<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
Mark One
[X] Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange
Act of 1934 for the quarterly period ended September 30, 1998.
[_] 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 33-1983
SURETY CAPITAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 75-2065607
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
1845 Precinct Line Road, Suite 100, Hurst, Texas 76054
(Address of principal executive offices)
(817) 498-2749
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes x No____
-----
Common stock outstanding on November 3, 1998, 5,760,235 shares.
<PAGE>
SURETY CAPITAL CORPORATION
INDEX
<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION Page No.
- - ------------------------------ --------
<S> <C>
Item 1. Financial Statements
- - ------
Consolidated Balance Sheets at September 30, 1998 and
December 31, 1997 3
Consolidated Statements of Operations for the Nine Months Ended
September 30, 1998 and 1997 4
Consolidated Statements of Operations for the Three Months Ended
September 30, 1998 and 1997 5
Statement of Comprehensive (Loss) Income for the Nine Months Ended
September 30, 1998 and 1997 and for the Three Months Ended 6
September 30, 1998 and 1997
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 1998 and 1997 7
Notes to Consolidated Financial Statements 9
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
- - -------
Operations 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk 24
- - -------
PART II. - OTHER INFORMATION
- - ------------------------------
Item 1. Legal Proceedings 25
- - -------
Item 2. Changes in Securities and Use of Proceeds 25
- - -------
Item 3. Defaults Upon Senior Securities 26
- - -------
Item 4. Submission of Matters to a Vote of Security Holders 26
- - -------
Item 5. Other Information 26
- - -------
Item 6. Exhibits and Reports on Form 8-K 26
- - -------
</TABLE>
2
<PAGE>
SURETY CAPITAL CORPORATION
CONSOLIDATED BALANCE SHEETS
September 30, 1998 and December 31, 1997
(Unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
-------------- --------------
<S> <C> <C>
Assets:
Cash and due from banks $ 9,054,812 $ 6,204,177
Federal funds sold 50,497,554 22,257,266
Interest bearing deposits in financial institutions 94,939 94,939
Investment securities: Available-for-sale 32,170,862 28,785,162
Loans 122,271,612 100,846,310
Less: Unearned interest (1,870,261) (2,212,391)
Allowance for credit losses (1,424,611) (950,809)
-------------- --------------
Net loans 118,976,740 97,683,110
Medical claims receivables, net 680,505 3,073,155
Premises and equipment, net 7,534,164 3,760,550
Accrued interest receivable 1,176,553 908,487
Other real estate and repossessed assets 739,343 158,271
Deferred tax asset 1,875,789 1,622,394
Other assets 1,849,952 2,381,887
Excess of cost over fair value of net assets acquired, net of
accumulated amortization of $2,884,344 and $2,377,636 at
September 30, 1998 and December 31, 1997, respectively 9,697,493 4,722,220
-------------- --------------
Total assets $234,348,706 $171,651,618
============== ==============
Liabilities and shareholders' equity:
Demand deposits $ 37,268,448 $ 22,185,320
Savings, NOW and money markets 61,510,203 44,477,424
Time deposits, $100,000 and over 35,004,547 23,492,179
Other time deposits 79,589,139 64,386,569
-------------- --------------
Total deposits 213,372,337 154,541,492
Accrued interest payable and other 987,243 1,232,793
liabilities
Convertible subordinated debt 4,350,000
-------------- --------------
Total liabilities 218,709,580 155,774,285
-------------- --------------
Shareholders' equity:
Preferred stock, $.01 par value, 1,000,000 shares authorized, - -
none issued at September 30, 1998 and December 31, 1997
Common stock, $.01 par value, 20,000,000 shares authorized,
5,840,071 and 5,790,171 shares issued at September 30, 1998 and
December 31, 1997, respectively, and 5,760,235 and 5,755,882
outstanding at September 30, 1998 and December 31, 1997, respectively 58,401 57,902
Additional paid-in capital 17,093,786 16,867,777
Accumulated deficit (1,326,261) (1,024,435)
Stock rights issuable 57,902 57,902
Treasury stock, 79,836 and 34,289 shares at September 30, 1998 and
at December 31, 1997 carried at cost (375,443) (172,828)
Accumulated other comprehensive income, net of tax 130,741 91,015
-------------- --------------
Total shareholders' equity 15,639,126 15,877,333
-------------- --------------
Total liabilities and shareholders' equity $234,348,706 $171,651,618
============== ==============
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements
3
<PAGE>
SURETY CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
for the nine months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30, September 30,
1998 1997
-------------------- ---------------------
<S> <C> <C>
Interest income:
Commercial and real estate loans $ 5,405,832 $ 3,717,187
Consumer loans 750,511 3,472,758
Insurance premium financing 2,463,288 1,713,678
Medical claims receivable factoring 1,457,520 968,832
Federal funds sold 1,407,009 323,455
Investment securities:
Taxable 1,471,938 1,561,055
Tax-exempt 152,682 237,685
Interest bearing deposits 4,373 12,763
-------------------- ---------------------
Total interest income 13,113,153 12,007,413
-------------------- ---------------------
Interest expense:
Savings, NOW and money market 1,062,856 937,393
Time deposits, $100,000 and over 1,349,675 839,902
Other time deposits 2,923,568 2,512,759
Convertible subordinated debt 191,949 -
-------------------- ---------------------
Total interest expense 5,528,048 4,290,054
-------------------- ---------------------
Net interest income before
provision for credit losses 7,585,105 7,717,359
-------------------- ---------------------
Provision for credit losses on loans 1,611,875 40,000
Net provision for medical claims receivables losses 26,244 255,000
-------------------- ---------------------
Net interest income 5,946,986 7,422,359
-------------------- ---------------------
Noninterest income 1,953,425 1,764,705
-------------------- ---------------------
Noninterest expense:
Salaries and employee benefits 4,206,919 3,392,296
Occupancy and equipment 1,467,719 1,123,513
General and administrative 2,735,872 2,265,249
-------------------- ---------------------
Total noninterest expense 8,410,510 6,781,058
-------------------- ---------------------
(Loss) income before income taxes (510,099) 2,406,006
Income tax (benefit) expense (208,273) 874,917
-------------------- ---------------------
Net (loss) income $ (301,826) $ 1,531,089
==================== =====================
Basic (loss) earnings per share of common stock $(0.05) $0.27
==================== =====================
Weighted average shares outstanding 5,759,338 5,751,212
==================== =====================
Diluted (loss) earnings per share of common stock $(0.05) $0.26
==================== =====================
Weighted average shares outstanding
And common stock equivalents 5,759,338 5,875,071
==================== =====================
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements
4
<PAGE>
SURETY CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
for the three months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended
September 30, September 30,
1998 1997
--------------- --------------
<S> <C> <C>
Interest income:
Commercial and real estate loans $2,131,854 $1,257,910
Consumer loans 148,278 1,167,596
Insurance premium financing 528,026 514,403
Medical claims receivable factoring 633,799 312,418
Federal funds sold 607,655 63,481
Investment securities:
Taxable 525,414 430,965
Tax-exempt 24,355 79,180
Interest bearing deposits 1,470 1,544
---------- ----------
Total interest income 4,600,851 3,827,497
---------- ----------
Interest expense:
Savings, NOW and money market 365,996 282,380
Time deposits, $100,000 and over 513,679 300,645
Other time deposits 1,024,314 856,708
Convertible subordinated debt 91,695
---------- ----------
Total interest expense 1,995,684 1,439,733
---------- ----------
Net interest income before
provision for credit losses 2,605,167 2,387,764
---------- ----------
Provision for credit losses on loans (13,904) 5,000
Net provision for medical claims receivables losses 13,904 140,000
---------- ----------
Net interest income 2,605,167 2,242,764
---------- ----------
Noninterest income 734,185 642,930
---------- ----------
Noninterest expense:
Salaries and employee benefits 1,515,663 974,048
Occupancy and equipment 521,999 389,769
General and administrative 1,104,296 724,199
---------- ----------
Total noninterest expense 3,141,958 2,088,016
---------- ----------
Income before income taxes 197,394 797,678
Income tax expense 46,889 277,304
---------- ----------
Net income $ 150,505 $ 520,374
========== ==========
Basic earnings per share of common stock $ 0.03 $ 0.09
========== ==========
Weighted average shares outstanding 5,759,338 5,751,882
========== ==========
Diluted earnings per share of common stock $ 0.03 $ 0.09
========== ==========
Weighted average shares outstanding
And common stock equivalents 5,759,338 5,875,741
========== ==========
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
5
<PAGE>
SURETY CAPITAL CORPORATION
STATEMENT OF COMPREHENSIVE (LOSS) INCOME
for the nine months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30, September 30,
1998 1997
------------- -------------
<S> <C> <C>
Net (loss) income $ (301,826) $ 1,531,089
Other comprehensive (loss) income, net of income tax
Unrealized holding gains on available-for-sale securities 39,726 44,717
---------- -----------
Comprehensive (loss) income $ (262,100) $ 1,575,806
========== ===========
Disclosure of reclassification amount:
Net unrealized holding gains arising during period $ 74,075 $ 55,096
Reclassification adjustment for net losses included in net (loss) income,
net of income tax (34,349) (10,379)
---------- -----------
Net unrealized gains on available-for-sale securities $ 39,726 $ 44,717
========== ===========
</TABLE>
SURETY CAPITAL CORPORATION
STATEMENT OF COMPREHENSIVE INCOME
for the three months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended
September 30, September 30,
1998 1997
-------------- ---------------
<S> <C> <C>
Net income $ 150,505 $ 520,374
Other comprehensive (loss) income, net of income tax
Unrealized holding gains (losses) on available-for-sale securities 109,281 (35,200)
----------- -----------
Comprehensive income $ 259,786 $ 485,174
=========== ===========
Disclosure of reclassification amount:
Net unrealized holding (losses) gains arising during period $ 109,281 $ 52,222
Reclassification adjustment for net (losses) gains included in net income,
net of income tax - (17,022)
----------- -----------
Net unrealized gains (losses) on available-for-sale securities $ 109,281 $ (35,200)
=========== ===========
</TABLE>
The accompanying notes are an Integral part
of the consolidated financial statements.
