Esquire Bank (NASDAQ: ESQ) Part 1

Esquire Bank (referred to as “Esquire”, “the bank”, “the business”) is a bank that offers banking and specialized lending products to the litigation industry in the United States along with providing real estate loans in the greater New York City area and merchant processing services. It is a branchless bank that has $1.3 billion in assets as of Q2 2022. I found this business after researching Plumas Bancorp which I’ve written up previously. In my initial report I mentioned that Plumas Bancorp was ranked #2 out of all community banks in the United States according to Raymond James. Esquire was #1 on that list for 2019 and 2020 and #2 in 2021 so I figured it deserved some attention. The business is headquartered in the mean streets of Jericho, New York.

*** NOTE: I posted the original version of this writeup last year on MicroCapClub and this post serves as Part 1 of the update to it. I decided to make this a two-part writeup because I’m closing in on 7500 – 8000 words and feel like it will be easier to digest over two parts. Part 1 includes the Introduction, History, CEO, CEO Compensation and What Does Esquire Bank Do sections. This updated version includes 2021 full year and 2022 midyear results. Portions of the older version have also been modified, deleted or reworded to fit in to my current writeup format. ***

History

The business was founded in 2006 in Jericho, New York and has offered its specialized lending services catered to the litigation industry and real estate loans in the greater New York City area since inception. It began its merchant processing services in 2012. The business used to have one branch in Garden City, New York, but has since closed it. It has one additional administrative office in Boca Raton, Florida. Esquire went public on June 30, 2017.

CEO

Andrew Sagliocca is the CEO of Esquire Bank and has served in this role since 2009. Per the Esquire Bank website, “Andrew Sagliocca has served as President and Chief Executive Officer of Esquire Bank since January 2009 and its financial holding company since inception. Andrew has led numerous capital raises for Esquire and other institutions including Esquire’s initial public offering in June 2017. Prior to this, Andrew served as Esquire’s Chief Financial Officer when he joined Esquire Bank in February 2007. Prior to joining Esquire, Andrew was a senior financial officer for 13 years at North Fork Bank, one of the top-performing financial institutions in the country. At North Fork Bank, Andrew was an integral part of growing this $1.5 billion community bank into a $60 billion regional commercial bank with over 300 branches in the New York metro area. Andrew was formerly a manager in KPMG LLP’s Financial Services Group, specializing in financial institutions. Andrew has over 30 years of experience in the financial services industry.

Andrew earned his Bachelor of Science degree in Accounting from Fairfield University’s Dolan School of Business, and in addition to being a Certified Public Accountant, is a member of the American Institute of Certified Public Accountants and the New York State Society of Certified Public Accountants.”

CEO Compensation

Mr. Sagliocca’s compensation is made up of a base salary, bonus, stock awards and “other compensation”. The “other compensation” will not be discussed as it is an immaterial amount of his overall compensation.

His base salary for 2020 was $600,149 and for 2021 it was $625,048. His 2022 salary is $675,000. Per p. 12 of the 2022 Proxy Statement, his salary may increase in the future, but cannot decrease which I found a bit odd.

The Board of Directors seems to be able to issue bonuses in any way they see fit. Per p. 12 of the 2022 Proxy Statement, “During the budgeting process at the end of each year, the board of directors allocates a bonus pool for potential allocation to all employees, including the named executive officers, to be distributed at the end of the following year. At the end of the year, the Chief Executive Officer and President evaluates the performance of the senior officers, including the named executive officers (other than himself), and recommends bonus amounts to the Compensation Committee of the Board of Directors. The Compensation Committee determines the bonus amount awarded to the Chief Executive Officer and President and reviews and approves the bonuses awarded to the other named executive officers.” There was no other information provided about the bonuses or what the performance measures were or currently are or what the hurdle rates are to achieve them. Let’s move on to stock awards.

