ITEM 1. BUSINESS
Registrant
The registrant, Heritage Financial Services, Inc., is an Illinois corporation which was incorporated on July 2, 1984, and a multi-bank holding company which is subject to the federal Bank Holding Company Act of 1956, as amended. On July 2, 1984, its predecessor by merger, County Bankshares, Inc., a Delaware corporation incorporated September 8, 1981, was merged into the registrant in order to reincorporate in Illinois. The stockholders of the predecessor thereby automatically became the shareholders of the registrant. Unless the context otherwise requires, as used hereafter the "Company" refers to Heritage Financial Services, Inc., its predecessor, County Bankshares, Inc. and its subsidiaries.
The Company was organized for the purpose of becoming a multi-bank holding company by acquiring and operating Illinois commercial banks. The Company's current subsidiaries are Heritage Bank, First National Bank of Lockport and Heritage Trust Company which operate from seventeen banking offices located in southwest suburban Chicago. See "Subsidiaries" below.
The Company derives substantially all its income from its principal subsidiary, Heritage Bank. The Company's primary source of cash is dividends from Heritage Bank. The amount of dividends paid by Heritage Bank is determined in relation to its earnings and capital position and the cash requirements of the Company. Also see "Supervision and Regulation-Dividends" below.
Financial information relating to the Company only is set forth in "Note 15 - Condensed Financial Statements - Parent Company" of the Notes to Consolidated Financial Statements included under Item 8 of this document.
Proposed Merger
On January 14, 1998, the Company, First Midwest Bancorp, Inc. ("First Midwest") and First Midwest Acquisition Corporation, a wholly owned subsidiary of First Midwest ("Acquisition Corporation"), entered into an Agreement and Plan of Merger ("Merger Agreement") whereby the Company will be merged with and into Acquisition Corporation (the "Merger"). Pursuant to the Merger Agreement, the transaction will be structured as a tax-free exchange and accounted for as a pooling-of-interests. Each of the Company's outstanding common shares will be converted into 0.7695 shares of First Midwest common stock. The Merger is conditioned upon, among other things, approval by the shareholders of both the Company and First Midwest and receipt of customary regulatory approvals. The Merger Agreement has been approved by the boards of directors of both companies. It is anticipated that the acquisition will be consummated late in the second quarter of 1998. Incident to the entry into the Merger Agreement, the Company and First Midwest executed a Stock Option Agreement (the "Option Agreement") pursuant to which the Company granted First Midwest an option to acquire up to 2,400,000 common shares (representing 19.9% of the Company's then outstanding common shares) at a price of $21.25 per share, subject to certain terms and conditions set forth in the Option Agreement. Copies of the Merger Agreement and Option Agreement have been filed as exhibits to the Company's Current Report on Form 8-K filed January 27, 1998.
Subsidiaries
Prior to October, 1991, the Company owned and operated four bank subsidiaries: Heritage Bank and Trust Company, Blue Island, Illinois, Heritage Bank of Oak Lawn, Oak Lawn, Illinois, Heritage Bank Crestwood, Crestwood, Illinois and Heritage Bank Tinley Park, Tinley Park, Illinois. In October, 1991, the four bank subsidiaries were merged into one bank, now known as Heritage Bank ("Heritage Bank" or the "Bank").
On January 10, 1992, the Company acquired all of the issued and outstanding common stock of 1st Heritage Bank, Country Club Hills, Illinois, for $6.9 million in cash. In October, 1992, 1st Heritage Bank was merged into the Bank and is operated as a branch. On December 11, 1992, the Bank purchased the banking facility and assumed approximately $6 million of deposit liabilities of First Chicago Bank for Savings, Frankfort, Illinois. The Frankfort banking office is also operated as a branch. On December 18, 1992, the Company acquired all of the issued and outstanding common stock of Alsip Bank and Trust, Alsip, Illinois, for approximately $8 million in cash. In April, 1993, Alsip Bank and Trust was merged into the Bank and is operated as a branch.
On July 8, 1994, the Company acquired all of the issued and outstanding common stock of Midlothian State Bank, Midlothian, Illinois, for $16.5 million in cash. Midlothian State Bank was merged into the Bank in October, 1994, and its banking facilities are operated as branches of the Bank.
On February 2, 1996, the Company acquired all of the issued and outstanding common stock of the First National Bank of Lockport ("Lockport"), Lockport, Illinois, for $16.8 million in cash. At the date of acquisition Lockport had total assets of $104 million. In April, 1996, the banking assets and liabilities of Lockport were transferred to Heritage Bank under a purchase and assumption transaction, and its banking office is operated as a branch. Lockport continues to operate as a national bank limited to trust and insurance agency operations. In 1996 Lockport was authorized by bank and insurance regulators to act as an insurance agent or broker. In 1997 Lockport, now headquartered in Monee, Illinois, began to offer insurance products through its Heritage Insurance Services division.
The Company also owns and operates Heritage Trust Company, an Illinois trust company located in Tinley Park, Illinois.
Description of Business
General
The Company conducts a full service banking business through the Bank, Lockport and Heritage Trust Company. The Bank offers a complete range of financial products and services to individuals, businesses and municipal customers. These products and services include checking, savings, NOW and money market accounts and certificates of deposit; commercial, real estate and consumer loans; mutual funds, annuities and discount brokerage; corporate cash management services, debit cards, safe deposit and night depository facilities; and other services tailored to customer needs. Automated teller machines ("ATMs"), which provide 24-hour banking services to customers, are installed at all branches and four off site locations. The Bank is a member of the "Cash Station" and "CIRRUS/National" systems of ATMs which operate a substantial number of ATMs in the Chicago metropolitan area.
The Bank also offers electronic banking services to commercial and retail customers. The Bank's Business Express software allows commercial and municipal customers to access accounts and initiate a number of transactions via on-line personal computers. Heritage's Phone Banker is an automated telephone system which provides customers access to account balance and transaction information and interest rates on most retail loan and deposit products and has an automated loan application feature which allows customers to apply for a number of retail loan products.
Heritage Trust Company offers a number of fiduciary, custodial and investment management services to individuals, corporations and municipalities at all of the Bank's locations. It also administers (as trustee and in other fiduciary and representative capacities) pension, profit sharing, 401K and other employee benefit plans, and personal trusts and estates. Lockport offers and services personal trust accounts.
Lending
The Bank concentrates its lending activities in the following areas: commercial and industrial loans, commercial real estate loans, residential real estate loans and home equity loans and lines of credit. It maintains comprehensive underwriting and credit policies which cover all aspects of commercial and retail lending. The Bank conducts substantially all of its lending activities in the southwest suburbs of Chicago and, to a lesser extent the Chicago metropolitan area.
For over 25 years, the Bank's primary organizational emphasis has been commercial lending. At December 31, 1997, approximately 47% of the Bank's loan portfolio was comprised of commercial and industrial loans, commercial real estate loans and construction loans. Commercial loans are provided on either a secured or unsecured basis to corporations, partnerships and individuals for working capital, business acquisitions, equipment purchases, plant expansion and commercial/industrial real estate financing. The Bank's lending limit to a single borrower exceeds $10 million, sufficient to satisfy the credit needs of most of the businesses located in its market area.
A majority of the commercial portfolio represents loans to small and mid- sized companies in businesses such as light manufacturing, wholesale, distribution and other service industries. The Company believes the commercial loan portfolio is well diversified by industry. The Bank has no energy or agricultural loans, loans to foreign countries or loans which would be classified as highly leveraged transactions.
In recent years the Bank has expanded its marketing and origination activities for retail loans to supplement the growth of the loan portfolio, attract new retail customers and increase the number of relationships with existing customers. At December 31, 1997, residential real estate loans and home equity loans comprised 52% of the loan portfolio. Residential real estate loans represent single-family, first mortgages secured by properties primarily located in southwest suburban Chicago. Home equity loans represent second mortgages secured by residential real estate properties located in Cook County and the adjacent collar counties. In addition to originating residential loans for its portfolio, the Bank originates home loans for sale to secondary market investors.
Market Information and Community Banking
The Company's primary market area is southwest suburban Cook County, and to a lesser extent adjacent Will County and DuPage County. For many years there has been significant economic and population growth in the outlying areas of southwest Cook County and DuPage County and in many parts of Will County. The market for banking and financial services may be characterized as competitive due to the number of financial institutions located in the area.
The Company's banking offices are located in rapidly growing residential areas as well as in stable neighborhoods of established suburbs. The general profile of retail banking customers consists of blue and white collar workers with excellent savings habits. A combination of retail, commercial and municipal customers provides the Company with stable sources of core deposits to fund its loans and investments.
The market area has a diverse economic base including manufacturing businesses, service industries, wholesalers and distributors. This diversity has contributed to the stability and success of the Company's lending business when compared to other areas of the country which, from time to time, have experienced economic declines. Real estate property values in the Chicago metropolitan area have generally been stable over the past five years.
The Company attributes its success in part to its community banking philosophy. This philosophy is based on the perception of the ongoing need for conveniently located financial institutions that offer a full range of products and services at competitive prices. The community banking approach also embodies a high level of personalized quality service and a commitment to local communities. Community banking, combined with commercial and retail lending expertise, has allowed the Company to grow within the southwest metropolitan Chicago area and has contributed to the Company's overall profitability.
Neither the Company nor any of its subsidiaries is dependent for a material part of its business upon a single customer, or very few customers, the loss of any one of which would have a materially adverse effect on the Company. The Bank's customers are not concentrated in any one industry, and many of them do business on a national basis, reducing the lending risk associated with downturns in particular industries or geographic areas.
Acquisitions and Expansion
In 1981, a strategic decision was made to form a holding company and expand operations through acquisitions. Since then, the Company has purchased Crestwood Bank in 1983, Heritage Bank of Oak Lawn in 1984, Bremen Bank and Trust in 1986, 1st Heritage Bank and Alsip Bank and Trust in 1992, Midlothian State Bank in 1994 and the First National Bank of Lockport in 1996. With the acquisition of these banks, the Company expanded its network for gathering stable deposits and reinforced its presence in the southwest metropolitan Chicago market.
As an additional means of entering new markets or increasing market share, the Company has also grown through the development or acquisition of strategically positioned branches. In 1989 two branch offices were opened in Cook County and one branch was opened in adjacent Will County. In 1992 the Bank purchased the branch facility and deposits of First Chicago Bank for Savings, located in Will County. In 1995 a branch office was opened in Monee, located in Will County. In 1997 the Bank opened a branch office in Joliet, located in Will County, and a branch office in Darien, located in southeast DuPage County. The Company plans to open at least one branch office in Will County in 1998. Management believes that branch expansion has and will continue to strengthen its current market position and will enhance the future growth of loans and retail core deposits.
Competition
The Company encounters significant competition in all of its activities. It competes for commercial and individual deposits, loans, trust business and other financial services with local and regional banks, thrifts, mortgage banking companies, finance companies, credit unions and a number of large national companies including manufacturers, insurance companies and brokerage firms. The Company faces additional competition in attracting deposits from money market funds, mutual funds and other investment funds. Many of the Company's competitors are generally much larger and have greater access to capital and other resources. Some of the financial institutions and financial services companies with which the Company competes are not subject to the same degree of regulation as that imposed on bank holding companies, and federally insured, state-chartered banks and national banks. As a result, such nonbank competitors have advantages over the Company in providing certain services.
The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce their costs. The Company is committed to addressing the needs of its customers by implementing technology that is cost-effective in delivering its products and services. However, many of the Company's competitors have substantial resources to invest in technological improvements, and therefore, may have an advantage in offering and marketing such products and services.
To compete in the banking and financial services industry, the Company is committed to delivering high quality financial products in a professional manner at a competitive price. The Company believes that competition for its products and services is based principally on location, convenience, service and price. The price factors primarily relate to interest rates and fees charged on loans, interest rates paid on deposits and service charges on deposits. While the pricing of products and services is an important element in competing for customers, the Company also believes that the delivery of quality service, as well as convenience will continue to be at least as important in retaining and expanding its customer base. See "Description of Business-Market Information and Community Banking" above.
Supervision and Regulation
General
Bank holding companies and banks are extensively regulated under federal and state laws and regulations. As a result, the business, financial condition and prospects of the Company and its subsidiaries can be affected not only by management decisions and general economic conditions, but also by applicable statutes and regulations and other regulatory pronouncements and policies adopted by regulatory agencies with authority over the Company and its subsidiaries. The effect of such statutes, regulations and other pronouncements and policies can be significant, cannot be predicted and can change over time.
The federal and state laws and regulations generally applicable to financial institutions regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, lending activities and practices, the nature and amount of and collateral for loans, the establishment of branches and mergers and acquisitions. The system of supervision and regulation applicable to the Company and its subsidiaries is intended to protect the deposit insurance system, the Bank's depositors and the public, rather than the Company's shareholders.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Under the Bank Holding Company Act, and the regulations promulgated thereunder, the Company is required to file annual and quarterly reports of its operations and such additional information as the Federal Reserve Board may require. It is also subject to examination by the Federal Reserve Board which has jurisdiction to regulate the terms of certain debt issues of the Company and the authority to impose capital and reserve requirements.
