ITEM 1. BUSINESS
GENERAL
Boston Private Financial Holdings, Inc. (the "Company") is incorporated under the laws of the Commonwealth of Massachusetts and is registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). On July 1, 1988, the Company became the parent holding company of Boston Private Bank & Trust Company (the "Bank"), a trust company chartered by the Commonwealth of Massachusetts and insured by the Federal Deposit Insurance Corporation (the "FDIC").
On October 31, 1997, the Company acquired Westfield Capital Management Company, Inc. ("Westfield"), a Massachusetts corporation engaged in providing a range of investment management services to individual and institutional clients, in exchange for 3,918,367 newly issued shares of the Company's common stock. The acquisition was accounted for as a "pooling of interests". Accordingly, the results of operations of the Company have been restated to reflect the results of operations on a consolidated basis.
On July 31, 1995, the Company acquired substantially all of the assets and assumed certain liabilities of an investment management business for a total purchase price of approximately $4.2 million, of which $2.1 million, consisting of $1.5 million in cash and 166,667 shares of the Company's common stock, was paid at closing. In each of January and July 1996 and 1997, the Company made additional scheduled payments consisting of $375,000 in cash and 41,667 shares of the Company's common stock. The acquisition was accounted for as a purchase. Accordingly, the results of operations of the acquired business have been included with those of the Company subsequent to the date of acquisition.
The Company conducts substantially all of its business through its wholly-owned subsidiaries, the Bank and Westfield. The Company's and the Bank's principal offices are located at Ten Post Office Square, Boston, Massachusetts, and Westfield's principal office is located at One Financial Center, Boston, Massachusetts. The Bank also has a branch located in Wellesley, Massachusetts.
The Bank pursues a "private banking" business strategy and is principally engaged in providing banking, investment and fiduciary products and services to high net worth individuals, their families and businesses in the greater Boston area and New England and, to a lesser extent, Europe and Latin America. The Bank seeks to anticipate and respond to the financial needs of its client base by offering high quality products, dedicated personal service and long-term banking relationships. The Bank offers its clients a broad range of basic deposit services, including checking and savings accounts, with automated teller machine ("ATM") access, and cash management services. The Bank also offers commercial, residential mortgage, home equity and consumer loans. In addition, it provides investment advisory and asset management services, securities custody and safekeeping services, and trust and estate administration. In December 1996, the Company received $3.4 million of additional equity capital from an offering of its Common Stock, all of which was subsequently invested in the Bank. In December 1998, the Company invested $1.0 million of additional capital in the Bank from the proceeds of an intra-company loan from Westfield.
Westfield is an investment management firm serving the investment needs of high net worth individuals and institutions with endowments, pensions and profit-sharing or 401(k) plans. The investment management team seeks out opportunities to purchase growth equities at a reasonable price by applying fundamental research techniques combined with an evaluation of a proprietary database of securities to identify prospective investments which have broad market opportunities, accelerating earnings growth, low financial leverage and sufficient cash flow. They often visit companies to interview management of prospective investments, seeking to find those situations where there is a diversity of current
investment opinion and where fundamental research can identify company specific events that create a competitive edge. After making an investment, Westfield monitors performance against a systematic set of sell disciplines including: downside price limits, an alteration of the investment case, changes in relative price momentum, valuation relative to its peer group and attractiveness versus alternative investments. Westfield primarily manages individually invested accounts and also acts as managing general partner for three limited partnerships, one of which invests primarily in technology stocks, another invests primarily in small capitalization equities and a third that was started in June 1998, which invests primarily in midcap equities.
The Company's operating results depend primarily on the operating results of the Bank and Westfield. The Company generates a significant amount of fee income from providing investment management and trust services to its clients at the Bank and from providing investment management services and acting as general partner for investment partnerships for clients at Westfield. Investment management and trust fees are generally based upon the value of assets under management, and, therefore, can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets and by investment performance of the Bank and Westfield. Fees earned as a general partner for investment partnerships are directly related to investment performance and, therefore, will be significantly affected by the investment performance of Westfield. The Bank also earns fees and other income from its lending and cash management services. The net income of the Bank depends primarily on its net interest income, which is the difference between interest income and interest expense or "cost of money", and the quality of its assets. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. The Bank's cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of assets further influences the amount of interest income lost on nonaccrual loans and the amount of additions to the allowance for loan losses.
INVESTMENT MANAGEMENT AND TRUST ADMINISTRATION
The Company, and its subsidiaries, provide a broad range of investment management services to individuals, family groups, trusts, endowments and foundations, retirement plans and investment partnerships. These services include management of equity, fixed income, balanced and strategic cash management portfolios. Portfolios are managed based on the investment objectives of each client, and each portfolio is positioned to benefit from long-term market trends. Acting as fiduciary, the Bank also provides trust services to both individuals and institutions. Westfield, acting as the general partner of three limited partnerships, also earns fees based on the performance of these limited partnerships. For the year ended December 31, 1998, the asset management business accounted for 93.2% of the Company's total fees and other income and 52.5% of the Company's total revenues, which is defined as net interest income plus fees and other income.
At December 31, 1998, the Company had approximately $2.6 billion in assets under management. Of this total, $2.5 billion was in investment advisory accounts, and $55.0 million was invested and administered under trust arrangements.
LENDING ACTIVITIES
General. The Bank specializes in lending to individuals and small businesses, including corporations, partnerships, associations and non-profit organizations. Loans made by the Bank to individuals include residential mortgage loans, unsecured and secured personal lines of credit, home equity loans, mortgage loans on investment and vacation properties, letters of credit and overdraft protection. Loans made by the Bank to businesses include commercial mortgage loans, revolving lines of credit, working capital loans, equipment financing and letters of credit. Commercial loans over $500,000, with the exception of cash collateralized loans, are required to be reviewed by the Credit Committee, consisting of members of the Bank's senior management. Commercial and residential mortgage loans over $1.5 million are required to be reviewed by the Loan Committee, which consists of four outside Directors of the Bank.
At December 31, 1998, the Bank had loans outstanding of $348.9 million, which represented approximately 76% of the Company's total assets. The interest rates charged on these loans vary with the degree of risk, maturity and amount, and are further subject to competitive pressures, market rates, the availability of funds and legal and regulatory requirements. At December 31, 1998, approximately 80% of the Bank's outstanding loans had interest rates that were either floating or adjustable in nature. See Part II, Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Sensitivity and Market Risk." At December 31, 1998, approximately 98.8% of the Bank's outstanding loans were secured, and approximately 82.4% were secured, in whole or in part, by real estate. Within the commercial loan portfolio, $96.5 million, or 62.3% of the portfolio was secured, in whole or in part by real estate.
At December 31, 1998, the Bank's statutory lending limit to any single borrower was approximately $5.8 million, subject to certain exceptions provided under applicable law. At December 31, 1998, the Bank had no outstanding lending relationships in excess of the legal lending limit. The Bank also has a policy of extending only secured loans to Directors
of the Company and its subsidiaries, and the aggregate principal amount of loans to all Directors of the Company and its subsidiaries is limited by law to 100% of capital. At December 31, 1998, the aggregate principal amount of all loans to Directors and related entities (including unused commitments under lines of credit) was $3.6 million, or 11.1% of capital.
Loan Portfolio Composition and Maturity. The following table sets forth the loan balances for certain loan categories at the dates indicated and the percent of each category to total gross loans.
The following table sets forth scheduled contractual maturities of loans in the Company's portfolio at December 31, 1998. Loans having no stated maturity are reported as due in one year or less. The following table also sets forth the dollar amounts of loans that are scheduled to mature after one year which have fixed or adjustable interest rates.
Scheduled contractual maturities typically do not reflect the actual maturities of loans. The average maturity of loans is substantially less than their average contractual terms because of prepayments and, in the case of conventional mortgage loans, due-on-sale clauses, which generally give the Bank the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage. The average life of mortgage loans tends to increase when current market rates are substantially higher than rates on existing mortgage loans and decrease when rates on existing mortgages are substantially lower than current market rates (due to refinancing of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates. In addition, due to the fact that the Bank will, consistent with industry practice, "rollover" a significant portion of commercial real estate and commercial loans at or immediately prior to their maturity by renewing credit on substantially similar or revised terms, the principal repayments actually received by the Bank are anticipated to be significantly less than the amounts contractually due in any particular period. A portion of such loans also may not be repaid due to the borrower's inability to satisfy the contractual obligations of the loan. At December 31, 1998, $629,000 of loans scheduled to mature within one year were non-performing. See Part II, Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset Quality."
Commercial Loans. Commercial loans include working capital loans, equipment financings, standby letters of credit, term loans, revolving lines of credit and commercial real estate and construction loans. Commercial loans to individuals include construction loans, secured and unsecured personal lines of credit and term loans.
At December 31, 1998, the Bank had outstanding commercial loans totaling $154.9 million, which represented 44.4% of total loans and 33.9% of total assets of the Company. Commercial loans, consisting primarily of loans to businesses, increased $20.3 million, or 15.0 %, during the year ended December 31, 1998, compared to an increase of $36.9 million, or 37.8%, during the year ended December 31, 1997. The growth in 1998 and 1997 reflects both an increase in market demand and initiatives by the Bank to increase market share. Of the Bank's total commercial loan portfolio, $70.2 million or 45.3% is due within one year and $84.8 million or 54.7% is due after one year. Loans are typically priced on a fixed rate basis or at a margin over the Bank's base rate. Floating rate loans accounted for 67.9% of the Bank's commercial loan portfolio as of December 31, 1998. The average balance of the Bank's outstanding commercial loans was approximately $282,000 at year end 1998.
The Bank has an independent loan review process under which loans are reviewed for adherence to internal policies and underwriting guidelines. The Bank also reviews a large percentage of outstanding commercial loans at least annually. Such credit reviews are first performed by the loan review function and, if necessary, are presented to the Credit Committee with further review in certain situations by the Loan Committee. In addition, the Loan Committee reviews loans on the Bank's internal "watch list" and classified loan report on a monthly basis. Each of these loans is required to have an action plan which is developed by the lending officer in charge of the credit.
Residential Mortgage and Home Equity Loans. At December 31, 1998, the Bank had outstanding residential mortgage loans and home equity loans of $173.8 million and $19.9 million, respectively, together representing 55.5% of the Bank's total loan portfolio. Residential mortgage loans and home equity loans increased $51.8 million, or 36.6%, during the year ended December 31, 1998, and increased $33.8 million, or 31.3%, during 1997. The increases in both 1998 and 1997 were primarily due to the relatively low level of adjustable mortgage loan interest rates, as well as promotional activities designed specifically to increase the Bank's volume of mortgage loan originations. While the Bank has no minimum size for its mortgage loans, it concentrates its origination activities in the "Jumbo" segment of the market. This segment consists of loans secured by single family properties in excess of the amount eligible for purchase by the Federal National Mortgage Association ("FNMA"), which was $227,150 at December 31, 1998. The average balance of the Bank's outstanding residential mortgage loans was approximately $340,000 at year end 1998.
In 1998, the Bank sold $23.7 million of residential mortgage loans on a non-recourse basis without retaining servicing. The Bank generally holds adjustable rate mortgage loans ("ARM's") in its own portfolio and sells most fixed rate mortgage loans to outside investors. At December 31, 1998, $153.4 million, or 88.3%, of loans in the Bank's residential mortgage portfolio were ARM's.
Other Loans. Other loans consist of balances outstanding on credit cards and loans arising from overdraft protection extended to individual customers. At December 31, 1998, aggregate outstanding balances on such loans were $335,000 compared to $306,000 at December 31, 1997. Other loans increased $29,000, or 9.5%, during the year ended December 31, 1998, and decreased $2,000, or 0.6%, during 1997. The balance of other loans is primarily dependent on client demand.
Allowance for Loan Losses. The following table is an analysis of the Bank's allowance for loan losses for the periods indicated:
The allowance for loan losses is determined using a systematic analysis and procedural discipline based on historical experience, product types, and industry benchmarks. The allowance is segregated into three components; "general", "specific" and "unallocated". The general component is determined by applying coverage percentages to groups of loans based on risk ratings and product types. A system of periodic loan reviews is performed to individually assess the inherent risk and assign risk ratings to each loan. Coverage percentages applied are determined based on industry practice and management's judgement. The specific component is established by allocating a portion of the allowance for loan losses to individual classified loans on the basis of specific circumstances and assessments. The unallocated component supplements the first two components based on management's judgement of the effect of current and forecasted economic conditions on the borrowers' abilities to repay, an evaluation of the allowance for loan losses in relation to the size of the overall loan portfolio, and consideration of the relationship of the allowance for loan losses to nonperforming loans, net charge-off trends, and other factors. While this evaluation process utilizes historical and other objective information, the classification of loans and the establishment of the allowance for loan losses relies to a great extent on the judgement and experience of management.
The following table represents the allocation of the Bank's allowance for loan losses and the percent of loans in each category to total loans as of the dates indicated:
This allocation of the allowance for loan losses reflects management's judgment of the relative risks of the various categories of the Bank's loan portfolio. This allocation should not be considered an indication of the future amounts or types of possible loan charge-offs.
INVESTMENT ACTIVITIES
The investment activity of the Bank is an integral part of the overall asset/liability management of the Company. The Bank's investment policy is to establish a portfolio of securities which will provide liquidity necessary to facilitate funding of loans and to cover deposit fluctuations while at the same time achieve a satisfactory return on the funds invested. The securities in which the Bank may invest are subject to regulation and are limited to securities which are considered "investment grade" securities. In addition, the Bank has an internal investment policy which restricts investments to the following categories: U.S. Treasury securities, obligations of U.S. government agencies and corporations, mortgage-backed securities, including securities issued by FNMA, the Government National Mortgage Association ("GNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"), securities of states and political subdivisions and corporate debt, all of which must be considered investment grade by a recognized rating service. The credit rating of each security or obligation in the portfolio is closely monitored and reviewed by the portfolio manager and by the Asset/Liability Management Committee. See Notes 5 and 6 to the Consolidated Financial Statements.
The following table summarizes the book value of investments at the dates indicated:
SOURCES OF FUNDS
Deposits. Deposits are the principal source of the Bank's funds for use in lending and for other general business purposes. At December 31, 1998, the Bank had a total of approximately 3,120 checking accounts consisting of demand deposit and NOW accounts with an average account balance of approximately $26,000; 670 savings accounts with an average account balance of approximately $6,000; and 3,860 money market accounts with an average account balance of approximately $45,000. Certificates of deposit of $100,000 or greater and certificates of deposit under $100,000 represented approximately 15.7% and 8.9% of total deposits at December 31, 1998 and 1997, respectively. See Note 10 to the Consolidated Financial Statements for further information.
