) Loan income includes loan fees of $12,185, $8,857, $7,492, $6,850 and $6,835 for 1998, 1997, 1996, 1995 and 1994, respectively.
A-8
A-9
PROVISION FOR CREDIT LOSSES
The provision for credit losses charged to operations reflects management's judgment of the adequacy of the allowance for credit losses and is determined through periodic analysis of the loan portfolio. This analysis includes a detailed review of the classification and categorization of problem and potential problem loans and loans to be charged off; an assessment of the overall quality and collectibility of the portfolio; and consideration of the loan loss experience, trends in problem loans and concentrations of credit risk, as well as current and expected future economic conditions (particularly in Southern California). The Bank has an internal risk analysis and review staff that ultimately reports to the Audit Committee of the Board of Directors and continuously reviews loan quality. Such reviews also assist management in establishing the level of the allowance for credit losses.
Since 1994, the Company has not recorded a provision for credit losses. In 1998 and 1996, net chargeoffs totaled $5.2 million and $1.4 million, respectively compared with net recoveries of $0.7 million and $7.1 million in 1997 and 1995, respectively. The Company did not record a provision for credit losses for the last four years because of the combination of loan growth; low net chargeoffs including net recoveries in two of the four years; a change in the risk profile of the loan portfolio, 23% of which now consists of residential first mortgages; the continued reduction in problem loans; and the improvement of the Southern California economy. Based on continued loan growth, the level of nonperforming loans, anticipated recoveries in the first half of 1999 of loans previously charged-off and a relatively constant level of chargeoffs, it is anticipated that the level of the allowance will remain stable through the first half of 1999 without a provision for credit losses. However, credit quality will be influenced by underlying trends in the economic cycle, particularly in Southern California, and other factors which are beyond management's control. Consequently, no assurances can be given that the Company will not sustain loan losses, in any particular period, that are sizable in relation to the allowance for credit losses. Additionally, subsequent evaluation of the loan portfolio, in light of factors then prevailing, by the Company and its regulators may indicate a requirement for increases in the allowance for credit losses through charges to the provision for credit losses.
NONINTEREST INCOME
Noninterest income in 1998 totaled $67.7 million, up $14.3 million or 26.7% from 1997 which was up $9.4 million or 21.4% from 1996. A breakdown of noninterest income by category is reflected below.
ANALYSIS OF CHANGES IN NONINTEREST INCOME
Service charges on deposit accounts increased $3.1 million, or 21.4%, compared to a 32.4% increase in 1997. The increase in 1998 is the result of the acquisition of HB and strong growth in deposits as well as higher service charge rates. The increase in 1997 was the result of the acquisitions of VCNB and RNB and strong growth in deposits. Service charges on deposit accounts are expected to increase in 1999 primarily as a result of higher service charge rates.
A-10
Investment services income, which includes fees, commissions and markups on securities transactions with customers, and fees on money market mutual funds, increased in 1998, compared to 1997, by $3.1 million or 24.0% primarily due to new investment products offered to customers and an increase in customers. Trust fees increased by $1.1 million, or 12.9% from 1997 to 1998 due to upgrading existing customers and to an increased number of customers. The increase in investment services income and trust fees from 1996 to 1997 was also attributable to the same factors discussed above. At December 31, 1998 the Company had approximately $14.9 billion of assets, including $1.8 billion in money market funds, under custody or management in City National Investments, compared to $7.6 billion at December 31, 1997. Although it is expected that there will be some attrition in assets under custody or management from the amounts acquired as part of the NATC acquisition, investment services income and trust fees are expected to increase in 1999 primarily as a result of the acquisition of NATC and a continued emphasis on developing and marketing new products in these areas.
International fee income increased $0.8 million or 11.5% from 1997 to 1998 and $2.1 million or 40.4% from 1996 to 1997 due to the hiring of several experienced foreign exchange traders and the expansion of international activities. International income is expected to increase in 1999, although at a slower rate than in past years. In 1998, the Company purchased Bank Owned Life Insurance which generated $2.1 million of income for the year.
Gains on the sale of available-for-sale securities in 1998 totaled $3.1 million compared to losses of $1.0 million in 1997 and gains of $0.2 million in 1996, respectively.
NONINTEREST EXPENSE
Noninterest expense totaled $211.3 million in 1998, up $29.5 million or 16.2% from 1997 which was up $37.2 million or 25.7% from 1996. A breakdown of noninterest expense by category is reflected below.
ANALYSIS OF CHANGES IN NONINTEREST EXPENSE*
*Certain prior years' data have been reclassified to conform to current year presentation.
Staff expense increased 17.8% in 1998 compared to a 26.8% increase in 1997. The increase in 1998 and 1997 is the result of the additional personnel that joined the Bank as a result of the acquisitions, the hiring of new personnel in the Bank's expansion efforts and higher costs associated with performance incentives and contributions to the City National Corporation Profit Sharing Plan. On a full-time equivalent basis, staff levels have increased to 1,670 at December 31, 1998 from 1,570 at December 31, 1997. Staff levels are expected to increase slightly in 1999.
A-11
The remaining expense categories increased $12.1 million, or 14.4%, between 1997 and 1998. The increase in professional expense resulted primarily from higher customer service expense on increased deposits. Marketing and advertising expense has grown as the Company expanded its advertising program. The increase in depreciation expense resulted from the Company's capital expenditures during 1998 of $18.0 million. The decrease in information services in 1998 relates to the absence of costs incurred in 1997 for data processing conversions and the buyout of the Company's former data processing contract. Amortization of goodwill and core deposit intangibles increased $1.3 million due to the acquisition of HB. Other expense in 1998 includes a $0.8 million charge for NATC integration expenses of which $0.6 million was paid in 1998 and $0.2 million will be paid during the first half of 1999. The remaining other increases resulted from the acquisition of HB, higher operating losses and other factors. Due to the acquisition of NATC on December 31, 1998, most categories of noninterest expense are expected to increase in 1999.
The remaining expense categories increased $16.6 million, or 24.6%, between 1996 and 1997. The increase in professional expense resulted primarily from $3.1 million in consulting and other professional fees attributed to the conversion to the new data processing system which was completed in the latter part of 1997. The increase in marketing and advertising expense resulted from the Company's expanded advertising program. The increase in depreciation expense resulted from the Company's expenditures during 1997 totaling $17.7 million for new PC's, item processing and telecommunications equipment as well as the major remodeling of several floors in City National Center, the Company's headquarters building. The increase in office expense resulted from higher office supplies and telecommunications expenses due to the increased number of personnel and branches, primarily resulting from the acquisitions of VCNB and RNB. In March 1997, the Company reached agreements with its insurance carriers regarding a lender liability lawsuit which it settled with a former bank customer in the fourth quarter of 1996. The insurance reimbursements of $2.5 million have been credited to other noninterest expense and offset most of the $3.4 million lender liability charge recorded in the fourth quarter of 1996. Amortization of goodwill and core deposit intangibles increased $4.1 million due to the acquisitions of VCNB and RNB. The remaining other increases resulted from the acquisitions of VCNB and RNB, including $1.7 million in acquisition related charges in 1997 compared to $0.7 million in 1996, higher operating losses and other factors. ORE operations included in other operating expense resulted in net income of $0.2 million, $2.6 million and $0.2 million in 1998, 1997 and 1996, respectively. The $2.6 million income from ORE activities in 1997 was primarily due to the sale of properties.
The Year 2000 issue is the result of computer programs written using two digits (rather than four) to define years. Computers or other equipment with date-sensitive software may recognize "00" as 1900 rather than 2000. This could result in system failure or miscalculations. If the Company or significant customers, suppliers or other third parties fail to correct Year 2000 issues, the Company's ability to operate could be affected. Following is the Company's "Year 2000 Readiness Disclosure":
"During 1998, efforts continued to address Year 2000 matters in accordance with the Company's five-phase project plan which covers information technology as well as embedded systems. The five phases are awareness, assessment, renovation, validation and implementation with contingency planning as a part of the validation phase. As previously reported, the first two phases of awareness and assessment have been completed. The Company has now completed approximately 85% of its renovation phase. The renovation phase pertains only to internal programs and applications that are not mission critical. There are no mission critical systems requiring renovation. As part of the validation phase, the Company has certified as Year 2000 ready 100% of its internal mission critical hardware and software applications and has certified approximately 50% of non mission critical hardware and software applications as Year 2000 ready. The Company expects to complete the validation of external service bureau and third party vendors by March 31, 1999. On October 4, 1998, M&I, the Bank's core processing provider, successfully completed the Year 2000 upgrade of its software. The upgrade had no production impact on either Bank customers or the Bank. Final Year 2000 certification will be completed with M&I by the end of the first quarter of 1999. In accordance with the Federal Financial Institution Examination Council's guidances, the Company
A-12
expects to complete its implementation of mission critical internal and external systems and applications by June 30, 1999. The Company has developed a contingency plan for each of its mission critical business functions which establish trigger dates for implementation of the plan for each software application that is not Year 2000 compliant. However, these plans do not guarantee that circumstances beyond the Company's control will not adversely impact operations. At this time, based on assessments and testing to date, the Company does not foresee any Year 2000 issues that would materially impair the Bank's ability to conduct business.