The Bank is a state bank chartered under the Illinois Banking Act. It is subject to regulation and examination by the Illinois Office of Banks and Real Estate and by the Federal Deposit Insurance Corporation ("FDIC") under the provisions of the Federal Deposit Insurance Act. Lockport is a national bank that is subject to regulation and examination by the Office of the Comptroller of the Currency ("OCC") and the FDIC. Heritage Trust Company is an Illinois chartered trust company subject to regulation and examination by the Illinois Office of Banks and Real Estate.
The Bank and Lockport are also subject to certain restrictions under the Federal Reserve Act and the Federal Deposit Insurance Act on loans and extensions of credit to the Company or its subsidiaries, investments in the stock or other securities of the Company or its other subsidiaries, or advances to any borrower collateralized by such stock or other securities.
References under this "Supervision and Regulation" heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations.
Deposit Insurance
As an FDIC insured institution, the Bank is required to pay deposit insurance premiums based on the risk it poses to the insurance fund. The FDIC has adopted a risk-based insurance premium system under which each insured depository institution is placed into one of nine risk categories and assessed insurance premiums based on its level of capital and supervisory evaluation. Financial institutions classified as "well-capitalized" (as defined by the FDIC) pay the lowest premium, while institutions that are less than adequately capitalized pay the highest premium. On a semi-annual basis, the FDIC assigns a risk classification and assessment rate for all institutions.
In 1996 and 1997, the Bank's assessment rate for each semi-annual period was zero. As of December 31, 1997, the FDIC continued to categorize the Bank as a "well capitalized" institution and assigned a zero assessment rate for the semi-annual period ending June 30, 1998. There are no assurances, however, that future assessment rates will remain at that level. See "Supervision and Regulation - Capital Adequacy" below.
Under federal law, FDIC insured institutions are responsible for servicing a portion of interest on Financing Corporation ("FICO") bonds that were issued by the government to pay for the thrift cleanup in the late 1980's. Until January 1, 2000, FICO assessments made against members of the FDIC's Bank Insurance Fund ("BIF") may not exceed 20% of the amount of FICO assessments against members of the FDIC's Savings Association Insurance Fund ("SAIF"). In 1997, the Company began paying FICO assessments at the rate of .013% of BIF deposits. For the semi-annual period ending June 30, 1998, the Bank's FICO assessment rate remained the same.
Capital Adequacy
The Federal Reserve and the FDIC have adopted risk-based capital guidelines and ratio requirements for bank holding companies and state-chartered nonmember banks, respectively. The risk-based capital guidelines are intended to provide a fair and consistent framework for comparing capital positions of all banking institutions. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, financial institutions 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. A bank's capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and 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 Tier I capital (as defined) to average assets (as defined). If the capital of a bank holding company falls below minimum guidelines, it may, among other things, be denied the approval to acquire or establish additional banks or non-bank businesses. The failure of a bank to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that may have a direct material effect on a bank's financial statements.
At December 31, 1997, the capital ratios of the Company and the Bank exceeded the thresholds required to meet the "well capitalized" capital category. For additional information on the capital requirements and ratios of the Company and the Bank, see "Note 16 - Regulatory Restrictions and Capital Adequacy" of the Notes to Consolidated Financial Statements included under Item 8 of this document.
The quantitative capital measures established by the FDIC and the Federal Reserve Board are minimum requirements and higher capital levels may be required if warranted by the particular circumstances or risk profiles of particular organizations. For example, the regulations of the FDIC and the Federal Reserve provide that additional capital may be required to take adequate account of, among other things, interest rate risk, or risks posed by concentrations of credit, nontraditional activities or securities trading activities.
Dividends
The Company has paid a cash dividend every quarter since it became a bank holding company in 1982. The Company's shareholders are entitled to receive such dividends as are declared by the board of directors, which considers payment of dividends quarterly. The dividend policy of the Company is designed to balance the shareholder interest in current return with the need to retain adequate capital to support future asset growth. While the Company anticipates paying quarterly cash dividends in the future, the timing and amount of dividends will depend upon the earnings, capital requirements and financial condition of the Company as well as general economic conditions and other relevant factors affecting the Company. The ability of the Company to pay dividends is dependent upon its receipt of dividends from the Bank. Regulatory authorities limit the amount of dividends which can be paid by the Bank without prior approval from such regulatory authorities. At December 31, 1997, the amount of undistributed earnings of the Bank available for payment of dividends within such limitations is more than adequate to fund dividends paid by the Company. For further information on the Bank's capital and dividend restrictions, see "Note 16 - Regulatory Restrictions and Capital Adequacy" of the Notes to Consolidated Financial Statements included under Item 8 of this document.
Acquisitions and Expansion
The Bank Holding Company Act requires the Company to obtain the prior approval of the Federal Reserve Board before merging with or consolidating into another bank holding company, acquiring substantially all the assets of any bank or bank holding company or acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank or bank holding company (unless the Company already owns a majority of the voting shares of such bank or bank holding company). In its approval process, the Federal Reserve Board is required to weigh the expected benefit to the public, such as greater convenience and increased competition, against the risks of possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board also gives consideration to the Bank's compliance with the Community Reinvestment Act, including the rating assigned by the FDIC. The Community Reinvestment Act obligates each financial institution to address the credit needs of its entire community, including low- and moderate-income areas. See "Supervision and Regulation - Community Reinvestment" below.
The Bank Holding Company Act also prohibits the Company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. The Company, however, may engage in, and may own shares of companies engaged in, certain businesses determined by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The non- banking activities currently permitted for bank holding companies include, among other things, mortgage, consumer and commercial finance activities, equipment leasing and the operation of a thrift. The Bank Holding Company Act, as implemented by Federal Reserve Board regulations, generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.
For many years, banks in Illinois were restricted as to the number and geographic location of branches which they could establish. In June, 1993, Illinois law was amended to eliminate all branching restrictions. Accordingly, banks located in Illinois are permitted to establish branches anywhere in Illinois without regard to the location of other banks' main offices or the number of branches previously established. See "Description of Business - Acquisitions and Expansion" above.
On September 29, 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("IBBA") was signed into law. In general, IBBA permits bank holding companies that are adequately capitalized and adequately managed to acquire banks located in any other state after September 29, 1995, subject to certain conditions, including limitations on the aggregate amount of deposits that may be held by the acquiring holding company and all of its insured depository institution affiliates. IBBA also allows interstate branching and merging of existing banks beginning June 1, 1997. States may elect to prohibit interstate branching and merger transactions if they enact legislation after September 29, 1994, and before June 1, 1997. This state "opt out" provision does not apply to bank holding company acquisitions. Effective June 1, 1997 the State of Illinois enacted legislation permitting interstate mergers subject to certain conditions, including a prohibition against such mergers if the Illinois bank involved has not been in existence and operation for at least five years.
Community Reinvestment
On April 19, 1995, federal banking agencies adopted a new rule amending the Community Reinvestment Act ("CRA"). The new CRA rule became effective July 1, 1995 under a phased-in implementation schedule. Beginning January 1, 1996, financial institutions are required to collect and periodically report certain information on loans. Effective July 1, 1997, all institutions will be evaluated under the new CRA performance tests which will include the following: (1) the lending test, which will evaluate an institution's record of helping to meet its assessment area's credit needs through its lending activities by evaluating home mortgage, small business and community development lending; (2) an investment test, which will evaluate a financial institution's record of meeting assessment area credit needs through qualified investments within its assessment area; and (3) a service test, by which the FDIC will analyze the availability and effectiveness of a financial institution's system for delivering retail banking services and the extent and innovativeness of its community development services. The FDIC will assign a rating of outstanding, satisfactory, needs to improve or substantial noncompliance, depending upon an institution's performance under each of the tests. Regulatory agencies will take into account a financial institution's rating when considering its application for approval of mergers, acquisitions and relocations of main or branch offices and may deny an application based on an unsatisfactory CRA rating. In 1997 the FDIC performed a CRA examination of the Bank and rated it "satisfactory".
Monetary/Fiscal Policies and Economic Conditions
The earnings of bank holding companies and their subsidiary banks are affected by general economic conditions and also by the monetary and fiscal policies of governmental authorities, including, in particular, those of the Federal Reserve Board which influences conditions in the money and capital markets through, among other means, open market operations in U.S. Government securities, varying the discount rate on bank borrowings and setting reserve requirements against bank deposits. Such operations and policies are designed to affect interest rates and the growth in bank credit, investments and deposits. The monetary and fiscal policies of the Federal Reserve Board have affected the operating results of all commercial banks in the past and are expected to do so in the future. The Company cannot predict the nature or the extent of any effect which economic conditions or fiscal or monetary policies may have on its business and earnings.
Securities Laws
The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934 (the "1934 Act"). These requirements include the obligation to file with the Securities and Exchange Commission annual, quarterly and other reports. In addition, the Company is subject to the proxy rules promulgated pursuant to the 1934 Act, and its directors, officers and principal shareholders are subject to the "short swing profits" and reporting provisions of Sections 16(a) and 16(b) of the 1934 Act.
Employees
As of December 31, 1997, the Company had approximately 441 full-time equivalent employees. The Company provides a variety of employment benefits, and management of the Company considers its employee relations to be excellent.
Miscellaneous
The Company's subsidiaries utilize the name "Heritage", including use pursuant to license agreement. Other financial institutions not part of the Company also use the name "Heritage".
ITEM 2.
ITEM 2. PROPERTIES
At December 31, 1997, the Company had 17 banking locations, of which 13 were owned and four were leased. The Bank also leases certain space which houses its operations center. Of the total banking locations, 11 are located in southwest suburban Cook County, five are located in adjacent Will County and one is located in southeast DuPage County. All bank-owned properties are free- standing buildings that provide adequate customer parking and drive-up facilities. The leased banking facilities are located in or near retail shopping centers, and all maintain drive-up facilities. All of these offices are considered by management to be well maintained and adequate for the purpose intended. See "Note 6 - Premises and Equipment" of the Notes to Consolidated Financial Statements included under Item 8 of this document for further information on properties.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial condition or results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER MATTERS
For purposes of the calculation of aggregate market value of the common shares held by nonaffiliates of the Company as set forth on the cover page of this report, the Company included in the shares held by affiliates 712,818 shares (as of December 31, 1997) which may be voted by certain officers of the Company as trustees of a profit sharing trust for the Company and subsidiaries.
The Company's common shares are traded on the Nasdaq National Market tier of the Nasdaq Stock Market under the symbol HERS. Stock price quotations can be found in the Wall Street Journal and other major daily newspapers. At December 31, 1997, there were approximately 785 holders of record of the Company's shares.
The following table sets forth the dividends paid, common share prices and number of shares traded during each quarter of 1997 and 1996, as reported by Nasdaq. The information has been adjusted to reflect the Company's three-for-two stock split paid in June, 1997:
The Company's shareholders are entitled to receive such dividends as are declared by the board of directors, which considers payment of dividends quarterly. Dividends are declared and paid quarterly in accordance with annual dividend policies established by the board of directors. The ability of the Company to pay dividends, as well as fund its operations and service debt, is dependent upon receipt of dividends from Heritage Bank. Regulatory authorities limit the amount of dividends which can be paid by the Bank without prior approval from such authorities. At December 31, 1997, the amount of undistributed earnings of the Bank available for payment of dividends within such limitations is more than adequate to fund the anticipated cash requirements of the Company. For a further discussion of the Bank's dividend restrictions and capital requirements see "Note 16 - Regulatory Restrictions and Capital Adequacy" of the Notes to Consolidated Financial Statements included under Item 8 of this document.
On January 13, 1998, the Company's board of directors increased the quarterly cash dividend to 11 cents per share payable February 10, 1998 to shareholders of record on January 26, 1998. While the Company anticipates paying quarterly dividends in the future, there can be no assurance that any such dividends will be paid by the Company or that such dividends will not be reduced or eliminated in the future. The timing and amount of dividends will depend upon the earnings, capital requirements and financial condition of the Company as well as general economic conditions and other relevant factors affecting the Company. Also see "Supervision and Regulation-Dividends" included under Item 1 of this document.
On January 14, 1998, the Company, First Midwest Bancorp, Inc. ("First Midwest") and First Midwest Acquisition Corporation, a wholly owned subsidiary of First Midwest ("Acquisition Corporation"), entered into an Agreement and Plan of Merger ("Merger Agreement") whereby the Company will be merged with and into Acquisition Corporation (the "Merger"). Pursuant to the Merger Agreement, the Company is prohibited from paying quarterly dividends in excess of 11 cents per share.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following sets forth a five year comparison of selected financial data. The financial data reflects the balances and results of operations of acquisitions which occurred in 1996 and 1994. The acquisitions were accounted for using the purchase method. Per share data has been adjusted to reflect a three-for-two stock split paid in June 1997. Earnings per share data has been restated to reflect the adoption of SFAS 128.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to provide a better understanding of the consolidated financial condition and results of operations of Heritage Financial Services, Inc. and subsidiaries (the "Company") for the years ended December 31, 1997, 1996 and 1995. This discussion and analysis should be read in conjunction with the consolidated financial statements, related notes and selected financial data appearing elsewhere in this report.
