OFG Bancorp - 10-Q quarterly report FY2019 Q3

TABLE OF CONTENTS

FORWARD-LOOKING STATEMENTS

The information included in this quarterly report on Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may relate to the financial condition, results of operations, plans, objectives, future performance and business of OFG Bancorp (“we,” “our,” “us” or “Oriental”), including, but not limited to, statements with respect to the adequacy of the allowance for loan losses, delinquency trends, market risk and the impact of interest rate changes, capital markets conditions, capital adequacy and liquidity, and the effect of legal proceedings and new accounting standards on Oriental’s financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “continues,” “expect,” “estimate,” “intend,” “project” and similar expressions and future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may,” or similar expressions are generally intended to identify forward-looking statements.

These statements are not guarantees of future performance and involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which by their nature are beyond Oriental’s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to:

·     the rate of growth in the economy and employment levels, as well as general business and economic conditions;

·     changes in interest rates, as well as the magnitude of such changes;

·     a credit default by municipalities of the government of Puerto Rico;

·     amendments to the fiscal plan approved by the Financial Oversight and Management Board for Puerto Rico;

·     determinations in the court-supervised debt-restructuring process under Title III of PROMESA for the Puerto Rico government and all of its agencies, including some of its public corporations;

·     the impact of property, credit and other losses in Puerto Rico as a result of hurricanes, earthquakes and other natural disasters;

·     the amount of government, private and philanthropic financial assistance for the reconstruction of Puerto Rico’s critical infrastructure, which suffered catastrophic damages caused by hurricane Maria;

·     the pace and magnitude of Puerto Rico’s economic recovery;

·     the fiscal and monetary policies of the federal government and its agencies;

·     changes in federal bank regulatory and supervisory policies, including required levels of capital;

·     the relative strength or weakness of the commercial and consumer credit sectors and the real estate market in Puerto Rico;

·     the performance of the stock and bond markets;

·     competition in the financial services industry; 

·     possible legislative, tax or regulatory changes; 

·     the receipt and timing of regulatory approvals required to consummate the acquisition of Scotiabank de Puerto Rico (“SBPR”) and certain branch assets and liabilities of The Bank of Nova Scotia (“BNS”) in Puerto Rico and its U.S. Virgin Islands operations (the “Scotiabank Transaction”); and

·     difficulties in integrating the operations expected to be acquired in the Scotiabank Transaction.

Other possible events or factors that could cause results or performance to differ materially from those expressed in these forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of non-performing assets, charge-offs and provision expense; changes in interest rates and market liquidity which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets; adverse movements and volatility in debt and equity capital markets; changes in market rates and prices which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; changes in accounting standards, rules and interpretations; increased competition; Oriental’s ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change Oriental’s business mix; and management’s ability to identify and manage these and other risks.

All forward-looking statements included in this quarterly report on Form 10-Q are based upon information available to Oriental as of the date of this report, and other than as required by law, including the requirements of applicable securities laws, Oriental assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

NOTE 1 – ORGANIZATION, CONSOLIDATION AND BASIS OF PRESENTATION  

Nature of Operations

OFG Bancorp (“Oriental”) is a publicly-owned financial holding company incorporated under the laws of the Commonwealth of Puerto Rico. Oriental operates through various subsidiaries including, a commercial bank, Oriental Bank (the “Bank”), a securities broker-dealer, Oriental Financial Services Corp. (“Oriental Financial Services”), an insurance agency, Oriental Insurance LLC. (“Oriental Insurance”), a retirement plan administrator, Oriental Pension Consultants, Inc. (“OPC”), and two operating subsidiaries of the Bank, OFG USA LLC ("OFG USA") and Oriental International Bank Inc. (“OIB”). Through these subsidiaries and their respective divisions, Oriental provides a wide range of banking and financial services such as commercial, consumer and mortgage lending, auto loans, financial planning, insurance sales, money management and investment banking and brokerage services, as well as corporate and individual trust services.

On April 30, 2010, the Bank acquired certain assets and assumed certain deposits and other liabilities of Eurobank, a Puerto Rico commercial bank, in an FDIC-assisted acquisition. On February 6, 2017, the Bank and the FDIC agreed to terminate the shared-loss agreements related to the Eurobank Acquisition. On December 18, 2012, Oriental acquired a group of Puerto Rico-based entities that included Banco Bilbao Vizcaya Argentaria Puerto Rico (“BBVAPR”), a Puerto Rico commercial bank, as well as a securities broker-dealer and an insurance agency, which is referred to herein as the “BBVAPR Acquisition.” These acquired businesses have been integrated with Oriental’s existing business.

