U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-KSB
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2003
Commission File No.: 01-13465
FALMOUTH BANCORP, INC.
(Name of small business issuer in its charter)
Delaware 04-3337685
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20 Davis Straits, Falmouth, Massachusetts 02540
(Address of principal executive offices)
(508) 548-3500
(Issuer's Telephone Number)
Securities registered pursuant to section 12(g) of the Exchange Act:
Name of Each Exchange
Title of each class on Which Registered:
------------------- ---------------------
Common Stock, par value $0.01 per share American Stock Exchange
Check whether the issuer (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past
90 days.
Yes X No
----- -----
Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B is not contained in this form, and no disclosure
will be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of
this Form 10-KSB or any amendment to this Form 10-KSB. [ ]
The revenues for the issuer's fiscal year ended September 30, 2003
were $7,862,818.
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which
the common equity was sold, as of a specified date within the last 60 days.
On December 1, 2003: $21,767,972.
State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date. The Company had 914,827
shares outstanding as of December 1, 2003.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement pursuant to Regulation 14A,
which was delivered to the Commission for filing on December 17, 2003, and
the 2003 Annual Report to Stockholders for the fiscal year ended September
30, 2003, are incorporated by reference into Part II and III of this report.
Transitional Small Business Disclosure Format (check one):
Yes No X
----- -----
TABLE OF CONTENTS
Page
----
FORWARD LOOKING STATEMENTS i
PART I
ITEM 1. DESCRIPTION OF BUSINESS 1
ITEM 2. DESCRIPTION OF PROPERTY 36
ITEM 3. LEGAL PROCEEDINGS 36
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 36
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED
STOCKHOLDER MATTERS 36
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 37
ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS 37
ITEM 8. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE 37
PART III
ITEM 9. DIRECTORS AND PRINCIPAL OFFICERS OF THE COMPANY 37
ITEM 10. EXECUTIVE COMPENSATION 38
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT 38
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 38
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K 39
ITEM 14. CONDITIONS AND PROCEDURES 40
SIGNATURES 41
EXHIBITS 42
FORWARD LOOKING STATEMENTS
This Form 10-KSB contains certain forward-looking statements
consisting of estimates with respect to the financial condition, results of
operations and business of the Company and the Bank that are subject to
various factors which could cause actual results to differ materially from
these estimates. These factors include, but are not limited to: general
and local economic conditions; changes in interest rates, deposit flows,
demand for mortgages and other loans, real estate values, and competition;
changes in accounting principles, policies, or guidelines; changes in
legislation or regulation; and other economic, competitive, governmental,
regulatory, and technological factors affecting our operations, pricing,
products and services.
Any or all of our forward-looking statements in this Form 10-KSB and
in any other public statements we make may turn out to be wrong. They can
be affected by inaccurate assumptions we might make or by known or unknown
risks and uncertainties. Consequently, no forward-looking statement can be
guaranteed.
We undertake no obligation to publicly update forward-looking
statements, whether as a result of new information, future events or
otherwise, except as required by law.
i
PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
Falmouth Bancorp, Inc. (the "Company" or "Bancorp"), a Delaware
corporation, is the holding company for Falmouth Co-operative Bank (the
"Bank"), a Massachusetts-chartered stock co-operative bank. At September
30, 2003, there were 913,727 shares outstanding. The Company's sole
business activity is ownership of the Bank. The Company also makes
investments in long and short-term marketable securities and other liquid
investments. The Company's common stock trades on the American Stock
Exchange under the symbol "FCB." Unless otherwise disclosed, the
information presented in this Report on Form 10-KSB represents the
consolidated activity of Falmouth Bancorp, Inc. and subsidiaries. The
Company had total assets of $166.1 million as of September 30, 2003.
The Bank conducts its business through an office located in Falmouth,
Massachusetts, where it was originally founded in 1925 as a Massachusetts
chartered mutual co-operative Bank, and branches located in East Falmouth
and North Falmouth, Massachusetts. The Bank opened a new branch office in
Bourne, Massachusetts in November 2003. The Bank's deposits are currently
insured up to applicable limits by the Bank Insurance Fund of the Federal
Deposit Insurance Corporation ("FDIC") and the Share Insurance Fund of the
Co-operative Central Bank of Massachusetts.
The Bank's principal business consists of attracting deposits from the
general public and uses these funds to originate mortgage loans secured by
one- to four-family residences located primarily in Falmouth, Massachusetts
and surrounding areas and to invest in United States Government and Agency
securities.
Business Strategy
The Bank's business strategy is to operate as a profitable and
independent community bank dedicated primarily to financing home ownership
and consumer needs in its market area and to provide quality service to its
customers. The Bank has implemented this strategy by: (i) closely monitoring
the needs of customers and providing quality service; (ii) emphasizing
consumer-oriented banking by originating residential mortgage loans and
consumer loans, and by offering checking accounts and other financial
services and products; (iii) focusing on expanding lending activities to
produce moderate increases in loan originations; (iv) maintaining asset
quality; (v) maintaining capital in excess of regulatory requirements; and
(vi) producing stable earnings.
The Bank serves its primary market area, the Massachusetts communities
of Falmouth and Mashpee located in the Cape Cod region of Massachusetts,
through its offices in Falmouth, North Falmouth and East Falmouth. The Bank
expanded its market area in November 2003 opening a branch office in the
Massachusetts community of Bourne. The Bank continues to offer
1
traditional retail and commercial banking services as well as electronic
services such as its toll free Voice Response System "ON CALL," which
enables its customers to access current balance information and transfer
funds between accounts by telephone, its new Internet Banking and Bill
Paying product on its web site at www.FalmouthBank.com, and three on-site,
as well as three off-site ATMs. The Bank competes with fifteen branches of
financial institutions (including national banks, savings banks, savings and
loans and credit unions), which are headquartered outside its market area.
The Bank is the only independent financial institution headquartered in
Falmouth.
To a lesser extent, the Bank also makes commercial real estate loans,
commercial and industrial, and consumer loans, including passbook loans,
automobile, home equity and other consumer loans. The Bank originates both
fixed-rate and adjustable-rate loans and emphasizes the origination of
residential real estate mortgage loans with adjustable interest rates, and
makes other investments which allow the Bank to more closely match the
interest rate and maturities of its assets and liabilities.
Market Area
The Bank considers its primary market area to be the communities of
Falmouth and Mashpee in Barnstable County, which is located in the Cape Cod
region of Massachusetts, approximately 72 miles south of Boston. The year-
round population of Barnstable County is over 200,000. The majority of the
Bank's lending has been in Falmouth and Mashpee. The Cape Cod region is a
major recreational resort/retirement community, with seasonal tourism being
the most significant economic activity. Falmouth's year-round population of
32,660 (2000 census) increases to a summer population of approximately
75,000. Falmouth is the second most populous and second largest town on the
Cape. Visitors find accommodations in the many motels, hotels and inns in
the area. Falmouth has approximately 44 miles of ocean and lake shoreline.
There are nine harbors and inlets, some with docking and most with mooring
facilities. Two major harbors offer access, via ferry, to the island of
Martha's Vineyard with service to the island of Nantucket during the summer
months from Woods Hole. In addition to swimming, boating, fishing and other
forms of water recreation, Falmouth also has four public and two private
golf courses.
The major employers in the Falmouth area are the Woods Hole
Oceanographic Institute, with approximately 800 employees, Falmouth
Hospital, with 750 employees and Woods Hole, Martha's Vineyard and Nantucket
Steamship Authority, with 500 employees. Other major employers include
Marine Biological Laboratories.
2
Employees
At September 30, 2003, the Bank employed 33 full-time and 6 part-time
employees. The Bank's employees are not represented by a collective
bargaining agreement, and the Bank considers its relationship with its
employees to be good.
Lending Activities
General. The principal lending activity of the Bank is the
origination of conventional mortgage loans for the purpose of purchasing or
refinancing owner-occupied, one- to four-family residential properties in
its designated community reinvestment area of the Massachusetts towns of
Falmouth and Mashpee. To a lesser extent, the Bank also originates consumer
loans including home equity and passbook loans and commercial loans. The
Bank also originates and retains in its loan portfolio adjustable-rate loans
and fixed-rate loans with maturities of up to 30 years. Traditionally,
fixed-rate loans with terms of up to 30 years are originated and sold in the
secondary market. Loan originations for the year ended September 30, 2003,
achieved the level of $111.2 million and were primarily single-family
residential loans. During this period, the Bank was ranked by Banker and
Tradesman as one of the largest producers of residential mortgage loans in
the Falmouth market. The mortgage market in the Falmouth area was vigorous
in both the purchase money and refinance categories during fiscal 2003. The
Bank is a qualified seller/servicer for the Federal National Mortgage
Association ("FNMA") and was servicing $68.1 million in loans for FNMA and
$1.9 million for other investors at September 30, 2003.
3
Loan Portfolio. The following table presents selected data relating
to the composition of the Bank's loan portfolio by type of loan on the dates
indicated.
At September 30,
-------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
----------------- ----------------- ----------------- ----------------- -----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Residential mortgage loans $50,525 58.06% $ 69,694 69.40% $ 94,084 79.63% $ 88,647 79.50% $ 67,709 81.02%
Commercial real estate loans 15,702 18.04 11,845 11.80 10,406 8.81 11,865 10.64 8,488 10.16
Consumer loans 403 .46 439 .44 546 .46 527 .47 577 .69
Home equity loans 15,451 17.75 13,251 13.20 8,486 7.18 7,143 6.41 4,621 5.53
Commercial loans 4,943 5.69 5,179 5.16 4,634 3.92 3,331 2.98 2,175 2.60
------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Gross loans 87,024 100.00% 100,408 100.00% 118,156 100.00% 111,513 100.00% 83,570 100.00%
------- ====== -------- ====== -------- ====== -------- ====== -------- ======
Less:
Deferred loan (cost), net
of origination fees (257) (297) (362) (190) (19)
Unadvanced principal 3,201 4,756 5,019 5,216 2,533
Allowance for loan losses 761 939 945 755 569
------- -------- -------- -------- --------
Loans, net $83,319 $ 95,010 $112,554 $105,732 $ 80,487
======= ======== ======== ======== ========
4
One- to Four-Family Residential Real Estate Lending. The primary
emphasis of the Bank's lending activity is the origination of conventional
mortgage loans secured by one- to four-family residential dwellings located
in the Bank's primary market area. As of September 30, 2003, loans on one-
to four-family residential properties accounted for 58.1% of the Bank's loan
portfolio and totaled $50.5 million.
The Bank's mortgage loan originations are for terms of up to 30 years,
amortized on a monthly basis with interest and principal due each month.
Residential real estate loans often remain outstanding for significantly
shorter periods than their contractual terms allow as borrowers may
refinance or prepay loans at their option, without penalty. Conventional
residential mortgage loans granted by the Bank customarily contain "due-on-
sale" clauses that permit the Bank to accelerate the indebtedness of the
loan upon transfer of ownership of the mortgaged property.