The following table sets forth the average balances and interest rates paid on the Bank's deposits:
Historically, the Bank has had a higher percentage of its time deposits in denominations of $100,000 or more than commercial banking averages. Within the banking industry, these deposits are generally considered to be volatile. However, a significant portion of the Bank's deposits in denominations of $100,000 or greater are maintained by individuals or entities with other relationships with the Company.
Time certificates of deposit in denominations of $100,000 or greater had the following schedule of maturities:
Borrowings. The Bank has established various borrowing arrangements to provide additional sources of liquidity and funding, thereby increasing flexibility. Management believes that the Bank currently has adequate liquidity available to respond to current demands. The Bank is a member of the FHLB of Boston, and as such has access to both short and long-term borrowings of up to $135.3 million at December 31, 1998. At December 31, 1998, the Bank had $76.3 million in FHLB advances outstanding with a weighted average interest rate of 5.74%. At December 31, 1997, there were $60.2 million in FHLB advances outstanding with a weighted average interest rate of 6.03%. Of the advances outstanding at December 31, 1998, $18.0 million have variable rates which reprice at least annually to market rates. The Bank has the opportunity to repay variable rate advances on their respective anniversary dates. See Note 12 to the Company's Consolidated Financial Statements for further information.
The Bank also obtains funds from the sales of securities to institutional investors under repurchase agreements. In a repurchase agreement transaction, the Bank will generally sell an investment security, agreeing to repurchase either the same or a substantially identical security on a specified later date (generally not more than 90 days) at a price slightly greater than the original sales price. The difference in the sale price and repurchase price is the cost of the use of the proceeds. The investment securities underlying these agreements are delivered to securities dealers who arrange such transactions as collateral for the repurchase obligation. Repurchase agreements represent a cost competitive funding source for the Bank. However, the Bank is subject to the risk that the lender of the securities may default at maturity and not return the collateral. In order to minimize this potential risk, the Bank only deals with large, established investment brokerage firms when entering into such transactions. Repurchase transactions are accounted for as financing arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reflected as a liability in the Company's Consolidated Financial Statements. At December 31, 1998, the total amount of outstanding repurchase agreements was $6.2 million with a weighted average interest rate of 4.16%. See Note 11 to the Company's Consolidated Financial Statements for additional information.
From time to time the Bank purchases federal funds from the FHLB and other banking institutions to supplement its liquidity position. The Company has negotiated federal fund lines of credit totaling $35.4 million with correspondent institutions to provide the Bank with immediate access to overnight borrowings. At December 31, 1998, the Bank did not have any borrowings outstanding under these federal funds lines. The Bank has also negotiated brokered deposit agreements with two institutions that have nationwide distribution capabilities. At December 31, 1998, the Bank did not have any brokered deposits outstanding under these agreements. See Part II, Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity."
Other Sources of Funds. Other sources of funds include investment management fees, loan repayments, maturities of investment securities, and sales of securities from the available for sale portfolio.
COMPETITION
The ability of the Bank to attract loans and deposits may be limited by its small size relative to its competitors. The Bank maintains a smaller staff and has fewer financial and other resources than larger institutions with which it competes in its market area.
In particular, in attempting to attract deposits and originate loans, the Bank encounters competition from other institutions, including larger downtown Boston and suburban-based commercial banking organizations, savings banks, credit unions, and other financial institutions and non-bank financial service companies serving Eastern Massachusetts and adjoining areas. The principal methods of competition include the level of loan interest rates charged to borrowers, interest rates paid on deposits, range of services provided and the quality of these services.
In this competitive environment, the Bank may be unable to attract sufficient and high-quality loans in order to continue its loan growth, which may adversely affect the Bank's results of operations and financial condition, including the level of its non-performing assets. The Bank's competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. In particular, the Bank's current commercial borrowing customers may develop needs for credit facilities larger than it can accommodate.
In addition, the ability of the Bank and Westfield to attract investment management and trust business may be inhibited by their relatively short history and record of performance. With respect to their investment management and trust services, the Bank and Westfield compete primarily with commercial banks and trust companies, mutual fund companies, investment advisory firms, stock brokerage firms, other financial companies and law firms. Competition is especially keen in the Bank's and Westfield's market area, because Boston has a well-established investment management industry. Many of the Bank's and Westfield's competitors have greater resources than either the Bank, Westfield, or the Company on a consolidated basis. In addition to competing directly for clients, competition can impact the fee structures of the Bank and Westfield. The Company believes that the ability of the Bank and Westfield to compete effectively with other firms is dependent upon their products, level of investment performance and client service, as well as the marketing and distribution of their investment products. There can be no assurance that the Bank and Westfield will be able to achieve favorable investment performance and retain their existing clients.
EMPLOYEES
At December 31, 1998, the Company had 138 full-time and 3 part-time employees. The Company's employees are not represented by any collective bargaining unit, and the Company believes its employee relations are good.
REGULATION
Banks and bank holding companies are subject to extensive government regulation through federal and state statutes and regulations, which are subject to changes that significantly affect the way in which such entities conduct business. Legislation enacted in recent years, as well as recent changes in regulatory policy, has substantially increased the level of competition among commercial banks, thrift institutions and nonbanking institutions, including insurance companies, brokerage firms, mutual funds and investment banks. In addition, the enactment of banking legislation such as the Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Act") has affected the banking industry by, among other things, enabling banks and bank holding companies to expand the geographic area in which they may provide banking services. The following summary is qualified in its entirety by the text of the relevant statutes and regulations.
REGULATION OF THE COMPANY
General. The Company has been incorporated as a business corporation under Massachusetts law. Thus, the rights of the Company's stockholders are governed, in part, by Massachusetts corporate law. As a bank holding company, the Company is subject to regulation and supervision by the Federal Reserve Board pursuant to the BHCA.
BHCA-Activities and Other Limitations. The BHCA prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank, or increasing such ownership or control of any bank, without prior approval of the Federal Reserve Board.
The BHCA also generally prohibits a bank holding company from engaging in any business other than banking or managing or controlling banks or from acquiring more than 5% of the voting shares of any company that is not a bank, unless the Federal Reserve Board has determined its activities to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto.
Capital Requirements. The Federal Reserve Board has adopted capital adequacy guidelines that generally require bank holding companies to maintain total capital equal to 8% of total risk-weighted assets, with at least one-half of that amount consisting of Tier 1 capital. Tier 1 capital for bank holding companies generally consists of the sum of common stockholders' equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stock which may be included as Tier 1 capital), less goodwill and other intangibles. Total capital consists of Tier 1 capital and supplementary capital, which includes: hybrid capital instruments and perpetual debt; perpetual preferred stock, which is not eligible to be included as Tier 1 capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses.
Assets are adjusted under the risk-based guidelines to take into account different levels of credit risk, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for the bulk of assets which are typically held by a bank, including commercial real estate loans, commercial business loans and consumer loans. In addition to the risk-based capital requirements, the Federal Reserve Board requires bank holding companies to maintain a minimum ratio of Tier 1 capital to total assets of 3%, with most bank holding companies required to maintain a 4% ratio. Furthermore, the bank holding company rating system used by the Federal Reserve Board to analyze the adequacy of a bank holding company's management, operations, earnings and capital generally evaluates "primary capital" and "total capital," with the leverage ratios for "well capitalized" institutions being 5.5% and 6%, respectively.
Limitations on Acquisitions of Common Stock. The Federal Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company unless the Federal Reserve Board has been given 60 days' prior written notice of such proposed acquisition and within that time period the Federal Reserve Board has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days the period during which such a disapproval may be issued. An acquisition may be made prior to expiration of the disapproval period if the Federal Reserve Board issues written notice of its intent not to disapprove the action. The acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under certain circumstances, constitute the acquisition of control.
In addition, any "company" would be required to obtain the approval of the Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of the company's outstanding common stock, or such lesser number of shares of voting securities and other indications of control as constitute control over the Company. Such approval would be contingent upon, among other things, the acquiror (if not already registered) registering as a bank holding company, divesting all impermissible holdings and ceasing any activities not permissible for a bank holding company.
Massachusetts Law. Massachusetts law requires all bank holding companies to receive prior written approval of the Board of Bank Incorporation (the "BBI") to, among other things, acquire all or substantially all of the assets of a banking institution or to merge or consolidate with a Massachusetts bank holding company. The Company owns no voting stock in any banking institution other than the Bank. In addition, prior approval of the BBI is required before any bank holding company owning 25% or more of the stock of two banking institutions may acquire additional voting stock in those banking institutions, or acquire more than 5% of the voting stock of another banking institution.
REGULATION OF THE BANK
General. The Bank is subject to extensive regulation and examination by the Commissioner of Banks of the Commonwealth of Massachusetts and by the FDIC, which insures its deposits to the maximum extent permitted by law, and to certain requirements established by the Federal Reserve Board. The federal and state laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans.
FDIC Insurance Premiums. Pursuant to the FDIC's risk-based assessment system, an institution is assigned to one of three capital groups based solely on the level of the institution's capital -- "well capitalized," "adequately capitalized" and "undercapitalized" -- which would be defined in generally the same manner as the regulations establishing the prompt corrective action system under Section 38 of the Federal Deposit Insurance Act (the "FDIA"), as discussed below. The three capital groups are divided into three subgroups which reflect varying levels of supervisory concern, from those considered to be healthy to those considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications. FDIC insurance rates under these classifications range from 0.013% of deposits for well capitalized, healthy institutions to 0.283% of deposits for undercapitalized institutions with substantial supervisory concerns. At December 31, 1998, the Bank was considered "well capitalized" with regard to these regulations.
Capital Requirements. The FDIC has promulgated regulations and adopted a statement of policy regarding the capital adequacy of state-chartered banks which, like the Bank, are not members of the Federal Reserve System. These requirements are substantially similar to those adopted by the Federal Reserve Board, as described above.
Prompt Corrective Action. The federal banking agencies have promulgated regulations to implement the system of prompt corrective action established by Section 38 of the FDIA. Under the regulations, a bank shall be deemed to be: (i) "well capitalized" if it has total risk-based capital of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to any written agreement, order or directive requiring the bank to maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Section 38 of the FDIA and the accompanying regulations also specify circumstances under which a federal banking agency may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized).
Regulatory Consequences of Failing to Meet Capital Requirements. A number of sanctions may be imposed on FDIC-insured banks that are not in compliance with the capital regulations, including, among other things, restrictions on asset growth and imposition of a capital directive that may require, among other things, an increase in regulatory capital, reduction of rates paid on savings accounts, cessation of or limitations on deposit-gathering, lending, purchasing loans, making specified investments, or issuing new accounts, limits on operational expenditures, an increase in liquidity and such other restrictions or corrective actions as the FDIC may deem necessary or appropriate. In addition, any FDIC-insured bank that is not meeting its capital requirements must provide the FDIC with prior notice before the addition of any new director or senior officer.
Brokered Deposits and Pass-Through Deposit Insurance Limitations. Well-capitalized institutions may accept brokered deposits. A depository institution that is adequately capitalized may not accept, renew or roll over any brokered deposit unless it obtains a waiver of statutory limitations from the FDIC. Even if an adequately capitalized institution receives such a waiver, it may offer yields on brokered deposits only within specified limits. An undercapitalized depository institution may not accept brokered deposits. The definitions of "well capitalized," "adequately capitalized," and "undercapitalized" generally conform to the definitions described above for prompt corrective action. In addition, "pass-through" insurance coverage may not be available for certain employee benefit accounts and eligible deferred compensation plans maintained by depository institutions that cannot accept brokered deposits.
Activities and Investments of Insured State-Chartered Banks. Section 24 of the FDIA, as amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), generally limits the equity investments and activities of FDIC-insured, state non-member banks and their subsidiaries to those that are permissible for national banks. Under the FDIC's final regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary that engages in activities permissible for subsidiaries of national banks, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the Bank's total assets, (iii) for insured state banks located in certain states, including Massachusetts, retaining under certain circumstances and subject to certain limitations, listed common and preferred shares or registered investment company shares, (iv) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees', and officers' liability insurance coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (v) acquiring or retaining the voting shares of a depository institution if certain requirements are met.
With respect to the activities limitations, pursuant to FDIC regulation, FDIC insured state chartered banks must obtain prior consent from the FDIC before directly, or indirectly through a majority-owned subsidiary, engaging "as principal" in any activity that is not allowed for a national bank. This limitation generally does not apply, however, to activities which the Federal Reserve Board has approved, securities activities performed in accordance with FDIC regulations, and activities that the FDIC determines do not pose a significant risk to the deposit insurance fund.
Safety and Soundness Guidelines. The federal banking agencies have adopted safety and soundness guidelines for all insured depository institutions and depository institution holding companies, prescribing in a general manner standards relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and other operational and managerial standards.
COMMUNITY REINVESTMENT ACT
The Community Reinvestment Act of 1977, as amended (the "CRA"), was enacted to encourage every financial institution to help meet the credit needs of its entire community, including low-and-moderate-income neighborhoods, consistent with its safe and sound operation. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution's discretion to develop the type of products and services that it believes are best suited to its particular community, consistent with the purposes of the CRA.
The federal bank regulatory agencies jointly issued amendments to the regulations implementing the CRA that substantially revised the applicable CRA framework effective January 1, 1996. The amended CRA regulations are based upon objective criteria of the performance of institutions under three key assessment tests: (i) a lending test, to evaluate the institution's record of making loans in its service areas; (ii) an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution's delivery of services through its branches, ATMs, and other offices. As of the date of the most recent regulatory exam in September 1997, the Bank's CRA rating was "satisfactory."
INTERSTATE BANKING LEGISLATION
Under the Interstate Act, different types of interstate transactions and activities will be permitted under federal law, each with different effective dates. Interstate transactions and activities provided for under this law include: (i) bank holding company acquisitions of separately held banks in a state other than a bank holding company's home state; (ii) mergers between insured banks with different home states, including consolidations of affiliated insured banks; (iii) establishment of interstate branches by branch acquisition; and (iv) affiliated banks acting as agents for one another for certain banking functions without regard to state law prohibitions on interstate branching or unauthorized banking. In general, nationwide interstate bank acquisitions are now permissible, irrespective of most state law limitations. Interstate mergers became permissible on July 1, 1997. States may at any time enact legislation permitting interstate branching. Banks are now permitted to act as agents for affiliated depository institutions. Each of the transactions and activities must be approved by the appropriate federal bank regulator, with separate and specific criteria established for each category.