The Company is engaged in the ongoing process of considering and examining whether or not there would be a material effect on its business, net income or balance sheet if its vendors, suppliers and customers do not become Year 2000 compliant in a timely manner. With regard to customer readiness, the Company has queried and continues to query all commercial borrowers with loans of $1.0 million and over. For those customers having responded, it has been determined that the customer base would either be only slightly impacted by Year 2000 matters or the customer's compliance efforts at this time are satisfactory. In addition, there is a group of customers who have indicated their compliance will be in the future and the Company continues to monitor their progress. The Company is also considering customized action plans and disengagement strategies for any high risk borrowers. Where the Company is a third party vendor to customers, as in the area of cash management, it is believed at this time, that the Company will reach readiness by March 31, 1999. However, if the Company is not compliant, customers will be allowed to terminate their contracts. The loss of revenue from this type of relationship would not be material. The Company's analysis of the corporate counterparties for its investments and current hedging position is underway and the effect if any should be finalized by March 31, 1999."
In 1998, approximately $1.7 million was directly and indirectly expensed on Year 2000 matters. This amount excludes hardware and software that was replaced in the normal course of business. Total direct and indirect expenses are expected to be at the same level in 1999.
INCOME TAXES
The 1998 effective tax rate was 35.9% compared to 36.1% in 1997 and 32.9% in 1996. The effective rates differed from the applicable statutory federal tax rate due to various factors including state taxes, tax exempt income including interest on bank owned life insurance, amortization of nondeductible goodwill and recognition of previously unrecorded deferred tax benefits.
The Company recognized $5.0 million in previously unrecorded California deferred tax benefits in 1996 resulting from the Company's continued and increasing profitability and the Company's evaluation of deferred tax assets which it believes are more likely than not to be realized on future tax returns.
The effective tax rate for 1999 is expected to increase but will still be below the combined statutory federal and California tax rates due to the impact of municipal securities and leases, bank owned life insurance, the dividends received deduction for preferred stock, and tax credits from investments in low income housing.
A-13
BALANCE SHEET ANALYSIS
CAPITAL
At December 31, 1998, the Company's and the Bank's Tier 1 capital, which is comprised of common shareholders' equity as modified by certain regulatory adjustments, amounted to $474.9 million and $446.5 million, respectively. At December 31, 1997, the Company's and the Bank's Tier 1 capital amounted to $448.0 million and $381.6 million, respectively. The increase from December 31, 1997 resulted from retention of 1998 earnings, the issuance of shares for the acquisition of HB and the exercise of stock options, less dividends paid and amounts related to shares repurchased.
The following table presents the regulatory standards for well capitalized institutions and the capital ratios for the Company and the Bank at December 31, 1998, 1997 and 1996.
The Company paid dividends totaling $0.56 per share of common stock in 1998 and $0.44 per share of common stock in 1997. On January 27, 1999, the Board of Directors authorized a regular quarterly cash dividend on common stock at an increased rate of $0.165 per share to shareholders of record on February 10, 1999, payable on February 22, 1999.
In September 1998, the Company announced a program for the repurchase of up to 1.0 million shares of its common stock. At December 31, 1998, a total of 128,000 shares had been repurchased at a cost of $3.5 million, or an average price of $27.38 per share. Also in September, the Company completed another 1.0 million common shares stock buyback program that had been announced in April at a cost of $34.3 million, or an average price of $34.27 per share. On April 29, 1998, the Company completed a share repurchase program announced in March 1997 of 1.5 million shares of its common stock at a total cost of $42.7 million, or an average price of $28.46 per share.
On January 12, 1998, the Company's wholly owned subsidiary, City National Bank, issued $125 million of 6 3/8% Subordinated Notes, due in 2008.
On March 3, 1997, the Company announced that its Board of Directors had adopted a Stockholder Rights Plan designed to assure that all City National shareholders would receive fair treatment in the event of any future "change of control" (as that term is defined in the Rights Plan) of the Company. The Rights Plan provides each City National Stockholder with one right for each common share held. Under certain conditions, each right would be exercisable to purchase that number of City National common shares having at that time a market value equal to two times the then current exercise price. The rights are subject to redemption by the board of directors at $.001 per right at any time prior to the first date upon which they become exercisable.
LIQUIDITY MANAGEMENT
The objective of liquidity management is the ability to maintain cash flow adequate to fund the Company's operations and meet obligations and other commitments on a timely and cost effective basis.
A-14
The Company achieves this objective through the selection of asset and liability maturity mixes that it believes best meet the needs of the Company. The Company's liquidity position is enhanced by its ability to raise additional funds as needed in the money markets.
The Company's core deposit base in recent years provided the majority of the Company's funding requirements. This relatively stable and low-cost source of funds has, along with shareholders' equity provided 72% and 76% of funding for average total assets in 1998 and 1997, respectively.
A significant portion of remaining funding of average total assets is provided by short-term federal fund purchases and sales of securities under repurchase agreements. This funding source, on average, totaled $407.3 million and $222.6 million in 1998 and 1997, respectively. Additionally, the Bank increased its funding from other borrowings, primarily Federal Home Loan Bank advances, to $355.8 million on average in 1998 from $338.9 million in 1997.
Liquidity is also provided by assets such as federal funds sold, securities purchased under resale agreements and trading account securities which may be immediately converted to cash at minimal cost. The aggregate of these assets averaged $122.2 million during 1998, up $51.3 million, or 72.4% from the prior year. This increase resulted from the Company's decision to actively manage this book of assets to generate income for the Company.
Liquidity is also provided by the portfolio of available-for-sale securities which totals $1,012.5 million at December 31, 1998. The unpledged portion of available-for-sale securities at December 31, 1998 totaled $450.6 million and would be available as collateral for borrowing. Maturing loans also provide liquidity, and $2,032.5 million of the Bank's loans are scheduled to mature in 1999.
ASSET LIABILITY MANAGEMENT
The principal objective of asset/liability management is to maximize net interest margin subject to margin volatility and liquidity constraints. Margin volatility results when the rate reset (or repricing) characteristics of assets are materially different from those of the Company's liabilities. Liquidity risk results from the mismatching of asset and liability cash flows. Management chooses asset/liability strategies that promote stable earnings and reliable funding. Interest rate risk and funding positions are kept within limits established by the Company's board of directors to ensure that risk-taking is not excessive and that liquidity is properly managed.
The Company has established three measurement processes to quantify and manage exposure to interest rate risk: net interest income simulation modeling, gap analysis, and present value of equity analysis. Net interest income simulations are used to identify the direction and severity of interest rate risk exposure across a twelve month forecast horizon. Gap analysis provides insight into structural mismatches of assets and liability repricing characteristics. Present value of equity calculations are used to estimate the theoretical price sensitivity of shareholder equity to changes in interest rates.
Generally, an asset sensitive gap indicates that net interest income will improve during a period of rising interest rates. The gap report is based on the contractual cash flows of all asset and liability balances on the Company's books. The contractual life of these balances may differ substantially from their expected lives however. For example, checking accounts are all subject to immediate withdrawal. Experience suggests that these accounts will have an average life of several years. Also, certain loans (such as first mortgages) are subject to prepayment. The cash flows shown in the gap report are adjusted to reflect these behaviors. The gap report also shows the effects that interest rate swaps have had on the repricing profile of the Company.
The table on page A-18 shows the Company's interest rate gap position as of December 31, 1998 and 1997. Rate sensitive assets are expected to exceed rate sensitive liabilities by $138.0 million over the first year of the cash flow horizon. The gap is the result of the Company's natural composition of assets and liabilities, which include loans tied to the prime and checking account deposits. This gap is further reduced
A-15
by interest rate swaps. The Company at December 31, 1998 had $710 million of notional principal in "receive" fixed-pay LIBOR interest rate swaps, of which $545 million have maturities greater than one year. The one year cumulative hedged gap is $(407.0) million, or about six percent of total assets. From December 31, 1997 to December 31, 1998, the Company's one year cumulative hedged gap decreased from $131.8 million to $(407.0) million as a result of increases in assets and interest rate swaps that do not reprice until after one year.