The Bank makes conventional mortgage loans and it uses standard FNMA
documents to allow for the sale of loans in the secondary mortgage market.
The Bank's lending policies generally limit the maximum loan-to-value ratio
on mortgage loans secured by owner-occupied properties to 95% of the lesser
of the appraised value or purchase price of the property, with the condition
that private mortgage insurance is required on loans with a loan-to-value
ratio in excess of 80%.
The Bank also offers adjustable-rate mortgage loans with terms of up
to 30 years. Adjustable-rate loans offered by the Bank include loans which
reprice every one, three, five and seven years and provide for an interest
rate which is based on the interest rate paid on United States Treasury
securities of a corresponding term, plus a margin of 2.75%. The Bank
currently offers adjustable-rate loans with initial rates below those that
would prevail under the foregoing computations, based upon the Bank's
determination of market factors and competitive rates for adjustable-rate
loans in its market area. For adjustable-rate loans, borrowers are qualified
at the initial rate plus an anticipated upward adjustment of 200 basis
points.
The Bank retains substantially all of the adjustable-rate mortgages it
originates. The Bank's adjustable-rate mortgages include caps on increases
or decreases of 2% per year, and 6% over the life of the loan (2% per yearly
adjustment, and 5% over the life of the loan for five-year adjustable-rate
loans). The retention of adjustable-rate mortgage loans in the Bank's loan
portfolio helps reduce the Bank's exposure to increases in interest rates.
However, there are unquantifiable credit risks resulting from potential
increased costs to the borrower as a result of repricing of adjustable-rate
mortgage loans. It is possible that during periods of rising interest rates,
the risk of default on adjustable-rate mortgage loans may increase due to
the upward adjustment of interest cost to the borrower.
During the year ended September 30, 2003, the Bank originated $8.6
million in adjustable-rate mortgage loans and $78.1 million in fixed-rate
mortgage loans for its portfolio. Approximately 57.1% of all loan
originations during fiscal 2003 were the refinancing of loans already in the
Bank's loan portfolio. At September 30, 2003, the Bank's loan portfolio
included $29.0 million in adjustable-rate one- to four-family residential
mortgage loans, or 34.5% of the Bank's total loan portfolio, and $33.3
million in fixed-rate one- to four-family residential mortgage loans, or
39.6% of the Bank's total loan portfolio.
5
The Bank engages in a limited amount of construction lending generally
for the construction of single-family residences. Most are
construction/permanent loans structured to become permanent loans upon the
completion of construction. All construction loans are secured by first
liens on the property. Loan proceeds are disbursed as construction
progresses and inspections warrant. Loans involving construction financing
present a greater risk than loans for the purchase of existing homes, since
collateral values and construction costs can only be estimated at the time
the loan is approved. Due to the small amount of construction loans in the
Bank's portfolio, the risk in this area is limited.
Commercial Real Estate Loans. At September 30, 2003, the Bank's
commercial real estate loan portfolio totaled $15.7 million, or 18.7% of
total loans. The Bank's largest loan is a commercial loan with an
outstanding commitment of $1.5 million at September 30, 2003 secured by a
lumber company located in Falmouth, Massachusetts.
Commercial real estate lending entails additional risks compared with
one- to four-family residential lending. For example, commercial real estate
loans typically involve large loan balances to single borrowers or groups of
related borrowers and the payment experience on such loans is typically
dependent on the successful operation of a real estate project and/or the
collateral value of the commercial real estate securing the loan. At
September 30, 2003, all of the Bank's commercial real estate loans were
performing.
Home Equity Loans. The Bank also originates home equity loans, which
are loans, secured by available equity based on the appraised value of one-
to four-family residential property. Home equity loans will be made for up
to 80% of the tax assessed or appraised value of the property (less the
amount of the first mortgage). Home equity loans have an adjustable
interest rate which ranges from 0% to 1% above the prime rate as reported in
The Wall Street Journal and have terms of twenty years or less. At September
30, 2003, the Bank had $33.7 million in home equity loans with unused credit
available to existing borrowers of $18.2 million.
Consumer Loans. The Bank's consumer loans consist of passbook loans,
and other consumer loans, including automobile loans. At September 30,
2003, the consumer loan portfolio totaled $403,000 or .48% of total loans.
Consumer loans generally are offered for terms of up to five years at fixed
interest rates. Consumer loans do not exceed $15,000 individually.
Management expects to continue to promote consumer loans as part of its
strategy to provide a wide range of personal financial services to its
customers and as a means to increase the yield on the Bank's diversified
loan portfolio.
The Bank makes loans up to 90% of the amount of the depositor's
savings account balance. The interest rate on the loan is 4.0% higher than
the rate being paid on regular savings accounts and 3% higher than the rate
being paid on certificates of deposit. The Bank also makes other consumer
loans, which may or may not be secured. The terms of such loans usually
depend on the collateral. At September 30, 2003, the total amount of
passbook and other consumer loans, including overdraft lines of credit, was
$201,000.
The Bank makes loans for automobiles, both new and used, directly to
the borrowers. The loans are generally limited to 80% of the purchase price
or the retail value listed by the National Automobile Dealers Book. The
terms of the loans are determined by the age and condition of the
6
collateral. Collision insurance policies are required on all these loans. At
September 30, 2003, the total amount of automobile loans was $202,000.
Consumer loans generally are originated at higher interest rates than
residential mortgage loans but also tend to have a higher credit risk than
residential loans due to the loan being unsecured or secured by rapidly
depreciable assets. Despite this risk, the Bank's level of consumer loan
delinquencies generally has been low. No assurance can be given, however,
that the Bank's delinquency rate on consumer loans will continue to remain
low in the future, or that the Bank will not incur future losses on these
activities.
Commercial Loans. The Bank employs a commercial loan officer with
over 20 years of experience in commercial lending in the Falmouth market.
The Bank is pursuing, on a selective basis, the origination of commercial
loans to meet the working capital and short-term financing needs of
established local businesses. Unless otherwise structured as a mortgage on
commercial real estate, such loans are generally being limited to terms of
five years or less. Substantially all such commercial loans have variable
interest rates tied to the prime rate as reported in The Wall Street
Journal. Whenever possible, the Bank collateralizes these loans with a lien
on commercial real estate, or alternatively, with a lien on business assets
and equipment and the personal guarantees from principals of the borrower.
Commercial loans do not presently comprise a significant portion of the
Bank's loan portfolio. At September 30, 2003 the Bank's non-real estate
commercial loan portfolio totaled $4.9 million or 5.9% of the Bank's loan
portfolio.
Commercial business loans generally are considered to involve a higher
degree of risk than residential mortgage loans because the collateral may be
in the form of intangible assets and/or inventory subject to market
obsolescence. Commercial loans also may involve relatively large loan
balances to single borrowers or groups of related borrowers, with the
repayment of such loans typically dependent on the successful operation and
income stream of the borrower. Such risks can be affected significantly by
economic conditions. In addition, commercial business lending generally
requires substantially greater oversight efforts compared to residential
real estate lending.
Loan Commitments. The Bank makes a 60-day loan commitment to
borrowers. At September 30, 2003, the Bank had $3.2 million in loan
commitments outstanding for the origination of one- to four-family
residential real estate loans.
Loan Solicitation Origination and Loan Fees. The Bank originates
loans through its main office located in Falmouth, Massachusetts and branch
offices located in East Falmouth, North Falmouth and Bourne. Loan
originations are derived from a number of sources, including the Bank's
existing customers, referrals, realtors, advertising and "walk-in" customers
at the Bank's offices.
The Bank has one full-time residential loan originator who is
compensated with commission. The originator meets with applicants at their
convenience and location and is in regular contact with real estate brokers,
attorneys, accountants, building contractors, developers and others in the
Bank's local market area. The Bank increased its advertising in locally
distributed newspapers and has utilized local radio advertising to increase
its market share of residential loan originations.
7
Upon receipt of a loan application from a prospective borrower, a
credit report and verifications are ordered to verify specific information
relating to the loan applicant's employment, income and credit standing.
For all mortgage loans, an appraisal of real estate intended to secure the
proposed loan is obtained from an independent fee appraiser who has been
approved by the Bank's Board of Directors. Fire, casualty and sometimes
flood insurance are required on all loans secured by improved real estate.
Insurance on other collateral is required, unless waived by the loan
committee. The Board of Directors of the Bank has the responsibility and
authority for the general supervision over the loan policies of the Bank.
The Board has established written lending policies for the Bank. All
applications for residential and commercial real estate mortgages and
commercial business loans must be ratified by the Bank's Board of Directors.
In addition, certain designated officers of the Bank have limited authority
to approve consumer loans.
Interest rates charged by the Bank on all loans are primarily
determined by competitive loan rates offered in its market area and the Bank
generally charges an origination fee on new mortgage loans. The origination
fees, net of direct origination costs, are deferred and amortized into
income over the life of the loan.
Loan Maturities. The following table sets forth certain information
at September 30, 2003 regarding the dollar amount of loans maturing in the
Bank's portfolio based on their contractual terms to maturity, including
scheduled repayments of principal. Demand loans, loans having no stated
schedule of repayments and any stated maturity, and overdrafts are reported
as due in one year or less.
8
At September 30, 2003(1)
-------------------------------
Real Consumer Total
Estate and Other Loans
-------------------------------
(In thousands)
Total loans scheduled to mature:
In one year or less $ 6,410 $1,924 $ 8,334
After one year through five years 12,756 945 13,701
Beyond five years 59,245 2,800 62,045
------- ------ -------
Total $78,411 $5,669 $84,080
======= ====== =======
Loan balance by type scheduled to
mature after one year:
Fixed $41,819 $1,238 $43,057
Adjustable $30,182 $2,507 $32,689
--------------------
Net of unearned income and unadvanced principal.
Originations and Sales of Loans. The following table sets forth
information with respect to originations and sales of loans during the
periods indicated. In recent years, the Bank has been retaining more of its
fixed-rate residential loans in excess of 15-year term with the intent of
selling such loans service retained.
Years Ended September 30,
------------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(In thousands)
Beginning balance(1) $ 95,949 $113,499 $106,487 $ 81,056 $ 78,182
-------- -------- -------- -------- --------
Mortgage loan originations(2) 96,411 65,782 44,141 39,853 28,279
Consumer loan originations 12,130 12,573 8,999 5,318 4,323
Commercial loan originations 2,644 3,914 1,519 1,619 2,249
Less:
Amortization and payoffs(3) (58,324) (62,992) (38,734) (21,299) (24,193)
Transfers to other real
estate owned (OREO) - - - - -
-------- -------- -------- -------- --------
Net loans originated 52,861 19,277 15,925 25,491 10,658
-------- -------- -------- -------- --------
Total loans sold (64,730) (36,827) (8,913) (60) (7,784)
-------- -------- -------- -------- --------
Ending balance(1) $ 84,080 $ 95,949 $113,499 $106,487 $ 81,056
======== ======== ======== ======== ========
--------------------
Net of unearned income and unadvanced principal.
