UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________________
F O R M 10 - KSB
[ X ] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the Fiscal Year Ended December 31, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________________ to ____________________
Commission file number 333-59824
SOUTHERN CONNECTICUT BANCORP, INC.
(Name of Small Business Issuer in Its Charter)
Connecticut 06-1609692
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
215 Church Street
New Haven, Connecticut 06510
(Address of Principal Executive Offices) (Zip Code)
Issuer's telephone number (203) 782-1100
Securities registered under Section 12(b) of the Exchange Act:
Common Stock, par value $.01 per share
(Title of Class)
Securities registered under Section 12(g) of the Exchange Act:
None
Check whether the issuer: (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes X No _____
Check if disclosure of delinquent filers in response to Item 405 of
Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]
State issuer's revenue for its most recent fiscal year: $4,895,086.
Aggregate market value of the voting stock held by nonaffiliates (assumes all
directors, executive officers and 10% or greater holders are affiliates) of the
registrant as of March 16, 2005: $20,421,912.
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Number of shares of the registrant's Common Stock, par value $.01 per share,
outstanding as of March 14, 2005 2,797,711
DOCUMENTS INCORPORATED BY REFERENCE
-----------------------------------
Proxy Statement for 2005 Annual Meeting of Incorporated into Part Shareholders.
(A definitive proxy statement III of this Form 10-KSB will be filed with the
Securities and Exchange Commission within 120 days after the close of the fiscal
year covered by this
Form 10-KSB.)
Transitional Small Business Disclosure Format (check one):
Yes _____; No X
2
Table of Contents
Part I Page
Item 1. Description of Business 4
Item 2. Description of Property 15
Item 3. Legal Proceedings 16
Item 4. Submission of Matters to a Vote of Security Holders 16
Part II
Item 5. Market for Common Equity, Related Shareholder Matters, and Small 16
Business Issuer Purchases of Equity Securities
Item 6. Management's Discussion and Analysis or Plan of Operation 19
Item 7. Financial Statements 32
Item 8. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure 32
Item 8A.Controls and Procedures 32
Item 8B.Other Information 33
Part III
Item 9. Directors and Executive Officers of the Registrant 33
Item 10. Executive Compensation 33
Item 11. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters 33
Item 12. Certain Relationships and Related Transactions 33
Item 13. Exhibit List and Reports on Form 8 - K 33
Item 14. Principal Accountant Fees and Services 35
Exhibit Index 38
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PART I
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Item 1. Description of Business.
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Background
Southern Connecticut Bancorp ("Bancorp") is a bank holding company
headquartered in New Haven, Connecticut that was incorporated on November 8,
2000. Bancorp's strategic objective is to serve as a bank holding company for
community-based commercial banks serving the greater New Haven and greater New
London markets, as well as the approximately 45 miles of coastal towns and
communities located between these two cities and extending to Rhode Island (the
"Southern Connecticut Market").
Bancorp owns 100% of the capital stock of The Bank of Southern
Connecticut, (the "Bank") a Connecticut-chartered bank with its headquarters in
New Haven, Connecticut. The Bank commenced operations on October 1, 2001 after
receiving its Final Certificate of Authority from the State of Connecticut and
its deposit insurance from the FDIC. Bancorp has received a temporary
certificate of authority from the State of Connecticut to charter a second,
wholly-owned bank to be headquartered in New London, Connecticut and to be named
The Bank of Southeastern Connecticut ("TBSEC"). The opening of TBSEC is subject
to receipt of final approval from the Department of Banking, the approval of
deposit insurance from the FDIC and the approval of the Federal Reserve Board.
Bancorp has applied to the FDIC to insure the deposits of TBSEC. As of September
30, 2004, the application with the FDIC was extended to permit Bancorp to
provide additional information regarding the infrastructure in place to support
the two banks and to revise certain proposed policies of TBSEC. By letter dated
March 2, 2005, the FDIC requested that Bancorp provide it with supplemental
information pertaining to the initial areas of inquiry noted above. Bancorp will
respond to the FDIC's information requests on or before the FDIC's requested
April 2, 2005 response date. Bancorp will also be required to apply for approval
from the Federal Reserve Bank after receipt of FDIC approval. At this time,
renovations on TBSEC's headquarters at 15 Masonic Street, New London, are nearly
complete and management anticipates that the premises will be ready for
occupancy by early April 2005. Subject to receipt of regulatory approvals, TBSEC
is expected to be open for business during the second half of 2005 and will be
staffed, managed and operated in a comparable manner to the Bank. Bancorp will
provide certain management and operations support and services to the two banks
as well as certain infrastructure. Bancorp believes that providing such services
will benefit TBSEC by lowering its operating costs in comparison to other de
novo banks and in providing common frameworks of operating policy and business
philosophy with its affiliate, the Bank.
The Bank focuses on serving the banking needs of small to medium-sized
businesses in the greater New Haven market. The Bank's target commercial
customer has between $1.0 and $25.0 million in revenues, 15 to 150 employees and
borrowing needs of up to $3.0 million. The primary focus on this commercial
market makes the Bank uniquely qualified to move deftly in responding to the
needs of its clients. The Bank has been successful in winning business by
offering a combination of competitive pricing for its services, quick decision
making processes and a high level of personalized customer service.
Bancorp's geographic market focus gives the Bank unique competitive
advantages by having Bancorp's headquarters, senior executives and key decision
makers all based in the local commercial communities that the Bank currently
serves and which the Bank and TBSEC are targeting to serve. In addition, both
subsidiary banks have or will have their own boards of directors comprised of
members of the local business communities. Although Bancorp faces competition
from much larger, better capitalized national or super-regional organizations,
Bancorp's local market knowledge, relationships, customer service and presence
has enabled it to successfully compete for and obtain new business and clients.
Bancorp has experienced significant growth in both assets and deposits. As
of December 31, 2004 Bancorp has assets of $81.7 million and deposits of $58.7
million, representing a 44.9% and 24.1% increase from
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December 31, 2003, respectively. Total loans, net outstanding as of December 31,
2004 were $49.8 million, a 21.9% increase from December 31, 2003. The growth has
been achieved while maintaining excellent credit quality and margins, with
non-performing loans at 0.02% of total loans as of December 31, 2004, and net
interest margin of 4.62% for the twelve months ended December 31, 2004.
Southern Connecticut Market
Bancorp's market focus is to serve the Southern Connecticut Market,
which is composed of the communities located in New Haven, Middlesex and New
London Counties, and communities bordering or economically linked to these
counties. The Southern Connecticut Market is located in the center of, and is a
critical component of, the commercial activity of the northeast corridor in New
England. The market focus resides in the busy transportation and commercial area
between New York City to the south, Hartford to the north, Providence to the
east, and Boston to the northeast. The diversified economic base of this market
region includes pharmaceutical, advanced manufacturing, healthcare, defense,
technology and energy companies, and Connecticut's leading port. The region is
also one of New England's most popular tourist destinations, featuring popular
shoreline and heritage sites. Additionally, New England's largest casinos,
Foxwoods and the Mohegan Sun, are located in the region.
Growth and Operating Strategy
Bancorp's strategic focus is to own and operate independent,
community-based commercial banks in southern Connecticut founded with the
philosophy of local relationships and providing prompt personal service and
quality banking products. Bancorp's target customers are small to medium-sized
businesses and their owners and employees. The Bank emphasizes personal
relationships with customers, community involvement by employees and the board
of directors, and responsive lending decisions by an accessible and experienced
local management team.
The key elements of the business strategy for Bancorp's current and
proposed commercial banks subsidiaries are:
o Provide individualized attention with local underwriting and credit
decision-making authority. As the only commercial bank based in and
wholly focused on the greater New Haven area, the Bank is better
able to provide the individualized customer service, combined with
prompt local underwriting and credit decision-making authority that
management believes small to medium-sized businesses desire.
Following formation of The Bank of Southeastern Connecticut, Bancorp
plans to extend that strategy into the greater New London area as
well.
o Take market share from large, non-local competitors. As the only
commercial bank headquartered in New Haven, the Bank competes with
large, non-locally owned and headquartered financial institutions.
TBSEC, when it commences operations, is expected to be the only
commercial bank headquartered in New London, a market also dominated
by large, non-locally owned and headquartered financial
institutions. Bancorp believes that the Bank has and can continue to
attract small to medium-sized businesses that prefer local
decision-making authority and interaction with banking professionals
who can provide prompt personalized and knowledgeable service.
o Optimize net interest margin. Bancorp seeks to optimize net interest
margin by funding commercial loans, when possible, with low cost
money market and non-interest bearing demand deposits.
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o Leverage personal relationships and community involvement. The
directors, officers and senior employees of Bancorp and the Bank
have extensive personal contacts, business relationships and
involvement in communities in which they live and work and which the
Bank serves. By building on and leveraging these relationships and
community involvement, Bancorp believes that it has and will
continue to generate enthusiasm and interest from small to
medium-sized businesses in the targeted market areas.
o Employ qualified and experienced banking professionals. Bancorp
seeks to continue to hire and retain highly experienced o and
qualified local commercial lenders and other banking professionals
with successful track records and established relationships with
small to medium-sized businesses in the targeted market areas.
o Maintain and enhance high credit quality. The success of Bancorp's
business plan depends to a significant extent on the quality of the
Bank's assets, particularly loans. The Bank has built a strong
internal emphasis on credit quality and has established stringent
underwriting standards and loan approval processes. The Bank
actively manages past due and non-performing loans in an effort to
minimize credit loss and related expenses and to ensure that the
allowance for loan losses is adequate.
Lending, Depository and Other Products
Lending Products. The Bank offers a broad range of loans to businesses and
individuals in its service area, including commercial and business loans,
personal loans, mortgage loans, home equity loans, and automobile loans. The
Bank has received lending approval status from the Small Business Administration
("SBA") to enable it to make SBA loans to both the greater New Haven business
community and companies located throughout the State of Connecticut.
Loans are made on a variable or fixed rate basis, with fixed rate loans
limited to five year terms. All loans are approved pursuant to lending policies
and procedures authorized by the Bank's board of directors. At the present time,
the Bank is not syndicating or securitizing loans. The Bank, at times,
participates in multi-bank loans to companies in its market area. Commercial
loans and commercial real estate loans may be written for maturities of up to
twenty years. Loans to purchase or refinance commercial real estate are
supported by personal guarantees of the principal owners and related parties and
are collateralized by the subject real estate, which may in cases be
supplemented by additional collateral in the form of liquid assets. Loans to
local businesses are generally supported by the personal guarantees of the
principal owners and are carefully underwritten to determine appropriate
collateral and covenant requirements.
Depository Products. The Bank has attracted a base of core deposits,
including checking accounts, money market accounts, savings accounts, sweep
accounts, NOW accounts and a variety of certificates of deposits and IRA
accounts. To continue to attract deposits, the Bank employs an aggressive
marketing plan in its service area and features a broad product line and rates
and services competitive with those offered in the greater New Haven market. The
primary sources of deposits have been and are expected to continue to be
residents of and businesses and their employees located in, greater New Haven.
The Bank obtains these deposits through personal solicitation by its officers
and directors, outside programs and advertisements published and/or broadcasted
in the local media. The Bank also offers drive-in teller services, automated
teller services, wire transfer, lock box and safe deposit services.
Other Services. The Bank provides a broad range of other services and
products, including cashier's checks, money orders, travelers' checks, bank-by
mail, direct deposit and U. S. Savings Bonds. The Bank is associated with a
shared network of automated teller machines that its customers are able to use
throughout Connecticut and other regions. The Bank does not expect to offer
trust services directly in the near future, but
6
may offer trust services in the future through a joint venture with a larger
institution. To directly offer trust services, the Bank would need the approval
of the Connecticut Banking Commissioner and the FDIC.
Investment Services
On November 17, 2003, SCB Capital, Inc., a wholly-owned subsidiary, was
incorporated and is intended to engage in a limited range of investment banking,
advisory and financial brokerage services primarily to small to medium-sized
business clients of Bancorp and others in the target market. SCB Capital is in
the process of applying for approval of and membership with the National
Association of Security Dealers ("NASD") as a broker-dealer. SCB Capital has
received only minimal capital and has not yet commenced operations. The amount
to be invested in SCB Capital will be determined by the Bancorp board of
directors following completion of the NASD application process. SCB Capital,
Inc. is expected to act solely as broker and advisor and is not intended to make
equity investments in capital raises it completes or assists in. SCB Capital,
Inc. may accept warrants, options or similar instruments in partial compensation
for its services.
Investment Securities
Another significant activity for Bancorp and the Bank is maintaining an
investment portfolio. Bancorp and the Bank's overall portfolio objective is to
optimize the long-term total rate of return through active management of
portfolio holdings taking into consideration estimated asset/liability and
liquidity needs, tax equivalent yields and maturities. Permissible investments
include debt securities such as U.S. Government securities, government sponsored
agency securities, municipal bonds, domestic certificates of deposit that are
insured by the FDIC, mortgage-backed securities and collateralized mortgage
obligations. The Bank's current investment portfolio is limited to U.S.
Government sponsored agency obligations and sponsored agency issued
collateralized mortgage obligations, which have been classified as available for
sale. Accordingly, the principal risk associated with the Bank's current
investing activities is market risk (variations in value resulting from general
changes in interest rates) rather than credit risk. Bancorp's current investment
portfolio is limited to U.S. Government sponsored agency obligations. Bancorp
also holds liquid investments, including funds allocated for investment in
TBSEC, in money market mutual funds.
Asset and Liability Management
Interest rate risk measures the impact that changing interest rates have
on current and future earnings. The goal is to optimize long-term profitability
while minimizing exposure to interest rate fluctuations. Interest rate risk
exposure is monitored through the Bank's ALCO, consisting of senior management
personnel and selected members of the Bank's board of directors. ALCO reviews
the interrelationships within the balance sheet to maximize net interest income
within acceptable levels of risk. ALCO reports to the board of directors on a
quarterly basis regarding the status of ALCO activities within the Bank.
Regulatory Compliance
Bancorp operates in a heavily regulated industry and is subject to
increasing regulatory review and scrutiny from the Federal Reserve Board, the
Connecticut Banking Commissioner and the FDIC. Bancorp has invested and
continues to invest significant time and resources to ensure compliance and
conformity with applicable regulations (see "Regulation and Supervision"). In
response to this regulatory environment, in March 2004 the board of directors of
the Bank adopted resolutions designed to strengthen and enhance the Bank's Bank
Secrecy Act and Gramm-Leach-Bliley Act compliance and the Bank's information
technology controls, promoted a new Bank Secrecy Act Officer and amended its
Bank Secrecy Act policies to strengthen compliance. In addition to responding to
the Bank's regulatory compliance commitment, in connection with asset and staff
increases, the Bank has hired a experienced loan administration officer to
manage the Bank's loan administration functions and enhance loan portfolio
administration practices and procedures. The Bank also engaged a full time
network administrator for its internal computer network and systems. Further,
the Bank
7
has retained an experienced outside consultant to assist it in developing and
implementing information technology controls. In addition, the board of
directors of the Bank has formed an Oversight Committee in March of 2004 with
responsibility to assist management, monitor systems and operations and hire and
retain outside consultants to help ensure ongoing compliance and conformity with
applicable regulations.
Competition
There are numerous banks and other financial institutions serving the
Southern Connecticut Market posing significant competition to attract deposits
and loans. The Bank competes for loans and deposits with other commercial banks,
savings and loan associations, finance companies, money market funds, credit
unions and other financial institutions, a number of which are much larger. To
grow, the Bank, and TBSEC in the future, will have to win existing customers
away from existing banks and financial institutions as well as successfully
compete for new customers from growth in the target markets.
The greater New Haven market is currently served by approximately 80
offices of commercial banks, none of which is headquartered in New Haven. All of
these banks are substantially larger than the Bank expects to be in the near
future and are able to offer products and services which may be impracticable
for the Bank to provide at this time. There are numerous banks and other
financial institutions serving the communities surrounding New Haven, which also
draw customers from New Haven, posing significant competition for the Bank to
attract deposits and loans. The Bank also experiences competition from
out-of-state financial institutions with little or no traditional bank branches
in New Haven. Many of such banks and financial institutions are well established
and better capitalized than the Bank, allowing them to provide a greater range
of services.
Intense market demands, economic pressures and significant legislative and
regulatory actions have eroded traditional banking industry classifications and
have increased competition among banks and other financial institutions. Market
dynamics as well as legislative and regulatory changes have resulted in a number
of new competitors offering services historically offered only by commercial
banks, non-bank corporations offering services traditionally offered only by
banks, increased customer awareness of product and service differences among
competitors and increased merger activity.
Over the past ten years, the Connecticut banking market has been
characterized by significant consolidation among financial institutions. Since
January 1994, there have been at least 60 completed acquisitions of Connecticut
based banks and thrifts. Although the Bank's competitors are currently much
larger than the Bank, the corporate service culture and operational
infrastructure at large banks is believed to not provide the type of
personalized service that many of the Bank's small to medium-sized business
clients desire and that the Bank strives to provide.
Employees
As of December 31, 2004, the Bank had 32 full-time and no part-time
employees. It is Bancorp's intention to move approximately 11 of these 32
employees who focus on finance and operations to Bancorp in 2005. These
employees will service the Bank, and once final approvals are received, TBSEC.
Relationships with all employees are believed to be excellent.
Bancorp intends to recruit a majority of directors, executive management
and employees of TBSEC from the greater New London area. Outside of staffing
TBSEC and new branch locations, Bancorp currently intends to add an additional
lending officer, a loan administration officer, an accountant and two additional
operations employees in early 2005.
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REGULATION AND SUPERVISION
Banks and bank holding companies are extensively regulated under both
federal and state law. Bancorp and the Bank have set forth below brief summaries
of various aspects of supervision and regulation that they are subject to, and
that TBSEC will be subject to upon commencement of its operations assuming that
all necessary approvals are obtained. These summaries do not purport to be
complete and which are qualified in their entirety by reference to applicable
laws, rules and regulations.
Regulations to which Bancorp is Subject
General. As a bank holding company registered in accordance with the BHC
Act, Bancorp is regulated by and subject to the supervision of the Federal
Reserve Board and is required to file with the Federal Reserve Board an annual
report and such other information as may be required. The Federal Reserve Board
has the authority to conduct examinations of Bancorp as well. The Federal
Reserve Board has the authority to issue orders to bank holding companies to
cease and desist from unsound banking practices and violations of conditions
imposed by, or violations of agreements with, the Federal Reserve Board. The
Federal Reserve Board is also empowered to assess civil money penalties against
companies or individuals who violate the BHC Act or orders or regulations there
under, to order termination of non-banking activities of non-banking
subsidiaries of bank holding companies, and to order termination of ownership
and control of a non-banking subsidiary by a bank holding company.
The BHC Act--Acquisitions and Permissible Activities. The BHC Act requires
the prior approval of the Federal Reserve Board for a bank holding company to
acquire substantially all the assets of a bank or acquire direct or indirect
ownership or control of more than 5% of any class of the voting shares of any
bank, bank holding company or savings association, or increase any such
non-majority ownership or control of any bank, bank holding company or savings
association, or merge or consolidate with any bank holding company. Federal law
generally authorizes bank holding companies to acquire banks located in any
state, subject to certain state-imposed age and deposit concentration limits,
and also generally authorizes interstate bank holding company and bank mergers
and to a lesser extent, interstate branching.
Unless a bank holding company becomes a financial holding company under
the Gramm-Leach-Bliley Act of 1999 ("GLBA") (as discussed below), the BHC Act
prohibits a bank holding company from acquiring a direct or indirect interest in
or control of more than 5% of any class of the voting shares of a company that
is not a bank or a bank holding company and from engaging directly or indirectly
in activities other than those of banking, managing or controlling banks or
furnishing services to its subsidiary banks, except that it may engage in and
may own shares of companies engaged in certain activities the Federal Reserve
Board has determined to be so closely related to banking or managing or
controlling banks as to be a proper incident thereto.
The GLBA, which was enacted on November 12, 1999, permits a qualifying
bank holding company to become a "financial holding company" and thereby engage
in a broader range of activities than is permissible for a traditional bank
holding company. In order to qualify for this election, all of the depository
institution subsidiaries of the bank holding company must be well capitalized
and well managed, as defined under Federal Reserve Board regulations, and all
such subsidiaries must have achieved a rating of "satisfactory" or better with
respect to meeting community credit needs. Pursuant to the GLBA, financial
holding companies are permitted to engage in activities that are "financial in
nature" or incidental or complementary thereto, as determined by the Federal
Reserve Board. The GLBA identifies several activities as "financial in nature,"
including, among others, insurance underwriting and agency activities,
investment advisory services, merchant banking and underwriting, and dealing in
or making a market in securities. At this time, Bancorp has not elected to
become a financial holding company and has no immediate plans to do so.