6
<PAGE>
SURETY CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the nine months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
September 30,
------------------------------------------------
1998 1997
---------------------- --------------------
<S> <C> <C>
Cash flows from operating activities:
Net (loss) income $ (301,826) $ 1,531,089
Adjustments to reconcile net income to net
cash provided by operating activities:
Net provision for losses 1,638,119 295,000
Depreciation 509,319 510,022
Amortization of intangible assets 333,738 390,428
Gain (loss) on sale of available-for-sale securities 53,670 (10,379)
Gain (loss) on sale or disposal of assets 11,371 (110,888)
Changes in assets and liabilities:
Unearned interest on loans (342,130) (35,850)
Other assets (179,858) 239,399
Accrued interest payable and other liabilities (953,768) (450,385)
------------ ------------
Net cash provided by operating activities 768,635 2,358,436
------------ ------------
Cash flows from investing activities:
Net increase (decrease) in loans 11,131,734 (9,101,888)
Payments received on purchased medical claims receivables 11,376,579 14,899,958
Purchases of medical claims receivables (9,010,173) (18,753,754)
Purchases of available-for-sale securities (18,878,609) (5,973,016)
Proceeds from sales of available-for-sale securities 4,256,197 2,948,507
Proceeds from maturities of available-for-sale securities 30,386,822 4,951,170
Proceeds from maturities of held-to-maturity securities - 4,185,158
Proceeds from maturities of interest bearing deposits in
Financial institutions - 95,842
Purchases of bank premises and equipment (497,196) (362,352)
Proceeds from sale of bank premises and equipment - 119,780
Proceeds from sale of other real estate and repossessed assets 289,750 613,539
Net cash acquired in acquisition 2,931,315
------------ ------------
Net cash provided by (used in) investing activities 31,986,419 (6,377,056)
------------ ------------
Cash flows from financing activities:
Net decrease in deposits (5,930,795) (691,022)
Issuance of subordinated debt 4,242,771 -
Purchase of treasury stock (202,615) (98,289)
Exercise of stock options 226,508 98,289
------------ ------------
Net cash used in financing activities (1,664,131) (691,022)
------------ ------------
Net increase (decrease) in cash and cash equivalents 31,090,923 (4,709,642)
Beginning cash and cash equivalents 28,461,443 22,866,457
------------ ------------
Ending cash and cash equivalents $ 59,552,366 $ 18,156,815
============ ============
</TABLE>
The accompanying notes are an Integral part
of the consolidated financial statements.
7
<PAGE>
SURETY CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the nine months ended September 30, 1998 and 1997
(unaudited)
<TABLE>
<CAPTION>
September 30,
--------------------------------------------
1998 1997
-------------------- ------------------
<S> <C> <C>
Supplemental schedule of noncash investing and financing
activities:
Transfers of repossessed collateral to other assets $ 147,393 $750,739
Additions to loans to facilitate the sale of other real estate
and other assets $ 3,225 $344,907
Adjustments to other assets subsequent to acquisition - $141,955
Net cash acquired through acquisitions:
Investment securities $ 19,141,707
Net loans 33,839,277
Premises and equipment, net 3,785,737
Other assets 910,488
Excess of cost over fair value of net assets acquired 4,838,987
Deposits (64,761,640)
Other liabilities (685,871)
--------------------
Net cash acquired in acquisition $ (2,931,315)
====================
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
8
<PAGE>
SURETY CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation:
---------------------
Surety Capital Corporation (the "Company") is a publicly-traded bank
holding company located in Hurst, Texas. The Company owns all of the
issued and outstanding capital stock of Surety Bank, National Association
("Surety Bank"), a national banking association with full service offices
located in Lufkin, Hurst, Chester, Wells, Kennard, Whitesboro, Waxahachie,
Midlothian, Universal City, Converse, New Braunfels, San Antonio, and
Schertz, Texas. See "Note 6. Subsequent Events" regarding the sale of the
Chester, Kennard, Lufkin and Wells branches. Surety Bank engages in general
commercial and consumer banking and concentrates its lending activities in
the area of insurance premium financing. The financial statements included
herein have been prepared by the Company pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information
and footnote disclosures normally included in annual financial statements
prepared in accordance with generally accepted accounting principles have
been condensed or omitted pursuant to such rules and regulations, although
the Company believes that the disclosures are adequate to make the
information presented not misleading. These condensed financial statements
should be read in conjunction with the financial statements and the notes
thereto included in the Company's latest annual report on Form 10-K. In the
opinion of the Company, all adjustments necessary to present fairly the
financial position of the Company as of September 30, 1998, and the results
of its operations and its cash flows for the indicated periods, have been
included. The results of operations for such interim period are not
necessarily indicative of the results to be expected for the fiscal year
ending December 31, 1998.
2. Acquisition:
-----------
TexStar National Bank, Universal City, Texas
On April 1, 1998, the Company completed the acquisition of TexStar National
Bank, Universal City, Texas ("TexStar"), through the merger of TexStar into
Surety Bank. With the completion of this acquisition, Surety Bank increased
its asset size by approximately 40%. As of April 1, 1998, TexStar had total
assets of $70,335,000, and Surety Bank's total assets as of the same date
were $177,871,000. The acquisition has been accounted for as a purchase in
the accompanying consolidated financial statements. The assets and
liabilities of TexStar have been recorded at their fair values as of April
1, 1998. The resulting goodwill is being amortized over 15 years on a
straight line basis.
The consolidated results of operations include the operations of TexStar
subsequent to April 1, 1998. The unaudited pro forma information for the
nine months ended September 30, 1998 and September 30, 1997, presented
below, reflect the acquisition of TexStar as if it had been acquired as of
January 1, 1997. Pro forma adjustments consisting of a provision for
income taxes and interest expense have been made to properly reflect the
unaudited pro forma information.