Stock awards are granted through the Equity Incentive Plan. Per p. 15 of the 2022 Proxy Statement, “The 2021 Equity Incentive Plan authorizes the issuance of up to 400,000 shares of the Company’s common stock pursuant to grants of restricted stock, restricted stock units, stock options, including incentive stock options and non-qualified stock options, any of which may vest based either on the passage of time or achievement of performance, or a combination of each, to officers, employees, directors and service providers of the Company and Esquire Bank.” You’ll notice that the way in which stock awards can be granted is vague. They can vest simply on the passage of time and not necessarily due to the business hitting certain performance metrics. I raised my eyebrow like The Rock after I read the sentence about the 2021 Equity Incentive Plan. I then tried to find what the performance measures were, but there was no further information about them in the 2022 Proxy Statement.

I was frustrated at this point, but I went back to the 2021 Proxy Statement and found some information about the stock award performance measures. Per p. 21 of the 2021 Proxy Statement, “If awards are granted subject to performance-based vesting conditions, the performance measures that may be used for such awards will be based on any one or more of the following performance measures, as selected by the Compensation Committee: book value or tangible book value per share; basic earnings per share (e.g., earnings before interest and taxes, earnings before interest, taxes, depreciation and amortization; or earnings per share); basic cash earnings per share; diluted earnings per share; return on equity; net income or net income before taxes; net interest income; non-interest income; non-interest expense to average assets ratio; cash general and administrative expense to average assets ratio; efficiency ratio; cash efficiency ratio; financial return ratios; core earnings, capital; increase in revenue, total stockholder return; net operating income, operating income; net interest margin or net interest rate spread; stock price; assets, growth in assets, loans or deposits, asset quality level, charge offs, loan reserves, non-performing assets, loans, deposits, growth of loans, loan production volume, non-performing loans, deposits or assets; regulatory compliance or safety and soundness; achievement of balance sheet or income statement objectives and strategic business objectives, or any combination of these or other measures.

Performance measures may be based on the performance of Esquire Financial as a whole or of any one or more subsidiaries or business units. Performance goals may be measured relative to a peer group, an index or a business plan and may be considered as absolute measures or changes in measures. The Compensation Committee may adjust performance measures after they have been set. In establishing the performance measures, the Compensation Committee may provide for the inclusion or exclusion of certain items.”

The TL;DR version is that the Compensation Committee can issue stock awards based on almost any metric and then modify them if they want. I did appreciate that the proxy statement laid this all out to anyone willing to read it, but I’m not a huge fan of the bonus structure considering that there is nothing set in stone.

There is one more thing I’d like to mention about the vague nature of Esquire’s compensation disclosures. It states in the most recent 10-K that the business provides reduced disclosures about Executive Compensation due to its status as an Emerging Growth Company. Per p. 27 of the Q2 2022 10-Q, “The Company will lose its emerging growth company status on December 31, 2022 since that would be the last day of the fiscal year of the Company following the fifth anniversary of the date of the first sale of the common equity securities of the Company pursuant to an effective registration statement under the Securities Act of 1933.” Unfortunately, we must wait a little bit longer for better disclosures. On to the Summary Compensation Table.

The Summary Compensation Table below was taken from p. 12 of the 2022 Proxy Statement.

Lastly, we arrive at the amount of insider ownership. Directors, executive officers and named executive officers collectively owned 18.5% of the outstanding shares as of the publishing date of the 2022 Proxy Statement. Andrew Sagliocca, Eric Bader (the COO) and Ari Kornhaber (Head of Corporate Development) own 3.6%, 1.8% and 1.6% of shares outstanding, respectively.

What Does Esquire Bank Do?

As stated above, Esquire has three segments: banking and specialty lending products to the legal industry, real estate loans in the greater New York City area and merchant processing services.

Banking and Lending Products

First, I’d like to reiterate that Esquire is a branchless bank which is a major advantage for the business. This reduces cost and increases ease of use because its clients can access all their banking products online.