New Accounting Updates Adopted in 2019

Leases. In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), the FASB issued ASU No. 2016-02, under the new guidance, lessees are required to recognize the following for all leases (with the exception of short-term leases): 1) a lease liability, which is the present value of a lessee’s obligation to make lease payments, and 2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Lessor accounting under the new guidance remains largely unchanged as it is substantially equivalent to existing guidance for sales-type leases, direct financing leases, and operating leases. Leveraged leases have been eliminated, although lessors can continue to account for existing leveraged leases using the current accounting guidance. Other limited changes were made to align lessor accounting with the lessee accounting model and the new revenue recognition standard. All entities will classify leases to determine how to recognize lease-related revenue and expense. Quantitative and qualitative disclosures are required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities. All entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. As Oriental elected the transition option provided in ASU No. 2018-11 (see below), the modified retrospective approach was applied on January 1, 2019 (as opposed to January 1, 2017). Oriental also elected certain relief options offered in ASU 2016-02 including the package of practical expedients and the option not to recognize right-of-use assets and lease liabilities that arise from short-term leases (i.e., leases with terms of twelve months or less). Oriental also elected the hindsight practical expedient, which allows entities to use hindsight when determining lease term and impairment of right-of-use assets. Oriental has several lease agreements, mainly branch locations, which are considered operating leases, and therefore, were not previously recognized on Oriental’s consolidated statements of financial condition. The new guidance requires these lease agreements to be recognized on the consolidated statements of financial condition as a right-of-use asset and a corresponding lease liability. The new guidance did not have a material impact on the consolidated statements of operations or the consolidated statements of cash flows. See Note 19 Leases for more information.

Leases - Targeted Improvements. In July 2018, the FASB issued ASU No. 2018-11 to provide entities with relief from the costs of implementing certain aspects of the new leasing standard, ASU No. 2016-02. Specifically, under the amendments in ASU 2018-11: (1) entities may elect not to recast the comparative periods presented when transitioning to the new leasing standard, and (2) lessors may elect not to separate lease and non-lease components when certain conditions are met. The amendments have the same effective date as ASU 2016-02 (January 1, 2019 for Oriental). Oriental adopted ASU 2018-11 on its required effective date of January 1, 2019 and elected both transition options mentioned above. ASU 2018-11 did not have a material impact on Oriental’s consolidated financial statements.

Narrow-Scope Improvements for Lessors. In December 2018, the FASB issued ASU No. 2018-20 which allows lessors to make an accounting policy election of presenting sales taxes and other similar taxes collected from lessees on a net basis, (2) requires a lessor to exclude lessor costs paid directly by a lessee to third parties on the lessor’s behalf and include lessor costs that are paid by the lessor and reimbursed by the lessee in the measurement of variable lease revenue and the associated expense, and (3) clarifies that when lessors allocate variable payments to lease and non-lease components they are required to follow the recognition guidance in the new leases standard for the lease component and other applicable guidance, such as the new revenue standard, for the non-lease component. Oriental adopted ASU 2018-20 on its required effective date of January 1, 2019 and elected to present sales taxes and other similar taxes collected from lessees on a net basis as described in (1) above. ASU 2018-20 did not have a material impact on Oriental’s consolidated financial statements.

Leases: Codification Improvements. In March 2019, the FASB issued ASU No. 2019-01 which states that for lessors that are not manufacturers or dealers, the fair value of the underlying asset is its cost, less any volume or trade discounts, as long as there isn’t a significant amount of time between acquisition of the asset and lease commencement; (2) clarifies that lessors in the scope of ASC 942 (such as Oriental) must classify principal payments received from sales-type and direct financing leases in investing activities in the statement of cash flows; and (3) clarifies the transition guidance related to certain interim disclosures provided in the year of adoption. To coincide with the adoption of ASU No. 2016-02, Oriental elected to early adopt ASU 2019-01 on January 1, 2019. The adoption of this ASU did not have a material impact on Oriental’s consolidated financial statements.

