Amended Annual Report (10-k/a)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-K/A

Amendment No. 1

(Mark One)

[ X ]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the fiscal year ended June 30, 2014

OR

[    ]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the transition period from _____ to ______

Commission file number 000-19483

SWS GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant's telephone number, including area code (214) 859-1800

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes____  No__X__

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes_____  No_X___

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes     X      No ______

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes    X       No _____

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  _____

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

   Yes _______            No __X____

The aggregate market value of voting and non-voting common equity held by non-affiliates on December 31, 2013 was $230,621,000 based on the closing price of the registrant’s common stock, $6.08 per share, as reported on the New York Stock Exchange on December 31, 2013.  For purposes of this computation, all officers, directors and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed an admission that such officers, directors or 10% beneficial owners are, in fact, affiliates of the registrant. 

 

As of August 30, 2014, there were 33,239,459 shares of the registrant's common stock, $0.10 par value, outstanding. 

 

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EXPLANATORY NOTE

SWS Group, Inc. (together with its subsidiaries, “we,” “our,” “us,” “SWS” or the “company”) is filing this Amendment No. 1 on Form 10-K/A (this “Amendment”) to its Annual Report on Form 10-K for the year ended June 30, 2014, originally filed on September 5, 2014 (the “Original Filing”). For the convenience of the reader, this Amendment sets forth the Original Filing in its entirety, as amended by this Amendment. However, this Amendment amends Part III of the Original Filing to include the information required by Items 10, 11, 12, 13, and 14 of Part III of the Original Filing because the company has not and will not file a Definitive Proxy Statement on Schedule 14A within 120 after the end of the fiscal year covered by this report. In addition, as required by Rule 12b-15 promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), new certifications by the company’s principal executive officer and principal financial officer are filed as exhibits to this Amendment.

Except as described above, this Amendment does not reflect events occurring after the filing of the Original Filing and unless otherwise stated herein, the information contained in the Amendment is current only as of the time of the Original Filing. Except as described above, no other changes have been made to the Original Filing. Accordingly, the Amendment should be read in conjunction with the company’s filings made with the Securities and Exchange Commission subsequent to the Original Filing. 

 

 

 

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SWS GROUP, INC. AND SUBSIDIARIES

INDEX TO 2014 ANNUAL REPORT ON FORM 10-K

 

 

 

 

 

 

For purposes of this report, unless the context otherwise indicates, references to “we,” “us,” “our,” “SWS” and the “company” mean SWS Group, Inc. collectively with all of our subsidiaries, and references to "SWS Group" mean solely SWS Group, Inc. as a single entity. 

 

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FORWARD-LOOKING STATEMENTS

From time to time we make statements (including some contained in this report) that predict or forecast future events, depend on future events for their accuracy, or otherwise contain "forward-looking" information and constitute “forward-looking statements” within the meaning of applicable U.S. securities laws.  Such statements are generally identifiable by terminology such as “plans,” “expects,” “estimates,” “budgets,” “intends,” “anticipates,” “believes,” “projects,” “indicates,” “targets,” “objective,” “could,” “should,” “may” or other similar words.  By their very nature, forward-looking statements require us to make assumptions that may not materialize or that may not be accurate. Readers should not place undue reliance on forward-looking statements and should recognize that such statements are predictions of future results, which may not occur as anticipated.    Actual results may differ materially as a result of various factors, some of which are outside of our control, including: 

Our future operating results also depend on our operating expenses, which are subject to fluctuation due to:

Other factors, risks and uncertainties that could cause actual results to differ materially from our expectations discussed in this report include those factors described in the sections titled Item 1. “Business,” Item 1A. “Risk Factors,” Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations - Overview,” “-Financial Condition,” and “-Critical Accounting Policies and Estimates” and those discussed in our other reports filed with and available from the Securities and Exchange Commission (the "SEC").  Our forward-looking statements are based on current beliefs, assumptions and expectations.  All forward-looking statements speak only as of the date on which they are made and, except as required by law, we expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances upon which any statement is based.

 

 

 

 

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IMPORTANT INFORMATION FOR INVESTORS AND SHAREHOLDERS

 

This Annual Report on Form 10-K does not constitute an offer to sell or the solicitation of an offer to buy any securities or a solicitation of any vote or approval, nor shall there be any sale of securities in any jurisdiction in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of such jurisdiction.  Hilltop has filed with the SEC a registration statement on Form S-4 containing a proxy statement/prospectus of SWS and Hilltop, and SWS and Hilltop will each file other documents with respect to the proposed transaction and a definitive proxy statement/prospectus will be mailed to shareholders of SWS.  INVESTORS AND SECURITY HOLDERS OF SWS ARE URGED TO READ THE PROXY STATEMENT/PROSPECTUS AND OTHER DOCUMENTS THAT WILL BE FILED WITH THE SEC CAREFULLY AND IN THEIR ENTIRETY WHEN THEY BECOME AVAILABLE BECAUSE THEY WILL CONTAIN IMPORTANT INFORMATION.  Investors and security holders of SWS will be able to obtain free copies of the registration statement and the proxy statement/prospectus (when available) and other documents filed with the SEC by SWS or Hilltop through the website maintained by the SEC at www.sec.gov.  Copies of the documents filed with the SEC by SWS will be available free of charge on SWS’s internet website at www.swst.com or by contacting SWS’s Investor Relations Department at (214) 859-1800.  Copies of the documents filed with the SEC by Hilltop will be available free of charge on Hilltop’s internet website at www.hilltop-holdings.com or by contacting Hilltop’s Investor Relations Department at (214) 252-4029.

 

SWS, Hilltop, their respective directors and certain of their executive officers and other members of management and employees may be considered participants in the solicitation of proxies in connection with the proposed transaction.   Information about the directors and executive officers of SWS is set forth herein for the year ended June 30, 2014.  Information about the directors and executive officers of Hilltop is set forth in its most recent proxy statement, which was filed with the SEC on May 2, 2014.  Other information regarding the participants in the proxy solicitations and a description of their direct and indirect interests, by security holdings or otherwise, will be contained in the proxy statement/prospectus and other relevant materials to be filed with the SEC when they become available.

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PART I

 

ITEM 1. BUSINESS

 

We are a diversified financial services holding company focused on delivering a broad range of investment banking, commercial banking and related financial services to corporate, individual and institutional investors, broker/dealers, governmental entities and financial intermediaries.  We are the largest full-service brokerage firm headquartered in the Southwestern United States (based on the number of financial advisors).

 

 

SWS Group is a Delaware corporation that was incorporated in 1972, and that has its common stock listed on the New York Stock Exchange (“NYSE”).  Our principal executive offices are located at 1201 Elm Street, Suite 3500, Dallas, Texas 75270.  Our telephone number is (214) 859-1800 and our website is www.swsgroupinc.com.  We do not intend for information contained on our website to be part of this Annual Report on Form 10-K (this “Form 10-K”).  We file annual, quarterly and current reports, proxy statements and other information with the SEC.  You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549.  Please call the SEC at 1-800-SEC-0330 for information on the public reference room.

 

The SEC also maintains an Internet site at www.sec.gov that contains our annual, quarterly and current reports, proxy and information statements and other electronic filings.  We make available free of charge on or through our website our annual, quarterly and current reports and amendments to those reports as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC.  Additionally, we will provide electronic or paper copies of our filings free of charge upon request.

   

Our principal brokerage subsidiary, Southwest Securities, Inc. (“Southwest Securities”), is a registered clearing broker/dealer and a member of the NYSE.  It is also a member of the Financial Industry Regulatory Authority (“FINRA”), Securities Investor Protection Corporation (“SIPC”), and other regulatory and trade organizations. 

 

Southwest Securities provides integrated trade execution, clearing and client account processing to over 140 financial service organizations, which include correspondent broker/dealers and registered investment advisors in 29 states and Canada.  Southwest Securities serves individual investors through its private client group offices in Texas, California and Oklahoma and also serves institutional investors nationwide.  Southwest Securities also extends margin credit and lends securities and manages and participates in underwriting equity and fixed income securities.   For the fiscal year ended June 30, 2014, revenues from Southwest Securities accounted for approximately 76% of our consolidated revenues.

 

We also operate SWS Financial Services, Inc. (“SWS Financial”), an introducing broker/dealer subsidiary that is also registered with FINRA.  SWS Financial contracts with 278 individual registered representatives (who are FINRA licensed salespersons) for the administration of their securities business.  While these registered representatives must conduct all of their securities business through SWS Financial, they may separately conduct insurance, real estate brokerage or other business for other companies or for their own accounts.  The registered representatives are responsible for all of their direct expenses and are paid higher commission rates than Southwest Securities' registered representatives to compensate them for their added expenses.  SWS Financial is a correspondent of Southwest Securities, which clears all customer transactions on a fully disclosed basis.

 

We offer full-service, traditional and Internet banking through Southwest Securities, FSB (the “Bank”).  The Bank is a federally chartered savings bank, organized and existing under the laws of the United States and regulated by the Office of the Comptroller of the Currency (the “OCC”) since July 21, 2011.  Prior to July 21, 2011, the Bank was regulated by the Office of Thrift Supervision (“OTS”).  As of July 21, 2011, the Federal Reserve Board (“FRB”) began supervising and regulating SWS Group and SWS Banc Holdings, Inc. (“SWS Banc”).  The Bank conducts business from its main operating facilities and headquarters in Dallas, Texas and eight banking center locations in Texas and New Mexico. In 2003, SWS Banc was incorporated in the state of Delaware as a wholly-owned subsidiary of SWS Group, and became the sole stockholder of the Bank in 2004.

 

On March 31, 2014, we entered into an Agreement and Plan of Merger (“Merger Agreement”) with Hilltop and Peruna LLC, a wholly-owned subsidiary of Hilltop (“Peruna”), whereby if the merger contemplated therein is completed, we will become a wholly-owned subsidiary of Hilltop. If the merger is completed, each share of SWS Group common stock will be converted into the right to receive $1.94 in cash and 0.2496 of a share of Hilltop common stock. The value of the merger consideration may fluctuate based upon the market value of Hilltop common stock.  We currently anticipate that completion of the merger will occur by the end of 2014, subject to receiving the approval of our stockholders and regulators and other customary closing conditions.

 

If the proposed merger with Hilltop occurs, Hilltop’s warrant to acquire our common stock, if outstanding, will be cancelled.  See Item 7.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Overview - Loan from Hilltop and Oak Hill.”

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Concurrently with the execution of the Merger Agreement, we entered into a Letter Agreement with Oak Hill Capital Partners III, L.P. (“OHCP”) and Oak Hill Capital Management Partners III, L.P. (collectively with OHCP, “Oak Hill”), dated March 31, 2014 (the “Oak Hill Letter Agreement”). Pursuant to the Oak Hill Letter Agreement and the Merger Agreement, at the closing of the proposed merger with Hilltop,  Oak Hill will deliver to SWS Group the certificates evidencing its warrants and any loans of Oak Hill to SWS Group that are then outstanding under the Credit Agreement by and among Oak Hill, Hilltop and us, dated as of July 29, 2011 (the “Credit Agreement”), and we will issue and deliver to Oak Hill, in exchange for its warrants and loans, the following consideration: (i) the merger consideration that Oak Hill would have been entitled to receive upon consummation of the merger if its warrants had been exercised immediately prior to the effective time of the merger and (ii) an amount equal to the Applicable Premium (as defined in the Credit Agreement, being a calculation of the present value of all required interest payments due on a loan through its maturity date on the date the loan is repaid) calculated as if the loans held by Oak Hill were prepaid in full as of the closing date of the merger.

PRODUCTS AND SERVICES

In fiscal 2014, we operated through four business segments grouped primarily by products, services and customer base: clearing, retail, institutional and banking.  The segments are managed separately based on the types of products and services offered and their related client bases and are consistent with how we manage our business and assess our performance.  For more information about each of these business segments, see Item 7.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.  Also see Note 23 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for information regarding the revenues, income (loss) and total assets of each of our business segments.

 

Clearing.  The Clearing segment provides clearing and execution services for other broker/dealers (predominantly on a fully disclosed basis).  Our clientele includes general securities broker/dealers and firms specializing in high-volume trading.  We currently support a wide range of clearing clients, including discount and full-service brokerage firms, registered investment advisors and institutional firms.  High-volume trading firms trade actively on a proprietary basis or provide services to those customers who trade actively on a daily basis.    

In a fully disclosed clearing transaction, the identity of the clearing client’s (“correspondent”) customer is known to us and we physically maintain the client’s account and perform a variety of services as agent for the correspondent.  Revenues in this segment are generated primarily through transaction charges to our correspondent firms for clearing their trades according to a contractual schedule.

 

In addition to clearing trades, we tailor our services to meet the specific needs of our clients and offer products and services such as recordkeeping, trade reporting, accounting, general back-office support, securities and margin lending, reorganization assistance and custody of securities. 

 

As of June 30, 2014, we provided clearing services for two high-volume trading firms.  The nature of services provided to the customers of high-volume trading firms and the internal costs necessary to support them are substantially lower than the standard correspondent costs and services.  Accordingly, fees for services to these correspondents, on a per trade basis, are discounted substantially from the fees normally charged to other customers. 

 

The terms of our agreements with our correspondents define the allocation of financial, operational and regulatory responsibility arising from the clearing relationship.  To the extent that the correspondent has available financial resources, we are protected against claims by customers of the correspondent arising from actions by the correspondent; however, if the correspondent is unable to meet its financial obligations, dissatisfied customers may attempt to recover from us.

 

Retail.  The Retail segment includes the sale of retail securities, insurance products and managed accounts.  This segment generates revenue primarily through commissions charged on securities transactions, fees from managed accounts and the sale of insurance products as well as net interest income from retail customer account balances.

Retail Securities. We act as securities broker for retail investors in the purchase and sale of securities, options, commodities and futures contracts that are traded on various exchanges or in the over-the-counter market through our employee registered representatives or our independent contractor arrangements.  As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions.  Through our insurance subsidiaries, we hold insurance licenses to facilitate the sale of insurance and annuity products by our financial advisors to retail clients.  In most cases, we charge commissions to our clients in accordance with our established commission schedule, subject to certain discounts based upon the client’s level of business, the trade size and other relevant factors.  Some of our registered representatives also maintain licenses to sell certain insurance products.  Southwest Securities is registered with the Commodity Futures Trading Commission ("CFTC") as a non-guaranteed introducing broker and is a member of the National Futures Association ("NFA").  Southwest Securities is also a fully disclosed client of two of the largest futures commission merchants in the United States.

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Our financial advisors work with their individual clients to create investment portfolios based on the client's specific financial goals and tolerance for risk.  We provide access to fee-based platforms and a wide array of products and services including access to investment management programs that can be tailored to the individual client relationship to enhance the financial advisor's business and benefit his or her clients.

At June 30, 2014, Southwest Securities employed 153 registered representatives in 16 retail brokerage offices (with one office located in each of Austin, Dallas, Houston, League City, Longview, Lufkin, Plano, San Antonio and Southlake, Texas; one office located in each of Oklahoma City and Norman, Oklahoma and one office located in each of Beverly Hills, Monterey, Sacramento, San Diego and San Francisco, California).  In addition, at June 30, 2014, SWS Financial had contracts with 278 independent retail representatives for the administration of their securities business. 

Insurance.  Southwest Financial Insurance Agency, Inc. and Southwest Insurance Agency, Inc (collectively, "SWS Insurance") hold insurance agency licenses in 43 states in order to allow our registered representatives to sell insurance and annuity products to their retail customers.   We retain no underwriting risk related to the insurance and annuity products that SWS Insurance sells.

Managed Accounts.  Through the Investment Management Group of Southwest Securities, we provide a number of advisory programs that offer advisors a wide array of products and services for their advisory business.

Margin Lending.  We extend credit on a secured basis directly to our customers, the customers of correspondent firms and the correspondent firms themselves in order to facilitate securities transactions.  This credit, which generates interest income, is known as "margin lending" and is conducted primarily in our clearing and retail segments.  We extend margin credit to correspondent firms only to the extent that such firms pledge their own ("proprietary") assets as collateral.  Our correspondents are required to indemnify us against margin losses in their customers’ accounts.  Because we must rely on the guarantees and general creditworthiness of our correspondents, we may be exposed to significant risk of loss if they are unable to meet their financial commitments should there be a substantial adverse change in the value of the margined securities.

In customer margin transactions, the client borrows money from us to purchase securities or for other purposes.  The loan is collateralized by the securities purchased or by other securities owned by the client.  Interest is charged to clients on the amount borrowed to finance margin transactions at a floating rate.  The interest rate charged depends on the average net debit balance in the client’s accounts, the activity level in the accounts and the applicable cost of funds.  The amount of the loan is subject to the margin regulations ("Regulation T") of the Board of Governors of the Federal Reserve System, FINRA margin requirements and our internal policies.  In most transactions, Regulation T limits the amount loaned to a customer for the purchase of securities to 50% of the purchase price.  Furthermore, in the event of a decline in the value of the collateral, FINRA requirements regulate the percentage of client cash or securities that must be deposited as collateral for the loan. Because we permit clients to make margin purchases, we are subject to the risk that the value of our collateral could fall below the amount of that client's indebtedness.  Agreements with margin account clients permit us to liquidate the clients’ securities with or without prior notice in the event of an insufficient amount of margin collateral.  Despite those agreements, we may be unable to liquidate the clients’ securities for a number of reasons including, but not limited to, a thin trading market, an excessive concentration or the issuance of a trading halt.

The primary source of funds to finance client margin account balances is credit balances in the client’s account.  We generally pay interest to clients on these credit balances at a rate determined periodically.  SEC regulations restrict the use of client funds to the financing of client activities including margin account balances.  Excess customer credit balances, as defined by SEC regulations, are invested in short-term securities segregated for the exclusive benefit of customers as required by SEC regulations.  We generate net interest income when there is a positive interest rate spread between the interest rate earned from margin lending and segregated short-term investments and the interest rate paid on customer credit balances.

Institutional.    The Institutional segment serves institutional customers in the areas of securities borrowing and lending, municipal finance, sales, trading and underwriting of taxable and tax-exempt fixed income securities and equity trading. Revenues in the institutional segment are derived from the net interest spread on stock loan transactions, commission and trading income from fixed income and equity products and investment banking fees from taxable and municipal securities transactions.

Securities Lending Activities.  Our securities borrowing and lending business includes borrowing and lending securities for other broker/dealers, lending institutions and our own clearing and retail operations.  These activities involve borrowing securities to cover short sales and to complete transactions in which clients have failed to deliver securities by the required settlement date and lending securities to other broker/dealers for similar purposes. 

When borrowing securities, we are required to deposit cash or other collateral or to post a letter of credit with the lender, and we generally receive a rebate (based on the amount of cash deposited) or a fee calculated to yield a negotiated rate of return.  When lending securities, we receive cash or similar collateral and generally pay interest (based on the amount of cash deposited)

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to the other party to the transaction.  We generate net interest income when there is a positive interest rate spread between the interest rate on cash or similar collateral we deposit and the interest rate paid on cash or similar collateral we receive.

Securities borrowing and lending transactions are executed pursuant to written agreements with counterparties that generally require securities borrowed and loaned to be marked-to-market on a daily basis, excess collateral to be refunded, and deficit collateral to be furnished.  Collateral adjustments are made on a daily basis through the facilities of various clearinghouses.  We are a principal in these securities borrowing and lending transactions and are liable for losses in the event of a failure of any other party to honor its contractual obligation.  Our management sets credit limits with each counterparty and reviews these limits regularly to monitor the risk level with each counterparty.  The securities lending business is conducted primarily from Southwest Securities’ New Jersey office using a specialized sales force.

 Municipal Finance.  Our municipal finance business earns investment banking revenues by assisting public entity clients in meeting their financial needs and advising them on the most advantageous means of raising capital.  Our municipal finance professionals assist public bodies in originating, syndicating and distributing securities of municipalities and political subdivisions.

Southwest Securities maintains municipal finance branch offices in Allen, Dallas and San Antonio, Texas; Aliso Viejo, Cardiff, Encino and Huntington Beach, California; Palm Beach Gardens, Florida; Chicago, Illinois; Lexington, Kentucky; New York, New York; Albuquerque, New Mexico; Charlotte, North Carolina; Columbia, South Carolina and Memphis, Tennessee. 

Participation in firm commitment municipal underwritings can expose us to material risk because we may not be able to sell the securities we have committed to purchase at the initial offering price.  In addition, federal and state securities laws and regulations also affect the activities of underwriters and impose substantial potential liabilities for violations of such laws and regulations in connection with sales of securities by underwriters to the public.  

Fixed Income Sales and Equity Trading.  Our fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, municipal bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products.  The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions.  Southwest Securities has fixed income offices in Dallas, Texas; Encino and San Francisco, California; Aspen and Evergreen, Colorado; Ft. Lauderdale and Palm Beach Gardens, Florida; Chicago, Illinois; and New York, New York. 

Our equity trading department focuses on executing equity and option orders on an agency basis for clients.  We also have a portfolio trading group that executes large institutional portfolios. 

Our syndicate department, housed within our fixed income sales group, coordinates the distribution of managed and co-managed corporate equity underwritings, accepts invitations to participate in competitive or negotiated underwritings managed by other investment banking firms and allocates and markets our selling allotments to institutional clients and to other broker/dealers.

Banking.  The Banking segment offers traditional banking products and services through eight full-service banking centers with six banking centers located in Texas, one located in each of Arlington, Dallas, El Paso, Fort Worth, Granbury and Waxahachie, and two banking centers located in New Mexico, one located in each of Albuquerque and Ruidoso.  Our focus in business banking includes small business ("SBA") lending.  We originate the majority of our loans internally, and we believe this business model helps us build more valuable relationships with our customers.

The Bank offers a full array of deposit products, including checking, savings, money market and certificates of deposit.  As a full-service lender, the Bank offers competitive rates and terms on business loans, as well as a full line of consumer loans.  Customers have access to comprehensive Internet banking services and online bill payment.  The Bank offers commercial loans, commercial real estate loans and consumer loans, primarily in Texas and New Mexico.

Our mortgage purchase division purchases participations in newly originated residential loans (mainly 1-4 family residential loans) from various mortgage bankers nationwide.  The purchased mortgage loans held for investment are held by the Bank on average for 25 days or less.  Approximately 95% of the loans conform to the standards of Fannie Mae, Freddie Mac or Ginnie Mae, and the rest are “A” credit jumbo loans.  As of the date of this report, the Bank had 36 customer/originators across the nation.  Although the Bank is exposed to credit risk before the loans are sold by the mortgage company, currently there is no recourse to the Bank after the mortgage company sells the loans to the secondary investors.

The Bank earns substantially all of its net revenues on the spread between the interest rates charged to customers on loans and the interest rates paid to depositors as well as interest income from investments.

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Revenues by Source

 

The following table shows our revenues by source for the last three fiscal years (dollars in thousands):

 

 

 

 

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COMPETITION

We encounter intense competition in our businesses.  We compete directly with securities firms and banks, many of which have substantially greater capital and other resources than we have.  We also encounter competition from insurance companies and financial institutions in many elements of our businesses.

 

Our brokerage subsidiaries compete with other brokerage and financial services companies principally on the basis of service, product selection, price, location and reputation.  We compete with discount brokerage firms that do not offer equivalent services but offer discounted prices.  We compete for the correspondent clearing business on the basis of service, reputation, financial strength, price, technology and product selection.    

 

Competition for successful securities traders, stock loan professionals and investment bankers among securities firms and other competitors is intense, as is competition for experienced financial advisors.  We recognize the importance of hiring and retaining skilled professionals so we invest heavily in the recruiting process.  The failure to attract and retain skilled professionals could have a material adverse effect on our business and on our performance.

The Bank also operates in an intensely competitive environment.  This environment includes other banks, credit unions, nonbank lenders and insurance companies.  The competition ranges from small community banks to large multinational commercial banks.  As with the securities industry, the ability to attract and retain skilled professionals is critical to the Bank’s success.  To enhance these activities the Bank utilizes SWS for assistance in recruiting and educational programs.  The Bank competes for community banking customers locally based on reputation, service, location and price.  The Bank also competes nationally for the purchase of residential loans through its mortgage purchase division. 

REGULATION 

We operate in the financial services industry as, among other things, a securities broker/dealer, an SEC registered investment adviser and a bank. As a result, our businesses are highly regulated by U.S. federal and state regulatory agencies, self-regulatory organizations and national securities exchanges and, to a lesser extent, by foreign governmental agencies and financial regulatory bodies.  As a matter of public policy, regulatory bodies in the United States are charged with, among other things, safeguarding the integrity of the securities and other financial markets and with protecting the interests of customers, including depositors, the Federal Deposit Insurance Fund (“DIF”), and the banking system as a whole, not with protecting the interests of regulated entities or their creditors or stockholders.

Important laws and regulations that are applicable to us are described below. The description is a summary that is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal, state and other regulatory bodies.

We are regulated by the SEC and are subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the "Exchange Act") and the regulations promulgated hereunder, as administered by the SEC.  As a public company with common stock listed on the NYSE, we are subject to corporate governance requirements established by the SEC and the NYSE, as well as applicable federal and state law. Under the Sarbanes-Oxley Act of 2002, as amended (the “Sarbanes-Oxley Act”), we are required to meet certain requirements regarding business dealings with members of our Board of Directors (“BOD”), the structure of our Audit Committee and ethical standards for our senior financial officers. Also, under Section 404 of the Sarbanes-Oxley Act, we are required to assess the effectiveness of our internal controls over financial reporting and to obtain an opinion from our independent auditors regarding the effectiveness of our internal controls over financial reporting.  Under applicable SEC rules and NYSE listing standards, we are required to comply with other standards of corporate governance, including having a majority of independent directors serve on our BOD, and the establishment of independent audit, compensation and corporate governance committees. 

SWS Group is a legal entity that is separate and distinct from its banking and non-banking subsidiaries. The principal sources of funds for SWS Group are cash dividends paid by its subsidiaries, capital contributions from the sale of its securities, investment income, and borrowings. Federal laws normally limit the amount of dividends or other capital distributions that a banking institution can pay, and the Bank must obtain prior approval from the OCC before it can pay dividends to us. 

 Due to the economic crisis, many new regulations and statutes have been proposed or enacted over the past several years that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions operating and doing business in the United States.  Most notably, on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was enacted.

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The Dodd-Frank Act sought to restore responsibility and accountability to the U.S. financial system by significantly altering the regulation of financial institutions and the financial services industry.  Most of the provisions contained in the Dodd-Frank Act have delayed effective dates, and full implementation will require many new rules to be issued by federal regulatory agencies over the next several years.  While we continue to closely monitor the implementation of the Dodd-Frank Act, including new and proposed regulations, the full impact of the new rules on our business is still uncertain.  

Among other things, the Dodd-Frank Act:

 

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory bodies.  These initiatives may include proposals to expand or contract the powers of holding companies and depository institutions or proposals to substantially change the regulatory system for financial institutions.  Such legislation could change banking and brokerage statutes and our operating environment in substantial and unpredictable ways.  If enacted, such legislation or regulatory changes could increase or decrease our cost of doing business (including increased compliance costs), limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions.  We cannot predict whether any such legislation or regulatory initiatives will be enacted, and, if enacted, the impact that it, and any implementing regulations, would have on our financial condition or results of operations.  Any change in statutes, regulations or regulatory policies, or their implementation, interpretation, or enforcement, applicable to us or any of our subsidiaries could have a material adverse effect on our business.

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Regulation of SWS Group.  SWS Group is regulated under the Savings and Loan Holding Company Act, as amended (the “SLHC Act”), and its subsidiaries that are not functionally regulated are subject to inspection, examination and supervision by the FRB.

The FRB has the power to order any savings and loan holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the FRB has reasonable grounds to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the holding company. 

 

The Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks, bank holding companies and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (including hedge funds and private equity funds), subject to certain exceptions.  This provision is commonly called the “Volcker Rule”.   Final rules to implement the Volcker Rule were issued by the federal financial regulatory agencies on December 10, 2013, with an effective date of April 1, 2014 and a compliance date of July 21, 2015. The Company’s securities trading and investment activities, which occur at the holding company, the broker/dealer and the Bank, are subject to these final rules. The final rules are highly complex, and many aspects of their application and interpretation by regulators remain uncertain.  

 

FRB policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement for savings and loan holding companies, including SWS Group. Under this requirement, SWS Group is expected to commit resources to support the Bank, including at times when it may not be in a financial position to provide such resources. Any capital loans by a holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks.  In the event of a holding company’s bankruptcy, any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment. The implementing regulations for this “source of strength” statute have not been proposed.

 

Regulation of the Securities Business. The securities industry in the United States is subject to extensive regulation under federal and state laws and regulations. Our U.S. broker/dealer subsidiaries are registered with the SEC and FINRA.  Self-regulatory organizations such as FINRA have also enacted rules (which are subject to approval by the SEC) that govern their members and the industry.  Securities firms are subject to regulation by state securities commissions in the states in which they conduct business. Southwest Securities and SWS Financial are registered in all 50 states and the District of Columbia. Southwest Securities is also registered in the U.S. Virgin Islands and Puerto Rico.  Federal, state and other regulatory authorities have the power to undertake periodic examinations of our securities broker/dealer operations for the purpose of assuring our compliance with the applicable rules and regulations.

Broker/dealers are subject to regulations that cover all aspects of the securities business, including the manner in which securities transactions are effected, net capital requirements, recordkeeping and reporting procedures, relationships and conflicts with customers, the handling of cash and margin accounts, sales methods and conduct, experience and training requirements for certain employees, the conduct of investment banking and research activities and the manner in which we prevent and detect money-laundering activities. Legislation and changes in rules promulgated by the SEC and by self-regulatory organizations or changes in the interpretation or enforcement of existing laws and rules often directly affect the method of operation and profitability of broker/dealers.  The SEC, self-regulatory organizations and states may conduct administrative and enforcement proceedings that can result in censure, fine, suspension or revocation of our U.S. broker/dealer subsidiaries, our officers or employees. 

Our broker/dealer subsidiaries are subject to the SEC’s net capital rule (Rule 15c3-1 under the Exchange Act).  Generally, a broker/dealer’s net capital is equal to its net worth plus qualified subordinated debt less deductions for non-allowable (or non-liquid) assets and other adjustments and operational charges.  The SEC and FINRA impose rules that require notification when net capital falls below a certain threshold.  These rules also dictate the ratio of debt-to-equity in the regulatory capital composition of a broker/dealer and constrain the ability of a broker/dealer to expand its business under certain circumstances.  If a firm fails to maintain the required net capital, it may be subject to suspension or revocation of registration by the applicable regulatory authority, and suspension or revocation by these regulators could ultimately lead to the firm’s liquidation.  Our broker/dealer subsidiaries that hold customers’ funds and securities are subject to the SEC’s customer protection rule (Rule 15c3-3 under the Exchange Act), which generally provides that such broker/dealers maintain physical possession or control of all fully-paid securities and excess margin securities carried for the account of customers and maintain certain reserves of cash or qualified securities. 

Compliance with the net capital requirements may limit our operations, requiring the intensive use of capital. Such rules require that a certain percentage of our assets be maintained in relatively liquid form and therefore act to restrict our ability to withdraw capital from our broker/dealer subsidiaries, which in turn may limit our ability to pay dividends, repay debt or redeem or purchase shares of our outstanding common stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect our ability to pay dividends, repay debt, meet our debt covenant requirements or to expand

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or maintain our operations. In addition, such rules may require us to make substantial capital contributions into one or more of our broker/dealer subsidiaries in order for such subsidiaries to comply with such rules, either in the form of cash or subordinated loans made in accordance with the requirements of the SEC’s net capital rule. As of June 30, 2014, Southwest Securities had regulatory net capital, as defined by Rule 15c3-1 under the Exchange Act, of $156.4 million, which exceeded the amounts required by $149.8 million. As of June 30, 2014, SWS Financial had regulatory net capital, as defined by Rule 15c3-1 under the Exchange Act, of $1.1 million, which exceeded the amounts required by $0.9 million.  However, the amount of net excess capital can change dramatically within a short period of time due to a variety of factors. 

 

Our broker/dealer subsidiaries are required by federal law to belong to the SIPC, whose primary function is to provide financial protection for the customers of failing brokerage firms.  SIPC provides protection for clients’ cash and securities up to $500,000 per customer account, of which a maximum of $250,000 may be in cash. 

 

Our broker/dealer subsidiaries must also comply with the USA PATRIOT Act of 2001, as amended, (the “Patriot Act”), and other rules and regulations designed to fight international money laundering and to block terrorist access to the U.S. financial system.  We are required to have systems and procedures to ensure compliance with such laws and regulations. 

 

Southwest Securities and SWS Financial are registered with, and subject to oversight and inspection by, the SEC as investment advisers under the Investment Advisers Act of 1940, as amended.  The investment advisory business of our subsidiaries is subject to significant federal regulation, including with respect to wrap fee programs, the management of client accounts, the safeguarding of client assets, client fees and disclosures, transactions among affiliates and recordkeeping and reporting procedures.  Legislation and changes in regulations promulgated by the SEC or changes in the interpretation or enforcement of existing laws and regulations often directly affect the method of operation and profitability of investment advisers.  The SEC may conduct administrative and enforcement proceedings that can result in censure, fine, suspension, revocation or expulsion of the investment advisory business of our subsidiaries, our officers or employees.

 

Certain activities of some SWS subsidiaries are regulated by the CFTC and various commodity exchanges. Southwest Securities and SWS Financial are registered as introducing brokers with the CFTC and NFA.  The CFTC also has net capital regulations (CFTC Rule 1.17) that must be satisfied. Our futures business is also regulated by the NFA, a registered futures association. Violation of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration restrictions or terminations, trading prohibitions or revocations of commodity exchange memberships.    

