California First National Bancorp, a California corporation (the “Company”), is a bank holding company headquartered in Orange County, California with leasing and bank subsidiaries. The Company has two leasing subsidiaries, California First Leasing Corporation (“CalFirst Leasing”) and Amplicon, Inc. (“Amplicon”), collectively the “Leasing Companies”. The Company has a bank subsidiary, California First National Bank (“CalFirst Bank” or the “Bank”), which is an FDIC-insured national bank.

 

The Leasing Companies and CalFirst Bank focus on leasing and financing capital assets, primarily computers, computer networks and other high technology assets, through centralized marketing programs designed to offer cost-effective leasing alternatives. Leased assets are re-marketed at lease expiration through sale or re-lease. CalFirst Bank also provides business loans to fund the purchase of assets leased by third parties, including the Leasing Companies. CalFirst Bank gathers deposits from a centralized location primarily through posting rates on the Internet.

Forward-Looking Statements

This Form 10-K contains forward-looking statements.. Forward-looking statements include, among other things, the information concerning our possible future consolidated results of operations, business and growth strategies, financing plans, our competitive position and the effects of competition. Forward-looking statements include all statements that are not historical facts and can be identified by forward-looking words such as “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “plan”, “may”, “should”, “will”, “would”, “project” and similar expressions. These forward-looking statements are based on information currently available to us and are subject to inherent risks and uncertainties, and certain factors could cause actual results to differ materially from those anticipated. Factors that might affect forward-looking statements include, among other things:

 
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General economic or industry conditions could be less favorable than expected, resulting in a reduced demand for capital assets, deterioration in credit quality, deterioration in the recoverability of our investment in leased property and lease residual values, and a change in the allowance for lease losses;
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Changes in the domestic interest rate environment, including the continuation of a flat yield curve, could reduce net interest income and higher interest rates can negatively affect certain lessees, which could increase lease losses;
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As CalFirst Bank grows and represents a greater portion of the Company’s assets, the Company’s sensitivity to changes in interest rates is increasing;
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The Company’s subsidiaries have retained an increasing number of lease transactions in their own portfolios which has increased the Company’s exposure to credit risk;
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CalFirst Bank may not attract or retain sufficient deposits at attractive interest rates to fund its lease portfolio, and therefore could require additional investment by the Company and produce lower lease growth;
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Security breaches, systems failures, computer viruses or other similar events could damage CalFirst Bank’s reputation, or Internet banks in general, and inhibit the ability to raise deposits;
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The conditions of the securities markets could change, adversely affecting certain lessees and the value or credit quality of the Company's assets, or the availability and terms of non-recourse financing obtained to complete certain lease transactions;
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The Company’s Common Stock trades on the NASDAQ Global Market System, but the volume of trading has been very limited and the low volume of trading severely limits the liquidity of the Common Stock;
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Changes in the extensive laws, regulations and policies governing financial services companies could alter the Company's business environment or affect operations;
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Catastrophic events could impair the Company’s business operations or systems, or that of its lessees, resulting in losses;
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All the above factors could impact the Company’s ability to remain in compliance with commitments made to federal bank regulators in connection with the formation of CalFirst Bank.


California First National Bancorp and Subsidiaries

     The result of these and other factors could cause a difference from expectations of the risk characteristics of the lease portfolio, the level of defaults and a change in the provision for lease losses. Forward-looking statements speak only as of the date made. The Company undertakes no obligations to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made.  

Leasing Activities

The Company leases most capital assets used by businesses and organizations, with a focus on high technology equipment and software systems. The leases are structured individually and can provide end-of-term options to accommodate a variety of our customers’ objectives. Approximately 36% and 45% of the leases booked in fiscal 2006 and 2005, respectively, involved computer workstations and networks, mid-range computers, computer automated design systems and computer software. Other major property groups during fiscal 2006 included furniture and fixtures (20%), manufacturing equipment (11%), yellow equipment (10%), transportation (8%) and telecommunications systems (6%).

Computer Systems . Advances in technology, including the rapidly expanding capabilities of personal computer systems and the Internet, have led to continued demand for more powerful computer servers and communications networks. Computer networks typically consist of a central server, which may be a mid-range computer or high-end microcomputer, multiple personal computers and workstations, network communications hardware and software, printers and associated products. Computer networks generally range in cost from $100,000 to $3,000,000. The leased property is used primarily by middle-market companies for centralized data processing, by subsidiaries and divisions of large companies to supplement mainframe computer systems, and by non-profit associations and institutions.

The computer systems and network products leased are manufactured by Apple Computers, Inc. (“Apple”), Cisco Systems, Inc. (“Cisco”), Dell Inc. (“Dell”), Gateway, Inc. (“Gateway”), Hewlett-Packard Company ("HP"), International Business Machines Corporation ("IBM"), and Sun Microsystems, Inc. (“Sun”), among many others.