Targeted Improvements to Accounting for Hedging Activities. In August 2017, the FASB issued ASU No. 2017-12 with the objectives to (1) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities; and (2) reduce the complexity of and simplify the application of hedge accounting by preparers. This guideline allows the entity to elect whether to perform quantitative or qualitative assessments for their hedge accounting transactions. In addition, the guideline provides that “an entity may reclassify a debt security from held-to-maturity (HTM) to available-for-sale (AFS) if the debt security is eligible to be hedged under the last-of-layer method in accordance with paragraph 815-20-25-12A. Any unrealized gain or loss at the date of the transfer shall be recorded in accumulated other comprehensive income in accordance with paragraph 320-10-35-10(c).” Transition elections must be adopted within the timeframe outlined in paragraphs 815-20-65-3(f) to 65-3(g). This includes the transition election available for the transfer of eligible securities from the HTM to the AFS category. ASU No. 2017-12 is effective for interim and annual reporting periods beginning after December 15, 2018. Oriental elected to maintain its current quantitative assessment for the existing hedge accounting transaction. In addition, Oriental elected to reclassify all of the securities in its held-to-maturity portfolio amounting to $424.7 million to its available-for-sale portfolio, as they were debt securities that qualified as eligible to be hedged under the last-of-layer method. The new guidance did not have a material impact on the consolidated statements of operations or the consolidated statement of cash flows.

New Accounting Updates Not Yet Adopted

Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (a consensus of the FASB Emerging Issues Task Force). In August 2018, the FASB issued Accounting Standards Update (“ASU”) 2018-15, which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). Accordingly, ASU 2018-15 requires an entity (customer) in a hosting arrangement that is a service contract to follow the guidance in Subtopic 350-40 to determine which implementation costs to capitalize as an asset related to the service contract and which costs to expense. The ASU also requires the entity (customer) to expense the capitalized implementation costs of a hosting arrangement that is a service contract over the term of the hosting arrangement, which includes reasonably certain renewals. This ASU is the final version of Proposed Accounting Standards Update 2018–230—Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract, which has been deleted.This ASU will be applied prospectively for annual and interim periods in fiscal years beginning after December 15, 2019. Early adoption is permitted. The effects of this standard on our consolidated statement of financial position, results of operations or cash flows are not expected to be material.

Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement. In August 2018, the FASB issued ASU 2018-13, which modifies disclosure requirements related to fair value measurement. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after

December 15, 2019.  Implementation on a prospective or retrospective basis varies by specific disclosure requirement.  Early adoption is permitted. The standard also allows for early adoption of any removed or modified disclosures upon issuance of this ASU while delaying adoption of the additional disclosures until their effective date.

Simplifying the Test for Goodwill Impairment. In January 2017, the FASB issued ASU No. 2017-04, which simplifies the measurement of goodwill impairment. An entity will no longer perform a hypothetical purchase price allocation to measure goodwill impairment. Instead, impairment will be measured using the difference between the carrying amount and the fair value of the reporting unit. This ASU will be applied prospectively for annual and interim periods in fiscal years beginning after December 15, 2019. The effects of this standard on our consolidated statement of financial position, results of operations or cash flows are not expected to be material.

Measurement of Credit Losses on Financial Instruments. In June 2016, the FASB issued ASU No. 2016-13 for the recognition of credit losses on financial instruments. The guidance introduces a new credit reserving methodology known as the Current Expected Credit Loss (“CECL”) methodology, which differs significantly from the incurred loss approach used today and will alter the estimation process, inputs and assumptions used in estimating the allowance for credit losses (“ACL”). The CECL methodology requires measurement of expected credit losses for the estimated life of the financial instrument, not only based on historical experience and current conditions, but also by including reasonable and supportable forecasts incorporating forward-looking information. At the date of adoption, the change in reserves will be recorded in retained earnings as a cumulative-effect adjustment under the modified retrospective method. CECL eliminates the existing guidance for purchase credit-impaired loans, but requires an allowance for purchased financial assets with more than insignificant deterioration since origination. In addition, it modifies the other-than-temporary impairment model for available-for-sale debt securities to require an allowance for credit impairment instead of a direct write-down, which allows for reversal of credit impairments in future periods based on improvements in credit. ASU No. 2016-13 is effective for fiscal years, and interim periods, beginning after December 15, 2019. Oriental will implement ASU No. 2016-13 on January 1, 2020. We continue to evaluate the impact the new guidance will have on our financial position, results of operations and regulatory risk-based capital. Our current planned approach for estimating lifetime credit losses for our loan portfolio includes the following key components:

·          An initial forecast period of one year for all portfolio segments based on historical loss experience, or economic forecast in case of limited historical loss experience;

·          An economic forecast period of two years based on the relation of losses with key economic variables for each portfolio segment;

·          Segmentation of loans into pools that share common risk characteristics;

·          Reversion to the mean period using straight-line method;

·          Used the discounted cash flow (DCF) method to measure credit impairment on most of our loan portfolios and estimate lifetime credit losses using the conceptual components described above; and

·          A most likely macroeconomic scenario in estimating expected credit losses.

As part of our evaluation of the estimated impacts of CECL, we have run simulations based on our portfolio composition and current expectations of future economic conditions. The results of those preliminary simulations indicate that our total reserves for credit losses related to our originated book, which accounts for 84% of total gross loans, could have a net increase between 16 % and 23 % as compared to the incurred loss model applied as of balance sheet date, mostly driven by the retail loan portfolios. At adoption, we expect to have a cumulative-effect adjustment to retained earnings for this change in the ACL, which would impact our capital. Oriental expects to continue to be well capitalized under the Basel III regulatory framework after the adoption of this standard. The Company will avail itself of the option to phase-in over a period of three years the day one effects on regulatory capital from the adoption of CECL. For the acquired book, which represents 16% of total gross loans, we expect its allowance will be enough to cover CECL implementation. Any adjustment will be made through the allowance and loan balances with no impact in capital. The ultimate effect of CECL on our ACL will depend on the size and composition of our portfolio, the portfolio’s credit quality and economic conditions at the time of adoption, as well as any refinements to our models, methodology and other key assumptions. We are continuing our cross-functional implementation efforts and have substantially completed development of our CECL models. Model validation, user acceptance testing, and parallel runs will continue through the remainder of 2019. In addition, we continue to develop the business processes, policies and controls that satisfy the requirements of the new guidance.

For available-for-sale debt securities, the new guidance prospectively replaces the other-than-temporary impairment model and requires the recognition of an allowance for reductions in a security’s fair value attributable to declines in credit quality, instead of a direct write-down of the security, when a valuation decline is determined to be other-than-temporary. Our available-for-sale debt securities only consist of U.S. Treasury or U.S. government-sponsored agencies securities; therefore, we do not currently expect the impact of the new guidance on available-for-sale securities to be material at adoption.  

NOTE 2 – SIGNIFICANT EVENTS

On June 26, 2019, OFG Bancorp (the “Company”) and Oriental Bank, a wholly-owned subsidiary of the Company (“Oriental Bank”), entered into (i) a definitive Stock Purchase Agreement (the “Stock Purchase Agreement”) with The Bank of Nova Scotia (“BNS”), (ii) a definitive Sale and Purchase Agreement (USVI) (the “USVI Purchase Agreement”) with BNS and (iii) a definitive Sale and Purchase Agreement (PR) (the “PR Purchase Agreement” and, together with the Stock Purchase Agreement and the USVI Purchase Agreement, the “Purchase Agreements”) with BNS.

The transactions contemplated by the Purchase Agreements (the “Scotiabank Transaction”), which are expected to close before year end of 2019, are subject to receipt of the requisite regulatory approvals, as well as the satisfaction of other customary closing conditions.

The Stock Purchase Agreement

On the terms and subject to the conditions set forth in the Stock Purchase Agreement, Oriental Bank will acquire (i) all of the issued and outstanding shares of common stock, par value $10.00 per share, of Scotiabank de Puerto Rico, a bank chartered under the laws of Puerto Rico (“SBPR”), and (ii) all of the issued and outstanding shares of second preferred non-cumulative redeemable stock, par value $10.00 per share, of SBPR (the “Preferred Stock”) (excluding any shares of Preferred Stock redeemed by SBPR prior to the SBPR Closing (as defined below) ((i) and (ii), the “Stock Purchase”). In addition, the Stock Purchase Agreement contemplates that, immediately following the consummation of the Stock Purchase, SBPR will merge with and into Oriental Bank, with Oriental Bank continuing as the surviving bank (the “Bank Merger”).

