UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2010

 

Commission File No. 1-31753

CapitalSource Inc.

(Exact name of registrant as specified in its charter)

 

 

5404 Wisconsin Avenue, 2nd Floor
Chevy Chase, MD 20815
(Address of Principal Executive Offices, Including Zip Code)
(866) 695-3457

 

(Registrant’s Telephone Number, Including Area Code)
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.  þ Yes  o No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  o Yes  þ No

 

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.  þ Yes  o 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).  þ Yes  o No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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.  o

 

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):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  o Yes  þ No

 

The aggregate market value of the Registrant’s Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 2010 was $1,396,051,494.

 

As of February 24, 2011, the number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding was 323,346,948.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of CapitalSource Inc.’s Proxy Statement for the 2011 annual meeting of shareholders, a definitive copy of which will be filed with the SEC within 120 days after the end of the year covered by this Form 10-K, are incorporated by reference herein as portions of Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

 

This Form 10-K, including the footnotes to our audited consolidated financial statements included herein, contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to numerous assumptions, risks, and uncertainties, including certain plans, expectations, goals and projections and statements about our deposit base and capital ratios, our intention to originate loans at CapitalSource Bank, our portfolio runoff and growth, our expectations regarding future credit performance, our delinquent, non-accrual and impaired loans, charge offs, expected payments on securitized loans related to the maturities of the term debt securitizations, our liquidity and capital position, repayment of our indebtedness, our plans regarding the 3.5% and 4.0% Convertible Debentures, CapitalSource Bank’s capitalization and accessing of financing, expected prepayment speeds of and our intention to hold our investment securities, economic and market conditions for our business, our expectations regarding our application to become a bank holding company and convert CapitalSource Bank’s charter to a commercial charter, the performance of our loans, in particular our high balance loans, loan yields, the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) on our operations, the impact of accounting pronouncements, taxes and tax audits and examinations, our unfunded commitments, risk management, and our valuation allowance with respect to, and our realization and utilization of, net deferred tax assets, net operating loss carryforwards and built-in losses. All statements contained in this Form 10-K that are not clearly historical in nature are forward-looking, and the words “anticipate,” “assume,” “intend,” “believe,” “forecast,” “expect,” “estimate,” “plan,” “continue,” “will,” “should,” “look forward” and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: changes in economic or market conditions or investment or lending opportunities may result in increased credit losses and delinquencies in our portfolio; movements in interest rates and lending spreads may adversely affect our borrowing strategy and rate of growth; operating under the Dodd-Frank regulatory regime could be more costly and restrictive than expected; we may not be successful in maintaining or growing deposits or deploying capital in favorable lending transactions or originating or acquiring assets in accordance with our strategic plan; competitive and other market pressures including a significant decline in market interest spreads could adversely affect loan pricing; the nature, extent, and timing of any governmental and regulatory actions and reforms; the success and timing of other business strategies and asset sales; continued or worsening charge offs, reserves and delinquencies may adversely affect our earnings and financial results; we may not receive the regulatory approvals needed to become a bank holding company within our expected time frame or at all, changes in tax laws or regulations could adversely affect our business; hedging activities may result in reported losses not offset by gains reported in our audited consolidated financial statements; and other risk factors described in our audited consolidated financial statements, and other risk factors described in this Form 10-K and documents filed by us with the Securities and Exchange Commission (the “SEC”). All forward-looking statements included in this Form 10-K are based on information available at the time the statement is made.

 

We are under no obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

 

The information contained in this section should be read in conjunction with our audited consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A, Risk Factors.

 

Overview

 

References to we, us, the Company or CapitalSource refer to CapitalSource Inc. together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references and to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank.

 

We are a commercial lender that, primarily through our wholly owned subsidiary, CapitalSource Bank, provides financial products to small and middle market businesses nationwide and provides depository products and services in southern and central California. As of December 31, 2010, we had 1,401 loans outstanding, with an aggregate outstanding principal balance of $6.4 billion. Included in the loan portfolio are certain loans shared between CapitalSource Bank and the Parent Company.

 

For the year ended December 31, 2010, we operated as two reportable segments: 1) CapitalSource Bank and 2) Other Commercial Finance. For the years ended December 31, 2009 and 2008, we operated as three reportable segments: 1) CapitalSource Bank, 2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. Our Healthcare Net Lease segment comprised our direct real estate investment business activities, which we exited completely with the sale of the remaining assets related to this segment during the year ended December 31, 2010. We have reclassified all comparative period results to reflect our two current reportable segments. For additional information, see Note 24, Segment Data, in our audited consolidated financial statements for the year ended December 31, 2010.

 

Through our CapitalSource Bank segment activities, we provide a wide range of financial products primarily to small and middle market businesses throughout the United States and also offer depository products and services in southern and central California, which are insured by the Federal Deposit Insurance Corporation (“FDIC”) to the maximum amounts permitted by regulation. As of December 31, 2010, CapitalSource Bank had 1,031 loans outstanding, with an aggregate outstanding principal balance of $3.8 billion and deposits of $4.6 billion.

 

Through our Other Commercial Finance segment activities, the Parent Company provides financial products primarily to small and middle market businesses. Our activities in the Parent Company consist primarily of satisfying existing loan commitments made prior to CapitalSource Bank’s formation and receiving payments on that loan portfolio. As of December 31, 2010, our Other Commercial Finance segment had 400 loans outstanding, and the Parent Company held total loans having an aggregate outstanding principal balance of $2.6 billion.

 

As of December 31, 2010, our average loan size was $4.5 million, and our average loan exposure by client was $5.7 million. Our loans generally have a remaining maturity of one to five years with a weighted average remaining term to maturity of 3.6 years as of December 31, 2010. The majority of our loans require monthly interest payments at variable rates and, in many cases, our loans provide for interest rate floors that help us maintain our yields when interest rates are low or declining. We price our loans based upon the risk profile of our clients. As of December 31, 2010, our geographically diverse client base consisted of 1,115 clients with headquarters in 49 states, the District of Columbia, Puerto Rico and select international locations, primarily in Canada and Europe.

 

Developments During Fiscal Year 2010

 

During 2010, we further simplified our business and progressed in our transformation to a banking model by continuing to originate new loans in CapitalSource Bank, completely divesting the remaining assets in our Healthcare Net Lease segment, substantially eliminating our involvement in and exposure to our 2006-A term debt securitization (the “2006-A Trust”), which resulted in our deconsolidating the entity, broadening our lending platform, improving our Parent Company liquidity, repaying a significant portion of Parent Company indebtedness, strengthening our balance sheet and implementing our strategy to convert our bank’s industrial charter to a commercial charter.

Exit of Skilled Nursing Home Ownership Business

 

In June 2010, we completed the sale of our long-term healthcare facilities to Omega Healthcare Investors, Inc., and, as a result, we exited the skilled nursing home ownership business. Consequently, we have presented the financial condition and results of operations for this business as discontinued operations for all periods presented. Additionally, the results of the discontinued operations include the activities of other healthcare facilities that have been sold since the inception of the business.

 

Deconsolidation of the 2006-A Term Debt Securitization

 

In July 2010, we delegated certain of our collateral management and special servicing rights in our 2006-A Trust and sold our equity interest and certain notes issued by the 2006-A Trust for $7.0 million. In October 2010, we assigned our special servicing rights so that we are no longer the named special servicer of the 2006-A Trust. As a result of the delegation and sale transaction, we concluded that we were no longer the primary beneficiary and deconsolidated the 2006-A Trust, which resulted in the removal of all of its assets and liabilities, including $801.9 million of loans, net, $55.6 million of restricted cash and $891.3 million of term debt from our consolidated balance sheet. Consequently, comparisons made to our operating results for the year ended December 31, 2010 reflect the impact of this deconsolidation on certain categories of income and expense in our audited consolidated statements of operations, including interest income, interest expense and the provision for loan losses.

 

Bank Charter Conversion

 

We are pursuing our strategy of converting CapitalSource Bank to a commercial bank. Our current strategy for achieving this goal involves becoming a bank holding company under the Bank Holding Company Act of 1956. Subject to ongoing discussions with regulatory authorities, we expect to file an application to convert the existing industrial charter of CapitalSource Bank to a commercial charter and to file an application to become a bank holding company. This process is moving forward and we continue to expect it can be concluded during the second half of 2011. There is no assurance that any of the regulatory authorities will approve our applications.

 

Broadening of Our Lending Platform

 

In 2010, we added three new lending platforms to our product offerings: Small Business Lending, which provides loans to small businesses, including loans guaranteed by the Small Business Administration (“SBA”); Corporate Asset Finance, which provides loans to clients for use in purchasing and leasing equipment, machinery and other assets necessary for their operations; and Professional Practice Lending, which provides loans to professional practices including dentists, physicians, pharmacists and optometrists.

 

Share Repurchase Program

 

In December 2010, our Board of Directors authorized the repurchase of up to $150.0 million of our common stock over a period of up to two years. Any share repurchases made under the stock repurchase plan will be made through open market purchases or privately negotiated transactions. The amount and timing of any repurchases will depend upon market conditions and other factors and repurchases may be suspended or discontinued at any time. In December 2010, we repurchased 1,415,000 shares of our common stock under the share repurchase plan, at an average price of $7.01 per share for a total purchase price of $9.9 million. All shares repurchased under the share repurchase plan were retired upon settlement.

 

Improvement in Parent Company Liquidity

 

In 2010, we closed several transactions that strengthened our balance sheet and improved liquidity at the Parent Company. As of December 31, 2009, we had four secured credit facilities with aggregate commitments of $691.3 million and an aggregate outstanding principal balance of $542.8 million. As of December 31, 2010, we had four secured credit facilities with aggregate commitments of $167.5 million and an aggregate outstanding principal balance of $67.5 million. During the first quarter of 2011, we repaid and terminated all of the credit facilities with the exception of our syndicated bank facility, which had no outstanding balance as of December 31, 2010.

 

As of December 31, 2010, the Parent Company’s unrestricted cash and immediately available borrowing capacity was $466.9 million and $100.0 million, respectively, representing increases of $50.5 million and $15.7 million, respectively, from December 31, 2009.

 

Loan Products and Service Offerings

 

Senior Secured Loans

 

We make senior secured, asset-based, real estate and cash flow loans, which have a first priority lien in the collateral securing the loan. Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable, inventory and/or machinery. Real estate loans are secured by senior mortgages on real property. We make cash flow loans based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our cash flow loans generally are secured by a security interest in all or substantially all of a client’s assets.