On February 2, 1996, the Company acquired all of the common stock of the First National Bank of Lockport ("Lockport") for $16.8 million in cash. At the date of acquisition, Lockport had total assets of $104 million. The acquisition was accounted for as a purchase and, accordingly, the results of operations of Lockport have been included in the consolidated statements of income from the date of acquisition.
Overview
In 1997 the Company achieved record net income and earnings per share. For the year, net income was $17.8 million, up 20% from $14.8 million in 1996. In 1996 net income increased 12% from $13.3 million in 1995. Diluted earnings per share were $1.43 compared with $1.19 in 1996 and $1.07 in 1995. The Company's return on average assets in 1997 was 1.40%, compared to 1.25% in 1996 and 1.31% in 1995. The return on average equity was 16.12% in 1997 compared to 15.00% in 1996 and 15.10% in 1995.
The growth in earnings in 1997 was principally due to increases in net interest income and other income. The improvement in net interest income was primarily attributable to the growth in the volume of earning assets and interest-bearing liabilities, reflecting strong internal growth during the year. The growth in other income primarily reflected increases in deposit service charges and other operating income. Earnings in 1997 were also positively affected by the following after-tax items: a recovery of $96,000 of interest income on a nonaccrual loan, the reimbursement of $90,000 of legal costs related to litigation settled in 1996, and the receipt of a state income tax refund which totaled $379,000.
In 1996 the increases in net interest income and other income were the major factors contributing to the increase in net income. The improvement in net interest income was attributable to the growth in the volume of earning assets and interest-bearing liabilities, primarily reflecting the acquisition of Lockport during the year. In 1996 a decline in the net interest spread partially offset the positive impact of volume growth. The growth in other income primarily reflected increases in deposit service charges and investment product fee income. A decrease in Federal Deposit Insurance Corporation ("FDIC") deposit insurance premiums also contributed to the increase in net income for the year.
Results of Operations
Net Interest Income
The largest source of operating revenue for the Company is net interest income. Net interest income represents the difference between total interest income earned on earning assets and total interest expense paid on interest- bearing liabilities. The amount of interest income is dependent upon many factors including the volume and mix of earning assets, the general level of interest rates and the dynamics of changes in interest rates. The cost of funds necessary to support earning assets varies with the volume and mix of interest- bearing liabilities and the rates paid to attract and retain such funds.
For purposes of this discussion and analysis, the interest earned on tax- exempt assets is adjusted to an amount comparable to interest subject to normal income taxes. The adjustment is referred to as the tax equivalent ("TE") adjustment.
The Company's average balances, interest income and expense and rates earned or paid for major balance sheet categories are set forth in the following table (in thousands):
_____ (1) Interest income and rates are presented on a tax equivalent basis, assuming a federal income tax rate of 35%. (2) Includes fees on loans of $1,181 in 1997, $1,305 in 1996 and $1,187 in 1995. (3) For presentation purposes in this table, other assets includes nonaccrual loans, the allowance for loan losses and the net unrealized gain (loss) on securities available-for-sale.
Changes in net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense. The following table summarizes the approximate relative contribution of changes in average volume and interest rates to changes in net interest income (TE) for the past two years (in thousands):
TABLE 2 Analysis of Changes in Interest Income and Interest Expense(1)
___________ (1) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amount of the change in each.
(2) Interest income is presented on a tax equivalent basis assuming a federal income tax rate of 35%.
On a tax equivalent basis, net interest income increased $4.1 million, or 8% in 1997, compared to an increase of $5.6 million, or 13% in 1996. As set forth in Table 2, the improvement in net interest income in both years was due to increases in the volume of earning assets and interest-bearing liabilities, partially offset by the effect of changes in interest rates.
In 1997 average earning assets increased by $86 million, or 8%, and average interest-bearing liabilities increased $67 million, or 11%, compared with 1996 (Table 1). The higher volume of earning assets and interest-bearing liabilities in 1997 reflected strong internal deposit growth during the year. In 1996 average earning assets increased by $158 million, or 17%, and average interest- bearing liabilities increased $128 million, or 16%, compared with 1995. Growth in the volume of earning assets and interest-bearing liabilities in 1996 resulted from the acquisition of Lockport coupled with internal deposit growth during the year. As a percentage of average earning assets, the level of average interest-bearing liabilities was 81.7% in 1997 compared to 82.1% in 1996 and 82.2% in 1995.
On a tax equivalent basis, the net interest spread decreased slightly to 3.65% in 1997 compared to 3.67% in 1996. The change in the net interest spread reflected an increase of .12% in the yield on average earning assets while the rate paid on interest-bearing liabilities increased .14%. The increase in the yield on earning assets was primarily due to a .27% increase in the yield on securities, reflecting higher rates earned on new purchases and the sale and reinvestment of lower-yielding securities. The increase in the rate paid on interest-bearing liabilities was primarily due to higher rates paid on money market deposit accounts and time deposits, reflecting higher rates paid on new account promotions during the year.
In 1996 the tax equivalent net interest spread decreased to 3.67% compared to 3.81% in 1995. The change in the net interest spread reflected a decrease of .17% in the yield on average earning assets while the rate paid on interest- bearing liabilities declined by only .03%. The decline in the yield on earning assets primarily resulted from the change in the mix of earning assets discussed above and generally lower rates earned on new volume of earning assets and rate sensitive assets, such as prime-based floating rate loans and federal funds sold. The cost of interest-bearing liabilities declined slightly as short-term market interest rates remained relatively stable throughout 1996 compared to 1995.
A factor also contributing to lower net interest spreads in 1997 and 1996 has been the flattening of the treasury yield curve. This trend is primarily attributable to the market's expectation of moderate economic growth with relatively low rates of inflation. The monetary policies and actions of the Federal Reserve Board have also influenced the shape of the yield curve. In general, a flatter yield curve reduces the interest spreads earned on new loans and securities compared to the cost of funds. Throughout 1996 and 1997, the yield curve generally flattened as the spreads between long-term and short-term market interest rates compressed. The Company cannot predict whether the changes in the yield curve will continue or be sustained. However, changes in the slope of the yield curve will continue to impact the spread earned on average earning assets. The mix of earning assets and funding sources will also impact future net interest spreads.
For additional information on the Company's interest rate risk and management practices, see the "Asset/Liability Management and Interest Rate Risk" section below.
Provision for Loan Losses
The provision for loan losses in 1997 was $600,000 compared to $400,000 in 1996 and $200,000 in 1995. The increase in provisions in 1997 and 1996 primarily resulted from increased loan growth and, in 1996, higher net charge-offs. The provisions in both years were also influenced by the improvement in asset quality and reductions in potential risks associated with impaired loans. For further information on the Company's nonperforming loans, impaired loans and loss experience, see the "Nonperforming Assets", "Impaired Loans" and "Allowance for Loan Losses" sections below.
Other Income
An important source of the Company's revenue is derived from other income. The following table sets forth the major components of other income for the last three years (in thousands):
Service charges on deposits, the largest component of other income, increased 16% in 1997 and 9% in 1996. The increase in service charge income in 1997 was principally due to changes in overdraft service charge methods. In 1996 the increase in income was due in part to the additional fee income of Lockport and the changes in overdraft service charge methods. While the Company has historically experienced increases in deposit service charges, the growth has been tempered by the introduction of
new retail products, such as free checking accounts. These products have been offered in response to similar products offered by local financial institutions and non-bank competitors. In the future, the introduction of similar products and customer cost preferences may limit the growth of service charge revenue.
Income from trust services increased 11% in 1997 and 6% in 1996. In 1997 the increase reflected continued growth of employee benefit plans and other asset management accounts serviced by Heritage Trust Company, a wholly owned subsidiary of the Company. The growth in trust revenue in 1996 was primarily attributable to the trust accounts acquired from Lockport. At December 31, 1997, total customer trust assets were approximately $227 million, up $44 million from year-end 1996.
Income from investment product fees is derived from sales of third-party mutual funds and annuities through arrangements with licensed broker-dealers. In 1996 the Company expanded the annuity and mutual fund product selections which it offers. The growth in investment product income in 1997 and 1996 was in part due to the increased product offerings combined with greater customer demand.
Other operating income increased 63% in 1997, primarily due to ATM surcharge fees which were established in December, 1996. The increase also reflected $231,000 of interest on a state income tax refund received in the fourth quarter of 1997. In 1996 other operating income increased 20%, reflecting the additional other operating income of Lockport.
Net securities gains in 1997 were $291,000 compared to net gains of $120,000 in 1996 and $223,000 in 1995. In 1997 the Company recognized net gains of $101,000 from the sale of $58 million of fixed-rate and adjustable-rate securities. The balance of net securities gains recognized in 1997 reflected a market value adjustment of an investment security classified as trading. In 1996 the Company recognized a net loss of $58,000 from the sale of $38 million of fixed-rate and adjustable-rate securities. In 1996 the Company also recognized a gain of $135,000 on the payoff of a nonaccrual tax-exempt obligation and gains of $30,000 from calls of municipal securities. In 1995 the Company sold $8 million of adjustable-rate mortgage pools for gains of $177,000 and realized gains of $46,000 from calls of municipal securities.
Other Expense
The major categories of other expense include salaries and employee benefits, occupancy and equipment expenses and other operating expenses associated with the day-to-day operations of the Company. Over the past two years the overall growth of operating expenses has been contained due to the realization of certain economies of scale from the Lockport acquisition, efficient staffing and management's ongoing efforts to reduce costs through investments in technology and competitive bidding. In 1996 the increase in most expense categories was attributable to the Lockport acquisition.
Operating expense levels of financial institutions are often measured using the efficiency ratio (operating expense divided by the sum of taxable equivalent net interest income plus other income, excluding securities transactions). The ratio reflects on average how much an institution spends to generate each dollar of revenue. The Company's efficiency ratio was 51.0% in 1997 compared to 54.5% in 1996 and 55.3% in 1995. The improvement in the efficiency ratio in 1997 and 1996 was primarily due to higher revenue growth combined with relatively lower operating expenses.
The following table sets forth the major components of other expense for the last three years (in thousands):
TABLE 4 Other Expense
Salaries and employee benefits, the largest component of other expense, increased 4% in 1997 compared to 10% in 1996. The increases in both years were primarily attributable to annual merit increases paid to employees and incentive compensation. In 1996 higher expenses were also due to the additional salary expense from Lockport and an increase in profit sharing expense. At December 31, 1997, the number of full-time equivalent ("FTE") employees totaled 441 compared to 446 and 434 at December 31, 1996 and 1995, respectively. The increase in the number of FTE employees in 1996 was primarily due to the additional employees of Lockport.
Occupancy expense increased 3% in 1997 and 19% in 1996. The significant increase in 1996 expense was primarily due to higher real estate taxes, reflecting increases in property valuations which were reassessed in 1996. A majority of Heritage Bank's real estate properties are reassessed by taxing authorities every three years. The growth in occupancy expense in 1997 and 1996 also reflects the additional costs of branch expansion. In June 1997 the Company moved into a permanent branch facility in Monee, Illinois. Prior to that, the Company had been leasing a temporary facility. In April 1997 the Company opened a branch office in Joliet, Illinois and in September 1997 opened a branch in Darien, Illinois. The Company currently plans to open one additional branch facility in 1998.
For several years the Company has continued to expand and upgrade computer, data processing and communications equipment to improve productivity, increase operating efficiencies and enhance customer sales and service. As a result, data processing and equipment expenses have increased each year. In 1997 data processing expense increased 13% compared to an increase of 35% in 1996. Equipment expense increased 2% in 1997 compared to an increase of 8% in 1996. The increase in data processing expense in 1997 was primarily due to general price increases in third-party data processing services. Higher data processing and equipment expenses in 1996 were primarily due to the upgrade of teller platform systems, the upgrade of bank-wide telephone systems and the purchase of approximately $1 million of new personal computers. The growth in data processing expense in 1996 also reflected the additional costs to process the activity of Lockport.
The Company utilizes and is dependent upon data processing systems and software to conduct its business. The data processing systems and software include those developed and maintained by a third-party data processing vendor and purchased software which is run on in-house computer networks. In 1997 the Company initiated a review and assessment of all hardware and software to confirm that it will function properly in the Year 2000. To date, those vendors which have been contacted and have responded indicate that their hardware or software is or will be Year 2000 compliant by the end of 1998. In 1997 the Company's third-party data processing vendor indicated that the Company would have to convert to new software applications in 1998 to be Year 2000 compliant. In light of this, the Company reviewed other third-party data processing application systems and products and, in January, 1998, elected to convert its data processing systems to a new third-party vendor. The data processing conversion is anticipated to occur in the fourth quarter of 1998 and will result in the Company incurring one-time conversion costs of approximately $250,000. As part of the data processing conversion, the Company will also install a new retail banking platform which will result in additional one-time costs of approximately $400,000.