The consideration payable by Oriental Bank to BNS at the closing of the Stock Purchase (the “SBPR Closing” and the date on which the SBPR Closing occurs, the “Closing Date”) will be $550,000,000 in cash minus the amount of any Pre-Closing Secondary Dividend (as defined below) actually paid to BNS after the execution of the Stock Purchase Agreement but on or prior to the Closing Date. In addition, the Stock Purchase Agreement contemplates that, prior to the SBPR Closing, SBPR will pay BNS (a) one or more dividends in an aggregate amount equal to $200,000,000 (subject to certain adjustments set forth in the schedules to the Stock Purchase Agreement) (the “Pre-Closing Primary Dividend”) and (b) secondarily to the Pre-Closing Primary Dividend, one or more additional dividends in an aggregate amount not to exceed $125,000,000 (the “Pre-Closing Secondary Dividend”).

The obligations of Oriental Bank and BNS to consummate the Stock Purchase are subject to the satisfaction or waiver of certain customary closing conditions, including (a) the receipt of the requisite regulatory approvals, including the requisite regulatory approvals of the Puerto Rico Office of the Commissioner of Financial Institutions, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System (and, in the case of Oriental Bank’s obligations to consummate the Stock Purchase, without the imposition of a Burdensome Condition (as defined below)), (b) the accuracy of the other party’s representations and warranties, subject to certain timing and materiality standards, (c) compliance in all material respects by the other party with its pre-closing covenants and agreements contained in the Stock Purchase Agreement and (d) the absence of any injunction or order prohibiting the consummation of the Stock Purchase, the Bank Merger or the other transactions contemplated by the Stock Purchase Agreement. The obligations of BNS to consummate the Stock Purchase are also subject to receiving the requisite regulatory approval for the payment of the Pre-Closing Primary Dividend. The Stock Purchase is not conditioned on the consummation of the transactions contemplated by the USVI Purchase Agreement or the PR Purchase Agreement.

Under the Stock Purchase Agreement, Oriental Bank and BNS agreed to use reasonable best efforts to obtain the requisite regulatory approvals. In addition, the Company and Oriental Bank agreed to take all actions necessary (including Remedial Actions and Capital Actions (each as defined in the Stock Purchase Agreement)) to obtain the applicable requisite regulatory approvals and consummate the Scotiabank Transaction as promptly as practicable, subject to an exception that provides that neither the Company nor Oriental Bank is required to take, or agree to take, any action that would constitute a Burdensome Condition. Under the Stock Purchase Agreement, the term “Remedial Action” is defined to include, among other things, divestitures, licenses or other dispositions of, or the holding separate of, deposits, loans, branches or operations of SBPR, the Company, Oriental Bank or their affiliates, and the term “Capital Acton” is defined to include, among other things, capital level and capital ratio maintenance commitments, capital plan creation and capital raising transactions. The Stock Purchase Agreement defines “Burdensome Condition” as any action, restriction or condition that would reasonably be expected to be materially burdensome to the Company, Oriental Bank and their affiliates, taken as a whole, following the consummation of the Stock Purchase, the Bank Merger or the transactions contemplated by the USVI Purchase Agreement or the PR Purchase Agreement. However, the Stock Purchase Agreement provides that a Capital Action will not constitute or be considered in determining whether any required action constitutes, a Burdensome Condition.

The Stock Purchase Agreement provides that, for three years after the Closing Date, BNS will not operate an FDIC-insured depository institution in Puerto Rico, offer retail banking or retail consumer finance products or services in Puerto Rico (excluding certain wealth management services) or accept deposits insured by the FDIC in Puerto Rico, in each case, subject to certain exceptions set forth in the Stock Purchase Agreement. In addition, from the date of the Stock Purchase Agreement and continuing for two years following the Closing Date, BNS agreed to certain restrictions on soliciting and hiring SBPR employees and soliciting SBPR customers, and Oriental Bank agreed to certain restrictions on soliciting and hiring certain BNS employees and soliciting certain BNS customers, in each case, subject to certain exceptions set forth in the Stock Purchase Agreement.