Software . Specialized application software packages and operating system software products represent a significant portion of property leased. These application software packages typically range in cost from $50,000 to $1,000,000. In addition to leasing stand-alone software packages, an increasing percentage of the cost of computer systems and networks consists of operating and application software. The software leased is acquired from vendors such as Microsoft Corporation, Oracle Corporation, J.D. Edwards & Company, Jenzabar, Inc., Parametric Technology Corporation, PeopleSoft, Inc., Geac Computer Corporation Limited, MSC.Software Corporation, and SAP AG, among many others.

Other Electronic Equipment . Advances in microcomputer technology have also expanded the scope of other electronic equipment utilized by the targeted customer base. Retail point-of-sale systems include those produced by IBM, Knogo Corporation, NCR Corporation (“NCR”), and Fujitsu Limited, while bank automated teller machines also have been procured from NCR. Telecommunications property leased includes digital private branch equipment, switching equipment and voice mail systems manufactured by Lucent Technologies Inc., NEC Corporation, Nortel Networks Limited, and Siemens Information and Communications Networks, Inc., as well as satellite tracking systems manufactured by QUALCOMM Incorporated. Other electronic equipment leased includes imaging systems, testing equipment, and copying equipment.

Production Equipment and Other Personal Property . Leased property also includes technology-related manufacturing and distribution management systems that include complex computer controlled manufacturing and production systems, printing presses and warehouse distribution systems. In addition, a wide variety of personal property in the “non-high technology” area, including machine tools, school buses, trucks, exercise equipment and office and dorm furniture are also leased.

California First National Bancorp and Subsidiaries

Marketing Strategy

     The Company’s subsidiaries market through centralized marketing programs and direct delivery channels, including the telephone, the Internet, facsimile and express mail. The marketing programs include a confidential database of current and potential users of business property, a training program to introduce new marketing employees to leasing, and an in-house computer and telecommunications system. The marketing programs have been augmented through the expanded use of web sites and email to identify and communicate with potential customers.

     The Company believes that a centralized marketing program is more cost effective than field sales representatives. Marketing through the telephone or the Internet, rather than through field sales representatives, has enabled us to limit selling, general and administrative expenses and allows the Company to offer more competitive lease rates to customers.

     Potential customers are identified through a variety of methods. Lists of target market participants and computer users are purchased from private sources, direct mail and telephone campaigns are conducted to generate sales leads, and proprietary records of contacts made with potential customers are maintained by sales professionals. Prospect management software is utilized to enhance the productivity of the sales force. Specific information about potential customers is entered into a confidential database accessible to sales professionals and their managers. As potential customers are contacted, the database is updated and supplemented with information about what computer and other property they are using, related lease expiration dates and any future system needs or replacement plans. The database allows sales professionals to efficiently identify the most likely purchaser or lessee of capital assets and to concentrate efforts on these prospective customers.

     The databases, combined with the respective prospect management software and an integrated in-house telecommunications system, permit sales management to monitor account executive activity, daily prospect status and pricing information. The ability to monitor account activity and offer immediate assistance in negotiating or pricing a transaction makes it possible to be responsive to customers and prospects.

      Capital Leases

     Leases are generally for initial terms ranging from two to five years. Substantially all leases are non-cancelable "net" leases which contain "hell-or-high-water" provisions under which the lessee must make all lease payments regardless of any defects in the property, and which require the lessee to maintain and service the property, insure the property against casualty loss and pay all property, sales and other taxes. The Leasing Companies or the Bank retain ownership of the property they lease, and in the event of default by the lessee, they, or the lender to whom the lease may have been assigned, may declare the lessee in default, accelerate all lease payments due under the lease and pursue other available remedies, including repossession of the property. Upon the expiration of the leases, the lessee typically has an option, which is dependent upon each lease's defined end of term options, to either purchase the property at a negotiated price, or in the case of a "conditional sales contract," at a predetermined minimum price, or to renew the lease. If the original lessee does not exercise the purchase option, once the leased property is returned, the Leasing Companies or CalFirst Bank will seek to sell the leased property. The terms of the software leases are substantially similar to equipment leases.

     The Leasing Companies and CalFirst Bank conduct their leasing business in a manner designed to minimize risk, however, they are subject to risks through their investment in lease receivables held in their own portfolio, lease transactions in process, and residual investments. The Leasing Companies and CalFirst Bank do not purchase leased property until they have received a binding non-cancelable lease from the customer. A portion of the Leasing Companies’ lease originations are discounted to banks or finance companies, including CalFirst Bank, on a non-recourse basis at fixed interest rates that reflect the customers' financial condition. The lender to which a lease has been assigned has no recourse against the Leasing Companies, unless the Leasing Companies are in default under the terms of the agreement by which the lease was assigned. The institution to which a lease has been assigned may take title to the leased property, but only in the event the lessee fails to make lease payments or otherwise defaults under the terms of the lease. If this occurs, the Leasing Companies may not realize their residual investment in the leased property.

California First National Bancorp and Subsidiaries

Lease Portfolio

     The Company has pursued a strategy of retaining lease transactions in its own portfolios. During the fiscal years ended June 30, 2006, 2005 and 2004, 91%, 93% and 88%, respectively, of the total dollar amount of new leases completed by the Company’s subsidiaries were retained in the Company’s portfolios, with 9%, 7% and 12% for fiscal years 2006, 2005 and 2004, respectively, of such leases discounted to unaffiliated financial institutions. Approximately 30% and 18% of the new leases booked by the Leasing Companies were assigned to CalFirst Bank during fiscal 2006 and 2005, respectively.