<TABLE>
<CAPTION>
Nine Months Ended Nine Months Ended
September 30, 1998 September 30, 1997
------------------- ------------------
<S> <C> <C>
Interest income $14,314,135 $15,881,805
Net (loss) income (1,133,684) 1,925,771
Net (loss) income per share
of common stock ($0.20) $ 0.33
</TABLE>
9
<PAGE>
3. Loans, net:
----------
At September 30, 1998 and December 31, 1997 the loan portfolio was composed
of the following:
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
--------------------- --------------------
<S> <C> <C>
Insurance premium financing $ 33,493,016 $ 40,373,695
Installment loans 8,894,323 10,632,451
Commercial loans 29,951,905 23,171,566
Real estate loans 49,932,368 26,668,598
--------------------- --------------------
Total gross loans 122,271,612 100,846,310
Unearned interest (1,870,261) (2,212,391)
Allowance for credit losses (1,424,611) (950,809)
--------------------- --------------------
Loans, net $118,976,740 $ 97,683,110
===================== ====================
</TABLE>
Loans on which the accrual of interest has been discontinued amounted to
approximately $870,000 and $92,000 at September 30, 1998 and December 31,
1997, respectively.
Activity in the allowance for credit losses is as follows:
<TABLE>
<CAPTION>
Nine Three Nine Three
Months Months Months Months
Ended Ended Ended Ended
September 30, 1998 September 30, 1998 September 30, 1997 September 30, 1997
-------------------- -------------------- -------------------- --------------------
<S> <C> <C> <C> <C>
Beginning balance $ 950,809 $1,474,720 $1,067,041 $1,003,978
Provision for credit losses 1,611,875 (13,904) 40,000 5,000
Bank acquisition 820,625
Loans charged off, net of
Recoveries (1,958,698) (36,205) (178,478) (80,415)
-------------------- -------------------- -------------------- --------------------
Ending balance $ 1,424,611 $1,424,611 $ 928,563 $ 928,563
==================== ==================== ==================== ====================
</TABLE>
10
<PAGE>
4. Medical Claims Receivables:
--------------------------
At September 30, 1998 and December 31, 1997, the medical claims receivables
portfolio was composed of the following:
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
---------------------- --------------------
<S> <C> <C>
Medical claims receivables $753,718 $ 8,079,524
Unearned interest (10,788) (698,484)
Allowance for medical claims
receivables losses (62,425) (4,307,885)
---------------------- --------------------
Medical claims receivables, net $680,505 $ 3,073,155
====================== ====================
</TABLE>
Activity in the allowance for medical claims receivables losses is as
follows:
<TABLE>
<CAPTION>
Nine Three Nine Three
Months Months Months Months
Ended Ended Ended Ended
September 30, 1998 September 30, 1998 September 30, 1997 September 30, 1997
-------------------- -------------------- -------------------- --------------------
<S> <C> <C> <C> <C>
Beginning balance $ 4,307,885 $58,280 $217,734 $296,589
Provision for credit losses 712,644 13,904 255,000 140,000
Unearned interest
Charged off (686,400)
Net provision for
-------------------- --------------------
Credit losses 26,244 13,904
Receivables charged off,
Net of recoveries (4,271,704) (9,759) (34,635) 1,510
-------------------- -------------------- -------------------- --------------------
Ending balance $ 62,425 $62,425 $438,099 $438,099
==================== ==================== ==================== ====================
</TABLE>
5. Convertible Subordinated Debt:
-----------------------------
Effective March 31, 1998, the Company issued $4,350,000 in 9% Convertible
Subordinated Notes Due 2008 (the "Notes"), pursuant to an indenture
("Indenture") between the Company and Harris Trust and Savings Bank,
Chicago, Illinois, as trustee (the "Trustee"). The Notes are general
unsecured obligations of the Company. The terms of the Notes are such that
they should qualify as Tier II capital under the Federal Reserve Board's
regulatory capital guidelines applicable to bank holding companies. The
Notes bear interest at a rate of 9% per annum until maturity. Interest on
the Notes is payable semi-annually on March 31 and September 30 of each
year, commencing September 30, 1998. No principal payments are due until
maturity on March 31, 2008.
11
<PAGE>
5. Convertible Subordinated Debt continued:
-----------------------------
The payment of the principal of $4,350,000, premium, if any, and interest
on the Notes are subordinated in right of payment to the prior payment in
full of all senior indebtedness of the Company. Upon the occurrence of
certain events involving the bankruptcy, insolvency, reorg anization,
receivership or similar proceedings of the Company, either the Trustee or
the holders of not less than 25% in aggregate principal amount of the
outstanding Notes may declare the principal of the Notes, together with any
accrued and unpaid interest, to be immediately due and payable. The Notes
do not otherwise provide for any right of acceleration of the payment of
principal thereof.
Each holder of Notes has the right at any time prior to maturity of the
Notes, unless previously redeemed, at the holder's option, to convert such
Notes, or any portion thereof which is an integral multiple of $10,000,
into shares of Common Stock of the Company, at the conversion price of
$6.00 per share, subject to certain antidilutive adjustments (the
"Conversion Price").
The Notes are not subject to mandatory redemption or sinking fund
provision. The Notes are redeemable for cash at the option of the Company
on at least 30 but not more than 60 days notice, in whole or in part, at
any time after the date of issuance and on or before March 31, 2002 at the
redemption prices set forth in the table below, plus accrued interest to
the date of redemption, if the closing sales price of the Common Stock
shall be at least 130% of the Conversion Price then in effect for a period
of 20 consecutive trading days in the principal market in which the Common
Stock is then traded. At any time after March 31, 2002 and prior to
maturity, the Notes are redeemable for cash at the option of the Company,
on at least 30 but not more than 60 days notice, in whole or in part, at
the redemption prices set forth in the table below, plus accrued interest
to the date of redemption.
<TABLE>
<CAPTION>
If Redeemed During Percentage of If Redeemed During Percentage of
12 Months Ended Principal 12 Months Ended Principal
March 31, Amount March 31, Amount
----------------------- ----------------------- ----------------------- -----------------------
<S> <C> <C> <C>
1999 109% 2004 104%
2000 108% 2005 103%
2001 107% 2006 102%
2002 106% 2007 101%
2003 105% 2008 100%
</TABLE>
6. Subsequent Events:
------------------
SALE OF LUFKIN BRANCHES
Surety Bank completed the sale to Commercial Bank of Texas, National
Association, Nacogdoches, Texas ("Commercial Bank"), of its four Lufkin-
area branches located in Chester, Kennard, Lufkin and Wells, Texas (the
"Branches") effective as of the close of business on October 16, 1998.
Following the sale, Surety Bank continues to operate nine full service
branches in Texas.
In connection with the closing Surety Bank sold loans totaling
approximately $10,978,000, real property, furniture and equipment totaling
approximately $604,000, and cash and other assets totaling approximately
$1,028,000, and Commercial Bank assumed deposits and other liabilities
totaling approximately $56,935,000. After giving effect to a deposit
premium of 3% on the deposits assumed totaling approximately $1,703,000,
Surety Bank paid approximately $42,617,000 in cash to Commercial Bank as
consideration for the net deposit liabilities assumed by Commercial Bank.
12
<PAGE>
6. Subsequent Events: continued
-----------------
With the completion of this sale, Surety Bank has decreased its asset base
by approximately 23.7%. As of the closing date, Surety Bank had total
assets of approximately $179,881,000, total deposits of approximately
$157,661,000, and total stockholders' equity of approximately $20,178,000.
PENDING FORMAL AGREEMENT WITH OCC
In connection with the recent examination of Surety Bank by the OCC, the
OCC has presented to the Board of Directors of Surety Bank a draft of a
formal written agreement to be executed by each member of the Board of
Directors (the "draft of the Formal Agreement") pursuant to which Surety
Bank is required to achieve certain capital levels and adopt and implement
certain plans, policies and strategies. See discussion under "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Capital Resources: Formal Agreement with the OCC" of this
Report.
13
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
- - ------- ---------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
GENERAL
The Company is a bank holding company registered under the Bank Holding Company
Act of 1956, as amended. The Company owns all of the issued and outstanding
shares of capital stock of Surety Bank.