Includes residential and commercial real estate loans.
Includes unadvanced principal.
Non-Performing Assets, Asset Classification and Allowances for Losses.
Loans are reviewed on a regular basis and are placed on a non-accrual status
when, in the opinion of management, the collection of principal and interest
is doubtful. The level established for the provision for loan losses is
determined by management in its effort to maintain an allowance for loan
losses that is adequate for the size and composition of its loan portfolio
and reflects the Bank's historical record of loan losses. Loans with
deviations in their quality are monitored on
9
the Bank's "watch list" and are assigned specific reserve allocations, such
as commercial loans and construction loans, which are weighted heavier than
owner occupied 1-4 family residential loans and warrant increased provisions
on an on-going basis. The Bank's non-real estate commercial loans totaled
$4.9 million at September 30, 2003, as compared to $5.2 million at September
30, 2002.
Management routinely reviews the risk weighting applied to each loan
type. These are estimates that can increase or decrease the provision
depending on the current risk assessment. Several risk weightings were
increased slightly during the twelve-month period ended September 30, 2003.
On September 30, 2003 the Bank had one delinquent residential real estate
loan, two delinquent consumer loans, and no non-performing loans.
Real estate acquired by the Bank as a result of foreclosure is
classified as real estate owned until such time as it is sold. When such
property is acquired, it is recorded at the lower of the unpaid principal
balance or its fair value. Any required write-down of the loan to its fair
value is charged to the allowance for loan losses.
At September 30,
------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands)
Loans 30-89 days past due
(not included in non-
performing loans) $ 81 $100 $ - $ - $ 57
Loans 30-89 days past due as a
percent of total loans .10% .10% -% -% .07%
Non-performing loans:
(90 days past due) $ - $ - $ - $ - $ -
OREO $ - $ - $ - $ - $ -
Total non-performing assets $ - $ - $ - $ - $ -
Non-performing loans as a percent
of total loans -% -% -% -% -%
Non-performing assets as a
percent of total assets -% -% -% -% -%
During the year ended September 30, 2003, no gross interest income
would have been recorded on loans accounted for on a non-accrual basis if
the loans had been current throughout the period.
No interest on such loans was included in income during the respective
periods. At September 30, 2003, management was not aware of any loans not
currently classified as non-accrual, 90 days past due or restructured but
which may be so classified in the near future because of concerns over the
borrower's ability to comply with repayment terms.
Federal and state regulations require each banking institution to
classify its asset quality on a regular basis. In addition, in connection
with examinations of such banking institutions, federal and state examiners
have authority to identify problem assets and, if appropriate, classify
them. An asset is classified substandard if it is determined to be
inadequately protected by the current net worth and paying capacity of the
obligor or of the collateral pledged, if any. As a
10
general rule, the Bank will classify a loan as substandard if the Bank can
no longer rely on the borrower's income as the primary source for repayment
of the indebtedness and must look to secondary sources such as guarantors or
collateral. An asset is classified as doubtful if full collection is highly
questionable or improbable. An asset is classified as loss if it is
considered uncollectible, even if a partial recovery could be expected in
the future. The regulations also provide for a special mention designation,
described as assets which do not currently expose a banking institution to a
sufficient degree of risk to warrant classification but do possess credit
deficiencies or potential weaknesses deserving management's close attention.
Assets classified as substandard or doubtful require a banking institution
to establish general allowances for loan losses. If an asset or portion
thereof is classified loss, a banking institution must either establish
specific allowances for loan losses in the amount of the portion of the
asset-classified loss, or charge off such amount. Examiners may disagree
with a banking institution's classifications and amounts reserved. If a
banking institution does not agree with an examiner's classification of an
asset, it may appeal this determination to the FDIC Regional Director. At
September 30, 2003, the Bank had no assets classified as special mention or
doubtful, no assets designated as substandard, and none classified as loss.
In originating loans, the Bank recognizes that credit losses will
occur and that the risk of loss will vary with, among other things, the type
of loan being made, the creditworthiness of the borrower over the term of
the loan, general economic conditions and, in the case of a secured loan,
the quality of the security for the loan. It is management's policy to
maintain an adequate general allowance for loan losses based on, among other
things, the Bank's and the industry's historical loan loss experience,
evaluation of economic conditions and regular reviews of delinquencies and
loan portfolio quality. Further, after properties are acquired following
loan defaults, additional losses may occur with respect to such properties
while the Bank is holding them for sale. The Bank increases its allowances
for loan losses and losses on real estate owned by charging provisions for
losses against the Bank's income. Specific reserves also are recognized
against specific assets when warranted.
Results of recent examinations by bank regulators indicate that these
regulators may be applying more conservative criteria in evaluating real
estate market values, requiring significantly increased provisions for
potential loan losses. While Falmouth believes it has established its
existing allowances for loan losses in accordance with generally accepted
accounting principles, there can be no assurance that regulators, in
reviewing the Bank's loan portfolio, will not request the Bank to increase
its allowance for loan losses, thereby negatively affecting the Bank's
financial condition and earnings.
The bank regulatory agencies, including the FDIC, have a policy
statement regarding maintenance of an adequate allowance for loan and lease
losses and an effective loan review system. This policy includes an
arithmetic formula for checking the reasonableness of an institution's
allowance for loan loss estimate compared to the average loss experience of
the industry as a whole. Examiners will review an institution's allowance
for loan losses and compare it against the sum of (i) 50% of the portfolio
that is classified doubtful; (ii) 15% of the portfolio that is classified as
substandard; and (iii) for the portions of the portfolio that have not been
classified (including those loans designated as special mention), estimated
credit losses over the upcoming twelve months given the facts and
circumstances as of the evaluation date. This amount is considered neither a
"floor" nor a "safe harbor" of the level of allowance for loan
11
losses an institution should maintain, but examiners will view a shortfall
relative to the amount as an indication that they should review management's
policy on allocating these allowances to determine whether it is reasonable
based on all relevant factors.
The following table analyzes activity of the Bank's allowance for loan
losses for the periods indicated.
Year Ended September 30,
----------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in thousands)
Average loans, net $85,333 $106,785 $111,573 $ 94,315 $77,657
------- -------- -------- -------- -------
Period-end total loans(1) $84,080 $ 95,949 $113,499 $106,487 $81,056
------- -------- -------- -------- -------
Allowance for loan losses at
beginning of period $ 939 $ 945 $ 755 $ 569 $ 527
Loans charged-off - 6 - 4 -
Recoveries 2 - - 1 -
Provision charged to operations (180) - 190 189 42
------- -------- -------- -------- -------
Allowance for loan losses at
end of period $ 761 $ 939 $ 945 $ 755 $ 569
======= ======== ======== ======== =======
Ratios:
Allowance for loan losses as a
percentage of period end total
loans .91% .98% .83% .71% .70%
Allowance for loan losses as a
percentage of non-performing
loans - - - - -
Net charge-offs to average loans,
net - .01% - - -
Net charge-offs to allowance for
loan losses - .64% - .40% -
--------------------
Net of unearned income and unadvanced principal.
12
The following table sets forth a breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. These
allocations are not necessarily indicative of future losses and do not
restrict the use of the allowance to absorb losses in any loan category.
At September 30,
-----------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
------------------- ------------------- ------------------- ------------------- -------------------
Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in
Each Each Each Each Each
Category to Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in Thousands)
Real estate
mortgage:
Residential $211 55.57% $330 65.56% $532 78.79% $436 78.53% $282 80.42%
Commercial 330 19.64 310 14.78 201 9.17 181 11.14 171 10.47
Commercial loans,
other 99 5.90 162 5.39 119 4.08 76 3.13 62 2.70
Consumer, including
home equity loans 121 18.89 137 14.27 93 7.96 62 7.20 54 6.41
---- ------ ---- ------ ---- ------ ---- ------ ---- ------
Total allowance
for loan losses $761 100.00% $939 100.00% $945 100.00% $755 100.00% $569 100.00%
==== ====== ==== ====== ==== ====== ==== ====== ==== ======
13
Investment Activities
General. The Bank is required to maintain an amount of liquid assets
appropriate for its level of net withdrawals from savings accounts and
current borrowings. Generally, it has been the Bank's policy to maintain a
liquidity portfolio in excess of regulatory requirements. At September 30,
2003, the Bank's liquidity ratio was 53.1%. Liquidity levels may be
increased or decreased depending upon the yields on investment alternatives,
management's judgment as to the attractiveness of the yields then available
in relation to other opportunities, management's expectations of the level
of yield that will be available in the future and management's projections
as to the short-term demand for funds to be used in Falmouth's loan
origination and other activities.
Interest income from investments in various types of liquid assets
provides a significant source of revenue for the Bank. In the late 1980s,
the Bank maintained its conservative underwriting standards in an effort to
avoid asset quality problems and chose instead to invest excess liquidity in
its investment portfolio. The Bank's short-term investments include United
States Treasury securities and United States Agency securities, commercial
paper, equity securities, short-term corporate debt securities and overnight
federal funds. The balance of the securities investments maintained by the
Bank in excess of regulatory requirements reflects management's historical
objective of maintaining liquidity at a level that assures the availability
of adequate funds, taking into account anticipated cash flows and available
sources of credit, for meeting withdrawal requests and loan commitments and
making other investments.
The Bank purchases securities through a primary dealer of United
States Government obligations or such other securities dealers authorized by
the Board of Directors and requires that the securities be delivered to the
safekeeping agent (Investors Bank & Trust Company) before the funds are
transferred to the broker or dealer. The Bank purchases investment
securities pursuant to an investment policy established by the Board of
Directors.
All securities and investments are recorded on the books of the Bank
in accordance with accounting principles generally accepted in the United
States of America (GAAP). The Bank does not purchase securities and
investments for trading. Available-for-sale securities are reported at fair
value with unrealized gains or losses reported as a separate component of
net worth. All purchases of securities and investments conform to the Bank's
interest rate risk policy.
14
The following table sets forth the scheduled maturities, average
yields, amortized cost and market value for the Bank's investment securities
at September 30, 2003.