Its banking products are very simple. Esquire offers checking, savings, money market and certificates of deposit with a variety of rates. Easy enough to understand, but what’s unique about this? The answer can be found on p. 9 of the 2022 10-K. Quoting it directly, “Our unique low cost core deposit model is primarily driven by escrow and operating accounts from law firms and other litigation settlements on a national basis, representing more than 65% of the $1.0 billion in total deposits at December 31, 2021. Our core deposits (excluding time deposits) represent 98.1% of our total deposits at December 31, 2021. Our total cost of deposits is 0.10% for the year ended December 31, 2021, anchored by our noninterest bearing demand deposits and litigation related escrow funds representing 39.8% and 40.1%, respectively, of total deposits. We require deposit balances associated with our commercial loan arrangements and cash management relationships maintained by our commercial lending. We do not use a traditional “brick and mortar” branch network to support our deposit growth and have only one branch, located in Jericho, New York. The vast majority of our customers utilize our online cash management technology to manage their operating and escrow accounts across the country.” Later on in the same page it states, “Our deposit strategy primarily focuses on developing borrowing and other service orientated relationships with customers rather than competing with other institutions on rate.”

The bank’s lending products are catered to the litigation industry in the United States which gives it a niche focus in a very large and growing market which I will discuss in the Tailwinds section of this writeup. As an added kicker, it is the only national bank in this market that I’m aware of. You may not think this is a big deal, but it is a big advantage for the company and here’s why. Taken directly from p. 5 of the 2022 10-K with the bullet points highlighted for emphasis:

“Competition for Attorney-Related Loans is derived primarily from a small number of nationally-oriented financial companies that specialize in this market. Some of these companies are focused exclusively on loans to law firms, while others offer loans to plaintiffs as well. While some overlap exists between the litigation market loan products offered by Esquire Bank and these companies (primarily lines of credit, case-cost and post-settlement commercial loans), there are a number of critical differences that management believes give Esquire Bank a competitive advantage:

• Esquire Bank can offer more competitive rates on loans compared to specialty finance companies because its cost of funds is much lower than the funding costs for these non-bank competitors;

• the non-bank companies are not able to offer deposit products or business services such as remote deposit capture or letters of credit, or debit cards; and

• non-banks cannot offer products uniformly across the country because they are not national banks.”

You may be wondering why law firms need to use Esquire in the first place and not a traditional bank. The answer to this problem was explained in depth in a June 2021 National Law Review article featuring Ari Kornhaber, the Executive Vice President of Esquire. Quoting the article, “Unlike traditional businesses, law firms cannot simply raise capital for operating expenses. Current legal ethics rules prohibit non-attorneys from taking ownership interests in law firms, which eliminates the use of securities as a funding option and while attorneys can borrow funds, it often must be from a non-traditional lender because a potential litigation victory generally falls outside the scope of what is considered acceptable collateral. This often leads law firm management to pursue alternative lending options from non-traditional lenders like litigation financers or specialty lenders, who emphasize their core differentiator is that they can use a law firm’s case inventory as collateral – however, this often comes with a less-competitive interest rate than traditional banks.” This is where Esquire steps in. It is unique in that it can underwrite loans to the litigation industry and provide them with financing but at a better rate than non-traditional lenders while still making a healthy spread of ~4-5%. This, combined with its deposit gathering strategy, is what makes the business unique versus the competition. Let’s take a deeper look into its loan portfolio.

Commercial Loans

Loans in this category are broken out in to two separate categories: Commercial Loans (previously referred to as Non-Attorney Related Loans) and Commercial Litigation-Related Loans (previously referred to as Attorney Related Loans). Per the p. 6 of the 2022 10-K, “Commercial Loans are originated to local small to mid-size businesses to provide short-term financing for inventory, receivables, the purchase of supplies, or other operating needs arising during the normal course of business and loans made to our qualified merchant customers. In addition, specialized and tailored commercial loans are offered to attorneys and law firms nationally. At December 31, 2021, commercial loans (excluding Commercial Litigation-Related Loans of $383.4 million) totaled $48.7 million (or 6.2% of total loans). All commercial loans totaled $432.1 million (or 55.0% of our total loans) at December 31, 2021.” Per the Q2 2022 10-Q, total Commercial Loans totaled $83 million and all commercial loans totaled $478.1 million.

