| • | Quad City Bank and Trust Company, (“Quad City Bank & Trust”) which is based in Bettendorf, Iowa and commenced operations in 1994, | ||
| • | Cedar Rapids Bank and Trust Company, (“Cedar Rapids Bank & Trust”) which is based in Cedar Rapids, Iowa and commenced operations in 2001, and | ||
| • | Rockford Bank and Trust Company, (“Rockford Bank & Trust”) which is based in Rockford, Illinois and commenced operations in 2005. | ||
| • | First Wisconsin Bank and Trust Company, (“First Wisconsin Bank & Trust”) which is based in Pewaukee, Wisconsin and commenced operations in 2007. |
The Company also engages in merchant and cardholder credit card processing through its wholly owned subsidiary, Quad City Bancard, Inc. (“Bancard”), based in Moline, Illinois, in direct financing lease contracts through its 80% equity investment in M2 Lease Funds, LLC (“M2 Lease Funds”), based in the Milwaukee, Wisconsin area, and in real estate holdings through its 57% equity investment in Velie Plantation Holding Company, LLC (“Velie Plantation Holding Company”), based in Davenport, Iowa.
Subsidiary Banks. Quad City Bank & Trust was capitalized on October 13, 1993 and commenced operations on January 7, 1994. Quad City Bank & Trust is an Iowa-chartered commercial bank that is a member of the Federal Reserve System with depository accounts insured to the maximum amount permitted by law by the Federal Deposit Insurance Corporation (the “FDIC”). Quad City Bank & Trust provides full service commercial and consumer banking and trust and asset management services in the Quad Cities and adjacent communities through its five offices that are located in Bettendorf and Davenport, Iowa and in Moline, Illinois. At December 31, 2006, Quad City Bank & Trust had total segment assets of $764.4 million. See Note 20. for additional business segment information.
Cedar Rapids Bank & Trust is an Iowa-chartered commercial bank that is a member of the Federal Reserve System with depository accounts insured to the maximum amount permitted by law by the FDIC. The Company commenced operations in Cedar Rapids in June 2001 operating as a branch of Quad City Bank & Trust. The Cedar Rapids branch operation then began functioning under the Cedar Rapids Bank & Trust charter in September 2001. Cedar Rapids Bank & Trust provides full-service commercial and consumer banking and trust and asset management services to Cedar Rapids, Iowa and adjacent communities through its two facilities, which were both completed in the summer of 2005. The headquarters for Cedar Rapids Bank & Trust is located in downtown Cedar Rapids, and its first branch location is located in northern Cedar Rapids. At December 31, 2006, Cedar Rapids Bank & Trust had total segment assets of $334.4 million. See Note 20. for additional business segment information.
On January 3, 2005, Rockford Bank & Trust opened as the Company’s third bank subsidiary. The Company commenced operations in Rockford, Illinois in September 2004 operating as a branch of Quad City Bank & Trust. Rockford Bank & Trust is an Illinois-chartered commercial bank that is a member of the Federal Reserve System with depository accounts insured to the maximum amount permitted by law by the FDIC. It provides full-service commercial and consumer banking to Rockford and adjacent communities through its original office located in downtown Rockford and its recently completed branch facility located on Guilford Road at Alpine Road in Rockford. At December 31, 2006, Rockford Bank & Trust had total segment assets of $106.8 million. See Note 20. for additional business segment information.
On February 20, 2007, the Company received its fourth bank charter, First Wisconsin Bank & Trust. The Company commenced operations in the Milwaukee area in April 2006, operating initially as a loan production office/deposit production office (LPO/DPO) of Rockford Bank & Trust, until June 2006, at which time it became a branch of Rockford Bank & Trust. In October 2006, the Company announced that it had entered into a series of agreements for the addition of a Wisconsin-chartered bank and the subsequent move of the branch into the charter. This transaction was consummated in February 2007. First Wisconsin Bank & Trust is a Wisconsin-chartered commercial bank that is a member of the Federal Reserve System with depository accounts insured to the maximum amount permitted by law by the Federal Deposit Insurance Corporation. It provides full-service commercial and consumer banking to the Milwaukee, Wisconsin area and adjacent communities through its office located in Pewaukee, Wisconsin.