September 30, 2003
------------------------------------------------------------------------------------------------------------
One Year or Less One to Five Years Five to Ten Years More than Ten Years Total Investment Portfolio
------------------ ------------------ ------------------ ------------------- ----------------------------
Amortized Average Amortized Average Amortized Average Amortized Average Amortized Average Market
Cost Yield Cost Yield Cost Yield Cost Yield Cost Yield Value
--------- ------- --------- ------- --------- ------- --------- ------- --------- ------- -------
(Dollars in thousands)
U.S. Government
Obligations $ 5,436 0.94% $ - -% $ - -% $ - -% $ 5,536 .94% $ 5,534
Mortgage-backed
Securities - - 32 7.74 352 7.49 118 7.27 502 7.45 531
Corporate Notes
and Bonds 53,094 1.99% 8,993 1.99 - - - - 62,088 1.99 62,045
------- ------ ---- ---- ------- --------
Total $58,630 3.22% $9,025 3.77% $352 7.49% $118 7.27% 68,126 1.94 68,110
======= ====== ==== ====
Marketable Equity
Securities 1,703 1.47 1,626
FHLB Stock 878 3.81 878
------- --------
Total Invest-
ment Portfolio $70,707 1.96% $70,614
======= =======
15
The following tables set forth information regarding the investment
portfolio at the dates indicated.
September 30, 2003
--------------------------------------------------------------------------------------------
Available-for-Sale Held-to-Maturity
-------------------------------------------- --------------------------------------------
Amortized Cost Market Value Percent(1) Amortized Cost Market Value Percent(2)
-------------- ------------ ---------- -------------- ------------ ----------
(Dollars in thousands)
Investment securities(3):
U.S. government obligations $ 5,536 $ 5,534 14.9% $ - $ - -%
Other bonds and obligations 29,688 29,643 79.7 32,400 32,401 99.5
Marketable equity securities 1,703 1,626 4.4 - - -
Mortgage-backed securities(4) 352 376 1.0 150 155 .5
------- ------- ----- ------- ------- -----
Total Investment Portfolio $37,279 $37,179 100.0% $35,550 $32,556 100.0%
======= ======= ===== ======= ======= =====
September 30,
-----------------------------------------------------------------
2003 2002 2001
------------------- ------------------- -------------------
Carrying Carrying Carrying
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Investment securities at carrying amount(3):
U.S. government obligations $ 5,534 7.9% $14,506 31.0% $ 4,581 23.7%
Other bonds and obligations 62,043 89.0 29,447 63.0 10,722 55.5
Marketable equity securities 1,626 2.3 1,984 4.2 2,630 13.6
Mortgage-backed securities(4) 526 0.8 836 1.8 1,398 7.2
------- ----- ------- ----- ------- -----
Total Investment Portfolio $69,729 100.0% $46,773 100.0% $19,331 100.0%
======= ===== ======= ===== ======= =====
--------------------
As a percentage of total market value.
As a percentage of total amortized cost.
Does not include federal funds sold of $4 million or Federal Home
Loan Bank Stock of $878,000.
Consists of GNMA, FHLMC and FNMA certificates.
16
Deposit Activity and Other Sources of Funds
General. Deposits are the primary source of the Bank's funds for
lending and other investment purposes. In addition to deposits, the Bank
derives funds from principal repayments and interest payments on loans and
investments as well as other sources arising from operations in the
production of net earnings. Loan repayments and interest payments are a
relatively stable source of funds, while deposit inflows and outflows are
significantly influenced by general interest rates and money market
conditions. Borrowings may be used on a short-term basis to compensate for
reductions in the availability of funds from other sources, or on a longer-
term basis for general business purposes.
Deposits. Deposits are attracted principally from within the Bank's
primary market area through the offering of a broad selection of deposit
instruments, including passbook savings, NOW accounts, demand deposits,
money market accounts and certificates of deposit. Deposit account terms
vary, with the principal differences being the minimum balance required, the
time periods the funds must remain on deposit and the interest rate.
The Bank's policies are designed primarily to attract deposits from
local residents and businesses rather than to solicit deposits from areas
outside its primary market. The Bank does not accept deposits from brokers
due to the volatility and rate sensitivity of such deposits. Interest rates
paid, maturity terms, service fees and withdrawal penalties are established
by the Bank on a periodic basis. Determination of rates and terms are
predicated upon funds acquisition and liquidity requirements, rates paid by
competitors, growth goals and federal regulations.
17
The following table sets forth the various types of deposit accounts
at the Bank and the balances in these accounts at the dates indicated.
At September 30,
------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
------------------ ------------------ ------------------ ------------------ ------------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
(Dollars in thousands)
Savings deposits $ 25,406 17.5% $ 21,463 16.3% $ 18,683 15.3% $ 19,380 17.2% $17,782 19.1%
NOW accounts 14,863 10.2 9,540 7.2 9,637 7.9 10,095 9.0 9,389 10.1
Money market deposits 31,386 21.6 26,049 19.8 19,413 15.9 16,462 14.7 14,188 15.3
-------- ----- -------- ----- -------- ----- -------- ----- ------- -----
Total 71,655 49.3 57,052 43.3 47,733 39.1 45,937 40.9 41,359 44.5
Demand deposits 20,426 14.0 17,552 13.3 16,147 13.2 14,243 12.6 8,091 8.7
Certificates of deposit 53,454 36.7 57,113 43.4 58,296 47.7 52,194 46.5 43,436 46.8
-------- ----- -------- ----- -------- ----- -------- ----- ------- -----
Total deposits $145,535 100.0% $131,717 100.0% $122,176 100.0% $112,374 100.0% $92,886 100.0%
======== ===== ======== ===== ======== ===== ======== ===== ======= =====
18
For more information on the Bank's deposit accounts, see Note 6 of the
Notes to Consolidated Financial Statements.
The following table indicates the amount of the Bank's certificates of
deposit of $100,000 or more by time remaining until maturity at September
30, 2003.
Certificates of
Maturity Period Deposit
---------------- ---------------
(In thousands)
Within three months $ 2,638
After three but within six months 3,272
After six but within twelve months 3,712
After twelve months 3,461
-------
Total $13,083
=======
The following table sets forth the deposit activity of the Bank for
the periods indicated.
Years Ended September 30,
--------------------------------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(In thousands)
Deposits $809,151 $675,994 $551,960 $448,303 $344,310
Withdrawals 797,522 669,546 546,278 432,244 335,933
-------- -------- -------- -------- --------
Net increase (decrease)
before interest credited 11,629 6,448 5,682 16,059 8,377
Interest credited 2,189 3,093 4,120 3,429 2,990
-------- -------- -------- -------- --------
Net increase
in deposits $ 13,818 $ 9,541 $ 9,802 $ 19,488 $ 11,367
======== ======== ======== ======== ========
Borrowings. Savings deposits historically have been the primary source
of funds for the Bank's lending and investment activities and for its
general business activities. The Bank is authorized, however, to use
advances from the FHLB of Boston to supplement its supply of lend able funds
and to meet deposit withdrawal requirements. Advances from the FHLB are
secured by the Bank's stock in the FHLB and a portion of the Bank's mortgage
loans. The Bank had $2.6 million of FHLB advances outstanding at September
30, 2003.
The FHLB of Boston functions as a central reserve bank providing
credit for savings institutions and certain other financial institutions. As
a member, the Bank is required to own capital stock in the FHLB and is
authorized to apply for advances on the security of such stock and certain
of its home mortgages and other assets (principally, securities which are
obligations of, or guaranteed by the United States) provided certain
standards related to creditworthiness have been met.
Competition
The Bank experiences substantial competition both in attracting and
retaining savings deposits and in the making of mortgage and other loans.
Direct competition for savings deposits primarily comes from larger
commercial banks and other savings institutions located in or near the
Bank's primary market area that generally have significantly greater
financial and
19
technological resources than the Bank. Additional significant competition
for savings deposits comes from credit unions, money market funds and
brokerage firms. The primary factors in competing for loans are interest
rates and loan origination fees and the range of services offered by the
various financial institutions. Competition for origination of real estate
loans normally comes from commercial banks, other thrift institutions,
mortgage bankers, mortgage brokers and insurance companies. Management
considers the Bank's competitors in its market area to consist of 15
branches of financial institutions headquartered outside of its market area.
The Bank is the only independent financial institution headquartered in
Falmouth.
FEDERAL AND STATE TAXATION
Federal Taxation
General. The following is intended only as a discussion of material
federal income tax matters and does not purport to be a comprehensive
description of the federal income tax rules applicable to the Bank or the
Company. The Bank's federal income tax return was last audited for the tax
year ended September 30, 1975. For federal income tax purposes, the Company
and the Bank, as members of the same affiliated group, file consolidated
income tax returns on a September 30 fiscal year basis using the accrual
method of accounting and are subject to federal income taxation in the same
manner as other corporations with some exceptions, including particularly
the Bank's tax reserve for bad debts, discussed below.
Bad Debt Reserves. The Bank, as a "small bank" (one with assets
having an adjusted tax basis of $500 million or less) is permitted to
maintain a reserve for bad debts with respect to "qualifying loans," which,
in general, are loans secured by certain interests in real property, and
to make, within specified formula limits, annual additions to the reserve
which are deductible for purposes of computing the Bank's taxable income.
Pursuant to the Small Business Job Protection Act of 1996, the Bank is now
recapturing (taking into income) over a multi-year period a portion of the
balance of its bad debt reserve as of September 30, 1996. See Note 9 to the
consolidated financial statements.
Distributions. To the extent that the Bank makes "non-dividend
distributions" to the Company, such distributions will be considered to have
been made from the Bank's "base year reserve," i.e., its reserve as of
September 30, 1988, and then from the Bank's supplemental reserve for losses
on loans, to the extent thereof, and an amount based on the amount
distributed (but not in excess of the amount of such reserves) will be
included in the Bank's income. Non-dividend distributions include
distributions in excess of the Bank's current and accumulated earnings and
profits, as calculated for federal income tax purposes, distributions in
redemption of stock, and distributions in partial or complete liquidation.
Dividends paid out of the Bank's current or accumulated earnings and profits
will not be so included in the Bank's income.
The amount of additional taxable income created from a non-dividend
distribution is an amount that, when reduced by the tax attributable to the
income, is equal to the amount of the distribution. Thus, if the Bank makes
a non-dividend distribution to the Company, approximately one and one-half
times the amount of such distribution (but not in excess of the amount of
such reserves) would be includible in income, assuming a 34% federal
corporate income tax rate. The
20
Bank does not intend to pay dividends that would result in a recapture of
any portion of its bad debt reserves.
Corporate Alternative Minimum Tax. The Code imposes a tax ("AMT") on
alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of
AMTI can be offset by net operating loss carryovers of which the Bank
currently has none. AMTI is also adjusted by determining the tax treatment
of certain items in a manner that negates the deferral of income resulting
from the regular tax treatment of those items. The Bank does not expect to
be subject to the AMT.
Elimination of Dividends; Dividends Received Deduction. The Company
may exclude from its income 100% of dividends received from the Bank as a
member of the same affiliated group of corporations. The corporate
dividends-received deduction is generally 70% in the case of dividends
received from unaffiliated corporations with which the Company and the Bank
will not file a consolidated tax return, except that if the Company or the
Bank owns more than 20% of the stock of a corporation distributing a
dividend, then 80% of any dividends received may be deducted.