The information presented below reflects the lending and related funding
business of the Company:
<TABLE>
<CAPTION>
Nine Months Nine Months
Ended Ended
September 30, September 30,
1998 1997
-------------------- --------------------
<S> <C> <C>
INSURANCE PREMIUM FINANCING:
Average balance outstanding $ 39,482,110 $ 45,009,669
Average yield 8.3% 11.0%
Interest income $ 2,463,288 $ 3,717,187
CONSUMER, COMMERCIAL AND REAL
ESTATE FINANCING:
Average balance outstanding $ 79,620,206 $ 58,794,258
Average yield 10.3% 10.1%
Interest income $ 6,156,343 $ 4,441,590
MEDICAL CLAIMS RECEIVABLES:
Average balance outstanding $ 4,554,559 $ 8,764,772
Average yield 42.7% 26.0%
Interest income $ 1,457,520 $ 1,713,678
COST OF FUNDS:
Average balance outstanding/(1)/ $199,435,970 $154,999,987
Average interest rate 3.7% 3.7%
Interest expense/(1)/ $ 5,528,048 $ 4,290,054
AVERAGE MONTHLY AMOUNTS:
Total interest income $ 1,457,017 $ 1,334,157
Total interest expense $ 614,228 $ 476,673
Provision for credit losses $ 179,097 $ 4,444
Provision for medical claims
receivables losses $ 2,916 $ 28,333
Noninterest income $ 217,047 $ 196,078
Noninterest expense $ 934,501 $ 753,451
</TABLE>
Note: Average balances are computed using daily balances throughout each period.
The average yields are gross yields and do not include provisions for
credit losses.
/(1)/ Includes $2,900,000 and $0 of borrowings and $191,949 and $0 of interest
expense on short-term borrowings for the nine months ended September 30,
1998 and 1997, respectively.
14
<PAGE>
AVERAGE BALANCE SHEET
<TABLE>
<CAPTION>
Nine Months Ended September 30, 1998
-------------------------------------------------
Average Interest Average
Balance Income/Expense Rate
------- -------------- --------
<S> <C> <C> <C>
ASSETS:
Interest earnings assets:
U.S. Treasury and agency securities and
due from time/(1)/ $ 33,814,231 $ 1,628,993 6.4%
Federal funds sold 34,841,783 1,407,009 5.4%
Loans/(2)//(3)/ 119,102,316 8,619,631 9.7%
Medical claims receivables 4,554,559 1,457,520 42.7%
Allowance for credit losses and factoring (4,090,560) N/A N/A
------------ ----------- -------
Total interest earning assets 188,222,329 $13,113,153 9.3%
------------ =========== =======
Cash and due from banks 8,728,742
Premises and equipment 5,951,259
Accrued interest receivable 1,043,215
Other assets 12,485,153
------------
Total assets $216,430,698
============
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest bearing liabilities:
Interest bearing demand deposits $ 46,440,196 $ 882,669 2.5%
Savings deposits 9,808,707 180,187 2.5%
Time deposits 108,475,169 4,273,243 5.3%
Notes payable 2,900,000 191,949 8.8%
------------ ----------- -------
Total interest bearing liabilities 167,624,072 5,528,048 4.4%
------------ ----------- -------
Net interest income $7,585,105
===========
Net interest spread 4.9%
-------
Net interest income to average earning assets 5.4%
=======
Noninterest bearing deposits 31,811,898
Accrued interest payable and other liabilities 997,567
------------
Total liabilities 200,433,537
Shareholders' equity 15,997,161
------------
Total liabilities and shareholders' equity $216,430,698
============
</TABLE>
/(1)/ Interest income on the tax-exempt securities does not reflect the tax
equivalent yield.
/(2)/ Loans on nonaccrual status have been included in the computation of
average balances.
/(3)/ The interest income on loans does not include loan fees. Loan fees are
immaterial and are included in
noninterest income.
15
<PAGE>
Nine Months Ended September 30, 1998 Versus Nine Months Ended September 30,
- - ---------------------------------------------------------------------------
1997.
- - -----
The Company and its wholly-owned subsidiary, Surety Bank, recorded a net loss of
$(301,826) or a net loss per basic common share of $(0.05) for the nine months
ended September 30, 1998, compared with earnings of $1,531,089 ($0.27 per basic
common share) for the nine months ended September 30, 1997. The reported loss
for the nine months ended September 30, 1998 was primarily the result of an
additional provision for credit losses and a net provision for factoring losses
totaling $1,638,119. These provisions were necessary as a result of factoring
receivables charge-offs of approximately $1,733,000 and insurance premium
finance loan charge-offs of approximately $526,000 recommended by the Office of
the Comptroller of the Currency ("OCC") in connection with a recent examination
of Surety Bank by the OCC, as more fully discussed below.
The yields earned by the Company on its consumer, commercial and real estate
loan portfolio during the nine months ended September 30, 1998 and 1997
increased 0.02% to 10.3% from 10.1%, respectively. The yields earned by the
Company on its insurance premium finance loans during the nine months ended
September 30, 1998 and 1997 decreased 2.7% to 8.3% from 11.0%. The decrease in
yield on the insurance premium finance loans is attributed to the reversal of
interest income recognized on insurance premium finance loans which were placed
on non-accrual status (the gross amount of insurance premium finance loans
placed on non-accrual status at September 30, 1998 was $553,753) along with a
decline in the average balance of insurance premium finance loans outstanding
for the nine months ended September 30, 1998 and 1997 in the amount of
$5,527,559 to $39,482,110 from $45,009,669. The average cost of funds for the
Company for the same periods was unchanged at 3.7%. The average balance of
loans outstanding increased 9.9% and was $123,656,875 and $112,568,699 for the
nine months ended September 30, 1998 and 1997, respectively. The increase in
loans outstanding is attributed to the acquisition of TexStar on April 1, 1998.
The loan-to-deposit ratio as of September 30, 1998 and 1997 was 56.4% and 67.2%,
respectively.
Total interest income increased 9.2% to $13,113,153 from $12,007,413, for the
nine months ended September 30, 1998 and 1997, respectively, while total
interest expense increased 28.9% to $5,528,048 from $4,290,054, for the nine
months ended September 30, 1998 and 1997, respectively, resulting in a 1.7%
decrease in net interest income before provision for credit losses to $7,585,105
from $7,717,359 for these same periods. The increase in interest expense for
the nine months ended September 30, 1998 as compared to the same period in 1997
in the amount of $1,237,994 is attributed to the additional deposits acquired in
the acquisition of TexStar and the interest expense incurred on the subordinated
debt of the Company. The Company's loan growth for the nine months ended
September 30, 1998 was concentrated within the real estate loan portfolio and
the commercial loan portfolio. Real estate lending increased by 87.2% to
$49,932,368 from $26,668,598, commercial lending increased by 29.3% to
$29,951,905 from $23,171,566, consumer lending decreased by 16.3% to $8,894,323
from $10,632,451, and insurance premium financing decreased by 17.0% to
$33,493,016 from $40,373,695. The overall net growth in the loan portfolio is
attributed to the acquisition of TexStar. The average volume of consumer,
commercial, and real estate lending increased 35.4%, with an increase in the
average yields on those loans from 10.1% to 10.3%. The 12.3% decrease in the
average volume of insurance premium financing loans was accompanied by a yield
of 8.3% and 11.0% on those loans for the nine months ended September 30, 1998
and 1997, respectively. The average balance of interest bearing deposits
increased 26.3%, while the average rate paid was 4.4% and 4.3% for the nine
months ended September 30, 1998 and 1997, respectively.
The Company recorded a $1,611,875 provision for credit losses on loans during
the nine months ended September 30, 1998 compared to a $40,000 provision for
loan losses during the nine months ended September 30, 1997. The substantial
increase in provisions for the nine months ended September 30, 1998 was a result
of a decision by the Company's management to accept recommendations made by the
OCC in connection with its recent examination of Surety Bank. The loan charge-
offs net of recoveries for the nine months ended September 30, 1998 were
$1,958,698. The loan charge-offs were primarily the result of insurance premium
finance loans generated by Surety Bank's southeastern United States insurance
premium finance operation, headquartered in Atlanta, Georgia. Due to
significantly higher rates of cancellations and several problem insurance agency
and insurance company relationships, the Bank's past dues and problem loans
originated from that market had increased significantly in recent months. The
Bank charged-off insurance premium finance loans net of recoveries in the amount
of $1,874,231 for the nine months ended September 30, 1998. The Atlanta office
has been closed and, with exception of a few good relationships, loan production
from that market has been terminated. Management will continue to actively and
aggressively attempt to collect these charged-off loans. Surety Bank's
traditional Texas insurance premium finance
16
<PAGE>
portfolio continues to perform well. Management believes that all known losses
in the portfolio have been recognized.