     The Leasing Companies apply a portfolio management system intended to develop portfolios with different risk/reward profiles. Each lease transaction held by the Leasing Companies must meet or exceed certain credit or profitability requirements established, on a case-by-case basis, by the credit committee for the portfolio. Through the use of non-recourse financing, the Leasing Companies avoid risks that do not meet their risk/reward requirements. Certain portfolios hold leases where the credit profile of the lessee or the value of the underlying leased property is not acceptable to other financial institutions. At June 30, 2006, 2005, and 2004, the discounted minimum lease payments receivable related to leases retained in the Leasing Companies’ portfolio amounted to $103.1 million, $107.9 million and $99.0 million, respectively. Such amounts represented 51%, 61% and 70% of the Company’s total investment in discounted lease payments receivable at June 30, 2006, 2005 and 2004, respectively.

     The Bank’s strategy is to develop a conservative, diversified portfolio of leases with high credit quality lessees. The Bank’s credit committee has established underwriting standards and criteria for the lease portfolio and monitors the portfolio on an ongoing basis. The Bank performs an independent credit analysis and due diligence on each lease transaction originated or purchased. The committee applies the same underwriting standards to all leases, regardless of how they are sourced. At June 30, 2006, 2005 and 2004, the Bank’s investment in discounted lease payments receivable amounted to $101.1 million, $68.0 million and $41.7 million or 49%, 39% and 30%, respectively, of the Company’s total portfolio. Of such amounts, approximately 62%, 74% and 71%, respectively, represented leases originated directly by the Bank.

     Through its lease purchase operations, the Bank purchases lease receivables on a non-recourse basis at fixed interest rates that reflect the proposed lessee's financial condition and current market conditions. The Bank does not assume any obligations as lessor for these transactions, and the original lessor retains ownership of any underlying asset, with the Bank taking a priority first lien position. The Bank verifies the completeness of all lease documentation prior to purchase, to confirm that all documentation is correct and held, that liens have been perfected, and legal documentation has been filed as appropriate. Pursuant to the Bank’s operating plan approved by regulators, no more than 50% of its lease portfolio will represent purchases of lease receivables from the Leasing Companies.

     The Leasing Companies and the Bank often make payments to purchase leased property prior to the commencement of the lease. The disbursements for such lease transactions in process are generally made to facilitate the property implementation schedule of the lessees. The lessee generally is contractually obligated to make rental payments during the period that the transaction is in process, and obligated to reimburse the Leasing Companies or the Bank for all disbursements under certain circumstances. Income is not recognized while a transaction is in process and prior to the commencement of the lease. At June 30, 2006, 2005, and 2004, the Company’s total investment in property acquired for transactions in process amounted to $41.7 million, $34.1 million and $30.5 million, respectively. Of such amounts, approximately 76% for each year related to the Leasing Companies, with the balance held by CalFirst Bank.

      Credit Risk Management

     The Company’s strategy for credit risk management includes stringent credit authority centered at the most senior levels of management. The strategy also emphasizes diversification on both a geographic and customer level, and spreading risk across a breadth of leases while minimizing the risk to any one area. The credit process includes a policy of classifying all leases in accordance with a risk rating classification system, monitoring changes in the risk ratings of lessees, identification of problem leases and special procedures for the collection of problem leases. The lease classification system is consistent with regulatory models under which leases may be rated as “pass”, “special mention”, “substandard”, “doubtful” or “loss”.

California First National Bancorp and Subsidiaries

     The day-to-day management and oversight of the Leasing Companies’ portfolios is conducted by an Asset Management (“AM”) group that reports directly to the Chief Financial Officer. The AM group monitors the performance of all leases held in the Leasing Companies’ portfolio, transactions in process as well as lease transactions assigned to lenders, if the Leasing Companies retain a residual investment in the leased property subject to the lease. The AM group conducts an ongoing review of all leases 10 or more days delinquent. The AM group contacts the lessee directly and generally sends the lessee a notice of non-payment within 15 days after the due date. In the event that payment is not then received, senior management becomes involved. Delinquent leases are coded in the AM tracking system in order to provide management visibility, periodic reporting, and appropriate reserves. Legal recourse is considered and promptly undertaken if alternative resolutions are not obtained. At 90 days past due, leases will be placed on non-accrual status such that interest income related to the lease no longer accretes into income.

 

     The Bank internally funds all Bank originations and lease purchases, and consequently, the Bank retains the credit risk on such leases. The AM group at the Leasing Companies provides servicing to the Bank and, as servicer, maintains a delinquency reporting and monitoring system to identify potential problems in the Bank’s portfolio early, and provide Bank management with information in a timely manner. Strategies similar to those used on the Leasing Companies’ portfolio are utilized by the Bank.