State Taxation
Massachusetts Taxation. The Bank currently files a separate
Massachusetts excise tax return, based on net income. Under state laws,
Massachusetts-based financial institutions may apportion income earned in
other states. However, the Massachusetts bank excise (income) tax applies
to non-bank entities and out-of-state financial institutions as well as
Massachusetts-based financial institutions. The Massachusetts excise tax
rate for co-operative banks is currently 10.50% of federal taxable income,
adjusted for certain items. Taxable income includes gross income as defined
under the Code, plus interest from bonds, notes and evidences of
indebtedness of any state, including Massachusetts, less deductions, but not
the credits, allowable under the provisions of the Code. Carry forwards and
carry backs of net operating losses are not allowed. In March of 2003, tax
legislation enacted by the Commonwealth of Massachusetts, effective
retroactively to 1999, eliminated the 95% income tax dividend exclusion on
dividends the Bank received from its real estate investment trust
subsidiary.
For additional information regarding taxation, see Note 9 of the Notes
to Financial Statements.
Delaware Taxation. As a Delaware holding company not earning income
in Delaware, the Company is exempt from Delaware corporate income tax but is
required to file an annual report with and pay an annual franchise tax to
the State of Delaware.
21
REGULATION AND SUPERVISION
General
As a co-operative bank chartered by the Commonwealth of Massachusetts,
whose deposits are insured by the Bank Insurance Fund of the FDIC, the Bank
is subject to extensive regulation under state law with respect to many
aspects of its banking activities; this state regulation is administered by
the Commissioner of the Massachusetts Division of Banks (the "Division").
In addition, the FDIC levies assessments or deposit insurance premiums on
the Bank and is vested with authority to supervise the Bank and to exercise
a broad range of enforcement powers. Finally, the Bank is required to
maintain reserves against deposits according to a schedule established by
the Federal Reserve System. These laws and regulations have been
established primarily for the protection of depositors and the deposit
insurance fund, not the Company's stockholders.
The Company, as the bank holding company controlling Falmouth Co-
operative Bank, is subject to the Bank Holding Company Act of 1956, as
amended, and its rules and regulations promulgated by the Federal Reserve
Board. The Company is also subject to certain Massachusetts banking laws
applicable to bank holding companies.
The following references to the laws and regulations under which the
Company and the Bank are regulated are brief summaries thereof, do not
purport to be complete and are qualified in their entirety by reference to
such laws and regulations.
Financial Services Modernization Legislation
On November 12, 1999, President Clinton signed into law the Gramm-
Leach-Bliley Financial Services Modernization Act of 1999 ("GLB Act"). This
federal legislation was intended to modernize the financial services
industry by establishing a comprehensive framework to permit affiliations
among commercial banks, insurance companies, securities firms and other
financial service providers.
Bank holding companies are now permitted to engage in a wider variety
of financial activities than permitted under prior law, particularly with
respect to insurance and securities activities if such companies elect to be
regulated as a financial holding company. In addition, in a change from
prior law, bank holding companies will be in a position to be owned,
controlled or acquired by any company engaged in financially related
activities.
Federal Banking Regulations
Capital Requirements. FDIC regulations require BIF-insured banks,
such as the Bank, to maintain minimum levels of capital. The FDIC
regulations define two tiers, or classes, of capital- Tier 1 Capital and
Tier 2 Capital.
22
Overall, the amount of Tier 2 Capital that may be included in total capital
cannot exceed 100% of Tier 1 Capital.
The FDIC regulations establish a minimum leverage capital requirement
for banks in the strongest financial and managerial condition, with a rating
of 1 (the highest examination rating of the FDIC for banks) under the
Uniform Financial Institutions Rating System, of not less than a ratio of
3.0% of Tier 1 capital to total assets. For all other banks, the minimum
leverage capital requirement is 4.0%, unless a higher leverage capital ratio
is warranted by the particular circumstances or risk profile of the
depository institution.
The FDIC regulations also require that co-operative banks meet a risk-
based capital standard. The risk-based capital standard requires the
maintenance of a ratio of total capital (which is defined as the sum of Tier
1 capital and Tier 2 capital) to risk-weighted assets of at least 8% and a
ratio of Tier 1 capital to risk-weighted assets of at least 4%. In
determining the amount of risk-weighted assets, all assets, plus certain off
balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on
the risks the FDIC believes are inherent in the type of asset or item.
The federal banking agencies, including the FDIC, have also adopted
regulations to require an assessment of an institution's exposure to
declines in the economic value of a bank's capital due to changes in
interest rates when assessing the bank's capital adequacy. Under such a
risk assessment, examiners will evaluate a bank's capital for interest rate
risk on a case-by-case basis, with consideration of both quantitative and
qualitative factors. According to the agencies, applicable considerations
include:
* the quality of the bank's interest rate risk management process;
* the overall financial condition of the bank; and
* the level of other risks at the bank for which capital is
needed.
Institutions with significant interest rate risk may be required to
hold additional capital. The agencies also issued a joint policy statement
providing guidance on interest rate risk management, including a discussion
of the critical factors affecting the agencies' evaluation of interest rate
risk in connection with capital adequacy.
The following table shows the Company's and the Bank's leverage
capital ratio, their Tier 1 risk-based capital ratio, and their total risk-
based capital ratio, at September 30, 2003:
23
At September 30, 2003
--------------------------------------------------
Capital Percent of Capital Percent of
Amount Assets(1) Requirement Assets(1)
------- ---------- ----------- ----------
(Dollars in thousands)
Falmouth Bancorp, Inc
Tier 1 leverage capital $17,696 10.74% $ 6,590 > or =4.0%
Tier 1 risk-based capital $17,696 13.36% $ 5,297 > or =4.0%
Total risk-based capital $18,457 13.94% $10,594 > or =8.0%
Falmouth Cooperative Bank
Tier 1 leverage capital $16,443 9.96% $ 6,602 > or =4.0%
Tier 1 risk-based capital $16,443 12.48% $ 5,269 > or =4.0%
Total risk-based capital $17,204 13.06% $10,538 > or =8.0%
--------------------
For purposes of calculating the Tier 1 leverage capital ratio, assets
include adjusted total average assets. In calculating Tier 1 risk-
based capital and total risk-based capital ratio, assets include total
risk-weighted assets.
As the table shows, the Bank and the Company exceeded the minimum
capital adequacy requirements at September 30, 2003.
Enforcement
The FDIC has extensive enforcement authority over insured co-operative
banks, including the Bank. This enforcement authority includes, among other
things, the ability to assess civil money penalties, to issue cease and
desist orders and to remove directors and officers. In general, these
enforcement actions may be initiated in response to violations of laws and
regulations and to unsafe or unsound practices.
The FDIC has authority under federal law to appoint a conservator or
receiver for an insured bank under certain circumstances. The FDIC is
required, with certain exceptions, to appoint a receiver or conservator for
an insured state bank if that bank is "critically undercapitalized." For
this purpose, "critically undercapitalized" means having a ratio of tangible
capital to total assets of less than 2%. The FDIC may also appoint a
conservator or receiver for a state bank on the basis of the institution's
financial condition or upon the occurrence of certain events, including: (i)
insolvency (whereby the assets of the bank are less than its liabilities to
depositors and others); (ii) substantial dissipation of assets or earnings
through violations of law or unsafe and unsound practices; (iii) existence
of an unsafe or unsound condition to transact business; (iv) likelihood that
the bank will be unable to meet the demands of its depositors or to pay its
obligations in the normal course of business; and (v) insufficient capital,
or the incurring or likely incurring of losses that will deplete
substantially all of the institution's capital with no reasonable prospect
of replenishment of capital without federal assistance.
Deposit Insurance
The FDIC has adopted a risk-based deposit insurance assessment system.
The FDIC assigns an institution to one of three capital categories based on
the institution's financial information, as of the reporting period ending
seven months before the assessment period,
24
consisting of (1) well capitalized, (2) adequately capitalized or (3)
undercapitalized, and one of three supervisory subcategories within each
capital group. The supervisory subgroup to which an institution is assigned
is based on a supervisory evaluation provided to the FDIC by the
institution's primary federal regulator and information that the FDIC
determines to be relevant to the institution's financial condition and the
risk posed to the deposit insurance funds. An institution's assessment rate
depends on the capital category and supervisory category to which it is
assigned. Assessment rates for BIF deposits currently range from 0 basis
points to 27 basis points. The Bank's assessment rate is currently 0 basis
points. The FDIC is authorized to raise the assessment rates in certain
circumstances, including maintaining or achieving the designated reserve
ratio of 1.25%, which requirement the BIF currently meets. The FDIC has
exercised its authority to raise rates in the past and may raise insurance
premiums in the future. If the FDIC takes such action, it could have an
adverse effect on the earnings of the Bank. In addition, legislation
requires BIF-insured institutions like the Bank to assist in the payment of
FICO bonds.
Under the Federal Deposit Insurance Act (the "FDI Act"), insurance of
deposits may be terminated by the FDIC upon a finding that the institution
has engaged in unsafe or unsound practices, is in an unsafe or unsound
condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the FDIC or the Division.
The management of the Bank does not know of any practice, condition or
violation that might lead to termination of deposit insurance.
Transactions with Affiliates and Insiders
Transactions between state non-member banks and any affiliate are
governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate
of a bank is any company or entity that controls, is controlled by or is
under common control with the bank. Currently, a subsidiary of a bank that
is not also a depository institution is not treated as an affiliate of the
bank for purposes of Sections 23A and 23B. Generally, Section 23A:
* limits the extent to which the bank or its subsidiaries may
engage in "covered transactions" with any one affiliate to an
amount equal to 10% of such bank's capital and surplus, and
contains an aggregate limit on all such transactions with all
affiliates to an amount equal to 20% of such capital and
surplus; and
* requires that all such transactions be on terms that are
consistent with safe and sound banking practices.
The term "covered transaction" includes the making of loans, purchase of
assets, issuance of guarantees and similar other types of transactions. In
addition, most extensions of credit by a bank to any of its affiliates must
be secured by collateral in amounts ranging from 100% to 130% of the loan
amounts, depending on the type of collateral. Section 23B requires that any
covered transaction, and certain other transactions, including the bank's
sale of assets and purchase of services from an affiliate must be on terms
that are substantially the same, or at least as favorable, to the
institution as those that would prevail in a comparable transaction with a
non-affiliate.
25
Effective April 1, 2003, the Federal Reserve Board, or FRB, rescinded
its interpretations of Sections 23A and 23B of the Federal Reserve Act and
replaced these interpretations with Regulation W. In addition, Regulation W
made various changes to existing law regarding Sections 23A and 23B,
including expanding the definition of what constitutes an affiliate subject
to Sections 23A and 23B and exempting certain subsidiaries of state-
chartered banks from the restrictions of Sections 23A and 23B.