In the previous section I stated that Esquire steps in when law firms need financing. That’s what they do. This section about its Commercial Litigation-Related Loans is how they do it. Pay close attention here because understanding how these loans are underwritten is core to understanding why Esquire is such a good business. The Commercial Litigation-Related Loans are described in detail on p. 6 of the 2022 10-K. It states, “Commercial Litigation-Related Loans are made to attorneys and law firms and the outstanding loan balances are included in the loan balance for commercial loans as noted above. A unique aspect of our underwriting involves advances of loan proceeds against a “borrowing base,” which typically consists of the inventory of litigation cases for the firm. We complement this with traditional commercial underwriting (See “— Credit Risk Management” below). Generally, the maximum amount a customer may borrow at any time is fixed as a percentage of the borrowing base outstanding at any time and takes into account the firm’s operating performance and related debt service coverage. In addition, on an opportunistic basis, we lend to law firms that may exhibit fluctuating earnings, cumulative deficits, and negative cash flows. In such cases, we employ an asset based lending model to the deal structure. We consider such financing opportunities where the terms and structure present manageable risks and the opportunity to achieve above average returns.”

There are four subtypes of Commercial Litigation-Related Loans plus PPP loans. The description of each type of Commercial Litigation-Related Loan was taken from pp. 6-7 of the 2022 10-K:

“Working Capital Lines of Credit (“WC LOC”) - WC LOCs are unsecured business lines of credit offered to law firms for general corporate purposes, including meeting cash flow needs, advertising, financing the purchase of fixed assets, or other reasons. The balance of such loans was $210.1 million at December 31, 2021 (or 54.4% of total Litigation-Related Loans).” Per the Q2 2022 10-Q, the balance of WC LOCs totaled $195.2 million.

“Case Cost Lines of Credit - Case Cost Lines of Credit (“Case Cost LOC”) are unsecured business lines of credit that are tied to the costs of contingency cases and totaled $127.9 million at December 31, 2021 (or 33.1% of total Litigation-Related Loans). Contingency case costs include court filing fees, investigative costs, expert witness fees, deposition costs, medical record costs, and other costs. Recovery of case costs is derived from gross settlement proceeds from the settled case. In our experience, an average case can take two to four years to litigate and law firms are prevented from charging their clients any interest for the out-of-pocket litigation costs, which amounts to an interest-free loan provided to the client from the law firm. Thus, instead of using the law firm’s cash flow, law firms use Case Cost LOCs to finance litigation cash flows because the finance charges can generally be charged against the settlement proceeds. Case Cost LOCs are not contingent loans, meaning that their repayment is not dependent on a favorable case settlement. In the event of an unfavorable outcome for the borrower, the loans are repaid from the cash flows of the law firm.” Per the Q2 2022 10-Q, the balance of Case Cost Lines of Credit totaled $134.9 million.

“Term Loans - Term loans are short-term unsecured business loans originated to law firms for general corporate purposes. These loans are offered to law firms at the same terms as those offered to other types of businesses. Term loans to law firms totaled $45.4 million at December 31, 2021 (or 11.8% of total Litigation-Related Loans).” Per the Q2 2022 10-Q, the balance of Term Loans totaled $64.6 million.

“Post-Settlement Commercial and Other Commercial Litigation-Related Loans - Post-settlement commercial loans are bridge loans secured by proceeds from non-appealable, settled cases. Other commercial litigation-related loans consist of both secured and unsecured loans to law firms and attorneys. At December 31, 2021 there were no post-settlement commercial loans outstanding.” The balance for these types of loans was also $0 as of the end of Q2 2022.

“Paycheck Protection Program Loans - In response to the COVID-19 pandemic, we elected to participate in the PPP administered by the U.S. Small Business Administration (“SBA”) with the intention to provide our customer base access to this critical program. The PPP provides borrower guarantees for lenders, as well as loan forgiveness incentives for borrowers that utilize the loan proceeds to cover employee compensation-related costs and other qualifying business costs. As of December 31, 2021, we had PPP loans totaling $4.2 million (or 1.0% of total commercial loans) of which $2.1 million were with our commercial litigation related customers that were not included in the Commercial Litigation-Related Loans product line.” The balance of these loans was $0 as of the end of Q2 2022.