 

Provisions of the Volcker Rule and the final rules implementing the Volcker Rule restrict certain activities provided by our broker/dealer, including proprietary trading. For purposes of the Volcker Rule, purchases or sales of financial instruments such as securities, derivatives, contracts of sale of commodities for future delivery or options on the foregoing for the purpose of short-term gain are deemed to be proprietary trading (with financial instruments held for less than 60 days presumed to be for proprietary trading unless an alternative purpose can be demonstrated), unless certain exemptions apply. Exempted activities include, among others, the following: 1) underwriting; 2) market making; 3) risk mitigating hedging; 4) trading in certain government securities; 5) employee compensation plans and 6) transactions entered into on behalf of and for the account of clients as agent, broker, custodian or in a trustee or fiduciary capacity. While management continues to assess compliance with the Volcker Rule, we have reviewed our processes and procedures in regard to proprietary trading and we believe we are currently complying with the provisions of the Volcker Rule regarding proprietary trading.  However, it remains uncertain how the scope of applicable restrictions and exceptions will be interpreted and administered by the relevant regulators.  Absent further regulatory guidance, we are required to make certain assumptions as to the degree to which our activities, processes and procedures in these areas comply with the requirements of the Volcker Rule.  If these assumptions are not accurate or if our implementation of compliance processes and procedures is not consistent with regulatory expectations, we may be required to make certain changes to our business activities, processes or procedures, which could further increase our compliance and regulatory risks and costs.

 

Banking Regulations.  We are subject to the extensive regulatory framework applicable to savings and loan holding companies as well as federal savings associations.

As a savings and loan holding company, we are subject to regulation and examination by the FRB. The Bank is subject to regulation and examination by the OCC (its primary federal regulator).  The banking regulators, including the OCC, FDIC and FRB have broad and, in some cases, overlapping authority to prohibit activities of holding companies, federal savings banks, their non-banking subsidiaries, directors, officers and other institution affiliated parties (such as attorneys and accountants) that represent unsafe and unsound banking practices or that constitute violations of laws or regulations.  The OCC can assess civil money penalties for violations of law, certain orders, written conditions or written agreements with the OCC, as well as certain knowing and reckless activities, if those activities caused a substantial loss to a depository institution.  The penalties can be as high as $1.375 million for each day the activities continue.

 

The Dodd-Frank Act transferred the functions of the OTS as they relate to the Bank to the OCC, and as they relate to SWS Group, to the FRB on July 21, 2011 (“Transfer Date”).  Eventually, we will be required to comply with capital and activity requirements similar to those currently applicable to bank holding companies.  On the Transfer Date, the OCC published a final rule clarifying the application of its rules to federal savings banks in certain areas, including assessments, preemption of state law, visitorial powers and other clarifying administrative matters and we will be required to be in compliance with the new

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minimum capital requirements (also known as Basel III, see discussion below) for depository institution holding companies and banks for reporting periods beginning after January 1, 2015.   

 

The Dodd-Frank Act also requires the FRB to mandate that any bank holding company or savings and loan holding company serve as a “source of strength” for any subsidiary that is a depository institution.  The Dodd-Frank Act gave the federal banking agencies one year after the Transfer Date to issue joint final rules related to the “source of strength” requirement, however, these rules have not been proposed.  “Source of strength” is defined as the ability of a company that directly or indirectly owns or controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.  Once these rules are finalized, SWS Group will be required to be a “source of strength” for the Bank. 

 

In July 2010, the FDIC voted to revise its existing Memorandum of Understanding with the primary federal regulators to enhance the FDIC’s existing authority over insured depository institutions that the FDIC does not directly supervise. As a result, the Bank may be subject to increased supervision by the FDIC.

 

With very limited exceptions, we may not be acquired by any company or by any individual without the approval of a governing bank regulatory agency.  That agency must complete an application review, and generally the public must have an opportunity to comment on any proposed acquisition.  Without prior approval from the FRB, we may not acquire more than five percent of the voting stock of any savings institution or bank.  The Dodd-Frank Act restricts a bank that is the subject of a formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter from converting its charter, subject to certain exceptions.

The Bank is currently subject to OCC capital requirements. Federal statutes and OCC regulations have established four ratios for measuring an institution’s capital adequacy: a “Tier 1 (core) capital” ratio — the ratio of an institution’s Tier 1 capital to adjusted tangible assets; a “Tier 1 risk-based capital” ratio — an institution’s adjusted Tier 1 capital as a percentage of total risk-weighted assets; a “total risk-based capital” ratio — the percentage of total risk-based capital to total risk-weighted assets; and a “tangible equity” ratio — the ratio of tangible capital to total tangible assets.

Federal statutes and OCC regulations have established five capital categories for federal savings banks:  well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.  The federal banking agencies have jointly specified by regulation the relevant capital level for each category.  An institution is defined as well-capitalized when its total risk-based capital ratio is at least 10%, its Tier 1 risk-based capital ratio is at least 6%, its Tier 1 (core) capital ratio is at least 5%, and it is not subject to any federal supervisory order or directive to meet a specific capital level.   As of June 30, 2014, the Bank was deemed to be “well capitalized,” without giving effect to the final Basel III rule.   See also Note 18 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

In December 2010, the Basel Committee on Banking Supervision (the “Basel Committee”) released a revised final framework for the regulation of capital and liquidity of internationally active banking organizations. These new frameworks are generally referred to as “Basel III”.   In July 2013, the OCC and FRB approved their final rule that implements the Basel III regulatory capital reform and certain changes required by the Dodd-Frank Act in the United States.   Under the final rule, minimum requirements will increase for both the quantity and quality of capital held by banking organizations, including the company and the Bank.  In addition, under the final rule, there is a new requirement to maintain a ratio of common equity Tier 1 capital ratio to risk-weighted assets.  The Basel III final rule will be effective for SWS Group and the Bank on January 1, 2015.  To be well capitalized for purposes of the prompt correction action levels of the Basel III final rule, an insured depository institution must maintain a total risk-based capital ratio of 10% or more; a Tier 1 risk-based capital ratio of 8% or more; a common equity Tier 1 capital ratio of 6.5% or more; and a leverage ratio of 5% or more.  An adequately-capitalized depository institution must maintain a total risk-based capital ratio of 8% or more; a Tier 1 risk-based capital ratio of 6% or more; a common equity Tier 1 capital ratio of 4.5% or more; and a leverage ratio of 4% or more.  An insured depository institution is undercapitalized under the final rule if its total capital ratio is less than 8%, if its Tier 1 risk-based capital ratio is less than 6%, its common equity Tier 1 capital ratio is less than 4.5%, or its leverage ratio is less than 4%.  If an institution’s Tier 1 risk-based capital ratio is less than 4%, or its common equity Tier 1 capital ratio is less than 3%, it would be considered significantly undercapitalized. The other numerical capital ratio thresholds for being significantly undercapitalized are the same as the current rules.

Under the Basel III final rule, the new common equity Tier 1 capital to risk-weighted assets ratio, the Tier 1 risk-based capital ratio and the total capital ratio will also have a capital conservation buffer of 2.5% of risk-weighted assets that will phase in beginning on January 1, 2016 though January 1, 2019.  An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount.    On the quality of capital side, the Basel III final rule emphasizes common equity Tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments.  The Basel III final rule also improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. 

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Under the Basel III final rule, the Bank will now calculate tangible equity based on average total assets rather than period-end total assets.  Bank regulators are required to take “prompt corrective action”, or PCA, to resolve problems associated with insured depository institutions whose capital declines below certain levels.  Federal banking agencies are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions that are “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.”  The severity of the action depends upon the capital category in which the institution is placed.  The new capital conservation buffer is designed to absorb losses in stressful periods and the banking agencies believe that it is appropriate for a depository institution to be able to use some of its capital conservation buffer without being considered less than well capitalized for PCA purposes.  Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. 

In the event an institution becomes undercapitalized, it must submit an acceptable capital restoration plan to the appropriate regulator.  The capital restoration plan will not be accepted by the regulators unless, among other requirements, each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount.  Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.

The aggregate liability of the holding company of an undercapitalized depository institution is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.”  The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan.  However, the guarantee can be limited for a holding company that is a “functionally regulated affiliate” of the depository institution, such as a holding company that is a broker/dealer registered with the SEC, if the functional regulator of the affiliate objects.  For example, the FRB could require an SEC registered broker/dealer holding company for an undercapitalized federal savings bank to guarantee the bank’s capital restoration plan, subject to the limitations summarized above and subject to an objection from the holding company’s functional regulator, the SEC.

 

An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.  The prompt corrective action regulations also establish procedures for downgrading an institution to a lower capital category based on supervisory factors other than capital.

 

The FDIC insures the deposits of the Bank up to the applicable maximum in each account, or up to $250,000 per account. FDIC deposit insurance is backed by the full faith and credit of the U.S. government. 

 

All FDIC insured institutions are required to pay assessments to the FDIC based on their average assets.  In fiscal 2012, the Bank paid an assessment rate of 23 basis points.  Due to continued improvement in the credit quality of the Bank’s loan portfolio, the FDIC assessment rate was decreased to 14 basis points in the second half of fiscal 2013.   Due to additional improvement in the credit quality of the Bank’s loan portfolio in fiscal 2014, the assessment rate currently stands at 7 basis points. The Bank believes that these changes will result in significant future FDIC insurance cost savings.

 

All FDIC insured institutions are required to pay additional assessments to the FDIC at an annual rate of approximately 0.64 basis points of average assets to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund.  These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.

 

Under the Dodd-Frank Act, the FDIC was given much greater discretion to manage the DIF, including where to set the designated reserve ratio (“DRR”).  The Dodd-Frank Act increased the DRR from 1.15% to 1.35% and left unchanged the requirement that the FDIC Board set the DRR annually.  The FDIC Board must set the DRR according to the following factors:  (i) risk of loss to the insurance fund; (ii) economic conditions affecting the banking industry; (iii) preventing sharp swings in the assessment rates and (iv) any other factors it deems important.  Based on those factors, the FDIC Board decided to set the DRR at 2.00% based on a historical analysis of losses to the DIF.  The analysis showed in order to maintain a positive fund balance and steady, predictable assessment rates, the DRR must be at least 2.00% as a long-term, minimum goal.  The DRR increase may increase FDIC deposit insurance assessments in the future. 

 

Numerous regulations promulgated by the federal banking agencies, including the Bureau, as amended from time to time, affect the business operations of the Bank. These include regulations relating to holding company regulation, equal credit opportunity, electronic fund transfers, fair credit reporting, fair debt collection, service members civil relief, collection of checks, insider lending, lending limits, truth in lending, truth in savings, home ownership and equity protection, transactions with affiliates and availability of funds. Under FRB regulations, the Bank is required to maintain a reserve against its transaction accounts (primarily interest-bearing and noninterest-bearing checking accounts). Because reserves must generally be maintained in cash or in noninterest-bearing accounts, the historical effect of the reserve requirements is to increase the Bank’s cost of funds. The Federal Reserve banks are authorized to pay interest on reserves, subject to regulations of the FRB, effective October 1, 2008.

 

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The Bank is subject to regulation by the Bureau, established by the Dodd-Frank Act as an independent entity within the Federal Reserve, which has the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks. The Bureau has broad rule-making authority for a wide range of consumer protection laws, including but not limited to, laws relating to alternative mortgage transaction parity, consumer leasing, electronic fund transfers, equal credit opportunity, fair credit billing, fair credit reporting, home owners protection, fair debt collection practices, lack of deposit insurance, consumer financial privacy, home mortgage disclosure, home ownership and equity protection, real estate settlement procedures, mortgage licensing, truth in lending and truth in savings, among other laws.  The Bureau also has the authority to prohibit “unfair, deceptive or abusive” acts and practices related to offering consumer financial services or products.  Because the Bank has less than $10 billion in total assets, the primary federal regulator with examination authority over the Bank for compliance with consumer financial protection laws is the OCC.

 

The Gramm-Leach-Bliley Act (“GLBA”) includes provisions that give consumers protections regarding the transfer and use of their nonpublic personal information by financial institutions. In addition, states are permitted under the GLBA to have their own privacy laws, which may offer greater protection to consumers than the GLBA. Numerous states in which the Bank does business have enacted such laws.

 

The Bank Secrecy Act, the PATRIOT Act and rules and regulation of the Office of Foreign Assets Control (“OFAC Rules”) include numerous provisions designed to fight international money laundering and to block terrorist access to the U.S. financial system. We have established policies and procedures to ensure compliance with the provisions of the Bank Secrecy Act, the PATRIOT Act and OFAC Rules.

 

The Community Reinvestment Act of 1977 (“CRA”) requires deposit institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice.  Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities.  Depository institutions are periodically examined for compliance with the CRA and are assigned ratings.  The primary federal regulatory agency assigns one of four possible ratings to an institution’s CRA performance and is required to make public an institution’s rating and written evaluation. The four possible ratings of meeting community credit needs are outstanding, satisfactory, needs to improve and substantial non-compliance. The OCC has recently completed its examination of the Bank’s compliance with the CRA.  As of the date of this report, we have not received the results from this examination.  However, in our last completed examination, we received a “satisfactory” CRA rating from the OTS.    

 

The Bank has committed $8.0 million to three investments in limited partnership equity funds as a cost effective way of meeting its obligations under the CRA.  As of June 30, 2014, the Bank had invested $480,000 of its aggregate commitment to the three funds.  These investments are subject to the Volcker Rule provisions of the Dodd-Frank Act.  The Volcker Rule prohibits, and would require banking entities to restructure and unwind, certain investments and relationships with “covered funds” as defined in the Volcker Rule.  Based on management’s interpretation of the Volcker Rule and the final rules implementing the Volcker Rule, the Bank’s equity method investments in these funds would be excluded from the definition of “covered funds” as these investments would meet the definition of “public welfare investment funds” designed primarily to promote the public welfare.  The Bank also believes that one of these investments would fall within the exemption for “small business investment companies” under the final rules.  Also, the Bank believes that its held to maturity and available for sale investments, which constitute investments in U.S. government agency and municipal obligations, would fall within applicable exceptions from the prohibition on proprietary trading under the Volcker Rule. If the Bank’s interpretation of the applicable requirements and exceptions is not accurate or consistent with regulatory interpretations, this could increase the Bank’s compliance and regulatory risks and costs, and the Bank could be forced to liquidate certain investments.

 

Transactions between the Bank and its nonbanking affiliates, including us, are subject to Section 23A of the Federal Reserve Act.  In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties.  Affiliate transactions are also subject to Section 23B of the Federal Reserve Act, which generally requires that certain transactions between the Bank and its affiliates be on substantially the same terms, or at least terms as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.  The FRB’s Regulation W implements Section 23A and 23B of the Federal Reserve Act and codifies prior interpretive guidance with respect to affiliate transactions.  On July 21, 2011, an amendment made in the Dodd-Frank Act became effective to amend the definition of “affiliate” in Section 23A of the Federal Reserve Act to include “any investment fund with respect to which a member bank or an affiliate thereof is an investment advisor.”

 

The restrictions on loans to directors, executive officers, principal stockholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions, their subsidiaries and holding companies.  These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made.  There is also an aggregate limitation on all loans to insiders and their related interests.  These loans cannot exceed the institution’s total unimpaired capital and surplus, and the OCC may determine that a lesser amount is appropriate.  Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.  On July 21, 2011, an amendment made in the Dodd-Frank Act became effective to amend the statutes placing limitations on loans to insiders by including credit exposures to the person arising from a derivatives transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction or securities borrowing transaction between the member bank and the person within the definition of an extension of credit to an insider.

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Subject to various exceptions, savings and loan holding companies and their affiliates are generally prohibited from tying the provision of certain services, such as extensions of credit, to certain other services offered by a holding company or its affiliates.

 

We are subject to the requirements of the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (the “SAFE Act”).  The SAFE Act requires mortgage loan originators who are employees of regulated institutions (including banks and certain of their subsidiaries) to be registered with the Nationwide Mortgage Licensing System and Registry (the “Registry”), a database established by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by each state.  As part of this registration process, mortgage loan originators must furnish the Registry with background information and fingerprints for a background check.  The SAFE Act generally prohibits employees of a regulated financial institution from originating residential mortgage loans without first registering with the Registry and maintaining that registration.  Financial institutions must also adopt policies and procedures to ensure compliance with the SAFE Act. 

 

Although our lending activities expose us to some risk of liability for environmental hazards, we do not currently have any significant liabilities for environmental matters.

 INSURANCE  

Our broker/dealer subsidiaries are required by federal law to belong to the SIPC.  SIPC provides protection for clients up to $500,000 each with a limitation of $250,000 for claims for cash balances for all of our broker/dealers.  Southwest Securities purchases insurance which, when combined with the SIPC insurance, provides insurance coverage for Southwest Securities and SWS Financial in certain circumstances for securities held in clients' accounts with a $100 million aggregate limit. 

The Bank’s deposits are insured by the DIF, which is administered by the FDIC, up to applicable limits of $250,000 for each depositor in accordance with FDIC rules.  The FDIC’s DIF is funded by assessments on insured depository institutions, which depend on the risk category of an institution and the amount of insured deposits that it holds. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis.

EMPLOYEES

At June 30, 2014, we employed 892 individuals.  Southwest Securities, SWS Financial and SWS Insurance employed 747 of these individuals, 199 of whom were full-time registered representatives, and the Bank employed 145 individuals.  In addition, 278 registered representatives were affiliated with SWS Financial as independent contractors.  

CUSTOMERS

As of the date of this report, we provided full-service securities brokerage to approximately 55,000 client accounts and clearing services to approximately 98,000 additional client accounts.  No single client accounted for a material percentage of our total business.

As of the date of this report, we provided deposit and loan services to approximately 86,000 customers through the Bank and its subsidiaries, which included approximately 83,000 Southwest Securities’ customer accounts.  No single customer accounted for a material percentage of the Bank’s or our total business.

TRADEMARKS

We own various registered trademarks and service marks, including "Southwest Securities," "SWS," "SWS Financial," "Southwest Securities, FSB," and "SWS Group," which are not material to our business.    We also own various design marks related to logos for various business segments. 

EXECUTIVE OFFICERS OF THE REGISTRANT

 The following table lists our executive officers and their respective ages and positions on September 5, 2014, followed by a brief description of their business experience over the past five years.  Each listed person has been appointed to the indicated office by our BOD.

 

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James H. Ross was named President, Chief Executive Officer and a member of the BOD of SWS Group on October 28, 2010. Prior to October 28, 2010, Mr. Ross had served as interim Chief Executive Officer and a member of the BOD since August 18, 2010. He previously served as Executive Vice President since November 2004 and, in September 2007, was elected President and Chief Executive Officer of Southwest Securities. Mr. Ross served as the Director of the Private Client Group at Southwest Securities from March 2004 to March 2008. He served as Chief Executive Officer of SWS Financial from September 2004 to April 2011.  Mr. Ross came to Southwest Securities in 2004 to head the Private Client Group’s brokerage office in Dallas, Texas. Prior to coming to Southwest Securities, Mr. Ross was with UBS Paine Webber, where, from April 1991 to December 2003, Mr. Ross held various positions ranging from financial advisor to branch manager. He began his securities industry career in 1975.

J. Michael Edge was named interim Chief Financial Officer and Treasurer on September 30, 2013.  Mr. Edge previously served as the Company’s Senior Vice President of Finance and Investor Relations since December 2011.  Previously, Mr. Edge served as Director of Finance and Investor Relations from August 2009 through November 2011, Financial Analyst from January 2005 through July 2009, and Internal Auditor from October 2000 through December 2004.  Prior to joining SWS, Mr. Edge served as Assistant Vice President—Senior Risk Analyst at Bank One from June 1998 through October 2000.  Mr. Edge is a Certified Public Accountant and holds a Bachelor of Business Administration degree in Finance from Texas A&M University and a Master of Business Administration degree with concentrations in Financial Consulting and Accounting from Southern Methodist University.  Mr. Edge also holds Series 7 and Series 27 securities licenses and is a graduate of the Securities Industry Institute of the University of Pennsylvania’s Wharton School of Business.

Daniel R. Leland has served as our Executive Vice President since May 2007. Mr. Leland was also Executive Vice President from February 1999 to September 2004.  He served as President and Chief Executive Officer of Southwest Securities from August 2002 to September 2004.  He also served as Executive Vice President of Southwest Securities from July 1995 to August 2002 and was re-elected in February 2006. Mr. Leland began his career at Barre & Company in June 1983 where he was employed in various capacities in fixed income sales and trading before becoming President of Barre & Company in 1993.  Mr. Leland has been an arbitrator for the National Association of Securities Dealers (NASD) and is a past Vice Chairman of the District 6 Business Conduct Committee.  He is a past board member of the Bond Dealers of America and previously served as the chair of the Taxable Committee.

Richard H. Litton has served as our Executive Vice President and as Executive Vice President of Southwest Securities for the Public Finance Division since July 1995.  Beginning in September 2006, he became primarily responsible for the entire municipal securities product area of Southwest Securities.  Previously, Mr. Litton was President of a regional investment bank and headed the Municipal Group in the Southwest for Merrill Lynch.  Mr. Litton served on various advisory committees for the Texas House of Representatives’ Financial Institutions Committee, is a past director of the Municipal Advisory Council of Texas and currently serves on the Municipal Executive Committee and the Municipal Legal Advisory Committee of the Securities Industry and Financial Markets Association (SIFMA). 

W. Norman Thompson has served as our Executive Vice President and Chief Information Officer since January 1995. Mr. Thompson was employed by Kenneth Leventhal & Co. (now a part of Ernst & Young LLP) in various capacities ranging from Audit Manager to Senior Consulting Manager from 1987 to 1994. Previously, Mr. Thompson was an auditor with KPMG LLP from 1981 to 1987. In the capacities he held with both Kenneth Leventhal & Co. and KPMG LLP, he was heavily involved in information technology auditing and consulting.

Allen R. Tubb was elected as our Vice President, General Counsel and Secretary in August 2002 and Executive Vice President in November 2011. He joined SWS as Corporate Counsel and Secretary in October 1999. From 1979 to 1999, Mr. Tubb was employed with Oryx Energy Company and its predecessor Sun Exploration and Production Company in various capacities including Chief Counsel, Worldwide Exploration and Production. Mr. Tubb is a member of the Texas Bar Association.

Robert A. Chereck has served as Executive Chairman and President of Southwest Securities, FSB since May 2012. Prior to joining Southwest Securities, FSB, Mr. Chereck was Executive Vice President, Southwest Division Manager and Dallas Regional

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President with Wells Fargo Bank, N.A., (“Wells Fargo”) in Dallas. He began with Wells Fargo in 1996 when the company acquired First Interstate Bank of Texas, N.A., where Mr. Chereck served as the Group Manager overseeing all of the wholesale activities of the bank. At Wells Fargo, he was Executive Vice President and Division Manager of 11 regional banking offices in New Mexico, Oklahoma and Texas. Mr. Chereck also managed the Energy Group of Wells Fargo until 2008. Mr. Chereck has also served as President and Owner of Norwich Financial Associates, Inc., a financial services and consulting company in Dallas, and as Managing Director of Mason Best Company, a privately held merchant banking firm. He began his career with InterFirst Bank Dallas, where he served in a variety of senior-level positions, including Executive Vice President managing the Dallas Corporate Division. Mr. Chereck is currently Chairman of the Board of Children’s Medical Center and Chairman of the Dallas Citizens Council. He is Past Chairman of the Dallas Regional Chamber and serves on the Board’s Executive Committee. Mr. Chereck has also served three terms on the City of Dallas Housing Finance Corporation and was a member of the Downtown Dallas Association Board. In addition, he is a member of the Advisory Council for the University of Texas McCombs Business School. He earned a Bachelor of Arts in political science and a Master of Business Administration in finance and accounting from the University of Texas at Austin.

 

ITEM 1A. RISK FACTORS

Our business, reputation, financial condition, operating results and cash flows can be impacted by a number of factors.  Many of these factors are beyond our control and may significantly impact us during periods of market volatility or reduced liquidity.  The potential harm from any one of these risks, or others, could cause our actual results to vary materially from recent results or from anticipated future results.  Some risks may adversely impact not only our own operations, but the banking or securities industry in general which could also produce marked swings in the trading price of our securities.   Although the risks described below are those that management believes are the most significant, these are not the only risks facing our company.  Additional risks and uncertainties not currently known to us or that we currently do not deem to be material may also materially affect our business, reputation, financial condition, operating results and cash flows.  We may amend or supplement these risk factors from time to time in the reports we file with the SEC.

RISKS SPECIFIC TO THE MERGER

Because the market price of Hilltop common stock will fluctuate and the per share merger consideration may be adjusted, our stockholders cannot be sure of the value of the merger consideration they will receive. Upon completion of the merger, each share of our common stock will be converted into merger consideration consisting of $1.94 in cash and 0.2496 of a share of Hilltop common stock. Because the stock portion of the merger consideration is based on a fixed ratio, the market value of the merger consideration may at any given time vary from the closing price of Hilltop common stock on the date the merger was announced. Any change in the market price of Hilltop common stock prior to completion of the merger will affect the market value of the merger consideration that our stockholders will receive upon completion of the merger. We are not permitted to terminate the Merger Agreement or resolicit the vote of our stockholders solely because of changes in the market price of Hilltop’s common stock, and there will be no adjustment to the merger consideration for changes in such market price. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in Hilltop’s or our respective businesses, operations and prospects, and regulatory considerations. Many of these factors are beyond our control. 

The merger is subject to the receipt of consents and approvals from government entities that may take longer than expected or may impose conditions that are not presently anticipated or that could have an adverse effect on the combined company following the merger. The merger is conditioned on the receipt of all requisite governmental and regulatory authorizations, consents, orders and approvals from the Federal Reserve Board and the Texas Department of Banking and, if applicable, the expiration or termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. These government entities may impose conditions on the completion of the merger or require changes to the terms of the merger. There can be no assurance that material conditions or changes will not be imposed that are in addition to the capital commitments we have in place with the OCC, and such conditions or changes could have the effect of delaying or preventing completion of the merger or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have an adverse effect on the combined company following the merger.

 

We will be subject to business uncertainties, and we are subject to contractual restrictions while the merger is pending. Uncertainty about the effect of the merger on employees and customers may have an adverse effect on us. These uncertainties may impair our ability to attract, retain and motivate key personnel while the merger is pending, and could cause customers and others that deal with us to seek to change existing business relationships with us. Retention of certain employees may be challenging during the pendency of the merger, as certain employees may experience uncertainty about their future roles. If key employees depart because of issues relating to such uncertainty or a desire not to remain with the business, our business could be negatively impacted.

 

In addition, the Merger Agreement restricts us from taking certain specified actions until the merger occurs without the consent of Hilltop. These restrictions may prevent us from pursuing business opportunities that may arise prior to the completion

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of the merger and may affect our strategic business plans. Lastly, our business may be indirectly adversely affected by the failure to pursue other opportunities due to the focus of management on the merger.

The merger is subject to certain closing conditions that, if not satisfied or waived, will result in the merger not being completed, which may cause the price of our common stock to decline.  The merger is subject to customary conditions to closing, including the receipt of required regulatory approvals and approval of our stockholders. If any condition to the merger is not satisfied or waived, the merger will not be completed. In addition, Hilltop and we may terminate the merger agreement under certain circumstances even if the merger is approved by our stockholders, including if the merger has not been consummated by March 31, 2015. If the merger is not completed, the trading price of our common stock may decline to the extent that the current market price reflects an assumption that the merger will be completed. In addition, neither company would realize any of the expected benefits of the merger. If the merger is not completed, additional risks could materialize, which could materially and adversely affect our business, financial condition and results of operations.

The Merger Agreement limits our ability to pursue an alternative transaction and requires us to pay a termination fee of $8 million under certain circumstances relating to alternative acquisition proposals. Under the Merger Agreement, we agreed that we will not, and will cause our subsidiaries not to, and will use our reasonable best efforts to cause our or their respective officers, directors, employees, representatives or agents not to, knowingly encourage, solicit, participate in, knowingly facilitate or initiate discussions, negotiations, inquiries, proposals or offers with or provide any non-public information to, any person relating to any third party acquisition or any inquiry, proposal or offer reasonably likely to lead to a third party acquisition, subject to exceptions set forth in the Merger Agreement. The Merger Agreement also provides for the payment by us of a termination fee in the amount of $8 million in the event that Hilltop terminates the Merger Agreement for certain reasons including a change in the recommendation of our BOD or a termination of the Merger Agreement in certain circumstances followed by an acquisition of, or an agreement to acquire, us by a third party. These provisions may discourage a potential competing acquiror that might have an interest in acquiring all or a significant part of us from considering or proposing such an acquisition.

 

Our Credit Agreement with Hilltop and Oak Hill contains a covenant restricting our ability to enter into alternative transactions and Hilltop has not waived this covenant.  The terms of the Credit Agreement with Hilltop and Oak Hill include a covenant prohibiting us from undergoing a “Fundamental Change,” which includes any merger, amalgamation or consolidation, and which we would breach by engaging in a merger, amalgamation or consolidation unless compliance were waived by each of Hilltop and Oak Hill. During the parties’ negotiations with respect to the merger, Hilltop indicated to us that it would not be willing to grant a waiver of this covenant to permit a third party transaction. The existence of the this covenant, and Hilltop’s unwillingness to waive it, may have discouraged and may continue to discourage potential competing acquirors that might have an interest in acquiring all or a significant part of us from considering or proposing such an acquisition.

 

Termination of the Merger Agreement could negatively impact us. If the Merger Agreement is terminated, there may be various consequences. For example, our business may have been adversely impacted by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of the merger. A termination of the Merger Agreement may also damage our reputation and franchise value. If the Merger Agreement is terminated and our BOD seeks another merger or business combination, our stockholders cannot be certain that we will be able to find a party willing to engage in a transaction or to pay the equivalent or greater consideration than that which Hilltop has agreed to pay in the merger.

 

The combined company expects to incur substantial expenses related to the merger. The combined company expects to incur substantial expenses in connection with completing the merger and combining the business, operations, networks, systems, technologies, policies and procedures of the two companies. Although we have assumed that a certain level of transaction and combination expenses would be incurred, there are a number of factors beyond our control that could affect the total amount or the timing of our combination expenses. Many of the expenses that will be incurred, by their nature, are difficult to accurately estimate. Due to these factors, the transaction and combination expenses associated with the merger could, particularly in the near term, exceed the savings that the combined company expects to achieve from the elimination of duplicative expenses and the realization of economies of scale and cost savings related to the combination of the businesses following the completion of the merger. As a result of these expenses, we expect to take charges against our earnings before and after the completion of the merger. The charges taken in connection with the merger are expected to be significant, although the aggregate amount and timing of such charges are uncertain. Further, if the merger is not completed, we would have to recognize these expenses without realizing the expected benefits of the merger.

 

If completed, the merger may not produce its anticipated results, and Hilltop and we may be unable to combine our operations in the manner expected. We and Hilltop entered into the Merger Agreement with the expectation that the merger will result in various benefits. Achieving the anticipated benefits of the merger is subject to a number of uncertainties, including whether the organizations can be combined in an efficient, effective and timely manner.

 

It is possible that the transition process could take longer than anticipated and could result in the loss of valuable employees, the disruption of each company’s ongoing businesses, controls, procedures, policies and compensation arrangements, any of which could adversely affect the combined company’s ability to achieve the anticipated benefits of the merger. The

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combined company’s results of operations could also be adversely affected by any issues attributable to either company’s operations that arise or are based on events or actions that occur prior to the closing of the merger. The companies may have difficulty addressing possible differences in corporate cultures and management philosophies. The transition process is subject to a number of uncertainties, and no assurance can be given that the anticipated benefits will be realized or, if realized, the timing of their realization. Failure to achieve these anticipated benefits could result in increased costs or decreases in the amount of expected revenues and could adversely affect the combined company’s future business, financial condition, operating results and prospects.

The completion of the merger may trigger change in control provisions in certain agreements to which we are a party.    The completion of the merger may trigger change in control provisions in certain agreements to which we are a party. If we and Hilltop are unable to negotiate consents or waivers of those provisions, the counterparties may exercise their rights and remedies under the agreements (including terminating the agreements or seeking monetary penalties). Even if we or Hilltop are able to obtain consents or waivers, the counterparties may demand a fee for such consents or waivers or seek to renegotiate the agreements on materially less favorable terms than those currently in place.

Pending litigation against us could result in an injunction preventing the completion of the merger or a judgment resulting in the payment of damages.  In connection with the merger, purported stockholders have filed putative shareholder class action lawsuits against us and the members of our BOD. Among other remedies, the plaintiffs seek to enjoin the merger. If the cases are not resolved, these lawsuits could prevent or delay completion of the merger and result in substantial costs to us, including any costs associated with the indemnification of directors and officers. Plaintiffs may file additional lawsuits against us and/or the directors and officers of the company, in connection with the merger. The defense or settlement of any lawsuit or claim that remains unresolved at the time the merger is completed may adversely affect our business, financial condition, results of operations and cash flows.

RISKS SPECIFIC TO OUR INDUSTRIES

Compliance with regulatory reform legislation may increase our costs and limit our ability to pursue business opportunities.  On July 21, 2010, the President of the United States signed into law the Dodd-Frank Act. The full impact of the Dodd-Frank Act and its implementing regulations on the financial services industry in general, and on us in particular, is still being determined. SWS Group and the Bank will be subject to additional significant regulatory requirements, which may have a material impact on each or both of them, or SWS as a whole. The principal effects of the Dodd-Frank Act on our business include:

 

As a result of the Dodd-Frank Act, the OTS was abolished and, on July 21, 2011, the OCC took over supervision and regulation of federal thrifts, such as the Bank, and the FRB took over supervision and regulation of savings and loan holding companies, including SWS Group. As a result, we are subject to the regulatory capital and activity requirements, including the new Basel III regulatory capital framework approved by the FRB in July 2013. The Dodd-Frank Act also requires that SWS Group serve as a “source of strength” for the Bank, however, implementing regulations have not been proposed.

The Dodd-Frank Act created a new independent regulatory body, the Bureau, which was given broad rulemaking authority to implement the consumer protection laws that apply to banks and thrifts and to prohibit “unfair, deceptive or abusive” acts and practices. The Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by this new independent regulatory body.