Under Regulation W, all transactions entered into on or before
December 12, 2002, which either became subject to Section 23A and 23B solely
because of Regulation W, and all transactions covered by Sections 23A and
23B, the treatment of which changed solely because of Regulation W on July
1, 2003. All other covered affiliate transactions became subject to
Regulation W on April 1, 2003. The Federal Reserve Board expects each
depository institution that is subject to Sections 23A and 23B to implement
policies and procedures to ensure compliance with Regulation W. We do not
expect that the changes made by Regulation W will have a material adverse
effect on our business.
Banks are also subject to the restrictions contained in Section 22(h)
of the Federal Reserve Act and the FRB's Regulation O, there under on loans
to executive officers, directors and principal stockholders. Under Section
22(h), loans to a director, an executive officer or a holder of more than
10% of the shares of a bank, as well as certain affiliated interests of such
persons, may not exceed, together with all other outstanding loans to such
person and affiliated interests, the loans-to-one-borrower limit applicable
to national banks (generally 15% of an institution's unimpaired capital and
surplus) and all loans to all such persons in the aggregate may not exceed
an institution's unimpaired capital and unimpaired surplus. Regulation O
also prohibits the making of loans in an amount greater than the lesser of
$25,000 or 5% of capital and surplus but in any event over $500,000, to a
director, executive officer and greater than 10% stockholder of a bank, and
the respective affiliates of such a person, unless such loans are approved
in advance by a majority of the board of directors of the bank, with any
"interested" director not participating in the voting. Further, the FRB
pursuant to Regulation O requires that loans to directors, executive
officers and principal stockholders (a) be made on terms substantially the
same as those that are offered in comparable transactions to persons not
affiliated with the bank and (b) follow credit underwriting procedures not
less stringent than those prevailing for comparable transactions with
persons not affiliated with the bank. Regulation O also prohibits a
depository institution from paying, with certain exceptions, an overdraft of
any of the executive officers or directors of the institution or any of its
affiliates unless the overdraft is paid pursuant to written pre-authorized
extension of interest-bearing extension of credit or transfer of funds from
another account at the bank.
Section 402 of the Sarbanes-Oxley Act of 2002, of Sarbanes-Oxley,
prohibits the extension of personal loans to directors and executive
officers of issuers (as defined in Sarbanes-Oxley). The prohibition,
however, does not apply to mortgages advanced by an insured depository
institution, such as the Bank, that are subject to the insider lending
restrictions of Section 22(h) of the FRA.
State chartered non-member banks are further subject to the
requirements and restrictions of 12 U.S.C. section 1972 against certain
tying arrangements and on extensions of credit involving correspondent
banks. Specifically, a depository institution is prohibited from
26
extending credit to or offering any other service, or fixing or varying the
consideration for such extension of credit or service, on the condition that
the customer obtain some additional service from the institution or certain
of its affiliates or not obtain services of a competitor of the institution,
subject to certain exceptions. In addition, a depository institution with a
correspondent banking relationship with another depository institution is
prohibited from extending credit to the executive officers, directors, and
holders of more than 10% of the stock of the other depository institution,
unless such extension of credit is on substantially the same terms as those
prevailing at the time for comparable transactions with other persons and
does not involve more than the normal risk of repayment or present other
unfavorable features.
Real Estate Lending Policies
Under FDIC regulations, state-chartered non-member banks must adopt
and maintain written policies that establish appropriate limits and
standards for extensions of credit that are secured by liens or interest in
real estate or are made for the purpose of financing permanent improvements
to real estate. These policies must establish loan portfolio
diversification standards, prudent underwriting standards, including loan-
to-value limits that are clear and measurable, loan administration
procedures and documentation, approval and reporting requirements. The real
estate lending policies must reflect consideration of the Interagency
Guidelines for Real Estate Lending Policies (the "Interagency Guidelines")
that have been adopted by the federal bank regulators.
Community Reinvestment Act
Under the Community Reinvestment Act (the "CRA"), any insured
depository institution, including the Bank, has a continuing and affirmative
obligation consistent with its safe and sound operation to help meet the
credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions nor does it limit an institution's
discretion to develop the types of products and services that it believes
are best suited to its particular community. The CRA requires the FDIC, in
connection with its examination of a bank to assess the depository
institution's record of meeting the credit needs of its community and to
take such record into account in its evaluation of certain applications by
such institution, including applications for additional branches and
acquisitions.
CRA regulations rate an institution based on its actual performance in
meeting community needs. In particular, the evaluation system focuses on
three tests:
* a lending test, to evaluate the institution's record of making
loans in its service areas;
* 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
* a service test, to evaluate the institution's delivery of
services through its branches, ATMs and other offices.
The CRA requires the FDIC to provide a written evaluation of an
institution's CRA performance utilizing a four-tiered descriptive rating
system and requires public disclosure of an
27
institution's CRA rating. The Bank received a "satisfactory" rating in its
CRA examination conducted by the FDIC on January 17, 1999.
Standards for Safety and Soundness
Pursuant to the requirements of the Federal Deposit Insurance
Corporation Improvement Act ("FDICIA"), as amended by the Riegle Community
Development and Regulatory Improvement Act of 1994, each federal banking
agency, including the FDIC, has adopted guidelines establishing general
standards relating to internal controls, information and internal audit
systems, loan documentation, credit underwriting, interest rate exposure,
asset growth, asset quality, earnings and compensation, fees and benefits.
In general, the guidelines require, among other things, appropriate systems
and practices to identify and manage the risks and exposures specified in
the guidelines. The guidelines prohibit excessive compensation as an unsafe
and unsound practice and describe compensation as excessive when the amounts
paid are unreasonable or disproportionate to the services performed by an
executive officer, employee, director, or principal shareholder. In
addition, the FDIC adopted regulations to require a bank that is given
notice by the FDIC that it is not satisfying any of such safety and
soundness standards to submit compliance plan to the FDIC. If, after being
so notified, a bank fails to submit an acceptable compliance plan or fails
in any material respect to implement an accepted compliance plan, the FDIC
may issue an order directing corrective and other actions of the types to
which a significantly undercapitalized institution is subject under the
"prompt corrective action" provisions of FDICIA. If a bank fails to comply
with such an order, the FDIC may seek to enforce such an order in judicial
proceedings and to impose civil monetary penalties.
Prompt Corrective Action
FDICIA also established a system of prompt corrective action to
resolve the problems of undercapitalized institutions. The FDIC, as well as
the other federal banking regulators, adopted regulations governing the
supervisory actions that may be taken against undercapitalized institutions.
The regulations establish five categories, consisting of "well capitalized,"
"adequately capitalized," "undercapitalized," "significantly
undercapitalized," and "critically undercapitalized." At September 30, 2003,
the Bank was categorized as "well capitalized."
The severity of the action authorized or required to be taken under
the prompt corrective action regulations increases as bank's capital
deteriorates within the three undercapitalized categories. All banks are
prohibited from paying dividends or other capital distributions or paying
management fees to any controlling person if, following such distribution,
the bank would be undercapitalized.
Federal Home Loan Bank System
The Bank is member of the FHLB System, which consists of 12 regional
Federal Home Loan Banks subject to supervision and regulation by the Federal
Housing finance Board ("FHFB"). The Federal Home Loan Banks provide a
central credit facility primarily for member institutions. As a member of
the FHLB, the Bank is required to acquire and hold shares of capital stock
in the FHLB in an amount equal to 1% of the aggregate unpaid principal of
its home mortgage loans, home purchase contracts, and similar obligations,
but not less than $500. The
28
Bank was in compliance with this requirement with an investment in FHLB
stock at September 30, 2003, of $878,000.
The FHLB serves as a reserve of central bank for its member
institutions within its assigned region. It is funded primarily from the
proceeds derived from the sale of consolidated obligations of the FHFB
System. It offers advances to members in accordance with policies and
procedures established by the FHLB and the Board of Directors of the FHLB.
Title 6 of the GLB Act, entitled the Federal Home Loan Bank System
Modernization Act of 1999 ("FHLB Modernization Act"), has amended the FHLB
Act by allowing for voluntary membership in, and the modernizing of the
capital structure and governance of, the FHLB system. The new capital
structure established under the FHLB Modernization Act sets forth new
leverage and risk-based capital requirements based on permanence of capital.
It also requires some minimum investment in FHLB stock of all member
entities. Capital will include retained earnings and two forms of stock:
Class A stock redeemable within six months, written notice and Class B stock
redeemable within five years, written notice. The FHLB Modernization Act
provides a transition period top the new capital regime, which will not be
effective until the FHLB enacts implementing regulations. The FHLB
Modernization Act also reduces the period of time in which a member exiting
the FHLB system must stay out of the system.
Pursuant to regulations promulgated by the FHFB, as required by the
GLB Act, the FHLB of Boston has adopted, and the FHFB has approved, a
capital plan that changes the foregoing minimum stock ownership requirements
for FHLB of Boston stock. Under the new capital plan, each member of the
FHLB of Boston must maintain a minimum investment in FHLB of Boston capital
stock in an amount equal to the sum of (i) .35% of member eligible
collateral (subject to a minimum of $10,000 and a maximum of $25,000,000,
per member), and (ii) 4.50% of the member's activity-based assets.
Federal Reserve System
Under FRB regulations, the Bank is required to maintain no interest-
earning reserves against its transaction accounts (primarily NOW and regular
checking accounts). The FRB regulations generally require that reserves of
3% must be maintained against aggregate transaction accounts of $42.1
million or less (subject to adjustment by the FRB) and an initial reserve of
$1.2 million plus 10% (subject to adjustment by the FRB between 8% and 14%)
against that portion of total transaction accounts in excess of $42.1
million. The first $6 million of otherwise reservable balances (subject to
adjustments by the FRB) are exempted from the reserve requirements. As of
September 30, 2003, the Bank met its reserve requirements.
29
Massachusetts Banking Laws and Supervision
Massachusetts's co-operative banks such as the Bank are also regulated
and supervised by the Division of Banks. The Division of Banks is required
to regularly examine each state-chartered bank. The approval of the
Division of Banks is required to establish or close branches, to merge with
another bank, to form a bank holding company, to issue stock or to undertake
many other activities. Any Massachusetts bank that does not operate in
accordance with the regulations, policies and directives of the Division of
Banks is subject to sanctions. The Division of Banks may under certain
circumstances suspend or remove directors or officers of a bank who have
violated the law, conducted a bank's business in a manner which is unsafe,
unsound or contrary to the depositors' interests, or been negligent in the
performance of their duties.
All Massachusetts-chartered co-operative banks are required to be
members of the Co-operative Central Bank and are subject to its assessments.