Since interest rate changes do not affect all categories of assets and liabilities equally or simultaneously, a cumulative gap analysis alone cannot be used to evaluate the Company's interest rate sensitivity position. To supplement traditional gap analysis, the Company uses simulation modeling to estimate the potential effects of changing interest rates. This process allows the Company to fully explore the complex relationships within the gap over time and various interest rate scenarios.
The following table presents in tabular form information about the Company's financial instruments that are sensitive to changes in interest rates. The table presents principal cash flows and related average interest rates by expected re-pricing or maturity dates and fair values as of December 31, 1998. Expected re-pricing or maturities of assets are contractual. Interest-bearing demand and savings deposits are included in the earliest maturity category, even though withdrawal of these balances is not contractually required and may not actually occur during that period. Average interest rates on variable rate instruments are based upon the Company's interest rate forecast. Actual re-pricing or maturities of interest-sensitive assets and liabilities could vary substantially from expectations if different assumptions are used or if actual experience differs from the assumptions used.
INTEREST-SENSITIVE FINANCIAL INSTRUMENT MATURITIES
The use of interest rate swaps to manage interest rate exposure involves the risk of dealing with counterparties and their ability to meet contractual terms. These counterparties must receive appropriate
A-16
credit approval before the Company enters into an interest rate contract. Notional principal amounts express the volume of these transactions, although the amounts potentially subject to credit and market risk are much smaller. At December 31, 1998, all of the Company's interest rate swaps were entered into as hedges against a decrease in interest income generated from prime based loans if the prime decreased or to convert fixed rate deposits and borrowings into floating rate liabilities. The Company has not entered into transactions involving any other interest rate derivative financial instruments, such as interest rate floors, caps and interest rate futures contracts.
The table below shows the notional amounts of the Company's interest rate swap maturities and average rates at December 31, 1998:
INTEREST RATE SWAP MATURITIES AND AVERAGE RATES
- - ------------------------------
(1) Estimated net gain to settle derivative contracts.
At December 31, 1998, the Company's outstanding foreign exchange contracts for both those purchased as well as sold totaled $10.5 million. The Company enters into foreign exchange contracts with its customers and counterparty banks solely for the purpose of offsetting or hedging transaction and economic exposures arising out of commercial transactions. The Company's policies prohibit outright speculation by the Company and its employees. The Company actively manages its foreign exchange exposures within prescribed risk limits and controls. All foreign exchange contracts outstanding at December 31, 1998 had remaining maturities of six months or less.
A-17
INTEREST RATE GAP POSITION
A-18
SECURITIES
Prior to December 31, 1998, the Company classified its securities as investment, available-for-sale or trading. Those securities which the Company had the ability and intent to hold to maturity were classified as investment securities. Effective on December 31, 1998, these investment securities were transferred to available-for-sale. Securities held to facilitate customer trading orders are classified as trading securities. All other securities are classified as available-for-sale.
Comparative period-end security portfolio balances are presented below:
INVESTMENT SECURITIES
AVAILABLE-FOR-SALE SECURITIES
At December 31, 1998, securities available-for-sale totaled $1,012.5 million, an increase of $405.3 million or 66.8% from December 31, 1997. The transfer of investment securities to available-for-sale securities on December 31, 1998 accounted for $182.6 million of the increase. The remaining increase was from investing a portion of deposit and borrowing growth which was not needed to fund loan growth. The average duration of total available-for-sale securities at December 31, 1998 was 4.3 years compared with 2.8 years for the combined investment and available-for-sale security portfolio at December 31, 1997.
A-19
The following tables provide the expected remaining maturities and yields (taxable-equivalent basis) of debt securities within the securities portfolio at December 31, 1998.
AVAILABLE-FOR-SALE DEBT SECURITIES
INVESTMENT DEBT SECURITIES
Dividend income included in interest income on securities in the Consolidated Statement of Income and Comprehensive Income was $8.7 million in both 1998 and 1997.
A-20
LOAN PORTFOLIO
The following table shows the Company's consolidated loans by type of loan or borrower and their percentage distribution:
LOAN PORTFOLIO
GENERAL
The Company's loan portfolio consists primarily of short-term loans for businesses and real estate purposes. At December 31, 1998, approximately 54% of the loan portfolio was commercial loans (including participations in domestic bank non-relationship syndicated loans that add geographic and industry diversification and liquidity to the portfolio), 23% was residential first mortgages and 22% was in real estate other. The legal lending limit for any one borrower was approximately $106 million at December 31, 1998.
The commercial loan portfolio primarily consists of loans to middle-market companies, professional and business borrowers and associated individuals. The Bank provides revolving lines of credit, term loans, asset based loans, residential first trust deed mortgages, commercial real estate secured loans, and trade facilities.
Included in commercial loans as of December 31, 1998 were participations in domestic bank non-relationship syndicated loans of approximately $507.3 million or 11.2% of total loans. As of December 31, 1997, participations in domestic bank non-relationship syndicated loans were $240.4 million or 6.3% of total loans.
In addition, commercial loans includes unsecured loans to real estate developers and customers involved in real estate investments and commercial loans where real estate partially secures the borrowing.
Residential first mortgage loans which comprise 23% of total loans at December 31, 1998, continued a five-year growth trend, increasing $58.2 million, or 5.9% to $1,038.2 million at December 31, 1998. At December 31, 1998, 75.2% of the portfolio was originated internally and the balance was purchased from third parties. The Company expects continued runoff of the purchased residential first mortgage loan portfolio in 1999.
A-21
The real estate construction portfolio (5% of the loan portfolio) consists of 81% commercial and 19% residential. Such loans are made on the basis of the economic viability for the specific project, the cash flow resources of the developer, the developer's equity in the project and the underlying financial strength of the borrower. The Company's policy is to monitor each loan with respect to incurred costs, sales price and sales cycle. Following is a breakdown of real estate construction loans by collateral type:
REAL ESTATE CONSTRUCTION LOANS BY TYPE
Real estate commercial mortgages (17% of the loan portfolio) consists of 79% commercial and 21% residential. The increase during 1998 was primarily due to the acquisition of HB. Following is a breakdown of real estate commercial mortgage loans by collateral type:
REAL ESTATE COMMERCIAL MORTGAGE LOANS BY TYPE
Installment loans consist primarily of loans to individuals for personal uses, such as installment purchases and a variety of other consumer purchases.
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Although the Company has a diversified loan portfolio, a substantial portion of the customers' ability to honor loan terms is reliant upon the economic stability of Southern California, which in some degree relies on the stability of entertainment and media companies. Loans are generally made on the basis of a secure repayment source as the first priority and collateral is generally a secondary source for loan qualification.
The Company's lending activities are predominately in Southern California although participations in domestic bank non-relationship syndicated loans, which comprise approximately 11.2% of the total loan
A-22
portfolio at December 31, 1998, are primarily to borrowers located out of state. The Bank has no direct foreign loans. However, the Company does have some loans to domestic customers who are engaged in international trade, operations, or film productions. The Company's diverse portfolio of carefully analyzed and selected loans to entities engaged in the entertainment or media businesses amounted to $720.1 million at December 31, 1998, a 53.0% increase from the $470.6 million at December 31, 1997.
Inherent in any loan portfolio are risks associated with certain types of loans. The Company assesses and manages credit risk on an ongoing basis through diversification guidelines, lending limits, credit review and approval policies and internal monitoring. As part of the control process, an independent credit review function regularly examines the Company's loan portfolio and other credit related products, including unused commitments and letters of credit. In addition to this internal credit process, the Company's loan portfolio is subject to examination by external regulators in the normal course of business. Credit quality will be influenced by underlying trends in the economic and business cycle. The Company seeks to manage and control its risk through diversification of the portfolio by type of loan, industry concentration and type of borrower as well as specific maximum loan-to-value (LTV) limitations as to various categories of real estate related loans. These ratios are as follows:
MAXIMUM LTV RATIOS
The Company's loan policy provides that any term loan on income-producing properties must have a minumum debt service coverage of at least 1.20 to 1 for non-owner occupied property and at least 1.05 to 1 for owner occupied.