     The Bank has developed policies and procedures for identifying and qualifying third-party lessors. In sourcing third-party lease originations, the Bank will target those seasoned leasing companies whose principals are determined to be reputable, ethical and experienced with positive leasing operations histories. The Bank’s due diligence, including background checks, qualifications verification and credit evaluation of the lessor firm and its principals, is considered to be as important as that conducted for each lessee.

 

      Allowance for Lease Losses

 

     The allowance for lease losses is an estimate of probable and assessable losses in the Company’s lease portfolios applying the principles of SFAS 5, “Accounting for Contingencies,” SFAS 114, “Accounting by Creditors for Impairment of a Loan,” and SFAS 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures.” The allowance recorded is based on a quarterly review of all leases outstanding and transactions in process. The determination of the appropriate amount of any provision is based on management’s judgment at that time and takes into consideration all known relevant internal and external factors that may affect the lease portfolio. The primary responsibility for setting reserves resides with the Chief Financial Officer, who reports quarterly to the Company’s Audit Committee and Board of Directors regarding overall asset quality, problem leases and the adequacy of valuation allowances.

 

     The Company individually analyzes the net book value of each non-performing or problem lease to determine whether the carrying value is less than or equal to the expected recovery anticipated to be derived from lease payments, additional collateral or residual realization. The amount estimated as unrecoverable is recognized as a reserve specifically identified for the lease. An analysis of the remaining portfolio is conducted, taking into account recent loss experience, known and inherent risks in the portfolio, levels of delinquencies, adverse situations that may affect lessees’ ability to repay, trends in volume and current and anticipated economic conditions in the market. This portfolio analysis includes a stratification of the lease portfolio by risk classification and estimation of potential losses based on risk classification. The composition of the portfolio based on risk ratings is monitored, and changes in the overall risk profile of the portfolio is factored into the evaluation of inherent risks in the portfolio. Regardless of the extent of the Company's analysis of customer performance or portfolio evaluation, certain inherent but undetected losses are probable within the lease portfolio. This is due to several factors including inherent delays in obtaining information regarding a lessee's financial condition or change in business conditions; the judgmental nature of individual lease evaluations and classification, and the interpretation of economic trends; volatility of economic or customer-specific conditions affecting the identification and estimation of losses and the sensitivity of assumptions utilized to establish allowances for leases, among other factors. Therefore, an estimated inherent loss not based directly on the specific problem assets is recorded as an unallocated allowance. The level of such unallocated allowance is determined based on a review of prior years’ loss experience, and may vary depending on general market conditions. The aggregate allowance in any one period is apportioned between allowance for doubtful accounts and allowance for valuation of residual value.

 

California First National Bancorp and Subsidiaries

Bank management reports monthly to the Bank’s Board of Directors regarding overall asset quality, the adequacy of valuation allowances and adherence to policies and procedures regarding asset classification and valuation. A key component to the evaluation is the internal lease classification process. The Bank's classification of its assets and the amount of its valuation allowances are subject to review by regulators who can order the establishment of additional loss allowances.

Banking Operations

The Bank is focused on gathering deposits from depositors nationwide for the primary purpose of funding its investment in capital leases. The Bank’s strategy is to be a low cost producer through marketing its products and services directly to end-users. The Bank believes that its operating costs generally will be lower than those of traditional "bricks and mortar" banks because it does not have the expense of a traditional branch network to generate deposits and conduct operations.

 

Deposit Products

The Bank’s deposits have been gathered primarily through the Internet. Other strategies to identify depositors are through direct mail, telephone campaigns, purchase of leads from private sources and more extensive print advertisements. The Bank offers two types of interest-bearing checking accounts, savings accounts and three (3) month to three (3) year certificates of deposit (“CDs”) to taxable and IRA depositors. CDs are offered with varying maturities in order to achieve a fair approximation or match of the average life of the Bank’s lease portfolio. With leases generally providing for fixed rental rates, a matching fixed rate CD book is intended to allow the Bank to minimize interest rate fluctuation risk. The Bank generally offers interest rates on deposit accounts that are higher than the national average.

To open a new account, a customer can complete an on-line enrollment form on the Bank’s Web site, or can call the Bank’s toll-free customer service number and open an account telephonically. Signature cards and deposits are then mailed to the Bank. Customers can make deposits by wire transfer, via direct deposit programs, or by mail. No teller line is maintained. The Bank’s customers have 24-hour access to account information. Customers can view their banking records and current balances, and transfer funds between accounts through the use of personal computers. They can also pay bills on-line. Each customer automatically receives a free ATM card upon opening an account. In order to obtain cash, the Bank’s customers use other banks’ automated teller machines that are affiliated with the Plus ’ system. The Bank generally will reimburse customers for some portion of any ATM fees charged by other financial institutions. The Bank believes that any inconvenience resulting from the Bank not maintaining automated teller machines or a local branch office will be offset by the Bank’s higher investment yields and lower banking fees.