Consumer Loans

Per p. 7 of the 2022 10-K, “Consumer loans are primarily post-settlement consumer and, to a lesser extent, structured settlement loans made to plaintiffs and claimants as described below. Consumer loans are also originated to individuals for debt consolidation, medical expenses, living expenses, payment of outstanding bills, or other consumer needs on both a secured and unsecured basis. At December 31, 2021, total consumer loans held for investment (excluding Consumer Litigation-Related Loans of $2.6 million) totaled $6.1 million (or 0.8% of total loans).

Post-settlement consumer loans are generally bridge loans to individuals secured by proceeds from settled cases. These loans generally meet the “life needs” of claimants in various litigation matters due to the delay between the time of settlement and actual payment of the settlement. These delays are primarily due to various administrative matters in the case. The balance of held for investment post-settlement consumer loans to individuals was $2.5 million at December 31, 2021.”

Per the Q2 2022 10-Q, the balance of all Consumer Loans totaled $2.4 million.

Credit Risk Management

I think this part of the business deserves its own section in the writeup due to the unique nature of Esquire’s Commercial Litigation-Related Loans. The information below was taken from p. 9 of the 2022 10-K and gives an excellent description of Esquire’s credit risk management strategy.

“Commercial Loans.  These loans are typically made on the basis of the borrower’s ability to make repayments from the cash flow of the borrower’s business and the collateral securing these loans which may fluctuate in value. Our commercial loans are originated based on the identified cash flow of the borrower and on the underlying collateral provided by the borrower. Most often, for our Litigation-Related Loans, this collateral consists of the case inventory of the law firm (borrowing base) and, to a lesser extent, accounts receivable or equipment.

·       Commercial Litigation-Related Loans (working capital lines of credit, case cost lines of credit, and term loans). We perform the underwriting criteria typical for commercial business loans (generally, but not limited to, three years of tax returns, three years of financial data, cash flows, partner guarantees, partner personal financials, credit history, background checks, etc.). We also review the firm’s case inventory to ascertain the value of their future receivables. Typically, at least three years of successful experience in plaintiff practice are required. Working capital lines of credit and case cost lines of credit are floating rate, prime-based loans. The proceeds of a Case Cost loan can only be used against case expenses. These loans are subject to a general security agreement evidenced by UCC-1 filing on all assets of the borrower, including but not limited to case inventory, accounts receivable, fixtures and deposits where applicable. A key component of the underwriting process is an evaluation of the pending cases of an applicant law firm to determine the probability and amount of future settlements. These loans are based on a borrowing base that was developed by us whereby a law firm’s case inventory is segmented into various stages and evaluated taking into account the firm’s operating performance and related debt service coverage. In connection with these loans, the Bank generally requires personal guarantees of key partners as well as assignment of life insurance of partners in most cases, in accordance with our Board approved Lending Policy.

From time to time we will have the opportunity to provide financing to a law firm that through its existence or its partners’ professional work histories have demonstrated long-term success with large, complex, and profitable litigations. Firms of this nature are structured in such a way that their business model and legal talent profile has been positioned to manage such activity. These are typically firms specializing in Mass Tort or Class Action claims which often exhibit cumulative deficits, fluctuating earnings, and extended periods of negative cash flow. When structured properly, with sufficient due diligence and the application of loan structuring concepts typically associated with asset based lending, such facilities can present manageable risks and above average returns. We will entertain such financing opportunities where the terms, structure, borrower willingness and ability to cooperate with our underwriting requirements will provide an appropriate risk adjusted return.”