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Capital Requirements. The Federal Reserve Board has adopted capital
adequacy guidelines pursuant to which it assesses the adequacy of capital in
examining and supervising a bank holding company and in analyzing applications
submitted to it under the BHC Act. These capital adequacy guidelines generally
require bank holding companies to maintain total capital equal to 8% of total
risk-adjusted assets and off-balance sheet items (the "Total Risk-Based Capital
Ratio"), with at least one-half of that amount consisting of Tier I or core
capital and the remaining amount consisting of Tier II or supplementary capital.
Tier I capital for bank holding companies generally consists of the sum of
common shareholders' equity and perpetual preferred stock (subject in the case
of the latter to limitations on the kind and amount of such stocks which may be
included as Tier I capital), less goodwill and other non-qualifying intangible
assets. Tier II capital generally consists of: hybrid capital instruments;
perpetual preferred stock, which is not eligible to be included as Tier I
capital; term subordinated debt and intermediate-term preferred stock; and,
subject to limitations, general allowances for loan losses. Assets are adjusted
under the risk-based guidelines to take into account different risk
characteristics.
In addition to the risk-based capital requirements, the Federal Reserve
Board requires bank holding companies to maintain a minimum leverage capital
ratio of Tier I capital (defined by reference to the risk-based capital
guidelines) to total average assets (the "Leverage Ratio") of 3.0%. Total
average assets for this purpose do not include goodwill and any other intangible
assets and investments that the Federal Reserve Board determines should be
deducted from Tier I capital. The Federal Reserve Board has announced that the
3.0% Leverage Ratio requirement is the minimum for the top-rated bank holding
companies without any supervisory, financial or operational weaknesses or
deficiencies or those that are not experiencing or anticipating significant
growth. For all other bank holding companies, the minimum leverage ratio is 4%,
and bank holding companies with supervisory, financial, managerial or
operational weaknesses or organizations expecting significant growth are
expected to maintain capital ratios well above minimum levels.
Bancorp is currently in compliance with the Total Risk-Based Capital
Ratio, Tier I Capital and the Leverage Ratio requirements. As of December 31,
2004, Bancorp had a Tier I Risk-Based Capital Ratio and a Total Risk-Based
Capital Ratio equal to 32.08% and 33.24%, respectively, and a Leverage Ratio
equal to 24.66%. U.S. bank regulatory authorities and international bank
supervisory organizations, principally the Basel Committee on Banking
Supervision, currently are considering changes to the risk-based capital
adequacy framework, including emphasis on credit, market and operational risk
components, which ultimately could affect the appropriate capital guidelines.
Limitations on Acquisitions of Common Stock. The federal Change in Bank
Control Act prohibits a person or group of persons from acquiring "control" of a
depository institution or a depository institution holding company unless the
appropriate federal banking agency has been given at least 60 days to review the
proposal and public notice has been provided. "Control" is generally defined
under this act as ownership of 25% or more of any class of voting stock. In
addition, under a rebuttable presumption established by the Federal Reserve
Board, the acquisition of 10% or more of a class of voting stock of a depository
institution or a depository institution holding company with a class of
securities registered under Section 12 of the Exchange Act would, under the
circumstances set forth in the presumption, constitute the acquisition of
control. Furthermore, any company, as that term is broadly defined in the BHC
Act, would be required to obtain the approval of the Federal Reserve Board under
BHC Act before acquiring 25% (5% in the case of an acquirer that is a bank
holding company) or more of any class of voting securities of a depository
institution or a depository institution holding company, or such lesser
percentage as the Federal Reserve Board deems to constitute a "controlling
influence."
Bank Holding Company Dividends. The Federal Reserve Board has authority to
prohibit bank holding companies from paying dividends if such payment is deemed
to be an unsafe or unsound practice. The Federal Reserve Board has indicated
generally that it may be an unsafe or unsound practice for bank holding
companies to pay dividends unless the bank holding companies net income over the
preceding year is sufficient to fund the
10
dividends and the expected rate of earnings retention is consistent with the
organization's capital needs, asset quality and overall financial condition.
Bank Holding Company Support of Subsidiary Banks. Under Federal Reserve
Board policy, a bank holding company is expected to act as a source of financial
and managerial strength to each of its subsidiary banks and to commit resources
to their support. This support may be required at times when the bank holding
company may not have the resources to provide it. Similarly, under the
cross-guarantee provisions of the Federal Deposit Insurance Act ("FDIA"), the
FDIC can hold any FDIC-insured depository institution liable for any loss
suffered or anticipated by the FDIC in connection with (1) the "default" of a
commonly controlled FDIC-insured depository institution; or (2) any assistance
provided by the FDIC to a commonly controlled FDIC-insured depository
institution "in danger of default."
The Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley")
implements a broad range of corporate governance and accounting measures for
public companies (including publicly-held bank holding companies such as
Bancorp) designed to promote honesty and transparency in corporate America.
Sarbanes-Oxley's principal provisions, many of which have been interpreted
through regulations released in 2003, provide for and include, among other
things: (i) the creation of an independent accounting oversight board; (ii)
auditor independence provisions that restrict non-audit services that
accountants may provide to their audit clients; (iii) additional corporate
governance and responsibility measures, including the requirement that the chief
executive officer and chief financial officer of a public company certify
financial statements; (iv) the forfeiture of bonuses or other incentive-based
compensation and profits from the sale of an issuer's securities by directors
and senior officers in the twelve month period following initial publication of
any financial statements that later require restatement; (v) an increase in the
oversight of, and enhancement of certain requirements relating to, audit
committees of public companies and how they interact with the company's
independent auditors; (vi) requirements that audit committee members must be
independent and are barred from accepting consulting, advisory or other
compensatory fees from the issuer; (vii) requirements that companies disclose
whether at least one member of the audit committee is a "financial expert" (as
such term is defined by the SEC); (viii) expanded disclosure requirements for
corporate insiders, including accelerated reporting of stock transactions by
insiders and a prohibition on insider trading during pension blackout periods;
(ix) a prohibition on personal loans to directors and officers, except certain
loans made by insured financial institutions on nonpreferential terms and in
compliance with other bank regulatory requirements; (x) disclosure of a code of
ethics and filing a Form 8-K for a change or waiver of such code; and (xi) a
range of enhanced penalties for fraud and other violations.
Regulations to which the Bank is Subject
General. The Bank is organized under the Banking Law of the State of
Connecticut. Its operations are subject to federal and state laws applicable to
commercial banks and to extensive regulation, supervision and examination by the
Connecticut Banking Commissioner, as well as by the FDIC, as its primary federal
regulator and insurer of deposits. While the Bank is not a member of the Federal
Reserve System, it is subject to certain regulations of the Federal Reserve
Board. In addition to banking laws, regulations and regulatory agencies, the
Bank is subject to various other laws, regulations and regulatory agencies, all
of which directly or indirectly affect the Bank's operations. The Connecticut
Banking Commissioner and the FDIC examine the affairs of the Bank for the
purpose of determining its financial condition and compliance with laws and
regulations. The Connecticut Banking Commissioner and the FDIC have the
authority to limit the Bank's payment of dividends based on such factors as the
maintenance of adequate capital, which could reduce the amount of dividends
otherwise payable. Following the commencement of its operations, TBSEC will be
subject to these same requirements.
The Connecticut Banking Commissioner and the FDIC have significant
discretion in connection with their supervisory and enforcement activities and
examination policies, including policies with respect to
11
the classification of assets and the establishment of adequate loan loss
reserves for regulatory purposes. Any change in such policies, whether by the
FDIC, Congress, the Connecticut Banking Commissioner or the Connecticut General
Assembly, could have a material adverse impact on the Bank.
Activities and Investments of Insured State-Chartered Banks. Section 24 of
the FDIA generally limits the activities as principal and equity investments of
FDIC-insured, state-chartered banks to those that are permissible for national
banks. Bancorp does not expect such provisions to have a material adverse effect
on Bancorp or the Bank.
Capital Requirements. The FDIC has issued regulations and adopted a
statement of policy regarding the capital adequacy of state-chartered banks,
such as the Bank. Under the regulations, a bank generally is deemed to be (i)
"well-capitalized" if it has a Total Risk-Based Capital Ratio of 10.0% or more,
a Tier I Risk-Based Capital Ratio of 6.0% or more, a Leverage Ratio of 5.0% or
more and is not subject to any written capital order or directive; or (ii)
"adequately capitalized" if it has a Total Risk-Based Capital Ratio of 8.0% or
more, a Tier I Risk-Based Capital Ratio of 4.0% or more, and a Leverage Ratio of
4.0% or more (3.0% under certain circumstances) and does not meet the definition
of "well-capitalized;" or (iii) "undercapitalized" if it has a Total Risk-Based
Capital Ratio that is less than 8.0%, a Tier I Risk-Based Capital Ratio that is
less than 4.0% or a Leverage Ratio that is less than 4.0% (3.0% under certain
circumstances); or (iv) "significantly undercapitalized" if it has a Total
Risk-Based Capital Ratio that is less than 6.0%, a Tier I Risk-Based Capital
Ratio that is less than 3.0% or a Leverage Ratio that is less than 3.0%, and (v)
"critically undercapitalized" if it has a ratio of tangible equity to total
assets that is equal to or less than 2.0%. If an institution becomes
undercapitalized, it would become subject to significant additional oversight
and regulation, as mandated by the FDIA.
As of December 31, 2004, the Bank was deemed to be a well-capitalized
institution for the above purposes. Pursuant to the FDIC's approval of the
Bank's application for deposit insurance, the Bank is required to maintain a
Leverage Ratio of 8.0% until October 1, 2004. Additionally, The Bank of
Southeastern Connecticut will be required to maintain an 8% Leverage Ratio for
its first three years of operations.
Prompt Corrective Action and Other Enforcement Mechanisms. Federal law
requires each federal banking agency to take prompt corrective action to resolve
the problems of insured depository institutions, including but not limited to
those that fall below one or more prescribed minimum capital ratios. An
institution that, based upon its capital levels, is classified as "well
capitalized," "adequately capitalized" or "undercapitalized" may be treated as
though it were in the next lower capital category if the appropriate federal
banking agency, after notice and opportunity for hearing, determines that an
unsafe or unsound condition or an unsafe or unsound practice warrants such
treatment. At each successive lower capital category, an insured depository
institution is subject to more restrictions. The federal banking agencies,
however, may not treat an institution as "critically undercapitalized" unless
its capital ratio actually warrants such treatment.
In addition to restrictions and sanctions imposed under the prompt corrective
action provisions, commercial banking organizations may be subject to potential
enforcement actions by the federal regulators for unsafe or unsound practices in
conducting their businesses or for violations of any law, rule, regulation or
any condition imposed in writing by the agency or any written agreement with the
agency. Enforcement actions may include the imposition of a conservator or
receiver, the issuance of a cease and desist order that can be judicially
enforced, the termination of insurance of deposits (in the case of a depository
institution), the imposition of civil money penalties, the issuance of
directives to increase capital, the issuance of formal and informal agreements,
the issuance of removal and prohibition orders against institution-affiliated
parties and the enforcement of such actions through injunctions or restraining
orders based upon a judicial determination that the agency would be harmed if
such equitable relief was not granted.
12
Premiums for Deposit Insurance. The FDIC has implemented a risk-based
assessment system, under which an institution's deposit insurance premium
assessment is based on the probability that the deposit insurance fund will
incur a loss with respect to the institution, the likely amount of any such
loss, and the revenue needs of the deposit insurance fund.
Under this risk-based assessment system, banks are categorized into one of
three capital categories (well capitalized, adequately capitalized, and
undercapitalized) and one of three categories based on supervisory evaluations
by its primary federal regulatory. The three supervisory categories are:
financially sound with only a few minor weaknesses (Group A), demonstrates
weaknesses that could result in significant deterioration (Group B), and poses a
substantial probability of loss (Group C). The capital ratios used by the FDIC
to define well capitalized, adequately capitalized and undercapitalized are the
same in the FDIC's prompt corrective action regulations. As of March 31, 2004,
the most recent notification from the FDIC and the State of Connecticut
Department of Banking categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action. There are no conditions or
events that management believes have changed the Bank's category.
FDIC insurance of deposits may be terminated by the FDIC, after notice and
hearing, upon finding by the FDIC that the insured institution has engaged in
unsafe or unsound practices, or is in an unsafe or unsound condition to continue
operations, or has violated any applicable law, regulation, rule or order of, or
conditions imposed by, the FDIC.
Safety and Soundness Standards. Federal law requires each federal banking
agency to prescribe for depository institutions under its jurisdiction standards
relating to, among other things: internal controls; information systems and
audit systems; loan documentation; credit underwriting; interest rate risk ;
asset growth; compensation; fees and benefits; and such other operational and
managerial standards as the agency deems appropriate. The federal banking
agencies have promulgated regulations and Interagency Guidelines Establishing
Standards for Safety and Soundness (the "Guidelines") to implement these safety
and soundness standards. The Guidelines set forth the safety and soundness
standards that the federal banking agencies use to identify and address problems
at insured depository institutions before capital becomes impaired. The
Guidelines address internal controls and information systems; internal audit
system; credit underwriting; loan documentation; interest rate risk exposure;
asset quality; earnings and compensation; fees and benefits. If the appropriate
federal banking agency determines that an institution fails to meet any
standards prescribed by the Guidelines, the agency may require the institution
to submit to the agency an acceptable plan to achieve compliance with the
standard set by the FDIA.
The federal banking agencies also have adopted regulations for real estate
lending prescribing uniform guidelines for real estate lending. The regulations
require insured depository institutions to adopt written policies establishing
standards, consistent with such guidelines, for extensions of credit secured by
real estate. The policies must address loan portfolio management, underwriting
standards and loan to value limits that do not exceed the supervisory limits
prescribed by the regulations.
Community Reinvestment Act. Under the Community Reinvestment Act ("CRA"),
as implemented by FDIC regulations, the Bank has a continuing and affirmative
obligation consistent with its safe and sound operation to help meet the credit
needs of its entire community, including low and moderate income neighborhoods.
The CRA does not prescribe specific lending requirements or programs for
financial institutions nor does it limit an institution's discretion to develop
the types of products and services that it believes are best suited to its
particular community, consistent with the CRA. The CRA requires the FDIC, in
connection with its examination of a depository institution, to assess the
institution's record of meeting the credit needs of its community and to take
such record into account in its evaluation of certain applications by such
institution. The FDIC is required to provide a written evaluation and make
public disclosure of an institution's CRA performance utilizing a four-tiered
descriptive rating system. Institutions are evaluated and rated by the FDIC as
13
"Outstanding," "Satisfactory," "Needs to Improve," or "Substantial Non
Compliance." Failure to receive at least a "Satisfactory" rating may inhibit an
institution from undertaking certain activities, including acquisitions or other
financial institutions, which require regulatory approval based, in part, on CRA
compliance considerations. In its CRA evaluation, dated July 14, 2003, the Bank
was rated as "Satisfactory."
Transactions with Affiliates. Sections 23A and 23B of the Federal Reserve
Act restrict transactions between a bank and an affiliated company, including a
parent bank holding company. The Bank is subject to certain restrictions on
loans to affiliated companies, on investments in the stock or securities
thereof, on the taking of such stock or securities as collateral for loans to
any borrower, and on the issuance of a guarantee or letter of credit on their
behalf. Among other things, these restrictions limit the amount of such
transactions, require collateral in prescribed amounts for extensions of credit,
prohibit the purchase of low quality assets and require that the terms of such
transactions be substantially equivalent to terms of similar transactions with
nonaffiliates. Generally, the Bank is limited in its extensions of credit to any
affiliate to 10% of the Bank's capital and in its extensions of credit to all
affiliates to 20% of the Bank's capital.
Customer Information Security. The FDIC and other bank regulatory agencies
have adopted guidelines (the "Security Guidelines") for safeguarding
confidential, personal customer information. The Security Guidelines require
each financial institution, under the supervision and ongoing oversight of its
board of directors or an appropriate committee thereof, to create, implement and
maintain a comprehensive written information security program designed to ensure
the security and confidentiality of customer information, protect against any
anticipated threats or hazards to the security or integrity of such information,
and protect against unauthorized access to or use of such information that could
result in substantial harm or inconvenience to any customer.
Privacy. Financial institutions are required to implement policies and
procedures regarding the disclosure of nonpublic personal information about
consumers to nonaffiliated third parties. In general, the statute requires
explanations to consumers on policies and procedures regarding the disclosure of
such nonpublic personal information, and, except as otherwise required by law,
prohibits disclosing such information except as provided in the financial
institution's policies and procedures.
USA PATRIOT Act. The Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the
"Patriot Act"), designed to deny terrorists and others the ability to obtain
access to the United States financial system, has significant implications for
depository institutions, brokers-dealers and other businesses involved in the
transfer of money. The Patriot Act, as implemented by various federal regulatory
agencies, requires financial institutions, including Bancorp and the Bank, to
implement new policies and procedures or amend existing policies and procedures
with respect to, among other matters, anti-money laundering, compliance,
suspicious activity and currency transaction reporting, and due diligence on
customers. The Patriot Act and its underlying regulations also permit
information sharing for counter-terrorist purposes between federal law
enforcement agencies and financial institutions, as well as among financial
institutions, subject to certain conditions, and require the Federal Reserve
Board (and other federal banking agencies) to evaluate the effectiveness of an
applicant in combating money laundering activities when considering applications
filed under the BHC Act or the Bank Merger Act.
14
Item 2. Description of Property.
------- -------------------------
Bancorp executed a lease for a free-standing building located at 215
Church Street, New Haven, Connecticut, in the central business and financial
district of New Haven. The lease was assigned to The Bank of Southern
Connecticut, and the Bank assumed all obligations thereunder. The location is a
former bank branch, which has been renovated for use as the headquarters of the
Bank and Bancorp. The building has a drive-up teller, an automated teller
machine, two vaults and a night deposit drop.
The lease is for an initial term of five years and three months,
commencing April 11, 2001 with an option to extend the lease for up to three
additional terms of five years. There was no base rent payable for the first
three months of the initial term and monthly rent was $4,117 until August 1,
2001. The annual base rent during the balance of the initial term will be
$107,400 for the first year and increases each year to $125,500 for the fifth
year. The base rent for the option periods is also fixed in the lease. The Bank
is responsible for all costs to maintain the building, other than structural
repairs, and for all real estate taxes. The Bank, as Bancorp's assignee, will
have a right of first refusal to purchase the building.
To the extent that the building contains space not needed for
operations, the Bank expects to sublease such excess to the extent practicable.
The Bank of Southern Connecticut had subleased approximately 1,045 square feet
to Laydon and Company, LLC, an entity owned by Elmer A. Laydon, the son of Elmer
F. Laydon, one of Bancorp's directors.
The following table sets forth the location of the Bank's branch offices
and other related information:
Office Location Square Feet Status
------ -------- ----------- ------
Main Office 215 Church Street, New Haven, Connecticut 11,306 Leased
Branford Office 445 West Main Street, Branford, Connecticut 3,714 Leased
Amity Office 1475 Whalley Avenue, New Haven, Connecticut 2,822 Owned
The Bank of Southern Connecticut entered into a lease agreement on
August 7, 2002 to lease the facility at 445 West Main Street, Branford,
Connecticut, the site of the Branford branch which opened for business on
October 7, 2002.
The Branford branch lease is for an initial term of five years, with an
option to extend the lease for up to three additional terms of five years. The
base rent payable for the initial term and monthly rent is $3,095 until
September 30, 2007. The base rent for the option periods increases and is fixed
in the lease. The Bank is responsible for all costs to maintain the building,
other than structural repairs, and for all real estate taxes.
On August 15, 2002 the Bank also purchased an additional branch
facility at 1475 Whalley Avenue, New Haven, Connecticut, the site of the Amity
branch location which opened March 24, 2003.
On January 14, 2004 Bancorp entered into a lease agreement to lease the
facility at 15 Masonic Street, New London, Connecticut, the site of the proposed
TBSEC. Pending regulatory approval of TBSEC, the facility is in the process of
being improved to accommodate the new bank, which is expected to be completed in
early April of 2005. Improvements, furnishings and equipment are estimated to be
$363,000. TBSEC is expected to commence operations during the second half of
2005. The Lease is for an initial term of five years, with three successive five
year option periods. Base rent is $45,580 annually until January 14, 2009. The
base rent for the option years is subject to increases. Bancorp is responsible
for pro rata allocations for taxes, utilities, common facility charges and other
customary tenant expenses of the premises. Upon the commencement of bank
operations, it is Bancorp's intention to assign the lease to TBSEC.