Full implementation of the Dodd-Frank Act will require many new rules to be issued by numerous federal regulatory agencies over the next several years. We expect that several aspects of the Dodd-Frank Act may affect our business, including, without limitation, increased capital requirements, increased mortgage regulation, restrictions on proprietary trading in securities, restrictions on investments in hedge funds and private equity funds, executive compensation restrictions and disclosure and reporting requirements.

Given the significance of the changes and the additional regulatory action required for many of the new provisions, we cannot predict all of the ways or the degree to which our business, financial condition and results of operations may be affected by the Dodd-Frank Act once it is fully implemented. Compliance with these new laws and regulations likely will result in additional costs, which could be significant and may adversely impact our results of operations, financial condition, and liquidity. For additional discussion of the Dodd-Frank Act, see "Item 1. Business-Regulation” included elsewhere in this report.

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We may be adversely affected by increased governmental and regulatory scrutiny or negative publicity.  Governmental and regulatory scrutiny from regulators, legislative bodies and law enforcement agencies with respect to matters relating to compensation, our business practices, our past actions and other matters has increased dramatically in the past several years.  The financial crisis and the current political and public sentiment regarding financial institutions has resulted in a significant amount of adverse press coverage, as well as adverse statements or charges by regulators or other government officials.  Press coverage and other public statements that assert some form of wrongdoing often result in some type of investigation by regulators, legislators and law enforcement officials or in lawsuits.  Responding to these investigations and lawsuits, regardless of the ultimate outcome of the proceeding, is time consuming and expensive and can divert the time and effort of our senior management from our business. Penalties and fines sought by regulatory authorities have increased substantially over the last several years, and certain regulators have been more likely in recent years to commence enforcement actions or to advance or support legislation targeted at the financial services industry.  Adverse publicity, governmental and regulatory scrutiny and legal and enforcement proceedings can also have a negative impact on our reputation and on the morale and performance of our employees, which could adversely affect our business, financial condition, and results of operations or cash flows.

Failure to comply with state and federal laws governing our securities and banking operations, or the regulations adopted by certain self-regulatory agencies could have a material adverse effect on our business.  Broker/dealers, investment advisors and banks are subject to regulation in almost every facet of their operations.  Our ability to comply with these regulations depends largely on the establishment and maintenance of an effective compliance system as well as our ability to attract and retain qualified compliance personnel.  We could be subject to disciplinary or other actions due to alleged non-compliance with these laws or regulations or possibly for the alleged non-compliance of our correspondents.  If non-compliance is alleged by a regulatory authority, our management’s efforts could be diverted to responding to such claim and we could be subject to a range of possible consequences, including the payment of fines and the suspension of one or more portions of our business.  Our clearing contracts generally include automatic termination provisions that are triggered in the event we are suspended from any of the national exchanges of which we are a member for failure to comply with the rules or regulations thereof.  In addition, the failure of the Bank to maintain its status as “well capitalized” could lead to regulatory sanctions and limitations and could lead federal banking agencies to take prompt corrective action.  Failure to comply with these laws and regulations could have a material adverse effect on our business, financial condition, results of operations or cash flows.

The impact of the changing regulatory capital requirements and new capital rules are uncertain.  In July 2013, the OCC and FRB approved a final rule that will substantially amend the risk-based capital rules applicable to SWS Group and the Bank. The final rule implements the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act. The final rule includes new minimum risk-based capital and leverage ratios, which will be effective for SWS Group and the Bank on January 1, 2015, and refines the definition of what constitutes “capital” for purposes of calculating these ratios. The new minimum capital requirements will be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4%. The final rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios and will result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0%; (ii) a Tier 1 to risk-based assets capital ratio of 8.5%; and (iii) a total capital ratio of 10.5%. The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019.  An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such actions. The application of more stringent capital requirements for SWS Group and the Bank could, among other things, adversely affect our results of operations and growth, require the raising of additional capital, restrict our ability to pay dividends or repurchase shares and result in regulatory actions if we were to be unable to comply with such requirements.

 

In July 2013, the SEC adopted various amendments to Rules 15c3-1 and 15c3-3 under the Exchange Act related to, among other things, securities lending, certain new deductions from net capital, proprietary accounts of broker/dealer customers, certain broker/dealer insolvency events and corresponding related amendments to books and records rules.

Our business has been and may continue to be materially and adversely affected by financial market conditions and economic conditions generally.  Our business is affected by conditions in the financial markets and economic conditions generally around the world. The financial services industry and the securities markets generally are materially and adversely affected by recessionary or volatile environments which can cause significant declines in the value of nearly all asset classes. Concerns about financial institution profitability and solvency as a result of general market conditions, particularly in the credit markets, may cause our customers and clients to reduce the level of business that they do with us. Declines in asset values, the lack of liquidity, general uncertainty about economic and market activity and a lack of consumer and investor confidence have negatively impacted, and may continue to negatively impact, our business.

Our financial performance is highly dependent on the business environment in which we operate. A favorable business environment is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence, active new issuance markets for fixed income and equity securities and strong business earnings. Slowing

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growth, contraction of credit, increasing energy prices, declines in business or investor confidence or risk tolerance, increases in inflation, higher unemployment, outbreaks of hostilities or other geopolitical instability, corporate, political or other scandals that reduce investor confidence in capital markets and natural disasters, among other things, can affect the global financial markets. In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally. In the event of changes in market conditions, such as interest or foreign exchange rates, equity, fixed income, commodity or real estate valuations, liquidity, availability of credit or volatility, our business could be adversely affected.

Overall, the business environment since 2008 has been difficult.   While many economists believe the recession ended in June 2009 and while select factors indicate signs of improvement, significant uncertainty still remains.  Unemployment and tight credit markets continue to create a fragile economic environment, and there is no guarantee that conditions will not worsen again leading to further decline in economic and market conditions.  Although Texas was largely insulated from severe job loss and real estate market deterioration at the start of the recession, it experienced distress in residential and commercial real estate values as well as elevated unemployment. These conditions had, and will continue to have, a direct and material impact on our results of operations and financial condition because performance in the financial services industry is heavily influenced by the overall strength of economic conditions and financial market activity.

Our ability to access capital markets is dependent on market conditions and our credit standing, which could change unfavorably.  Factors that are significant to the determination of our credit worthiness or otherwise affect our ability to raise financing include the level and volatility of our earnings and whether we have net losses, our relative competitive position in the markets in which we operate, our product diversification, our ability to retain key personnel, our risk profile, our risk management policies, our cash liquidity, our capital adequacy, our corporate lending credit risk and legal and regulatory developments.  Additionally, market conditions can be unfavorable for our industry causing banks and other liquidity sources to reduce or limit credit to our industry.  This could limit the availability of, and thus our access to, capital and/or increase the cost of funding new or existing businesses.

Our revenues may decrease if securities transaction volumes decline.  Our securities business depends upon the general volume of trading in the U.S. securities markets.  If the volume of securities transactions should decline, revenues from our securities brokerage, securities lending and clearing businesses would decrease and our business, financial condition, results of operations or cash flows would be materially and adversely impacted.

Market fluctuations could adversely impact our securities business.  We are subject to risks as a result of fluctuations in the securities markets.  Our securities trading, market-making and underwriting activities involve the purchase and sale of securities as a principal, which subjects our capital to significant risks.  Market conditions could limit our ability to sell securities purchased or to purchase securities sold in such transactions.  If price levels for equity securities decline generally, the market value of equity securities that we hold in our inventory could decrease and trading volumes could decline.  In addition, if interest rates increase, the value of debt securities we hold in our inventory would decrease.  Rapid or significant market fluctuations could adversely affect our business, financial condition, results of operations and cash flow.

In addition, during periods of market disruption, it may be difficult to value certain assets if comparable sales become less frequent or market data becomes less observable.  Certain classes of assets or loan collateral that were in active markets with significant observable data may become illiquid due to the current financial environment.  In such cases, asset valuations may require more estimation and subjective judgment.  Rapidly changing real estate market conditions could materially impact the valuation of assets and loan collateral as reported in our financial statements and changes in estimated values could vary significantly from one period to the next.  Decreases in value may have a material adverse effect on our business, financial condition or results of operations.

The soundness of other financial institutions could adversely affect us.    Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different counterparties and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, credit unions, investment banks, mutual and hedge funds, and other institutional clients. As a result, defaults by, or even negative speculation about, one or more financial services institutions, or the financial services industry in general, have led to market wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the receivable due us. Any such losses could be material and could materially and adversely affect our business, financial condition, results of operations or cash flows.

RISKS RELATED TO OUR COMPANY

Agreements with Hilltop and Oak Hill provide them with influence over certain matters requiring director and stockholder approval.  In connection with loans made under the Credit Agreement by and among Oak Hill and Hilltop (the

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“Investors”) and us, the Investors were each issued warrants to purchase an aggregate of 8,695,652 shares of our common stock (the “Warrants”). For each Investor, the Warrants represent approximately 17% of our common stock (assuming that all of the Warrants are exercised in full).  The Investors have the right to exercise the Warrants to purchase shares of our common stock at an agreed upon exercise price. 

 

Pursuant to an Investor Rights Agreement, by and between the Investors and us, dated as of July 29, 2011 (the “Investor Rights Agreement”), each of the Investors has the right to appoint one representative of the Investor to serve as a member of our BOD, and one representative of the Investor to serve as an observer of the BOD.  Our BOD consists of 10 directors, including five who qualify as independent under the NYSE listing standards and the two directors who were appointed by the Investors. The representatives of Oak Hill and Hilltop appointed to serve as members of the BOD share in the duties of the BOD by generally participating in and voting during board meetings. 

 

The Credit Agreement with the Investors contains certain covenants, including a covenant that prohibits us from prepaying the loan other than following a period during which the closing price for our common stock exceeds 150% of the exercise price of the warrants (i.e., exceeds $8.625) for 20 out of any 30 consecutive trading days and a covenant that prohibits us from undergoing a “Fundamental Change,” which includes any merger, amalgamation or consolidation. 

 

As a result of the Warrants, Investor Rights Agreement and the Credit Agreement, the Investors have influence over certain matters requiring director and stockholder approval, including, among other things, any merger, consolidation or sale of all or substantially all of the Company’s assets and the election of certain members of the  BOD.

Deteriorating credit quality, particularly in commercial, construction and real estate loans, has adversely impacted the Bank and may adversely impact the Bank.  Beginning in fiscal 2009, the Bank began to experience a downturn in the overall credit performance of its real estate loans held for investment, as well as acceleration in the deterioration of general economic conditions in Texas and other areas of the United States.  This deterioration, as well as increases in Texas unemployment levels, worsened in the third quarter of fiscal 2010.  These conditions caused increased financial stress on many of the Bank’s borrowers and negatively impacted their ability to repay their loans. Classified and non-performing assets increased significantly in fiscal 2010 and 2011 and real estate collateral values continued to decline in both fiscal 2010 and 2011.  Due to these factors, the Bank significantly increased its loan loss reserves in fiscal 2010 and 2011. 

Both classified and non-performing assets have improved throughout fiscal 2012, 2013 and 2014, and in fiscal 2014 and 2013, the Bank recognized a recapture for loan losses of $5.4 million and $7.7 million, respectively. Deterioration in the credit quality of the Bank's real estate loan portfolio could significantly increase non-performing loans, require additional increases in loan loss reserves and elevate charge-off levels.  The occurrence of any of these events could have a material adverse effect on the Bank's capital, financial condition or results of operations and increase the risk of additional regulatory action.

The Bank is subject to regulatory capital requirements that may limit its operations and potential growth.  The Bank is a federal savings bank that is subject to comprehensive supervision and regulation of the OCC, including risk-based, leverage and tangible capital ratio requirements. Capital requirements may rise above normal levels when the Bank experiences deteriorating earnings and credit quality, and the OCC may increase the Bank’s capital requirements based on general economic conditions and the Bank’s particular condition, risk profile and growth plans. The Bank has made a commitment to the OCC that the Bank will, among other things: (i) adhere to the Bank’s written business and capital plan as amended from time to time and (ii) maintain a Tier 1 (core) capital ratio at least equal to nine percent (9%) and a total risk-based capital ratio of at least twelve percent (12%).  Compliance with capital requirements may limit the Bank’s operations that require the intensive use of capital and could adversely affect the Bank’s ability to expand or maintain present business levels.

The preparation of our consolidated financial statements requires the use of estimates that may vary from actual results and new accounting standards could adversely affect future reported results. The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates and assumptions may require management to make difficult, subjective and complex judgments about matters that are inherently uncertain. See Item 7. “Management's Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates,” for additional information on the nature of these estimates.

 

Our financial instruments, including certain trading assets and liabilities, available for sale securities, certain loans, interest rate swaps and warrants, require management to make a determination of their fair value in order to prepare our consolidated financial statements. Where quoted market prices are not available, we may make fair value determinations based on internally developed models or other means which ultimately rely to some degree on our judgment. Some of these instruments and other assets and liabilities may have no direct observable inputs, making their valuation particularly subjective, being based on significant estimation and judgment by management. In addition, sudden illiquidity in markets or declines in prices of certain securities may make it more difficult to value certain items, which may lead to the possibility that such valuations will be subject to change or adjustment and could lead to declines in our earnings in subsequent periods.

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Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board (“FASB”) and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. In addition, accounting standard setters and those who interpret the accounting standards may change or even reverse their previous interpretations or positions on how these standards should be applied. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in a restatement of prior period financial statements.

 

Failure to achieve and maintain effective internal controls could result in a misstatement of our financial statements.    Pursuant to Section 404 of the Sarbanes-Oxley Act, we are required to furnish an annual report by our management assessing the effectiveness of our internal control over financial reporting. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. A material weakness is a control deficiency, or a combination of deficiencies, that results in more than a remote likelihood that a material misstatement of our annual or interim financial statements will not be prevented or detected. 

 

Ineffective internal controls could adversely impact our ability to provide timely and accurate financial information. If we are unsuccessful in maintaining effective internal controls, we may be unable to accurately and timely report financial information or maintain effective disclosure controls and procedures. Any such failure in the future could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act and the rules promulgated hereunder.  If we are unable to report financial information in a timely and accurate manner or to maintain effective disclosure controls and procedures, we could be in default under our Credit Agreement or be subject to, among other things, investigations or regulatory or enforcement actions by the SEC, the FRB, the FDIC, the OCC or other governmental authorities.   In addition, any failure to maintain effective internal controls could cause investors to lose confidence in the accuracy and completeness of our financial reports, which in turn could cause our stock price to decline.

 

Risk management processes may not fully mitigate exposure to the various risks that we face, including market, liquidity and credit risk.  We continue to refine our risk management techniques, strategies and assessment methods on an ongoing basis. However, risk management techniques and strategies, both ours and those available to the market generally, may not be fully effective in mitigating our risk exposure in all economic market environments or against all types of risk. For example, we might fail to identify or anticipate particular risks that our systems are capable of identifying, or the systems that we use, and that are used within the industry generally, may not be capable of identifying certain risks. Some of our strategies for managing risk are based upon our use of observed historical market behavior. We apply statistical and other tools to these observations to quantify our risk exposure. Any failures in our risk management techniques and strategies to accurately quantify our risk exposure could limit our ability to manage risks. In addition, any risk management failures could cause our losses to be significantly greater than the historical measures indicate. Further, our quantified modeling does not take all risks into account. As a result, we also take a qualitative approach in reducing our risk.  Our qualitative approach to managing those risks could also prove insufficient, exposing us to material unanticipated losses.

Our business is significantly dependent on net interest margins.  The profitability of our margin and stock lending businesses depends to a great extent on the difference between interest income earned on loans and investments of customer cash balances and the interest expense paid on customer cash balances and borrowings.  The earnings and cash flows of the Bank are also dependent upon the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. 

Interest rates are sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System.  Changes in monetary policy, including changes in interest rates, could affect the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings.  Such changes could also affect our ability to originate loans and obtain deposits and the fair value of our financial assets and liabilities.  If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore our earnings, could be adversely affected.  Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

Our net interest margins may decrease based on the mix of assets in the Bank’s portfolio and our investment strategy.  In recent years, interest rates have declined to levels that have negatively impacted the net interest margin at the Bank and the broker/dealer. Additionally, as we have repositioned the Bank’s balance sheet to include a portfolio of conservative investment securities, the net interest margin on these assets is likely to be less than we have historically earned on our loan portfolio. Our earnings and results of operations could be adversely affected by any reduction in our net interest margin due to our investment policies, returns on investments or market dynamics. Additionally, the Bank expects to periodically experience "gaps" in the interest rate sensitivities of its assets and liabilities, meaning that either the Bank’s interest-bearing liabilities will be more sensitive to changes in market interest rates than the Bank’s interest-earning assets, or vice versa. In either event, if market

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interest rates should move contrary to the Bank’s position, this "gap" may work against the Bank, and the Bank’s earnings may be adversely affected.

As part of the Bank’s risk mitigation strategy to reduce its exposure to variability in interest payments on the Bank’s variable rate deposits, forward-start interest rate swaps designated as cash flow hedging instruments have been utilized.  The Bank’s forward-start interest rate swaps exchange fixed for variable interest payments beginning at a pre-specified date in the future according to the terms of the swap agreements.  There is no guarantee that the structure of these derivative transactions will operate as designed and remain effective.  If these transactions are not effective, our results of operations could be adversely affected.

We may not be able to reduce our operating expenses as a way to reduce any operating losses.  To the extent our net interest income declines or we face other declines in revenues, we may look to reduce our operating expenses where possible. However, we have limited control over certain costs, and in particular, the cost of meeting regulatory requirements and our cost to access capital or financing, if needed. If we are unable to reduce our operating expenses, our financial condition, results of operations or cash flows could be adversely affected.

Our margin lending, stock lending, securities trading and execution, bank lending and mortgage purchase businesses are all subject to credit risk.  Credit risk in all areas of our business increases if securities prices decline rapidly because the value of our collateral could fall below the amount of the indebtedness it secures.  In rapidly appreciating markets, credit risk increases due to short positions.  Our securities lending business as well as our securities trading and execution businesses subject us to credit risk if a counterparty fails to perform or if collateral securing its obligations is insufficient.  In securities transactions, we are subject to credit risk during the period between the execution of a trade and the settlement by the customer.  

In addition, the Bank is exposed to the risk that its loan customers may not repay their loans in accordance with their terms, the collateral securing the loans may be insufficient, or its loan loss reserve may be inadequate to fully compensate the Bank for the outstanding balance of the loan plus the costs to dispose of the collateral.  Our mortgage warehousing activities subject us to credit risk during the period between funding by the Bank and when the mortgage company sells the loan to a secondary investor.

Significant failures by our customers, including correspondents, or clients to honor their obligations, together with insufficient collateral and reserves, could have a material adverse affect on our business, financial condition, results of operations or cash flows.

Our investment advisory business may be affected by the poor investment performance of our investment products.  Poor investment returns and declines in client assets in our investment advisory business, due to either general market conditions or underperformance (relative to our competitors or to benchmarks) by our investment products, affects our ability to retain existing assets, prevent clients from transferring their assets out of our products or their accounts, or inhibit our ability to attract new clients or additional assets from existing clients. This could adversely affect our advisory business and the advisory fees that we earn on client assets.

 

The Bank’s allowance for loan losses may not be sufficient to cover actual loan losses.  The Bank’s borrowers may fail to repay their loans according to the loan terms, and the collateral securing the payment of these loans may be insufficient to assure repayment. Such loan losses could have a material adverse effect on our operating results. We make various assumptions, estimates and judgments about the collectability of the Bank’s loan portfolio, including the creditworthiness of the borrowers and the value of the real estate and other assets serving as collateral for the loans. In determining the amount of the allowance for loan losses, the Bank relies on a number of factors, including its experience and evaluation of economic conditions. If the Bank’s assumptions prove to be incorrect, its allowance for loan losses may not be sufficient to cover losses inherent in its loan portfolio, and adjustments may be necessary that would have a material adverse effect on our operating results.

The Bank’s commercial real estate, commercial and mortgage lending businesses are dependent on the general health of the Texas and New Mexico economies.  Any downturn in the Texas and New Mexico local economies could adversely affect the Bank’s commercial real estate, commercial and mortgage lending businesses, and consequently our financial condition, results of operations and cash flows.  Additionally, any decline in real estate values generally and in Texas and New Mexico specifically could impair the value of our collateral and our ability to sell the collateral upon any foreclosure. In the event of a default with respect to any of these loans, the amounts we receive upon sale of the collateral may be insufficient to recover the outstanding principal and interest on the loan.    

Our business and prospects, including our ability to attract and retain customers, clients and employees, may be adversely affected if our reputation is harmed. Our business is subject to significant reputational risks. If we fail, or appear to fail, to deal appropriately with various legal, regulatory or business issues, our reputation, business and prospects, including our ability to attract and retain customers, clients and employees, could be seriously harmed. This could be the case not only in situations involving actual violations of law but also in circumstances where no laws have been violated. Our reputation could be harmed in many different ways, including as a result of the perceived or actual failure to address conflicts of interest or ethical

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issues, failure to comply with legal or regulatory requirements, allegations of money laundering, violation of privacy policies, failure to properly maintain customer, client and employee personal information, failure to maintain adequate or accurate records, allegations of unfair sales and trading practices, and improper identification of the legal, reputational, credit, liquidity and market risks inherent in our products. Publicity of a failure to appropriately address these issues could result in litigation claims or subject us to enforcement actions, fines and penalties and cause us to incur related costs and expenses. Legal liability or regulatory actions as a result of negative publicity could in turn cause significant additional reputational harm.

We depend on the highly skilled, and often specialized, individuals we employ.  Competition for the services of personnel in our loan production, private client group, securities lending and trading businesses is intense, and we may not be able to retain them.  We generally do not enter into employment or noncompetition agreements with our employees.  Our business, financial condition, operating results or cash flows could be materially impacted if we were to lose the services of certain of our loan production, private client group, securities lending or trading professionals.  In particular, in our retail and institutional securities brokerage business, we depend on the brokers and financial advisors that advise our customers and clients, certain of whom generate significant income for us.

We depend on our computer and communications systems and an interruption in service would negatively affect our business.  Our businesses rely on electronic data processing and communications systems.  The effective use of technology allows us to better serve customers and clients, increases efficiency and reduces costs.  Our continued success will depend, in part, upon our ability to successfully maintain, secure and upgrade the capability of our systems, our ability to address the needs of our clients by using technology to provide products and services that satisfy their demands and our ability to retain skilled information technology employees.  Significant malfunctions or failures of our computer systems, computer security, software or any other systems in the trading process (e.g., record retention and data processing functions performed by third parties, and third party software, such as Internet browsers) could cause delays in customer trading activity.  Such delays could cause substantial losses for customers and could subject us to claims from customers for losses, including litigation claiming fraud or negligence.  In addition, if our computer and communications systems fail to operate properly, regulations would restrict our ability to conduct business.  Any such failure could prevent us from collecting funds relating to customer and client transactions, which would materially impact our cash flows.  Any computer or communications system failure or decrease in computer system performance that causes interruptions in our operations could have a material adverse effect on our business, financial condition, results of operations or cash flows.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively or timely implement new technology-driven products and services or be successful in marketing these products and services to our customers and clients. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business, our financial condition, and results of operations or cash flows.  

Our computer systems and network infrastructure could be vulnerable to security problems. Third parties may attempt to penetrate our network security and may be able to penetrate our network security to misappropriate proprietary information which could have a material adverse effect on our business.  We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effect secure transmissions of confidential information.  Advances in computer capabilities, discoveries in the field of cryptography and other discoveries, events or developments could lead to a compromise or breach of the algorithms that our licensed encryption and authentication technology uses to protect such confidential information.  We may be required to expend significant capital and resources and engage the services of third parties to protect against the threat of such security, encryption and authentication technology breaches or to alleviate problems caused by such breaches.  Security breaches or the inadvertent transmission of computer viruses could expose us to a risk of loss or litigation and possible liability which could have a material adverse affect on our business, financial condition, results of operations or cash flows.

Our Credit Agreement with Hilltop and Oak Hill contains restrictions and covenants that impact our business and expose us to risks that could adversely affect our liquidity and financial condition.  On July 29, 2011, we entered into a Credit Agreement which contains customary covenants that require us to, among other things:

 

In addition, certain of these covenants limit our and certain of our subsidiaries’ ability to, among other things:

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If we are unable to generate sufficient cash flow or otherwise obtain the funds necessary to make required payments under the Credit Agreement, or we fail to comply with the requirements of our indebtedness, we could be in default under the Credit Agreement. Any default that is not cured or waived could result in the acceleration of the obligations under the Credit Agreement. Any such default which actually causes an acceleration of obligations could have a material adverse effect on our liquidity, financial condition or cash flows. Additionally, the covenants in such agreement or future debt agreements may restrict the conduct of our business, which could adversely affect our business by, among other things, limiting our ability to engage in financings, mergers, acquisitions and other corporate opportunities that may be beneficial to our business.

Misconduct or errors by our employees or entities with which we do business could harm us and are difficult to detect and prevent.  There have been a number of highly publicized cases involving fraud or other misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct or employee errors could occur at our company.  For example, misconduct could result from the improper use or disclosure of confidential information, and error could involve the failure to follow or implement procedures, either of which could result in regulatory sanctions and serious reputational or financial harm.  It is not always possible to deter misconduct or errors and the precautions we take to detect and prevent this activity may not be effective in all cases.  Our ability to detect and prevent misconduct or errors by entities with which we do business may be even more limited.  We may suffer reputational harm for any misconduct or errors by our employees or those entities with which we do business.

We face liquidity risk, which is the potential inability to repay short-term borrowings with new borrowings or assets that can be quickly converted into cash while meeting other ongoing obligations.  Our liquidity may be impaired due to circumstances that we may be unable to control, such as general market disruptions or an operational problem that affects our trading clients, depositors, third parties or ourselves.  Our ability to sell assets may also be impaired by regulatory constraints or if other market participants are seeking to sell similar assets at the same time.  Our inability to borrow funds or sell assets to meet maturing obligations may have an adverse effect on our business, financial condition, results of operations or cash flows.

 

In addition, if our customers decide not to invest with us, our liquidity could be adversely affected.  If our retail banking and securities clients withdraw their deposits or our institutional customers withdraw their trading lines with us, our liquidity would be impaired.  Furthermore, we currently have access to advances from the Federal Home Loan Bank (“FHLB”).  If we become subject to regulatory actions, we may not have access to these advances and our liquidity could be impaired.

Our securities business is subject to numerous operational risks.  Our securities business must be able to consistently and reliably obtain securities pricing information and accurately assess loan values, process transactions and provide reports and other customer or client services.  Any failure to keep current and accurate books and records can render us liable to disciplinary action by governmental and self-regulatory authorities, as well as to claims by our customers and clients.  If any of our financial, portfolio accounting or other data processing systems do not operate properly or are disabled, or if there are other shortcomings or failures in our internal processes, people or systems, we could suffer an impairment to our liquidity, a financial loss, a disruption of our businesses, liability to our customers and clients, regulatory problems or damage to our reputation.  These systems may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, including a disruption of electrical or communications services or our inability to occupy one or more of our buildings.  In addition, our operations are dependent upon information from, and communications with, third parties, and operational problems at third parties may adversely affect our ability to carry on our business.

We are subject to risks relating to litigation and potential securities law liabilities.  Many aspects of our business involve substantial risks of liability.  In the normal course of our business, we have been subject to claims by customers and clients alleging unauthorized trading, churning, mismanagement, suitability of investments, breach of fiduciary duty or other alleged misconduct by our employees or brokers.  We are sometimes brought into lawsuits based on allegations concerning our correspondents.  As underwriters, we are subject to substantial potential liability for material misstatements and omissions in prospectuses and other communications with respect to underwritten offerings of securities.  Prolonged litigation producing significant legal expenses or a substantial settlement or adverse judgment could have a material adverse effect on our business, financial condition, results of operations or cash flows.

We face strong competition from larger firms.  The financial services business is intensely competitive and we expect it to remain so. We compete on the basis of a number of factors, including client relationships, reputation, the abilities of our professionals, market focus and the relative quality and price of our services and products. Many of our competitors have a broader range of products and services, greater financial and marketing resources, larger customer bases, greater name recognition, more professionals to serve their clients’ needs and better established relationships with clients than we have. These larger competitors may be better able to respond to industry change, compete for skilled professionals, finance acquisitions, fund internal growth and compete for market share generally.

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Our portfolio trading business is highly price competitive and serves a very limited market.  Our portfolio trading business serves one small component of the portfolio trading execution market with a small customer base and a high service model, charging competitive commission rates.  Consequently, growing or maintaining market share is very price sensitive.  We rely upon a high level of customer service and product customization to maintain our market share; however, should prevailing market prices fall, or the size of our market segment or customer base decline, our profitability would be adversely impacted.  In addition, in our portfolio trading business, we purchase securities as principal, which subjects our capital to significant risks.  See “– Market fluctuations could adversely impact our securities business.”

 

Our existing correspondents may choose to perform their own clearing services, move their clearing business to one of our competitors or exit the business.  As our correspondents’ operations grow, they often consider the option of performing clearing functions themselves, in a process referred to as "self-clearing." The option to convert to self-clearing operations may be attractive due to the fact that as the transaction volume of a broker/dealer grows, the cost of implementing the necessary infrastructure for self-clearing may eventually be offset by the elimination of per transaction processing fees that would otherwise be paid to a clearing firm.  Additionally, performing their own clearing services allows self-clearing broker/dealers to retain their customers’ margin balances, free credit balances and securities for use in margin lending activities.  Furthermore, our correspondents’ may decide to use the clearing services of one of our competitors or exit the business.  Any significant loss of correspondents due to self-clearing or because of their use of a competitor’s clearing service could have a material adverse affect on our business, financial condition, results of operations or cash flows.

 

Several of our product lines rely on favorable tax treatment and changes in federal tax law could impact the attractiveness of these products to our customers.  We offer a variety of services and products, such as Individual Retirement Accounts and municipal bonds that rely on favorable federal income tax treatment to be attractive to our customers.  Should favorable tax treatment of these products be eliminated or reduced, sales of these products could be materially impacted, which could have a material adverse effect on our business, financial condition, results of operations or cash flows.

 

Our businesses may be adversely affected by new or changing tax laws.  Our business can be directly or indirectly adversely affected by new tax legislation, the expiration of existing tax laws, or the interpretation of existing tax laws.  In the normal course of business, we are subject to reviews by federal, state and local tax authorities. Reviews by federal, state and local tax authorities may result in adjustments to the timing or amount of taxes due which could adversely affect our business, financial condition, results of operations or cash flows.

 

We may not be able to realize the value of our deferred tax assets.  We recognize deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. As of June 30, 2014, our net deferred tax assets were approximately $37.7 million, before our $35.5 million valuation allowance. We regularly review our deferred tax assets for recoverability based on our history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carry-back years, as well as future taxable income.  A period of sustained losses or other changes in facts and circumstances could require us to recognize changes in the valuation allowance.  If we fail to realize our deferred tax assets or we determine that increases to the deferred tax asset valuation allowance is required in future reporting periods, our financial condition, results of operations or cash flows may be materially adversely affected.

 

Rising insurance costs and regulations could adversely affect our business.  Our operations and financial results are subject to risks and uncertainties associated with the increasing costs and regulations related to our use of a combination of insurance, self-insured retention and self-insurance for a number of risks, including, without limitation, property and casualty, workers’ compensation, general liability, and the company-funded portion of employee-related health care benefits. While the nature and scope of increasing costs and regulatory changes cannot be predicted, they could have a material adverse effect on our business, financial condition, results of operations or cash flows.

 

The exercise of our outstanding warrants would significantly dilute the ownership interest of existing stockholders. The exercise by Hilltop and/or Oak Hill of all or a substantial portion of our outstanding warrants would significantly dilute the ownership interests of existing stockholders. Any sales in the public market of the common stock issuable upon such exercise could adversely affect prevailing market prices of our common stock.

 

Our operations rely on external vendors.  We rely on certain external vendors to provide products and services necessary to maintain our day-to-day operations, particularly in the areas of operations, treasury management systems, information technology and security, exposing us to the risk that these vendors will not perform as required by our agreements. An external vendor’s failure to perform in accordance with our agreement could be disruptive to our operations, which could have a material adverse impact on our business, financial condition and results of operations.

 

An investment in our securities is not an insured deposit. Our common stock, preferred stock and indebtedness are not bank deposits and, therefore, are not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of securities of any company. As a result, if you acquire our common stock, preferred stock or indebtedness, you may lose some or all of your investment.

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Anti-takeover provisions of our restated certificate of incorporation, restated bylaws and Delaware law may make it more difficult for you to receive a change in control premium.  Certain provisions of our restated certificate of incorporation and restated bylaws could make a merger, tender offer or proxy contest more difficult, even if such events were perceived by many of our stockholders as beneficial to their interests. These provisions include advance notice for nominations of directors and stockholders’ proposals, and authority to issue “blank check” preferred stock with such designations, rights and preferences as may be determined from time to time by the BOD. In addition, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law which, in general, prevents an interested stockholder, defined generally as a person owning 15% or more of a corporation’s outstanding voting stock, from engaging in a business combination with our company for three years following the date that person became an interested stockholder unless certain specified conditions are satisfied.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

Our principal executive offices and primary broker/dealer and banking operations are located in approximately 156,000 square-feet of leased space in an office building in Dallas, Texas.  The lease expires in 2020.  Our other office locations are leased and generally do not exceed 30,000 square feet of space.  We conduct our clearing operations primarily at our Dallas headquarters, and our securities lending activities are conducted from our office in Old Bridge, New Jersey. 

We have 16 retail brokerage offices with nine offices located in Texas, five offices located in California and two offices located in Oklahoma.        

We have 15 municipal finance branches, with four offices located in California, three offices located in Texas and one office located in each of Florida, Illinois, Kentucky, New Mexico, New York, North Carolina, South Carolina and Tennessee.  We have 10 fixed income branch offices, three offices located in Florida, two offices located in each of California and Colorado, and one office located in each of Illinois, New York and Texas. 