 

Our lending activities are primarily focused on the following sectors:

 

 

Depository Products and Services

 

Through CapitalSource Bank’s 21 branches in southern and central California, we provide savings and money market accounts, individual retirement account products and certificates of deposit. These products are insured up to the maximum amounts permitted by the Federal Deposit Insurance Corporation (“FDIC”).

As of December 31, 2010, our portfolio of assets by type was as follows (percentages by gross carrying values):

 

Loan Products and Investments by Type

 

 

As of December 31, 2010, our loan portfolio by geographic region was as follows:

 

Loan Portfolio by Geographic Region(1)

 

 

 

 

CapitalSource Bank Segment Overview

 

As of December 31, 2010 and 2009, the CapitalSource Bank segment included:

 

 

 

 

Cash and Cash Equivalents

 

Cash and cash equivalents consist of amounts due from banks, U.S. Treasury securities, short-term investments and commercial paper with original maturity of three months or less. For additional information, see Note 4, Cash and Cash Equivalents and Restricted Cash, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

Investment Securities, Available-for-Sale

 

Investment securities, available-for-sale, consists of discount notes issued by Fannie Mae, Freddie Mac and the Federal Home Loan Bank (“FHLB”) (“Agency discount notes”), callable notes issued by Fannie Mae, Freddie Mac, the FHLB and Federal Farm Credit Bank (“Agency callable notes”), bonds issued by the FHLB (“Agency debt”), residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (“Agency MBS”), residential mortgage-backed securities rated AAA issued by non-government-agencies (“Non-agency MBS”), corporate debt securities and U.S. Treasury and agency securities. CapitalSource Bank pledged a significant portion of its investment securities, available-for-sale, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) and the Federal Reserve Bank (“FRB”) as a source of borrowing capacity as of December 31, 2010. For additional information on our investment securities, available-for-sale, see Note 6, Investments, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

Investment Securities, Held-to-Maturity

 

Investment securities, held-to-maturity, consists of commercial mortgage-backed securities rated AAA. For additional information on our investment securities, held-to-maturity, see Note 6, Investments, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

Commercial Real Estate “A” Participation Interest

 

The “A” Participation Interest, representing our share in a pool of commercial real estate loans and related assets, was fully repaid during the fourth quarter of 2010. For additional information on the “A” Participation Interest, see Note 5, Commercial Lending Assets and Credit Quality, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

CapitalSource Bank Segment Loan Portfolio Composition

 

Total CapitalSource Bank loan portfolio reflected in the portfolio statistics below includes loans held for sale of $14.2 million as of December 31, 2010. CapitalSource Bank did not have loans held for sale as of December 31, 2009.

 

As of December 31, 2010 and 2009, the composition of the CapitalSource Bank loan portfolio by loan type was as follows:

 

 

 

 

The CapitalSource Bank loan portfolio has original maturities ranging from three to eight years. As of December 31, 2010, the weighted average original term to maturity and weighted average remaining term of our CapitalSource Bank loan portfolio were approximately 6.5 years and 4.5 years, respectively. As of December 31, 2010, the weighted average remaining lives of the CapitalSource Bank loan portfolio by loan type were as follows:

 

 

 

 

As of December 31, 2010, approximately 68% of the adjustable rate portfolio comprised loans that are subject to an interest rate floor and are accruing interest. Due to low market interest rates as of December 31, 2010, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 1.91% as of December 31, 2010. To the extent the underlying indices subsequently increase, CapitalSource Bank’s interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.

As of December 31, 2010, the composition of CapitalSource Bank loan balances by index and by loan type was as follows:

 

 

 

 

As of December 31, 2010, our CapitalSource Bank loan portfolio by industry was as follows (percentages by gross carrying values as of December 31, 2010):

 

CapitalSource Bank Loan Portfolio by Industry

 

As of December 31, 2010, CapitalSource Bank’s largest loan had an outstanding balance of $129.2 million. As of December 31, 2010, our CapitalSource Bank commercial loan portfolio by loan balance was as follows:

 

CapitalSource Bank Loan Portfolio by Loan Balance

 

 

As of December 31, 2010, the number of loans, average loan size, number of clients and average loan size per client by loan type for CapitalSource Bank were as follows:

 

 

 

 

FHLB SF Stock

 

Investments in FHLB SF stock are recorded at historical cost. FHLB SF stock does not have a readily determinable fair value, but can generally be sold back to the FHLB SF at par value upon stated notice. The investment in FHLB SF stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB and its overall financial condition. No impairment losses have been recorded through December 31, 2010.

Deposits

 

As of December 31, 2010 and 2009, a summary of CapitalSource Bank’s deposit portfolio by product type and the maturities of the certificates of deposit portfolio were as follows:

 

 

 

FHLB SF Borrowings

 

FHLB SF borrowings increased to $412.0 million as of December 31, 2010 from $200.0 million as of December 31, 2009. These borrowings were used primarily for interest rate risk management and short-term funding purposes. The weighted average remaining maturities of the borrowings were approximately 2.3 years and 1.9 years as of December 31, 2010 and 2009, respectively.

 

As of December 31, 2010, the remaining maturity and the weighted average interest rate of FHLB SF borrowings were as follows:

 

Other Commercial Finance Segment Overview

 

As of December 31, 2010 and 2009, the Other Commercial Finance segment included:

 

 

 

 

Other Commercial Finance Segment Loan Portfolio Composition

 

Total Other Commercial Finance loan portfolio reflected in the portfolio statistics below includes loans held for sale of $191.1 million and $0.7 million as of December 31, 2010 and 2009, respectively.

 

As of December 31, 2010 and 2009, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:

 

 

 

 

Our loans generally have original maturities ranging from three to ten years. As of December 31, 2010, the weighted average term to maturity and weighted average remaining term of our Other Commercial Finance loan portfolio were approximately 6.5 years and 2.3 years, respectively. As of December 31, 2010, the weighted average remaining lives of the Other Commercial Finance loan portfolio by loan type were as follows:

 

 

 

 

As of December 31, 2010, approximately 45% of the adjustable rate loan portfolio comprised loans that are subject to an interest rate floor and are accruing interest. Due to low market interest rates as of December 31, 2010,

substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 2.34% as of December 31, 2010. To the extent the underlying indices subsequently increase, the interest yield on these adjustable rate loans will not rise as quickly due to the effect of the interest rate floors.

 

As of December 31, 2010, the composition of Other Commercial Finance loan balances by index and by loan type was as follows:

 

 

 

 

As of December 31, 2010, our Other Commercial Finance loan portfolio by industry was as follows (percentages by gross carrying values as of December 31, 2010):

 

Other Commercial Finance Loan Portfolio by Industry

 

 

As of December 31, 2010, the largest commercial loan in our Other Commercial Finance segment had an outstanding balance of $325.0 million and is a mezzanine loan to a borrower that owns, operates, leases or manages 211 skilled nursing facilities, 24 assisted living facilities and three transition care units in 13 states. As of December 31, 2010, our Other Commercial Finance loan portfolio by loan balance was as follows:

 

Other Commercial Finance Loan Portfolio by Loan Balance

 

As of December 31, 2010, our Other Commercial Finance loan portfolio by geographic region was as follows:

 

Other Commercial Finance Loan Portfolio by Geographic Region(1)

 

 

 

 

As of December 31, 2010, the number of loans, average loan size, number of clients and average loan size per client by loan type were as follows:

 

 

 

 

Other Investments

 

The Parent Company has made investments in some of our borrowers in connection with the loans provided to them. These investments usually comprised equity interests such as common stock, preferred stock, limited liability company interests, limited partnership interests and warrants.

 

Investment Securities, Available-for-sale

 

Investment securities, available-for-sale consist of corporate debt, equity securities and our interests in the 2006-A Trust.

Enterprise Risk Management

 

We take an enterprise-wide approach to risk management designed to support our organizational and strategic objectives and to enhance shareholder value. Global risk oversight is conducted by senior management and overseen by the Board of Directors. As part of its oversight responsibilities, the Board monitors how management operates the Company and manages strategic, credit, liquidity, financial, market, regulatory/compliance, legal, fraud, reputation, compensation, and operational risks. The involvement of the full Board in setting our business strategy is a fundamental part of its assessment and establishment of appropriate risk tolerances for the Company.

 

Board Level Risk Oversight

 

While the full Board of Directors is responsible for risk oversight, committees of the Board provide direct oversight of risks arising from specific activities. The Audit Committee oversees financial and accounting risk, including internal controls, and operational and regulatory risk. The Audit Committee receives periodic risk assessment reports from our internal audit department assessing the primary accounting and financial risks facing CapitalSource and management’s considerations for mitigating these risks. The Audit Committee also assesses the guidelines and policies that govern the processes for identifying and assessing significant financial and accounting risks and formulating and implementing steps to minimize such risks and exposures. The Audit Committee considers risks in the financial reporting and disclosure process and review policies on financial risk control assessment and accounting risk exposure. The Audit Committee meets with management, including our Co-Chief Executive Officers, Chief Financial Officer, our internal audit department, auditors and our independent registered public accounting firm in executive sessions at least quarterly, and with our General Counsel as necessary from time to time.

 

The Audit Committee also supervises the internal audit function, which provides the Audit Committee with periodic assessments of our risk management processes and internal quality-control procedures. The Audit Committee periodically reviews our internal audit department, including its independence and reporting authority and obligations and the development and coordination of proposed audit plans for coming years. The Audit Committee receives notification of material adverse findings from internal audits and a progress report at least quarterly on the proposed internal audit plan, as appropriate, with explanations for changes from the original plan. The Audit Committee reviews with management and the independent audit department the adequacy of our internal control structure and procedures for financial reporting and the resolution of any identified material weaknesses or significant deficiencies in such internal control structure and procedures.

 

The Asset, Liability and Credit Policy (“ALCP”) Committee meets periodically but no less frequently than quarterly and assists the Board in overseeing and reviewing our asset, liability and credit risk management and strategies, including the significant policies, procedures and practices employed to manage these risks. The ALCP Committee periodically reviews our liquidity and cash management, the quality of our loan portfolio, and our credit practices, policies and procedures. The ALCP Committee also reviews information regarding problem assets and portfolio concentrations and trends.

 

The Compensation Committee provides oversight with respect to compensation-related risks and strives to ensure that the Company’s incentive and other compensation policies and practices are consistent with the Company’s business strategies and in compliance with applicable laws and regulatory guidance. Management regularly assesses our compensation policies and practices to identify and mitigate compensation-related risks as appropriate.