On June 23, 2004, Bancorp, through a nominee, entered into an agreement
to purchase an approximately one acre improved site with two buildings in
Clinton, Connecticut for the primary purpose of establishing a
15
branch office of the Bank. The net purchase price of the property is $495,000.
The entity under which title to the property will be ultimately held is to be
determined. During 2004, the Bank filed applications to the Connecticut
Department of Banking and the FDIC to establish bank operations at the Clinton
location. Due to a delay in completing the acquisition of the Clinton property,
the Bank's initial application to the FDIC to establish the Clinton branch was
withdrawn pending completion of the acquisition of the property. Bancorp intends
that Bancorp or the Bank will improve the facility to accommodate banking
services. The costs of such improvements have not been fully determined at this
time. Development of the property is expected to begin in the second half of
2005, at which time the Bank will reapply with the FDIC for permission to
establish the Clinton branch.
Item 3. Legal Proceedings.
------- ------------------
There are no legal proceedings currently pending or threatened against
Bancorp, its subsidiaries or their property. Bancorp is not aware of any
proceeding contemplated by a governmental entity involving Bancorp or a
subsidiary.
Item 4. Submission of Matters to a Vote of Security Holders.
------- ----------------------------------------------------
No matter was submitted to a vote of shareholders of Bancorp during the
fourth quarter of the fiscal year covered by this Form 10-KSB.
PART II
-------
Item 5. Market for Common Equity, Related Stockholder Matters and Small
------- ---------------------------------------------------------------
Business Issuer Purchases Of Equity Securities.
-----------------------------------------------
Bancorp's Common Stock has been quoted on the American Stock Exchange
under the symbol "SSE" since June 17, 2004. Prior to that date, Bancorp's Common
Stock was quoted on the OTC Bulletin Board under the symbol "SCNO".
16
The following table sets forth the high and low sales price* per share
of Bancorp's Common Stock, as reported on Bloomberg Market Data System (TM) for
the last two years:
(The prices listed may not reflect actual transactions.)
Quarter Ended High Low
------------- ------------- ------------
March 31,2004 $11.70 $ 7.95
June 30, 2004 $ 9.80 $ 7.95
September 30, 2004 $ 8.75 $ 7.55
December 31, 2004 $ 8.53 $ 8.16
March 31,2003 $ 7.50 $ 7.09
June 30, 2003 $ 9.77 $ 7.00
September 30, 2003 $ 9.36 $ 7.86
December 31, 2003 $ 9.09 $ 7.86
*2003 share prices have been adjusted to reflect the 10% stock dividend
declared January 13, 2004.
Holders
-------
There were approximately 114 registered shareholders of record of
Bancorp's Common Stock as of March 14, 2005.
Dividends
---------
No cash dividends have been declared to date by Bancorp. Management
expects that earnings, if any, will be retained and that no cash dividends will
be paid in the near future. Bancorp may, however, declare stock dividends at the
discretion of its Board of Directors. Bancorp declared a 10% stock dividend on
January 13, 2004 to shareholders of record as January 30, 2004. Bancorp issued
96,653 shares in connection with the stock dividend.
Bancorp's sole operating subsidiary is the Bank. Bancorp is dependent
upon the ability of the Bank to declare and pay dividends to Bancorp. The Bank's
ability to declare dividends is dependent upon the Bank's ability to earn
profits and to maintain acceptable capital ratios, as well as meet regulatory
requirements and remain compliant with banking law.
The policy of the Connecticut Banking Commissioner is to not permit
payment of any cash dividends prior to recapture of organization and
pre-operating expenses from operating profits. In addition, the Bank is
prohibited by Connecticut law from declaring a cash dividend on its Common Stock
without prior approval of the Connecticut Banking Commissioner except from its
net profits for that year and any retained net profits of the preceding two
years. "Net profits" is defined as the remainder of all earnings from current
operations. In some instances, further restrictions on dividends may be imposed
by the FDIC. However, during 2002, the Bank requested, and was granted,
permission from the State of Connecticut Department of Banking, to pay a special
cash dividend to Bancorp in the amount of $200,000. At December 31, 2004 and
2003, no cash dividends may be declared by the Bank without regulatory approval.
The payment of dividends by the Bank may also be affected by other
factors, such as the requirement to maintain capital in accordance with
regulatory guidelines. If, in the opinion of the Connecticut Banking
Commissioner, the Bank were engaged in or was about to engage in an unsafe or
unsound practice, the
17
Commissioner could require, after notice and a hearing, the Bank to cease and
desist from the practice. The federal banking agencies have indicated that
paying dividends that deplete a depository institution's capital base to an
inadequate level would be an unsafe and unsound banking practice. Under the
Federal Deposit Insurance Corporation Improvements Act of 1991, a depository
institution may not pay any dividend if payment would cause it to become
undercapitalized or if it already is undercapitalized. Moreover, the federal
banking agencies have issued policy statements that provide that bank holding
companies and insured banks should generally only pay dividends out of current
operating earnings.
Equity Compensation Plan Information
The following schedule provides information with respect to the
compensation plans (including individual compensation arrangements) under which
equity securities of Bancorp are authorized for issuance as of December 31,
2004:
------------------------------------------------------------------------------------------------------------------------
Plan Category Number of securities to Weighted-average Number of securities
be issued upon exercise exercise price of remaining available for
of outstanding options, outstanding options, future issuance under
warrants and rights warrants and rights equity compensation
(a) (b) plans (excluding
securities reflected in
column (a)
------------------------------------------------------------------------------------------------------------------------
Equity Compensation Plan 346,507 $8.43 83,173
approved by security
holders
------------------------------------------------------------------------------------------------------------------------
Equity Compensation Plan 73,509 $10.91 0
not approved by security
holders (1)
------------------------------------------------------------------------------------------------------------------------
Total 420,016 $8.86 83,173
------------------------------------------------------------------------------------------------------------------------
Bancorp adopted a 2001 Warrant Plan and 2001 Supplemental Warrant Plan
(collectively, the "Warrant Plans") on April 11, 2001 and October 16, 2001. The
Warrant Plans were not approved by security holders. Under the Warrant Plans,
each director of Bancorp, other than Mr. Joseph V. Ciaburri, and each director
of the Bank who is not a director of Bancorp, as of the initial public offering
of Bancorp in July 2001, received a warrant to purchase one share of Bancorp
common stock for each four shares purchased in the offering by such director or
members of such director's immediate family. Under the 2001 Supplemental Warrant
Plan, certain organizers of Bancorp who are not directors, officers or employees
of Bancorp or the Bank but who made contributions to Bancorp's enterprise
received a warrant to purchase one share of Bancorp common stock for each five
shares purchased in the offering by such person or member of such person's
immediate family. The warrants have a term of ten years. The exercise price of
the warrants is $10.91, the price at which Bancorp's common stock was sold in
the initial public offering, as adjusted for the January 2004 10% stock
dividend. They became exercisable as to 40%, 30% and 40% of the shares covered
thereby on the first, second and third anniversary of the closing of the initial
public offering of Bancorp, respectively. In the event of a change in control,
the warrants will become exercisable in full.
18
Recent Sales of Unregistered Securities
---------------------------------------
Bancorp has not sold unregistered securities.
Repurchase of Securities
------------------------
Bancorp has not repurchased any of its securities.
Item 6. Management's Discussion and Analysis or Plan of Operation.
------- -----------------------------------------------------------
The following discussion is intended to assist you in understanding the
financial condition and results of operations of Bancorp and the Bank, and
should be read in conjunction with the consolidated financial statements and
related notes beginning on page F-3.
Overview
Southern Connecticut Bancorp is a bank holding company headquartered in
New Haven, Connecticut that was incorporated on November 8, 2000. Bancorp's
strategic objective is to serve as a bank holding company for community based
commercial banks serving the greater New Haven and greater New London markets,
as well as the approximately 45 miles of coastal towns and communities located
between these two cities and extending to Rhode Island.
Bancorp owns 100% of the capital stock of The Bank of Southern
Connecticut, a Connecticut-chartered bank with its headquarters in New Haven,
Connecticut, which commenced operations on October 1, 2001 after receiving its
Final Certificate of Authority from the State of Connecticut and its deposit
insurance from the FDIC. Bancorp has received a temporary certificate of
authority from the State of Connecticut to charter a second, wholly-owned bank
to be headquartered in New London, Connecticut. The establishment of TBSEC is
subject to receipt of final approval from the Department of Banking, the
approval of deposit insurance from the FDIC and the approval of the Federal
Reserve Board; as further described in "Description of Business - Background" on
page 4. Subject to these approvals, the New London based bank, to be named The
Bank of Southeastern Connecticut, is expected to be open for business during the
second half of 2005 and will be staffed, managed and operated in a comparable
manner to the Bank.
Bancorp's net loss for fiscal year 2004 was $98,000, a decrease of
$500,000 from the net loss of $598,000 in fiscal year 2003. The decrease in the
net loss from 2003 to 2004 reflects increased net interest income and
non-interest income (from fees and other income, including referral fees and
gains on sale of loan participations related to SBA guaranteed loans) during
2004 due to increased average earning assets in 2004 in comparison to 2003, and
a larger average volume of customer accounts and higher transaction volume in
2004 as well. Increases in non-interest expense in 2004 in comparison to 2003
were due to increased asset and deposit volumes as well as to the development of
infrastructure to support expanded operations, increased provision to the
allowance for loan losses, and the cost of developing the proposed TBSEC,
partially offset the increased revenue from net interest income and fee and
other income.
The Bank offers a wide range of services to businesses, professionals and
individuals. The Bank focuses on serving the banking needs of small to
medium-sized businesses in its geographic areas. The Bank makes commercial
loans, real estate and construction loans, consumer loans and accepts savings,
time and demand deposits and provides a broad range of other services to its
customers, either directly or through third parties.
19
The Bank derives revenues principally from interest earned on loans and fees
from other banking-related services. The operations of the Bank are influenced
significantly by general economic conditions and by policies of financial
institution regulatory agencies, primarily the Connecticut Banking Commissioner
and the FDIC. Bancorp's cost of funds is influenced by interest rates on
competing investments and general market interest rates. Lending activities are
affected by the demand for financing of real estate and other types of loans,
which in turn is affected by the interest rates at which such financings may be
offered.
Year Ended December 31, 2004 Compared to December 31, 2003
Financial Condition
Operating Data 2004 2003
--------------------------------------- --------------- ---------------
Interest income $3,949,111 $2,512,086
Interest expense 792,767 574,795
Net interest income 3,156,344 1,937,291
Provision for loan losses 341,108 213,100
Noninterest income 945,975 496,332
Noninterest expenses 3,859,495 2,818,450
Net loss (98,284) (597,927)
Basic and diluted loss per share (0.05) (0.56)
Balance sheet data
---------------------------------------
Cash and due from banks $1,986,193 $1,147,883
Federal funds sold 5,385,000 966,000
Short-term investments 8,372,689 454,115
Investment securities 11,371,894 8,478,068
Loans, net 49,763,952 40,818,718
Total assets 81,694,743 56,386,040
Total Deposits 58,700,377 47,273,875
Repurchase agreements 827,031 339,752
Total shareholders equity 20,697,727 7,314,302
Assets
Bancorp's total assets were $81.7 million as of December 31, 2004, an
increase of $25.3 million over December 31, 2003. Earning assets comprise $75.8
million of the total asset volume, and consist of Federal funds sold, short-term
investments, securities and loans, a $24.6 million increase from 2003. Bancorp
has maintained liquidity by maintaining balances in overnight Federal funds sold
and in short-term investments, primarily money market mutual funds, to provide
funding for higher yielding loans as they are approved. As of December 31, 2004,
Federal funds sold balances were $5.4 million and short-term investments
balances were $8.4 million. Bank investment securities classified as available
for sale were $11.4 million and $8.5 million as of December 31, 2004 and 2003,
respectively. The gross loan portfolio was $50.5 million and $41.2 million as of
December 31, 2004 and 2003 respectively, a net increase of $9.3 million.
The earning asset increase in 2004 has been partially funded by deposit
growth within the Bank's market area. Deposits were $58.7 million and $47.3
million as of December 31, 2004 and 2003 respectively, a net increase of $11.4
million. The mix of deposits as of December 31, 2004 includes non-interest
bearing checking accounts of $17.3 million, interest- bearing checking deposits
of $8.7 million, savings deposits of $3.3 million, money market deposits of
$20.6 million, as well as time certificates of deposit of $8.8 million. The
deposit mix
20
between 2004 and 2003 has not substantially changed, other than the
reduction in the time deposit component due to a marketing de-emphasis of this
product. The Bank has not accepted brokered deposits.
Investments
The following table presents the maturity distribution of investment
securities at December 31, 2004 and the weighted average yield of such
securities. The weighted average yields were calculated based on the amortized
cost and effective yields to maturity of each security.
One Year After Five
One Year Through but Within Over No
Available for sale or Less Five Years Ten Years Ten Years Maturity Total
---------------------------- ---------------- ---------------- --------------- -------------- ------------- ----------------
U. S. Government sponsored
agency obligations $ 998,097 $ 6,494,857 $3,199,640 $500,000 $ - $11,192,594
Mortgage-backed securities - - - - 396,036 396,036
---------------- ---------------- --------------- -------------- ------------- ----------------
Total $ 998,097 $ 6,494,857 $3,199,640 $500,000 $396,036 $11,588,630
================ ================ =============== ============== ============= ================
The following table presents a summary of investments for any issuer that
exceeds 10% of shareholders' equity at December 31, 2004.
Amortized Fair
Cost Value
------------------ ---------------
Federal National Mortgage Association $3,997,326 $3,932,190
Federal Home Loan Bank 3,797,171 3,730,910
Federal Home Loan Mortgage Corporation 3,728,373 3,644,740
Loans
The Bank's net loan portfolio was $49.8 million at December 31, 2004.
Loan demand has been significant throughout the year. The net loan to deposit
ratio as of December 31, 2004 was 84.9%. In comparison, the net loan to deposit
ratio as of December 31, 2003 was 86.3%. Bancorp's current target for this ratio
is 80% to 85%, and attributes the year end 2004 ratio to the success of the
Bank's loan business development program to small to medium businesses, as well
as an improving economy, in generating loan demand. Management believes that the
ratio will generally remain within this band over time as the Bank's branch
system deposit base grows and additional lending capacity is developed. The
deployment of new deposit funds into the loan portfolio has produced a positive
impact on net interest spread. See the table depicting the Distribution of
Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest
Differential on Page 26 of this Form 10-KSB. There are no significant loan
concentrations in the loan portfolio.
The following table presents the maturities of loans in Bancorp's
portfolio at December 31, 2004 by type of loan, and the sensitivities of loans
to changes in interest rates:
21
Due after
Due in one year
one year through Due after
(Thousands of dollars) or less five years five years Total % of Total
------------------------------------------------------------------------------------------------------- -------------
Commercial loans secured
by real estate $ 5,763,400 $14,904,778 $1,794,185 $22,462,363 44.36%
Commercial loans 17,897,241 6,263,476 257,741 24,418,458 48.22%
Construction loans 2,232,461 44,357 - 2,276,818 4.50%
Consumer home equity 421,399 432,459 - 853,858 1.69%
Consumer installment 238,660 386,670 - 625,330 1.23%
----------------- ----------------- --------------- ----------------- -------------
Total $26,553,161 $22,031,740 $2,051,926 $50,636,827 100.00%
================= ================= =============== ================= =============
Fixed rate loans $ 1,490,673 $ 2,622,407 $2,051,926 $ 6,165,006
Variable rate loans 25,062,488 19,409,333 - 44,471,821
----------------- ----------------- --------------- -----------------
Total $26,553,161 $22,031,740 $2,051,926 $50,636,827
================= ================= =============== =================
Critical Accounting Policy
In the ordinary course of business, Bancorp has made a number of
estimates and assumptions relating to reporting the results of operations and
financial condition in preparing its financial statements in conformity with
accounting principals generally accepted in the United States of America. Actual
results could differ significantly from those estimates under different
assumptions and conditions. Bancorp believes the following discussion addresses
Bancorp's only critical accounting policy, which is the policy that is most
important to the portrayal of Bancorp's financial condition and results and
requires management's most difficult, subjective and complex judgments, often as
a result of the need to make estimates about the effect of matters that are
inherently uncertain. Bancorp has reviewed this critical accounting policy and
estimates with its audit committee. Refer to the discussion below under
"Allowance for Loan Losses" and Note 1 to the consolidated financial statements
for a detailed description of our estimation process and methodology related to
the allowance for loan losses.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to
have occurred through a provision for loan losses charged to earnings. Loans are
charged against the allowance when management believes the uncollectibility of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance.
The allowance for loan losses is evaluated on a regular basis by
management and is based upon management's periodic review of the collectibility
of the loans in light of historical experience, the nature and volume of the
loan portfolio, adverse situations that may affect the borrower's ability to
repay, estimated value of any underlying collateral and prevailing economic
conditions. This evaluation is inherently subjective as it requires estimates
that are susceptible to significant revision as more information becomes
available.
The allowance consists of specific, general and unallocated components.
The specific component relates to loans that are classified doubtful,
substandard or special mention. For such loans that are also classified as
impaired, an allowance is established when the discounted cash flows (or
collateral value or observable market price) of the impaired loan is lower than
the carrying value of that loan. The general component covers non-classified
loans and is based on historical loss experience adjusted for qualitative
factors. An unallocated component may be maintained to cover uncertainties that
could affect management's estimate of probable losses.
22
The unallocated component of the allowance reflects the margin of
imprecision inherent in the underlying assumptions used in the methodologies for
estimating specific and general losses in the portfolio.
Based upon this evaluation, management believes the allowance for loan
losses of $752,000 or 1.49% of gross loans at December 31, 2004 is adequate,
under prevailing economic conditions, to absorb losses on existing loans. At
December 31, 2003, the allowance for loan loss was $421,000 or 1.02% of gross
loans outstanding. The increase in the allowance is attributable to management's
assessment of the relevant factors impacting the quality of the loan portfolio,
particularly the increase in the Bank's non-performing loans to approximately
$227,000 in the fourth quarter of 2004, including one impaired loan requiring a
specific allowance of $107,000.
The accrual of interest income on loans is discontinued whenever
reasonable doubt exists as to its collectibility and generally is discontinued
when loans are past due 90 days as to either principal or interest, or are
otherwise considered impaired. When the accrual of interest income is
discontinued, all previously accrued and uncollected interest is reversed
against interest income. The accrual of interest on loans past due 90 days or
more may be continued if the loan is well secured, and it is believed all
principal and accrued interest income due on the loan will be realized, and the
loan is in the process of collection. A non-accrual loan is restored to an
accrual status when it is no longer delinquent and collectibility of interest
and principal is no longer in doubt.
Management considers all non-accrual loans, other loans past due 90
days or more, based on contractual terms, and restructured loans to be impaired.
In most cases, loan payments that are past due less than 90 days and the related
loans are not considered to be impaired. Bancorp considers consumer installment
loans to be pools of smaller balance homogeneous loans, which are collectively
evaluated for impairment.
As of December 31,
--------------------------------
2004 2003
--------------- ----------------
Balance at beginning of period $ 421,144 $ 232,000
Charge-offs (28,976) (24,572)
Recoveries 19,118 616
Provision charged to operations 341,108 213,100
--------------- ----------------
Balance at end of period $ 752,394 $ 421,144
=============== ================
Net charge-offs to average loans .02% .08%
=============== ================
23
2004 2003
------------------------------- --------------------------------
Percent of Percent of
Loans in Each Loans in Each
Category to Category to
Balance Total Loans Balance Total Loans
------------- ----------------- -------------- -----------------
Commercial loans secured by real estate $311,218 44.36% $165,986 43.66%
Commercial loans 338,319 48.22% 192,075 44.98%
Construction loans 31,545 4.50% 35,589 3.63%
Residential mortgages - 0.00% 4,833 2.29%
Consumer home equity loans 11,830 1.69% 1,300 2.52%
Consumer installment loans 8,664 1.23% 21,361 2.92%
Unallocated 50,818 0.00% -
------------- ----------------- -------------- -----------------
$752,394 100.00% $421,144 100.00%
============= ================= ============== =================
Non-Accrual, Past Due and Restructured Loans
Non-accrual loans at December 31, 2004 and 2003 totaled $227,358 and
$94,063 respectively. In 2004 and 2003, there were no loans considered "troubled
debt restructurings" and no loans greater than 90 days past due and still
accruing interest.