Operations

The Bank’s operations have been developed by outsourcing certain principal operational functions to leading bank industry service providers and by sharing established systems utilized by the Leasing Companies or the Company. Outsourced systems include the Bank’s core processing and electronic banking system, electronic bill payment systems and depositary services, including item processing. The Bank believes it benefits from the service provider's expertise and investments in developing technology. A critical element to the Bank’s success is the ability to provide secure transmission of confidential information over the Internet. The Bank’s service providers utilize sophisticated technology to provide maximum security. All banking transactions are encrypted and all transactions are routed from the Internet server through a "firewall" that limits access to the Bank’s and service provider’s systems. Systems are in place to detect attempts by third parties to access other users' accounts and feature a high degree of physical security, secure modem access, service continuity and transaction monitoring.

The Leasing Companies provide certain services to the Bank pursuant to formal agreements, including servicing the Bank’s lease portfolio on the Bank’s behalf.

 

California First National Bancorp and Subsidiaries

Investments

In addition to leases, the Company had total investments of $41.9 million at June 30, 2006, which includes interest-earning deposits with banks, money market securities, federal funds sold, Federal Reserve Bank stock and other investments, compared to $44.8 million at June 30, 2005. The Company is also authorized to invest in high-quality United States agency obligations, mortgage pool securities, and investment grade corporate bonds.

Customers

Leasing customers are primarily middle-market companies, subsidiaries and divisions of Fortune 1000 companies and organizations and institutions located throughout the United States with credit ratings acceptable to the Leasing Companies, CalFirst Bank or unaffiliated lenders providing non-recourse loans. The Company does not believe the loss of any one customer would have a material adverse effect on its operations taken as a whole.

The Bank’s deposit customers are individuals from across the nation who place a substantial portion of their savings in safe, government-insured investments and businesses that spread their liquid investments among a breadth of banks in order to ensure that they are government insured. Such depositors are seeking to maximize their interest income and, therefore, are more inclined to move their investments to a bank that offers the highest yield regardless of the geographic location of the depository.

Competition

The Company competes for the lease financing of capital assets with other independent leasing companies, commercial finance companies, banks and other financial institutions, credit companies affiliated with equipment manufacturers, such as IBM, Dell, and HP, and equipment brokers and dealers. Many of the Company's competitors have substantially greater resources, capital, and more extensive and diversified operations than the Company. The Company believes that the principal competitive factors are rate, responsiveness to customer needs, flexibility in structuring lease financing arrangements, financial technical proficiency and the offering of a broad range of lease financing options. The level of competition varies depending upon market and economic conditions, the interest rate environment, and availability of capital. Competition has increased in recent years as developments in the capital markets, and particularly the expansion of the securitization market, has increased access to capital to certain lenders that offer aggressive lease rates. Competition has also been heightened as credit companies affiliated with manufacturers have become more aggressive with respect to the financing terms offered.

 

The Bank competes with other banks and financial institutions to attract deposits. As a new entity, the Bank faces competition from established local and regional banks and savings and loan institutions. Many of them have larger customer bases, greater name recognition and brand awareness, greater financial and other resources and longer operating histories. T he market for internet banking has seen increased competition over the past several years as large national banks have deployed and aggressively promoted their own online banking platforms. These competitors have improved the functionality, dropped the fees and increased rates offered on on-line deposit accounts. Additionally, new competitors and competitive factors are likely to emerge with the continued development of Internet banking.

Supervision and Regulation

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is registered with, regulated and examined by the Board of Governors of the Federal Reserve System (the “FRB”). In addition to the regulation of the Company, the Bank is subject to extensive regulation and periodic examination, principally by the Office of the Comptroller of the Currency (“OCC”). The Bank’s deposits are insured up to $100,000 by the Federal Deposit Insurance Corporation (“FDIC”) and the Bank is a member bank within the San Francisco Federal Reserve district.

The Bank Holding Company Act, the Federal Reserve Act, and the Federal Deposit Insurance Act subject the Company and the Bank to a number of laws and regulations. The primary concern of banking regulation is “Safety and Soundness” with an emphasis on asset quality and capital adequacy. These laws and regulations also encompasses a broad range of other regulatory concerns including insider transactions, the adequacy of the allowance for lease losses, inter-company transactions, regulatory reporting, adequacy of systems of internal controls and limitations on permissible activities. The federal banking agencies possess broad powers to take corrective action as deemed appropriate for an insured depository institution and its holding company. The FRB routinely examines the Company, which exam includes the Leasing Companies. The OCC, which has primary supervisory authority over the Bank, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. These examinations are designed for the protection of the Bank’s depositors rather than the Company’s shareholders. The Bank must furnish annual and quarterly reports to the OCC, which has the authority under the Financial Institutions Supervisory Act to prevent a national bank from engaging in an unsafe or unsound practice in conducting its business. Many of these laws and regulations have undergone significant change in recent years. Future changes to these laws and regulations, and other new financial services laws and regulations are likely, and cannot be predicted with certainty.

 

California First National Bancorp and Subsidiaries

 

Under FRB policy, the Company is expected to serve as a source of financial and managerial strength to the Bank and, under appropriate circumstances, to commit resources to support the Bank. Certain loans by the Company to the Bank would be subordinate in right of payment to deposits in, and certain other indebtedness of, the Bank.