The Bank leases branch offices in Fort Worth, Dallas and El Paso, Texas, and Albuquerque and Ruidoso, New Mexico.  The Bank also owns a non-operational drive-in facility located in central Arlington, Texas.  The Bank owns its banking facilities in Granbury, Waxahachie and South Arlington, Texas.

The company has developed business continuity plans that are designed to permit continued operation of business critical functions in the event of disruptions to our Dallas, Texas headquarters facility as well as critical facilities used by our major subsidiaries. Our critical activities can be relocated among our normal operating facilities and our business recovery centers in South Arlington and Southlake, Texas and a disaster recovery center in Richardson, Texas.  The center located in South Arlington utilizes space in the property owned by the Bank and the Southlake center’s facilities are leased.  Our Richardson facility houses redundant securities and bank processing facilities adequate to replace those found in our primary data center.  Our disaster recovery plans are periodically tested, and we participate in industry-wide tests within the securities industry. 

Management believes that our present facilities are adequate for the business for the foreseeable future, exclusive of expansion opportunities.

 

ITEM 3. LEGAL PROCEEDINGS

In the general course of our brokerage business and the business of clearing for other brokerage firms, we have been named as defendants in various pending lawsuits and arbitration and regulatory proceedings.  These claims allege violations of various federal and state securities laws, among other matters.  The Bank is also involved in certain claims and legal actions arising in the ordinary course of business.  We believe that resolution of these claims will not result in a material adverse effect on our business, consolidated financial condition, results of operations or cash flows.

 

Merger Litigation. Two putative class actions on behalf of purported stockholders of SWS challenging the proposed merger of SWS Group and Peruna are pending in the Court of Chancery of the State of Delaware.  Both lawsuits name as defendants SWS, the individual members of the BOD, Hilltop, and Peruna, (Joseph Arceri v. SWS Group, Inc. et al and Chaile Steinberg v. SWS Group, Inc. et al filed April 8, 2014 and April 11, 2014, respectively),  On May 13, 2014, the Delaware Chancery Court consolidated the two actions for all purposes. On June 10, 2014, plaintiffs filed a consolidated amended complaint.

The complaint generally alleges, among other things, that the BOD breached its fiduciary duties to stockholders by failing to take steps to maximize stockholder value or to engage in a fair sale process before approving the merger, and that the other defendants aided and abetted such breaches of fiduciary duty.  The complaint alleges, among other things, that the BOD labored under conflicts of interest, and that certain provisions of the Merger Agreement unduly restrict our ability to negotiate with other potential bidders, and that the Form S-4 filed by Hilltop on May 29, 2014 omits or misstates certain material

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information.  The complaint seeks relief that includes, among other things, an injunction prohibiting the consummation of the merger, rescission to the extent the merger terms have already been implemented, damages for the alleged breaches of fiduciary duty, and the payment of plaintiffs’ attorneys’ fees and costs.  On June 16, 2014, plaintiffs moved for a preliminary injunction prohibiting the consummation of the merger, and for expedited proceedings in connection therewith.  Pursuant to negotiations between the parties to the lawsuit, plaintiffs subsequently withdrew those motions.

 

We believe the claims are without merit and intend to defend against them vigorously.  There can be no assurance, however, with regard to the outcome of this lawsuit.  Currently, a loss resulting from these claims is not considered probable or reasonably estimable in amount.

 

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market for Common Stock.    Our common stock trades on the NYSE under the symbol "SWS."  At August 30, 2014, there were 94 holders of record of our common stock and approximately 4,120 beneficial holders of our common stock.  The following table sets forth for the periods indicated the high and low market prices for the common stock and the cash dividend declared per common share:

 

 

 

 

 

 

 

 

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Stock Performance Graph and Cumulative Total Return.  The following table compares the cumulative total stockholder return on our common stock for the 60-month period from June 2009 through June 2014, with the cumulative total return of the Wilshire 5000 Index and the Nasdaq Financial Index over the same period. The graph depicts the results of investing $100 in our common stock, Wilshire 5000 Index and the Nasdaq Financial Index in June 2009, including the reinvestment of dividends.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among SWS Group, Inc., Wilshire 5000 Index and the NASDAQ Financial Index

 

 

*$100 invested on 6/30/09 in stock or index, including reinvestment of dividends.  Represents amount invested as of June 30th of the applicable year.

 

 

Stock Repurchases.    We did not repurchase any common stock during the quarter ended June 30, 2014.  We do not currently have a repurchase plan approved by our BOD.            

 

Dividend policy.  On a quarterly basis, the BOD determines whether we will pay a cash dividend.   The payment and rate of dividends on our common stock is subject to several factors including limitations imposed by the terms of our Credit Agreement with Hilltop and Oak Hill, regulatory approval, operating results, our financial requirements, and the availability of funds from our subsidiaries, including the broker/dealer subsidiaries, which may be subject to restrictions under the net capital rules of the SEC and FINRA, and the Bank, which may be subject to restrictions by federal banking agencies. Specifically, our Credit Agreement with Hilltop and Oak Hill limits our quarterly cash dividend to $0.01 per share and only so long as we are not in default of any terms of the Credit Agreement. We currently intend to retain earnings and do not plan to pay dividends on our common stock in the near future.

Equity Compensation Plan Information 

Restricted Stock Plan.  On November 15, 2012, the stockholders of SWS Group, Inc. approved the adoption of the SWS Group, Inc. 2012 Restricted Stock Plan (“2012 Restricted Stock Plan”). The 2012 Restricted Stock Plan allows for awards of restricted stock to SWS’s directors, officers and employees and authorizes up to 2,630,000 shares of SWS’s common stock to be delivered pursuant to awards granted under the 2012 Restricted Stock Plan. The 2012 Restricted Stock Plan expires on November 15, 2022. 

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On November 12, 2003, our stockholders approved the adoption of the SWS Group, Inc. 2003 Restricted Stock Plan ("2003 Restricted Stock Plan").  In November 2007, the stockholders of SWS Group approved an amendment to the 2003 Restricted Stock Plan to increase the number of shares available thereunder by 500,000 shares.  The Restricted Stock Plan allows for awards of up to 1,250,000 shares of our common stock to our directors, officers and employees.  No more than 300,000 of the authorized shares may be newly issued shares of common stock.  The Restricted Stock Plan terminated on August 21, 2013. 

The vesting period for awards under the 2003 Restricted Stock Plan and the 2012 Restricted Stock Plan is determined on an individualized basis by the Compensation Committee of the BOD.  In general, restricted stock granted to employees under the restricted stock plans fully vests after three years or is subject to a four year cliff vesting schedule, and restricted stock granted to non-employee directors vests on the first anniversary of the date of grant.  At June 30, 2014, the total number of shares of restricted stock outstanding under the 2012 Restricted Stock Plan and the 2003 Restricted Stock Plan was 417,137 shares and the total number of shares available for future awards under the 2012 Restricted Stock Plan was 2,383,016 shares.

Deferred Compensation Plan. On November 10, 2004, the stockholders of SWS Group approved the 2005 Deferred Compensation Plan, with an effective date of January 1, 2005, for eligible officers and employees to defer a portion of their bonus compensation and commissions.  The deferred compensation plan was designed to comply with the American Jobs Creation Act of 2004.  Contributions to the deferred compensation plan consist of employee pre-tax contributions and SWS Group’s matching contributions, in the form of SWS Group common stock, up to a specified limit.

 

The assets of the deferred compensation plan include investments in SWS Group’s common stock, Westwood Holdings Group, Inc.’s ("Westwood") common stock and company-owned life insurance ("COLI").  Investments in SWS Group’s common stock are carried at cost and are held as treasury stock with an offsetting deferred compensation liability in the equity section of the Consolidated Statements of Financial Condition. The deferred compensation plan limited the number of shares of SWS Group common stock that may be issued to 375,000 shares.  On November 17, 2009, the stockholders of SWS Group voted to increase the authorized number of shares of SWS Group common stock available for issuance under the deferred compensation plan from 375,000 shares to 675,000 shares.  The number of shares of SWS Group common stock available for future issuance under the plan was 126,679 at June 30, 2014.  Investments in Westwood’s common stock are carried at market value and recorded as securities available for sale.  Investments in COLI are carried at the cash surrender value of the insurance policies and recorded in other assets in the Consolidated Statements of Financial Condition. 

 

For the fiscal year ended June 30, 2014, we had approximately $22.8 million in deferred compensation plan assets, including $0.4 million in cash, with a market value of $21.8 million.  At June 30, 2014, $3.2 million was invested in 310,941 shares of our common stock.  Approximately $1.8 million of compensation expense was recorded for participant contributions and employer matching contributions related to the deferred compensation plan in fiscal 2014. 

 

The trustee of the deferred compensation plan is Wilmington Trust Company. 

 

Stock Option Plans.  We did not have any active stock option plans at June 30, 2014.  All previously issued outstanding options under the SWS Group, Inc. stock option plans have expired.  See Note 1(u) in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

 

The following table sets forth certain information concerning our equity compensation plans approved by our stockholders as of June 30, 2014. 

 

 

 

 

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ITEM 6. SELECTED FINANCIAL DATA

 

The selected financial data presented below for the five fiscal years ended June 30, 2014 have been derived from our Consolidated Financial Statements as audited by our independent registered public accounting firm.  The historical financial data are qualified in their entirety by, and should be read in conjunction with, the Consolidated Financial Statements and the notes thereto, the other financial information contained in this report and “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Events and Transactions.”

 

 

 

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW 

We are engaged in full-service securities brokerage and full-service commercial banking.  During the twelve-months ended June 30, 2014, 87% of our total revenues were generated by our full-service brokerage business and 13% of our total revenues were generated by our commercial banking business.  While brokerage and banking revenues are dependent upon trading volumes and interest rates, which may fluctuate significantly, a large portion of our expenses are fixed.  Consequently, net operating results can vary significantly from period to period. 

Our business is also subject to substantial governmental regulation and changes in legal, regulatory, accounting, tax and compliance requirements, which may have a substantial impact on our business and results of operations.  We also face substantial competition in each of our lines of business.  See “Forward-Looking Statements,” Item 1. “Business-Competition,” Item 1. “Business-Regulation” and Item 1A. “Risk Factors.”

We operate through four segments grouped primarily by products, services and customer base:  clearing, retail, institutional and banking.

Clearing.    The Clearing segment provides clearing and execution services for other broker/dealers (predominantly on a fully disclosed basis).  Our clientele includes general securities broker/dealers and firms specializing in high-volume trading.  We currently support a wide range of clearing clients, including discount and full-service brokerage firms, registered investment advisors and institutional firms.  In addition to clearing trades, we tailor our services to meet the specific needs of our clients and offer products and services such as recordkeeping, trade reporting, accounting, general back-office support, securities and margin lending, reorganization assistance and custody of securities. 

Revenues in this segment are generated primarily through transaction charges to our correspondents for clearing their trades.  Revenue is also earned from various fees and other processing charges as well as through net interest income on correspondent customer balances.

Retail.    The Retail segment includes the sale of retail securities (such as equities, mutual funds and fixed income products), insurance products and managed accounts through the activities of our employee that are registered representatives and our independent contractors.  As a securities broker, we extend margin credit on a secured basis to our retail customers in order to facilitate securities transactions.  This segment generates revenue primarily through commissions charged on securities transactions, fees from managed accounts and the sale of insurance products as well as net interest income from retail customer balances. 

Institutional.    The Institutional segment serves institutional customers in the areas of securities borrowing and lending, municipal finance, sales, trading and underwriting of taxable and tax-exempt fixed income securities and equity trading.  Our securities borrowing and lending business includes borrowing and lending securities for other broker/dealers, lending institutions, and our own clearing and retail operations.  Our municipal finance business earns investment banking revenues by assisting public entity clients in originating, syndicating and distributing securities of municipalities and political subdivisions.   

Our fixed income sales and trading group specializes in trading and underwriting U.S. government and government agency bonds, corporate bonds, municipal bonds, mortgage-backed, asset-backed and commercial mortgage-backed securities and structured products.  The clients of our fixed income group include corporations, insurance companies, banks, mutual funds, money managers and other institutions.  Our equity trading department focuses on executing equity and option orders on an agency basis for clients.  We also have a portfolio trading group that executes large institutional portfolio trades.

Revenues in the institutional segment are derived from the net interest spread on stock loan transactions, commissions, and trading income from fixed income and equity products and investment banking fees from taxable and municipal securities transactions. 

Banking.  The Banking segment offers traditional banking products and services.  We specialize in three primary areas, business banking, focusing on industrial and small business lending, commercial real estate lending and mortgage purchase.  We originate the majority of our loans internally, and we believe this business model helps us build more valuable relationships with our customers.     

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The Bank earns substantially all of its net revenues on the spread between the interest rates charged to customers on loans and the interest rates paid to depositors as well as interest income from investments. 

The Bank has committed to the OCC that the Bank will, among other things: (i) adhere to the Bank’s written business and capital plan as amended from time to time; and (ii) maintain a Tier 1 capital ratio at least equal to nine percent (9%) of adjusted total assets and a total risk-based capital ratio of at least twelve percent (12%).  As of June 30, 2014, the Bank was in compliance with these commitments.

The "other" category includes SWS Group, corporate administration and SWS Capital Corporation, which is a dormant entity. 

Loan from Hilltop and Oak Hill

 

In March 2011, we entered into a Funding Agreement (the “Funding Agreement”) with Hilltop and Oak Hill.  On July 29, 2011, after receipt of stockholder and regulatory approval, we completed the following transactions contemplated by the Funding Agreement:

 

 

We entered into the Credit Agreement with Hilltop and Oak Hill to ensure that the Bank would maintain adequate capital ratios under an Order to Cease and Desist and could continue to reduce classified assets in a strategic and efficient manner, as well as to ensure that the broker/dealer business lines would operate without disruption.  See also Note 16 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for additional discussion on the Credit Agreement with Hilltop and Oak Hill.

The funds advanced pursuant to the Credit Agreement with Hilltop and Oak Hill were recorded on our Consolidated Statements of Financial Condition as restricted cash.  We are required to keep these funds in a restricted account until our BOD, Hilltop and Oak Hill determine the amount(s) to be distributed to our subsidiaries.  Upon the approval of the BOD, Hilltop and Oak Hill, SWS Group contributed $20.0 million of this cash to the Bank as capital in the second quarter of fiscal 2012, loaned $20.0 million to Southwest Securities in the third quarter of fiscal 2012 to use in general operations by reducing Southwest Securities’ use of short-term borrowings for the financing of the company’s day-to-day cash management needs, paid $20.0 million toward its intercompany payable to Southwest Securities and contributed $10.0 million in capital to Southwest Securities in the fourth quarter of fiscal 2012.  In the third quarter of fiscal 2013, the $20.0 million loan from SWS Group to Southwest Securities was repaid and the BOD, Hilltop and Oak Hill approved, and SWS Group contributed, $20.0 million of cash as a capital contribution to Southwest Securities.  During the third quarter of fiscal 2014, upon approval by the BOD, Hilltop and Oak Hill, the remaining $30.0 million was loaned to Southwest Securities to use in general operations reducing Southwest Securities’ use of short-term borrowings for the financing of its day-to-day cash management needs.  

Merger Agreement

On March 31, 2014, we entered into an Agreement and Plan of Merger (“Merger Agreement”) with Hilltop and Peruna, whereby if the merger contemplated therein is completed, we will become a wholly-owned subsidiary of Hilltop.  If the merger is completed, each share of SWS Group common stock will be converted into the right to receive $1.94 in cash and 0.2496 of a share of Hilltop common stock.  The value of the merger consideration may fluctuate based upon the market value of Hilltop common stock.  We currently anticipate that completion of the merger will occur by the end of 2014, subject to receiving the approval of our stockholders and regulators and other customary closing conditions. 

If the proposed merger with Hilltop occurs, Hilltop’s warrant to acquire our common stock, if outstanding, will be cancelled.

Concurrently with the execution of the Merger Agreement, we entered into a Letter Agreement with Oak Hill dated March 31, 2014 (the “Oak Hill Letter Agreement”).  Pursuant to the Oak Hill Letter Agreement and the Merger Agreement, at the closing of the proposed merger with Hilltop, Oak Hill will deliver to SWS Group the certificates evidencing its warrants and any loans of Oak Hill to SWS Group then outstanding under the Credit Agreement, and we will issue and deliver to Oak Hill, in exchange for its warrants and loans, the following consideration: (i) the merger consideration that Oak Hill would have been

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entitled to receive upon consummation of the merger if its warrants had been exercised immediately prior to the effective time of the merger and (ii) an amount equal to the Applicable Premium (as defined in the Credit Agreement, being a calculation of the present value of all required interest payments due on a loan through its maturity date on the date the loan is repaid) calculated as if the loans held by Oak Hill were prepaid in full as of the closing date of the merger.

Business Environment

Performance in the financial services industry in which we operate is highly correlated to the overall strength of the economy and financial market activity.  Overall market conditions are a product of many factors, which are beyond our control and can be unpredictable.  These factors may affect the financial decisions made by investors, including their level of participation in the financial markets, which may in turn, affect our business results.  With respect to financial market activity, our profitability is sensitive to a variety of factors, including the volatility of the equity and fixed income markets, the level and shape of various yield curves, the volume of trading in securities, the value of our customers’ assets under management, the demand for loans, the value of real estate in our market areas and the current political environment. 

 

As of June 30, 2014, equity market indices were up versus a year ago with the Dow Jones Industrial Average (the “DJIA”) up 12.9%, the Standard & Poor’s 500 Index (“S&P 500”) up 22.0% and the NASDAQ Composite Index (“NASDAQ”) up 29.5%.  The DJIA closed at 16,826.60 on June 30, 2014 up from 14,909.60 and 12,880.09 on June 30, 2013 and June 29, 2012, respectively.  While the indexes showed improvement and reached closing prices that have not been reached since 2008, the average daily trading volume on the NYSE decreased 8% as compared to the same period of our prior fiscal year.  The continued uncertainty in the economic environment, with the federal government shutdown in October 2013, the required implementation by businesses and individuals of the Patient Protection and Affordable Care Act, continued low levels of workforce participation and high unemployment rates, each contributed to volatility during fiscal 2014.  For our clearing, retail and in particular our institutional segment, the uncertainty about the Federal Reserve’s plans for monetary easing added to the volatility in interest rates and fixed income inventory valuations.  For our banking segment, this uncertainty makes it difficult to mitigate interest rate risk in a rising interest rate environment.

 

Continued economic and regulatory uncertainty also created a challenging operating environment for us in fiscal 2014.  The national unemployment rate, which was approximately 6.1% at the end of June 2014, was down from a high of 10.0% at the end of December 2009, and 7.6% at the end of June 2013, but remains at historically high levels.  The FRB reduced the federal funds target rate to 0 - 0.25% on December 16, 2008 and announced in January 2013, and reaffirmed as recently as the June 2014 Federal Open Market Committee meeting, that it anticipated that rates were unlikely to increase as long as the unemployment rate remained above 6.5%, the short-term inflation rate was projected to be no more than 0.5% above the Federal Open Market Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be stable.

 

The disruptions and developments in the world economy and the credit markets over the past three years resulted in a range of actions by the U.S. and foreign governments to attempt to bring liquidity and order to the financial markets and to prevent an extended recession in the world economy. For more details regarding some of the actions taken by U.S. and foreign governments, see the discussion under Item 1. “Business-Regulation.”

 

Government intervention in the markets for the past several years has created artificially low short-term interest rates.  Public announcements by the FRB regarding timing of reduced intervention or increased interest rates has led to substantial volatility in the fixed income markets.  This volatility has produced and could continue to produce material changes in the value of our fixed income trading portfolio. 

 

Texas, along with the rest of the country, experienced distress in residential and commercial real estate values as well as elevated unemployment rates beginning in the last calendar quarter of 2010.  Real estate values, along with unemployment statistics, have improved in fiscal 2014; however, with the improvement, competition in the banking business has increased as loan demand is not yet robust. 

 

Impact of Economic Environment

 

Brokerage:  Volatility in the U.S. credit and mortgage markets, low interest rates and reduced volume in the U.S. stock markets continue to have an adverse effect on several aspects of our brokerage business, including depressed net interest margins, reduced liquidity and lower trading volumes.

 

Exposure to European Sovereign Debt

We have no exposure to European sovereign debt or direct exposure to European banks.  However, we do participate in securities lending with U.S. subsidiaries of several European banks.  Receivables from securities lending are secured by collateral equal to 102% of the market value of the underlying securities, and the collateral is adjusted daily to maintain the 102% margin.

 

Net Interest Margins

Historically, the profitability of our brokerage business has been highly dependent upon net interest income.  We earn net interest income on the spread between the interest rates earned and paid on customer and correspondent balances

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as well as from our securities lending business.  With interest rates at historically low levels, the interest rate spread we are able to earn has been reduced, primarily from the extremely low yields on our portfolio of assets segregated for regulatory purposes.  Additionally, the interest rate spread in our securities lending business has declined.  Lastly, because the yields on money market funds have declined significantly, revenue sharing arrangements with our primary money market fund providers have been substantially reduced.  We do not expect any significant changes in these dynamics until short-term interest rates rise.

 

We have taken actions to mitigate the impact of this margin contraction by renegotiating arrangements with our clearing customers, changing the mix of our assets segregated for regulatory purposes and developing new business in our securities lending portfolio.  Despite these actions, profits from net interest remain substantially below historical levels.

 

Liquidity

Dislocation in the credit markets has led to increased liquidity risk.  All but $45.0 million of our borrowing arrangements are uncommitted lines of credit and, as such, can be reduced or eliminated at any time by the lenders extending the credit.  While we have not experienced any reductions in our uncommitted borrowing capacity, over the past three years, our lenders have taken actions that indicate their concerns regarding liquidity in the marketplace.  These actions included reduced advance rates for certain security types, more stringent requirements for collateral, higher interest rates and pre-funding of daily settlements.  Should our lenders take any actions that could negatively impact the terms of our lending arrangements, the cost of conducting our business would increase and our volume of business would be limited. 

 

The volatility in the U.S. stock markets and the recent policy changes at our various clearing houses, following the financial crisis in 2008, has also impacted our liquidity through increased margin requirements.  These margin requirements are determined by the clearing houses through a combination of risk formulas that are periodically adjusted to reflect perceived risk in the market.  To the extent we are required to post cash or other collateral to meet these requirements, we will have less liquidity to finance our other business.  We expect these margin requirements may increase over the next 9-12 months.

 

Valuation of Securities

We regularly trade mortgage, asset-backed and other types of fixed income securities.  We monitor our trading limits daily to ensure that these securities are maintained at levels we consider prudent given current market conditions.  We price these securities using a third-party pricing service and we review the prices monthly to ensure reasonable valuations.  At June 30, 2014, we held mortgage and asset-backed securities of approximately $28.1 million included in securities owned, at fair value on the Consolidated Statements of Financial Condition.

 

Bank:  Shortly after closing the Hilltop and Oak Hill transaction, we contributed $20.0 million in capital to the Bank.   We believe the $20.0 million capital contribution provided the Bank with a sound foundation and with flexibility to accelerate the reduction of classified assets.

 

The Bank continued to reduce classified assets during fiscal 2014.  Classified assets were $41.3 million at June 30, 2014, down from $67.6 million at June 30, 2013.  Classified assets as a percentage of total capital plus the allowance for loan losses was 22.7% at June 30, 2014 and 37.4% at June 30, 2013.  Non-performing assets (a subset of classified assets) decreased to $22.9 million at June 30, 2014 from $38.0 million at June 30, 2013.  The Bank has significantly reduced classified assets and improved performance over the past seven quarters, but the reduction in classified assets could slow and additional loans could be moved to problem status should the economic environment deteriorate. 

 

The Bank’s loan loss allowance at June 30, 2014 was $7.9 million, or 1.82% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, as compared to $12.3 million, or 2.85% of loans held for investment, excluding purchased mortgage loans held for investment and loans measured at fair value, at June 30, 2013.

 

The Tier 1 (core) capital ratio was 14.1% and the total risk-based capital ratio was 25.5% at June 30, 2014, as compared to 13.5% and 24.9%, respectively, at June 30, 2013 (without giving effect to the Basel III final rules).  With the stability of these capital ratios, the Bank’s management has focused on diversifying the balance sheet by reducing loan concentrations and building an investment portfolio.  In conjunction with building an investment portfolio, the Bank entered into $140.0 million of interest rate swaps, to reduce deposit cost variability by focusing on protecting earnings in a rising interest rate environment.  The Bank held $115.0 million of interest rate swaps at June 30, 2014.  The Bank plans to continue implementing this strategy, along with other balance sheet considerations, to manage interest rate risk.  The Bank’s liquidity has increased due to reduced mortgage purchase program volumes.  Because the volumes have not been replaced with current loan originations, the Bank made two loan purchases in the third quarter of fiscal 2014. The loans purchased were all single family residence mortgages and totaled approximately $40.0 million.

 

The Bank is focused on implementing and executing its business plan, which includes the continued diversification of the balance sheet and conservative growth strategies. The Bank’s available for sale investment portfolio was $494.7 million and $503.1 million at June 30, 2014 and June 30, 2013, respectively.  The Bank plans to continue to manage a tiered investment

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portfolio designed to provide cash flows for loan originations.  At June 30, 2014 and June 30, 2013, the Bank’s mortgage purchase program loan balance was $133.9 million and $174.0 million, respectively.  These loans are held for investment on average for 25 days or less, which substantially limits credit risk. 

 

The primary funding source for the Bank’s balance sheet growth is core deposits from Southwest Securities’ brokerage customers.  These core deposits provide the Bank with a stable and low cost funding source.  At June 30, 2014 and June 30, 2013, the Bank had $873.1 million and $878.4 million, respectively, in funds on deposit from customers of Southwest Securities, representing approximately 87.3% and 88.4%, respectively, of the Bank’s total deposits.

 

 

Events and Transactions

A description of material events and transactions impacting our results of operations in the periods presented are discussed below: 

Merger Agreement.  During fiscal 2014, we incurred expenses of approximately $3.8 million in legal and professional fees recorded in other expenses on the Consolidated Statements of Comprehensive Loss in connection with entry into the Merger Agreement and the proposed merger with Hilltop.  We expect to incur additional costs until the merger is completed.   

 

Employee reduction.  Due to our decline in total revenues for the past three fiscal years, management determined that expense reductions were needed in order to improve operating results and execute our strategic business plan.  As a result, we reduced the number of our employees by approximately 7% during the three-months ended September 30, 2013 and recorded in commissions and other employee compensation on the Consolidated Statements of Comprehensive Loss approximately $1.2 million in severance expense for the three-months ended September 30, 2013.  While we continue to monitor our staffing needs, we do not anticipate any additional headcount reductions at this time.

 

Deferred tax asset valuation allowance.  Deferred tax assets derived from operating losses are realized when we generate consolidated taxable income within the applicable carryback and carryforward periods.  In the fourth quarter of fiscal 2013, based on an evaluation of our historical results of operations and various other factors, management determined that it was appropriate to increase the valuation allowance for its remaining deferred tax assets with the exception of the Bank’s available for sale securities.  See additional discussion regarding our deferred tax asset valuation allowance in Note 17 in the Notes to the Consolidated Financial Statements. In fiscal 2013, management determined that an increase in the valuation allowance was appropriate after reviewing the impact of our fiscal 2013 fourth quarter operating results and our fiscal 2014 financial forecast.  Accordingly, we increased our valuation allowance by $30.0 million from $872,000 at June 29, 2012 to $30.9 million at June 30, 2013. Based on activity in the current fiscal year, we increased our valuation allowance by $4.6 million from $30.9 million at June 30, 2013 to $35.5 million at June 30, 2014.

 

Warrant valuation.    The warrants issued to Hilltop and Oak Hill are presented as liabilities carried at fair value on the Consolidated Statement of Financial Condition.  During fiscal 2014, the value of these warrants increased primarily due to the increase in the market value of our common stock.  The closing price of our common stock increased from $5.45 at June 30, 2013 to $7.28 at June 30, 2014.  The increase in the price of our common stock, combined with other factors, resulted in an unrealized pre-tax loss of $3.6 million. 

 

During fiscal 2013, the value of these warrants decreased primarily due to the decrease in the derived volatility of our common stock from 52% at June 30, 2012 to 51% at June 30, 2013 and the effect of the time to maturity.  The decrease in value resulted in an unrealized pre-tax gain of $3.6 million for fiscal 2013. 

 

Recapture in allowance for loan loss.  The quality of the Bank’s assets continued to improve in fiscal 2014 resulting in a recapture of $5.4 million of the Bank’s provision for loan loss for the year ended June 30, 2014.  For the year ended June 30, 2013, the Bank recorded a $7.7 million recapture of its provision for loan loss.  See the discussion above under “Overview—Business Environment—Impact of Economic Environment—Bank”, “Financial Condition – Loans and Allowance for Probable Loan Losses” and Note 5 in the Notes to the Consolidated Financial Statements for fiscal years June 30, 2014, June 30, 2013, and June 29, 2012 included in Item 8 “Financial Statements and Supplementary Data.”

 

Auction rate security.    Since fiscal 2010, we held an auction rate municipal bond at 95.7% of par.  As a result of a trade in a similar security at a value less than par and related market conditions, we determined that our security should be written down to 92.5% of par in the first quarter of fiscal 2013.  This resulted in a $702,000 write down at September 28, 2012.  During the third quarter of fiscal 2013, we sold this security with no gain or loss recognized on the transaction.

 

Transaction with Hilltop and Oak Hill.  In March 2011, we entered into a Funding Agreement with Hilltop and Oak Hill and on July 29, 2011, after receipt of stockholder and regulatory approval, we completed the transactions contemplated by the Funding Agreement and entered into a $100.0 million, five year, unsecured Credit Agreement with Hilltop and Oak Hill that accrues interest at 8% per annum.  For fiscal 2014, 2013 and 2012, we recorded interest expense of $13.2 million, $12.5 million and $11.0 million, respectively. 

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RESULTS OF OPERATIONS

Consolidated

 

Net losses for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 were $7.1 million, $33.4 million and $4.7 million, respectively.  Fiscal years 2014, 2013 and 2012 contained 252, 249 and 256 trading days, respectively.  We estimate the impact on total revenues of the seven day decrease in trading days from fiscal 2012 to fiscal 2013 was approximately $4.3 million.

 

Southwest Securities was custodian for $32.7 billion, $30.0 billion and $29.2 billion in total customer assets at June 30, 2014, June 30, 2013 and June 29, 2012, respectively.

 

The following is a summary of fiscal year–to–fiscal year increases (decreases) in categories of net revenues and operating expenses (dollars in thousands):

 

 

 

 

 

Fiscal 2014 versus 2013

 

Net revenues decreased $5.3 million for the fiscal year ended June 30, 2014 as compared to the prior fiscal year. Net interest revenue decreased $8.7 million primarily driven by a $6.3 million decrease in net interest revenue in our banking segment due to a 24% decrease in our average loan balance and a 50 basis point decrease in the net interest yield at the Bank as compared to the same period of the prior fiscal year.  Net interest revenue in the institutional segment decreased $2.0 million primarily due to a $1.7 million decrease in net interest earned in our fixed income businesses and a $0.3 million decrease in net interest income in the stock loan business primarily due to an 11 basis point decrease in our average net interest spread, which was partially offset by a 28% increase in our average stock borrowed portfolio balances.  In addition, net interest revenue decreased $0.7 million in the other segment due to a $0.6 million increase in the accretion expense on the discount of the $100.0 million of indebtedness under the Credit Agreement.

 

Commissions revenue decreased $6.1 million.  Institutional commissions were down $4.4 million primarily due to lower portfolio trading transaction volume in fiscal 2014 compared to fiscal 2013.  Our retail segment commissions revenue decreased $1.7 million primarily due to a decrease in the number of independent representatives and customer activity at SWS Financial.

 

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Investment banking, advisory, and administrative fees decreased $5.2 million for the fiscal year ended June 30, 2014 compared to the prior fiscal year.  Institutional segment fees decreased $8.8 million due to a $5.2 million reduction in underwriting fees earned by our taxable fixed income group and a $3.6 million decrease in corporate finance fees as we exited the business in June 2013.  Retail advisory fees increased $3.6 million as assets under management grew 14% from the prior fiscal year offsetting a portion of the decline. 

 

Net gains on principal transactions increased $12.3 million for the fiscal year ended June 30, 2014 compared to the prior fiscal year due primarily due to a $15.2 million increase in the institutional segment.  This increase was mainly attributable to improved market stability in our municipal finance and taxable fixed income businesses after a noted decline in the later half of the prior fiscal year as a result of the challenging market environment.  Particularly, in the fourth quarter of the prior year, municipal and taxable yields increased significantly and the yield on the 10-year treasury note increased by approximately 65 basis points from April 2013 to June 2013.  This dramatic rise in rates resulted in corresponding trading losses in our fourth fiscal quarter of 2013.  Net gains on principal transactions in the other segment decreased $2.9 million as fiscal year 2013 included a $3.6 million realized gain related to the sale of our shares of USHS common stock. 

 

Other revenues increased $2.4 million.  This improvement was due to a $2.0 million increase in third party servicing fees in our clearing and retail segments and a $1.0 million increase in gains related to the valuation adjustment for our deferred compensation plan investments.  In addition, income from the holding company’s limited partnership venture capital fund improved $0.7 million in the other segment, offsetting a $1.1 million decline in retail insurance revenues.  Other revenue in the banking segment decreased $0.7 million due to a $1.6 million decline in gains recognized on the valuation of the Bank’s equity method investments and a $1.6 million reduction in gains on SBA loan sales.  Net REO losses declined $1.6 million and gains on available for sale securities improved $0.7 million offsetting these declines.

 

Operating expenses decreased $5.9 million for the fiscal year ended June 30, 2014 as compared to the prior fiscal year.  Commissions and other employee compensation expense reductions of $10.8 million included a $9.0 million decrease in employee salaries and benefits primarily resulting from the staff reductions in the first three-months of fiscal 2014 and our exit from the corporate finance business in June 2013 and a $2.4 million decrease in incentive compensation, which was partially offset by a $0.7 million increase in deferred compensation expense. 

