ITEM 1. BUSINESS
GENERAL
First Essex Bancorp, Inc. - ------------------------- First Essex Bancorp, Inc. ("First Essex" or the "Company") is a Delaware corporation whose primary activity is to act as the parent holding company for First Essex Bank, FSB (the "Bank"). Until December 1, 1993, the business of First Essex Bancorp, Inc. was conducted through two banking subsidiaries, First Essex Savings Bank, a Massachusetts-chartered savings bank and First Essex Savings Bank of New Hampshire, a Guaranty Savings Bank. The New Hampshire bank was owned through a second tier holding company, First Essex Bancorp of New Hampshire, Inc., which was merged into First Essex Bancorp, Inc. on December 1, 1993.
On December 30, 1996, the Company acquired all of the outstanding shares of the common stock of Finest Financial Corp. ("Finest"). The purchase price was composed of 1,353,998 shares of common stock issued at a price of $11.50 per share and a total cash outlay of $16.3 million. Included in the total acquisition cost was approximately $1.4 million of capitalized costs incurred in connection with the acquisition. This transaction was accounted for as a purchase and, accordingly, the consolidated statement of operations includes the results of Finest's operations since the acquisition.
On December 30, 1996, Finest Financial Corp. ("Finest"), the parent holding company of Pelham Bank and Trust Company ("Pelham"), a New Hampshire chartered bank, was merged into the Company in a transaction that was accounted for as a purchase. Pelham was simultaneously merged into the Bank.
First Essex Bank, FSB - --------------------- The Bank was originally founded under a Massachusetts legislative charter issued in 1847. On December 1, 1993, First Essex Savings Bank converted to a federal savings bank with a charter issued by the Office of Thrift Supervision, (the "OTS") under the name of First Essex Bank, FSB. On the same day First Essex Savings Bank of New Hampshire was merged into First Essex Bank, FSB. As stated above, the Bank merged with Pelham on December 30, 1996.
At December 31, 1996, the Bank had total assets of $1.1 billion, of which approximately $196.6 million was attributable to the acquisition of Pelham. The Bank is principally engaged in the business of attracting deposits from the general public and investing in residential mortgage, construction, commercial real estate, commercial and consumer loans. The Bank also makes investments in various investment securities to provide a source of interest and dividend income. The Bank currently maintains fifteen full service banking offices at various locations throughout its market area. The Bank's deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC").
MARKET AREA
First Essex's market area is centered in the Merrimack Valley, approximately 25 miles north of Boston and five miles south of New Hampshire, at the intersection of two major highways: Interstate Route 93, the major north-south roadway connecting Boston with the northern Boston suburban communities and New Hampshire, and Interstate Route 495. The Bank's principal executive offices are located in Andover, Massachusetts, and its main banking office and two of its branches are located in Lawrence, Massachusetts. Other branches are in the surrounding communities of Andover, North Andover, Haverhill, Lowell and Methuen, Massachusetts and Londonderry, Pelham, Salem and Windham, New Hampshire. First Essex also has loan centers in Lowell and Wellesley, Massachusetts, and in Nashua and North Hampton, New Hampshire.
CURRENT MARKET CONDITIONS
The New England region, including those portions of northeastern Massachusetts and southern New Hampshire that constitute First Essex's market area, continues to experience growth.
Loan demand to finance new and existing home sales was stronger in 1996 and 1995 than in prior years. The growth in commercial loans to small and mid-size businesses in the area has also shown strength, although the competition among lenders for these loans is intense. First Essex was able to grow loans while adhering to its credit quality guidelines. Automobile sales continued to show their strength in 1996 and First Essex has been able to participate in that growth through an indirect automobile lending program that was begun early in 1994. The general improvement in consumer confidence and the consumer's willingness to take on additional debt has also resulted in growth in direct lending to consumers.
REGULATION
General - ------- The Office of Thrift Supervision ("OTS") is the primary regulator of the Company and the Bank. The Bank's deposits are insured up to applicable limits by the Bank Insurance Fund ("BIF") of the FDIC. The Company and the Bank must file reports with the OTS concerning activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. Periodic examinations are conducted by the OTS to test the Company's and the Bank's compliance with various regulatory requirements. The Bank is also a member of the Federal Home Loan Bank ("FHLB") system, which provides a central credit facility primarily for member institutions. The Company, as a savings and loan holding company, is also required to file certain reports, and otherwise comply, with the rules and regulations of the OTS and of the Securities and Exchange Commission ("SEC") under the federal securities laws.
Business Activities - ------------------- The activities of federal savings institutions are governed by the Home Owners' Loan Act, as amended (the "HOLA") and, in certain respects, the Federal Deposit Insurance Act (the "FDI Act"). The HOLA and the FDI Act were amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA, among other things, requires that federal banking regulators intervene promptly when a depository institution experiences financial difficulties, mandates the establishment of a risk-based deposit insurance assessment system and requires the imposition of numerous additional safety and soundness operational standards and restrictions. FDICIA contains provisions affecting numerous aspects of the operations of federal savings institutions and empowers the OTS and the FDIC, among other agencies, to promulgate regulations implementing its provision.
Qualified Thrift Lender Test - ---------------------------- The HOLA requires saving institutions to meet a qualified thrift lender ("QTL") test. Under the QTL test, as modified by FDICIA, a savings association is required to maintain at least 65% of its "portfolio assets" (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill, and (iii) the value of property used to conduct the association's business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed securities) on a monthly basis in 9 out of every 12 months.
Limitation on Capital Distributions - ----------------------------------- OTS regulations impose limitations upon all capital distributions, other than stock dividends, by savings institutions. The rule establishes three tiers of institutions, which are based primarily on an institution's capital level. An institution that meets or exceeds all fully phased-in capital requirements before and after a proposed capital distribution ("Tier 1 Bank") and has not been advised by the OTS that it is in need of more than normal supervision, could, after prior notice but without the approval of the OTS, make capital distributions during a calendar year equal to the greater of: (i) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (the percentage by which its capital to assets ratio exceeds the ratio of its fully phased-in capital requirements to its assets) at the beginning of the calendar year; or (ii) 75% of its net income for the previous four quarters. Any additional capital distributions would require prior regulatory approval. In the event the Bank's capital fell below its fully-phased in requirement or the OTS notified the Bank that it was in need of more than normal supervision, the Bank's ability to make capital distributions would be restricted. In addition, the OTS could prohibit any proposed capital distribution by any institution if
it determines that such distribution would constitute an unsafe or unsound practice. Furthermore, under the OTS prompt corrective action regulations, which took effect on December 19, 1992, the Bank generally would be prohibited from making any capital distribution if, after the distribution, the Bank would have (i) a total risk-based capital ratio of less than 8%, (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a Tier 1 core capital ratio of less than 3%. As of December 31, 1996, the Bank exceeds all fully-phased in capital requirements.
Branching - --------- The HOLA and OTS regulations permit savings institutions to branch nationwide provided the institutions meet certain asset composition tests. The OTS authority preempts any state law purporting to regulate branching by savings institutions. As of December 31, 1996, the Bank would be permitted to engage in such nationwide interstate branching.
Capital Requirements - -------------------- The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures are established by regulation to ensure the capital adequacy required of the Bank to maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk- weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1996, that the Company meets all capital adequacy requirements to which it is subject.
As of December 31, 1996, the most recent notification received from the OTS categorized the Company as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Company must maintain the total risk-based, Tier I risk-based and Tier I average asset ratios. There are no conditions or events since that notification that management believes have changed the institution's category.
FDICIA required that the OTS revise risk-based capital standards, with appropriate transition rules, to ensure that they take account of interest rate risk, concentration of risk and the risks of nontraditional activities. Under OTS regulation effective January 1, 1994, a savings institution with interest rate risk exposure above a specified percentage must deduct a specified interest rate risk component when calculating total capital for purposes of determining whether it meets OTS risk-based capital requirements. As of December 31, 1996, the OTS did not deem it necessary for an interest-rate risk component to be deducted from capital in determining risk-based capital requirements.
The Company may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
The capital ratios discussed above, along with the Company's actual capital amounts and ratios are presented in a table within footnote 15 to the consolidated financial statements included in response to Item 8 "Financial Statements and Supplementary Data" of this report.
INSURANCE OF DEPOSIT ACCOUNTS
As required by FDICIA, in 1993, the FDIC established a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities, the likely amounts of any loss, and the revenue needs of the insurance fund.
Insurance of deposits may be terminated by the FDIC after notice and hearing, upon finding by the FDIC that the savings institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, rule, regulation, order or condition imposed by, or written agreement with, the FDIC. Additionally, if insurance termination proceedings are initiated against a savings institution, the FDIC temporarily may suspend insurance on new deposits received by an institution under certain circumstances. Management is not aware of any activity or condition which could result in a termination of its deposit insurance.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board regulations require savings institutions to maintain noninterest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). Because required reserves must be maintained in the form of either vault cash, a noninterest bearing account at a Federal Reserve Bank or a pass-through account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce the Bank's interest-earning assets.
HOLDING COMPANY REGULATION
The Company is a nondiversified unitary savings and loan holding company within the meaning of the HOLA. As such, the Company has registered with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. As a unitary savings and loan holding company, the Company generally will not be restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a QTL. The HOLA requires the Company to obtain regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other institutions or holding companies.
LENDING ACTIVITIES
General At December 31, 1996, the loan portfolio, before deducting the allowance for possible loan losses, was $704.7 million, representing 66.0% of total assets and an increase of $204.6 million over the prior year. The increase in loans included $97.5 million of loans acquired from Finest Financial Corp ("Finest") at the time of its acquisition by the Company.