Among the regulations that affect the Company and the Bank are provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of loans or extensions of credit the Bank may make to affiliates and the amount of assets purchased from affiliates, except for transactions exempted by the FRB. The aggregate of all of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank's capital and surplus. The Bank and the Company must also comply with certain provisions designed to avoid the Bank buying low-quality assets. The Company and the Bank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. All services provided by the Company or its subsidiaries to the Bank are in accordance with this provision.

In December 2002, the FRB approved Regulation W (“Reg. W”), which implements, interprets and applies statutory provision in sections 23A and 23B, and became effective April 1, 2003. Under Reg. W, a bank does not have to comply with the quantitative limits of Section 23A when making a loan or extension of credit to an affiliate if 1) the extension of credit was originated by the affiliate; 2) the bank makes an independent evaluation of the creditworthiness of the borrower and commits to purchase the extension of credit before the affiliate makes or commits to make the extension of credit; 3) the bank does not make a blanket advance commitment to purchase loans from the affiliate and 4) the dollar amount of all purchases over any 12 month period by the bank from an affiliate does not represent more than 50% of that affiliate’s credit extensions during such period. The Company believes the Bank’s purchase of lease receivables from the Leasing Companies conform to the requirements of Reg. W. In addition, the Company has agreed with the FRB that the Bank’s purchase of leases from the Leasing Companies will not exceed 50% of the Bank’s lease portfolio.

At the time that Reg. W was published in December 2002, the FRB proposed for public comment an amendment to Reg. W that would limit the amount of extensions of credit that a bank could purchase from an affiliate to 100% of the bank’s capital and surplus. If Reg. W is amended in accordance with this proposal, the ability of the Bank to purchase lease receivables from the Leasing Companies would be impacted. The final structure of Reg. W cannot be determined at this time, and there are no assurances that future regulations or interpretations from the FRB will not limit further or prohibit the Bank’s purchases of leases from the Leasing Companies.

 

California First National Bancorp and Subsidiaries

 

In connection with its approval of the Company’s purchase of the stock of the Bank, the FRB and the OCC required the Company and the Bank to make certain commitments with respect to the operation of the Bank. During fiscal 2006, in light of the Bank’s achievement of profitability, the commitments were modified to include the following on an on-going basis: (i) the Bank and the Company have entered into a binding written agreement setting forth the Company’s obligations to provide capital maintenance and liquidity support to the Bank, if and when necessary; (ii) the Bank must obtain prior approval from the OCC before implementing any significant deviation or change from its original operating plan; and (iii) the Company must comply with Reg. W.

Bank holding companies are subject to risk-based capital guidelines adopted by the FRB. The Company currently is required to maintain (i) Tier 1 capital equal to at least six percent of its risk-weighted assets and (ii) total capital (the sum of Tier 1 and Tier 2 capital) equal to ten percent of risk-weighted assets. The FRB also requires the Company to maintain a minimum Tier 1 "leverage ratio" (measuring Tier 1 capital as a percentage of adjusted total assets) of at least five percent. At June 30, 2006 and 2005, the Company exceeded all these requirements.

The Bank is also subject to risk-based and leverage capital requirements mandated by the OCC. In general, banks are required to maintain a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, banks are generally required to maintain a minimum ratio of Tier 1 capital to adjusted total assets, referred to as the leverage ratio, of 4%. At June 30, 2006 and 2005, the Bank had capital in excess of all minimum risk-based and leverage capital requirements.

Under the Community Reinvestment Act (“CRA”), the Bank has a continuing and affirmative obligation, consistent with safe and sound operation, to help meet the credit needs of their entire communities, including low- and moderate-income neighborhoods. CalFirst Bank is designated as a wholesale institution for CRA purposes. To evaluate the CRA performance of banks with this designation, regulatory agencies use the community development test. This includes an assessment of the level and nature of the Bank’s community development lending, investments and services. The CRA requires the OCC, in connection with its examination of the Bank, to assess and assign one of four ratings to the Bank’s record of meeting the credit needs of its community. The CRA also requires that the Bank publicly disclose their CRA ratings. During fiscal 2005, CalFirst Bank was subjected to its first CRA examination and received a “satisfactory” rating on the CRA performance evaluation.

The principal source of cash flow to the Company, including cash flow to pay dividends on its common shares, is dividends from its subsidiaries and fees for services rendered to its subsidiaries. Various statutory and regulatory provisions limit the amount of dividends or fees that may be paid to the Company by the Bank. The Company does not depend on the Bank for such amounts, and believes the Leasing Companies have sufficient cash flow and assets to meet the Company’s requirements.

On November 12, 1999, the Gramm-Leach-Bliley Act (“Gramm-Leach”) became law. Gramm-Leach significantly changed the regulatory structure and oversight of the financial services industry. Most importantly for the Company and the Bank, Gramm-Leach established new requirements for financial institutions to provide new privacy protections to consumers. In June of 2000, the Federal banking agencies jointly adopted a final regulation providing for the implementation of these protections. It requires a financial institution to provide notice to customers about its privacy policies and practices, describes under what conditions a financial institution may disclose nonpublic personal information about consumers to non-affiliated third parties, and provides an "opt-out" method for consumers to prevent the financial institution from disclosing that information to non-affiliated third parties. Financial institutions were required to be in compliance with the final regulation by July 1, 2001, and the Bank and the Company believe that they were in compliance at such date, and continue to be in compliance.