The significant decline in deposit insurance expense in 1996 was due to a reduction in the Bank Insurance Fund ("BIF") assessment rates. Effective June 1, 1995, the FDIC reduced Heritage Bank's assessment rate from .23% of deposits to .04% of deposits. In 1996 and 1997 the Bank's assessment rate for each semi- annual period was zero. In December, 1997, the FDIC set the Company's BIF assessment rate for the semi-annual assessment period ending June 30, 1998, at zero. There are no assurances, however, that future assessment rates will remain at that level. In 1996, the Economic Growth and Regulatory Paperwork Reduction Act of 1996 ("Economic Growth Act") was signed into law which, among other things, authorized the FDIC to recapitalize the Savings Association Insurance Fund ("SAIF") by imposing a special assessment on institutions holding SAIF deposits. Under the Economic Growth Act, members of the BIF and SAIF will be jointly responsible to service a portion of interest on Financing Corporation ("FICO") bonds that were issued by the government to pay for the thrift cleanup in the late 1980's. In 1997 the Company paid FICO assessments at the rate of .013% of BIF deposits.
The increase in the amortization of intangible assets in 1996 resulted from the acquisition of Lockport. The increase in professional fees in 1997 was primarily due to certain consulting fees incurred in connection with special projects during the year. Higher marketing and promotion expenses in 1997 and 1996 were primarily attributable to increased advertising and direct mail costs associated with loan and deposit promotions. The increase in other operating expenses in 1996 reflected a charge of approximately $300,000 to settle a lawsuit filed by Federal Insurance Company in May, 1995. In the first quarter of 1997, the Company received $150,000 from its insurance carrier as a reimbursement of legal costs related to this litigation.
Income Taxes
In the 1997 fourth quarter, the Company received a refund of state income taxes as a result of an amendment to a prior year income tax return. As a result of the refund, the Company amended other state income tax returns and paid taxes due with such returns. On a net basis, the Company recognized $148,000 of income tax benefits as a result of the tax refund and interest earned thereon.
Excluding the benefits of the state income tax refund described above, income tax expense increased $1,114,000 in 1997 and $600,000 in 1996. Higher income tax expense in both years was principally due to the increases in pre-tax earnings. The Company's effective tax rate was 31.2% in 1997 (excluding the net state income tax refund), 31.7% in 1996 and 32.2% in 1995. The decrease in the effective tax rate in 1997 and 1996 was primarily due to an increase in the amount of tax-exempt income earned on state and municipal securities.
Analysis of Balance Sheets
Loans
The loan portfolio is the largest category of the Company's earning assets. The following table summarizes the composition of the loan portfolio for the last five years (in thousands):
TABLE 5 Composition of Loans
The Company's primary organizational emphasis is commercial lending. A majority of the commercial loan portfolio represents loans to small and mid- sized companies in businesses such as light manufacturing, wholesale, distribution and other service operations. Commercial and industrial loans consist primarily of secured loans made for business working capital and purchases of inventory and equipment. Commercial real estate loans generally represent intermediate-term mortgages (five to fifteen years) made to finance owner-occupied property, plant expansion or the acquisition of income-producing property. While most of the Company's commercial borrowers operate in the southwest suburbs of Chicago, a number of these customers conduct business nationally.
Combined, commercial and industrial, commercial real estate and construction loans increased $28 million or 9% in 1997 compared to an increase of $22 million or 8% in 1996. The Company continues to actively pursue commercial borrowers within the markets it serves. However, increased competition and aggressive pricing by both bank and non-bank competitors has tempered the growth of commercial loans over the past several years.
Residential real estate loans primarily represent single-family, first mortgages with intermediate terms secured by properties primarily located in the Company's general market area. In 1997 this portfolio increased $36 million or 15% compared to $39 million or 19% in 1996. The Company continues to grow the residential real estate portfolio based on its asset/liability mix and interest rate sensitivity position. A majority of the new loans originated in 1997 and 1996 were 15-year and 30-year bi-weekly loans.
Home equity loans represent second mortgages secured by residential real estate properties primarily located in Cook County and the adjacent collar counties. At December 31, 1997, approximately $37 million, or 39%, of home equity loans were floating rate advances under equity lines of credit. The remaining balance of the portfolio consisted of fixed-rate installment loans with terms of five to 15 years.
The maturity distribution and interest rate sensitivity of commercial and industrial, commercial real estate and construction loans at December 31, 1997 are set forth below (in thousands):
- ----------------- (1) Based on scheduled principal repayments. (2) Includes demand loans, past due loans and overdrafts.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, loans where scheduled payments are 90 days or more past due and other real estate owned. The Company places loans on nonaccrual status when management believes, after considering the borrower's financial condition and other relevant factors, that future collection of principal or interest in accordance with contractual terms may be doubtful. Loans 90 days or more past due are transferred to nonaccrual status unless they are well secured and in the process of collection. Other real estate owned includes properties acquired through foreclosure or deed in lieu of foreclosure. The properties are recorded at the lower of the book value of the loan or fair value, less estimated costs to sell.
The following table sets forth the aggregate amount of the Company's nonperforming assets for the last five years (in thousands):
At December 31, 1997, the composition of nonperforming loans primarily consisted of loans secured by local commercial real estate or residential real estate of which no single loan exceeded $125,000. Other real estate owned primarily consisted of residential real estate. At December 31, 1997, the largest OREO property was a residential property with a carrying value of $280,000.
In addition to the loans classified as nonperforming at December 31, 1997, other loans with a total principal balance of approximately $2.3 million were identified by management to be possible problem loans. While these borrowers are in compliance with present repayment terms, their financial conditions have caused management to believe that their loans may result in classification as past due or nonaccrual loans at some future time. These loans have been considered in the recognition and evaluation of impaired loans described below.
Impaired Loans
Under the Company's credit policy, all loans, except for home equity loans and other consumer loans, are subject to impairment recognition on a quarterly basis. A loan is considered impaired when it is probable that all principal and interest due under the contractual terms of a loan will not be collected. The Company generally considers most loans 90 days or more past due and all nonaccrual loans to be impaired. Loan impairment is measured based on the present value of expected future cash flows or the fair value of collateral if the loan is collateral dependent. If the fair value of an impaired loan is less than its recorded investment, a specific valuation allowance is allocated to the loan. Interest income on impaired loans, other than nonaccrual loans, is recorded on an accrual basis.
The following table sets forth the recorded investment in impaired loans and the related valuation allowance for each loan category as of December 31, 1997 and 1996 (in thousands):
Of the total amount of impaired loans at December 31, 1997, $717,000 were measured using the present value of expected future cash flows and $2,052,000 were measured based on the fair value of collateral. The average recorded investment in impaired loans for the years ended December 31, 1997 and 1996, were $2,942,000 and $5,855,000, respectively. Interest income recognized on impaired loans totaled $144,000 in 1997 and $236,000 in 1996.
The amount of impaired loans is not directly comparable with the amount of nonperforming loans previously disclosed in Table 7. The primary differences between nonperforming loans and impaired loans are: i.) all loan categories are considered in determining nonperforming loans while impaired loan recognition is limited to commercial and industrial loans, commercial real estate loans and residential real estate loans; and ii.) impaired loan recognition considers not only loans 90 days or more past due and nonaccrual loans but also may include possible problem loans other than delinquent loans. Included in the total balance of impaired loans at December 31, 1997 were nonaccrual loans of $742,000 and loans 90 days or more past due of $79,000. At December 31, 1996, the balance of impaired loans included nonaccrual loans of $2,951,000.
Allowance for Loan Losses
The allowance for loan losses is an amount which is available to absorb potential credit losses. The allowance is comprised of both specific and general valuation allowances and is maintained at a level management believes to be adequate to provide for known and potential risks inherent in the Company's loan portfolio. Management assesses the adequacy of the allowance for loan losses on a quarterly basis. Management's evaluation of the adequacy of the allowance considers such factors as prior loss experience, loan portfolio growth, loan delinquency levels and trends, and reviews of impaired loans and the value of underlying collateral securing these loans. A provision for loan losses is charged to income to increase the allowance to a level deemed to be adequate, but not excessive, based on management's evaluation. When a loan or a part thereof is considered by management to be uncollectible, a charge is made against the allowance. Recoveries of loans previously charged off are credited back to the allowance.
The following table summarizes the changes in the allowance for loan losses for the last five years (in thousands):
TABLE 9 Allowance for Loan Losses
The Company minimizes credit risk by adhering to sound underwriting and credit review policies. These policies are reviewed at least annually, and changes are approved by Bank's board of directors. Senior management is actively involved in business development efforts and the maintenance and monitoring of credit underwriting and approval. Loans and lines of credit over $2 million are reviewed and approved by the executive committee of the Bank's board of directors. The Company's loan review system and controls are designed to identify, monitor and address asset quality problems in an accurate and timely manner. The Bank's loan review committee meets monthly to assess delinquent and problem loans and develop collection strategies to minimize potential loan losses. The Bank's board of directors also reviews the status of delinquent loans monthly. In addition to internal policies and controls, regulatory authorities and the Company's independent auditors periodically review asset quality and the overall adequacy of the allowance for loan losses as integral parts of their examinations.
The Company recorded higher loan loss provisions in 1997 and 1996 primarily due to increased loan growth and, in 1996, to higher net charge-offs. The provisions in both years were also influenced by the improvement in asset quality and reductions in potential risks associated with impaired loans. The loan loss provision in 1994 was influenced by a large recovery of a previously charged-off commercial real estate loan. Excluding the large recovery, the Company's net charge-off ratio for 1994 would have been .06%.
At December 31, 1997, the allowance for loan losses as a percentage of loans was 1.35% compared to 1.47% at year-end 1996. The decrease in the level of the allowance was primarily due to the growth in the loan portfolio. As a percentage of nonperforming loans, the allowance increased to 860% at December 31, 1997 compared to 224% at December 31, 1996. The increase in the allowance coverage of nonperforming loans was primarily attributable to the reduction in nonperforming loans in 1997.
The following table sets forth an allocation of the Company's allowance for loan losses for the last five years (in thousands):
TABLE 10 Allocation of the Allowance for Loan Losses (1)
- ------ (1) See Table 5 for the percentage of each loan category to total loans.
Changes in the allocation of the allowance to individual loan categories at December 31, 1997 and 1996 were primarily the result of loan portfolio growth and changes in management's risk assessment and assignment of unallocated reserves. In 1995 the change in the allocation reflected the adoption of the impaired loan accounting standard.
Securities
The Company's overall investment goal is to maximize earnings while maintaining liquidity in securities having minimal credit risk. The types and maturities of securities purchased are primarily based on the Company's current and projected liquidity and interest rate sensitivity positions.
The following table sets forth the year-end carrying value of securities for the last three years (in thousands):
TABLE 11 Composition of Securities
Mortgage-backed securities primarily consist of mortgage pass-through securities directly or implicitly backed by the full faith and credit of the United States government. Approximately one-half of the mortgage-backed portfolio represents investments in fixed-rate tranches of real estate mortgage investment conduits ("REMICs") and collateralized mortgage obligations ("CMOs"). Mortgage-backed securities are acquired based on their relative yield advantage over other investment alternatives with similar maturity characteristics. Acquisitions of these securities involve a thorough analysis of their estimated prepayment speeds and yield performance with movements in market interest rates of plus or minus 300 basis points. Asset-backed securities generally represent interests in pools of short-term loans or receivables, such as auto, home equity and credit card loans. All asset-backed securities are AAA rated bonds.
In 1997 and 1996 the Company increased its investments in fixed-rate, intermediate- and long-term mortgage-backed securities having average lives ranging from three to ten years. Fixed-rate mortgage-backed securities comprised 54% of total securities at December 31, 1997, compared to 51% in 1996 and 44% in 1995. The Company also increased its holdings of longer-term bank- qualified tax-exempt securities. The maturities of these securities primarily range from seven to 15 years. Cash flows from payments and sales of adjustable- rate mortgage ("ARM") pools were used to partially fund the growth of mortgage- backed and municipal securities.
At December 31, 1997, concentrations of securities of a single issuer consisted of investments in tax-exempt obligations issued by the Village of Alsip. The amortized cost and market value of these securities were $14,106,000 and $14,691,000, respectively. In addition to securities, the Company has granted tax-exempt loans to the Village of Alsip which totaled $4,462,000 at December 31, 1997. All securities and loans are secured by the general taxing authority of the Village of Alsip except for $257,000 in securities which are secured solely by revenue from certain real estate taxes. Some loans are further secured by real estate or other marketable collateral. The Company has no other securities of any one issuer, excluding mortgage-backed securities, that exceed 10% of shareholders' equity.