Loan originations increased in 1996 primarily due to the stabilization of the New England residential real estate market, and in the Massachusetts and New Hampshire economies generally. The increase also reflects a stronger marketing effort by the Bank in the commercial and consumer loan areas. First Essex originates residential first mortgage loans, commercial real estate loans, construction loans, consumer loans and commercial loans. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition."
The following table sets forth information concerning First Essex's loan portfolio, including mortgage loans held for sale, at the dates indicated. The balances shown in the table are net of unadvanced funds and unearned discounts and fees. Required disclosure regarding maturity distribution is shown on pages 26 and 27.
Residential Mortgage Loans The Bank originates residential first mortgage loans in its market area. At December 31, 1996, the residential mortgage loan portfolio was $301.9 million, representing 42.9% of the loan portfolio. The Company's residential first mortgage loan products consist of six month, one-year, three-year, five year and seven year adjustable-rate mortgages and fixed-rate mortgages, having terms of 15 to 30 years.
Commercial Real Estate Loans The Bank also holds loans secured by commercial real estate, such as manufacturing, retail, apartment and office buildings. At December 31, 1996, First Essex's commercial real estate loan portfolio had an outstanding balance of $102.7 million, representing 14.6% of First Essex's loan portfolio.
Generally, commercial real estate loans in the portfolio have been made to finance the acquisition or retention of income producing properties. The current policy of First Essex is to limit commercial real estate loans primarily to properties in eastern Massachusetts and southern New Hampshire.
Commercial real estate loans generally reprice over periods ranging from six months to five years based on a margin over a published prime rate or other index.
Construction Loans Construction loans are primarily made to developers and builders for the construction of commercial and single family properties. Construction loans have generally been made with maturities of one year or less at a margin floating over the published prime, subject to renewal or extension by the Bank. Additionally, loans are made to qualified individuals for construction of single-family owner-occupied homes that convert to permanent mortgages upon completion of construction. At December 31, 1996, the Bank's construction loan portfolio had an outstanding balance of $24.9 million, representing 3.5% of the loan portfolio.
Owner-Occupied Commercial Real Estate Loans Owner-occupied commercial real estate loans are extensions of credit to commercial borrowers for the construction or purchase of business space, primarily for the borrower's own use, or loans to commercial borrowers for operating purposes in which the Bank has taken real estate occupied by the borrower as collateral. In these instances, the cash flow of the borrower's business is the primary source of repayment. At December 31, 1996, this portfolio had total outstandings of $29.5 million, representing 4.2% of the Bank's loan portfolio.
Commercial Loans At December 31, 1996, the portfolio of commercial loans totalled $88.5 million, representing 12.6% of the loan portfolio. Included in that total are $24.8 million of commercial aircraft loans. The Bank offers various types of
commercial aircraft loans. The Bank offers various types of commercial loans, which are short term or have adjustable rates at a margin above the prime rate, including secured and unsecured demand loans, time loans, term loans, lines of credit and working capital loans. Commercial loans are originated by the Bank's commercial lending officers and supported by a credit, processing and documentation staff.
Consumer Loans The portfolio of consumer loans, consisting of automobile loans, fully or partially secured personal loans, boat loans, aircraft loans, second mortgage loans, home equity loans and education loans, as well as unsecured personal loans, totalled $157.3 million, including $8.5 million of consumer aircraft loans, at December 31, 1996, representing 22.3% of the loan portfolio. Automobile loans include dealer indirect loans, as well as loans originated directly in retail branches. The Bank offers a variable rate home equity line of credit called "First Line Equity Credit". This product consists of a line of credit, secured by a second mortgage on residential property, with a monthly adjustable interest rate at a margin above a published prime rate.
Risks Associated with Commercial Real Estate, Commercial, Owner-Occupied Commercial Real Estate and Construction Loans Commercial real estate and commercial lending involve significant additional risks compared with one-to-four family residential mortgage lending, and, therefore, typically account for a disproportionate share of delinquent loans and real estate owned through foreclosure. Such lending generally involves larger loan balances to single borrowers or groups of related borrowers than does residential lending, and repayment of the loan depends in part on the underlying business and financial condition of the borrower and is more susceptible to adverse future developments. If the cash flow from income-producing property is reduced (for example, because leases are not obtained or renewed), the borrower's ability to repay the loan may be materially impaired. These risks can be significantly affected by considerations of supply and demand in the market for office, manufacturing and retail space and by general economic conditions. As a result, commercial real estate and commercial loans are likely to be subject, to a greater extent than residential property loans, to adverse conditions in the economy generally.
Construction loans are, in general, subject to the same risks as commercial real estate loans, but involve additional risks as well. Such additional risks are due to uncertainties inherent in estimating construction costs, delays arising from labor problems, shortages of material, uncertain marketability of a complete project and other unpredictable contingencies that make it relatively difficult to determine accurately the total loan funds required to complete a project or the value of the completed project. Construction loan funds are advanced on the security of the project under construction, which is of uncertain value prior to the completion of construction. When a construction project encounters cost overruns, marketing or other problems, it may become necessary, in order to sustain the project and to preserve collateral values, for the lender to advance additional funds and to extend the maturity of its loan. In a declining market, there is no assurance that this strategy will successfully enable the lender to recover outstanding loan amounts and interest due. Moreover, foreclosing on such properties results in administrative expense and substantial delays in recovery of outstanding loan amounts and provides no assurance that the lender will recover all monies due to it, either by developing the property, subject to regulatory limitations and to the attendant risks of development, or by selling the property to another developer.
Residential Loan Servicing and Purchase and Sale of Loans The Bank has a general policy of writing residential mortgage loans to meet the requirements for sale in the secondary market. From time to time, the Bank sells residential mortgage loans and residential loan servicing. Such loan sales represent a potential source of liquidity to meet lending demand and deposit flows. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management."
At December 31, 1996, the Bank's loan servicing portfolio totalled $95.8 million.
NON-PERFORMING ASSETS
General Non-performing assets consist of non-accruing loans (including loans impaired under the Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan,"), other real estate
owned and other foreclosed property. For further information regarding the impairment of loans see "Provision for Possible Loan Losses" included in Item 7 - - "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Non-Accruing Loans It is the general practice of the Bank to discontinue accrual of interest on loans for which payment of interest or principal is 90 days or more past due and such other loans where collection of interest and principal is doubtful. All previously accrued but uncollected interest is reversed against current period interest income when a loan is placed on non-accrual status. At December 31, 1996, the Bank's non-accruing loans totalled $4.7 million compared to $4.4 million on December 31, 1995. For further information regarding the Bank's non-accruing loans, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Non-Performing Assets."
Restructured Loans These are loans on which concessions have been made in light of the debtor's financial difficulty with the objective of maximizing recovery and with respect to which the renegotiated payment terms are being met. At December 31, 1996 and 1995, the Bank had restructured loans with principal balances of $1.0 million outstanding. For further information regarding restructured loans, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Non-Performing Assets."
Foreclosed Property Foreclosed property at December 31, 1996 totalled $1.9 million, compared to $1.8 million at December 31, 1995. Such properties were acquired through foreclosure.
Foreclosed property consists of real or tangible property that collateralized a loan prior to foreclosure or repossession. These properties are carried at the lower of cost or the estimated net realizable values. Any decreases in value prior to sale are charged to operations.
For further information regarding the Bank's foreclosed property, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Non-Performing Assets."
INVESTMENT ACTIVITIES
The Bank maintains an investment portfolio to provide a source of interest and dividend income and a potential source of liquidity to meet lending demand and deposit flows. At December 31, 1996, the investment portfolio, consisting of short-term investments, investment securities, mortgage-backed securities, stock in the Federal Home Loan Bank of Boston and stock of the Savings Bank Life Insurance Company of Massachusetts, was $315.7 million, or 29.6% of total assets. Investment securities totalling $62.1 million are attributable to the acquisition of Finest.
Interest and dividend income on the investment portfolio generated 26.2% of total interest and dividend income for the year ended December 31, 1996. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Investments" for further information regarding the investment portfolio.
The Bank's investment strategy seeks to enhance liquidity and seeks to realize current income while preserving principal. The Bank will generally invest only in government or corporate bonds or securities issued in the United States and will only purchase bonds which are rated A or higher at the time of purchase.
DEPOSITS
The Bank offers a range of deposit accounts including regular passbook savings, NOW, money market and demand deposit accounts. The Bank offers a number of relationship products which allow customers to combine balances in checking and savings accounts in order to avoid service and maintenance fees, and obtain free banking services. It also includes discounts on installment loans and bonus rates on certificates of deposit. The
Bank also offers 60-day to 7 year term deposit certificates. Interest rates on these certificates vary according to the term selected and are based upon several indices, including the rates on government securities with similar maturities. From time to time, the Bank promotes various types of accounts with the intention of changing the maturity schedule of its liabilities.
The Bank offers its retail banking customers a wide range of deposit services and the convenience of drive-up ATMs. The Bank is a member of the NYCE(TM), EXCHANGE(TM), TX(TM) and CIRRUS(TM) networks. These networks allow the Bank's depositors access to their accounts through ATMs at the Bank, other banks and locations nationwide and worldwide.
COMPETITION
The Bank faces competition both in originating loans and in attracting deposits. Competition in originating loans comes from a variety of sources, including, but not limited to, other thrift institutions, commercial banks, mortgage companies, insurance companies and consumer and commercial finance companies. The Bank competes for loans principally on the basis of interest rates and loan fees, the types of loans originated and the quality of services provided to borrowers. In attracting deposits, the primary competitors are other thrift institutions, commercial banks, mutual funds and credit unions. The ability to attract and retain deposits depends on the ability to provide investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The Bank competes for deposits on the basis of interest rates and by offering convenient branch locations, extended business hours and an automated teller network.