Potential Problem Loans
Other than loans identified as non-accrual at December 31, 2004, the
Bank had no material loans as to which management has significant doubts as to
the ability of the borrower to comply with the present repayment terms.
Deposits
Total deposits were $58.7 million at December 31, 2004, an increase of
$11.4 million in comparison to total deposits as of December 31, 2003 of $47.3
million. The deposit total at December 31, 2004 consists of non-interest bearing
checking of $17.3 million (29.5%), interest bearing checking and money market
deposits of $29.3 million (50.0%), savings deposits of $3.3 million (5.6%) and
certificates of deposit of $8.8 million (14.9%). In 2004 the Bank emphasized
growth in core non-interest checking accounts and related interest bearing
checking, money market deposit, and savings accounts and was less aggressive in
attracting higher cost time deposits. The Bank has not accepted any brokered
deposits and has no present plans to review this policy.
The Bank continues to offer competitive interest rates in the very
competitive New Haven County marketplace in order to fund expected loan growth.
24
As of December 31, 2004 the Bank's maturities of time deposits were:
$100,000 Less than
or greater $100,000 Totals
---------- -------- ------
(Thousands of dollars)
Three months or less $ 2,230 $ 858 $ 3,088
Over three months to one year 2,616 1,413 4,029
Over one year 665 971 1,636
-------- --------- --------
$ 5,511 $ 3,242 $ 8,753
======== ========= ========
Other
The increase in cash and due from banks is due to end of day settlement
activity between the Bank and other financial institutions as of the close of
business on December 31, 2004, and primarily represents checks deposited subject
to customary Federal Reserve System inter-bank collection, typically of one
business day duration.
The increase in loans held for sale is due to The Bank of Southern
Connecticut's program of selling participations in SBA guaranteed loans. At
December 31, 2004, $99,000 of SBA guaranteed portion of loans were originated
and held for sale by the Bank. At December 31, 2003, the Bank held no loans for
sale.
The increase in Premises and equipment, net, is primarily due to the
ongoing remodeling of the New London site for TBSEC. At December 31, 2004,
$141,000 of improvements had been completed in that facility. In addition,
$11,353 of equipment for TBSEC had been purchased and Bancorp has deposited
$25,000 with the seller of the proposed Clinton branch office property of the
Bank.
In September, 2002, the Bank began offering repurchase agreements to
customers, which are classified as secured borrowings, and generally mature
within one to three days from the transaction date. Repurchase agreements are
recorded at the amount of cash received in connection with the transaction. The
Bank may be required to provide additional collateral based on the changes in
fair value of the underlying securities. At December 31, 2004, repurchase
agreement liabilities totaled $827,000 in comparison to $340,000 as of December
31, 2003.
The following table presents average balance sheets (daily
averages), interest income, interest expense, and the corresponding annualized
rates on earning assets and rates paid on interest bearing liabilities for the
years ended December 31, 2004 and 2003.
25
Distribution of Assets, Liabilities and Shareholders' Equity;
Interest Rates and Interest differential
2004 2003
--------------------------- ---------------------------
Fluctuations
Interest Interest in interest
Average Income/ Average Average Income/ Average Income/Expense
(Dollars in thousands) Balance Expense Rate Balance Expense Rate Total
-------- ---------- ------- --------- --------- ------- ------------
Interest earning assets
Loans (1) $ 47,680 $ 3,542 7.43% $ 29,091 $ 2,224 7.64% $ 1,318
Short-term investments 3,895 55 1.41% 993 7 0.70% 48
Investments 10,687 269 2.52% 8,747 256 2.93% 13
Federal funds sold 6,064 83 1.37% 2,379 25 1.05% 58
-------- --------- --------- -------- ------------
Total interest earning assets 68,326 3,949 5.78% 41,210 2,512 6.10% 1,437
-------- ------- -------- ------ ------------
Cash and due from banks 992 1,396
Premises and equipment, net 3,403 3,381
Allowance for loan losses (483) (303)
Other 1,256 1,068
--------- ---------
Total assets $ 73,494 $ 46,752
========= =========
Interest bearing liabilities
Time certificates $ 11,441 245 2.14% $ 6,534 166 2.54% 79
Savings deposits 3,097 38 1.23% 1,984 21 1.06% 17
Money market /
checking deposits 26,170 330 1.26% 18,381 211 1.15% 119
Capital lease obligations 1,190 171 14.37% 1,191 169 14.19% 2
Repurchase agreements 1,336 9 0.67% 914 8 0.88% 1
-------- --------- --------- -------- ------------
Total interest bearing
liabilities 43,234 793 1.83% 29,004 575 1.98% 218
-------- ------- -------- ------- ------------
Non-interest bearing deposits 15,453 9,645
Accrued expenses and
other liabilities 423 357
Shareholder's equity 14,384 7,746
-------- ---------
Total liabilities and equity $ 73,494 $ 46,752
======== =========
Net interest income $ 3,156 $ 1,937 $ 1,219
======== ======== ============
Interest spread 3.95% 4.12%
======= =======
Interest margin 4.62% 4.70%
======= =======
(1) Includes nonaccruing loans.
26
RATE VOLUME VARIANCE ANALYSIS
The following table summarizes the variance in interest income and
expense for 2004 and 2003 resulting from changes in assets and liabilities and
fluctuations in interest rates earned and paid. The changes in interest income
and expense attributable to both rate and volume have been allocated to both
rate and volume on a pro rata basis.
2004 vs 2003
-----------------------------
Variance due to:
----------------
(Dollars in thousands) Volume Rate Total
-------------------------- ---------------- ---------
Interest earning assets
Loans $1,381 $ (63) $ 1,318
Short-term investments 4 44 48
Investments 52 (39) 13
Federal funds sold 30 28 58
------- ------ ---------
Total interest earning assets 1,467 (30) 1,437
------- ------ ---------
Interest bearing liabilities
Time certificates 108 (29) 79
Savings deposits 10 7 17
Money market / checking deposits 83 36 119
Capital lease obligations - 2 2
Repurchase agreements 3 (2) 1
------- ------ ---------
Total interest bearing liabilities 204 14 218
------- ------ ---------
Net interest income $1,263 $ (44) $ 1,219
======= ====== =========
The improvements realized in net interest income during 2004 primarily
reflect substantial increased earning asset volume over 2003, as the average
earning assets in 2004 of $68.3 million were 66% greater than average earning
assets in 2003, and increases of 125 basis points in the level of short term
interest rates occurring since midyear 2004. The increase in short term interest
rates, such as the federal funds rate and the prime lending rate and other short
term lending indices charged by banks, including the Bank, increased due to
actions taken by the Federal Reserve on five occasions beginning in June 2004.
Overall, interest income attributed to volume considerations considerably
outweighed rate considerations (increase of $1.5 million versus a decrease of
$30,000). Due to the decrease in the volume of the higher rate, longer term
fixed interest rate portion of the loan portfolio, and a shortening of the
duration of the investment portfolio during 2004, the impact of rising short
term rates on the average yield in these portfolios was mitigated and the loan
and investment average portfolio yields realized declined in 2004 in comparison
to 2003. Variances in the 2004 cost of interest bearing liabilities in
comparison to 2003 were due to increased volume considerations of $204,000 and
increased rate considerations of $14,000.
The increase in the net loan portfolio and increases in investments in
short term investments, investments, and federal funds sold have been the
primary factor in improving net interest income. The net loan portfolio increase
of $8.9 million and net increase in investments, short-term investments and
federal funds sold of $15.2 million in 2004 was accompanied by a $1.2 million
increase in net interest income of Bancorp. Bancorp intends for the Bank, and
TBSEC in the future, to continue to emphasize lending to small to medium
businesses in its market area as its strategy to increase assets under
management and to improve earnings. The Bank will seek opportunities to increase
its deposit base, with a primary objective of attracting core non-interest
checking and related money market deposit accounts, in order to support its
earning assets through marketing, and by considering additional branch locations
and new product and service offerings.
27
The following are measurements of Bancorp's earnings (loss) in relation
to assets and equity, and average equity to average assets for the year ended
December 31, 2004 and 2003.
2004 2003
---------------- ---------------
Return (Loss) on average assets (.13%) (1.28%)
Return (Loss) on average equity (.68%) (7.72%)
Average equity to average assets 19.57% 16.56%
Results of Operations
Bancorp's net loss for fiscal year 2004 was $98,000, a decrease of
$500,000 from the net loss of $598,000 in fiscal year 2003. The decrease in the
2004 loss was primarily due to increases in net interest income of $1.2 million
and non-interest income of $450,000, partly offset by increases in non-interest
expenses of $1.0 million and in the provision for loan losses of $128,000. The
increase in non-interest expense was due to increases in staffing due to
increased loan and deposit activity and other expenses relating to the
development of the Bank's infrastructure. Also during 2004, Bancorp continued to
incur expenses relating to the development of TBSEC.
Net Interest Income
The principal source of our revenues is net interest income. Bancorp's
net interest income is dependent primarily upon the difference or spread between
the average yield earned on loans receivable and securities and the average rate
paid on deposits and borrowings, as well as the relative amounts of such assets
and liabilities. Bancorp, like other banking institutions, is subject to
interest rate risk to the degree that its interest-bearing liabilities mature or
reprice at different times, or on a different basis, than its interest-earning
assets.
For the year December 30, 2004, net interest income was $3.2 million
versus $1.9 million for the year ended December 31, 2003, a $1.3 million or
62.9% increase. The 2004 increase was primarily the result of a $27.1 million
increase in average interest earning assets. The increase in average interest
earning assets was comprised of increases in average loans of $18.6 million,
investments of $1.9 million, short term investments of $2.9 million and federal
funds sold of $3.7 million.
The yield on average interest earning assets for the twelve months
ended December 31, 2004 was 5.78% versus 6.10% for same period in 2003, a
decrease of 32 basis points. The decrease in the yield on assets reflects the
increased level of average investments, short term investments, and federal
funds sold during 2004 in comparison to 2003, which yield less than loan assets,
as well as the lower yield on average loans due to a shortening of the average
life to repricing of loans that occurred during 2004. Decreases in the yield on
average earning assets in 2004 due to the mix of assets and due to the
shortening of the loan portfolio average life were partially offset by the
increases in market interest rates that occurred after midyear 2004,
particularly in the prime lending rate and the Bank's base lending rate.
The cost of average interest bearing liabilities was 1.83% for the
twelve months ended December 31, 2004 versus 1.98% for the same period in 2003,
a favorable decrease of 15 basis points. The decrease in the cost of interest
bearing liabilities was due to the $7.8 million increase in the average
outstanding balances of low rate money market and interest bearing checking
deposits in comparison to the total increase in interest bearing liabilities of
$14.2 million. The average rate of interest paid on money market and interest
bearing checking deposits increased 11 basis points in 2004 in comparison to
2003, significantly less than the general increase in the level of market rates
during the year. Also, the Bank's average cost of funds for time deposits
decreased 40 basis points in 2004 in comparison to 2003.
Due to the change in the mix of assets and the resulting decrease in
the average yield on earning assets in 2004, partially offset by the favorable
decrease in the cost of interest bearing liabilities, the interest spread
decreased to 3.95% for fiscal year 2004, a decrease of 17 basis points from the
interest spread realized in 2003. Net interest margin decreased to 4.62% in 2004
from 4.70% in 2003, a change of 8 basis points which largely reflects the change
in the mix of assets in
28
the second half of 2004 to a higher percentage of investments, short term
investments and federal funds sold in comparison to 2003.
Noninterest Income
The $450,000 increase in non-interest income for the twelve months
ended December 31, 2004 versus 2003 is comprised of an increase of $221,000 in
referral fee income and gains on sales of loan participations related to SBA
guaranteed loans, increased deposit account service charges and fees of $204,000
and an increase in other noninterest fee income of $65,000, offset by a decrease
in gains on the sales of investment securities of $41,000. The Bank intends to
continue to originate SBA guaranteed loans in the future and expects to continue
to realize gains and earn fee income from SBA loan participation sales and
referrals. It is anticipated that TBSEC will also originate and sell
participations in the guaranteed portion of such loans. The increase in other
noninterest fee income is attributable to volume growth in the loan and deposit
portfolios, as well as increases in prepayment penalties on loans of $18,000,
and investment banking fees of $25,000.
Noninterest Expenses
Total noninterest expenses were $3.9 million for the year ended
December 31, 2004 versus $2.8 million for 2003, an increase of $1,041,000 or
37%. The increase in expenses is due to the increases in Bancorp's loan and
deposit volume, additional staffing in the lending, loan review and operations
areas of the Bank, and other operating expenses. As a result, salaries and
benefits increased $501,000 to $2.0 million in fiscal year 2004 in comparison to
fiscal year 2003, and occupancy and equipment expenses increased by $148,000 in
fiscal year 2004 to $518,000.
Bancorp and the Bank engaged various legal and other professional
advisors and consultants during 2004 for the purposes of advising on matters
relating to the public offering completed during 2004, the New London bank
franchise initiative, and to develop the infrastructure of the Bank.
Professional services for the year ended December 31, 2004 increased $171,000
over the year ended December 31, 2003. Other operating expenses for 2004 totaled
$438,000, an increase of $110,000 over the total for 2003. The increase in other
operating expense is primarily attributable to higher insurance costs of
$50,000, and an increase in filing fees, largely attributable to SEC and stock
exchange requirements, of $22,000. Data processing expense increased $87,000
during 2004 in comparison to 2003, to total $284,000. The increase is
attributable to increased processing costs at the Bank primarily relating to
volume, increased services and expanded infrastructure.
Off-Balance-Sheet Arrangements
See Note 12 to the accompanying consolidated Financial Statements for
required disclosure regarding off-balance-sheet arrangements.
Liquidity
Bancorp's liquidity position as of December 31, 2004 and December 31,
2003 consisted of liquid assets totaling $27.2 million and $11.1 million,
respectively. This represents 33.2% and 19.6% of total assets at December 31,
2004 and 2003, respectively. The liquidity ratio is defined as the percentage of
liquid assets to total assets. The following categories of assets as described
in the accompanying balance sheet are considered liquid assets: Cash and due
from banks, federal funds sold, short-term investments and securities available
for sale. Liquidity is a measure of Bancorp's ability to generate adequate cash
to meet financial obligations. The principal cash requirements of a financial
institution are to cover downward fluctuations in deposits and increases in its
loan portfolio. The liquidity ratio as of December 31, 2004 is substantially
higher than that at year end 2003 primarily due to the public offering in June
2004 pursuant to which $13.3 million in net capital was raised, of which $6
million has been invested by Bancorp in short term investments in anticipation
of funding the capital of TBSEC during 2005.
29
Management believes Bancorp's short-term assets provide sufficient
liquidity to cover potential fluctuations in deposit accounts and loan demand
and to meet other anticipated operating cash and investment requirements, such
as the capitalization of TBSEC and the establishment of the proposed Clinton
branch office of the Bank. Other than these uses of Bancorp and the Bank's
short-term liquid assets, there are no current plans involving the significant
purchase or sale of property or equipment.
Capital
Bancorp Bank
--------------------------------------- ---------------------------------------
December 31, December 31, December 31, December 31,
2004 2003 2004 2003
-------------------- ------------------ -------------------- ------------------
Tier 1 (Leverage) Capital Ratio to Average assets 24.66% 14.18% 14.87% 14.16%
Tier 1 Capital to Risk Weighted Assets 32.08% 16.36% 19.59% 16.33%
Total Capital to Risk Weighted Assets 33.24% 17.27% 20.84% 17.24%
Capital adequacy is one of the most important factors used to determine
the safety and soundness of individual banks and the banking system. Based on
the above ratios, the Bank is considered to be "well capitalized" under
applicable regulations. To be considered "well capitalized" an institution must
generally have a leverage capital ratio of at least 5%, a Tier 1 risk-based
capital ratio of at least 6% and a total risk-based capital ratio of at least
10%.
Bancorp's required ratios are not substantially different from those
shown above.
Subject to final regulatory approval, Bancorp intends to establish The
Bank of Southeastern Connecticut in the second half of 2005. Bancorp also
anticipates commencing the operations of SCB Capital, Inc. in late 2005.
Currently, the Bank has limited authority to conduct investment banking activity
under Regulation B of the Federal Reserve Act, which authority, unless extended,
expires March 31, 2006. Provided the new bank subsidiary and SCB Capital Inc.
receive regulatory approval, Bancorp will capitalize these entities in 2005. The
application for TBSEC specifies that the initial capitalization of TBSEC will be
approximately $6 million. The National Association of Security Dealers rules and
regulations require a minimum capitalization for SCB Capital, Inc. to be not
less than $25,000.
Market Risk
Market risk is defined as the sensitivity of income to fluctuations in
interest rates, foreign exchange rates, equity prices, commodity prices and
other market-driven rates or prices. Based upon on the nature of the Company's
business, market risk is primarily limited to interest rate risk, which is
defined as the impact of changing interest rates on current and future earnings.
Bancorp's goal is to maximize long-term profitability, while minimizing
its exposure to interest rate fluctuations. The first priority is to structure
and price Bancorp's assets and liabilities to maintain an acceptable interest
rate spread, while reducing the net effect of changes in interest rates. In
order to reach an acceptable interest rate spread, Bancorp must generate loans
and seek acceptable long-term investments to replace the lower yielding balances
in Federal Funds sold and short-term investments. The focus also must be on
30
maintaining a proper balance between the timing and volume of assets and
liabilities re-pricing within the balance sheet. One method of achieving this
balance is to originate variable loans for the portfolio to offset the
short-term re-pricing of the liabilities. In fact, a number of the interest
bearing deposit products have no contractual maturity. Customers may withdraw
funds from their accounts at any time and deposits balances may therefore run
off unexpectedly due to changing market conditions.
The exposure to interest rate risk is monitored by the Asset and
Liability Management Committee ("ALCO") consisting of senior management
personnel and selected members of the Board of Directors. ALCO reviews the
interrelationships within the balance sheet to maximize net interest income
within acceptable levels of risk. ALCO reports to the Board of Directors on a
quarterly basis regarding the status of ALCO activities within Bancorp.
Impact of Inflation and Changing Prices
Bancorp's financial statements have been prepared in terms of
historical dollars, without considering changes in relative purchasing power of
money over time due to inflation. Unlike most industrial companies, virtually
all of the assets and liabilities of a financial institution are monetary in
nature. As a result, interest rates have a more significant impact on a
financial institution's performance than the effect of general levels of
inflation. Interest rates do not necessarily move in the same direction or in
the same magnitude as the prices of goods and services. Notwithstanding this
fact, inflation can directly affect the value of loan collateral, in particular,
real estate. Inflation, or disinflation, could significantly affect Bancorp's
earnings in future periods.
Factors Affecting Future Results
Some of the statements under "Management's Discussion and Analysis of
Financial Condition and Results of Operations," "Business" and elsewhere in this
Annual Report on Form 10-KSB may include forward-looking statements which
reflect our current views with respect to future events and financial
performance. Statements which include the words "expect," "intend," "plan,"
"believe," "project," "anticipate" and similar statements of a future or
forward-looking nature identify forward-looking statements for purposes of the
federal securities laws or otherwise. All forward-looking statements address
matters that involve risks and uncertainties. Accordingly, there are or will be
important factors that could cause actual results to differ materially from
those indicated in these statements or that could adversely affect the holders
of our common stock. These factors include, but are not limited to, (1) changes
in prevailing interest rates which would affect the interest earned on Bancorp's
interest earning assets and the interest paid on its bearing liabilities, (2)
the timing of re-pricing of Bancorp's interest earning assets and interest
bearing liabilities, (3) the effect of changes in governmental monetary policy,
(4) the effect of changes in regulations applicable to Bancorp and the conduct
of its business, (5) changes in competition among financial service companies,
including possible further encroachment of non-banks on services traditionally
provided by banks and the impact of recently enacted federal legislation, (6)
the ability of competitors which are larger than Bancorp to provide products and
services which it is impracticable for Bancorp to provide, (7) the volatility of
quarterly earnings, due in part to the variation in the number, dollar volume
and profit realized from SBA guaranteed loan participation sales in different
quarters, (8) the effect of a loss of any executive officer, key personnel, or
directors, (9) the effect of Bancorp's opening of branches and organization of a
new bank and the receipt of regulatory approval to complete both actions, (10)
concentration of Bancorp's business in Southern Connecticut, (11) the
concentration of Bancorp's loan portfolio in commercial loans to small-to-medium
sized businesses, which may be impacted more severely than larger businesses
during periods of economic weakness, (12) lack of seasoning in Bancorp's loan
portfolio, which may increase the risk of future credit defaults, and (13) the
effect of any decision by Bancorp to engage in any business not historically
permitted to it. Other such factors may be described in other filings made by
Bancorp with the SEC.