The Company recorded a net $26,244 provision for medical claims factoring losses
during the nine months ended September 30, 1998 compared to a $255,000 provision
for medical claims factoring losses during the nine months ended September 30,
1997. The increase in provisions for the nine months ended September 30, 1998
was a result of a decision by the Company's management to accept recommendations
made by the OCC in connection with its recent examination of Surety Bank. The
medical claims factoring charge-offs net of recoveries for the nine months ended
September 30, 1998 were $4,271,704. The medical claims factored receivables
charged off during the nine months ended September 30, 1998 were originated
before December 31, 1997. The OCC recommended that due to the slower than
expected collection pace of these factoring receivables, the receivables should
be charged-off in their entirety and collection should be reflected as
recoveries. The current balance of medical claims factored receivables net of
unearned interest and allowance is at $680,505 as of September 30, 1998 and is
not expected to increase. Management is currently evaluating exit strategy
options for the medical claims factoring division of Surety Bank. Management
will continue to actively pursue the collection of these charged-off
receivables. Management believes that all known losses in the portfolio have
been recognized.
The Company's noninterest income increased 10.7% to $1,953,425 from $1,764,705
for the nine months ended September 30, 1998 and 1997, respectively. This
increase compares to an increase in average noninterest bearing deposits of
42.5% to $31,811,898 from $22,317,694 for these same periods. Noninterest income
is generated primarily from fees associated with noninterest and interest
bearing accounts along with fees charged on insurance premium finance loans.
Noninterest expense increased 24.0%, primarily the result of a 24.0% increase in
salaries and employee benefits, a 30.6% increase in occupancy and equipment
expenses, and a 20.8% increase in general and administrative expenses. The
increase in salaries and benefits was due primarily to additional staffing
required by the acquisition of TexStar. Increases in occupancy and equipment
expenses relate primarily to the operation of the five additional branches added
through the TexStar acquisition.
Three Months Ended September 30, 1998 Versus Three Months Ended September 30,
- - -----------------------------------------------------------------------------
1997
- - ----
The Company recorded net income of $150,505 or net earnings per basic common
share of $0.03 for the three months ended September 30, 1998, compared with
earnings of $520,374 ($0.09 per basic common share) for the three months ended
September 30, 1997. Total interest income increased 20.2% to $4,600,851 from
$3,827,497, while total interest expense increased 38.6% to $1,995,684 from
$1,439,733, resulting in a 9.1% decrease in net interest income before provision
for losses to $2,605,166 from $2,387,764.
The Company recorded no provision for credit losses or medical claims factoring
losses during the nine months ended September 30, 1998 compared to a $145,000
provision for credit losses and medical claims factoring losses during the nine
months ended September 30, 1997.
The Company's noninterest income increased 14.2% to $734,185 from $642,930 for
the three months ended September 30, 1998 and 1997, respectively. Noninterest
expense increased 50.5%, primarily the result of a 55.6% increase in salaries
and employee benefits, a 33.9% increase in occupancy and equipment expenses, and
a 52.5% increase in general and administrative expenses. The increase in
salaries and benefits along with occupancy and equipment and general and
administrative expenses were due primarily to additional staffing required by
the acquisition of TexStar.
Allowance for Credit Losses
The Company recorded a $1,611,875 provision for credit losses on loans during
the nine months ended September 30, 1998 compared to a $40,000 provision for
loan losses during the nine months ended September 30, 1997. The substantial
increase in provisions for the nine months ended September 30, 1998 was a result
of a decision by the Company's management to accept recommendations made by the
OCC in connection with its recent examination of Surety Bank. The loan charge-
offs net of recoveries for the nine months ended September 30, 1998 were
$1,958,698. The loan charge-offs were primarily the result of insurance premium
finance loans generated by Surety Bank's southeastern United States insurance
premium
17
<PAGE>
finance operation, headquartered in Atlanta, Georgia. Due to significantly
higher rates of cancellations and several problem insurance agency and insurance
company relationships, the Bank's past dues and problem loans originated from
that market had increased significantly in recent months. The Bank charged-off
insurance premium finance loans net of recoveries in the amount of $1,874,231
for the nine months ended September 30, 1998. The Atlanta office has been closed
and, with exception of a few good relationships, loan production from that
market has been terminated. Management will continue to actively and
aggressively attempt to collect these charged-off loans. Surety Bank's
traditional Texas insurance premium finance portfolio continues to perform well.
Management believes that all known losses in the portfolio have been recognized.
The Company recorded a net $26,244 provision for medical claims factoring losses
during the nine months ended September 30, 1998 compared to a $255,000 provision
for medical claims factoring losses during the nine months ended September 30,
1997. The increase in provisions for the nine months ended Septem ber 30, 1998
was a result of a decision by the Company's management to accept recommendations
made by the OCC in connection with its recent examination of Surety Bank. The
medical claims factoring charge-offs net of recoveries for the nine months ended
September 30, 1998 were $4,271,704. The medical claims factored receivables
charged off during the nine months ended September 30, 1998 were originated
before December 31, 1997. The OCC recommended that due to the slower than
expected collection pace of these factoring receivables, the receivables should
be charged-off in their entirety and collection should be reflected as
recoveries. The current balance of medical claims factored receivables net of
unearned interest and allowance is at $680,505 as of September 30, 1998 and is
not expected to increase. Management is currently evaluating exit strategy
options for the medical claims factoring division of Surety Bank. Management
will continue to actively pursue the collection of these charged-off
receivables. Management believes that all known losses in the portfolio have
been recognized.
The Company's provision for credit losses is based upon quarterly loan portfolio
reviews by management. The purpose of the reviews is to assess loan quality,
analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and
recoveries, and assess general economic conditions in the market economy. Credit
losses different from the allowance provided by the Company are likely, and
credit losses in excess or deficient of the allowance for credit losses are
possible. Credit losses in excess of the amount of the allowance could and
probably would have a material adverse effect on the financial condition of the
Company.
The ratio of the allowance for credit losses to total loans was 1.2% on
September 30, 1998 as compared to 0.9% on December 31, 1997. The allowance for
credit losses was $1,424,611 and $950,809 on Septem ber 30, 1998 and December
31, 1997, respectively. At September 30, 1998, nonaccrual loans were
approximately $870,000, loans past due 90 days or greater and still accruing
interest were $408,284, and total non-performing loans were approximately
$1,278,000.
The allowance for medical claims receivables losses to total medical claims
receivables was 8.4% at September 30, 1998 as compared to 58.4% on December 31,
1997. The allowance for medical claims receivables losses was $62,425 and
$4,307,885 on September 30, 1998 and December 31, 1997, respectively.
Parent Company Only Results of Operations
The Company did not own Surety Bank prior to December 30, 1989. Since that
time, the Company has served as a parent company to Surety Bank and has
minimized its own separate business activities. For the nine months ended
September 30, 1998, the Company had only nominal interest income of
approximately $18,000, approximately $196,000 in interest expense on its
subordinated debt and approximately $124,000 in noninterest expenses. The
noninterest expenses, which increased 5.1% from the same period in the prior
year, consisted primarily of legal and professional fees incurred in the
operation of the Company and in the maintenance of the Company's public company
status under applicable securities laws and regulations.
Current Trends and Uncertainties
Economic trends and other developments could adversely affect the Company's
operations. Regulatory changes may increase the Company's cost of doing
business or otherwise impact it adversely.
18
<PAGE>
Liquidity
The Company's investment securities portfolio, including federal funds sold, and
its cash and due from bank deposit balances serve as the primary sources of
liquidity. At September 30, 1998, 16.8% of Surety Bank's interest bearing
liabilities were in the form of time deposits of $100,000 and over. Although
unlikely, if a large number of these time deposits matured at approximately the
same time and were not renewed, Surety Bank's liquidity could be adversely
affected. Currently, the maturities of Surety Bank's large time deposits are
spread throughout the year, and Surety Bank monitors those maturities in an
effort to minimize any adverse effect on liquidity.