Subject to applicable state law "opt-out" or "opt-in" provisions in the case of interstate mergers and de novo branching, the appropriate federal bank regulator may approve the respective interstate transactions only if certain criteria are met. First, in order for a banking institution (a bank or bank holding company) to receive approval for an interstate transaction, it must be "adequately capitalized" and "adequately managed." The phrase "adequately capitalized" is generally defined as meeting or exceeding all applicable federal regulatory capital standards, while the phrase "adequately managed" is left undefined. Second, the appropriate federal bank regulator must consider the applicant's and its affiliated institutions' records under the CRA, as well as the applicant's record under applicable state community reinvestment laws.
The Interstate Act also applies deposit "concentration limits" to interstate acquisition and merger transactions. Specifically, a banking institution may not receive federal approval for interstate expansion if it and its affiliates would control (i) more than 10% of the deposits held by all insured depository institutions in the United States, or (ii) 30% or more of the deposits of all insured depository institutions in any state in which the banks or branches involved in the transactions (or any affiliated depository institution) overlap.
In 1996, Massachusetts enacted interstate banking laws in response to the Interstate Act. The laws permit, subject to certain deposit and other limitations, interstate acquisitions, mergers and banking on a reciprocal basis. The new interstate banking law is likely to make it easier for out-of-state institutions to attempt to purchase or otherwise acquire or to compete with the Bank in Massachusetts and similarly make it easier for Massachusetts banks to compete outside the state.
GOVERNMENT REGULATION
Virtually all aspects of the Company's investment management business are subject to extensive regulation. Westfield and Boston Private Asset Management ("BPAM"), an investment management subsidiary of the Bank, are registered with the Securities and Exchange Commission (the "Commission") as investment advisers under the Investment Advisers Act. As an investment adviser, each is subject to the provisions of the Investment Advisers Act and the Commission's regulations promulgated thereunder. The Investment Advisers Act imposes numerous obligations on registered investment advisers, including fiduciary, recordkeeping, operational, and disclosure obligations. Westfield and BPAM are investment advisers also subject to regulation under the securities laws and fiduciary laws of certain states. Each of the mutual funds for which Westfield acts as adviser, or subadviser, is registered with the Commission under the Investment Company Act, shares of each such fund are registered with the Commission under the Securities Act, and the shares of each fund are qualified for sale (or exempt from such qualification) under the laws of each state and the District of Columbia to the extent such shares are sold in any of such jurisdictions. As an adviser or subadviser to a registered investment company, Westfield is subject to requirements under the 1940 Act and the Commission's regulations promulgated thereunder. Westfield is also subject to ERISA, and to regulations promulgated thereunder, insofar as it is a "fiduciary" under ERISA with respect to certain of its client. ERISA and the applicable provisions of the Internal Revenue Code of 1986, as amended (the "Code"), impose certain duties on persons who are fiduciaries under ERISA, and prohibit certain transactions by the fiduciaries (and certain other related parties) to such plans.
Under the Investment Advisers Act, every investment advisory contract between a registered investment adviser and its clients must provide that it may not be assigned by the investment adviser without the consent of the client. In addition, under the Investment Company Act, each contract with a registered investment company must provide that it terminates upon its assignment. Under both the Investment Advisers Act and the Investment Company Act, an investment advisory contract is deemed to have been assigned in the case of a direct "assignment" of the contract as well as in the case of a sale, directly or indirectly, of a "controlling block" of the adviser's voting securities. Such an assignment may be deemed to take place when a firm is acquired by the Company.
The foregoing laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict either Westfield or BPAM from conducting their business in the event that they fail to comply with such laws and regulations. Possible sanctions that may be imposed in the event of such noncompliance include the suspension of individual employees, limitations on the business activities for specified periods of time, revocation of registration as an investment adviser, commodity trading adviser and/or other registrations, and other censures and fines. Changes in these laws or regulations could have a material adverse impact on the profitability and mode of operations of the Company and Westfield.
FEDERAL TAXATION
The Company, the Bank and Westfield are subject to those rules of federal income taxation generally applicable to corporations under the Code. The Bank is also, under Subchapter H of the Code, subject to certain special rules applicable to banking institutions as to securities, reserves for loan losses, and any common trust funds. The Company, the Bank and Westfield, as members of an affiliated group of corporations within the meaning of Section 1504 of the Code, will file a consolidated federal income tax return, which has the effect of eliminating or deferring the tax consequences of inter-company distributions, including dividends, in the computation of consolidated taxable income for federal tax purposes.
In addition to regular corporate income tax, corporations are subject to an alternative minimum tax which generally is equal to 20% of alternative minimum taxable income (taxable income, increased by tax preference items and adjusted for certain regular tax items). The preference items which are generally applicable include an amount equal to 75% of the amount by which a bank's adjusted current earnings (generally alternative minimum taxable income computed without regard to this preference and prior to reduction for net operating losses) exceeds its alternative minimum taxable income without regard to this preference. Alternative minimum tax paid can be credited against regular tax due in later years.
STATE AND LOCAL TAXATION
Commonwealth of Massachusetts. The Bank is subject to an annual Massachusetts excise tax. The tax rate applicable to financial institutions, including trust companies, will be reduced to 10.50% by 1999 on net income apportioned to Massachusetts. The rate was 11.72% for 1996, 11.32% for 1997, 10.91% for 1998 and will be 10.50% for 1999. Net income for years beginning before January 1, 1999 includes gross income as defined under the provisions of the Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less the deductions, excluding the deductions for dividends received, state taxes, and net operating losses, but not the credits as defined under the provisions of the Code. For taxable years beginning on or after January 1, 1999, the definition of Massachusetts net income is modified to allow a deduction for 95% of dividends received from stock where the Bank owns 15% or more of the voting stock of the institution paying the dividend and to allow deductions from certain expenses allocated to federally tax exempt obligations. Finally, affiliated financial institutions are not permitted to file a combined tax return in Massachusetts under the new legislation.
Bank holding companies and certain non-bank subsidiaries are subject to the Massachusetts corporate excise tax on business corporations provided they were subject to such tax in taxable years before 1995. Under the corporate excise tax, a corporation is taxed on its net income apportioned to Massachusetts at the rate of 9.5% plus a tax of .26% on either its apportioned net worth or tangible property. These grandfathered corporations may elect to file a combined Massachusetts excise tax return through 1998. For taxable years beginning in 1999, these corporations will be taxed as a financial institution and taxed at a rate of 10.5% on their net income apportioned to Massachusetts. Certain of the Bank's subsidiaries meeting certain definitional tests relating to investments are not subject to either the corporate excise tax or the tax on financial institutions, but instead are taxed on their gross income at the rate of 1.32%.
The Bank and certain of its affiliates are subject to local property taxes. Massachusetts excise or local property taxes paid by the Bank or its affiliates are generally deductible for federal income tax purposes.
ITEM 2.
ITEM 2. PROPERTIES
In October 1994, the Company executed a lease for the banking premises located at Ten Post Office Square, Boston, Massachusetts, which is the headquarters of the Bank. The lease for this space, which expires in February 2005, initially provided for 19,661 square feet, two five-year options to renew and a number of options for future expansion. In December, 1996, the Company executed a lease amendment for an additional 7,308 square feet of space at this location.
In January 1996, Westfield executed a lease for 11,320 square feet of office space at One Financial Center. This lease expires in August 2001 and is renewable for an additional five years. Approximately 13% of this space is subleased to a tenant under a noncancellable operating lease, which expires in August 2001.
In November 1997, the Bank executed a lease for a 6,216 square foot building at 336 Washington Street, Wellesley, Massachusetts. The lease for this office expires in October 2012 and provides for three five year options for renewal.
The Company has from time to time also acquired properties through foreclosure, which are marketed by local real estate brokers or by its lending staff.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In January 1994, the Bank became aware of a dispute among various parties involved in a transaction in which it served as bank of deposit for certain certificates stated to reflect debt obligations of a foreign bank. In December 1994, the party which allegedly purchased the certificates filed a complaint in the United States District Court for the District of Massachusetts alleging certain claims arising out of the transaction against numerous individuals and entities, including the Bank and one of its former officers. The plaintiff sought to recover compensatory damages of approximately $4 million.
In August 1995, the Bank filed for summary judgment against the plaintiff's claims. The plaintiff also filed a motion for partial summary judgment on one of its claims. On March 19, 1996, the court granted the Bank's summary judgment motion and denied the plaintiff's motion, resulting in the dismissal of all claims against the Bank. The plaintiff sought reconsideration of its motion, and on November 26, 1996, the court denied plaintiff's motion for reconsideration of the summary judgment previously granted in favor of the Bank.
Notwithstanding the Court's dismissal of the underlying claims against the Bank and its denial of the plaintiff's motion for reconsideration, litigation continues among other parties. On December 31, 1998, the plaintiff filed another motion asking the Court to reconsider the legal basis for its decision granting summary judgment to the Bank. Among other things, plaintiff alleged that it had new evidence which it asserts supports its claims against the Bank. The Bank filed its opposition to plaintiff's motion on February 2, 1999. The Bank continues to believe it has valid defenses to, and will vigorously defend all claims and allegations of wrongdoing in connection with the transaction. The Company incurred legal expenses of approximately $4,000 net of recoveries under an insurance policy during 1998. Legal expenses incurred to date in 1999 net of recoveries under and insurance policy are estimated to be approximately $4,000. No further estimate of any loss can be made at this time.
The Company is also involved in routine legal proceedings occurring in the ordinary course of business. In the opinion of management, final disposition of these proceedings will not have a material adverse effect on the financial condition or results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the stockholders of the Company during the fourth quarter of the fiscal year ended December 31, 1998.
PART II
The discussions set forth below and elsewhere herein contain certain statements that may be considered 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's actual results could differ materially from those projected in the forward-looking statements as a result of, among other factors, the factors listed under "Risk Factors and Factors Affecting Forward Looking Statements", changes in loan defaults and charge-off rates, reduction in deposit levels necessitating increased borrowing to fund loans and investments, changes in interest rates, fluctuations in assets under management and other sources of fee income, the impact of year 2000 issues on the Company, its clients and its vendors, and changes in assumptions used in making such forward-looking statements.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET FOR COMMON STOCK
The Company's common stock, par value $1.00 per share (the "Common Stock"), is traded on the Nasdaq National Market ("Nasdaq") under the symbol "BPFH". At February 22, 1999 there were 10,802,513 shares of Common Stock outstanding, which were held by approximately 400 holders of record.
The following table sets forth the high and low closing sale prices for the Company's Common Stock for the periods indicated, as reported by Nasdaq:
DIVIDENDS
The Company has never paid any dividends in respect to its Common Stock. The Company does not presently have any specific plans to pay cash dividends on its Common Stock. Declaration of dividends by the Board of Directors of the Company will depend on a number of factors, including capital requirements, regulatory limitations, the Company's operating results and financial condition and general economic conditions. The Bank and Westfield are the principal assets of the Company, and as such, provide the only source of payment of dividends by the Company. Under Massachusetts law, trust companies such as the Bank may pay dividends only out of "net profits" and only to the extent that such payments will not impair the Bank's capital stock and surplus account. These restrictions on the ability of the Bank to pay dividends to the Company restrict the ability of the Company to pay dividends to the holders of the Common Stock. Although Massachusetts law does not define what constitutes "net profits" it is generally assumed that the term includes a bank's retained earnings and does not include its additional paid-in capital account. There are no such comparable statutory restrictions on Westfield's ability to pay dividends.
RECENT SALES OF UNREGISTERED SECURITIES
On December 9, 1996 the Company issued 730,000 shares of its Common Stock in a private placement exempt from registration pursuant to Regulation D promulgated under the Securities Act of 1933, as amended, for an aggregate offering price of approximately $3.2 million.
The information contained in the Company's Current Report on Form 8-K, filed with the Commission on August 21, 1997, as amended by Form 8-K/A filed with the Commission on November 14, 1997, regarding the issuance of 3,918,367 shares of the Company's Common Stock in connection with the acquisition of Westfield is incorporated herein by reference thereto.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table represents selected financial data for the five fiscal years ended December 31, 1998. The data set forth below does not purport to be complete. It should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Company's Consolidated Financial Statements and related Notes, appearing elsewhere herein.
(1) Interest rate spread represents the difference between the weighted average yield on interest-earning assets on a fully-taxable equivalent basis, and the weighted average cost of interest-bearing liabilities, and net interest margin represents net interest income on a fully-taxable equivalent basis as a percent of average interest-earning assets. (2) After deducting $1.2 million of non-recurring merger expenses, net income for the year ended December 31, 1997 was $4.7 million, or $0.43 per share, return on average assets was 1.52%, and return on average equity was 18.21%. (3) Total revenue is defined as net interest income plus fees and other income.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Management's discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements, their notes, and other statistical information included in this annual report. The discussions set forth below and elsewhere herein contain certain statements that may be considered 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's actual results could differ materially from those projected in the forward-looking statements as a result of, among other factors, the factors listed under "Risk Factors and Factors Affecting Forward Looking Statements," changes in loan defaults and charge-off rates, reduction in deposit levels necessitating increased borrowing to fund loans and investments, changes in interest rates, fluctuations in assets under management and other sources of fee income, the impact of year 2000 issues on the Company, its clients, and its vendors, and changes in assumptions used in making such forward-looking statements. In addition, prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs, could significantly affect the operations of financial institutions such as the Company.
LIQUIDITY
Liquidity is defined as the ability to meet current and future financial obligations of a short-term nature. The Company further defines liquidity as the ability to respond to the needs of depositors and borrowers as well as to earnings enhancement opportunities in a changing marketplace. Primary sources of liquidity consist of investment management fees, deposit inflows, loan repayments, borrowed funds, and maturity and sales of investment securities. These sources fund the Company's lending and investment activities.
Management is responsible for establishing and monitoring liquidity targets as well as strategies to meet these targets. In general, the Company maintains a high degree of liquidity. At December 31, 1998, cash, federal funds sold and securities available for sale amounted to $89.9 million, or 19.7% of total assets of the Company. This compares to $50.3 million, or 13.6% of total assets, at December 31, 1997.
In general, the Bank maintains a liquidity target of 10% to 20% of total assets. The Bank is a member of the FHLB of Boston, and as such has access to both short and long-term borrowings of up to $135.3 million at the current time. In addition, the Bank maintains a line of credit at the FHLB of Boston as well as other lines of credit with several correspondent banks. Management believes that the Bank has adequate liquidity to meet its commitments for the foreseeable future.
Westfield's primary source of liquidity consists of investment management fees which are collected on a quarterly basis. At December 31, 1998, Westfield had working capital of approximately $2.0 million. Management believes that Westfield has adequate liquidity to meet its commitments for the foreseeable future.
The Company's primary sources of funds are dividends from its subsidiaries, issuance of its Common Stock and borrowings. Management believes that the Company has adequate liquidity to meet its commitments for the foreseeable future.
CAPITAL RESOURCES
Total stockholders' equity of the Company at December 31, 1998 was $32.3 million, compared to $25.9 million at December 31, 1997. This increase of $6.4 million was primarily the result of the Company's net income for 1998 of $5.5 million combined with the proceeds of Common Stock issued and options exercised.
As a bank holding company, the Company is subject to a number of regulatory capital requirements which have been adopted by the Federal Reserve Board. At December 31, 1998, the Company's Tier I leverage capital ratio stood at 6.57%, compared to 6.54% at December 31, 1997. The Company is also subject to a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. According to these standards, the Company had a Tier I risk-based capital ratio of 10.52% and a Total risk-based capital ratio of 11.77% at December 31, 1998. This compares to a Tier I risk-based capital ratio of 9.81% and a Total risk-based capital ratio of 11.07% at December 31, 1997. The minimum Tier I leverage, Tier I risk-based, and Total risk-based capital ratios necessary to enable the Company to be
classified for regulatory purposes as a "well capitalized" institution are 5.00%, 6.00% and 10.00%, respectively. The Company was considered to be "well capitalized" as of December 31, 1998.
The Bank is also subject to a number of regulatory capital measures. At December 31, 1998, the Bank's Tier I leverage capital ratio stood at 5.96%, as compared to 6.28% at December 31, 1997. The Bank is also subject to a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. According to these standards, the Bank had a Tier I risk-based capital ratio of 9.62% and a Total risk-based capital ratio of 10.87% at December 31, 1998. This compares to a Tier I risk-based capital ratio of 9.43% and a Total risk-based capital ratio of 10.68% at December 31, 1997. The minimum Tier I leverage, Tier I risk-based, and Total risk-based capital ratios necessary to be classified for regulatory purposes as a "well capitalized" institution are 5.00%, 6.00% and 10.00%, respectively. The Bank was considered to be "well capitalized" as of December 31, 1998.
FINANCIAL CONDITION
Total Assets. Total assets increased $88.3 million, or 23.9%, to $457.2 million at December 31, 1998 from $368.9 at December 31, 1997. This increase was attributed primarily to an increase in portfolio loan originations and was primarily funded by an increase in deposits.
Investments. Total investments (consisting of federal funds sold, investment securities and mortgage-backed securities) were $77.0 million, or 16.8% of total assets, at December 31, 1998, compared to $65.8 million, or 17.8% of total assets, at December 31, 1997. This increase of $11.3 million, or 17.1%, was primarily due to an inflow of cash deposits at year-end which was invested in overnight federal funds sold, and reinvestment of interest income within the investment portfolio. As of December 31, 1998, all investments are classified as available for sale. The investment portfolio carried a total of $175,000 in net unrealized gains at December 31, 1998.
Loans. Loans totaled $349.0 million, or 76.3% of total assets, at December 31, 1998, compared with $276.8 million, or 75.0% of total assets, at December 31, 1997. This increase of $72.1 million, or 26.1%, was due to a larger allocation of resources devoted to loan originations, as well as the combination of a healthy local economy and low interest rates which helped fuel loan demand. During 1998, commercial loans increased $20.3 million, or 15.0%, to $154.9 million from $134.7 million at December 31, 1997; residential mortgage loans increased $48.9 million, or 39.2%, to $173.8 million from $124.9 million at December 31, 1997; and home equity and other loans increased $2.9 million, or 17.1%, to $20.2 million from $17.3 million at December 31, 1997.
Deposits. The Company experienced an increase of $76.6 million, or 29.6%, in deposits during 1998, from $258.3 million, or 70.0% of total assets at December 31, 1997, to $334.9 million, or 73.2% of total assets, at December 31, 1998. The Company opened a new banking office in Wellesley, Massachusetts in April 1998, which contributed approximately $11.5 million of deposits as of December 31, 1998.
Borrowings. Total borrowings (consisting of securities sold under agreements to repurchase ("repurchase agreements"), federal funds purchased, FHLB borrowings, and other short-term borrowings) increased $2.9 million, or 3.6%, during 1998 to $82.6 million from $79.7 million at December 31, 1997. The increase was mainly attributable to an increase in FHLB borrowings to help fund loan growth. Management takes advantage of opportunities to fund asset growth with borrowings, but on a long-term basis, the Company intends to replace a portion of its borrowings with lower-cost core deposits.
ASSET QUALITY
The Company's non-performing assets include non-performing loans and other real estate owned ("OREO"). Non-performing loans include both nonaccrual loans and loans past due 90 days or more but still accruing.
The following table sets forth information regarding non-performing loans, other real estate owned, and delinquent loans 30-89 days past due as to interest or principal, held by the Company at the dates indicated.
RISK ELEMENTS OF THE LOAN PORTFOLIO
The Company discontinues the accrual of interest on a loan when the collectibility of principal or interest is in doubt. In certain instances, loans that have become 90 days past due may remain on accrual status if the value of the collateral securing the loan is sufficient to cover principal and interest and the loan is in the process of collection. OREO consists of real estate acquired through foreclosure proceedings and real estate acquired through acceptance of a deed in lieu of foreclosure. In addition, the Company may, under certain circumstances, restructure loans as a concession to a borrower.
Non-Performing Assets. At December 31, 1998, the Company had non-performing assets of $565,000, which were 0.12% of total assets, representing a decrease of $267,000, or 32.1%, from $832,000 at December 31, 1997. As of December 31, 1998, the Company's non-performing assets consisted entirely of nonaccruing loans. The Company continues to evaluate the underlying collateral of each non-performing loan and pursues the collection of interest and principal. Also see Notes 7 and 8 to the Company's Consolidated Financial Statements for further information on non-performing assets.
Delinquencies. At December 31, 1998, $3.3 million of loans were 30 to 89 days past due, an increase of $1.7 million, or 102.6%, from the $1.6 million reported at December 31, 1997. Most of these loans are adequately secured and management's success in keeping these borrowers current varies from month to month.
Adversely Classified Loans. The Company's management adversely classifies certain loans using an internal rating system based on criteria established by federal bank regulatory authorities. These loans evidence weakness or potential weakness related to repayment history, the borrower's financial condition, or other factors. Delinquent loans may or may not be adversely classified depending upon management's judgment with respect to each individual loan. Certain of these loans are non-performing or may become non-performing in future periods. At December 31, 1998, the Company had classified $2.9 million of loans as substandard or doubtful based on the rating system adopted by the Company. In addition, at December 31, 1998, the Company had designated $210,000 of loans as special mention.
Allowance for Loan Losses. The allowance for loan losses is established through provisions charged to operations. Assessing the adequacy of the allowance for loan losses involves substantial uncertainties and is based upon management's evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing various factors. Among these factors are the risk characteristics of the loan portfolio, the quality of specific loans, the level of nonaccruing loans, current economic conditions, trends in delinquencies and charge-offs, and the value of underlying collateral, all of which can change frequently. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties.
While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution's allowance for loan losses and carrying amounts of other real estate owned. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
NET INTEREST INCOME AND MARGIN
Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Net interest margin is the amount of net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. The average yield on interest earning assets is the amount of taxable equivalent interest income expressed as a percentage of average earnings assets. The average rate paid on funding sources is equal to interest expense as a percentage of average interest-earning assets.
The following table sets forth average assets, liabilities, and stockholders' equity, interest income and interest expense, average yields and rates, and the composition of the Company's net interest margin for the years ended December 31, 1998, 1997, and 1996.
(1) Interest income on non-taxable investments is presented on a fully taxable-equivalent basis using the federal statutory rate of 34% for each year presented. These adjustments were $537,000, $346,000, and $115,000 for the years ended December 31, 1998, 1997, and 1996, respectively. (2) Nonaccrual loans are included in average loan balances. (3) Average balances are derived from daily balances.
RATE/VOLUME ANALYSIS
The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volumes (changes in volume multiplied by prior rate) and (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume). Changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories.
COMPARISON OF YEARS ENDED DECEMBER 31, 1998 AND 1997
Net Income. The Company reported net income of $5.5 million, or $0.50 per diluted share, for the year ended December 31, 1998. For the year ended December 31, 1997 the Company's net income was $3.5 million, or $0.32 per diluted share after deducting $1.2 million of non-recurring acquisition expenses, net of tax. The 57.0% increase of $2.0 million in reported net income is primarily the result of the effect on the Company's 1997 net income of the $1.2 million of non-recurring acquisition expenses and the tax-exempt, S-Corporation status of Westfield prior to the acquisition in 1997. Not including non-recurring acquisition expenses, and had Westfield been fully taxable in 1997, the Company would have reported proforma net income of $4.5 million, or $0.42 per diluted share, for the year ended December 31, 1997.
Net Interest Income. For the year ended December 31, 1998, net interest income was $14.1 million, an increase of $2.8 million, or 24.2%, over the same period in 1997. This increase was primarily attributable to higher loan volumes. Average earning assets were $94.1 million, or 32.0% higher, and average interest-bearing liabilities were $86.9 million, or 34.5% ,higher than the comparable period a year earlier. The net interest margin decreased 21 basis points, or 5.3%, from 3.99% in 1997 to 3.78% in 1998 due mainly to lower yields earned on the loan portfolio.
Interest Income. Loans. Income on commercial loans was $13.1 million for 1998 compared to $9.6 million for 1997, an increase of $3.5 million, or 36.8%. Income from residential mortgage loans was $10.7 million compared to $8.2 million, an increase of $2.5 million, or 30.6%, and income from home equity and other loans was $1.4 million compared to $1.2 million, an increase of $217,000, or 18.4%, for the same periods, respectively. These increases in interest income are due to higher average balances, partially offset by lower yields. The average balances of commercial and residential mortgage loans during 1998 increased $40.7 million, or 40.8%, and $40.9 million, or 37.0%, respectively, compared to 1997. The average balance of home equity and other loans increased $2.7 million, or 19.0%. The yield on commercial loans decreased 27 basis points, or 2.8%, the yield on residential mortgage loans decreased 35 basis points, or 4.7%, and the yield on home equity loans decreased 5 basis points, or 0.6%, compared to the prior year.
Interest Income. Cash and Investments. Total cash and investment income increased to $4.1 million during 1998 compared to $3.8 million during 1997. This increase in cash and investment income of $327,000, or 8.6%, was primarily attributable to a 14.1% increase in the average balance of interest-bearing cash and investments, partially offset by a decrease in the yield earned.
Interest Expense. Interest paid on deposits and borrowings increased $3.8 million, or 33.6%, to $15.1 million for 1998, from $11.3 million for 1997. This increase in the Company's interest expense primarily reflects an increase in the average balance of interest-bearing liabilities of $86.9 million, or 34.5%, between the two periods. The overall cost of interest-bearing liabilities decreased 3 basis points, or 0.6%, compared to the prior year.
Provision for Loan Losses. The provision for loan losses was $1.0 million for 1998 compared to $810,000 for 1997. Management frequently evaluates several factors, including the risk characteristics of the loan portfolio, actual and estimated charge-offs, and new loan originations, when determining the provision for loan losses. The Company's ratio of loan loss allowance to total loans was 1.26% at December 31, 1998 and 1.32% at December 31, 1997.
Fees and Other Income. Total fees and other income was $18.2 million for 1998 compared to $13.8 million for 1997. Investment management and trust fees increased $2.0 million, or 14.8%, primarily as the result of a 14.3% increase in the Company's average assets under management from $2.1 billion for 1997 to $2.4 billion for 1998. Westfield earned performance fees of $1.8 million in 1998 as general partner for the limited partnerships it manages. In 1997, no such fees were earned.
Operating Expense. Total operating expense for 1998 was $23.0 million compared to $19.0 million for 1997. This represents an increase of $4.0 million, or 21.2%, as compared to 1997. The increase in salary expense of $4.5 million, or 37.3%, is primarily due to bonuses to employees of Westfield of $1.1 million related to performance fees earned on the limited partnerships Westfield manages, a 22.1% increase in the number of employees during 1998, and normal salary increases. The increase of $1.1 million, or 19.6%, in the remainder of operating expense, not including non-recurring merger expenses of $1.5 million in 1997, was primarily the result of the Company's growth, continuing investments in technology and expansion of leased premises.
Income Tax Expense. The Company recorded income tax expense of $2.9 million in 1998 as compared to $1.9 million in 1997. The effective tax rate was 34.4% and 35.2% in 1998 and 1997, respectively. The increase in tax expense is partially due to the fact that Westfield was a tax-exempt S-Corporation prior to the date of acquisition. If Westfield had been a fully taxable entity, the Company would have incurred approximately $186,000, or $0.02 per share, of additional income tax expense in 1997. Under these circumstances, the effective tax rate in 1997 would have been 38.7%.
COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND 1996
Net Income. The Company reported net income of $3.5 million, or $0.32 per diluted share, for the year ended December 31, 1997 after deducting $1.2 million of non-recurring acquisition expenses, net of tax. For the year ended December 31, 1996 the Company's net income was $5.5 million, or $0.55 per diluted share. The 35.9% decrease of $2.0 million in reported net income is the result of the $1.2 million of non-recurring acquisition expenses and the tax-exempt, S-Corporation status of Westfield prior to the acquisition, which provided $1.2 million of tax savings in 1996. Not including non-recurring acquisition expenses, and had Westfield been fully taxable in 1997 and 1996, the Company would have reported proforma net income of $4.5 million, or $0.42 per diluted share, and $4.2 million, or $0.43 per diluted share, for the years ended December 31, 1997 and 1996, respectively.
Net Interest Income. For the year ended December 31, 1997, net interest income was $11.4 million, an increase of $2.1 million, or 22.4%, over the same period in 1996. This increase was primarily attributable to higher loan volumes. Average earning assets were $50.5 million, or 20.1% higher, and average interest-bearing liabilities were $40.3 million, or 19.1%, higher than the comparable period a year earlier. The net interest margin increased 7 basis points, or 1.8% from 3.80% in 1996 to 3.87% in 1997 due mainly to higher yields earned on the loan portfolio.
Interest Income. Loans. Income on commercial loans was $9.6 million for 1997 compared to $7.5 million for 1996, an increase of $2.1 million, or 27.9%. Income from residential mortgage loans was $8.2 million compared to $6.4 million, an increase of $1.8 million, or 28.5%, and income from home equity and other loans was $1.2 million compared to $810,000, an increase of $369,000, or 45.6%, for the same periods, respectively. These increases in interest income are due to higher average balances, and, to a lesser extent, higher yields. The average balances of commercial and residential mortgage loans during 1997 increased $21.2 million, or 26.9%, and $23.8 million, or 27.3%, respectively, compared to 1996. The average balance of home equity and other loans increased $4.7 million, or 47.6%. The yield on commercial loans increased 7 basis points, or 0.7%, the yield on residential mortgage loans increased 7 basis points, or 1.0%, and the yield on home equity loans increased 4 basis points, or 0.5% compared to the prior year.
Interest Income. Cash and Investments. Total cash and investment income decreased to $3.8 million during 1997 compared to $4.0 million during 1996. This decrease in cash and investment income of $224,000, or 5.5%, was primarily attributable to a 5.9% decrease in the average yield from 5.79% for 1996 to 5.45% for 1997.
Interest Expense. Interest paid on deposits and borrowings increased $2.0 million, or 20.9%, to $11.3 million for 1997, from $9.4 million for 1996. This increase in the Company's interest expense primarily reflects an increase in the average balance of interest-bearing liabilities of $40.3 million, or 19.1%, between the two periods. The overall cost of interest-bearing liabilities increased 6 basis points, or 1.4% from 4.44% for 1996 to 4.50% for 1997.
Provision for Loan Losses. The provision for loan losses was $810,000 for 1997 compared to $619,000 for 1996. Management frequently evaluates several factors, including the risk characteristics of the loan portfolio, actual and estimated charge-offs, and new loan originations, when determining the provision for loan losses. The Company's ratio of loan loss allowance to total loans was 1.32% at December 31, 1997 and 1.25% at December 31, 1996. Also see discussion under "Risk Elements of the Loan Portfolio."
Fees and Other Income. Total fees and other income was $13.8 million for 1997 compared to $12.8 million for 1996. Investment management and trust fees increased $2.2 million, or 19.8%, primarily as the result of an 18.9% increase in the Company's average assets under management from $1.7 billion for 1996 to $2.1 billion for 1997. In 1997, Westfield earned no performance fees as general partner from the limited partnerships it manages, compared to $1.1 million of fee income in 1996.
Operating Expense. Total operating expense for 1997 was $18.9 million. This represents an increase of $4.1 million, or 27.8% as compared to 1996, however, the 1997 expense includes a non-recurring charge of $1.5 million related to the Westfield acquisition. An increase in salary expense of $1.8 million, or 18.2%, and an increase in the remainder of operating expenses of $774,000, or 16.4%, were primarily the result of the Company's growth, continuing investments in technology and expansion of leased premises.
Income Tax Expense. The Company recorded income tax expense of $1.9 million in 1997 as compared to $1.2 million in 1996. The effective tax rate was 35.2% and 18.2% in 1997 and 1996, respectively. The increase in tax expense is due to the fact that Westfield was a tax-exempt S-Corporation prior to the date of acquisition. If Westfield had been a fully taxable entity, the Company would have incurred approximately $186,000, or $0.02 per diluted share, and $1.2 million, or $0.12 per diluted share, of additional income tax expense in 1997 and 1996, respectively.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge. Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. This Statement is effective for fiscal years beginning after June 15, 1999, and is not expected to have a material impact on the Company's consolidated financial statements.
In October, 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of FASB Statement No. 65." This Statement requires that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. This Statement was adopted on January 1, 1999, and did not have a material effect on the Company's consolidated financial statements.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and related Notes thereto, presented in Item 8 - Financial Statements, have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.
Unlike many industrial companies, substantially all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant impact on the Company's performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as inflation.
YEAR 2000 READINESS DISCLOSURE
Scope and Overview. In 1996, the Company formed a Year 2000 project team to identify information technology and non-information technology systems, procedures, and practices that require modification or replacement. The Year 2000 problem concerns the inability of computer-based systems, including among others, computer hardware, embedded chips, and computer software programs, to recognize properly and process date-sensitive information involving 20th and 21st century dates. Data processing for the Company's major operating systems (investment management, custody, loans and deposits) is conducted through third party vendors using on-site computer interfaces. Inventory and Year 2000 readiness assessment of all information technology and non-information technology systems and applications have been completed and all third party vendors who service the Company have been contacted. Efforts to bring the major operating systems, and certain outsourced applications, into compliance with Year 2000 requirements have or will be accomplished primarily through the installation of updated or replacement hardware or programs developed by third parties. In addition the status of all Company facilities and all significant third-party providers of goods and services to the Company has been assessed.
State of Readiness. The Company's Year 2000 Readiness Program contains a number of discrete segments, including Awareness and Assessment, Project Planning, Remediation, User Acceptance Test Plans, Unit Testing, Commercial, Personal, Contingency Plans for Information Systems and Contingency Plans for Business Continuation. Awareness and Assessment, Project Planning for all aspects and User Acceptance Test Plans for mission critical systems have been completed. Mission critical systems are defined by the Company as those vital to the successful continuance of core business activities. Contingency Planning for all mission critical information technology systems and for Business Continuation has been completed and will be updated periodically during 1999.
The Company relies on several third party service providers for key business processes. It continues to work closely with these companies to monitor the progress of their Year 2000 efforts. The Company's Year 2000 project team has contacted all material service providers to discuss and assess their Year 2000 readiness. In addition, the Company is seeking verbal and written verification from its material third party service providers as to their Year 2000 readiness. The Company began Year 2000 testing with material third party service providers during the third quarter of 1998, and plans to complete testing by June 30, 1999. This schedule continues to track in line with the Company's overall Year 2000 project plan.
The Remediation phase, wherein non-compliant software and hardware are either modified or replaced, was substantially completed by December 31, 1998 for mission critical applications and is presently scheduled to be substantially completed by March 31, 1999 for non-mission critical applications. The Company has yet to identify any operating system which appears unlikely to be Year 2000 compliant or for which a suitable alternative cannot be implemented. The Company expects to complete User Acceptance Testing for mission critical information technology and non-information technology systems by June 30, 1999. Test Plans for non-critical applications are in process of development and are expected to be completed during the third quarter of 1999.
The initial portion of the Commercial phase, which includes the evaluation of credit risk stemming from problems borrowers may have in resolving their own Year 2000 issues, has been completed; however, monitoring of the remediation efforts of high risk customers will be ongoing. During the monitoring stage the Company is taking steps designed to reduce any increased potential credit risk as a result of borrowers' Year 2000 issues. Assessment of Year 2000 risk has been incorporated into the loan underwriting process. During this phase the Company is also evaluating investments made on behalf of investment management and trust clients and in the Company's own investment portfolio to determine risk stemming from problems securities issuers may have in resolving their own Year 2000 issues. Also encompassed in this phase, are in-process evaluation, assessment and monitoring of the state of readiness of the Company's funds providers and the capital markets. The Personal phase is largely focused on customer communications as to the state of the Company's Year 2000 readiness. Initial communications have been distributed and the process is ongoing.
Risks of Year 2000 Issues. The Company's businesses are substantially dependent upon its data processing software and hardware systems, and on its ability to process information. If the Company failed to be Year 2000 compliant, as compared to its competitors, there could be an adverse effect on the Company's business. In addition, since the Company is regulated by various regulatory agencies of state and federal banking authorities, failure to be Year 2000 compliant could subject the Company to formal supervisory or enforcement actions, which could have an adverse impact on the Company's business.
Since the Company relies on third parties for software and other support, there are risks that the Company's operations could be disrupted by adverse developments affecting the operations of these third parties. Such risks include, among others, an inability to process and underwrite loan applications, to credit deposits and withdrawals from deposit accounts, to credit loan payments or track delinquencies, to properly reconcile and record daily activity or to engage in normal banking activities. The Company continues to discuss these matters with, obtain written certification from, and test the systems of third party service providers as to Year 2000 compliance. However, there can be no assurance that any potential impact associated with incompatible systems after December 31, 1999 would not have a material adverse effect on the Company's business, financial condition or results of operation.
Additionally, if those commercial borrowers whose operations depend heavily on automated systems experience Year 2000 compliance problems affecting their ability to repay, the Company's financial condition and results of operations could be adversely affected by requirements to record additional loan loss provision. Furthermore, the Company faces financial risk from its fund providers as the Year 2000 problem may produce some deposit contraction forcing a change to alternative and higher costing funding sources. Finally, to the extent that certain utility and communication services utilized by the Company face Year 2000 problems, the Company's operations could be disrupted.
Contingency Plans. The Company believes that, with modifications to existing systems and conversions to new systems, the Year 2000 problem will not pose significant operational problems for the Company's systems as so modified and converted. The Company expects that the necessary modifications will be implemented prior to the Year 2000, although there can be no assurance that this will be the case. In the event that modifications are not completed prior to the Year 2000, the Company has developed contingency plans. However, there can be no assurance that these plans will fully mitigate any failures or problems. Furthermore, there may be certain mission critical third party services where alternative arrangements are limited or unavailable.
Expenses. Year 2000 Readiness Program expenses are absorbed within normal spending levels. The Company upgrades its hardware and associated software and invests in new information technology systems as part of its ongoing operations. Neither the upgrades, nor new investments made to date through December 31, 1998, have been accelerated due to the Year 2000 Readiness Program. Management currently estimates that out-of-pocket costs related to the Year 2000 Readiness Program will be less than $100,000. The Company's credit risk associated with borrowers may increase to the extent that borrowers fail to adequately address Year 2000 issues. As part of the Company's Year 2000 project, existing loans have been evaluated to identify and monitor those loans with the highest exposure to Year 2000 risk.
The Company currently expects that the total aggregate expenses to address the Year 2000 issue will not be material to the Company's consolidated results of operations, although as the Company proceeds with its implementation plan, there may be additional unforeseen costs, which may be significant.
The preceding "Year 2000 Readiness Disclosure" discussion contains various forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1933. These forward-looking statements represent the Company's beliefs or expectations regarding future events. When used in the "Year 2000 Readiness Disclosure" discussion, the words "believes," "expects," "estimates," and similar expressions are intended to identify forward-looking statements. Forward-looking statements include, without limitation, the Company's expectations as to when it will complete the modification and testing phases of its Year 2000 project plan as well as its Year 2000 contingency plans; its estimated cost of achieving Year 2000 readiness; and the Company's belief that its internal systems will be Year 2000 compliant in a timely manner. All forward-looking statements involve a number of risks and uncertainties that could cause the actual results to differ materially from the projected results. Factors that may cause these differences include, but are not limited to, the availability of qualified personnel and other information technology resources; the ability to identify and remediate all date sensitive lines of computer code or to replace embedded computer chips in affected systems or equipment; and the actions of governmental agencies or other third parties with respect to Year 2000 problems.
RISK FACTORS AND FACTORS AFFECTING FORWARD-LOOKING STATEMENTS
This Annual Report, including the information incorporated herein by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. The Company's actual results could differ materially from those projected in the forward-looking statements set forth in this Annual Report including the information incorporated herein by reference. Factors which may cause such a material difference include those set forth below. Investors in the Company's Common Stock should carefully consider the discussion of risk factors below, in addition to the other information contained in this Annual Report.
COMPETITION
The ability of the Bank to attract loans and deposits may be limited by its small size relative to its competitors. The Bank maintains a smaller staff and has fewer financial and other resources than larger institutions with which it competes in its market area.
In particular, in attempting to attract deposits and making loans, the Bank encounters competition from other institutions, including larger downtown Boston and suburban-based commercial banking organizations, savings banks, credit unions, other financial institutions and non-bank financial service companies serving eastern Massachusetts and adjoining areas. The principal modes of competition include the interest rates charged on loans, the interest rates paid on deposits, efforts to obtain deposits, the range of services provided and the quality of those services.
In this competitive environment, the Bank may be unable to attract sufficient and high-quality loans in order to continue its loan growth, which may materially adversely affect the Bank's results of operations and financial condition, including the level of its non-performing assets. The Bank's competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. In particular, the Bank's current commercial borrowing customers may develop needs for credit facilities larger than it can accommodate.
In addition, the ability of the Bank and Westfield to attract investment management and trust business may be inhibited by their relatively short history and limited record of performance. With respect to their investment management and trust services, the Bank and Westfield compete primarily with commercial banks and trust companies, mutual fund companies, investment advisory firms, stock brokerage firms, law firms and other financial companies. Competition is especially keen in the Bank's and Westfield's market area, because Boston has a well-established investment management industry. Many of the Bank's and Westfield's competitors have greater resources than the Company on a consolidated basis. In addition to competing directly for clients, competition can impact the fee structures of the Bank and Westfield. The Company believes that the ability of the Bank and Westfield to compete effectively with other firms is dependent upon their products, level of investment performance and client service, as well as the marketing and distribution of their investment products. There can be no assurance that the Bank and Westfield will be able to achieve favorable investment performance and retain their existing clients.
ASSET QUALITY
The success of bank holding companies, such as the Company, depends to a significant extent upon the quality of their assets. Non-performing assets of the Company, which include non-performing loans and real estate acquired through foreclosure proceedings and through acceptance of a deed in lieu of foreclosure (collectively, other real estate owned or "OREO"), can lead to charge-offs and an increase in the Bank's allowance for possible loan losses. Other adverse effects of non-performing assets include, but are not limited to, foregone interest income and increased operating expenses as a result of the allocation of management time and resources to the collection and work-out of these non-performing assets.
Management of the Bank determines the Bank's allowance for possible loan losses based on the facts and circumstances available to it at the time of determination. The net carrying value of OREO is determined by Management to equal the lower of (i) the assets' balances when transferred to OREO or (ii) the estimated net fair value, after reduction for estimated selling costs, of the property acquired. The allowance for possible loan losses, however, can only be estimated by the Company, based upon, among other things, the quality of the loan portfolio, economic conditions, the value of the underlying collateral and the level of non-accruing loans held by the Bank. Future provisions to the allowance for possible loan losses or provisions in carrying values of OREO could become necessary as a result of deterioration in the real estate market and/or the economy in the Company's primary market area, future increases in non-performing assets or for other reasons. Such provisions could adversely affect the Company's financial condition and results of operations.
In addition, bank regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for possible loan losses and the carrying value of its OREO. Such agencies could require the Bank to make further provisions to the allowance for possible loan losses and adjustments to the carrying values of OREO based on their judgments at the time of examination.
LOAN CONCENTRATIONS
The Bank's loans are concentrated with respect to geography, type of customer and type of collateral. Because the Bank serves primarily individuals and smaller businesses located in eastern Massachusetts and adjoining areas, with a particular concentration in the Greater Boston Metropolitan Area, the Bank's asset quality is affected by the economic conditions in these areas. The Bank's commercial loans are generally concentrated in the following customer groups: (i) real estate developers and investors, (ii) financial services, (iii) technology, manufacturing and communications, (iv) professional services and (v) general commercial, industrial and personal loans. The Bank's commercial loans, with limited exceptions, are secured by either real estate (income producing residential and commercial properties), marketable securities or corporate assets (accounts receivable, equipment and inventory). Substantially all of the Bank's residential mortgage and home equity loans are secured by residential property in eastern Massachusetts. Conditions in the real estate market specifically, and the Massachusetts economy generally, could impact the ability of these borrowers to service their loans in the future and/or the value of the collateral securing these loans. In addition, this loan concentration coupled with adverse economic conditions in the area could negatively impact the asset quality of the Company in future periods. See "--Asset Quality."
INTEREST RATE ENVIRONMENT
The general interest rate environment affects the Company's financial results. The Bank's main source of income from banking operations is its net interest income, which is defined as the difference between the interest income received on its interest-bearing assets, including loans and investment securities, and the interest expense incurred in connection with its interest-bearing liabilities, including deposits and borrowings. The Bank's net interest income can be affected significantly by changes in market interest rates. In particular, decreasing interest rates may reduce the Bank's net interest income as the spread between interest income and interest expense decreases. The Bank has adopted asset and liability management policies to minimize the potential adverse effects of changes in interest rates on its net interest income, primarily by altering the mix and maturity of the Bank's loans, investments and funding sources.
An increase in interest rates could also have a material adverse effect on the Company's results of operations by reducing the ability of its borrowers to service their current indebtedness, thereby increasing the Bank's delinquent and non-performing loans and necessitating further provisions to the Bank's allowance for possible loan losses.
SOURCES OF FUNDS
The Bank has traditionally obtained funds principally through deposits and through borrowings. The Bank's ability to obtain deposits depends upon general economic conditions, market interest rates and competitive pressures. Thus, in order to provide liquidity and flexibility to its operations, the Bank may have to rely more heavily on borrowings as a source of funds in the future.
Moreover, the volatility of the Bank's deposits may impact the Bank's overall liquidity. Historically and in comparison to commercial banking averages, the Bank has had a higher percentage of its time deposits in denominations of $100,000 or more. Within the banking industry, these deposits are generally considered to be volatile.
THE PERFORMANCE OF THE COMPANY MAY BE ADVERSELY AFFECTED BY CHANGES IN ECONOMIC AND MARKET CONDITIONS
The Company offers a broad range of investment management services and styles to institutional and retail investors. Consequently, the Company's performance is directly affected by conditions in the financial and securities markets.
The financial markets and the investment management industry in general have experienced record performance and record growth in recent years. The financial markets and businesses operating in the securities industry, however, are highly volatile and are directly affected by, among other factors, domestic and foreign economic conditions and general trends in business and finance, all of which are beyond the control of the Company. There can be no assurance that broader market performance will be favorable in the future. Any decline in the financial markets or a lack of sustained growth may result in a corresponding decline in performance by the Company and may adversely affect assets under management and/or fees earned by the Company.
THE COMPANY'S INVESTMENT MANAGEMENT CONTRACTS ARE SUBJECT TO TERMINATION ON SHORT NOTICE
Following the acquisition of Westfield in October 1997, the Company expects that more than 50% of its revenues will be derived from investment management contracts which are typically terminable upon less than 30 days' notice. Because of this, clients of the Company may withdraw funds from accounts under management generally in their sole discretion. In addition, the Company's contracts generally provide for fees payable for investment management services based on the market value of assets under management, although a portion also provide for the payment of fees based on investment performance. Because most contracts provide for a fee based on market values of securities, fluctuations in securities prices may have an adverse effect on the Company's consolidated results of operations and financial condition. Changes in the investment patterns of clients will also affect the total assets under management. In addition, in the case of contracts which provide for the payment of performance-based fees, the investment performance of the Company will affect the Company's results of operations and financial condition.
EXISTENCE OF REGISTRATION RIGHTS
The holders of 3,140,367 shares of Common Stock have the right in certain circumstances to require the Company to register up to 800,000 of their shares annually under the Securities Act for resale to the public, and the holders of 3,140,367 shares have the right to include their shares in a registration statement filed by the Company. These registration rights may enable such holders to publicly sell shares which would otherwise be ineligible for sale in the public market. The sale of a substantial number of shares of Common Stock into the public market, or the availability of such shares for future sale, could adversely affect the market price for the Common Stock and could impair the Company's ability to obtain additional capital in the future through an offering of equity securities should it desire to do so.
THE COMPANY'S INVESTMENT MANAGEMENT BUSINESS IS HIGHLY REGULATED
Each direct or indirect subsidiary of the Company which provides investment management services is highly regulated, primarily at the federal level. The failure of any such subsidiary to comply with applicable laws or regulations could result in fines, suspensions of individual employees or other sanctions, including revocation of such subsidiary's registration as an investment adviser. Both Westfield and Boston Private Asset Management, Inc., a wholly-owned subsidiary of the Bank ("BPAM"), are registered with the United States Securities and Exchange Commission (the "Commission") as investment advisers under the Investment Advisers Act of 1940, as amended (the "Investment Advisers Act"), and are subject to the provisions of the Investment Advisers Act and the Commission's regulations promulgated thereunder. The Investment Advisers Act imposes numerous obligations on registered investment advisers, including fiduciary, record keeping, operational and disclosure obligations. Both Westfield and BPAM as investment advisers are also subject to regulation under the securities laws and fiduciary laws of certain states. Westfield acts as a subadviser to a mutual fund which is registered with the Commission under the Investment Company Act of 1940, as amended (the "1940 Act"). As a subadviser to a registered investment company, Westfield is subject to requirements under the 1940 Act and the Commission's regulations promulgated thereunder. In addition, the Company is subject to the Employee Retirement Income Security Act of 1974 ("ERISA"), and to regulations promulgated thereunder, insofar as it is a "fiduciary" under ERISA with respect to certain of its clients. ERISA and the applicable provisions of the Internal Revenue Code of 1986, as amended (the "Code"), impose certain duties on persons who are fiduciaries under ERISA, and prohibit certain transactions involving the assets of each ERISA plan which is a client of the Company, as well as certain transactions by the fiduciaries (and certain other related parties) to such plans.
In addition, applicable law provides that the investment management contracts under which the Company manages assets for other parties either terminate automatically if assigned, or are not assignable unless the applicable client consents to the assignment. Assignment, as generally defined, includes direct assignments as well as assignments which may be deemed to occur, under certain circumstances, upon the direct or indirect transfer of a "controlling block" of the voting securities of the Company. Moreover, applicable law provides that all investment contracts with mutual fund clients may be terminated by such clients, without penalty, upon no later than 60 days' notice. Investment contracts with institutional and other clients are typically terminable by the client, also without penalty, upon 30 days' notice.
The Company itself does not manage investments for clients, does not provide any investment management services and, therefore, is not registered as an investment adviser under federal or state law.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE SENSITIVITY AND MARKET RISK
Management considers interest rate risk to be a significant market risk for the Company. Interest rate risk is the exposure to adverse changes in the net income of the Company as a result of changes in interest rates. Consistency in the Company's earnings is related to the effective management of interest rate sensitive assets and liabilities, and on the degree of fluctuation of investment management fee income due to changes in interest rates.
Fee income from investment management and trust services is not directly dependent on market interest rates and provides the Company a steady source of income in varying market interest rate environments. However, this fee income is generally based upon the value of assets under management and, therefore, can be significantly affected by changes in the values of equities and bonds. Furthermore, performance fees earned by Westfield as the general partner of limited partnerships are directly dependent upon short-term investment performance which can fluctuate significantly with changes in the capital markets.
The principal objective of the Bank's asset and liability management is to maximize profit potential while minimizing the vulnerability of its operations to changes in interest rates by means of managing the ratio of interest rate sensitive assets to interest rate sensitive liabilities within specified maturities or repricing dates. The Bank's actions in this regard are taken under the guidance of its Asset/Liability Committee ("ALCO"), which is comprised of members of senior management. This committee is actively involved in formulating the economic assumptions that the Bank uses in its financial planning and budgeting process and establishes policies which control and monitor the sources, uses and pricing of funds. The Bank evaluates hedging techniques to reduce interest rate risk where possible; however, no off-balance sheet hedging activities have been used to date.
The ALCO uses both interest rate "gap" sensitivity and simulation analysis to measure inherent risk in the bank's balance sheet at a specific point in time. The simulations look forward at one and two year increments with instantaneous and sustained interest rate shocks of up to 200 basis points, and take into account the repricing, maturity, and prepayment characteristics of individual products and investments. The simulation results are reviewed to determine whether the exposure to net interest income and to the fair value of the available for sale investment portfolio is within the guidelines which are set and monitored at both the ALCO and Board levels. The ALCO committee reviews the results with regard to the established tolerance levels and recommends appropriate strategies to manage this exposure. As of December 31, 1998, net interest income simulation and fair market value simulation indicated that the Bank's exposure to changing interest rates was within the established tolerance levels. While the ALCO reviews simulation assumptions to ensure that they reflect historical experience, it should be noted that income simulation may not always prove to be an accurate indicator of interest rate risk because the actual repricing, maturity, and prepayment characteristics of individual products may differ from the estimates used in the simulations.
The following table presents the impact of instantaneous and sustained interest rate shocks on pro forma net interest income over a twelve month period:
The Bank also uses interest rate sensitivity "gap" analysis to provide a general overview of the Bank's interest rate risk profile. The effect of interest rate changes on the assets and liabilities of a financial institution may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest rate sensitivity gap. An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net income. During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely.
The Bank has historically sought to maintain a relatively narrow gap position and has, in some instances, foregone investment in higher yielding assets when such investment, in management's opinion, exposed the Bank to undue interest rate risk. However, the Bank does not attempt to perfectly match interest rate sensitive assets and liabilities and will indeed selectively mismatch its assets and liabilities to a controlled degree when it considers it both appropriate and prudent to do so. There are a number of relevant time periods in which to measure the gap position, such as at the 30, 60, 90, or 180 day points in the maturity schedule. Management monitors the Bank's gap position at each of these maturity points, and also tends to focus closely on the gap at the one year point in making its principal funding decisions, such as with respect to the Bank's one year adjustable rate mortgage loan portfolio.
The repricing schedule for the Bank's interest-earning assets and interest-bearing liabilities is based on actual cash flows and repricing characteristics, and incorporates market-based assumptions regarding the impact of changing interest rates on the prepayment speeds of certain assets and liabilities. The schedule also includes senior management projections for activity levels in product lines offered by the Bank. Assumptions based on the historical behavior of deposit rates and
balances in relation to changes in interest rates are also incorporated into the repricing schedule. These assumptions are inherently uncertain and, as a result, the repricing schedule cannot precisely measure net interest income or predict the impact of fluctuations in interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
The following table presents the repricing schedule for the Company's interest-earning assets and interest-bearing liabilities at December 31, 1998:
(1) Adjustable and floating-rate assets are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due, and fixed rate loans are included in the periods in which they are scheduled to mature. (2) Does not include $47.8 million of demand accounts because they are non-interest bearing. (3) While Savings and NOW accounts can be withdrawn at any time, management believes they contain characteristics which make their effective maturity longer.
The preceding table does not necessarily indicate the impact of general interest rate movements on the Bank's net interest income because the repricing of various assets and liabilities is discretionary and is subject to competitive and other factors. As a result, assets and liabilities indicated as repricing within the same period may in fact reprice at different times and at different rate levels.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
The Board of Directors Boston Private Financial Holdings, Inc.:
We have audited the accompanying consolidated balance sheets of Boston Private Financial Holdings, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the years in the three year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Boston Private Financial Holdings, Inc. and subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1998, in conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
Boston, Massachusetts January 19, 1999
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) ORGANIZATION
Boston Private Financial Holdings, Inc. (the "Company") is a holding company which owns all of the issued and outstanding shares of common stock of Boston Private Bank & Trust Company (the "Bank"), a Massachusetts chartered trust company, and Westfield Capital Management Company Inc. ("Westfield"), a registered investment advisor. On October 31, 1997, the Company acquired Westfield, a Massachusetts corporation engaged in providing a range of investment management services to individual and institutional clients, in exchange for 3,918,367 newly issued shares of the Company's common stock. The acquisition was accounted for as a "pooling of interests". Accordingly, the results of operations of the Company reflect the financial position and results of operations on a consolidated basis. On July 31, 1995, the Company acquired substantially all of the assets and assumed certain liabilities of an investment management business for a total purchase price of approximately $4.2 million, of which $2.1 million, consisting of $1.5 million in cash and 166,667 shares of the Company's common stock, was paid at closing. In each of January and July 1996 and 1997, the Company made additional scheduled payments consisting of $375,000 in cash and 41,667 shares of the Company's common stock. The acquisition was accounted for as a purchase. Accordingly, the results of operations of the acquired business have been included with those of the Company subsequent to the date of acquisition. The Company conducts substantially all of its business through its wholly-owned subsidiaries, the Bank and Westfield.
The Bank pursues a "private banking" business strategy and is principally engaged in providing banking, investment and fiduciary products to high net worth individuals, their families and businesses in the greater Boston area and New England and, to a lesser extent, Europe and Latin America. The Bank seeks to anticipate and respond to the financial needs of its client base by offering high quality products, dedicated personal service and long-term banking relationships. The Bank offers its clients a broad range of basic deposit services, including checking and savings accounts, with automated teller machine ("ATM") access, and cash management services through sweep accounts and repurchase agreements. The Bank also offers commercial, residential mortgage, home equity and consumer loans. In addition, it provides investment advisory and asset management services, securities custody and safekeeping services, trust and estate administration and IRA and Keogh accounts.
Westfield serves the investment management needs of high net worth individuals and institutions with endowments or retirement plans in the greater Boston area, New England, and other areas of the U.S. It also acts as the managing general partner for three limited partnerships that invest according to the mandates in the partnership agreements.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of the Company conform to generally accepted accounting principles and to prevailing industry practices. The following is a summary of the significant accounting and reporting policies used by management in preparing and presenting the consolidated financial statements.
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, the Bank and Westfield. The Bank's consolidated financial statements include the accounts of its wholly-owned subsidiaries, BPB Securities Corporation and Boston Private Asset Management Corporation. All significant intercompany accounts and transactions have been eliminated in consolidation.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ from those estimates. Material estimates related to the determination of the allowance for loan losses are particularly susceptible to change. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current year's presentation.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Statement of Cash Flows
For purposes of reporting cash flows, the Company considers cash and due from banks to be cash equivalents. Cash flows relating to short term investments with original maturities of less than 90 days, loans, and deposits are presented net in the statements of cash flows.
Cash and Due From Banks
The Bank is required to maintain average reserve balances in a non-interest bearing account with the Federal Reserve Bank based upon a percentage of certain deposits. As of December 31, 1998, the daily amount required to be held was $1.2 million.
Investment and Mortgage-Backed Securities
Investment and mortgage-backed securities are classified as held to maturity, available for sale, or trading. Securities classified as held to maturity are carried at amortized cost only if the Company has a positive intent and the ability to hold these securities to maturity. Securities classified as trading are carried at fair value, with unrealized gains and losses included in earnings, if they are bought and held principally for the purpose of selling in the near term. Securities not classified as either held to maturity or trading are classified as available for sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as other comprehensive income, net of estimated income taxes.
During the quarter ended September 30, 1998, the Bank reconsidered its intent to hold investments until maturity. As a result, investment and mortgage-backed securities classified as held to maturity with an amortized cost of $17.9 million and an unrealized gain of $170,000 at September 30, 1998 were reclassified as available for sale. As of December 31, 1998, all of the Company's investment and mortgage-backed securities were classified as available for sale.
Premiums and discounts on investment and mortgage-backed securities are amortized or accreted into income by a method which approximates the level-yield method. Actual prepayment experience is reviewed periodically and the timing of the accretion and amortization is adjusted accordingly. If a decline in fair value below the amortized cost basis of an investment or mortgage-backed security is judged to be other than temporary, the cost basis of the investment is written down to fair value. The amount of the writedown is included as a charge against gain on sale of investment and mortgage-backed securities. Gains and losses on the sale of investment and mortgage-backed securities are recognized at the time of sale on a specific identification basis.
Loans
Impaired loans are loans for which it is probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreements. Impaired loans are accounted for at the present value of the expected future cash flows discounted at the loan's effective interest rate, except those loans that are accounted for at fair value or at the lower of cost or fair value. Accrual of interest income is discontinued and all interest previously accrued but not collected is reversed against current period income when a loan is classified as impaired. Interest received on impaired loans is either applied against principal or reported as income according to management's judgment as to the collectibility of principal. At December 31, 1998 and 1997, the amount of impaired loans was immaterial.
Loans on which the accrual of interest has been discontinued are designated nonaccrual loans. Accrual of interest income on loans is discontinued when concern exists as to the collectibility of principal or interest. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period income. Loans are removed from nonaccrual status when they become less than ninety days past due and when concern no longer exists as to the collectibility of principal or interest. Interest received on nonaccruing loans is either applied against principal or reported as income according to management's judgment as to the collectibility of principal.
Loan origination fees, net of related direct incremental loan origination costs, are deferred and recognized into income over the contractual lives of the related loans as an adjustment to the loan yield, using a method which approximates the level-yield method. When a loan is sold or paid off, the unamortized portion of net fees is recognized into income.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Allowance for Loan Losses
The allowance for loan losses is established through a charge to operations. When management believes that the collectibility of a loan's principal balance is unlikely, the principal amount is charged against the allowance. Recoveries on loans which have been previously charged off are credited to the allowance as received.
The allowance for loan losses is determined using a systematic analysis and procedural discipline based on historical experience, product types, and industry benchmarks. The allowance is segregated into three components; "general", "specific" and "unallocated". The general component is determined by applying coverage percentages to groups of loans based on risk ratings and product types. A system of periodic loan reviews is performed to individually assess the inherent risk and assign risk ratings to each loan. Coverage percentages applied are determined based on industry practice and management's judgement. The specific component is established by allocating a portion of the allowance for loan losses to individual classified loans on the basis of specific circumstances and assessments. The unallocated component supplements the first two components based on management's judgement of the effect of current and forecasted economic conditions on the borrowers' abilities to repay, an evaluation of the allowance for loan losses in relation to the size of the overall loan portfolio, and consideration of the relationship of the allowance for loan losses to nonperforming loans, net charge-off trends, and other factors. While this evaluation process utilizes historical and other objective information, the classification of loans and the establishment of the allowance for loan losses relies to a great extent on the judgement and experience of management.
While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution's allowance for loan losses. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
Premises and Equipment
Premises and equipment are carried at cost, less accumulated depreciation and amortization. Depreciation and amortization is computed primarily by the straight-line method over the estimated useful lives of the assets, or the terms of the leases if shorter.
Excess of Cost Over Net Assets Acquired
The excess of cost over net assets acquired is being amortized to expense using the straight-line method over 15 years. On an ongoing basis, management reviews the valuation and amortization of its intangible assets, taking into consideration any events and circumstances that might have diminished their value. During 1995, the acquisition of an investment management company generated additions to intangible assets of $4.3 million. Accumulated amortization amounted to $1.4 million, $1.1 million, and $763,000 at December 31, 1998, 1997 and 1996, respectively.
Investment Management and Trust Assets
Investment management and trust assets amounted to $2.6 billion and $2.2 billion at December 31, 1998 and 1997, respectively. These assets are not included in the consolidated financial statements because they are held in a fiduciary or agency capacity and are not assets of the Company.
Employee Benefits
The Company maintains a Section 401(k) savings plan (the "401(k) Plan") for employees of the Company and the Bank. Under the plan, the Company makes a matching contribution of one-half of the amount contributed by each participating employee, up to 6% of the employee's yearly salary. The Company's contributions are charged against current operations in the year they are made.
The Company maintains a defined contribution profit-sharing plan (the "Profit Sharing Plan") for the employees of Westfield. The annual contribution to the plan is determined by the Board of Directors of Westfield.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The Company measures compensation cost for stock-based compensation plans as the difference between the exercise price of options granted and the fair market value of the Company's stock at the grant date. The Company discloses proforma net income and earnings per share in the notes to their consolidated financial statements as if compensation cost was measured at the grant date based on the value of the award and recognized over the service period.
Income Taxes
The Company recognizes income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are established for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income during the period that includes the enactment date.
Earnings Per Share
Basic earnings per share ("EPS") excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. 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 or resulted in the issuance of common stock that then shared in the earnings of the entity.
The following table is a reconciliation of the numerators and denominators of basic and diluted EPS computations for the years ended December 31.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". This Statement establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge. Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk. This Statement is effective for fiscal years beginning after June 15, 1999, and is not expected to have a material impact on the Company's consolidated financial statements.
In October, 1998, the FASB issued SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of FASB Statement No. 65." This Statement requires that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. This Statement was adopted on January 1, 1999, and did not have a material effect on the Company's consolidated financial statements.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(3) COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards ("SFAS") No.130, "Reporting Comprehensive Income." This Statement establishes standards for reporting and display of comprehensive income and its components in financial statements. Comprehensive income is defined by the Statement as net income plus revenues, expenses, gains, and losses that under generally accepted accounting principles are excluded from net income. This Statement requires that an entity classify items of comprehensive income by their nature in the financial statements, and display the accumulated balance of comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. This Statement only affects presentation in the financial statements, it has no impact on the Company's results of operations.
The Company's other comprehensive income (loss) and related tax effects for the years ended December 31, 1998, 1997, and 1996 is as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(4) BUSINESS SEGMENTS
Management Reporting
The Company has two reportable segments, the Bank and Westfield. The financial performance of the Company is managed and evaluated by business segment. The segments are managed separately because each business is a company with different clients, employees, systems, risks, and marketing strategies.
Description of Business Segments
The Bank pursues a "private banking" business strategy and is principally engaged in providing banking, investment and fiduciary products to high net worth individuals, their families and businesses in the greater Boston area and New England and, to a lesser extent, Europe and Latin America. The Bank offers its clients a broad range of basic deposit services, including checking and savings accounts, with automated teller machine ("ATM") access, and cash management services through sweep accounts and repurchase agreements. The Bank also offers commercial, residential mortgage, home equity and consumer loans. In addition, it provides investment advisory and asset management services, securities custody and safekeeping services, trust and estate administration and IRA and Keogh accounts. The Bank's investment management emphasis is on large-cap equity and actively managed fixed income portfolios.
Westfield serves the investment management needs of high net worth individuals and institutions with endowments or retirement plans in the greater Boston area, New England, and other areas of the U.S. Westfield specializes in growth equity portfolios with a particular focus on identifying and managing small and mid-cap equity positions. It also acts as the managing general partner for three limited partnerships, one invests primarily in technology stocks, another invests primarily in small capitalization equities and a third that was started in June 1998, invests primarily in midcap equities.
Measurement of Segment Profit and Assets
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Revenues, expenses, and assets are recorded by each segment, and separate financial statements are reviewed by management. In addition to direct expenses, each business segment is allocated a share of holding company expenses based on the segment's percentage of consolidated net income.
Reconciliation of Reportable Segment Items
The following tables are a reconciliation of the revenues, net income, assets, and other significant items of reportable segments as of and for the years ended December 31, 1998, 1997, and 1996.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(5) INVESTMENT SECURITIES
A summary of investment securities follows:
The following table sets forth the maturities of investment securities available for sale at December 31, 1998 and the weighted average yields of such securities:
The weighted average remaining life of investment securities available for sale at December 31, 1998 was 2.0 years. As of December 31, 1998, approximately $6.5 million of investment securities available for sale were callable before maturity.
The following table presents the sale of investment securities with the resulting realized gains, losses, and net proceeds from such sales:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(6) MORTGAGE-BACKED SECURITIES
A summary of mortgage-backed securities follows:
The following table sets forth the maturities of mortgage-backed securities at December 31, 1998 and the weighted average yields of such securities:
These securities have final maturities ranging from 1.25 to 25.3 years. The weighted average remaining life of mortgage-backed securities was 16.3 years as of December 31, 1998. Expected maturities will differ from contractual maturities because borrowers may repay obligations without prepayment penalties.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(7) LOANS
The Company's lending activities are conducted principally in the Boston Metropolitan Area and, to a lesser extent, elsewhere in Massachusetts and New England. The Company originates single and multi-family residential loans, commercial real estate loans, commercial loans and consumer loans (principally home equity loans). Most loans made are secured by borrowers' personal or business assets. The ability of the Company's single family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the lending area. Commercial borrowers' ability to repay is generally dependent upon the health of the economy and the real estate sector in particular. Accordingly, the ultimate collectibility of a substantial portion of the Company's loan portfolio is susceptible to changing conditions in the New England economy. As of December 31, 1998, the Company had $68.2 million of fixed rate loans and $280.8 million of variable rate loans outstanding.
The Company's lending limit to any single borrower is limited by regulation to approximately $5.8 million. The Bank had no relationships with an individual borrower at December 31, 1998 which were in excess of the legal lending limit established for Massachusetts state-chartered banks. Mortgage loans serviced for others totaled $1.3 million and $2.6 million at December 31, 1998 and 1997, respectively.
Loans outstanding to executive officers and directors of the Company aggregated $3.6 million and $293,000 at December 31, 1998 and 1997, respectively. An analysis of the activity of these loans is as follows:
All loans included above were made in the ordinary course of business under normal credit terms, including interest rates and collateral, prevailing at the time of origination for comparable transactions with other persons, and do not represent more than normal credit risk.
The following table presents a summary of risk elements within the loan portfolio:
(8) ALLOWANCE FOR LOAN LOSSES
An analysis of the activity in the allowance for loan losses is as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(9) PREMISES AND EQUIPMENT
Premises and equipment consisted of the following:
Depreciation and amortization expense was $678,000, $624,000, and $417,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Rent expense for the years ended December 31, 1998, 1997 and 1996 was $1.1 million, $848,000, and $594,000 respectively. In October 1994, the Company executed a lease for the premises located at Ten Post Office Square, Boston, Massachusetts, which is the headquarters of the Bank. The lease for this space, which expires in February 2005, initially provided for 19,661 square feet, two five-year options to renew and a number of options for future expansion. In December, 1996, the Company executed a lease amendment for an additional 7,308 square feet of space at this location.
In January 1996, Westfield executed a lease for 11,320 square feet of office space at One Financial Center which expires in August 2001 and is renewable for an additional five years. Approximately 13% of this space is subleased to a tenant under a noncancellable operating lease, which expires in August 2001. Rental income from this sublease agreement was $47,000 for the years ended December 31, 1998, 1997 and 1996.
In November 1997, the Bank executed a lease for a 6,216 square foot building at 336 Washington Street, Wellesley, Massachusetts. This lease for this office expires in October 2012, and contains three five year options for renewal.
The Company is obligated for minimum rental payments under these noncancellable operating leases. In accordance with the terms of these leases, the Company is currently committed to minimum annual rent as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(10) DEPOSITS
Deposits are summarized as follows:
Interest expense on certificates of deposit greater than $100,000 was $2.8 million, $2.4 million, and $2.2 million for the years ended December 31, 1998, 1997, and 1996, respectively.
(11) SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
The Company enters into sales of securities under agreements to repurchase with clients and brokers. These agreements are treated as financings, and the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets. The securities underlying the agreements remain under the Company's control. Information concerning securities sold under agreements to repurchase is as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(12) FEDERAL HOME LOAN BANK BORROWINGS
A summary of borrowings from the Federal Home Loan Bank of Boston ("FHLB") is as follows:
Borrowings from the Federal Home Loan Bank of Boston are secured by the Bank's stock in the FHLB and a blanket lien on "qualified collateral" defined principally as 90% of the market value of U.S. Government and federal agency obligations and 75% of the carrying value of certain residential mortgage loans. Unused borrowings with the FHLB at December 31, 1998 were $58.4 million. The Bank had additional short-term federal fund lines with the FHLB and correspondent banks of $35.5 million at December 31, 1998. As of December 31, 1998, there were no federal funds purchased.
As a member of the FHLB, the Bank is required to invest in the common stock of the FHLB in the amount of one percent of its outstanding loans secured by residential housing, or three tenths of one percent of total assets, or five percent of its outstanding advances from the FHLB, whichever is highest. As and when such stock is redeemed, the Bank would receive from the FHLB an amount equal to the par value of the stock. As of December 31, 1998, the Bank's FHLB stock holdings totaled $4.7 million. The Bank's investment in FHLB stock is recorded at cost, and is redeemable at par.