Operating Subsidiaries. Bancard was capitalized in April 1995 as a Delaware corporation that provides merchant and cardholder credit card processing services. Bancard provides credit card processing for merchants and cardholders of the Company’s four subsidiary banks and approximately seventy-five agent banks. During 2006, Bancard processed in excess of 3.6 million merchant transactions with a dollar volume exceeding $368.9 million.
On August 26, 2005, Quad City Bank & Trust acquired 80% of the membership units of M2 Lease Funds. John Engelbrecht, the President and Chief Executive Officer of M2 Lease Funds, retained 20% of the membership units. M2 Lease Funds, which is based in the Milwaukee, Wisconsin area, is engaged in the business of leasing machinery and equipment to commercial and industrial businesses under direct financing lease contracts. Quad City Bank & Trust’s acquisition of M2 Lease Funds resulted in goodwill of $3.4 million and minority interest, which at December 31, 2006, was $797 thousand. In accordance with the provisions of FAS Statement 142, goodwill is not being amortized, but is being evaluated annually for impairment. There was no impairment of goodwill in 2006.
Since 1998, the Company has held a 20% equity investment in Velie Plantation Holding Company, LLC. In 2006, the Company acquired an additional 37% of the membership units bringing its total investment to 57% in aggregate. Velie Plantation Holding Company is engaged in holding the real estate property known as the Velie Plantation Mansion in Moline, Illinois. Six additional investors in Velie Plantation Holding Company have retained 43% of the membership units. The acquisition of a majority of the membership units resulted in minority interest of $566 thousand at December 31, 2006.
Trust Preferred Subsidiaries. In February 2004, the Company issued $12.0 million of fixed/floating rate trust preferred securities and $8.0 million of floating rate trust preferred securities through two newly formed subsidiaries, QCR Holdings Statutory Trust II (“Trust II”) and QCR Holdings Statutory Trust III (“Trust III”), respectively. Trust II and Trust III are each 100% owned non-consolidated subsidiaries of the Company. Trust II and Trust III each used the proceeds from the sale of the trust preferred securities, along with the funds from their equity, to purchase junior subordinated debentures of the Company in the amounts of $8.2 million and $12.4 million, respectively.
On May 5, 2005, the Company issued $5.0 million of floating rate capital securities through a newly formed subsidiary, QCR Holdings Statutory Trust IV (“Trust IV”). Trust IV is a 100% owned non-consolidated subsidiary of the Company. Trust IV used the proceeds from the sale of the trust preferred securities, along with the funds from its equity, to purchase junior subordinated debentures of the Company in the amount of $5.2 million.
On February 24, 2006, the Company issued $10.0 million of fixed/floating rate capital securities through a newly formed subsidiary, QCR Holdings Statutory Trust V (“Trust V”). Trust V is a 100% owned non-consolidated subsidiary of the Company. Trust V used the proceeds from the sale of the trust preferred securities, along with the funds from its equity, to purchase junior subordinated debentures of the Company in the amount of $10.3 million.
Conclusion. The Company owns 100% of Quad City Bank & Trust, Cedar Rapids Bank & Trust, Rockford Bank & Trust, First Wisconsin Bank & Trust, and Bancard, and 100% of the common securities of Trust II, Trust III, Trust IV, and Trust V. The Company also holds an 80% equity interest in M2 Lease Funds and a 57% equity interest in Velie Plantation Holding Company. In addition to such ownership, the Company invests its capital in stocks of financial institutions and mutual funds, as well as participates in loans with the subsidiary banks. In addition, to its wholly-owned and majority-owned subsidiaries, the Company has an aggregate investment of $114 thousand in two associated companies, Nobel Electronic Transfer, LLC, and Nobel Real Estate Investors, LLC. The Company owns 20% equity
positions in each of these affiliated companies. In June 2005, Cedar Rapids Bank & Trust entered into a joint venture as a 50% owner of Cedar Rapids Mortgage Company, LLC (“Cedar Rapids Mortgage Company”).