Real Estate Loans

Esquire has four types of real estate loans. Again, please don’t forget that these loans are mainly in the New York City metro area. The description of each type of real estate loan was taken from p. 7 of the 2022 10-K:

“Multifamily - Multifamily loans are the largest component of the real estate loan portfolio and totaled $254.9 million (or 32.5% of total loans) as of December 31, 2021. The multifamily loan portfolio consists of loans secured by apartment buildings and mixed-use buildings (predominantly residential income producing) in our primary market area. We originate and purchase multifamily loans. Whether originated or purchased, all loans are independently underwritten by us utilizing the same underwriting criteria per our Board established credit policy.” Per the Q2 2022 10-Q, the balance of these loans totaled $259.6 million.

“1 – 4 Family - Mortgage loans are primarily secured by 1 – 4 family cash flowing investment properties ($40.8 million, or 5.2% of total loans, as of December 31, 2021) in our market area. The residential mortgage loan portfolio includes 1 – 4 family income producing investment properties, primary and secondary owner occupied residences, investor coops and condos. The majority of residential mortgages are originated internally, although we do purchase residential mortgages from time to time. Purchased loans are subject to all the asset quality and documentary precautions normally used when originating a loan.” Per the Q2 2022 10-Q, the balance of these loans totaled $33.6 million.

“Commercial Real Estate (“CRE”) - CRE loans totaled $48.6 million (or 6.2% of total loans) as of December 31, 2021 and consisted primarily of loans secured by hospitality properties (47.7% of the CRE portfolio), warehouses (31.8% of the CRE portfolio), condo associations and office/retail properties (11.3% of the CRE portfolio) with the remainder comprised of mixed use properties (9.2% of the CRE portfolio). Owner-occupied loans represented 12.3% of the CRE portfolio at December 31, 2021. We both originate and purchase CRE loans. All loans are independently underwritten by us utilizing the same underwriting criteria per our Board established credit policy.” Per the Q2 2022 10-Q, the balance of these loans totaled $80.5 million.

“Construction Loans - Construction loans are originated on an opportunistic basis. At December 31, 2021, there were no construction loans.” The balance of these loans was $0 as of the end of Q2 2022.

Payment Processing Activities (formerly Merchant Services)

Per p. 8 of the 2022 10-K, “We provide payment processing as an acquiring bank primarily through the third-party or ISO business model in which we process credit and debit card transactions on behalf of merchants. This model is designed to mitigate the risks associated with merchant losses resulting from chargebacks, fraud, non-compliance issues or even ISO or merchant insolvency. In an ISO model, the bank and the ISO jointly enter into the merchant agreement with each merchant. We believe this model provides an added layer of protection against losses from merchants since losses that are not absorbed by a merchant would be the liability of the ISO payable from reserves posted by the ISO or other funds the bank owes to the ISO. Even with this recourse, Esquire Bank is ultimately liable for losses from actions of merchants and those of ISOs. To date, Esquire Bank has not incurred any losses from its payment processing activities.

We entered into the payment processing business as an acquiring bank in 2012 in an effort to increase our noninterest income revenue and to provide cross selling opportunities for other business banking products and services. For the year ended December 31, 2021, payment processing revenues were approximately $20.9 million, which was 32.2% of our total revenue and represented an increase of 47.9% as compared to 2020. At December 31, 2021, we had 28 active ISOs, servicing approximately 65,000 merchants, and for the year ended December 31, 2021, we processed $23.7 billion in card volume. We intend to continue to expand our payment processing business.” Per the Q2 2022 10-Q, payment processing generated $11.7 million in fees for Esquire in the first half of the year.

PART 1 STOPS HERE. PART 2 WILL BE POSTED IN TWO WEEKS.

Thanks again as always for reading. If you liked this writeup then please feel free to share it and subscribe!

Please reach out to me at possiblevalueresearch@gmail.com, @PossibleValue on Twitter and @Heshy on MicroCapClub with any comments, concerns or questions. Lastly, don’t forget to tell someone that you love them.

*** Remember that this isn’t investing advice. Consult a trusted financial or investment advisor before making any kind of investment decision. ***

Disclosure: I do not own stock in Esquire Bank.