 

Other expenses decreased $3.9 million primarily due to a $1.5 million decrease in REO expenses, a $1.2 million decrease in the REO loss provision, a $1.1 million decrease in regulatory fees and a $0.4 million decrease in outside services at the Bank as asset quality improved, reducing problem asset costs.  A $3.1 million decline in ongoing legal and professional fees was offset by $3.8 million of legal and professional fees incurred in connection with the proposed merger with Hilltop.

 

Lastly, the Bank recorded a $2.4 million decrease in its loan loss recapture for the fiscal year ended June 30, 2014 when compared to the prior fiscal year.  We recorded a $5.4 million loan loss recapture for fiscal 2014 and a $7.7 million loan loss recapture for fiscal 2013. 

 

Offsetting these operating expense reductions, we recorded $7.2 million of additional expense related to the warrant valuation.  We recognized a $3.6 million loss on the warrant valuation for fiscal 2014 and a $3.6 million gain on the warrant valuation for fiscal 2013.

 

Fiscal 2013 versus 2012

 

Net revenues decreased $21.8 million from fiscal 2012 to fiscal 2013. The largest components of the decrease were a $10.7 million decrease in net gains on principal transactions, a $10.9 million decrease in net interest and a $6.2 million decrease in commissions, offset by a $4.4 million increase in investment banking, advisory and administrative fees and $2.3 million increase in other revenue.  The $10.7 million decrease in net gains on principal transactions was primarily driven by a $14.7 million decrease in our institutional segment, with $12.5 million coming from our municipal distribution business and $2.3 million from our taxable fixed income business as a result of the market environment during the third and fourth quarters of fiscal 2013.  These decreases were offset by the $3.6 million realized gain on the sale of our shares of U.S. Home Systems, Inc. (“USHS”) common stock.  

 

The $10.9 million decrease in net interest revenue was primarily driven by a $5.8 million decrease in net interest revenue in our banking segment due to a 21% decrease in our average loan balance and a 30 basis point decrease in net interest yield at the Bank as compared to the same period of the prior fiscal year.  The institutional segment contributed an additional $3.2 million of the net interest revenue decrease primarily due to a 12 basis point decrease in our average net interest spread in our stock lending business and an 8% decrease in our average stock lending portfolio.  Interest expense under the Credit Agreement contributed $1.5 million of the decrease in net interest revenue as there was one month less of interest expense for fiscal 2012. 

 

The $6.2 million decrease in commissions revenue from fiscal 2012 to fiscal 2013 was due to a $4.7 million decrease in the institutional segment and a $1.5 million decrease in commissions in the retail segment.  Both decreases were due in part to a decrease in the number of trading days from 256 days in fiscal year 2012 to 249 days in fiscal year 2013.  The decrease in commissions in the retail segment was also due to the loss of a team of high performing independent registered representatives. 

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The decrease in commissions in the institutional segment was also due to the narrowing of bid/ask spreads and an increase in market volatility in the last half of the year.  

 

The $4.4 million increase in investment banking and advisory fees was primarily due to a 43% increase in our assets under management and an increase in administrative fee income from revenue sharing with money market fund providers in our clearing and retail segments.   The $2.3 million increase in other revenues was primarily a result of a $1.7 million increase in the sale of insurance products in our retail segment, a $1.3 million increase in the value of our deferred compensation investments and a $2.3 million increase in gains on the sale of loans.  These increases were partially offset by a $1.0 million increase in net losses on the sale of real estate owned (“REO”) and a $0.4 million decrease in the gains from sale of securities. 

 

Operating expenses decreased $21.0 million in fiscal year 2013 as compared to the same period of the prior fiscal year.  The largest components of this decrease were a $10.2 million decrease in our provision for loan loss, a $7.3 million decrease in expense related to the change in the value of the warrants, a $2.1 million decrease in other expenses and a $1.4 million decrease in commissions and other employee compensation expense.  We recognized a loan loss recapture of $7.7 million for fiscal year 2013 compared to a provision of $2.5 million for fiscal year 2012.  We recognized a $3.6 million gain on the warrant valuation in fiscal year 2013 and a $3.7 million loss on the warrant valuation in fiscal year 2012.  The $2.1 million decrease in other expenses in fiscal 2013 was primarily due to a $1.7 million decrease in legal fees from fiscal year 2012.   The $1.4 million decrease in commissions and other employee compensation was primarily due to overall segment revenue declines leading to a decrease in commission expense and incentive compensation of $8.9 million.  These decreases were partially offset by an increase in our liability to participants in the deferred compensation plan of $1.4 million and salary and benefit expenses of $6.1 million.

 

Net Interest Income    

 

We generate net interest income from our brokerage segments and our banking segment.  Net interest income from the brokerage segments is dependent upon the level of customer and stock loan balances as well as the spread between the interest rates we earn on those assets compared to the cost of funds.  Net interest is the primary source of income for the Bank and represents the amount by which interest and fees generated by earning assets exceed the cost of funds.  The Bank’s cost of funds consists primarily of interest paid to the Bank’s depositors on interest-bearing accounts and long-term borrowings with the FHLB.  Net interest income from our brokerage, corporate and banking segments were as follows for the fiscal years 2014, 2013 and 2012 (in thousands):

 

 

 

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Average balances of interest earning assets and interest-bearing liabilities in our brokerage operations were as follows for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 (in thousands):

 

 

 

Net interest revenue generated by each segment is reviewed in detail in the segment analysis below.

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Income Tax Expense (Benefit)    

 

For fiscal 2014, income tax expense (effective rate of -15.8%) differed from the amount that would have otherwise been calculated by applying the federal corporate tax rate (35%) to loss before income tax expense due to the value of COLI, tax exempt interest and an increase in the value of our deferred tax valuation allowance.  See further discussion regarding reconciliation of the effective income tax rate and the federal corporate income tax rate in Note 17 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

For fiscal 2013, income tax expense (effective rate of -400.0%) differed from the amount that would have otherwise been calculated by applying the federal corporate income tax rate (35%) to loss before income tax expense due to non-deductible compensation and a $30.0 million increase in our valuation allowance offset by tax exempt interest, state income taxes and decreases in the value of COLI. 

Periodic reviews of the carrying amount of deferred tax assets are made to determine if the establishment of a valuation allowance is necessary when it is more likely than not that all or a portion of a deferred tax asset will not be realized.  In fiscal 2013, management considered all available evidence, both positive and negative from the following expected sources of income, while assessing the realization of its deferred tax assets:  expected future reversals of deferred tax assets and liabilities, projected future taxable income, cumulative losses in recent years and tax planning strategies. In making such judgments, significant weight was given to evidence that can be objectively verified.  Accounting Standards Codification (“ASC") 740, “Income Taxes” provides that a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable and also restricts the reliance on projections of future taxable income to support the recovery of deferred tax assets.  The company previously had an allowance for deferred tax assets associated with its capital losses from investments.  Based on an evaluation of the positive and negative evidence, management determined that it was appropriate to increase the valuation allowance for its remaining deferred tax assets, except for the Bank’s available for sale securities.  See also Note 17 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

For fiscal 2012, income tax benefit (effective rate of 20.4%) differed from the amount that would have otherwise been calculated by applying the federal corporate income tax rate (35%) to loss before income tax benefit due to state income taxes and other permanently excluded items, such as tax exempt interest and compensation. 

Segment Information

The following is a summary of net revenues and pre-tax income (loss) by segment for fiscal 2014, 2013 and 2012 (dollars in thousands):

 

 

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(1)  The net revenues and pre-tax income reported for the banking segment is for the period ended June 30, 2012.

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Clearing.  The following is a summary of the results for the clearing segment for fiscal 2014, 2013 and 2012 (dollars in thousands):

 

 

 

 

 

Total correspondent clearing customer assets under custody were $16.9 billion, $15.1 billion and $14.7 billion at June 30, 2014, June 30, 2013 and June 29, 2012, respectively.

 

The following table reflects the number of client transactions processed for each of the last three fiscal years and the number of correspondents at the end of each fiscal year:

 

 

Fiscal 2014 versus 2013

 

For the fiscal year ended June 30, 2014, net revenues in the clearing segment increased 7% while clearing fee revenues increased 1%. Other revenues increased 28% compared to fiscal year 2013. 

 

The 1% increase in clearing fee revenue for the fiscal year ended June 30, 2014 when compared to the fiscal year ended June 30, 2013 was primarily due to a 3% increase in the number of general securities tickets processed and an increase in the revenue per ticket.  Revenue per ticket increased approximately 39% from $8.99 for the fiscal year ended June 30, 2013 to $12.47 for the fiscal year ended June 30, 2014.  The change in the mix of tickets processed led to an increase in revenue per ticket as fees charged to high-volume trading firms are discounted substantially from the fees charged to general securities broker/dealers.  Management believes that the increase in clearing volume for general security broker/dealers corresponds with improved conditions in the equity markets.  For the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013, tickets processed for high-volume trading firms decreased 87%.  Approximately one-half of this decline was due to the loss of one correspondent through a broker/dealer withdrawal.

 

The increase in other revenue was primarily driven by a $1.2 million increase in third party servicing fee income.

 

Operating expenses decreased 13% for the year ended June 30, 2014 as compared to the prior fiscal year primarily due to a 44% decrease in compensation expense and a 9% decrease in operations and information technology expenses due primarily to headcount reductions.

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Fiscal 2013 versus 2012

 

For fiscal 2013, net revenues in the clearing segment increased 2% while clearing fee revenues decreased 7% and other revenues increased 31% compared to fiscal year 2012. 

 

The $0.7 million decrease in clearing revenue was primarily due to lower activity levels for existing correspondents and a decrease from 256 trading days in fiscal year 2012 to 249 trading days in fiscal 2013.   The decrease in clearing fee revenues was offset by an increase in other revenues primarily due to a $0.5 million increase in revenue sharing with money market fund providers and increased earnings on customer assets.

 

For fiscal 2013 compared to fiscal 2012, tickets processed for high-volume trading firms decreased 66% while tickets processed for general securities broker/dealers decreased by 10%.  Revenue per ticket increased approximately 60% from $5.61 for fiscal 2012 to $8.99 for fiscal 2013.  The change in the mix of tickets processed led to an increase in revenue per ticket as fees charged to high-volume trading firms are discounted substantially from the fees charged to general securities broker/dealers.

 

Operating expenses for fiscal 2013 decreased $0.9 million, or 5%, from fiscal 2012 primarily due to a decrease in operations and information technology expenses.      

 

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Retail.  The following is a summary of the results for the retail segment for fiscal 2014, 2013 and 2012 (dollars in thousands):

 

 

 

 

 

Fiscal 2014 versus 2013

 

Net revenues in the retail segment increased 2% for the fiscal year ended June 30, 2014 as compared to the prior fiscal year.  Improvement in PCG accounted for most of the additional revenues reflecting underlying improvement in retail client activity and success in retaining key producers.  Advisory fees increased $3.6 million with improvements in all areas due to a 14% increase in assets under management.  Commissions revenue was down $1.7 million primarily due to a 6% decrease in the number of independent representatives and a decrease in customer activity at SWS Financial.  Other revenues remained relatively flat for fiscal year 2014 as compared to the prior fiscal year as a $1.1 million decrease in insurance related income was offset by a $0.9 million increase in third party servicing fee income.

 

Total customer assets were $15.4 billion at June 30, 2014 and $14.3 billion at June 30, 2013.  Assets under management were $1.2 billion at June 30, 2014 versus $1.1 billion at June 30, 2013.

 

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Operating expenses decreased 5% for the fiscal year ended June 30, 2014 as compared to the prior fiscal year.  This decrease was primarily due to a $2.3 million decrease in commissions and other employee compensation expense, $0.8 million decrease in legal expenses, a $0.7 million reduction in operations and information technology expense and a $0.5 million decrease in travel and entertainment expenses.

 

Fiscal 2013 versus 2012

 

Net revenues in the retail segment increased 3% in fiscal 2013 compared to fiscal 2012 despite the seven fewer trading days during the fiscal 2013 period.  Advisory fees were up in all areas of the retail business due to a 43% increase in assets under management as well as increased fees from money market fund revenue sharing.  In addition, insurance products revenue was up 12% from the prior year period.  Commission revenues increased 6% in our PCG group while representative turnover resulted in an overall 15% reduction in commissions revenue at SWS Financial.

 

Total customer assets were $14.3 billion at June 30, 2013 and $13.6 billion at June 29, 2012.  Assets under management were $1.1 billion at June 30, 2013 versus $761.1 million at June 29, 2012.

 

Operating expenses decreased 1% from fiscal 2012 to fiscal 2013.  This decrease was primarily due to a $2.5 million decrease in legal expenses offset by a $1.1 million increase in commissions and other employee compensation primarily at our PCG group.

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Institutional.  The following is a summary of the results for the institutional segment for fiscal 2014, 2013 and 2012 (dollars in thousands): 

 

 

 

Average balances of interest-earning assets and interest-bearing liabilities for the institutional segment as of June 30, 2014, June 30, 2013 and June 29, 2012 were as follows (in thousands):

 

 

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The following table sets forth the number and aggregate dollar amount of new municipal bond underwritings conducted by Southwest Securities for the last three fiscal years:

 

 

 

 

Fiscal 2014 versus 2013

 

Net revenues in the institutional segment were flat while pre-tax income was up 13% for the fiscal year ended June 30, 2014 as compared to the fiscal year ended June 30, 2013.  Commissions revenue decreased $4.4 million primarily driven by a $5.5 million decrease in the portfolio trading business on lower trading volumes and a $2.1 million decrease in the municipal finance business when compared to the same period in the prior fiscal year.  The decrease was offset by a $3.2 million increase in taxable fixed income commissions.  Investment banking, advisory and administrative fees decreased $8.8 million primarily due to a $5.2 million reduction in underwriting fees earned by our taxable fixed income group.  In addition, corporate finance fees were down $3.6 million as we exited the business in the fourth quarter of fiscal 2013.  Net interest revenue decreased $2.0 million primarily due to a $1.7 million decline in net interest earned in our fixed income businesses.  In addition, our stock lending business was down $0.3 million due to an 11 basis point decrease in the average net interest spread, which was partially offset by a 28% increase in our average stock lending balances.  Net gains on principal transactions increased $15.2 million primarily due to a $12.1 million increase in municipal finance trading gains and a $3.1 million increase in our taxable fixed income gains.  The increase in trading gains was primarily the result of market turbulence in the later half of the prior fiscal year, particularly in the fourth quarter in which municipal and taxable yields increased significantly and the yield on the 10-year treasury note increased by approximately 65 basis points from April 2013 to June 2013.  This dramatic rise in rates resulted in corresponding trading losses in our fourth fiscal quarter of 2013.

 

Operating expenses decreased 3% during the fiscal year ended June 30, 2014, primarily due to a $3.3 million decrease in compensation expense due to our exit from the corporate finance line of business in the fourth quarter of fiscal 2013.  These savings were partially offset by a $0.6 million increase in quotation costs and a $0.4 million increase in floor brokerage and clearing organization costs.

 

Fiscal 2013 versus 2012

 

Net revenues from the institutional segment decreased 17% while pre-tax income was down 47% from fiscal 2012 to fiscal 2013.  This decrease was due primarily to a $14.7 million decrease in net gains on principal transactions, a $4.7 million decrease in commission revenues and a $3.2 million decrease in net interest revenue.  The decrease in net gains on principal transactions was primarily due to a $12.5 million decrease in municipal finance trading gains and a $2.3 million decrease in taxable fixed income gains.  The decrease in both the taxable fixed income and municipal finance trading gains was primarily the result of the challenging market environment in the latter half of fiscal 2013, particularly in the fourth quarter in which municipal and taxable yields increased significantly and the yield on the 10-year treasury note increased by approximately 65 basis points from April 2013 to June 2013.  This dramatic rise in rates resulted in corresponding trading losses in our fourth fiscal quarter of 2013.

 

The decrease in commission revenues was primarily driven by a $3.4 million decrease in taxable fixed income and a $1.6 million decrease in municipal finance.  The decreases in taxable fixed income and municipal finance were primarily attributable to the narrowing of bid/ask spreads and an increase in market volatility. 

 

Net interest revenue decreased $3.2 million for fiscal 2013 as compared to fiscal 2012.  This decrease in net interest revenue was primarily due to a 12 basis point decrease in the average net interest spread in our stock loan business and a 6% reduction in average stock borrow balances.  Other net interest decreased $0.6 million for fiscal year 2013 primarily due to an increase in borrowing costs for our municipal and taxable fixed income businesses.

 

Operating expenses decreased 4% for fiscal 2013 as compared to fiscal 2012, primarily due to a $6.6 million decrease in compensation expenses due to weaker segment revenues offset by a $1.1 million increase in quotations and a $0.9 million increase in operations and technology expense.

 

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Banking.  The following is a summary of the results for the banking segment for fiscal 2014, 2013 and 2012 (dollars in thousands):  

 

 

 

 

Fiscal 2014 versus 2013

 

The Bank’s net revenues decreased $7.1 million due primarily to a $6.3 million reduction in net interest revenues and a $0.7 million decrease in other revenues for the fiscal year ended June 30, 2014 as compared to the fiscal year ended June 30, 2013.  The decrease in net interest revenue is primarily due to the 24% decrease in average loan balances, as well as a 50 basis point decrease in the net yield on interest earning assets as excess cash generated from loan repayments was reinvested in an investment portfolio with lower comparable yields.  The decrease in other revenue was due to a $1.6 million decline in the valuation of the Bank’s equity method investments,  a $1.6 million decrease in gains on SBA loan sales, a $0.2 million increase in losses recognized in relation to the Bank’s investment in interest rate swaps and a $0.2 million increase in losses recognized on the sale of fixed assets, which was partially  offset by a $1.6 million decrease in net losses on the sale of REO, a $0.7 million increase in gains from the sale of available for sale securities, and a $0.6 million increase in the fair value of REO foreclosed property where appraised values were greater than the loan’s book value. 

 

The Bank’s operating expenses decreased $5.1 million for the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013.  The expense reduction was primarily attributable to a $2.8 million decrease in commissions and other employee compensation. Other operating expense savings included a $2.7 million decrease in REO related expenses, which included a $1.2 million decrease in the REO loss provision, a $0.8 million decrease in the Bank’s regulatory fees, a $0.6 million decrease in outside services and legal expenses.  Reductions in REO related expenses and regulatory fees were due to continued REO reduction and overall improvement at the Bank. 

 

In addition, the decrease in operating expenses was partially offset by a $2.4 million decrease in the Bank’s loan loss recapture. 

 

Fiscal 2013 versus 2012

 

For fiscal year 2013, the Bank’s net revenues decreased 12% compared to fiscal 2012 due primarily to a $5.8 million reduction in net interest.  This reduction in net interest was primarily due to the 21% decrease in average loan balances, as well as a 30 basis point decrease in the net yield on interest-earning assets.  The reduction in net interest yield was due to the roll off of the held for investment loan portfolio with proceeds being invested in the Bank’s investment portfolio.  This portfolio is weighted to provide liquidity as the Bank begins to record net loan originations.  For the 2013 fiscal year-to-date, the Bank had originations of $5.6 billion and repayments on loans of $5.8 billion.

 

The Bank’s operating expenses decreased $11.3 million, or 26%, for fiscal 2013 compared to fiscal 2012 and was primarily attributable to the $10.2 million decrease in the provision for loan losses as the Bank recorded $2.5 million in provision expense for fiscal 2012 compared to a $7.7 million loan loss recapture for fiscal 2013.  Other operating expenses decreased $1.1 million for fiscal 2013 compared to fiscal 2012.  This decrease was due primarily to a $0.8 million decrease in legal expenses, a $0.7 million decrease in REO related expenses and a $0.5 million decrease in regulatory fees.  These decreases were offset by a $1.4 million increase in commission and other employee compensation and a $0.5 million increase in the REO loss provision.

 

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Net Interest Income

 

The following table sets forth an analysis of the Bank’s net interest income by each major category of interest-earning assets and interest-bearing liabilities for fiscal 2014, 2013 and 2012 (dollars in thousands):

 

 

 

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(*)  Loan fees included in interest income for fiscal 2014, 2013 and 2012 were $1,496, $2,221 and $2,083, respectively.

 

A number of factors, including interest rate trends, changes in the U.S. economy, competition and the scheduled maturities and interest rate sensitivity of the loan portfolios and deposits, affect the interest rate spreads earned by the Bank.

The following table sets forth a summary of the changes in the Bank’s interest income and interest expense resulting from changes in volume and rate (in thousands):

 

 

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Other.    The following discusses the financial results for the other segment comprised of SWS Group, corporate administration and SWS Capital Corporation.

 

Fiscal 2014 versus 2013

 

Pre-tax loss from the other segment was $52.3 million for the fiscal year ended June 30, 2014 compared to a pre-tax loss of $42.3 million for the fiscal year ended June 30, 2013.  The primary driver of the $10.9 million increase in the pre-tax loss was related to the change in warrant valuation resulting in a $7.2 million increase in expense in the fiscal year ended June 30, 2014 compared to fiscal year ended June 30, 2013.  We recorded a $3.6 million unrealized loss on the valuation of the warrants held by Hilltop and Oak Hill for the fiscal year ended June 30, 2014 compared to a $3.6 million unrealized gain on the valuation for the warrants held by Hilltop and Oak Hill for the fiscal year ended June 30, 2013. 

 

Net revenues decreased $1.8 million for the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013.    The decrease was primarily due to a $3.6 million realized gain recognized from the sale of our shares of USHS common stock in fiscal 2013 and a $0.6 million increase in interest expense caused by an increase in the accretion expense on the discount of the $100.0 million of indebtedness under the Credit Agreement, offset by a $1.0 million increase in the valuation adjustment for our deferred compensation plan investments, a $0.7 million loss incurred in fiscal 2013 related to our municipal auction rate bond and a $0.7 million improvement in earnings on SWS Group’s equity method investments.

 

Overall operating expenses increased $1.9 million for the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013 primarily due to $3.8 million in merger related fees and higher deferred compensation expense which increased $0.9 million, offset by a $2.5 million decrease in administrative incentive compensation, salary expense and benefits and a $0.4 million decrease in other legal fees.

 

Fiscal 2013 versus 2012

 

Pre-tax loss from the other segment was $42.3 million for fiscal year 2013 compared to a pre-tax loss of $49.3 million for fiscal year 2012.  The primary driver of the $7.0 million decrease in the pre-tax loss was related to the recognition of a $3.6 million unrealized gain on the valuation of the warrants held by Hilltop and Oak Hill for the fiscal year 2013 compared to a $3.7 million unrealized loss on the valuation for the warrants held by Hilltop and Oak Hill for the fiscal year 2012.

 

Net revenues increased $2.3 million for fiscal 2013 compared to fiscal 2012.  The increase in net revenues was primarily due to the $3.6 million gain recognized from our sale of USHS shares in addition to a $1.3 million increase in the value of our deferred compensation plan’s investments.  These increases were partially offset by a $0.7 million write down in fair value of an auction rate municipal bond and a $1.5 million increase in interest expense related to the outstanding borrowings under the Credit Agreement with Hilltop and Oak Hill in fiscal 2013 compared to fiscal 2012 which included one less month of interest expense.

 

Operating expenses increased $2.7 million for the fiscal year 2013 as compared to the fiscal year 2012 primarily due to a $1.4 million increase in the value of our deferred compensation plan’s funds and a $1.2 million increase in legal expenses. 

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FINANCIAL CONDITION

Investments

In fiscal 2014, the Bank implemented an investment strategy to diversify its balance sheet, absorb excess liquidity, and maximize interest income through investment in a conservative securities portfolio.  The securities portfolio is structured to provide cash flows to ensure that adequate funds are available for new loan originations. 

 

The book value of the Bank’s investment portfolio at June 30, 2014, 2013 and 2012 was as follows (in thousands):

 

 

 

Loans and Allowance for Probable Loan Losses

The Bank grants loans to customers primarily within Texas and New Mexico.  In the ordinary course of business, the Bank also purchases mortgage loans that have been originated in various areas of the United States.  Although the Bank has a diversified loan portfolio, a substantial portion of its portfolio is dependent upon the general economic conditions in Texas and New Mexico.  Substantially all of the Bank’s loans are collateralized with real estate.

The allowance for loan losses is maintained to absorb management’s estimate of probable loan losses inherent in the loan portfolio at each reporting date.  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management determines the collection of principal is remote.  Subsequent recoveries are recorded through the allowance.  The determination of an adequate allowance is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available or circumstances change. 

The allowance for loan losses consists of a specific and a general allowance component. 

The specific component provides for estimated probable losses for loans identified as impaired.  A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts of principal and interest when due according to the contractual terms of the loan agreement.  Management considers the borrower’s financial condition, payment status, historical payment record and any adverse situations affecting the borrower’s ability to repay when evaluating whether a loan is deemed impaired.  Loans that experience insignificant payment delays and shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis taking into consideration all circumstances surrounding the loan and the borrower, including the length of delay, the reasons for the delay, the borrower’s prior payment record and the amount of shortfall in relation to the principal and interest outstanding. 

A specific reserve is recorded when and to the extent (i) the present value of expected future cash flows discounted at the loan’s original effective rate, (ii) the fair value of collateral if the loan is collateral-dependent or (iii) the observable market price of the impaired loan is lower than its recorded investment.  If the fair value of collateral is used to measure impairment of a collateral-dependent loan and repayment is dependent on the sale of the collateral, the fair value is adjusted to incorporate estimated costs to sell.  Impaired loans that are collateral-dependent are primarily measured for impairment using the fair value of the collateral as determined by third party appraisals using the income approach, recent comparable sales data or a combination thereof.  In certain instances it is necessary for management to adjust the appraised value, less estimated costs to sell, to reflect changes in fair value occurring subsequent to the appraisal date.  Management considers a guarantor’s capacity and willingness to perform, when appropriate, and the borrower’s resources available for repayment when measuring impairment. 

The general allowance provides for estimated and probable losses inherent in the remainder of the Bank’s loan portfolio.  The general allowance is determined through a statistical calculation based on the Bank's historical loss experience adjusted for

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certain qualitative factors as deemed appropriate by management.  The statistical calculation is conducted on a disaggregated basis for groups of homogeneous loans with similar risk characteristics (product types).  The historical loss element is calculated as the average ratio of charge-offs, net of recoveries, to the average recorded investment for the current and previous seven quarters.  See Note 5 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for additional information concerning the historical loss element of the general component of the allowance for loan losses.  Management adjusts the historical loss rates to reflect deterioration in the real estate market, current market environment for commercial loans, credit quality to reflect increased credit risk not captured in the historical loss, significant concentrations of product types and trends in portfolio volume to capture additional risk of loss associated with the total loan portfolio.   Prevailing economic conditions and specific industry trends are taken into consideration when establishing the adjustments to historical loss rates.

Certain types of loans, such as option adjustable rate mortgage (“ARM”) products, junior lien mortgages, high loan-to-value ratio mortgages, single family interest only loans, sub-prime loans, and loans with initial "teaser" rates, can have a greater risk of non-collection than other loans.  At June 30, 2014, the Bank had $7.1 million in junior lien mortgages. These loans represented less than 2% of the Bank’s total loans at June 30, 2014.  At June 30, 2014, the Bank did not have any exposure to sub-prime loans or loans with initial teaser rates and had no single family interest only loans.

At June 30, 2014, the Bank’s loan portfolio included a total of $1.0 million in loans with high loan-to-value ratios.  High loan-to-value ratios are defined by regulation and range from 75%-90% depending on the type of loan.  At June 30, 2014, all of these loans were 1-4 single family or lot loans to home builders in North Texas.  We addressed the additional risk in these loans in our allowance calculation primarily through our review of the real estate market deterioration adjustment to the historical loss ratio. Additionally, at June 30, 2014, the Bank had no loans with a high loan-to-value ratio that were deemed impaired.  Regulatory guidelines suggest that high loan-to-value ratio loans should not exceed 100% of total capital.  At June 30, 2014, the Bank’s high loan-to-value ratio loans represented less than 1% of total capital.

We obtain appraisals on real estate loans at the time of origination from third party appraisers approved by the Bank’s BOD. We may also obtain additional appraisals when the borrower’s performance indicates it may default.  After a loan default and foreclosure, we obtain new appraisals to determine the fair value of the foreclosed asset. We obtain updated appraisals on foreclosed properties on an annual basis, or more frequently if required by market conditions, until we sell the property. 

Management reviews the loan loss computation methodology on a quarterly basis to determine if the factors used in the calculation are appropriate. In the past four years, because our problem loans and losses were concentrated in real estate related loans, we paid particular attention to real estate market deterioration and the concentration of capital in our real estate related loans. Improvement or additional deterioration in the residential and commercial real estate market may have an impact on these factors in future quarters. To the extent we underestimate the impact of these risks, our allowance for loan losses could be materially understated.

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Loans receivable, including loans measured at fair value, at June 30, 2014, 2013, 2012, 2011 and 2010 are summarized as follows (in thousands):

 

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 (*)  There is no allowance for probable loan loss for loans measured at fair value. There is a $136 allowance for loan loss for the fiscal year ended June 30, 2014 and no allowance for probable loan loss for fiscal years ended June 30, 2013, 2012, 2011 and 2010 for purchased mortgage loans held for investment.  Purchase mortgage loans held for investment are held on average for 25 days or less, substantially reducing credit risk.

 

The decrease in purchased mortgage loans held for investment from June 30, 2013 to June 30, 2014 was representative of an overall decline in the mortgage industry’s production levels.  The nature of purchased mortgage loans held for investment business is volatile and subject to significant variation depending on interest rates, competition and general economic conditions.

The following table shows the scheduled maturities of certain loan categories at June 30, 2014, and segregates those loans with fixed interest rates from those with floating or adjustable rates (in thousands):

 

 

 

 

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We maintain an internally classified loan list that helps us assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses.  Loans on this list are classified as substandard, doubtful or loss based on probability of repayment, collateral valuation and related collectability.  This list is used to identify loans that are considered non-performing.

We classify loans as non-performing when they are 90 days or more past due as to principal or interest or when reasonable doubt exists as to timely collectability.  The Bank uses a standardized review process to determine which non-performing loans should be placed on non-accrual status.  At the time a loan is placed on non-accrual status, we reverse previously accrued and uncollected interest against interest income.  We recognize interest income on non-accrual loans to the extent we receive cash payments for the loans with respect to which ultimate full collection is likely.  For loans where full collection is not likely, we apply interest payments to the outstanding principal and we recognize income only if full payment is made.   

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Non-performing assets and classified loans as of June 30, 2014, 2013, 2012, 2011 and 2010 were as follows (dollars in thousands):

 

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 (*)  The remaining balance of loans modified as a troubled debt restructuring is included in non-performing loans.  See discussion of the Bank’s troubled debt restructuring loans in Note 5  in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

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Approximately $0.7 million, $1.0 million and $1.1 million of gross interest income would have been recorded in fiscal 2014, 2013 and 2012, respectively, had the non-accrual loans been recorded in accordance with their original terms.  Interest income recorded on the non-accrual loans, prior to being placed on non-accrual status, in fiscal 2014, 2013 and 2012 totaled approximately $0.1 million, $0.3 million and $1.2 million, respectively. 

Total classified assets to Bank capital plus allowance for loan loss was 22.7% at June 30, 2014.  Classified assets decreased $26.2 million from June 30, 2013 to June 30, 2014 and substantially all classified loans by collateral location are in Texas.  Bank management continues to reduce the classified asset ratio through the disposal of these assets.  Depending on the method used, the Bank may be required to record additional write-downs of these assets.  While management is diligently working to dispose of these assets quickly, lack of demand for certain property types, length of sales cycle and manpower limitations will impact the time required to ultimately reduce the classified assets to a more acceptable level.

The following table presents an analysis of REO for the fiscal years ended June 30, 2014, 2013, 2012, 2011 and 2010 (in thousands):

 

 

 

The following table presents the Bank’s classified assets as of June 30, 2014 by year of origination of the loan (in thousands):

 

 

 

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The following table presents an analysis of the allowance for probable loan losses for the fiscal years ended June 30, 2014, 2013, 2012, 2011 and 2010 (dollars in thousands):

 

 

The Bank frequently reviews and updates its processes and procedures for the extension of credit, allowance for loan loss computation and internal asset review and classification.  Recent changes include more stringent underwriting guidelines for loan-to-value ratios, guarantor’s financial condition, owner-occupied versus investor loans and speculative versus custom construction.  The Bank currently requires more extensive documentation and data than it did in prior years in order to reclassify existing non-performing loans as performing loans.  The Bank is also updating appraisals more frequently, including for performing loans, which serve as an early indicator of loan deterioration. 

 

As a result of the current economic environment, the Bank significantly limited the growth of its loan portfolio in fiscal 2011 and 2012 in order to allocate the time, resources and capital necessary to support the existing loan portfolio.  During fiscal 2013, the Bank reestablished marketing efforts to implement a conservative loan growth plan which we believe will enhance our core earnings in future years.  Throughout fiscal 2014, the Bank has continued these marketing efforts in order to grow the Bank’s loan portfolio.

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The allowance for probable loan losses by type of loans as of June 30, 2014, 2013, 2012, 2011 and 2010 was as follows (dollars in thousands):

 

 

 

 

 

 

 

 

 

At June 30, 2014, approximately 32.8% of the Bank’s loan loss allowance was allocated to its commercial real estate loan portfolio while the Bank’s commercial real estate loan portfolio represented approximately 31.1% of its total loan portfolio.  This is up from June 30, 2013 when 26.7% of the Bank’s loan loss allowance was allocated to its commercial real estate loan portfolio.  Commercial real estate loans tend to be individually larger than residential loans and deterioration in this portfolio can lead to volatility in our earnings.  At June 30, 2014, the loan loss allowance related to multifamily loans was 33.1% as compared to multifamily loans constituting 22.7% of the Bank’s total loan portfolio.  The larger allocation of the allowance to multifamily loans reflects the recent growth in this portfolio. 