One of the significant risks associated with real estate lending is the risk associated with the possible existence of environmental risks or hazards on or in property affiliated with the loan. The Bank mitigates such risks through the use of an Environmental Risk Questionnaire for all loans secured by real estate. A Phase I environmental report is required if indicated by the questionnaire or if for any other reason it is determined appropriate. Other reasons would include the industrial use of environmentally sensitive substances or the proximity to other known environmental problems. A Phase II report is required in certain cases, depending on the outcome of the Phase I report.
ACTIVITY
Total loans were $4,530.4 million, $3,825.2 million and $2,839.4 million at December 31, 1998, 1997 and 1996, respectively. Gross loans averaged $4,213.9 million, $3,387.8 million and $2,539.3 million for the years 1998, 1997 and 1996, respectively. The increase in total loans of $705.2 million during 1998 relates to the overall growth in the Bank's loan portfolio and the acquisition of HB. The most significant areas of growth were the increase in commercial loans of $485.7 million. In addition, residential first mortgages increased $58.2 million, while real estate construction and real estate commercial mortgages increased by $92.5 million and $61.5 million, respectively. Similar growth occurred in 1997. These increases were mainly
A-23
due to the Bank's business development efforts and the strength of the local economy as well as the expansion of participations in domestic bank non-relationship syndicated loans.
The economic climate in Southern California has been generally strong in 1998 and 1997. However, the competitive environment within the Company's marketplace for additional loan growth has become more aggressive between lenders resulting in increasing competitive pricing. To the extent that such competitive activity continues during 1999 and the Company finds it necessary to meet such competition, the Company's net interest margin could decline.
At December 31, 1998, 44.0% of commercial loans, 40.2% of real estate loans and 5.6% of installment loans outstanding were floating interest rate loans. Floating rate loans comprised 41.9% of the total loan portfolio at December 31, 1998 and 44.8% at December 31, 1997. Total loans at December 31, 1998 consisted of 44.9% due in one year or less, 21.1% due in 1-5 years and 34.0% due after 5 years.
The loan maturities shown in the table below are based on contractual maturities. As is customary in the banking industry, loans that meet sound underwriting criteria can be renewed by mutual agreement between the Bank and the borrower. Because the Bank is unable to estimate the extent to which its borrowers will renew their loans the table is based on contractual maturities.
LOAN MATURITIES
A-24
ASSET QUALITY
ALLOWANCE FOR CREDIT LOSSES
A consequence of lending activities is that losses may be experienced. The amount of such losses will vary from time to time depending upon the risk characteristics of the loan portfolio as affected by economic conditions, rising interest rates and the financial experience of borrowers. The allowance for credit losses, which provides for the risk of losses inherent in the credit extension process, is increased by the provision for credit losses charged to expense and decreased by the amount of chargeoffs, net of recoveries. There is no precise method of predicting specific losses or amounts that ultimately may be charged off on particular segments of the loan portfolio. Similarly, the adequacy of the allowance for credit losses and the level of the related provision for credit losses is determined on a judgmental basis by management based on consideration of previous loan loss experience, management's evaluation of the current loan portfolio including industry trends and concentrations and on current and expected economic conditions. Examinations of the loan portfolio are also conducted periodically by its regulators. Management and the Audit Committee of the Board of Directors evaluate the allowance and determine its desired level. Based on known information available to it at the date of this Report, management believes that the Company's allowance for credit losses was adequate for foreseeable losses at December 31, 1998.
Based on expected loan growth, the level of nonperforming loans, anticipated recoveries in the first half of 1999 of loans previously charged-off and a relatively constant low level of chargeoffs, it is anticipated that the level of the allowance will remain stable through the first half of 1999 without a provision for credit losses.
The following table summarizes the activity in the allowance for credit losses for the five years ended December 31, 1998:
Net chargeoffs were $5.2 million or 0.12% of average loans during 1998. Net recoveries were $0.7 million or 0.02% of average loans during 1997. During 1996, the Company experienced net chargeoffs
A-25
of $1.4 million or 0.06% of average loans during 1996. The increase in net chargeoffs in 1998 resulted primarily from a decrease in recoveries on real estate-commercial mortgages. Management believes that it will continue to have a significant amount of recoveries in 1999 but that recoveries will continue to decrease.
The allowance for credit losses as a percentage of total loans was 2.99%, 3.60% and 4.58% at December 31, 1998, 1997 and 1996, respectively. The allowance for loan losses as a percentage of nonperforming loans was 584.9%, 499.8% and 313.1% at December 31, 1998, 1997 and 1996, respectively. See "Nonaccrual, Past Due and Restructured Loans".
Based on an evaluation of individual credits, previous loan loss experience, management's evaluation of the current loan portfolio and current and expected economic conditions, management has allocated the allowance for credit losses as shown for the past five years in the table below.
ALLOCATION OF ALLOWANCE FOR CREDIT LOSSES
While the allowance is allocated to portfolios, the allowance is general in nature and is available for the portfolio in its entirety. Due to commercial loan growth including participations purchased from other lenders, possible loan losses as a result of Year 2000 computer problems that may adversely impact borrowers, and a continuing decrease in problem loans in the real estate mortgage category during 1998, an increased portion of the allowance for credit losses was allocated to the commercial loan category from that allocated in 1997. An increase in problem loans in the commercial category and a decrease in problem loans in the real estate commercial mortgage category during 1997 resulted in an increased portion of the allowance for credit losses being allocated to the commercial category from that allocated in 1996. The level of the allowance has remained stable since 1995 primarily as a result of a low level of net (chargeoffs) recoveries as indicated in the previous table.
At December 31, 1998, there was no allowance for impaired loans while there was a $0.5 million allowance on impaired loans with outstanding balances of $3.0 million at December 31, 1997. The allowance represents the difference between the value of the collateral supporting those loans and the outstanding balances of those loans and is included in the allowance for credit losses. A loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Once a loan is determined to be impaired, SFAS No. 114 requires that the impairment be measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the impairment may be measured by using the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company's policy is to record cash receipts on impaired loans first as reductions in principal and then to interest income. At December 31, 1998 and 1997, the Company had identified impaired loans with recorded investments of $13.7 million and $16.6 million, respectively.
A-26
NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS
The following table presents information concerning nonaccrual loans, ORE, accruing loans which are contractually past due 90 days or more as to interest or principal payments and still accruing, and restructured loans:
NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS
Bank policy requires that a loan be placed on nonaccrual status if either principal or interest payments are past due in excess of ninety days unless the loan is both well secured and in process of collection, or if full collection of interest or principal becomes uncertain, regardless of the time period involved.
At December 31, 1998, in addition to loans disclosed above as past due, nonaccrual or restructured, management also identified $2.9 million of loans about which the ability of the borrowers to comply with the present loan payment terms in the future is questionable. However, the inability of the borrowers to comply with repayment terms was not sufficiently probable to place the loan on nonaccrual status. This amount was determined based on analysis of information known to management about the borrower's financial condition and current and expected economic conditions. If economic conditions change, adversely or otherwise, or if additional facts on borrowers' financial condition come to light, then the amount of potential problem loans may change, possibly significantly. Estimated potential losses from these potential problem loans have been provided for in determining the allowance for credit losses.
A-27
The table below summarizes the approximate changes in nonaccrual loans for the years ended December 31, 1998 and 1997.
CHANGES IN NONACCRUAL LOANS
The additional interest income that would/(would not) have been recorded from nonaccrual loans, if the loans had not been on nonaccrual status was $2.0 million, $(0.1) million and $2.1 million for the years ended December 31, 1998, 1997 and 1996, respectively. Interest payments received on nonaccrual loans are applied to principal unless there is no doubt as to ultimate full repayment of principal, in which case, the interest payment is recognized as interest income. Interest income includes $2.0 million, $5.5 million and $4.1 million for the years ended December 31, 1998, 1997, and 1996, respectively, from collection of interest related to nonaccrual loans. Interest income not recognized on nonaccrual loans reduced the net interest margin by 4, 0 and 6 basis points for the years ended December 31, 1998, 1997 and 1996, respectively.
OTHER REAL ESTATE
The Company's OREO totaled $3.5 million at year end 1998 compared to $2.1 million a year ago. The Company's policy is to record these properties at estimated fair value, net of selling expenses, at the time they are transferred into ORE, thereby tying future gains or losses from sale or potential additional write-downs to underlying changes in the market.
COMMITMENTS AND LINES OF CREDIT
In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, letters of credit and financial guarantees. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the consolidated statement of financial conditions. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis.