The Company and its subsidiaries collectively employed 351 individuals at December 31, 2006.
Business. The Company’s principal business consists of attracting deposits from the public and investing those deposits in loans and securities. The deposits of the subsidiary banks are insured to the maximum amount allowable by the FDIC. The Company’s results of operations are dependent primarily on net interest income, which is the difference between the interest earned on its loans and securities and the interest paid on deposits and borrowings. Its operating results are affected by merchant credit card fees, trust fees, deposit service charge fees, fees from the sale of residential real estate loans and other income. Operating expenses include employee compensation and benefits, occupancy and equipment expense, professional and data processing fees, advertising and marketing expenses, bank service charges, insurance, and other administrative expenses. The Company’s operating results are also affected by economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities, as described more fully in this form 10-K.
The Board of Governors of the Federal Reserve System (the “Federal Reserve”) is the primary federal regulator of the Company and its subsidiaries. In addition, Quad City Bank & Trust and Cedar Rapids Bank & Trust are regulated by the Iowa Superintendent of Banking (the “Iowa Superintendent”), Rockford Bank & Trust is regulated by the State of Illinois Department of Financial and Professional Regulation (“the Illinois DFPR”), and First Wisconsin Bank & Trust is regulated by the State of Wisconsin Department of Financial Institutions (the “Wisconsin DFI”). In addition, the FDIC, as administrator of the Deposit Insurance Fund, has regulatory authority over the subsidiary banks.
Lending. The Company and its subsidiaries provide a broad range of commercial and retail lending and investment services to corporations, partnerships, individuals and government agencies. The subsidiary banks actively market their services to qualified lending customers. Lending officers actively solicit the business of new borrowers entering their market areas as well as long-standing members of the local business community. The subsidiary banks have established lending policies which include a number of underwriting factors to be considered in making a loan, including location, loan-to-value ratio, cash flow, interest rate and the credit history of the borrower.
Quad City Bank & Trust’s current legal lending limit is approximately $11.1 million. As of December 31, 2006, commercial loans made up approximately 81% of the loan portfolio, while residential mortgages comprised approximately 10% and consumer loans comprised approximately 9%.
Cedar Rapids Bank & Trust’s current legal lending limit is approximately $4.3 million. As of December 31, 2006, commercial loans made up approximately 85% of the loan portfolio, while residential mortgages comprised approximately 7% and consumer loans comprised approximately 8%.
Rockford Bank & Trust’s current legal lending limit is approximately $2.4 million. As of December 31, 2006, commercial loans made up approximately 88% of the loan portfolio, while residential mortgages and consumer laons comprised approximately 6%.
At First Wisconsin Bank & Trust, commercial loans made up approximately 95% of the loan portfolio, while residential mortgages comprised approximately 3% and consumer loans comprised approximately 2%, at February 28, 2007.
As part of the loan monitoring activity at the four subsidiary banks, credit administration personnel interact closely with senior bank management. The Company has also instituted a separate loan review function to analyze credits of the subsidiary banks. Management has attempted to identify problem loans at an early stage and to aggressively seek a resolution of these situations.
As noted above, the subsidiary banks are active commercial lenders. The areas of emphasis include loans to wholesalers, manufacturers, building contractors, developers, business services companies and retailers. The banks provide a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of facilities, equipment and other purposes. Collateral for these loans generally includes accounts receivable, inventory, equipment and real estate. In addition, the subsidiary banks often take personal
guarantees to help assure repayment. Loans may be made on an unsecured basis if warranted by the overall financial condition of the borrower. Terms of commercial business loans generally range from one to five years. A portion of the subsidiary banks’ commercial business loans has floating interest rates or reprice within one year. The banks also make commercial real estate loans. Collateral for these loans generally includes the underlying real estate and improvements, and may include additional assets of the borrower.
The subsidiary banks sell the majority of their real estate loans in the secondary market. During the year ended December 31, 2006, the subsidiary banks originated $134.3 million of real estate loans and sold $84.2 million, or 63%, of these loans. During the year ended December 31, 2005, the subsidiary banks originated $122.1 million of real estate loans and sold $99.6 million, or 82%, of these loans. During the year ended December 31, 2004, the subsidiary banks originated $124.6 million of real estate loans and sold $83.5 million, or 67%, of these loans. Generally, the subsidiary banks’ residential mortgage loans conform to the underwriting requirements of Freddie Mac and Fannie Mae to allow the subsidiary banks to resell loans in the secondary market. The subsidiary banks structure most loans that will not conform to those underwriting requirements as adjustable rate mortgages that mature in one to five years, and then retain these loans in their portfolios. The subsidiary banks’ real estate loan portfolios, net of loans held for sale, were approximately $75.4 million at December 31, 2006. Servicing rights are not presently retained on the loans sold in the secondary market.
The consumer lending departments of each bank provide all types of consumer loans including motor vehicle, home improvement, home equity, signature loans and small personal credit lines.
Competition. The Company currently operates in the highly competitive Quad City, Cedar Rapids, Rockford, and Milwaukee markets. Competitors include not only other commercial banks, credit unions, thrift institutions, and mutual funds, but also, insurance companies, finance companies, brokerage firms, investment banking companies, and a variety of other financial services and advisory companies. Many of these competitors are not subject to the same regulatory restrictions as the Company. Many of these unregulated competitors compete across geographic boundaries and provide customers increasing access to meaningful alternatives to banking services. Additionally, the Company competes in markets with a number of much larger financial institutions with substantially greater resources and larger lending limits. These competitive trends are likely to continue and may increase as a result of the continuing reduction on restrictions on the interstate operations of financial institutions. Under the Gramm-Leach-Bliley Act of 1999, effective in March 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services.
Appendices. The commercial banking business is a highly regulated business. See Appendix A for a summary of the federal and state statutes and regulations, which are applicable to the Company and its subsidiaries. Supervision, regulation and examination of banks and bank holding companies by bank regulatory agencies are intended primarily for the protection of depositors rather than stockholders of bank holding companies and banks.
See Appendix B for tables and schedules that show selected comparative statistical information required pursuant to the securities laws, relating to the business of the Company. Consistent with the information presented in Form 10-K, results are presented for the fiscal years ended December 31, 2006, 2005, 2004 and 2003, along with the six-month transition period ended December 31, 2002, and the previous fiscal year ended June 30.
Internet Site. The Company maintains Internet sites for itself and its four banking subsidiaries. The Company makes available free of charge through these sites its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act after it electronically files such material with, or furnishes it to, the Securities and Exchange Commission. Also available are many of our corporate governance documents, including our Code of Ethics. The sites are www.qcrh.com , www.qcbt.com , www.crbt.com , www.rfrdbank.com , and www.firstwisconsinbank.com .
Item 1.A. Risk Factors
In addition to the other information in this Annual Report on Form 10-K, stockholders or prospective investors should carefully consider the following risk factors:
Our business is concentrated in and dependent upon the continued growth and welfare of the Quad City, Cedar Rapids, Rockford and Milwaukee markets.
We operate primarily in the Quad City, Cedar Rapids, Rockford, and Milwaukee markets, and as a result, our financial condition, results of operations and cash flows are subject to changes in the economic conditions in those areas. We have developed a particularly strong presence in Bettendorf, Cedar Rapids and Davenport, Iowa and Moline, Illinois and their surrounding communities. Our success depends upon the business activity, population, income levels, deposits and real estate activity in these markets. Although our customers’ business and financial interests may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, affect the ability of our customers to repay their loans to us and generally affect our financial condition and results of operations. Because of our geographic concentration, we are less able than other regional or national financial institutions to diversify our credit risks across multiple markets.
We face intense competition in all phases of our business from other banks and financial institutions.
The banking and financial services businesses in all of our markets are highly competitive. Our competitors include large regional banks, local community banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market mutual funds, credit unions and other non-bank financial service providers. Many of these competitors are not subject to the same regulatory restrictions as we are. Many of our unregulated competitors compete across geographic boundaries and are able to provide customers with a feasible alternative to traditional banking services. Additionally, if the regulatory trend toward reducing restrictions on the interstate operations of financial institutions continues, we will continue to experience increased competition as a result.
Increased competition in our markets may also result in a decrease in the amounts of our loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are more favorable to the borrower. Any of these results could have a material adverse effect on our ability to grow and remain profitable. If increased competition causes us to significantly discount the interest rates we offer on loans or increase the amount we pay on deposits, our net interest income could be adversely impacted. If increased competition causes us to relax our underwriting standards, we could be exposed to higher losses from lending activities. Additionally, many of our competitors are much larger in total assets and capitalization, have greater access to capital markets and larger lending limits and offer a broader range of financial services than we can offer.
Our community banking strategy relies heavily on our subsidiaries’ independent management teams, and the unexpected loss of key managers may adversely affect our operations.
We rely heavily on the success of our bank subsidiaries’ independent management teams. Accordingly, much of our success to date has been influenced strongly by our ability to attract and to retain senior management experienced in banking and financial services and familiar with the communities in our market areas. Our ability to retain executive officers, the current management teams, branch managers and loan officers of our operating subsidiaries will continue to be important to the successful implementation of our strategy. It is also critical, as we grow, to be able to attract and retain qualified additional management and loan officers with the appropriate level of experience and knowledge about our market areas to implement our community-based operating strategy. The unexpected loss of services of any key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business, financial condition and results of operations.
Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our existing capital resources will satisfy our capital requirements for the foreseeable future. However, we may at some point need to raise additional capital to support our continued growth. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth, branching, de novo bank formations and/or acquisitions could be materially impaired.
We may experience difficulties in managing our growth and our growth strategy involves risks that may negatively impact our net income.
While we have no current plans, we may expand into additional communities or attempt to strengthen our position in our current markets by undertaking additional de novo bank formations or branch openings. Based on our experience, we believe that it generally takes several years for new banking facilities to achieve overall profitability, due to the impact of organization and overhead expenses and the start-up phase of generating loans and deposits. If we undertake additional branching and de novo bank and business formations, we are likely to continue to experience the effects of higher operating expenses relative to operating income from the new operations, which may have an adverse effect on our levels of reported net income, return on average equity and return on average assets. Other effects of engaging in such growth strategies may include potential diversion of our management’s time and attention and general disruption to our business.
In addition to branching and de novo bank formations, we may acquire banks and related businesses that we believe provide a strategic fit with our business. To the extent that we grow through acquisitions, we cannot assure you that we will be able to adequately and profitably manage this growth. Acquiring other banks and businesses will involve similar risks to those commonly associated with branching and de novo bank formations, but may also involve additional risks, including:
| • | potential exposure to unknown or contingent liabilities of banks and businesses we acquire; | ||
| • | exposure to potential asset quality issues of the acquired bank or related business; | ||
| • | difficulty and expense of integrating the operations and personnel of banks and businesses we acquire; and | ||
| • | the possible loss of key employees and customers of the banks and businesses we acquire. |
Interest rates and other conditions impact our results of operations.
Our profitability is in part a function of the spread between the interest rates earned on investments and loans and the interest rates paid on deposits and other interest-bearing liabilities. Like most banking institutions, our net interest spread and margin will be affected by general economic conditions and other factors, including fiscal and monetary policies of the federal government, that influence market interest rates and our ability to respond to changes in such rates. At any given time, our assets and liabilities will be such that they are affected differently by a given change in interest rates. As a result, an increase or decrease in rates, the length of loan terms or the mix of adjustable and fixed rate loans in our portfolio could have a positive or negative effect on our net income, capital and liquidity. We measure interest rate risk under various rate scenarios and using specific criteria and assumptions. A summary of this process, along with the results of our net interest income simulations is presented at “Quantitative and Qualitative Disclosures About Market Risk” included under Item 7A of Part II of this Form 10-K. Although we believe our current level of interest rate sensitivity is reasonable and effectively managed, significant fluctuations in interest rates may have an adverse effect on our business, financial condition and results of operations.
We must effectively manage our credit risk.
There are risks inherent in making any loan, including risks inherent in dealing with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and risks resulting from changes in economic and industry conditions. We attempt to minimize our credit risk through prudent loan application approval procedures, careful monitoring of the concentration of our loans within specific industries and periodic independent reviews of outstanding loans by our credit review department. However, we cannot assure you that such approval and monitoring procedures will reduce these credit risks.
The majority of our subsidiary banks’ loan/lease portfolios are invested in commercial loans/leases, and we focus on lending to small to medium-sized businesses. The size of the loans/leases we can offer to commercial customers is less than the size of the loans/leases that our competitors with larger lending limits can offer. This may limit our ability to establish relationships with the area’s largest businesses. As a result, we may assume greater lending risks than financial institutions that have a lesser concentration of such loans/leases and tend to make loans/leases to larger businesses. Collateral for these loans/leases generally includes accounts receivable, inventory, equipment and real estate. However, depending on the overall financial condition of the borrower, some loans are made on an unsecured basis. In addition to commercial loans/leases, our subsidiary banks are also active in residential mortgage and consumer lending.
Commercial and industrial loans/leases make up a large portion of our loan/lease portfolio.
Commercial and industrial loans/leases were $449.2 million, or approximately 47% of our total loan/lease portfolio as of December 31, 2006. Our commercial loans/leases are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral is accounts receivable, inventory and equipment. Credit support provided by the borrower for most of these loans/leases and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists. As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing other loans/leases may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
Our loan/lease portfolio has a significant concentration of commercial real estate loans, which involve risks specific to real estate value.
Commercial real estate lending comprised a significant portion of our loan/lease portfolio, $350.3 million or approximately 36%, as of December 31, 2006. The market value of real estate can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located. Although a significant portion of such loans are secured by real estate as a secondary form of collateral, adverse developments affecting real estate values in one or more of our markets could increase the credit risk associated with our loan portfolio. Additionally, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of the control of the borrower or lender could negatively impact the future cash flow and market values of the affected properties.
If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.
Our allowance for loan/lease losses may prove to be insufficient to absorb potential losses in our loan/lease portfolio.
We established our allowance for loan/lease losses in consultation with management of our subsidiaries and maintain it at a level considered adequate by management to absorb loan/lease losses that are inherent in the portfolio. The amount of future loan/lease losses is susceptible to changes in economic, operating and other conditions, including changes in
interest rates, which may be beyond our control, and such losses may exceed current estimates. At December 31, 2006, our allowance for loan/lease losses as a percentage of total gross loans/leases was 1.10% and as a percentage of total non-performing loans/leases was approximately 144%. Although management believes that the allowance for loan/lease losses is adequate to absorb losses on any existing loans/leases that may become uncollectible, we cannot predict loan/lease losses with certainty, and we cannot assure you that our allowance for loan/lease losses will prove sufficient to cover actual loan/lease losses in the future. Loan/lease losses in excess of our reserves may adversely affect our business, financial condition and results of operations. Additional information regarding our allowance for loan/lease losses and the methodology we use to determine an appropriate level of reserves is located in the “Management’s Discussion and Analysis” section included under Item 5 of Part II of this Form 10-K.
Our Bancard operation faces other risks.
Bancard, our credit card processing subsidiary, is subject to certain risks, which could have a negative impact on its operations. Primarily, for Bancard these risks are competition, credit risks and the possibility that merchants’ willingness to accept credit cards will decline. Many of Bancard’s competitors have greater financial, technological, marketing and personnel resources than Bancard and there can be no assurance that Bancard will be able to compete effectively with such entities.
Bancard is also subject to credit risks. When a billing dispute arises between a cardholder and a merchant, and if the dispute is not resolved in favor of the merchant, the transaction is charged back to the merchant. If Bancard is unable to collect such chargeback from the merchant’s account, and if the merchant refuses or is unable to reimburse Bancard for the chargeback due to bankruptcy or other reasons, Bancard bears the loss for the amount of the refund paid to the cardholder. Bancard, in general, handles processing for smaller merchants, which may present greater risk of loss. Although Bancard maintains a reserve against these losses, there is no assurance that it will be adequate.
Additionally, VISA and MasterCard have the ability to increase the “interchange” rates charged to merchants for credit card transactions. There can be no assurance that merchants will continue to accept credit cards as payment if they feel rates are too high. Bancard is also subject to an approval process by the VISA and MasterCard credit card associations. In the event Bancard fails to comply with these standards, Bancard’s designation as a certified processor could be suspended or terminated. There can be no assurance that VISA or MasterCard will maintain Bancard’s registrations or that the current VISA or MasterCard rules allowing Bancard to provide transaction processing services will remain in effect.
We have a continuing need for technological change and we may not have the resources to effectively implement new technology.
The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our market areas. Many of our larger competitors have substantially greater resources to invest in technological improvements. As a result, they may be able to offer additional or superior products to those that we will be able to offer, which would put us at a competitive disadvantage. Accordingly, we cannot provide you with assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.
System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities.
The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations. Computer
break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and may cause existing and potential customers to refrain from doing business with us. Although we, with the help of third-party service providers, intend to continue to implement security technology and establish operational procedures to prevent such damage, there can be no assurance that these security measures will be successful. In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data. A failure of such security measures could have a material adverse effect on our financial condition and results of operations.
We are subject to certain operational risks, including, but not limited to, customer or employee fraud and data processing system failures and errors.
Employee errors and employee and customer misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence.
We maintain a system of internal controls and insurance coverage to mitigate against operational risks, including data processing system failures and errors and customer or employee fraud. Should our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could have a material adverse effect on our business, financial condition and results of operations.
Government regulation can result in limitations on our operations.
We operate in a highly regulated environment and are subject to supervision and regulation by a number of governmental regulatory agencies, including the Federal Reserve, the FDIC, the Iowa Superintendent, the Illinois DFPR, and the Wisconsin DFI. Regulations adopted by these agencies, which are generally intended to provide protection for depositors and customers rather than for the benefit of stockholders, govern a comprehensive range of matters relating to ownership and control of our shares, our acquisition of other companies and businesses, permissible activities for us to engage in, maintenance of adequate capital levels and other aspects of our operations. These bank regulators possess broad authority to prevent or remedy unsafe or unsound practices or violations of law. The laws and regulations applicable to the banking industry could change at any time and we cannot predict the effects of these changes on our business and profitability. Increased regulation could increase our cost of compliance and adversely affect profitability. For example, new legislation or regulation may limit the manner in which we may conduct our business, including our ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads.
Failure to pay interest on our debt or dividends on our preferred stock may adversely impact our ability to pay common stock dividends.
As of December 31, 2006, we had $36.1 million of junior subordinated debentures held by four business trusts that we control. Interest payments on the debentures, which totaled $2.5 million for 2006, must be paid before we pay dividends on our capital stock, including our Common Stock. We have the right to defer interest payments on the debentures for up to 20 consecutive quarters. However, if we elect to defer interest payments, all deferred interest must be paid before we may pay dividends on our capital stock. In the fourth quarter of 2006, the Company issued 268 shares of its Series B Non-cumulative Perpetual Preferred Stock (the “Preferred Shares”) at $50 thousand per share with a stated rate of 8.00%, although the Preferred Shares will accrue no dividends. Dividends will be payable on the Preferred Shares only if declared, but no dividends may be declared on the Company’s common stock unless and until dividends have been declared on the outstanding shares. Deferral, of either interest payments on the debentures or preferred dividends on the Preferred Shares, could cause a subsequent decline in the market price of our Common Stock because the Company would not be able to pay dividends on its Common Stock.
There is a limited trading market for our common shares, and you may not be able to resell your shares at or above the price stockholders paid for them.
Although our common shares are listed for quotation on The Nasdaq Capital Market, the trading in our common shares has substantially less liquidity than many other companies listed on Nasdaq. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the market of willing buyers and sellers of our common shares at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. We cannot assure you that the volume of trading in our common shares will increase in the future.
Item 1.B. Unresolved Staff Comments
There are no unresolved staff comments.
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