 

Management Level Risk Oversight

 

While the Board has ultimate oversight responsibility for our risk management, we have utilized management level committees to actively assess and manage risks across the Company. As of February 2011, our Board of Directors established a formal enterprise-wide management level Enterprise Risk Management (“ERM”) infrastructure that aligns with bank regulatory guidance. The ERM infrastructure is governed by a Board approved ERM Policy and administered by a management ERM Committee (“ERMC”) chaired by our Chief Compliance Officer. The ERMC comprises executive and senior level management and reports to the Board on enterprise-wide risks and risk management. The ERMC is responsible for implementing risk identification, assessment and monitoring systems, where applicable, and has oversight responsibility for the processes that identify, measure, mitigate and

report on the Company’s risk categories, including strategic, credit, liquidity, financial, market, regulatory compliance, legal, fraud, reputation, compensation and operational risks.

 

Financing

 

We depend on depository and external financing sources to fund our operations. We employ a variety of financing arrangements, including deposits, secured credit facilities, term debt, convertible debt, subordinated debt and equity. As a member of the FHLB SF, one of 12 regional banks in the FHLB system, CapitalSource Bank had financing availability with the FHLB SF as of December 31, 2010 equal to 20% of CapitalSource Bank’s total assets.

 

Competition

 

Our markets are competitive and characterized by varying competitive factors. We compete with a large number of financial services companies, including:

 

 

Some of our competitors have substantial market positions. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors also have access to a lower cost of capital. We believe we compete based on:

 

 

Supervision and Regulation

 

Our bank operations are subject to regulation by federal and state regulatory agencies. This regulation is intended primarily for the protection of depositors and the deposit insurance fund, and secondarily for the stability of the U.S. banking system. It is not intended for the benefit of stockholders of financial institutions. CapitalSource Bank is a California industrial bank and is subject to supervision and regular examination by the FDIC and the California Department of Financial Institutions (“DFI”). CapitalSource Bank’s deposits are insured up to the maximum amounts permitted by regulation.

 

Although the Parent Company is not directly regulated or supervised by the DFI, the FDIC, the Federal Reserve Board or any other federal or state bank regulatory authority either as a bank holding company or otherwise, the FDIC has authority pursuant to arrangements with the Parent Company and CapitalSource Bank to examine the Parent Company and its relationship and transactions between it and CapitalSource Bank and the effect of such relationships and transactions on CapitalSource Bank. The Parent Company also is subject to regulation by other applicable federal and state agencies, such as the SEC. We are required to file periodic reports with these regulators and provide any additional information that they may require.

 

The following summary describes some of the more significant laws, regulations, and policies that affect our operations; it is not intended to be a complete listing of all laws that apply to us. From time to time, federal, state and foreign legislation is enacted and regulations are adopted which may have the effect of materially increasing the

cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. We cannot predict whether or when potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.

 

General

 

CapitalSource Bank must file reports with the DFI and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to changing its approved business plan or entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. CapitalSource Bank will complete its initial three year de novo period in July 2011. It is our expectation that upon completion of the initial three year de novo time period, both CapitalSource Bank and the Parent Company will cease being subject to the various conditions contained in the FDIC Order granting deposit insurance and the DFI Order establishing CapitalSource Bank as is customarily the case for de novo banks upon reaching their three-year anniversary date. Notwithstanding the termination of any such conditions, we will remain subject to bank safety and soundness requirements as well as to various regulatory capital requirements established by federal and state regulatory agencies, including any new conditions that our regulators may determine.

 

Under current FDIC guidance CapitalSource Bank is required to file a revised business plan for years four to seven of an expanded de novo period. During this expanded time period, CapitalSource Bank may be subject to increased supervision than would otherwise be applicable to a bank that has been in existence longer than three years, including enhanced FDIC supervision for compliance examinations and Community Reinvestment Act evaluations. There are periodic examinations by the DFI and the FDIC to evaluate CapitalSource Bank’s safety and soundness and compliance with various regulatory requirements. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the credit classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the regulators or Congress, could have a material adverse impact on our operations.

 

The FDIC and DFI have enforcement authority over our operations, which includes, among other things, the ability to assess civil money penalties, issue cease-and-desist or removal orders and initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inaction may provide the basis for enforcement action, including misleading or untimely reports filed with the FDIC or DFI. Except under certain circumstances, public disclosure of final enforcement actions by the FDIC or DFI is required.

 

In addition, the investment, lending and branching authority of CapitalSource Bank is prescribed by state and federal laws and CapitalSource Bank is prohibited from engaging in any activities not permitted by these laws.

 

California law provides that industrial banks are generally subject to a limit on loans to one borrower. An industrial bank based in California may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily marketable collateral. As of December 31, 2010, CapitalSource Bank’s limit on loans to one borrower was $157.4 million if unsecured and $262.4 million if secured by collateral.

 

The FDIC and DFI, as well as the other federal banking agencies, have adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan.

 

The Parent Company has entered into a supervisory agreement with the FDIC (the “Parent Agreement”) consenting to examination of the Parent Company by the FDIC to monitor compliance with the laws and regulations applicable to CapitalSource Bank and its affiliates. The Parent Company and CapitalSource Bank are parties to a Capital Maintenance and Liquidity Agreement (“CMLA”) with the FDIC providing that, to the extent CapitalSource Bank independently is unable to do so, the Parent Company must maintain CapitalSource Bank’s total risk-based capital ratio at not less than 15% and must maintain CapitalSource Bank’s total risk-based capital ratio at all

times to meet or exceed the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. Additionally, pursuant to requirements of the FDIC, the Parent Company has provided a $150.0 million unsecured revolving credit facility that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. The Parent Agreement also requires the Parent Company to maintain the capital levels of CapitalSource Bank at the levels required in the CMLA.

 

It is important to meet minimum capital requirements established by the FDIC and the DFI for CapitalSource Bank to avoid mandatory or additional discretionary actions initiated by these regulatory agencies. These potential actions could have a direct material effect on our audited consolidated financial statements. Based upon the regulatory framework, we must meet specific capital guidelines that involve quantitative measures of the banking assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts, the ability to pay dividends and other requirements and classifications are also subject to qualitative judgments by the regulators about risk weightings and other factors.

 

The international Basel Committee on Banking Supervision published the final text of Basel III on December 16, 2010, which introduces new minimum capital requirements, two liquidity ratios, a charge for credit value adjustment and a leverage ratio, among other things. The Basel III requirements will be implemented over an extended period of time. This time period will not commence and will have a minimal impact on us until such time as the U.S. banking regulators adopt the Basel III requirements. We will continue to monitor developments relating to Basel III adoption in the U.S. and its potential impact on our operations.

 

Federal Home Loan Bank System

 

CapitalSource Bank is a member of the FHLB SF. Among other benefits, each FHLB serves as a reserve or central bank for its members within its assigned region and makes available advances and loans to its members. Each FHLB is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. As a member, CapitalSource Bank is required to purchase and maintain stock in the FHLB SF. As of December 31, 2010, CapitalSource Bank had $19.4 million in FHLB SF stock, which was in compliance with this requirement. There can be no assurance that the FHLB SF will pay dividends at the same rate it has paid in the past, or that it will pay any dividends in the future.

 

Dodd-Frank Act

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), an initiative directed at the financial services industry, was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the “BCFP”), and will require the BCFP and other federal agencies, including the SEC, to undertake assessments and rulemaking. The majority of the provisions in the Dodd-Frank Act are aimed at financial institutions that are significantly larger than the Parent Company or CapitalSource Bank. Nonetheless, there are provisions with which we will have to comply both as a public company and a financial institution. At this time, it is difficult to predict the full extent to which the Dodd-Frank Act or the resulting regulations will impact our business and operations. As rules and regulations are promulgated by the federal agencies responsible for implementing and enforcing the provisions in the Dodd-Frank Act, we will need to apply adequate resources to ensure that we are in compliance with all applicable provisions. Compliance with these new laws and regulations may result in additional costs and may otherwise adversely impact our results of operations, financial condition or liquidity, any of which may impact our financial condition or results of operations.

 

A requirement of the Dodd-Frank Act is for the FDIC to set a designated minimum Deposit Insurance Fund (“DIF”) ratio of 1.35% for any year, compared to the current minimum DIF ratio of 1.15%, by September 30, 2020. The FDIC is also required to offset the effect that this DIF rate increase has on insured depository institutions (“IDI”) with total consolidated assets of less than $10.0 billion. The Dodd-Frank Act also provides that an IDI’s assessment base be changed from the IDI’s insured deposits to its average total consolidated assets minus average tangible equity during the assessment period.

In the fourth quarter of 2010, in response to the Dodd-Frank Act, the FDIC adopted a new Restoration Plan, which foregoes the FDIC’s previously announced assessment rate increase of three basis points previously scheduled to go into effect January 1, 2011, keeps the current assessment rate schedule in effect, and aims to bring the DIF ratio to 1.35% by September 20, 2020 as mandated by the Dodd-Frank Act. The FDIC will also release a new definition of the assessment base. The FDIC will pursue further rulemaking in 2011 to establish its methods for reaching the 1.35% DIF rate by the statutory deadline and the manner by which the DIF rate offset will take effect.

 

With the goals of maintaining a positive fund balance and steady, predictable assessment rates throughout economic and credit cycles, the FDIC also adopted a notice of proposed rulemaking to set the designated reserve ratio at 2.0% and to lower assessment rates when the reserve ratio reaches 1.15%. In addition, the FDIC would continue to adopt lower rate schedules in lieu of issuing dividends when the reserve ratio exceeds 2.0% and 2.5%.

 

The Dodd-Frank Act also established requirements for financial institutions with consolidated assets in excess of $1 billion to established risk based incentive compensation programs. Federal regulatory agencies are currently drafting rules to implement this component of the Dodd-Frank Act. We are monitoring the rulemaking process and reviewing current incentive compensation programs for compliance with and in preparation for future implementation of joint agency rules.

 

Insurance of Accounts and Regulation by the FDIC

 

CapitalSource Bank’s deposits are insured up to the maximum amounts permitted by the DIF of the FDIC, currently $250,000. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC insured institutions. It also may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against insured institutions.

 

On October 7, 2008, the FDIC established a Restoration Plan for the DIF to return the DIF to its statutorily mandated minimum reserve ratio of 1.15% within five years. In 2009, the Restoration Plan was amended to extend the restoration period to seven years and Congress subsequently amended the statute to allow the FDIC up to eight years to return the DIF reserve ratio to 1.15%, absent extraordinary circumstances. To meet this reserve ratio by the end of 2016, the FDIC amended its Restoration Plan and adopted a uniform 3 basis point increase in the initial assessment rates effective January 1, 2011.