Over the long term, the ability of the Company to meet its cash obligations,
including interest payments on the Notes, will depend substantially on its
receipt of dividends from Surety Bank, which are limited by banking statutes and
regulations, and will be further limited by the draft of the Formal Agreement,
when formally executed by the Board of Directors of Surety Bank.
Pursuant to 12 U.S.C. (S) 56 a national bank may not pay dividends from its
capital. All dividends must be paid out of undivided profits, subject to other
applicable provisions of law. As of September 30, 1998 Surety Bank had undivided
profits of $28,298. Payment of dividends out of undivided profits is further
limited by 12 U.S.C. (S) 60(a), which prohibits a national bank from declaring a
dividend on its shares of common stock until its surplus equals its common
capital, unless there has been transferred to surplus not less than 1/10th of
the national bank's net income of the preceding half year in the case of
quarterly or semi-annual dividends or not less than 1/10th of the national
bank's net income of the preceding two consecutive half year periods in the case
of annual dividends. The payment of dividends by Surety Bank is also subject to
the provisions of 12 U.S.C. (S) 60(b), which provides that no dividend may be
declared or paid without the prior approval of the OCC if the total of all
dividends, including the proposed dividend, in any calendar year exceeds the
total of Surety Bank's net income for that year combined with its retained net
income (or loss) of the preceding two years. Surety Bank incurred an accumulated
loss for fiscal years 1996 and 1997 and for the nine months ended September 30,
1998 in the amount of ($1,808,544).
The draft of the Formal Agreement prohibits the Board of Directors of Surety
Bank from declaring or paying any dividends unless Surety Bank is (1) in
compliance with 12 U.S.C. (S)(S) 56 and 60, its approved capital program
provided for in the draft of the Formal Agreement, and the Tier I capital levels
set forth in the draft of the Formal Agreement, and (2) has obtained, if
required, the prior written approval of the OCC.
Surety Bank currently is precluded from declaring a dividend during this year
until it has profits for the current year in excess of $1,712,220, and has
satisfied the other requirements of the draft of the Formal Agreement, including
receipt of approval for the declaration and payment of the dividend from the
OCC, if required. No assurance can be given if and when Surety Bank will attain
the requisite level of profitability required by 12 U.S.C. (S)(S) 56 and 60 to
declare and pay a dividend and, even if such level of profitability is attained,
whether or not the OCC will approve the declaration and payment thereof.
As of September 30, 1998 the Company had $465,309 in cash, which represents an
amount sufficient to pay interest payments on the Notes through March 31, 1999.
The Company may use such cash for debt service on the Notes and other expenses.
Capital Resources
Shareholders' equity at September 30, 1998 was $15,639,126 as compared to
$15,877,333 at December 31, 1997. The Company had consolidated net loss of
$(301,826) for the nine months ended September 30, 1998.
General Capital Requirements. Under the regulatory risk-based capital
framework, Surety Bank is required to meet a minimum risk-based capital ratio to
risk-weighted assets ratio of 8%, of which at least one-half, or 4%, must be in
the form of Tier 1 (core) capital. The remaining one-half, or 4%, may be either
in the form of Tier 1 (core) or Tier 2 (supplementary) capital. The amount of
the loan loss allowances that may be included in capital is limited to 1.25% of
risk-weighted assets. The ratio of Tier 1 (core) and the combined amount of
Tier 1 (core) and Tier 2 (supplementary) capital to risk-weighted assets for
Surety Bank was 7.5% and 8.6%, respectively, at September 30, 1998 and 9.92% and
11.28%, respectively, at December 31, 1997. In addition, Surety Bank is
expected to maintain a Tier 1 capital to total assets ratio (Tier 1 leverage
ratio) of at least 3%. Surety Bank is currently, and expects to continue to be,
in compliance with these capital requirements.
19
<PAGE>
OCC Mandated Capital Levels in Connection with TexStar Acquisition. In
connection with the acquisition of TexStar by the Company through the merger of
TexStar with Surety Bank (the "Merger"), the OCC conditionally approved the
Merger, contingent upon (1) the Company contributing at least $4,000,000 in
additional capital to Surety Bank, (2) Surety Bank maintaining certain OCC-
mandated capital ratios in excess of the minimum "well-capitalized" capital
ratios for the years ending December 31, 1998, 1999 and 2000, and (3) in the
event of the failure of Surety Bank to maintain such minimum capital ratios, the
Company initiating efforts to bring Surety Bank back into compliance with such
minimum capital ratios (the "TexStar OCC Mandated Capital Levels"). At October
30, 1998, following the sale of the Branches, Surety Bank was well above the
TexStar OCC Mandated Capital Levels and the Company believes that Surety Bank
will continue to be well above the TexStar OCC Mandated Capital Levels for the
years ending December 31, 1998, 1999 and 2000, absent the occurrence of
unforeseeable events. No assurance, however, can be given that Surety Bank will
maintain such TexStar OCC Mandated Capital Levels for the years ending December
31, 1998, 1999 and 2000. If Surety Bank fails to maintain such TexStar OCC
Mandated Capital Levels for the years ending December 31, 1998, 1999 and 2000,
the Company is required (1) to contribute additional capital to Surety Bank,
which, if necessary, may be obtained by the Company through a traditional loan
from a financial institution or through an offering of the Company's securities,
or (2) to liquidate some of the assets of Surety Bank. Any loan obtained by the
Company will rank senior to the Notes, and the issuance of additional securities
by the Company may have a dilutive effect on the Common Stock issuable upon
conversion of the Notes. No assurance can be given that the Company will be
successful in such efforts. In the event Surety Bank fails to maintain such
TexStar OCC Mandated Capital Levels, the OCC may impose a number of corrective
measures on Surety Bank, including (1) the imposition of restrictions on certain
activities involving asset growth, acquisitions, branch establishment, expansion
into new lines of business, declaration and payment of dividends, and
transactions with affiliates, (2) the imposition of certain additional mandated
capital raising activities, and (3) as a last resort, the appointment of a
receiver or conservator of Surety Bank.
Formal Agreement with the OCC. In connection with the recent examination of
Surety Bank by the OCC, the OCC has presented to the Board of Directors of
Surety Bank a draft of a formal written agreement to be executed by each member
of the Board of Directors (the "draft of the Formal Agreement") pursuant to
which Surety Bank is required to achieve certain capital levels and adopt and
implement certain plans, policies and strategies. Pursuant to the draft of the
Formal Agreement presented to Surety Bank, Surety Bank is required to achieve by
March 31, 1999 Tier I and Tier II combined capital at least equal to 14% of
risk-weighted assets and Tier I leverage capital at least equal to 7.5% of
adjusted total assets. Surety Bank has been orally advised by the OCC that the
draft of the Formal Agreement will be revised prior to its submission to the
Board of Directors of Surety Bank to require Surety Bank to achieve by March 31,
1999 Tier I and Tier II combined capital at least equal to 12% of risk-weighted
assets and Tier I leverage capital at least equal to 7.5% of adjusted total
assets, and by December 31, 1999 Tier I and Tier II combined capital at least
equal to 14% of risk-weighted assets. Management believes that the draft of the
Formal Agreement, as orally proposed to be amended by the OCC, will be signed by
each member of the Board of Directors at the November 1998 meeting of the Board
of Directors.
The capital requirements imposed by the draft of the Formal Agreement are more
onerous than the TexStar OCC Mandated Capital Levels and the general capital
requirements discussed above under "Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Capital Resources:
General Capital Requirements." At October 16, 1998, following the consummation
of the sale of the four Branches, Surety Bank had Tier I and Tier II combined
capital of 10.6% of risk-weighted assets and Tier I leverage capital of 6.7% of
adjusted total assets. Management believes that it will be able to achieve the
requisite Tier I and Tier II combined capital levels and the requisite leverage
ratio required by March 31, 1999 and December 31, 1999, respectively, as set
forth in the draft of the Formal Agreement, as proposed to be amended. However,
no assurance can be given that management will be successful in such efforts.