The Co-operative Central Bank maintains the Share Insurance Fund, a private
deposit insurer, which insures all deposits in member banks in excess of
FDIC deposit insurance limits. In addition, the Co-operative Central Bank
acts as a source of liquidity to its members in supplying them with low-cost
funds, and purchasing certain qualifying obligations from them.
Lending Activities. A Massachusetts-chartered co-operative bank may
make a wide variety of mortgage loans. Fixed-rate loans, adjustable-rate
loans, variable-rate loans, participation loans, graduated payment loans,
construction loans, condominium and co-operative loans, second mortgage
loans and other types of loans may be made in accordance with applicable
regulations. Mortgage loans may be made on real estate in Massachusetts or
in another New England state if the bank making the loan has an office there
or under certain other circumstances. In addition, certain mortgage loans
may be made on improved real estate located anywhere in the United States.
Commercial loans may be made to corporations and other commercial
enterprises with or without security. With certain exceptions, such loans
may be made without geographic limitations. Consumer and personal loans may
be made with or without security and without geographic limitations. Loans
to individual borrowers generally will be limited to 20% of the total of the
Bank's capital accounts and stockholders' equity.
Investments Authorized. Massachusetts-chartered co-operative banks
have broad investment powers under Massachusetts's law, including so-called
"leeway" authority for investments that are not otherwise specifically
authorized. Federal law to permit only investments of the kinds that would
be permitted for national banks restricts the investment powers authorized
under Massachusetts's law. The Bank has authority to invest in all of the
classes of loans and investments that are permitted by its existing loan and
investment policies.
Payment of Dividends. A Massachusetts-chartered co-operative bank may
only pay dividends on its capital stock from net profits and no dividends
may be declared, credited or paid so long as there is any impairment of the
capital stock. Prior approval by the Division is required if the Bank
intends to declare dividends on its common stock for any period other than
for which dividends are declared upon the preferred stock. The approval of
the Division is also required for a co-operative bank to declare a dividend
if the total of all dividends declared by the Bank in any calendar year
exceeds the total of its net profits for that year combined with its
retained net
30
profits of the preceding two years, less any required transfer to surplus or
a fund for the retirement of any preferred stock.
Branches. With the approval of the Division of Banks, bank branches
may be established in any city or town in Massachusetts. In addition, co-
operative banks may operate automated teller machines at any of their
offices or, with the approval of the Division of Banks, anywhere in
Massachusetts. Sharing of ATMs or "networking" is also permitted with the
approval of the Division of Banks. Massachusetts-chartered co-operative
banks may also operate ATMs outside of Massachusetts if permitted to do so
by the law of the jurisdiction in which the ATM is located.
Interstate Banking. An out-of-state bank may (subject to various
regulatory approvals and to reciprocity in its home state) establish and
maintain bank branches in Massachusetts by:
* merging with a Massachusetts bank that has been in existence for
at least three years;
* acquiring a branch or branches of a Massachusetts bank without
acquiring the entire bank; or
* opening such branches de novo.
Massachusetts banks' ability to exercise similar interstate banking powers
in other states depends upon the laws of the other states. For example,
according to the law of the bordering state of New Hampshire, out-of-state
banks may acquire New Hampshire banks by merger, but may not establish de
novo branches in New Hampshire.
Community Reinvestment Act. The Bank is also subject to provisions of
the Massachusetts banking laws that, like the provisions of the federal
Community Reinvestment Act, impose continuing and affirmative obligations
upon a banking institution organized in Massachusetts to serve the credit
needs of its local communities. The obligations of the Massachusetts
Community Reinvestment Act are similar to those imposed by the federal
Community Reinvestment Act with the exception of the assigned exam ratings.
Massachusetts banking law provides for an additional exam rating of "high
satisfactory" in addition to the federal Community Reinvestment Act ratings
of "outstanding," "satisfactory," "needs to improve" and "substantial
noncompliance." The Division has adopted regulations to implement the
Massachusetts Community Reinvestment Act that are based on the federal
Community Reinvestment Act. The Division is required to consider a bank's
Massachusetts Community Reinvestment Act rating when reviewing the bank's
application to engage in certain transactions, including mergers, asset
purchases and the establishment of branch offices or automated teller
machines, and provides that such assessment may serve as a basis for the
denial of any such application. The Massachusetts Community Reinvestment
Act requires the Division to assess a bank's compliance with the
Massachusetts Community Reinvestment Act and to make such assessment
available to the public. The Bank received a "high satisfactory" rating in
its Community Reinvestment Act examination conducted by the Commonwealth of
Massachusetts on June 18, 2003.
Other Powers. Massachusetts-chartered co-operative banks may also
lease machinery and equipment, act as trustee or custodian for tax qualified
retirement plans, establish trust
31
departments and act as professional trustee or fiduciary, provide payroll
services for their customers, issue or participate with others in the
issuance of mortgage-backed securities and establish mortgage banking
companies and discount securities brokerage operations. Some of these
activities require the prior approval of the Division of Banks.
Loans to Bank's Insiders. The Massachusetts banking laws prohibit any
officer, director or trustee from borrowing, otherwise becoming indebted, or
becoming liable for a loan or other extension of credit by such bank to any
other person, except for any of the following loans or extensions of credit:
* loan or extension of credit, secured or unsecured, to an officer
of the bank in an amount not exceeding $20,000;
* loan or extension of credit intended or secured for educational
purposes to an officer of the bank in an amount not exceeding
$75,000;
* loan or extension of credit secured by a mortgage on residential
real estate to be occupied in whole or in part by the officer to
whom the loan or extension of credit is made, in an amount not
exceeding $275,000; or
* loan or extension of credit to a director or trustee of the bank
who is not also an officer of the bank in an amount permissible
under the bank's loan-to-one borrower limit.
The loans listed above require approval of the majority of the members of
the Bank's executive committee, excluding any member involved in the loan or
extension of credit. No such loan or extension of credit may be granted
with an interest rate or other terms that are preferential in comparison to
loans granted to persons not affiliated with the Bank.
Regulation of Holding Company
Federal Regulation. The Company is subject to examination, regulation
and periodic reporting under the BHCA, as administered by the FRB. The FRB
has adopted capital adequacy guidelines for bank holding companies on a
consolidated basis substantially similar to those of the FDIC for the Bank.
The Company is required to obtain the prior approval of the FRB and
the Massachusetts Board of Bank Incorporation ("BBI") to acquire all, or
substantially all, of the assets or any bank of bank holding company. Prior
FRB and BBI approval would be required for the Company to acquire direct or
indirect ownership or control of any voting securities of any bank or bank
holding company if, after giving effect to such acquisition, it would,
directly or indirectly, own or control more than 5% of any class of voting
shares of such bank or bank holding company.
The Company is required to give the FRB prior written notice of any
purchase or redemption of its outstanding equity securities if the gross
consideration for the purchase or redemption, when combined with the net
consideration paid for all such purchases or redemptions during the
preceding 12 months, is equal to 10% or more of the Company's consolidated
net worth. The FRB may disapprove such a purchase or redemption if it
determines
32
that the proposal would constitute an unsafe and unsound practice, or would
violate any law, regulation, FRB order or directive, or any condition
imposed by, or written agreement with, the FRB. Such notice and approval is
not required for a bank holding company that would be treated as "well
capitalized" under applicable regulations of the FRB, both before and after
the redemption that is well managed, and that is not the subject of any
unresolved supervisory issues.
The status of the Company as a registered bank holding company under
the BHCA does not exempt it from certain federal and state laws and
regulations applicable to corporations generally, including, without
limitation, certain provisions of the federal securities laws.
In addition, a bank holding company which does not qualify as a
financial holding company under the GLB Act, is generally prohibited from
engaging in, or acquiring 5% or more of any class of voting securities of
any company engaged in, non-banking activities. One of the principal
exceptions to this prohibition is for activities found by the FRB to be so
closely related to banking or managing or controlling banks as to be a
proper incident thereto. Bank holding companies that qualify as a financial
holding company may engage in activities that are financial in nature or
incident to activities that are financial in nature. To date, the Company
has not elected to become regulated as a financial holding company.
Under the Federal Deposit Insurance Act, depository institutions are
liable to the FDIC for losses suffered or anticipated by the FDIC in
connection with the default of a commonly controlled depository institution
or any assistance provided by the FDIC to such an institution in danger of
default. This law would have potential applicability if the Company ever
acquired as a separate subsidiary a depository institution in addition to
the Bank.
USA PATRIOT Act
In response to the events of September 11th, President George W. Bush
signed into law the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001,
or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the
federal government new powers to address terrorist threats through enhanced
domestic security measures, expanded surveillance powers, increased
information sharing, and broadened anti-money laundering requirements. By
way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act
takes measures intended to encourage information sharing among bank
regulatory agencies and law enforcement bodies. Further, certain provisions
of Title III impose affirmative obligations on a broad range of financial
institutions, including banks, thrifts, brokers, dealers, credit unions,
money transfer agents and parties registered under the Commodity Exchange
Act.
Among other requirements, Title III of the USA PATRIOT Act imposes the
following requirements with respect to financial institutions:
* Pursuant to Section 352, all financial institutions must
establish anti-money laundering programs that include, at
minimum: (i) internal policies, procedures, and controls, (ii)
specific designation of an anti-money laundering compliance
officer, (iii) ongoing employee training programs, and (iv) an
independent audit function to test the anti-money laundering
program.
33
* Pursuant to Section 326, on May 9, 2003 the Secretary of the
Department of Treasury, in conjunction with other bank
regulators, issued a Joint Final Rule that provides for minimum
standards with respect to customer identification and
verification. The Bank was required to comply with this rule by
October 1, 2003.
* Section 312 requires financial institutions that establish,
maintain, administer, or manage private banking accounts or
correspondent accounts in the United States for non-United
States persons or their representatives (including foreign
individuals visiting the United States) to establish
appropriate, specific, and, where necessary, enhanced due
diligence policies, procedures, and controls designed to detect
and report money laundering.
* Effective December 26, 2001, financial institutions are
prohibited from establishing, maintaining, administering or
managing correspondent accounts for foreign shell banks (foreign
banks that do not have a physical presence in any country), and
are subject to certain record-keeping obligations with respect
to correspondent accounts of foreign banks.
* Bank regulators are directed to consider a holding company's
effectiveness in combating money laundering when ruling on
Federal Reserve Act and Bank Merger Act applications.
Although we anticipate that we will incur additional expense in
complying with the provisions of the USA PATRIOT ACT and the resulting
regulations, management does not expect that such compliance will have
a material impact on our results of operations or financial condition.