 

The Dodd-Frank Act establishes a minimum designated reserve ratio (“DRR”) of 1.35% of estimated insured deposits, provides discretion to the FDIC to develop a new assessment base, mandates the FDIC adopt a restoration plan should the fund balance fall below 1.35%, and provides dividends to the industry should the fund balance exceed 1.50%. The Dodd-Frank Act requires the DRR to be achieved by September 30, 2020. On February 7, 2011, the FDIC adopted a final rule that revises the assessment base and assessment rate schedule effective April 1, 2011, and, in lieu of dividends, provides for reduced assessment rates once the DRR exceeds 2.00% and again at 2.50%. Assessments generally will be calculated using an insured depository institution’s average assets minus average tangible equity. The initial assessment rates range between 5 basis points for a low risk institution to 35 basis points for a high risk institution, with further rate adjustments for the level of unsecured debt and brokered deposits held by an institution.

 

A significant increase in FDIC assessment rates would have an adverse effect on the operating expenses and results of operations of CapitalSource Bank. There can be no prediction as to what assessment rates will be in the future. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the DFI.

 

Prompt Corrective Action

 

The FDIC and DFI are required to take certain supervisory actions against undercapitalized banks, the severity of which depends upon the institution’s degree of undercapitalization. Generally, an institution is considered to be “undercapitalized” if it has a core capital ratio of less than 4.0% (3.0% or less for institutions with the highest examination rating), a ratio of total capital to risk-weighted assets of less than 8.0%, or a ratio of Tier 1 capital to

risk-weighted assets of less than 4.0%. An institution that has a core capital ratio that is less than 3.0%, a total risk-based capital ratio less than 6.0%, and a Tier 1 risk-based capital ratio of less than 3.0% is considered to be “significantly undercapitalized” and an institution that has a tangible capital ratio equal to or less than 2.0% is deemed to be “critically undercapitalized.” Subject to a narrow exception, the FDIC or DFI is required to appoint a receiver or conservator for a bank that is “critically undercapitalized.” Regulations also require that a capital restoration plan be filed with the FDIC and DFI within 45 days of the date an institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. “Significantly undercapitalized” and “critically undercapitalized” institutions are subject to more extensive mandatory regulatory actions. The FDIC or DFI also could take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

 

The risk-based capital standard requires banks to maintain Tier 1 and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively, to be considered “adequately capitalized.” In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are assigned by a risk-weight factor of 0% to 100%, per regulation based on the risks believed inherent in the type of asset. Core capital is defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.

 

To remain in compliance with the conditions imposed by the FDIC, CapitalSource Bank is required to maintain a total risk-based capital ratio of not less than 15% and must at all times be “well-capitalized,” which requires CapitalSource Bank to have minimum total risk-based capital ratio of 15%, Tier 1 risk-based capital ratio of 6% and Tier 1 leverage ratio of 5%. Further, the DFI approval order requires that CapitalSource Bank, during the first three years of operations, maintain a minimum ratio of tangible shareholder’s equity to total tangible assets of 10.0%. As of December 31, 2010, CapitalSource Bank had Tier-1 leverage, Tier-1 risked-based capital and total risk based capital ratios of 13.15%, 16.86% and 18.13%, respectively, each in excess of the minimum percentage requirements for “well-capitalized” institutions. As of December 31, 2010, CapitalSource Bank satisfied the DFI capital ratio requirement with a ratio of 12.61%. For additional information, see Note 18, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

Limitations on Capital Distributions

 

FDIC and DFI regulations impose various restrictions on banks with respect to their ability to make distributions of capital, which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account. Generally, banks may make capital distributions during any calendar year up to 100% of net income for the year-to-date plus retained net income for the two preceding years if they are well-capitalized both before and after the proposed distribution. However, an institution deemed to be in need of more than normal supervision by the FDIC and DFI may have its dividend authority restricted by the regulating bodies. CapitalSource Bank is prohibited from paying dividends without consent from our regulators.

 

Transactions with Affiliates

 

CapitalSource Bank’s authority to engage in transactions with “affiliates” is limited by Sections 23A and 23B of the Federal Reserve Act as implemented by the Federal Reserve Board’s Regulation W. The term “affiliates” for these purposes generally means any company that controls or is under common control with an institution, and includes the Parent Company as it relates to CapitalSource Bank. In general, transactions with affiliates must be on terms that are as favorable to the institution as comparable transactions with non-affiliates. In addition, specified

types of transactions are restricted to an aggregate percentage of the institution’s capital. Collateral in specified amounts must be provided by affiliates to receive extensions of credit from an institution. Federally insured banks are subject, with certain exceptions, to restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these institutions are prohibited from engaging in specified tying arrangements in connection with any extension of credit or the providing of any property or service.

 

Community Reinvestment Act

 

Under the Community Reinvestment Act, every FDIC insured institution has a continuing and affirmative obligation consistent with safe and sound banking practices to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the FDIC, in connection with the examination of CapitalSource Bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications, such as a merger or the establishment of a branch, by CapitalSource Bank. The FDIC may use an unsatisfactory rating as the basis for the denial of an application. Due to the heightened attention being given to the Community Reinvestment Act in the past few years, CapitalSource Bank may be required to devote additional funds for investment and lending in its local community.

 

Regulatory and Criminal Enforcement Provisions

 

The FDIC and DFI have primary enforcement responsibility over CapitalSource Bank and have the authority to bring action against all “institution-affiliated parties,” including stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers or directors, receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or $1.1 million per day in especially egregious cases. The FDIC has the authority to take such action under certain circumstances. Federal law also establishes criminal penalties for specific violations.

 

Environmental Issues Associated with Real Estate Lending

 

The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), a federal statute, generally imposes strict liability on all prior and current “owners and operators” of sites containing hazardous waste. However, Congress acted to protect secured creditors by providing that the term “owner and operator” excludes a person whose ownership is limited to protecting its security interest in the site. Since the enactment of the CERCLA, this “secured creditor exemption” has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for clean-up costs on contaminated property that they hold as collateral for a loan. To the extent that legal uncertainty exists in this area, all creditors, including the Parent Company and CapitalSource Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property.

 

Privacy Standards

 

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (“GLBA”) modernized the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. CapitalSource Bank is subject to regulations implementing the privacy protection provisions of the GLBA. These regulations require CapitalSource Bank to disclose its privacy policy, including identifying with whom it shares “non-public personal information” to consumers at the time of establishing the customer relationship and annually thereafter. The State of California’s Financial Information Privacy Act provides greater protection for consumer’s rights under California Law to restrict affiliate data sharing.

Anti-Money Laundering and Customer Identification

 

As part of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”), Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLAFATA”). IMLAFATA amended the Bank Secrecy Act (“BSA”) and adopted additional measures that established or increased existing obligations of financial institutions, including CapitalSource Bank, to identify their customers, monitor and report suspicious transactions, respond to requests for information by federal banking regulatory authorities and law enforcement agencies, and, at the option of CapitalSource Bank, share information with other financial institutions. The U.S. Secretary of the Treasury has adopted several regulations to implement these provisions. Pursuant to these regulations, CapitalSource Bank is required to implement appropriate policies and procedures relating to anti-money laundering matters, including compliance with applicable regulations, suspicious activities, currency transaction reporting and customer due diligence. Our BSA compliance program is subject to federal regulatory review.

 

Other Laws and Regulations

 

We are subject to many other federal statutes and regulations, such as the Equal Credit Opportunity Act, the Truth in Savings Act, the Fair Credit Reporting Act, the Fair Housing Act, the National Flood Insurance Act and various federal and state privacy protection laws. These laws, rules and regulations, among other things, impose licensing obligations, limit the interest rates and fees that can be charged, mandate disclosures and notices to customers mandate the collection and reporting of certain data regarding customers, regulate marketing practices and require the safeguarding of non-public information of customers. Penalties for violating these laws could subject us to lawsuits and could also result in administrative penalties, including, fines and reimbursements. We are also subject to federal and state laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition.

 

In recent years, examination and enforcement by the state and federal banking agencies for non-compliance with the above-referenced laws and their implementing regulations have become more intense. Due to these heightened regulatory concerns, we may incur additional compliance costs or be required to expend additional funds for investments in our local community.

 

The federal government continues to evaluate possible new laws and regulations, which if enacted, could have a material impact on us, including among other things increased reporting obligations, restrictions on current lending activities, federal and state supervision and increased expenses to operate as a bank.

 

Regulation of Other Activities

 

Some other aspects of our operations are subject to supervision and regulation by governmental authorities and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things:

 

 

In addition, many of our healthcare clients receive significant funding from governmental sources and are subject to licensure, certification and other regulation and oversight under the applicable Medicare and Medicaid

programs. These regulations and governmental oversight, both on federal and state levels, indirectly affect our business in several ways as discussed below.

 

 

Employees

 

As of December 31, 2010, we employed 625 people, 329 of whom were employed by CapitalSource Bank. We believe that our relations with our employees are good.

Executive Officers

 

Our executive officers and their ages and positions are as follows:

 

 

 

Biographies for our executive officers are as follows:

 

John K. Delaney, 47, a founder of the Company, has served as our Executive Chairman since January 2010, as a director and Chairman of our Board since our inception in 2000, and as our Chief Executive Officer from our inception in 2000 until January 2010. Mr. Delaney received his undergraduate degree from Columbia University and his juris doctor degree from Georgetown University Law Center.

 

Steven A. Museles, 47, has served as a director and Co-Chief Executive Officer since January 2010. Mr. Museles previously served as our Executive Vice President, Chief Legal Officer and Secretary from our inception in 2000 until January 2010, and in similar capacities for CapitalSource Bank from July 2008 through December 2009. Mr. Museles received his undergraduate degree from the University of Virginia and his juris doctor degree from Georgetown University Law Center.

 

James J. Pieczynski, 48, has served as a director and Co-Chief Executive Officer since January 2010. Mr. Pieczynski previously served as our President — Healthcare Real Estate Business from November 2008 until January 2010, our Co-President — Healthcare and Specialty Finance from January 2006 until November 2008, Managing Director — Healthcare Real Estate Group from February 2005 through December 2005, and Director — Long Term Care from November 2001 through January 2005. Mr. Pieczynski served on the board of directors and audit committee of Florida East Coast Industries Inc. from June 2004 until June 2006. Mr. Pieczynski received his undergraduate degree from the University of Illinois, Urbana-Champaign.