The Stock Purchase Agreement contains certain customary representations and warranties made by each party, which are qualified by confidential disclosures provided to each party by the other party in connection with the Stock Purchase Agreement. Each of Oriental Bank and BNS has agreed to various customary covenants, including, in the case of BNS, covenants regarding the conduct of SBPR’s business prior to the SBPR Closing. The Stock Purchase Agreement provides for post-Closing indemnification obligations with respect to breaches of the representations, warranties and covenants of each party in the Purchase Agreements, as well as indemnification obligations with respect to certain other matters. Each party’s indemnification obligations with respect to breaches of its representations and warranties generally are subject to a de minimis “per loss” requirement of $100,000, a deductible basket equal to 1% of the aggregate purchase price under the Purchase Agreements and a cap equal to 10% of the aggregate purchase price under the Purchase Agreements, except for breaches of certain fundamental representations and warranties. Following the SBPR Closing, during any period in which the USVI Transaction (as defined below) or the PR Transaction (as defined below) has not been consummated, the indemnification deductible basket will be reduced by 1% of the purchase price under the USVI Purchase Agreement and 1% of the purchase price under the PR Purchase Agreement, as applicable, and the indemnification cap will be reduced by 10% of the purchase price under the USVI Purchase Agreement and 10% of the purchase price under the PR Purchase Agreement, as applicable.

Each party has the right to terminate the Stock Purchase Agreement under certain circumstances, including if the Stock Purchase has not occurred on or prior to March 26, 2020, subject to an extension by either party until June 26, 2020 if the requisite regulatory approvals have not been obtained. Upon the termination of the Stock Purchase Agreement as a result of the failure to obtain the requisite regulatory approvals as of the outside date referenced above (as extended), Oriental Bank will be required to reimburse BNS for its reasonable and documented out-of-pocket transaction expenses. The Stock Purchase Agreement also provides that the aggregate amount of reimbursable expenses under the Stock Purchase Agreement, the USVI Purchase Agreement and the PR Purchase Agreement will not exceed $2,000,000.

USVI Purchase Agreement

On the terms and subject to the conditions set forth in the USVI Purchase Agreement, at the closing of the transactions contemplated by the USVI Purchase Agreement (the “USVI Closing” and the date on which the USVI Closing occurs the “USVI Closing Date”), Oriental Bank will acquire the U.S. Virgin Islands (the “USVIs”) banking operations of BNS through an acquisition of certain assets (including loans, ATMs and physical branch locations) and an assumption of certain liabilities (including deposits) (the “USVI Transaction”). The consideration payable in the USVI Transaction will be equal to the difference between (a) the sum of (i) cash on hand at the purchased branches and cash located in the purchased ATMs, (ii) the net book value of the purchased assets (which, in the case of the purchased loans, will be equal to the gross book value of the purchased loans minus $6,700,000 (or, if greater, the actual amount of reserves associated with the purchase loans as of the close of business on the day immediately preceding the USVI Closing Date)), (iii) a $10,000,000 deposit premium and (iv) the fair market value of Other Assets (as defined in the USVI Purchase Agreement) that Oriental Bank elects to include as a purchased asset and (b) the net book value of the assumed liabilities, in each case, as of the close of business on the day immediately preceding the USVI Closing Date. If the foregoing calculation produces a positive number, that amount will be payable by Oriental Bank to BNS at the USVI Closing and if the foregoing calculation produces a negative number, the absolute value of that amount will be payable by BNS to Oriental Bank at the USVI Closing.

The obligations of Oriental Bank and BNS to consummate the USVI Transaction are subject to the satisfaction or waiver of certain customary closing conditions, including (a) the receipt of the requisite regulatory approvals, including the requisite regulatory approvals of the Puerto Rico Office of the Commissioner of Financial Institutions, the Federal Deposit Insurance Corporation, the Virgin Islands Banking Board and the Lieutenant Governor of the Virgin Islands, Division of Banking, Insurance and Financial Regulation (and, in the case of Oriental Bank’s obligations to consummate the USVI Transaction, without the imposition of a Burdensome Condition), (b) the accuracy of the other party’s representations and warranties, subject to certain timing and materiality standards, (c) compliance in all material respects by the other party with its pre-closing covenants and agreements contained in the USVI Purchase Agreement and (d) the absence of any injunction or order prohibiting the consummation of the transactions

contemplated by the USVI Purchase Agreement. The consummation of the USVI Transaction is also subject to the consummation of the Stock Purchase either substantially contemporaneously with or prior to the USVI Closing.

The covenants and agreements in the Stock Purchase Agreement that address the obligations of the parties to obtain the requisite regulatory approvals, including those provisions addressing Remedial Actions, Capital Actions and Burdensome Conditions, also apply under the USVI Purchase Agreement with respect to the requisite regulatory approvals for the USVI Transactions.