31
Although Bancorp believes that it offers the loan and deposit products
and has the resources needed for success, future revenues and interest spreads
and yields cannot be reliably predicted. These trends may cause Bancorp to
adjust its operations in the future. Because of the foregoing and other factors,
recent trends should not be considered reliable indicators of future financial
results or stock prices.
Any forward-looking statement speaks only as of the date on which such
statement is made, and we undertake no obligation to publicly update or review
any forward-looking statement, whether as a result of new information, future
developments or otherwise.
Item 7. Financial Statements
------- --------------------
The consolidated balance sheets of Bancorp as of December 31, 2004 and 2003, and
the related consolidated statements of operations, shareholders' equity and cash
flows for the years then ended, together with the report thereon of McGladrey &
Pullen, LLP dated March 5, 2004 are included as part of this Form 10-KSB in the
"Financial Report" following page 39 hereof.
Item 8. Changes in and Disagreements with Accountants on Accounting and
------- -----------------------------------------------------------------------
Financial Disclosure
--------------------
Not applicable.
Item 8A. Controls and Procedures
-------- -----------------------
(a) Evaluation of disclosure controls and procedures
Based upon an evaluation of the effectiveness of Bancorp's disclosure
controls and procedures performed by Bancorp's management, with participation of
Bancorp's Chief Executive Officer, Chief Operating Officer and its Chief
Financial Officer as of the end of the period covered by this report, Bancorp's
Chief Executive Officer, Chief Operating Officer and Chief Financial Officer
concluded that Bancorp's disclosure controls have been effective in ensuring
that material information relating to Bancorp, including its consolidated
subsidiary, is made known to the certifying officers by others within Bancorp
and the Bank during the period covered by this report.
As used herein, "disclosure controls and procedures" mean controls and
other procedures of Bancorp that are designed to ensure that information
required to be disclosed by Bancorp in the reports that it files or submits
under the Securities Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the Commission's rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed by
Bancorp in the reports that it files or submits under the Securities Exchange
Act is accumulated and communicated to Bancorp's management, including its
principal executive and principal financial officers, or persons performing
similar functions, as appropriate to allow timely decisions regarding required
disclosure.
(b) Changes in Internal Controls
There have not been any significant changes in Bancorp's internal
controls or in other factors that occurred during Bancorp's fiscal year ended
December 31, 2004 that could significantly affect these controls subsequent to
the evaluation referenced in paragraph (a) above.
32
Item 8B. Other Information
-------- -----------------
Not Applicable.
PART III
--------
Item 9. Directors and Executive Officers of the Registrant
------- --------------------------------------------------
The information required by this Item 9 is incorporated into this Form
10-KSB by reference from Bancorp's definitive proxy statement for its 2005
Annual Meeting of Shareholders (the "Definitive Proxy Statement").
Item 10. Executive Compensation
-------- ----------------------
The information required by this Item 10 is incorporated into this Form
10-KSB by reference from the Definitive Proxy Statement.
Item 11. Security Ownership of Certain Beneficial Owners and Management and
-------- ----------------------------------------------------------------------
Related Stockholder Matters
---------------------------
The information required by this Item 11 is incorporated into this Form
10-KSB by reference from the Definitive Proxy Statement.
Item 12. Certain Relationships and Related Transactions
-------- ----------------------------------------------
The information required by this Item 12 is incorporated into this Form
10-KSB by reference from the Definitive Proxy Statement.
Item 13. Exhibits, List and Reports on Form 8-K
-----------------------------------------------
(a) Exhibits
No. Description
--- -----------
3(i) Amended and Restated Certificate of Incorporation of the Issuer
(incorporated by reference to Exhibit 3(i) to Issuer's Quarterly Report
on Form 10-QSB dated June 30, 2002)
3(ii) By-Laws of the Issuer (incorporated by reference to Exhibit 3(ii) to
the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
10.1 Lease, dated as of August 17, 2000, between 215 Church Street, LLC and
the Issuer (incorporated by reference to Exhibit 10.1 to the Issuer's
Registration Statement on Form SB-2 (No. 333-59824))
10.2 Letter agreement dated January 3, 2001 amending the Lease between 215
Church Street, LLC and the Issuer (incorporated by reference to Exhibit
10.2 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
10.3 First Amendment to Lease dated March 30, 2001 between 215 Church
Street, LLC and the Issuer (incorporated by reference to Exhibit 10.3
to the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
33
10.4 Second Amendment to Lease dated March 31, 2001 between 215 Church
Street, LLC and the Issuer (incorporated by reference to Exhibit 10.4
to the Issuer's Registration Statement Form SB-2 (No. 333-59824))
10.5 Assignment of Lease dated April 11, 2001 between the Issuer and The
Bank of Southern Connecticut (incorporated by reference to Exhibit 10.5
to the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
10.6 Sublease dated January 1, 2001 between Michael Ciaburri, d/b/a Ciaburri
Bank Strategies and The Bank of Southern Connecticut (incorporated by
reference to Exhibit 10.10 to the Registrants Statement on Form SB-2
(No. 333-59824))
10.7 Sublease dated January 1, 2001 between Laydon & Company, LLC and The
Bank of Southern Connecticut (incorporated by reference to Exhibit
10.11 to the Registrants Statement on Form SB-2 (No. 333-59824))
10.8 Lease dated August 2, 2002 between 469 West Main Street LLC and The
Bank of Southern Connecticut (incorporated by reference to Exhibit
10.18 to the Registrants Form 10-KSB dated March 30, 2004)
10.9 Lease dated January 14, 2004 between The City of New London and the
Registrant (incorporated by reference to Exhibit 10.16 to the
Registrant's Form 10-KSB dated March 30, 2004)
10.10 Purchase Agreement dated June 22, 2004 between Dr. Alan Maris and
James S. Brownstein, Trustee relating to property and premises located
at 51-53 West Main Street, Clinton, Connecticut
10.11 Employment Agreement dated as of January 23, 2001, between The Bank of
Southern Connecticut, the Issuer and Joseph V. Ciaburri (incorporated
by reference to Exhibit 10.6 to the Issuer's Registration Statement on
Form SB-2 (No. 333-59824))
10.12 Amendment to Employment Agreement dated as of October 20, 2003 among
the Registrant, The Bank of Southern Connecticut and Joseph V. Ciaburri
(incorporated by reference to Exhibit 10.6 to the Registrants
Registration Statement on Form SB-2 (No.
333-59824)
10.13 Amendment to Employment dated as of January 20, 2005, among the
Registrant The Bank of Southern Connecticut and Michael M. Ciaburri
10.14 Registrants 2001 Stock Option Plan (incorporated by reference to
Exhibit 10.8 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
10.15 Registrants 2001 Warrant Plan (incorporated by reference to Exhibit
10.9 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
10.16 Registrant's 2001 Supplemental Warrant Plan (incorporated by reference
to Exhibit 10.12 to Issuer's Annual Report on Form 10-KSB dated March
28, 2002)
10.17 Issuer's 2002 Stock Option Plan (incorporated by reference to Appendix
B to Issuer's Definitive Proxy Statement dated April 18, 2002).
10.18 Form of Stock Option Agreement for Non-qualified Stock Option granted
under the Registrant's 2002 Stock Option Plan (incorporated by
reference to the Registrant's Form 10-QSB dated November 15, 2004.
10.19 Form of Stock Option Agreement for Incentive Stock Option granted
under the Registrant's 2002 Stock Option Plan (incorporated by
reference to the Registrant's Form 10-QSB dated November 15, 2004.
10.20 Underwriting agreement dated June 16, 2004 among A.G.Edwards & Sons,
Inc. and Keefe, Bruyette & Woods, and the Registrant (Incorporated by
reference to Exhibit 1.1 to the Issuer's Registration Statement on
Form SB-2 (no. 333-598824)).
34
14 Amended and Restated Code of Ethics
21. Subsidiaries (incorporated by reference to Exhibit 21 to Issuer's form
10-KSB dated March 31, 2003)
31.1 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by Chairman and
Chief Executive Officer.
31.2 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by President and
Chief Operating Officer.
31.3 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by Vice President
and Chief Financial Officer.
32.1 Section 1350 Certification by Chairman and Chief Executive Officer.
32.2 Section 1350 Certification by President and Chief Operating Officer.
32.3 Section 1350 Certification by Vice President and Chief Financial
Officer
(b) Reports on Form 8-K
The following reports on Form 8-K were made by Southern Connecticut
Bancorp, Inc. during the last quarter of the year ending December 31,
2004:
Item 14. Principal Accountant Fees and Services
-------- ---------------------------------------
Bancorp's Principal Accountants, McGladrey & Pullen, LLP, provide
audit, audit related and tax advisory and tax return preparation services for
Bancorp and The Bank of Southern Connecticut. The following table summarizes the
fees provided in 2004 and 2003, respectively:
2004 2003
---- ----
Audit Fees $187,885 $ 81,583
Audit Related Fees 2,500 6,235
Tax Fees 8,065 7,565
All Other Fees NONE NONE
Audit fees consist of fees for professional services rendered for the
audit of the consolidated financial statements, review of financial statements
included in quarterly reports included on Form 10-QSB, and services connected
with statutory and regulatory filings or engagements including fees in
connection with the 2004 registration statement filed on Form SB-2. Audit
related fees are principally for consultations on various accounting and
reporting matters. Tax service fees consist of fees for tax return preparation
for Bancorp.
35
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
SOUTHERN CONNECTICUT BANCORP, INC.
(Registrant)
By: /S/ Joseph V. Ciaburri
--------------------------
Name: Joseph V. Ciaburri
Title: Chairman and Chief Executive Officer
Date: March 28, 2005
--------------------
In accordance with the Exchange Act, this report has been signed
below by the following persons on behalf of the registrant and in capacities and
on the dates indicated.
/S/ Joseph V. Ciaburri March 28, 2005
---------------------- --------------
Joseph V. Ciaburri Date
Chairman, Chief Executive Officer and Director
/S/ Elmer F. Laydon March 28, 2005
------------------- --------------
Elmer F. Laydon Date
Vice Chairman and Director
/S/ Michael M. Ciaburri March 28, 2005
----------------------- --------------
Michael M. Ciaburri Date
President, Chief Operating Officer and Director
/S/ Joshua H. Sandman, Ph.D. March 28, 2005
---------------------------- --------------
Joshua H. Sandman Date
Director
/S/ Alphonse F. Spadaro, Jr. March 28, 2005
---------------------------- --------------
Alphonse F. Spadaro, Jr. Date
Director
/S/ Carl R. Borrelli March 28, 2005
-------------------- --------------
Carl R. Borrelli Date
Director
/S/James S. Brownstein, Esq. March 28, 2005
---------------------------- --------------
James S. Brownstein, Esq. Date
Director
/S/Juan Miquel Salas-Romer March 28, 2005
-------------------------- --------------
Juan Miguel Salas-Romer Date
Director
36
/S/ William F. Weaver March 28, 2005
--------------------- --------------
William F. Weaver Date
Chief Financial Officer
/S/ Anthony M. Avellani March 28, 2005
----------------------- --------------
Anthony M. Avellani Date
Chief Accounting Officer
37
Exhibit Index
No. Description
--- -----------
3(i) Amended and Restated Certificate of Incorporation of the Issuer
(incorporated by reference to Exhibit 3(i) to Issuer's Quarterly Report
on Form 10-QSB dated June 30, 2002)
3(ii) By-Laws of the Issuer (incorporated by reference to Exhibit 3(ii) to
the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
10.1 Lease, dated as of August 17, 2000, between 215 Church Street, LLC and
the Issuer (incorporated by reference to Exhibit 10.1 to the Issuer's
Registration Statement on Form SB-2 (No. 333-59824))
10.2 Letter agreement dated January 3, 2001 amending the Lease between 215
Church Street, LLC and the Issuer (incorporated by reference to Exhibit
10.2 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
10.3 First Amendment to Lease dated March 30, 2001 between 215 Church
Street, LLC and the Issuer (incorporated by reference to Exhibit 10.3
to the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
10.4 Second Amendment to Lease dated March 31, 2001 between 215 Church
Street, LLC and the Issuer (incorporated by reference to Exhibit 10.4
to the Issuer's Registration Statement Form SB-2 (No. 333-59824))
10.5 Assignment of Lease dated April 11, 2001 between the Issuer and The
Bank of Southern Connecticut (incorporated by reference to Exhibit 10.5
to the Issuer's Registration Statement on Form SB-2 (No. 333-59824))
10.6 Sublease dated January 1, 2001 between Michael Ciaburri, d/b/a Ciaburri
Bank Strategies and The Bank of Southern Connecticut (incorporated by
reference to Exhibit 10.10 to the Registrants Statement on Form SB-2
(No. 333-59824))
10.7 Sublease dated January 1, 2001 between Laydon & Company, LLC and The
Bank of Southern Connecticut (incorporated by reference to Exhibit
10.11 to the Registrants Statement on Form SB-2 (No. 333-59824))
10.8 Lease dated August 2, 2002 between 469 West Main Street LLC and The
Bank of Southern Connecticut (incorporated by reference to Exhibit
10.18 to the Registrants Form 10-KSB dated March 30, 2004)
10.9 Lease dated January 14, 2004 between The City of New London and the
Registrant (incorporated by reference to Exhibit 10.16 to the
Registrant's Form 10-KSB dated March 30, 2004)
10.10 Purchase Agreement dated June 22, 2004 between Dr. Alan Maris and James
S. Brownstein, Trustee relating to property and premises located at
51-53 West Main Street, Clinton, Connecticut
10.11 Employment Agreement dated as of January 23, 2001, between The Bank of
Southern Connecticut, the Issuer and Joseph V. Ciaburri (incorporated
by reference to Exhibit 10.6 to the Issuer's Registration Statement on
Form SB-2 (No. 333-59824))
10.12 Amendment to Employment Agreement dated as of October 20, 2003 among
the Registrant, The Bank of Southern Connecticut and Joseph V. Ciaburri
(incorporated by reference to Exhibit 10.6 to the Registrants
Registration Statement on Form SB-2 (No.
333-59824)
10.13 Amendment to Employment dated as of January 20, 2005, among the
Registrant, The Bank of Southern Connecticut and Michael M. Ciaburri
10.14 Registrants 2001 Stock Option Plan (incorporated by reference to
Exhibit 10.8 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
38
10.15 Registrants 2001 Warrant Plan (incorporated by reference to Exhibit
10.9 to the Issuer's Registration Statement on Form SB-2 (No.
333-59824))
10.16 Registrant's 2001 Supplemental Warrant Plan (incorporated by reference
to Exhibit 10.12 to Issuer's Annual Report on Form 10-KSB dated March
28, 2002)
10.17 Issuer's 2002 Stock Option Plan (incorporated by reference to Appendix
B to Issuer's Definitive Proxy Statement dated April 18, 2002).
10.18 Form of Stock Option Agreement for Non-qualified Stock Option granted
under the Registrant's 2002 Stock Option Plan (incorporated by
reference to the Registrant's Form 10-QSB dated November 15, 2004.
10.19 Form of Stock Option Agreement for Incentive Stock Option granted under
the Registrant's 2002 Stock Option Plan (incorporated by reference to
the Registrant's Form 10-QSB dated November 15, 2004.
10.20 Underwriting agreement dated June 16, 2004 among A.G.Edwards & Sons,
Inc. and Keefe, Bruyette & Woods, and the Registrant (Incorporated by
reference to Exhibit 1.1 to the Issuer's Registration Statement on Form
SB-2 (no. 333-598824)).
14 Amended and Restated Code of Ethics
21. Subsidiaries (incorporated by reference to Exhibit 21 to Issuer's form
10-KSB dated March 31, 2003)
31.1 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by Chairman and
Chief Executive Officer.
31.2 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by President and
Chief Operating Officer.
31.3 Section Rule 13(a)-14(a)/15(d)-14(a) Certification by Vice President
and Chief Financial Officer.
32.1 Section 1350 Certification by Chairman and Chief Executive Officer.
32.2 Section 1350 Certification by President and Chief Operating Officer.
32.3 Section 1350 Certification by Vice President and Chief Financial
Officer.
39
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
FINANCIAL REPORT
December 31, 2004 and 2003
CONTENTS
--------------------------------------------------------------------------
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 1
--------------------------------------------------------------------------
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets 2
Consolidated Statements of Operations 3
Consolidated Statements of Shareholders' Equity 4
Consolidated Statements of Cash Flows 5-6
Notes to Consolidated Financial Statements 7-35
--------------------------------------------------------------------------
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
To the Board of Directors
Southern Connecticut Bancorp, Inc. and Subsidiaries
New Haven, Connecticut
We have audited the accompanying consolidated balance sheets of Southern
Connecticut Bancorp, Inc. and Subsidiaries (the "Company") as of December 31,
2004 and 2003, and the related consolidated statements of operations,
shareholders' equity and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). 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 Southern Connecticut
Bancorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the results
of their operations and their cash flows for the years then ended, in conformity
with accounting principles generally accepted in the United States of America.
/s/ McGladrey & Pullen, LLP
---------------------------
New Haven, Connecticut
March 4, 2005
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003
------------------------------------------------------------------------------------------------------------------
2004 2003
-------------------------------
ASSETS
Cash and due from banks (Note 2) $ 1,986,193 $ 1,147,883
Federal funds sold 5,385,000 966,000
Short-term investments (Note 2) 8,372,689 454,115
-------------------------------
Cash and cash equivalents 15,743,882 2,567,998
-------------------------------
Available for sale securities (at fair value) (Note 3) 11,371,894 8,478,068
Federal Home Loan Bank stock (Note 7) 47,100 21,500
Loans receivable (net of allowance for loan losses: 2004 $752,394;
2003 $421,144) (Note 4) 49,763,952 40,818,718
Loans held for sale (at fair value) 98,742 -
Accrued interest receivable 265,581 196,545
Premises and equipment, net (Note 5) 3,516,814 3,467,998
Other assets 886,778 835,213
-------------------------------
Total assets $ 81,694,743 $ 56,386,040
===============================
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits (Note 6)
Noninterest bearing deposits $ 17,334,393 $ 13,781,286
Interest bearing deposits 41,365,984 33,492,589
-------------------------------
Total deposits 58,700,377 47,273,875
Repurchase agreements 827,031 339,752
Accrued expenses and other liabilities 279,422 267,232
Capital lease obligations (Note 8) 1,190,186 1,190,879
-------------------------------
Total liabilities 60,997,016 49,071,738
-------------------------------
Commitments and Contingencies (Notes 7, 8, 11, 12, 13, 16 and 17)
Shareholders' Equity (Notes 10 and 13)
Preferred stock, no par value; 500,000 shares authorized;
none issued - -
Common stock, par value $.01; shares authorized: 5,000,000;
shares issued and outstanding: 2004 2,797,711; 2003 1,063,320 27,977 10,633
Additional paid-in capital 24,085,612 10,704,269
Accumulated deficit (3,199,126) (3,100,842)
Accumulated other comprehensive loss - net unrealized loss on
available for sale securities (216,736) (299,758)
-------------------------------
Total shareholders' equity 20,697,727 7,314,302
-------------------------------
Total liabilities and shareholders' equity $ 81,694,743 $ 56,386,040
===============================
See Notes to Consolidated Financial Statements.
2
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2004 and 2003
-------------------------------------------------------------------------------------------------------------------
2004 2003
------------------------------
Interest Income:
Interest and fees on loans $ 3,542,468 $2,224,547
Interest on securities 268,707 255,545
Interest on Federal funds sold and short-term investments 137,936 31,994
------------------------------
Total interest income 3,949,111 2,512,086
------------------------------
Interest Expense:
Interest expense on deposits (Note 6) 612,519 397,993
Interest expense on capital lease obligations 171,105 168,767
Interest expense on repurchase agreements and other borrowings 9,143 8,035
------------------------------
Total interest expense 792,767 574,795
------------------------------
Net interest income 3,156,344 1,937,291
------------------------------
Provision for Loan Losses (Note 4) 341,108 213,100
------------------------------
Net interest income after
provision for loan losses 2,815,236 1,724,191
------------------------------
Noninterest Income:
Service charges and fees 332,233 128,251
Gains and fees from sales and referrals of SBA loans 397,801 177,018
Gains on sales of available for sale securities (Note 3) 3,912 44,505
Other noninterest income 212,029 146,558
------------------------------
Total noninterest income 945,975 496,332
------------------------------
Noninterest Expenses:
Salaries and benefits (Note 7) 1,963,187 1,462,085
Occupancy and equipment expense 517,574 369,794
Professional services 478,843 307,423
Data processing and other outside services 283,798 196,820
Advertising and promotional expenses 98,755 94,614
Forms, printing and supplies 79,059 59,828
Other operating expenses 438,279 327,886
------------------------------
Total noninterest expenses 3,859,495 2,818,450
------------------------------
Net loss $ (98,284) $ (597,927)
==============================
Basic and Diluted Loss per Share $ (0.05) $ (0.56)
==============================
Dividends per Share $ - $ -
==============================
See Notes to Consolidated Financial Statements.