 

Douglas H. (Tad) Lowrey, 58, has served as the Chief Executive Officer and President of CapitalSource Bank since its formation on July 25, 2008. Prior to his appointment, Mr. Lowrey served as Executive Vice President of Wedbush, Inc., a private investment firm and holding company, from January 2006 until June 2008. Mr. Lowrey served as Chairman, President and Chief Executive Officer of Jackson Federal Bank from 1999 until February 2005 following its sale to Union Bank of California. Mr. Lowrey is an elected director of the Federal Home Loan Bank of San Francisco. He received his undergraduate degree from Arkansas Tech University and was licensed in 1977 in the state of Arkansas as a certified public accountant.

 

Donald F. Cole, 40, has served as our Chief Financial Officer since May 2009. Mr. Cole previously served as our Chief Administrative Officer from September 2008 until May 2009, our interim Chief Accounting Officer from March 2008 until September 2008, our Chief Administrative Officer from January 2007 until March 2008, our Chief Operations Officer from February 2005 until January 2007, and our Chief Information Officer from July 2003 until February 2005. Mr. Cole received his undergraduate degree and masters of business administration from the State University of New York at Buffalo and a juris doctor degree from the University of Virginia School of Law. He was licensed in 1996 in the state of New York as a certified public accountant.

 

John A. Bogler, 45, has served as Chief Financial Officer of CapitalSource Bank since its formation on July 25, 2008. Prior to his appointment, Mr. Bogler served as Chief Financial Officer of Affinity Financial Corporation from January 2008 until July 2008. Mr. Bogler served as a financial consultant specializing in bank acquisition and de novo activities from February 2005 until January 2008 and was Chief Financial Officer at Jackson Federal Bank from April 2000 until February 2005. Mr. Bogler received his undergraduate degree from Missouri State University

in 1988, became a certified public accountant in the State of Missouri in 1991 and became a chartered financial analyst in 1998.

 

Bryan D. Smith, 40, has served as our Chief Accounting Officer since September 2008 and was appointed Senior Vice President and Chief Accounting Officer in May 2009. Previously, Mr. Smith worked as a consultant to us from June 2008 until his appointment as our Chief Accounting Officer in September 2008, and served as our Controller — Strategy Execution from January 2007 until May 2008, and our Controller from October 2003 until January 2007. Mr. Smith received his undergraduate degree from Virginia Tech in 1993 and was licensed in 1994 in the State of Maryland as a certified public accountant.

 

Other Information

 

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website at www.capitalsource.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission or by contacting CapitalSource Investor Relations, at (800) 695-3457 or investor.relations@capitalsource.com.

 

We also provide access on our website to our Principles of Corporate Governance, Code of Business Conduct and Ethics, the charters of our Audit, Compensation, Asset, Liability and Credit Policy and Nominating and Corporate Governance Committees and other corporate governance documents. Copies of these documents are available to any shareholder upon written request made to our corporate secretary at our Chevy Chase, Maryland address. In addition, we intend to disclose on our website any changes to or waivers for our executive officers or directors from, our Code of Business Conduct and Ethics.

 

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition or results of operations could suffer, and the trading price of our securities could decline. The U.S. economy is still in the process of recovering from an economic recession, and a slow recovery may adversely impact on our business and operations, including, without limitation, the credit quality of our loan portfolio, our liquidity and our earnings. You should know that many of the risks described may apply to more than just the subsection in which we grouped them for the purpose of this presentation. As a result, you should consider all of the following risks, together with all of the other information in this Annual Report on Form 10-K, before deciding to invest in our securities.

 

Risks Related to Our Lending Activities

 

Our results of operation and financial condition would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses.

 

Experience in the financial services industry indicates that a portion of our loans in all categories of our lending business will become delinquent or impaired, and some may only be partially repaid or may never be repaid at all. Our methodology for establishing the adequacy of the allowance for loan losses depends on subjective determinations and judgments about our borrowers’ ability to repay. Despite management’s efforts to estimate the specific allowance, ultimate resolutions of specific loans may result in actual losses that are greater than our allowance. Deterioration in general economic conditions and unforeseen risks affecting customers may have an adverse effect on our borrowers’ capacity to repay their obligations, whether our risk ratings or valuation analyses reflect those changing conditions. Changes in economic and market conditions may increase the risk that the allowance would become inadequate if borrowers experience economic and other conditions adverse to their businesses. Maintaining the adequacy of our allowance for loan losses may require that we make significant and unanticipated increases in our provisions for loan losses, which would materially affect our results of operations and capital adequacy. Recognizing that many of our loans individually represent a significant percentage of our total allowance for loan losses, adverse collection experience in a relatively small number of loans could require an increase in our allowance. Federal and State regulators, as an integral part of their respective supervisory functions, periodically review a portion of our loan portfolio. The regulatory agencies may require changes to credit ratings or grades on loans, which could lead to an increase in the allowance for loan losses, increased provisions for loan losses and as appropriate, recognition of further loan charge-offs based upon their judgments, which may be different from ours. Increases in the allowance for loan losses required by these regulatory agencies could have a negative effect on our results of operations and financial condition.

 

We may not recover all amounts that are contractually owed to us by our borrowers.

 

We expect to experience charge-offs and delinquencies on our loans in the future. In addition, like other commercial lenders, we have experienced missed and late payments, failures by clients to comply with operational and financial covenants in their loan agreements and client performance below that which we expected when we originated the loan. Most of our loans bear interest at variable interest rates. If interest rates increase, interest obligations of our clients may also increase. Some of our clients may not be able to make the increased interest payments, resulting in defaults on their loans. If we experience material losses on our portfolio, such losses would have a material adverse effect on our revenues, net income, results of operation and financial condition, to the extent the losses exceed our allowance for loan losses.

 

We may be unable to act in a timely fashion so as to prevent a loss of our loan to a client and we may make errors in evaluating information reported by our clients. As a result, we may suffer losses on loans or may make advances that we would not have made if we had properly evaluated the information.

 

Our clients may experience operational or financial problems that, if not timely addressed, could result in a substantial impairment or loss of the value of our loan to the client. We may fail to identify problems because our

client did not report them in a timely manner or, even if the client did report the problem, we may fail to address it quickly enough or at all. Even if clients provide us with full and accurate disclosure of all material information concerning their businesses, we may misinterpret or incorrectly analyze this information. Mistakes may cause us to make loans that we otherwise would not have made or, to fund advances that we otherwise would not have funded, or result in losses on one or more of our loans. As a result, we could suffer loan losses which could have a material adverse effect on our revenues, net income and results of operations and financial condition, to the extent the losses exceed our allowance for loan losses.

 

We make loans to privately owned small and medium-sized companies that present a greater risk of loss than loans to larger companies.

 

Our portfolio consists primarily of commercial loans to small and medium-sized, privately owned businesses. Compared to larger, publicly owned firms, these companies generally have limited access to capital and higher funding costs, may be in a weaker financial position and may need more capital to expand or compete. These financial challenges may make it difficult for our clients to make scheduled payments of interest or principal on our loans. Accordingly, loans made to these types of clients entail higher risks than loans made to companies that are able to access a broader array of credit sources.

 

In addition, there is generally no publicly available information about the small and medium-sized privately owned companies to which we lend. Therefore, we underwrite our loans based on detailed financial information and projections provided to us by our clients and we must rely on our clients and the due diligence efforts of our employees to obtain the information relevant to making our credit decisions. We rely upon the management of these companies to provide full and accurate disclosure of material information concerning their business, financial condition and prospects. We may not have access to all of the material information about a particular client’s business, financial condition and prospects, or a client’s accounting records may be poorly maintained or organized. The client’s business, financial condition and prospects may also change rapidly in the current economic environment. In such instances, we may not make a fully informed credit decision which may lead, ultimately, to a failure or inability to recover our loan in its entirety.

 

Some of our clients require licenses, permits and other governmental authorizations to operate their businesses, which may be revoked or modified by applicable governmental authorities. Any revocation or modification could have a material adverse effect on the business of a client and, consequently, the value of our loan to that client.

 

In addition to clients in the healthcare industry subject to Medicare and Medicaid regulation, clients in other industries require permits and licenses from various governmental authorities to operate their businesses. These governmental authorities may revoke or modify these licenses or permits if a client is found to be in violation of any regulation to which it is subject. In addition, these licenses may be subject to modification by order of governmental authorities or periodic renewal requirements or changes as a result of changes in the law. The loss of a permit or license, whether by termination, modification or failure to renew, could impair the client’s ability to operate its business, which could impair the client’s ability to generate cash flows necessary to service our loan or repay indebtedness upon maturity, either of which outcomes would reduce our revenues, cash flow and net income. See the Supervision and Regulation section of Item 1, Business, above for additional discussion of specific regulatory and governmental oversight applicable to many of our healthcare clients.

 

Our concentration of loans to a limited number of clients within a particular industry or region could impair our revenues if the industry or region were to experience economic difficulties or changes in the regulatory environment.

 

In our normal course of business, we engage in lending activities with clients primarily throughout the United States. As of December 31, 2010, the single largest industry concentration was healthcare and social assistance, which made up approximately 22% of our loan portfolio. As of December 31, 2010, taken in the aggregate, non-healthcare real estate loans made up approximately 24% of our loan portfolio. As of December 31, 2010, the two largest geographical concentrations were Florida and California, which each making up approximately 10% of our loan portfolio. As of December 31, 2010, $931.9 million, or 15%, of our portfolio consisted of

loans to four clients with aggregate loan balances that are individually greater than $100.0 million. Of this amount, loans to one real estate client totaling $121.1 million were on non-accrual. If any particular industry or geographic region were to experience economic difficulties, the overall timing and amount of collections on our loans to clients operating in those industries or geographic regions may differ from what we expected and it could have a material adverse impact on our financial condition or results of operations.

 

Because of the nature of our loans and the manner in which we disclose client and loan concentrations, it may be difficult to evaluate our risk exposure to any particular client or group of related clients

 

We have several clients that are related to each other through common ownership or management. In situations where clients are related through common ownership, to the extent the common owner suffers financial distress, the common owner may be unable to continue to support our clients, which could, in turn, lead to financial difficulties for those clients. Further, some of our clients are managed by the same entity and, to the extent that management entity suffers financial distress or is otherwise unable to continue to manage the operations of the related clients, those clients could, in turn, face financial difficulties. In both of these cases, our clients could have difficulty servicing their debt to us, which could have an adverse effect on our financial condition.

 

Our balloon loans and bullet loans may involve a greater degree of risk than other types of loans.

 

As of December 31, 2010, approximately 88% of the outstanding balance of our commercial loans comprised either balloon loans or bullet loans. A balloon loan is a term loan with a series of scheduled payment installments calculated to amortize the principal balance of the loan so that, upon maturity of the loan, more than 25%, but less than 100%, of the loan balance remains unpaid and must be satisfied. A bullet loan is a loan with no scheduled payments of principal before the maturity date of the loan.