     On October 26, 2001, the USA Patriot Act became law. The United States Treasury Department has issued a number of implementing regulations, which apply various requirements of the USA Patriot Act to financial institutions such as CalFirst Bank. These regulations impose obligations to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of customers. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences. With its existing systems and controls required as an Internet bank, the Bank believes it complies with the USA Patriot Act.

     The commercial banking business is also influenced by the monetary and fiscal policies of the federal government and the policies of the FRB. The FRB implements national monetary policies through its management of the discount rate, the money supply, and reserve requirements on bank deposits. Indirectly, such policies and actions may impact the ability of non-bank financial institutions to compete with the Bank. Monetary policies of the FRB have had, and will continue to have, a significant effect on the operating results of financial institutions. The nature and impact of any future changes in monetary or other policies of the FRB cannot be predicted.

 

California First National Bancorp and Subsidiaries

 

The laws, regulations and policies affecting financial services businesses are continually under review by Congress and state legislatures and federal and state regulatory agencies. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory agencies and other professional agencies. Changes in the laws, regulations or policies that impact the Company cannot necessarily be predicted, and they may have a material effect on the business and earnings of the Company.

Employees

The Company and its subsidiaries had 171 employees as of June 30, 2006, including 103 sales managers and account executives and 28 professionals engaged in finance and credit. None of the Company's employees are represented by a labor union. The Company believes that its relations with its employees are satisfactory.

Available Information

Our Internet address is www.calfirstbancorp.com. There we make available, by link to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practical after we electronically file such material with, or furnish it to, the SEC. Our SEC reports can be accessed through the Investor Information section of our Web site. Our Corporate Governance Guidelines and our Code of Ethics for Senior Financial Management are available for viewing and printing under the Corporate Governance section of our Internet site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC and is not incorporated by reference herein.

ITEM 1A. RISK FACTORS

There are a number of factors, including those specified below, that may adversely affect the Company's business, financial results or stock price. Additional risks that the Company currently does not know about or currently views as immaterial may also affect the Company's business or adversely impact its financial results or stock price.

Industry Risk Factors

The Company's business and financial results are subject to general business and economic conditions. The Company's business activities and earnings are affected by general business conditions in the United States. An economic downturn could result in a deterioration of credit quality of lessees, a change in the allowance for lease losses, or reduced demand for leasing capital assets. Changes in the financial performance and condition of lessees could negatively affect the repayment of receivables. In addition, changes in securities markets and monetary fluctuations could adversely affect the availability and terms of funding necessary to meet the Company's liquidity needs.

California First National Bancorp and Subsidiaries

 

Changes in the domestic interest rate environment could reduce the Company's net direct finance and interest income. The Company's net direct finance and interest income, which is the difference between income earned on leases and investments and interest expense paid on deposits, is affected by market rates of interest, which in turn are affected by prevailing economic conditions, by the fiscal and monetary policies of the federal government and by the policies of various regulatory agencies.

Changes in the laws, regulations and policies governing financial services companies could alter the Company's business environment and adversely affect operations. The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part the Company's cost of funds and the return that can be earned on leases and investments, both of which affect the Company's net direct finance and interest income.

The Company and the Bank are regulated by governmental entities. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Changes in statutes, regulations or policies could affect the Company in substantial and unpredictable ways. The Company cannot predict whether any potential legislation will be enacted, and if enacted, the effect that it or any regulations would have on the Company's financial condition or results of operations.

The financial services industry is highly competitive, and competitive pressures could intensify and adversely affect the Company's financial results. The Company operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes. The Company competes with other commercial banks, savings and lease associations, mutual savings banks, finance companies, credit unions and investment companies, many of which have greater resources that the Company.

Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions.

Company Risk Factors

The Company's allowance for lease losses may not be adequate to cover actual losses. The Company maintains an allowance for lease losses to provide for probable and estimatable losses in the portfolio. The Company's allowance for lease losses is based on its historical experience as well as an evaluation of the risks associated with its lease portfolio, including the size and composition of the lease portfolio, current economic conditions and concentrations within the portfolio. The Company's allowance for lease losses may not be adequate to cover actual lease losses, and future provisions for lease losses could materially and adversely affect its financial results.

The Company may suffer losses in its lease portfolio despite its underwriting practices. The Company seeks to mitigate the risks inherent in its lease portfolio by adhering to specific credit practices. Although the Company believes that its criteria are appropriate for the various kinds of leases it makes, the Company may incur losses on leases that meet these criteria.

The change in residual value of leased assets may have an adverse impact on the Company's financial results. A large part of the Company's leases are subject to the risk that the residual value of the property under lease will be less than the Company's recorded value. Adverse changes in the residual value of leased assets can have a negative impact on the Company's financial results. The risk of changes in the realized value of the leased assets compared to recorded residual values depends on many factors outside of the Company's control.