3
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Years Ended December 31,
2004 and 2003
------------------------------------------------------------------------------------------------------------------------------------
Accumulated
Additional Other
Number Common Paid-In Accumulated Comprehensive
of Shares Stock Capital Deficit Income (Loss) Total
------------------------------------------------------------------------------------
Balance, December 31, 2002 966,667 $ 9,667 $ 10,705,382 $ (2,502,915) $ 62,545 $ 8,274,679
Comprehensive loss:
Net loss - - - (597,927) - (597,927)
Unrealized holding loss on available for
sale securities (Note 15) - - - - (362,303) (362,303)
--------------
Total comprehensive loss (960,230)
--------------
10% stock dividend declared January 13,
2004 - 96,653 shares 96,653 966 (966) - - -
Fractional shares payable in cash - - (147) - - (147)
------------------------------------------------------------------------------------
Balance, December 31, 2003 1,063,320 10,633 10,704,269 (3,100,842) (299,758) 7,314,302
--------------
Comprehensive loss:
Net loss - - - (98,284) - (98,284)
Unrealized holding gain on available for
sale securities (Note 15) - - - - 83,022 83,022
--------------
Total comprehensive loss (15,262)
--------------
Exercise of stock options and warrants (Note 10) 11,391 114 105,561 - - 105,675
Issuance of common stock in public
offering (Note 10) 1,723,000 17,230 13,275,782 - - 13,293,012
--------------------------------------------------------------------- --------------
Balance, December 31, 2004 2,797,711 $27,977 $ 24,085,612 $ (3,199,126) $ (216,736) $ 20,697,727
===================================================================== ==============
See Notes to Consolidated Financial Statements.
4
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2004 and 2003
------------------------------------------------------------------------------------------------------------------
2004 2003
-----------------------------------
Cash Flows From Operations
Net loss $ (98,284) $ (597,927)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Amortization and accretion of premiums and discounts
on investments, net (3,004) 34,071
Provision for loan losses 341,108 213,100
Gains on sales of available for sale securities (3,912) (44,505)
SBA loans originated for sale (3,354,927) -
Proceeds from sales of SBA loans 3,613,839 1,295,122
Gains on sales of SBA loans (357,654) (122,269)
Depreciation and amortization 283,250 219,853
Increase in cash surrender value of life insurance (37,684) (38,344)
Changes in assets and liabilities:
Increase in deferred loan fees 35,677 29,219
Increase in accrued interest receivable (69,036) (8,873)
Increase in other assets (13,881) (148,063)
Increase in accrued expenses and other liabilities 12,190 88,596
-----------------------------------
Net cash provided by operating activities 347,682 919,980
-----------------------------------
Cash Flows From Investing Activities
Purchases of available for sale securities (11,965,630) (10,949,683)
Principal repayments on available for sale securities 1,161,057 1,038,338
Proceeds from maturities of available for sale securities 6,000,000 6,185,000
Proceeds from sales of available for sale securities 2,000,685 4,357,995
Purchase of FHLB stock (25,600) (21,000)
Net increase in loans receivable (9,438,532) (23,184,678)
Purchases of premises and equipment (332,066) (626,847)
Proceeds from sale of OREO 116,513 -
-----------------------------------
Net cash used in investing activities (12,483,573) (23,200,875)
-----------------------------------
Cash Flows From Financing Activities
Net increase in demand, savings and money market deposits 12,782,371 18,523,708
Net (decrease) increase in time certificates of deposit (1,355,869) 3,757,236
Net increase (decrease) in repurchase agreements 487,279 (482,507)
Principal repayments on capital lease obligations (693) (973)
Net proceeds from common stock offering 13,293,012 -
Proceeds from exercise of stock options and warrants 105,675 -
-----------------------------------
Net cash provided by financing activities 25,311,775 21,797,464
-----------------------------------
Net increase (decrease) in cash and cash equivalents 13,175,884 (483,431)
Cash and cash equivalents
Beginning 2,567,998 3,051,429
-----------------------------------
Ending $ 15,743,882 $ 2,567,998
===================================
(Continued)
5
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued
For the Years Ended December 31, 2004 and 2003
------------------------------------------------------------------------------------------------------------------
2004 2003
-----------------------------------
Supplemental Disclosures of Cash Flow Information:
Cash paid for:
Interest $ 777,142 $ 551,398
===================================
Income taxes $ - $ -
===================================
Supplemental Disclosures of Non-Cash Investing and Financing Activities:
Transfer of loans to OREO $ 116,513 $ -
===================================
Unrealized holding gains (losses) on available for sale securities arising
during the period $ 83,022 $ (402,208)
===================================
Fractional stock dividend shares payable in cash $ - $ 147
===================================
See Notes to Consolidated Financial Statements.
6
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 1. Nature of Operations and Summary of Significant Accounting Policies
Southern Connecticut Bancorp, Inc. (the "Company"), a Connecticut corporation,
is a bank holding company incorporated on November 8, 2000 and is the sole
shareholder of the Bank of Southern Connecticut (the "Bank"). The Bank provides
a full range of banking services to commercial and consumer customers, primarily
concentrated in the New Haven County area of Connecticut, through its main
office in New Haven, Connecticut and two branch offices in New Haven and
Branford, Connecticut. In 2003, SCB Capital, Inc. was formed as a Connecticut
corporation, and in 2004, the Company capitalized SCB Capital, Inc., which
became a subsidiary of the Company. SCB Capital, Inc., which is currently
inactive, will engage in a limited range of investment banking, advisory and
brokerage services, primarily with small and medium size business clients.
Principles of consolidation and basis of financial statement presentation
-------------------------------------------------------------------------
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, the Bank and SCB Capital, and have been prepared
in accordance with accounting principles generally accepted in the United States
of America and general practices within the banking industry. All significant
intercompany balances and transactions have been eliminated. In preparing the
consolidated financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities, and
disclosures of contingent assets and liabilities as of the date of the balance
sheet and the reported amounts of income and expenses for the reporting period.
Actual results could differ from those estimates.
Significant group concentrations of credit risk
-----------------------------------------------
Most of the Company's activities are with customers located within the New Haven
County region of Connecticut. Note 3 discusses the types of securities that the
Company invests in and Note 4 discusses the types of lending that the Company
engages in. The Company does not have any significant concentrations in any one
industry or customer.
The following is a summary of the Company's significant accounting policies.
Cash and cash equivalents and statement of cash flows
-----------------------------------------------------
Cash and due from banks, Federal funds sold, and short-term investments are
recognized as cash equivalents in the statements of cash flows. Federal funds
sold generally mature in one day. For purposes of reporting cash flows, the
Company considers all highly liquid debt instruments purchased with an original
maturity of three months or less to be cash equivalents. Cash flows from
deposits are reported net. The Company maintains amounts due from banks and
Federal funds sold which, at times, may exceed Federally insured limits. The
Company has not experienced any losses from such concentrations.
7
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Investments in debt and marketable equity securities
----------------------------------------------------
Management determines the appropriate classification of securities at the date
individual investment securities are acquired, and the appropriateness of such
classification is reassessed at each balance sheet date.
Debt securities that management has the positive intent and ability to hold to
maturity are classified as "held to maturity" and recorded at amortized cost.
"Trading" securities, if any, are carried at fair value with unrealized gains
and losses recognized in earnings. Securities not classified as held to maturity
or trading, including equity securities with readily determinable fair values,
are classified as "available for sale" and recorded at fair value, with
unrealized gains and losses excluded from earnings and reported in other
comprehensive income, net of taxes.
Purchase premiums and discounts are recognized in interest income using the
interest method over the terms of the securities. Declines in the fair value of
held to maturity and available for sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized losses.
In estimating other-than-temporary impairment losses, management considers (1)
the length of time and the extent to which the fair value has been less than
cost, (2) the financial condition and near-term prospects of the issuer, and (3)
the intent and ability of the Company to retain its investment in the issuer for
a period of time sufficient to allow for any anticipated recovery in fair value.
Gains and losses on the sale of securities are recorded on the trade date and
are determined using the specific identification method.
The sale of a held to maturity security within three months of its maturity date
or after collection of at least 85% of the principal outstanding at the time the
security was acquired is considered a maturity for purposes of classification
and disclosure.
Loans held for sale
-------------------
Loans held for sale are those guaranteed portions of SBA loans the Company has
the intent to sell in the foreseeable future, and are carried at the lower of
aggregate cost or market value. Gains and losses on sales of loans are
recognized at the trade dates, and are determined by the difference between the
sales proceeds and the carrying value of the loans.
Transfers of financial assets
-----------------------------
Transfers of financial assets are accounted for as sales when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right to pledge or exchange the transferred assets and no
condition both constrains the transferee from taking advantage of that right and
provides more than a trivial benefit for the transferor, and (3) the transferor
does not maintain effective control over the transferred assets through either
(a) an agreement that both entitles and obligates the transferor to repurchase
or redeem the assets before maturity or (b) the ability to unilaterally cause
the holder to return specific assets, other than through a cleanup call.
8
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Servicing
---------
Servicing assets are recognized as separate assets when rights are acquired
through purchase or through sale of financial assets. Generally, purchased
servicing rights are capitalized at the cost to acquire the rights. For sales of
loans, a portion of the original cost of the loan is allocated to the servicing
right, and if the pass-through rate to the investor is less than the note rate,
to an interest-only strip, based on relative fair value. Fair value is based on
a valuation model that calculates the present value of estimated future net
servicing and interest income. The valuation model incorporates assumptions that
market participants would use in estimating future net servicing and interest
income, such as the cost to service, the discount rate, the custodial earnings
rate, an inflation rate, ancillary income, prepayment speeds and default rates
and losses. Capitalized servicing rights are reported in other assets and are
amortized into non-interest income in proportion to, and over the period of, the
estimated future net servicing income of the underlying financial assets.
Interest only strips are also reported in other assets and are amortized into
interest income under the same method as servicing assets.
Servicing assets and interest-only strips are evaluated for impairment based
upon the fair value of the assets as compared to amortized cost. Impairment is
determined by stratifying the assets into tranches based on predominant risk
characteristics, such as interest rate, loan type and investor type. Impairment
is recognized through a valuation allowance for an individual tranche, to the
extent that fair value is less than the capitalized amount for the tranche. If
the Company later determines that all or a portion of the impairment no longer
exists for a particular tranche, a reduction of the allowance may be recorded as
an increase to income.
Servicing fee income is recorded for fees earned for servicing loans. The fees
are based on a contractual percentage of the outstanding principal, or a fixed
amount per loan, and are recorded as income when earned. The amortization of
mortgage servicing rights is netted against loan servicing fee income, and the
amortization of interest-only strips is netted against interest income.
Loans receivable
----------------
Loans receivable are stated at their current unpaid principal balances, net of
the allowance for loan losses and net deferred loan origination fees and costs.
The Company has the ability and intent to hold its loans receivable for the
foreseeable future or until maturity or payoff.
Impaired loans, if any, are measured based on the present value of expected
future cash flows discounted at the loan's effective interest rate or, as a
practical expedient, at the loan's observable market price or the fair value of
the collateral, if the loan is collateral dependent. The amount of impairment,
if any, and any subsequent changes are recorded as adjustments to the allowance
for loan losses. A loan is impaired when it is probable the Company will be
unable to collect all contractual principal and interest payments due in
accordance with the terms of the loan agreement.
9
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
A loan is classified as a restructured loan when certain concessions have been
made to the original contractual terms, such as a reduction in interest rate or
deferral of interest or principal payments, due to the borrower's financial
condition.
Management considers all nonaccrual loans, other loans past due 90 days or more,
and restructured loans to be impaired. In most cases, loan payments that are
past due less than 90 days, based on contractual terms, are considered minor
collection delays, and the related loans are not considered to be impaired.
Allowance for loan losses
-------------------------
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loans are
charged against the allowance when management believes the uncollectibility of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance.
The allowance for loan losses is evaluated on a regular basis by management and
is based upon management's periodic review of the collectibility of the loans in
light of historical experience, the nature and volume of the loan portfolio,
adverse situations that may affect the borrower's ability to repay, estimated
value of any underlying collateral and prevailing economic conditions. This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The
specific component relates to loans that are classified as either doubtful,
substandard or special mention. For such loans that are also classified as
impaired, an allowance is established when the discounted cash flows (or
collateral value or observable market price) of the impaired loan is lower than
the carrying value of that loan. The general component covers non-classified
loans and is based on historical loss experience adjusted for qualitative
factors. An unallocated component may be maintained to cover uncertainties that
could affect management's estimate of probable losses. The unallocated component
of the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.
Interest and fees on loans
--------------------------
Interest on loans is accrued and included in operating income based on
contractual rates applied to principal amounts outstanding. The accrual of
interest income is discontinued whenever reasonable doubt exists as to its
collectibility and generally is discontinued when loans are past due 90 days,
based on contractual terms, as to either principal or interest, or are otherwise
considered impaired. When the accrual of interest income is discontinued, all
previously accrued and uncollected interest is reversed against interest income.
The accrual of interest on loans past due 90 days or more may be continued if
the loan is well secured, and it is believed all principal and accrued interest
income due on the loan will be realized, and the loan is in the process of
collection. A nonaccrual loan is restored to an accrual status when it is no
longer delinquent and collectibility of interest and principal is no longer in
doubt.
Loan origination fees, net of direct loan origination costs, are deferred and
amortized as an adjustment of the loan's yield generally over the contractual
life of the loan, utilizing the interest method.
10
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Other real estate owned
-----------------------
Other real estate owned, if any, consists of properties acquired through, or in
lieu of, loan foreclosure or other proceedings and is initially recorded at fair
value at the date of foreclosure, which establishes a new cost basis. After
foreclosure, the properties are held for sale and are carried at the lower of
cost or fair value less estimated costs of disposal. Any write-down to fair
value at the time of acquisition is charged to the allowance for loan losses.
Properties are evaluated regularly to ensure the recorded amounts are supported
by current fair values, and valuation allowances are recorded as necessary to
reduce the carrying amount to fair value less estimated cost of disposal.
Revenue and expense from the operation of other real estate owned and valuation
allowances are included in operations. Costs relating to the development and
improvement of the property are capitalized, subject to the limit of fair value
of the collateral. Gains or losses are included in operations upon disposal.
Premises and equipment
----------------------
Premises and equipment are stated at cost for purchased assets, and, for assets
under capital lease, at the lower of fair value or the net present value of the
minimum lease payments required over the term of the lease, net of accumulated
depreciation and amortization. Leasehold improvements are capitalized and
amortized over the shorter of the terms of the related leases or the estimated
economic lives of the improvements. Depreciation is charged to operations using
the straight-line method over the estimated useful lives of the related assets
which range from 3 to 20 years. Gains and losses on dispositions are recognized
upon realization. Maintenance and repairs are expensed as incurred and
improvements are capitalized.
Impairment of long-lived assets
-------------------------------
Long-lived assets, including premises and equipment, which are held and used by
the Company, are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If impairment is indicated by that review, the asset is written
down to its estimated fair value through a charge to noninterest expense.
Repurchase agreements
---------------------
Repurchase agreements, which are classified as secured borrowings, generally
mature within one to three days from the transaction date, and are reflected at
the amount of cash received in connection with the transaction. The Company may
be required to provide additional collateral based on the fair value of the
underlying securities.
Income taxes
------------
The Company recognizes income taxes under the asset and liability method. Under
this method, deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, and loss carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered
11
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
or settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Deferred tax assets are reduced by a valuation allowance when, in the opinion of
management, it is more likely than not that some portion or all of the deferred
tax assets will not be realized.
Stock compensation plans
------------------------
Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation," encourages all entities to adopt a fair value based
method of accounting for employee stock compensation plans, whereby compensation
cost is measured at the grant date based on the value of the award and is
recognized over the service period, which is usually the vesting period.
However, it also allows an entity to continue to measure compensation cost for
those plans using the intrinsic value based method of accounting prescribed by
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," whereby compensation cost is the excess, if any, of the quoted
market price of the stock at the grant date (or other measurement date) over the
amount an employee must pay to acquire the stock. Stock options issued to
employees and directors under the Company's stock option and warrant plans have
no intrinsic value at the grant date, and under Opinion No. 25 no compensation
cost is recognized for them. The Company has elected to continue with the
accounting methodology in Opinion No. 25 and, as a result, has provided pro
forma disclosures of net loss and earnings (loss) per share and other
disclosures, as if the fair value based method of accounting had been applied.
See "Recent Accounting Pronouncements" below for developments regarding
accounting for stock compensation plans.
Had compensation cost for issuance of such options and warrants been recognized
based on the fair values of awards on the grant dates, in accordance with the
method described in SFAS No. 123, reported net loss and per share amounts for
2004 and 2003 would have been increased to the pro forma amounts shown below:
2004 2003
--------------------------------------
Net loss, as reported $ (98,284) $ (597,927)
Deduct: total stock-based employee
compensation expense determined
under fair value based method
for all awards (304,387) (229,473)
--------------------------------------
Pro forma net loss $ (402,671) $ (827,400)
======================================
Basic and diluted loss per share:
As reported $ (0.05) $ (0.56)
======================================
Pro forma $ (0.20) $ (0.78)
======================================
12
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Related party transactions
--------------------------
Directors and officers of the Company and the Bank and their affiliates have
been customers of and have had transactions with the Bank, and it is expected
that such persons will continue to have such transactions in the future.
Management believes that all deposit accounts, loans, services and commitments
comprising such transactions were made in the ordinary course of business, and
on substantially the same terms, including interest rates, as those prevailing
at the time for comparable transactions with other customers who are not
directors or officers. In the opinion of management, the transactions with
related parties did not involve more than normal risks of collectibility or
favored treatment or terms, or present other unfavorable features. Notes 2, 8
and 14 contain details regarding related party transactions.
Comprehensive income
--------------------
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available for sale
securities, are reported as a separate component of the shareholders' equity
section of the balance sheets, such items, along with net income or loss, are
components of comprehensive income.
Fair value of financial instruments
-----------------------------------
The following methods and assumptions were used by the Company in estimating the
fair value of its financial instruments.
Cash and due from banks, Federal funds sold, short-term investments,
accrued interest receivable and repurchase agreements
The carrying amount is a reasonable estimate of fair value.
Securities
Fair values, excluding restricted Federal Home Loan Bank stock, are based
on quoted market prices or dealer quotes, if available. If a quoted market
price is not available, fair value is estimated using quoted market prices
for similar securities. The carrying value of Federal Home Loan Bank stock
approximates fair value based on the redemption provisions of the stock.
Loans held for sale
The fair value is based on prevailing market prices.
Loans receivable
For variable rate loans which reprice frequently, and have no significant
changes in credit risk, fair value is based on the loan's carrying value.
The fair value of fixed rate loans is estimated by discounting the future
cash flows using the year-end rates at which similar loans would be made
to borrow.
13
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Servicing assets
The fair value is based on market prices for comparable servicing
contracts, when available, or alternatively, is based on a valuation model
that calculates the present value of estimated future net servicing
income.
Deposits
The fair value of demand deposits, regular savings and certain money
market deposits is the amount payable on demand at the reporting date. The
fair value of certificates of deposit and other time deposits is estimated
using a discounted cash flow calculation that applies interest rates
currently being offered for deposits of similar remaining maturities to a
schedule of aggregated expected maturities on such deposits.
Off-balance-sheet instruments
Fair values for the Company's off-balance-sheet instruments (lending
commitments) are based on fees currently charged to enter into similar
agreements, taking into account the remaining terms of the agreements and
the counterparties' credit standing.
Recent accounting pronouncements
--------------------------------
In April 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 149, "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities." This Statement
amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities," and clarifies accounting for derivative instruments, including
certain derivative instruments embedded in other contracts, and for hedging
activities under SFAS No. 133. This Statement is effective for contracts entered
into or modified after June 30, 2003. This Statement had no effect on the
Company's financial statements.