The Company had outstanding loan commitments aggregating $2,273.8 million at December 31, 1998. In addition, the Company had $150.3 million outstanding in bankers acceptances and letters of credit of which $129.0 relate to standby letters of credit at December 31, 1998. Substantially all of the Company's loan commitments are on a variable rate basis and are comprise of real estate and commercial loan commitments.
A-28
DEPOSITS AND BORROWED FUNDS
Providing a stable source of low-cost funding, core deposits include noninterest bearing demand deposits, NOW and money market accounts, savings accounts and time deposits less than $100,000. Average core deposits were $3,506.6 million in 1998 compared to $3,079.6 million in 1997. The increase was due primarily to internally generated growth and in the acquisition of HB.
Short and long-term borrowed funds provided additional funding to support loan growth. Average borrowed funds were $763.1 million in 1998 compared to $561.5 million in 1997.
A maturity distribution of certificates of deposits of $100,000 or more at year-end follows:
At December 31, 1998 and 1997, the aggregate amount of deposits by foreign depositors in domestic offices totaled $36.4 million and $31.8 million, respectively, the majority of which was interest bearing. The Bank had brokered deposits of $90.0 million and $21.7 million, at December 31, 1998 and 1997, respectively.
Details regarding federal funds purchased and securities sold under repurchase agreements as well as other short-term borrowings follows.
A-29
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Company wishes to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 as to "forward looking" statements in this Form 10-K which are not historical facts. The Company cautions readers that the following important factors could affect the Company's business and cause actual results to differ materially from those expressed in any forward looking statement made by, or on behalf of, the Company.
- ECONOMIC CONDITIONS. The Company's results are strongly influenced by general economic conditions in its market area, Southern California, and a deterioration in these conditions could have a material adverse impact on the quality of the Bank's loan portfolio and the demand for its products and services. In particular, changes in economic conditions in the real estate and entertainment industries may affect the Company's performance.
- INTEREST RATES. Management anticipates that interest rates will remain flat or slightly higher. If interest rates vary substantially from present levels, this may cause the Company's results to differ materially.
- GOVERNMENT REGULATION AND MONETARY POLICY. All forward-looking statements presume a continuation of the existing regulatory environment and U.S. Government monetary policies. The banking industry is subject to extensive federal and state regulations, and significant new laws or changes in, or repeals of, existing laws may cause results to differ materially. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Bank, primarily through open market operations in U.S. government securities, the discount rate for member bank borrowing and bank reserve requirements, and a material change in these conditions would be likely to have an impact on results.
- COMPETITION. The Bank competes with numerous other domestic and foreign financial institutions and non-depository financial intermediaries. Results may differ if circumstances affecting the nature or level of competitive change, such as the merger of competing financial institutions.
- CREDIT QUALITY. A significant source of risk arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The Bank has adopted underwriting and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying the Bank's credit portfolio, but such policies and procedures may not prevent unexpected losses that could adversely affect the Company's results.
- OTHER RISKS. From time to time, the Company details other risks to its business and/or its financial results in its filings with the Securities and Exchange Commission.
While management believes that its assumptions regarding these and other factors on which forward-looking statements are based are reasonable, such assumptions are necessarily speculative in nature, and actual outcomes can be expected to differ to some degree. Consequently, there can be no assurance that the results described in such forward-looking statements will, in fact, be achieved.
A-30
QUARTERLY RESULTS
The following table summarizes quarterly operating results for 1998 and 1997.
1998 QUARTERLY OPERATING RESULTS
1997 QUARTERLY OPERATING RESULTS
- - --------------------------
(1) Due to rounding quarterly per share amounts do not add up to total.
A-31
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Company's consolidated financial statements and related information appearing in this annual report. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions, and that the consolidated financial statements reasonably present the Company's financial position and results of operations in conformity with generally accepted accounting principles. Management also has included in the Company's consolidated financial statements amounts that are based on estimates and judgements that it believes are reasonable under the circumstances.
The independent auditors audit the Company's consolidated financial statements in accordance with generally accepted auditing standards and provide an objective, independent review of the fairness of reported operating results and financial position.
The Board of Directors of the Corporation has an Audit Committee composed solely of three non-management Directors. The Committee meets periodically with financial management, the internal auditors and the independent auditors to review accounting control, auditing and financial matters.
/s/ RUSSELL GOLDSMITH Russell Goldsmith Chief Executive Officer /s/ BRAM GOLDSMITH Bram Goldsmith Chairman of the Board /s/ FRANK P. PEKNY Frank P. Pekny Executive Vice President and Chief Financial Officer
A-32
INDEPENDENT AUDITORS' REPORT
To Board of Directors and Shareholders of City National Corporation:
We have audited the accompanying consolidated balance sheet of City National Corporation and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of income and comprehensive income, changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of City National Corporation and subsidiaries as of December 31, 1998 and 1997 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles.
KPMG LLP
Los Angeles, California January 14, 1999
A-33
CITY NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEET
See accompanying Notes to Consolidated Financial Statements.
A-34
CITY NATIONAL CORPORATION CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
See accompanying Notes to Consolidated Financial Statements.
A-35
CITY NATIONAL CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS
See accompanying Notes to Consolidated Financial Statements.
A-36
CITY NATIONAL CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
See accompanying Notes to Consolidated Financial Statements.
A-37
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of City National Corporation (the Corporation) and of City National Bank (the Bank) and its subsidiaries conform to generally accepted accounting principles and to prevailing practices within the banking industry. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates.
City National Corporation and subsidiaries (the Company), through its primary subsidiary, the Bank, provides private and business banking services primarily in the Southern California market. The Bank's principal customer base comprises small- to middle-market companies with annual sales revenue of up to $250 million, entrepreneurs, professionals, and high net worth individuals. The Bank typically serves customers seeking relationship banking, which it seeks to provide through a high level of personal service, tailored products, and private banking teams. The Bank offers commercial and personal loans of all types, deposit, cash management, international banking and other products and services. In addition, the Bank lends, invests and provides services in accordance with its Community Reinvestment Act commitment. Through City National Investments, the bank offers personal and employee benefit trust and estate services and deals in money market and other investments for its own account and for the customers. The Bank also offers mutual funds in association with other companies.
BASIS OF PRESENTATION
The consolidated financial statements of the Company include the accounts of the Corporation; its non-bank subsidiary; the Bank, and the Bank's wholly owned subsidiaries after elimination of all material inter-company transactions. Certain prior years' data have been reclassified to conform to current year presentation.
The Company and its subsidiaries are on the accrual basis of accounting for income and expenses. In accordance with the usual practice of banks, assets and liabilities of individual trust, agency and fiduciary funds have not been included in the financial statements.
SECURITIES
On December 31, 1998, the Company changed its intent to hold all investment securities to maturity and therefore has classified all securities other than trading securities as available-for-sale valued at fair value. Trading securities are valued at market value with any unrealized gains or losses included in income. Unrealized gains or losses on available-for-sale securities are excluded from net income but are included in comprehensive income net of taxes. Premiums or discounts on available-for-sale securities are amortized or accreted into income using the interest method. Realized gains or losses on sales of available-for-sale securities are recorded using the specific identification method. Investment services income consists of fees, commissions and markups on securities transactions with customers and money market mutual fund fees.
LOANS
Loans are generally carried at principal amounts less net deferred loan fees. Net deferred loan fees include deferred unamortized fees less direct incremental loan origination costs. Interest income is accrued as earned. Net deferred fees are accreted into interest income using the interest method.
A-38
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Loans are placed on nonaccrual status when a loan becomes 90 days past due as to interest or principal unless the loan is both well secured and in process of collection. Loans are also placed on nonaccrual status when the full collection of interest or principal becomes uncertain. When a loan is placed on nonaccrual status, the accrued and unpaid interest receivable is reversed and the accretion of deferred loan fees is ceased. Thereafter, interest collected on the loan is accounted for on the cash collection or cost recovery method until qualifying for return to accrual status. Generally, a loan may be returned to accrual status when all delinquent principal and interest are brought current in accordance with the terms of the loan agreement and certain performance criteria have been met.
The Company considers a loan to be impaired when it is probable that it will be unable to collect all amounts due according to the contractual terms of the loan agreement. Once a loan is determined to be impaired, the impairment is measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the impairment is measured by using the loan's observable market price or the fair value of the collateral if the loan is collateral dependent.
When the measurement of the impaired loan is less than the recorded amount of the loan, an impairment is recognized by creating a valuation allowance with a corresponding charge to the allowance for credit losses or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to the allowance for credit losses.