The USVI Purchase Agreement provides that, for three years after the USVI Closing Date, BNS will not (a) open or operate a branch, subsidiary or depository institution that accepts deposits in the USVIs or (b) offer retail banking or retail consumer finance products or services in the USVIs (excluding certain wealth management services), in each case, subject to certain exceptions set forth in the USVI Purchase Agreement. In addition, from the date of the USVI Purchase Agreement and continuing for two years following the USVI Closing Date, BNS agreed to certain restrictions on soliciting and hiring USVI branch employees and soliciting USVI branch customers, in each case, subject to certain exceptions set forth in the USVI Purchase Agreement.

The USVI Purchase Agreement contains certain customary representations and warranties made by each party, which are qualified by confidential disclosures provided to each party by the other party in connection with the USVI Purchase Agreement. Each of Oriental Bank and BNS has agreed to various customary covenants, including, in the case of BNS, covenants regarding the conduct of the USVI branch business prior to the USVI Closing.

Each party has the right to terminate the USVI Purchase Agreement under certain circumstances, including if (i) the Stock Purchase Agreement has been terminated or (ii) the USVI Transactions have not occurred on or prior to March 26, 2020, subject to an extension by either party until June 26, 2020 if the requisite regulatory approvals have not been obtained. If the Stock Purchase has not been consummated and the USVI Purchase Agreement is terminated as a result of the failure to obtain the requisite regulatory approvals as of the outside date referenced above (as extended), Oriental Bank will be required to reimburse BNS for its reasonable and documented out-of-pocket transaction expenses. The USVI Purchase Agreement also provides that the aggregate amount of reimbursable expenses under the Stock Purchase Agreement, the USVI Purchase Agreement and the PR Purchase Agreement will not exceed $2,000,000.

PR Purchase Agreement

On the terms and subject to the conditions set forth in the PR Purchase Agreement, at the closing of the transactions contemplated by the PR Purchase Agreement (the “PR Closing” and the date on which the PR Closing occurs, the “PR Closing Date”), Oriental Bank will acquire certain loans and other assets, and assume certain deposits and other liabilities, from BNS’s Puerto Rico branch (the “PR Transaction”). The consideration payable in the PR Transaction will be equal to the difference between (a) the net book value of the purchased assets (which, in the case of the purchased loans, will be equal to the gross book value of the purchased loans minus $27,700,000 (or, if greater, the actual amount of reserves associated with the purchase loans as of the PR Effective Time (as defined in the PR Purchase Agreement))) and (b) the net book value of the assumed liabilities, in each case, as of PR Effective Time. If the foregoing calculation produces a positive number, that amount will be payable by Oriental Bank to BNS at the PR Closing and if the foregoing calculation produces a negative number, the absolute value of that amount will be payable by BNS to Oriental Bank at the PR Closing.

The obligations of Oriental Bank and BNS to consummate the PR Transaction are subject to the satisfaction or waiver of certain customary closing conditions, including (a) the receipt of required regulatory approvals of the Federal Deposit Insurance Corporation (and, in the case of Oriental Bank’s obligations to consummate the PR Transaction, without the imposition of a Burdensome Condition), (b) the accuracy of the other party’s representations and warranties, subject to certain timing and materiality standards, (c) compliance in all material respects by the other party with its pre-closing covenants and agreements contained in the PR Purchase Agreement and (d) the absence of any injunction or order prohibiting the consummation of the transactions contemplated by the PR Purchase Agreement. The consummation of the PR Transaction is also subject to the consummation of the Stock Purchase either substantially contemporaneously with or prior to the PR Closing.

The covenants and agreements in the Stock Purchase Agreement that address the obligations of the parties to obtain the requisite regulatory approvals, including those provisions addressing Remedial Actions, Capital Actions and Burdensome Conditions, also apply under the PR Purchase Agreement with respect to the requisite regulatory approvals for the PR Transaction.

Under the PR Purchase Agreement, from the date of the PR Purchase Agreement and continuing for two years following the PR Closing Date, BNS agreed to certain restrictions on soliciting PR branch customers, subject to certain exceptions set forth in the PR Purchase Agreement.