The maturities and weighted average yields of securities as of December 31, 1997, are presented in the following table. The amounts and yields of fixed-rate mortgage-backed securities and asset-backed securities are presented based on current estimated principal cash flows of each security. The amount and yield of ARM securities are presented in the "Within 1 Year" maturity period since these securities reprice at least annually. Yields on state and municipal securities are stated on a tax equivalent basis assuming a federal income tax rate of 35% (in thousands):
TABLE 12 Securities Maturities and Yields
Deposits
Funding of earning assets is substantially provided by a combination of consumer, commercial and public fund deposits. The Company continues to focus its marketing strategies and emphasis on retail core deposits, the major component of funding sources. The Company offers a number of different products which are priced competitively within the markets it serves. These products, including promotions, are designed to attract new customers, retain existing customers and create opportunities to offer other bank products or services. While the market and pricing for deposit funds is very competitive, the Company believes that personalized, quality service is also an important element in retaining core deposit customers.
The following table summarizes the composition of major deposit categories for the last three years (in thousands):
TABLE 13 Composition of Deposits
At December 31, 1997, total deposits increased $86 million or 8% compared to year-end 1996. The increase resulted from strong internal deposit growth in 1997. In 1996 total deposits increased $138 million or 15%, reflecting the acquisition of Lockport and strong deposit growth during the year.
Over the past two years the composition of deposits continued to reflect a shift to higher interest-bearing deposits such as money market accounts and time deposits. In 1997 and 1996 the growth in these accounts was primarily due to premium-rate account promotions. The growth also reflected the shift of funds from savings deposits as a result of the widening of the interest rate differential between savings deposits and money market and time deposits. While it has been the Company's experience that savings deposits are relatively insensitive to changes in interest rates, the Company believes that further shifting of savings may occur based on the current level of interest rates offered on time deposits. The potential shift of savings has been considered and incorporated in the Company's asset/liability analysis and measurement of interest rate risk.
The following table sets forth the maturity distribution of time deposits of $100,000 or more for the past three years (in thousands):
TABLE 14 Maturity Distribution of Time Deposits of $100,000 or More
Short-term Borrowings
Short-term borrowings consist of securities sold under agreements to repurchase, federal funds purchased and notes payable. Information relating to short-term borrowings for the last three years is presented below (in thousands):
TABLE 15 Short-term Borrowings
TABLE 15 Short-term Borrowings (continued)
Securities sold under agreements to repurchase primarily represent borrowings originated as part of cash management services offered to corporate customers. Substantially all of the borrowings mature in one business day. Federal funds purchased represent temporary overnight borrowings from correspondent banks.
Notes payable represented borrowings by the Company to partially fund bank acquisitions. For more information on acquisitions and borrowings, see "Note 2- Acquisition" and "Note 7 - Notes Payable" of the Notes to Consolidated Financial Statements included under Item 8
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (dollars in thousands)
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (dollars in thousands except per share data)
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (in thousands except per share data)
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and conform to prevailing practices within the banking industry. The significant accounting and reporting policies of Heritage Financial Services, Inc. and subsidiaries are as follows:
Principles of Consolidation
The consolidated financial statements include the accounts of Heritage Financial Services, Inc. and its wholly-owned subsidiaries, Heritage Bank, First National Bank of Lockport (a national banking association limited to trust and insurance agency operations) and Heritage Trust Company (collectively, the "Company"). Significant intercompany accounts and transactions are eliminated in consolidation. Certain amounts in the 1996 and 1995 consolidated financial statements have been reclassified to conform to the 1997 presentation.
Nature of Operations
The Company is a multi-bank holding company which provides a full range of banking and trust services to individuals and business customers located in the southwest metropolitan Chicago market. The Company's primary business is the extension of credit to commercial, real estate and consumer loan customers in its market area. Funding of the Company's assets is substantially provided by a combination of consumer, commercial and public fund deposits. The Company encounters significant competition for loans and deposits from other financial institutions and non-bank companies. The Company is regulated by federal and state banking agencies and undergoes periodic examinations by those agencies.
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 disclosure of contingent assets and liabilities as of the date of the financial statements, as well as the reported amounts of income and expenses during the reported periods. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant changes relate to the determination of the allowance for loan losses.
Statements of Cash Flows
For purposes of reporting cash flows in the Statements of Cash Flows, cash and cash equivalents include cash and due from banks, federal funds sold and interest-bearing deposits at other institutions. Generally, federal funds are sold for one-day periods and interest-bearing deposits generally mature in 90 days or less. Included in the 1996 Statement of Cash Flows is the purchase price of an acquisition, net of cash and cash equivalents acquired.
Securities
Securities which the Company has the ability and intent to hold to maturity are classified as held-to-maturity and are carried at amortized cost. Securities that may be sold as part of the Company's management of interest rate risk, liquidity, or in response to or in anticipation of changes in interest rates and prepayment risk, or for other similar factors, are classified as available-for-sale. Securities available-for-sale are carried at their estimated market values, and net unrealized gains and losses, net of tax, are reported as a separate category of shareholders' equity. Premiums and discounts on securities held-to-maturity and securities available-for-sale are amortized in a manner that approximates the level yield method. Trading securities are carried at market value and changes in fair value are recorded as securities gains or losses. Realized gains and losses on securities sold are computed based on the adjusted cost of the specific securities sold.
On November 15, 1995, the Financial Accounting Standards Board ("FASB") issued a Special Report on the implementation of Statement of Financial Accounting Standards No. ("SFAS") 115, "Accounting for Certain Investments in Debt and Equity Securities". In accordance with the Special Report, the Company transferred all of its taxable securities classified as held-to-maturity at December 31, 1995 to available-for-sale. At the date of transfer, the securities had an approximate market value of $207,000,000 and an unrealized gain of $1,928,000.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Loans
Interest income on nondiscounted loans is recognized based upon the principal amount outstanding during the period. Interest income on discounted loans is recognized based on methods that approximate a level yield. The accrual of interest income is discontinued when management believes, after considering the borrower's financial condition and other relevant factors, that future collection of principal or interest in accordance with contractual terms may be doubtful. Loans 90 days or more past due are transferred to nonaccrual status unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, interest previously accrued is reversed and charged against current year income. Interest income on nonaccrual loans is recognized on a cash basis. Certain loan origination fees in excess of incremental direct costs are deferred and recognized over the term of the loan using the level yield method.
Allowance for Loan Losses
The allowance for loan losses is an amount which is available to absorb potential credit losses. The allowance is comprised of both specific and general valuation allowances and is maintained at a level management believes to be adequate to provide for known and potential risks inherent in the Company's loan portfolio. Management assesses the adequacy of the allowance for loan losses on a quarterly basis. Management's evaluation of the adequacy of the allowance considers such factors as prior loss experience, loan portfolio growth, loan delinquency levels and trends, and reviews of impaired loans and the value of underlying collateral securing these loans. A provision for loan losses is charged to income to increase the allowance to a level deemed to be adequate, but not excessive, based on management's evaluation. When a loan or a part thereof is considered by management to be uncollectible, a charge is made against the allowance. Recoveries of loans previously charged off are credited back to the allowance.
Under the Company's credit policy, all loans, except for home equity loans and other consumer loans, are subject to impairment recognition on a quarterly basis. A loan is considered impaired when it is probable that all principal and interest due under the contractual terms of a loan will not be collected. The Company generally considers most loans 90 days or more past due and all nonaccrual loans to be impaired. Loan impairment is measured based on the present value of expected future cash flows or the fair value of collateral if the loan is collateral dependent. If the fair value of an impaired loan is less than its recorded investment, a specific valuation allowance is allocated to the loan. Interest income on impaired loans, other than nonaccrual loans, is recorded on an accrual basis.
Derivative Financial Instruments
A derivative financial instrument is a futures, forward, swap, or option contract, or other financial instrument with similar characteristics. At December 31, 1997 and 1996, the Company's derivative financial instruments were limited to fixed-rate and variable-rate loan commitments.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization have been computed principally using the straight-line method. Rates of depreciation are generally based on the following useful lives: building--40 to 50 years; building improvements, furniture and equipment--3 to 15 years.
Other Real Estate Owned
Other real estate owned represents properties acquired through foreclosure or deed in lieu of foreclosure. These properties are recorded at the lower of the book value of the loan or fair value, less estimated costs to sell. The excess, if any, of the loan amount over fair value is charged to the allowance for loan losses. Subsequent declines in the fair value of other real estate owned, along with related operating expenses, are charged to other operating expenses.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Intangible Assets
The net assets of subsidiaries acquired in purchase transactions have been recorded at fair value at the acquisition date. The values of the acquired deposit base intangibles recognized in purchase transactions are being amortized on a straight-line basis over periods ranging from 5 to 8 years. Goodwill, representing the cost in excess of the fair value of net assets acquired, is being amortized on a straight-line basis over periods ranging from 15 to 25 years. Management reviews intangible assets for possible impairment if there is a significant event that detrimentally affects operations. Impairment is measured by comparing the carrying amount of intangibles to the current and estimated future net income of businesses acquired.
Stock Options
The Company accounts for employee stock option plans under APB Opinion 25 and related Interpretations. Accordingly, no compensation expense is recognized for grants of stock options.
Income Taxes
The Company files consolidated federal and state income tax returns. Accordingly, no income tax is applicable to the dividends received by Heritage Financial Services, Inc. from its subsidiaries. Deferred tax assets and liabilities are recorded based on the expected tax effect of future taxable income or deductions resulting from differences in the financial statement and tax bases of assets and liabilities and the expected tax effect of carryforwards for tax purposes.
Earnings Per Share
Effective December 15, 1997, the Company adopted SFAS 128, "Earnings Per Share". SFAS 128 establishes standards for computing and presenting earnings per share ("EPS") and applies to entities with publicly held common stock or potential common stock. SFAS 128 replaces the presentation of primary EPS with earnings per common share ("basic EPS"). Basic EPS is computed by dividing net income by the weighted average number of common shares outstanding for the period. SFAS 128 also requires presentation of EPS assuming dilution ("diluted EPS"). Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Company's potential dilutive instruments represent common shares issuable under its stock option plans. The dilutive effect of stock options is computed using the treasury stock method. In accordance with SFAS 128, the Company has restated all prior period earnings per share data. Weighted average common shares have also been adjusted to reflect the Company's 1997 three-for-two stock split. The computation of basic and diluted EPS is set forth in Note 12 .
Capital Structure
Effective December 15, 1997, the Company adopted SFAS 129, "Disclosure of Information About Capital Structure". SFAS 129 essentially consolidates disclosure requirements found in other previously existing literature regarding capital structure. Since SFAS 129 contains no changes in disclosure requirements, the adoption of this standard had no effect on the Company's capital structure disclosures.
Transfers of Financial Assets, Servicing Rights and Extinguishment of Liabilities
As of January 1, 1997, the Company adopted the provisions of SFAS 125, "Accounting for Transfers of Financial Assets, Servicing Rights, and Extinguishment of Liabilities". SFAS 125 sets forth accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The standards are based on consistent application of a financial- components approach that focuses on control. Under the approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. In December 1996, FASB issued SFAS 127, "Deferral of the Effective Date of Certain Provisions of SFAS 125". SFAS 127 defers the effective date of certain provisions of SFAS 125 for one year. The adoption of SFAS 125 did not have a material effect on the Company's consolidated financial condition or results of operations.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
New Accounting Pronouncements Not Yet Effective
In June 1997, FASB issued SFAS 130, "Reporting Comprehensive Income", which establishes standards for reporting and display of comprehensive income and its components in a full set of financial statements. Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under generally accepted accounting principles bypass reported net income. SFAS 130 requires that comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements and requires an entity to (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and surplus in the equity section of the balance sheet. SFAS 130 is effective for fiscal years beginning after December 15, 1997. Companies are also required to report comparative totals for comprehensive income in interim reports. Management is currently considering the impact of SFAS 130, but does not believe it will have a material effect on the Company's consolidated financial statements.
In June 1997, FASB issued SFAS 131, "Disclosures About Segments of an Enterprise and Related Information", which establishes standards for public companies to report certain financial information about operating segments in interim and annual financial statements. Operating segments are components of a business about which separate financial information is available and that are evaluated regularly by the chief operating decision maker in assessing performance and deciding how to allocate resources. The statement also requires public companies to report certain information about their products and services and the geographic areas in which they operate. SFAS 131 is effective for financial statements for fiscal years beginning after December 15, 1997. The statement does not need to be applied to interim financial statements in the initial year of its application, but such comparative information will be required in interim statements in the second year. At this time, management is assessing this statement and has not determined whether the new reporting provisions will require supplemental disclosures by the Company.
NOTE 2 - ACQUISITION
On February 2, 1996, the Company acquired all of the common stock of the First National Bank of Lockport ("Lockport") for $16,820,000 in cash. The acquisition was funded with cash and borrowings of $14,000,000 under a revolving line of credit facility. The acquisition was accounted for as a purchase and, accordingly, the results of operations of Lockport have been included in the consolidated statement of income from the date of acquisition. In connection with the acquisition, the Company acquired assets with an aggregate fair value of $104,375,000 and assumed deposits and other liabilities of $87,555,000.
NOTE 3 - SECURITIES
The amortized cost and estimated market values of securities held-to-maturity are as follows (in thousands):
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The amortized cost and estimated market values of securities available-for- sale are as follows (in thousands):
Securities with carrying values of $155,514,000 and $162,920,000 at December 31, 1997 and 1996, respectively, were pledged principally to secure public fund deposits and securities sold under agreements to repurchase.