The Company's policy is to record cash receipts received on impaired loans first as reductions to principal and then to interest income.
ALLOWANCE FOR CREDIT LOSSES
The provision for credit losses charged to operations reflects management's judgement of the adequacy of the allowance for credit losses and is determined through quarterly analytical reviews of the loan portfolio, problem loans and consideration of such other factors as the Company's loan loss experience, trends in problem loans, concentrations of credit risk, and current and expected future economic conditions, as well as the results of the Company's ongoing credit examination process and that of its regulators.
PREMISES AND EQUIPMENT
Bank premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed generally on a straight-line basis over the estimated useful life of each type of asset. Gains and losses on dispositions are reflected in current operations. Maintenance and repairs are charged to operating expenses.
OTHER REAL ESTATE (ORE)
Other real estate is comprised of real estate acquired in satisfaction of loans. Properties acquired by foreclosure or deed in lieu of foreclosure are transferred to ORE and are recorded at fair value less estimated costs to sell, at the date of transfer of the property. The fair value of the ORE property is based upon a current appraisal. Losses that result from the ongoing periodic valuation of these properties are charged against ORE expense in the period in which they are identified. Expenses for holding costs are charged to operations as incurred.
A-39
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INCOME TAXES
The Company files a consolidated federal income tax return and a combined state income tax return. Deferred tax assets and liabilities are recognized for the expected future tax consequences of existing differences between financial reporting and tax reporting basis of assets and liabilities, as well as for operating losses and tax credit carry forwards, using enacted tax laws and rates. Deferred tax assets will be reduced through a valuation allowance whenever it becomes more likely than not that all, or some portion, will be realized. Deferred income taxes (benefit) represents the net change in the deferred tax asset or liability balance during the year. This amount, together with income taxes currently payable or refundable in the current year, represents the total income taxes (benefit) for the year.
NET INCOME PER SHARE
Basic earnings per share is based on the weighted average shares of common stock, which were calculated as 46,357,000, 46,018,000 and 43,888,000 for 1998, 1997 and 1996, respectively. Diluted earnings per share gives effect to all dilutive potential common shares that were outstanding during part or all of the year and were calculated as 48,141,000, 47,809,000 and 45,146,000, respectively.
GOODWILL AND CORE DEPOSIT INTANGIBLES
Goodwill represents the excess of the purchase price over the estimated fair value of net assets associated with acquisition transactions of the Company accounted for as purchases and is amortized over fifteen years. Core deposit intangibles represent the intangible value of depositor relationships resulting from deposit liabilities assumed in acquisitions and are amortized over seven years. Goodwill and core deposit intangibles are evaluated periodically for other than temporary impairment. Should such an assessment indicate that the undiscounted value of an intangible may be impaired, the net book value of the intangible would be written down to net estimated recoverable value. The carrying value of goodwill and core deposit intangibles is net of accumulated amortization of $11.2 million and $7.1 million at December 31, 1998 and December 31, 1997, respectively.
INTEREST-RATE-RISK MANAGEMENT ACTIVITIES
For those interest-rate instruments that alter the repricing characteristics of assets or liabilities, the net differential to be paid or received on the instrument is treated as an adjustment to the yield on the underlying assets or liabilities (the accrual method). To qualify for the accrual method, the interest-rate instrument must be designated to specific assets or liabilities or pools of assets or liabilities, and must be effective at altering the interest-rate characteristics of the related assets or liabilities.
STOCK OPTION PLAN
Compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. As a practice, the exercise price equals the current market price and there is no compensation expense. Pro forma net income and pro forma net income per share disclosures for employee stock option grants are based on recognition as expense, over the vesting period, of the fair value on the date of grant of all stock-based awards made in 1995 and subsequent years.
A-40
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) COMPREHENSIVE INCOME
Beginning in 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No, 130), which requires the disclosure of comprehensive income and its components in a full set of general purpose financial statements. Changes in unrealized gain (loss) on available-for-sale securities net of income taxes is the only component of other comprehensive income for the Company.
SEGMENT REPORTING
Beginning in 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" (SFAS No. 131). Management of the Company has determined that it is engaged in only one operating segment, providing private and business banking services.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133). This Statement establishes accounting and reporting standards for derivative instruments and for hedging activities. This Statement is effective for fiscal years beginning after June 15, 1999. The Company uses interest rate swaps to manage interest rate exposure, which are accounted for as hedging activities and does not believe that the implementation will have a significant impact on the Company's financial position, net income or net comprehensive income.
NOTE 2. ACQUISITIONS
On December 31, 1998, the Company completed its acquisition of North American Trust Company, an independent trust company for $11.5 million in an all cash transaction. The acquisition of North American Trust Company resulted in the recording of intangibles of approximately $11.3 million under the purchase method of accounting including $1.0 million of severance, excess space and other purchase price costs of which $0.2 million were paid in 1998. Payments are expected to be made in the first half of 1999 of $0.3 million and the remaining payments of $0.5 million relating to excess space are to be made over the remaining 6.5 years of a lease.
On January 9, 1998, the Company completed its acquisition of Harbor Bancorp (HB) for $34.5 million. The Company issued approximately 540,000 shares, primarily from treasury with an aggregate market value of $17.9 million and paid the remainder in cash. The acquisition of HB resulted in the recording of goodwill and intangibles of approximately $24.0 million under the purchase method of accounting. At December 31, 1998, the remaining unamortized balance was approximately $21.7 million.
On January 24, 1997, the Company completed its acquisition of Riverside National Bank (RNB). The Company paid approximately $41.4 million for RNB by issuing approximately 1.0 million treasury shares with an aggregate market value of approximately $20.7 million and paid the remainder in cash. The acquisition of RNB was accounted for under the purchase method of accounting and resulted in the recording of goodwill and intangibles of approximately $27.4 million. At December 31, 1998, the remaining unamortized balance was approximately $21.6 million. The results of RNB's operations are included in those reported by the Company beginning on January 25, 1997.
A-41
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2. ACQUISITIONS (CONTINUED) On January 17, 1997, the Company completed its acquisition of Ventura County National Bancorp (VCNB). The Company paid approximately $49.1 million for VCNB by issuing approximately 1.3 million treasury shares with an aggregate market value of approximately $28.1 million and paid the remainder in cash. The acquisition of VCNB was accounted for under the purchase method of accounting and resulted in the recording of goodwill and intangibles of approximately $27.4 million. At December 31, 1998, the remaining unamortized balance was approximately $19.1 million. The results of VCNB's operations are included in those reported by the Company beginning on January 18, 1997.
NOTE 3. INVESTMENT SECURITIES
On December 31, 1998, all investment securities were transferred to available-for-sale. The following is a summary of the amortized cost and estimated fair value for the major categories of investment securities as of December 31, 1997:
A-42
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4. SECURITIES AVAILABLE-FOR-SALE
The following is a summary of amortized cost and estimated fair value for the major categories of securities available-for-sale:
A-43
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4. SECURITIES AVAILABLE-FOR-SALE (CONTINUED)
Gross realized gains and losses related to the available-for-sale portfolios were $5,299,000 and $2,227,000, respectively, for the year ended December 31, 1998, $638,000 and $1,686,000, respectively, for the year ended December 31, 1997 and $2,784,000 and $2,597,000, respectively, for the year ended December 31, 1996.
The following table provides the expected remaining maturities and yields (taxable-equivalent basis) of debt securities at December 31, 1998, by contractual maturity:
Available-for-sale securities totaling $561.9 million were pledged to secure trust funds, public deposits, or for other purposes required or permitted by law at December 31, 1998.
NOTE 5. LOANS AND ALLOWANCE FOR CREDIT LOSSES
The following is a summary of the major categories of loans:
At December 31, 1998 and 1997, the Company had identified impaired loans with recorded investments of $13.7 million and $16.6 million, respectively. There were no impaired loans with allocated allowances for credit losses as of December 31, 1998. Allowances of $0.5 million on loans with outstanding balances of $3.0 million existed as of December 31, 1997. The allowances represent the differences between the value of the collateral supporting the loans and their outstanding balances. For 1998 and 1997, the average balance of impaired loans was $0.3 million and $21.2 million, respectively. During 1998, 1997 and 1996, no interest income was recognized on impaired loans until the book balances of these loans were paid off.