The OCC has extensive enforcement authority over the operations of all national
banks, including Surety Bank. If Surety Bank fails to comply with all of the
requirements set forth in the draft of the Formal Agreement by the dates set
forth in such draft of the Formal Agreement, the OCC may under certain
circumstances assess civil monetary damages against Surety Bank and the
Directors of Surety Bank, issue cease-and-desist or removal orders and initiate
injunctive actions.
Additionally, pursuant to the draft of the Formal Agreement the Board of
Directors is required to develop a three year capital program, a plan to enhance
its management information systems, a three year strategic plan establishing
objectives for Surety Bank's earnings performance, growth, balance sheet mix,
off-
20
<PAGE>
balance sheet activities, liability structure, capital adequacy, reduction in
the volume of nonperforming assets, product line development and market segments
which Surety Bank intends to promote or develop, together with strategies to
achieve those objectives, a revised loan policy, and a loan classification
policy, each for submission to, and approval by, the OCC.
Also, the draft of the Formal Agreement prohibits the Board of Directors from
declaring or paying any dividends unless Surety Bank is in compliance with (1)
12 U.S.C. (S)(S) 56 and 60, its approved capital program provided for in the
draft of the Formal Agreement, and the Tier I capital levels set forth in the
draft of the Formal Agreement, and (2) has obtained the prior written approval
of the OCC. Because of the dividend restrictions pursuant to 12 U.S.C. (S)(S)
56 and 60, no assurance can be given that the OCC will approve a dividend
payment by Surety Bank to the Company to enable the Company to make the
September 30, 1999 interest payment on the Notes. The Notes may not be
accelerated as a result of any failure of the Company timely to pay interest on
the Notes. The Notes may only be accelerated in the event of the bankruptcy,
insolvency or reorganization of the Company. In the event of a default in the
payment of interest by the Company, the holders of the Notes (or the Trustee on
behalf of the holders of all of the Notes affected) may, in lieu of accelerating
the maturity of the Notes, seek to enforce payment of such interest.
While the Company believes it has sufficient financing for its working capital
needs until the end of its 1998 fiscal year, there can be no assurance that the
Company's present capital and financing will be sufficient to finance future
operations thereafter. If the Company sells additional shares of common and/or
preferred stock to raise funds, the terms and conditions of the issuances and
any dilutive effect may have an adverse impact on the existing stockholders. If
additional financing becomes necessary, there can be no assurance that the
financing can be obtained on satisfactory terms. In this event, the Company
could be required to restrict its operations.
The Board of Governors of the Federal Reserve System (the "Federal Reserve") has
announced a policy sometimes known as the "source of strength doctrine" that
requires a bank holding company to serve as a source of financial and managerial
strength to its subsidiary banks. The Federal Reserve has interpreted this
requirement to require that a bank holding company, such as the Company, stand
ready to use available resources to provide adequate capital funds to its
subsidiary banks during periods of financial stress or adversity. The Federal
Reserve has stated that it would generally view a failure to assist a troubled
or failing subsidiary bank in these circumstances as an unsound or unsafe
banking practice, a violation of Regulation Y, or both, justifying a cease and
desist order or other enforcement action, particularly if appropriate resources
are available to the bank holding company on a reasonable basis. The
requirement that a bank holding company, such as the Company, make its assets
and resources available to a failing subsidiary bank could have an adverse
effect upon the Company and its stockholders.
Recent Accounting Pronouncements
In June 1997 the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income"
("SFAS 130"). SFAS 130 establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains, and losses)
in a full set of general-purpose financial statements. SFAS 130 requires that
all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. SFAS 130 does
not require a specific format for the financial statement but requires that an
enterprise display an amount representing total comprehensive income for the
period in that financial statement. SFAS 130 is effective for fiscal years
beginning after December 15, 1997. Reclassification of financial statements for
earlier periods provided for comparative purposes is required. The Company
adopted SFAS 130 in the fiscal quarter ended March 31, 1998.
In June 1997, FASB issued Statement of Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information" ("SFAS
131"). SFAS 131 establishes standards for the way that public enterprises
report information about operating segments in annual financial statements, and
requires that those enterprises report information about operating segments in
annual financial statements and report selected information about operating
segments in interim financial reports issued to shareholders. SFAS 131 also
establishes standards for related disclosures about products and services,
geographic areas, and major customers.
21
<PAGE>
SFAS 131 requires that a public business enterprise report financial and
descriptive information about its reportable operating segments. Operating
segments are components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision maker in deciding how to allocate resources and in assessing
performance. Generally, financial information is required to be reported on the
basis that it is used internally for evaluating segment performance and deciding
how to allocate resources to segments.
SFAS 131 is effective for fiscal years beginning after December 15, 1997. In
the initial year of application, comparative information for earlier years is to
be restated. SFAS 131 will be adopted by the Company on December 31, 1998. The
Company is expected to have two operating segments to report on, the traditional
banking segment and the insurance premium finance segment.
In June 1998, FASB issued Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS
133 establishes accounting and reporting standards for derivative instruments
and hedging activities. It requires recognition of all derivatives as either
assets or liabilities in the statement of financial condition and measurement of
those instruments at fair value. The accounting for gains and losses on
derivatives depends on the intended use of the derivative. This Statement is
effective for all fiscal quarters of fiscal years beginning after June 15, 1999,
with earlier application encouraged. Retroactive application is not permitted.
Management has not completed its evaluation of the expected impact of SFAS 133
on the financial condition or operations of the Company.
Management believes that the adoption of these pronouncements will not have a
material impact on the financial condition or results of operations of the
Company.
Year 2000 Computer Problem
The following section contains forward-looking statements which involve risks
and uncertainties. The actual impact of the Year 2000 issue on the Company could
materially differ from that which is anticipated in these forward-looking
statements as a result of certain factors identified below.
Company's State of Readiness. Management is aware of the possibility of
exposure by banks to a computer problem known as the "Year 2000 Problem" or the
"Millennium Bug" (the inability of some computer programs to distinguish between
the year 1900 and the year 2000). If not corrected, some computer applications
could fail or create erroneous results by or at year 2000. This could cause
entire system failures, miscalculations, and disruptions of normal business
operations including, among other things, a temporary inability to process
transactions, send statements, or engage in similar day to day business
activities. The extent of the potential impact of the Year 2000 Problem is not
yet known, and if not timely corrected, could affect the global economy.
Management has assessed the extent of vulnerability of the Company's computer
systems to the Year 2000 Problem. The Company's conversion in August 1998 to
its data processor's updated software for core banking application software and
the purchase of a new NCR 3000 series hardware system on which to run the core
processing software has greatly minimized the Company's exposure to these
problems. The software of the Company's data processor was certified by Wayne
Barnett, CPA, MBA, an experienced EDP examiner proficient in COBOL, on July 21,
1998 to be Year 2000 compliant. The NCR 3000 series hardware received Year 2000
certification from NCR. Some testing of critical systems has already been
completed. However, internal testing and validation for the primary mission
critical systems is scheduled for November 1998 and management expects that the
process will be completed by December 1998.
Risk Assessment of Year 2000. The Company believes that with modifications to
existing software and hardware and conversions to new software and hardware the
Year 2000 problem will not pose a significant operational problem for the
Company. However, because most computer systems are, by their very nature,
interdependent, it is possible that non-compliant computers of third parties
with whom the Company has a material relationship could impact the Company's
operations. The Company has taken steps to communicate with such third parties
to assess Year 2000 readiness by such third parties. The Company is also
currently assessing the impact, if any, the Year 2000 may have on its large loan
(credit risk) and deposit customers.
22
<PAGE>
Costs of Year 2000. As described above, the primary banking application is Year
2000 compliant; therefore, little programming costs will be incurred. Most of
the costs incurred in addressing this problem are related to planning, internal
testing and validation which are expected to be expensed as incurred. The
financial impact to the Company of Year 2000 compliance has not been, and is not
anticipated to be, material to the Company's financial position or results of
operations for 1998 or 1999. Management estimates the costs will be
approximately $143,000. However, there can be no guarantee that actual costs
incurred will be in line with these estimates. Specific factors that might cause
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to replace non-compliant third
parties with whom the Company has a material relationship, and similar
uncertainties.
Contingency Plans. The Company has not finalized its contingency plans, but
intends to complete them by December 31, 1998.