 

Balloon loans and bullet loans involve a greater degree of risk than other types of loans because they generally require the borrower to make a large, final payment upon the maturity of the loan. The ability of a client to make this final payment upon the maturity of the loan typically depends upon its ability to generate sufficient cash flow to repay the loan prior to maturity, to refinance the loan or to sell the related collateral securing the loan, if any. The ability of a client to accomplish any of these goals will be affected by many factors, including the availability of financing at acceptable rates to the client, the financial condition of the client, the marketability of the related collateral, the operating history of the related business, tax laws and the prevailing general economic conditions. Consequently, a client may not have the ability to repay the loan at maturity, and we could lose some or all of the principal of our loan.

 

We are limited in pursuing certain of our rights and remedies under our Term B, second lien and mezzanine loans, which may increase our risk of loss on these loans.

 

Term B loans generally are senior secured loans that are equal as to collateral and junior as to right of payment to clients’ other senior debt. Second lien loans generally are junior as to both collateral and right of payment to clients’ senior debt. Mezzanine loans may not have the benefit of any lien against clients’ collateral and generally are junior to any lienholder both as to collateral (if any) and payment. Collectively, Term B, second lien and mezzanine loans comprised 16% of the aggregate outstanding balance of our commercial loan portfolio as of December 31, 2010. As a result of the subordinate nature of these loans, we may be limited in our ability to enforce our rights to collect principal and interest on these loans or to recover any of the loan balance through our right to foreclose upon collateral. For example, we typically are not contractually entitled to receive payments of principal on a subordinated loan until the senior loan is paid in full, and may only receive interest payments on these loans if the client is not in default under its senior loan. In many instances, we are also prohibited from foreclosing on these loans until the senior loan is paid in full. Moreover, any amounts that we might realize as a result of our collection efforts or in connection with a bankruptcy or insolvency proceeding under these loans must generally be turned over to the senior lender until the senior lender has realized the full value of its own claims. These restrictions may materially and adversely affect our ability to recover the principal of any non-performing Term B, second lien or mezzanine loans.

The collateral securing a loan may not be sufficient to protect us from a partial or complete loss if we have not properly obtained or perfected a lien on such collateral or if the loan becomes non-performing, and we are required to foreclose.

 

While most of our loans are secured by a lien on specified collateral of the client, there is no assurance that we have obtained or properly perfected our liens, or that the value of the collateral securing any particular loan will protect us from suffering a partial or complete loss if the loan becomes non-performing and we move to foreclose on the collateral. In such event, we could suffer loan losses which could have a material adverse effect on our revenue, net income, financial condition and results of operations.

 

Our leveraged loans are not fully covered by the value of assets or collateral of the client and, consequently, if any of these loans becomes non-performing, we could suffer a loss of some or all of our value in the loan.

 

Leveraged lending involves lending money to a client based primarily on the expected cash flow, profitability and enterprise value of a client rather than on the value of its assets. As of December 31, 2010, approximately 33% of the loans in our portfolio were leveraged loans under which we had advanced 38% of the aggregate outstanding loan balance of our portfolio. The value of the assets which we hold as collateral for these loans is typically substantially less than the amount of money we advance to a client under these loans. When a leveraged loan becomes non-performing, our primary recourse to recover some or all of the principal of our loan is to force the sale of the entire company as a going concern or restructure the company in a way we believe would enable it to generate sufficient cash flow over time to repay our loan. Neither of these alternatives may be an available or viable option or generate enough proceeds to repay the loan. Additionally, given recent and current economic conditions, many of our leveraged loan clients have and may continue to suffer decreases in revenues and net income, making them more likely to underperform and default on our loans and making it less likely that we could obtain sufficient proceeds from a restructuring or sale of the company. If we are a subordinate lender rather than the senior lender in a leveraged loan, our ability to take remedial action is constrained by our agreement with the senior lender and our financial condition may suffer.

 

We are not the agent for a portion of our loans and, consequently, have little or no control over how those loans are administered or controlled.

 

We are neither the agent of the lending group that receives payments under, nor the agent of the lending group that controls the collateral for purposes of administering, loans comprising approximately 28% of the aggregate outstanding balance of our loan portfolio as of December 31, 2010. We may not receive the same financial or operational information as we receive for loans for which we are the agent. As a result, it may be more difficult for us to track or rate these loans than it is for the loans for which we are the agent. Additionally, we may be prohibited or otherwise restricted from taking actions to enforce the loan or to foreclose upon the collateral securing the loan or otherwise exercise remedies without the agreement of other lenders holding a specified minimum aggregate percentage, generally a majority or two-thirds of the outstanding principal balance. It is possible that an agent for one of these loans may not manage the loan to our standards or may choose not to take the same actions to enforce the loan, to foreclose upon the collateral securing the loan or to exercise remedies that we would or would not take if we were agent for the loan. We also could experience losses in the event of the bankruptcy of the agent.

 

We are the agent for loans in which syndicates of lenders participate and, in the event of a loss on any such loan, we could have liability to other members of the syndicate related to our management and servicing of the loan.

 

As of December 31, 2010, we were either the paying, administrative or the collateral agent or all for a group of third-party lenders for loans with outstanding commitments of $2.1 billion. When we are the agent representing a syndicate of lenders for a loan in administering the loan, receiving all payments under the loan and/or controlling the collateral for purposes of administering the loan, we often receive financial and/or operational information directly from the borrower and are responsible for providing some or all of this information to our co-lenders. We may also be responsible for taking actions on behalf of the lending group to enforce the loan, to foreclose upon the collateral securing the loan or to exercise remedies. It is possible that as agent for one of these loans we may not

manage the loan to the applicable standard. In addition, we may choose a different course of action than one or more of our co-lenders would take to enforce the loan, to foreclose upon the collateral securing the loan or to exercise remedies if our co-lenders were in a position to manage the loan. If we do not administer these loans in accordance with our obligations and the applicable legal standards and the lending syndicate suffers a loss on the loan, we may have liability to our co-lenders.

 

If we do not obtain or maintain the necessary licenses and approvals, we will not be allowed to acquire, fund or originate small business loans or residential mortgage loans or other loans in some states, which could adversely affect our operations.

 

We engage in lending activities which involve the collection of numerous accounts, as well as compliance with various federal, state and local laws that regulate consumer lending. Many states in which we do business require that we be licensed, or that we be eligible for an exemption from the licensing requirement, to conduct our business. We also engage in small business lending which is regulated by the Small Business Administration. We cannot assure you that we will be able to obtain all the necessary licenses and approvals, or be granted an exemption from the licensing requirements, that we will need to maximize the acquisition, funding or origination of residential mortgages, small business, or other loans or that we will not become liable for a failure to comply with the myriad of regulations applicable to our lines of business.

 

We are in a competitive business and may not be able to take advantage of attractive opportunities.

 

Our markets are competitive and characterized by varying competitive factors. We compete with a large number of companies, including:

 

 

Some of our competitors have greater financial, technical, marketing and other resources and market positions than we do. They also have greater access to capital than we do and at a lower cost than is available to us. Furthermore, we would expect to face increased price competition on deposits and if finance companies, banks or other competitors seek to expand within or enter our target markets. Increased competition could cause us to reduce our pricing and lend greater amounts as a percentage of a client’s eligible collateral or cash flows. Even with these changes, in an increasingly competitive market, we may not be able to attract and retain depositors or clients or maintain or grow our business and our market share and future revenues may decline. If our existing clients choose to use competing sources of credit to refinance their loans, the rate at which loans are repaid may be increased, which could change the characteristics of our loan portfolio as well as cause our anticipated return on our existing loans to vary.

 

Risks Impacting Funding our Operations

 

Our ability to operate our business depends on our ability to maintain our external financing and raise sufficient deposits.

 

CapitalSource Bank’s ability to maintain or raise sufficient deposits may be limited by several factors, including:

 

 

 

While we expect to maintain and continue to raise deposits at a reasonable rate of interest, there is no assurance that we will be able to do so successfully.

 

In addition, given the short average maturity of CapitalSource Bank’s deposits to the maturity of its loans, the inability of CapitalSource Bank to raise or maintain deposits could compromise our ability to operate our business, impair our liquidity and threaten our solvency.

 

Aside from deposit funding, CapitalSource Bank may obtain back-up liquidity from the Parent Company pursuant to the $150.0 million revolving credit facility it has established with the Parent Company, and other facilities it has established with the FHLB SF, and the FRB. The availability of these sources of funds may be limited or threatened in the event of a severe economic crisis. If the liquidity or financial performance of the Parent Company weakens, CapitalSource Bank may not be able to draw on the $150.0 million revolving credit facility. The access to borrowing from FHLB SF may be materially impacted should Congress alter or dissolve the Federal Home Loan Bank system. Our access to the FRB primary credit program may be materially impacted should the FRB modify its credit program and limit CapitalSource Bank’s access to the program. As a result, if the ability of CapitalSource Bank to attract and retain suitable levels of deposits weakens, this could negatively impact our business, financial condition, results of operations and the market price of our common stock.

 

CapitalSource Bank is prohibited from paying dividends without the consent of our regulators, and we do not anticipate that dividends from CapitalSource Bank will provide liquidity to find the operations of the Parent Company for the foreseeable future. The Parent Company is dependent on loan collections and the proceeds of loan sales to fund its operations. A shortfall in loan proceeds may impair our ability to fund our operations or to repay our existing debt.

 

Mandatory redemption provisions under our indebtedness may limit our ability to maintain sufficient liquidity.

 

The terms of our outstanding convertible debentures require us to make offers to repurchase them in 2011 and 2012. As of December 31, 2010 the principal amounts of convertible debentures that we may be required to purchase in those years are $280.5 million in July 2011 and $250.0 million in July 2012. If the conversion prices of all of these debentures remain significantly out of the money, we would expect that all of the holders would elect to tender their debentures to us in response to these offers, requiring us to pay the respective principal amounts in cash at the conclusion of each offer. If we are unable to sell sufficient assets, raise new capital or restructure these payment obligations, we may not have sufficient liquidity to make these required prepayments by these dates. Consequently, we could default on these payment obligations, which would trigger cross-defaults under our other debt. In such circumstances, our business, liquidity and operations would be materially adversely affected, and we may not be able to continue operating.

 

We must comply with various covenants and obligations under our indebtedness and our failure to do so could adversely affect our ability to operate our business, manage our portfolio or pursue certain opportunities.