 

Additionally, at June 30, 2014, 15.4% of the Bank’s loan loss allowance was allocated to its commercial loans portfolio, while the Bank’s commercial loan portfolio represented approximately 9.9% of its total loan portfolio.  This decrease in percentage of the allowance for loan loss from June 30, 2013 was due primarily to the $2.1 million payment received on an outstanding loan for which the Bank had a specific impairment reserve recorded.

 

The Bank’s written loan policies address specific underwriting standards for commercial real estate loans.  These policies include loan to value requirements, cash flow requirements, acceptable amortization periods and appraisal guidelines.  In addition, specific covenants, unique to each relationship, may be used where deemed appropriate to further protect the lending relationship.  Collateral in the commercial real estate portfolio varies from owner-occupied properties to investor properties.  We periodically review the portfolio for concentrations by industry as well as geography.  All commercial relationships are stress tested at the time of origination and major relationships are also stress tested on an annual basis.

 

Deposits

 

Average deposits and the average interest rate paid on the deposits for fiscal 2014, 2013 and 2012 can be found in the discussion of the Bank’s net interest income under the caption "-Results of Operations-Segment Information-Banking." 

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The Bank had $11.5 million and $12.5 million in certificates of deposit of $100,000 or greater at June 30, 2014 and 2013, respectively.  The Bank is funded primarily by deposits from SWS’s brokerage customers, which are classified as core deposits.  These core deposits provide the Bank with a stable and low cost funding source.  The Bank also utilizes long-term FHLB borrowings to match long-term fixed rate loan funding.  At June 30, 2014, the Bank had $873.1 million in funds on deposit from customers of Southwest Securities, representing approximately 87% of the Bank’s total deposits.

Short-Term Borrowings and Advances from Federal Home Loan Bank

The following table represents short-term borrowings and advances from the FHLB that were due within one year during the fiscal years ended June 30, 2014, 2013 and 2012 (dollars in thousands):

 

 

 

LIQUIDITY AND CAPITAL RESOURCES

Management believes that our current assets and available liquidity are adequate to meet our liquidity needs over the next 12 months.  However, our forecast may not prove to be accurate or we may need to raise additional capital.  As a result, from time to time, management evaluates various opportunities to supplement the company’s sources of liquidity and capital.  In fiscal 2012, this evaluation led to us entering into the Credit Agreement with Hilltop and Oak Hill, as discussed below.  Should we determine we need to obtain additional debt at SWS Group, we would require regulatory approval and approval from Hilltop and Oak Hill.    

Credit Agreement

On July 29, 2011, we entered into a Credit Agreement with Hilltop and Oak Hill pursuant to which we obtained a $100.0 million, five year, unsecured loan that accrues interest at a rate of 8% per annum.  In addition, we issued warrants to Hilltop and Oak Hill allowing each to purchase up to 8,695,652 shares of common stock at an exercise price of $5.75 per share (subject to anti-dilution adjustments), representing approximately 17% of our common stock per investor as of July 29, 2011 (assuming the warrants are exercised in full).  The Credit Agreement contains restrictions and covenants that we must adhere to as long as the unsecured loan is outstanding.  As of June 30, 2014, SWS Group had utilized all of the $100.0 million under the unsecured loan by (i) contributing $20.0 million in capital to the Bank to promote growth in the Bank’s loan portfolio, (ii) reducing SWS Group’s intercompany payable to Southwest Securities by $20.0 million, (iii) contributing $30.0 million in capital to Southwest Securities and (iv) loaning $30.0 million to Southwest Securities to use in general operations by reducing Southwest Securities’ use of short-term borrowings for the financing of its day-to-day cash management needs.  See Note 16 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for additional information concerning this Credit Agreement.

Brokerage

A substantial portion of our assets are highly liquid in nature and consist mainly of cash or assets that are readily convertible into cash.  Our equity capital, short-term bank borrowings, interest bearing and non-interest bearing client credit balances, correspondent deposits and other payables finance these assets.  We maintain an allowance for doubtful accounts that represents amounts that are necessary in the judgment of management to adequately absorb losses from known and inherent risks in receivables from clients, clients of correspondents and correspondents. The highly liquid nature of our assets provides us with flexibility in financing and managing our anticipated operating needs.  Management believes that the present liquidity position of the brokerage businesses is adequate to meet its needs over the next 12 months.

Short-Term Borrowings. At June 30, 2014, we had short-term borrowing availability under broker loan lines, a $20.0 million unsecured line of credit and a $45.0 million revolving committed credit facility, each of which is described below.

Broker Loan Lines.  At June 30, 2014, we had uncommitted broker loan lines of up to $400.0 million.  These lines of credit are used primarily to finance securities owned, securities held for correspondent broker/dealer accounts and receivables in customers’ margin accounts.  These lines may also be used to release pledged collateral against day loans.  These credit arrangements are provided on an "as offered" basis, are not committed lines of credit and can be terminated at any time by the

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lender.  Any outstanding balances under these credit arrangements are due on demand and bear interest at rates indexed to the federal funds rate.  At June 30, 2014, $59.0 million was outstanding under these secured arrangements, which was collateralized by securities held for firm accounts valued at $99.2 million.  Our ability to borrow additional funds is limited by our eligible collateral.  See additional discussion under Item 1A. “Risk Factors."

Unsecured Line of Credit.  We also have a $20.0 million unsecured line of credit that is due on demand and bears interest at rates indexed to the federal funds rate. This credit arrangement is provided on an "as offered" basis and is not a committed line of credit.  The total amount of borrowings available under this line of credit is reduced by the amount outstanding under any unsecured letters of credit at the time of borrowing.  At June 30, 2014, we had no outstanding unsecured letters of credit, there were no amounts outstanding on this line, and we had $20.0 million available for borrowing under this line of credit.

Revolving Committed Credit Facility.    On January 28, 2011, Southwest Securities entered into a $45.0 million committed revolving credit facility with an unaffiliated bank.  The commitment fee for the credit facility is 0.375% per annum and, when drawn, the interest rate is equal to the federal funds rate plus 125 basis points.  The credit facility requires Southwest Securities to maintain tangible net worth of $150.0 million.  As of June 30, 2014, there was no outstanding balance under this credit facility.

 

Net Capital Requirements.    Our broker/dealer subsidiaries are subject to the requirements of the SEC relating to liquidity, capital standards and the use of client funds and securities.  The amount of the broker/dealer subsidiaries’ net assets that may be distributed to the parent of the broker/dealer is subject to restrictions under applicable net capital rules.  Historically, we have operated in excess of the minimum net capital requirements.  See Note 18 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for additional information concerning these requirements.

 

Secured Borrowings.  We participate in transactions involving securities sold under repurchase agreements (“repos”), which are secured borrowings that we record in our statement of financial condition as other liabilities.  These securities generally mature within one to four days from the transaction date.  Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transactions.  We may be required to provide additional collateral based on the fair value of the underlying securities.

Banking

Liquidity is monitored daily to ensure the Bank’s ability to meet deposit withdrawals, maintain reserve requirements and otherwise sustain operations.  The Bank’s liquidity is maintained in the form of readily marketable loans and investment securities, balances with the FHLB, Federal Reserve Bank of Dallas, federal funds sold to correspondent banks and vault cash.  At June 30, 2014, the Bank had net borrowing capacity from the FHLB of $142.8 million.  In addition, at June 30, 2014, the Bank had the ability to borrow up to $42.9 million in funds from the Federal Reserve Bank of Dallas under its secondary credit program.   

In the second quarter of fiscal 2010, the Bank entered into a secured line of credit agreement with the Federal Reserve Bank of Dallas.  This line of credit is secured by the Bank's commercial loan portfolio.  This line is due on demand and bears interest at a rate of 50 basis points over the federal funds target rate.  At June 30, 2014, there were no amounts outstanding under this line of credit.

The Bank’s asset and liability management policy is intended to manage interest rate risk.  The Bank manages the periodic repricing of its interest-earning assets and its interest-bearing liabilities.  Overall interest rate risk is monitored through reports showing both sensitivity ratios, a simulation model, and existing "GAP" data.  (See the Bank’s GAP analysis in "-Risk Management-Market Risk-Interest Rate Risk-Banking.")  At June 30, 2014, $873.1 million of the Bank’s deposits were from the brokerage customers of Southwest Securities. 

Capital Requirements. The Bank is subject to various regulatory capital requirements administered by federal agencies.  Quantitative measures, established by regulation to ensure capital adequacy, require maintaining minimum amounts and ratios of total and Tier 1 capital (as defined in 12 CFR 165 and 12 CFR 167) to risk-weighted assets (as defined) and of Tier 1 (core) capital (as defined) to adjusted assets (as defined) (without giving effect to the Basel III final rule).  At June 30, 2014, the Bank had a total risk-based capital ratio of 25.5% and the Bank had a Tier 1 (core) capital ratio of 14.1%.  At June 30, 2014, the Bank had a Tier 1 risk-based capital ratio of 24.4%.  Under federal law, the OCC may require the Bank to apply other measures of risk-weight or capital ratios that the OCC deems appropriate.  In connection with the termination of the Order to Cease and Desist, Order No. WN-11-0003, effective on February 4, 2011, on January 14, 2013, the Bank committed to the OCC that the Bank would, among other things, maintain a Tier 1 capital ratio at least equal to 9% of adjusted total assets and a total risk-based capital ratio of at least 12%.

The Bank has historically met all of its capital adequacy requirements.  As of June 30, 2014, the Bank met all capital requirements to which it was subject and satisfied the requirements to be defined as well-capitalized.

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Off-Balance Sheet Arrangements

We generally do not enter into off-balance sheet arrangements, as defined by the SEC.  However, our broker/dealer subsidiaries enter into transactions in the normal course of business that expose us to off-balance sheet risk.  See Note 27 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

Contractual Obligations and Contingent Payments

 

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 (1) Long-term debt is comprised of advances from the FHLB with maturities greater than one year and outstanding borrowings under the Credit Agreement with Hilltop and Oak Hill.

(2) Amount of interest payable includes the interest on advances from the FHLB based on rates ranging from less than 1% to 6% and outstanding borrowings under the Credit Agreement with Hilltop and Oak Hill based on an effective interest rate of 15%. 

(3) Of the $40,483 in lease commitments, no amounts are reserved for impairment.

(4) We have commitments to our employees for deferred compensation in the amount of $6,115 that become payable in future fiscal years as defined by the plan and determined by participants who have formally requested payment of their plan balances.  See Note 19 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

(5)Due date cannot be estimated.  See Note 1(s), Note 17 and Note 24 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

 

Cash Flow

 

Net cash provided by operating activities totaled $48.2 million in fiscal 2014 and net cash used in operating activities totaled $64.5 million and $1.5 million in fiscal 2013 and 2012, respectively.  The net cash provided by operating activities for the fiscal year ended June 30, 2014 was due to the $86.5 million decrease in net receivable from broker, dealer and clearing organizations and a $50.7 million decrease in client accounts offset by a $20.6 million increase in securities purchased under agreements to resell, a net $39.4 million increase in our securities inventory and a $25.5 million increase in our customer reserve requirement.  The net cash used in operating activities for fiscal 2013 was due to the $89.2 million increase in net receivable from broker, dealer and clearing organization accounts, a $42.5 million increase in net receivable from client accounts and a $26.8 million increase in securities purchased under agreements to resell.  These increases were offset by an $86.1 million decrease in our net trading inventory and an $11.6 million decrease in assets segregated for regulatory purposes.    

Net cash used in investing activities was $5.4 million and $219.8 million in fiscal 2014 and 2012, respectively, and cash provided by investing activities was $59.6 million in fiscal 2013.  For fiscal 2014, cash used in investing activities was due to purchases of securities of $177.1 million and offset by cash used for loan originations net of proceeds from cash received at the Bank from loan pay-downs of $10.6 million and proceeds from the Bank’s investments and loans held for investment of $175.1 million. The primary reason for the increase in cash provided by investing activities in fiscal 2013 as compared to fiscal 2012 was proceeds from cash received at the Bank from loan pay-downs net of originations of $203.5 million, along with $51.1 million in proceeds from the sale of REO, loans, and other assets at the Bank, were used to increase the Bank’s net investment portfolio by $190.2 million. 

Net cash used in financing activities totaled $54.2 million for fiscal 2014 and net cash provided by financing activities totaled $34.1 million and $4.3 million for fiscal 2013 and 2012, respectively.  For fiscal 2014, the primary driver of the cash used

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in financing activities was a decrease in net cash proceeds from short-term borrowings and advances form the FHLB offset by an increase in deposits at the Bank. The primary driver of the cash provided by financing activities in fiscal 2013 was an increase in cash proceeds from short-term borrowings and the FHLB, offset by a decrease in deposits at the Bank. 

We expect that cash flows provided by operating activities and short-term borrowings will be the primary source of working capital for the next 12 months.

Treasury Stock

We periodically repurchase our shares of common stock.  We currently have no approved plan, and any such plan would require, in addition to BOD approval, the approval of Hilltop, Oak Hill and regulatory authorities.

The trustee under our deferred compensation plan periodically purchases shares of our common stock in the open market in accordance with the terms of the plan.  This stock is classified as treasury stock in our consolidated financial statements, but participates in future dividends declared by us.  During fiscal year 2014, the plan purchased 50,000 shares of common stock at a cost of approximately $288,000, or $5.76 per share, and approximately 40,719 shares were sold or distributed to participants pursuant to the plan.  See Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”

As restricted stock grants vest, grantees may sell a portion of their vested shares to us to cover the tax liabilities arising from vesting.  As a result, in fiscal 2014, we repurchased approximately 1,100 shares of common stock with a market value of approximately $6,100, or an average of $5.55 per share, to cover tax liabilities. 

Inflation

Our financial statements included herein have been prepared in accordance with GAAP.  GAAP requires us to measure our financial position and operating results primarily in terms of historic dollars.  Changes in the relative value of money due to inflation or recession are generally not considered under GAAP.  Our assets are primarily monetary, consisting of cash, securities inventory and receivables from customers and broker/dealers.  These monetary assets are generally liquid and turn over rapidly and, consequently, are not significantly affected by inflation.  The rate of inflation affects various expenses of the company, such as employee compensation and benefits, communications, and occupancy and equipment, which may not be readily recoverable in the price of our services.  The rate of inflation can also have a significant impact on securities prices and on investment preferences by our customers, generally.  In management’s opinion, changes in interest rates affect the financial condition of a financial services firm to a greater degree than changes in the inflation rate.  While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate.  Interest rates are highly sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities among other things.  See Item 1A, “Risk Factors - Risks Specific to Our Industries.”

RISK MANAGEMENT

In an effort to assist the company in managing enterprise risk, and at the BOD’s request, the company engaged a firm to perform an analysis of the company’s enterprise risk management process in 2010.  During fiscal 2011, based on the BOD’s recommendations, we initiated an enterprise risk management program and formed an enterprise risk management committee.  Enterprise risk is viewed as the threat from an event, action or loss of opportunity that, if it occurs or has occurred, may adversely affect any, or any combination of, our company objectives, business strategies, business model, regulatory compliance, reputation and existence.  The committee works with our various departments and committees to manage our enterprise risk management program and reports the results of this work to the Audit Committee of the BOD on a quarterly basis.  During fiscal 2013, we hired a full time risk manager for the consolidated group who serves as the primary liaison with our risk management consultants.  We continue to utilize the consultants to improve risk management processes, procedures and reporting.

We manage risk exposure through the involvement of various levels of management.  We establish, maintain and regularly monitor maximum positions by industry and issuer in both trading and inventory accounts.  Current and proposed underwriting, banking and other commitments are subject to due diligence reviews by senior management, as well as professionals in the appropriate business and support units.  The Bank seeks to reduce the risk of significant adverse effects of market rate fluctuations by minimizing the difference between rate-sensitive assets and liabilities, referred to as "GAP," and maintaining an interest rate sensitivity position within a particular timeframe.  Credit risk related to various financing activities is reduced by the industry practice of obtaining and maintaining collateral.  We monitor our exposure to counterparty risk through the use of credit information, the monitoring of collateral values and the establishment of credit limits.  We have established various risk management committees that are responsible for reviewing and managing risk related to interest rates, trading positions, margin and other credit risk and risks from capital market transactions.

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Credit Risk

A description of the credit risk for our brokerage and banking segments is as follows:

Brokerage.  Credit risk arises from the potential nonperformance by counterparties, customers or debt security issuers.  We are exposed to credit risk as a trading counterparty and as a stock loan counterparty to dealers and customers, as a holder of securities and as a member of clearing organizations.  We have established credit risk committees to review our credit exposure in our various business units.  These committees are composed of senior management of the company.  Credit exposure is also associated with customer margin accounts, which are monitored daily.  We monitor exposure to individual securities and perform sensitivity analysis on a regular basis in connection with our margin lending activities.  We adjust our margin requirements if we believe our risk exposure is not appropriate based on market conditions. 

Banking.  Credit risk is the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms and is inherent in all types of lending.  The Bank has developed and continues to update its policies and procedures to provide a process for managing credit risk.  These policies and procedures include underwriting guidelines, credit and collateral tracking and detailed loan approval procedures. The Bank also maintains a detailed loan review process to monitor the quality of its loan portfolio. The Bank makes loans to customers primarily within Texas and New Mexico.  The Bank also purchases mortgage loans, which have been originated in other areas of the United States.  Although the Bank has a diversified loan portfolio, a substantial portion of its portfolio is dependent upon the general economic conditions in Texas and New Mexico. Policies and procedures, which are in place to manage credit risk, are designed to be responsive to changes in these economic conditions.

Operational Risk

 

Operational risk refers generally to risk of loss resulting from our operations, including but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in our operating systems, and inadequacies or breaches in our control processes.  We operate in diverse markets and rely on the ability of our employees and systems to process large numbers of transactions.  In order to mitigate and control operational risk, we have developed and continue to enhance specific policies and procedures that are designed to identify and manage operational risk at appropriate levels.  We also use periodic self-assessments and internal audit examinations as further review of the effectiveness of our controls and procedures in mitigating our operational risk. 

Legal Risk 

Legal risk includes the risk of non-compliance with applicable legal and regulatory requirements.  We are subject to extensive regulation in the different jurisdictions in which we conduct business.  We have established procedures based on legal and regulatory requirements that are designed to reasonably ensure compliance with applicable statutory and regulatory requirements.  We also have established procedures that are designed to ensure that executive management’s policies relating to conduct, ethics and business practices are followed.  In connection with our business, we have various procedures addressing significant issues such as regulatory capital requirements, sales and trading practices, new products, use and safekeeping of customer funds and securities, granting credit, collection activities, money laundering, privacy and record keeping.

Market Risk 

Market risk generally represents the risk of loss that may result from the potential change in value of a financial instrument as a result of fluctuations in interest rates, market prices, investor expectations and changes in credit ratings of the issuer.  Our exposure to market risk is directly related to our role as a financial intermediary in customer-related transactions and to our proprietary trading activities and securities lending activities.

Interest Rate Risk. A description of the interest rate risk for our brokerage and banking segments is as follows:

Brokerage.  Interest rate risk is a consequence of maintaining inventory positions and trading in interest rate sensitive financial instruments and maintaining a matched stock loan book.  Our fixed income activities also expose us to the risk of loss related to changes in credit spreads.  Credit spread risk arises from the potential that changes in an issuer’s credit rating or credit perception could affect the value of financial instruments.

Banking.  Our primary emphasis in interest rate risk management for the Bank is the matching of assets and liabilities of similar cash flow and re-pricing time frames.  This matching of assets and liabilities reduces exposure to interest rate movements and aids in stabilizing positive interest spreads.  We strive to structure our balance sheet as a natural hedge by matching floating rate assets with variable short-term funding and by matching fixed rate liabilities with similar longer term fixed rate assets.  The Bank has established percentage change limits in both interest margin and net portfolio value.  To verify that the Bank is within the limits established for interest margin, the Bank prepares an analysis of net interest margin based on various shifts in interest rates.  To verify that the Bank is within the limits established for net portfolio value, the Bank analyzes

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data prepared using internal modeling data for net portfolio value.  These analyses are conducted on a quarterly basis for the Bank’s BOD. 

The following table illustrates the estimated change in net interest margin based on shifts in interest rates of positive 300 basis points to negative 100 basis points:

 

 

 

The following GAP Analysis table indicates the Bank’s interest rate sensitivity position at June 30, 2014 (in thousands):

 

 

 

 

Market Price Risk.  We are exposed to market price risk as a result of making markets and taking proprietary positions in securities.  Market price risk results from changes in the level or volatility of prices, which affect the value of securities or instruments that derive their value from a particular stock or bond, a basket of stocks or bonds or an index. 

The following table categorizes “Securities owned, at fair value” net of “Securities sold, not yet purchased, at fair value,” which are in our securities owned and securities sold, not yet purchased, portfolios and “Securities available for sale” in our available-for-sale portfolio which are subject to interest rate and market price risk at June 30, 2014 (dollars in thousands):

 

 

 

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and related disclosures.  We review our estimates on an on-going basis.  We base our estimates on our experience and on various other assumptions that we believe to be reasonable under the circumstances.  Actual results may differ from these estimates under different assumptions or conditions.  The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data.”

Fair Value

We adopted the fair value accounting standard of the FASB effective June 28, 2008.  Fair value accounting establishes a framework for measuring fair value and expands disclosures about fair value measurements. 

Under fair value accounting, fair value refers to the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market in which the reporting entity transacts.  The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability.  In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions.  The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data.  Under the standard, fair value measurements are separately disclosed by level within the fair value hierarchy.  The standard describes three levels of inputs that may be used to measure fair value: 

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The availability of observable inputs can vary for different assets.  Fair value is a market-based measure; therefore, when market observable inputs are not available, our judgment is applied to reflect those judgments that we believe a market participant would use in valuing the same asset or liability.  We use prices and inputs that are current as of the measurement date even in periods of market disruption or illiquidity.  Greater judgment in valuation is required when inputs are less observable or unobservable in the marketplace and judgment must be applied in determining the appropriateness of available prices, particularly in assessing whether available data reflects current prices and/or reflects the results of recent market transactions.  The valuation of financial instruments classified in Level 3 of the fair value hierarchy involves the greatest amount of management judgment.

 

Valuation Process for Financial Instruments.  Financial instruments are valued at quoted market prices, if available.  For financial instruments that do not have readily determinable fair values through quoted market prices, the determination of fair value is based upon consideration of available information including current financial information, fair values of underlying financial instruments and quotations for similar instruments.  Certain financial instruments have bid and ask prices that can be observed in the marketplace.  For financial instruments whose inputs are based on bid-ask prices, mid-market pricing is applied and adjusted to the point within the bid-ask range that meets our best estimate of fair value.

 

The valuation process for financial instruments may include the use of valuation models and other techniques.  Management makes adjustments to valuations derived from valuation models based on a number of factors, including but not limited to, the size of the position in the financial instrument in an inactive market, the features of the financial instrument such as its complexity, the market in which the financial instrument is traded or if a financial instrument is subject to sales restrictions that would result in a price less than the quoted market price.  Adjustments from the price derived from a valuation model reflect management’s judgment that other participants in the market for the financial instrument would consider the same factors in valuing the financial instrument. 

 

Management makes assumptions about risk, uncertainties and market conditions in preparing adjustments to prices derived from a valuation model.  Results from valuation models and valuation techniques in one period may not be indicative of future period fair value measurements.  

Certain financial instruments and other assets trade infrequently and therefore have outdated market prices.  As a result, we may use alternative valuation models as methods for determining fair value of these assets.  When using alternative valuation techniques or valuation models, the following techniques are applied to different financial instrument classes:

●Non-agency mortgage-backed and other asset-backed securities are valued by benchmarking to yields from market prices for comparable securities and calibrated based on expected cash flow characteristics of the underlying assets.

The following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying statement of financial condition, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Loans measured at fair value.  The fair value of loans for which the fair value option has been elected is calculated based on the present value of expected future discounted cash flows using market interest rates currently being offered for loans with similar terms to borrowers with comparable credit risk.  Due to lack of observable market data, these loans are classified as Level 3.

 

Securities Owned and Securities Sold, Not Yet Purchased Portfolio.  Securities classified as Level 1 securities primarily consist of financial instruments whose values are based on quoted market prices in active markets such as corporate equity securities and U.S. government and government agency obligations, primarily U.S. treasury securities.    

 

Securities classified as Level 2 securities include financial instruments that are valued using models or other valuation methodologies.  These models are primarily industry standard models that consider various assumptions, including time value, yield curve, volatility factors, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures.  Substantially all of these assumptions are observable in the marketplace, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.  Securities in this category include corporate obligations, U.S. government and government agency obligations and municipal obligations. 

Securities classified as Level 3 securities are securities whose fair values are estimated based on internally developed models or methodologies, including discounted cash flow, utilizing significant inputs that are generally less readily observable.  The models and methodologies considered the quality of the underlying loans, any related secondary market activity and expectations regarding future interest rate movements.  Included in this category are certain corporate equity securities, corporate and municipal obligations.

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Securities Available for Sale.    Because quoted market prices are available in an active market, our deferred compensation plan’s investment in Westwood’s common stock is classified within Level 1 of the valuation hierarchy.  Our investments in U.S. government and government agency obligations and municipal obligations held by the Bank as available for sale are valued in a similar manner to our Level 2 securities owned and securities sold, not yet purchased portfolio, noted above.

Interest rate swaps.  Interest rate swaps are valued using an income approach incorporating various assumptions, including the term of the swap, the notional amount of the swap, discount rates interpolated based on relevant swap curves, the rate on the fixed leg of the swap and a credit value adjustment for counterparty non-performance.  The approach also takes into consideration the potential impact of collateralization and netting agreements.  These interest rate swaps are classified as Level 2.

Stock purchase warrants.    The warrants held by Hilltop and Oak Hill are valued quarterly using a binomial model.  The model considers the following variables: price and volatility of our common stock, treasury yield, annual dividend, and the remaining life of the warrants.  The derived volatility estimate considers both the historical and implied forward volatility of our common stock.   All else being equal, the warrants will lose time value as they near maturity.  Other than remaining life, the primary drivers of value are the price and volatility of our common stock.  As the volatility and/or stock price increase, the value of the warrants increase as well.  The movement of these two variables will amplify or offset one another depending on the direction and velocity of their movements.  These securities are classified as Level 3.  

Contingencies

Accounting for contingencies requires the use of judgment and estimates in assessing the magnitude of the exposure and the likely outcome of the situation.  In many cases, the outcome will be determined by third parties, which may include governmental or judicial bodies.  The provisions made in our consolidated financial statements, as well as the related disclosures, represent management’s best estimates of the current status of such matters and their potential outcome based on a review of the facts and, when warranted, in consultation with outside legal counsel.  Management evaluates and revises its estimates on a quarterly basis.  Adverse legal or arbitration judgments, inability to collect receivables, sudden declines in the fair value of securities held in margin accounts or other actions could result in material changes to the estimates recorded in these financial statements.  Resolution of these matters in amounts different from what has been accrued in the consolidated financial statements could materially impact our financial position and results of operations.

Long-Lived Assets and Goodwill 

Our long-lived assets are subject to impairment testing if specific events warrant the review.  We test goodwill for impairment at least annually.  The impairment test is based on determining the fair value of the specified reporting units.  Judgment is required in assessing the effects of external factors, including market conditions, and projecting future operating results.  These judgments and assumptions could materially change the value of the specified reporting units and, therefore, could materially impact our consolidated financial statements.  If actual external conditions and future operating results differ from management’s judgments, impairment charges may be necessary to reduce the carrying value of these assets to the appropriate fair value.  See additional discussion in Note 1(k) in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data”.

Allowance for Probable Loan Losses 

We provide an allowance for probable loan losses.  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.  Should actual losses differ from management’s estimates, our consolidated financial statements could be materially impacted.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific and general components.  The specific component relates to loans that are classified as doubtful, substandard or special mention.  For such loans that are also classified as impaired, an allowance is established when the collateral value (or discounted cash flows or observable market price) of the impaired loan is lower than the carrying value of that loan.  The general component covers all loans and is based on historical loss experience adjusted for qualitative factors.  

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These factors include: concentrations of risk in the portfolio, estimated changes in the value of underlying collateral, and changes in the volume and growth in the portfolio.  

Impaired loans are accounted for at the fair value of the collateral.  If the loan is collateral dependent, the net present value of expected future cash flows discounted at the loan’s effective interest rate or at the observable market price of the loan.   

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Income Tax Accrual and Allowance for Deferred Tax Assets 

We operate in multiple taxing jurisdictions, and as a result, accruals for tax contingencies require us to make estimates and judgments with respect to the ultimate tax liability in any given fiscal year.  Actual results could vary from these estimates.  Changes in tax laws, new tax rulings, or results of tax audits could cause management’s estimates to change.  In our opinion, adequate provisions for income taxes have been made for all fiscal years.

We record net deferred tax assets to the extent management believes these assets are more likely than not to be realized.  In making such determination, management considers all available positive and negative evidence, including: expected future reversals of deferred tax assets and liabilities, projected future taxable income, cumulative losses in recent years and tax planning strategies and recent financial operations.  A valuation allowance is established against deferred tax assets when management determines that these deferred assets are more likely to not be realized.  In the event management subsequently determines that we would be able to realize deferred income tax assets in excess of their net recorded amount, we would reduce the valuation allowance, which would reduce the provision for income taxes.

RECENT Accounting Pronouncements

See Note 1(y) in the Notes to the Consolidated Financial Statements for the fiscal years ended June 30, 2014, June 30, 2013 and June 29, 2012 included under Item 8. “Financial Statements and Supplementary Data” for information regarding the effect of new accounting pronouncements on our consolidated financial statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this item is incorporated herein by reference to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Market Risk."

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The company’s consolidated financial statements and supplementary data are included in pages F-2 through F-59 of this Annual Report on Form 10-K. See accompanying Item 15. “Exhibits and Financial Statement Schedules" and “Index to the Financial Statements” on page F-1.

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UNAUDITED QUARTERLY FINANCIAL INFORMATION
(In thousands, except per share amounts)

 

 

 

 

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

Our management, including the principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act) as of June 30, 2014.  Based on such evaluation, our management, including the principal executive officer and principal financial officer, has concluded that as of June 30, 2014, our disclosure controls and procedures were effective for the purpose of ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the periods specified in the SEC’s rules and forms. 

Changes in Internal Control Over Financial Reporting.

The Company completed a transition to the new 2013 Committee of Sponsoring Organization of the Treadway Commission (“COSO”) framework during the fourth quarter of 2014.  This was completed by performing an assessment of our internal control over financial reporting and reviewing compliance with the 17 principles outlined by the 2013 COSO framework.  Compliance with the 2013 COSO framework was obtained through enhancing our control documentation as all of the procedures

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that were added to our controls’ documentation were procedures already in place at the Company and have been and continue to be part of our day-to-day operations.  

Other than the foregoing changes, there have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2014 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined by Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act.  Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management assessed the effectiveness of our internal control over financial reporting as of June 30, 2014.  In making this assessment, we used the criteria set forth by COSO in its 2013 Internal Control-Integrated Framework.  A control system, no matter how well conceived, implemented and operated, can provide only reasonable, not absolute, assurance that the objectives of the internal control system are met.  Because of such inherent limitations, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected.  Based on our assessment and those criteria, our management concluded that our internal control over financial reporting was effective as of June 30, 2014.

Our independent registered public accounting firm has audited the effectiveness of our internal control over financial reporting as of June 30, 2014 as stated in their report, dated September 5, 2014, which appears herein. 

ITEM 9B. OTHER INFORMATION

The table set forth below presents the amount awarded under our cash bonus plan for fiscal 2014 and the amount of common stock awarded under the 2012 Restricted Stock Plan to each of our named executive officers.  Our BOD approved the awards on August 20, 2014. 

 

 

 

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(1) These values are based on the last reported sales price of our common stock on the NYSE on August 20, 2014, which was $7.29 per share. 

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PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Directors and Executive Officers

 

For information with respect to our executive officers, see Item 1. “Business-Executive Officers of the Registrant”.   The names of our directors and their respective ages, positions and qualifications are listed below as of September 26, 2014.  Each such director was elected to serve on our BOD at the 2013 annual meeting of stockholders that was held on November 14, 2013. 

 

Robert A. Buchholz (age 54)

Mr. Buchholz has served as a director since May 2008.  Mr. Buchholz is the Chief Financial Officer of the Episcopal School of Dallas, an independent school serving Pre-Kindergarten to 12th grade students.  He has served in that capacity since October 2011.  Mr. Buchholz is Chairman of the Board and founder of Town Center Holdings, Inc. in Dallas, Texas.  Town Center Holdings, Inc. is the former parent company of Town Center Bank.  Town Center Bank merged with Independent Bank of McKinney, Texas on July 30, 2010. Before organizing Town Center Bank in 2003, Mr. Buchholz was a practicing attorney in North Carolina.  Prior to entering the legal field, Mr. Buchholz served as an officer of Southwest Securities Group, Inc. (now SWS Group, Inc.) in Dallas from 1985 to 1995, advancing to President and serving as a member of the BOD.  He is also a former certified public accountant. Mr. Buchholz is a director of Blue Sky Technologies, Inc.  He is a member of the Business Honors Program Advisory Council of the University of Texas at Austin.  The BOD concluded that Mr. Buchholz should serve as a director of the company for the following reasons:  (i) his prior role as Chairman and founder of Town Center Bank allows him to assist the BOD with the oversight of our bank and its interaction with various regulators; (ii) as a former director and executive officer of the company, he is well versed in the business of our broker/dealer and its oversight by multiple regulators;  (iii) he brings both legal and accounting expertise to the BOD from his prior professional experience as an attorney and a certified public accountant and (iv) as a past executive of the company and of Town Center Bank, he is capable of assisting the BOD with oversight of senior level management, as well as oversight of the company’s business policies.