Proceeds from sales of securities available-for-sale were $57,740,000 in 1997, $38,093,000 in 1996 and $7,962,000 in 1995. In 1997 gross gains from sales were $482,000 and gross losses were $381,000. In 1997 calls of securities resulted in gross gains of $1,000. The balance of securities gains recognized in 1997 reflected a market value adjustment of an investment security classified as trading. In 1996 gross gains from sales were $63,000 and gross losses were $121,000. In 1996 a gain of $135,000 was recognized on the payoff of a tax- exempt obligation that was in default and carried on nonaccrual status. In 1996 calls of securities resulted in gross gains of $30,000. In 1995 gross gains from sales were $177,000. In 1995 calls of securities resulted in gross gains of $47,000 and gross losses of $1,000. Income tax expense recognized on net securities gains was $116,000 in 1997, $43,000 in 1996 and $93,000 in 1995.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The following table summarizes the contractual maturities of securities held- to-maturity and available-for-sale at December 31, 1997. Expected maturities may differ from contractual maturities because certain issuers have the right to call or prepay these obligations without penalties. The stated maturities of mortgage-backed and asset-backed securities are presented in total since the principal cash flows of these securities are not received at a single maturity date (in thousands):
NOTE 4 - LOANS
The following table summarizes loan balances by category as of December 31, 1997 and 1996 (in thousands):
Loans on which the accrual of interest has been discontinued amounted to $903,000 and $3,421,000 at December 31, 1997 and 1996, respectively. If interest on those loans had been accrued at their original terms, such income would approximate $58,000 in 1997 and $170,000 in 1996. The amount of interest accrued on these loans and included in interest income was $18,000 in 1997 and $76,000 in 1996. At December 31, 1997, restructured loans totaled $139,000. There were no restructured loans at December 31, 1996.
Real estate loans with carrying values of $10,843,000 and $10,686,000 at December 31, 1997 and 1996, respectively, were pledged to secure public fund deposits.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Certain directors and executive officers of the Company and companies with which they are affiliated have obtained loans from the Bank on various occasions. All loans and loan commitments have been made in the ordinary course of business and on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons. The aggregate balance of these loans was $8,670,000 at December 31, 1997 and $9,056,000 at December 31, 1996. During 1997 $5,802,000 of new loans were made and repayments were $6,188,000.
NOTE 5 - ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS
The changes in the allowance for loan losses for the years ended December 31, 1997, 1996 and 1995 are as follows (in thousands):
The following table sets forth the recorded investment in impaired loans and the related valuation allowance for each loan category as of December 31, 1997 and 1996 (in thousands):
The average recorded investment in impaired loans for the years ended December 31, 1997 and 1996, were $2,942,000 and $5,855,000, respectively. Interest income recognized on impaired loans totaled $144,000 in 1997 and $236,000 in 1996. Included in the total balance of impaired loans at December 31, 1997 and 1996, were nonaccrual loans of $742,000 and $2,951,000, respectively. Of the total amount of impaired loans at December 31, 1997, $717,000 were measured using the present value of expected future cash flows and $2,052,000 were measured based on the fair value of collateral.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 6 - PREMISES AND EQUIPMENT
The following is a summary of the Company's premises and equipment as of December 31, 1997 and 1996 (in thousands):
The Company leases certain banking facilities under noncancelable operating leases which expire on various dates from 1998 through 2017. The leases contain renewal options for varying terms expiring between 2001 through 2007 and require the payment of property taxes, insurance and related expenses. The Company also leases certain equipment under cancelable and noncancelable leases with terms of up to three years. Total rent expense under operating leases amounted to $268,000 in 1997, $270,000 in 1996 and $234,000 in 1995. Aggregate amounts of minimum rental commitments under noncancelable operating leases are $2,957,000 and for each of the years subsequent to December 31, 1997, are $246,000 (1998), $253,000 (1999), $211,000 (2000), $172,000 (2001) and $117,000 (2002).
NOTE 7 - NOTES PAYABLE
Notes payable, which were repaid in 1997, represented borrowings under a $20 million unsecured revolving line of credit. At December 31, 1996, the weighted average interest rate of notes payable was 6.59%.
NOTE 8 - COMMON AND PREFERRED SHARES
In 1987 shareholders authorized 12,000,000 no par value preferred shares. The preferred shares may be issued in one or more series by the board of directors, which has been given the authority to establish or change the number of shares of each series, fix the designation and relative powers, preferences and rights and restrictions. At December 31, 1997 and 1996 there were no preferred shares issued.
Pursuant to a Registration Statement on Form S-8 filed in March, 1993, as amended by a Post-Effective Amendment filed in May, 1997, the Company registered 1,241,700 common shares for issuance pursuant to the Company's stock option plans. Common shares issued pursuant to the exercise of stock options totaled 177,808 in 1997, 41,510 in 1996 and 35,081 in 1995.
In June, 1996, the Company's board of directors approved a stock repurchase program which authorized the repurchase of up to 325,000 common shares to be used for the issuance of shares under the Company's stock option plans. In May, 1997, the board of directors authorized the repurchase of an additional 68,850 shares as a result of the Company's 1997 three-for-two stock split. The shares were authorized to be repurchased from time to time in the open market or in private transactions. In 1997, on a split adjusted basis, the Company repurchased 205,001 common shares at a cost of $3,446,000 and reissued 296,128 treasury shares upon the exercise of stock options. In 1996, on a split adjusted basis, the Company repurchased 130,950 common shares at a cost of $1,852,000 and reissued 1,912 treasury shares upon the exercise of stock options. At December 31, 1997, the Company had 129,049 common shares remaining to be repurchased under the stock repurchase program.
On May 14, 1997, the Company's board of directors declared a three-for-two stock split, payable June 13, 1997, to shareholders of record at the close of business on May 27, 1997. The board of directors also voted to eliminate the par value of common shares. As a result of the stock split, shareholders of record as of May 27, 1997 received one additional common share for every two shares owned. Shareholders entitled to fractional shares received cash in lieu of fractional shares. Per share information included in the consolidated financial statements has been adjusted to reflect the split.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 9 - STOCK OPTION PLANS
In April, 1991, shareholders approved the 1990 Executive Equity Incentive Plan (the "Plan") which provides for the grant to certain officers and key employees of the Company of incentive and non-qualified stock options, tandem stock appreciation rights, stand-alone stock appreciation rights and limited stock appreciation rights, with respect to not more than 675,000 common shares (split adjusted). The Plan replaced the 1987 Stock Option Plan (the "Prior Plan") for grants of stock options after September, 1990. The Prior Plan provided for options of up to 1,125,000 common shares (split adjusted). Options outstanding under the Prior Plan retain the terms as set forth at the time such options were granted. The Plan and the Prior Plan (the "Option Plans") are administered by a Committee of the board of directors.
The exercise prices of stock options granted under Option Plans were equal to the market prices on the dates of grant, and each such option has a maximum duration of ten years. Each option generally becomes exercisable in up to four annual installments, commencing one year from the date of grant.
A summary of the Company's stock options for the years ended December 31, 1997 and 1996 is presented below (shares in thousands):
A summary of the Company's outstanding and exercisable options at December 31, 1997 is presented below (shares in thousands):
NOTE 10 - PROFIT SHARING PLAN
The Company has a noncontributory profit sharing plan which covers substantially all employees who meet certain age and employment requirements. The contribution to the plan each year is made in accordance with a resolution passed by the board of directors. Charges to expense with respect to the plan for the years ended December 31, 1997, 1996 and 1995 amounted to $1,120,000, $1,184,000 and $940,000, respectively.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 11 - INCOME TAXES
The components of income tax expense (benefit) for the years ended December 31, 1997, 1996 and 1995 are as follows (in thousands):
A reconciliation of the federal statutory tax rate to the Company's effective tax rate for the years ended December 31, 1997, 1996 and 1995 is as follows:
The tax effects of temporary differences which comprise the significant portions of the Company's deferred tax assets and deferred tax liabilities as of December 31, 1997 and 1996 are as follows (in thousands):
Management believes that it is more likely than not that deferred tax assets will be fully realized. As a result, no valuation allowances were recorded at December 31, 1997 and 1996.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 12 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 1997, 1996 and 1995 (in thousands, except per share data):
NOTE 13 - COMMITMENTS AND CONTINGENT LIABILITIES
Credit
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 include lines of credit, letters of credit and other commitments to extend credit. Each of these instruments involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company uses the same credit policies and requires similar collateral in approving lines of credit and commitments and issuing letters of credit as it does in making loans. The exposure to credit losses on financial instruments is represented by the contractual amount of these instruments; however, the Company does not anticipate any losses from these instruments.
The off-balance sheet financial instruments whose contract amounts represent credit risk at December 31, 1997 and 1996 are as follows (in thousands):
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Lines of credit are agreements by which the Bank agrees to provide a borrowing accommodation up to a stated amount as long as there is no violation of any condition established in the loan agreement. The borrower may periodically reduce or retire amounts drawn under a line and subsequently redraw these amounts. Lines of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.
Commitments to originate credit represent approved commercial and real estate loans which generally are expected to be funded within ninety days.
Letters of credit are conditional commitments issued by the Company to guarantee the financial performance of customers to third parties. Letters of credit are primarily issued to facilitate trade or support borrowing arrangements and generally expire in one year or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending credit facilities to customers.
Concentrations of Credit Risks
In addition to financial instruments with off-balance sheet risk, the Company, to a certain extent, is exposed to varying risks associated with concentrations of credit. Concentrations of credit risk generally exist if an individual or number of counterparties are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by economic or other conditions.
At December 31, 1997, approximately 60% of the securities portfolio was comprised of mortgage-backed securities which consisted of pass-through securities directly or implicitly backed by the full faith and credit of the United States government. Concentrations of securities of a single issuer consisted of investments in tax-exempt obligations issued by the Village of Alsip. At December 31, 1997, the amortized cost and market value of Village of Alsip securities were $14,106,000 and $14,691,000, respectively. In addition to securities, the Company has granted tax-exempt loans to the Village of Alsip which totaled $4,462,000 at December 31, 1997. All securities and loans are secured by the general taxing authority of the respective issuer except for $257,000 in securities which are secured solely by revenue from certain real estate taxes. Some loans are further secured by real estate or other marketable collateral.
The Company conducts substantially all of its lending activities in the southwest suburbs of Chicago and, to a lesser extent, the Chicago metropolitan area. Loans granted to businesses are primarily secured by business assets, owner-occupied real estate or personal assets of commercial borrowers. Loans to individuals are primarily secured by automobiles, residential real estate or other personal assets. Since the Company's borrowers and its loan collateral have geographic concentration in the Chicago metropolitan area, the Company could have exposure to a decline in the local economy and real estate market. However, management believes that the diversity of its customer base and local economy, its knowledge of the local market and its proximity to customers limit the risk from exposure to adverse economic conditions.
Litigation
The Company is a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial condition or results of operations of the Company.
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
As a financial institution, most of the Company's assets and liabilities are considered financial instruments. However, many of the Company's financial instruments lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Presented below are the carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 1997 and 1996 (in thousands):
The estimated fair values of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment was used by the Company in interpreting market data to develop the estimates of fair value. In addition, significant estimations and present value calculations were used by the Company for purposes of this disclosure. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and estimation methodologies may have a material effect on the estimated fair value amounts.
The Company has used an entry-value market perspective as a basis of estimating the fair value of most financial instruments. For purposes of fair value disclosures the carrying values of cash and cash equivalents, accrued interest receivable, demand deposits, NOW accounts, money market accounts, savings deposits, federal funds purchased, securities sold under agreements to repurchase, notes payable and interest payable are assumed to approximate fair value since these assets and liabilities have no stated maturity or are relatively short-term financial instruments.
Securities have been valued using quoted market prices, dealer quotes or prices from independent pricing services that specialize in matrix pricing and modeling techniques.
Net loans with stated maturities have been valued using present value discounted cash flow techniques. The discount rates used to calculate the fair values of loans were the applicable risk-adjusted spreads to the U.S.Treasury curve to approximate current entry-value interest rates applicable to each category. No adjustment was made to the entry-value interest rates for changes in credit of performing loans for which there are no known credit concerns. The Company believes that the risk factor embedded in the entry-value interest rates results in a fair valuation of such loans on an entry-value basis. It is assumed that the fair value of floating rate loans approximates the recorded book value. For real estate loans, contractual cash flows were adjusted for anticipated prepayments. For loans delinquent ninety days or more and nonaccrual loans, fair value is assumed to equal the recorded book value less specific reserves which have been allocated to these financial instruments.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Time deposits with stated maturities have been valued using present value discounted cash flow techniques. The discount rates used to calculate the fair value of time deposits were the market rates currently offered for deposits of similar remaining maturities.
There is no material difference between the contract amount and the estimated fair value of off-balance sheet items which are primarily comprised of unfunded loan commitments which are either floating-rate or generally funded within ninety days.