The financial services business involves significant operational risks. Operational risk is the risk of loss resulting from the Company's operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation.

California First National Bancorp and Subsidiaries

 

Quarterly operating results may fluctuate significantly. Operating results may differ from quarter to quarter due to a variety of factors, including the volume and profitability of leased property being remarketed, the size and credit quality of the lease portfolio, the interest rate environment, the volume of new lease originations, including variations in the mix and funding of such originations and economic conditions in general. The results of any quarter may not be indicative of results in the future.

Negative publicity could damage the Company's reputation and adversely impact its business and financial results. Reputation risk, or the risk to the Company's business from negative publicity, is inherent in the Company's business. Negative publicity can result from the Company's actual or alleged conduct in any number of activities, including leasing practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect the Company's ability to keep and attract customers and can expose the Company to litigation and regulatory action.

The Company's reported financial results are subject to certain assumptions and estimates and management's selection of accounting method. The Company's management must exercise judgment in selecting and applying many accounting policies and methods so they comply with generally accepted accounting principles and reflect management's judgment of the most appropriate manner to report the Company's financial condition and results. In some cases, management may select an accounting policy which might be reasonable under the circumstances yet might result in the Company's reporting different results than would have been reported under a different alternative.

Certain accounting policies are critical to presenting the Company's financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include the estimate of residual values, the allowance for lease losses, and income taxes. For more information, refer to "Critical Accounting Policies and Estimates".

Changes in accounting standards could materially impact the Company's financial statements. The Financial Accounting Standards Board (FASB) may change the financial accounting and reporting standards that govern the preparation of the Company's financial statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the Company's restating prior period financial statements.

Loss of certain of certain key officers would adversely affect the Company's business. The Company's business and operating results are substantially dependent on the certain key employees, including the Chief Executive Officer, Chief Operating Officer, Senior Vice President of Credit, Chief Financial Officer, the President and Chief Credit Officer of the Bank and certain key sales managers. The loss of the services of these individuals, particularly the Chief Executive Officer, would have a negative impact on the business because of their expertise and years of industry experience.

The Company's business could suffer if the Company fails to attract and retain qualified people. The Company's success depends, in large part, on its ability to attract and retain key people. Competition for personnel in most activities the Company engages in can be intense. The Company may not be able to hire the best people or to keep them.

The Company relies on other companies to provide components of the Company's business infrastructure. Third party vendors provide certain components of the Company's business infrastructure such as the Bank's core processing and electronic banking systems, item processing, and Internet connections. While the Company has selected these third party vendors carefully, it does not control their actions. Any problems caused by these third parties not providing the Company their services for any reason or their performing their services poorly, could adversely affect the Company's ability to deliver products and services to the Company's customers and otherwise to conduct its business. Replacing these third party vendors could also entail significant delay and expense.

 

A natural disaster could harm the Company's business. Natural disasters could harm the Company's operations directly through interference with communications, including the interruption or loss of the Company's websites, which would prevent the Company from gathering deposits, originating leases and processing and controlling its flow of business, as well as through the destruction of facilities and the Company's operational, financial and management information systems.

 


California First National Bancorp and Subsidiaries

 

The Company faces systems failure risks as well as security risks, including "hacking" and "identity theft." The computer systems and network infrastructure the Company and others use could be vulnerable to unforeseen problems. These problems may arise in both our internally developed systems and the systems of our third-party service providers. Our operations are dependent upon our ability to protect computer equipment against damage from fire, power loss or telecommunication failure. Any damage or failure that causes an interruption in our operations could adversely affect our business and financial results. In addition, our computer systems and network infrastructure present security risks, and could be susceptible to hacking or identity theft.

The Company relies on dividends from its subsidiaries for its liquidity needs. The Company is a separate and distinct legal entity from the Leasing Companies and the Bank. The Company receives substantially all of its cash from dividends paid by the Leasing Companies. These dividends are the principal source of funds to pay dividends on the Company's stock. Various regulations limit the amount of dividends that the Bank may pay to the Company.

The Company's stock price can be volatile. The Company's stock price can fluctuate widely in response to a variety of factors, including: actual or anticipated variations in the Company's quarterly operating results; operating and stock price performance of other companies that investors deem comparable to the Company; news reports relating to trends, concerns and other issues in the financial services industry, and changes in government regulations. General market fluctuations, industry factors and general economic and political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, could also cause the Company's stock price to decrease regardless of the Company's operating results. In addition, the volume of trading in the Company's stock is very limited and can result in fluctuations in prices between trades.

The Company is a "controlled company" as defined by NASDAQ, with over 50% of the stock held by the Chief Executive Officer, over 65% held by two senior executives and fewer than 100 shareholders of record. As a result, senior management has the ability to exercise significant influence over the Company's policies and business, and determine the outcome of corporate actions requiring stockholder approval. These actions may include, for example, the election of directors, the adoption of amendments to corporate documents, the approval of mergers, sales of assets and the continuation of the Company as a registered company with obligations to file periodic reports and other filings with the SEC.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.