EMPLOYEES
At December 31, 1996, the Bank had 294 employees, of whom 50 were part-time. None of the employees of the Bank are represented by a collective bargaining group and management considers its relations with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The Company's principal banking subsidiary, First Essex Bank, FSB, operates banking facilities in ten locations in northern Massachusetts, and five locations in southern New Hampshire. The offices of the Bank are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities serviced.
The offices of the Company are located in the Bank's branch office at 71 Main Street in Andover, Massachusetts.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incident to its business, none of which is believed by management to be material to the financial condition or operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A Special Meeting of Stockholders was held on December 19, 1996 for the purpose of considering and voting upon a proposal to approve and adopt the Agreement and Plan of Reorganization dated August 5, 1996, as amended as of September 27, 1996 (the "Merger Agreement"), by and among First Essex, Finest and Pelham, and each of the transactions contemplated thereby, including the merger (the "Merger") of Finest with and into First Essex, upon the terms and subject to the conditions set forth in the Merger Agreement.
An affirmative vote of the majority of holders of the outstanding shares of First Essex Common Stock was required for approval of the Merger Agreement and the transactions contemplated thereby. Abstentions and broker non-votes had the same effect as votes against the Merger Agreement. At the close of business on the record date of October 31, 1996 outstanding shares totalled 6,058,935 requiring a vote in favor of the Merger Agreement of shares totalling 3,029,468. The number of votes cast in favor of the Merger Agreement totalled 3,207,560. Shares voted against totalled 79,139 with abstentions of 28,739 and non-votes totalling 2,743,497.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
First Essex Bancorp, Inc. common stock is traded over-the-counter on the National Market System of the National Association of Securities Dealers, Inc. Automated Quotation System (NASDAQ) under the symbol FESX.
At December 31, 1996, there were 7,421,433 shares outstanding and approximately 1,190 shareholders of record. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms.
The price information regarding the Company's common stock in the following table is based on high and low closing sales prices on NASDAQ.
The only funds available to the Company for the payment of dividends are cash and cash equivalents held at the holding company level, dividends from the Bank and borrowings. In addition, bank regulatory authorities generally restrict the amounts available for the payment of dividends by the Bank to First Essex to the net profit of the Bank for that year, see Item 1 - "Business - Regulation - Limitation on Capital Distributions". The Federal Reserve Act also restricts the Bank in lending or advancing funds to First Essex unless such loans are collateralized by specific obligations, and limits collateralized loans to 10% of the Bank's capital stock and surplus.
The Bank is prohibited from paying cash dividends, to the extent that any such payment would reduce its capital below required regulatory capital levels or would impair the liquidation account established in connection with its conversion from mutual to stock form. See Note 14 to the consolidated financial statements included in response to Item 8 - "Financial Statements and Supplementary Data" of this report for further discussion.
The payment of dividends by the Bank could carry significant adverse tax consequences. To the extent that distributions by the Bank to the holding company exceeds the Bank's current and accumulated earnings and profits (as computed for federal income tax purposes for taxable years beginning after December 31, 1951), those distributions would be treated for tax purposes as first being made out of the Bank's bad debt reserve. In that case, the Bank would have federal taxable income equal to approximately one and one-half times the amount of the actual shareholder distribution that is treated as made out of the Bank's bad debt reserves.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Investment securities include short term investments, U.S. government and agency obligations, mortgage-backed securities, other bonds and obligations, stock in the Federal Home Loan Bank of Boston and stock in the Savings Bank Life Insurance Company.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
General
The results of operations of the Company consist primarily of the results of operations of the Bank which is the Company's sole subsidiary. Pretax income for 1996 rose $1.6 million or 22% over 1995. The improvement was in part due to the 2.3% increase in average earning assets combined with decreased levels of nonperforming assets. See Item 1. "Business - Current Market Conditions/Recent Operating Results."
Net income for the year ended December 31, 1996 totalled $9.1 million (or $1.47 per share) compared to $7.5 million (or $1.22 per share) for the same period in 1995. The increase in net income is mainly due to an increase of $2.4 million in net interest income and higher gains in the sale of investment securities of $510,000, offset by an increase in the provision for possible loan losses of $645,000 and an increase in salaries and employee benefit expense of $1.1 million.
Analysis of Average Yields Earned and Rates Paid The following table presents an analysis of average yields earned and rates paid for the years indicated:
Rate/Volume Analysis The following table presents, for the periods indicated, the changes in interest and dividend income and the changes in interest expense attributable to changes in interest rates and changes in the volume of interest earning assets and interest bearing liabilities. The change attributable to both volume and rate has been allocated proportionally to the two categories.
Net Interest Income Net interest income increased by $2.4 million to $26.2 million for the year ended December 31, 1996, representing a 10.0% increase from $23.8 million in 1995. The increase in net interest income is primarily due to the $18.5 million increase (2.3%) in average earning assets along with an increase of 23 basis points in the net yield on average earning assets. The increase in the net yield is attributable to the declining interest cost of borrowed funds and interest bearing deposits.
Net interest income increased by $1.5 million to $23.8 million for the year ended December 31, 1995, representing a 6.6% increase from $22.3 million in 1994. The increase in net interest income is primarily due to the $124.6 million increase (18.6%) in average earning assets offset by a 34 basis point decrease in the net yield on average earning assets. The decrease in net yield is attributable to the rising interest cost of borrowed funds and interest bearing deposits.
Interest and Dividend Income Interest and dividend income increased by $2.6 million (4.3%) to $63.5 million for the year ended December 31, 1996 from $60.9 million in 1995. This increase was primarily due to the increase in average earning assets. Average earning assets increased from $796.3 million in 1995 to $814.8 million in 1996, a 2.3% increase. The net yield on average earning assets rose 23 basis points from the 1995 yield of 2.99% to 3.22% in 1996.
Interest and dividend income increased by $15.9 million (35.2%) to $60.9 million for the year ended December 31, 1995 from $45.1 million in 1994. This increase was primarily due to the increase in average earning assets. Average earning assets increased from $671.7 million in 1994 to $796.3 million in 1995, an 18.6% increase. The average weighted yield on loans rose 48 basis points from the 1994 yield of 8.23% to 8.71% in 1995. The average weighted yield on investment securities rose from the 1994 yield of 5.28% to 6.11% in 1995.
Interest Expense Interest expense increased by $236,000 (0.6%) to $37.3 million for the year ended December 31, 1996 from $37.1 million in 1995. The increase is attributable in part to an increase of $2.1 million in the amount paid on depositors' accounts offset by a decrease of $1.9 million paid on borrowed funds. The total weighted cost of funds decreased slightly from a level of 5.09% in 1995 to 5.08% in 1996.
Interest expense increased by $14.4 million (63.3%) to $37.1 million for the year ended December 31, 1995 from $22.7 million in 1994. The main reason for the increase was an increase of $112.9 million (18.3%) in interest bearing liabilities utilized to support asset growth. The remainder was primarily due to the 1.4 percentage point increase in the cost of funds. The total weighted cost of funds increased from a level of 3.69% in 1994 to 5.09% in 1995.
Provision for Possible Loan Losses Beginning in 1995, the Company adopted SFAS No. 114, as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114"). Under SFAS No. 114, the Company considers a loan impaired if it is ninety days or more past due as to principal and interest, or if management's credit risk assessment determines that it is probable that principal and interest will not be collected as contractually scheduled. In addition, loans which are restructured at market rates and comparable to loans with similar risks are considered impaired only in the year of the restructuring, so long as they continue to perform according to the restructured terms. Excluded from the impaired category, but otherwise considered non-accruing loans, are small balance homogeneous loans which are ninety days or more past due. Small balance homogeneous loans include residential mortgage loans, residential construction loans to individuals (excluding builder construction loans) and consumer loans. The Company evaluates a loan's level of impairment by measuring the net present value of the expected future cash flows using the loan's original effective interest rate, or looking at the fair value of the collateral if the loan is collateral dependent. When the difference between the net present value of the impaired loan (or fair value of the collateral if the loan is collateral dependent) is lower than the recorded investment of the loan, the difference is provided to expense with a resulting valuation allowance.
Possible losses on loans are provided for under the accrual method of accounting. Assessing the adequacy of the allowance for possible loan losses involves substantial uncertainties and is based upon management's evaluation of the amount required to meet estimated losses inherent in the loan portfolio after weighing various factors. Among the factors management may consider are the quality of specific loans, risk characteristics of the loan portfolio generally, the level of non-accruing loans, current economic conditions, trends in delinquencies and charge-offs and collateral values of the underlying security. Ultimate losses may vary significantly from the current estimates. Losses on loans, including impaired loans, are charged against the allowance when management believes the collectibility of principal is doubtful.
Provisions for possible loan losses totalled $1.4 million and $770,000 for the years ended December 31, 1996 and 1995, respectively. Included in those amounts were $659,000 and $356,000, respectively, of provisions for possible losses related to loans impaired under SFAS No. 114. There were no provisions for possible loan losses for the year ended December 31, 1994. Provisions result from management's continuing internal review of the loan portfolio as well as its judgment as to the adequacy of the reserves in light of the condition of the regional real estate market and the economy generally. As a result of increased loans, there is an expectation that the Bank will continue to find it necessary to make provisions for possible loan losses in the future. See "Financial Condition - Non-Performing Assets."
The Bank's total allowance for possible loan losses was $10.5 million (including $4.1 million acquired from Finest) or 222.4% of non-accruing loans at December 31, 1996 compared to $6.6 million or 148.4% at December 31, 1995 and $7.2 million or 99.0% at December 31, 1994.