NOTE 15 - CONDENSED FINANCIAL STATEMENTS - PARENT COMPANY
The following presents the condensed Balance Sheets as of December 31, 1997 and 1996, and Statements of Income and Statements of Cash Flows for each of the three years ended December 31, 1997, for Heritage Financial Services, Inc. (in thousands):
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 16 - REGULATORY RESTRICTIONS AND CAPITAL ADEQUACY
Heritage Bank ("the Bank") is required to maintain vault cash and non- interest-bearing balances with the Federal Reserve Bank to satisfy reserve requirements. The average reserve requirement balances for the years ended December 31, 1997 and 1996 were $12,382,000 and $15,126,000, respectively.
The Bank is subject to various capital requirements administered by its principal regulatory agency. 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 and consolidated 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 regulators about components, risk weightings, and other factors.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Quantitative measures established by regulation to ensure capital adequacy require the Company and 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 Tier I capital (as defined) to average assets (as defined). The following table sets forth the actual and required regulatory capital amounts and ratios of the Company and Bank as of December 31, 1997 and 1996:
Management believes that the Company and the Bank meet all capital adequacy requirements as of December 31, 1997. The most recent notification from the Federal Deposit Insurance Corporation, dated December 31, 1997, 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 Tier 1 and total risk-based capital ratios and Tier 1 leverage ratios as set forth in the table above. Since December 31, 1997, there are no conditions or events that management believes have changed the Bank's capital category.
Regulatory authorities limit the amount of dividends which can be paid by the Bank to Heritage Financial Services, Inc. without prior approval from such authorities. At December 31, 1997, $31,222,000 of undistributed earnings of the Bank were available for payment of dividends to Heritage Financial Services, Inc. without prior regulatory approval.
NOTE 17 - SUBSEQUENT EVENTS
On January 14, 1998, the Company, First Midwest Bancorp, Inc. ("First Midwest") and First Midwest Acquisition Corporation, a wholly owned subsidiary of First Midwest ("Acquisition Corporation"), entered into an Agreement and Plan of Merger ("Merger Agreement") whereby the Company will be merged with and into Acquisition Corporation (the "Merger"). Pursuant to the Merger Agreement, the transaction will be structured as a tax-free exchange and accounted for as a pooling-of-interests. Each of the Company's outstanding common shares will be converted into 0.7695 shares of First Midwest common stock. In conjunction with the approval of the Merger Agreement, the Company rescinded the balance of its stock repurchase program authorized in June 1996.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Merger is conditioned upon, among other things, approval by the shareholders of both the Company and First Midwest and receipt of customary regulatory approvals. The Merger Agreement has been approved by the boards of directors of both companies. It is anticipated that the acquisition will be consummated late in the second quarter of 1998.
Incident to the entry into the Merger Agreement, the Company and First Midwest executed a Stock Option Agreement (the "Option Agreement") pursuant to which the Company granted First Midwest an option to acquire up to 2,400,000 common shares (representing 19.9% of the Company's then outstanding common shares) at a price of $21.25 per share, subject to certain terms and conditions set forth in the Option Agreement.
NOTE 18 - QUARTERLY FINANCIAL DATA (unaudited)
The following sets forth condensed quarterly results of operations for 1997 and 1996 (in thousands, except per share data):
MANAGEMENT'S REPORT
Management of Heritage Financial Services, Inc. and subsidiaries (the "Company") has prepared and is responsible for the integrity and fairness of the financial statements and other financial information included in this annual report. The financial statements are prepared in accordance with generally accepted accounting principles and, when appropriate, include amounts based on management's estimates and judgment.
To meet its responsibility both for the integrity and fairness of these financial statements and information, management maintains accounting systems and related internal accounting controls. These systems and controls provide for an appropriate division of responsibility and are designed to provide reasonable assurance that transactions are properly authorized and recorded, that assets are safeguarded and financial records are reliably maintained.
The Company monitors the effectiveness and compliance of its internal control systems through a continuous program of internal audits. Management has reviewed the recommendations of its internal auditors and Arthur Andersen LLP, independent auditors, and has responded in an appropriate, cost-effective manner.
The Audit Committee of the board of directors, composed of three outside directors, meets periodically with the Company's internal auditors and the independent auditors to review matters relative to financial reporting, internal accounting controls and the scope and results of audits. In addition, reports of examination conducted by federal and state regulatory agencies are reviewed by management and the board of directors.
RICHARD T. WOJCIK PAUL A. ECKROTH
Chairman and CEO Executive Vice President and Treasurer
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders of Heritage Financial Services, Inc.:
We have audited the accompanying consolidated balance sheets of Heritage Financial Services, Inc. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years then ended. 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 audit.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits 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 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Chicago, Illinois, January 19, 1998
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
Certain matters discussed in this Annual Report on Form 10-K are "forward- looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Company intends such forward-looking statements to be covered by the safe harbors provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, goals, objectives, strategies and expectations of the Company, are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project," or other similar words or expressions. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to: significant fluctuations in market interest rates; changes in general economic conditions and inflation; changes in the competitive environment that can affect the Company's funding and asset generation capabilities; changes in management's assessment of the adequacy of the allowance for loan losses based upon changes in the composition of the loan portfolio, loan delinquency rates, the level of loan losses, and business and market conditions that affect the value of collateral securing loans; legislative or regulatory changes which adversely affect the business of the Company or its subsidiaries, including federal deposit insurance premiums; changes in accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such forward-looking statements. The forward-looking statements included herein are only made as of the date of this Annual Report on Form 10-K and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The directors of the Company are divided into three classes having staggered terms of three years. Class I consists of Messrs. Groebe, Sterling and Stranczek, whose terms expire in the year 2000. Class II consists of Messrs. Sampias, Gallagher, Mathis and Sieloff, whose terms expire in the year 1998. Class III consists of Messrs. Wojcik, Payan, Tichenor and Velo, whose terms expire in the year 1999. Each of the directors has served as a director of the Company, including its predecessor by merger, since 1981, except Mr. Stranczek, who became a director in 1983, Mr. Groebe, who became a director in 1984, and Messrs. Payan and Sieloff, who became directors in 1995. Messrs. Wojcik, Sampias and Groebe are also directors of the First National Bank of Lockport and Heritage Trust Company. None of the Company's directors or executive officers is related by blood, marriage or adoption.
The following table sets forth certain information about each of the Company's directors and executive officers:
Mr. Wojcik has been Chairman of the Board and Chief Executive Officer of the Company and Heritage Bank and Chairman of the Board and President of Heritage Trust Company for more than the past five years. He currently serves as Chairman of the Board and a Director of the First National Bank of Lockport and served in such positions for Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993 and for Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Mr. Sampias has been President and a Director of the Company and Heritage Bank and Vice Chairman and a Director of Heritage Trust Company for more than the past five years. He currently serves as President and a Director of the First National Bank of Lockport and served in such positions for Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993 and for Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Mr. Groebe has been a Director of the Company, Heritage Bank and Heritage Trust Company for more than the past five years. He has been the Senior Executive Vice President of the Company and Heritage Bank since April, 1993 and prior to that was the Executive Vice President of the Company and the Bank for more than the past five years. Mr. Groebe served as Executive Vice President, Secretary and a Director of Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993. He currently serves as Senior Executive Vice President, Secretary and a Director of the First National Bank of Lockport and served in such positions for Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Mr. Gallagher has been Chairman or President of Gallagher Asphalt Corporation, asphalt paving contractors, for more than the past five years.
Mr. Mathis has been President of G. E. Mathis Company, a steel fabricator, for more than the past five years.
Mr. Payan has been a Senior Executive of Payan, Alberts & Thompson, Ltd., an independent insurance agency, for more than the past five years.
Mr. Sieloff has been Senior Vice President and Partner or Vice President of Wm. C. Groebe & Co., a real estate company, for more than the past five years.
Mr. Sterling has been President of and has owned and operated Sterling Lumber Company for more than the past five years. He served as a Director of Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993 and of Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Mr. Stranczek has been Chairman or President of Cresco Lines, Inc., a trucking company, for more than the past five years.
Mr. Tichenor has been Chairman of the Board of California Amforge Corporation, a manufacturer of forgings, for more than the past five years.
Mr. Velo has been Chairman of D.J. Velo & Company, a general contractor, for more than the past five years. He served as a Director of Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993 and of Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Mr. Ajwani has been an Executive Vice President of Heritage Bank for more than the past five years.
Mr. Barry has been an Executive Vice President of Heritage Bank and a Director of Heritage Trust Company for more than the past five years.
Mr. Eckroth has been Treasurer of the Company for more than the past five years. He became Executive Vice President of the Company in April 1993 and prior to that was Senior Vice President. Mr. Eckroth became Executive Vice President of Heritage Bank in June 1993. Prior to that he was Senior Vice President of Heritage Bank since October 1991. Mr. Eckroth currently serves as Vice President and Controller of the First National Bank of Lockport. He served as Controller of Heritage Bank Alsip from December 1992 until that bank's merger into Heritage Bank in April 1993. He also served as Executive Vice President and Treasurer of Heritage Bank Midlothian from July 1994 until that bank's merger into Heritage Bank in October 1994.
Ms. Peterson has been an Executive Vice President of Heritage Bank since June 1993. Prior to that she was Senior Vice President of Heritage Bank beginning in January 1992. She became a Director of Heritage Trust Company in January 1993.
Mr. Stroka has been an Executive Vice President and General Counsel of Heritage Bank since June 1993. Prior to that he was Senior Vice President and General Counsel of Heritage Bank since October 1991.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 and regulations thereunder require directors and certain officers of the Company and persons who beneficially own more than 10% of the Company's stock to file initial reports of ownership and reports of changes in ownership of the Company's stock with the Securities and Exchange Commission and to furnish the Company with copies of such reports. Based solely upon a review of copies of such reports furnished to the Company and representations of reporting persons, all such persons filed on a timely basis reports required by Section 16(a) during the most recent fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Director Compensation
Currently, each Director of the Company receives an annual fee of $8,000 for these services. Each is also a Director of Heritage Bank and receives an annual fee of $8,000 for these services, which is paid by Heritage Bank. In addition, Directors receive a $1,000 or $500 fee for attendance at certain meetings of committees of the boards of the Company and Heritage Bank and received a $500 fee for attendance at a special meeting of the board of the Company in 1997.
Executive Officer Compensation
Summary Compensation Table
The following table sets forth the indicated compensation with respect to each of the last three fiscal years for the Company's Chief Executive Officer and its four other most highly compensated executive officers:
- ----------- (1) Amounts shown for certain officers include that portion of income earned on deferred compensation accounts above 120% of the applicable federal long- term rate. (2) Amounts shown in this column represent contributions allocated to each officer under the Company's profit sharing plan.
Option Exercises and Year-End Value Table
For each of the executive officers named in the Summary Compensation Table above, the following table sets forth the number of shares acquired and value realized on exercise of stock options and the indicated year-end 1997 value and number of unexercised options.
- -----------
(1) Common shares and options have been adjusted to reflect the Company's 1997 three-for-two stock split.
(2) Based on the common share closing price of $29.00 at December 31, 1997.
Employment and Termination Benefits Agreements
The Company has an Employment Agreement with each of Messrs. Wojcik, Sampias, Groebe and Eckroth. The Agreements provide for salaries and other compensation as may be authorized by the board of directors, subject to specified salary minimums. The current term under the Agreements expires December 31, 2000. The Agreements may be terminated by the Company with or without cause or upon the disability of the employee. Upon termination without cause (including, generally, within two to three years after a change in control of the Company), the Company is obligated to pay the employee his base compensation for a three year period beginning on the date of termination. Base compensation generally represents the average of the last five years' compensation. In the event of termination upon disability, the Company is obligated to pay the employee, at an annual rate equal to one and one-half times his base compensation, less Company-provided disability insurance benefits, for the lesser of two years or the remainder of the term. The Company has an Employment Termination Benefits Agreement with Mr. Barry which provides that, upon his termination (other than for cause, disability or death) generally within two years after a change in control of the Company, the Company is obligated to pay his base compensation for a two year period beginning on the date of termination.
Compensation Committee Interlocks and Insider Participation
Messrs. Mathis, Sieloff, Sterling and Velo, who are members of the Compensation Committee, and their associates and families, were indebted to Heritage Bank during 1997. All such outstanding loans, commitments to make loans, transactions in repurchase agreements and certificates of deposit and depository relationships, in the opinion of management, were made in the ordinary course of business, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than the normal risk of collectibility or present other unfavorable features.
Company Stock Price Performance
The graph below compares the cumulative total shareholder return on the Company's common shares ("Company Index") for the last five years with the cumulative total returns for the CRSP NASDAQ Stock Market (U.S. Companies) index ("Market Index") and the CRSP NASDAQ Holding Offices index (1) ("Peer Index") over the same period. The stock price performance shown on the graph is not necessarily indicative of future price performance.
[GRAPH APPEARS HERE] Comparison of Five-Year Cumulative Total Returns (2)
- ----------- (1) The Holding Offices peer index represents NASDAQ U.S. companies which are primarily engaged in holding or owning the securities of banks or other financial companies.