The Sarbanes-Oxley Act
On July 30, 2002, President George W. Bush signed into law the
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range
of corporate governance and accounting measures for public companies
designed to promote honesty and transparency in corporate America and better
protect investors from the type of corporate wrongdoing that occurred in
Enron, WorldCom and similar companies. The Sarbanes-Oxley Act's principal
legislation includes:
* the creation of an independent accounting oversight board;
* Auditor independence provisions which restrict non-audit
services that accountants may provide to their audit clients;
* additional corporate governance and responsibility measures,
including the requirement that the chief executive officer and
chief financial officer certify financial statements;
* the forfeiture of bonuses or other incentive-based compensation
and profits from the sale of an issuer's securities by directors
and senior officers in the twelve
34
month period following initial publication of any financial
statements that later require restatement;
* an increase the oversight of, and enhancement of certain
requirements relating to audit committees of public companies
and how they interact with the company's independent auditors;
* requirement that audit committee members must be independent and
are absolutely barred from accepting consulting, advisory or
other compensatory fees from the issuer;
* requirement that companies disclose whether at least one member
of the committee is a "financial expert" (as such term will be
defined by the Securities and Exchange Commission) and if not,
why not;
* expanded disclosure requirements for corporate insiders,
including accelerated reporting of stock transactions by
insiders and a prohibition on insider trading during pension
blackout periods;
* a prohibition on personal loans to directors and officers,
except certain loans made by insured financial institutions;
* disclosure of a code of ethics and filing a Form 8-K for a
change or waiver of such code;
* mandatory disclosure by analysts of potential conflicts of
interest; and
* a range of enhanced penalties for fraud and other violations.
The SEC has been delegated the task of enacting rules to implement
various provisions with respect to, among other matters, disclosure in
periodic filings pursuant to the Securities Exchange Act. To date, the SEC
has implemented some of the provisions of the Sarbanes-Oxley Act. However,
the SEC continues to issue final rules, reports, and press releases. As the
SEC provides new requirements, we review those rules and comply as required.
Although we anticipate that we will incur additional expense in
complying with the provisions of the Sarbanes-Oxley Act and the resulting
regulations, management does not expect that such compliance will have a
material impact on our results of operations or financial condition.
Federal Securities Laws
The Company's common stock is registered with the SEC under Section
12(b) of the Securities Exchange Act of 1934 (the "Exchange Act"). The
Company is subject to the information, proxy solicitation, insider trading
restrictions and other requirements under the Exchange Act.
35
ITEM 2. DESCRIPTION OF PROPERTY
The following table sets forth certain information at September 30,
2003 regarding Falmouth office facilities, and certain other information
relating to the properties at that date.
Year Completed Square Net Book Value
or Acquired Footage at September 30, 2003
-------------- ------- ---------------------
Main Office:
20 Davis Straits
Falmouth, MA 02540 1978 10,696 $276,369
Branch Offices:
North Falmouth, MA
78 County Rd.
N. Falmouth, MA 02556 1998 1,706 $ 525,520
East Falmouth, MA
397 E. Falmouth Hwy
E. Falmouth, MA 02536 1998 2,380 $718,308
Bourne, MA
172 Clay Pond Road
Bourne, MA Under Construction 2,000 $ 60,995
At September 30, 2003, the net book value of Falmouth's computer
equipment and other furniture, fixtures and equipment at its offices totaled
$330,702. For more information, see Note 5 of the Notes to Consolidated
Financial Statements.
ITEM 3. LEGAL PROCEEDINGS
Although the Bank and the Company, from time to time, are involved in
various legal proceedings in the normal course of business, there are no
material legal proceedings to which the Bank or the Company, its directors
or its officers is a party or to which any of its property is subject as of
the date of this Form 10-KSB.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders, through the
solicitation of proxies or otherwise, during the quarter ended September 30,
2003.
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
Certain of the above-captioned information is included in the Falmouth
Bancorp, Inc. 2003 Annual Report to Stockholders (the "Annual Report") and
is incorporated herein by reference. See "Market for the Company's Common
Stock" on page 18 of the Annual Report and which is attached to this 10-KSB
as Exhibit 13.1.
36
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The above-captioned information is included in the Annual Report and
is incorporated herein by reference. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Financial
Highlights" on pages 5 through 17 of the Annual Report.
ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS
The following information included in the Annual Report is
incorporated herein by reference. See "Consolidated Financial Statements
and Notes to Consolidated Financial Statements" on pages 19 through 51 of
the Annual Report.
ITEM 8. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
The Company has not filed any current report on Form 8-K within 24
months prior to the date of the most recent financial statements reporting a
change of accountants and/or reporting disagreements of any matter of
accounting principle or financial statement disclosure.
ITEM 8A. CONTROLS AND PROCEDURES
Management, including the Company's President and Chief Executive
Officer and Senior Vice President, Treasurer and Clerk, has evaluated the
effectiveness of the Company's disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the
period covered by this report. Based upon that evaluation, the President
and Chief Executive Officer and Senior Vice President, Treasurer and Clerk,
concluded that the disclosure controls and procedures were effective, in all
material respects, to ensure that information required to be disclosed in
the reports the Company files and submits under the Exchange Act is
recorded, processed, summarized and reported as and when required.
There have been no changes in the Company's internal control over
financial reporting identified in connection with the evaluation that
occurred during the Company's last fiscal quarter that has materially
affected, or that is reasonably likely to materially affect, the Company's
internal control over financial reporting.
PART III
ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The above-captioned information is included in the Company's 2003
Proxy Statement for the 2004 Annual Meeting of Stockholders filed with the
SEC on December 18, 2003 ("Proxy Statement") and is incorporated herein by
reference. See "Election of Directors," "Nominees and Continuing
Directors," "Executive Officers," and "Section 16(a) Beneficial Ownership
Reporting Compliance."
37
ITEM 10. EXECUTIVE COMPENSATION
The above-captioned information is included in the Proxy Statement and
is incorporated herein by reference. See "Proposal 1 - Election of Directors
- Director Compensation," "- Compensation Table," "-Employment Agreements,"
" -Stock Option Plan," "-Recognition and Retention Plan," and "-
Transactions with Certain Related Persons."
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Certain of the above-captioned information are included in the Proxy
Statement and are incorporated herein by reference. See "Stock Ownership of
Management" and "Security Ownership of Certain Beneficial Owners."
The following table sets forth the aggregate information of the
Company's equity compensation plans in effect as of September 30, 2003.
Number of securities
Number of securities remaining available for
to be issued Weighted-average future issuance under equity
upon exercise of exercise price of compensation plans
outstanding options, outstanding options, (excluding securities
Plan category warrants and rights warrants and rights reflected in column (a))
------------- -------------------- -------------------- ----------------------------
(a) (b) (c)
Equity compensation plans
approved by security holders 83,260 $14.494 23,778
------- ------- ------
Equity compensation plans
not approved by security holders 23,778 $16.112 0
------- ------- ------
Total 107,038 $14.854 23,778
======= ======= ======
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The above-captioned information is included in the Proxy Statement and
is incorporated herein by reference. See "Transactions with Certain Related
Persons."
38
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following financial statements included in the 2003 Annual
Report are incorporated herein by reference:
Balance Sheets - At September 30, 2003 and 2002;
Statements of Income - Years Ended September 30, 2003, 2002 and
2001;
Statements of Changes in Stockholders' Equity - Years Ended
September 30, 2003, 2002 and 2001;
Statements of Cash Flows - Years Ended September 30, 2003, 2002
and 2001; and
Notes to Financial Statements - Years Ended September 30, 2003,
2002 and 2001
(b) Exhibits. The following exhibits are either filed as part of
this report or are incorporated herein by reference:
3.1 Certificate of Incorporation of Falmouth Bancorp, Inc. (1)
3.2 By-laws of Falmouth Bancorp, Inc.(1)
4.1 Specimen Stock Certificate of Falmouth Bancorp, Inc. (1)
10.1 1997 Stock Option Plan for Outside Directors, Officers
and Employees of Falmouth Bancorp, Inc. (1)
10.2 Amendments to 1997 Stock Option Plan for Outside
Directors, Officers and Employees of Falmouth Bancorp,
Inc. (2)
10.3 1997 Recognition and Retention Plan for Outside
Directors, Officers and Employees of Falmouth Bancorp,
Inc. (1)
10.4 Agreement and Plan of Reorganization by and between
Falmouth Co-operative Bank and Falmouth Bancorp, Inc.,
dated November 25, 1997 (1)
10.5 Employment Agreement by and between Falmouth Co-
operative Bank and Santo P. Pasqualucci. (2)
10.6 Change of Control Agreement by and among Falmouth Co-
operative Bank, Falmouth Bancorp, Inc., and George E.
Young III
10.7 Falmouth Co-operative Bank Employee Stock Ownership
Plan. (1)
10.7(a) Amendment No. 5 to Falmouth Co-operative Bank Employee
Stock Ownership Plan.
10.8 Falmouth Bancorp, Inc. Employee Stock Ownership Trust. (1)
13.1 Annual Report to Stockholders for the Year Ended
September 30, 2003.
14.1 Code of Ethics
21.1 Subsidiaries of the Registrant.
23.1 Consent of Shatswell, MacLeod & Company, P.C.
31.1 Certifications Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002.
32.1 Certifications Pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002.
39
--------------------
Incorporated herein by reference to the Registration Statement on Form
S-4 (Registration No. 333-16931), as filed with the Securities and
Exchange Commission on November 27, 1996.
Incorporated herein by reference to the Annual Report on Form 10-KSB
for the year ended September 30, 2001, as filed with the Securities
and Exchange Commission on December 22, 2001.
(c) The Company filed a report or form 8-K with the SEC on July 25,
2003 reporting its earnings for the period ended June 30, 2003.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The above - captioned information is included in the Proxy Statement
and is incorporated herein by reference. See "Audit Fees" and "Audit
Committee Report."
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SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
FALMOUTH BANCORP, INC.
By: /s/ Santo P. Pasqualucci
------------------------
Santo P. Pasqualucci
President and Chief Executive Officer
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities
and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Santo P. Pasqualucci Director, President and December 29, 2003
------------------------- Chief Executive Officer
Santo P. Pasqualucci (Principal executive officer)
/s/ George E. Young, III Senior Vice President and Chief December 29, 2003
------------------------- Financial Officer (Principal
George E. Young, III financial officer)
/s/ Peter A. Frizzell, DMD Director December 29, 2003
-------------------------
Peter A. Frizzell, DMD
/s/ Wayne C. Lamson Director December 29, 2003
-------------------------
Wayne C. Lamson
/s/ Gardner L. Lewis Director December 29, 2003
-------------------------
Gardner L. Lewis
/s/ John J. Lynch, Jr. Chairman of the Board December 29, 2003
-------------------------
John J. Lynch, Jr.
/s/ Eileen C. Miskell Director December 29, 2003
-------------------------
Eileen C. Miskell
/s/ Robert H. Moore Director December 29, 2003
-------------------------
Robert H. Moore
/s/ Henry D. Newman, III Director December 29, 2003
-------------------------
Henry D. Newman, III
/s/ William E. Newton Director December 29, 2003
-------------------------
William E. Newton
41