(13) INCOME TAXES
The components of income tax expense (benefit) are as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The difference between the statutory federal income tax rate and the effective federal income tax rate is as follows:
The components of gross deferred tax assets and gross deferred tax liabilities are as follows:
Management believes the existing net deductible temporary differences that give rise to the net deferred tax asset will reverse in periods the Company generates net taxable income. The Company would need to generate approximately $3.2 million of future net taxable income to realize the net deferred tax asset at December 31, 1998. Management believes that it is more likely than not that the net deferred tax asset will be realized based on the generation of future taxable income.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(14) EMPLOYEE BENEFITS
Employee 401(k) Plan
The Company maintains the 401(k) Plan for the benefit of employees at the Company and the Bank which qualifies as a tax exempt plan and trust under Sections 401 and 501 of the Internal Revenue Code. Generally, employees who are at least twenty-one (21) years of age and have completed one year of service are eligible to participate in the 401(k) Plan. Expenses associated with the 401(k) Plan were $153,000, $100,000, and $93,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Profit Sharing Plan
The Company maintains the Profit Sharing Plan for the benefit of employees of Westfield which qualifies as a tax exempt plan under Section 401 of the Internal Revenue Code. Generally, employees who are at least twenty-one (21) years of age and have completed one year of service are eligible to participate in the Profit Sharing Plan. Expenses associated with the Profit Sharing Plan were $288,000, $288,000, and $258,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Stock Option Plans
The Company offers options on its common stock to officers, key employees, and directors under an Incentive Stock Option Plan and a Directors' Stock Option Plan. The Company accounts for these plans by measuring compensation at the grant date as the difference between the fair market value of the Company's stock and the exercise price of the options granted. Accordingly, no compensation cost has been charged against income. Had compensation cost been determined consistent with a fair value based approach, the Company's net income and earnings per share would have been reduced to the proforma amounts indicated below.
Under the 1997 Incentive Stock Option Plan, the Company may grant options to its employees for an amount not to exceed 4% of the number of shares of common stock outstanding as of the previous year-end. Under the Directors' Stock Option Plan, the Company may grant options to its non-employee directors for up to 200,000 shares of common stock. Under both plans, the exercise price of each option equals the market value of the stock on the date the options are granted, and all options expire ten years from the date granted. Generally, options vest over a three year period after the grant date under the 1997 Incentive Stock Option Plan. Under the Directors' Stock Option Plan, options generally vest one year after the grant date.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996: expected life of 7 years; expected volatility of 37% in 1998, 40% in 1997, and 40% in 1996, and risk-free interest rates of 5.7% in 1998, 5.3% in 1997, and 6.1% in 1996.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
A summary of the status of the Company's two fixed stock option plans as of December 31, 1998, 1997, and 1996, and changes during the years then ended is presented below.
The following table summarizes information about fixed stock options outstanding at December 31, 1998.
(15) OTHER OPERATING EXPENSE
Major components of other operating expense are as follows:
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(16) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is 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 commitments to originate loans, unused lines of credit and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Financial instruments with off-balance sheet risk are summarized as follows:
Commitments to originate loans and unused lines of credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
(17) FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by using available quoted market information or other appropriate valuation methodologies. The aggregate fair value amounts presented do not represent the underlying value of the Company taken as a whole.
The fair value estimates provided are made at a specific point in time, based on relevant market information and the characteristics of the financial instrument. The estimates do not provide for any premiums or discounts that could result from concentrations of ownership of a financial instrument. Because no active market exists for some of the Company's financial instruments, certain fair value estimates are based on subjective judgments regarding current economic conditions, risk characteristics of the financial instruments, future expected loss experience, prepayment assumptions, and other factors. The resulting estimates involve uncertainties and therefore cannot be determined with precision. Changes made to any of the underlying assumptions could significantly affect the estimates.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The book values and fair values for the Company's financial instruments are as follows:
Cash and due from banks
The carrying values reported in the balance sheet for cash and due from banks approximate the fair value because of the short maturity of these instruments.
Federal funds sold
The carrying values reported in the balance sheet for federal funds sold approximate the fair value because of the short maturity of these instruments.
Stock in the Federal Home Loan Bank of Boston
The fair value of stock in the FHLB equals the carrying value reported in the balance sheet. This stock is redeemable at full par value only by the FHLB.
Investment and mortgage-backed securities
The fair values presented for investment and mortgage-backed securities are based on quoted bid prices received from a third party pricing service.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Loans receivable
Fair value estimates are based on loans with similar financial characteristics. Loans have been segregated by homogenous groups into commercial, residential mortgage, home equity and other loans. Fair values of commercial and residential mortgage loans are estimated by discounting contractual cash flows adjusted for prepayment estimates and using discount rates approximately equal to current market rates on loans with similar characteristics and maturities. The incremental credit risk for non-performing loans has been considered in the determination of the fair value of loans. The fair value estimated for home equity and other loans equals their carrying value because of the floating rate nature of these loans.
Deposits
The fair values reported for demand deposits, NOW, savings, and money market accounts are equal to their respective book values reported on the balance sheet. The fair values disclosed are, by definition, equal to the amount payable on demand at the reporting date. The fair values reported for certificates of deposit are based on the discounted value of contractual cash flows. The discount rates used are representative of approximate rates currently offered on certificates of deposit with similar remaining maturities.
FHLB borrowings
The fair value reported for FHLB borrowings is estimated based on the discounted value of contractual cash flows. The discount rate used is based on the Company's estimated current incremental borrowing rate for FHLB borrowings of similar maturities.
Securities sold under agreements to repurchase
The carrying values reported in the balance sheet for repurchase agreements approximate fair value because of the short-term nature of these instruments.
Other short-term borrowings
The fair value reported for other short-term borrowings is estimated based on the discounted value of contractual cash flows. The discount rate used is based on the Company's estimated current incremental borrowing rate for debt of similar maturities.
Accrued interest receivable and payable
The carrying values for accrued interest receivable and payable approximate fair value because of the short-term nature of these financial instruments.
Financial instruments with off-balance sheet risk
The Company's commitments to originate loans, and for unused lines and outstanding letters of credit are primarily at market interest rates and therefore there is no fair value adjustment.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(18) BOSTON PRIVATE FINANCIAL HOLDINGS, INC. (PARENT COMPANY ONLY)
CONDENSED BALANCE SHEETS
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
CONDENSED STATEMENTS OF CASH FLOWS
(19) REGULATORY MATTERS
The Company and its subsidiaries are subject to extensive regulation and examination by the Massachusetts Commissioner of Banks and by the Federal Deposit Insurance Corporation ("FDIC"), which insures its deposits to the maximum extent permitted by law, and to certain requirements established by the Federal Reserve Board. The federal and state laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds, and the nature and amount of collateral for certain loans. The laws and regulations governing the Bank generally have been promulgated to protect depositors and not for the purpose of protecting stockholders. The Bank was last examined by the FDIC in January of 1997 and by the Massachusetts Commissioner of Banks in March 1998. The Company was examined by the Federal Reserve Bank of Boston in September 1997.
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Current Federal Deposit Insurance Corporation regulations regarding capital requirements of FDIC-insured institutions require banks to maintain a leverage capital ratio of at least 3% and a qualifying total capital to risk-weighted assets of at least 8%, of which at least 4% must be Tier I capital. Tier I capital is defined as common equity and retained earnings, less goodwill, and is compared to Total Risk Weighted Assets. Assets and off-balance-sheet items are assigned to four risk categories, each with appropriate weights. The resulting capital ratio represents Tier I capital as a percentage of risk-weighted assets and off-balance-sheet items. The risk-based capital rules are designed to make regulatory capital more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance-sheet exposure and to minimize disincentives for holding liquid assets. As of December 31, 1998, management believes that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 1998, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
Actual capital amounts and regulatory capital requirements as of December 31, 1998 and 1997 are presented in the tables below.
Bank regulatory authorities restrict the Bank from lending or advancing funds to, or investing in the securities of, the Company. Further, these authorities restrict the amounts available for the payment of dividends by the Bank to the Company.
BOSTON PRIVATE FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(20) LITIGATION
In January 1994, the Bank became aware of a dispute among various parties involved in a transaction in which it served as bank of deposit for certain certificates stated to reflect debt obligations of a foreign bank. In December 1994, the party which allegedly purchased the certificates filed a complaint in the United States District Court for the District of Massachusetts alleging certain claims arising out of the transaction against numerous individuals and entities, including the Bank and one of its former officers. The plaintiff sought to recover compensatory damages of approximately $4 million.
In August 1995, the Bank filed for summary judgment against the plaintiff's claims. The plaintiff also filed a motion for partial summary judgment on one of its claims. On March 19, 1996, the court granted the Bank's summary judgment motion and denied the plaintiff's motion, resulting in the dismissal of all claims against the Bank. The plaintiff sought reconsideration of its motion, and on November 26, 1996, the court denied plaintiff's motion for reconsideration of the summary judgment previously granted in favor of the Bank.
Notwithstanding the Court's dismissal of the underlying claims against the Bank and its denial of the plaintiff's motion for reconsideration, litigation continues among other parties. The deadline for an appeal by plaintiff has not yet expired because no judgment has been obtained for or against the other defendants remaining in the case. The Bank continues to believe it has valid defenses to, and will vigorously defend, all claims and allegations of wrongdoing in connection with the transaction. The Company incurred legal expenses of approximately $4,000 net of recoveries under an insurance policy during 1998. No further estimate of any loss can be made at this time.
The Company is also involved in routine legal proceedings occurring in the ordinary course of business. In the opinion of management, final disposition of these proceedings will not have a material adverse effect on the financial condition or results of operations of the Company.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
The information called for by Items 10-13 of Part III of Form 10-K is incorporated herein by reference to the Company's Definitive Proxy Statement for the 1999 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days after December 31, 1998.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) FINANCIAL STATEMENTS AND EXHIBITS
(1) FINANCIAL STATEMENTS PAGE NO.
a) Consolidated Balance Sheets 35
b) Consolidated Statements of Operations 36
c) Consolidated Statements of Changes in Stockholders' Equity 37
d) Consolidated Statements of Cash Flows 38
e) Notes to Consolidated Financial Statements 40
(2) FINANCIAL SCHEDULES
None.
(3) EXHIBITS
EXHIBIT NO. DESCRIPTION
3.1(i) Articles of Organization are incorporated herein by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K filed with the Commission on May 27, 1994 (the "Form 8-K").
3.1(ii) By-Laws of the Company are incorporated herein by reference to Exhibit 3.2 to Form 8-K.
4.1 Instruments Defining the Rights of Security Holders, including Indentures are incorporated herein by reference to the Articles of Organization and the By-Laws of the Company set forth in Exhibits 3.1 and 3.2 to Form 8-K.
10.1 Employee Incentive Stock Option Plan is incorporated herein by reference to Exhibit 10.5 to the Company's Registration Statement on Form S-1 filed with the Commission on April 1, 1991 (33-39690) (the "Form S-1").
10.2 Employee Incentive Compensation Plan is incorporated herein by reference to Exhibit 10.6 to the Form S-1.
10.3 Directors' Stock Option Plan adopted May 26, 1993, as amended March 15, 1995, is incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-KSB for the fiscal year ended December 31, 1996 filed with the Commission on March 25, 1997.
10.4 Employment Agreement dated January 1, 1996 by and among the Company, the Bank and Timothy L. Vaill is incorporated herein by reference to Exhibit 10.4 to the Company's Form 10-KSB for the year ended December 31, 1996 filed with the Commission on March 25, 1997.
10.5 Commercial Lease dated October 31, 1994, by and between the Company and Leggat McCall Properties Management, Inc. incorporated herein by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1994.
10.6 Asset Purchase Agreement dated as of June 16, 1995 by and among the Company and the stockholders of CH&P, Inc., is incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the Commission on June 28, 1995.
10.7 Agreement and Plan of Merger dated August 13, 1997, by and among the Company, Boston Private Investment Management Inc., and the stockholders of Westfield, is incorporated herein by reference to the Company's current report on Form 8-K filed with the Commission on August 21, 1997.
10.8 Employment agreement dated August 13, 1997 by and among the Company, Westfield, and Arthur J. Bauernfeind is incorporated herein by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1997 filed with the Commission on February 27, 1998 ("Form 10-KSB").
10.9 Employment agreement dated August 13, 1997 by and among the Company, Westfield, and C. Michael Hazard is incorporated herein by reference to Exhibit 10.8 of Form 10-KSB.
21 Subsidiaries of the Company are incorporated herein by reference to Exhibit 22.0 to Form S-1.
23.1 Independent Auditors' Consent.* 67
27 Financial Data Schedule.* 68
- ----------------- * Filed herewith.
(b) Reports on Form 8-K
The Company did not file any reports on Form 8-K during the fourth quarter ended December 31, 1998.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 25th day of February, 1999.
Boston Private Financial Holdings, Inc.
By: /s/ Timothy L. Vaill ------------------------------------- Timothy L. Vaill President and Chief Executive Officer (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities on the date indicated.
/s/ Timothy L. Vaill Chairman of the Board, February 25, 1999 - ----------------------------- President and Chief Timothy L. Vaill Executive Officer
/s/ Walter M. Pressey Executive Vice President February 25, 1999 - ----------------------------- and Chief Financial Walter M. Pressey Officer (Principal Financial Officer)
/s/ Charles O. Wood, III Lead Director February 25, 1999 - ----------------------------- Charles O. Wood, III
/s/ Herbert S. Alexander Director February 25, 1999 - ----------------------------- Herbert S. Alexander
/s/ Arthur J. Bauernfeind Director February 25, 1999 - ----------------------------- Arthur J. Bauernfeind
/s/ Eugene S. Colangelo Director February 25, 1999 - ----------------------------- Eugene S. Colangelo
/s/ C. Michael Hazard Director February 25, 1999 - ----------------------------- C. Michael Hazard
/s/ Lynn Thompson Hoffman Director February 25, 1999 - ----------------------------- Lynn Thompson Hoffman
/s/ E. Christopher Palmer Director February 25, 1999 - ----------------------------- E. Christopher Palmer
/s/ Robert A. Radloff Director February 25, 1999 - ----------------------------- Robert A. Radloff
/s/ Dr. Allen Sinai Director February 25, 1999 - ----------------------------- Dr. Allen Sinai