In December 2003, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 03-3 ("SOP 03-3"), "Accounting for Certain
Loans or Debt Securities Acquired in a Transfer." SOP 03-3 addresses the
accounting for differences between contractual cash flows and the cash flows
expected to be collected from purchased loans or debt securities if those
differences are attributable, in part, to credit quality. SOP 03-3 requires
purchased loans and debt securities to be recorded initially at fair value based
on the present value of the cash flows expected to be collected with no
carryover of any valuation allowance previously recognized by the seller.
Interest income should be recognized based on the effective yield from the cash
flows expected to be collected. To the extent that the purchased loans or debt
securities experience subsequent deterioration in credit quality, a valuation
allowance would be established for any additional cash flows that are not
expected to be received. However, if more cash flows subsequently are expected
to be received than originally estimated, the effective yield would be adjusted
on a prospective basis. SOP 03-3 will be effective for loans and debt securities
acquired after December 31, 2004. Management does not expect the adoption of
this statement to have a material impact on the Company's financial statements.
14
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
On September 30, 2004, the Financial Accounting Standards Board ("FASB") issued
FASB Staff Position ("FSP") Emerging Issues Task Force ("EITF") Issue No. 03-1-1
delaying the effective date of paragraphs 10-20 of EITF 03-1, "The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments,"
which provides guidance for determining the meaning of "other-than-temporarily
impaired" and its application to certain debt and equity securities within the
scope of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," and investments accounted for under the cost method. The guidance
requires that investments which have declined in value due to credit concerns or
solely due to changes in interest rates must be recorded as
other-than-temporarily impaired unless the Company can assert and demonstrate
its intention to hold the security for a period of time sufficient to allow for
a recovery of fair value up to or beyond the cost of the investment which might
mean maturity. The delay of the effective date of EITF 03-1 will be superseded
concurrent with the final issuance of proposed FSP Issue 03-1-a. Proposed FSP
Issue 03-1-a is intended to provide implementation guidance with respect to all
securities analyzed for impairment under paragraphs 10-20 of EITF 03-1.
Management continues to closely monitor and evaluate how the provisions of EITF
03-1 and proposed FSP Issue 03-1-a will affect the Company.
In December 2004, the FASB published FASB Statement No. 123 (revised 2004),
"Share-Based Payment" ("SFAS 123(R)"). SFAS 123(R) requires that the
compensation cost relating to share-based payment transactions, including grants
of employee stock options, be recognized in financial statements. That cost will
be measured based on the fair value of the equity or liability instruments
issued. SFAS 123(R) covers a wide range of share-based compensation arrangements
including stock options, restricted share plans, performance-based awards, share
appreciation rights, and employee share purchase plans. SFAS 123(R) is a
replacement of FASB Statement No. 123, "Accounting for Stock-Based
Compensation," and supersedes APB Opinion No. 25, "Accounting for Stock Issued
to Employees," and its related interpretive guidance (APB 25).
The effect of SFAS 123(R) will be to require entities to measure the cost of
employee services received in exchange for stock options based on the grant-date
fair value of the award, and to recognize the cost over the period the employee
is required to provide services for the award. SFAS 123(R) permits entities to
use any option-pricing model that meets the fair value objective in the
Statement.
The Company will be required to apply SFAS 123(R) as of the beginning of its
first interim period that begins after December 15, 2005, which will be the
quarter ending March 31, 2006.
SFAS 123(R) allows two methods for determining the effects of the transition:
the modified prospective transition method and the modified retrospective method
of transition. Under the modified prospective transition method, an entity would
use the fair value based accounting method for all employee awards granted,
modified, or settled after the effective date. As of the effective date,
compensation cost related to the non-vested portion of awards outstanding as of
that date would be based on the grant-date fair value of those awards as
calculated under the original provisions of Statement No. 123; that is, an
entity would not remeasure the grant-date fair value estimate of the unvested
portion of awards granted prior to the effective date. An entity will have the
further option to either apply SFAS 123(R) to all quarters in the fiscal year of
adoption. Under the modified retrospective method of transition, an entity would
revise its previously
15
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
issued financial statements to recognize employee
compensation cost for prior periods presented in accordance with the original
provisions of Statement No. 123.
The Company has not completed its study of the transition methods or made any
decisions about how it will adopt FAS 123(R). The impact of FAS 123(R) on the
Company in Fiscal 2006 and beyond will depend upon various factors, among them
being the Company's future compensation strategy. The pro forma compensation
costs presented in the table above and in prior filings for the Company have
been calculated using a Black-Scholes option pricing model and may not be
indicative of amounts which should be expected in future years. No decisions
have been made as to which option-pricing model is most appropriate for the
Company for future awards.
In March 2004, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin ("SAB") No. 105, "Application of Accounting Principles to
Loan Commitments," which provides guidance regarding loan commitments that are
accounted for as derivative instruments. In this SAB, the SEC determined that an
interest rate lock commitment should generally be valued at zero at inception.
The rate locks will continue to be adjusted for changes in value resulting from
changes in market interest rates. This SAB did not have any effect on the
Company's financial position or results of operations.
Reclassifications
-----------------
Certain 2003 amounts have been reclassified to conform with the 2004
presentation, and such reclassifications had no effect on 2003 net loss or
shareholders' equity.
Note 2. Restrictions on Cash and Cash Equivalents
The Company is required to maintain reserves against its respective transaction
accounts and non-personal time deposits. At December 31, 2004 and 2003, the
Company was required to have cash and liquid assets of approximately $248,000
and $208,000, respectively, to meet these requirements. In addition, at December
31, 2004 and 2003, the Company was required to maintain $125,000 in the Federal
Reserve Bank for clearing purposes. Also, at December 31, 2004 and 2003,
approximately $158,000 and $212,000, respectively, of short-term investments are
maintained at another financial institution to secure available customer letters
of credit with that institution, and approximately $11,000 of short-term
investments was maintained with that institution at December 31, 2003 to secure
an available credit card line of credit for a Company director.
16
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 3. Available for Sale Securities
The amortized cost, gross unrealized gains, gross unrealized losses and
approximate fair values of available for sale securities at December 31, 2004
and 2003 are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
2004 Cost Gains Losses Value
---- -------------------------------------------------------------------
U.S. Government Sponsored Agency $11,192,594 $ 3,398 $ (214,486) $10,981,506
obligations
Mortgage-backed securities 396,036 - (5,648) 390,388
-------------------------------------------------------------------
$11,588,630 $ 3,398 $ (220,134) $11,371,894
===================================================================
Gross Gross
Amortized Unrealized Unrealized Fair
2003 Cost Gains Losses Value
---- -------------------------------------------------------------------
U.S. Government Sponsored Agency $ 7,200,948 $ - $ (269,550) $ 6,931,398
obligations
Mortgage-backed securities 1,576,878 - (30,208) 1,546,670
-------------------------------------------------------------------
$ 8,777,826 $ - $ (299,758) $ 8,478,068
===================================================================
The following table presents the Company's available for sale securities' gross
unrealized losses and fair value, aggregated by the length of time the
individual securities have been in a continuous loss position, at December 31,
2004.
Less Than 12 Months 12 Months or More Total
----------------------------- ---------------------------- ------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
----------------------------- ---------------------------- ------------------------------
U.S. Government
Sponsored Agency
obligations $ 497,030 $ 2,970 $ 7,482,916 $ 211,516 $ 7,979,946 $ 214,486
Mortgage-backed
securities - - 390,388 5,648 390,388 5,648
----------------------------- ---------------------------- ------------------------------
Totals $ 497,030 $ 2,970 $ 7,873,304 $ 217,164 $ 8,370,334 $ 220,134
============================= ============================ ==============================
17
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
At December 31, 2003, all unrealized losses on available-for-sale securities
existed for periods of less than twelve months.
At December 31, 2004, the Company had 12 available for sale securities in an
unrealized loss position. Management believes that none of the unrealized losses
on available for sale securities are other than temporary because all of the
unrealized losses in the Company's investment portfolio relate to debt and
mortgage-backed securities issued by U.S. Government sponsored agencies, which
the Company has both the intent and the ability to hold until maturity or until
the fair value fully recovers. In addition, management considers the issuers of
the securities to be financially sound and the Company will receive all
contractual principal and interest related to these investments.
The amortized cost and fair value of available for sale debt securities at
December 31, 2004 by contractual maturity are presented below. Actual maturities
of mortgage-backed securities may differ from contractual maturities because the
mortgages underlying the securities may be called or repaid without any
penalties.
Because mortgage-backed securities are not due at a single maturity date, they
are not included in the maturity categories in the following summary:
Amortized Fair
Cost Value
-------------------------------------
Maturity:
Within one year $ 998,097 $ 992,810
After 1 but within 5 years 6,494,857 6,430,475
After 5 but within 10 years 3,199,640 3,084,906
Over 10 years 500,000 473,315
Mortgage-backed securities 396,036 390,388
-------------------------------------
$ 11,588,630 $ 11,371,894
=====================================
At December 31, 2004 and 2003, available for sale securities with a carrying
value of $4,838,791 and $2,911,572, respectively, were pledged as collateral
under repurchase agreements with Bank customers and to secure public deposits.
During 2004 and 2003, proceeds from sales of available for sale securities were
$2,000,685 and $4,357,995, respectively, and gross gains of $3,912 and $44,505,
respectively, were recognized on such sales.
18
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 4. Loans Receivable and Allowance for Loan Losses
A summary of the Company's loan portfolio at December 31, 2004 and 2003 is as
follows:
2004 2003
-------------------------------------
Commercial loans secured by real estate $ 22,462,363 $ 18,043,588
Commercial loans 24,418,458 18,584,292
Construction and land loans 2,276,818 1,500,891
Residential mortgages - 948,258
Consumer home equity loans 853,858 1,042,717
Consumer installment loans 625,330 1,204,920
-------------------------------------
Total loans 50,636,827 41,324,666
Net deferred loan fees (120,481) (84,804)
Allowance for loan losses (752,394) (421,144)
-------------------------------------
Loans receivable, net $ 49,763,952 $ 40,818,718
=====================================
The Company services certain loans that it has sold without recourse to third
parties. The aggregate of loans serviced for others approximated $5,796,324 and
$1,174,000 as of December 31, 2004 and 2003, respectively.
The balance of capitalized servicing rights, included in other assets at
December 31, 2004 and 2003, was $66,959 and $20,798, respectively. No impairment
charges related to servicing rights were recognized during the years ended
December 31, 2004 and 2003.
The changes in the allowance for loan losses for the years ended December 31,
2004 and 2003 are as follows:
2004 2003
------------------------------
Balance, beginning of year $ 421,144 $ 232,000
Provision for loan losses 341,108 213,100
Recoveries of loans previously charged-off 19,118 616
Loans charged-off (28,976) (24,572)
------------------------------
Balance, end of year $ 752,394 $ 421,144
==============================
At December 31, 2004 and 2003, the unpaid principal balances of loans placed on
nonaccrual status were $227,358 and $94,063, respectively. At December 31, 2004
and 2003, there were no loans delinquent 90 days or more and still accruing
interest.
19
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
The following information relates to impaired loans as of and for the years
ended December 31, 2004 and 2003:
2004 2003
--------------------------------
Loans receivable for which there is a related allowance for credit
losses $ 224,154 $ 94,063
================================
Loans receivable for which there is no related allowance for credit
losses $ 3,204 $ -
================================
Allowance for credit losses related to impaired loans $ 106,589 $ 21,381
================================
Average recorded investment in impaired loans $ 37,367 $ 13,317
================================
Interest income collected and recognized on impaired loans was $4,286 in 2004,
and no interest was collected or recognized on impaired loans in 2003. If
nonaccrual loans had been current throughout their terms, additional interest
income of approximately $2,300 and $4,800 would have been recognized in 2004 and
2003, respectively. The Company has no commitments to lend additional funds to
borrowers whose loans are impaired.
The Company's lending activities are conducted principally in the New Haven
County section of Connecticut. The Company grants commercial and residential
real estate loans, commercial business loans and a variety of consumer loans. In
addition, the Company may grant loans for the construction of residential homes,
residential developments and for land development projects. All residential and
commercial mortgage loans are collateralized by first or second mortgages on
real estate. The ability and willingness of borrowers to satisfy their loan
obligations is dependent in large part upon the status of the regional economy
and regional real estate market. Accordingly, the ultimate collectibility of a
substantial portion of any resulting real estate acquired is susceptible to
changes in market conditions.
The Company has established credit policies applicable to each type of lending
activity in which it engages, evaluates the creditworthiness of each customer on
an individual basis and, when deemed appropriate, obtains collateral. Collateral
varies by each borrower and loan type. The market value of collateral is
monitored on an ongoing basis and additional collateral is obtained when
warranted. Important types of collateral include business assets, real estate,
automobiles, marketable securities and time deposits. While collateral provides
assurance as a secondary source of repayment, the Company ordinarily requires
the primary source of repayment to be based on the borrower's ability to
generate continuing cash flows.
20
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 5. Premises and Equipment
At December 31, 2004 and 2003, premises and equipment consisted of the
following:
2004 2003
-------------------------------------
Land $ 255,766 $ 255,766
Premises under capital lease 1,192,036 1,192,036
Building and improvements 674,046 674,046
Leasehold improvements 852,647 817,366
Furniture and fixtures 433,305 399,032
Equipment 545,428 483,626
Software 49,643 26,589
Construction in process 177,656 -
-------------------------------------
4,180,527 3,848,461
Less accumulated depreciation and amortization (663,713) (380,463)
-------------------------------------
$ 3,516,814 $ 3,467,998
=====================================
For the years ended December 31, 2004 and 2003, depreciation and amortization
expense related to premises and equipment totaled $283,250 and $219,853,
respectively.
Premises under capital lease of $1,192,036, and related accumulated amortization
of $165,292 and $105,690, as of December 31, 2004 and 2003, respectively, are
included in premises and equipment.
Note 6. Deposits
At December 31, 2004 and 2003, deposits consisted of the following:
2004 2003
-------------------------------------
Noninterest bearing $ 17,334,393 $ 13,781,286
-------------------------------------
Interest bearing:
Checking 8,708,930 3,499,378
Money market 20,604,704 17,251,327
Savings 3,299,676 2,633,341
Time certificates, less than $100,000 3,241,527 3,057,294
Time certificates, $100,000 or more 5,511,147 7,051,249
-------------------------------------
Total interest bearing 41,365,984 33,492,589
-------------------------------------
Total deposits $ 58,700,377 $ 47,273,875
=====================================
21
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Contractual maturities of time certificates of deposit as of December 31, 2004
are summarized below:
Due within:
1 year $ 7,117,220
1-2 years 807,758
2-3 years 632,416
3-4 years 139,805
4-5 years 55,475
------------------
$ 8,752,674
==================
Interest expense on certificates of deposit in denominations of $100,000 or more
was $150,468 and $90,394 for the years ended December 31, 2004 and 2003,
respectively.
Note 7. Commitments
Federal Home Loan Bank borrowings and stock
-------------------------------------------
The Bank is a member of the Federal Home Loan Bank of Boston ("FHLB"). At
December 31, 2004 and 2003, the Bank had the ability to borrow from the FHLB
based on a certain percentage of the value of the Bank's qualified collateral,
as defined in the FHLB Statement of Products Policy, at the time of the
borrowing. In accordance with an agreement with the FHLB, the qualified
collateral must be free and clear of liens, pledges and encumbrances. There were
no borrowings outstanding with the FHLB at December 31, 2004 and 2003.
The Bank is required to maintain an investment in capital stock of the FHLB in
an amount equal to a percentage of its outstanding mortgage loans and contracts
secured by residential properties, including mortgage-backed securities. No
ready market exists for FHLB stock and it has no quoted market value. For
disclosure purposes, such stock is assumed to have a market value which is equal
to cost since the Bank can redeem the stock with FHLB at cost.
Employment agreements
---------------------
The Company entered into an employment agreement (the "Chairman Agreement") with
the Chairman and Chief Executive Officer of the Company and the Bank with an
initial term of five years beginning October 1, 2001, which may be extended for
additional one-year terms at the end of the initial term. In October 2003, the
Company amended the Chairman Agreement to extend the initial five-year term by
one year. The Chairman Agreement provides for a base salary with annual
adjustments, and an annual bonus, as determined by the Board of Directors. The
Chairman Agreement also provides for vacation and various insurance benefits and
reimbursement for travel, entertainment and bank-related education and
convention expenses.
Also, under the Chairman Agreement, the Company issued to the Chairman options
to purchase 50,000 shares of the Company's stock under the terms of the
Company's 2001 Stock Option Plan (see Note 10).
22
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
In the event of the early termination of the Chairman for any reason other than
cause, the Company would be obligated to compensate the Chairman, in accordance
with the terms of the Chairman Agreement, through the full term of the Chairman
Agreement. Also upon termination of the Chairman, for reasons other than cause,
the Chairman Agreement provides that the Chairman will serve as a consultant to
the Company, on a year to year basis, and will be compensated at the rate of
$60,000 per year plus the employee benefits previously described. Further, in
the event the Chairman's position shall end or his responsibilities be
significantly reduced as a result of a business combination (as defined), the
Chairman will be entitled to a lump sum payment equal to three times his then
current annual compensation.
Also, the Company entered into an employment agreement (the "President
Agreement") with the President of the Bank effective in January 2005, which
expires on December 31, 2006 with an automatic extension through December 31,
2007, unless earlier terminated by the Company. The President Agreement provides
for a base salary, with annual adjustments, and an annual bonus as determined by
the Board of Directors. The President Agreement also provides for vacation and
various insurance benefits and reimbursement for automobile, travel,
entertainment, club dues and bank-related education and convention expenses.
Also, under a prior agreement, the Company issued to the President options to
purchase 20,000 shares of the Company's stock under the terms of the Company's
2002 Stock Option Plan (see Note 10).
In the event of the early termination of the President for any reason other than
cause, the Company would be obligated to compensate the President, in accordance
with the terms of the Present Agreement, through the full term of the President
Agreement. Further, in the event the President's position shall end or his
responsibilities be significantly reduced as a result of a business combination
(as defined), the President will be entitled to a lump sum payment equal to
three times his then current annual compensation, plus his bonus for the prior
year.
Note 8. Lease and Subleases
The Company leases the Bank's main office under a twenty-year capital lease that
expires in 2021. In addition, the Company leases its Branford branch office
under a twenty-year capital lease that expires in 2022. Under the terms of the
leases, the Bank will pay all executory costs including property taxes,
utilities and insurance. The Company has also entered into an operating lease
for the main office of its new bank subsidiary expected to be formed and become
operational in 2005 (see Note 17). The initial term of the lease expires in
2009, and the lease contains three five-year renewal options. The Company also
leases the driveway to its main office and certain equipment under
non-cancelable operating leases.
The Company has also entered into a five-year sublease agreement for excess
office space in its premises with a tenant, the principal of which is related to
the Company's Vice Chairman.
23
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
At December 31, 2004, future minimum lease payments to be made and received
under these leases by year and in the aggregate, are as follows:
Year Capital Leases Operating Leases Sublease Income
--------------------------------------------------------------------------------------------------------
2005 $ 161,506 $ 57,636 $ 14,107
2006 166,028 56,146 3,553
2007 171,424 53,747 -
2008 178,564 49,199 -
2009 183,087 54,625 -
2010 and thereafter 2,639,885 850,306 -
-------------------- --------------------------------------
3,500,494 $ 1,121,659 $ 17,660
======================================
Less amount representing interest (2,310,308)
--------------------
Present value of future minimum lease
payments - capital lease obligation $ 1,190,186
====================
Total rent expense charged to operations under the operating leases approximated
$4,400 and $3,200 for the years ended December 31, 2004 and 2003, respectively.
Rental income under the subleases approximated $17,300 and $17,200 for the years
ended December 31, 2004 and 2003, respectively.
Note 9. Income Taxes
A reconciliation of the anticipated income tax benefit (computed by applying the
statutory Federal income tax rate of 34% to the loss before income taxes) to the
amount reported in the statement of operations for the years ended December 31,
2004 and 2003 is as follows:
2004 2003
--------------------------
Benefit for income taxes at statutory Federal rate $ (33,417) $ (203,295)
State tax benefit, net of Federal benefit (4,469) (29,201)
Increase in valuation allowance 43,803 253,878
Other (5,917) (21,382)
--------------------------
$ - $ -
==========================
24
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
At December 31, 2004 and 2003, the components of gross deferred tax assets and
liabilities are as follows:
2004 2003
-------------------------------------
Deferred tax assets:
Allowance for loan losses $ 293,057 $ 164,036
Net operating loss carryforwards 856,086 906,259
Start-up costs 85,430 142,401
Unrealized loss on available for sale securities 84,419 116,756
Other 104,587 66,796
-------------------------------------
Gross deferred tax assets 1,423,579 1,396,248
Less valuation allowance (1,316,075) (1,304,609)
-------------------------------------
Deferred tax assets - net of valuation allowance 107,504 91,639
-------------------------------------
Deferred tax liabilities:
Tax bad debt reserve 21,897 25,736
Depreciation 85,607 65,903
-------------------------------------
Gross deferred tax liabilities 107,504 91,639
-------------------------------------
Net deferred tax liability $ - $ -
=====================================
As of December 31, 2004, the Company had tax net operating loss carryforwards of
approximately $2,200,000 available to reduce future Federal and state taxable
income, which expire in 2021 through 2023.