 

The Parent Company is subject to financial and non-financial covenants under our indebtedness, including, without limitation, with respect to restricted payments, interest coverage, minimum tangible net worth, leverage, maximum delinquent and charged-off loans, servicing standards, and limitations on incurring or guaranteeing indebtedness, refinancing existing indebtedness, repaying subordinated indebtedness, making investments, dividends, distributions, redemptions or repurchases of our capital stock, entering into transactions with affiliates selling assets, creating liens and engaging in a merger, sale or consolidation. If we were to default under our indebtedness by violating these covenants or otherwise, our lenders’ remedies would include the ability to, among other things, transfer servicing to another servicer, foreclose on collateral, accelerate payment of all amounts

payable under such indebtedness and/or terminate their commitments under such indebtedness. A default under our indebtedness could have a material adverse affect on our business, financial condition, liquidity position and our ability to continue to operate our business.

 

In addition, upon the occurrence of specified servicer defaults our lenders under our credit facility and the holders of the notes issued in our term debt securitizations may elect to terminate us as servicer of the loans under the applicable facility or term debt securitizations and appoint a successor servicer or replace us as cash manager for our secured facilities and term debt securitizations. If we were terminated as servicer, we would no longer receive our servicing fee. In addition, because there can be no assurance that any successor servicer would be able to service the loans according to our standards, the performance of our loans could be materially adversely affected and our income generated from those loans significantly reduced.

 

Substantially all of the assets of the Parent Company are pledged or otherwise encumbered by liens we have granted in favor of our lenders. The restrictive covenants in our indebtedness may, among other things, impair our ability and reduce our flexibility to operate our business, restrict our ability to optimally restructure our existing debt, plan for or react to changes in our business, the economy and/or markets, or limit our ability to engage in activities that may be in our long-term best interest, thereby negatively impacting our financial condition or results of operations. Our failure to comply with these restrictive covenants could result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our debt.

 

Our commitments to lend additional amounts to existing clients exceed our resources available to fund these commitments.

 

As of December 31, 2010, we had $1.9 billion of unfunded commitments to extend credit, of which $958.7 million were commitments of CapitalSource Bank and $977.7 million were commitments of the Parent Company. Due to their nature, we cannot know with certainty the aggregate amounts we will be required to fund under these unfunded commitments. In many cases, our obligation to fund unfunded commitments is subject to our clients’ ability to provide collateral to secure the requested additional fundings, the collateral’s satisfaction of eligibility requirements, our clients’ ability to meet specified preconditions to borrowing, including compliance with the loan agreements, and/or our discretion pursuant to the terms of the loan agreements. In other cases, however, there are no such prerequisites to future fundings by us, and our clients may draw on these unfunded commitments at any time. Clients may seek to draw on our unfunded commitments to improve their cash positions. We expect that these unfunded commitments will continue to exceed the Parent Company’s available funds. Our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract and lender liability for us and irreparably damage our reputation in the marketplace, which would have a material adverse effect on our ability to continue to operate our business.

 

Fluctuating interest rates could adversely affect our profit margins.

 

We borrow money from our lenders at variable interest rates and raise short-term deposits at prevailing rates in the relevant markets. We generally lend money at variable rates based on either prime or LIBOR indices. Our operating results and cash flow depend on the difference between the interest rates at which we borrow funds and raise deposits and the interest rates at which we lend these funds. Because many of our loans are currently below their contractual interest rate floors, upward movements in interest rates will not immediately result in additional interest income, although these movements would increase our cost of funds. Therefore, any upward movement in rates may result in a reduction of our net interest income. For additional information about interest rate risk, see Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk Management.

 

Interest on some of our borrowings is based in part on the rates and maturities at which vehicles sponsored by our lenders issue asset backed commercial paper. Changes in market interest rates or the relationship between market interest rates and asset backed commercial paper rates could increase the effective cost at which we borrow funds under some of our indebtedness.

In addition, changes in market interest rates, or in the relationships between short-term and long-term market interest rates, or between different interest rate indices, could affect the interest rates charged on interest earning assets differently than the interest rates paid on interest bearing liabilities, which could result in an increase in interest expense relative to our interest income.

 

Hedging instruments involve inherent risks and costs and may adversely affect our earnings.

 

We have entered into interest rate swap agreements and other contracts for interest rate risk management purposes. Our hedging activities vary in scope based on a number of factors, including the level of interest rates, the type of portfolio investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

 

 

Because we do not employ hedge accounting, our hedging activity may materially adversely affect our earnings. Therefore, while we pursue such transactions to reduce our interest rate risks, it is possible that changes in interest rates may result in losses that we would not otherwise have incurred if we had not engaged in any such hedging transactions. For additional information, see Note 21, Derivative Instruments, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

The cost of using hedging instruments increases as the period covered by the instrument increases and during periods of rising and volatile interest rates. We may increase our hedging activity and, thus, increase our hedging costs during periods when interest rates are volatile or rising. Furthermore, the enforceability of agreements associated with derivative instruments we use may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. In the event of default by a counterparty to hedging arrangements, we may lose unrealized gains associated with such contracts and may be required to execute replacement contract(s) on market terms which may be less favorable to us. Although generally we seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.

 

We may enter into derivative contracts that could expose us to future contingent liabilities.

 

Part of our investment strategy involves entering into derivative contracts that require us to fund cash payments in certain circumstances. Our ability to fund these contingent liabilities will depend on the liquidity of our assets and access to funding sources at the time, and the need to fund these contingent liabilities could materially adversely impact our financial condition. For additional information, see Note 21, Derivative Instruments, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

Risks Related to Our Operations

 

We are subject to extensive government regulation and supervision, which limit our flexibility and could result in adverse actions by regulatory agencies against us.

 

We are subject to extensive federal and state regulation and supervision that govern, limit or otherwise affect almost all aspects of our operations. Such banking regulation and supervision is intended primarily to protect

customers, depositors and the FDIC Deposit Insurance Fund — not our shareholders. These laws and regulations, among other matters, establish minimum capital requirements, limit the business activities we can conduct, prohibit various business practices, limit the dividends or distributions CapitalSource Bank can pay, establish reporting requirements, require approvals or consent for many types of transactions or business changes, and establish standards for financial and managerial safety and soundness. Our state and federal regulators periodically conduct examinations of our business, including for compliance with laws and regulations. Failure to comply with laws, regulations, policies or the regulatory orders pursuant to which we operate, even if unintentional or inadvertent, could result in adverse actions by regulatory agencies against us. Such actions could result in higher capital requirements, higher insurance premiums, additional limitations on our activities, termination of deposit insurance, civil monetary penalties and fines, which in each case could have material adverse effects on our business, financial condition, results of operation or reputation. See the Supervision and Regulation section of Item 1, Business, above, Note 18, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2010 and Item 7, Financial Statements and Supplementary Data.

 

Changes in laws and regulations, including the enactment of the Dodd-Frank Act, may have a material effect on our operations.

 

We are currently facing increased regulation and supervision of our industry as a result of the financial crisis in the banking and financial markets. Additional regulation and supervision may increase our costs and limit our ability to pursue business opportunities. Federal and state legislatures and regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to banking laws or regulations, including changes in their interpretation or implementation, could materially affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit or restrict our ability to use capital for business purposes, limit the types of financial services and products we may offer or increase the ability of non-banks to offer competing financial services and products, among other things. In addition, increased regulatory requirements, whether due to the adoption of new laws and regulations, changes in existing laws and regulations, or more expansive or aggressive interpretations of existing laws and regulations, may have a material adverse effect on our business, financial condition, results of operations and reputation.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, imposes a number of significant regulatory and compliance changes in the banking and financial services industry. Many provisions of the Dodd-Frank Act must be implemented by regulations to be adopted by various government agencies. These regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that may impact us. Certain provisions of the Dodd-Frank Act that may have a material effect on our business are noted below.

 

 

 

These rules and regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that could increase our compliance costs and materially adversely affect our business, operations, financial results and the price of our common stock.

 

Regulators are considering increased capital standards for banking organizations, including under the Basel III framework, which may have a material effect on our operations.

 

We are required by regulators to satisfy minimum capital standards. On September 12, 2010, the oversight body of the Basel Committee on Banking Supervision announced an international agreement to a heightened set of capital requirements for internationally active banking organizations in the United States and around the world, known as Basel III. The Basel III changes, and other regulatory initiatives in the wake of the financial crisis, are expected to result in higher regulatory capital standards and expectations for banking organizations. However, the timing and scope of U.S. implementation of Basel III and other regulatory capital initiatives remain uncertain, and it is difficult at this time to predict how any new standards would be applied to us and CapitalSource Bank. Higher capital requirements, or changes in the manner in which regulatory capital standards are implemented, could adversely affect our financial results.

 

We face risks in connection with our strategic undertakings and new businesses, products or services.

 

If appropriate opportunities present themselves, we may engage in strategic activities, which could include acquisitions, joint ventures, or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.

 

In order to finance future strategic undertakings, we might obtain additional equity or debt financing. Such financing might not be available on terms favorable to us, or at all. If obtained, equity financing could be dilutive and the incurrence of debt and contingent liabilities could have material adverse effect on our business, results of operations and financial condition.

 

Our ability to execute strategic activities successfully will depend on a variety of factors. These factors likely will vary on the nature of the activity but may include our success in integrating the operations, services, products, personnel and systems of an acquired company into our business, operating effectively with any partner with whom we elect to do business, retaining key employees, achieving anticipated synergies, meeting expectations and otherwise realizing the undertaking’s anticipated benefits. Our ability to address these matters successfully cannot be assured. In addition, our strategic efforts may divert resources or management’s attention from ongoing business operations and may subject us to additional regulatory scrutiny. If we do not successfully execute a strategic undertaking, it could adversely affect our business, financial condition, results of operations, reputation and growth prospects. In addition, if we were able to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which should adversely affect our results of operations.

In addition, from time to time, we may develop and grow new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.

 

The change of control rules under Section 382 of the Internal Revenue Code may limit our ability to use net operating loss carryovers and other tax attributes to reduce future tax payments or our willingness to issue equity.

 

We have net operating loss carryforwards for federal and state income tax purposes that can be utilized to offset future taxable income. If we were to undergo a change in ownership of more than 50% of our capital stock over a three-year period as measured under Section 382 of the Internal Revenue Code, our ability to utilize our net operating loss carryforwards, certain built-in losses and other tax attributes recognized in years after the ownership change generally would be limited. The annual limit would equal the product of the applicable long term tax exempt rate and the value of the relevant taxable entity’s capital stock immediately before the ownership change. These change of ownership rules generally focus on ownership changes involving stockholders owning directly or indirectly 5% or more of a company’s outstanding stock, including certain public groups of stockholders as set forth under Section 382, and those arising from new stock issuances and other equity transactions, which may limit our willingness and ability to issue new equity. The determination of whether an ownership change occurs is complex and not entirely within our control. No assurance can be given as to whether we have undergone, or in the future will undergo, an ownership change under Section 382 of the Internal Revenue Code.