Noninterest Income Noninterest income consists of net gains or losses from sales of securities, net gains from sales of loans and loan servicing rights, fee and other noninterest income.
Noninterest income increased to $4.3 million for the year ended December 31, 1996 compared to $3.7 million in 1995. The primary reason for the increase from 1995 to 1996 was an increased gain on the sale of investment securities, which rose by $510,000 from a loss of $13,000 in 1995, to a gain of $497,000 in 1996. Loan fees also increased by $36,000 from $477,000 in 1995 to $513,000 in 1996.
Noninterest income increased to $3.7 million for the year ended December 31, 1995 compared to $2.6 million in 1994. The primary reason for the increase from 1994 to 1995 was increased gains from sales of loans and loan servicing rights, which rose by $1.2 million from the gain of $260,000 in 1994 to the gain of $1.4 million in 1995. Loan fees also increased by $84,000 from $393,000 in 1994 to $477,000 in 1995.
Noninterest Expenses Noninterest expenses increased by $681,000 (3.5%) to $19.9 million for the year ended December 31, 1996 compared to $19.2 million in 1995. This increase is primarily due to a $1.4 million increase in salary and employee benefits and building and equipment costs, offset by a decrease of $606,000 and $118,000 in other operating and foreclosed property expenses, respectively.
Noninterest expenses stayed constant at $19.2 million for the year ended December 31, 1995 compared to 1994. Salary and employee benefits and building and equipment costs, increased by $1.3 million, which was almost entirely offset by a decrease of $1.2 million in foreclosed property expenses.
Salaries and employee benefits increased by $1.1 million (11.7%) to $10.1 million for the year ended December 31, 1996 from $9.0 million in 1995 and $8.1 million in 1994. The increases for both years were primarily due to costs associated with increases in personnel of 12% in 1996 and 6% in 1995 to support business growth.
Building and equipment costs increased $349,000 to $3.6 million for 1996 compared to $3.3 million in 1995 and $2.8 million in 1994. The increase in 1996 was due in part to costs associated with the opening during 1996 of two new branches, one located in Salem, New Hampshire, the other at the Crosspoint Towers in Lowell, Massachusetts.
Expenses associated with foreclosed property totalled $666,000 for the year ended December 31, 1996 compared to $784,000 in 1995. These expenses include $82,000 of additional write-downs of the carrying values of properties during 1996 compared to $361,000 in 1995. Other expenses associated with the ownership of foreclosed property totalled $584,000 in 1996 compared to $423,000 in 1995. While the regional economy and real estate market continues to recover from the difficulties of the past several years, there is no assurance that the Bank will not experience further write-downs in the carrying values of foreclosed property.
Expenses associated with foreclosed property totalled $784,000 for the year ended December 31, 1995 compared to $2.0 million in 1994. These expenses include $361,000 of additional write-downs of the carrying values of properties during 1995 compared to $1.1 million in 1994. Other expenses associated with the ownership of foreclosed property totalled $423,000 in 1995 compared to $934,000 in 1994.
All other operating expenses decreased in total by $606,000 (9.8%) to $5.6 million for the year ended December 31, 1996 compared to $6.2 million in 1995 and $6.1 million in 1994. The decrease is mainly due to reduction of $498,000 in insurance expense to $192,000 for 1996 when compared to $690,000 in the prior year.
Income Taxes The net provision for income taxes amounted to $40,000 in 1996 compared to a provision of $75,000 recorded in 1995. The amounts recorded in each year were based on management's quarterly review of the operations of the Company, the realizability of the deferred tax asset, and management's analysis of future taxable income. Management has valued the deferred tax asset in accordance with regulatory guidelines which resulted in the elimination, during 1996, of the deferred tax valuation allowance that existed at December 31, 1995.
Management expects that during 1997 the Company will return to the position of having a provision for income taxes that more closely aligns with statutory rates. For further information on income taxes, see Note 8 of Notes to Consolidated Financial Statements.
FINANCIAL CONDITION
Total assets amounted to $1.1 billion at December 31, 1996, an increase of $258.4 million or 32.0% from $808.8 million at December 31, 1995. Included in the increase for 1996 is $191.1 million of assets acquired through the purchase and acquisition of Finest, which was consummated on December 31, 1996.
Loans At December 31, 1996, the loan portfolio, excluding the allowance for possible loan losses, and including mortgage loans held-for-sale, was $704.7 million, representing 66.0% of total assets, compared to $500.1 million or 61.8% of total assets at December 31, 1995. The increase in loans is attributable in part to the acquisition of Finest and its $101.5 million loan portfolio. See Item 1 - "Business - Lending Activities General" for a table setting forth the composition of the loan portfolio of the Bank at the end of each of the past five years.
The Bank's indirect automobile lending program resulted in $92.2 million, $76.6 million and $34.7 million of automobile loans for the years ending December 31, 1996, 1995 and 1994, respectively. Aircraft loans, an increasing lending activity for the Bank, totalled $33.3 million in 1996 compared to $14.5 million in 1995, and $22,000 in 1994.
Non-Performing Assets Non-performing assets consist of non-accruing and restructured loans (including loans impaired under SFAS No. 114), and foreclosed property. Non-performing assets totalled $6.6 million at December 31, 1996, compared to $6.2 million at December 31, 1995 and $10.4 million at December 31, 1994. Included in the 1996 total of $6.6 million, are $1.7 million of non-performing assets acquired from Finest.
The Bank's general practice is to discontinue the accrual of interest on loans (including loans impaired under SFAS No. 114) for which payment of interest or principal is ninety days or more past due or for such other loans as considered necessary by management if collection of interest and principal is doubtful. When a loan is placed on non-accrual status, all previously accrued but uncollected interest is reversed against current period interest income.
The principal balance of restructured loans was $1.0 million for both years ended December 31, 1996 and 1995. There were no restructured loans outstanding in 1994.
If the non-accruing loans at December 31, 1996 and 1995 had been current in accordance with their original terms, the amount of interest income that would have been recorded is $140,000 and $389,000, respectively. Interest income recognized on impaired loans, using the cash basis of accounting, amounted to approximately $244,000 for the year ended December 31, 1996 compared to approximately $166,000 in 1995. The amount of interest that was collected and recorded as income on non-performing loans was $350,000 and $511,000 for the years ended December 31, 1996 and 1995 respectively.
Foreclosed property at December 31, 1996 totalled $1.9 million compared to $1.8 million at December 31, 1995 and consists mainly of real estate collateral from loans which were foreclosed. Included in the 1996 total is $740,000 of foreclosed property acquired from Finest at the time of the purchase.
At December 31, 1996, the recorded investment in loans that are considered to be impaired under SFAS No. 114 totalled $1.4 million of which $1.1 million had a related allowance for possible loan losses of $491,000. The remaining $286,000 of impaired loans did not require a related allowance for possible loan losses. The average recorded investment in impaired loans during 1996 was approximately $1.9 million.
The following table shows the composition of non-performing assets for the five years ended December 31, 1996.
The following table summarizes the activity of foreclosed property during the year ended December 31, 1996:
Allowance for Possible Loan Losses The allowance for loan losses is maintained at a level determined by management to be adequate to provide for probable losses inherent in the loan portfolio including commitments to extend credit. The allowance for loan loss is maintained through the provision for loan losses, which is a charge to operations. The potential for loss in the portfolio reflects the risks and uncertainties inherent in the extension of credit.
The determination of the adequacy of the allowance of possible loan losses is based upon management's assessment of risk elements in the portfolio, factors affecting loan quality and assumptions about the economic environment in which the Company operates. The process includes identification and analysis of loss potential in various portfolio segments utilizing a credit risk grading process and specific reviews and evaluations of significant individual problem credits. In addition, management reviews overall portfolio quality through an analysis of current levels and trends in charge-off, delinquency and nonaccruing loan data, review of forecasted economic conditions and the overall banking environment. These reviews are of necessity dependent upon estimates, appraisals and judgments, which may change quickly because of changing economic conditions and the Company's perception as to how these factors may affect the financial condition of debtors.
The following table summarizes the activity in the allowance for possible loan losses for the five years ended December 31, 1996:
Investments At December 31, 1996, the Company's investment portfolio, consisting of short-term investments, investment securities, mortgage-backed securities, Federal Home Loan Bank ("FHLB") stock and Savings Bank Life Insurance Company of Massachusetts stock, totalled $315.7 million or 29.6% of assets, compared to $275.9 million or 34.1% of assets at December 31, 1995. The portfolio included U.S. government and agency obligations having a book value of $51.9 million and a fair value of $52.0 million and mortgage-backed securities with a book value of $205.6 million and a fair value of $204.6 million. Interest and dividend income on the Company's investment portfolio generated 26.2% of total interest and dividend income for the year ended December 31, 1996. During 1996 the investment portfolio decreased by $22.3 million, net of the effect of $62.1 million of investment securities available-for-sale acquired through the purchase and acquisition of Finest.
To identify and control risks associated with the investment portfolio, the Company has established policies and procedures, which include stop loss limits and stress testing on a periodic basis.
The Company does not have any investments in off balance sheet financial instruments, except as noted in footnote 9 to the consolidated financial statements included in response to Item 8
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of FIRST ESSEX BANCORP, INC.:
We have audited the accompanying consolidated balance sheets of First Essex Bancorp, Inc. and subsidiaries (the "Company") as of December 31, 1996 and 1995, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Essex Bancorp, Inc. and subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Boston, Massachusetts January 13, 1997
FIRST ESSEX BANCORP, INC. CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued)
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of First Essex Bancorp, Inc. ("the Company"), and its principal subsidiary, First Essex Bank, FSB ("the Bank"). All significant intercompany balances have been eliminated in consolidation.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Operating results in the future could vary from the amounts derived from management's estimates and assumptions.