 

Brodie L. Cobb (age 53) (2)

Mr. Cobb has served as a director since 1999.  He is the founder, Chief Executive Officer and Managing Director of San Francisco-based The Presidio Group LLC, a specialty advisory firm focusing on mergers and acquisitions, private financings and wealth management, where he has served from 1997 to the present.  Mr. Cobb's previous experience includes serving as a Vice President at Montgomery Securities from 1995 to 1997 and as an Associate at Credit Suisse First Boston LLC from 1992 to 1995.  The BOD concluded that Mr. Cobb should serve as a director of the company for the following reasons: (i) as a founder and managing director of The Presidio Group he provides expertise in overseeing senior management and (ii) he is frequently called upon to share his expertise with the full BOD on strategic planning.

J. Taylor Crandall (age 60) (3) 

Mr. Crandall has served as a director since August 2011.  Mr. Crandall is a founding Managing Partner of Oak Hill Capital Management, LLC (“OHCM”) and has been part of the firm (and its predecessors) since 1986.  He has senior responsibility for originating, structuring and managing investments for the firm's Media and Telecom and Technology industry groups.  Mr. Crandall has also served as Chief Operating Officer of Keystone, Inc., the primary investment vehicle for Robert M. Bass.  Prior to joining OHCM, Mr. Crandall was a Vice President with the First National Bank of Boston.  Mr. Crandall serves on the Board of Directors of LocalTV Holdings, LLC, Intermedia.net, Inc., Wave Division Holdings, LLC, Dave & Buster’s, Inc., ViaWest, Inc., and subsidiaries of Firth Rixson.  Mr. Crandall is the secretary-treasurer of the Anne T. and Robert M. Bass Foundation, the trustee of the Lucile Packard Foundation for Children’s Health and currently serves on the boards of trustees of the Cystic Fibrosis Foundation, The Park City Foundation, Powdr Corporation and the U.S. Ski and Snowboard Team Foundation.  Mr. Crandall earned a B.A. degree, magna cum laude, from Bowdoin College, where he has served on the Board of Overseers.  Mr. Crandall also received an honorary doctorate in humane letters from Bowdoin College in 2010.  The  BOD concluded that Mr. Crandall should serve as a director of the company for the following reasons: (i) his financial and accounting experience; (ii) his experience in management and board governance, including his experience originating, structuring, managing and overseeing investments as Managing Partner of OHCM and (iii) his management experience as Chief Operating Officer of Keystone, Inc. and Vice President of First National Bank of Boston, as well as (iv) his oversight experience from serving on the Board of Directors of several public and private companies.

 

Christie S. Flanagan (age 76) (1)(2)    

Mr. Flanagan has served as a director since November 2011.  Mr. Flanagan has practiced law since 1962 and has served as Counsel to Hunton & Williams, LLP, of Dallas since April 2007. From 2002 to 2007, he was Of Counsel to Jenkens & Gilchrist where he also practiced from 1968 to 1994, including serving as head of the Corporate/Securities Section and as Managing Partner. From 1994 to 2002, Mr. Flanagan was Executive Vice President and General Counsel of California Federal Bank and its predecessor, First Nationwide Bank, San Francisco, California.  He has a BBA degree from the University of Notre Dame with a major in accounting and a minor in finance, and he has been a licensed attorney since 1962. Further, Mr. Flanagan has served as executive vice president and general counsel for several banks or financial institutions during his career. The BOD concluded that Mr. Flanagan should serve as a director of the company for the following reasons: (i) he has significant industry knowledge and experience in dealing with legal,

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financial, accounting and regulatory matters; (ii) his previous experience as Executive Vice President and General Counsel for several banks or financial institutions and (iii) his extensive legal knowledge of corporate, securities, and banking laws and regulations.

 

Gerald J. Ford (age 70) 

Mr. Ford has served as a director since August 2011.  Mr. Ford has served as Chairman of the Board of Hilltop, a public company, since August 2007 and has served as a director of Hilltop since June 2005.  He served as interim Chief Executive Officer of Hilltop from January 1, 2010 until March 11, 2010.  Mr. Ford is a banking and financial institutions entrepreneur who has been involved in numerous mergers and acquisitions of private and public sector financial institutions, primarily in the southwestern United States, over the past 40 years.  In that capacity, he acquired and consolidated 30 commercial banks from 1975 to 1993, forming First United Bank Group, Inc., a multi-bank holding company for which he functioned as Chairman of the Board and Chief Executive Officer until its sale in 1994.  During this period, he also led investment consortiums that acquired numerous financial institutions, forming in succession, First Gibraltar Bank, FSB, First Madison Bank, FSB and First Nationwide Bank. Mr. Ford also served as Chairman of the Board of Directors and Chief Executive Officer of Golden State Bancorp Inc. and its subsidiary, California Federal Bank, FSB, from 1998 to 2002.  Mr. Ford serves as a director Freeport McMoRan Copper & Gold Inc. and Scientific Games Corporation, each of which is a public company.  Mr. Ford also currently serves on the Board of Trustees of Southern Methodist University, the Executive Board of Southern Methodist University’s School of Law, trustee of Southwestern Medical Foundation and Children’s Medical Foundation, a member of the Board of Overseers of Weill Medical College and Graduate School of Medical Sciences of Cornell University and is the Managing Partner of Ford Financial Fund II, L.P., a private equity fund.  Mr. Ford previously served as a director of Triad Financial Corporation and Chairman of the Board of Directors of First Acceptance Corporation and Pacific Capital Bancorp as well as a director of McMoRan Exploration Co.  The  BOD concluded that Mr. Ford should serve as a director of the company for the following reasons: (i) his extensive banking industry experience, which provide him with significant knowledge in dealing with financial, accounting and regulatory matters; (ii) his experience as a financial institutions entrepreneur and private investor involved in numerous mergers and acquisitions of private and public sector financial institutions over the past 40 years and (iii) his service on the board of directors and audit and corporate governance committees of a number of public companies, which gives him important insights into the role of the board of directors and various committees.

 

Larry A. Jobe (age 74) (1)(2)

Mr. Jobe has served as a director since July 2005.  Mr. Jobe, a certified public accountant, is founder and Chairman of the Board of Legal Network, Ltd. and founder and President of P 1 Resources, L.L.C., both Dallas, Texas based companies. Mr. Jobe founded Legal Network, Ltd. in 1993, a company that provides litigation support, temporary support staff and contract attorneys to law firms and corporate legal departments.  In 1994, he founded P 1 Resources, L.L.C., which provides engineering and light industrial staffing services to the construction industry.  Mr. Jobe was affiliated with Grant Thornton LLP from 1961 to 1969 and from 1973 to 1991, serving as Managing Partner of the Dallas office from 1973 to 1986 and as Regional Managing Partner of the Southwest Region from 1983 to 1991.  From 1969 to 1972, Mr. Jobe served as the United States Assistant Secretary of Commerce for Administration.  Mr. Jobe currently serves as Chairman of the Board of Directors of Independent Bank of Texas and Mannatech Incorporated, a global wellness solutions company.  Until October 2012, Mr. Jobe served as a member of the Board of Directors and the Audit Committee Chairman of USHS.  The BOD concluded that Mr. Jobe should serve as a director of the company for the following reasons: (i) he serves as the chairman of our Audit Committee and brings extensive accounting and audit expertise to the BOD from his 26 years of experience at Grant Thornton LLP; (ii) as a founder and head of Legal Network, Ltd. and  P 1 Resources, L.L.C., he has gained extensive experience in managing senior executives and the overall profitability of a company and (iii) his experience on other public and non-public boards brings important executive management experience to the BOD.

 

Tyree B. Miller (age 61) (1)(3)

Mr. Miller has served as a director since November 2011.  Mr. Miller has been in private equity and money management since 2004 and has served as the President of A.G. Hill Partners, LLC since 2009. He formerly served as a venture partner of Austin Ventures, a private equity fund located in Austin, Texas, from 2005 to 2008. From 1976 to 2004, Mr. Miller worked at Bank One Corporation, a company that merged with JP Morgan/Chase in 2004. During his employment at Bank One Corporation, he served as President and Chief Executive Officer of Global Treasury Services from 2000 to 2004 and as Chairman and Chief Executive Officer of Bank One Texas, NA from 1998 to 2000. Mr. Miller currently serves on the Board of Directors as the lead director and is a member of the Audit Committee of A.H. Belo Corporation, a public company, and on the Investment Sub-Committee of Texas Health Resources.  His previous experience includes serving as a Director and member of the Compensation Committee of PreCash, Inc. in Houston, Texas from 2005 to 2010, as a Chairman and Director of Paymetric, Inc., a payment processing technology company, from 2004 to 2008 and as Director and member of the Audit and Compensation Committees of Corillian, Inc., from 2005 until 2007. The BOD concluded that Mr. Miller should serve as a director of the company for the following reasons: (i) his experience in private equity and money management; (ii) his 28 years of work experience in the banking industry in various management and supervisory positions at Bank One and (iii) his experience as a director and audit and compensation committee member of several companies.

 

Dr. Mike Moses (age 62)

Dr. Moses has served as a director since March 2006.  Dr. Moses serves as Senior Education Advisor for Raise Your Hand Texas, a non-profit educational advocacy organization.  From November 2004 to July 2006, he served as Vice Chairman of the Board of Directors for Higher Ed Holdings, LLC, which develops education programs for teachers and administrators and is focused on improving teacher training and redesigning high schools throughout the nation.  Prior to joining Higher Ed Holdings, LLC, Dr. Moses was affiliated with the Dallas Independent School District, serving as its General Superintendent from January 2001 to August 2004.  From 1995 to 1999, Dr. Moses served as Texas Commissioner of Education, appointed twice by then Texas Governor George W. Bush.  In 1999, he joined the Texas Tech University System as Deputy Chancellor where he served until December 2000. Dr. Moses serves

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on the board of Scientific Learning Corporation, a public company and a producer of reading and language intervention programs for Pre-Kindergarten through 12th grade schools.  Dr. Moses served on the Board of Directors and as a member of the Audit Committee of Trammell Crow Company, a real estate property management company until its sale in 2007 to CB Richard Ellis.  The BOD concluded that Dr. Moses should serve as a director of the company because his positions as General Superintendent of Dallas Independent School District and Texas Commissioner of Education bring strong administrative, finance and executive management and oversight expertise to the BOD.

 

Joel T. Williams III (age 66) (1)(3)

Mr. Williams has served as a director since November 2009.  Mr. Williams, an attorney, has been the President of Bristol Investment Company, Inc., a private investment firm, since 1985.  He formerly served as President and Chief Executive Officer of Texas Federal Financial Corporation, a savings and loan holding company, prior to its sale in 1984.  A long time advocate and volunteer for Children's Medical Center, Mr. Williams served as its Chairman from 1993 to 2000, and Chairman of its holding company, Children's Health Services of Texas, from 2000 to 2003.  He currently serves as Chairman Emeritus of Children's Health Services of Texas and on the Executive Committee of Children's Medical Center Foundation.  He is the founder and has been the President of Passion for Children's Inc., a not-for-profit corporation that raises money exclusively for Children's Medical Center.  He also serves as Mayor of the Town of Highland Park, Texas.  Mr. Williams has demonstrated his commitment to excellence by earning a Governance Fellowship with the National Association of Corporate Directors (“NACD”) and is a NACD Governance Fellow.  He has demonstrated his commitment to boardroom excellence by completing NACD’s comprehensive program of study for corporate directors.  He continues to supplement his director expertise through ongoing activities with the NACD which provides access to its corporate director community and leading best practices.  The BOD concluded that Mr. Williams should serve as a director of the company for the following reasons:  (i) his experience as President of Bristol Investment Company and President and Chief Executive Officer of Texas Federal Financial Corporation enables him to assist the BOD with the oversight of senior level management and management of our business lines and (ii) he also brings legal knowledge and expertise to the BOD as an attorney.

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(1)    Member of the Audit Committee.

(2)   Member of the Compensation Committee.

(3)   Member of the Nominating/Corporate Governance Committee.

 

CORPORATE GOVERNANCE

 

General

 

             We manage our business under the direction of the BOD.  The BOD meets at least quarterly during the year to establish strategies and polices for the company, to review significant developments and to act on matters requiring BOD approval.  The BOD held 12 meetings during fiscal 2014.  Each director attended at least 62% of the BOD and committee meetings in fiscal 2014, during the period each director served. 

 

The BOD has a practice of separating the offices of Chairman and Chief Executive Officer (“CEO”) to ensure the Chairman is independent from management.  The BOD believes it is important to maintain flexibility in the BOD leadership structure and has had different leadership structures in place in the past depending on the company’s needs at the time but firmly supports having the Chairman role separate from the role of CEO at this time.  Our restated by-laws separate the offices of the Chairman of the BOD and the CEO and have separate descriptions of the duties of the Chairman of the BOD and the CEO. 

We have a Nominating/Corporate Governance Committee that considers and recommends candidates for BOD vacancies, actively recruits qualified candidates, reviews and makes recommendations regarding committee assignments and committee structure, and assists the BOD in developing and implementing corporate governance practices and policies.

The BOD has adopted a comprehensive set of Corporate Governance Guidelines that address a number of important governance issues, including director independence, as well as matters such as criteria for BOD membership, expectations regarding attendance and participation at meetings, committee responsibilities, management succession planning, and annual BOD self-evaluation.  We have published these guidelines on the Corporate Governance page of our website, which can be accessed at www.swsgroupinc.com.  In addition, a copy of our guidelines may be obtained free of charge, upon written request to our Corporate Secretary at SWS Group, Inc., 1201 Elm Street, Suite 3500, Dallas, Texas 75270.

Committees of the Board of Directors

 

The BOD has implemented formal charters setting forth the powers and responsibilities of each of the Audit, Compensation and Nominating/Corporate Governance Committees.  The current copies of all three charters may be accessed on the Corporate Governance page of our website at www.swsgroupinc.com.  In addition, a copy of each charter may be obtained free of charge, upon written request to our Corporate Secretary at SWS Group, Inc., 1201 Elm Street, Suite 3500, Dallas, Texas 75270. 

The non-management directors of the BOD meet in executive sessions during each of the BOD’s regularly scheduled meetings without any management directors and any other members of management present.  The non-management directors rotate the presiding position among the chairs of the authorized BOD committees.

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Compensation Committee:  The Compensation Committee is comprised of three non-employee directors, each of whom is "independent," as independence is defined in the NYSE's listing standards.  The Compensation Committee determines the salaries of our executive officers, assists in determining the salaries of other personnel, oversees the grant of awards under our restricted stock plan and performs other similar functions.  The Compensation Committee may form and delegate its authority to subcommittees, when appropriate.  The Compensation Committee held five meetings during fiscal 2014 and was comprised of Messrs. Cobb (chairman), Flanagan, and Jobe.   In fiscal 2014, each committee member attended all committee meetings that occurred during his term. 

Audit Committee:  The BOD has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  The Audit Committee is comprised of four non-employee directors, each of whom is "independent," as independence is defined in the NYSE's listing standards and applicable SEC rules.  The Audit Committee assists the BOD in monitoring the integrity of our financial statements, our independent accountant's qualifications and independence, the performance of our internal audit function and our compliance with legal and regulatory requirements, and facilitating our enterprise risk management framework.  The Audit Committee held nine meetings during fiscal 2014 and was comprised of Messrs. Jobe (chairman), Flanagan, Miller and Williams. In fiscal 2014, each committee member attended all committee meetings that occurred during his term.  The BOD has determined that Mr. Jobe is an "audit committee financial expert" as defined by applicable SEC rules.   

The responsibilities of the Audit Committee include appointing and engaging an independent registered public accounting firm.  Additionally, and as appropriate, consulting with our management, our internal audit personnel and the independent accountants, the Audit Committee reviews, evaluates, discusses and reports on:

In fiscal 2014, the Audit Committee reviewed and updated its formal charter, which sets forth the powers and responsibilities of the Audit Committee.

Nominating/Corporate Governance Committee:  For fiscal year 2014, the Nominating/Corporate Governance Committee was comprised of four non-employee directors, each of whom is "independent," as independence is defined in the NYSE's listing standards.  The Nominating/Corporate Governance Committee is responsible for identifying individuals qualified to serve as members of the BOD, recommending to the BOD qualified director nominees to be proposed for election at the annual meeting of stockholders, recommending to the BOD to be appointed to the various committees of the BOD and developing and recommending to the BOD effective corporate governance practices and policies.  The Nominating/Corporate Governance Committee held four meetings during fiscal 2014 was comprised of Messrs. Crandall, Ford, Miller and Williams (chairman). In fiscal 2014, each committee member attended at least 75% of all of the committee meetings that occurred during his term.  Mr. Ford ceased serving as a member of the Nominating/Corporate Governance Committee, effective August 20, 2014.

The Nominating/Corporate Governance Committee reviews the composition of the BOD and whether the addition of directors with particular experience, skills, or characteristics would make the BOD more effective.  When a need arises to fill a vacancy or it is determined that a director possessing particular experience, skills, or characteristics would make the BOD more effective, the Nominating/Corporate Governance Committee initiates a search.  As a part of the search process, the committee may consult with other directors and members of management, and may hire a search firm to assist in identifying and evaluating potential candidates. The Nominating/Corporate Governance Committee seeks members from diverse professional backgrounds who combine a broad spectrum of experience and expertise with a reputation for integrity.  When considering a candidate, the Nominating/Corporate Governance Committee reviews the candidate's experience, skills, and characteristics.  Specifically, candidates should have experience in positions with a high degree of responsibility and be leaders in the companies or institutions with which they are affiliated.  Our Nominating/Corporate Governance Committee evaluates each individual in the context of the BOD as a whole, with the objective of recommending to stockholders a group that collectively can best serve the long-term interest of our employees, customers, and stockholders.

While there is no formal BOD policy with regards to diversity, the BOD considers diversity in terms of experience, gender, ethnicity, color and age, with the goal of obtaining diverse perspectives.  The BOD’s primary consideration is to identify candidates with the background, experience, and skills that will best fulfill the BOD’s and our needs each year and at any time a search is being conducted.  Therefore, the BOD does not believe it is appropriate to either nominate or exclude from nomination an individual based solely on gender, ethnicity, color, age, or similar factors.

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The Nominating/Corporate Governance Committee considers director nominees recommended by our stockholders within a reasonable time prior to the annual meeting. Pursuant to our restated by-laws, any stockholder who wishes to submit a business proposal and/or nomination must include certain information relating to such stockholder (and the beneficial owner, if any, on whose behalf the business proposal or nomination is being made), the business, if any, proposed to be brought before the meeting, and the director nominee, if any, being submitted for election to our BOD. Our restated by-laws also set forth a time period during which such notice must be delivered.  Stockholders wishing to submit such a recommendation should send the director nominee's name, business and management experience, and all other required information regarding the director nominee to the Nominating/Corporate Governance Committee, c/o SWS Group, Inc., Attn:  General Counsel, 1201 Elm Street, Suite 3500, Dallas, Texas 75270.     

Board Oversight of Business Risk

 

Our management is primarily responsible for managing our business risk.  Management manages business risk primarily through risk management committees assigned to oversee specific areas of risk.  The BOD’s oversight of major risks occurs at both the full BOD level and the BOD committee level.  The BOD and its committees use the following procedures to monitor and assess risks:

 

The Board of Directors: In an effort to assist the company in managing enterprise risk and at the BOD’s request, the company engaged a firm to perform an analysis of the company’s enterprise risk management process.  During fiscal 2011, based on the BOD’s recommendations, we initiated an enterprise risk management program and formed an enterprise risk management committee.  Enterprise risk is viewed as the threat from an event, action or loss of opportunity that, if it occurs or has occurred, may adversely affect any, or any combination of, our  objectives, business strategies, business model, regulatory compliance, reputation and existence.  The committee works with our various departments and committees to manage our enterprise risk management program and reports the results of this work to the Audit Committee of the BOD on a quarterly basis.  During fiscal 2013, we hired a full time risk manager for the consolidated group who serves as the primary liaison with our risk management consultants.  We continue to utilize consultants to improve risk management processes, procedures and reporting.

 

The CEO, members of senior management, and other personnel and advisors, as requested by the BOD, report on our financial and operating strategies, as well as related risks, at regular meetings of the BOD.  Based on these reports, the BOD requests follow-up data and presentations to address its specific concerns and recommendations.  As necessary, information from the risk committee is provided to the BOD.     

 

The Audit Committee: In accordance with the requirements of the NYSE, the Audit Committee assists the BOD with its oversight responsibilities by discussing our major financial risk exposures, its policies with respect to risk assessment and risk management, and the steps management takes or has taken to monitor and control or mitigate financial and regulatory risk exposures.  The Audit Committee discusses with our management, as well as our Internal Audit Department (including in executive sessions), our policies with respect to risk assessment and risk management and advises management on its risk assessment approach and its prioritization of risks.  The Audit Committee also receives regular reports on, and assessments of, our internal control over financial reporting from our Internal Audit Department and members of management responsible for disclosure controls.  In addition, the Audit Committee receives the independent auditor’s assessment of our internal controls and financial risks, which includes the independent auditor’s report on its procedures for identifying fraud, including procedures for the submission of anonymous reports.  At each of its regular meetings, the Audit Committee also receives management reports regarding specific areas of financial risk and discusses strategies to mitigate enterprise risk.

The Nominating/Corporate Governance Committee:  The Nominating/Corporate Governance Committee receives updates and advice from management and outside advisors regarding our procedures for complying with corporate governance regulations, as well as with respect to our governance structure.  This committee also reviews the company’s Corporate Governance Guidelines at least annually to provide effective governance.  The Nominating/Corporate Governance Committee also assists the BOD with its annual review of succession planning.

The Compensation Committee:  The Compensation Committee receives management updates and advice on the advisability of our compensation practices.  The Compensation Committee is aware of the need to routinely assess our compensation policies and practices as they relate to our risk management and how our compensation policies and practices affect risk taking by our employees.  The Compensation Committee has determined that the compensation policies and practices for our employees are not reasonably likely to have a material adverse effect on our financial position and results of operations.

The Compensation Committee has the authority to retain a compensation consultant to assist in the evaluation of executive officer and BOD compensation.  In October 2011, the Compensation Committee retained a consultant to serve as the Compensation Committee’s outside compensation consultant.  The consultant was asked by the Compensation Committee to conduct a competitive compensation assessment and review incentive compensation programs and recommend enhancements where appropriate. The consultant provided recommendations for a new executive compensation plan that was implemented in fiscal 2013 and continued in fiscal 2014. 

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The Compensation Committee annually reviews the performance, independence and related fees paid to its compensation consultants and concluded that its current compensation consultant is independent. 

The Compensation Committee used the information provided by the compensation consultant to inform, as opposed to determine, the Compensation Committee’s decisions for fiscal 2014 and to assist it in applying a long-term approach for the company’s compensation programs.  While the Compensation Committee relies heavily on the information provided by the outside compensation consultant, its decisions are ultimately made on its own assessment of the information provided to it in the context of the totality of the company’s circumstances at any given point in time.  Additional details regarding the work performed by the compensation consultant as well as the Compensation Committee’s related determinations can be found in “Compensation Discussion and Analysis”.

Board of Directors Attendance at Annual Meetings

 

Although we do not have a formal policy that requires BOD members to attend the annual meeting of stockholders, attendance is encouraged and all of our directors attended the 2013 annual meeting.  

 

Section 16(a) Beneficial Ownership Reporting Compliance 

 

Section 16(a) of the Exchange Act and regulations of the SEC require our executive officers and directors and persons who own more than 10% of our common stock to file initial reports of beneficial ownership and reports covering any changes in beneficial ownership with the SEC and the NYSE.  Executive officers, directors and persons owning more than 10% of our common stock are required by SEC regulations to furnish us with all such reports they file.

 

To our knowledge and based solely on a review of copies of such reports furnished to us and written representations that no other reports were required for such person, each of our directors, officers and persons owning more than 10% of our common stock complied with all applicable Section 16(a) filing requirements during fiscal 2014, except on April 3, 2014, OHCM filed a Form 3 with the SEC reporting ownership of shares of our common stock. The filing date requirement for the Form 3 was December 2, 2013.

Code of Business Conduct and Ethics

 

We have adopted a corporate Code of Business Conduct and Ethics (the "Code") that applies to all directors, officers and employees of SWS.  This Code is intended to promote honest and ethical conduct, avoidance of conflicts of interest, full, fair, accurate, timely, and understandable disclosure in the reports and documents that the company files with, or submits to, the SEC, and in all other public communications made by SWS, compliance with all governmental laws, rules, and regulations, prompt internal reporting of violations of the Code, and accountability for adherence to the Code.  The Code is a product of SWS’s commitment to honesty.  The Code is posted on our corporate website at www.swsgroupinc.com.  In addition, a copy of the Code may be obtained free of charge, upon written request to our Corporate Secretary at SWS Group, Inc., 1201 Elm Street, Suite 3500, Dallas, TX 75270.  Any amendments to the Code and any waivers that are required to be disclosed by the rules of the SEC and the NYSE will be posted on our corporate website.

 

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

 

During fiscal 2014, the members of the Compensation Committee were Messrs. Cobb, Jobe and Flanagan. None of the members were at any time during fiscal 2014, or at any other time, an officer or employee of the company. During fiscal 2014, none of our executive officers served as a member of the Compensation Committee or similar committee or as a member of the board of directors of any other entity of which an executive officer served on our Compensation Committee or our BOD. Please refer to the section of this Amendment No. 1 on Form 10-K/A entitled “Certain Relationships and Related Transactions, and Director Independence” for information regarding certain relationships between members of our Compensation Committee and the company. 

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COMPENSATION COMMITTEE REPORT

 

The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis as required by Item 402(b) of Regulation S-K with management. Based on this review and discussion, the Compensation Committee has recommended to the full BOD that the Compensation Discussion and Analysis be included in this Amendment No. 1 on Form 10-K/A.

 

The Compensation Committee of the Board of Directors

 

Brodie L. Cobb, Chairman

Larry A. Jobe

Christie S. Flanagan

 

 

COMPENSATION DISCUSSION AND ANALYSIS

 

The following Compensation Discussion and Analysis should be read in conjunction with the “Summary Compensation Table” and related tables that are presented below.  For the purposes of this Compensation Discussion and Analysis, the Compensation Committee is referred to as the “Committee”.

 

For purposes of the following discussion, our named executive officers (“NEOs”) consist of all persons serving as our CEO or Chief Financial Officer (“CFO”) during fiscal 2014 and our three most highly compensated executive officers (other than our CEO and CFO) who were serving as executive officers as of June 30, 2014.  For fiscal 2014, our NEOs consisted of James H. Ross, J. Michael Edge, Stacy M. Hodges, Daniel R. Leland, Richard H. Litton and Robert A. Chereck. Ms. Hodges resigned from her positions with the company on September 30, 2013 and Mr. Edge was appointed as interim CFO, effective October 1, 2013.

 

Committee’s Consideration of 2013 Say-on-Pay Vote and 2011 Frequency Vote

 

At our 2011 annual meeting of stockholders, our stockholders voted, on an advisory basis, in favor of holding future advisory votes on executive compensation on an annual basis.  In accordance with these voting results, we approved a one year frequency for holding future advisory votes on executive compensation. 

 

At our 2013 annual meeting of stockholders, approximately 35% of the votes were voted, on an advisory basis, in favor of the compensation of our NEOs. Due to the results from the say-on-pay vote at our 2013 annual meeting, the Committee engaged a proxy advisory firm and researched issues that it believed may have led to the outcome of the vote. As a result of this research and feedback, the Committee has updated and revised the disclosure related to executive compensation included herein in order to provide our stockholders with a better understanding of the objectives and substance of our executive compensation program.  

Compensation Philosophy and Objectives

 

As a securities and banking firm, one of our greatest assets is the skill, experience and efforts of our employees.  Our long-term success depends on our ability to provide products and services that enable our clients to achieve their financial and business goals.  In our industry, employee talents are easily transferred from one employer to another, and there is continual competitive activity to recruit talented individuals with valuable experience.

Our executive officer compensation program is designed to reward and retain talented executive officers while holding them accountable for the performance of the company and, where applicable, the business units they manage by basing elements of their compensation on a combination of company and business unit results.  By offering a combination of compensation elements including salary, annual incentive awards and long-term equity-based incentive compensation,  we seek to achieve the following objectives:

 

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Because our industry depends, in large measure, on the successful efforts of commission-earning sales professionals, which commissions have historically been paid in cash, compensation within broker/dealers of comparable size is more heavily weighted to cash than is found in many other industries.  The Committee takes these realities into account and also seeks to align the cash compensation of NEOs with the success of both the individual business unit over which they have managerial authority and the success of the overall company.   

The Committee evaluates both the compensation (particularly salary, annual incentive awards and long-term equity-based incentive compensation) and performance of our executive officers, measured by our financial results, relative to other companies in a comparative group to ensure that we maintain the ability to attract and retain superior employees in key positions comparative to the market.  The Committee seeks to compensate NEOs at a level that is competitive with similar firms in the securities and banking industries and to align NEOs’ incentives with the interests of our stockholders. While the Committee has primary responsibility for compensation across the company, all stock grants are subject to final approval by the BOD.

 

Setting Executive Compensation

 

Based on the foregoing objectives, the Committee has structured salary, annual incentive awards and long-term equity-based incentive compensation in a manner designed to motivate NEOs to achieve our business goals and to reward the NEOs for achieving those goals.  In establishing total annual compensation for the CEO, CFO and the other NEOs, the Committee performs the following reviews:

 

 

Some of the companies in the group have greater revenues and resources than we do.  The mix of banking and securities business in these comparison companies is also materially different than ours.  The Committee is aware of these disparities, and takes them into account when reviewing and comparing executive compensation levels.  The

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Committee also considers the relative profitability of the comparative group, the market challenges faced and overcome and the general trend lines of their businesses.  The Committee does not target a specific percentile within the comparative group, but uses the levels of compensation as a guide in evaluating and setting compensation for our NEOs.

 

There is no pre-established policy or target for the allocation between either cash incentives or long-term equity-based incentive compensation.  Rather, the Committee considers information provided by the comparative group analysis as well as its own judgment to determine the appropriate level and mix of each component of the compensation program.  Also, the Committee reviews our short-term and long-term goals and objectives when considering the right mix of cash and equity compensation.

 

With respect to our CEO and CFO, total compensation has been set to reward performance, productivity and profitability on a company-wide basis.  In addition to receiving competitive base salaries, these executives receive cash incentive awards and long-term equity incentive awards that are based on performance of the company as a whole versus a preset Budget and upon their individual performance in order to focus their efforts on creating long-term stockholder value. For fiscal 2014, the pre-tax income Budget for the consolidated company was $10,082,834.

 

Many of our other executive officers, including Messrs. Chereck, Leland and Litton, have roles that blend both management and production supervisory responsibilities.  In setting their total compensation, the Committee considers not only the general comparative group information but also how the executive officers performed against their individual Budgets for the fiscal year as well as consolidated company results.  Consequently, their incentive award is derived from the internally measured profitability of the business unit for which each has primary responsibility, and consolidated company performance against internal Budgets.  These executives are paid a percentage of that internally measured profitability, which depending on results, may be reduced or increased by preset percentages depending on actual results compared to the Budgets.  The following is a more detailed description of the executive incentive compensation formula for business units.  However, because the Budgets for individual business units contain confidential commercial and financial information, the disclosure of which the company believes would result in competitive harm,  the amounts of such Budgets have not been disclosed.    The Budgets for individual business units are determined each year at a level based upon historical financial results and pro-forma projections with input from the business units and senior executive management. These projections are then reviewed by the Board and subjected to an overlay that assumes generally favorable market and economic conditions and reflects prevailing analyst views on short-term interest rates.  The Budgets are set to be challenging but attainable for the business unit executives. The company believes that if favorable market and economic conditions occur, the executive is more likely than not to meet his Budget.  The challenging nature of the Budgets is evidenced by the fact that, over the preceding two years, the Budgets were not attained 50% of the time.

 

At the beginning of the fiscal year, the BOD establishes a Budget goal for the consolidated company’s pre-tax income, as well as for each business unit.  Where an executive is in charge of a business unit, an incentive compensation calculation is created by multiplying the business unit’s budgeted pre-tax income by a set percentage.  This percentage is different for each business unit’s Budget.  The calculation of the business unit’s pre-tax income multiplied by the preset percentage creates a maximum pool of incentive compensation.  Depending on how actual results compare to the Budgets, the pool of incentive compensation may be increased or reduced in the following manner.  If the consolidated results of the company meet the Budget or exceed the Budget by no more than 24.9%, the preset percentage used to calculate the incentive compensation pool is not reduced.  If the consolidated results exceed the Budget by 25% or more, the preset percentage used to calculate the incentive compensation pool will be increased by 25%.  If the company does not meet the pre-tax income consolidated Budget, the preset percentage will be reduced by 25%. 

 

Further, the incentive compensation pool is also measured against the individual performance of the business unit the executive controls.  The individual business unit’s preset percentage may be offset, in addition to the consolidated offset, depending on the individual business unit’s financial results.  If the pre-tax income of the individual’s business unit is between 75% and 100% of its Budget, the preset percentage will not be reduced.  If the pre-tax income of the individual’s business unit is between 50% and 74.9% of its Budget, the preset percentage will be reduced by 25%.  If pre-tax income of the individual’s business unit is below 50% of its Budget, the executive will receive a predetermined minimum amount of incentive compensation (which for Messrs. Leland and Litton was $350,000 for fiscal 2014) which is paid to retain the executive in years where production may lack due to forces outside the control of the executive.   

 

The incentive pool is divided between cash and restricted stock vesting ratably over three years.  NEOs that are responsible for a business unit receive the first $150,000 of their pool in cash, with any excess over $150,000 paid 60% in restricted stock, vesting ratably over three years, and 40% in cash.

 

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Role of Executive Officers in Compensation Decisions

 

The Committee makes all compensation decisions affecting the CEO’s compensation.  Compensation for all other executive officers, including the NEOs (other than the CEO), is determined by the Committee after considering the individual’s role and responsibilities, external market data and recommendations made by the CEO. 

 

The CEO annually reviews the performance of each of the NEOs (excluding himself).  The conclusions reached and recommendations based on these reviews are presented to the Committee.  The Committee can exercise its discretion in modifying any recommended adjustments or awards with respect to the NEOs, or any other employee.

 

Proposed Merger with Hilltop

 

On March 31, 2014, the company, Hilltop and Peruna entered into the Merger Agreement, pursuant to which the company will be merged with and into Peruna, with Peruna as the surviving entity in the merger. If the proposed merger is completed, each share of the company’s common stock that is outstanding immediately prior to the completion of the proposed merger will be converted into the right to receive $1.94 in cash and 0.2496 of a share of Hilltop common stock. 

 

In connection with the proposed merger, the BOD and the special committee of the BOD (the “Special Committee”) have” instructed management to ensure that the company remains on course to close the merger based on the timeline agreed between the company and Hilltop. Management has been working, and continues to work, closely with the BOD and the Special Committee in closing and preparing for the proposed merger. In recognition of their contributions to the proposed merger, the company has awarded additional cash and equity compensation to the NEOs and certain other executive officers and key employees, as summarized below. For further information regarding the compensation that our NEOs are eligible to receive in connection with the merger, see “The Merger – Interests of SWS Directors and Executive Officers in the Merger” in Amendment No. 3 to the Registration Statement on Form S-4 filed by Hilltop with the SEC on September 15, 2014 (the “Form S-4/A”).

 

The Merger Agreement provides that our NEOs’ equity-based awards (and those of our directors and other employees) will be treated as set forth below in connection with the merger.

 

 

 

Under the Merger Agreement, our executive officers and other employees are entitled to cash severance in accordance with the company’s severance practice on termination of employment by the employer without “cause” at any time following the effective time of the merger and on or prior to December 31, 2015, contingent on the executive’s or other employee’s execution and non-revocation of a release of claims. The amount of such severance is equal to two weeks of base salary for each year of service, not to exceed 24 weeks of base salary.

 

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Following the end of fiscal 2014, as permitted under the terms of the Merger Agreement, the company entered into retention agreements with certain executive officers (and other employees) that provide for cash retention payments in the aggregate amount of $4,418,800, of which $975,000 in the aggregate is payable under the agreements with the executive officers. These retention amounts will be paid in a lump sum within 30 days after the six-month anniversary of the effective time of the merger, subject to continued employment with SWS through such six-month anniversary (except that, on a termination of employment by the employer without “cause” (as defined in the retention agreement) after the effective time, the retention payment will be paid within 30 days after such termination date, contingent on the executive’s (or other employee’s) execution and non-revocation of a release of claims). 

 

Elements of Compensation

 

Base Salaries.  Each NEO receives cash compensation in the form of a base salary.  Base salaries are set to be competitive within our industry and our comparative group, with consideration given to our size and geographic location.  The base salary amounts are reviewed annually and may be adjusted based on the individual NEO’s level of responsibility and performance.  The Committee did not award any increases in base salary to our NEOs in fiscal 2014.

The Committee views base salary as a way to provide a non-performance-based element of compensation that is certain and predictable.  Decisions on NEO compensation are made by focusing on all components of total direct compensation while being sensitive to the needs of our NEOs for a certain level of compensation stability.  The Committee believes the established base salary levels strike the proper balance between aligning the interest of the NEO as closely as possible with those of the stockholders while avoiding exposing them to undue compensation risk.  The Committee’s determination of the appropriate level of base salary paid to NEOs is subjective and not formulaic.  Factors that influence the Committee’s determination of base salary include, but are not limited to:

 

Incentive Awards.  Our NEOs are also eligible to receive annual incentive awards based partially or entirely on our consolidated fiscal year operating results, measured by the company’s Budgets versus actual pre-tax income and the individual NEO’s contribution for the year.  This methodology creates an incentive by linking our overall financial achievements to the achievement of an individual NEO’s goals and objectives.

 

The incentive awards produced by the formula below are subject to the review and discretion of the Committee, which may adjust the incentive award to compensate for unusual events that might otherwise affect the calculation and produce results contrary to the Committee’s compensation policies.

 

For Messrs. Chereck, Leland and Litton, if the executive earns an incentive award that exceeds $150,000, the excess amount is split between cash and equity, with 40% of the excess paid in cash on the date of approval by the BOD and 60% of the excess awarded in restricted stock that vests ratably over three years. If the executive earns an incentive award of $150,000 or less, the award is paid entirely in cash.

 

Incentive plan award calculations for Mr. Ross were based on the company’s consolidated results. Because the company’s pre-tax consolidated income did not meet the consolidated Budget for fiscal 2014, Mr. Ross did not receive an incentive award for fiscal 2014.  However, due to his positive role and contributions to the proposed merger, and his efforts to maximize stockholder value through employee and expense reductions, the Committee used its discretion to award Mr. Ross $225,000 in the form of a cash incentive award and $300,000 in the form of a restricted stock incentive award for fiscal 2014. 

 

The incentive award for Mr. Edge, who was not in charge of any individual business unit in fiscal 2014, was based 50% on his individual management responsibilities, performance and contributions to the proposed merger, with the remaining 50% based on the company’s consolidated results compared to the consolidated Budget.  Mr. Edge received a discretionary cash incentive award of $67,500 and a $75,000 discretionary restricted stock award based on his management responsibilities, performance and contributions to the proposed merger.   Because the company did not meet consolidated Budget for fiscal 2014, Mr. Edge did not receive any cash incentive compensation for this portion of his award.   

 

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Incentive plan award calculations for Messrs. Chereck, Leland, and Litton, who each controlled individual business units, were based on the pre-tax income of the controlled business unit as compared to the controlled business unit’s Budget, as described above.  

 

Mr. Chereck received an incentive award of $140,175 for fiscal 2014. Mr. Chereck’s incentive pool was generated by multiplying the pre-tax income from the business unit he controls (the Bank) by a preset percentage.  Because the Bank’s pre-tax income was between 75% and 100% of its Budget, the preset percentage used to calculate the incentive compensation pool was not initially reduced.  However, because the consolidated company did not meet the consolidated Budget for fiscal 2014, the preset percentage used to calculate the incentive compensation pool was subsequently reduced by 25%, which resulted in an incentive award amount for Mr. Chereck that totaled $140,175, all of which was paid in cash.

 

Mr. Leland received an incentive award of $350,000 for fiscal 2014.  Because the business units’, controlled by Mr. Leland-portfolio trading and taxable fixed income for Southwest Securities, Inc., pre-tax incomes were below 50% of their respective Budgets,  Mr. Leland’s incentive award was reduced to the minimum amount of compensation set by the Committee.   Since Mr. Leland received the minimum amount of $350,000, as discussed above, his incentive award was not reduced by an additional 25% because the company’s pre-tax consolidated income did not meet the consolidated Budget for fiscal 2014.  This resulted in an incentive amount for Mr. Leland that totaled $350,000, with the first $150,000 paid in cash and the remaining $200,000 being awarded 40% in cash ($80,000) and 60% in restricted stock ($120,000). 

 

Mr. Litton received an incentive award of $793,305 for fiscal 2014.  Mr. Litton’s incentive pool was generated by multiplying the pre-tax income for the business unit he controls (municipal finance for Southwest Securities, Inc.) by a preset percentage for the unit.  Because the municipal finance unit achieved between 75% and 100% of its Budget, Mr. Litton’s incentive compensation was not reduced from its preset percentage.  However, because the consolidated company did not meet the consolidated Budget for fiscal 2014, the preset percentage used to calculate the incentive compensation pool for municipal finance trading was reduced by 25%.   This resulted in an incentive award amount for Mr. Litton that totaled $793,305, with the first $150,000 paid in cash and the remaining $643,305 being awarded 40% in cash ($257,322) and 60% in restricted stock ($385,983).

 

Deferred Compensation Plan.  We also maintain a Deferred Compensation Plan (the “Deferred Compensation Plan”) that works in tandem with our incentive program.  The plan was created in order to increase retention of executive officers and senior management, as well as to increase stock ownership among participants in the plan.  The plan allows participants to defer up to 50% of each incentive award and to invest such amounts in various investment alternatives, including our common stock.  We match 15% of the deferrals made by participants up to $15,000 through matching contributions that vest ratably over four years.  The Committee believes programs such as the Deferred Compensation Plan further align the NEOs’ long-term financial and strategic interests with those of our stockholders. For information about the treatment of deferred shares reflected in the accounts of executive officers under the Deferred Compensation Plan in the proposed merger, see “-Proposed Merger with Hilltop” above.

Long-Term Incentive Compensation.  The last component of our NEO compensation program is long-term incentive compensation.  Long-term incentive compensation is comprised of the following components:

 

Profit Sharing/401(k) Plan.  We have a defined contribution Profit Sharing/401(k) Plan (the “401(k) plan”) that provides certain retirement benefits.  This plan covers substantially all of our employees, including NEOs.  Amounts contributed to the 401(k) plan by employees are based on gross compensation, subject to limitations imposed by the Internal Revenue Code of 1986, as amended, and regulations adopted by the Internal Revenue Service.  We make profit sharing contributions in cash to employee accounts depending on our profits.  These contributions vest over a period of six years.  We also provide 401(k) matching contributions of up to 4% of eligible compensation, which vest immediately.

2012 Restricted Stock Plan. On November 15, 2012, the stockholders of SWS Group, Inc. approved the adoption of the SWS Group, Inc. 2012 Restricted Stock Plan (the “2012 Restricted Stock Plan”). The 2012 Restricted Stock Plan allows for awards of restricted stock to SWS’s directors, officers and employees and authorizes up to 2,630,000 shares of SWS’s common stock to be delivered pursuant to awards granted under the 2012 Restricted Stock Plan. The 2012 Restricted Stock Plan expires on November 15, 2022.  The vesting period for awards under the 2012 Restricted Stock Plan is determined on an individualized basis by the Committee. 

Annual restricted stock awards to our NEOs generally vest ratably over a three year period.  This component of annual compensation helps us retain our NEOs because, at the BOD’s discretion, an award is subject to forfeiture if an NEO leaves the company prior to vesting for any reason other than retirement.  Consequently, because a sizeable portion of each NEO’s restricted stock grant is not vested in the year it is awarded, the cost of leaving the company can be significant to the NEO.  This also has the benefit of creating NEO wealth concentrated in our stock, which aligns their long-term interests with those of our stockholders.  Finally, these awards contain restrictive covenants against post-termination competition, use of confidential information and solicitation of employees.

The Committee believes that incentive compensation should include a material grant of restricted stock to provide meaningful ownership to NEOs and to keep their interest aligned with stockholders.  For the CEO and CFO of the company, the grant of restricted stock is discretionary based on the achievement of both financial and non-financial goals.  For NEOs who control a business unit, the restricted stock grant consists of 60% of any amount of incentive compensation over $150,000.

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Mr. Ross received a discretionary $300,000 award of restricted stock for fiscal 2014.   The BOD used its discretion to award this subjective restricted stock grant based on his performance as CEO in 2014.  The 2014 restricted stock award for Mr. Ross is scheduled to vest over a three year period. 

Mr. Edge received a discretionary $75,000 award of restricted stock for fiscal 2014.  The BOD believed that Mr. Edge should be granted a discretionary award based on his performance as CFO for fiscal 2014. The 2014 restricted stock award for Mr. Edge is scheduled to vest over a three year period. 

 

Mr. Leland received a $120,000 award of restricted stock for fiscal 2014.  This award represented 60% of his incentive compensation that exceeded the $150,000 paid in cash. The 2014 restricted stock award for Mr. Leland is scheduled to vest over a three year period. 

 

Mr. Litton received a $385,983 award of restricted stock for fiscal 2014.  This award represented 60% of his incentive compensation that exceeded the $150,000 paid in cash. The 2014 restricted stock award for Mr. Litton is scheduled to vest over a three year period. 

 

For information about the treatment of these restricted stock awards in the proposed merger, see “-Proposed Merger with Hilltop” above. If the proposed merger does not close, these awards will vest according to the terms of the 2012 Restricted Stock Plan.

Explanation of Fluctuations in NEO Compensation from Fiscal 2013 to Fiscal 2014

 

Mr. Ross’ total compensation as shown in the Summary Compensation Table increased by $275,200 from fiscal 2013 to fiscal 2014.  The increase was due to a $50,000 increase in the value of stock awards and a $225,000 increase in the cash incentive portion of his fiscal 2014 bonus that Mr. Ross received at the discretion of the Committee.  Mr. Ross did not receive a cash bonus for fiscal 2013.

 

Mr. Edge’s total compensation as shown in the Summary Compensation Table increased by approximately $242,500 from fiscal 2013 to fiscal 2014.  The increase in compensation was primarily due to Mr. Edge being appointed interim CFO as of October 1, 2013.  

 

Mr. Chereck’s total compensation as shown in the Summary Compensation Table decreased by approximately $44,000 from fiscal 2013 to fiscal 2014.  The decrease in compensation was primarily due to an approximately $20,000 decrease in his cash incentive award and because he did not receive a stock award in fiscal 2014.  These decreases were due to the Bank’s actual profits being lower than the fiscal 2014 Budget.

 

Mr. Leland’s total compensation as shown in the Summary Compensation Table decreased by $139,800 from fiscal 2013 to fiscal 2014.  The decrease was due primarily to a $56,000 decrease in his cash incentive compensation and an $84,000 decrease in the value of his stock awards due to decreases in the pre-tax income of his business units as compared to the Budget.

 

Mr. Litton’s total compensation as shown in the Summary Compensation Table increased by approximately $443,500 from fiscal 2013 to fiscal 2014.  The increase was due primarily to an approximately $177,300 increase in his cash incentive compensation and an approximately $266,000 increase in the value of his stock awards due to increases in the pre-tax income of his business unit as compared to the Budget.  

 

Chief Executive Officer’s Compensation

 

In keeping with our general compensation philosophy, our CEO’s base salary was established to place emphasis on incentive compensation while remaining competitive with others in our industry.  The Committee reviewed measures of individual performance to determine the cash incentive award portion of the CEO’s annual compensation.  Our CEO participates in the same profit sharing plan as the other executive officers and employees.  In determining Mr. Ross’ fiscal 2014 compensation, the Committee considered Mr. Ross’ performance, his compensation history and other subjective factors in light of our financial results over the last completed fiscal year.  The Committee believes that Mr. Ross’ fiscal 2014 total compensation package was commensurate with the compensation paid to the chief executive officers of corporations in similar lines of business after adjustment to compensate for differences in the size, business mix and geographic area of the companies reviewed.

 

Employment Agreements

 

Historically, we have not entered into employment agreements with our executive officers. However, the Committee may enter into an employment agreement if the Committee determines that an employment agreement is necessary and appropriate to attract an executive based on company needs and/or it determines that an employment agreement is desirable for the company to obtain a measure of assurance as to the executive’s continued employment. 

 

As of June 30, 2014, we did not have any employment or other agreements to provide severance protection to any NEO.  All of the long-term compensation plans provide for payment or vesting due to scenarios such as a change of control of the company.  Accordingly, had the CEO or any other NEO terminated his or her employment for any reason as of June 30, 2014 and

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in the absence of a change of control of the company as of such date, any severance payments or other benefits would have been at the discretion of the Committee.

 

Under the Merger Agreement, our executive officers and other employees are entitled to cash severance in accordance with the company’s severance practice on specified terminations of employment following the effective time of the merger. In addition, following the end of fiscal 2014, as permitted under the terms of the Merger Agreement, the company entered into agreements with certain executive officers and other employees that provide for retention and severance payments. For more information about these severance and retention arrangements, see “-Proposed Merger with Hilltop” above and “The Merger – Interests of SWS Directors and Executive Officers in the Merger – Severance and Retention Payments” in the Form S-4/A.

 

Tax Considerations

 

Section 162(m) of the Internal Revenue Code of 1986, as amended, limits our ability to deduct the cost of certain annual compensation in excess of $1,000,000 paid to individuals required to be named in the Summary Compensation Table.  This limitation did not allow the company to deduct approximately $1,019,000 in its 2013 federal income tax return that was filed in September 2014.  However, the Committee believes it is important to balance the effectiveness of executive compensation plans with the materiality of potentially reduced tax deductions.  Accordingly, the Committee may continue to authorize payments that may not be fully deductible if the Committee believes it is in our best interests to do so.  

Summary Compensation Table

 

The following table sets forth information concerning compensation earned by our NEOs during the fiscal years ended June 30, 2014, June 30, 2013, and June 29, 2012.

 

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____________________

(*)Ms. Hodges resigned from her positions with the company on September 30, 2013, at which time, Mr. Edge was appointed as interim CFO, effective October 1, 2013.   

(#)As a result of Mr. Edge’s appointment as interim CFO, his annual base salary was increased to $360,000 per year, effective as of the date of appointment.

 

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Grants of Plan-Based Awards in Fiscal Year 2014

 

The following table summarizes all grants of plan-based awards made to our NEOs in fiscal 2014. 

 

____________________

 

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Outstanding Equity Awards at Fiscal Year-End

The following table summarizes all outstanding equity awards held by our NEOs as of June 30, 2014:

 

 

____________________

 

Stock Vested

The following table summarizes all shares held by our NEOs that vested in fiscal 2014.

 

____________________

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Nonqualified Deferred Compensation

The following table summarizes changes to the Deferred Compensation Plan for our NEOs for fiscal 2014.  For a description of the material terms of the Deferred Compensation Plan, see “-Deferred Compensation Plan” above.  At June 30, 2014, only Messrs. Edge and Litton held deferred shares of the Company’s common stock under the Deferred Compensation Plan.  For a description of how these deferred shares will be treated in the proposed merger, see “-Proposed Merger with Hilltop-Deferred Shares” above. 

 

 

Potential Payments upon Termination or Change of Control

 

At June 30, 2014, we did not have separate change of control or severance agreements with any NEO.  However, certain of our compensation plans have provisions that are triggered by a change of control or termination of a NEO, and under the Merger Agreement, our NEOs and other employees are entitled to cash severance in accordance with the company’s severance practice on specified terminations of employment following the effective time of the merger. In addition, following the end of fiscal 2014, as permitted under the terms of the Merger Agreement, the company entered into agreements with certain executive officers and other employees that provide for retention and severance payments.

 

Under the Deferred Compensation Plan, upon termination of a NEO’s employment, the vested account balance of the deferred compensation will be paid as a termination benefit.  Upon a change of control, the NEO may receive a change of control benefit equal to the NEO’s vested account balance or have the account balance remain subject to the terms and conditions of the plan, depending on the election of the NEO at the time the NEO began participating in the plan.  The payment of this benefit will not result in additional compensation expense to the company.

 

Under the 2012 Restricted Stock Plan and the 2003 Restricted Stock Plan, which expired on August 21, 2013, but for which restricted shares are still outstanding, termination of an employee’s service under the plan (including, but not limited to, voluntary resignation or termination with or without cause) before the restricted shares vest will result in the forfeiture of any unvested shares. However, in the event of a change of control, as defined by the applicable plan, or the death of an NEO (if set forth in the applicable award agreement), all outstanding awards granted prior to the date of the Merger Agreement will automatically vest. For a description of the treatment of restricted stock awards granted after the date of the Merger Agreement, see “-Proposed Merger with Hilltop-Restricted Shares (Post-Merger Agreement Grants)” above.

 

For the restricted shares granted on February 2, 2012 under the 2003 Restricted Stock Plan, termination of an employee’s service under the plan (including, but not limited to, voluntary resignation or termination with or without cause) before the restricted shares become vested will result in the forfeiture of any unvested shares. However, in the event of a change of control, as defined by the plan and set forth in the award agreement,  all outstanding awards will automatically vest.  In the event of the death of an NEO during the following timeframes, the restricted shares shall vest as follows:

 

 

   Under the Deferred Compensation Plan and the 2012 Restricted Stock Plan, a change of control is generally defined as: (1) any consolidation, merger or share exchange of the company in which the company is not the continuing or surviving corporation; (2) any sale, lease, exchange or other transfer of all or substantially all of the assets of the company; (3) the stockholders of the company approve any plan or proposal for the liquidation or dissolution of the company; (4) the cessation of control (by virtue of their not constituting a majority of directors) of the BOD, subject to certain conditions; (5) the acquisition of beneficial ownership (within the meaning of Rule 13d‑3 under the Exchange Act) of an aggregate of 20% of the voting power of

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the company’s outstanding voting securities; or (6) in the case of the 2012 Restricted Stock Plan, a Title 11 bankruptcy proceeding, the appointment of a trustee or the conversion of a case involving the company to a case under Chapter 7. The closing of the proposed merger pursuant to the Merger Agreement would constitute a change of control for purposes of these plans.

 

The table below represents the number of shares and the market value of those shares that would have vested had a change of control occurred, or had the NEOs died, as of June 30, 2014 using the closing market price of our common stock on the NYSE on June 30, 2014, which was $7.28 per share. For further details regarding the compensation that our NEOs are eligible to receive in connection with the proposed merger, including the treatment of their equity awards, see “-Proposed Merger with Hilltop” above and “The Merger – Interests of SWS Directors and Executive Officers in the Merger” in the Form S-4/A.

 

 

Ms. Hodges did not receive any termination-related payments or benefits upon her resignation on September 30, 2013.  However, as noted in the “-Nonqualified Deferred Compensation” table above, the $205,273 balance of her account under the Deferred Compensation Plan was distributed to her in accordance with the terms of the plan. 

     

COMPENSATION OF NON-EMPLOYEE DIRECTORS

Members of the BOD who are non-employee directors receive an annual retainer of $35,000 paid on a quarterly basis and $1,000 for attendance at each committee meeting.  The committee chairmen receive $2,000 per committee meeting.  The non-employee directors are also eligible to participate in the 2012 Restricted Stock Plan.  On November 14, 2013, each non-employee director received a grant of 5,963 restricted shares, which had a value of $5.87 per share based on the closing price of our common stock on the date of the grant. 

 

In addition to the normal BOD and committee compensation, the Special Committee was formed to (i) determine and recommend to the BOD whether a potential transaction was advisable,  fair and in the best interests of the company’s stockholders and (ii) retain and compensate advisors to the Special Committee.  Members of the Special Committee are independent directors who are not affiliated with either Oak Hill or Hilltop and consist of Messrs. Buchholz, Miller and Williams.  For their service on the Special Committee, Mr. Miller received a one-time retainer fee of $45,000 as Chairman of the Special Committee, and Messrs. Buchholz and Williams each received a one-time retainer fee of $35,000. Members of the Special Committee also received a fee of $2,500 for attendance at each Special Committee meeting.  These amounts are reflected in the totals below.

 

For details regarding the treatment of equity awards held by our directors in connection with the proposed merger under the Merger Agreement, see “-Proposed Merger with Hilltop” above and “Summary–Interests of SWS Directors and Executive Officers in the Merger” in the Form S-4/A.

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Director Compensation Table

 

The following table shows the overall compensation earned for fiscal 2014 by each of our non-employee directors.

 

Director Compensation for Fiscal Year 2014

 

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Outstanding Equity Awards at Fiscal Year-End

 

As of June 30, 2014, the directors had the following outstanding unvested restricted shares:

 

 

 

_________                                

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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS

The following table sets forth information concerning the beneficial ownership of our common stock as of August 30, 2014, by each person who is known to us to beneficially own more than 5% of our common stock, each of our directors and NEOs, and all of our directors and executive officers as a group.    Unless otherwise indicated, the address of each officer and director is 1201 Elm Street, Suite 3500, Dallas, Texas  75270.

 

_________

(*)Denotes less than 1% ownership.

 

 

 

 

 

 

 

The Credit Fund is the beneficial owner of 571,712 shares of common stock that it holds directly. NexPoint, as the investment advisor to the Credit Fund, and NexPoint GP, as the general partner of NexPoint, may be deemed the beneficial owners of the 571,712 shares of common stock held by the Credit Fund. The Select Fund is the beneficial owner of 1,993,074 shares of common stock that it holds directly. Select GP, as the general partner of the Select Fund, Select LLC, as the general partner of Select GP, Highland Capital, as the general partner of Select LLC, and Strand, as the general partner of Highland Capital, may be deemed the beneficial owners of the 1,993,074 shares of common stock held by the Select Fund. Mr. Dondero may be deemed the beneficial owner of the 2,564,786 shares of common stock held by the Funds. The Credit Fund, NexPoint and NexPoint GP may be deemed the beneficial owners of 1.7% of the outstanding shares of common stock held by the Credit Fund. The Select Fund, Select GP, Select LLC, Highland Capital and Strand may be deemed the beneficial owners of 6.0% of the outstanding shares of common stock held by the Select Fund. Mr. Dondero may be deemed the beneficial owner of 7.7% of the outstanding shares of common stock held by the Funds.  The Credit Fund has the sole power to vote and dispose of the 571,712 shares of common stock that it holds directly. NexPoint and NexPoint GP have the shared power to vote and dispose of the 571,712 shares of common stock held by the Credit Fund. The Select Fund has the sole power to vote and dispose of the 1,993,074 shares of common stock that it holds directly. Select GP, Select LLC, Highland Capital and Strand have the shared

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power to vote and dispose of the 1,993,074 shares of common stock held by the Select Fund. Mr. Dondero has the shared power to vote and dispose of the 2,564,786 shares of common stock held by the Funds.

 

 

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

Certain Relationships and Related Persons Transactions with Related Persons

 

To the extent permitted by the Sarbanes-Oxley Act of 2002, as amended, directors and executive officers of the company and their associates, including family members, from time to time may be or may have been indebted to the company or its subsidiaries under lending arrangements offered by those companies to the public. For example, such persons may be or may have been indebted to Southwest Securities or the Bank, as customers, in connection with margin account loans, revolving lines of credit and other extensions of credit. Such indebtedness is extended in the ordinary course of business, is on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated third parties who are not employees of the company and does not involve a more than normal risk of collectability or present other unfavorable features. 

 

On July 29, 2011, we entered into the Credit Agreement with the Investors that provides for a five-year unsecured term loan of $100.0 million in the aggregate.  Interest accrues on the term loan at 8% per year and may be prepaid (in whole or in part) under certain circumstances after three years.  During fiscal 2014, we paid each of Hilltop and Oak Hill a total of $4.0 million in interest on the outstanding indebtedness under the Credit Agreement.

 

In connection with the Credit Agreement, on July 29, 2011, the company issued a warrant to Hilltop to purchase up to 8,695,652 shares of common stock of the company, a warrant to OHCP to purchase up to 8,419,148 shares of the common stock of the company and a warrant to OHCMP to purchase up to 276,504 shares of common stock of the company (each, a “Warrant”).  For each of Hilltop and Oak Hill, the Warrants represent an approximately 17% equity interest in the company (assuming the Warrants are exercised in full).  The Warrants are exercisable for five years, but will expire to the extent that the company makes prepayments on the loans and the Investors do not promptly exercise a corresponding portion of the Warrants. 

 

On July 29, 2011, we also entered into an Investor Rights Agreement with the Investors to provide the Investors with certain preemptive and registration rights with respect to the common stock that may be issued upon the exercise of the Warrants or upon the conversion of the shares of Series A Preferred Stock if a holder exercises its Warrants for shares of Series A Preferred Stock instead of common stock.  Pursuant to the Investor Rights Agreement, each Investor will be granted the right to designate one representative to the BOD for so long as that Investor continues to beneficially own 9.9% or more of our outstanding common stock.  Our BOD elected Mr. Gerald J. Ford and Mr. J. Taylor Crandall as directors of the company, effective July 29, 2011, and each has subsequently been re-elected by the stockholders. 

 

In addition, under the Investor Rights Agreements each of Hilltop and Oak Hill have the right to appoint an observer to be invited to all BOD meetings for so long as that Investor continues to beneficially own 4.9% or more of the company’s outstanding common stock. Hilltop has appointed Mr. Jeremy Ford and Oak Hill has appointed Mr. Scott Kauffman as their respective observers, effective July 29, 2011. Each observer has entered into a Confidentiality Agreement with the company.

 

Mr. Gerald J. Ford has a 17.2% beneficial ownership in Hilltop and disclaims any beneficial ownership of the Warrant held by Hilltop, except to the extent of his pecuniary interest therein.   Mr. Jeremy Ford, President and Chief Executive Officer of Hilltop, is the son of Mr. Gerald J. Ford and a beneficiary of a trust that indirectly owns part of the 17.2% ownership in Hilltop.  Mr. Corey Prestidge is the General Counsel of Hilltop.  Mr. Prestidge’s wife, the daughter of Mr. Gerald J. Ford, is also a beneficiary of a trust that owns part of the 17.2% interest in Hilltop.  Also, Hilltop and the company have entered into the Merger Agreement and under the Merger Agreement, the company will be merged with and into Hilltop’s wholly owned subsidiary, Peruna.  Peruna will be the surviving entity in the merger.  In addition to the 8,695,652 shares of the company’s common stock issuable to Hilltop upon exercise of its Warrant, as of August 30, 2014, Hilltop held an additional 1,475,387 shares of the company’s common stock, equivalent to 4.4% of the outstanding shares of the company’s common stock or 24.3% of the outstanding shares of the company’s common stock if Hilltop’s Warrant was fully exercised.  At the closing of the proposed merger, if Hilltop’s Warrant to acquire common stock is outstanding, it will be cancelled.  Based on the company’s outstanding shares of common stock, equity awards and Warrants as of June 30, 2014, and assuming that, as of the closing of the proposed merger, all equity awards are vested and exercised and all Warrants are exercised, the preliminary estimated merger 

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consideration is approximately $366,563,000 of which approximately $74,639,000 represents Hilltop’s current investment in the company. 

 

Mr. J. Taylor Crandall is Managing Partner of OHCM (the investment advisor to OHCP and OHCMP).

 

During fiscal year 2014, Dr. Moses received $187,433 for finder’s fees and related expenses pursuant to the company’s referral fee program and $76,395 for office space and administrative services provided to Dr. Moses within the company's home office location.  Dr. Moses is paid a finder’s fee of 15% of the income the company earns for initiating contact between municipal officials and municipal securities representatives of Southwest Securities which result in municipal securities engagements.  He does not communicate, directly or indirectly, with public investors, structure offerings or negotiate terms.

 

Policies and Procedures with Respect to Related Person Transactions

 

The BOD recognizes that related person transactions can present a heightened risk of conflicts of interest.  Our written Related Party Transaction Policies and Procedures may be accessed on the corporate governance page of our website at www.swsgroupinc.com.  For purposes of SEC rules as well as our Related Party Transaction Policies and Procedures, a “related person transaction” is any transaction in which the company was, is or will be a participant and the amount involved exceeds $120,000 and in which any related person had, has or will have a direct or indirect material interest.  The term “related person” means:

 

The Audit Committee reviews relationships and transactions in which the company and a related person are participants to determine whether those persons have a direct or indirect material interest in such transactions.  The Audit Committee has determined that, barring additional facts or circumstances, a related person does not have a direct or indirect material interest in the following categories of transactions:

To identify potential related person transactions, under our policy, we request information from our directors and executive officers about related person transactions as defined above.  Where appropriate, we also ask that our directors seek pre-approval for related person transactions. We then review the information provided for any related person transactions. The Audit Committee reviews and approves or ratifies any related person transaction.  As required under SEC rules, transactions that are determined to be directly or indirectly material to the company or a related person will be disclosed in the company’s proxy statement or Annual Report on Form 10-K.  Any member of the Audit Committee who is a related person with respect to a transaction under review may not participate in the deliberations or voting for the approval or ratification of the transaction.

Director Independence and Related Matters

 

The BOD is comprised of a majority of directors who qualify as "independent," as defined in the listing standards of the NYSE.  In determining independence, the BOD affirmatively determines on an annual basis whether any director has a "material relationship" with the company that would impair the director's independence from management.  When assessing the "materiality" of a director's relationship with the company, the BOD considers all relevant facts and circumstances, not merely from the director's standpoint, but from that of the persons or organizations with which the director has an affiliation.   

The BOD has affirmatively determined that the following members of the BOD are "independent," as defined in the NYSE's listing standards and the rules of the SEC, and that no material relationship exists between the company and each listed director outside their service as a member of the BOD:  Brodie L. Cobb, J. Taylor Crandall, Christie S. Flanagan, Larry A. Jobe,

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Tyree B. Miller and Joel T. Williams III.   In making its determination, the BOD considered the transactions with certain related persons disclosed in the section titled “Certain Relationships and Related Transactions with Related Persons”.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Fees Paid to Independent Registered Public Accounting Firm

 

The following table presents fees for professional audit services performed by Grant Thornton LLP for the audit of our annual consolidated financial statements for the fiscal years ended June 30, 2014 and June 30, 2013 and fees billed for other services rendered by Grant Thornton LLP during those periods. 

 

 

 

_________________

 

Pre-Approval of Independent Accountants Services

 

Pursuant to the Audit Committee's charter, the Audit Committee pre-approves all auditing services and permitted non-audit services (including the fees and terms thereof) to be performed for the company by its independent accountants, subject to a de minimis exception for non-audit services, which are approved by the Audit Committee prior to the completion of the audit.

The Audit Committee may delegate authority to grant pre-approvals of audit and permitted non-audit services to a subcommittee, provided that decisions of such subcommittee to grant pre-approvals are presented to the full Audit Committee at its next scheduled meeting.

All services provided by and all fees paid to Grant Thornton LLP in fiscal 2014 and 2013 were approved by the Audit Committee in accordance with the Audit Committee's pre-approval policy.  None of the services provided in fiscal 2014 or 2013 were approved pursuant to the de minimis exception.

 

 

 

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PART IV

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

(a)List of documents filed as a part of this report:

1.The financial statements required to be filed with this report are listed in the index appearing on page F-1 of this report.

2.The following consolidated financial statement schedules of the Registrant and its subsidiaries, and the Reports of Independent Registered Public Accounting Firm thereon, are attached hereto:

 

 

 

All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable, and therefore have been omitted.

3.The following exhibits of the Registrant and its subsidiaries are attached hereto as required by Item 15(b): 

 

* Filed herewith

+ Management contract or compensatory plan or arrangement.

#   The certification attached as Exhibits 32.1 and 32.2 to this Annual Report on Form 10-K shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 (“the Exchange Act”), or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.