 

The requirements of the Investment Company Act impose limits on our operations that impact the way we acquire and manage our assets and operations.

 

We conduct our operations so as not to be required to register as an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. We believe that we are primarily engaged in the business of commercial lending, and not in the business of investing, reinvesting, and trading in securities, and therefore are not required to register under the Investment Company Act.

 

While we do not believe we are engaged in an investment company business, we nevertheless endeavor to conduct our operations in a manner that would permit us to rely on one or more exemptions under the Investment Company Act. Our ability to rely on these exemptions may limit the types of loans and other assets we own.

 

One of our wholly owned subsidiaries, CapitalSource Finance LLC (“Finance”), is a guarantor on certain of our indebtedness, which guarantees could be deemed to cause Finance to have outstanding securities for purposes of the Investment Company Act. Finance or other subsidiaries may guarantee future indebtedness from time to time. Even if one or more of our subsidiaries were deemed to be engaged in investment company business and the provisions of the Investment Company Act were deemed to apply on an individual basis to our wholly owned subsidiaries, we attempt to conduct our business in a manner that we believe would permit our entities to rely on exemptions from registration under the Investment Company Act.

 

If we or any subsidiary were required to register under the Investment Company Act and could not rely on an exemption or exclusion, we or such subsidiary could be characterized as an investment company. Such characterization would require us to either change the manner in which we conduct our operations, or register the relevant entity as an investment company. Any modification of our business for these purposes could have a material adverse

effect on us. Further, if we or a subsidiary were determined to be an unregistered investment company, we or such subsidiary:

 

 

If changes in the market value of and/or net income from certain assets of one or more of our subsidiaries would affect our ability to rely on certain exemptions from registration under the Investment Company Act, we may need to make decisions with respect to these assets that we otherwise would not make absent the Investment Company Act consideration. Such decisions may have a material adverse effect on our business, operations, financial results and the price of our common stock.

 

Our systems may experience an interruption or breach in security which could subject us to increased operating costs as well as litigation and other liabilities.

 

We rely on the computer and telephone systems and network infrastructure that we use to conduct our business. These systems and infrastructure could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer and telephone equipment against damage from fire, power loss, telecommunications failure or a similar catastrophic event. Any damage or failure that causes an interruption in our operations could have an adverse effect on our clients. In addition, we must be able to protect the computer systems and network infrastructure utilized by us against physical damage, security breaches and service disruption caused by the internet or other users. Such break-ins and other disruptions would jeopardize the security of information stored in and transmitted through our systems and network infrastructure, which may result in significant liability to us and deter potential clients. While we have systems, policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our systems and infrastructure, there can be no assurance that these measures will be successful and that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. In addition, the failure of our clients to maintain appropriate security for their systems also may increase our risk of loss in connection with loans made to them. The occurrence of any failures, interruptions or security breaches of systems and infrastructure could damage our reputation, result in a loss of business and/or clients, result in losses to us or our clients, subject us to additional regulatory scrutiny, cause us to incur additional expenses, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.

 

Our controls and procedures may fail or be circumvented.

 

We review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition. In addition, if we identify material weaknesses in our internal control over financial reporting or are otherwise required to restate our financial statements, we could be required to implement expensive and time-consuming remedial measures and could lose investor confidence in the accuracy and completeness of our financial reports. This could

have an adverse effect on our business, financial condition and results of operations, including our stock price, and could potentially subject us to litigation.

 

We revoked our REIT election which could have adverse legal implications.

 

We operated as a REIT through 2008, but revoked our REIT election as of January 1, 2009. We had agreed in contracts relating to some of our financings that we will use reasonable efforts to remain qualified as a REIT. While we believe our decision not to qualify as a REIT for 2009 was reasonable, it could nevertheless be deemed to breach certain of our agreements. If the counterparties to these financings allege breaches of those agreements, we may be subject to lengthy and costly litigation, and if we were not to prevail in such litigation, we may be required to repay certain indebtedness prior to stated maturity, which would materially impair our liquidity.

 

We are under audit for our 2006 through 2008 taxable years and, if the Internal Revenue Service determined that we violated REIT requirements and failed to qualify as a REIT or otherwise under reported tax liabilities during those years which we operated as a REIT, it could adversely impact our results of operations.

 

We operated as a REIT from January 1, 2006 through December 31, 2008. Our senior management had limited experience in managing a portfolio of assets under the highly complex tax rules governing REITs and we cannot assure you that we operated our business within the REIT requirements. Given the highly complex nature of the rules governing REITs and the importance of factual determinations, the Internal Revenue Service, or IRS, could contend that we violated REIT requirements in one or more of these years. We are currently under audit by the IRS for our 2006, 2007 and 2008 or otherwise underreported tax liabilities tax returns. To the extent it were to be determined that we did not comply with REIT requirements for one or more of our REIT years or otherwise under reported tax liability, we could be required to pay additional corporate federal income tax and certain state and local income taxes for the relevant years. Also, we could be required to pay taxes (which could be significant in amount) that would be due if we were to avail ourselves of certain savings provisions, if they are available, to preserve our REIT status for the relevant years, either of which could have adverse affects on our financial results and the value of our common stock.

 

Risks Related to our Common Stock

 

We may not pay dividends on our common stock.

 

We expect to retain a majority of our earnings, consistent with dividend policies of other commercial depository institutions, to redeploy in our business. Our board of directors, in its sole discretion, will determine the amount and frequency of dividends to our shareholders based on a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations, borrowing capacity and other factors, including debt covenant restrictions prohibiting the payment of dividends after defaults. In addition, for so long as our 2014 Senior Secured Notes are outstanding, absent sufficient restricted payment capacity, we cannot make cash dividend payments that exceed $0.01 per share per quarter. As of December 31, 2010, we had $142.5 million, or $0.44 per share, of restricted payment capacity, however, we cannot assure we will have restricted payment capacity in the future, or that even if we do, we will utilize such restricted capacity to pay any dividend on our common stock. If we change our dividend policy our stock price could be adversely affected.

 

Some provisions of Delaware law and our certificate of incorporation and bylaws as well as certain banking laws may deter third parties from acquiring us.

 

Our certificate of incorporation and bylaws provide for, among other things:

 

 

We also are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which restricts the ability of any shareholder that at any time holds more than 15% of our voting shares to acquire us without the approval of shareholders holding at least 662/3% of the shares held by all other shareholders that are eligible to vote on the matter.

 

Federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, which could inhibit a business combination and adversely affect the market price of our common stock.

 

These laws and anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors of your choosing and cause us to take other corporate actions than you desire.

 

 

None.

 

 

We lease office space in Los Angeles, California and Chevy Chase, Maryland, a suburb of Washington, D.C., under operating leases. We also maintain offices in Arizona, California, Colorado, Connecticut, Delaware, Georgia, Florida, Illinois, Massachusetts, Missouri, New York, North Carolina, Pennsylvania, Tennessee, Texas, Wisconsin and in the United Kingdom. We believe our leased facilities are adequate for us to conduct our business.

 

In June 2010, we completed the sale of our long-term healthcare facilities to Omega Healthcare Investors, Inc. (“Omega”) and as a result, we exited the skilled nursing home ownership business. Consequently, we have presented the financial condition and results of operations for this business as discontinued operations for all periods presented. Additionally, the results of the discontinued operations include the activities of other healthcare facilities that have been sold since the inception of the business. For additional information, see Note 3, Discontinued Operations, in our accompanying audited consolidated financial statements for the year ended December 31, 2010.

 

 

From time to time, we are party to legal proceedings. We do not believe that any currently pending or threatened proceeding, if determined adversely to us, would have a material adverse effect on our business, financial condition or results of operations, including our cash flows.

 

 

Price Range of Common Stock

 

Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “CSE.” The high and low sales prices for our common stock as reported by the NYSE for the quarterly periods during 2010 and 2009 were as follows:

 

 

On February 24, 2011, the last reported sale price of our common stock on the NYSE was $7.66 per share.

 

Holders

 

As of February 24, 2011, there were 750 holders of record of our common stock. The number of holders does not include individuals or entities who beneficially own shares, but whose shares are held of record by a broker or clearing agency, and each such broker or clearing agency is included as one record holder. American Stock Transfer & Trust Company serves as transfer agent for our shares of common stock.

 

Dividend Policy

 

For the years ended December 31, 2010 and 2009, we declared and paid dividends as follows:

 

 

For shareholders who held our shares for the entire year, the $0.04 per share dividend declared and paid in 2010 was classified for tax reporting purposes as return of capital.

 

We expect to retain a majority of our earnings, consistent with dividend policies of other commercial depository institutions, to redeploy in our business. Our Board of Directors, in its sole discretion, will determine the amount and frequency of dividends to be provided to our shareholders based on a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax

considerations, borrowing capacity and other factors, including debt covenant restrictions prohibiting the payment of dividends after defaults. In addition, for so long as our 2014 Senior Secured Notes are outstanding, absent sufficient restricted payment capacity , we cannot make cash dividend payments that exceed $0.01 per share per quarter. As of December 31, 2010, we had $142.5 million, or $0.44 per share, of restricted payment capacity, however, we cannot assure we will have restricted payment capacity in the future.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

A summary of our repurchases of shares of our common stock for the three months ended December 31, 2010, was as follows:

 

 

 

Performance Graph

 

The following graph compares the performance of our common stock during the five-year period beginning on December 31, 2005 to December 31, 2010, with the S&P 500 Index and the S&P 500 Financials Index. The graph depicts the results of investing $100 in our common stock, the S&P 500 Index, and the S&P 500 Financials Index at closing prices on December 31, 2005, assuming all dividends were reinvested. Historical stock performance during this period may not be indicative of future stock performance.

 

Comparison of Cumulative Total Return

 

 

 

You should read the data set forth below in conjunction with our audited consolidated financial statements and related notes, Management’s Discussion and Analysis of Financial Condition and Results of Operations and other financial information appearing elsewhere in this report. The following tables show selected portions of historical consolidated financial data as of and for the five years ended December 31, 2010. We derived our selected consolidated financial data as of and for the five years ended December 31, 2010, from our audited consolidated financial statements, which have been audited by Ernst & Young LLP, independent registered public accounting firm.