INVESTMENT SECURITIES
The Company accounts for its investment securities under Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Under this statement, investments in debt securities may be classified as held-to-maturity and measured at amortized cost only if the Company has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values are classified as trading securities or available-for-sale securities. Trading securities are investments purchased and held principally for the purpose of selling in the near term; available-for-sale securities are investments not classified as trading or held-to-maturity. Unrealized holding gains and losses for trading securities are included in earnings; unrealized holding gains and losses for available-for-sale securities are reported in a separate component of stockholders' equity.
At December 31, 1995, the Bank made a one-time reassessment of its classification of investment securities held-to-maturity and reclassified $82.3 million to investment securities available-for-sale, with an unrealized loss of $1.1 million, as allowed by the special report of implementation of SFAS No. 115. This reclassification does not call into question the Company's intent to hold its remaining investment securities classified as held-to-maturity.
Dividend and interest income, including amortization of premiums and discounts, is included in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using a method that approximates the level-yield method, adjusted for estimated prepayments in the case of mortgage-backed securities.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
In October 1994, the Financial Accounting Standards Board ("FASB") issued SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments". The statement is effective for financial statements issued for fiscal years ending after December 15, 1994. Derivative Financial Instruments, as defined by SFAS No. 119, include futures, forwards, swaps or option contracts, or other financial instruments with similar characteristics. The Company did not have any such instruments as of December 31, 1996 and 1995, except as noted in Note 10.
LOANS RECEIVABLE
Loans are stated at the amount of unpaid principal, net of the allowance for possible loan losses, unearned discounts and unearned net loan origination fees. Loan origination fees, discounts and certain direct loan origination costs are deferred and amortized as an adjustment to the related loan yield over the contractual life of the loan. When loans are sold or fully repaid, the unamortized fees, discounts and costs are recognized in income.
Interest on loans is included in income as earned based upon interest rates applied to unpaid principal. Interest is not accrued on loans 90 days or greater past due or on other loans when management believes collection is doubtful. When a loan is placed on nonaccrual status, all interest previously accrued is reversed against current-period interest income.
The allowance for possible loan losses is based on management's estimate of the amount required to reflect the risks in the loan portfolio, based on circumstances and conditions known or anticipated at each reporting date. There are inherent uncertainties with respect to the final outcome of the Bank's loans and nonperforming loans. Because of these inherent uncertainties, actual losses may differ from the amounts reflected in these consolidated financial statements. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and their effect on borrowers, the performance of individual loans in relation to contract terms, and estimated fair values of underlying collateral. Losses are charged against the allowance when management believes the collectibility of principal is doubtful.
Key elements of the above estimates, including assumptions used in independent appraisals, are dependent upon the economic conditions prevailing at the time of the estimates. Accordingly, uncertainty exists as to the final outcome of certain of the valuation judgments as a result of economic conditions in the region. The inherent uncertainties in the assumptions relative to projected sales prices or rental rates may result in the ultimate realization of amounts on certain loans that are significantly different from the amounts reflected in these consolidated financial statements.
Effective January 1, 1995, the Company adopted SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" as amended by SFAS No. 118 ("SFAS No. 114"). This standard requires that impaired loans be measured based on the present value of expected future cash flows discounted at each loan's effective interest rate or, as a practical expedient, at each loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The statement also changes the accounting for in-substance foreclosures and troubled debt restructurings. This statement was applied prospectively with any adjustment reflected in the provision for possible loan losses. The adoption of this statement did not have a material effect on the financial position or results of operations of the Company.
Mortgage loans held-for-sale are carried at the lower of aggregate cost or fair value. Gains and losses on sales of mortgage loans are recognized at the time of sale.
In May 1995, the FASB issued SFAS No. 122, "Accounting for Mortgage Servicing Rights", which became effective for fiscal years beginning after December 15, 1995. The Company adopted the provisions of SFAS No.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
122 on January 1, 1996. SFAS No. 122 requires an enterprise involved in mortgage banking activities to recognize, as separate assets, rights to service mortgage loans for others regardless of the manner in which the servicing rights are acquired. In addition, capitalized mortgage servicing rights are required to be assessed for impairment based on the fair value of those rights. The impact of this statement depends on the volume of mortgage loans originated and sold, and servicing rights retained. The current practice of the Company is to sell most of the mortgage loans it originates with servicing released. Accordingly, the adoption of this statement did not have a material effect on the financial position or results of operations of the Company.
FORECLOSED PROPERTY
Collateral acquired through foreclosure is recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition. A valuation allowance is established for the estimated costs to sell and is charged to expense. Subsequent changes in the fair value of other real estate owned are reflected in the valuation allowance and charged or credited to expense. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of operations. Because of current market conditions, there are inherent uncertainties in the assumptions with respect to the estimated fair value of other real estate owned. Because of these inherent uncertainties, the amount ultimately realized on other real estate owned may differ from the amounts reflected in the consolidated financial statements.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, amounts due from banks, interest-bearing deposits, federal funds sold and investments with original maturities of less than three months.
BANK PREMISES AND EQUIPMENT
Real estate held for banking purposes, leasehold improvements and furniture and fixtures are stated at cost, less accumulated depreciation and amortization. Depreciation is computed principally on the straight-line method over estimated service lives. Amortization of leasehold improvements is computed on the straight-line method over the shorter of the estimated useful lives of the assets or the related lease term. Expenditures for maintenance, repairs and renewals of minor items are charged to expense as incurred.
In March 1995, the FASB issued SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", which became effective for fiscal years beginning after December 15, 1995. The Company adopted the provisions of SFAS No. 121 on January 1, 1996. SFAS No. 121 requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The statement also requires that certain long-lived assets and identifiable intangibles to be disposed of be reported at the lower of the carrying amount or fair value less cost to sell. The adoption of this statement did not have a material effect on the results of operations or financial condition of the Company.
INTANGIBLE ASSETS
Intangible assets are the excess of the purchase price over the fair value of net assets acquired (goodwill) in the acquisition of Finest Financial Corp. Goodwill is being amortized on a straight-line basis over 15 years. The Company will periodically evaluate intangible assets for impairment on the basis of whether these assets are fully recoverable from projected, undiscounted net cash flows of the related acquired entity, as required under SFAS
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
No. 121 as discussed earlier.
INCOME TAXES
The Company records income taxes under the liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting bases and the tax bases of the Company's assets and liabilities. Deferred taxes are measured using enacted tax rates that are expected to be in effect when the amounts related to such temporary differences are realized or settled. The Company's deferred tax asset is reviewed quarterly and adjustments are recognized in the provision or benefit for income taxes based on management's judgments relating to realizability.
EARNINGS PER SHARE
Earnings per common share are calculated using the weighted average number of common shares and common stock equivalents outstanding.
RECLASSIFICATIONS
Certain reclassifications have been made to the 1995 and 1994 consolidated financial statements to conform to the 1996 presentation.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125"). SFAS 125 supersedes SFAS No. 122 and establishes, among other things, new criteria for determining whether a transfer of financial assets in exchange for cash or other consideration should be accounted for as a sale or as a pledge of collateral in a secured borrowing. SFAS 125 also establishes new accounting requirements for pledged collateral. SFAS 125 is effective for most transactions occurring after December 31, 1996 with other provisions of the statement deferred for one year. The Company has determined that the adoption of SFAS 125 will not have a material impact on its consolidated financial statements.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share", which establishes new standards for computing earnings per share and makes them comparable to international earnings per share calculations and standards. This statement is effective for the Company's 1997 financial statements and has no significant impact on reported financial results.
2. ACQUISITION
On December 30, 1996, the Company acquired all of the outstanding shares of the common stock of Finest Financial Corp. ("Finest"). The purchase price was composed of 1,353,998 shares of common stock issued at a price of $11.50 per share and a total cash outlay of $16.3 million. Included in the total acquisition cost was approximately $1.4 million of capitalized costs incurred in connection with the acquisition. This transaction was accounted for as a purchase and, accordingly, the consolidated statement of operations includes the results of Finest's operations since the acquisition.
The purchase price was allocated to assets acquired and liabilities assumed based on estimates of fair value at the
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
date of acquisition. The excess of purchase price over the fair value of assets acquired has been recorded as goodwill. The fair value of these assets and liabilities is summarized as follows (in thousands):
The following is supplemental information reflecting selected unaudited pro forma results as if this acquisition had been consummated as of January 1, 1995:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
3. INVESTMENT SECURITIES
Investment securities at December 31, 1996 and 1995 follow:
At December 31, 1996 and 1995, U.S. government obligations and mortgage-backed securities with amortized cost of $144,009,000 and $150,449,000, respectively, and fair value of $143,212,000 and $150,728,000, respectively, were pledged to collateralize certain borrowings, deposit accounts and repurchase agreements.
For the year ended December 31, 1996, there were realized gross gains of $497,000 from the sale of investment securities available-for-sale. For the year ended December 31, 1995, there were realized gross losses of $13,000 from the sale of investment securities. There were no gains or losses from the sale of investment securities in 1994.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The following table shows the maturity distribution of the amortized cost of the Company's investment securities at December 31, 1996:
The following table shows the maturity distribution of the fair value of the Company's investment securities at December 31, 1996:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
4. LOANS RECEIVABLE
Major classifications of loans receivable at December 31, 1996 and 1995 follow: - --------------------------------------------------------------------------------
1996 1995 -------- -------- (Dollars in thousands) Mortgage loans: Residential $292,954 $229,383 Commercial 102,718 53,504 Construction 24,855 14,210 -------- -------- Total mortgage loans 420,527 297,097 -------- --------
Owner-occupied commercial real estate (1) 29,465 --
Commercial 63,695 66,737
Aircraft 33,267 14,478
Consumer loans: Home equity 12,088 12,558 Automobile 92,175 76,590 Other Consumer 44,527 26,770 -------- -------- Total consumer loans 148,790 115,918
Less: Allowance for possible loan losses 10,538 6,552 -------- --------
Total loans receivable $685,206 $487,678 ======== ========
(1) During 1996, management began to report this category of loans separate from its other commercial and commercial real estate loans. Management believes this category of loans is distinguishable from its other commercial lending products. In 1996, the Company reclassified certain loans to this category from other more historical classification categories.
- --------------------------------------------------------------------------------
The Company's lending activities are conducted principally in eastern Massachusetts and southern New Hampshire. The Company originates single family and multifamily residential loans, commercial real estate loans, commercial loans, aircraft loans, automobile loans and a variety of consumer loans. In addition, the Company originates loans for the construction of residential homes, multifamily properties, commercial real estate properties and land development. Most loans originated by the Company are collateralized by real estate. The ability and willingness of the single family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the geographic areas and real estate values. The ability and willingness of commercial real estate, commercial and construction loan borrowers to honor their repayment commitments is generally dependent on the health of the real estate economic sector in the borrowers' geographic areas and the general economy.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
A summary of changes in the allowance for possible loan losses for the years ended December 31, 1996, 1995 and 1994 follows:
- -------------------------------------------------------------------------------
1996 1995 1994 -------- -------- -------- (Dollars in thousands)
Balance at beginning of year $ 6,552 $ 7,237 $ 7,747 Acquired allowance - Finest (Note 2) 4,080 -- -- Provision for possible loan losses 1,415 770 -- Charge-offs (2,335) (2,485) (2,111) Recoveries 826 1,030 1,601 -------- -------- --------
Balance at end of year $ 10,538 $ 6,552 $ 7,237 ======== ======== ========
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Under SFAS No. 114, the Company considers a loan impaired if it is ninety days or more past due as to principal and interest, or if management's credit risk assessment determines that it is probable that principal and interest will not be collected as contractually scheduled. In addition, loans which are restructured at market rates and comparable to loans with similar risks are considered impaired only in the year of the restructuring, so long as they continue to perform according to the restructured terms. Excluded from the impaired category, but otherwise considered non-accruing loans, are small balance homogeneous loans which are ninety days or more past due. Small balance homogeneous loans include residential mortgage loans, residential construction loans to individuals (excluding builder construction loans) and consumer loans. The Company evaluates a loan's level of impairment by measuring the net present value of the expected future cash flows using the loan's original effective interest rate, or looking at the fair value of the collateral if the loan is collateral dependent. When the difference between the net present value of the impaired loan (or fair value of the collateral if the loan is collateral dependent) is lower than the recorded investment of the loan, the difference is provided to expense with a resulting valuation allowance. The average recorded investment in impaired loans was approximately $1.9 million in 1996 and $1.4 million in 1995.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The following table indicates the recorded investment of non-performing assets and the related valuation allowance for impaired loans.
Interest income recognized on impaired loans, using the cash basis of income recognition, amounted to approximately $244,000 for the year ended December 31, 1996 compared to $166,000 in 1995.
The amount of interest that would have been earned had the nonaccrual and restructured loans performed in accordance with original terms and conditions was $140,000, $389,000 and $754,000 for the years ended December 31, 1996, 1995 and 1994, respectively.
The maximum amount of aggregate loans to directors, executive officers and principal stockholders for the year ended December 31, 1996 was less than 5% of stockholders' equity.
At December 31, 1996 and 1995, the Bank was servicing loans sold to the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Massachusetts Home Finance Agency and various other banks and institutions on a nonrecourse basis (except as discussed in Note 9), in the amount of $95,848,000 and $74,330,000, respectively. The amount of loans sold and serviced for others is not included in loans receivable.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
5. BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31, 1996 and 1995 follows:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
6. DEPOSITORS' ACCOUNTS
A summary of depositors' accounts at December 31, 1996 and 1995 follows: - --------------------------------------------------------------------------------
1996 1995 -------- -------- (Dollars in thousands) Personal and business checking accounts (noninterest-bearing) $ 58,769 $ 30,391 NOW accounts 42,246 31,288 Money market accounts 92,173 73,730 Savings accounts 75,782 49,361 Time deposits 421,983 306,699 -------- --------
$690,953 $491,469 ======== ========
The following is a summary of original maturities of time deposits as of December 31, 1996:
(Dollars in thousands)
1997 $277,221 1998 95,941 1999 21,106 2000 10,148 2001 11,382 Thereafter 6,185 -------- $421,983
The following table shows the remaining maturities of certificates of deposits with balances in excess of $100,000 at December 31, 1996:
(Dollars in thousands)
Three months or less $13,993 Over 3 months and less than 6 months 3,998 Over 6 months and less than 12 months 11,816 12 months and over 18,530 ------- $48,337
- --------------------------------------------------------------------------------
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
7. BORROWED FUNDS
Borrowed funds at December 31, 1996 and 1995 are summarized below: - --------------------------------------------------------------------------------
1996 1995 -------- -------- (Dollars in thousands)
Due during 1996, interest rates from 4.84% to 6.98% $ -- $123,100 Due during 1997, interest rates from 5.35% to 6.24% 193,000 35,000 Due during 1998, interest rates from 5.82% to 6.42% 60,597 58,597 Due during 1999, interest rates from 6.30% to 6.42% 2,000 -- Due during 2000, interest rates from 5.29% to 6.52% 4,660 2,896 Due during 2001, interest rates from 6.54% to 6.58% 3,943 -- Due during 2010, interest rates from 4.51% to 6.08% 78 80 Due during 2016, interest rates at 7.25% 2,997 -- Repurchase agreements 7,683 25,896 -------- --------
$274,958 $245,569 ======== ========
- --------------------------------------------------------------------------------
Total lines of credit available under both short-term and long-term borrowings from the FHLB are dependent upon the amount of FHLB stock owned and other assets available as collateral with the total credit available being $310,340,000, of which $43,065,000 was unused at December 31, 1996. The advances from the FHLB are secured by all FHLB stock (book value of $15,517,000 and $14,869,000 at December 31, 1996 and 1995) and a pledge of certain assets as collateral. Repurchase agreements outstanding at December 31, 1996 mature in three months or less with average interest rates of 5.18% and are secured by certain U.S. government and agency securities.
The following table summarizes the maximum and average amounts of borrowings outstanding during 1996 and 1995 together with the weighted average interest rates thereon.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
8. INCOME TAXES
The provision (benefit) for income taxes for each of the three years in the period ended December 31, 1996 consists of the following:
- --------------------------------------------------------------------------------
1996 1995 1994 ------- ------- ------- (Dollars in thousands)
Current $ 1,948 $ 20 $ 20
Deferred (1,908) 55 (825) ------- ------- -------
$ 40 $ 75 $ (805) ======= ======= =======
- --------------------------------------------------------------------------------
The difference between the total expected provision (benefit) for income taxes computed by applying the statutory federal income tax rate to income before provision (benefit) for income taxes and the recorded provision (benefit) for income taxes for the three years in the period ended December 31, 1996 follows: - --------------------------------------------------------------------------------
1996 1995 1994 ------- ------- ------- (Dollars in thousands)
Provision at statutory rate $ 3,112 $ 2,559 $ 1,945 State taxes, net of federal benefit 783 903 20 Nondeductible expenses 23 -- -- Dividend received deduction (2) (10) (10) Change in valuation allowance (4,185) (3,312) (2,770) Other, net (309) (65) 10 ------- ------- ------- Provision (benefit) for income taxes $ 40 $ 75 $ (805) ======= ======= =======
- --------------------------------------------------------------------------------
At December 31, 1996, tax loss carryforwards, for tax return purposes, of approximately $4,394,000 are available to be carried forward to future periods and, if unused, will expire between 2006 and 2010.
In August of 1996, Congress passed the Small Business Job Protection Act of 1996. Included in the bill was the repeal of IRC Section 593, which allowed thrift institutions special provisions in calculating bad debt deductions for income tax purposes. Thrift institutions now will be viewed as commercial banks for income tax purposes. The repeal is effective for tax years beginning after December 31, 1995.
One effect of this legislative change is to suspend the Bank's bad debt reserve for income tax purposes as of its base year (October 31, 1988). Any bad debt reserve in excess of the base year amount is subject to recapture over a six-year time period. The suspended (i.e. base year) amount is subject to recapture upon the occurrence of certain events, such as a complete or partial redemption of the Bank's stock or if the Bank ceases to qualify as a bank for income tax purposes.
At December 31, 1996, the Bank's surplus includes approximately $7,700,000 of bad debt reserves, representing the base year amount, for which income taxes have not been provided. Since the Bank does not intend to use the suspended bad debt reserve for purposes other than to absorb the losses for which it was established, deferred taxes in the amount of $3,150,000 have not been recorded with respect to such reserve.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The components of the net deferred tax asset at December 31, 1996 and 1995 follow: - --------------------------------------------------------------------------------
1996 1995 ------- ------- (dollars in thousands)
Allowance for possible loan losses $ 2,196 $ 2,227 Deferred tax loan loss reserve (1,447) (2,548) Depreciation 919 789 Deferred loan fees 107 142 Deferred compensation 288 262 Pension accrual 336 238 Net operating loss carryforwards 1,494 4,647 Limited partnership investments (499) (525) Foreclosed property write-downs 40 851 Contributions -- 133 General business credits 880 490 Purchase business combination 521 -- AMT credits 435 291 Charge-off remaining lease payments 49 77 Unrealized loss on available-for-sale securities -- 230 State income taxes 666 202 Other, net 140 109 ------- ------- 6,125 7,615 Valuation allowance -- (4,185) ------- ------- Net deferred tax asset included in other assets $ 6,125 $ 3,430 ======= =======
- --------------------------------------------------------------------------------
The change in the valuation allowance for the years ended December 31, 1996 and 1995 follows: - --------------------------------------------------------------------------------
1996 1995 ------- ------- (dollars in thousands)
Balance at January 1 $(4,185) $(7,653) Decrease due to change in estimate of future taxable earnings 4,185 3,468 ------- -------
Balance at December 31 $ -- $(4,185) ======= =======
- --------------------------------------------------------------------------------
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
9. PENSION BENEFITS
The Company has a defined benefit pension plan covering most employees. Employees are eligible to participate upon the attainment of age 21 and the completion of one year of service. Benefits are based primarily on years of service and employees' final five year average pay.
Contributions by the Company are consistent with the funding requirements of federal law and regulations. Pension plan assets consist primarily of mutual funds, bonds and government securities.
The weighted average discount rate was 7.5% in 1996 and 7.0% in 1995. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.0% in 1996 and 1995. The expected long-term rate of return on assets was 8.0% in 1996 and 1995.
The following table sets forth the plan's funded status and amounts recognized in the Company's consolidated financial statements at December 31, 1996 and 1995:
The Company has no material postretirement or postemployment benefit arrangements other than pension benefits with its employees.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
10. COMMITMENTS AND CONTINGENCIES
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments, held for purposes other than trading, include commitments to originate loans, standby letters of credit, recourse arrangements on sold assets, unadvanced portions of construction loans and forward commitments. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the accompanying consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby letters of credit and recourse arrangements is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. For forward commitments, the contract or notional amounts do not represent exposure to credit loss. The Company controls the credit risk of its forward commitments through credit approvals, limits and monitoring procedures.
Financial instruments with off-balance sheet risk at December 31, 1996 and 1995 follow: - --------------------------------------------------------------------------------
Contract Amount 1996 1995 ------- ------- (Dollars in thousands)
Commitments to originate loans $20,676 $24,104 Unused lines of credit 40,458 38,428 Commercial and standby letters of credit 3,644 882 Loans sold with recourse 2,073 2,758 Unadvanced portions of construction loans 14,759 10,495 Forward commitments 8,915 5,821
- --------------------------------------------------------------------------------
Commitments to originate loans are agreements to lend to customers provided there are no violations of any conditions established in the contracts. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based upon management's credit evaluation of the borrower.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
LEASE COMMITMENTS
The Company has operating leases on eleven of its facilities. Most of the leases have renewal options. Total rent expense under these leases for 1996, 1995 and 1994 was $712,000, $661,000 and $386,000, respectively.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The following is a schedule of future minimum lease payments for operating leases (dollars in thousands): - -------------------------------------------------------------------------------
Year ending December 31,
1997 $ 853 1998 820 1999 689 2000 498 2001 380 Thereafter 1,259 -----
Total future minimum lease payments $4,499 ======
- -------------------------------------------------------------------------------
EMPLOYMENT AND TERMINATION AGREEMENTS
The Company and the Bank have entered into employment agreements with three executive officers. One agreement which commenced January 1, 1994 had an original term of three years and the other agreements with commencement dates of January 1, 1994 and December 30, 1996, have an original term of two years. Each agreement may be extended annually for an additional year by vote of the Boards of Directors. The employment agreements generally provide for the continued payment of specified compensation and benefits to the executive officer for specified periods after termination, unless the termination is for "cause" as defined in the employment agreement. The current expiration dates of the three year agreement and two year agreements are December 31, 1999 and December 31, 1998, respectively.
In addition, the Company, the Bank and the officers, referred to above, have entered into special termination agreements that provide for the payment, under certain circumstances, of a lump-sum amount upon termination following a "change of control" which is generally defined to mean a person or group acquiring ownership of 25% or more of the outstanding common stock of the Company, or certain other events resulting in a change in control of the Company. The lump-sum amounts are based on three times two of the executive officer's base annual compensation and two times the other executive officer's base annual compensation as defined in the agreements and would be in lieu of any benefits under the officers' employment agreements, but in addition to amounts payable pursuant to other benefit plans. Four other senior officers have similar termination agreements effective following a "change of control." The lump-sum amount for these officers is equivalent to two times the officer's base annual compensation.
LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incidental to its business, none of which is believed by management, based on discussion with legal counsel, to be material to the financial condition or operations of the Company.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
11. MANAGEMENT INCENTIVE COMPENSATION PLAN
The Company has a Management Incentive Compensation Plan (the "Incentive Plan") as a means of recognizing achievement on the part of individual officers and management as a whole. In 1996, 1995 and 1994 the Company awarded $310,000, $117,000 and $130,000, respectively, for bonuses in connection with the Incentive Plan.
12. STOCK OPTION PLAN
The Company has two stock options plans. The first was adopted in 1987 as a performance incentive for its directors, officers, employees and other key persons (the "1987 Stock Option Plan"). Options granted under the 1987 Stock Option Plan have an exercise price per share equal to at least the fair market value of a share of the Company's common stock on the date the option is granted and expire no later than 10 years after the date of grant. The Company has reserved 800,000 shares for issuance pursuant to options granted under the 1987 Stock Option Plan. Both "Incentive Stock Options" and "Non-qualified Stock Options" may be granted pursuant to the 1987 Stock Option Plan.
The second stock option plan (the "1996 Stock Option Plan") was adopted under the terms of the agreement related to the Company's purchase of Finest (Note 2) on December 30, 1996. Non-qualified options totaling 114,465 shares have been granted under this plan at an exercise price of $7.67 per share to two former officers of Finest. All the options are vested and exercisable as of December 31, 1996. Of the total, 26,415 options expire March 31, 1997. The remainder expire not later than October 1, 2005. The weighted average life of these outstanding options is 6.8 years. The estimated fair value of these options was recorded as part of the acquisition price and, accordingly, the proforma compensation cost discussed below excludes the effect of these options.
Effective January 1, 1996, the Company adopted the provisions of SFAS No. 123, "Accounting for Stock- Based Compensation." The Company has elected to continue to account for stock options at intrinsic value with disclosure of the effects of fair value accounting on net income and earnings per share on a pro forma basis. Had compensation costs for the stock option plans been determined using the fair value method, the Company's 1996 and 1995 net income and earnings per share from continuing operations would have been reduced to the following pro forma amounts (dollars in thousands):
- --------------------------------------------------------------------------------
1996 1995 ----- ----- Net income: As reported $9,113 $7,452 Pro forma 8,957 7,451
Primary EPS: As reported $ 1.47 $ 1.22 Pro forma $ 1.45 $ 1.22
- --------------------------------------------------------------------------------
Pro forma compensation cost may not be representative of that to be expected in future years.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The following table summarizes various 1987 Stock Option Plan facts and assumptions for the three years ended December 31, 1996, 1995 and 1994:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
13. 401(k) PLAN
During 1994, the Company established a 401(k) plan (the "Plan") covering most of its employees and merged its former Employees' Stock Ownership Plan ("ESOP") into the Plan. Under the Plan, eligible employees ("participants") may make contributions up to 15% of their compensation, with certain limitations. The Company may elect to make basic matching contributions. During 1996 and 1995, the Company made basic matching contributions equal to 50% of the first 4% of each participant's compensation, or a maximum of 2%. Basic matching contributions for 1996, 1995 and 1994 amounted to $116,000, $98,000 and $53,000, respectively. The Plan also provides for discretionary supplemental matching contributions. These contributions are allocated to participants in the same manner as described above. Supplemental matching contributions to the Plan for 1996, 1995 and 1994 amounted to $58,000, $38,000, and $25,000, respectively.
14. STOCKHOLDERS' EQUITY
At the time of conversion to stock form, the Bank established a liquidation account in the amount of $41,426,000 (unaudited). In accordance with Massachusetts statutes, the liquidation account is maintained for the benefit of Eligible Account Holders who continue to maintain their accounts in the Bank after the conversion. The liquidation account is reduced annually to the extent that Eligible Account Holders have reduced their qualifying deposits. Subsequent increases will not restore an Eligible Account Holder's interest in the liquidation account. In the event of a complete liquidation, each Eligible Account Holder is entitled to receive a distribution from the liquidation account in a proportionate amount to the current adjusted qualifying balances for the account then held. The unaudited balance in the liquidation account was $4,701,000 at December 31, 1996.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
15. REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1996, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 1996, the most recent notification from the Office of Thrift Supervision ("OTS") categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have the institutions's category.
The Bank's actual capital amounts and ratios are also presented in the table. As of December 31, 1996, the OTS did not deem it necessary for an interest-rate risk component to be deducted from capital in determining risk-based capital requirements.
The Bank may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The following table displays the Bank's capital calculations as defined under prompt corrective action for the periods indicated:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
16. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS - FIRST ESSEX BANCORP, INC.
Condensed financial statements of First Essex Bancorp, Inc. as of December 31, 1996 and 1995, and for the years ended December 31, 1996, 1995 and 1994 follow: - --------------------------------------------------------------------------------
1996 1995 ------- ------- (Dollars in thousands) Balance Sheets
Assets Cash and cash equivalents $ 3,663 $ 5,928 Investment in First Essex Bank, FSB 73,924 55,550 Other assets 7,195 1 ------- -------
Total assets $84,782 $61,479 ======= =======
Liabilities and stockholders' equity
Other liabilities $ 1,641 $ 1,307 Stockholders' equity 83,141 60,172 ------- -------
Total liabilities and stockholders' equity $84,782 $61,479 ======= =======
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
17. RESTRICTIONS ON SUBSIDIARY BANK LOANS, ADVANCES AND DIVIDENDS
The Federal Reserve Act restricts the Bank with respect to lending or advancing funds to the Company unless such loans are collateralized by specific obligations and limits collateralized loans to 10% of the Bank capital stock and surplus. At December 31, 1996, no amounts were available to be transferred from the Bank to the Company in the form of loans or advances. In addition, under the OTS prompt corrective action regulations, which took effect on December 19, 1992, the Bank generally would be prohibited from making any capital distribution if, after the distribution, the Bank would have (i) a total risk-based capital ratio of less than 8%, (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a Tier 1 core capital ratio of less than 3%.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
18. QUARTERLY DATA (UNAUDITED)
A summary of quarterly financial data for the years ended December 31, 1996 and 1995 follows:
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
19. PREFERRED STOCK
The Company's Board of Directors has authorized a series of 100,000 shares of preferred stock designated as Series A Junior Participating Cumulative Preferred Stock, par value $0.10 per share ("Series A Stock") and has declared a dividend distribution of one Preferred Stock Purchase Right (the "Right") for each outstanding share of the Company's common stock.
Pursuant to the Company's Shareholder Rights Plan, each Right entitles the holder to purchase from the Company a unit consisting of one one-hundredth of a share of Series A Stock, par value $0.10 per share, at an initial cash exercise price of $28 per unit, subject to adjustment. The Rights are not exercisable and remain attached to all outstanding shares of the Company's common stock until the earliest of (i) ten days following a public announcement that a person or group of affiliated or associated persons (an "Acquiring Person") has acquired beneficial ownership of 20% or more of the outstanding shares of the Company's common stock (the date of said announcement being referred to as the "Stock Acquisition Date"), (ii) ten business days following the commencement of a tender offer or exchange offer that would result in a person or group becoming an Acquiring Person or (iii) the declaration by the Company's Board of Directors that a person is an "Adverse Person," as such term is defined in the Company's Shareholder Rights Plan.
In the event that a Stock Acquisition Date occurs or the Board determined that a person is an Adverse Person, each holder of a Right will be entitled to receive, upon exercise, that number of units of Series A Stock having a fair value of two times the exercise price of the Right. In the event that, at any time following the Stock Acquisition Date, (i) the Company is acquired in a merger or other business combination transaction or (ii) 50% or more of the Company's assets or earning power is sold, each holder of a Right shall thereafter have the right to receive, upon exercise, common stock of the acquiring company having a fair value equal to two times the exercise price of the Right. The holders of Series A Stock would be entitled to preferred rights with respect to dividends, voting and liquidation.
20. FAIR VALUE OF FINANCIAL INSTRUMENTS
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, amounts due from banks, interest-bearing deposits, federal funds sold and investments with original maturities of less than three months. Cash and cash equivalents are recorded at cost which approximates fair value.
INVESTMENT SECURITIES
Fair values for investment securities, excluding Federal Home Loan Bank (FHLB) and Savings Bank Life Insurance (SBLI) stock, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of FHLB and SBLI stock approximates fair value.
LOANS RECEIVABLE
For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for certain mortgage loans (e.g., one-to-four family residential) are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values of other loans (e.g., commercial real estate and rental property mortgage loans, commercial, industrial loans, and consumer loans) are estimated using a discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of mortgage loans held-for-sale and accrued interest
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
approximates its fair value.
DEPOSITORS' ACCOUNTS
The fair values disclosed for certain deposits (e.g., interest and noninterest-bearing checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on a schedule of aggregated expected monthly maturities on time deposits. The carrying amount of accrued interest payable approximates its fair value.
BORROWED FUNDS
The carrying amounts of borrowings within ninety days approximate their fair values. Fair values of other borrowings are estimated using discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. The carrying value for repurchase agreements approximates fair value due to the short term nature of these instruments.
OFF-BALANCE-SHEET INSTRUMENTS
The fair values of the Company's off-balance-sheet instruments (lending commitments and letters of credit) are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties' credit standing.
At December 31, 1996 and 1995, the estimated fair value of off-balance-sheet financial instruments, consisting primarily of loan commitments, were not material.
ASSUMPTIONS
Fair value estimates are made at a specific point in time, based on relevant market information about specific financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
FIRST ESSEX BANCORP, INC. NOTES to CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996
The estimated fair values of the Company's financial instruments follow:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in, or disagreements with, accountants on accounting and financial disclosures.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item appears under the headings "Information Regarding Directors and Nominees" and "Executive Officers" of the Company's definitive Proxy Statement dated March 31, 1997 for the Annual Meeting of Stockholders to be held May 1, 1997 filed with the Securities and Exchange Commission (the "Proxy Statement"), and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item appears in the Proxy Statement under the headings "Summary Compensation Table," "Stock Options Granted in 1996," "Long Term Incentive Plan Awards Granted in 1996," " Aggregate Option/SAR Exercises in Last Fiscal Year, and FY-End Option/SAR Value," "Pension Plan," "Executive Salary Continuation Agreement," "Employment Contracts, Termination of Employment and Change in Control Arrangements," "Compensation/Nominating Committee Interlocks and Insider Participation" and "Compensation/Nominating Committee Report on Executive Compensation" and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item appears in the Proxy Statement under the headings "Principal and Management Stockholders", "Information Regarding Directors and Nominees" and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item appears in the Proxy Statement under the heading "Certain Transactions with Management and Others" and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Index of Financial Statements: The following financial statements appear in response to Item 8 of this Report.
Reports of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1996 and 1995 Consolidated Statements of Operations for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Stockholders Equity for the Years Ended December 31, 1996, 1995 and 1994 Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994 Notes to Consolidated Financial Statements
(a) (2) Index of Financial Statement Schedules: The following financial statement schedules appear in response to Item 8 of this Report or as part of this Item 14: Schedule I - Indebtedness to Related Parties. The information required by this Schedule is not material and is therefore omitted. Schedule II - Guarantees of Securities of other Issuers. Not applicable. (b) Reports on Form 8-K: No reports on Form 8-K were filed by First Essex during the fiscal quarter ended December 31, 1996. (c) Exhibits:
(3) Articles of Incorporation and By-laws:
3.1 The Restated Certificate of Incorporation of the Company is incorporated herein by reference to Exhibit 3.1 to Amendment No. 1 to the Company's Registration Statement on Form S-1, Registration No. 33-10966, filed with the Securities and Exchange Commission on April 17, 1987 ("Amendment No. 1 to the Form S-1");
3.2 The Amended and Restated By-laws of the Company are incorporated herein by reference to Exhibit 4.1 of the Company's current report on Form 8-K filed on December 28, 1992.
(10) Material Contracts:
*10.1- The First Essex Bancorp, Inc. 1987 Stock Option Plan is incorporated herein by reference to Appendix B to the prospectus included in the Company's Registration Statement on Form S-8, registration number 33-21292, filed on April 15, 1988; 10.2- The Shareholder Rights Agreement is incorporated herein by reference to the exhibit to the Company's Current Report on Form 8-K filed on October 12, 1989, as amended by the Amendment to the Shareholder Rights Plan, incorporated herein by reference to Exhibit 28.2 to the Company's Current Report on Form 8-K filed on February 12, 1990; *10.3- Amended and Restated Employment Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson is incorporated herein by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1995; *10.4- Amended and Restated Employment Agreement between First Essex Bancorp, Inc., First Essex Bank,
FSB and David W. Dailey is incorporated herein by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. *10.5- Special Termination Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson is incorporated herein by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993; *10.6- Special Termination Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and David W. Dailey is incorporated herein by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993; *10.7- Executive Salary Continuation Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson is incorporated herein by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988; *10.8- Form of Special Termination Agreement between First Essex Bancorp, Inc, First Essex Bank, FSB and each of John M. DiGaetano, David L. Savoie and William F. Burke (at one year terms) and Wayne C. Golon (at a 2 year term) is incorporated by reference to Exhibit 10.8 to the Company's annual report on Form 10-K for the fiscal year ended December 31, 1993 *10.9- First Essex Bancorp, Inc. Senior Management Incentive Compensation Plan is incorporated herein by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. *10.10- Form of Employment Agreement and Form of Special Termination Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Brian W. Thompson incorporated herein by reference to Amendment Number 1 to Form S-4, registration number 333-12793, filed on November 6, 1996. *10.11- Common Stock Option Plan for Brian W. Thompson incorporated herein by reference to Form S-8, registration number 333-22183, filed on February 21, 1997. (12) Statements Regarding Computation of Ratios: Not applicable, as First Essex does not have any debt securities registered under Section 12 of the Securities Exchange Act of 1934. (21) Subsidiaries of Registrant: A list of subsidiaries of the Company is incorporated by reference to Exhibit 22 to the Company's annual report on Form 10-K for the fiscal year ended December 31, 1993. (23) Consent of Experts and Counsel: Consent of Arthur Andersen LLP is attached hereto as Exhibit 23. (27) Financial Data Schedule
* Management contract or compensatory plan.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST ESSEX BANCORP, INC.
Date: March 13, 1997
by /s/Leonard A. Wilson ------------------------------------ Leonard A. Wilson President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following people on behalf of the registrant in the capacities and on the dates indicated.