(2) The indices, as well as the graph data, were prepared by the Center for Research in Security Prices ("CRSP") of the University of Chicago Graduate School of Business. The graph amounts represent year-end index levels derived from compounded daily returns that include all dividends. The graph assumes that the value of the investment in the Company's common shares (and in each of the other indices) was $100 on December 31, 1992.
Report of Compensation Committee
The Compensation Committee (the "Committee") is comprised of Messrs. Mathis, Sieloff, Sterling and Velo, all of whom are Directors of the Company and its principal subsidiary, Heritage Bank (the "Bank"), and none of whom is a former or current officer or employee of the Company or any of its subsidiaries. The Committee is responsible for administering, setting and approving annual compensation and incentive awards affecting the Company's executive officers (as disclosed in the Summary Compensation Table above) as well as other elected officers of the Bank. It does not itself determine awards under the Company's 1990 Executive Equity Incentive Plan ("Stock Incentive Plan"), which are made by the stock option committee described below.
In general the Company's compensation programs, which affect executive officers and other elected officers, are balanced to provide competitive salaries combined with incentive compensation which is substantially contingent upon the annual earnings and growth performance of the Company. To promote long term performance, awards of stock options have been made to certain employees under the Stock Incentive Plan and its predecessor stock option plan. The Company's board of directors believes that stock options align the interests of shareholders and employees through the appreciation in the value of the Company's common shares.
The Committee reviewed and set 1997 salaries for Messrs. Wojcik, Sampias, Groebe, Barry and Eckroth and reviewed and approved 1997 salary recommendations made by management regarding the other elected officers of the Bank. The 1997 base salaries of executive officers, including Mr. Wojcik, Chairman and CEO, and the salaries of the other elected officers of the Bank have been established primarily based on surveys of competitive salaries being paid to officers with similar responsibilities in peer group banks. To a lesser extent, increases in base salaries of executive officers and other elected officers have also been adjusted to recognize the Company's growth and corresponding increase in officers' responsibilities.
The Committee also approved the incentive compensation paid to executive officers and other elected officers based upon the achievement of annual Company net income and growth goals and accomplishment of individual management objectives established at the beginning of the year. The amount of incentive compensation is based upon an officer's level of responsibility and contribution to the Company's achievement of its financial performance goals. For executive officers, incentive compensation, as a percentage of base salary, can range from 0% to a maximum of approximately 55%. The incentive compensation paid to Mr. Wojcik for 1997 was based solely upon the financial performance of the Company and represented approximately 55% of his base salary.
All Directors of the Company, except those who are officers/employees, serve as a stock option committee which administers and approves awards under the Stock Incentive Plan. On an annual basis the stock option committee determines which employees receive grants of stock options and accompanying limited stock appreciation rights ("LSARs") under the Stock Incentive Plan and the number of shares subject to each award. In 1997 the committee made no stock option or LSAR awards.
Lael W. Mathis Arthur E. Sieloff John L. Sterling Dominick J. Velo
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following tabulation shows, as of February 10, 1998 unless otherwise indicated, the name, address and common share ownership for certain shareholders of the Company including each person known by the Company to be the beneficial owner of more than five percent of the Company's outstanding common shares (the only class of voting securities outstanding). Information with respect to beneficial ownership is based on information furnished to the Company by such shareholders or contained in the records of the Company.
Carl C. Greer has sole voting power over all of the 757,620 shares referred to below under his heading, 390,315 as sole beneficial owner and 367,305 as President of Martin Marketing Corporation ("Martin Marketing"), the sole general partner of Martin Oil Marketing, Ltd. ("Martin Oil Marketing"), which holds such shares. Mr. Greer has sole dispositive power over all his own shares and dispositive power (which may be shared with certain Martin Marketing officers) over the Martin Oil Marketing shares.
Joyce M. Brown, Eloise W. Martin and Melinda M. Sullivan, as the three trustees of each of five testamentary trusts under the Will of Harold T. Martin, deceased, share voting and dispositive power over 725,730 shares held by the trusts. In addition, Ms. Sullivan herself owns 13,256 shares, as to which she has sole voting and dispositive power.
_____ * Not greater than 1%
(1) The address for the persons listed under the Greer heading in the table is P.O. Box 298, Blue Island, Illinois 60406. The nature of their beneficial ownership is sole voting and investment power, except as described above and set forth in the footnotes below. (2) All such shares are held by Martin Oil Marketing. (3) Mr. Greer has sole voting power over such 757,620 shares, 390,315 as beneficial owner and 367,305 as President of Martin Marketing. (4) The address for the three trustees of the testamentary trusts created under the Will of Harold T. Martin, deceased, is 4501 W. 127th Street, Alsip, Illinois 60803. (5) As of December 31, 1997. The address for the Trust is 17500 S. Oak Park Avenue, Tinley Park, Illinois 60477. The nature of beneficial ownership is sole voting power, with no investment power. The shares are voted by Messrs. Wojcik, Sampias, Groebe, Barry and another bank officer as trustees. (6) First Midwest Bancorp, Inc., which has entered into an Agreement and Plan of Merger, dated January 14, 1998, to acquire the Company, has an option to purchase up to 2,400,000 of the Company's common shares (up to 19.9% of the then outstanding shares).
Security Ownership of Management
The following tabulation shows the common share ownership (including exercisable options) for each Director, each of the executive officers named in the Summary Compensation Table and all Directors and executive officers as a group.
Percent of Outstanding Number of Common Common Shares Owned Shares (Including Beneficially Exercisable Name of Beneficial Owners Owned (1) Options) - ------------------------- ------------ ------------
Richard T. Wojcik 500,019 (2) 4.1% Frederick J. Sampias 320,355 (3) 2.6% Ronald P. Groebe 232,764 (4) 1.9% John J. Gallagher 82,017 * Lael W. Mathis 131,475 (5) 1.1% Jack Payan 14,355 (6) * Arthur E. Sieloff 16,125 (7) * John L. Sterling 146,706 (8) 1.2% Chester Stranczek 495,900 (9) 4.1% Arthur G. Tichenor 557,344 4.6% Dominick J. Velo 11,372 (10) * John E. Barry 140,147 (11) 1.2% Paul A. Eckroth 121,650 (12) 1.0% All directors and executive officers as a group (16 persons) 2,970,726 (13) 24.4% ______ * Not greater than 1%
(1) As of February 10, 1998, except as otherwise indicated. The nature of beneficial ownership is sole voting and investment power, except as set forth in the footnotes below. Information with respect to beneficial ownership is based on information furnished to the Company by the shareholders or contained in the records of the Company. Fractional shares subject to options are not reflected. All of the Directors and executive officers have entered into an Affiliate's Letter and Agreement of Affiliates which indicate that they will vote their shares in favor of the acquisition by First Midwest Bancorp, Inc. and which specify restrictions on disposition of their shares.
(2) Includes 28,712 shares held in a self-directed IRA trust and Keogh trust for the benefit of Mr. Wojcik, 314,584 shares held in trust by Mr. Wojcik and 96,800 shares which may be acquired upon the exercise of stock options. Includes 59,922 shares held for the benefit of Mr. Wojcik in the Company's Profit Sharing Trust as of December 31, 1997 but excludes the other shares referred to in footnote 13 below.
(3) Includes 135,179 shares held in trust by Mr. Sampias, 8,364 shares held in custody for the benefit of Mr. Sampias, 3,972 shares held in trust for the benefit of Mr. Sampias, 110,044 shares which may be acquired upon the exercise of stock options, 12,375 shares held in trust by his wife, 3,981 shares held in trust for the benefit of his wife, 2,250 shares held by his wife as custodian for their son and 450 shares held by their son. Includes 43,739 shares held for the benefit of Mr. Sampias in the Company's Profit Sharing Trust as of December 31, 1997 but excludes the other shares referred to in footnote 13 below.
(4) Includes 20,194 shares held in a self-directed IRA trust and Keogh Plan for the benefit of Mr. Groebe, 2,046 shares held in trust for the benefit of his wife and 68,962 shares which may be acquired upon the exercise of stock options. Includes 41,563 shares held for the benefit of Mr. Groebe in the Company's Profit Sharing Trust as of December 31, 1997 but excludes the other shares referred to in footnote 13 below.
(5) Includes 63,900 shares held in trust by Mr. Mathis and 67,575 shares held in trust by his wife.
(6) Includes 4,230 shares held in trust by Mr. Payan, 8,625 shares held in trust by his wife and 1,500 shares held by a corporation owned by Mr. Payan and his wife.
(7) Includes 15,000 shares held in joint tenancy with Mr. Sieloff's wife.
(8) Includes 12,000 shares held in joint tenancy with his wife, 122,763 shares held in trust for the benefit of Mr. Sterling and his wife and 11,643 shares held by Mr. Sterling's son.
(9) Includes 379,500 shares held in trust by Mr. Stranczek, 108,150 shares held in trust for the benefit of Mr. Stranczek and 7,500 shares held by Mr. Stranczek's wife as trustee for a relative.
(10) Includes 1,372 shares held for the benefit of Mr. Velo by the D.J. Velo & Company Profit Sharing Trust as of October 31, 1997, for which Mr. Velo is the Trustee. Excludes the remaining 51,609 shares in such Trust voted by Mr. Velo but held for the benefit of others. Includes 10,000 shares held in joint tenancy with Mr. Velo's wife.
(11) Includes 74,887 shares which may be acquired upon the exercise of stock options and 13,142 shares held for the benefit of Mr. Barry in the Company's Profit Sharing Trust as of December 31, 1997 but excludes the other shares referred to in footnote 13 below.
(12) Includes 72,000 shares held by Mr. Eckroth in joint tenancy with his wife and 49,650 shares which may be acquired upon the exercise of stock options.
(13) Excludes 712,818 shares as of December 31, 1997 voted by Messrs. Wojcik, Sampias, Groebe, Barry and another bank officer as the trustees of the Heritage Financial Services Profit Sharing Trust, except to the extent held for such named officers' individual benefit and hence included as indicated in the foregoing footnotes. Includes 86,400 shares which may be acquired upon the exercise of stock options by, and 49,952 shares held as of December 31, 1997 in the Company's Profit Sharing Trust for the benefit of, three executive officers not named above.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Directors and executive officers of the Company and their associates and families were customers of, and had transactions with, Heritage Bank during 1997, and, at December 31, 1997, were indebted to Heritage Bank in the aggregate amount of $8,670,000. All such outstanding loans, commitments to make loans, transactions in repurchase agreements and certificates of deposit and depository relationships, in the opinion of management, were made in the ordinary course of business, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than the normal risk of collectibility or present other unfavorable features. Additional transactions may be expected to take place in the future.
Mr. Payan is employed by Payan, Alberts & Thompson, Ltd. ("P,A&T"), which is owned in part by three of his sons and which provides services as insurance agent to the Company. In 1997 the Company paid P,A&T approximately $428,000, including premiums, for business insurance coverage. In addition, P,A&T served as agent with respect to the Company's employee group insurance coverage, for which approximately $883,000 was paid directly to the insurers in 1997. As agent, P,A&T solicits competitive bids for all of the Company's business and employee group insurance coverage.
The Company has an indemnification agreement with each Director of the Company which provides that the Company shall indemnify the Director against certain claims which may be asserted against the Director by reason of serving on the board.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) and (2) - Financial Statements and Financial Statement Schedules
The following consolidated financial statements and financial statement schedules of the registrant are filed as a part of this document under Item 8. Financial Statements and Supplementary Data:
Consolidated Balance Sheets - December 31, 1997 and 1996
Consolidated Statements of Income - For the Years Ended December 31, 1997, 1996 and 1995
Consolidated Statements of Changes in Shareholders' Equity - For the Years Ended December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows - For the Years Ended December 31, 1997, 1996 and 1995
Notes to Consolidated Financial Statements - For the Years Ended December 31, 1997, 1996 and 1995
Quarterly Financial Data
(a)(3) - Exhibits
(a) (3) - The exhibits required by Item 601 of Regulation S-K and filed herewith are listed in the Exhibit Index which follows the Signature Page and immediately precedes the exhibits filed. The management contracts and compensatory plans and arrangements which are required to be filed are listed in the Exhibit Index as Exhibit Numbers 10(a) - 10(j) inclusive.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed by the registrant during the quarter ended December 31, 1997. On January 27, 1998, the Company filed a Current Report on Form 8-K disclosing under Item 5 of Form 8-K the granting of a stock option to and proposed merger with, First Midwest Bancorp, Inc.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Heritage Financial Services, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this the 2nd day of March, 1998.
HERITAGE FINANCIAL SERVICES, INC. (Registrant)
by /s/ Richard T. Wojcik --------------------------------- Richard T. Wojcik Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 2nd day of March, 1998 by the following persons on behalf of the Registrant and in the capacities indicated.
HERITAGE FINANCIAL SERVICES, INC. EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K)
HERITAGE FINANCIAL SERVICES, INC. EXHIBIT INDEX (continued) (Pursuant to Item 601 of Regulation S-K)
- ----------------- Heritage Financial Services, Inc. will furnish those of the above exhibits which are filed herewith to requesting security holders.