The net changes in the valuation allowance for 2004 and 2003 were increases of
$11,466 and $370,634, respectively. The changes in the valuation allowance have
been allocated between operations and equity to adjust the deferred tax asset to
an amount considered by management more likely than not to be realized. The
portion of the change in the valuation allowance allocated to equity is to
eliminate the tax benefit related to the unrealized holding gains or losses on
available for sale securities.
Note 10. Shareholders' Equity
On June 17, 2004, the Company completed a public offering of 1,723,000 shares of
its common stock at $8.50 per share, with net proceeds of $13,293,012, after
deduction of the underwriter's discount and offering expenses aggregating
$1,352,489.
In addition, in conjunction with the exercise of stock options and warrants, the
Company issued 11,391 shares of its common stock, with aggregate proceeds of
$105,675 in 2004.
25
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Stock dividend
--------------
On January 13, 2004, the Company declared a 10% stock dividend that was
distributed on February 16, 2004. As a result, the 2003 balance sheet and
statement of changes in shareholders' equity, and all per share amounts, have
been retroactively revised to reflect this dividend as if it were effective at
December 31, 2003. Generally accepted accounting principles require such
dividends to be recorded at fair value; however, when there is an accumulated
deficit, the Securities and Exchange Commission ("SEC") advises that such stock
dividends be accounted for by capitalizing the stock issued at par value only,
through a reduction in additional paid-in capital.
Income (loss) per share
-----------------------
The Company is required to present basic income (loss) per share and diluted
income (loss) per share in its statements of operations. Basic and fully diluted
income (loss) per share are computed by dividing net income (loss) by the
weighted average number of common shares outstanding. Diluted per share amounts
assume exercise of all potential common stock instruments unless the effect is
to reduce the loss or increase the income per share. For the periods presented,
the common stock equivalents described below have been excluded from the
computation of the net loss per share because the inclusion of such equivalents
is anti-dilutive. Weighted average shares outstanding were 2,001,772 and
1,063,320 for the years ended December 31, 2004 and 2003, respectively, after
giving effect in 2003 to the stock dividend declared in January 2004.
Stock options
-------------
The Company has adopted two stock option plans, the 2001 Stock Option Plan (the
"2001 Option Plan") and the 2002 Stock Option Plan (the "2002 Option Plan"),
under which an aggregate of 429,680 shares of the Company's common stock are
reserved for issuance upon the exercise of both incentive options and
nonqualified options granted under both option plans.
Under both option plans, the exercise price for each share covered by an option
may not be less than the fair market value of a share of the Company's common
stock on the date of grant. For incentive options granted to a person who owns
more than 10% of the combined voting power of the Company or any subsidiary
("ten percent shareholder"), the exercise price cannot be less than 110% of the
fair market value on the date of grant.
Options under both plans have a term of ten years unless otherwise determined at
the time of grant, except that incentive options granted to any ten percent
shareholder will have a term of five years unless a shorter term is fixed. Under
both option plans, unless otherwise fixed at the time of grant, 40% of the
options become exercisable one year from the date of grant, and 30% of the
options become exercisable at each of the second and third anniversaries from
the date of grant.
Upon adoption of the 2002 Option Plan in May 2002, the Company determined that
no additional options will be granted under the 2001 Option Plan.
26
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
A summary of the status of the stock options at December 31, 2004 and 2003, and
changes during the years then ended, is as follows.
2004 2003
------------------------------- ------------------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Shares Price Shares Price
------------------------------------------------------------------
Outstanding at beginning of year 317,480 $8.37 74,140 $10.91
Granted 53,260 8.59 255,110 7.66
Terminated (18,386) 8.05 (11,770) 9.08
Exercised (5,847) 7.73 - -
------------ ------------
Outstanding at end of year 346,507 8.43 317,480 8.37
============ ============
Exercisable at end of year 156,015 $9.01 44,814 $10.91
============ ========== ============ =========
Weighted-average fair value per option
of options granted during the year $ 3.43 $ 2.44
============ ============
At December 31, 2004 and 2003, the exercise prices on outstanding options ranged
from $7.27 to $10.91. The weighted-average remaining contractual life for the
options outstanding at December 31, 2004 and 2003 is 8.4 and 9.2 years,
respectively.
The fair value of options issued in 2004 and 2003 was estimated at the grant
date using the Black-Scholes option-pricing model with the following
assumptions:
2004 2003
-----------------------------------
Dividend rate - -
Risk free interest rate 3.51% to 4.37% 2.88% to 4.02%
Weighted-average expected lives 8 years 8 years
Volatility 20% 20%
Stock warrants
--------------
The Company adopted the 2001 Warrant Plan and the 2001 Supplemental Warrant Plan
(the "Warrant Plans"), under which an aggregate of 73,509 shares of the
Company's common stock are reserved for issuance upon the exercise of warrants
granted to non-employee directors of the Company and the Bank, and certain other
individuals involved in the organization of the Bank.
27
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Warrants under the Warrant Plans have a term of ten years. Forty percent of the
warrants become exercisable one year from the date of grant, and 30% of the
warrants become exercisable at each of the second and third anniversaries from
the date of grant.
A summary of the status of the warrants at December 31, 2004 and 2003, and
changes during the years then ended, is as follows.
2004 2003
------------------------------ ----------------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Shares Price Shares Price
----------------------------------------------------------------
Outstanding at beginning of year 79,953 $10.91 79,953 $10.91
Granted - - - -
Exercised (5,544) 10.91 - -
Terminated (900) 10.91 - -
---------- ----------
Outstanding at end of year 73,509 10.91 79,953 10.91
========== ==========
Exercisable at end of year 73,509 $10.91 55,967 $10.91
========== ========= ========== =========
Weighted-average fair value per
warrant of warrants granted during
the year N/A N/A
========== ==========
The weighted-average remaining contractual life for the warrants outstanding at
December 31, 2004 and 2003 is 6.7 and 7.7 years, respectively.
Note 11. 401(k) Profit Sharing Plan
The Bank's employees are eligible to participate in the Bank of Southern
Connecticut 401(k) Profit Sharing Plan (the "Plan") under Section 401(k) of the
Internal Revenue Code. The Plan covers substantially all employees of the Bank.
Under the terms of the Plan, participants can contribute a discretionary
percentage of compensation, with total annual contributions subject to Federal
limitations. The Bank may make discretionary contributions to the Plan.
Participants are immediately vested in their contributions and become fully
vested in employer contributions after three years of service. There were no
discretionary contributions made by the Bank during 2004 and 2003.
28
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 12. Financial Instruments with Off-Balance-Sheet Risk
In the normal course of business, the Company is a party to financial
instruments with off-balance-sheet risk to meet the financing needs of its
customers. These financial instruments include commitments to extend credit and
involve, to varying degrees, elements of credit and interest rate risk in excess
of the amounts recognized in the financial statements. The contractual amounts
of these instruments reflect the extent of involvement the Company has in
particular classes of financial instruments.
The contractual amounts of commitments to extend credit represents the amounts
of potential accounting loss should: the contract be fully drawn upon; the
customer default; and the value of any existing collateral become worthless. The
Company uses the same credit policies in making commitments and conditional
obligations as it does for on-balance-sheet instruments and evaluates each
customer's creditworthiness on a case-by-case basis. Management believes that
the Company controls the credit risk of these financial instruments through
credit approvals, credit limits, monitoring procedures and the receipt of
collateral as deemed necessary.
Financial instruments whose contract amounts represent credit risk are as
follows at December 31, 2004:
2004 2003
--------------------------------------
Commitments to extend credit:
Future loan commitments $ 5,855,800 $ 3,752,000
Unused lines of credit 8,767,479 9,065,661
Undisbursed construction loans 103,900 729,220
Financial standby letters of credit 1,138,055 933,055
--------------------------------------
$ 15,865,234 $ 14,479,936
======================================
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
to extend credit generally have fixed expiration dates or other termination
clauses and may require payment of a fee by the borrower. Since these
commitments could expire without being drawn upon, the total commitment amounts
do not necessarily represent future cash requirements. The amount of collateral
obtained, if deemed necessary by the Company upon extension of credit, is based
on management's credit evaluation of the counter party. Collateral held varies,
but may include residential and commercial property, deposits and securities.
Standby letters of credit are written commitments issued by the Company to
guarantee the performance of a customer to a third party. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. As of January 1, 2003, newly issued
or modified guarantees that are not derivative contracts have been recorded on
the Company's consolidated balance sheet at their fair value at inception. The
liability related to guarantees recorded at December 31, 2003 was not
significant.
29
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 13. Regulatory Matters
The Company (on a consolidated basis) 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 and the Bank'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 assets,
liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The 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 I capital (as defined in the
regulations) to risk-weighted assets (as defined), and of Tier I capital (as
defined) to average assets (as defined). Management believes, as of December 31,
2004, that the Company and the Bank meet all capital adequacy requirements to
which they are subject.
As of December 31, 2004, the most recent notification from the Federal Deposit
Insurance Corporation and the State of Connecticut Department of Banking
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 I risk-based, and Tier I leverage ratios
as set forth in the table. There are no conditions or events since then, that
management believes have changed the Bank's category.
The Company's and the Bank's actual capital amounts and ratios at December 31,
2004 and 2003 were (dollars in thousands):
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
2004 Actual Purposes Action Provisions
---- ------------------------- ---------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
-----------------------------------------------------------------------------
The Company:
------------
Total Capital to Risk-Weighted Assets $ 21,667 33.24% $ 5,215 8.00% N/A N/A
Tier I Capital to Risk-Weighted Assets 20,915 32.08% 2,608 4.00% N/A N/A
Tier I Capital to Average Assets 20,915 24.66% 3,393 4.00% N/A N/A
30
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
------------------------- ---------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
-----------------------------------------------------------------------------
The Bank:
---------
Total Capital to Risk-Weighted Assets $ 12,285 20.84% $ 4,716 8.00% $ 5,895 10.00%
Tier I Capital to Risk-Weighted Assets 11,546 19.59% 2,358 4.00% 3,536 6.00%
Tier I Capital to Average Assets 11,546 14.87% 3,106 4.00% 3,882 5.00%
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
2003 Actual Purposes Action Provisions
---- ------------------------- ---------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
-----------------------------------------------------------------------------
The Company:
------------
Total Capital to Risk-Weighted Assets $ 8,035 17.27% $ 3,722 8.00% N/A N/A
Tier I Capital to Risk-Weighted Assets 7,614 16.36% 1,862 4.00% N/A N/A
Tier I Capital to Average Assets 7,614 14.18% 2,148 4.00% N/A N/A
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
------------------------- ---------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
-----------------------------------------------------------------------------
The Bank:
---------
Total Capital to Risk-Weighted Assets $ 8,013 17.24% $ 3,718 8.00% $ 4,648 10.00%
Tier I Capital to Risk-Weighted Assets 7,592 16.33% 1,860 4.00% 2,789 6.00%
Tier I Capital to Average Assets 7,592 14.16% 2,145 4.00% 2,681 5.00%
Restrictions on dividends, loans or advances
--------------------------------------------
The Company's ability to pay cash dividends is dependent on the Bank's ability
to pay dividends to the Company. However, certain restrictions exist regarding
the ability of the Bank to transfer funds to the Company in the form of cash
dividends, loans or advances. Regulatory approval is required to pay cash
dividends in excess of the Bank's net earnings retained in the current year plus
retained net earnings for the preceding two years. The Bank is also prohibited
from paying dividends that would reduce its capital ratios below minimum
regulatory requirements, and the Federal Reserve Board may impose further
dividend restrictions on the Company. During 2002, the Bank requested, and was
granted, permission from the State of Connecticut Department of Banking, to pay
a special dividend to the Company in the amount of $200,000. At December 31,
2004 and 2003, no dividends may be declared by the Bank without regulatory
approval.
31
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Under Federal Reserve regulation, the Bank is also limited to the amount it may
loan to the Company, unless such loans are collateralized by specified
obligations. Loans or advances to the Company by the Bank are limited to 10% of
the Bank's capital stock and surplus on a secured basis.
Note 14. Related Party Transactions
In the normal course of business, the Company may grant loans to executive
officers, directors and members of their immediate families, as defined, and to
entities in which these individuals have more than a 10% equity ownership. Such
loans are transacted at terms including interest rates, similar to those
available to unrelated customers.
Changes in loans outstanding to such related parties during 2004 and 2003 are as
follows:
2004 2003
--------------------------------------
Balance, beginning of year $ 797,421 $ 534,637
Additional loans 1,081,259 1,225,195
Repayments (1,079,208) (962,411)
Adjustment for former related parties (10,777) -
--------------------------------------
Balance, end of year $ 788,695 $ 797,421
======================================
Related party deposits aggregated approximately $3,164,000 and $7,108,000 as of
December 31, 2004 and 2003, respectively.
Included in professional services for the years ended December 31, 2004 and 2003
are approximately $15,500 and $4,800, respectively, of legal fees incurred for
services provided by law firms, principals of which were directors of the
Company. Included in consulting fees for the years ended December 31, 2004 and
2003 are $6,300 and $29,300, respectively, in consulting fees and expenses paid
to entities, the principals of which are related to Company directors.
During 2004 and 2003, the Company paid approximately $6,300 and $1,500,
respectively, for capital expenditures and maintenance to certain companies,
principals of which are directors of the Company.
During 2004 and 2003, the Company purchased investment securities, including
accrued interest and fees, of approximately $7,975,000 and $10,950,000,
respectively, through an investment brokerage firm, an employee of which is
related to the Company's Chairman and Chief Executive Officer.
As described in Note 8, rental income and expense reimbursements of
approximately $13,400 and $16,500 were received in 2004 and 2003, respectively,
from a tenant, the principal of which is related to the Company's Vice Chairman.
In January 2004, the Company sold a $250,000 participation interest in a loan
relationship to a company, the principals of which are directors of the Company.
In April 2004, the Company repurchased the participation interest from this
Company.
32
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Note 15. Other Comprehensive Income
Other comprehensive income, which is comprised solely of the change in
unrealized gains and losses on available for sale securities, is as follows:
2004
---------------------------------------------------
Before-Tax Taxes Net-of-Tax
Amount Amount
----------------------------------------------------
Unrealized holding gains arising during period $ 86,934 $ - $ 86,934
Less reclassification adjustment for gains recognized
in income (3,912) - (3,912)
---------------------------------------------------
Unrealized holding gain on available for sale
securities, net of taxes $ 83,022 $ - $ 83,022
===================================================
2003
---------------------------------------------------
Before-Tax Taxes Net-of-Tax
Amount Amount
----------------------------------------------------
Unrealized holding losses arising during period $ (446,713) $ 44,321 $ (402,392)
Less reclassification adjustment for gains recognized
in income 44,505 (4,416) 40,089
---------------------------------------------------
Unrealized holding loss on available for sale
securities, net of taxes $ (402,208) $ 39,905 $ (362,303)
===================================================
Note 16. Fair Value of Financial Instruments and Interest Rate Risk
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments"
("Statement No. 107"), requires disclosure of fair value information about
financial instruments, whether or not recognized in the balance sheet, for which
it is practicable to estimate that value. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. In that regard, the derived fair value estimates cannot be substantiated
by comparisons to independent markets and, in many cases, could not be realized
in immediate settlement of the instrument. Statement No. 107 excludes certain
financial instruments from its disclosure requirements. Accordingly, the
aggregate fair value amounts presented do not represent the underlying value of
the Company.
33
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Management uses its best judgment in estimating the fair value of the Company's
financial instruments; however, there are inherent weaknesses in any estimation
technique. Therefore, for substantially all financial instruments, the fair
value estimates presented herein are not necessarily indicative of the amounts
the Company could have realized in a sales transaction at December 31, 2004 and
2003. The estimated fair value amounts for 2004 and 2003 have been measured as
of their respective year-ends, and have not been reevaluated or updated for
purposes of these consolidated financial statements subsequent to those
respective dates. As such, the fair values of these financial instruments
subsequent to the respective reporting dates may be different from the amounts
reported at each year-end.
The information presented should not be interpreted as an estimate of the fair
value of the entire Company since a fair value calculation is only required for
a limited portion of the Company's assets and liabilities. Due to the wide range
of valuation techniques and the degree of subjectivity used in making the
estimate, comparisons between the Company's disclosures and those of other bank
holding companies may not be meaningful.
As of December 31, 2004 and 2003, the recorded book balances and estimated fair
values of the Company's financial instruments were:
2004 2003
--------------------------------------------------------------
Recorded Recorded
Book Book
Balance Fair Value Balance Fair Value
--------------------------------------------------------------
Financial Assets:
Cash and due from banks $ 1,986,193 $ 1,986,193 $ 1,147,883 $ 1,147,883
Federal funds sold 5,385,000 5,385,000 966,000 966,000
Short-term investments 8,372,689 8,372,689 454,115 454,115
Available for sale securities 11,371,894 11,371,894 8,478,068 8,478,068
Federal Home Loan Bank stock 47,100 47,100 21,500 21,500
Loans receivable, net 49,763,952 49,537,489 40,818,718 40,818,116
Accrued interest receivable 265,581 265,581 196,545 196,545
Servicing rights 66,959 66,959 20,798 20,798
Financial Liabilities:
Noninterest-bearing deposits 17,334,393 17,334,353 13,781,286 13,781,256
Interest bearing checking accounts 8,708,930 8,708,930 3,499,378 3,499,378
Money market deposits 20,604,704 20,604,704 17,251,327 17,251,327
Savings deposits 3,299,676 3,299,676 2,633,341 2,633,341
Time certificates of deposits 8,752,674 8,636,377 10,108,543 10,197,429
Repurchase agreements 827,031 827,031 339,752 339,752
34
SOUTHERN CONNECTICUT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
December 31, 2004 and 2003
--------------------------------------------------------------------------------
Unrecognized financial instruments
----------------------------------
Loan commitments on which the committed interest rate is less than the current
market rate are insignificant at December 31, 2004 and 2003.
The Company assumes interest rate risk (the risk that general interest rate
levels will change) as a result of its normal operations. As a result, the fair
values of the Company's financial instruments will change when interest rate
levels change and that change may be either favorable or unfavorable to the
Company. Management attempts to match maturities of assets and liabilities to
the extent believed necessary to minimize interest rate risk. However, borrowers
with fixed rate obligations are less likely to prepay in a rising rate
environment and more likely to prepay in a falling rate environment. Conversely,
depositors who are receiving fixed rates are more likely to withdraw funds
before maturity in a rising rate environment and less likely to do so in a
falling rate environment. Management monitors rates and maturities of assets and
liabilities and attempts to minimize interest rate risk by adjusting terms of
new loans and deposits and by investing in securities with terms that mitigate
the Company's overall interest rate risk.
Note 17. Business Developments
During 2003, the Company's Board of Directors approved the establishment of a
new commercial bank in New London, Connecticut, and will fund the establishment
of the new bank with capital raised during 2004. Subject to final regulatory
approval, the Company plans to open the new bank in the middle of 2005.
In June 2004, the Company, through a nominee, entered into an agreement to
purchase a site with land and two buildings in Clinton, Connecticut for the
primary purpose of establishing a branch office of the Bank. The net purchase
price of the property is $495,000. During 2004, the Bank filed applications to
the Connecticut Department of Banking and the FDIC to establish bank operations
at the Clinton location. Due to a delay in completing the acquisition of the
Clinton property, the Bank's initial application to the FDIC to establish the
Clinton branch was withdrawn pending completion of the acquisition of the
property. Development of the property is expected to begin in the second half of
2005, at which time the Bank will reapply with the FDIC for permission to
establish the Clinton branch.
Note 18. Fourth Quarter Adjustments (Unaudited)
During the fourth quarter of 2004, the Company recorded a provision for loan
losses of approximately $223,000 primarily due to an increase in, and evaluation
of, impaired loans during the fourth quarter.
35