A-44
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5. LOANS AND ALLOWANCE FOR CREDIT LOSSES (CONTINUED) In the normal course of business, the Bank has loans to officers and directors as well as loans to companies and individuals affiliated with or guaranteed by officers and directors of the Company and the Bank. These loans were made in the ordinary course of business at rates and terms no more favorable than those offered to other customers with a similar credit standing. The aggregate dollar amounts of these loans were $17.2 million and $17.0 million at December 31, 1998 and 1997, respectively. During 1998, new loans made totaled $0.4 million and repayments totaled $0.2 million. Interest income recognized on these loans amounted to $1.5 million, $1.4 million and $1.4 million during 1998, 1997 and 1996, respectively. At December 31, 1998, none of these loans were on nonaccrual status. Based on analysis of information presently known to management about the loans to officers and Directors and their affiliates, management believes all have the ability to comply with the present loan repayment terms.
Loans past due 90 days or more and still accruing interest totaled $8.6 million, $26.2 million and $12.4 million at December 31, 1998, 1997 and 1996, respectively. Restructured loans totaled $3.7 million, $4.1 million, and $2.6 million at December 31, 1998, 1997 and 1996, respectively.
The following is a summary of activity in the allowance for credit losses:
The following is a summary of non-performing loans and related interest foregone (received):
A-45
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5. LOANS AND ALLOWANCE FOR CREDIT LOSSES (CONTINUED)
The Company has pledged all of its eligible residential first mortgages to the Federal Home Loan Bank of San Francisco under that institution's blanket lien program although not all of the pledged mortgages are being utilized to collateralize current borrowings.
NOTE 6. PREMISES AND EQUIPMENT
The following is a summary of data for the major categories of premises and equipment:
Depreciation and amortization expense was $8.8 million in 1998, $6.1 million in 1997 and $5.1 million in 1996. Net rental payments on operating leases included in net occupancy of premises in the Consolidated Statement of Income and Comprehensive Income were $8.4 million in 1998, $7.1 million in 1997, and $6.4 million in 1996.
The future net minimum rental commitments were as follows at December 31, 1998:
A majority of the leases provide for the payment of taxes, maintenance, insurance and certain other expenses applicable to the leased premises. Many of the leases contain extension provisions and escalation clauses. The Bank paid $1.1 million per year in 1998, 1997 and 1996 for rent and operating expense pass throughs to a real estate partnership in which the Bank owns a 32% interest, and Mr. Bram Goldsmith, Chairman, indirectly owns a 14% interest.
A-46
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 6. PREMISES AND EQUIPMENT (CONTINUED) The rental commitment amounts in the table above reflect the contractual obligations of the Company under all leases including those assumed from the Acquired Banks and North American Trust Company. Lease obligations assumed from the Acquired Banks and North American Trust Company have been adjusted to current market values through purchase accounting adjustments. The allowance thus created will be accreted over the terms of the leases and reduce the total expense recognized by the Company in its operating expenses. At December 31, 1998, the Company is contractually entitled to receive minimum future rentals of $8.8 million under noncancellable sub-leases.
NOTE 7. INCOME TAXES
Income tax (benefit) in the Consolidated Statement of Income and Comprehensive Income includes the following amounts:
A-47
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7. INCOME TAXES (CONTINUED) The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below.
NET DEFERRED TAX ASSETS
A-48
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7. INCOME TAXES (CONTINUED)
Income taxes resulted in effective tax rates that differ from the statutory federal income tax rate for the following reasons:
The tax benefit of deductible temporary differences and net operating loss carry forwards are recorded as an asset to the extent that management assesses the utilization of such temporary differences and carry forwards to be "more likely than not." The realization of tax benefits of deductible temporary differences and carry forwards depends on whether the Company has sufficient taxable income within the carry back and carry forward period permitted by the tax law to allow for utilization of the deductible amounts. As of any period end, the amount of deferred tax asset that is considered realizable could be reduced if estimates of future taxable income are reduced.
As of January 1, 1996, the Company had a $19.8 million valuation allowance principally related to net California deductible temporary differences of $76.0 million and net operating loss carryforwards of First LA. California law does not permit carry backs and requires a 50% reduction of tax losses that are carried forward. In 1996, the Company reduced the valuation allowance by $6.0 million as part of the Company's periodic reevaluation of deferred tax assets which it believes are more likely than not to be realized in future tax returns. The Company considered, among other factors, the record net income reported in 1997 in its evaluation of those deferred tax assets that it believes to be more likely than not to be realized.
At December 31, 1998, First LA's federal net operating loss carry forwards total $43.8 million, of which $18.6 million will expire in 2009 and $25.2 million will expire in 2010. First LA's California net operating loss carry forwards total $21.3 million, of which $10.1 million will expire in 1999 and $11.2 million will expire in 2000. During 1998, the Company reversed approximately $3.0 million of the valuation allowance resulting from the acquisition of First LA and reduced core deposit intangibles by a corresponding amount.
NOTE 8. RETIREMENT PLAN
The Company has a profit sharing retirement plan with an IRS Section 401 (k) feature covering eligible employees. Contributions are made on an annual basis into a trust fund and are allocated to the participants based on their salaries. The profit sharing contribution requirement is based on a percentage of annual operating income. For 1998, 1997 and 1996, the Company recorded total contributions expense of $8.1 million, $6.7 million and $5.6 million, respectively.
A-49
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 8. RETIREMENT PLAN (CONTINUED) Eligible employees may contribute up to 15% of their salary, but not more than the maximum allowed under IRS regulations. In 1998 and 1997, the Bank matched 50% of the first six percent of covered compensation. In 1996, the Bank matched 10% of the first four percent of covered compensation contributed using forfeitures and cash. For 1998, 1997, and 1996 the Bank's matching contribution included in the total contribution above was $1,374,000, $1,318,000 and $40,000, respectively.
The Company does not provide for any post retirement employee benefits beyond the profit sharing retirement plan.
NOTE 9. STOCK OPTION PLANS
Under the 1995 Omnibus Plan (the Plan), 3,000,000 shares of the Company's common stock were reserved for grant of stock options. The Corporation's 1983 Stock Option Plan and 1985 Stock Option Plan have expired but options granted thereunder remain outstanding. Grants to employees will be at prices at least equal to the market price of the Company's stock on the effective date of the grant. In each succeeding year following the date of grant, 25% of the options become exercisable. After ten years from grant, all unexercised options will expire.
The per share weighted-average fair value of stock options granted during 1998, 1997 and 1996 was $15.55, $9.09 and $4.51 on the date of grant using the Black Scholes option-pricing model with the following weighted-average assumptions: 1998-expected dividend yield of 2.00%, volatility of 33.6%, risk-free interest rate of 5.58% and expected life of 7.5 years; 1997-expected dividend yield of 2.00%, volatility of 33.8%, risk-free interest rate of 6.49% and an expected life of 7.5 years; 1996-expected dividend yield of 1.64%, volatility of 35.0%, risk-free interest rate of 6.01%, and an expected life of 7.5 years.
The Company applies APB Opinion No. 25 in accounting for the Plan and, accordingly, no compensation cost has been recognized for its stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's net income would have been reduced to the pro forma amounts indicated below:
Pro forma net income reflects only options granted in 1998, 1997, 1996 and 1995. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net income amounts presented above because compensation cost is reflected over the options' vesting period of generally four years and compensation cost for options granted prior to January 1, 1995 is not considered.
A-50
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9. STOCK OPTION PLANS (CONTINUED) The following is a summary of the transactions under the stock option plans described above:
STOCK OPTION PLANS:
During 1998 the Company issued 1,008,079 treasury shares and 53,342 newly issued shares in connection with the exercise of stock options. In 1997 the Company issued 459,891 treasury shares and 398,109 newly issued shares in connection with the exercise of stock options. In 1996 the Company issued 749,058 of newly issued shares for the exercise of stock options.
The information concerning currently outstanding and exercisable options at December 31, 1998 are as follows:
At December 31, 1998, nonstatutory and incentive stock options covering 835,357 and 1,015,435 shares, respectively, of the Company's common stock were exercisable under the plans. At December 31, 1998, 179,744 shares were available for future grants.
In addition to the above, the Corporation's 1995 Omnibus Plan provides for the automatic annual grant, on the date of the Annual Meeting of Stockholders, of a discounted stock option (which is not Incentive Stock Option) to each non-employee director, including members of the Compensation and
A-51
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9. STOCK OPTION PLANS (CONTINUED) Directors Nominating Committee to purchase 500 shares of the Corporation's Common Stock ("Director Stock Options"). The exercise price of Director Stock Options is $1.00 per share, payable in cash or cash equivalents, by surrender of the Corporation's Common Stock held by the director for at least a year before exercise, or any combination of the two. Director Stock Options vest 6 months after the date of issuance or upon the termination of the holder's directorship (other than for cause), whichever is earlier, and expire 10 years after the date of grant. Such options fully vest six months after grant. During 1998 and 1997, options to purchase 3,500 and 4,000 shares respectively, were granted to directors of the Company.