Impact of Inflation, Changing Prices and Monetary Policies
The financial statements and related financial data concerning the Company in
this report have been prepared in accordance with generally accepted accounting
principles, which require the measurement of financial position and operating
results in terms of historical dollars without considering changes in the
relative purchasing power of money over time due to inflation. The primary
effect of inflation on the operations of the Company is reflected in increased
operating costs. Unlike most industrial companies, virtually all of the assets
and liabilities of a financial institution are monetary in nature. As a result,
changes in interest rates have a more significant effect on the performance of a
financial institution than do the effects of changes in the general rate of
inflation and changes in prices. Interest rates do not necessarily move in the
same direction or in the same magnitude as the prices of goods and services.
Interest rates are highly sensitive to many factors, which are beyond the
control of Surety Bank, including the influence of domestic and foreign economic
conditions and the monetary and fiscal policies of the United States government
and federal agencies, particularly the Federal Reserve Bank. The Federal
Reserve Bank implements national monetary policy such as seeking to curb
inflation and combat recession by its open market operations in United States
government securities, control of the discount rate applicable to borrowing by
banks and establishment of reserve requirements against bank deposits. The
actions of the Federal Reserve Bank in these areas influence the growth of bank
loans, investments and deposits, and affect the interest rates charged on loans
and paid on deposits. The nature, timing and impact of any future changes in
federal monetary and fiscal policies on Surety Bank and its results of
operations are not predictable.
Forward-Looking Statements
All statements other than statements of historical fact regarding the Company's
financial condition, results of operation, business strategy and future
acquisitions or operations are "forward-looking statements" within the meaning
of the Private Securities Litigation Reform Act of 1995. When used herein,
words such as "believes," "anticipates," "intends," "expects," "should," and
words of similar import identify a forward-looking statement. Such forward-
looking statements may involve numerous assumptions about known and unknown
trends, risks and uncertainties, including economic conditions; actions taken by
the Federal Reserve Board and the OCC; other legislative and regulatory actions
and reforms; as well as other factors, all of which change over time and which
may ultimately prove to be inaccurate These other factors include the Company's
ability to successfully use excess liquidity following the acquisition of
TexStar, to continue to make future acquisitions, to collect charged-off and
provisioned for insurance premium financing loans and medical claims factoring
receivables, and to comply with the requirements of the draft of the Formal
Agreement. Actual results may differ materially from any future results
expressed or implied by such forward-looking statements.
23
<PAGE>
Item 3. Qualitative and Quantitative Disclosure About Market Risk
In the normal course of conducting business activities, the Company is exposed
to market risk, principally interest rate risk, through the operations of its
banking subsidiary. Interest rate risk arises from market driven fluctuations in
interest rates that affect cash flows, income, expense and values of financial
instruments. Interest rate risk is managed by management and the board of
directors of the Company. No material changes in market risk strategy occurred
during the current period. A detailed discussion of market risk is provided in
the Company's Annual Report on Form 10-K for the period ended December 31, 1997.
24
<PAGE>
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
Surety Bank (the "Bank") is a defendant in two related cases: Tennessee Ex
Rel. Douglas Sizemore, Commissioner of Commerce and Insurance for the State
of Tennessee, et al. vs. Surety Bank, N.A., filed in June 1995 in the
Federal District Court for the Northern District of Texas, Dallas Division
(the "Anchorage Case"), and United Shortline Inc. Assurance Services, N.A.
et al. vs. MacGregor General Insurance Company, Ltd., et al., now pending
in the 141st Judicial District Court of Tarrant County, Texas (the
"MacGregor Case").
The claimant in the Anchorage Case is the Tennessee Commissioner of
Commerce and Insurance ("Tennessee"), appointed by the Chancery Court for
the State of Tennessee, Twentieth Judicial District, Davidson County, to
liquidate Anchorage Fire and Casualty Insurance Company ("Anchorage"),
including Anchorage deposits at the Bank. Tennessee seeks to recover
compensatory and punitive damages on various alleged causes of action,
including violation of orders issued by a Tennessee court, fraudulent and
preferential transfers, common law conversion, fraud, negligence, and bad
faith, all of which are based on the same underlying facts and course of
conduct. The plaintiff in the MacGregor Case, United Shortline Inc.
Assurance Services, N.A. ("Shortline"), is the holder of a Florida judgment
against MacGregor General Insurance Company, Ltd. ("MacGregor") who seeks
to recover funds allegedly belonging to MacGregor which were held by the
Bank.
Both cases arise out of the Bank's alleged exercise of control over funds,
representing the Bank's collateral, held in accounts at the Bank under
agreements with Anchorage and MacGregor. The Bank asserts that it had a
right to exercise control over its collateral under contractual agreements
between the Bank and the respective insurance companies or the Bank and the
policyholders, and also in order to protect the Bank against the
possibility of inconsistent orders regarding the same funds. Tennessee
also seeks to recover funds allegedly transferred in and out of the
Anchorage/MacGregor accounts at the Bank during an approximate four-month
period in 1993.
When the MacGregor case was initially filed, Shortline sought a restraining
order against the Bank concerning the MacGregor funds. When the Bank
received notice of competing claims to some or all of these funds by
Tennessee, the Bank intervened and interpled approximately $600,000 into
the court's registry. Shortline now seeks, inter alia, damages against the
Bank from an alleged wrongful offset wherein the Bank allegedly exercised
control over the MacGregor funds at the Bank pursuant to agreements with
MacGregor. The Bank moved for and obtained a summary judgment that its
intervention and interpleader of funds was proper. Shortline also sought
and obtained a summary judgment from the trial court that the funds
interpled by the Bank into the court's registry belonged to Shortline.
Tennessee appealed the summary judgment to the Fort Worth Court of Appeals.
The Fort Worth Court of Appeals affirmed the trial court's ruling that the
Bank's intervention and interpleader was proper but reversed the trial
court's ruling that the funds in the court belonged to Shortline. After
appeal by Tennessee, the Texas Supreme court affirmed the judgement of the
Court of Appeals. Tennessee has filed a Motion for Rehearing, which is
currently pending.
On July 27, 1998 the United States District Court in the Anchorage case
granted a summary judgement in favor of the Bank that Tennessee take
nothing by its suit. This judgement has recently been entered, and it is
expected that Tennessee will appeal to the United States Court of Appeals.
The Bank believes both of these cases lack merit and will continue to
defend them vigorously. The final outcome of both of these cases is
uncertain at this time.
Item 2. Changes in Securities and Use of Proceeds.
Not applicable.
25
<PAGE>
Item 3. Defaults Upon Senior Securities.
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
Item 5. Other Information.
Not applicable.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
27 Financial Data Schedule *
______________
* Filed herewith.
(b) Reports on Form 8-K
On July 27, 1998 the Company filed a Current Report on Form 8-K to
report that on July 13, 1998 Surety Bank entered into a Branch Purchase
and Assumption Agreement with Commercial Bank of Texas, National
Association, Nacogdoches, Texas, to sell to Commercial Bank Surety
Bank's four east Texas branches located in Lufkin, Kennard, Wells and
Chester.
On October 6, 1998 the Company filed a Current Report on Form 8-K/A
(Amendment No. 3) to amend the Form 8-K filed on April 9, 1998 to
include unaudited financial statements of the acquired bank.
On November 2, 1998 the Company filed a Current Report on Form 8-K to
report that on October 16, 1998 the Company's subsidiary, Surety Bank,
National Association, completed the sale of its four Lufkin-area
branches located in Lufkin, Kennard, Wells and Chester, Texas to
Commercial Bank of Texas, National Association, Nacogdoches, Texas. The
following financial statements were included: Pro Forma Balance Sheet
as of September 30, 1998 and Pro Forma Income Statement for the nine
months ended September 30, 1998 and for the twelve months ended December
31, 1997.
26
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: November 12, 1998 SURETY CAPITAL CORPORATION
By: /s/ Bobby W. Hackler
---------------------------------
Bobby W. Hackler
Chairman of the Board
By: /s/ B.J. Curley
---------------------------------
B.J. Curley
Vice President, Chief Accounting
Officer and Secretary
27
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<PAGE>
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<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 9,054,812
<INT-BEARING-DEPOSITS> 94,939
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0
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