The PR Purchase Agreement contains certain customary representations and warranties made by each party, which are qualified by confidential disclosures provided to each party by the other party in connection with the PR Purchase Agreement. Each of Oriental Bank and BNS has agreed to various customary covenants, including, in the case of BNS, covenants regarding the administration of the purchased assets and assumed liabilities of PR branch prior to the PR Closing.

Each party has the right to terminate the PR Purchase Agreement under certain circumstances, including if (i) the Stock Purchase Agreement has been terminated or (ii) the PR Transactions have not occurred on or prior to March 26, 2020, subject to an extension by either party until June 26, 2020 if the requisite regulatory approvals have not been obtained. If the Stock Purchase has not been consummated and the PR Purchase Agreement is terminated as a result of the failure to obtain the requisite regulatory approvals as of the outside date referenced above (as extended), Oriental Bank will be required to reimburse BNS for its reasonable and documented out-of-pocket transaction expenses. The PR Purchase Agreement also provides that the aggregate amount of reimbursable expenses under the Stock Purchase Agreement, the USVI Purchase Agreement and the PR Purchase Agreement will not exceed $2,000,000.

The foregoing description of the Purchase Agreements and related transactions does not purport to be complete and is qualified in its entirety by reference to the Purchase Agreements, which were filed as Exhibit 2.1, Exhibit 2.2 and Exhibit 2.3 to the Current Report on Form 8-K on July 2, 2019, and are incorporated therein by reference. The Purchase Agreements establish and govern the legal relations between the parties with respect to the transactions contemplated thereby and are not intended to be a source of factual, business or operational information about the parties or their respective businesses. The representations and warranties set forth in the Purchase Agreements may not be accurate or complete as of any specified date, may be subject to a contractual standard of materiality different from those generally applicable to shareholders or different from what a shareholder might view as material, may have been used for purposes of allocating risk between the parties to the Purchase Agreements rather than establishing matters as facts, may have been qualified by certain disclosures not reflected in the Purchase Agreements that were made to the other party in connection with the negotiation of the Purchase Agreements and generally were solely for the benefit of the parties to the Purchase Agreements.

Accordingly, investors and security holders should not rely on such representations and warranties as characterizations of the actual state of facts or circumstances because they were only made as of the date of the Purchase Agreements and are modified by confidential disclosure schedules delivered in connection with the Purchase Agreements. Moreover, information concerning the subject matter of such representations and warranties may change after the date of the Purchase Agreements, which subsequent information may or may not be fully reflected in the Company’s public disclosures.

NOTE 3 – RESTRICTED CASH

The following table includes the composition of Oriental’s restricted cash:

At September 30, 2019 and December 31, 2018, the Bank’s international banking entities, OIB and Oriental Overseas, a division of the Bank, held short-term highly liquid securities in the amount of $305 thousand and $325 thousand, respectively, as the legal reserve required for international banking entities under Puerto Rico law.  These instruments cannot be withdrawn or transferred by OIB or Oriental Overseas without the prior written approval of the Office of the Commissioner of Financial Institutions of Puerto Rico (the "OCFI").

As part of its derivative activities, Oriental enters into collateral agreements with certain financial counterparties.  At September 30, 2019 collateral agreements have expired. At December 31, 2018, Oriental had delivered approximately $2.0 million of cash as collateral for such derivatives activities.

Oriental has a contract with FNMA which requires collateral to guarantee the repurchase, if necessary, of loans sold with recourse. At September 30, 2019 and December 31, 2018, Oriental delivered as collateral cash amounting to approximately $1.1 million, for both periods.

The Bank is required by Puerto Rico law to maintain average weekly reserve balances to cover demand deposits. The amount of those minimum average reserve balances for the week that covered September 30, 2019 was $210.4 million (December 31, 2018 - $211.6 million). At September 30, 2019 and December 31, 2018, the Bank complied with this requirement. Cash and due from bank as well as other short-term, highly liquid securities, are used to cover the required average reserve balances.

NOTE 4 – INVESTMENT SECURITIES

Money Market Investments

Oriental considers as cash equivalents all money market instruments that are not pledged and that have maturities of three months or less at the date of acquisition. At September 30, 2019 and December 31, 2018, money market instruments included as part of cash and cash equivalents amounted to $8.0 million and $4.9 million, respectively.

Investment Securities

The amortized cost, gross unrealized gains and losses, fair value, and weighted average yield of the securities owned by Oriental at September 30, 2019 and December 31, 2018 were as follows: