| EUROBANCSHARES INC ITEM 1A RISK FACTORS 25 ITEM 1A Risk Factors |
| SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING INFORMATION Statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, including our expectations, intentions, beliefs, or strategies regarding the future |
| Any statements in this document about expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements |
| These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “will continue,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” and similar expressions |
| Accordingly, these statements involve estimates, assumptions and uncertainties, which could cause actual results to differ materially from those expressed in them |
| Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this document |
| All forward-looking statements concerning economic conditions, rates of growth, rates of income or values as may be included in this document are based on information available to us on the dates noted, and we assume no obligation to update any such forward-looking statements |
| It is important to note that our actual results may differ materially from those in such forward-looking statements due to fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which we conduct operations, including our plans, objectives, expectations and intentions and other risk factors, as detailed below |
| The following risk factors could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us, and you should not place undue reliance on any such forward-looking statements |
| Any forward-looking statement speaks only as of the date on which it is made and we do not undertake any obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events |
| New factors emerge from time to time, and it is not possible for us to predict which will arise |
| In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements |
| Risks Relating to Our Business Our decisions regarding credit risk could be inaccurate and our allowance for loan and lease losses may be inadequate, which could materially and adversely affect our business, financial condition, results of operations, cash flows and/or future prospects |
| Our loan and lease portfolio and investments in marketable securities subject us to credit risk |
| Inherent risks in lending also include fluctuations in collateral values and economic downturns |
| Making loans and leases is an essential element of our business, and there is a risk that our loans and leases will not be repaid |
| We attempt to maintain an appropriate allowance for loan and lease losses to provide for losses inherent in our loan and lease portfolio |
| As of December 31, 2005, our allowance for loan and lease losses totaled dlra18dtta2 million, which represents approximately 1dtta15prca of our total loans and leases |
| There is no precise method of predicting loan and lease losses, and therefore, we always face the risk that charge-offs in future periods will exceed our allowance for loan and lease losses and that we would need to make additional provisions to our allowance for loan and lease losses |
| 25 _________________________________________________________________ Our methodology for the determination of the adequacy of the allowance for loan and lease losses for impaired loans is based on classifications of loans into various categories and loss percentages that are commonly used for regulatory purposes |
| For non-classified loans, the estimated allowance is based on historical loss experiences as adjusted for changes in trends and conditions on an annual basis |
| These trends are monitored to prevent possible deviations from the loss factors used for the methodology |
| In connection with our ongoing evaluation and testing activities under Section 404 of the Sarbanes Oxley Act of 2002 and related rules and regulations, we have assessed the effectiveness of our internal control over financial reporting as of December 31, 2005 |
| In making our assessment of internal control over financial reporting, we are using the criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) |
| Based on the criteria established in COSO, we concluded that certain conditions exist which constitute a “material weakness” in our internal control over financial reporting as of December 31, 2005 |
| As part of our assessment of the effectiveness of internal control over the allowance for loan and lease losses adequacy, we identified several deficiencies, which when evaluated in the aggregate, were considered a material weakness |
| Such deficiencies are related to controls over certain aspects of the monitoring and documentation of recent loss trends of portfolios, the segregation of portfolios for purposes of the calculations of the adequacy of the allowance for loan and lease losses, and the documentation of the unallocated portion of the allowance |
| As a result of the material weakness, we have concluded that our internal control over financial reporting was not effective as of December 31, 2005 |
| Notwithstanding the foregoing, the financial information that appear elsewhere in this Annual Report on Form 10-K has been adjusted to properly account for recent loss trends and conditions |
| An adjustment to the allowance for loan and lease losses in the amount of dlra2dtta4 million (dlra1dtta6 million net of taxes) was recorded prior to the issuance of the Company’s financial statements as of December 31, 2005 |
| In addition, we have commenced a remediation process post year end and intend to improve and remediate the material weakness in our internal control over financial reporting |
| For additional information concerning this material weakness, see the Item 9A Controls and Procedures |
| In addition, the FDIC as well as the Commissioner of Financial Institutions of Puerto Rico review our allowance for loan and lease losses and may require us to establish additional reserves |
| Additions to the allowance for loan and lease losses will result in a decrease in our net earnings and capital and could hinder our ability to grow our assets |
| We have a concentration of exposure to a number of individual borrowers and a significant loss on any one of these credits could materially affect our financial condition and results of operations |
| Under applicable law, there are quantitative limitations on the amount of loans we can make to one borrower or a group of related borrowers |
| As of December 31, 2005, our legal lending limit was approximately dlra18dtta6 million in the unsecured category, and approximately dlra41dtta0 million in the secured category |
| As of December 31, 2005, we had 11 individual borrowers with a loan principal balance of more than dlra10dtta0 million per borrower and 24 individual borrowers with a loan principal balance of more than dlra5dtta0 million per borrower |
| Given the size of these current outstanding loans relative to our capital levels and earnings, a significant loss on any one of these credits could materially and adversely affect our business, financial condition, results of operations, cash flows and/or future prospects |
| A significant portion of our leases are secured by automobiles, and the loss of purchasers for our leases or a downturn in automobile purchases could have a material adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects |
| A significant portion of our leases are secured by automobiles |
| As of December 31, 2005, the total amount of automobile leases was dlra487dtta9 million or 20dtta39prca of our total assets |
| We sometimes sell our leases to other financial institutions in order to manage our lease financing concentration |
| The loss of purchasers of our leases could cause us to reduce our lease originations, reducing our net income |
| Alternatively, we may increase the portion of the leases that we retain for our portfolio with the result that our exposure to automobile leases will increase |
| In addition, a downturn in automobile purchases could have a material adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects |
| 26 _________________________________________________________________ We rely heavily on short-term funding sources, such as brokered deposits and repurchase obligations, which are generally more sensitive to changes in interest rates and can be adversely affected by local and general economic conditions |
| We have frequently utilized as a source of funds certificates of deposit obtained through deposit brokers that solicit funds from their customers for deposit with us, or brokered deposits |
| Brokered deposits, when compared to retail deposits attracted through a branch network, are generally more sensitive to changes in interest rates and volatility in the capital markets |
| In addition, brokered deposit funding sources may be more sensitive to significant changes in our financial condition |
| As of December 31, 2005, Brokered deposits amounted to dlra967dtta2 million, or approximately 55dtta77prca of our total deposits, compared to non-brokered certificates of deposit in the amount of dlra325dtta7 million, or approximately 18dtta78prca of our total deposits for the same period |
| Approximately dlra705dtta1 million of these brokered deposits, or approximately 73dtta1prca of our total brokered deposits, mature within one year |
| Our ability to continue to acquire brokered deposits is subject to our ability to price these deposits at competitive levels, which may substantially increase our funding costs |
| We also have borrowings in the form of repurchase obligations with the Federal Home Loan Bank, or the FHLB, and other broker-dealers |
| These agreements are collateralized by some of our investment securities |
| As of December 31, 2005, our repurchase obligations totaled dlra419dtta9 million, of which dlra247dtta6 million, or approximately 59dtta0prca of the total repurchase obligations, mature within one year |
| If we are unable to borrow in the form of repurchase obligations, we may be required to seek higher cost funding sources, which could materially and adversely affect our net interest income |
| We have experienced rapid growth in recent years and we may be unable to successfully continue to implement our growth strategy, which may adversely affect our business, financial condition, results of operations, cash flows and/or future prospects |
| Our assets have grown rapidly in recent years |
| With the ultimate goal of increasing net income, we have grown our assets from dlra607dtta7 million as of December 31, 2001 to dlra2dtta4 billion as of December 31, 2005 |
| The types of assets on our balance sheet that have experienced the largest categorical increases are commercial loans and lease financings |
| We have funded this growth, in part, with brokered deposits, FHLB advances, and other borrowings |
| These types of funds are generally more costly and volatile than traditional retail deposits |
| We may not be able to sustain our current growth rate |
| Throughout our recent expansion, we have been successful in attracting new customers, expanding new services to existing customers, adding new business lines, engaging in acquisitions and increasing our deposit base |
| We cannot assure you that we will be able to continue this trend, and it will become more difficult to maintain sustained growth as we increase in size |
| Our ability to implement our strategy for continued growth depends on our ability to attract and retain customers in a highly competitive market, on the growth of those customers’ businesses, on entering and expanding in lines of business in which we do not have significant past experience or for which we have only recently added personnel with the requisite experience, on our ability to continue to identify new acquisition targets and on our ability to increase our deposit base |
| Many of these growth prerequisites may be affected by circumstances that are beyond our control |
| Our inability to meet any of these growth prerequisites could have a material adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects |
| We rely heavily on our management team and the unexpected loss of key officers could adversely affect our business, financial condition, results of operations, cash flows and/or future prospects |
| Our success has been and will continue to be greatly influenced by our ability to retain the services of existing senior management and, as we expand, to attract and retain qualified additional senior and middle management |
| Rafael Arrillaga-Torrens, Jr, our President and Chief Executive Officer, has been instrumental in managing our business affairs |
| Our other senior executive officers have had, and will continue to have, a significant role in the development and management of our business |
| Arrillaga or any of our other senior executive officers could have an adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects |
| We have not established a formal management succession plan |
| Accordingly, should we lose the services of Mr |
| Arrillaga, our Board of Directors may have to search outside of EuroBancshares for a qualified permanent replacement |
| This search may be prolonged and we cannot assure you that we will be able to locate and hire a qualified replacement |
| We do not maintain key man life insurance policies on any of our senior executive officers |
| We currently do not have any employment agreements with our senior executive officers, with the exception of a Severance Payment Agreement with Yadira R Mercado, our Executive Vice President and Chief Financial Officer |
| If any of our senior executive officers leaves his or her respective position, our business, financial condition, results of operations, cash flows and/or future prospects may suffer |
| 27 _________________________________________________________________ The regulatory capital treatment of our junior subordinated debentures and related trust preferred securities is uncertain |
| Financial holding companies with more than dlra150dtta0 million in assets, like us, must maintain minimum capital ratios |
| In particular, we must maintain a leverage ratio of Tier 1 capital to average assets of 5dtta0prca; a Tier 1 risk-based capital ratio of 6dtta0prca of risk-weighted assets; and a total risk-based capital ratio (Tier 1 and Tier 2 capital) of 10dtta0prca of risk-weighted assets to be considered “well-capitalized” for regulatory purposes |
| The Federal Reserve Board’s current rules regarding the capital treatment of trust preferred securities allow us to count trust preferred securities as Tier 1 capital up to 25dtta0prca of our total Tier 1 capital for regulatory purposes |
| On March 1, 2005 the Federal Reserve Board adopted the final rule that allows the continued limited inclusion of trust preferred securities in the tier 1 capital of bank holding companies (BHCs) |
| Under the final rule, trust preferred securities and other restricted core capital elements would be subject to stricter quantitative limits |
| The Federal Reserve Board’s final rule limits restricted core capital elements to 25prca of all core capital elements, net of goodwill less any associated deferred tax liability |
| Internationally active BHCs, defined as those with consolidated assets greater than dlra250 billion or on-balance-sheet foreign exposure greater than dlra10 billion, will be subject to a 15prca limit |
| But they may include qualifying mandatory convertible preferred securities up to the generally applicable 25prca limit |
| Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital |
| The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits |
| As of December 31, 2005, we had dlra45dtta0 million in trust preferred securities of which all counted as Tier 1 capital |
| A determination by the Federal Reserve Board not to continue to allow the inclusion of our junior subordinated debentures or the trust preferred securities in Tier 1 capital, or otherwise limiting the inclusion of such debentures or securities in Tier 1 capital, could have a material and adverse impact on our regulatory capital levels and cause our capital ratios to fall below the levels necessary to be considered “well-capitalized” under current regulatory guidelines |
| This could impact our ability to grow our assets |
| In addition, inadequate regulatory capital levels may result in the imposition of certain operating restrictions on us and Eurobank |
| We have certain risks associated with our lease servicing activities |
| We retain the responsibility for servicing the automobile leases that we sell, and are therefore entitled to an ongoing fee based on the outstanding principal balances of the leases we service |
| As of December 31, 2005, we had servicing assets amounting to dlra2dtta4 million |
| The value of these servicing assets is subject to credit, prepayment and interest rate risk |
| Significant decreases in interest rates may lead to increases in the prepayment of leases by borrowers, which may reduce the value of our servicing assets |
| If prepayments increase above the expected levels, the value of our servicing assets will decrease |
| We may be required to recognize this decrease in value by taking a charge against our current earnings |
| The amount of this charge is not easily quantifiable because it depends on a number of factors as discussed above |
| However, the worse case scenario would result in the complete charge-off of the unamortized servicing assets |
| Risks Relating to an Investment in Our Common Stock Our common stocks have a short trading history and you may not be able to trade our common stock if an active trading market does not prevail |
| Additionally, the price of our common stock may fluctuate significantly |
| Prior to our initial public offering on August 11, 2004, there had been no public market for our common stock |
| Because of our short trading history, we cannot predict the extent to which investor interest in us will lead to an active trading market in our common stock or how liquid that market might become |
| A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace of willing buyers and sellers of the common stock at any given time, which presence is dependent upon the individual decisions of investors over which neither we nor any market maker has any control |
| 28 _________________________________________________________________ Our executive officers and directors own a significant number of shares of our common stock, allowing management significant control over our corporate affairs |
| As of December 31, 2005, our executive officers and directors beneficially own 48dtta65prca of the outstanding shares of our common stock |
| Accordingly, these executive officers and directors will be able to control, to a significant extent, the outcome of all matters required to be submitted to our stockholders for approval, including decisions relating to the election of directors, the determination of our day-to-day corporate and management policies and other significant corporate transactions |
| Your share ownership may be diluted by the issuance of additional shares of our common stock in the future |
| First, we have adopted a stock option plan that provides for the granting of stock options to our directors, executive officers and other employees |
| As of December 31, 2005, 1cmam216cmam312 shares of our common stock were issuable under options granted in connection with our stock option plan |
| In addition, 575cmam000 shares of our common stock are reserved for future issuance to directors, officers and employees under our stock option plan |
| It is probable that the stock options will be exercised during their respective terms if the fair market value of our common stock exceeds the exercise price of the particular option |
| In addition, our amended and restated certificate of incorporation authorizes the issuance of up to 150cmam000cmam000 shares of common stock, but does not provide for preemptive rights to the holders of our common stock |
| Any authorized but unissued shares are available for issuance by our Board of Directors |
| As a result, if we issue additional shares of common stock to raise additional capital or for other corporate purposes, you may be unable to maintain your pro rata ownership in EuroBancshares |
| Future sales of common stock by existing stockholders may have an adverse impact on the market price of our common stock |
| Sales of a substantial number of shares of our common stock in the public market, or the perception that large sales could occur, could cause the market price of our common stock to decline or limit our future ability to raise capital through an offering of equity securities |
| As of December 31, 2005, there were 19cmam398cmam848 shares of our common stock outstanding, which are freely tradable without restriction or further registration under the federal securities laws unless purchased by our “affiliates” within the meaning of Rule 144 under the Securities Act |
| Holders of our junior subordinated debentures have rights that are senior to those of our stockholders |
| On December 18, 2001, we issued dlra25dtta8 million of floating rate junior subordinated debentures in connection with a dlra25dtta0 million trust preferred securities issuance by our subsidiary, Eurobank Statutory Trust I The 2001 junior subordinated debentures mature in 2031 |
| On December 19, 2002, we issued dlra20dtta6 million of floating rate junior subordinated interest debentures in connection with a dlra20dtta0 million trust preferred securities issuance by our subsidiary, Eurobank Statutory Trust II The 2002 junior subordinated debentures mature in 2032 |
| The purpose of these transactions was to raise additional capital to fund our continued growth |
| Payments of the principal and interest on the trust preferred securities of Eurobank Statutory Trust I and Eurobank Statutory Trust II are conditionally guaranteed by us |
| The 2001 and 2002 junior subordinated debentures are senior to our shares of common stock |
| As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock |
| We have the right to defer distributions on the 2001 and 2002 junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock |
| 29 _________________________________________________________________ Holders of our Series A Preferred Stock have rights senior to those of our common stockholders |
| In connection with our acquisition of BankTrust, we issued 430cmam537 shares in the amount of dlra10dtta8 million of our Series A Preferred Stock to certain stockholders of BankTrust in exchange for their shares of the Series A and Series B preferred stock of BankTrust |
| Our Series A Preferred Stock has rights and preferences that could adversely affect holders of our common stock |
| For example, we generally are unable to declare and pay dividends on our common stock if there are any accrued and unpaid dividends on our Series A Preferred Stock for the preceding twelve months |
| Additionally, upon any voluntary or involuntary liquidation, dissolution, or winding up of our business, the holders of our Series A Preferred Stock are entitled to receive distributions out of our available assets before any distributions can be made to holders of our common stock |
| Provisions of our amended and restated certificate of incorporation and amended and restated bylaws could delay or prevent a takeover of us by a third party |
| Our amended and restated certificate of incorporation and amended and restated bylaws could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our stockholders, or could otherwise adversely affect the price of our common stock |
| For example, our bylaws contain advance notice requirements for nominations for election to our Board of Directors and for proposing matters that stockholders may act on at stockholder meetings |
| We also have a staggered board of directors, which means that only one-third of our Board of Directors can be replaced by stockholders at any annual meeting |
| We currently do not intend to pay dividends on our common stock |
| In addition, our future ability to pay dividends is subject to restrictions |
| As a result, capital appreciation, if any, of our common stock will be your sole source of gains for the foreseeable future |
| We have not historically and we currently do not intend to pay any dividends on our common stock |
| In addition, since we are a financial holding company with no significant assets other than Eurobank, we have no material source of income other than dividends that we receive from Eurobank |
| Therefore, our ability to pay dividends to our stockholders will depend on Eurobank’s ability to pay dividends to us |
| Moreover, banks and bank holding companies are both subject to federal and Puerto Rico regulatory restrictions on the payment of cash dividends |
| Accordingly, you should not expect to receive dividends from us in the foreseeable future |
| We are also restricted from paying dividends on our common stock if we have deferred payments of the interest on, or an event of default has occurred with respect to, our junior subordinated debentures |
| In addition, we generally are unable to declare and pay dividends on our common stock if there are any accrued and unpaid dividends on our Series A Preferred Stock for the preceding 12 months |
| Your shares are not an insured deposit |
| Your investment in our common stock will not be a bank deposit and will not be insured or guaranteed by the FDIC or any other government agency |
| Your investment will be subject to investment risk, and you must be capable of affording the loss of your entire investment |
| Risks Related to United States Taxation If we or any of our subsidiaries are determined to be a passive foreign investment company, US Holders of our stock could be subject to adverse tax consequences |
| If we or any of our subsidiaries are determined to be a passive foreign investment company, known as a “PFIC”, US Holders could be subject to adverse United States federal income tax consequences |
| Specifically, if either we or any of our subsidiaries are determined to be a PFIC for any taxable year, each US Holder would generally be subject to taxation under special rules, regardless of whether we or any of our subsidiaries remains a PFIC, with respect to (1) any “excess distribution” made by us to the US Holders during that taxable year, and (2) any gain realized on the sale, pledge or other disposition during that taxable year of our common stock or the stock of the subsidiary that was determined to be a PFIC These rules could, in addition to other consequences, cause certain income otherwise classified as capital gain to be taxed at ordinary income rates or the highest rate of tax for ordinary income in the year to which it is allocated regardless of the US Holder’s particular tax situation and cause the US Holder to be subject to an interest charge on the deemed deferred amount at the underpayment rate |
| “Excess distributions” generally are any distributions received by the US Holder on the common stock in a taxable year that exceed 125prca of the average annual distributions received by the US Holder in the three preceding taxable years, or the US Holder’s holding period for the common stock, if shorter |
| We believe that neither we nor any of our subsidiaries will be determined to be a PFIC in our current taxable year, and we expect to continue to conduct our affairs in a manner so that neither we nor any of our subsidiaries qualifies as a PFIC in the foreseeable future |
| However, we have not requested or received an opinion from our United States tax counsel as to whether we will be determined to be a PFIC in our current taxable year and we can give no assurance in this regard |
| For a more detailed explanation of the tax consequences of PFIC classification to US Holders and the tax consequences to individuals who are bona fide residents of Puerto Rico (who are subject to special United States federal income tax provisions), see the section captioned “Taxation — United States Taxation — Passive Foreign Investment Company Rules” in our Prospectus on Form S-1 dated August 11, 2004 |
| Prior to December 31, 2004, if we or any of our subsidiaries were classified as a foreign personal holding company, known as a “FPHC”, certain US holders of our stock could have been subject to adverse United States federal income tax consequences |
| The 2004 American Jobs Creation Act repealed the foreign personal holding company rules, effective for taxable years beginning after December 31, 2004, and for taxable years of US shareholders with or within which the taxable year of applicable foreign corporation ends |
| For a more detailed explanation of the tax consequences of FPHC classification to US shareholders and the tax consequences to individuals who are bona fide residents of Puerto Rico (who are subject to special United States federal income tax provisions) for 2004, see the section captioned “Taxation — United States Taxation — Foreign Personal Holding Company Rules” in our Prospectus on Form S-1 dated August 11, 2004 |