NOTE 10. BORROWED FUNDS
The following is a summary of borrowed funds of the Company excluding overnight federal funds purchased and securities sold under agreements to repurchase.
BORROWED FUNDS
Short-term borrowings consist of funds with remaining maturities of one year or less, and long-term debt consists of borrowings with remaining maturities of greater than one year. The maximum amount of other short-term borrowings at any month end was $483.1 million, $267.9 million and $206.6 million in 1998, 1997 and 1996, respectively.
A-52
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 10. BORROWED FUNDS (CONTINUED)
The maximum amount of securities sold under agreements to repurchase outstanding at any month end was $47.2 million, $127.5 million and $141.3 million, in 1998, 1997 and 1996, respectively. The average amount of securities sold under agreements to repurchase was $17.5 million, $53.4 million and $95.2 million during 1998, 1997 and 1996, respectively. The securities underlying the agreements to repurchase remain under the Company's control.
On January 12, 1998, the Bank issued $125.0 million of 6 3/8% Subordinated Notes, due in 2008, in a private offering. These Subordinated Notes qualify as Tier II capital. The carrying value of the Subordinated Notes is net of discount and issuance costs which are being amortized to interest expense to yield an effective interest rate of 6.62%.
Federal Home Loan Bank advances outstanding as of December 31, 1998 (in thousands of dollars) mature as follows:
Federal Home Loan Bank advances outstanding were $50.0 million as of December 31, 1997; $25.0 million maturing on November 18, 2002, but putable beginning on November 19, 1999 and any time thereafter, with a fixed interest rate of 5.58% and $25.0 million maturing on December 16, 2002 with a fixed interest rate of 5.99%.
The Bank had $403.8 million and $464.5 million of unused borrowing capacity from the FHLB at December 31, 1998 and 1997, respectively.
NOTE 11. AVAILABILITY OF FUNDS FROM SUBSIDIARIES; RESTRICTIONS ON CASH BALANCES; CAPITAL
The Company is authorized to issue 5,000,000 shares of Preferred Stock. The Board of Directors has the authority to issue the preferred stock in one or more series, and to fix the designations, rights, preferences, privileges, qualifications and restrictions, including dividend rights, conversion rights, voting rights, rights and terms of redemption, liquidation preferences and sinking fund terms.
Historically, the majority of the funds for the payment of dividends by the Company have been obtained from the Bank. Under federal banking law, dividends declared by national banks in any calendar year may not, without the approval of the Office of the Comptroller of the Currency (OCC), exceed net profits (as defined), for that year combined with its retained net income for the preceding two calendar
A-53
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11. AVAILABILITY OF FUNDS FROM SUBSIDIARIES; RESTRICTIONS ON CASH BALANCES; CAPITAL (CONTINUED) years. At December 31, 1998, the Bank could have declared dividends of $79 million without the approval of regulators.
Federal banking law also prohibits the Corporation from borrowing from the Bank on less than a fully secured basis. At December 31, 1998 and 1997, the Corporation had borrowed from the Bank $13.1 million and $45.0 million, respectively, all of which was appropriately secured in compliance with regulatory requirements.
Federal Reserve Board regulations require that the Bank maintain certain minimum reserve balances. Cash balances maintained to meet reserve requirements are not available for use by the Bank or the Company. During 1998 and 1997, reserve balances averaged approximately $16.0 million and $45.4 million, respectively.
The Company and the Bank are subject to various regulatory capital requirements administered by the 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 and Bank's assets, liabilities and certain off-balance-sheet items as calculated under the 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). Management believes, as of December 31, 1998, the Company and the Bank meet all capital adequacy requirements to which it is subject.
As of December 31, 1998, the most recent notification from the OCC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk based and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution's category.
A-54
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11. AVAILABILITY OF FUNDS FROM SUBSIDIARIES; RESTRICTIONS ON CASH BALANCES; CAPITAL (CONTINUED) The Company's actual amounts and ratios are presented in the table:
A-55
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11. AVAILABILITY OF FUNDS FROM SUBSIDIARIES; RESTRICTIONS ON CASH BALANCES; CAPITAL (CONTINUED) The Bank's actual amounts and ratios are presented in the table:
A-56
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12. COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk. These financial instruments include commitments to extend credit, letters of credit and financial guarantees. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the consolidated statement of financial condition.
Exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, letters of credit and financial guarantees written, is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis.
The Company had outstanding loan commitments aggregating $2,273.8 million and $1,947.8 million at December 31, 1998 and 1997, respectively. In addition, the Company had $150.3 million and $140.3 million outstanding in bankers acceptances and letters of credit of which $129.0 million and $115.5 million relate to standby letters of credit at December 31, 1998 and 1997, respectively. Substantially all of the Company's loan commitments are on a variable rate basis and are comprised of real estate and commercial loan commitments.
The Corporation or its subsidiaries are defendants in various pending lawsuits claiming substantial amounts. Based upon present knowledge, management and in-house counsel are of the opinion that the final outcome of such lawsuits will not have a material adverse effect on the Corporation.
NOTE 13. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
CASH AND DUE FROM BANKS AND FEDERAL FUNDS SOLD
For these short-term instruments, the carrying amount is a reasonable estimate of fair value.
SECURITIES AND TRADING ACCOUNT ASSETS
For securities held as investments or available-for-sale, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. For trading account securities, fair values are based on quoted market prices or dealer quotes.
LOAN RECEIVABLES
For certain homogeneous categories of loans, such as some residential mortgages, and other consumer loans, fair value is estimated using dealer quotes, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining
A-57
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 13. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) maturities. In establishing the credit risk component of the fair value calculations for loans, the Company concluded that the allowance for credit losses represented a reasonable estimate of the credit risk component of the fair value of loans at December 31, 1998 and 1997.
DEPOSIT LIABILITIES
The fair value of demand and interest checking deposits, savings deposits, and certain money market accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.
SHORT-TERM BORROWINGS
For short-term borrowings, the carrying amount is a reasonable estimate of fair value.
LONG-TERM DEBT
The fair value of long term debt was estimated by discounting the future payments at current interest rates.
COMMITMENTS TO EXTEND CREDIT, STANDBY LETTERS OF CREDIT, AND FINANCIAL GUARANTEES WRITTEN
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. The Company does not make fixed-rate loan commitments. The fair value of letters of guarantee and letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date.
DERIVATIVES
The fair value of exchange traded derivatives is based on quoted market prices or dealer quotes. The fair value of non-exchange traded derivatives consists of net unrealized gains or losses, accrued interest receivable or payable and any premiums paid or received.
A-58
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 13. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The estimated fair values of financial instruments of the company are as follows:
- - ------------------------
(1) Notional Amount
(2) Estimated net gains (losses) to settle derivative contracts as of respective period ends
A-59
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14. PARENT COMPANY ONLY CONDENSED FINANCIAL STATEMENTS
Condensed parent company financial statements, which include transactions with subsidiaries, follow:
CONDENSED BALANCE SHEET
CONDENSED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
A-59
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14. PARENT COMPANY ONLY CONDENSED FINANCIAL STATEMENTS (CONTINUED) CONDENSED STATEMENT OF CASH FLOWS
NOTE 15. DERIVATIVE FINANCIAL INSTRUMENTS
The following table presents the notional amount and fair value of interest-rate risk-management instruments at December 31, 1998 and 1997:
Interest-rate swap agreements involve the exchange of fixed- and variable-rate interest payments based upon a notional principal amount and maturity date. The Company's interest-rate risk-management instruments had an exposure to credit risk of $6.4 million and $1.8 million at December 31, 1998 and 1997,
A-60
CITY NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED) respectively. The credit exposure represents the cost to replace, on a present value basis and at current market rates, all profitable contracts outstanding at year end. The Company's swap agreements require the deposit of collateral to mitigate the amount of credit risk if certain thresholds are exceeded. No amounts were required to be deposited by the Company or its counterparties as of December 31, 1998.
The periodic net settlement of interest-rate risk-management instruments is recorded as an adjustment to net interest income. These interest-rate risk-management instruments generated $1.7 million, $0.8 million and $0.3 million in net interest income in 1998, 1997 and 1996, respectively.
A-61